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.
Usually, most loans are repaid by the maturity date, but there are instances where a debtor in a secured transaction is unable to repay the loan debt because they have become insolvent. When this situation occurs, it is usually followed by some sort of insolvency proceeding, which is a process “intended to liquidate or rehabilitate the estate” of the insolvent debtor. (UCC § 1-201(b)(22)). Typically, an insolvency proceeding is carried out by filing a bankruptcy petition, which initiates a bankruptcy proceeding for an insolvent debtor.
In general, bankruptcy proceedings allow debtors to reorganize their finances and pay off the debts they owe to creditors. For lenders, however, bankruptcy proceedings have the ability to affect a security interest they hold in a debtor’s property. Specifically, creditors may not be able to recover the entire debt owed by a borrower once they initiate a bankruptcy proceeding.
This article discusses, in the context of security interests, important features of a bankruptcy proceeding that have the ability to affect a lender’s security interest in collateralized property. Overall, lenders aware of these bankruptcy features may be able to limit the risks of losing a security interest in certain collateralized property.
Bankruptcy Background
Bankruptcy is governed by federal law. Title 11 of the United States Code contains the Bankruptcy Code which provides the provisions for case administration, creditor claims, debtor’s estate, and bankruptcy relief. The chapters of the Code containing debtor-relief provisions are specifically designed for particular types of debtors or different outcomes for debtors. Importantly, a chapter of the Code includes a type of bankruptcy specifically designed for agricultural producers, which is found under Chapter 12 of the Code.
During the 1980s farm crisis, many U.S. farmers faced financial stress. Congress responded to this economic crisis by enacting a unique type of bankruptcy proceeding directly tailored to farmers and ranchers, known as Chapter 12. In general, this producer-specific chapter of bankruptcy provides a framework that enables a farmer to successfully reorganize their finances so they can repay all or part of their debts while also keeping the farm operation in business.
When a producer becomes insolvent, they may choose to file for bankruptcy under Chapter 12 because it allows a producer to continue their farming operation during the bankruptcy process. Specifically, Chapter 12 provides a producer with far more flexibility and control over reorganization of their debts than other types of bankruptcy. Because of the advantages Chapter 12 offers producers, creditors must be aware of the effect an agricultural bankruptcy has on their security interest in an insolvent debtor’s property.
While Chapter 12 provides some advantages, farmers are not limited to Chapter 12 bankruptcy proceedings. Depending on the farmer’s situation, filing for bankruptcy under Chapters 7, 11, or 13 may better serve the farmer’s bankruptcy goals. Chapter 7 bankruptcy provides the process for liquidation bankruptcy. Under liquidation bankruptcy, also referred to as “straight bankruptcy,” a debtor will turn over all assets to a bankruptcy trustee who distributes cash from the disposition of the assets to creditors and obtains a discharge from the debts for the debtor. Bankruptcy under Chapters 11 or 13 provides debtors the ability to reorganize their debts, similar to the bankruptcy process under Chapter 12. In general, Chapters 11 and 13 have different debtor qualification requirements, and usually provide different bankruptcy outcomes.
In terms of security interests, though, there are three important features of a bankruptcy proceeding that have the ability to affect a lender’s interest in an insolvent producer’s property. Ultimately, each of these features may prevent lenders from fully enforcing their security interest, or collecting the entire loan debt owed to them by an insolvent producer-debtor.
Automatic Stay
The first feature that may affect a creditor’s security interest is an injunction known as the automatic stay. In general, the automatic stay bars nearly all collection efforts against a debtor, and becomes effective when a debtor files a petition with a court, which initiates a bankruptcy proceeding. In other words, when a debtor files for bankruptcy, the automatic stay is activated and almost every action a creditor may take against a debtor to collect their debt is automatically suspended. Hence, the automatic stay prohibits creditors from initiating or continuing a lawsuit against a debtor, efforts to obtain possession of property subject to a creditor’s security interest, and efforts to create or perfect a security interest against a debtor’s property.
