Lendors and Vendors Need to Protect Interests When Dealing With Consignment Transactions
The Sports Authority bankruptcy filing in March 2016 was a wake-up call to lenders and vendors of the company. It should set off an alarm for all lenders, vendors, and their attorneys to focus on steps to protect their respective interests when it comes to consignment transactions.
In the past, the typical retailer paid for goods when they were purchased from a manufacturer or a supplier, assuming the risk it could sell the goods to the consumer. Over time, manufacturers and wholesalers more frequently have extended terms to favored customers in which the retailer pays for inventory 30, 60, 90 days or longer after inventory is delivered to the retailer.
Now, however, suppliers also are providing inventory to retailers on what the parties believe to be a consignment relationship. In this arrangement, the expectation is the supplier will be paid only if the retailer sells the merchandise to a customer.
Manufacturers and wholesalers may lose their right to be paid for any products delivered on consignment (or “on memo”) if a retailer files for bankruptcy.
In the instance of Sports Authority, many of its sales were generated by consigned goods from the company’s 170 vendors. Consignment vendors usually lose control of merchandise they deliver to a retailer – and the right to receive payment from a retailer – if the supplier has not properly protected itself before the retailer goes bankrupt. When a chain of stores with substantial consignment inventory goes out of business, most proceeds do not go to the suppliers who provided goods on consignment but to the lenders who claim a security interest in the inventory under an all asset security interest.
Most lenders, suppliers, and retailers do not understand what is involved when goods are delivered on a consignment basis. Lenders, suppliers, and retailers frequently are under the impression that in a consignment:
- The consignee only pays for the goods if and when it sells or uses them.
- The consignee has the right to return the goods if it cannot use or sell the goods.
- Title to the consigned goods – and the risk of loss or damage – remains with the consignor until the goods are either sold or used by the consignee.
The Complex Consignment Relationship
Although the relationship between consignor and consignee at first blush seems to be relatively straightforward, it is not. A consignment transaction means different things depending on whether it is viewed in the context of a sale of goods, or whether it is viewed in the context of the competing rights of a retailer’s creditors. Most significantly, a transaction is treated as a sale on consignment only if it meets the strict Uniform Commercial Code (UCC) requirements. In practice, most sales transactions the supplier and the retailer believe to be consignment sales are in reality not treated as such under the UCC.
What most retailers and suppliers may characterize as a consignment really is a sale with the “right of return” of the goods that the retailer chooses to return to the supplier. Documenting the “sale or return” relationship between the supplier and the retailer is fairly straightforward in the UCC. Protecting the supplier’s interests against the rights of third parties with conflicting claims requires the supplier to jump through some hoops, such as determining whether the consigning merchant has a perfected senior security interest in the consigned merchandise.
In most instances, the supplier is trying to protect itself against conflicting claims from third party creditors (secured lenders with all asset security interests in the retailer’s business assets, trustees in bankruptcy, landlords, judgment creditors, etc.).
How to Protect the Supplier’s Interests
In order to protect the supplier, both the retailer and the supplier will need to comply with the technical provisions of the UCC. For the most part, these requirements can be addressed in a consignment agreement by giving of notice to senior lenders and the filing of a UCC-1 financing statement.
Both the retailer and the supplier will need to proceed in a disciplined way in order to protect the supplier’s interest in the consigned inventory.
1) The retailer and the supplier will have to formalize the sale with right of return agreement memorializing the supplier’s interest in the consigned goods.
2) The supplier must deliver a proper notice to each secured creditor of the retailer (most significantly to lenders with a recorded security interest) with a description of the consigned merchandise before it is delivered to the retailer.
3) The retailer will have to segregate the consigned merchandise from its other inventory.
4) Depending upon the circumstances, the supplier and the retailer may want to approach senior secured lenders in order to negotiate an agreement laying out the rights and liabilities of each creditor.
In most instances, the ability of a merchant to obtain merchandise on consignment is beneficial to all parties. The merchant has more goods available to sell, which, in theory, should improve the overall viability of its business, therefore boosting the investment of the secured creditors.
These are very technical requirements and if supplier and retailer don't adhere to the requirements spelled out in the UCC, the supplier’s claim to the consigned merchandise could be defeated by the claims of secured creditors with properly perfected security interests. In this case, the supplier would be deprived of its security interest in the consigned merchandise.
Arnie Spevack is a commercial transactions attorney who represents individuals, businesses, lenders and borrowers in financings, closings, negotiations and in the courts. For more information on consignment transactions, contact Arnie at (301) 657-0749 or firstname.lastname@example.org.