Effective supply chain management sometimes requires a manufacturer to shift its inventory carrying costs to its suppliers. In those instances, a supplier might agree to place its inventory with the manufacturer on a consignment basis, meaning that the manufacturer will take title to the inventory only when it uses the goods in the manufacturing process.
Consignment arrangements raise potential legal issues for a supplier if the manufacturer becomes insolvent. Article 9 of the Uniform Commercial Code (UCC) treats most consignment transactions as secured transactions, therefore the rules applicable to a purchase money security interest in inventory apply. As a result, a supplier’s failure to comply with the UCC’s requirements to perfect the supplier’s security interest will cause the supplier’s inventory to be subject to the claims of the manufacturer’s secured creditors and the supplier’s claims against the manufacturer are reduced to those of an unsecured creditor. These considerations are important to a lender whose borrower is a supplier that consigns inventory as part of its business; they become critical when the lender is asked to extend loans based on the value of the consigned inventory.
Consignments Under the UCC
The UCC defines a consignment as any transaction, regardless of form, that involves the delivery of goods to a merchant for purposes of sale, and for which the merchant deals in goods of that kind under a name other than the name of the person making the delivery, is not an auctioneer and is not generally known by its creditors to be substantially engaged in selling others’ goods.
Additionally, the aggregate value of each delivery of goods must exceed $1,000, the goods must not be consumer goods before delivery and the transaction should not create a security interest that secures an obligation.1
A supplier’s placement of its inventory with a manufacturer for use by the manufacturer will typically satisfy all of the UCC criteria. During these transactions, the questions that typically arise are whether or not the goods are delivered to the merchant for purposes of sale, whether the merchant deals in goods of that kind and whether the transaction creates a security interest that secures an obligation.
The first two questions are answered by the Official Comments to the UCC — created by the organizations that draft and amend the rules — and supporting case law. The Official Comments contend goods delivered to a merchant for a purpose other than sale, such as for milling or processing, are still to be considered delivered for “sale” in a consignment governed by Article 9.
Case law has also followed this interpretation.2 Similarly, when the manufacturer incorporates a component into an end product, courts have regularly concluded that the merchant/manufacturer deals in the component parts even though it is the end product, and not the supplied inventory, that the manufacturer eventually sells to its customers.3
Determining if the transaction creates a security interest that secures an obligation requires a review of the underlying contract documents. Labelling the agreement a “consignment agreement” or referring to the parties as “consignor” and “consignee” does not by itself render the agreement an Article 9 consignment.4 Instead, the substance of the terms controls it. If the contract references other debt owed by the manufacturer, or provides that the manufacturer will pay for the inventory whether or not it is used, then the transaction may create a security interest that secures an obligation.5 In such a case, the transaction would still be subject to Article 9; however, it would not be classified as a consignment, making it subject to the foreclosure provisions, which do not apply to an Article 9 consignment.
Perfecting the Consignor’s Security Interest
In cases where the transaction constitutes a consignment, the security interest created in the inventory in favor of the supplier is deemed to be a purchase money security interest (PMSI). The UCC allows the supplier, as secured party, to obtain a perfected first priority security interest in the inventory that will have priority over the secured creditors holding a previously perfected security interest in the manufacturer’s inventory. To do so, however, the supplier must satisfy each of the following steps:
- Perfect its purchase money security interest by filing a UCC financing statement prior to the date the manufacturer receives delivery of the inventory
- Send a written notification of its security interest to all third parties that hold a conflicting security interest in the goods (i.e., the manufacturer’s secured creditors)
- State in the notification that the supplier has or expects to acquire a purchase money security interest in inventory and describes the inventory placed on consignment
- Deliver the notification to the manufacturer’s secured creditors within five years before the manufacturer receives the inventory.6
Unless all steps are accomplished, the supplier’s security interest, even if perfected, will not have first priority PMSI status and may be subject to all conflicting claims of the manufacturer’s secured creditors, or the manufacturer’s bankruptcy trustee.7
Protecting the Lender’s Interest
Any request for a lender to make loan advances against the value of the supplier’s inventory on consignment should trigger due diligence and the addition of specific eligibility criteria to the credit agreement to protect both itself and its borrower against potential claims by a creditor of the manufacturer or the manufacturer’s bankruptcy trustee.
As part of due diligence, the lender must first determine whether the transaction satisfies all criteria to constitute an Article 9 consignment. This requires a review of the consignment agreement’s terms. A well-structured consignment agreement typically provides: 1) Title to the inventory remains with the supplier until used by the manufacturer; 2) The manufacturer will segregate the consigned inventory from other inventory; 3) The manufacturer will be invoiced for consigned inventory when it is used (the agreement should contain a method for reporting this information); 4) The manufacturer may return unused inventory to the supplier rather than be required to purchase it; and 5) The supplier may reclaim the inventory from the manufacturer at any time.
If the terms of the consignment agreement do not contain these provisions, the transaction could be construed as a seller-financed sale and not a consignment. Potential indicators of a seller-financed sale include:
- Terms that provide title passes to the manufacturer before it uses the inventory.
- No provisions that require the inventory be segregated from similar inventory purchased by the manufacturer from other sources.
