When Timing is Everything:  Treatment of Consignment Agreements in Bankruptcy

by: Paul R. HageJaffe Raitt Heuer & Weiss, P.C.; Southfield, MI

In certain industries, it is not uncommon for parties to a commercial transaction to alter the normal debtor-creditor relationship by entering into consignment arrangements. Under a typical consignment arrangement, the consignor of the goods (typically a manufacturer or distributor) delivers such goods to the consignee (typically a retailer) to be sold. The consignee generally does not pay for the consignment goods until it sells such goods to a customer. The benefit of a consignment arrangement to a consignor is that title to the consigned goods remains with the consignor until the consignee has found a purchaser for such goods. Thus, the consignment goods do not become an asset of the consignee until the moment that they are sold to a customer. For this reason, consignment agreements can provide a degree of protection to a trade creditor who wants to supply goods to a financially troubled retailer. If the consignor follows the proper steps, it should be able to take its goods back from the retailer upon its insolvency or the commencement of a bankruptcy case, although it may need to file a motion for relief from the automatic stay. 

The Uniform Commercial Code (UCC) applies to consignment transactions. In order for the consignment arrangement to be enforceable against the retailer’s secured creditors or, upon the commencement of a bankruptcy case, a trustee in bankruptcy, notice of the consignment arrangement must be provided. This notice is typically accomplished through the filing of a UCC-1 financing statement. While a consignor may be able to prove up the existence of the consignment relationship and prevail against a trustee in bankruptcy absent the filing of a financing statement, the diligent consignor should always file a financing statement identifying its ownership interest in the goods before delivering such goods to the consignee. The filing of a financing statement, in combination with a well-drafted consignment agreement, should be sufficient to defeat claims of secured creditors or the trustee in such goods upon the commencement of a bankruptcy case.

In recent years, as retailers have faced increased financial distress, consignment arrangements have become even more common. Unfortunately, consignors all too often fail to file the requisite financing statement to perfect their interest in their

goods and to give notice to third parties, including the consignee’s secured creditors, that the goods being provided to the consignee are subject to the interest of the consignor. The failure of a consignor to perfect its interests generally will result in the consignor being treated as a general unsecured creditor in the retailer’s bankruptcy case. Like all unsecured creditors, the consignor will often need to scramble to receive payment for the goods that it delivered pre-petition and, adding insult to injury, may be faced with a preference action from the trustee in bankruptcy for those payments that it received during the 90 days prior to the bankruptcy filing.

Two recent opinions highlight some of the issues that courts have faced in dealing with unperfected consignment agreements in bankruptcy. First, in In re Circuit City

Stores, Inc., [1]the bankruptcy court addressed the issue of when consignment goods are “received” for purposes of § 503(b)(9) of the Bankruptcy Code, which gives an otherwise unsecured trade creditor priority in payment for goods delivered to a debtor during the 20 days before the commencement of its bankruptcy case. Second, in In re Felt Manufacturing Co. Inc., [2]the bankruptcy court addressed the issue of whether goods provided on a consignment basis constitute “new value” for purposes of defeating a preference action and, if so, when such new value is given to the debtor. Interestingly, the courts seem to reach contrasting conclusions. 

In re Circuit City Stores Inc.: When Are Consignment Goods “Received” for Purposes of § 503(b)(9)?In In re Circuit City Stores Inc., the court addressed the issue of when consignment goods are “received” for purposes of § 503(b)(9). As noted previously, § 503(b)(9) grants trade creditors an administrative expense, and thus priority in payment, for the value of any goods received by the debtor within 20 days before the date of commencement of a case under [title 11] in which the goods have been sold to the debtor in the ordinary course of such debtor’s business. [3]

In Circuit City, a creditor who sold consumer electronics equipment to the debtors on a consignment basis shipped certain goods to the debtors for sale prior to the 20 days before the commencement of the bankruptcy case. [4] Such goods were sold by the debtor during the 20-day period. [5] The issue before the court was whether the goods should be deemed to have been “received” by the debtors on the date that the goods were physically delivered or, alternatively, on the date

that the goods were sold by the debtors to their customers, thereby resulting in title to the goods passing from the creditor to the debtors under the consignment agreement. [6] Ultimately, the court concluded that regardless of when title passed, the goods were “received” for purposes of § 503(b)(9) when the debtor took physical possession of them.

