The financing of a commercial farming operation presents unique issues for lenders, regardless of their status as secured, potentially secured, or unsecured.1 Many of these issues are intrinsic to production agriculture. Others are the product of special legislation. Still others are attributable to the increased concentration and integration of commercial agricultural operations in the 21st century.
While many observers of the agricultural industry are currently drawing comparisons to the farm crisis of the 1980s, many structural changes have occurred that distinguish the current situation from the last upheaval in the industry. Agricultural businesses are larger, and more vertically integrated. Production is frequently separated from ownership of the land and facilities employed in the business.
This article explores issues that may confront an agricultural lender when dealing with a financially stressed producer. Such lenders in the current economic setting may well conclude “the thrill is gone” when it comes to agricultural lending.
One of the unique and universal aspects of financing production agriculture is that a lender’s collateral—crops, livestock, or poultry, for example—may die. This is true regardless of whether the borrower is a small organic producer or an integrated multinational corporation. In addition, the output of many agricultural producers is a commodity. As a price taker, an agricultural producer can only increase its bottom line by controlling costs or producing more commodities. Finally, many agricultural producers are subject to a single annual marketing opportunity.
These fundamentals become more important when a lender is faced with a financially stressed producer.
The 2001 revisions to Article 9 of the Uniform Commercial Code (UCC) facilitated the financing of production agriculture. Holders of security interests in farm products are generally subject to the general rules of Article 9, including the first to file or perfect priority rule. There are, however, a few potential traps for secured lenders lurking in an otherwise friendly statute.
Article 9 does not provide for a purchase money security interest (PMSI) for lenders that supply crop inputs.2 Thus, a lender with a senior perfected security interest in crops, products of crops, or their proceeds will likely be able to assert a priority lien in future crops even if it did not provide financing for the production of those future crops.
However, purchase money priority is available for lenders which finance livestock, provided they comply with the requirements of UCC Section 9-324(d). That section requires (i) the security interest to be perfected when the debtor receives possession of the livestock; (ii) the purchase money secured party provides notice to the holders of competing security interests within six months of the debtor obtaining possession of the livestock; and (iii) the notice describes the livestock.3
The livestock purchase money secured party enjoys a priority in all proceeds of the livestock, including accounts and products related to the livestock. Thus, the scope of the livestock PMSI is more extensive than the similar inventory PMSI provided inventory lenders.
In light of the unique production risks inherent in crop and livestock production, the common practice of goods and services being sold on credit, and the limited availability of a priority security interest in crops and livestock, many states have enacted statutory liens to provide financial protection to otherwise unsecured crop and livestock creditors. Such liens generally benefit livestock feeders, veterinarians, harvesters, and landlords. Some states’ statutes extend to input suppliers as well. Many statutory liens remain archaic and are not consistent with Article 9, however.
Article 9 incorporates, to a limited extent, “agricultural liens” into its reach. Generally, an agricultural lien is a statutory lien that secures the debtor’s performance of an obligation for goods or services furnished the debtor or for rent for real property leased to a debtor in connection with the debtor’s farming operation.4 The UCC leaves to other state law the requirements for the creation and scope of such agricultural liens. As a result, the nature and extent of agricultural liens is dependent upon other state law. There is thus no uniform law relating to agricultural liens.5
The UCC governs the perfection, priority, and enforcement of agricultural liens. A financing statement is required to perfect agricultural liens to obtain priority under Article 9.6 In a unique approach, the priority of agricultural liens vis a vis competing security interests is not necessarily established by the general first to file or perfect rule. Rather, if the statute creating the agricultural lien creates a priority rule, Article 9 recognizes the state’s priority scheme.7
While Article 9 requires the filing of a financing statement to perfect an agricultural lien, the proper location to file a financing statement to perfect an agricultural lien is the jurisdiction where the farm products are located rather than the state where the producer is located.8 In addition, for many agricultural liens, no advance notice is required to be given to the lender, placing the burden on the lender to review UCC-1 filings for any applicable agricultural liens. A perfected agricultural lien may be enforced under Article 9 in the same manner as a security interest.9
For secured lenders, agricultural liens may create significant issues in a workout, collection, or bankruptcy setting. It is critically important that lenders establish a process to regularly investigate and assess the scope and priority of all agricultural liens that may be asserted by third parties that may prime their security interest in crops or livestock. Lenders should be familiar with the scope and priority afforded agricultural liens under the applicable state law and factor them into their underwriting and workout analyses.
American agricultural has, over the past several years, moved toward becoming a more vertically integrated industry. This has led to the widespread use of various types of contractual relationships with livestock feeders, contracts for the production of specialty crops, and multiyear marketing agreements. It is important for secured lenders to focus on the legal structure of these contracts to protect their collateral position.
