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What You Need to Know When Supplying Goods to Struggling Retailers on Consignment

The retail industry is having a difficult year.  Thus far, 2016 has been marked by the fall (or at least stumble) of a number of well-known retail behemoths.  Sports Chalet, Sports Authority, Wet Seal, Pacific Sunwear, and Aeropostle have all filed for bankruptcy protection.  According to an article in the Wall Street Journal, "Sears and other retailers including Macy's, Inc., and J.C. Penney Co. have closed hundreds of stores in recent years …."  As anchor tenants close stores, a ripple effect may ensue.  We may be witnessing a change in the retail industry as we know it.
As retail companies become financially distressed, those doing business with them should take steps to protect themselves in case a bankruptcy is in the cards.  For example, Sports Authority's bankruptcy case revealed that its inventory was provided on consignment.

Supplying inventory to a distressed company on consignment would appear to be a sound strategy.  After all, under a true consignment arrangement, title to the inventory remains with the consignor, and does not transfer to the consignee retailer.  However, as the dispute in the Sports Authority bankruptcy case highlighted, consigned goods can potentially be used to satisfy the claims of the retailer.

Consignors, those providing inventory on a consignment basis, must take steps to protect themselves.  Between the consignor and the consignee, the parties' intent dictates the structure of the transaction.  To determine whether a particular agreement creates a true consignment, courts look at a number of factors.  Courts examine who (consignor or consignee) sets the sale price and whether the consignee must pay for the inventory even if it is not sold.  If the parties intended a true consignment, then the supplier, and not the retailer, owns the consigned inventory.

However, regardless of the parties' intent, the creditors of a bankrupt retailer may have rights to the consignor's goods.  In California, whether the rights of a true consignor trump those of the consignee's creditors is determined by the California Commercial Code.  Under the Commercial Code, for purposes of determining the rights of the consignee's creditors, the consignee has the same rights and title as the consignor with respect to the goods in the consignee's possession.  In plain English, this means a retailer's creditors can use the consigned goods in the retailer's possession to satisfy their debts and the retailer can encumber the consigned goods as if the goods are its own.  This would include using the cosigned goods as collateral for the consignee's lender.

All is not lost as there are ways for consignors to fight back.  A consignment transaction creates a purchase money security interest in favor of the consignor.  Generally speaking, competing security interests rank in priority based on the time of perfection.  A security interest in inventory can be perfected by the filing of a financing statement.  A properly perfected security interest can prevail over the claims and liens of the consignee's creditors, but the timing of perfection is crucial.  For a purchase money security interest to have priority over a pre-existing perfected security interest in the same inventory, the consignor must both perfect its security interest and provide notice to the conflicting interest holder and must do so before the retailer receives possession of the collateral.

All this assumes that the transaction meets the definition of "consignment" under the California Commercial Code.  To be considered a consignment arrangement for purposes of the Commercial Code, the consignee in question must meet certain conditions.  In particular, the retailer must deal in goods of the kind in question in a name other than the name of the consignor.  In addition, the creditors of the retailer must not generally know that the consignee is substantially engaged in the sale of the goods of others.  Put another way, the retailer must sell the consigned goods in its name and the fact that the retailer sells consigned goods must not be known to its creditors.  The issue is one of notice.  If the consignee meets the conditions of the California Commercial Code, then its creditors would not know that the inventory on its shelves belongs to others, i.e., the consignor, and not the retailer itself.

Following bankruptcy by a retailer, the consignors must continue to take steps to protect their rights.  Really, this goes for any supplier or creditor of the bankrupt retailer.  

The California Commercial Code does not alter the rights to ownership to consigned goods as between the consignor and the consignee.  This suggests that consignors should prevail over the rights of a retailer in bankruptcy.  However, the Bankruptcy Code grants the debtor the rights of a judgment lien creditor as of the petition date.  Standing in the shoes of a theoretical judgment lien creditor, the debtor can eliminate any unperfected security interests.  Thus, the unperfected purchase money security interests of a consignor can be eliminated.

To avoid or eliminate a lien, the debtor must commence a lawsuit before the bankruptcy court.  A determination regarding who owns consigned goods (the retailer or the supplier) may also require a formal proceeding.  Nonetheless, a debtor may attempt to bypass these procedural requirements and attempt to take action contrary to the consignors' interests by motion practice early in the case.  Consignors should appear in any bankruptcy case at the outset and force the debtor to use the proper procedures.  The requirement that the debtor commence a lawsuit, and the resulting delay, could practically impair the debtor's ability to operate, and, therefore, could increase a consignor's leverage.

The debtor also has the ability to keep or rid itself of outstanding, unperformed contracts.  An "executory" contract is one where material performance remains for both parties.  Debtors can assume executory contracts and continue to perform.  For a consignor, this means that the debtor can continue to sell the consigned goods pursuant to the terms of the parties' contract.  Assumption makes the contract an obligation of the bankruptcy estate, and, as a result, damages resulting from any subsequent breach by the debtor is entitled to one of the highest priorities of payment.  However, even if a consignor's contract is assumed, the issue remains as to who gets the proceeds from the sale of the consigned goods, the consignor or the debtor's other creditors.  Thus, while assumption has some benefits, it does not necessarily ensure that a consignor will receive the proceeds from its goods.

The debtor can sell property free and clear of disputed interests.  A security interest that is unperfected, and, thus, avoidable, would fall into this category.  However, the disputed lien must attach to the proceeds from the sale pending the resolution of the dispute in accordance with the proper procedure.  The later disposition and disbursement of the proceeds will depend on the ultimate outcome of the dispute.  This again highlights the importance of perfection to ensure consignors receive the ultimate benefit of their bargain, i.e., the proceeds from the sale of the consigned goods.

Providing inventory to a struggling retailer on a consignment basis can help protect a supplier, but it is not enough.  Consignors must take further steps to protect their lien rights and must enforce their rights in any subsequent bankruptcy to create maximum leverage.  There is still more than can and should be done.  Vendors should also take steps to protect themselves from a debtor's rights to claw back certain pre-bankruptcy payments they may have received.  If a supplier or other creditor suspects a company it is doing business with is financially distressed and may be approaching bankruptcy, it should consult with counsel as soon as possible.

Robert Marticello is the immediate past president and board member of the California Bankruptcy Forum and is a partner of Smiley Wang Ekvall, LLP, a Southern California firm specializing in business litigation, real estate transactions, and bankruptcy and insolvency matters. 


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