Agricultural producers typically utilize financing from lenders to fund their farming operation. The USDA projects farm sector debt will be over $433 billion by the end of 2020. Borrowing large amounts of capital and incurring considerable debts in order to produce an agricultural commodity has become a custom practice in the industry. Because producers frequently enter into complex contractual obligations to borrow money from lenders for every aspect of the farming operation, it is important that each party understands the laws governing agricultural financing transactions and how these transactions operate in order to protect themselves financially.
Transactions that involve one person providing credit to another in exchange for a security interest in property or the performance of and agreed upon action by the borrower is considered a secured transaction. Secured transactions are primarily governed by Article 9 of the Uniform Commercial Code (“UCC”). Article 9 applies to secured transactions in personal property and fixtures including loans on crops, livestock, supplies, and equipment. The scope of Article 9 also extends to agricultural liens, inventories, accounts receivable, consignments, and certain sales or leases of goods. However, Article 9 does not apply to real estate security interests, such as mortgages.
Who are the Parties?
There may be multiple parties involved in a transaction, but every secured transaction includes a debtor and creditor. A debtor is one who takes the loan and provides a security interest in personal property. Other terms used to describe a debtor include “borrower,” “obligor,” or “buyer.” A creditor is an individual or entity that has a claim against a debtor. In general, a creditor is either the seller or lender. Other terms used to describe a creditor include “secured party,” “obligee,” “lender,” “financer,” or “seller.”
What is Collateral?
In every Article 9 secured transaction, the personal property subject to a security interest is referred to as collateral. The term “collateral” includes both tangible and intangible personal property. Examples of tangible collateral include consumer goods, equipment, inventory, farm products, and fixtures. Intangible collateral, which is personal property that cannot be seen or touched, includes accounts receivable, chattel paper, deposit accounts, and investment property. These different types of collateral have been specifically separated because Article 9 treats secured transactions differently depending upon the category of collateral involved. Thus, it is crucial to recognize the type of collateral involved in each secured transaction.
In general, a secured transaction is one that produces a security interest for a creditor. Under the UCC, a security interest is defined as “an interest in personal property or fixtures which secures payment or performance of an obligation.” U.C.C. § 1-201(b)(35). In other words, it is an interest held by a creditor in personal property that has been pledged as collateral by a debtor to “secure” a debt.
There are two different types of security interests. The first is a possessory security interest. Possessory security interests occur where the creditor maintains possession of the collateral subject to the security interest. The second type is a non-possessory security interest. With this type of interest, the debtor retains possession of the collateral given as a security interest. The majority of security interests are non-possessory because debtors typically need to maintain the collateralized property. For example, a loan to plant crops would be useless if the farmer-debtor is not allowed to take possession of the seeds until the loan was completely paid off. Instead, the creditor will provide the funds to the farmer-debtor to purchase and possess the seeds to plant for that production cycle, and the farmer will give the creditor a security interest in the crops grown and the proceeds from the sale of the crops.
There are two important functions a security interest provides creditors. First, if the debtor fails to repay the loan, the creditor may take possession of the collateral secured by the loan and use or sell it to satisfy the debt. Second, if other creditors assert a claim to the debtor’s personal property, the creditor may be able to claim a superior position in the rights to the collateral through the security interest.
A secured transaction within the scope of Article 9 ordinarily arises under two basic types of transactions. The first type arises where a loan is made to the owner of personal property which is secured by that property. For example, suppose Ag Bank entered into a loan agreement with Felix Farmer to loan him $20,000. To secure the debt, Felix provided Bank with a security interest in livestock he owned as collateral. Thus, Felix provided property he already owned to secure the loan.
The second basic type of secured transaction occurs where a buyer purchases personal property on credit and gives a security interest in the property to either the seller, or the person who provided the funds to enable the buyer to purchase the property. In other words, a creditor is granted a security interest in the collateral which the creditor enabled the purchaser-debtor to obtain. This type of transaction creates a purchase-money security interest, and certain Article 9 provisions afford creditors special advantages for holding such interests. For example, assume Peyton Producer wanted to purchase a new tractor for his farming operation. Peyton goes to Mr. Blue’s tractor dealership and picks out a tractor, but he does not have the money to cover the entire cost of the tractor. The parties enter into an agreement where Mr. Blue sells the tractor to Peyton on credit, and Peyton provides Mr. Blue a security interest in the tractor. Thus, this transaction created a purchase-money security interest because Mr. Blue enabled Peyton to purchase the tractor and Peyton provided Mr. Blue with security interest in the tractor he purchased with the credit.
Creditors enter into secured transactions to benefit financially, primarily by collecting interest on a loan. Because creditors enter into these transactions intending to make a profit, they want to ensure they are repaid for the money loaned to a debtor. Thus, another reason a creditor enters into a secured transaction is because the debt can be secured by a security interest, which provides a creditor with easier ways to collect the debt. In order for a creditor to use this protection afforded under a secured transaction, the creditor must become a “secured creditor.”
In general, creditors can be secured or unsecured. A creditor is “unsecured” when they loan money to a borrower and the creditor is not given a security interest in collateral. This type of transaction usually occurs when a lender provides a loan based on the borrower’s promise to repay the loan. A creditor becomes “secured” when they hold a security interest in collateral offered by the debtor and when the parties execute a security agreement. A security agreement is “an agreement which creates or provides for a security interest,” and basically serves as a contract for a loan. U.C.C. § 9-102(a)(74). In a situation where a creditor holds a security interest and entered into an agreement, the creditor may use the collateralized property to satisfy the unpaid debt.
In the two previous examples above, Ag Bank and Mr. Blue are both secured creditors. Thus, if Felix or Peyton failed to repay their loan, known as “defaulting,” their creditor could take possession of the collateralized property, sell it in accordance with Article 9, and apply the proceeds to the debt they are owed. If Ag Bank or Mr. Blue were unsecured creditors, the remedies would be far more limited if their debtor defaulted. An unsecured creditor cannot take possession of the debtor’s property to satisfy the debt. These creditors must obtain a judgment from a court and initiate collections proceedings, which is an expensive process, and can take months or years until the debt is completely satisfied. Thus, to properly protect themselves, it is important for a creditor to secure their loan with collateral offered by a debtor.
This article is the first 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 examine the necessity and effectiveness of a security agreement, and the steps a creditor must take to properly enforce a security interest against a debtor.
For a general overview of agricultural lending, 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.