Maryland Legal Alert for Financial Services

In retail bankruptcy cases, disputes occasionally arise between a secured lender and a seller of goods on consignment as to which party has a superior interest in the goods. In a recent decision, the United States Bankruptcy Court for the District of Delaware discussed the priority issue in great depth and ruled in favor of the lenders in the case.

A sporting goods and apparel company filed its Chapter 11 case on March 2, 2016. Earlier, in 2006, a group of lenders extended financing to the company and was granted a second lien in inventory that was perfected by the filing of a financing statement. This second lien became a first lien after the first lienholder was paid in full during the company’s bankruptcy proceeding.

In 2011, a sporting goods manufacturer agreed to sell its goods to the company on consignment. Under the consignment agreement, the manufacturer was entitled to receive 45% of the retail selling price on each sale. The manufacturer did not file a financing statement covering its goods until January 25, 2016. It sent notice of the filing to the predecessor administrative agent for the lending group but did not notify the current agent even though a search of the financing statement records would have disclosed the name and address of the current agent. During the bankruptcy case the court permitted the company to pay the manufacturer as goods were sold subject to the right of the lenders to seek disgorgement from the manufacturer if the lenders' lien was subsequently held to have priority.

Both the lenders and the manufacturer moved for summary judgment on the lien priority issue. The lender’s position was based on its filing of a financing statement perfecting its lien prior to any filing by the manufacturer. However, the manufacturer argued that its arrangement with the company was not a “consignment” under the Uniform Commercial Code (U.C.C.) §9-102 (20) and therefore not subject to the U.C.C. filing requirements. Second, the manufacturer argued that its filing of a financing statement gave it priority over the lenders under U.C.C. §9-324 (b). Under that section, a party that obtains a purchase money security interest (PMSI), such as a consignment interest, takes priority over a prior perfected security interest provided certain notice requirements are met.

The court rejected the manufacturer’s first argument ruling that the manufacturer failed to prove that its transaction with the company was not a “consignment” under the U.C.C. Crucial to the court’s ruling was its finding that the manufacturer did not show that the company was known to the lenders to be “substantially engaged in the selling of goods of others”, or that the lenders' administrative agent knew that the manufacturer was selling to the company on consignment. Had the lenders been under the impression that the company substantially engaged in the selling of others’ goods, then the U.C.C.’s filing requirements likely would not have applied in the case. However, the court found that even though 14% of the company’s sales were on consignment, the “substantially engaged” requirement required that at least 20% of the company’s sales be on consignment. The manufacturer’s second argument was overruled because of its failure to provide notice of its filing to the current administrative agent of the lender group. Under U.C.C. 9-324 (b)(1)-(4) the later filed PMSI takes priority only if the holder of the conflicting security interest is given notice of the PMSI in inventory. The manufacturer’s notice to the predecessor agent for the lender group was found to be insufficient.

While this decision was decided under Delaware law, Maryland’s U.C.C. provisions are identical. For further information, please contact Lawrence D. Coppel.