Many agricultural producers borrow money to successfully run their operations. Typically, the lender requires the borrower to give a security interest in property such as land, equipment or commodities before supplying the funds. This type of transaction is considered a secured transaction, 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. Thus, the producer who borrows money from the creditor will provide a security interest in their agricultural property to the creditor. Previous articles in this series discuss the rules governing these types of transactions.
Creditors take security interests in a debtor’s property to provide themselves with the ability to enforce their interest in the collateralized property. In most cases, debtors repay their debts by the maturity date. However, if a debtor defaults on their loan, a creditor can enforce their interest to satisfy the debt owed to them.
When a creditor must enforce their interest, Article 9 provides certain rights to those creditors. In general, Article 9 provides creditors two options as to how they may enforce their interest in order to satisfy a debtor’s unpaid debt: (1) dispose of the collateral, or (2) keep collateral in satisfaction of the debt.
Many creditors choose to dispose of collateral by selling the property at an auction or to a private buyer. When doing so, lenders must satisfy two steps required under Article 9: (1) provide reasonable notice to parties who have an interest in the collateral being disposed, and (2) dispose of collateral in a “commercially reasonable” manner. If a creditor satisfies these steps, they will receive the proceeds from the collateral sale. However, creditors are required to distribute these proceeds in accordance with Article 9 rules.
Distribution of Proceeds Overview
Many creditors choose to sell collateral and collect the proceeds in order to satisfy a debtor’s indebtedness. However, after receiving proceeds of a collateral sale, Article 9 requires creditors to distribute these funds in four separate levels. Section 9-615 of the UCC specifies the order of priority in which proceeds must be distributed. In other words, there is a precise order in which creditors must distribute the proceeds, and creditors must satisfy each level before distributing any proceeds to the next level of priority.
Article 9 requires creditors to first distribute proceeds to two types of expenses. First, creditors must distribute proceeds to any “reasonable expenses of retaking, holding, preparing for disposition, processing, and disposing” of the collateral. U.C.C. § 9-615(a)(1). In other words, a creditor can recover or keep expenses they incur while collecting, holding, repairing, or selling the collateral. Generally, if a creditor’s actions were commercially reasonable in the collection and disposal of the collateral, the expenses they incurred are “reasonable” for the purposes of this provision. Second, a creditor must apply the proceeds to any reasonable legal fees they incur while enforcing their interest (e.g., attorney’s fees). However, a creditor can only recover these expenses if these fees are provided for in the parties’ security agreement.
Apply to Unpaid Debt
After satisfying expenses, creditors must then apply the proceeds to satisfy the debt “secured by the security interest or agricultural lien under which the disposition is made.” U.C.C. § 9-615(a)(2). This means the creditor enforcing their security interest applies the funds received from selling the collateral to pay off or reduce the debtor’s unpaid debt. However, the creditor cannot apply proceeds to a debt that does not secure the collateral which produced the proceeds. In other words, if the creditor is enforcing multiple security interests against the same debtor, the creditor must ensure they distribute the proceeds earned from collateral to satisfy the specific debt covering that collateral.
For example, suppose an agricultural lender provides two separate loans to a producer. One loan is secured by the producer’s combine while the other is secured by the producer’s soybean crop. Ultimately, the producer defaults on both loans and the lender enforces their security interest by repossessing and selling all of the collateral. In this example, the lender cannot commingle the proceeds from the collateral sales because each loan secures different collateral. The lender can only use the proceeds earned from selling the combine to satisfy the loan secured by the combine, and the proceeds from the soybean crop can only be applied to the loan securing those crops.
Generally, creditors avoid this by including cross-collateralization clauses within their security agreements. These clauses provide that the same property is secured as collateral for multiple loans from the same creditor. Thus, if the lender from the example above includes a cross-collateralization clause in its agreement with the procedure, the lender can use the proceeds earned from combine and soybean crop to satisfy the unpaid debt of both loans.
If the proceeds of a collateral sale are insufficient to completely satisfy the debt owed to the creditor enforcing their interest, the debtor is generally liable to the creditor for the remaining outstanding debt. Essentially, disposing of the collateral does not extinguish the debtor’s debt, rather it provides funds to the creditor to satisfy the debt in whole or in part. Thus, Article 9 permits the creditor to bring a deficiency action against the debtor in state court to retrieve the remaining amount of the debt. But if the creditor fails to comply with the notice and disposition requirements under Article 9, a court may reduce the amount of the creditor’s deficiency claim.
If the proceeds completely satisfy the indebtedness, creditors cannot bring a deficiency action and must forward the funds to the third level of priority, which consists of junior creditors and lienholders.
Junior creditors and lienholders are considered “junior” to the creditor because they hold a lower priority in the collateral. In other words, the creditor with higher priority has the right to receive payment before creditors and lienholders with lower priority. In most cases, priority is determined by the order in which creditors file their financing statement securing the collateral. Thus, the first creditor to file a financing statement typically has priority over creditors who file later in time.
Under Article 9, the creditor who enforces their interest in the collateral is responsible for distributing the proceeds to these junior creditors before the debtor obtains any surplus. However, the creditor is only required to distribute proceeds to junior creditors who provide an “authenticated demand for proceeds before distribution of the proceeds is completed.” U.C.C. § 9-615(a)(3)(A). The creditor that receives such a demand can request the junior creditor to furnish proof of their interest in the collateral. If the junior creditor does not comply, the creditor has no obligation to distribute proceeds to them. Nevertheless, a creditor becomes liable for any unpaid interest if they do not distribute proceeds to a junior creditor who makes a proper demand and provides proof of its interest.
If proceeds from the collateral still remain after satisfying the previous levels of priority, the creditor must distribute the funds to the debtor. Because a security interest is limited to the amount necessary to satisfy the debtor’s unpaid debt, any surplus belongs to the debtor. However, there are some exceptions to this general rule. First, if the creditor knows the collateral is owned by someone other than the debtor when enforcing their security interest, the debtor is not entitled to the surplus. Rather, the creditor must distribute the proceeds to the party who owned the collateral at the time of enforcement. Second, if a consignor has an interest in the collateral, the creditor must provide the consignor with any surplus proceeds instead of the primary debtor.
Creditors must distribute proceeds from a collateral sale in accordance with Article 9. Section 9-615 provides creditors the order in which proceeds must be distributed, and specifies that each level of priority must be completely satisfied before applying any proceeds to the next. First, creditors must pay off all reasonable legal and non-legal expenses. Second, creditors must distribute the funds to themselves in order to satisfy the indebtedness, and creditors may generally pursue a deficiency action against the debtor if the proceeds do not satisfy the unpaid debt. Third, if the proceeds satisfy the creditor’s entire debt, they must distribute funds to junior creditors who provide the creditor with a proper demand. Fourth, if any excess proceeds remain, the creditor must distribute the funds to the debtor unless an exception applies. Creditors that do not distribute proceeds in accordance with Article 9 may risk becoming liable for any unpaid funds due to an interested party.
The next article in this series will discuss an alternative method of satisfying a debtor’s indebtedness: keeping the collateral in satisfaction of the debt.
To read the other articles of this series, 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.