In a dispute regarding entitlement to proceeds resulting from an auction of livestock in possession of a dairy farmer/debtor,[1] the U.S. Court of Appeals for the Sixth Circuit issued an order on Aug. 14, 2014, in favor of a dairy cattle lessor, despite the secured creditor’s pre-existing security interest in all livestock that is “currently owned or hereafter acquired.” The court found that the dairy cattle leases were not disguised security agreements, as the bankruptcy and district courts in Kentucky had concluded, but were instead true leases. As a result, the lessor — not the debtor — owned the leased livestock that was auctioned, and the cows were not subject to the secured creditor’s security interest. This case provides important lessons for creditors seeking to obtain a security interest in livestock, including what precautions those creditors should take to ensure that their interests in the livestock are protected.
Purdy Litigation
In 2008, the debtor, Lee H. Purdy, obtained a loan from Citizens First Bank using his dairy cattle herd as collateral.[2] In July 2009, Purdy refinanced his loan with the bank and in connection with the refinance, granted the bank a purchase money security interest in, among other collateral, all livestock “currently owned [or] hereafter acquired.”[3] Purdy and the bank entered into similar security agreements in August 2010 and in May 2012.[4] All of the bank’s security interests were perfected.[5]
Between August 2009, after the initial refinance of his loan with Citizens First, and July 2012, Purdy entered into five agreements with Sunshine Heifers LLC to lease dairy cows from Sunshine. Under the terms of the leases, Purdy paid monthly rent to Sunshine, which leased to Purdy 435 dairy cows for 50 months.[6] In July 2012, after Sunshine and Purdy entered into the leases, Purdy had approximately 750 dairy cows on his farm.[7]
Purdy filed a chapter 12 petition in November 2012.[8] At the time of the filing, only 389 dairy cows were present on his farm, the majority of which bore both tags indicating that they were subject to Citizens First’s security interest and brands indicating that they were owned by Sunshine.[9] Forty-three additional dairy cows were returned to Purdy by another farmer shortly thereafter, 39 of which Sunshine claimed bore its brand.[10]
In Purdy’s bankruptcy case, Citizens First argued that the dairy cows in Purdy’s possession were owned by him and therefore, the entire remaining herd was covered by the bank’s pre-existing security interest.[11] Sunshine argued that it owned the remaining dairy cows and Purdy only maintained a leasehold interest in the cows.[12] In evaluating whether the cattle leases were true leases or disguised security agreements, which would determine who owned the livestock, the bankruptcy court found that the leases were disguised security agreements and ruled in Citizens First’s favor.[13] Sunshine appealed, the district court affirmed and Sunshine appealed to the Sixth Circuit, which reversed the bankruptcy court.[14]
Due to the leases’ choice-of-law provisions, the Sixth Circuit looked to relevant Arizona law.[15] In determining that the leases were true leases, the Sixth Circuit applied Arizona’s two-part test: first considering whether the economic life of the leased goods was equal to or greater than the term of the lease and if so, evaluating the specific facts of the case.[16] The Sixth Circuit found that because Purdy had the duty to only return the same number of cattle, rather than the very same cows that he originally leased, to Sunshine, and since Sunshine had taken measures to ensure that the cows that were actually returned would be worth at least a minimum set amount, the leased good was the herd of cattle, rather than the individual cows, and further found that a herd has an economic life “far greater than the lease term.”[17] The Sixth Circuit concluded that the leases were not per se security agreements.[18]
Next, the Sixth Circuit evaluated the specific facts and determined that those facts indicated that the leases were in fact true leases.[19] The court found that Sunshine had a “meaningful reversionary interest” in the cattle, focusing primarily on the fact that the leases did not contain an option for Purdy to purchase the cattle, and therefore found that the leases were not security agreements, but were in fact true leases.[20]
Precautions for Creditors
The Purdy litigation contains some important lessons for creditors who wish to take a security interest in livestock, especially in the context of a dairy farmer. Increasingly, dairy farmers are turning to dairy cattle leasing as a way to deal with problems of limited capital. Dairy cattle leasing allows dairy farmers to gain access to higher-quality dairy cows than they could normally afford, leaving them free to use capital for other purposes, such as land or machinery.
