Sports Authority and Consignments: Lessons for Lenders and Vendors

A Delaware bankruptcy court (the “Court”) recently considered conflicting security interest claims of (i) a vendor that manufactured and consigned goods to a merchant that later filed for bankruptcy, and (ii) a secured lender that had a perfected lien on inventory and proceeds. The decision has important lessons relating to consignments.

Summary

The consignor failed to file a financing statement to perfect its security interest in inventory sold by the Debtors on consignment. Lenders filed a financing statement on inventory and its proceeds. In TSA Stores, Inc. v. Sport Dimension Inc. (In re TSAWD Holdings, Inc.), 2019 Bankr. LEXIS 1181 (Bankr. D. Del.) (“TSA”), Bankruptcy Judge Mary F. Walrath determined that the lender’s interest was superior to the consignor’s; a consignment exception to the Uniform Commercial Code (“UCC”) priority rules did not apply; and the consignor was required to disgorge proceeds of the consigned goods at issue.

Factual Background

On March 2, 2016 (the “Petition Date”), The Sports Authority Holdings, Inc. and its affiliates (collectively, the “Debtors”) filed voluntary bankruptcy petitions under chapter 11. In 2006 the Debtors entered into a secured financing facility including a term loan which, following a 2010 refinancing, aggregated $300 million. B was the original administrative agent for the Term Loan lenders and was succeeded in that capacity by W on December 31, 2015 (the “Term Loan Agent”).

As part of their business, the Debtors developed a program for the sale of goods on consignment. The Debtors paid participating vendors either a fixed amount for each item sold or a percentage of the retail sales price. SD (“Consignor”) manufactured athletic apparel and entered into the Debtors’ consignment program in 2011. Consignor did not file a UCC-1 to cover the goods it provided to the Debtors on consignment until approximately one month prior to the Petition Date.

Early in the bankruptcy case, the Court allowed the Debtors to sell consigned goods held in inventory but preserved the Term Loan Agent’s right to recoup payments made to consignors from the sale of consigned goods if it was determined that the Term Loan Agent had a superior security interest.

On March 16, 2016, the Debtors commenced an adversary action against Consignor seeking declaratory relief on competing claims to inventory, and its proceeds, sold by the Debtors on consignment from SD (the “Disputed Goods”). The Term Loan Agent intervened, seeking declaration that its perfected security interest was senior to Consignor’s interest in the Disputed Goods and disgorgement of proceeds paid to SD. Consignor answered and counterclaimed seeking declaration that the Term Loan Agent’s security interest did not attach to the Disputed Goods and, if it did, that W’s security interest was subordinate to SD’s. On September 10, 2018 the parties filed cross-motions for summary judgment seeking a determination of their respective interests in the Disputed Goods.

Issues

The Court examined four questions relating to the consignment: first, did UCC Article 9 govern priority in the Disputed Goods; second, what constituted “actual knowledge” of “substantial engagement” in consignment sales; third, did the Term Loan Agent have actual knowledge of the specific consignor; and, fourth, which security interest, that of the Term Loan Agent or that of Consignor, had priority?

Did UCC Article 9 govern the priority in the Disputed Goods?

The Term Loan Agent stated that Article 9 governed priority in the Disputed Goods and that its security interest was filed first. Consignor countered that Article 9 did not govern because the Disputed Goods did not satisfy the UCC definition of “consignment.”

UCC Section 9-102(a)(20) defines “consignment” as a transaction in which a person delivers goods to a merchant for sale and, in relevant part, the merchant “is not generally known by its creditors to be substantially engaged in selling the goods of others” (the ”Exception”).[1]

Judge Walrath explained that the Exception could be satisfied – meaning that the consignment would be outside of Article 9 – if (1) Consignor could show that Sports Authority’s creditors generally knew that Sports Authority was substantially engaged in selling the goods of others, or (2) Consignor could prove the Term Loan Agent actually knew that Sports Authority was selling the specific consignor’s consigned goods.

The Term Loan Agent argued that its knowledge about consignments was not relevant or material to its duties as agent, which were limited under the loan agreement. Consignor argued that knowledge of the competing liens was material to the agent’s duties and, therefore, imputable to the lenders.[2]

The Court rejected the Term Loan Agent’s argument, stating “It was clearly within the scope of the Term Loan Agent’s duties to ascertain what other interests existed on property that it was taking as security for the Term Loan.”[3]

Consequently, the Court concluded that, if the Term Loan Agent (i) had actual knowledge that the Debtors were substantially engaged in selling the goods of others or (ii) had actual knowledge of Consignor’s specific consignment relationship with the Debtors, then such knowledge would be imputed to the lenders.[4]

What constitutes “actual knowledge” of “substantial engagement” in consignment sales?