The parties agreed that the goods at issue were in the physical possession of the debtors prior to the 20-day period. [7] The creditor asserted, however, that it was entitled to an administrative expense because the goods, although delivered to the debtors’ warehouses and stores, were not technically “received” by the debtors until title to the goods passed under the consignment agreement. [8] In short, the creditor asserted that the debtors held the goods as a bailee until they were sold to a customer. [9]

The court began its analysis by noting that the plain language of § 503(b)(9) ensures that a creditor is only entitled to an administrative expense for claims arising from the sale of goods “received” by the debtors during the 20-day period. [10] The court noted that the Bankruptcy Code does not define “received,” and there is no controlling law directly on point. [11]Accordingly, the court found, canons of statutory construc[12]tion dictated that the term should be defined “in accord with its ordinary or natural meaning.” Additionally, citing to Fourth Circuit precedent, the court noted that state law can be used to define terms in the Bankruptcy Code that are not otherwise defined by Congress. [13] However, application of state law in this case, the court noted, would be impractical because the debtors had done business in almost every state in the country. [14] 

The court elected to adopt and apply a federal definition for the term “received” for purposes of § 503(b)(9). [15] In identifying this definition, the court noted that although the UCC does not define the term “received,” it does define “receipt” of goods as “taking physical possession of them.” [16] The court noted that other bankruptcy courts had utilized this definition in the context of interpreting the term “receipt” as used in section 546(c) of the Bankruptcy Code, which deals with a creditor’s reclamation rights. [17] The court noted:

The Supreme Court has recognized that when two words are similar and concern related issues they may be treated as “functional equivalent[s]” and interpreted identically. Although the word “receipt” does not appear in § 503(b)(9), both

“receipt” and “received” appear in the same sentence in § 546(c). Both § 503(b)(9) and the amendments to § 546(c) were enacted as part of § 1227 of the [sic] Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) to “enhance certain types of reclamation claims.” The Court concludes that “receipt” and “received” are similar words and concern related issues. Therefore, they should be treated as functional equivalents and interpreted identically. As “receipt” in Article 2 of the UCC and § 546(c) is defined as taking “physical possession,” the Court holds that “received” for the purposes of § 503(b)(9) means having taken into “physical possession.” [18]

In establishing this federal definition for the term “received,” the court also looked to Black’s Law Dictionary and Webster’s Ninth New Collegiate Dictionary. [19] The former defined the term “received” as “the [a]ct of receiving; also, the act of receiving or being received,” and the term “receive” as “[t]o take into possession and control; to accept custody of.” [20] The latter, the court noted, defined the term “receive[d]” as “[having] come into possession of.” [21] 

Finding that the consignment agreement itself contained language that seemed to refer to the “receipt” of the goods as occurring at the time that the debtors obtained physical possession of them, the court concluded that “the Parties contemplated this ‘ordinary and natural meaning’ of the word ‘received’ when they entered into the Consignment Agreement.”[22] 

The court rejected the creditor’s argument that “the consignment nature of their transaction requires ‘received’ to mean the time at which title transferred, as the ‘sale’ of the Consigned Goods by [the creditor] to [the debtors] did not occur until after the Consigned Goods were in the physical possession of [the debtors]….” [23] To the contrary, alluding to the ability of a shipper of consignment goods to file a financing statement to perfect its interest in such goods, the court stated, “It seems highly unlikely … that Congress intended for § 503(b)(9) to serve as a backstop for creditors who otherwise failed to timely enforce their lien rights against proceeds resulting from the sale of consigned goods.” [24]

In closing, the court held that the definition of “received” means “having taken into physical possession” and, moreover, that this definition should be applied as the federal definition of the term “received” for purposes of interpreting § 503(b)(9). [25]Accordingly, because the debtors took physical possession of the consigned goods prior to the commencement of the 20-day period, the creditor

was not entitled to an administrative expense under § 503(b)(9) of the Bankruptcy Code for the value of such goods. [26]

In re Felt Manufacturing Co. Inc.: When Is New Value Provided in a Consignment Relationship?In In re Felt Manufacturing Co. Inc., [27]the liquidating trustee of a trust established under the debtor’s confirmed plan of reorganization, commenced an adversary proceeding against a supplier to avoid and recover six payments totaling $519,346.55 as preferential transfers under § 547(b) of the Bankruptcy Code.

The defendant supplied raw polymer resin during the preference period to the debtor, a non-woven fabric manufacturer, for use in its manufacturing process on a consignment basis. [28] Under the consignment agreement, the defendant periodically shipped a railcar of resin to the debtor’s manufacturing facility. [29] Although the railcar sat on the debtor’s premises, title to the resin contained therein did not pass to the debtor until it was extracted from the railcar by the debtor so that it could be used. [30] Because the debtor was financially distressed, the parties agreed that the debtor could not extract the resin from the defendant’s railcars unless and until it was authorized to do so by the defendant. [31] Such authorization was contingent on receipt of payment from the debtor on certain outstanding invoices. [32]

