Navigating Security Interests in Retail Merchandise

Customers are the lifeblood of a retail company. Through purchases of merchandise, they provide necessary liquidity for the retailer’s operations and going-concern value. For many retailers, this liquidity often comes in the form of customer deposits for merchandise to be manufactured by the retailer and received by customers at a future date.

A distressed retailer who relies on customer deposits may face unique obstacles in delivering purchased merchandise to its customers. For example, the merchandise may be in the possession of an unpaid warehouseman or carrier who asserts a possessory lien and refuses to deliver. The retailer may also be a borrower under a secured financing facility pursuant to which the lender holds liens on all the retailer’s assets, including inventory, cash, and proceeds. The lender could even sweep the retailer’s bank accounts in the event of default, eliminating the liquidity essential to the retailer’s operations and delivery of purchased merchandise to its customers.

Under such circumstances, the retailer’s ability to maintain its going-concern value for the benefit of all its stakeholders will be threatened.

In the event of a bankruptcy filing by the retailer, though, section 507(a)(7) of the Bankruptcy Code provides a customer with a priority unsecured claim up to $3,350 for any deposit. The customer’s ability to recoup the deposit depends on, among other things, whether:

1. Priority claims will be paid in full.
2. A plan of reorganization or liquidation is confirmed and distributions are made.
3. The customer provided a deposit greater than the priority cap.

More importantly for the retailer, the allowance of customer claims under section 507(a)(7) means that customers did not receive their purchased merchandise. So, what options does a retailer have to deliver merchandise to customers?

The Bankruptcy Code, the Uniform Commercial Code (UCC), and related state law claims may provide relief. Customers may argue that they are entitled to receipt of their purchased merchandise, notwithstanding the security interests of secured lenders and third-party logistics companies (3PLs).

Lenders Secured by Financing Statements

Where a retailer’s secured lender has a properly perfected security interest on all the retailer’s assets due to the filing of a financing statement, including any inventory, cash, and proceeds, the lender likely will have a strong claim to such assets upon the event of a default by the retailer. Nonetheless, the lender’s security interest alone is likely insufficient to prevent the retailer’s delivery of goods to its customers.

(In the event of a default by the retailer, the delivery of merchandise to customers that constitutes collateral may be a breach of the financing documents. The retailer should review the provisions of the financing documents before delivering merchandise to customers that may constitute collateral.)

A retailer has at least two arguments that it can deliver merchandise to customers notwithstanding a lender’s security interest. First, in the event of a bankruptcy filing by the retailer, the automatic stay of section 362(a) of the Bankruptcy Code prevents the lender from exercising control over the retailer’s property. This includes any foreclosure action that the lender could initiate to seize the retailer’s merchandise.

Second, whether in or out of bankruptcy, customers are likely entitled to receive their purchased merchandise notwithstanding the lender’s security interest as buyers in the ordinary course of business (BIOC) under sections 1-201(b)(9) and 9-320(a) of the UCC. Section 9-320(a) provides, in part, that “a buyer in ordinary course of business, other than a person buying farm products from a person engaged in farming operations, takes free of a security interest created by the buyer’s seller, even if the security interest is perfected and the buyer knows of its existence.”

Section 1-201(b)(9) of the UCC defines a BIOC, in part, as “a person that buys goods in good faith, without knowledge that the sale violates the rights of another person in the goods, and in the ordinary course from a person, other than a pawnbroker, in the business of selling goods of that kind,” and who has possession of the goods or a right to recover the goods from the seller under Article 2 of the UCC. Pursuant to section 1-202(b), “knowledge” means actual knowledge. In addition, some courts have held that “possession” includes constructive possession, which may occur upon identification of the purchased goods in the sales contract. Courts have also held that BIOC status is determined at the time of the sale.

Customers who meet the requirements of these provisions—by purchasing merchandise in good faith from an ordinary course seller, without actual knowledge that the sale may violate the lender’s rights, and that have possession or a right to recover the goods from the retailer—are entitled to receive their purchased merchandise notwithstanding a lender’s security interest. These provisions are intended to protect innocent customers who purchase goods.

