NEW YORK, NY - On November 26, 2008, Big box retailer bankruptcy filings are expected to mushroom following predicted tepid holiday sales this year, posing vexing challenges for their suppliers.

During good times or bad, large retailers typically apply leverage over the supply chain and dictate terms to vendors large and small. These terms may include supplying goods on consignment. In retail sectors like jewelry, consignments are fairly common, yet just as frequently flawed in execution. With ad hoc consignment agreements in place, suppliers freely turn over millions of dollars worth of goods to customers' stores and warehouses.

At the same time, suppliers too often fail to do what is necessary to protect their goods and receivables. It follows they may unwittingly forfeit their right to get paid or reclaim goods from financially troubled customers.

Despite the obvious risk to suppliers, consignment offers an overwhelming advantage to financially strapped retailers: no payment need be made until the goods are sold. When credit is tight, cash is king. From the retailer's perspective, bringing in truckloads of inventory on consignment conserves cash and avoids tying up scarce working capital.

That's all well and good for the retailer. Suppliers, on the other hand, may presume their goods are automatically protected from claims of the retailer's creditors. This assumption is simply wrong. Under the Uniform Commercial Code (UCC), consigned goods-even if sold on memorandum and never owned by the retailer-remain at risk unless UCC rules are strictly followed.

The UCC's consignment rules are anything but intuitive. Is the shipment a true sale or a consignment? What do the parties intend? Who are to be notified of the shipment? Where and how is the UCC filed? How are the goods described? What due diligence investigation must be completed?

The UCC defines consignment as an arrangement where:

A supplier delivers goods worth more than $1,000 to a merchant;

The merchant deals in similar goods but under a different name;

The merchant is neither an auctioneer nor generally known by creditors to be substantially engaged in selling such goods;

The goods are not consumer goods immediately before delivery; and

The arrangement does not create a security interest for the payment of money. UCC 9-102.

For the transaction to be considered a true consignment, the UCC requires the consignor to create a "purchase money security interest" (PMSI) in the inventory. UCC 9-103 (d).

The UCC treats consignments differently from other sales, offering the consignor PMSI rights and priority over earlier filed security interests. By permitting the consignor to trump the retailer's secured lenders, suppliers are encouraged to sell goods to retailers without worry of ensnarement in filed liens of the retailer's lenders.

To establish and maintain lien priority, the UCC requires consignors to take three steps before delivery to the retailer:

File a UCC financing statement in the proper location;

Send authenticated notices to holders of prior security interests; and

Fully describe the goods and state seller has or expects to acquire a PMSI in those goods. UCC 9-324 (b).

When it comes to filing and perfection, the devil is in the details. Spelling counts. And of course the financing statement must be filed in the proper location. Mistakes can be fatal. In addition, the financing statement and authenticated notifications must be renewed every five years. UCC 9-515.

In short, consignors must follow the same rules as other secured lenders to establish a security interest in consigned goods and maintain lien priority.

What happens if the rules are ignored, and the customer seeks bankruptcy protection? The consignor will likely lose control of its goods. Without crossing the T's and dotting the I's, the consigned goods may be sold off as part of retailer's assets to satisfy the claims of its other creditors.

To make matters worse, the supplier may further lose lien rights on any sale proceeds, and get treated like other unsecured creditors. Not a good result.

To avoid getting kicked to the curb, suppliers are well advised to carefully review their consignment programs and protocols with experienced creditor's rights counsel before their customer's bankruptcy notice arrives in the mail.

About the author
Richard E. Weltman is a principal of Weltman & Moskowitz, LLP, a business law firm focusing on creditor's rights and bankruptcy, state and federal trials, business divorce, mediation, cyberlaw, and transactional matters. He serves clients in New York and New Jersey