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Distribution Contracts: Steps to Take to Protect Your Inventory

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Entering into an agreement with a distributor, or a publisher acting as a distributor, can be an effective means of increasing sales for the small or mid-sized publisher. However, once you begin to work through a distributor, a

portion of your book inventory is at risk. If your distributor declares bankruptcy, you may lose ownership of the portion of your inventory under its control.

Many publishers think they’re protected against this danger because their distribution agreements provide that the inventory under the distributor’s control is being held on a consignment basis–”to be sold” to a third party, so that title (ownership) to the inventory does not pass from the publisher until the distributor makes a sale. If the distributor fails to sell all or part of the inventory to third parties, then the distributor simply returns the unsold goods to the publisher and has no obligation to pay the publisher for them.

Trouble crops up, though, because of a legal principle known as the “ostensible ownership doctrine.” This doctrine provides that any time a distributor holds inventory on consignment, the inventory becomes subject to claims by creditors of the distributor. As a result, a creditor may rely on the possession of goods by its debtor as an indication of the debtor’s ownership of those goods.

In other words, a distributor’s creditor may assume that inventory of yours that the distributor has in its possession belongs to it–unless you have taken specific steps to secure your claim to it.

 

“True Consignment” or “Secured Transaction”

Your goal is to set up a relationship with your distributor that provides you with a“true consignment” or a “secured transaction”to protect your inventory. In a “true consignment,” the title to the publisher’s inventory remains with the publisher; this means that the distributor’s creditors get no interest in it. You retain absolute ownership rights over your inventory irrespective of any claims of the distributor’s creditors.

In a “secured transaction,” on the other hand, a “security agreement” gives the party consigning goods (for instance, a publisher consigning its inventory to a distributor) a “security interest” in those goods. Unless the publisher “attaches and perfectsits security interest in its inventory by filing a UCC-1 with the appropriate government office, it could lose the inventory to the distributor’s creditors, given the rules that determine who has first claim on the distributor’s assets, which include the publisher’s inventory. ???Where does the quote end?

Unfortunately, it’s usually extremely difficult to determine whether a transaction between the publisher and distributor is a true consignment or a secured transaction. In a bankruptcy proceeding, both secured and unsecured creditors will argue that the consignor (publisher) should get its goods back only according to creditor priority rules, which are found in the Bankruptcy Code and Article 9 of

the UCC.

States that have adopted the UCC typically require that the owner of the goods, such as a publisher, “prove” that the agreement with the distributor is a true consignment rather than a secured transaction. However the UCC does not provide a definition of “true consignment.” Furthermore, the common law regarding consignment, which frequently favored the consignor, has significantly changed under the UCC so that unless the consignor strictly adheres to the security interest rules enumerated in Article 9 (or possibly the consignment notice rules under Article 2) the consignor is highly unlikely to prevail against secured creditors.

 

Conditions to Consider

Under subsection 2-326 (3) of the UCC, which is strictly interpreted by the courts, a publisher’s inventory would not be subject to the claim of a distributor’s creditors if one of the following conditions applies:

  1. The publisher’s interest in its inventory is evidenced by a physical “sign” stating that the inventory is not owned by the distributor.
  2. The publisher establishes that the distributor is generally known by its creditors to be substantially engaged in selling the goods of others.
  3. The publisher complies with the security interest provisions of Article 9 of the UCC.

The first exception provides that a sign must conspicuously inform third parties that the distributor does not own the inventory. This exception offers little protection for the publisher, as only a few states actually permit it.

The second exception does not usually offer much protection either, since it’s difficult to prove what most of a distributor’s creditors “actually know.”

The third exception provides the most protection to the publisher who wishes to protect ownership title to its inventory from the distributor’s creditors.
Preventive Measures

Although most courts have interpreted UCC 2-326 strictly, some have construed the statute liberally in order to favor the consignor of the goods. In a bankruptcy, however, you don’t want to depend on a liberal interpretation of the UCC laws to save your inventory from creditors since that is the exception and not the norm.

Therefore, publishers should take preventive measures when entering into a distribution agreement. This may be easier said then done, depending on how flexible the distributor is when it comes to negotiating and including “protection of inventory” terms in its agreement.

Specifically, I recommend two preventive measures.

First, insist that the distribution agreement explicitly provide that ownership title to your inventory remains with you until the distributor sells the inventory to third party customers and/or the inventory is fully paid for by the distributor. This type of contract clause may help prevent the bankruptcy trustee or creditor from claiming title to your books.

Second, and even more important, include a contract clause that permits you to file a security interest agreement that “perfects” your interest in your inventory and assures you of priority over the distributor’s creditors. This is accomplished by having the distributor sign a standard form, known as UCC-1, that is then filed with the Secretary of State or in the County Clerk’s office in the county in which the inventory is located.

You do not want to put your faith in a bankruptcy clause in the distribution agreement. The purpose of this clause is to permit the publisher to reclaim its inventory if the distributor files a petition for bankruptcy or reorganization. But, in reality, bankruptcy law will ultimately determine the fate of your inventory and your priority as a creditor for the distributor’s assets. Moreover, Section 365(e) of the federal Bankruptcy Reform Act has invalidated bankruptcy clauses under certain circumstances.

Summing Up

As you can see, protecting yourself against a distributor’s bankruptcy is a job for a lawyer who knows the territory and the moves, and your best chance comes when you make your distribution deal. If you are already caught up with a distributor who is going bankrupt, an attorney may be able to help you minimize the damage. Unfortunately, no easy solution exists.

© Lloyd L. Rich 2002. This article is not legal advice. You should consult an attorney if you have legal questions that relate to your specific

publishing issues and projects.

Lloyd L. Rich is an attorney practicing publishing, cyberspace, and intellectual property law. He can be reached at 1163 Vine Street, Denver, CO 80206. Phone: 303/388-0291; fax: 303/388-0477; e-mail:

rich@publishingattorney.com; Web site http://www.publishingattorney.com. Research for this article was provided by Holly Panetta, a student at the University of Denver School of Law.

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