Unique Issues in Agricultural Finance

By John P. McNearney

American agriculture is a vital component of life in the United States. Our ability to grow and market our food supply is foundational to our personal liberty. Agriculture is a driving component of our economy. The number of farms and the percentage of population engaging in farming has been steadily decreasing for many years, but, although currently under some signs of stress, the productivity and profitability of American farmers have been generally increasing. The family farmer is being replaced by the corporate farm. Technology is becoming prevalent in farming operations in many ways, from satellite driven planting, fertilizing, and harvesting to genetically modified seeds.

The basic components of a farming operation are land, crops, water, livestock, and equipment. This article takes a look at the size, scope, and profitability of the agricultural economy and explores some of the legal issues in financing America’s farmers, including issues associated with each of the five components.

Real Estate—What’s Different About Title to Farmland?

Some Issues Are Created by Size

Farm loans generally involve large tracts of land—not five acres but 500 or 5,000 acres. The mere size of tracts of farmland generally makes surveys prohibitively expensive. Whether the property line is in one location or 50 feet away usually makes no difference. Farm properties are often encumbered by dozens, if not hundreds, of easements (for example, ingress and egress easements, easements to discard livestock waste, wind easements, mineral easements, and oil and gas easements). Access, ingress, and egress may be imperfect by means of gravel roads and paths. Rail lines may bisect the land, with no apparent legal means to drive a tractor from one side of the track to the other. Phase I environmental reports are rare. Lenders often rely on borrower affidavits regarding environmental issues. Storage tanks are common (for example, those containing propane, waste oil, and weed killing chemicals). There may be a variety of waterways, lakes, and ponds that are on, or border, the property. The location of the high-water mark may change from year to year. Creeks change their paths. Flooding or drought can have major effects on the tillable acreage available from time to time.

There Are Unique Title Issues

In some states, title evidence may be an opinion of title rather than a title policy (Iowa, Minnesota, and South Dakota, for example). When title insurance is obtained, however, farm lending often involves dealing with rural title companies that may not be on the same schedule as a money-center lender. There is usually a need to obtain insured closing protection letters (CPLs). Some CPL forms contain dollar limits on the amount of coverage. The dollar amount of the loan needs to be within the dollar limit of that coverage. Some CPL forms contain restrictive language regarding the scope of coverage in the event closing instructions require title coverage inconsistent with issued title commitments.

Farm property is often in more than one county or even more than one state. Attention needs to be paid to rights to foreclose on all property in just one of the counties. Foreclosing on a farming operation that is located in more than one state requires more than one foreclosure action. The ALTA 20-06 “First Loss” and 12-06 “Aggregation” endorsements are commonly needed.

The Aggregation endorsement allows the issuance of several policies for lesser amounts that are tied together so the insured gets the benefit of any increases in the value of any particular parcel. The amount of insurance available to cover a loss is the aggregate of the amount of insurance available under all of the policies that are identified in the endorsement. For the Aggregation endorsement to be available, each insured mortgage must state that it secures the entire indebtedness. The insured allocates the total debt among the policies and the Aggregation endorsement aggregates the total amount of insurance available to be the sum of the identified policies.

The First Loss endorsement changes the measure of loss under a loan policy of title insurance. Without the First Loss endorsement, the insured lender typically needs to foreclose on all the insured property to establish the measure of loss under a loan policy. The insured property would need to sell for less than the debt for the lender to suffer a loss. The First Loss endorsement is only available when there is more than one insured parcel. It allows for coverage of a “loss” if a substantial impairment against one parcel is shown without requiring foreclosure against all of the parcels. The First Loss endorsement provides that the insurance company will pay the amount by which a covered matter diminishes the value of the one applicable parcel below the amount of indebtedness allocated to that parcel. The company can still require foreclosure against the parcel with the defect to establish the loss.

