Secured Transactions: An Overview

Background

As agriculture becomes more industrialized, credit becomes more of an integral part of the production process. Lenders secure loans to agricultural producers with collateral in property such as crops, livestock, and equipment. The mechanism that governs these transactions is primarily contained in Article 9 of the Uniform Commercial Code (UCC) as adopted in each state. For a discussion of agricultural lending as it pertains to real property and operating capital, please visit the Finance and Credit Reading Room.

As of January 1, 2002, Revised Article 9 of the UCC, the first major revision since 1972, has taken effect in all fifty states and the District of Columbia. Revised Article 9 broadens the scope of covered transactions and attempts to simplify the creation, perfection, and enforcement of security interests. In 2010, the American Law Institute approved amendments to Article 9. All fifty states and the District of Columbia have enacted the revisions, which were effective on July 1, 2013.  The UCC is a uniform act, recommending laws to the states. Enactment of the UCC across the states includes some variations incorporated by individual state legislatures, and this overview focuses generally on Article 9 of the UCC as revised, and how it functions in agricultural lending. Due to the complex nature of the rules governing secured transactions, careful attention must be paid to the rules and the details applicable to each transaction to avoid potential pitfalls.

Secured Transactions Generally

An obligor is the person requesting credit. A secured transaction occurs when a credit provider grants an obligor credit and in return is given a security agreement that grants a security interest in collateral of the obligor. A credit provider who receives the benefit of a security interest is called a secured party; a security agreement is the contractual agreement that creates the security interest; and a security interest is an interest in property that secures payment or performance of an obligation. The collateral is the property in which the security interest attaches.

There are two types of security interests: possessory and non-possessory. A possessory security interest is where the secured party has possession of the collateral. With a non-possessory security interest, the debtor retains possession of the collateral. Most security interests are non-possessory because the debtor wants to use the collateralized property. The type of security interest usually does not impact a creditor’s interest in the collateral. However, depending on the type of collateral, a creditor with a possessory security interest may have a superior claim to the collateral over other creditors with non-possessory security interests.

A secured transaction has several stages, including attachment and perfection. Attachment occurs when the security interest becomes enforceable against the debtor. A security interest is enforceable only when (1) value is given, (2) the debtor has rights in the collateral, and (3) the debtor has authenticated a security agreement that contains a description of the collateral or the secured party has possession of the collateral.

With a few exceptions, perfection is the point in time after which the secured party is protected from subsequent creditors’ claims in the same collateral. Perfection generally requires the filing of a financing statement or possession by the secured party of the collateral. A financing statement must contain the name of the debtor, the name of the secured party, the collateral to be covered, and must be filed in the appropriate location(s) in accordance with state law.

Determining the priority of a security interest is important. Perfection assists in determining the order of priority against other secured creditors of the same collateral. This priority is the order in which secured creditors will receive proceeds from the same collateral. If a security interest is perfected after a lien creditor comes into existence, the lien creditor will have priority. A perfected security interest has priority over an unperfected interest, and between two interests of the same status, either the first interest perfected or the first interest that is attached will have priority.

However, an important exception to these priority rules exists when there is a transaction that creates a purchase money security interest (PMSI). A PMSI is created when a creditor loans money to a debtor so that they can purchase an item, and in return, the debtor gives the creditor a security interest in that property. Under Article 9, a PMSI enables a creditor who finances a debtor’s purchase of goods to acquire a first priority security interest in the purchase-money collateral. Generally, depending on the type of collateral, this holds true even if another creditor holds an earlier perfected security interest.

If the obligor defaults, the secured party may take possession of the collateral or use other remedies provided in Article 9. If the obligor becomes bankrupt, the secured party may receive the collateral rather than only a portion of the bankruptcy estate after it is divided among creditors.

Agricultural Secured Transactions

Article 9 of the UCC applies to agricultural liens; agricultural liens are interests in farm products that are not formed by security agreements. Agricultural liens often arise from state law and demonstrate a desire by the states to provide extra protection to specific groups of people. Agricultural liens secure payment for goods and services furnished to farm operations or rent for agricultural lands and are not dependent on the possession of the farm products. “Farm products” includes crops that are grown, growing, or will be grown; livestock born or unborn, including aquatic goods produced in aquaculture; supplies used or produced in a farming operation; and products of crops or livestock in their unmanufactured states.

For an agricultural lien to be perfected under Article 9, a financing statement must be filed. The priority for an agricultural lien is the same as any other lien unless the statute that creates it provides for superior status. In an effort to preserve historical protections for some persons, some states have specifically removed certain statutory agricultural liens, such as landlord, liens from the definition of agricultural liens so that filing is not required for their perfection. These special agricultural liens are often granted super-priority over other interests and liens. In addition, local law, where the farm products are located, governs perfection of the agricultural lien rather than the Article 9 standard, “where the debtor is located.” Careful study of state law provisions must be employed to avoid losing priority to a superior unfiled statutory lien. For a listing of states’ statutory agricultural liens, click here.

Farm program payments are often a desirable source of collateral in secured transactions. Due to the differences between programs, the payments they provide may not always fit into the same general language contained in standard security agreements. In addition, case law is inconsistent on the proper treatment of program payments. Careful drafting of security agreements is required if farm program payments are to be used as collateral.

Lenders with a perfected purchase-money security interest in livestock can have priority over conflicting security interests in the same livestock, their proceeds, and unmanufactured products. The lender must perform steps so that the interest is perfected when the debtor receives possession of the livestock, and notice must be sent to the holder of the conflicting security interest.

Federal law preempts Article 9 when dealing with the sale of farm products. Generally, a security interest will follow the collateral even after it is sold and attaches to proceeds from the sale. As a result, the buyer of secured property may have to pay twice for the goods, once to the seller and once to the secured party. An exception is granted under Article 9 to buyers in the ordinary course of business, but this exception specifically excludes persons buying farm products from persons engaged in farming operations. However, the federal farm products rule, 7 U.S.C. § 1631, which was enacted as part of the Food Security Act of 1985, preempts Article 9 and protects buyers of farm products from previous security interests. Thus, under the federal farm products rule, a buyer that buys farm products from a producer in the ordinary course of business is not subject to any security interest created by the seller as long as the requirements of the federal farm products rule are met, even if the interest is perfected and the buyer knows of its existence.

It should be noted that the Food Security Act provides mechanisms relating to notice that allow secured parties to prevent a buyer from taking clear of the security interest. First, in states that follow the direct notice system, a secured creditor may send the buyer of farm products a written notice that includes the list of specific information contained under §1631(e). If the secured party sends direct notice to the buyer before the products are purchased the security interest is maintained. The other method of notice established under the Food Security Act is called the central filing system. In states that have adopted a central filing system, a creditor has the option to either send a buyer direct notice or file an effective financing statement (“EFS”) with the state’s Secretary of State, as explained under §1631(c)(4).Thus, if the state has adopted a central filing system and the buyer has received notice from the Secretary of State of an effective filing of a financing statement (EFS) or notice of the security interest in the farm products, the buyer must obtain a waiver from the secured party or the interest will continue in the products.