Production contracts are agreements under which a person agrees to feed or care for livestock for another in exchange for a payment from the livestock owner. A typical example is a poultry contract in which the integrator owns the poultry and agrees to provide the feed for the producer (or grower) to raise the poultry on the producer’s farm until the poultry is ready to be processed. Under such contracts, the grower does not typically acquire sufficient rights in the poultry to grant a security interest. However, the parties’ intent as expressed in the contract will likely control this determination.10
In addition to the potential impairment of the lenders’ collateral, such production contracts carry the additional risk that an unpaid feeder’s claim may prime the lender if the state provides a priority agricultural lien for such feeders. If the statute creating the lien grants such a priority, Article 9 will recognize it in a dispute between the feeder and the lender.
In any arrangement in which the debtor transfers physical possession of the lender’s collateral to a third party, the lender should review the contracts carefully and ensure it understands the operative terms. The lender may want to consider obtaining a waiver or intercreditor agreement from the feeder to maintain its priority while, at the same time, addressing the feeder’s concerns about the ability of the debtor to perform under the contract.
In addition to production contracts, agricultural producers may be parties to multiyear marketing agreements. Such agreements provide producers with a secure and stable market for their commodities while at the same time ensuring the buyer with a known supply. From a secured lender’s perspective, such agreements may provide additional comfort by limiting market risk for the producer.
However, such contracts are not without risk for the lender. The pricing formulas contained in such contracts are often complex. Lenders should ensure they clearly understand all the terms of any such agreements. In addition, as executory contracts, the buyer may reject them in a subsequent bankruptcy if the price established by the contract is above market or if the buyer no longer requires all of the commodities for which it has contracted.
Since the early 1900s, the federal government has provided a variety of support programs for producers. They have included price support programs, commodity set-asides, production controls, payment-in-kind, loan deficiency programs, and, most recently, nonrecourse marketing assistance loans, subsidized crop insurance, and direct payments. Federal farm programs are administered through the Farm Service Agency (FSA) within the U.S. Department of Agriculture.
A variety of crop insurance may also be purchased directly by producers to guard against both crop/yield loss and decreased crop revenue. The federal government subsidizes the crop insurance premium. Although it must perfect its security interest in farm products under Article 9, a lender also must obtain an assignment of benefits of a crop insurance policy that is recognized by the FSA.11 Upon receipt of crop insurance proceeds, Article 9 governs the attachment and priority of security interests in such proceeds.
Article 9 does not assist lenders in determining the type of collateral presented by federal programs. Such program benefits may be an account, a payment intangible, a general intangible, proceeds of collateral, or “another type of collateral.”12 As a result, the best practice for a lender is to ensure it obtains a security interest in all farm products, accounts, and general intangibles. As an added precaution, it would be advisable for a lender to specifically include all rights to payment under current or future federal or state government farm programs in its security agreement and financing statement.
Producers have traditionally used multiple farming entities for estate planning and government program purposes. Producers often own the real estate in their individual names or trusts and use legal entities to operate the farm by leasing the real estate and owning the farm equipment, crops, and livestock and, in some instances, multiple legal entities to lease various real estate. Lenders should understand the farming model used by the producer and, specifically, which entity owns what property.
Relying upon secondary sources or documents is not sufficient. The lender should insist upon obtaining bills of sale, deeds, mortgages, title commitments, titles to vehicles, and other documents that evidence ownership. All related-party contracts should also be carefully reviewed and understood. The best practice is to require the individual producer and each legal entity to grant a security interest in all farm products, accounts, equipment, inventory, and general intangibles to avoid a later dispute as to which individual or entity owns the collateral. 13
Producers also often own non-farming assets or assets that are not directly related to the farming operation. For instance, a producer may be a member and own capital in a farm cooperative which provides (or will provide in the future) cooperative patronage.
A producer may also have an equity interest in an ethanol production facility, soybean crush facility, or grain elevator. Depending on the type of entity, the equity interest may be investment property or a general intangible. If the equity interest is certificated, the lender should obtain possession of the certificated stock or membership interest of the producer. The best practice is to require the producer to grant a security interest in all investment property and general intangibles and, to the extent the equity interest is certificated, require the producer to deliver the certificated stock or membership interest to the lender.
It is extremely important that the lender understand the limitations on assignability of any equity interest set forth in a limited liability entity’s organizational documents and state law. Generally, state law and limited liability entity agreements permit members to assign only their financial interest in such entities. Management rights, or rights to financial information, may not be subject to assignment without the consent of all other members of the entity. Too often, lenders are surprised to learn a membership interest in a limited liability company is not treated as an interest in a corporation.
