Using consignments as alternative financing arrangements while protecting suppliers from their pitfalls

The prolonged downturn in the economy and the corresponding stresses to business cash flow have made some traditional commercial transactions between customers and suppliers more challenging. On one hand, suppliers face increased risk when selling to customers with poor or deteriorating credit, and on the other hand, difficulty in accessing credit may mean that customers have limited working capital available to invest in inventory. Carefully administered consignment arrangements can serve as a useful way to bridge these two competing considerations.  

Under a consignment arrangement, the supplier delivers goods to its customer, but maintains title until the goods are either used by the customer in a further manufacturing process or sold by the customer to a third party, at which point title to the goods becomes vested in the customer (if only for an instant in the case of a sale to a third party). Consequently, the customer does not typically pay for the goods until the point at which title transfers – the point of use or sale of the goods by the customer.  

This arrangement can benefit both the supplier and customer. The supplier’s credit concerns are significantly mitigated because the supplier maintains title to the goods while they are held in inventory on the customer’s premises. Similarly, the customer enjoys the ability to stock inventory without having to take on additional credit obligations and other costs of ownership of the inventory prior to resale or use, making the supplier’s goods more attractive than similarly priced competing products and increasing the supplier’s sales opportunities.  

Consignment arrangements are not a panacea, however. They do present risks and traps for the unwary. The rights of consignment suppliers vis-à-vis the rights of third party secured creditors are governed by Article 9 of the Uniform Commercial Code, which treats consignment arrangements in a manner similar to the treatment of purchase money security interests in inventory. If a supplier of goods on consignment fails to take the required steps to protect its interest in the goods or fails to give notice to the customer’s existing secured creditors, the goods may fall subject to a pre-existing secured creditor’s lien on the customer’s inventory. In such a situation, the supplier will find its ownership interest in the consigned inventory junior in priority to existing liens on the customer’s inventory.  

The result may be devastating to the supplier. If a customer files for protection under the bankruptcy code and has a pre-existing secured creditor with a blanket lien on its inventory, a consignment supplier that has failed to properly perfect and protect its interest in the consigned goods will find that upon delivery those goods became subject to the secured creditor’s lien on the customer’s inventory. If the customer’s assets subject to the liens are insufficient to satisfy the customer’s obligations to the secured creditor, the supplier’s consigned inventory will be sold and the supplier will not receive any recovery.  

Before delivering consigned inventory to a customer, a supplier should consider taking steps to properly perfect and maintain its interest in the goods, including:  

• Negotiating and executing a consignment agreement with the customer consistent with the requirements of Article 9 of the Uniform Commercial Code.
• Filing a properly completed UCC-1 financing statement in the appropriate jurisdiction.
• Performing a search for other financing statements indicative of liens against the customer’s inventory.
• Providing proper notification of the consignment arrangement to existing secured creditors with liens against the customer’s inventory.

Taking these precautions prior to delivering consigned inventory to a customer can help protect a consignment supplier’s rights against those of a third party secured lender.