T h e P u b l i cat i on F or C r e d i t & F i nanc e P rof e ss i ona l s
January 2009
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Bruce Nathan, Esq.
Recent Court Decisions on
Consignments and Other
Security Arrangements:
The Benefits of Aggressive Creditor
Action and the Pitfalls of Failing to
Document Properly!
n certain industries, vendors frequently enter into
consignment arrangements to facilitate their sale of
goods. In the typical consignment, the vendor/consignor delivers goods to the buyer/consignee, retains
title to the goods and does not record a sale until the
consignee reports that it sold or used the consigned
goods or, if the consignment agreement provides, kept
the goods on hand for a fixed period of time.
consigned goods delivered to Whitehall were property
of Whitehall’s bankruptcy estate. That required Whitehall to first commence separate lawsuits against each of
the 124 consignment creditors to determine ownership
of the consigned goods. The court’s decision shifted the
balance of power in the case in favor of the consignment
creditors, thereby enabling them to reach a favorable
resolution of their consignment claims.
A consignor has enhanced rights to the goods delivered
to the consignee so long as the consignor satisfies all the
requirements for a protected consignment interest.
However, rights can be easily lost if a consignment creditor fails to take aggressive action to collect and protect
its claim in response to its customer’s bankruptcy filing
and also if the creditor fails to dot its “i’s” and cross its
“t’s” in the documentation that creates and secures payment of its consignment claim.
In another case, the United States District Court for the
Eastern District of Virginia, in In re the Holladay House,
Inc., upheld the Bankruptcy Court’s ruling that a consignment creditor had a prior perfected interest in only
the inventory delivered under its consignment agreement with the debtor, and not also in all of the debtor’s
other non-consigned inventory as the creditor had
intended to obtain under its consignment and security
agreement with the debtor. While the debtor had granted the creditor a security interest in all debtor’s inventory in the consignment and security agreement, the
creditor’s UCC financing statement limited the creditor’s perfected security interest to its consigned goods.
The court’s ruling illustrates the importance to a secured
creditor of conforming the collateral description in its
security agreement and Uniform Commercial Code
The United States Bankruptcy Court for the District of
Delaware, in In re Whitehall Jewelers, Inc., recently dealt
with whether a Chapter 11 debtor could sell consignment goods free and clear of the interests of consignment creditors. The Bankruptcy Court refused to
approve the sale without first ruling on whether the
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(UCC) financing statement. Otherwise, the secured creditor
will not be able to recover all the collateral it had bargained
for. A real downer!
Consignments
In a consignment, the consignor retains title to the goods delivered to the consignee. Title usually passes to the consignee upon
the consignee’s use or sale of the goods. The consignor issues an
invoice after the consignee’s reported sale or use of the goods,
and the consignee can return unsold or unused goods to the
consignor.
The terms of the consignment are frequently governed by a
written agreement between the consignor and consignee. The
agreement should contain all of the necessary terms and conditions to protect the consignor’s interest in the consigned
goods. Consignments are also governed by each state’s UCC.
UCC Article 9 governs most consignment transactions. UCC
Section 9-102(a)(20) defines a consignment as a transaction
in which a person delivers goods to a merchant for purposes
of sale, and (a) the merchant deals in goods of that kind under
a name other than the name of the person making delivery, is
not an auctioneer and is not generally known by its creditors
to be substantially engaged in selling the goods of others; (b)
the goods must have a value of at least $1,000.00 at the time of
delivery; (c) the goods are not consumer goods immediately
before delivery; and (d) the transaction does not create a
security interest.
The consignor should file a UCC financing statement describing the goods in the correct jurisdiction in order to maintain
a protected interest in the goods. Otherwise, the consignee’s
creditors can obtain judicial liens and security interests in the
goods with priority over the consignor’s unperfected consignment interest. According to UCC Section 9-317(a), a judicial
lien creditor, including a bankruptcy trustee or debtor-inpossession, has priority over an unperfected consignor. UCC
Article 9 allows a consignor to file a UCC financing statement
on its own, without the consignee’s signature, as long as there
is a consignment agreement executed or otherwise authenticated by the consignee that describes the consigned goods.
The consignor uses the same UCC form that a secured creditor uses in perfecting a security interest in personal property
collateral.
