SUPPORT SALES WHILE MINIMIZING RISK

By David Balovich

The majority of credit professionals will agree that the function of credit involves two primary goals. First, in its most basic form, the function of credit is to support and promote sales. Secondly, is to protect the organizations second most important asset, the account receivable, by minimizing risk.

Risk is inherent in all credit transactions regardless of the size or reputation of the customer. This has certainly been substantiated during the past eleven years. Since the year 2000 1,721 publicly held companies filed for bankruptcy protection. Included among those have been household names that many of us grew up with and would never have expected to see on a bankruptcy docket. Of greater concern is the total number of business bankruptcy filings, public and private, that have taken place during those eleven years and there does not appear to be any indication that business bankruptcy filings are coming to an end. Since January this year there have been over 190 bankruptices of which 8 were publicly held companies along with 96 of their subsidiaries.

The risk is just as great today as it has been previously in selling on open terms of credit especially to key accounts. The question credit professionals continue to ponder is how do we support sales while minimizing the risk?

One method is to secure the sale and be a secured creditor. Any creditor has the ability to become a secured creditor at any time during the customer-supplier relationship. Secured creditors enjoy advantages over unsecured creditors. In the event the customer files for bankruptcy protection – and even when the customer becomes delinquent - secured creditors have the ability to protect the account receivable by either foreclosing on the pledged assets when delinquent or are often entitled to receive equal value up to the amount of the asset pledged in bankruptcy.

The dilemma that trade creditors often face in becoming secured creditors is two-fold. One, customers are often reluctant to allow trade creditors to become secured creditors.

In some cases, customers are prohibited by their bank or lending institutions from providing assets to trade creditors as collateral. Other customers refuse to pledge assets to creditors on the grounds that if they do it for one creditor they will be obligated to provide security to other creditors if asked.

Secondly, maintaining a secured position can be burdensome on the secured creditor. In addition to filing correctly in the proper jurisdiction, the secured creditor has to make timely amendments to their filings in order to maintain a secured position. For example, continuations have to be filed prior to the expiration date of the filing; should the debtor changes their name, or legal entity, or address, changes to the filing has to be made within a specific period to be valid. If the creditor changes their address than they also have to file amendments reflecting their new address to all of their filings within the minimum specified period otherwise their filings could be ruled invalid if challenged by the customer, another trade creditor (secured or unsecured), or trustee.

Credit professionals have to be creative in finding methods to meet their responsibilities that often require “out-of-the-box” solutions.

One of those solutions may be by utilizing the “consignment sale”. When the word “consignment” is mentioned we often think of one of our neighbor’s driveway on a Saturday morning strewn with many of our other neighbors “stuff” to be sold to neighbors and passers by. At the end of the day the neighbor who hosted the event commonly known as the “garage sale” either returns the unsold “stuff” to the neighbors to whom it belongs or if the “stuff” was sold pays them the proceeds minus a percentage (fee) for handling the transaction. There are also retail consignment stores that do the same but on a much larger scale.

Unfortunately, in the business world, and certainly since the adoption of the Uniform Commercial Code, selling on consignment is more complicated than our neighborhood garage sale. Nevertheless, consignment provides a unique opportunity for the seller (the consignor) to sell to its customer (the consignee) in situations where the consignor would not otherwise consider making the sale.

For instance, in sales to a poor credit risk, consignment gives the seller more protection than the traditional unsecured open account sale. This is not to say that only poor credit risks should be considered for consignment sales. There are many situations where consignment may be a prudent method to sell our goods.

A consignment sale is essentially an arrangement whereby the seller of goods (the "consignor") delivers its goods to the customer (the "consignee") for sale by the consignee to their customer, and the proceeds of the sale being remitted to the consignor. The title to the consigned goods never passes to the consignee, and becomes a "sale or return," rather then the normal “sale on approval” and the seller (consignor) protects its ownership of the inventory from loss to both prior and subsequent perfected secured creditors, including banks, as well as other unsecured creditors including trustees in bankruptcy.

Why Consignment?

Although one of the most common reasons for using consignment, as stated above, is to allow a sale to an otherwise poor credit risk, some other, and even more important, reasons should be considered. Very often the customer (consignee) has entered into a borrowing arrangement with its bank that expressly prohibits taking on additional debt. If additional debt is prohibited, then the taking of a purchase money security interest, a security agreement that is sometimes used in credit risk situations, is not possible because it constitutes debt. Consignment is a way around this because, unlike a purchase money security interest, no debt is ever created by the consignment agreement.

The consignment concept also allows the consignor to control the volume of the inventory, because it is owned by the seller(consignor)and never by the customer (consignee). Since the customer (consignee) has no financial stake in the inventory they are never adversely impacted by any sale that includes introductory merchandise, specialty merchandise, or seasonal merchandise.

Most importantly, in a soft economy or with poor credit risks, it is the right and obligation of the seller (consignor) to protect its inventory against any secured creditors who may otherwise take or claim their inventory in the customer’s possession based upon their "blanket lien" on all of the inventory and proceeds. This same kind of protection of the customer (consignor) will also apply to a trustee in bankruptcy because, generally, once a bankruptcy is filed, all of the unsecured assets of the bankrupt become the property of the estate.

Consigned inventory is always owned by the seller (consignor) and, therefore, is never part of the assets of the bankrupt (consignee).

