Purchase of Goods on Consignment by tva37509


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									                                                                                                     JULY/AUGUST 2009

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                                                                                                                                    Bruce Nathan, Esq.

                                                 The Limits of Consignment
                                                 Rights When Consigned
                                                 Goods Are Manufactured
                                                 Into Finished Product

                                                A          vendor may choose to sell its goods on a con-
                                                           signment basis. In a consignment transaction,
                                                 the vendor, as consignor, delivers goods to the buyer, as
                                                 consignee. The consignee then either holds the goods for
                                                 sale or uses the goods to manufacture a finished prod-
                                                 uct. As a general rule, the consignor retains title to its
                                                 consigned goods, and does not record a sale of the goods
                                                 until the consignee has either sold or used the goods.

                                                 A consignor that complies with all of the requirements
                                                 of Article 9 of the Uniform Commercial Code and “dots
                                                 all of its i’s and crosses all of its t’s” has enhanced rights
                                                 in the consigned goods. But what happens to the con-
                                                 signor’s interest when the consignee uses the consigned
                                                 goods to manufacture a finished product? Does the
                                                 consignor have any interest in the finished goods, the
                                                 accounts receivable arising from their sale, and other                 The United States Bankruptcy Court for the Western
                                                 proceeds? The answer in a nutshell may be affected by                  District of Pennsylvania, in In re Excalibur Machine Co.,
                                                 the terms of the consignment agreement.                                Inc. (“Excalibur Machine”), recently addressed this
                                                                                                                        issue. A supplier and a manufacturer entered into a con-
                                                                                                                        signment agreement where the supplier consigned raw
                                                                                                                        stainless steel plate to the manufacturer. The manufac-
        A supplier and a manufacturer entered                                                                           turer agreed to store the consigned goods in a segregat-
        into a consignment agreement where the                                                                          ed area on the manufacturer’s premises and purchase
                                                                                                                        the goods, as needed, to produce finished goods.
        supplier consigned raw stainless steel
                                                                                                                        The supplier argued that its interest in the consigned
        plate to the manufacturer.                                                                                      goods continued in the finished product. The court dis-
                                                                                                                        agreed, relying on the consignment agreement. The

   1   B U S I N E S S C R E D I T J U LY / A U G U S T 2 0 0 9
consignment agreement granted the supplier enhanced con-            trustee or debtor-in-possession, has priority over an unper-
signment rights and a security interest in the consigned goods      fected consignor. UCC Article 9 allows a consignor to file a
that were stored at the manufacturer’s premises and the pro-        UCC financing statement on its own, without the consignee’s
ceeds of any sale of these goods to third parties. The agree-       signature, as long as there is a consignment agreement execut-
ment did not extend the supplier’s interest to any finished          ed or otherwise authenticated by the consignee that describes
goods that the manufacturer had produced using the con-             the consigned goods. The consignor uses the same UCC form
signed raw steel, any accounts receivable and other proceeds        that a secured creditor uses in perfecting a security interest in
arising from the sale of these goods, or for that matter, even in   personal property collateral.
any products of the consigned goods.
                                                                    The consignor must jump through additional hoops to obtain
Bottom Line: The supplier should have negotiated for the            priority over the rights of the consignee’s pre-existing secured
grant of security interest in the manufacturer’s finished goods      lender, or other creditor, with a prior blanket security interest
and their proceeds, in addition to the consigned goods.             in the consignee’s inventory. According to UCC Section
                                                                    9-103(d), a consignor has a purchase money security interest
Overview of Consignment Arrangements                                in its consigned goods. As such, the consignor would have pri-
In a consignment, the consignor retains title to the goods          ority over creditors holding prior floating liens in the con-
delivered to the consignee. Title usually passes to the consign-    signee’s inventory, including the consigned goods, if the con-
ee upon the consignee’s use or sale of the goods. As a general      signor satisfies all of the purchase money security interest
rule, the consignor issues an invoice to the consignee confirm-      requirements contained in UCC Section 9-324. These require-
ing the sale of the goods after the consignee’s reported sale or    ments include (a) filing a UCC financing statement describ-
use of the goods.                                                   ing the goods prior to the consignee’s receipt of the goods; (b)
                                                                    sending an authenticated notification to the holders of con-
The consignment terms are frequently governed by a written          flicting security interests in the consignee’s inventory that
consignment agreement between the consignor and consign-            states that the consignor has, or expects to, acquire a consign-
ee. A consignment agreement should contain all of the neces-
                                                                    ment interest in the goods and describes the goods; and (c)
sary terms and conditions to protect the consignor’s interest
                                                                    receipt of such notice by the holders of conflicting inventory
in the consigned goods. Consignments are also governed by
                                                                    security interests within five years before the consignee’s
each state’s Uniform Commercial Code (UCC). UCC Article
                                                                    receipt of the goods.
9 deals with most consignment transactions. UCC Section
9-102(a)(20) defines a consignment as a transaction in which
                                                                    The Excalibur Machine Case
a person delivers goods to a merchant for purposes of sale,
                                                                    On December 3, 2004, Samuel Son & Co., Inc. (“Samuel Son”)
and (a) the merchant deals in goods of that kind under a
                                                                    as consignor, and Excalibur Machine Co., Inc. and affiliated
name other than the name of the person making delivery, is
                                                                    companies (collectively “Excalibur Machine”), as consignee,
not an auctioneer and is not generally known by its creditors
to be substantially engaged in selling the goods of others; (b)     entered into a Consignment Security Agreement. Samuel Son
the goods must have a value of at least $1,000 at the time of       consigned raw stainless steel plate (the “Consigned Goods”)
delivery; (c) the goods are not consumer goods immediately          to Excalibur Machine under the Consignment Security Agree-
before delivery; and (d) the transaction does not create a          ment. The Consignment Security Agreement further gov-
security interest.                                                  erned Samuel Son’s and Excalibur Machine’s rights and obli-
                                                                    gations as follows:

