By Joshua Levin-Epstein, Esq.
Jewelry manufacturers who seek to recover their assets from retailers who have gone bankrupt face special challenges, in large measure due to the reliance on memorandum transactions — the customary industry practice in which jewelry suppliers provide goods to retailers on consignment. The legal standing of consigned goods in a jewelry company’s bankruptcy heightens the risks associated with memorandum transactions and complicates the recovery of consigned goods. The purpose of this article is to: (1) provide an understanding of the consequences of improperly documenting memorandum transactions; (2) explain the risks associated with memorandum transactions in bankruptcies; and (3) advise on the protection and perfection of the consigned vendors’ interest in its collateral.
Since the Great Recession, the geographic and economic diversity of jewelry companies that have filed for bankruptcy demonstrates jewelry companies’ vulnerability to liquidity crises and sustained economic downturns. In the aftermath of the Great Recession, the list of jewelry companies that filed for bankruptcy included jewelry companies across the economic spectrum that ranged from high-end, specialty retailers, such as Fred Leighton, to jewelry companies that concentrate on the general public, such as Fortunoff and Ultra Stores, Inc. From 2008 to 2012, the list of bankrupt jewelry companies included: Shane Company, Michael Beaudry Inc., David Webb, Inc., Friedman’s Inc., Crescent, Arrowhead Jewelry, Dia Deb International, Whitehall Jewelers, and Christian Bernard. For jewelry professionals, then, it is important to understand the risks associated with memorandum transactions.
The Reasons for Jewelry Bankruptcies and Failures
The reasons for jewelry company bankruptcies include corruption and fraud, liquidity crises in periods of economic difficulty, increased international competition due to the rise of online shopping, increased costs of precious metals and gemstones, and economic downturns that limit demand for luxury and non-essential purchases. The failures of jewelry companies are particularly pronounced during recessions. In fact, during the Great Recession 1,300 US jewelry businesses closed in 2008, and 900 US jewelry businesses closed in 2009. In the failure or bankruptcy of jewelry businesses, the creditors’ recovery of consigned goods is fraught with legal obstacles, challenges, and frustration.
Special Problems in a Jewelry Business Bankruptcy
While the reasons for the bankruptcies and failures of jewelry companies vary, the difficulty in locating, identifying, and repossessing consigned goods is a common problem for consignment vendors. Due to the nature of the jewelry business, which includes the shipment of fungible goods overseas, customary business practices of consignment transactions, and a dependency on bank financing to fund operations, suppliers must contemplate the challenge of repossessing goods from a bankrupt or failed jewelry enterprise. The type of failure of a jewelry company is significant because different laws apply depending on whether the failed enterprise commences bankruptcy proceedings, which are governed under federal law, or winds down outside of federal court.
The special problems in a jewelry business failure center on the legal challenges involved in the suppliers’ establishment of rights and title to its consigned goods. To the astonishment of consignment vendors that are unaware of the laws governing consignment transactions, the consignee may have the right to use the consigned goods as collateral in loan transactions. For example, in a bankruptcy case, a bank that financed the bankrupt jewelry business’s day-to-day operations may assert that the proceeds of the consigned goods constitute collateral of the bank, not the consignor. In a real world example of the failure to properly document the consignment transaction, in In re: Morgansen’s, the bankruptcy court authorized the bankruptcy trustee to auction the bankrupt jewelry company’s consigned goods, over the consigned vendors’ objection, because the consignment vendors failed to execute the appropriate legal documents. The financial consequences of the failure to properly document a memorandum transaction are potentially catastrophic.
The adversarial nature of bankruptcies pit creditors against each other in a contest for priority of payment and distribution of payment. The failure to properly document the memorandum transaction may result in several undesirable scenarios, such as other creditors leapfrogging the creditor that improperly perfected its interests in consigned goods, a bankruptcy trustee auctioning the consigned goods at a bankruptcy fire-sale over the objection of the consignment vendor, or other undesirable scenarios. The purpose of the proper documentation of the consignment transaction is to elevate the consignment vendor’s legal status to secured creditor status.
In a bankruptcy case, the difference in legal classification between a secured and unsecured creditor can mean the difference between getting paid and not getting paid.
The Bankruptcy Code includes a federal statutory scheme for the priority and distribution of payment that generally provides payment for secured creditors ahead of unsecured creditors, known in bankruptcy jargon as the “absolute priority rule”. As a corollary to the “absolute priority rule”, the Bankruptcy Code provides for the equal treatment of similarly situated creditors. For example, general unsecured creditors receive a pro rata distribution of funds that are left over after secured claims have been satisfied. The main concern for consignment vendors in bankruptcies is the potential classification as an unsecured creditor.
The Advantages of Properly Documenting a Consignment Transaction
The proper documentation of the consignment transaction enhances the consignment vendor’s legal status, in a bankruptcy case, vis-a-vis other creditors. In a bankruptcy case, the legal advantages for a consignor in the proper documentation of a consignment transaction include: (i) the prevention of other creditors asserting judicial liens and security interests in the consigned goods, (ii) the establishment of the consignor’s status as a secured creditor by virtue of its perfected security interest in the consigned goods, (iii) the priority of payment and distribution of proceeds in a bankruptcy case, and (iv) the ability to repossess the goods. From a practical business standpoint, the enhancement of the consignment vendor’s legal status heightens the probability of a greater financial recovery in a bankruptcy case.