During the preference period, the defendant shipped $625,481.90 worth of resin to the debtor. [33] The defendant asserted that this resin constituted new value within the scope of § 547(c)(4) of the Bankruptcy Code, which, generally speaking, allows a defendant to reduce its exposure on a preferential transfer to the extent that subsequent to such transfer, the defendant provides new value in the form of goods or services to the debtor on an unsecured basis. [34] This new value, the defendant asserted, could be used to reduce its maximum exposure on the alleged preferential transfers to approximately $165,827.30.[35]

Because the statute requires that new value be “subsequent” to a preferential transfer, the timing of when new value is actually provided can have significant implications. In this case, the trustee didn’t dispute that the defendant was entitled to some new value credit but, rather, argued that the defendant was

improperly applying the new-value defense to its benefit. [36] The court summarized the issue as follows:

[The trustee] and [the defendant] both agree that the crux of the new value dispute centers around when [the defendant] gave the Debtor new value. But that’s where their agreement ends. [The trustee] argues that [the defendant] gave new value at the time it shipped the resin to the Debtor’s facility on May 27, 2005. [The trustee] therefore believes the shipment date controls when new value was given. On the other hand, [the defendant] argues that it did not give new value until a few weeks later, in late June, when it authorized the Debtor to withdraw the resin from the railcars sitting at the Debtor’s facility. [The defendant] therefore believes that the delivery date controls when new value was given. [37]

In support of its position that the new value was provided upon shipment of the resin to the debtor’s manufacturing facility by railcar, the trustee cited to a number of bankruptcy court decisions and a Seventh Circuit decision, Gouveia v.

RDI Group (In re Globe Bldg. Materials Inc.), wherein the courts held that new value is given on the date of shipment. [38] The defendant responded by noting that the decisions cited by the trustee were factually distinguishable because they did not involve a consignment arrangement. [39] Rather, the defendant argued, the cases cited by the trustee merely restated the default rule that “the date of shipment controls unless the parties agree otherwise.” [40]

The defendant relied on Silverman Consulting Inc. v. Canfor Wood Prod. Mktg. (In

re Payless Cashways Inc.), an opinion by the Tenth Circuit BAP, to argue that the parties essentially agreed to alter the default rule by entering into the consignment arrangement. [41] Under the consignment agreement, the defendant asserted, the date of delivery was changed from the shipment date to the date that the debtor became authorized to extract the resin, thereby transferring title to the debtor.[42]

In holding that the defendant provided new value on the date title transferred, instead of the shipment date, the court noted that the consignment agreement itself expressly provided that the plastic resin “remains the property of [the defendant] until the resin is released to [the debtor] by written authorization of [the defendant].” [43] Based on the express written terms agreed to by both parties, the court reasoned, “the resin was [the defendant’s] property from

shipment through transit and up until [the defendant] sent written authorization, after it received confirmation that the Debtor sent a payment.” [44] Thus, the court found, new value was not provided under the consignment agreement until title to the resin changed hands.

Citing to Rushton v. E & S Int’l. Enters. Inc. (In re Eleva Inc.), an opinion by the Tenth Circuit BAP, the court noted that the term “give” is defined in Webster’s

Dictionary as “to part with: relinquish.” [45] The court found that new value was “given” under the consignment agreement when the resin was relinquished upon the transfer of title to the debtor. [46] The court reasoned that if the resin had been lost or destroyed while sitting at the debtor’s facility before authorization, “the risk of loss remained with [the defendant].” [47]

Finally, the court noted that the Payless Cashways decision likewise stood for the proposition that “new value was provided on the delivery date, not the shipment date, because the parties’ invoices created a destination contract, rather than the more normal shipment contract.” [48] The court stated:

Likewise here, the Consignment Agreement changed the Requirements Contract by changing what was a shipment contract into a destination contract because the Consignment Agreement expressly states that the goods remained [the defendant’s] property until they were released…. Therefore, [the defendant] did not accomplish delivery until it told the Debtor it could release the resin and placed the goods at the Debtor’s disposal, and new value was not given until that point. [49]

Accordingly, the court held that the new value was provided by the defendant to the debtor on the date that title to the goods transferred.transferred. [50]

ConclusionIt is difficult to reconcile the opinions reached by the courts in Circuit City and Felt

Manufacturing. Under Circuit City,consignment goods are “received” when they are shipped to the debtor, even if the debtor does not take title to such goods. In Felt Manufacturing, a consignor “gives” new value when title to the consignment goods transfers under the agreement upon the sale of such goods to a customer. In any event, while these issues may be interesting to bankruptcy attorneys, they are frustrating for a trade creditor who believed that the consignment arrangement provided it with a degree of protection. To avoid dealing with the issues addressed in these and other cases, it is important that a consignor (1) pay careful attention to the language used when drafting the

consignment agreement, and (2) properly and timely files a financing statement before shipping the goods at issue. [51]