May/June 2012

Secured Lender Loses to IP Owner in Dispute Over Proceeds of Trademarked Inventory

In Variety Wholesalers, Inc. v. Prime Apparel, the borrower sold to a customer certain goods that incorporated a trademark owned by the borrower’s vendor. This case highlights an often overlooked category of risk for secured lenders — the risks associated with financing inventory sold in violation of third-party intellectual property rights.



In an unorthodox ruling, a North Carolina appellate court recently held that a factor of trade receivables had neither a valid ownership interest nor security interest in certain of its borrower’s accounts receivable, or the proceeds thereof, because those accounts receivable were generated from inventory sold in violation of a third party’s trademark rights.

In Variety Wholesalers, Inc. v. Prime Apparel, LLC, 2011 WL 6036084 (N.C.App. Dec. 6, 2011), the borrower sold to a customer certain goods that incorporated a trademark owned by the borrower’s vendor. Prior to the customer’s payment for the goods, the vendor demanded that the customer cease payment to the borrower for the goods. The customer, unsure of the rightful payee, deposited the payment with a North Carolina state trial court and asked the court to determine to whom the payment should be made. The borrower’s factor, which had purchased the underlying receivables and had also made secured advances against them, claimed that it had a superior interest in the payment because it had a valid and perfected ownership interest and security interest in such receivables and the proceeds thereof.

Because it failed to respond to a series of pleadings, the trial court entered a default judgment against the borrower for trademark infringement and violation of state unfair trade practices law. Separately, the court found that the vendor was entitled to the proceeds as damages for these violations, and that the factor had no interest in such proceeds. On appeal, the North Carolina Court of Appeals affirmed. Without any discussion of its reasoning or citation of dispositive case law, the appellate court held that the borrower had no right to the goods or the proceeds from the sale and, as a result, there were “no accounts receivable it could [assign] to [the factor] through their prior agreement.” Although the appellate court did not elaborate, its holding suggests that it viewed the proceeds of the receivables arising from the infected inventory sales as subject to a constructive trust for the benefit of the vendor — a draconian remedy.

This case highlights an often overlooked category of risk for secured lenders — the risks associated with financing inventory sold in violation of third-party intellectual property rights. The court in this case took an aggressive position with respect to trademark infringement remedies. Even in instances where damages are awarded for trademark violations, it is unusual, though not without precedent, for a court to determine that the proceeds of the infringing sales may be subject to a constructive trust.

This said, federal and state law does provide courts with substantial latitude in crafting remedies for trademark infringement violations, some of which may impact an infringing seller’s secured lender. Courts have broad powers to issue injunctions against future infringing sales, to freeze assets during the pendency of a trial and/or to require the infringing party to take certain actions such as accounting for the profits realized. As Variety illustrates, courts also have the power to award various categories of damages. In most cases, however, any such judgment for damages will constitute an unsecured claim — and the trademark owner will not be entitled to any special status vis-à-vis the other creditors of the infringing seller. While the remedy imposed by the Variety court is unusual, the case serves as a warning to lenders that the outcome of a trademark infringement case can be unpredictable.

Robert B. Stein is a partner in the New York office of Blank Rome, LLP. He brings more than 30 years of experience to the practice of law in the area of financial services. Stein represents many leading institutional lenders, including major commercial banks, finance subsidiaries of banks, independent factors and finance companies in areas such as middle-market banking, cash flow and asset-based lending, debtor-in-possession financing, acquisition financing, factoring and other complex secured transactions.

Stein has authored numerous industry related works that have been included in the Uniform Commercial Code Law Journal and The Secured Lender, and cited in The Law of Secured Transaction under The Uniform Commercial Code. He recently co-authored an article titled “Can a Usury Savings Clause Save the Lender?” that appeared in The Deal magazine. Stein has received the highest possible rating from Martindale-Hubbell.

Kory Grushka, an associate in Blank Rome’s Philadelphia office, concentrates his practice in the areas of commercial and corporate finance. Grushka represents national and regional banks, commercial finance companies and private equity funds in connection with asset-based and cashflow financings, leveraged buyouts, mezzanine financings, equipment leasing and finance and loan syndications/participations.

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