A consignment agreement should                                      • Samuel Son retained title to the Consigned Goods and
                                                                      Excalibur Machine was required to identify the goods as
contain all of the necessary terms                                    Samuel Son’s property;
                                                                    • Excalibur Machine had to segregate the Consigned Goods
and conditions to protect the                                         at its premises in Linesville, Pennsylvania and could not
consignor’s interest in the                                           commingle the Consigned Goods with Excalibur Machine’s
                                                                      other property;
consigned goods.                                                    • Excalibur Machine could not remove the Consigned Goods
                                                                      from its premises without Samuel Son’s prior written
The consignor should file a UCC financing statement describ-          • Excalibur Machine could either use the Consigned Goods
ing the goods in the correct jurisdiction in order to maintain        for the production of finished product or sell the Con-
a protected perfected interest in the goods. Otherwise, the           signed Goods for cash at a price not less than the minimum
consignee’s creditors can obtain judicial liens and security          purchase price specified by Samuel Son;
interests in the goods with priority over the consignor’s           • Excalibur Machine was required to report to and invoice
unperfected consignment interest. According to UCC Section            Samuel Son for all Consigned Goods that were either used
9-317(a), a judicial lien creditor, including a bankruptcy            or sold and Excalibur Machine agreed to pay all invoices

                                                                                                                 B U S I N E S S C R E D I T J U LY / A U G U S T 2 0 0 9   2
                         owing to Samuel Son within 30 days of the date of invoice;     security interest in Excalibur’s accounts receivable arising
                         and                                                            from the sale of these finished goods and all proceeds from
                       • Excalibur Machine granted Samuel Son a security interest       the collection of such accounts.
                         in the Consigned Goods and all proceeds of the sale of these
                         goods to third parties. The security interest did not extend   Excalibur Machine opposed Samuel Son’s motion, arguing
                         to finished goods or even to products derived from the          that Samuel Son’s consignment and security interest extended
                         Consigned Goods. This is the critical provision the            only to the Consigned Goods that were segregated in Excali-
                         Excalibur Machine court relied upon in denying Samuel          bur Machine’s yard. Once Excalibur Machine used the goods
                         Son any interest in the finished goods produced from the        to produce finished product, and Samuel Son invoiced Excali-
                         Consigned Goods.                                               bur Machine for the goods, Samuel Son no longer owned the
                                                                                        goods and lacked any interest in the finished product and the
                       Samuel Son filed a UCC financing statement with the state of       accounts receivable arising from their sale.
                       Pennsylvania. The UCC financing statement covered the
                       Consigned Goods and their proceeds.                              The Court’s Decision in Favor of Excalibur Machine
                                                                                        The court had to decide whether the Consignment Security
                       Samuel Son delivered the Consigned Goods to Excalibur            Agreement extended Samuel Son’s security interest in the
                       Machine’s premises. Excalibur Machine segregated the Con-        Consigned Goods to the finished goods that Excalibur Machine
                       signed Goods in an outdoor storage area. Excalibur Machine       had produced using the Consigned Goods and the accounts
                       did not pay for, and had no obligation to pay for, the Con-      receivable arising from the sale of these goods. The court ruled
                       signed Goods while they were stored in the segregated area.      that the Consignment Security Agreement limited Samuel
                                                                                        Son’s consignment and security interest to only the Consigned
                                                                                        Goods and the proceeds of their sale, and not to the finished
    Excalibur Machine did not pay for,                                                  goods and their accounts receivable and other proceeds.

