While lessors are rarely involved directly with inventory financing, there are times when it is important for them to understand the issues surrounding security interests in inventory. Once in a while, a lessee’s inventory may be looked to as additional collateral in certain transactions. A lessor may also lease/finance goods that become “inventory” in the hands of the lessee (e.g. an equipment rental lessee). A lessor may place recovered goods with a remarketer “on consignment.” As such, it is important for lessors to understand the treatment of consignments under revised Article 9 of the Uniform Commercial Code (the “UCC”).
Consignments underwent a radical change in July 2001, when major revisions to UCC Article 9 (“Article 9”) went into effect. Specifically, the revisions brought all consignments entirely under the scope of Article 9 and removed “non-security” consignments from the purview of UCC Article 2 (in Section 2-326(3)), as that section has been deleted from Article 2.
A consignment is generally understood to be a method by which a vendor (consignor) delivers goods to a customer (consignee) for that customer to hold until it uses them (either in its own operations or by sale to another). When the consignee uses the consigned goods, the consignee has “purchased” the goods and is liable to the consignor for the price of the goods. If he does not sell the goods, he must either return them to the consignor or be liable for the price of the goods. Title to the goods remains in the consignor during the consignment and passes directly to the purchaser, when the goods are sold.
To qualify as a “consignment” under revised Article 9, the goods must be delivered to a merchant for the purpose of sale, have a value over $1,000, and not be consumer goods in the hands of the person making delivery to the merchant. The merchant must deal in goods of the kind under his own name, not be an auctioneer, and not be generally known to sell goods of others. If the consignor does not meet this definition, either because it is consigning consumer goods or the merchant does not deal in goods of the kind, Article 9 offers little protection. The non-Article 9 consignor must look to pre-code law to determine his/her rights. While the drafters of the UCC may have intended that non-Article 9 consignor’s would treat such consignments as bailments and allow them to recover their goods without following the normal steps under the UCC, there is no guarantee this will be the result in the various state courts. Non-Article 9 consignors should familiarize themselves with the applicable state common and statutory law pertaining to bailment to protect themselves and these types of transactions.
It used to be that a consignor protected itself against creditors of the consignee (or against the consignee’s trustee in bankruptcy) by either clearly marking the goods as property of the consignor or by filing a financing statement (UCC-1) covering the consignment. The “marking” frequently took the alternative forms of (a) labeling each piece of the goods as property of the consignor, or (b) segregating the goods in a discrete area designated as containing property of the consignor.
The rationale for this previous system may be instructive. Inventory financers are (or should be) accustomed to regular inspections and counting of inventory securing their debts. Their inspectors will come to the warehouse of, let’s say, a widget seller, looking for security for the debt and see, for instance, a thousand cases of widgets for sale. Since the inventory financer knows the number of widgets in a case and the value of a widget, it could calculate the value of its security.
If, among the cases of widgets, it saw a hundred cases marked “property of and consigned by ABC Manufacturing Co.,” it could know that the inventory secured by the inventory financer’s loan was only nine hundred cases of widgets, rather than the entire thousand. A problem with this system is that there was no convenient way to determine quickly whether the “consigned” widgets were really new inventory or whether those cases had previously been part of the inventory financer’s product. Further, while the “marking” system made logical sense, it left a myriad of questions for courts about how much marking or segregation was enough.
One of the difficulties with the system of “perfecting” consignments by filing UCC-1 financing statements was that when the consignor filed a financing statement covering the goods, it often conflicted with the prior perfected inventory financer and caused the court difficulty in determining the priorities among conflicting holders. Also, the filing often left the consignor (who hadn’t expected to be a secured creditor at all) with a security interest that might not meet all of the tests of perfection.
With the 2001 revisions to Article 9, the drafters determined to place consignments squarely within the realm of security interests. Since the consignor intended to get his specific goods back if there was a problem, the drafters likened the consignor’s interest to a purchase money security interest (a “PMSI”) in inventory (of the debtor). Of course, a PMSI is the lien that a seller (or financer) obtains on goods he sells on credit (or for which he provides funding). Article 9 has always had special treatment for PMSIs. For a PMSI in inventory, there are special priorities as well as special perfection requirements. Since the law now treats a consignment just like a PMSI in inventory, one needs to understand those rules in order to be able to operate in the world of consignments.