Tell-tale Signs a Jewelry Business is Experiencing Financial Difficulties
The suppliers’ careful monitoring of retailers’ creditworthiness is an essential measure to safeguard memorandum transactions. Prior to entering into an agreement for a memorandum transaction, the supplier should examine the customer for tell-tale signs of financial difficulties, as follows: (i) the initiation of lawsuits for failure to pay taxes; (ii) the initiation of lawsuits for failure to pay vendors; (iii) the assessment of the customer’s financial health; (iv) the review of jewelry industry specific resources, such as The Jewelers Board of Trade, for customers’ creditworthiness; (v) the review of Uniform Commercial Code (UCC) filings, credit reports, such as Dun & Bradstreet reports, and, for public companies, the review of filings with the Securities and Exchange Commission. The consignment vendor’s performance of due diligence should continue throughout the duration of the business relationship.
In the period following the agreement for a memorandum transaction, the supplier should continue to monitor the customer for indications of financial difficulties, as follows: (i) a change in customer payment habits; (ii) the failure of the customer’s check to clear; (iii) a change in
the customer’s purchase habits, and (iv) signs of impaired cash-flow and profitability, such as employee lay-offs, decreased advertising, and major changes in business strategy. With respect to changes in business strategy, for example, large jewelry companies contemplating bankruptcy may purchase unusually large quantities of goods prior to the initiation of a bankruptcy proceeding in order to garner greater cash flow in the immediate post-bankruptcy period. Taken together, the suppliers’ careful monitoring of retailers’ creditworthiness and prophylactic legal planning are important safeguards for memorandum transactions.
Documenting a Memorandum Transaction
As a further precautionary measure for memorandum transactions, the appropriate legal documents are critical for protecting suppliers’ interests in the event of a bankruptcy or failed jewelry business. Without the proper legal documentation, the supplier is at risk of the bankruptcy court’s issuance of unfavorable legal determinations concerning: (i) the title of the consigned goods and (ii) the suppliers’ security interest in the consigned goods. The bankruptcy court’s determination that a consignment vendor is simply an unsecured creditor severely impairs the vendor’s potential recovery.
The proper legal documentation of a memorandum transaction includes: (i) a consignment or memorandum agreement that includes all of the required terms and conditions to qualify as a legally enforceable consignment agreement; (ii) a UCC-1 financing statement, and (iii) notice to creditors who holding perfected liens prior to the filing of the UCC-1 financing statement.
The Consignment Agreement
Consignment agreements are generally governed under Article 9 of the Uniform Commercial Code, which is a set of model laws for commercial transactions that most states have adopted. Section 9-102(a)(20) of the Uniform Commercial Code defines “consignment” as follows:
“Consignment” means a transaction, regardless of its form, in which a person delivers goods to a merchant for the purpose of sale and:
(A) the merchant:
(i) deals in goods of that kind under a name other than the name of the person making delivery;
(ii) is not an auctioneer; and
(iii) is not generally known by its credi
tors to be substantially engaged in selling the goods of others;
(B) with respect to each delivery, the aggregate value of the goods is $1,000 or more at the time of delivery;
(C) the goods are not consumer goods immediately before delivery; and
(D) the transaction does not create a security interest that secures an obligation.
A consignment agreement must include all of the terms and conditions set forth in section 9-102(a)(20) of the UCC for the consignment transaction to qualify as a legally enforceable consignment agreement. Section 9-319 of the UCC, in turn, provides that, unless the consignment vendor “perfected” its security interest in the consigned goods, the consignee is deemed to have “rights and title to the goods identical to those the consignor had.” The import of section 9-319(a) of the UCC is that, where no perfected security interest exists, the consignee has the identical rights to the consigned goods as the consignment vendor. The practical business implications of UCC section 9-319(a), for example, permit the consignee to use the consigned goods for collateral for a bank loan.
The UCC-1 Financing Statement and Notice to Existing Creditors
A UCC-1 financing statement is also an essential legal form in the perfection of the consignment vendor’s security interests. To perfect its interests in consigned goods, consignment vendors should: (i) file a UCC-1 financing statement, which is a legal form that provides public notice that the consignment vendor has legal title to the goods, putting future creditors on notice as to the consignment vendors security interest; and (ii) provide notification letters of the UCC-1 financing statement to the consignee’s existing creditors, putting existing creditors on notice that the consigned goods are not property of the consignee. The purpose of the consignment agreement and UCC-1 financing statement is to establish a security interest in the consigned goods and ensure that the memorandum transaction qualifies as a “consignment” transaction in accordance with the governing law.
While memorandum transactions inherently include a degree of risk, consignment vendors have the ability to lessen certain of the legal risks associated with memorandum transactions through proper documentation of the loan transaction. Through the proper execution of the consignment agreement, UCC-1 financing statement, and the UCC-1 financing statement notice, the consignment vendor can mitigate the risks inherent in consignment transactions.