Pity the Poor Consignor: Term Loan Lender Prevails

July 23, 2021 | Industry Insights, News, 

July 2019 – Stephen Selbst

In TSA Stores, Inc. v. Sport Dimension, Inc., the United States Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”) recently held that a term lender with a junior lien on the debtor’s inventory prevailed over a consignor that had failed to perfect its security interest under the Uniform Commercial Code (the “UCC”).1 The decision drives home a reminder that consignors who fail to perfect will not find courts sympathetic to protecting their interests. In TSA Stores, the Bankruptcy Court relied on a non-statutory rule for determining whether a consignor’s goods would be exempted from the filing requirements, but one which most consignors will be not be able to satisfy.

Under the UCC, a consignor is granted a purchase money security interest in consigned goods, but to perfect it must (1) send notice to other creditors with a lien on inventory at least ten days prior to the consignor’s first shipment, and (2) file a UCC financing statement. While those requirements are not onerous, the steady drumbeat of cases shows that consignors frequently fail to comply. When their consignees file for bankruptcy, the consignors’ claims have general unsecured status, which is disastrous. In many recent retail bankruptcy cases, holders of unsecured claims have received very small – or no – distributions on their claims.

Under the UCC, a consignment is any transaction where a seller delivers goods to a merchant for resale, but the statute excludes cases in which the merchant is generally known by its creditors to be substantially engaged in selling the goods of third parties. The case law also excludes cases where the non-consignor party had specific knowledge that the goods in dispute were consigned.

TSA Stores Background

TSA Stores arose from the chapter 11 proceedings of The Sports Authority (“TSA”), which filed in 2016. Although TSA had sales of approximately $2.6 billion in 2015, it could not reorganize and liquidated in 2016. Sport Dimension sold water sports related equipment to TSA under the name Body Glove. It began its relationship with TSA in the 1990s. Around 2011, Sport Dimension began selling on consignment to TSA under a program known as “pay on scan.” Under pay on scan, the consignor retained title to the consigned goods and was paid when the goods sold. Many of TSA’s vendors participated in its pay on scan program. When TSA filed for chapter 11, it held $84 million of consigned goods from 170 vendors, meaning that the average consignment was approximately $500,000. According to TSA Stores, some vendors had complied with the UCC perfection requirements while others, including Sport Dimension, had not.

TSA Stores Dispute

After TSA filed, it requested authority from the Bankruptcy Court to sell all its’ inventory, including the consigned goods. The consignors objected, arguing that they held title and that the goods could not be sold without their consent. Ultimately, the Bankruptcy Court allowed the consigned goods to be sold but required TSA to commence litigation to resolve the rights of each consignor.

Prior to bankruptcy, TSA had two tiers of secured financing, a first-lien facility where the lenders had a first lien on accounts receivable and inventory, and a second-lien facility where the lenders had a first lien on TSA’s real estate and a junior lien on the accounts receivable and inventory. The liquidation of TSA generated enough money to pay the first-lien lenders, but not enough to pay the second-lien lenders. When TSA commenced litigation against Sport Dimension, Wilmington Savings Fund Society (“WSFS”), the agent for the second-lien lenders, intervened to protect the second-lien lenders.

In the litigation, WSFS relied on the lien priority provisions of the UCC. It argued that it had perfected its security interest in TSA’s inventory and that its interest was superior to Sport Dimension’s because Wilmington Security had filed first. Sport Dimension argued that the UCC’s priority rules did not govern because its transactions with TSA were outside the UCC’s definition of a consignment. Specifically, it argued that TSA was substantially engaged in selling the goods of third parties, and that WSFS had knowledge that TSA was selling Sport Dimension goods. WSFS argued that the consigned inventory amounted to 14% of TSA’s goods, an amount insufficient for “substantial engagement”, and that it had no specific knowledge of Sport Dimension’s goods being sold on consignment.

