In My Legal Opinion….By Leonard M. Weiner, Esq., PhD.

– (This the second in a series of columns that deals with contemporary legal and commercial issues that are currently facing the diamond and jewelry industry and I invite reader email responses and dialogue regarding the issues raised. Please see previous article).

We left off last time discussing the need for a super priority position to protect the Consignor from claims made by a customer’s secured creditors. The UCC provides for just such a super priority position called a PURCHASE money security interest or PMSI. But how does this work? In order to receive a super priority position over existing filed secured creditors, one must follow a very specific and detailed procedure outlined in the UCC. In addition to following the requirements to “perfect” a security interest, which basically consists of receiving an authorization from the debtor or Consignee (your customer), filing the UCC in the appropriate jurisdiction (a topic in itself, which we will discuss at a later date), entering into a “Security Agreement” ( as defined by the UCC), and preparing and filing a proper description of the collateral, one must also obtain a list of prior secured creditors of the customer, send notices to such secured creditors, and only then send the goods to the customer. The procedure is strictly construed and any deviation from its statutory requirements will invalidate the PMSI. The difference between having a PMSI and having filed a perfected security interest in many cases is the difference between recovering your goods after bankruptcy are losing your claim to such goods to a previously filed secured creditor. Unfortunately, many attorneys who are not versed in the details of the required procedure are filing UCC’s on behalf of their clients incorrectly, either in the wrong jurisdictions, without the proper collateral description, without a Security Agreement, without sending the proper notices to the secured creditors and allowing their clients to provide the goods to their customers prior to having completed all of these procedures.

In the Whitehall bankruptcy case, for example, the attorneys for Whitehall challenged the filings of the secured creditors and insisted that each one individually prove that it had followed the procedures necessary in order to secure a PMSI against Whitehall. It turned out, in fact, that many of the companies that had filed UCC’s filed improperly, including the wrong jurisdictions, the wrong legal name of Whitehall, etc. and if you think that the law firm that may be representing you and filing your UCC’s is experienced in the matter and know what it is doing, think again.

In a case just recently published in the New York Law Journal dated January 22, 2015 two of the top major law firms in New York City representing J.P. Morgan Chase and GM in a 1.5 billion dollar loan transaction failed to correctly terminate a UCC -1, a filing mistake that rendered a secured loan unsecured The error will allow a group of creditors to pursue a clawback of some $1.5 billion in the GM bankruptcy case. The court insisted that despite the clear intentions of the parties, the proper procedures were not followed and the consequences were dramatic.

Assuming now that your attorney has followed the proper procedure and secured a PMSI for your company, exactly what does this security interest protect? Depending on how broad, the collateral description was formulated, and depending on the terms of the authorization of your customer. In the vast majority of cases the security interest applies only to the goods on consignment while they are still on consignment and in your customer’s possession, but once those goods are sold to its customers, the security interest is no longer applicable and does not follow the proceeds of such sale. Even if the collateral description in fact allows for a security interest in the proceeds of the sale of the goods on consignment, unless your customer actually segregates such proceeds in an identifiable account in your name, or in other words, if the customer commingles the proceeds of the sale of your goods with his general receivables, your security interest does not apply to such commingled proceeds.
You may ask, why I can’t insist that the collateral description include the proceeds and that the funds be segregated in a separate account. The answer in most cases is that your customer’s lender has filed a blanket security interest on all accounts receivable, including the proceeds of the sale of your goods, and will not allow your customer to impair that security interest by providing you with a PMSI on such proceeds. –

Let’s stop a moment and analyze exactly what is happening here. By providing your customer with these consignment goods, you are actually providing his bank or lender with additional collateral once the goods are sold in the form of the proceeds of the sale of such goods, and therefore it is in the advantage of both the bank, and the customer to acquire as much consignment goods as possible from his many suppliers as possible. The more consignment goods a customer receives from all of the suppliers, the larger the credit line it receives from its lender. The bank is prepared to provide them additional credit because the lender can look to the proceeds of the sale of your goods as collateral for the loan it is making to your customer.

It is imperative that you understand the exposure that you have, that you reduce that exposure by properly filing a PMSI, and that you understand that even with this filing any goods that are sold are no longer covered under your security interest, and you remain an unsecured creditor with regard to the money owed for the goods sold. Even with this serious limitation, by filing a PMSI, you have provided yourself with a priority interest against all unsecured creditors, and have a secured super priority interest in the collateral that you have provided to your customer, with a priority claim for the return of your consignment merchandise.

In order for the bank or lender to ensure that you the Consignor will not oppose its claim to the proceeds of the sale of your goods and not demand payment or the return of such goods, many such lenders including GE Capital have insisted that its clients have their suppliers sign an “Inter-Creditor Agreement”. Beware! Don’t sign it! (To be continued).