Production Contracts – An Overview
Background
Agricultural production contracts are agreements between producers (e.g. farmers) contractors (e.g. ag businesses) for agricultural commodities. These contracts usually identify the production practices to be used, identify the party responsible for supplying the required resources, and specify the quantity, quality, and method of payment for the commodity. Farmers and ranchers utilize production contracts as a tool to manage the risks inherent in agricultural production. Agricultural businesses employ production contracts to manage risk and control expenditures. The legal implications of production contracts are unique to each jurisdiction because the law of each state governs their interpretation. In addition, variations in terms and language contained in individual production contracts make each one distinct.
Producer Benefits and Disadvantages
Production contracts can provide farmers and ranchers with many benefits and disadvantages. Risk reduction is a principal benefit of production contracts because payment for commodity production is predetermined and outlined in the contract. Assuming that the contract terms are fulfilled, this removes the uncertainties of traditional open agricultural markets and guarantees a market for production. In addition, prices under production contracts may be above market rates.
Another possible benefit of production contracts is that capital requirements may be reduced because the elements of production (e.g. seeds or livestock)are owned by the contractor, and therefore the producer does not need to expend resources to acquire them. The stable income under contracts reassures lenders that lending capital is more readily available. Some contractors may even provide financing directly to their producers.
Specialized information and technology are often available from contractors to producers under production contracts. Certain biotechnology or genetically superior breeds or varieties may only be available to producers who sign production contracts because contracting companies often limit access in an attempt to protect their investments and their intellectual property rights in these technologies. Contractors may also provide technical information, production support, and advice to producers through advisors and consultants.
The primary disadvantage associated with agricultural production contracts is that producers lose independence or control over their farming operations. By its nature, a production contract specifies the methods and practices that must be used to produce the covered agricultural commodity, thus removing authority from the producer. These restrictions may also require expensive methods or inputs or ones that can only be purchased from the contractor.
Another disadvantage is that capital investment may be required in the form of highly specialized facilities that have little or no alternative use and high initial costs. Termination of a contract is also a producer risk, especially if the producer has expended significant amounts of capital to comply with the contract.
The timing of payment under the contract may be longer after harvest than under traditional open markets, leaving the producer as an unsecured creditor of the contractor. In traditional agricultural marketing, unpaid producers of certain agricultural commodities are typically protected by federal laws; under production contracts, these protections may be lost.
Grading of the commodity, if done solely by the contractor, may present a disadvantage to the producer. The processor alone decides whether the commodity meets the required criteria for the contract and what level of payment is deserved.
Production contracts can shift additional risk to producers. These risks can include environmental liabilities and crop or yield loss risks, even though the producers do not own the crop or livestock.
Contractor Benefits and Disadvantages
A major advantage that production contracts provide contractors is control over supply. That allows contractors to control the operating costs of labor and equipment used to process the commodity. Contractors have sufficient control to manipulate the flow of commodities into the production process, as well as larger volumes of production, which enables contractors to operate more cost-efficiently.
Production contracts also enable contractors to exert influence over the production process so that consumer-appealing, uniform products are produced. This allows changes in consumer preference to be more quickly incorporated into the contractors’ products. Production contracts also encourage contractors to make investments in technology because financial returns can be guaranteed from the controlled release of the technical information to producers.
Production contracts help insulate processors from liabilities. Under production contracts, producers are considered to be independent contractors thus protecting the processor from the liabilities associated with production, such as labor or environmental consequences.
The primary disadvantage faced by the contractors is the assumption of market risk. By guaranteeing a certain level of payment for commodities, the contractor has the risk that the market price will change to its detriment. However, contracting can also help reduce the contractor risk if they obtain commodities from different regions and diversify their supply.
Legal Regulation
As with any agreement, production contracts can be drafted to disproportionately favor one party over another, which often occurs when one party lacks bargaining power. This type of contract may create a multitude of new and different disadvantages for the weaker party. Commentators suggest that due to concentration in the agricultural industry, there is little competition between contractors. This lack of competition results in a situation where producers have little bargaining power and must accept unfavorable contracts because they have no other economically feasible options. This potential for unbalanced bargaining power and its effects has resulted in legislation to aid producers who enter into production contracts.
A portion of the Farm Security and Rural Investment Act of 2002, 7 U.S.C. § 229b, negates production contract confidentiality clauses in specific instances for livestock and poultry producers. It enables producers to discuss the details and terms of a production contract with federal or state agencies, legal advisers, lenders, accountants, managers, landlords, and immediate family members, despite any confidentiality clause that may appear in the contract. The law does not preempt any state law that affords producers greater protections from production contract confidentiality clauses.
