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On August 14, 2014, in a dispute regarding entitlement to proceeds resulting from an auction of livestock in possession of a dairy farmer-debtor, the U.S. Court of Appeals for the Sixth Circuit issued an order in favor of a dairy cattle lessor, despite the secured creditor’s pre-existing security interest in all livestock “currently owned or hereafter acquired.” The Court found that the dairy cattle leases were not disguised security agreements, as the bankruptcy court and district court in Kentucky had concluded, but instead were in fact true leases. As a result, the lessor, not the debtor, was actually the owner of a portion of the livestock which was auctioned, and those dairy cows were not subject to the secured creditor’s security interest. The result of this case provides important lessons for creditors seeking to obtain a security interest in livestock, including what precautions those creditors should take to ensure their interest in the livestock is protected.

Purdy litigation

In 2008, the debtor, Lee H. Purdy, obtained a loan from Citizens First Bank, using his dairy cattle herd as collateral. In July 2009, Mr. Purdy refinanced his loan with Citizens First and in connection with the refinance, granted the bank a purchase money security interest in, among other items, all livestock “currently owned [or] hereafter acquired.” Purdy and the bank entered into similar security agreements in August 2010 and in May 2012. All of the bank’s security interests were perfected.

In August 2009, after the initial refinance of his loan with Citizens First, Mr. Purdy entered into a lease with Sunshine Heifers, LLC to lease dairy cows from Sunshine. Between August 2009 and July 2012, Mr. Purdy and Sunshine entered into five leasing contracts. Under the terms of the leases, Purdy paid monthly rent to Sunshine, and Sunshine leased to Purdy 435 dairy cows for 50 months. In July 2012, after Sunshine and Mr. Purdy entered into the Leases, Purdy had approximately 750 dairy cows on his farm.

Due to market changes, Purdy’s dairy operation struggled, and he filed a chapter 12 bankruptcy petition in November 2012. At the time of the bankruptcy filing, only 389 dairy cows were present on his farm, the majority of which bore both tags indicating they were subject to Citizens First’s security interest and brands indicating they were owned by Sunshine. Forty-three additional dairy cows were returned to Purdy by another farmer shortly thereafter, 39 of which Sunshine claimed bore its brand.

A dispute arose in the bankruptcy case between Citizens First and Sunshine regarding the status of ownership of the dairy cattle remaining on Purdy’s farm. The bank argued that the remaining dairy cows were all owned by Mr. Purdy, and therefore, the entire remaining herd was covered by the bank’s pre-existing security interest. Sunshine argued that it owned the remaining dairy cows, and Mr. Purdy only maintained a leasehold interest in the remaining cattle; as a result, Sunshine argued, the cows were not subject to the bank’s security interest. The primary issue the bankruptcy court had to consider, therefore, was whether the leases were actually true leases or whether they were disguised security agreements. The bankruptcy court found that the Leases were disguised security agreements and subsequently granted Citizens First relief from the stay, allowing the bank to foreclose and auction the cattle. Sunshine appealed, requesting the portion of the sale proceeds resulting from the auction of the portion of the herd that was leased. The District Court affirmed; however, the Sixth Circuit reversed.

Due to the leases’ choice of law provisions, the Sixth Circuit looked to relevant Arizona law. 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. The Sixth Circuit found that because Purdy had the duty only to return the same number of cattle, rather than the very same cows he originally leased, to Sunshine, and because Sunshine had taken measures to ensure the cows actually returned would be worth at least a minimum set amount, the Sixth Circuit determined that the leased good was the herd of cattle, rather than the individual cows, as the bankruptcy court had concluded, and that a herd of cattle as a whole has an economic life “far greater than the lease term.” The Sixth Circuit found that therefore, the leases were not per se security agreements.

The Sixth Circuit next evaluated the specific facts of the case and determined that those facts indicated the Leases were in fact true leases. The Sixth Circuit 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 Mr. Purdy to purchase the cattle, and therefore found that the Leases were not security agreements, but were true leases. The Sixth Circuit also pointed out that the fact the parties had not adhered to the terms of the leases in all aspects was irrelevant, as there was no evidence that Purdy and Sunshine had altered the lease terms in any respect. The Sixth Circuit remanded the case to the bankruptcy court to make additional findings consistent with its finding regarding the leases and the ownership of the remaining cattle.

Precautions for creditors to consider

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, giving them the ability to free up capital for other purposes and to avoid using credit they may need for other purchases, such as land or machinery.

However, although dairy cattle leasing holds significant benefits for dairy farmers, the Purdy case shows that it can raise significant issues for secured creditors if protective measures are not taken. Here are a few precautions secured creditors can take to ensure that their security interest in livestock of a borrower is protected:

  1. First, and most obviously, always make certain that any security interest is properly perfected.
  2. At the time the borrower grants the security interest, require a detailed description of the livestock in which the creditor is being granted a security interest-primarily, number of livestock and the ages of the livestock.
  3. At the time the borrower grants the security interest, ensure that the borrower is the actual owner of the livestock which 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.
  4. Make certain that each animal subject to the security interest is tagged distinctly with a tag unique to livestock subject to the security interest.
  5. 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, is culled (separated) from the herd, is otherwise removed and/or replaced, and each time additional cows are added to the herd.
  6. Prohibit cattle leasing without prior written notice to the secured creditor. Put that prohibition in your UCC filing. Comply with the filing requirements of the Food Security Act, 7 U.S.C. Section 1631 (applicable in approximately 19 states). Consider the use of an inter-creditor agreement with a proposed lessor. Require leased cattle to be individually tagged and limit the lessor’s recovery to its tagged cattle.
  7. Require the borrower to allow periodic visits to the farm to ensure 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).

These precautions will go a long way to avoiding the problems that occurred in the Purdy litigation and will provide secured creditors with a greater likelihood of recovery in the event of a default by the borrower.

Important provisions

Further, in the event a dispute does arise with a lessor of dairy cattle regarding the ownership of certain dairy cattle in possession of the borrower, the Purdy case shows that the following provisions of the lease can be critical:

  1. Any 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, both interpreted Arizona law, because the leases both contained Arizona choice of law provisions. Which state’s law applies may make a significant difference to a court’s ultimate resolution of the dispute.
  2. The term 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.
  3. 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.

In the event of a dispute with a lessor, an examination of the lease at issue for the existence of these provisions, as well as any additional provisions indicating that the lessee actually owns the goods and that the lease is therefore actually a security agreement in disguise, will assist a secured creditor in predicting how a court will interpret a lease agreement and will help the secured creditor determine how best to proceed in attempting to recover with respect to its collateral.