The consignor must jump through additional hoops to obtain
priority over the rights of the consignee’s secured lender, or
other creditor, with a prior blanket security interest in the
consignee’s inventory. According to UCC Section 9-103(d), a
consignor has a purchase money security interest in its consigned goods. As such, the consignor would have priority over
creditors holding prior floating liens in the consignee’s inventory, including the consigned goods, if the consignor satisfies
all of the purchase money security interest requirements contained in UCC Section 9-324. These requirements include (a)
filing a UCC financing statement describing the goods prior
to the consignee’s receipt of the goods; (b) sending an authenticated notification to the holders of conflicting security interests in the consignee’s inventory that states that the consignor
has, or expects to, acquire a consignment interest in the goods
and describes the goods; and (c) receipt of such notice by the
holders of conflicting inventory security interests within
five years before the consignee’s receipt of the goods.
The Whitehall Jewelers Case
The debtors, Whitehall Jewelers Holdings Inc. and affiliated
entities, were a nationwide specialty retailer of fine jewelry.
Whitehall operated 373 retail stores in 39 states, offering a
selection of goods that included diamonds, gold, precious and
Whitehall acquired most of its inventory
pursuant to consignment arrangements
with its vendors.
semi-precious jewelry and watches.
Whitehall acquired most of its inventory pursuant to consignment arrangements (usually confirmed in written consignment agreements) with its vendors. The consignment agreements characterized the vendors’ arrangements with Whitehall
as consignments; confirmed that each vendor owned and had
full title to the consigned goods and Whitehall had no right,
title or interest in the goods until their resale; and adopted
UCC Article 9 as the governing law.
The consignment vendors delivered their consigned goods to
Whitehall for resale to Whitehall’s customers. Whitehall did
not segregate the consigned goods from Whitehall’s non-consignment inventory, or otherwise identify the goods, as consigned goods, to its customers.
On or about June 25, 2007, Whitehall changed its name from
“Whitehall Jewellers” to “Whitehall Jewelers.” UCC Article 9
required Whitehall’s consignment vendors to amend their
UCC financing statements to reflect the name change within
four months of the change as a condition for retaining their
perfected interest in the consigned goods. Certain consignment creditors claimed that after its name change, Whitehall
had continued to conduct business with them under its old
name of “Whitehall Jewellers,” instead of its new name of
“Whitehall Jewelers.” They were thereby induced to rely on
their existing UCC financing statements instead of filing UCC
amendments to reflect Whitehall’s correct name.
Whitehall’s Chapter 11 Filing
On June 23, 2008, Whitehall filed its Chapter 11 petition.
Whitehall had approximately $63 million of consigned goods,
received from approximately 124 vendors, in Whitehall’s
stores when it filed Chapter 11. The consigned goods comprised most of Whitehall’s inventory and the consignment
creditors were Whitehall’s largest creditors.
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Whitehall owed approximately $71.5 million to LaSalle Bank
and other lenders. The lenders’ claims were secured by first
priority liens and security interests in substantially all of
Whitehall’s assets, including Whitehall’s inventory. Whitehall
also owed approximately $40 million to another lender whose
affiliates owned a majority of Whitehall’s stock. The claim was
secured by a second lien and security interest in Whitehall’s
assets, including inventory.
Whitehall’s Proposed Asset Sale
The same day as its Chapter 11 filing, Whitehall moved for
court approval of the sale of substantially all of its assets,
including the consignment goods, free and clear of all liens,
security and consignment interests and other encumbrances.
The proposed purchasers were a group of liquidators that
intended to conduct going-out-of-business sales at Whitehall’s stores. The proposed purchase price was approximately
50% of the cost value of the goods.
Expeditious and aggressive action by
Whitehall’s consignment vendors in
objecting to the immediate sale of their
goods resulted in the favorable
treatment of their claims.
Whitehall argued that the Bankruptcy Court had the power,
under Bankruptcy Code Section 363(f), to approve the sale of
the consigned goods free and clear of all consignment interests because Whitehall had challenged all of its consignment
vendors’ interests in their goods. Section 363(f)(4) permits a
debtor to sell assets free and clear of liens, security interests,
encumbrances and other interests by proving such liens and
other interests are subject to bona fide dispute.
Whitehall disputed its vendors’ consignment interests and
claimed they were unsecured creditors on several alternative
grounds. Certain vendors had failed to file UCC financing
statements to perfect their consignment interests. Other vendors had filed UCC financing statements that were defective,
thereby rendering their consignment interests unperfected.
