Many agricultural producers borrow money to successfully run their operations. Typically, the lender requires the borrower to give a security interest in land, equipment or commodities before supplying the funds. This type of transaction is considered a secured transaction, as explained in the first article of this series, which is primarily governed by Article 9 of the Uniform Commercial Code (“UCC”). In general, a secured transaction is one that creates a security interest for the creditor. The creditor holds a security interest in debtors’ personal property, known as collateral, to ensure that the debtor repays the debt.

However, Article 9 requires the creditor to take several steps to make that security interest enforceable. As recently discussed in the second article of this series, the first of those steps is attachment. This step is important because, once the interest attaches, the creditor has the right to enforce the security interest in the collateral against the debtor. However, attachment alone does not allow creditors to enforce security interests against third parties that also have claims to the collateral. To do that, the creditor must complete the next step by perfecting their security interest.

The third article of this series explained that perfection is necessary to put other persons on notice of a creditor’s security interest, and it also helps determine priority among creditors who claim a similar interest. Article 9 offers creditors many mechanisms to perfect, such as perfecting by possession or control, automatically, or by filing a financing statement. However, the fourth article of this series explained that the majority of security interests in agriculture are perfected by filing a financing statement.

The creditor who completes each of these steps will hold a strong security interest against third parties, but there are some situations where a third party will have priority to the debtor’s property over the creditor. Article 9 contains rules that determine which party has priority over others. Therefore, the creditor who knows the priority rules will protect themselves against competing interests in the collateral.

Priority Overview

Priority is an important aspect of secured transactions. Under the UCC, priority is the order in which creditors receive money to satisfy a debtor’s loan debt. In other words, when multiple creditors have a security interest in the same property, the creditor with higher priority will receive payment before a creditor with lower priority.

Importance of Priority

Priority is important among creditors, but the order of priority is important in only a few instances. When two or more creditors claim an interest in the same collateral, the priority must be determined. This is because priority determines the order of repayment among the creditors.

Usually, collateral is sold after the debtor defaults. The money received from the sale, known as proceeds, is used to repay the creditors’ loans. Proceeds are distributed in order of priority. This means the creditor with first priority is the first creditor to receive proceeds. Thus, the first priority creditor has their loan repaid before all other creditors.

The first priority creditor not only receives proceeds before other third parties, but it provides the creditor with a better opportunity for their loan to be fully repaid. In some instances, collateral is sold at a price that will not completely repay every creditor’s loan debt. When this occurs, lower priority creditors may only receive a small portion of the proceeds, or none at all. Consequently, these unpaid creditors may wait months or years before their loan is repaid!

Priorities Generally

In most cases, perfection determines priority. Article 9 provides a creditor with a perfected security interest a significant amount of protection against other parties who have an interest in the same collateral. Creditors with unperfected security interest are provided some protections against third-party claims, but only against certain third parties. Accordingly, a creditor must perfect their interest to gain the most protection against other claims.

Although perfecting helps determine priority, “[a] perfected security interest may still be or become subordinate to other interests.” UCC § 9-308, Cmt. 2. In other words, secured creditors with perfected security interests do not have first priority over all third-party claims. This is because Article 9 contains several rules to determine priority among parties claiming an interest in the same collateral.

A specific Article 9 rule will determine which party has priority in every priority dispute. Primarily, the priority rule that applies to a dispute depends on the basis for the parties’ claims and what type of party they are. Therefore, it is necessary to identify the type of parties involved, whether creditors have perfected or unperfected interests, and the type of transactions involved.

Types of Claimants

There are several different types of parties that claim an interest to collateral. Usually, these parties can be broken into two categories: purchasers of the collateral, and other creditors of the debtor. The most common parties that fall within these two categories include:

• Buyers of the collateralized property;
• Other secured creditors;
• Unsecured creditors;
• Representatives of the debtor, such as a bankruptcy trustee; and
• Persons who obtained a lien on the collateral by statute.

The type of parties involved in a priority dispute helps determines which Article 9 rule applies. For example, a specific rule applies when two creditors are in a priority dispute, but a different rule applies when the priority dispute is between a creditor and buyer. In this example, different priority rules apply to both disputes because the types of parties are different. In every dispute, a court must determine the type of each party because it helps the court select the correct Article 9 priority rule. However, determining which rule applies also depends on whether a creditor has an unperfected or perfected security interest.

Priority of Unperfected Security Interests

Under Article 9, different rules apply to priority disputes when a creditor’s interest is perfected or unperfected. Most agricultural lenders perfect their interests by filing a financing statement. If a lender does not file, their interest is likely unperfected. Consequently, certain types of third parties are given priority over lenders with unperfected interests.

Section 9-317 of the UCC describes which parties have priority over unperfected creditors. Some of these parties include:

• Creditors holding perfected security interests have priority over creditors with unperfected security interests. This stays true even when the unperfected creditor received their security interest before the perfected creditor.
• A lien creditor will have priority over the unperfected creditor. A lien creditor is a person who is awarded an interest in another person’s property. This interest is created by a statute or judge in a lawsuit.
• Some buyers of certain collateral will have priority. A buyer will have priority over an unperfected creditor if the buyer: (i) pays value for the property; (ii) receives delivery of the property; and (iii) did not know a creditor holds a security interest in the property.