    and had no obligation to pay for, the                                               The court relied on the Consignment Security Agreement
                                                                                        which granted Samuel Son a security and consignment inter-
    Consigned Goods while they were                                                     est in only the Consigned Goods and the proceeds of their sale
    stored in the segregated area.                                                      to third parties. The agreement did not extend Samuel Son’s
                                                                                        security interest to the finished goods that Excalibur Machine
                                                                                        had manufactured using the Consigned Goods.
                       When Excalibur Machine needed the steel plate in its manu-
                       facturing process, Excalibur Machine moved the necessary         The court also noted that while the Consignment Security
                       Consigned Goods from the segregated area into its building       Agreement permitted Excalibur Machine to sell Consigned
                       for processing. Excalibur Machine then notified Samuel Son        Goods to third parties, Samuel Son and Excalibur Machine
                       of Excalibur Machine’s use of the Consigned Goods and Sam-       did not intend that Excalibur Machine would be making such
                       uel Son invoiced Excalibur Machine for these goods. Samuel       sales. Samuel Son was permitted to maintain an inventory of
                       Son would then provide additional Consigned Goods to             raw steel plate in a segregated storage area at Excalibur
                       Excalibur Machine to replenish Excalibur Machine’s available     Machine’s premises and have these goods available for pur-
                       inventory of raw stainless steel plate.                          chase by Excalibur Machine on an “as needed” basis. When
                                                                                        Excalibur Machine needed steel plate to manufacture into fin-
                       Once Excalibur Machine moved the Consigned Goods into            ished goods, Excalibur Machine purchased the goods out of
                       its building, the goods were processed into a finished prod-      consignment by moving them into its building. At that point,
                       uct. Excalibur Machine then sold the finished product to its      title to the goods transferred from Samuel Son to Excalibur
                       customers. Samuel Son’s interest in and rights to the finished    Machine. Excalibur Machine was then required to give notice
                       goods and their proceeds was at issue in the Excalibur           to Samuel Son of Excalibur Machine’s movement of the goods
                       Machine case.                                                    and Samuel Son was supposed to issue an invoice to Excalibur
                                                                                        Machine for the purchase price of the goods, which was pay-
                       Excalibur Machine’s Chapter 11 Filing                            able on 30-day terms.
                       On January 31, 2009, Excalibur Machine filed Chapter 11 with
                       United States Bankruptcy Court for the Western District of       Once Excalibur Machine purchased the Consigned Goods
                       Pennsylvania. On February 11, 2009, Samuel Son moved in          and incorporated them into its finished product, Excalibur
                       the bankruptcy court to prohibit Excalibur Machine’s use of      Machine treated the goods as its own property. Excalibur
                       the cash proceeds from, and for adequate protection of Sam-      Machine was obligated to pay for the goods in accordance
                       uel Son’s interest in, Excalibur Machine’s finished goods,        with the terms of the invoices that Samuel Sons had issued
                       accounts receivable and other proceeds. Samuel Son argued        confirming its sale of the goods. Excalibur Machine had no
                       that its security interest in the Consigned Goods continued in   obligation to account to Samuel Son for the processed steel
                       the finished goods that Excalibur Machine had produced with       and its proceeds, or return any of the finished goods and any
                       the Consigned Goods. As such, Samuel Son also claimed a          proceeds to Samuel Son.

3   B U S I N E S S C R E D I T J U LY / A U G U S T 2 0 0 9
As the Excalibur Machine case makes clear, consignment
rights do not necessarily continue when the consignee uses
the consigned goods in the manufacture of finished products.
UCC Section 9-336 states that if a creditor’s collateral becomes
part commingled goods, the creditor’s security interest may
continue in the product. It is interesting that the Excalibur
Machine court never addressed this provision. Instead, the
court relied on a consignment agreement that did not extend
Samuel Son’s security interest to the Excalibur Machine’s fin-
ished goods, or to even the products derived from Excalibur
Machine’s use of the consigned goods.

The moral of this story is that a consignor who wishes to
obtain a perfected security interest in the finished product
that incorporates its consigned goods should make sure its
consignment arrangement includes a grant of a security inter-
est in its favor in the finished goods and all accounts receiv-
able and other proceeds (in addition to the consigned goods)
and use a UCC financing statement that includes finished
goods, accounts receivable and other proceeds (in addition to
consigned goods) in the description of collateral. Once again,
“dotting your i’s and crossing your t’s” saves the day. ●

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 bnathan@lowenstein.com.

*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.

                                                                         B U S I N E S S C R E D I T J U LY / A U G U S T 2 0 0 9   4

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