Borrowing large amounts of capital and incurring considerable debts in order to produce an agricultural commodity is necessary farmers and ranchers in many cases. Ordinarily, the lender loaning money will require the agricultural producer to provide a security interest in crops, livestock, or equipment. 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 produces a security interest for a creditor. Creditors hold a security interest in debtors’ personal property, known as collateral, to ensure that the debtor repays the debt.
However, Article 9 requires that a creditor 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 crucial because without attachment, a security interest does not exist. However, once the interest attaches, the creditor has the right to enforce the security interest in the collateral against the debtor. However, attachment 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. Article 9 offers creditors many mechanisms to perfect, such as perfecting by possession or control, automatically, or by filing a financing statement.
Purposes & Methods of Perfection
Perfection places other persons on notice of a creditor’s security interest. The notice is especially important to other creditors, because most will not want to secure a loan using collateral that is already secured by another creditor.
Perfection also helps determine priority among creditors. Priority is the order in which creditors to the same collateral will receive proceeds after a debtor defaults. When perfecting a security interest, it’s important to consider both the process and the timing. The first creditor to perfect the interest will have priority over any subsequent creditors to perfect a similar interest. Further, that security interest- once perfected- will also protect the creditor’s interest against future buyers of the property.
Article 9 provides creditors several methods for perfecting a security interest. For agricultural secured transactions, there are a few general methods of perfection: (1) possession of the collateral; (2) control of the collateral; (3) automatic perfection when the security interest attaches; and (4) filing a financing statement. In general, the particular method used to perfect a security interest depends on the type of property serving as collateral.
Perfection by Possession
One way a creditor can perfect is by taking possession of the collateral. Taking “possession” means the creditor has physical custody of the collateralized property. When a creditor has physical possession, it informs third persons that the creditor has an interest in that property. This form of perfection isn’t seen much in agriculture, because the farmer-debtor usually relies on using the collateral for the farming operation. For example, a farmer obtains a loan to buy a combine, and in return provides the lender with a security interest in that equipment. It would be unproductive for the lender to perfect by taking possession because the farmer needs the equipment to successfully operate the farm and repay the loan.
Perfection by Control
In some cases, a creditor may perfect its security interest by controlling the collateral. However, this method of perfection is only available when the collateral pledged by the debtor is intangible property, such as investment property. The most common types of investment property include stocks or bonds, but in agricultural financing, it may include commodity accounts and contracts. Having “control” of collateral means that the creditor has some right to collect from or manage the collateral.
An example would be a debtor giving a creditor a security interest in their commodities account, which the creditor chose to perfect by control. To do so, the creditor is named as the owner of the account. As a result, if the debtor defaults on their loan with the creditor, the creditor can enforce its security interest and collect the money from the account to repay the debt owed by the debtor. This method is used in agriculture more frequently than perfection by possession, but still not as common as other methods because farmers typically pledge tangible property such as equipment, crops, or livestock as collateral.
The UCC outlines some specific kinds of collateral are automatically perfected once a security interest is attached. Typically, these transactions, called “purchase money security interests” or “PMSI”, occur when a creditor loans money to a debtor so that they can purchase an item. In return, the debtor gives the creditor a security interest in that property. In terms of agriculture, a PMSI exists when a lender loans money so that a farmer can purchase livestock, and the farmer gives the lender a security interest in the livestock purchased. In order to gain priority over other creditors, however, Article requires that creditors meet certain criteria. Under UCC §9-324(d), a creditor will have priority over an earlier-filed security interest in the same livestock if: (1) the creditor perfects their interest by filing a financing statement before the debtor receives possession of the livestock; (2) the purchase-money creditor provides a signed notice to the holder of the conflicting security interest; (3) the holder of the conflicting security interest receives the notice within six months before the debtor receives possession of the livestock, and (4) the notice specifies that the purchase-money creditor has or expects to acquire a PMSI in the debtor’s livestock and describes the livestock.
For example, consider the following situation:
- Hometown Bank extends an operating loan to Jane. The parties executed a security agreement which provided the bank a security interest in all of Jane’s cattle she presently owns, and any cattle Jane purchases in the future. The bank perfects this interest by properly filing a financing statement.
- Jane wants to purchase 40 calves from Tim, but does not have the cash to do so. Tim sells her the calves on credit, and the two enter into a security agreement that provides Tim a security interest in the cattle. Tim properly files a financing statement reflecting this interest.
- Tim sends a letter to Hometown Bank stating that he provided Jane money to purchase the 40 calves.
- One day after the bank received Tim’s letter, Tim delivered the 40 calves to Jane.