Certain defective UCC financing statements incorrectly identified “Whitehall Jewellers” as the debtor, despite Whitehall’s
prior name change to “Whitehall Jewelers.” Other vendors had
failed to satisfy UCC Article 9’s requirements for a purchase
money security interest that would have otherwise granted
them priority over Whitehall’s secured lenders with a floating
lien in all of Whitehall’s inventory. Whitehall also argued that
the consignment arrangements were “sales or returns” under
UCC Section 2-326 and were therefore subject to the claims
of Whitehall’s creditors.
Certain vendors objected to the sale of their goods free of their
consignment interests. They claimed that Whitehall could not
satisfy Section 363(f), which is a prerequisite for court approv
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al of the sale of their consigned goods free and clear of their
interests, because they, not Whitehall, owned the goods.
The Whitehall Court’s Decision
The Bankruptcy Court refused to approve the sale until it
determined the ownership of the consigned goods. Bankruptcy Code Section 363(b) allows a debtor to sell only property
of the debtor’s estate. Property of the estate includes “all legal
or equitable interests of the debtor in property as of the commencement of the case.”
The court rejected Whitehall’s argument that it owned the
consigned goods by virtue of its possession of and obligation
to insure the consigned goods, its identical treatment of consigned goods and other inventory and its ability to sell, and
pass title to, the consigned goods without the permission of
the consignment vendors. Whitehall’s consignment agreements stated that its consignment vendors owned the consigned goods. In addition, Whitehall disclaimed ownership of
the consigned goods in its filings with the Securities and
Exchange Commission.
The court also ruled that it could not determine whether the
consigned goods were property of Whitehall’s bankruptcy
estate in the context of a contested matter, such as Whitehall’s
Section 363 sale motion. The court could only invalidate a
lien or other interest, such as a consignment interest, following the commencement of an adversary proceeding, a full
blown lawsuit, pursuant to Bankruptcy Rule 7001(2), and not
by a motion. The court, therefore, required Whitehall to first
commence adversary proceedings against each of its 124 consignment vendors prior to any determination of Whitehall’s
and its vendors’ interests in the consigned goods.
Impact of the Whitehall Court’s Refusal
to Approve an Immediate Sale of the
Consignment Goods
The Whitehall court’s refusal to approve Whitehall’s immediate sale of the consigned goods allowed the consignment
creditors to delay the sale process. The court also directed
Whitehall to segregate all proceeds in an amount equal to the
cost of such goods, of consigned goods sold post-petition,
into a separate escrow account and prohibited any sale of consigned goods at prices below cost. Whitehall faced the prospect of a substantial delay of the sale process and limitations
on the sale and disposition of the proceeds of its consigned
goods while it litigated 124 separate lawsuits over the issue of
whether the consigned goods were property of its bankruptcy
estate. This ended up shifting the balance of power in the case
in favor of the consignment vendors.
The vendors exploited their advantage to negotiate a global
settlement of their claims on favorable terms to them. As part
of the settlement, Whitehall agreed to return the consigned
goods to vendors participating in the settlement and pay these
vendors from the escrow account for the post-petition sale of
their consigned goods. A win-win for consignment vendors!
The moral of the Whitehall case is that expeditious and
aggressive action by Whitehall’s consignment vendors in
objecting to the immediate sale of their goods resulted in the
favorable treatment of their claims.
The Holladay House Case
The debtor, Holladay House, was a furniture retailer. In September, 2007, Holladay entered into a consignment and security agreement with D.M. Reid Associates under which D.M.
Reid had consigned furniture to Holladay for sale to Holladay’s customers as part of a 90-day sales promotional event.
The consignment and security agreement memorialized Holladay’s consignment arrangement with D.M. Reid and granted
D.M. Reid a security interest in all of Holladay’s consigned
and non-consigned inventory to secure payment of all of Holladay’s obligations to D.M. Reid. D.M. Reid timely filed a UCC
financing statement with the State Corporation Commission
for the Commonwealth of Virginia, the UCC filing office.
Unfortunately, D.M. Reid did not adequately describe its collateral in its financing statement.
D.M. Reid’s collateral, as described in the consignment and
security agreement, included all of Holladay’s inventory, in
addition to the consigned goods from D.M. Reid, and all
products and proceeds. However, D.M. Reid’s UCC financing
statement contained the following narrower description of
collateral:
“All inventory, furniture and furnishings of every
kind, accessories, goods, merchandise, finished
inventory, delivered to consignee at any time by
consignor pursuant to a consignment agreement
between the consignee and consignor, whether now
existing or hereafter arising, wherever located and
all proceeds thereof.”
