Section 1631 and the Farm Products Exception to the UCC Exception—Fertile Traps for the Unwary

9 Min Read By: Brooke Schumm

Debt limits in chapter 12 of the Bankruptcy Code are often exceeded by farm operations, necessitating a chapter 11, and issues involving perfection and realization of security interests, or voiding of rights, will be an important issue for business bankruptcy lawyers involved in farm bankruptcies—sometimes perjoratively called industrial farm bankruptcies, which tells one the scale of debt that can be involved.The issue of farm bankruptcy merited a recent Wall Street Journal article:  “‘This One Here Is Gonna Kick My Butt’—Farm Belt Bankruptcies Are Soaring,”  Feb. 6, 2019.

Farm operations have more complex statutory overlays than many businesses. In addition to the usual Uniform Commercial Code issues, there are two important overlays of law: First, 7 U.S.C. § 1631 revising at a federal level the so-called farm products exception in the UCC, and second, a potpourri of statutory liens varying from state to state, generically referred to as agricultural liens, mostly falling within the UCC definition of “agricultural liens.” These are not new problems—just ones that are likely to re-emerge given current prices, the size of operations, and foreign trade issues.

Fertile opportunities are presented for bankruptcy lawyers to recover assets and avoid liens, and unfortunately there are many opportunities for error by commercial lawyers generally. For lawyers who are associated with traditional financing who never heard of section 1631, it can be a rude awakening, particularly with the section 1631(c) exception that actual notice makes no difference (i.e., knowing about the lender’s UCC filing make no difference) and that the governing location for filing and “effective financing statement” is not the “birthplace state” for 1631 protections—yet , by contrast, for perfection of a security interest against the debtor and its creditors, the filing location remains the “birthplace state.”

Chapter 12 focused on family farm bankruptcies. Chapter 12 had what seemed to be generous debt limits at the time of passage, but as the economies of scale of farming have increased, and the complexity of farm ownership structures has increased, the debt limits are often exceeded, and nonfarm operation affiliates are involved. In order to be a family farmer eligible for chapter 12, among other requirements, the debt must be under a certain level, and 50 percent of the debt must arise out of the farming operation, excluding principal residence debt. The current total debt limit is $4,153,150. There is no separate limit for secured debt.

In the “old days” prior to 1985, the controlling law on farm products and security interests was in what is now UCC 9-320(1):

(a) Except as otherwise provided in subsection (e), 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 [emphasis added].

In plain English, once a lender was perfected under the UCC, no buyer of farm products took free of a lien unless the buyer had a waiver or delivered the proceeds to the lender (that usually worked).

Since 1985, for lenders, buyers, and those reserving rights in goods, the most critical statute is 7 U.S.C. § 1631. For farm products, section1631 pre-emptively overrides state law and the so-called farm products exception in UCC section 9-320(a). In pertinent part, section 1631 entitled “Purchases free of security interest” reads:

Except as provided in subsection (e) and notwithstanding any other provision of Federal, State, or local law, a buyer who in the ordinary course of business buys a farm product from a seller engaged in farming operations shall take free of a security interest created by the seller, even though the security interest is perfected; and the buyer knows of the existence of such interest. [Emphasis added.]

Referring to UCC 2-401(1):

Title to goods cannot pass under a contract for sale prior to their identification to the contract (Section 2-501), and unless otherwise explicitly agreed the buyer acquires by their identification a special property as limited by this Act. Any retention or reservation by the seller of the title (property) in goods shipped or delivered to the buyer is limited in effect to a reservation of a security interest. Subject to these provisions and to Article 9, title to goods passes from the seller to the buyer in any manner and on any conditions explicitly agreed on by the parties. [emphasis added]

Unfortunately, some parties read the contracts and not the law governing contracts and forget the UCC rule that title is often immaterial, and words that may not look like a security interest are, in fact, a security interest. This is particularly important once title or possession has passed to a buyer.

In theory, under section 1631, lenders using farm products as collateral can still protect their security interest against buyers by an “effective financing statement.” In practice, it is more difficult. Attorneys might make the mistake of thinking an effective financing statement is like a UCC financing statement, but that is not the case; there may be different places of filing and perfection and different technical requirements. The section 1631 form must be technically perfect to protect the lender. Complicating the notice aspects are two statutory schemes in section 1631 that may govern depending on the “birthplace” state of a farm operation and the location of where the product is located or produced. There are U.S. Dept. of Agriculture regulations implementing section 1631 that deserve attention.

