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When Timing is Everything: Treatment of Consignment

Agreements in Bankruptcy
by: Paul R. Hage
Jaffe 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 retailers
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 consignees 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 retailers 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 debtors
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 creditors 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 Blacks Law Dictionary and Websters 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 creditors 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 debtors 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 debtors manufacturing
facility. [29] Although the railcar sat on the debtors 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
defendants 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 didnt 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
thats where their agreement ends. [The trustee] argues that [the defendant]
gave new value at the time it shipped the resin to the Debtors 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 Debtors 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 debtors 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 defendants] 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 Intl. Enters. Inc. (In re Eleva Inc.), an opinion by the
Tenth Circuit BAP, the court noted that the term give is defined in Websters
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 debtors 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 defendants]
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
Debtors 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]
Conclusion
It 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]

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