In this situation, Tim would have priority over the bank even though the bank perfected its interest before Tim. Here, Tim obtains a PMSI in livestock because he sold cattle to Jane on credit. He also properly filed a financing statement, sent the bank with notice that he was taking an interest in the 40 head of cattle, and the bank received this notice. Importantly, Jane did not take possession of the cattle until all of these steps were complete. Thus, Tim perfected his security interest and obtained priority over the bank in the 40 head of cattle.
Perfection by Filing
While each of the above situations provide for perfection of a security interest utilized by agricultural lenders, the majority of security interests in agriculture are perfected by filing a financing statement in a public office, such as a state’s Secretary of State. Each state provides online filing and searches of other creditor’s financing statements. Agricultural lenders typically choose to perfect by filing because the financing statement is a form, such as this UCC example, which can perfect all kinds of property, including crops, livestock, farm equipment, inventory, and accounts. Another benefit to perfection by filing is that a single financing statement is able to cover a series of transactions, including transactions that had not yet occurred at the time the financing state was filed, as long as an after-acquired property clause is included in the security agreement. An after-acquired property clause is a provision that allows a creditor’s security interest to cover property the debtor acquires after the security agreement is executed.
Section 9-502(a) and (b) of the UCC explains the information that must be included in a financing statement. To be effective, it must include the name and address of the debtor, whether the debtor is an individual or an organization, the name and address of the secured creditor, and an indication of the collateral covered by the financing statement. Unlike a security agreement, a financing statement does not require the debtor’s signature.
Under § 9-506(a), a financing statement that contains minor errors or omissions will still satisfy the requirements under Article 9. However, if the errors or omissions make the financing statement seriously misleading, the notice will be ineffective and the creditor may lose priority in the collateral. Therefore, it is very important that a creditor includes the debtor’s correct name in the financing statement.
Filing a financing statement with an error in the debtor’s name can easily make the financing statement seriously misleading. Financing statements are filed under the debtor’s name, which is how other parties search for existing security interests. Thus, including the debtor’s correct name in the financing statement is essential to notify third parties of an interest.
Article 9 requires financing statements to provide the full legal name of the individual or organizational name of the debtor. If the debtor is a partnership, the creditor should include all the names of each partner. For debtors that are registered entities under state law, like a corporation, the creditor’s financing statement must reflect the exact name of the entity shown in the public records. For example, a corporation obtained a loan from the bank. Under the state’s records, the corporations registered name is “Corporation X.Y.Z.” When the bank files a financing statement for the corporation’s loan, it must indicate “Corporation X.Y.Z.” is the debtor. Any mistake in the name may cost the bank priority in its security interest.
Suppose the bank filed a financing statement under the corporation’s trade name, “X.Y.Z. Corp.” Using a debtor’s trade name is one of the most common ways a financing statement becomes seriously misleading. A slight mistake in the name may cost a creditor’s priority in its security interest.
However, Article 9 does provide some flexibility to creditors who include an incorrect name for the debtor. Under § 9-501(c), a financing statement is not seriously misleading if a person, using the debtor’s correct name, can still find a financing statement against the debtor under an incorrect name. Hence, a creditor can still perfect its security interest and have priority over other creditors even if the financing statement includes an incorrect name.
Description of Collateral
Like security agreements, a financing statement must include an adequate description of the collateral subject to a creditor’s security interest. Under Article 9, the description must reasonably identify what property is being used as collateral. In other words, if a third person would understand what collateral is being covered by the financing statement, the description is probably sufficient. Unlike security agreements, creditors may use generic descriptions to identify collateral in a financing statement. Thus, the creditor can identify what collateral is covered in the financing statement by using a description like “all the debtor’s personal property” or “all the debtor’s assets.” U.C.C. § 9-504(2).
For an example on a collateral description, suppose Farmer Matt received an operating loan from Hometown Bank. For doing so, the bank required Matt to grant it a security interest in Matt’s equipment, livestock, and accounts to serve as collateral. The parties executed a security agreement reflecting this security interest in the collateral. Hometown Bank filed a financing statement that described the collateral as “equipment and accounts.” Although the bank has properly attached its security interest in Matt’s livestock as well, the bank’s interest is unperfected as to livestock because that collateral is not described in the financing statement. In other words, if the creditor’s financing statement does not accurately describe the collateral, the creditor’s financing statement will be ineffective and will risk losing priority in the collateral to future creditors.
Creditors must pay special attention to the rules laid out in Article 9 to ensure they properly perfect a security interest. Without perfecting their security interest, the creditor will not be able to assert a superior claim to the collateral if other perfected creditors have a conflicting interest in the same collateral. Additionally, it is always wise for creditors to check the state’s financing statement database before supplying a loan because a debtor may be offering collateral that is already secured by another creditor.
This article is the third 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 take a more in-depth look at other requirements placed on creditors who choose to perfect their security interest by filing a financing statement.
To read the first article in this series, click here.
To read the second 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.