In re TSAWD Holdings, Inc. (Bankr. D.Del.) – Consignor Whose Financing Statement Had Lapsed Still Prevails Over Lender Due to Lender’s Actual Knowledge of Consignment Relationship

The following is a case update prepared by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, analyzing a recent decision of interest:

SUMMARY:

A bankruptcy court in Delaware has held that a consignor whose financing statement had lapsed nevertheless prevailed over an inventory lender due to the lender’s actual knowledge of the existence of a consignment relationship. [In re TSAWD Holdings, Inc., 2018 Westlaw 6839743 (Bankr. D.Del.).]

Facts: A vendor sold goods to a retailer on consignment. Although the initial shipment was covered by a UCC-1 financing statement, the vendor never filed a continuation statement. After that initial financing statement was filed, the retailer borrowed approximately $1.1 billion, secured by a lien on its inventory. By the time the retailer filed a bankruptcy petition, roughly 11% of its business was done on consignment.

Following the bankruptcy, the lender brought suit, seeking disgorgement of the sales proceeds received by the consignor. The lender contended that the original financing statement filed by the consignor had lapsed and that the lender’s lien attached to all of the goods held for sale by the retailer, including goods sold on consignment. Both parties moved for summary judgment, and the court ruled in favor of the consignor.

Reasoning: The consignor argued that the lender was aware of the consignment relationship. The court first discussed §9-102 of the UCC:

Under section 9-102(a)(20), an arrangement is not a consignment subject to the priorities of the UCC if a consignor can show that the consignee’s creditors generally knew that it was substantially engaged in selling consigned goods . . . . If that is the case, then the consignee’s creditors cannot obtain a lien or other interest in the consigned goods.

The court then noted that there was a case-made extension of that rule:

In addition, some courts have held that Article 9’s priority rules will not apply vis-a-vis another secured creditor if it had actual knowledge that goods were held on consignment when its security interest was granted . . . .

The reasoning of those courts is that the UCC policy of protecting creditors from the “secret lien” of a consignor is not implicated if the creditor in question has actual knowledge of the consignor’s lien. The courts note that if a creditor’s constructive knowledge of a consignment lien (from the filing of a UCC financing statement or from the fact that other creditors generally know the debtor is selling consigned goods) is sufficient to give the consignor priority, it would be absurd to conclude that actual knowledge of the consignment is not sufficient . . .

The court acknowledged that there were some cases to the contrary but elected to follow the “actual knowledge” rule. As applied, the court held that the lender in this case did have knowledge of the consignment arrangement because the consignor’s interest in the property was designated as a “permitted lien” in the loan documents.

Author’s Comment: If the drafters of the UCC had wanted to make the actual knowledge of a lender relevant to a priority dispute with a consignor, the drafters would have said so. They did not. The only statutory basis for considering the parties’ knowledge is whether the consignee’s creditors, considered as a group, generally knew that it was substantially engaged in selling consigned goods. Here, there was no proof of that fact. Nor is it clear that the retailer was “substantially” engaged in consignment sales, since only about 11% of its sales were on consignment.

Further, I disagree with the court’s statement that it would be absurd to disregard a lender’s subjective knowledge while imposing “constructive notice” in favor of a consignor that files a financing statement. The key difference is that an inquiry into who knew what and when is expensive, messy, and difficult. By contrast, an inquiry into whether a certain document was filed by a certain date is cheap, clean, and easy. Any rule of priority that depends on subjective knowledge is an invitation to litigation.

See Schechter, Judicial Lien Creditors vs. Prior Unrecorded Transferees of Real Property: Rethinking the Goals of the Recording System and Their Consequences, 62 So. Cal. L. Rev. 105, 166 (1988), dealing with the real property system but also applicable to Article 9:

[T]he evidentiary uncertainty of the knowledge issue increases not only the costs of litigation; it increases the actual likelihood of litigation in any given case. The very existence of a triable issue of fact may encourage prior unrecorded [parties] to gamble by litigating the knowledge issue, rather than capitulating when presented with unassailable evidence of the subsequent [party’s] priority of record.

I predict that someday, maybe 50 years from now, the last vestiges of “knowledge” will be expunged from Article 9, and it will at last become a pure “race” system, in which the public record is the only thing that matters.

For a discussion of an earlier opinion stemming from the same bankruptcy case, see 2017-13 Comm. Fin. News. NL 26, Clause in Consignment Agreement Stating that Article 9 Was Applicable is Unenforceable Because Consignee Might Have Been Generally Known as Consignment Dealer.

These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.