In our society, ownership usually beats other claims to property. As lawyers learn in first year Property class, “a thief can’t convey good title.”

But in business, sometimes ownership doesn’t matter.

In one common situation, an undisputed owner will lose its property, to someone it may never have known about. How can this happen? More importantly, as a business owner, how can you avoid it? This risk arises when property is consigned to another firm, rather than sold. Consignment allows a seller to obtain possession of property for resale, without having to pay for it. Sellers sometimes prefer consignment, because of the naïve perception that retaining the title is safer than selling to a customer with less than stellar credit – a “poor man’s” form of security, without the legal fees.

I suspect that most people think of pawn shops and upscale resale boutiques when they hear “consignment”.

However, even before the Pandemic’s challenges, some businesses relied on consignments as a way to reduce their firm’s cash flow needs. For example, I worked with one client that financed inventory acquisition for its manufacturing process by accepting it on consignment, rather than purchasing it. Rather than pay upfront for inventory, such firms pay for it only as it is used after they have the cash from a sale. This transfers the carrying costs and risk of financing, from an intermediate buyer to the original seller. If the intermediate seller doesn’t find a buyer, the original seller – who still owns the inventory – can, in theory, take it back, and try to sell it elsewhere.

But that takes time and money, including shipping costs.

As a legal matter, firms supplying inventory to such firms must understand that commercial rules in all states require extremely specific steps to protect the owner’s interest. If the owner of the property doesn’t follow the procedures of the Uniform Commercial Code on consignments, secured creditors of the intermediate buyer will have a better claim to the inventory than its owner.

In simple terms, the intermediate buyer’s lender can foreclose on inventory that its buyer doesn’t own, as illogical as that seems. The owner that supplied it to the buyer can complain, but will lose – unless it took two simple steps before shipping the inventory:

• File a UCC-1 Financing Statement against the recipient of the inventory (the “consignee”, in legal jargon), identifying the transaction as a “consignment” (a check box on the form). The consignee no longer must sign the UCC-1, but you, as a supplier of the goods, should demand that it sign an “authorization” for you to file against the consignee that receives your goods.
• In writing, notify the recipient’s secured creditors that the consignee will receive your inventory. (You must pay for a public records search to identify them.)

Again, you must do both of these, before the recipient receives any inventory, to protect your ownership of your consigned goods. If you miss a detail, the law makes your ownership of the consigned inventory irrelevant.

Even though the recipient hasn’t paid you for it – remember, you shipped on consignment – your ownership is legally meaningless. The recipient’s creditors can seize that inventory on foreclosure to satisfy the recipient’s debt, without any obligation to pay you for them, even though you were (not “are”) the owner of those goods. You still have a claim against the recipient to recover the goods’ value, but good luck. If the recipient’s lender has begun a foreclosure, you have to decide whether suing for the value of the inventory you “owned” (again, past tense) would just be throwing good money after bad.

If all of this sounds complex, congratulations! You are correct – secured credit involving consigned goods is not something anyone should try at home. As a practical matter, don’t let a lender force you to incur significant legal fees, by encouraging you to be able to borrow more, by including consigned goods in your borrowing base. The lender may believe – perhaps sincerely, but wrongly – that it is as easy as filing a UCC-1. In fact, you will probably have to pay your lender’s additional legal fees under the typical “borrower pays all lender expenses” provision of your loan agreement.

Instead, consult with counsel to understand the legal cost of consigning inventory, rather than selling it. Then balance that expense against the benefit of the additional borrowing availability from such added collateral, and the carrying cost of continuing to own those consigned goods until the recipient actually sells them, and can pay you for them.

In other words, there is a reason most boilerplate asset-based loan agreements exclude consigned goods in the possession of a third party (the recipient of the goods) from the consignor’s borrowing base. A typical lender may see inventory onsite, without realizing that its borrower does not own it (and can’t use it as collateral). The business moral of the story is simple: call your counsel before incurring costs on a new business arrangement, whether as a supplier or lender. If you don’t, the cliché, “you snooze, you lose” will become “you own, you lose” – and you will pay your counsel for the privilege of doing so.

For further information on this issue, or on writing your form agreements to protect your business and assets in everyday transactions, please contact Stanley Jaskiewicz (https://www.sgrvlaw.com/attorney/stanley-p-jaskiewicz/) at 215-241-8866, or sjaskiewicz@sgrvlaw.com for a no-cost initial consultation.