Finally, rights to patronage distributions from cooperatives may, or may not, constitute proceeds of the debtor’s equity in the cooperatives.
Article 9 generally provides that a lender’s security interest remains attached to any identifiable proceeds from the sale of collateral.14 For instance, if a borrower sells certain equipment in which the lender has a security interest, the security interest attaches to the identifiable proceeds from the sale of the equipment. In certain circumstances, the security interest may also remain as to the equipment now owned by the buyer.
The purchase of farm products is subject to a unique rule. Under federal law, a buyer of farm products may take them free of a security interest if the buyer complies with the applicable statute.15 To protect its position, a lender must either file an effective financing statement with the appropriate filing office (in a “central filing” state) or give direct notice to any potential buyers of the farm products (in a “direct notice” state).16 To acquire the farm product free of the lien, the buyer need only make the check payable to the producer and the lender.
It is important to note that a lender’s filing of an effective financing statement or giving direct notice to potential buyers of the farm products does not perfect its security interest. It only provides the lender recourse against the buyer if the buyer fails to make the check jointly payable to the borrower and lender. If the lender fails to file the effective financing statement or give direct notice, the buyer still acquires the farm products free of the lender’s lien, and the lender has no recourse against the buyer.
Enforcing an agricultural security interest or real estate mortgage lien or deed of trust may raise additional issues. Often agricultural loans involve living or growing collateral requiring the lender to advance additional funds during the enforcement action to preserve and maintain the collateral. Lenders must evaluate the economics of carrying livestock to market weight; the costs of maintaining, harvesting, and marketing crops; and any benefit that may be realized by either.
In addition, some states require a creditor to mediate a dispute with the producer and other creditors before bringing an enforcement action.17 States may also impose additional limitations on lenders that seek to realize upon their collateral. Extended redemption periods, limitations on assignments of rent, rights of first refusal, and limitations on deficiency judgments may be afforded to the producer under various state laws.
To the extent a money judgment is obtained against a producer, a lender may have little recourse against farming assets. In several agricultural states, an individual judgment debtor may claim as exempt a significant amount of agricultural property. For example, in Minnesota, an individual judgment debtor may exempt 160 acres of land up to $1.05 million in value.18
Agricultural producers enjoy several protections under the U.S. Bankruptcy Code that lenders must consider. In addition, the very nature of agricultural production requires lenders to be cognizant of the inherent risks of the industry when negotiating cash collateral and debtor-in-possession (DIP) financing agreements.
A lender likely cannot commence an involuntary bankruptcy case against an individual farmer. Specifically, Section 303(a) of the Bankruptcy Code prohibits the entry of an order for relief against a “farmer” or “family farmer.” Existing case law generally holds that it is necessary for the debtor to assert its protected status as an affirmative defense to an involuntary petition.19 However, if the debtor can successfully establish its status, the involuntary bankruptcy case remedy is likely not available to its creditors.
Similarly, Section 1112(c) precludes the conversion of a Chapter 11 case to a Chapter 7 liquidation if the debtor is a farmer. This may create significant issues for a lender that is confronted with a debtor that is not able to comply with the requirements of the Bankruptcy Code or court orders.20
Following the farm crisis of the 1980s, Congress enacted Chapter 12 of the Bankruptcy Code, which is reserved for family farmers. For an individual, the debtor must meet each of the statutory requirements to be eligible.21 Chapter 12 permits the dismissal of a case or its conversion to a Chapter 7 on the request of a creditor only if the debtor has committed fraud in connection with the case.22
Because of the debt limitation contained in the code, Chapter 12 is not likely available for today’s large-scale commercial farming operations. However, for those agricultural producers that can meet the rigid requirements, it may provide a cost-effective option.
Regardless of the chapter of the Bankruptcy Code employed by a debtor, secured lenders must carefully consider any cash collateral agreement offered by the debtor if the proceeds of prepetition crops are to be used for the payment of post-petition farming expenses. Given the inherent risks in crop production, lenders must ensure that any adequate protection offered by the debtor realistically addresses the production risk.
It may be necessary to obtain a security interest in unencumbered assets or assets in which the debtor may have equity to provide realistic adequate protection. In addition, lenders must take care to obtain replacement liens and assignments of crop insurance proceeds and farm program benefits related to the post-petition crops.
The current economics of production agriculture are requiring a new generation of agricultural lenders to educate themselves on the inherent risks presented by a unique industry as well as the sometimes arcane rules surrounding agricultural liens, federal farm programs, and exceptions to the usual rules established by Article 9. It is critical that lenders who venture into the agribusiness universe understand these rules or risk the possibility of significant losses and an expensive education.