January/February 2018

When Is a Consignment Not a Consignment? A Look at the Ongoing Sports Authority Bankruptcy Case

In the world of bankruptcy, the definition of “consignment” is not as simple as it would seem. In the ongoing Sports Authority bankruptcy case, the company is trying to remain afloat by selling merchandise it obtained on consignment. The consigners, of course, want to be paid, as do the company’s lenders. Judge Cyganowski reviews the case, which has not yet been resolved, and explains the complexities of consignment.



The Honorable Melance L. Cyganowski, Chair, Bankruptcy Department, Otterbourg P.C.

The Honorable Melance L. Cyganowski, Chair, Bankruptcy Department, Otterbourg P.C.

Just what is a “consignment”? The dictionary defines “consign” as simply “to give over to another’s care … to give, transfer or deliver into the hands or control of another.” Under Article 9 of the Uniform Commercial Code, what actually constitutes a consignment is more complicated and has ramifications regarding the priority of competing security interests.1 Article 9 “distinguishes between consignments that satisfy the definition contained in 9–102(a)(20) and those that do not.”2 Consignments that do meet the definition set forth in 9–102(a)(20) “require perfection in accordance with the UCC. Consignments that do not satisfy the UCC definition are governed by state common and statutory law.”3

From its outset, the Sports Authority Chapter 11 bankruptcy cases raised the issue of consignment sales and the interplay of those sales with bankruptcy law, lenders’ rights and the UCC.4 Given the facts and the cases’ posture, the bankruptcy court in Sports Authority never determined whether the creditors’ security interests took priority over the rights of consignors. The court found the matter to be premature because of a lender’s motion for judgment on the pleadings. In the end, the court gave great weight to the consignors’ interests in their merchandise balanced against the debtors’ desire to continue as an ongoing entity.

Debtors vs. Consignors

Among their first day motions, the debtors sought court approval to “continue to sell inventory delivered on consignment” in the “ordinary course of business.” Practically speaking, the motion was a matter of corporate survival as consignment sales were the debtors’ lifeblood. As of the March 2, 2016 petition date, Sports Authority possessed “approximately 8.5 million units of consigned goods with an invoice cost to the debtors of approximately $84.8 million in the aggregate.”5

If the debtors could not continue selling the consigned merchandise, they faced losing the business, with its lenders left holding the bag. On the other hand, permitting the debtors to hold consigned merchandise left the consignors at risk. Against this backdrop, the consignors filed a series of objections to the debtors’ first day motion and, in turn, the debtors commenced more than 160 adversary proceedings to block the possible seizure of merchandise by the consignors.

The legal arguments contained in the debtors’ complaints focused on the consignors’ failure to perfect their security interests in the consigned merchandise, and they argued alleged perfected security interests prevailed over non-perfected ones.6 But the core of the debtors’ contentions was its potential demise.7

After much back-and-forth, on May 3, 2016, the court ordered Sports Authority to sell the consigned goods in the ordinary course of business on the condition that it complied with its prepetition agreements, including remitting a portion of the sale proceeds to the consignment vendors.8 Significantly, the debtors only agreed to this mechanism after the court had initially refused to permit the debtors to sell the consigned merchandise until the “court could determine the competing interests in the consigned goods and proceeds therefrom ….”9 Rather than roll the dice, the debtors blinked.

Secured Creditors vs. Consignors

The court’s May 3 order did not put the consignment issue to rest. Instead, it ultimately pitted the debtors’ lenders against the consignors when one of those lenders, Wilmington Savings Fund Society (WSFS), sought a declaration that it possessed a prior perfected security interest in the debtors’ inventory and sale proceeds senior to that of M.J. Soffe, a consignor. More than $5.4 million in goods shipped and delivered prepetition to the debtors by Soffe stood between Soffe and WSFS.

Both WSFS and Soffe contended that their purported interests emanated from separate pre-petition agreements with the debtors. In WSFS’ view, Soffe failed to perfect its security interest as it was required to do as a consignor, while Soffe contended it was not a “consignor” as defined by Article 9 because the debtors were not “merchants” as defined by Article 9.

According to Soffe, the debtors were not “merchants” because their creditors knew that they were selling “the goods of others” and were thus outside the defined scope of §9-102(a) (20)(A)(iii). WSFS sought to rebut that argument by pointing to the express terms of the agreement between Soffe and the debtors, which expressly referenced and incorporated §9-102, and provided “that the arrangement shall qualify as a consignment under §9– 102(a)(20) of both the Colorado and Delaware versions of the UCC.’’10

The court was not persuaded by WSFS’ argument, holding that the parties may not contractually alter the meaning of the UCC’s terms, and if the debtors were known to sell goods belonging to others, then the debtors were not merchants and Soffe was not a consignor. Bankruptcy Judge Mary Walrath found that UCC §1-302 allows parties to vary the effect of the UCC but not the meaning of defined terms and “the UCC limits the contracting parties’ ability to define their legal relationship as within the UCC’s ambit by changing the UCC’s definitions[.]” Walrath also quoted the official comments to §1-302, which states: “[t]he meaning of a statute itself must be found in its text, including its definitions, and in appropriate extrinsic aids; it cannot be varied by agreement.”

The Aftermath

The litigation between WSFS and Soffe remains pending before the bankruptcy court. Separately, in IPC (USA), v. Ellis (In re Pettit Oil Company),11 the 9th Circuit’s Bankruptcy Appellate Panel (BAP) confronted the issue of a consignor who failed to comply with the perfection requirements of the UCC and affirmed the bankruptcy court’s decision granting partial summary judgment to the Chapter 7 trustee, finding that under §544 of the bankruptcy code and Article 9 of the UCC, the trustee held an interest superior to the consigning fuel distributor.

In IPC, the trustee began an adversary proceeding against IPC seeking, among other things, a declaration that the agreement was a true consignment and that IPC had an unperfected security interest on the petition date in the consigned fuel, accounts receivable and cash. Unlike Soffe, IPC conceded it was a party to a true consignment. Accordingly, the bankruptcy court concluded Article 9 supported the notion IPC had not perfected its security interest in the fuel and granted the trustee’s motion for summary judgment.

On appeal, the BAP held that the bankruptcy court correctly analyzed the trustee’s rights as a judicial lien creditor under Article 9. The BAP further stated the UCC treats a “true” consignment as a secured transaction and the rights of a true consignor are identical to a secured party, unless otherwise provided by the UCC. Given the facts before it, the BAP concluded that IPC did not comply with the UCC’s requirements to perfect its security interest against the debtor’s other creditors and that therefore, IPC was an unsecured creditor and subordinate to the trustee’s rights as a judicial lien holder.

Conclusion

The lesson to consignors is clear: properly perfect any attendant security interests. Further, consignors must vigilantly review pertinent transaction documents. In the case of Soffe and Sports Authority, facts on the ground superseded contractual text. That outcome, however, should not be presumed in all cases. As for IPC, it appears that neglect in the filing process ultimately extracted a price. Both situations may have been avoidable.