Consignor and the Term Loan Agent stipulated that the Debtors’ total inventory never included more than 14% of consigned goods. Consignor maintained that the Term Loan Agent had actual knowledge that the Debtors were “substantially engaged” in consignment sales and that 14% of inventory being consigned goods was sufficient to prove substantial engagement in consignment sales. The Term Loan Agent explained that the Debtors never were “substantially engaged” in consignment sales, which required at least 20% of the Debtors’ inventory consisting of consigned goods.

Relying on prior Delaware bankruptcy court decisions, the Court rejected Consignor’s argument and held that the threshold for “substantial engagement” was satisfied only if consigned goods comprised 20% or more of the value of the Debtors’ inventory. The Court also determined that Consignor failed to prove that the Term Loan Agent actually knew the Debtors were “substantially engaged” in selling consigned goods.[5]

Did the Term Loan Agent have actual knowledge of the specific consignor?

Consignor contended that the Term Loan Agent’s actual knowledge that “some” portion of the Debtors’ inventory included consigned goods was sufficient to satisfy the Exception. Consignor argued the lenders had actual knowledge of other consignments, as evidenced by a loan agreement schedule listing other consignors, the Debtors’ audited financials identifying consigned inventory of other consignors, and the UCC-1 filings of several other consignors. The Term Loan Agent maintained that actual knowledge of either “substantial engagement” or of the specific consignor was required to satisfy the Exception.

The Court agreed with the Term Loan Agent and concluded that neither prong of the Exception had been satisfied and, therefore, that Article 9 governed the parties’ priorities.[6]

Did the Term Loan Agent or Consignor have priority?

Under UCC Section 9-322(a), the first to file generally has priority over a later filed security interest. However, UCC Section 9-324(b) provides an exception for a party who obtains a purchase money security interest (“PMSI”), such as a consignment interest, in inventory collateral that is subject to a prior perfected security interest.[7] Under UCC Section 9-324(b), a consignor, as the later filing PMSI-holder, may obtain a priority interest in inventory it delivers to the consignee if, among other things, the consignor “sends an authenticated notification to the holder of the conflicting security interest” timely.[8]

Consignor filed a UCC-1 financing statement on January 25, 2016, creating a PMSI in inventory delivered to the Debtors on consignment after that date. Consignor provided notices of its UCC-1 filing that same day to a number of the Debtors’ creditors, including B who was the predecessor Term Loan Agent, but not W. Consignor asserted that it had satisfied the requirements of section 9-324(b) and its security interest had priority over the Term Loan Agent’s prior perfected interest.

The Term Loan Agent argued that Consignor’s notice to B, the predecessor Agent, failed to satisfy the UCC’s notice requirement. To satisfy the notice requirement, a consignor must send notifications to the addresses of other secured parties that appear on their respective UCC-1s.[9] When Consignor notified B (January 25, 2016), W, as successor Term Loan Agent, had already filed an amended UCC-1 reflecting its address (December 31, 2015).

The Court agreed with the Term Loan Agent, noting that Consignor provided no legal authority to support its assertion that proper notification had been made by the notice sent to the predecessor agent.[10] The Court concluded that Consignor had failed to satisfy the requirements of section 9-324(b) and, consequently, the Term Loan Agent’s lien had priority.[11] The Court therefore ordered that W’s motion for summary judgment be granted, SD’s motion for summary judgment be denied, and SD to disgorge to W all proceeds of the Disputed Goods that SD had received to date.[12]

Conclusions

The TSA decision has lessons and reminders for market participants engaged in consignment transactions, including:

• A merchant selling goods on consignment should file appropriate UCC-1 financing statements as soon as possible, ideally when the consignment sales commence, and give proper notice to all secured creditors of record.
• A secured lender will want to keep its UCC-1 financing statements current and also monitor filings of other creditors of borrower.
• An administrative agent for lenders will want to be attentive to other interests in property constituting security for the loan.
• Although not required to be addressed by the TSA Court, if Consignor had given proper notice to W, rather than the predecessor Term Loan Agent, the Court might have had to consider whether Consignor’s UCC-1, filed one month prior to the Petition Date, could be attacked as an avoidable preference.
• A secured lender may also wish to monitor whether and to what extent borrower’s inventory includes consigned goods and whether safeguards exist if a borrower is “substantially engaged” in selling consigned goods or if the lender actually knows about a specific consignor.
• A retailer that sells consigned goods and also borrows money on a secured basis may want to consider how those arrangements might affect its business and its ability to access credit and maintain inventory for sale.

Douglas Schneller handles a broad range of complex transactional matters involving bank finance and lending; restructuring, bankruptcy and insolvency; inter-creditor and subordination arrangements, including for mezzanine, leveraged, multi-lien and unitranche financings; claims analysis and reconciliation; and purchases and sales of par and distressed assets such as bank loans, notes, accounts receivable, trade claims, bankruptcy claims, and equity interests. Read more about Douglas.