- Terms that provide, after a specified period, the inventory will be invoiced to the manufacturer or the manufacturer will be required to purchase it, whether or not the manufacturer has used the inventory.
- Terms permitting the supplier to reclaim the inventory only upon a default by the manufacturer under the consignment agreement.
If the transaction is deemed to grant a security interest that secures an obligation, the transaction would still be subject to UCC Article 9; however, it would not be considered a consignment, and a PMSI would not be created automatically. A supplier can protect against this risk by including in the consignment agreement an express grant of a purchase money security interest in the inventory. This cautionary grant would allow the supplier to avail itself of the PMSI provisions of Article 9 to enable perfection of its security interest and allow priority over conflicting creditors in the absence of an Article 9 consignment. A lender would also benefit from this grant where it is asked to lend against the consigned inventory.
The lender’s second step is to determine whether the supplier has complied with each notification requirement under UCC Section 9-324. The lender should review whether the supplier has:
- Filed a UCC financing statement in the state where the manufacturer is headquartered. This financial statement might have lapsed or been terminated or rendered ineffective with respect to future inventory delivered due to the manufacturer’s change in name or legal status.
- Identified all secured creditors of the manufacturer that may have conflicting security interest to the inventory. This requires conducting lien searches in the manufacturer’s home state.
- Provided written notice to third parties with conflicting security interest, informing the third party of the supplier’s purchase money security interest and adequately describing the inventory.
- Sent written notice so the third party received it no more than five years prior to the date of the manufacturer’s receipt of the inventory.
When asked to lend against the inventory, a lender must take all the aforementioned steps before the manufacturer receives the inventory. If the supplier has not satisfied all steps at that point, the supplier can still do so and obtain a PMSI, although the PMSI may not have first priority status with respect to any inventory placed on consignment prior to completion of all steps.
Both the supplier and lender should also be aware that the list of secured creditors can change over time. As a result, lien searches should be conducted periodically to confirm whether notification must be sent to additional third parties that have become secured creditors with conflicting liens in the manufacturer’s inventory after the date of the most recent lien search. Finally, any notification sent is valid for only five years. In long-standing consignment relationships, the supplier must remember that it will need to “refresh” its notification even if the identity of the secured parties has not changed.8
A UCC financing statement filing against the manufacturer must be refreshed by filing a UCC continuation statement six months prior to the fifth anniversary of original UCC financing statement filing and each fifth anniversary of that date. Additional UCC filings may also be needed if the manufacturer changes its legal name, state of organization or legal status.9
Loan Agreement Provisions
The lender should also modify the borrowing base provisions in its credit agreement with the supplier to account for borrowing availability based on the value of consigned inventory. Although each lender may reach its own conclusion regarding the scope of eligibility requirements, some of the more common terms include:
- The existence of a written consignment agreement signed by both the supplier and manufacturer that is satisfactory to the lender.
- An express grant of a purchase money security interest in the consigned inventory in the consignment agreement.
- A UCC financing statement filed by the supplier in the proper filing office in the manufacturer’s home state that lists as collateral all consigned inventory and all cash and non-cash proceeds and which has been assigned by the supplier so it shows the lender as the secured party’s assignee.
- Lien searches conducted with respect to the manufacturer in its jurisdiction of organization.
- Evidence that each third party that may have a conflicting security interest in the consigned inventory has received proper notice of the supplier’s purchase money security interest no more than five years prior to the manufacturer’s receipt of the consigned inventory.
- The lender’s receipt of an insurance certificate and a lender’s loss payable endorsement with respect to the consigned inventory, regardless of which party has agreed to bear the risk of loss with respect to the inventory.
The lender may also want to condition eligibility on the creditworthiness of the manufacturer, as determined by the lender. This allows the lender a “safety valve” in the event the manufacturer’s financial performance falters, at which time the lender can either reduce or eliminate availability based on inventory consigned to the manufacturer.
Lending against consigned inventory comes with risks. A lender can minimize its risk by conducting proper due diligence regarding the underlying consignment arrangement, ensuring compliance with Article 9’s PMSI requirements and structuring its credit agreement in a manner that protects against any missteps by its borrower or the manufacturer. By taking these steps, the lender can both serve the borrower and protect its interests in the collateral.
- UCC § 9-102(20) (2010)
- UCC § 9-102, Off. Cmt. 14 (2010); In re Georgetown Steel Co., LLC, 318 B.R. 352, 358 (Bankr. S.C. 2004)
- Georgetown Steel, 318 B.R. at 358-59; In re Excalibur Machine Co., Inc., 404 B.R. 834, 839-840 (Bankr. W.D. Pa. 2004)
- In re Britt Motorsports, 2015 WL 1880057 at *3 (Bankr. E.D.N.C. Apr. 22, 2015)
- Georgetown Steel, 318 B.R. at 360; White and Summers, UCC § 30:17 (2015)
- UCC § 9-324(b) (2010)
- UCC § 9-319 (2010)
- T. Gluck & Co., Inc. v. Craig Drake Mfg., Inc., 2013 N.Y. Misc. LEXIS 2384 (N.Y. Sup. Ct. June 4, 2013)
- UCC §§ 316(b), 9-507(c) & 9-508 (2010)