On December 21, 2007, Holladay filed Chapter 11. D.M. Reid
claimed that Holladay owed $172,437.88 to D.M. Reid when
Holladay filed Chapter 11. On January 30, 2008, Holladay
moved for court approval of the use of cash collateral. D.M.
Reid objected to Holladay’s cash collateral motion, asserting
that Holladay could not adequately protect the security interest that D.M. Reid had asserted in all of Holladay’s inventory.
The Bankruptcy Court overruled D.M. Reid’s objection to
Holladay’s cash collateral motion. The court held that D.M.
Reid did not have a perfected security interest in all of Holladay’s inventory, but instead had a perfected interest in only
D.M. Reid’s consigned goods, because of the narrower description of D.M. Reid’s collateral (covering only consigned goods)
in its UCC financing statement. D.M. Reid then appealed
from the Bankruptcy Court’s decision.
The District Court’s Decision
The United States District Court for the Eastern District of
Virginia also held that D.M. Reid had a perfected security
interest in only the consigned goods that D.M. Reid had deliv-
ered to Holladay under the consignment and security agreement, and not in any other inventory of Holladay House as
provided in the consignment and security agreement.
A creditor obtains a security interest in a debtor’s assets by the
debtor’s execution of a security agreement that describes the
collateral. However, the creditor must then perfect its security
interest in its collateral in order to prevail over all of the debtor’s lien creditors, such as a bankruptcy trustee. Most security
interests are perfected by filing a properly completed UCC
financing statement with the appropriate UCC filing office.
The financing statement must include the name of the debtor,
the name of the secured party and a proper description of the
secured creditor’s collateral. This requirement is designed to
give notice to third parties of the existence of the creditor’s
security interest in the debtor’s assets. If the description of the
collateral in the financing statement is narrower than the
description in the security agreement, or the UCC’s collateral
description contains significant disparities or omissions when
compared to the description in the security agreement, the
creditor’s perfected security interest is limited to the narrower
or incomplete collateral description contained in the financing statement.
The Holladay decision further points
out the need for secured creditors to
properly document their security
arrangements, including properly
describing their collateral in their UCC
financing statements.
The description of collateral (consigned goods) that D.M.
Reid had included in its UCC financing statement was narrower than the description of its collateral, all of Holladay’s
consigned and non-consigned inventory, contained in the
consignment and security agreement. As a result, the financing statement did not put third parties on notice of the need
to inquire about D.M. Reid’s security interest in Holladay’s
non-consigned inventory. That limited D.M. Reid’s perfected
security interest to only its consigned goods.
The court also noted that D.M. Reid’s filing of the consignment and security agreement with the UCC filing office was
not sufficient to perfect D.M. Reid’s security interest in all of
Holladay’s inventory. D.M. Reid’s UCC financing statement
did not refer to the consignment and security agreement and
incorporate its terms, including its reference to Holladay’s
consigned and non-consigned inventory as collateral security
for payment of Holladay’s obligations to D.M. Reid. Once
again, as a result of this omission, a reasonable searcher could
rely only on the more limited collateral description, consigned
goods, contained in D.M. Reid’s financing statement.
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Bottom line, D.M. Reid was done in by an incomplete collateral description in its financing statement.
Conclusion
The Whitehall decision illustrates the benefits to consignment
vendors that aggressively protect their consignment interests
(in that case, by opposing Whitehall’s sale of their consigned
goods). The court’s refusal to approve the sale, without first
determining ownership of the consigned goods, posed a sufficient enough risk to the sales process to induce Whitehall to
settle with its consignment vendors on favorable terms to the
vendors.
The Holladay decision further points out the need for secured
creditors to properly document their security arrangements,
including properly describing their collateral in their UCC
financing statements. D.M. Reid’s failure to include in its UCC
financing statement the broader description of its collateral
(all of Holladay’s inventory) that was contained in the consignment and security agreement limited D.M. Reid’s perfected security interest to only D.M. Reid’s consigned goods as
described in its financing statement.
Bottom line folks: aggressive creditor action, coupled with
proper drafting, maximizes trade creditor recovery! ●
Bruce Nathan, Esq. is a partner in the New York City office of the law
firm of Lowenstein Sandler PC. He is a member of NACM and is on
the Board of Directors of the American Bankruptcy Institute and is a
former co-chair of ABI’s Unsecured Trade Creditors Committee. He
can be reached via email at [email protected].
This is reprinted from Business Credit magazine, a publication of the
National Association of Credit Management. This article may not be
forwarded electronically or reproduced in any way without written
permission from the Editor of Business Credit Magazine.
Business Credit January 2009