Although obvious, it should be noted here that inventory is the kind of secured property that is fungible and changes over time. As old inventory is sold or used and new inventory is purchased, the whole still remains “inventory.” Once a creditor perfects a security interest in a debtor’s “inventory,” all after-acquired inventory falls under that security interest. Therefore, a debtor’s “inventory” can be fluid simply identified as “inventory” without having to specify what is exactly contained within that description. Of course, where appropriate, a seller or lender could identify specific inventory, such as “all inventory of 10-inch widgets” or “all widgets manufactured by ABC Manufacturing Co.”
In order for a PMSI in inventory to have the first lien, meaning a first position ahead of an existing inventory financer, the seller (for our purposes, “seller” includes the provider of the purchase money, whether the seller or another financer) must:
(a) have perfected (by filing a UCC-1 financing statement) the PMSI prior to the time the debtor receives possession of the property;
(b) must send notice of the intended delivery to the inventory financer;
(c) the prior perfected inventory financer must receive the notice within five years before the debtor receives possession of the property; and
(d) the notice must tell the recipient that the seller intends to acquire a PMSI and must describe the inventory to be sold.
These four requirements blend the historical rationale with the desire for uniformity and clarity. The prior perfected inventory financer gets notice before the new goods are delivered, so there is no misunderstanding. The PMSI must be perfected (by filing) before the goods are delivered, which prevents the prior security interest in inventory from attaching to the new inventory before the PMSI can attach.
Determining the appropriate party to whom to give notice is still a bit of a challenge (at least until 2006). Under former Article 9, security interests in inventory were generally recorded in the jurisdiction where the inventory was located. For example, if the inventory was located in the New Jersey warehouse of a Delaware corporation, whose headquarters are in Pennsylvania, the UCC-1 was probably filed in New Jersey. What’s more, in some states, secured creditors were required to dual file, that is, file with both the state and local government.
Under revised Article 9 (effective in almost all states in July 2001), the filing place is the state where the debtor is located. In the above example, since the debtor is a Delaware corporation, it is considered to be “located” in Delaware. This means that, until the old financing statements lapse (a maximum of five years from effective date of revised Article 9), when searching for a security interest, one must examine the filings made in the “old Article 9” filing jurisdictions, as well as the revised Article 9 filing places. What one is looking for is all evidence of existing security interests in “inventory.”
There is good news on the searching front, however. Since all filings (other than for fixtures) are now made centrally (with the state), and since the revisions to Article 9 were also meant to facilitate electronic filing and searching, many states have improved their online searching availability. The bad news is that these online results do not always disclose exactly what the security interest is in, leaving consignors in the dark when looking for inventory financers.
The answer to this dilemma depends upon how much lead time you have before the delivery of the consigned goods to a merchant. If there is ample time, then one can order copies of the prior financing statements to determine the inventory financers and send them notices of the intended consignment before the goods are delivered. The other alternative is to notify all of the holders of security interests that could possibly cover the merchant’s inventory.
Sellers often assess risk when selling on credit. Similarly, they should assess the risk of selling on consignment. When doing so, the seller must understand that an “unperfected” consignment is nothing more than a sale on open account. The seller is relying solely upon the credit of the customer. If the customer fails to make payment, chances are that the “consigned” goods will be snapped up by the inventory financer or by a bankruptcy trustee, and will not be available as security for the consignor. The consignment method was probably chosen in the first place because the seller wasn’t willing to sell on open account. An unperfected consignment means that the seller/consignor has lost its “string” on its goods.
Consignments can be a valuable credit enhancement in the right situation. Like other enhancements, the proper steps must be followed in order to be afforded the appropriate protections. Failure to follow the rules can lead to unintended risks and a failure of protection..
This article appeared in Equipment Leasing Today , September 2003 (published by the Equipment Leasing Association).