Various states have also enacted laws to protect producers from inequitable production contracts. In 2000, the Iowa Attorney General, along with fifteen other state attorney general offices, developed a model act for state legislation that would regulate agricultural production contracts. This proposed legislation, known as the Producer Protection Act (PPA), was modeled after existing and proposed laws in several states such as Iowa, Minnesota, Kansas, and Mississippi. The model act attempted to strike a balance – protecting producers without overburdening contractors. Variations of the PPA were proposed in state legislatures, but only portions of the act were adopted in a few states. The PPA’s provisions provide an overview of the variety of different state laws enacted to govern production contracts.
An implied promise of good faith is established for all agricultural contracts. As defined in the Uniform Commercial Code (UCC), this is honesty in fact in the concerned transaction that imposes a sense of fairness on the contract that could help protect producers. Unfair practices are also identified and outlawed. Producers are protected from retaliation, coercion, or discrimination by the contractor for exercising producer rights. These rights include joining associations, contracting with associations, whistle blowing, and other PPA-created statutory rights. Contractual waivers of any rights created by the PPA are also prohibited.
Disclosure of risks is mandated. The contract must include a cover sheet that explains, in simple language, the material risks of the contract.
The entire contract must be written in simple language. The readability of the contract must meet identified standards and may be certified as compliant by an authorized official. It must also include an index that marks important sections of the contract and a statement urging the producer to read the agreement.
A three-day cooling-off period is required in all production contracts; the producer is given the right to cancel a contract within three days of executing the document. This right must be clearly stated in every production contract.
Confidentiality clauses are deemed void. This prohibition is broader than the similar federal law, but the intent is the same. It encourages producers to seek advice from professionals or even other family members and creates transparency in agricultural markets.
In instances where the producer is required to invest $100,000.00 or more in facilities to produce a commodity pursuant to a production contract, the processor’s unilateral ability to terminate a contract is limited. If there is no alleged breach of the production contract, the producer must receive 90 days notice and damages based on the useful life of the facilities before the production contract may be terminated. If a material breach is alleged by the contractor, the producer must be given 45 days notice of the breach and 30 days to remedy the breach before contract termination can occur. Contractors are exempt from the notice requirements if the producer abandons the contract or is convicted of theft or fraud against the contractor.
Production contracts must be governed by the laws of the state where the producer lives. This ensures that a choice of law clause in the contract will not operate to remove statutory producer protections.
A production contract lien is also established. This enables a producer to receive a first priority lien against the produced commodity, its cash proceeds, or contractor property.
Alternative dispute resolution is required. A mediation release is required before a court may hear a contract dispute. This attempts to provide an economical solution to disputes at an early stage in the disagreement.
The state attorney general’s office is given primary authority for enforcement of the provisions of the act. However, a private right of action is given to producers, and awards for attorney’s fees are permitted to facilitate producers’ access to legal representation.
Another protection that some state laws authorize is parent-company liability. If a subsidiary company acting as a contractor defaults on an obligation to a producer, the parent company becomes liable to the producer for the amount owed under the contract.
In addition to special statutory protection for producers that execute production contracts, traditional business law may also provide protection. Some production contracts may be structured as sales contracts. These types of contracts usually are governed by the UCC. The UCC provides remedies to producers upon breach of contract by the contractor.
Depending upon how the production contract is structured, other federal laws such as the Perishable Agricultural Commodities Act (PACA), 7 U.S.C. §§ 499a-499t, and the Packers and Stockyards Act (PSA), 7 U.S.C. §§ 181-229, may provide protections to producers. PACA provides protections to sellers of fresh fruits and vegetables, prohibits unfair practices, and creates a statutory trust for unpaid sellers of covered commodities. The PSA protects livestock producers by prohibiting unfair business practices, requiring prompt payment, and creating a statutory trust for unpaid sellers. For further discussion of these Acts please visit the Perishable Agricultural Commodities Act Reading Room. and the Packers and Stockyards Reading Room.
The Agricultural Fair Practices Act of 1967, 7 U.S.C. §§ 2301-2306, prohibits agricultural product handlers from discriminating against or using unfair trade practices against producers that join producer associations or that contract with producer associations. These prohibitions on unfair trade practices are similar to protections proposed in the PPA.
In 1994, the merger of the Federal Grain Inspection Service and the Packers and Stockyards Administration resulted in the formation of the Grain Inspection, Packers and Stockyards Administration (GIPSA). The purpose of this agency was to facilitate fair and competitive trading practices in the marketing of livestock, poultry, meat, cereals, oilseeds, and related agricultural products. Once a standalone USDA Marketing and Regulatory Program, GIPSA merged into the Agricultural Marketing Service (AMS) in 2017. The AMS now has oversight of all programs initiated under GIPSA. For more information about the new regulatory structure, consult the following links:
ORGANIZATIONAL CHARTS OF NEW AMS STRUCTURE:
Federal Grain Inspection Service Chart
For more information on the general contract aspect of production contracts, consult the Commercial Transactions Reading Room.