Delaware’s Judge Walrath Writes a Primer on Consignments

If a consignor neglects to file a UCC financing statement, sophisticated arguments are unlikely to prevent the term loan or revolving credit lender from coming out ahead of the consignor.

Sports Authority, a major sporting goods retailer, had a term loan secured by inventory and proceeds dating back to 2006. In 2011, Sports Authority entered into a consignment agreement with a supplier who was entitled to receive 45% of the sale price of consigned goods. However, the consignor-supplier did not file a UCC financing statement.

Sensing impending doom, the consignor finally filed a financing statement one month before Sports Authority’s chapter 11 filing.

Once in chapter 11, the inevitable dispute over priority in inventory was temporarily resolved by a stipulation allowing the sale of consigned goods. Although the consignor received the required percentage of post-petition sales, the stipulation allowed the lender to recoup the payments if the court were to determine later that the lender had superior rights in proceeds and inventory.

Naturally, there was an adversary proceeding among the debtor, the lender and the consignor to decide who was on top. On cross motions for summary judgment, Bankruptcy Judge Mary F. Walrath of Delaware ruled in favor of the term loan lender. Her April 12 opinion is a primer on the basics of consignments.

Question # 1: Does the UCC Govern the Priority in Inventory?

The consignor argued that the priority scheme in the UCC did not apply because its interest in the disputed inventory did not match the UCC’s definition of “consignment.”

UCC § 9-102(a)(20) defines a consignment as a transaction where someone delivers goods to a merchant for sale and, among other things, the merchant “is not generally known by its creditors to be substantially engaged in selling goods of others.” [Emphasis added.]

Understanding the law governing consignments is confusing because the UCC uses double and triple negatives. For example, an auctioneer holds goods under a “true” consignment because everyone knows that the auctioneer is selling goods belonging to someone else. The UCC’s provisions on consignments therefore do not apply to an auctioneer. The rights of parties in goods held by an auctioneer would be covered by other provisions in state law, not the UCC.

Look at it this way: The UCC covers “ordinary” consignments where the retailer is not known to be selling consigned goods.

Judge Walrath explained that the UCC does not provide the rules of priority if the consignor proves that the retailer’s creditors generally know that the retailer is selling goods of others. Also, she said, the consignor can prove that the lender actually knew the retailer was selling the specific consignor’s consigned goods.

The consignor won the first battle, but lost the war.

The term loan agent argued that its knowledge about consignments was irrelevant because its duties as agent were narrow and did not require informing the lenders about consignors.

Judge Walrath disagreed. She said the agent’s duties “clearly” entailed ascertaining the existence of other interests in the collateral.

The judge therefore ruled that the term loan agent’s knowledge would be imputed to the lenders if the consignor could show that the term loan agent had actual knowledge that Sports Authority was “substantially engaged” in selling consigned goods.

Question # 2: The Standard for Actual Knowledge

The parties agreed that 14% of Sports Authority’s sales represented consigned goods. However, Judge Walrath followed precedent and ruled that a retailer is not “substantially engaged” in selling consigned goods unless 20% or more of sales comes from consignments.

Because Sports Authority was not selling 20% of its goods on consignment and the consignor had not shown that the agent actually knew the retailer was “substantially engaged” in selling consigned goods, Judge Walrath ruled that the transaction did not meet the UCC’s definition of a “consignment.”

Question # 3: Knowledge of the Specific Consignor

Also, the UCC would not apply if the lender actually knew the retailer was selling the specific consignor’s consigned goods. However, the supplier-consignor conceded there was no evidence that the agent or the lenders actually knew that Sports Authority was selling its goods on consignment.

Judge Walrath therefore concluded that neither prong of Section 9-102(a)(20) had been satisfied. Thus, the parties’ priorities were governed by Article 9.

Question # 4: Article 9 Priorities

Recall that the consignor finally got around to filing a financing statement one month before the Sports Authority chapter 11 filing. UCC § 9-322(a) thus came into play by sorting out conflicting security interests.

Generally, the first to file comes out on top, but there is an exception for purchase money security interests that can slip in ahead of a prior perfected security interest. The UCC treats a consignment as a purchase money security interest. See UCC § 9-103(d).

To prevail, the holder of a purchase money security interest must, among other things, send an “authenticated notification” to the holder of the conflicting security interest under Section 9-324(b)(1)-(4).

On the same day it finally filed a financing statement, the supplier gave notice to the prior term loan agent.

Judge Walrath found no authority excusing the consignor from giving notice to the successor term loan agent whose identity and address were among the UCC filings. Having failed to satisfy the notice requirements in Section 9-324(b), she held that the lien of the term loan lenders had priority over the interest of the consignor.

The opinion would have been more complex had the consignor given proper notice to the term loan agent. If there had been proper notice, would perfection of the consignor’s security interest have been an avoidable preference? If it were avoidable, could the debtor have preserved the lien for the benefit of the estate, to the disadvantage of the term loan lender? Would the lien have been avoided entirely or only with regard to goods already received by the retailer?