Native American Indian Tribes

Many farms are located on Native American tribal trust lands or on fee land located next to or within the boundaries of tribal trust land. There are currently 566 federally recognized Indian tribes in the United States. Indian tribes are governments, each with its own laws and justice systems. They are sovereign political communities. The U.S. Secretary of the Interior maintains a list of recognized Indian tribes. Indian Entities Recognized and Eligible to Receive Services from the United States Bureau of Indian Affairs, 79 Fed. Reg. 4748 (Jan. 29, 2014).

Tribal trust land is land the title to which is held in trust by the United States for an individual Indian or a tribe. 25 C.F.R. § 151.2(d). Neither fee nor leasehold interests in tribal trust land can be mortgaged or sold without the approval of the U.S. Secretary of the Interior. 25 U.S.C. § 5135.

Refusal to make loans subject to tribal court jurisdiction may violate the Equal Credit Opportunity Act, 15 U.S.C. §§ 1691–1691f, as well as the Civil Rights Act of 1968, 42 U.S.C. §§ 3601–3619. In United States v. Blackpipe State Bank, Civ. No. 93-5115 (D.S.D. 1993) (consent decree), the United States brought such an action against Blackpipe State Bank alleging that the bank had for many years engaged in discriminatory lending practices against American Indians through its explicit policy of refusing to make any loans secured by collateral that may be subject to tribal court jurisdiction. The bank agreed to end its explicit policy, to develop a plan to address any inconsistencies in its lending determinations by implementing loan policies that ensure the fair and nondiscriminatory treatment of all loan applicants, and agreed to pay $125,000 to any person determined to be adversely affected by the bank’s policies and practices. Id. The court entered a comprehensive order against the bank enjoining it from refusing to provide credit because an applicant is an American Indian, resides on a reservation, or provides collateral that is located on a reservation. The order required the bank to revise its lending policies, establish a marketing program designed to attract applicants from all segments of its delineated community, develop outreach programs to American Indians, apply to become an approved lender of guaranteed loans from the Bureau of Indian Affairs, and develop activities directed to American Indian borrowers to teach about topics such as managing credit, controlling a household budget, and applying for loans. Id.

Keeping the Blackpipe case in mind, however, it is prudent to include nondiscriminatory protections for the benefit of the lender in the making and underwriting of loans involving Native American Indians and tribal land. For example, when making loans to Native American Indians, tribes, tribal entities, or secured by land located within a reservation or constituting tribal trust land, the lender may wish to obtain a series of protections as may be applicable to each of those situations. Some examples for the lender to consider include acknowledgment of the application of state versus tribal law, waiver of sovereign immunity, waiver of exhaustion of remedies, consent to the jurisdiction of state and federal versus tribal courts, an acknowledgment of the application of the police power of the state to the collateral, and an acknowledgement of whether the making of the loan or realization on the collateral will require any permit, license, or approval from the tribe.

Water

Water Is Critical

The availability of water is critical to a successful farming operation. Dry land is worth much less than irrigated land and the range of its productive uses is more limited. Rights in water can take many forms, ranging from water stock in private or public companies, wells on-site or off-site, water-sharing arrangements, private or public water districts, rivers, streams, lakes, and ponds. From an agricultural lender’s perspective, the issue will be what types of water rights, permits, and authorizations are associated with the applicable agricultural operations and how a lien in those water rights is granted and perfected.

The Source of Water Rights

Water rights arise in a variety of ways and state laws on water rights are not uniform. There are two primary categories of water rights.

Riparian Rights. The riparian rights doctrine was developed in England and the eastern United States, where water is relatively abundant. The doctrine grants an owner of land adjacent to a surface water body a nonpossessory right to make use of the water adjacent to the land. David B. Anderson, Water Rights as Property in Tulare v. United States, 38 McGeorge L. Rev. 461, 480 (2007). Each riparian owner has an equal right to use water, and there is no system of allocation of rights during a dry period. Riparian rights in water are appurtenant to the land. A landowner generally has a right to use the water so long as the use bears a reasonable relationship to the natural use of the land and does not exhaust the community’s water supply. See, e.g., Canada v. City of Shawnee, 64 P.2d 694, 697 (Okla. 1936); Bristor v. Cheatham, 255 P.2d 173, 176 (Ariz. 1953).