Although filing for bankruptcy triggers the automatic stay, there are situations where a bankruptcy court may lift the stay. Usually after a debtor files for bankruptcy, their creditors will request a bankruptcy court to lift the automatic stay. In making this request to a court, creditors typically claim that the property subject to their security interest is not being properly cared for or is declining in value. If a court agrees with these claims, it may order a debtor to provide adequate protection to its creditors.
There are several ways a debtor can satisfy a court’s order to provide creditors with adequate protection. One way a debtor may satisfy this order is by providing a creditor with an additional security interest in some other property to cover the difference of a decrease in value of collateralized property. An alternative method includes a debtor providing a creditor with cash payments to compensate for a decrease in value of a creditors’ interest in property.
These methods usually satisfy a court’s order, but debtors often have difficulties providing adequate protection because they are bankrupt, which means they likely do not have the resources to satisfy a court’s order. When a debtor cannot satisfy a court’s order, a court may lift the automatic stay for some of a debtor’s property. Accordingly, creditors who hold a security interest in property no longer subject to the automatic stay may attempt to take possession of the property so they can sell it and use the funds to satisfy the debtor’s loan debt.
Overall, the automatic stay prevents creditors from fully enforcing their security interests against insolvent debtors. While the Bankruptcy Code offers a way for creditors to lift the automatic stay, courts often do not lift the stay on secured property. Thus, creditors’ interests are usually subject to the bankruptcy process in order to receive repayment of their debtor’s debt.
Post-Petition Property
A Chapter 12 bankruptcy proceeding may also affect a creditor’s security interest in property a debtor acquires after filing for bankruptcy. Before creditors supply a loan to a debtor, they typically require a debtor to execute a security agreement. Most creditors place a provision known as an after-acquired property clause within their security agreements because it allows a creditor’s security interest to cover property a debtor acquires after a security agreement is executed. However, a creditor’s security interest in after-acquired property can be impaired when a debtor files for bankruptcy.
In general, the Bankruptcy Code restricts a secured creditor’s interest in a debtor’s after-acquired property. A creditor’s security interest no longer extends to certain property a debtor obtains after they initiate a bankruptcy proceeding, even when a creditor obtained an interest in a debtor’s after-acquired property before filing for bankruptcy.
For example, an agricultural lender loans money to a cattle farmer. The security agreement provides the lender with a security interest in “all of the farmer’s beef cattle currently owned, all presently conceived but unborn cattle, and all increase of the farmer’s cattle, whether purchased or not yet conceived, hereafter acquired.” The lender perfects this interest by filing a financing statement. Months later, the famer becomes insolvent and files a Chapter 12 bankruptcy petition. Afterwards, the farmer acquires 20 head of cattle from their neighbor. The agricultural lender claims they have a security interest in this additional 20 head of cattle.
In this example, the agricultural lender’s security interest does not extend to the 20 head of cattle. Although the lender and farmer entered into a security agreement that provides the lender a security interest in the farmer’s after-acquired cattle, the farmer commenced a bankruptcy case before acquiring the additional cattle. Therefore, the lender does not have a security interest in the 20 head of cattle the farmer acquired after filing for bankruptcy.
Even though a creditor’s after-acquired security interest may become ineffective after a debtor files for bankruptcy, there is an exception to this rule. Under § 552(b)(1) of the Bankruptcy Code, proceeds, products, offspring, rents or profits a debtor receives after filing for bankruptcy may be subject to a creditor’s security interest if the parties’ security agreement extends to such property.
For example, suppose Payton purchases a new tractor, the Big Blue 7000, from Taylor’s Tractor Dealership on credit. Taylor presents Payton with a security agreement which states, “Payton grants Taylor a security interest in the Big Blue 7000 tractor and its proceeds.” Taylor perfects this interest by filing. Later, Payton begins to face financial struggles, so he decides to sell the Big Blue 7000 tractor to Jennifer. However, Jennifer does not have the funds to cover the purchase price of the tractor, but promises to pay Payton in three weeks. Payton agrees and delivers the tractor to Jennifer. A week later, Payton files a petition for Chapter 12 bankruptcy. Two weeks after filing for bankruptcy, Jennifer pays Payton for the tractor, and Taylor claims he has an interest in the proceeds from the sale of the Big Blue 7000.