Thus, if a secured lender attempts to stop a distressed retailer from delivering goods to its customers, the retailer should evaluate whether its customers are BIOC and, if so, challenge the secured lender’s efforts to seize customer goods. This will not only protect the customer’s legal rights to receive the goods, but also preserve the going-concern value of the retailer that would otherwise be lost if the retailer is unable to fulfill customer orders.

3PL Possessory Liens

Retailers face more of an uphill battle to deliver merchandise that is in the possession of a 3PL. 3PLs are service providers that handle one or more supply chain function for retail businesses, including storing and delivering merchandise. When a distressed retailer is unable to satisfy outstanding obligations to a 3PL, that 3PL may have a possessory lien as a warehouseman or carrier on merchandise in its possession under the UCC. (In addition to possessory liens under the UCC, most jurisdictions recognize other statutory or common law possessory liens for the shipping or transportation of goods.)

Retailers in chapter 11 often request authority from the bankruptcy court to pay pre-petition amounts due to 3PLs to ensure that customers receive purchased merchandise. This approach is generally preferred but typically requires that the retailer have debtor-in-possession financing or access to cash collateral to make such payments.

When the retailer does not have sufficient liquidity to make payments, the ability to deliver merchandise in the possession of a 3PL is more complicated. Unlike in the case of a lender whose security interest is perfected due to a filed financing statement, BIOC status does not provide relief where the 3PL has a valid possessory lien on the merchandise. Section 9-320(e) of the UCC provides that BIOC protection “does not affect a security interest in goods in the possession of [a 3PL as] the secured party under Section 9-313.” The retailer, therefore, is unable to rely on a customer’s BIOC status to demand the release of purchased merchandise.

As a result, the ability of a retailer to demand the release of purchased merchandise likely turns on the extent of the 3PL’s security interest. Section 7-307(1) provides that a carrier has a “specific” lien on merchandise in its possession “for charges subsequent to the date of its receipt of the goods for storage or transportation… and for expenses necessary for preservation of the goods incident to their transportation or reasonably incurred in their sale pursuant to law.” In addition, section 7-209 provides that a warehouse may have a specific or general lien on merchandise in its possession for similar charges and expenses, depending on the language of the warehouse receipt or storage agreement.

To the extent the 3PL retains possession of merchandise on which it does not have a valid lien under the UCC or common law, the 3PL may be subject to a conversion claim for retaining possession of the paid-for merchandise. For example, under Delaware law, a claim for conversion exists where a plaintiff shows that:

1. It had a property interest in equipment or other property.
2. It had a right to possession of the property.
3. The property was converted.

A customer who has purchased merchandise likely satisfies the first two prongs of the test, particularly if title of the property has already passed to the customer as may be set forth in the agreement between the retailer and 3PL pursuant to section 2-401 of the UCC. The third prong of the test is also likely satisfied because, absent a valid lien, the 3PL is likely “wrongfully exerting dominion or control over the merchandise in a manner that denies the customer’s right” to it.

Although a distressed retailer may face obstacles in delivering merchandise to its customers that is subject to security interests by third parties, it is not without options. The retailer (and its customers) may look to the Bankruptcy Code, the UCC, and applicable nonbankruptcy law to deliver or receive merchandise notwithstanding security interests. These tools may prove valuable in a retailer’s efforts to deliver value to not just its customers, but to all its stakeholders.

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Curtis S. Miller, Matthew O. Talmo and Erin L. Williamson, “Navigating Security Interests in Retail Merchandise,” TMA Journal of Corporate Renewal (April 2024)

Reproduced with permission. Published April 2024 by Turnaround Management Association. These materials have been prepared solely for informational and educational purposes, do not create an attorney-client relationship with the author(s) or Morris, Nichols, Arsht & Tunnell LLP, and should not be used as a substitute for legal counseling in specific situations. These materials reflect only the personal views of the author(s) and are not necessarily the views of Morris, Nichols, Arsht & Tunnell LLP or its clients.