Lenders typically have extensive requirements for what inventory will be deemed “eligible” and included in a borrower’s borrowing base for purposes of determining how much the lender is required to lend. One of those typical requirements is that the inventory be owned by the borrower and located at a borrower location in the United States of America, where it will be subject to the Uniform Commercial Code and amenable to an Article 9 security interest.

A typical exception is allowed for inventory in transit from vendors or suppliers as long as (a) the lender has received appropriate evidence of casualty insurance covering lender, (b) the relevant bill of lading (i) is negotiable, (ii) has been inspected by the lender and found without discrepancies, and (iii) is issued in the name of the borrower and is consigned to the order of the lender, (c) an acceptable agreement has been executed by the lender with the borrower’s customs broker, in which the customs broker agrees that it holds possession of such negotiable bill as agent for the lender and has granted access to such lender to the inventory, (d) the common carrier transporting the inventory is not an affiliate of the applicable vendor or supplier, (e) the inventory has not been procured with the proceeds of a letter of credit issued by the lender, (f) the inventory has been inspected by the borrower (or its agent) before shipment, and (g) the lender has a valid and prior, fully perfected security interest in the inventory, free and clear of all liens of any person (except to the extent, if any, of permitted liens).  

Given these requirements, what could possibly go wrong? The lender has required a negotiable bill of lading consigned to the lender, has formalized its relationship with the customs broker (who has a superior statutory lien if not paid) and has a perfected first priority security interest in the inventory which is owned by the borrower. The potential problem is an unpaid vendor.

Even though the borrower owns the inventory in transit, the borrower’s rights in and to the inventory might still be subject to a right in favor of the vendor to stop the transit of the goods, and to withhold delivery except for cash, under Sections 2-702(1) and 2-705 of the Uniform Commercial Code. The right to stop transit and withhold delivery until the borrower pays cash arises when the vendor discovers the borrower to be insolvent which, of course, is the same time the lender will be concerned that it enjoys the benefit of its intended collateral.

The vendor’s rights under Section 2-702(1) may be exercised even if the borrower has already acquired title to the relevant goods, and the vendor may stop transit without violating the automatic stay under bankruptcy. See, In re National Sugar Refining Company, 27 B.R. 565 (S.D.N.Y. 1983). This gives the vendor some significant leverage with the lender, at least until the borrower obtains “receipt” of the relevant goods. UCC Section 2-705(2)(a). UCC Section 2-103(1)(c) defines “receipt” to mean taking physical possession.

All of this is recognized under the Bankruptcy Code, which also permits vendors to exercise limited reclamation rights and accords administrative priority to claims for payment for goods “received” by the debtor within 20 days prior to the debtor’s bankruptcy filing. Bankruptcy Code Section 503(b)(9).

The administrative priority given to vendors for goods received within 20 days of bankruptcy was added to the Bankruptcy Code in 2005, and presumably has caused vendors to refrain from exercising stoppage in transit rights as they are otherwise protected. In such cases, the lender may get the benefit of the addition of the new goods to its collateral while the vendor is also protected.

There is an important difference between the UCC stoppage right and the Bankruptcy Code administrative priority. While both right are cut off by the debtor’s “receipt” of the relevant goods, the UCC’s definition of “receipt” is not always the proper one to apply. This was the sad lesson learned by the vendor in In re World Imports Ltd., 2014 WL 2750258 (Bankr. E.D. Pa., June 18, 2014). After examining the contracting documents, the court concluded that the sale was governed by the Convention on Contracts for the International Sale of Goods (the “CISG”) (which could have been disclaimed by agreement) and not by the UCC.. The court held that under the CISG, the debtor “received” the relevant goods when they were loaded “free on board” onto the carrier’s ships in China, prior to the 20-day period prior to bankruptcy, and not when they were physically received by the debtor in the USA within the 20-day period.

To encourage vendors to rely on Bankruptcy Code Section 503(b)(9) rather than stoppage in transit or other rights that impair collateral, lenders may want to impose additional requirements on borrowers who want to have in transit inventory from foreign vendors in their borrowing base. A lender may want to have borrowers’ purchase contracts clearly disclaim the CISG and instead be governed by the UCC, or it might require different shipping terms that postpone the time of “receipt.”