While dairy cattle leasing might benefit dairy farmers, the Purdy case shows that it can raise significant issues for secured creditors if protective measures are not taken. The following are a few precautionary measures that secured creditors can take to ensure that their security interests in livestock of a borrower remain protected:
- First, always make certain that any security interest is properly perfected.
- At the time that the borrower grants the security interest, require a detailed description of the livestock in which the creditor is being granted a security interest (primarily, the number and ages of such livestock).
- At the time that the borrower grants the security interest, ensure that the borrower is the actual owner of the livestock that will be subject to the security interest. In other words, make sure that the borrower is not in possession of the livestock only by virtue of a lease.
- Each animal subject to the security interest should be marked distinctly with a tag that is unique to livestock subject to the security interest.
- Include a provision in the security agreement dealing with changes in the herd. For example, require the borrower to provide written notice each time an animal dies or is culled (separated), or otherwise removed and/or replaced from the herd, as well as when cows are added to the herd.
- Prohibit cattle leasing without prior written notice to the secured creditor, and include the prohibition in UCC filings.
- Comply with the filing requirements of the Food Security Act, 7 U.S.C. § 1631 (applicable in approximately 19 states).[21]
- Consider the use of intercreditor agreements with lessors or proposed lessors.
- Require leased cattle to be individually tagged and limit the lessor’s recovery to its tagged cattle.
- Require the borrower to allow periodic visits to the farm to ensure that all livestock subject to the security interest are actually present on the farm. Then, follow up with periodic inspections of the herd using knowledgeable inspectors (not unlike an inventory floor-plan lender).
Important provisions
Further, in the event that a dispute arises with a lessor of dairy cattle regarding the ownership of certain dairy cattle in the borrower’s possession, an examination of the lease at issue will assist a secured creditor in predicting how a court will interpret a lease agreement. The Purdy case shows that the following provisions of the lease can be critical:
- Choice-of-law provisions. The Purdy case and another case, also involving Sunshine and the same issue regarding whether the lease was a true lease or a disguised security agreement,[22] both interpreted Arizona law due to the choice-of-law provisions in the leases.
- The terms of the lease. Whether the remaining economic life of the goods is greater than the term of the lease is a critical question. If the lease term is longer than the economic life of the goods, the lease will very likely be found to be a security agreement.
- A purchase option for the lessee. The existence of a purchase option allowing the lessee to purchase the leased goods during the term of the lease, especially for a nominal price, will likely support a finding that the lease is actually a security agreement.
[1] Sunshine Heifers LLC v. Citizens First Bank (In re Purdy), 763 F.3d 513 (6th Cir. 2014).
[2] Id. at 516.
[3] Id.
[4] Id.
[5] Id.
[6] Id.
[7] Id. at 517.
[8] Id.
[9] Id.
[10] Id.
[11] Id. at 517.
[12] Id.
[13] Id. at 518.
[14] Id.
[15] Id. at 519.
[16] Id.
[17] Id. at 519-20.
[18] Id. at 520.
[19] Id. at 520-21.
[20] Id. at 521.
[21] The U.S. Department of Agriculture’s website provides that of June 27, 2013, the states which have enacted Central Filing Systems certified by the U.S. Department of Agriculture as meeting the requirements of the Food Security Act are as follows: Alabama, Colorado, Idaho, Louisiana, Maine, Minnesota, Mississippi, Montana, Nebraska, New Hampshire, New Mexico, North Dakota, Oklahoma, Oregon, South Dakota, Utah, Vermont, West Virginia, Wyoming. United States Department of Agriculture, Grain Inspection, Packers & Stockyards Administration, Clear Title (Central Filing Systems), http://www.gipsa.usda.gov/Lawsandregs/cleartitle.html .
[22] Sunshine Heifers LLC v. Moohaven Dairy LLC, Case No. 13-10319, 2014 WL 1509573 (E.D. Mich. April 16, 2014).