In ruling for WSFS, the Bankruptcy Court held that the 14% of TSA inventory represented by consigned goods fell below the 20% threshold that prior cases had established for the “substantially engaged” test. Although the 20% test is not contained in the UCC, several courts have adopted that rule, and there are cases where courts have held that inventory levels below 20% did not meet the “substantially engaged” test. On the second issue, the Bankruptcy Court recognized that WSFS was aware that TSA was selling goods on consignment. But it found that Sport Dimension had failed to prove that WSFS had specific knowledge that its products were being sold on consignment, and it also ruled against Sport Dimension on the second exception to the UCC’s definition of a consignment.

TSA Stores relied on existing case law to back its “substantially engaged” determination, and it found that Sport Dimension had failed to prove WSFS had knowledge of its consignment. On that level the decision is straightforward, but it remains troubling. First, the 20% test is not found in the statute or in its official notes. A more sympathetic court could have found that a retailer that had $84 million of consigned goods– not a trivial amount — when it filed for bankruptcy was “substantially engaged” in selling consigned goods. Secondly, the record established that WSFS had knowledge that TSA was selling consigned goods. To require Sport Dimension to prove that WSFS had specific knowledge of its goods, when there were 170 vendors selling on a consignment basis is extremely difficult. A more sympathetic court could have found that based on WSFS’s knowledge of TSA’s widespread consignments, the court could impute knowledge of each vendor imputed to WSFS.

There are also strong policy arguments to support a ruling in favor of Sport Dimension. When the consignment rules were developed in the mid-20th century, the theory behind requiring UCC filings was to prevent the existence of “secret liens” that would fool unsuspecting trade creditors into believing the merchant had title to the consigned goods, which was called “ostensible ownership.” Those arguments reflected the market of the times when few retailers operated multiple locations and generally did not obtain secured inventory financing.

Today’s retail marketplace is vastly different. Inventory-based secured financing is now the norm. In the 15 largest U.S. retail bankruptcy cases, the size of the debtors, measured by asset size, ranged from $1.7 billion to $14 billion.Those retailers operated hundreds of locations and each had secured inventory financings. Even if the ostensible ownership rationale had force initially, its basis disappeared long ago. Lenders who make loans to retailers today are not relying on visual assessments of inventory. They receive financial statements and detailed information regarding inventories from their borrowers. Lenders know consigned inventory cannot be carried as an asset on borrowers’ balance sheets because the borrowers don’t hold title to these assets. Accordingly, lenders do not rely on consigned inventory in making loans. Moreover, because these lenders have blanket liens on their borrower’s assets, they comply with the UCC’s filing procedures, which provides actual notice to other creditors that the borrower’s inventory is subject to a lien. Given their detailed knowledge of their borrowers, the ostensible ownership theory does not support protecting these lenders from a consignor’s “secret liens.” The ostensible ownership theory also fails to make a persuasive case for why a junior secured creditor like WSFS should benefit from the avoidance of a consignor’s unperfected security interest. It didn’t lend against the consigned inventory, and it knew of TSA’s reliance on consignment sales. That WSFS didn’t know the names of the specific consignors is a happenstance, but one that resulted in it receiving a windfall that it never bargained for.

TSA Stores joins a line of recent cases where consignors who have failed to perfect their security interests have lost in their attempts to avoid the harshness of the UCC’s consignment provisions. While there are reasons to question both the Bankruptcy Court’s analysis and the underlying policies behind the filing requirements, consignors who fail to file UCC financing statements are likely to fail in their challenges. The lesson to consignors is clear: perfect your interest before starting to ship goods on consignment or suffer the consequences.

For more information on this alert or other restructuring & bankruptcy matters please contact:

Stephen B. Selbst at +1 212 592 1405 or sselbst@herrick.com

© 2019 Herrick, Feinstein LLP. This alert is provided by Herrick, Feinstein LLP to keep its clients and other interested parties informed of current legal developments that may affect or otherwise be of interest to them. The information is not intended as legal advice or legal opinion and should not be construed as such.

1.TSA Stores, Inc. v. Sport Dimension, Inc., case 16-50368 (MFW) (April 12, 2019).