Unperfected creditors have little protection against most third-parties claims, but some situations arise when an unperfected creditor has priority. Typically, this occurs when two unperfected creditors are in a priority dispute.

Under § 9-322(a)(3), the first unperfected creditor that attached their interest has priority over the other unperfected creditor. Most secured transactions use security agreements to record the loan agreement between the lender and debtor. Once the agreement is signed by the debtor, the lender’s interest attaches. Therefore, the first lender who enters into a security agreement with the debtor will have priority.

For example, suppose Julia operates a dairy farm. She has plans to increase her dairy production, but needs a loan to expand the operation. Julia goes to Agri Bank to obtain a loan for $100,000. The Bank agreed to loan her only $75,000, and told her to come back the next day to sign the loan agreement.

That same day, Julia goes to the local Farmers Co-Op. While there, she spoke to a Co-Op employee about her growing dairy operation. Julia mentioned that she would not be able to increase her diary production as planned because she could not receive the entire amount of funding she needed. Conveniently, the Co-Op employee tells Julia that they offered financing for farm operation expenses, and that the Co-Op would gladly advance the additional financing she needed. The Co-Op presented Julia a loan agreement, which stated “I, Julia, give Farmers Co-Op a security interest in all of my farm equipment and dairy cattle.” Both parties sign the document and the Co-Op hands Julia a check for $25,000.

The next day, Julia returns to the Bank to sign the loan agreement. The Bank’s agreement read, “For this loan of $75,000, Julia provides the Bank a security interest in all of her dairy cattle and farm equipment.” Both parties sign the agreement and the Bank gives Julia the money. Neither the Bank or the Co-Op file a financing statement to perfect their security interest in the collateral. After four months, Julia defaults on both loans.

In the example above, the Co-Op has priority over the Bank. Both creditors have interest in the same collateral, but both hold unperfected security interests. The Co-Op’s interest attaches before the Bank’s interest because Julia signs the Co-Op’s security agreement before the Bank’s. The Bank’s offer to supply the loan does not have an affect on this outcome. Under Article 9, the Co-Op has priority over the Bank.

Priority of Perfected Security Interests

As previously stated, secured creditors who perfect their security interest are protected against most third parties who claim an interest in the same collateral. Special priority rules under Article 9 give priority to another party over an earlier perfected creditor in certain situations. However, many cases involve priority disputes between two or more perfected creditors.

Most perfected agricultural lenders perfect their security interests by filing a financing statement. Under Article 9, when two or more lenders hold security interests that are perfected by filing, priority is determined by the time of filing. This is known as the “first-to-file” rule. In other words, the first creditor who filed their financing statement has priority.

Because priority is based on the date of filed, creditors may take advantage of pre-filing their financing statements. In general, Article 9 permits creditors to file a financing statement before a debtor signs a security agreement. The date the creditor files the financing statement is the date of perfection.

For example, Roy needs financing to operate his cattle ranch. On February 1, Roy goes to Farm Credit Bank and applies for a $25,000 loan. To secure this loan, he gives Farm Credit Bank a security interest in all of his cattle. On February 2, Farm Credit Bank files a financing statement. On February 4, Roy goes to Hometown Bank and obtains a loan for $15,000. He gives Hometown Bank a security interest in all of his cattle. Hometown Bank files a financing statement that same day. On February 20, Farm Credit Bank approves Roy’s loan and gives him a $25,000 check. After seven months of making timely payments, Roy defaults on both loans.

In this case, Farm Credit Bank has priority over Hometown Bank. Because both parties perfected by filing, priority depends on the date of filing. Farm Credit Bank is the first party to file a financing statement. It does not matter that its interest had not yet attached when filing the financing statement. Therefore, Farm Credit Bank has first priority because it perfected its interest by filing before Hometown Bank.

Conclusion

Priority order is important for creditors. The order of priority helps lenders that have not yet provided a loan. When a lender discovers an earlier perfected security interest in a person’s property, the lender is less likely to lend money because the earlier perfected creditor will have priority if a default occurs. The order of priority is also important because it determines when the creditor’s loan will be repaid, and oftentimes if the creditor will be repaid. A lower priority creditor may go unpaid because the proceeds are distributed to satisfy higher priority parties. However, creditors can minimize this risk. Overall, a creditor who perfects their security interest in a timely manner gains protection against other parties who claim an interest in the same collateral.

Upcoming

This article is the fifth in a series that the National Agricultural Law Center will publish over the next several weeks discussing the law surrounding secured transactions. The next article will discuss some special exceptions to the first-to-file rule, and also explain priorities involving agricultural liens.

To read the first article in this series, click here.

To read the second article in this series, click here.

To read the third article in this series, click here.

To read the fourth article in this series, click here.

For a general overview of agricultural lending, click here.

For U.C.C. Forms and Filing Information, click here.

For more National Agricultural Law Center resources on finance and credit, click here.

For more National Agricultural Law Center resources on secured transactions, click here.