Appropriative Rights. On the other hand, appropriative rights are conferred by a state and grant a right to take a specified portion of water. The Doctrine of Prior Appropriation was developed in the western United States, where water is less plentiful and had to be diverted for use away from the source. In those states, water is declared to be the property of the public or the state. Some state statutes require the landowner to acquire a permit from the state before taking and using the water. See, e.g., Colo. Rev. Stat. Ann. § 37-90-107; Or. Rev. Stat. § 537.700. The typical method of acquiring an appropriative right in water is to apply for and receive a permit authorizing the taking and use of a specified quantity of water. Harry Miller & Marvin Starr, Miller and Starr California Real Estate 3d, 6 Cal. Real Est. § 17:25 (2013). In some states, the right to use the appropriated water is a real property right that can be transferred or mortgaged. In other states, the right to use appropriated water is personal property, and perfection of a security interest is accomplished by a UCC filing or a filing with the appropriate governmental agency that appropriated the water right. The permit holder typically has the right to reasonably take and use the water only in accordance with the terms of the permit. An appropriative right may be limited in times of water shortage, however, if the state agency granting the right has granted a higher priority appropriative right to another person. A primary principle of the prior appropriation doctrine is that the holders of earlier rights have a senior priority for use of the water in times of shortage.

Perfection of Security Interests in Water Rights Generally

States are split on whether water rights can be transferred separately from the underlying land. Mark W. Tader, Reallocating Western Water: Beneficial Use, Property, and Politics, 1986 U. Ill. L. Rev. 277, 287 (1986). Generally, water rights are considered real property. Thus, perfecting a security interest is frequently accomplished by granting a security interest to the water right in a deed of trust or mortgage, recorded in the county in which the water is located. R.L. Knuth, Conveyancing and Collateralizing Utah Water Rights, 12 Utah B.J. Dec. 1999, at 12; see, e.g., Beecher v. Cassia Creek Irr. Co., 154 P.2d 507, 509 (Idaho 1944); In re Bear River Drainage Area, 271 P.2d 846, 848 (Utah 1954). For example, in Utah the only way to acquire a new water right is by applying to the state engineer for a water certificate. Utah Code Ann. § 73-3-1. Existing water rights are transferable by deed in substantially the same manner as real estate. Id. § 73-1-10. By statute, water rights in Utah are presumed to be appurtenant unless specifically provided otherwise. Id. § 73-1-11. Similarly, security interests in water rights in Nevada are perfected by recording a deed with the local county recorder. Dan Reaser et al., High and Dry in Nevada, Bus. L. Today, Mar./Apr. 2006, at 35, 37. But because Nevada water rights are granted by permits, lenders face the risk that the water right may be canceled, forfeited, or abandoned. Under Nevada law, the state engineer must give notice to security interest holders when a permit will be altered only if the interest holder has notified the state of its interest. Nev. Dep’t of Conservation and Nat. Res., Div. of Water Res. v. Foley, 109 P.3d 760 (Nev. 2005). Therefore, in Nevada, perfection of a security interest in water should include appropriate filings with the state engineer.

Perfection of Security Interests in Water Stock

The process for perfecting a security interest in shares of stock of a water corporation is relatively unsettled. States are split on whether shares in a mutual water company are real or personal property. Se. Colo. Water Conservancy Dist. v. Fort Lyon Canal Co., 720 P.2d 133, 141 (Colo. 1986) (holding shares are real property); cf. Utah Code Ann. § 73-1-10 (amended in 1996 stating that “shares of stock in a corporation shall be transferred in accordance with the procedures applicable to securities”). In states where the shares are personal property, a security interest in the shares is perfected by taking possession of the share certificates. In re Anderson, No. 10-31252, 2014 WL 172222 (Bankr. D. Utah Jan. 15, 2014), at *7. Recording a deed of trust suffices if the shares are real property. California and Colorado classify shares of stock in a water corporation as real property. De Boni Corp. v. Del Norte Water Co., 134 Cal. Rptr. 3d 226, 230 (Ct. App. 2011); Shigo, LLC v. Hocker, 338 P.3d 421, 426 (Colo. Ct. App. 2014). Thus, a security interest is perfected by listing the water right on a recorded deed of trust.