One statutory scheme authorized under section 1631 creates a central filing scheme similar in scope to a UCC central filing scheme. There are 17 states with this type of system listed on a USDA website. For section 1631 purposes, the state for a central filing is where the farm product is located or produced, not necessarily the birthplace state. The rest of the states and other jurisdictions, including obvious major farm states (e.g., Iowa, Wisconsin, New York, California), do not have a central filing scheme. In those states, actual notice of the section 1631 form of effective financing statement must be given to buyers, which is a daunting task for a lender—arguably so much so that it is not realistic for protection and might explain why these 33 states chose not to be central filing states.

A first question in an insolvency context is whether a security interest or reservation of rights constituting a security interest is created. Suppose there is perfection under the UCC, but no effective financing statement, and a buyer buys farm products; these purchased farm products are clearly free and clear of any security interest under section 1631 and many 1631 cases. However, the buyer may not be free and clear of agricultural liens, and if one of them is not perfected and can be avoided, do sections 544/547 come into play? Agriculture liens generally would be perfected in the “birthplace state.” Failing proper perfection of an agricultural lien, does the preservation of an avoided lien for the benefit of the estate come into play? What if the lender perfected by an effective financing statement where the products are produced or located, but filed a UCC-1 in the nonbirthplace jurisdiction or did not file at all? Can the trustee avoid the lien on proceeds (not the sale to the buyer) for the benefit of the estate? What if the debtor-to-be moves the collateral to another state just before or perhaps after the effective financing statement is filed? Does the buyer win and the lender lose because of the “located or produced” rule? If the buyer were buying free and clear, so the secured lender loses to the buyer, but the lender did perfect its security interest under the UCC, does the lender receive a lien on the proceeds? Similar to inventory cases where the merchant sells inventor to buyers in the ordinary course, the answer would seem to be “yes.” What if a contracting party failed to recognize they have what amounts to a security interest under UCC 2-401(1) and took no action to perfect under the UCC and/or section 1631?

Farm product prices were significantly higher in 2013, but in the last few years as production increased and global production increased, there has been significant downward farm price pressure. Economies of scale have absorbed some of the pressure on margins, but generally if a significant price reversal occurs and U.S. farm price supports are inadequate to buttress operations against that pressure, a farm bankruptcy is inevitable. Although farm businesses are traditionally smaller than many other chapter 11 cases, the numbers are becoming respectable enough to attract and support the fees of skilled lawyers.

A nice case example illustrating the various section 1631 issues arose out of Mississippi in First Bank v. Eastern Livestock Co., 837 F. Supp. 792, 802 (S.D. Miss. 1993). Proceeds of a security interest were not remitted to First Bank, which claimed that Eastern Livestock was on notice of First Bank’s UCC-perfected security interest and should have remitted those proceeds to the bank because Eastern Livestock had to recognize the security interest (Eastern Livestock had already paid the seller, which was the borrower from the bank):

First Bank argues that regardless of the disposition of the issue of whether First Bank’s UCC–1F was sufficient, it is entitled to summary judgment since Eastern had actual notice of First Bank’s security interest by virtue of Wells’ having identified First Bank as a lienholder on a certain cattle purchase confirmation contract with Eastern. However, whether Eastern had actual notice of the Bank’s claimed security interest is not material. [italics added] The Act provides the only means by which a buyer may be made subject to a security interest, i.e., filing of an “effective financing statement” or providing “written notice,” and explicitly states that unless one of those methods is followed, then a buyer who buys a farm product in the ordinary course of business from a seller engaged in farming operations takes free of a security interest created by the seller, even if “the buyer knows of the existence of such interest.” Thus, actual notice is not relevant, unless such actual notice is imparted to the buyer by the secured party in the manner prescribed by the Act.18 [f.n. 18: The court would note that there is, in any event, a factual dispute between the parties concerning whether Eastern, in fact, had actual notice as claimed by the Bank.]”

I would be completely remiss without crediting a member of our section with lead articles on the subject:, Drew L. Kershen & J. Thomas Hardin, Congress Takes Exception to the Farm Products Exception of the UCC, Retroactivity and Preemption, 36 U. Kan. L. Rev. 1 (1987) (in two parts) available (for a fee) at Hein Online. The articles are the starting point to begin to comprehend this area of the law.

By: Brooke Schumm

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