How to Perfect the Rights in the Consigned Inventory

All too often, a consignment is looked upon as nothing more than a "sale and return." When one delivers inventory to another for the purpose of selling that inventory, but with the right to return unsold inventory, the transaction (unless perfected as set forth hereafter) is nothing more than a sale, making the seller who believed they were a consignor nothing more than a general unsecured creditor. In a true consignment the consignor does not intend a sale to the customer (the consignee) to take place. Title to the goods never passes to the customer, only the ultimate purchaser/user (the consignees customer)creates the sale. The perfection process evidences the legal existence of the consignment agreement.

To perfect the rights of the consignor in the consigned inventory, one must strictly adhere to the terms of Article Nine of the Uniform Commercial Code. First, there should be a formal agreement, a consignment agreement, not unlike a security agreement in a secured transaction.

The consignment agreement sets the rights of both parties and defines their interests, i.e., seller is consignor; customer is consignee; title only passes to third-party ultimate users, etc. Second, notice of the consignment arrangement must be properly given.

The consignor must file or cause to be filed a UCC-1 financing statement, and while a consignment is not a security interest in and of itself, the same type of notice of perfection is required by the UCC, except that the secured party is called "consignor" and the debtor is called "consignee". The financing statement must state that this is "a delivery on consignment." The rules for the filing jurisdiction and time of filing are identical to those for perfecting a purchase money security interest.

The consignor must give prior written notice to all prior holders of security interests where holders filed financing statements covering the same types of goods. A UCC search has to be conducted and those creditors who have a security interest in “inventory” must be notified by certified mail in accordance with UCC-9-324.

The written notice should state that consignor expects to deliver goods on consignment to the consignee and give a description of the goods by item or type. 

When all of these above requirements have been complied with, then all inventory delivered by consignor to consignee will be protected against any parties who may claim a right in the consigned inventory under a previous filed security agreement. Any consigned inventory delivered before all perfection steps are completed will be subject to the claims of prior perfected secured creditors. All inventory delivered after perfection is protected against claims of prior secured creditors.

Even if the consignor fails to give prior written notice to existing secured parties, but has filed UCC 1 financing statements, all subsequent secured parties after the consignment filing will have their interests subject to that of consignor. The consignor further has a right to all of the identifiable cash proceeds received on or before delivery of the consigned inventory to an ultimate buyer. 

It must be clearly understood that a third-party purchaser, the customer’s customer, who purchases the consigned inventory in the ordinary course of business will defeat any ownership rights of the consignor.

 "Ordinary" means just that and does not include, for example, such parties as bulk sale purchasers, assignees for the benefit of creditors, and trustees in bankruptcy.

Advantages of Utilizing a Consignment Program

If properly perfected, as described above, title to the inventory does not pass to the customer (consignee). Therefore, no rights of secured creditors, unsecured creditors, bankruptcy trustees and assignees for the benefit of creditors, to name a few, can be asserted against the consigned inventory.

Additionally, since title to the inventory never passes to the consignee, the seller (consignor) is not a secured creditor in bankruptcy who could be subject to cram-down or payment schedules. In fact, the consignor is entitled to the return of their inventory or payment for same, unlike the secured creditor or even a reclaiming creditor, where the relief might only be a super priority lien or claim. 

Disadvantage of Using a Consignment Program

Because selling on consignment is not actually a sale, with neither right to payment nor creation of a receivable until the consignee sells the inventory to their customer, the consignor must treat the consigned inventory as if a sale has not taken place. This distinction between creation of a receivable and merely having off-site inventory can have tax and profit consequences.

Having said that, the consignment can still be utilized to support sales in fulfilling a large order whether the customer is a risk or a key account. For example, a customer places an order for a million dollars and the acceptable risk for whatever reason is two hundred fifty thousand. Utilizing a consignment agreement we can ship the $250K and immediate book the sale and ship the balance of $750K on consignment and record the additional sale as the goods are sold. It is a win-win for everyone. The customer gets the product, sales gets an immediate sale and will eventually get credit for the entire sales amount and the company’s asset is protected.

Purchase Money Security Interest Versus Consignment

The Uniform Commercial Code has the same perfection requirements, and timing of same, for purchase money security interests (PMSI) and consignment, with the only significant difference being in the meaning of each. A PMSI is a sale, with the seller retaining a security interest in the inventory to secure payment.

A consignment is not a sale to the consignee, because no sale takes place until the consignee sells the inventory to its customer. In a consignment the seller retains ownership in the goods rather than a security interest.

A PMSI requires a written agreement not unlike a consignment agreement. The exception is that in a Chapter 11 reorganization, the court might determine that the secured inventory (as distinguished from consigned inventory) is essential to the successful reorganization of the bankrupt and grant a priority lien or similar secured position in the bankruptcy and not allow recovery of the inventory. This is a logical conclusion, because with a PMSI the bankrupt party and ultimately the trustee is the owner of the inventory. This is not the case in a consignment because title to the goods never passed between seller and buyer and therefore the seller (consignor) is entitled to the return of its goods.

Consignment is not THE answer to selling to risk customers or minimizing risk in a poor economy. It is, however, an option the credit professional has available to consider whether or not to use. It is not the intention of this article to make the argument to utilize consignment but rather provide the reader the information to determine if it is a useful alternative that can be used in their organization.

I wish you well.

David Balovich is an author, credit consultant, educator, and public speaker.
He can be reached at 3jmcompany@gmail.com or through the Creditworthy website.