SUPPORT SALES WHILE MINIMIZING RISK
By David Balovich
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
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.
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?
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
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.
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.
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.
professionals have to be creative in finding methods to meet their
responsibilities that often require “out-of-the-box” solutions.
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.
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.
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.
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.
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.
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.
inventory is always owned by the seller (consignor) and, therefore, is
never part of the assets of the bankrupt (consignee).
Perfect the Rights in the Consigned Inventory
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
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.
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.
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
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.
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.
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
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
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
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.
Money Security Interest Versus Consignment
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.
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
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
can be reached at
email@example.com or through the Creditworthy website.