How Bankrupt Retailers Treat Customer Deposits

How Bankrupt Retailers Treat Customer Deposits

Recent news of major retail bankruptcies sent shockwaves through several retail sectors, from toys to jewelry to grocery. But what happens to retailers’ consignment inventory and customer deposits in the wake of their financial distress? This post explores how retailers manage their consigned goods and deposits after they file for bankruptcy. 
What Happens to Customer Deposits?
Consumer product companies, such as furniture or appliance retailers, typically require a significant deposit from the customer before they will order the product from their supplier. Many consumers make deposits with retailers when they buy goods that are expensive, custom-designed, held for delivery, or when the consumer has a poor credit score. In many cases, customer deposits can be as large as 50 percent or more of the retail price charged by the retailer. Consumers should be aware that when they give a deposit to a retailer, they are essentially making a loan to that retailer.

Impact on Customers
When a retailer spirals into bankruptcy, all its assets are immediately frozen, which can leave millions of dollars in customer deposits on orders that were not yet completed and/or delivered to customers. Consumers who are owed refunds of their deposits have to get in line and compete with the retailer’s other creditors for any cash that is available.  In many cases, however, there is nothing the consumer can do but accept the fact that they have lost all or most of their deposit paid to the bankrupt business.

Credit Cards Provide Safety Net
It is recommended that consumers pay deposits to retailers by using credit cards rather than by writing a check or paying cash. The Fair Credit Billing Act allows consumers to dispute charges with the credit card issuer for unshipped merchandise and have the charge removed from their account. To protect themselves from these chargebacks, credit card processors may reserve or withhold other funds due to the retailer.

Recovery on Customer Deposits
Bankruptcy Code Section 507(a)(7) establishes a priority for individuals’ unsecured claims if their customer deposits for goods that were not delivered total a maximum of $2,850. The remaining portion of the un-refunded deposit would become a general unsecured claim. Consumers who are owed deposits are only paid after all the secured creditors and administrative expenses of the bankruptcy, such as bankruptcy lawyers’ fees, are paid. As priority creditors, holders of deposits would be paid up to $2,850 before any of the retailer’s general unsecured obligations are satisfied.

Difficulties of Fulfilling Customer Merchandise Orders
At the time of the bankruptcy filing, the retailer most likely has not yet received a large number of orders that are subject to customer deposits. In addition, many of the retailer’s vendors likely still possess merchandise that was special-ordered for the retailer’s customers but have not yet been shipped to the retailer. Due to the financial constraints imposed by its lenders, particularly if the retailer is liquidating, it may not have the funding available to finance the purchase or delivery of this inventory.

As a result, unless the retailer is able to fulfill or ship merchandise on account of unfulfilled customer deposit orders, the retailer faces sizable claims in the bankruptcy, including:

  • Priority claims asserted by its customers for customer deposits that have not been honored;

  • Chargebacks incurred and/or reserves established by the retailer’s credit card processors;

  • General unsecured claims resulting from the non-priority portion of unfulfilled orders; and

  • General unsecured claims from the retailer’s vendors for goods ordered for its customers.

What Happens to a Vendor’s Consignment Inventory?
In a consignment agreement, the vendor (the consignor of the goods) delivers the consigned goods to the retailer (the consignee) to be sold. Typically, the retailer does not have to pay the vendor for these goods until they are sold to the retailer’s customers. As such, the vendor retains title to the consigned goods until they are sold. The retention of title to the consigned goods provides a degree of protection to the vendor that wants to ship goods to a financially troubled retailer.
If the vendor follows the proper steps, it will have the option to reclaim its goods from the retailer upon a bankruptcy filing. In recent years, as more retailers have faced financial difficulties, more consignment arrangements have been used by vendors. However, consignors must file the proper paperwork to perfect their interest in the consigned goods and give notice about the consignment arrangement to third parties. If the consignor fails to properly perfect its interests in the consigned inventory, it may result in the vendor being treated as a general unsecured creditor. The goods will be sold off and the proceeds distributed to satisfy administrative, secured, and priority claims before being distributed pro-rata to all general unsecured creditors.
What does the vendor have to do to perfect its interest in consigned goods?  Vendors can take three steps to protect their inventory (perfection requirements):

  1. File a financing statement describing the inventory in the appropriate place.

  2. Send an authenticated notification to the retailer of the security interest.

  3. Ensure that the notification describes the goods and states that the supplier has or expects to acquire a security interest in inventory of the retailer.

The vendor must understand that an unperfected consignment is nothing more than a sale on open account. In other words, an unperfected consignment means that the vendor has lost its hold on its goods, and if the retailer fails to make a payment, the consignor may not be able to reclaim the consigned goods.
Sports Authority’s Vendors & Perfection Requirements
After sporting goods retailer Sports Authority declared bankruptcy in 2016, most of its vendors realized they had failed to observe the Uniform Commercial Code’s (UCC) perfection requirements. As a result, these vendors found themselves in litigation with both the debtors and the secured lenders with security interests in the pre-petition inventory. Sports Authority asked the bankruptcy court to rule that these unperfected consignment vendors should take a back seat to the secured lenders’ liens on inventory.  After several months of dispute, the retailer reached a settlement with a substantial number of consignment vendors and secured lenders where a certain percentage of the sale proceeds from consigned goods was provided to settling vendors.
The Sports Authority case demonstrates the importance of consignment vendors closely following the UCC’s perfection requirements.  If the consignment vendor follows these procedures, the vendor knows that its interests will be protected in a bankruptcy, even against a secured lender with a lien on inventory.  If the consignor fails to do so, it may find itself treated as a general unsecured creditor in the retailer’s bankruptcy. 
However, as in the case of Sports Authority, even if a vendor has not followed the perfection requirements, the vendor may still be able to obtain some value by contesting the secured lenders’ liens.
This article provides updates to two previous posts on the Consumer Business Compass Blog: Treatment of Consignment Inventory in a Retail Bankruptcy and Treatment of Customer Deposits After a Retailer Files for Bankruptcy.
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