A Chapter 7 bankruptcy liquidation proceeding, in its simplest form, is straightforward. When a person or company is unable to pay its debts, a bankruptcy trustee is appointed. The debtor’s property becomes a bankruptcy “estate,” administered by the trustee. The trustee gathers up the debtor’s assets, and (after setting aside certain property as exempt assets) distributes the proceeds among the debtor’s creditors.
 
Often, however, things are not that simple. Complications frequently involve disputes over whether property in a debtor’s possession is actually the debtor’s property. Examples might include a customer’s car in a bankrupt auto repair business’s shop, goods stored at a bankruptcy debtor’s warehouse, or funds held by the debtor in trust for someone else.

In those cases, even though the property in question might be in the debtor’s possession, the debtor will not be the actual owner, and the property will generally be excluded from the bankruptcy estate.
 
Sometimes, however, the line between the debtor’s property and others’ property may not be so clear. For example, in a consignment arrangement, one person (the consignor) furnishes property to another person (the consignee) to have the consignee offer it for sale. Depending on how the transaction is structured, a consignment may result in the property being considered to belong to the consignee, leaving the consignor with only a security interest (or lien) instead of outright ownership. If the consignor has not “perfected” its security interest by filing a UCC-1 financing statement, its priority in a bankruptcy distribution may end up being junior to that of another lien creditor, and the consignor may ultimately receive nothing.
 
An even more complicated issue arises when a customer for a finished product is the one who buys the materials the product will be made from. This sometimes occurs in manufacturing and construction contracts. For example, a large construction contractor seeking to buy specially fabricated structural trusses from a small supplier might seek to reduce the product’s final price by using its greater credit to buy the raw lumber that the small supplier will use. If the supplier declares bankruptcy before fabricating the lumber into the finished trusses, who owns the lumber – the supplier, or the contractor?
 
In one illustrative case from a while back in Maine, Underwood, a manufacturer of pork and beans (we’ll call it “Beanco”) found itself swamped with more orders than it could fill at its own plant. To get the extra beans packed, it contracted with another canner, Medomak, (“Cancorp”). This “co-packing” agreement provided that Beanco would buy and ship the ingredients – the pork, beans, and cans – to Cancorp. Cancorp would then use the ingredients to manufacture finished cans of pork and beans, which Beanco would then buy.
 
After Cancorp filed bankruptcy before packing the beans, the bankruptcy trustee asserted that the co-packing arrangement constituted a sale of the raw materials by Beanco to Cancorp – meaning that Cancorp took ownership of the materials when they were delivered, and so they could be sold and the proceeds distributed among all of Cancorp’s creditors, rather than returned to Beanco.
 
The bankruptcy court disagreed, finding that Beanco furnished the materials to Cancorp as a “bailment” and not a sale. The court noted that no purchase price was set for the materials, and that there were no entries in either party’s books reflecting a sale. Therefore, the court held, the pork, beans and cans remained Beanco’s property until Cancorp actually manufactured them into the completed cans of pork and beans that Beanco had agreed to buy.
 
Although bankruptcy is governed by federal law, bankruptcy courts look to state property law in determining whether certain property is property of a bankruptcy estate. Courts applying other states’ laws have occasionally reached other conclusions, finding that a prospective buyer of a final product who supplies raw materials to a fabricator retains too little real ownership in the property for it not to become part of the fabricator’s bankruptcy estate. However, California law is relatively broad with regard to what kind of property may be subject to bailments. The fact that bailed raw materials are intended to be fabricated into finished goods should probably not prevent the buyer’s interest in the property from being recognized.
 
To avoid any such complications, someone considering an arrangement like the one discussed above should ensure as much as possible that the ownership of the property is made clear. Contracts should specify explicitly that title to the property remains with the buyer until such precise time (if any) it shifts to the fabricator. If possible, the materials should be physically separated from the rest of the fabricator’s inventory, and labeled as the buyer’s property.
 
Bankruptcy can present complex questions of ownership of property, but careful attention to how transactions are structured can help minimize unpleasant surprises.
 
This article first appeared in The Press-Enterprise on March 19, 2017. Republished with permission.

[View source.]