Here, Taylor will most likely have a security interest in the proceeds from the tractor. In this example, Taylor obtains perfected security interest in the tractor and any money Payton receives from selling the tractor. Even though Payton did not receive the money from Jennifer until after filing for bankruptcy, the exception to the general exclusionary rule is satisfied because Taylor holds a perfected security interest in after-acquired proceeds of the tractor, and Payton sold the tractor before filing for bankruptcy. Therefore, Taylor has a right to receive the proceeds from the tractor.
Although the Bankruptcy Code offers this exception to the general rule, it may not always be available. The Bankruptcy Code gives bankruptcy courts the ability to prohibit a creditor from using the exception if a court believes it would be unfair to a debtor. Thus, the court in Payton’s case could find it inequitable to allow Taylor to use the exception, and not provide Taylor with a security interest in the proceeds. Overall, while creditors have the ability to satisfy an exception to save their security interest, it is not guaranteed in every bankruptcy proceeding.
Avoiding Security Interests
The last important function creditors must be aware of in a bankruptcy proceeding is exempt property. In general, there is certain property of a debtor which is exempt from a bankruptcy proceeding. Property that is exempt from bankruptcy cannot be distributed among the creditors to pay off a debtor’s debts. Therefore, exempt property will survive a bankruptcy proceeding and a debtor is permitted to keep ownership of the property that is exempt.
Property exemptions are established under both federal and state law. Even though bankruptcy is governed by federal law, federal bankruptcy law permits states to enact its own set of property exemptions. Additionally, federal law allows states to prohibit a debtor from using the federal exemptions in the bankruptcy courts located within that state. In other words, states may limit a debtor to state law exemptions, which occurs in the majority of states.
The property a debtor elects to exempt is important among creditors because it may affect their security interest in a debtor’s property. In most Chapter 12 bankruptcies, creditors are authorized to hold their security interest in collateralized property. However, there are situations where a creditor holds a security interest in property a debtor has exempt from bankruptcy. When this occurs, a creditor risks having their security interest invalidated.
Under the Bankruptcy Code, certain security interests in exempt property become invalid in bankruptcy. This means a debtor can avoid a creditor’s security interest in property they are exempting from their bankruptcy proceeding. If a debtor avoids a creditor’s security interest, that creditor loses the ability to enforce their interest against the debtor’s property to receive repayment of the debt owed by the debtor!
For the most part, debtors may avoid a security interest when the property subject to an interest is exempt. Under § 522(f), a debtor can avoid a “nonpossessory, nonpurchase-money security interest in any . . . animals, crops, [or] . . . tools of the trade.” Tools of the trade are typically tangible personal property that a debtor uses for a business purpose, and several bankruptcy courts have ruled that many types of farm assets fall under this exemption, such as agricultural equipment and breeding livestock. If property falls under this exemption, the debtor retains possession of the property and the creditor is unable to foreclose on the property to satisfy the debtor’s loan debt.
Agricultural lenders have the ability to take a security interest in various types of personal property of the debtor when providing a loan. Typically, however, agricultural lenders take an interest in a producer’s livestock, crops, farm machinery or equipment as collateral for a loan. These types of property fall under the exemption contained in the Bankruptcy Code. Therefore, if an insolvent producer files for bankruptcy and exempts this property, a lender’s security interest in this agricultural property will likely be invalidated.
Conclusion
Overall, bankruptcy proceedings allow debtors to reorganize their finances and pay off the debts they owe to creditors. However, lenders are not typically in favor of bankruptcy proceedings because they may not be able to recover the entire debt owed by a borrower. Specifically, there are features of bankruptcy, such as the automatic stay, the inability to recover post-petition property, and avoidance that affect a security interest.
To read the other articles of this series, click here.
To read Chapter 12 of the Bankruptcy Code, click here.
To read about the entire Chapter 12 bankruptcy process, click here.
For more National Agricultural Law Center information on Bankruptcy, click here.
For more National Agricultural Law Center information on Secured Transactions, click here.