But the law is less than clear in some states. For example, in Utah, after the legislature amended Utah statutory law, Utah Code Ann. § 73-1-10, to classify the shares in a water company as personal property, the Utah Supreme Court nonetheless declared that the shares were real property. Badger v. Brooklyn Canal Co., 922 P.2d 745, 749 (Utah 1996). In 2014, a federal bankruptcy court interpreting Utah law held “that water shares remain real property under Utah law and a security interest therein may be perfected by the shares’ inclusion in a recorded deed of trust.” Anderson, 2014 WL 172222, at *10. Although the bankruptcy court decision is not binding on Utah courts, it is strong guidance to lenders that the security interest should be granted in the deed of trust.

On the other hand, the Wyoming Constitution provides that all natural waters within the boundaries of the state are property of the state; however, the right to divert and use water can be acquired by an individual. Wyo. Const. art. 8, § 1. Wyoming follows the doctrine of prior appropriation when determining which water rights have priority. Id. § 3. Beneficial use is the measure and limit of the water right. Wyo. Stat. Ann. § 41-3-101. The state engineer and the Board of Control are primarily responsible for administering Wyoming water law and the water permit system. It is important to distinguish between surface water and groundwater. Surface water rights are more common in Wyoming. The procedure for obtaining water rights consists of three steps: (1) application for a permit, (2) approval for constructing diversion and storage structures, and (3) final proof of appropriation. Id. § 41-4-501. In addition, to obtain authorization for a change in use of an existing water right, the appropriator must petition the Board of Control. Id. § 41-3-104.

Agricultural uses are not preferred, and water rights that are not preferred may be condemned to supply water for preferred uses. The following surface water uses are preferred by statute in Wyoming: (1) for drinking by people and livestock; (2) for municipal purposes; (3) for other domestic purposes, railways, and power plants; and (4) for other industrial purposes. Id. § 41-3-102. In Wyoming, security interests in water rights are generally created and perfected in the same manner as mortgages in land. A water right is a real property interest, which may be sold and conveyed separate from the land to which it was first applied. The water right is sold by means of a water deed. Water rights are appurtenant to the land, which means they pass with the conveyance of the land, unless otherwise specifically reserved. Rennard v. Vollmar, 977 P.2d 1277 (Wyo. 1999); Frank v. Hicks, 35 P. 475 (Wyo. 1894). Because a water right is a real property right, a lien can be perfected by mortgage.

Water rights are also subject to abandonment by nonuse. Wyo. Stat. Ann. § 41-3-401. Therefore, when water rights secure an obligation, steps should be taken to protect the collateral. Borrowers should be required to provide evidence that the water rights are being put to full beneficial use at least once every five years to avoid forfeiture (photographs, irrigation records, and so on). If the property lies within the boundaries of an irrigation district, the secured party should put the district on notice that it holds a security interest in the water right. In some areas of Wyoming, water is also obtained through private ditch companies. In these cases, there can be “shares” of the ditch company issued to patrons, and such shares are personal property and should be described as collateral in a UCC security agreement and financing statement. It is crucial that the lender obtain sufficient information from the borrower to know whether the borrower has actual permitted water rights from the state, or instead “buys” the water through a private ditch company or similar structure, and that the lender secures its interest by means of the proper document.

Crops

Most farmers are primarily in the business of growing crops. Growing crops involves crop inputs such as seeds and fertilizer, crop care and maintenance, crop harvesting and storage, and the sale of the crops. Crops can be annual, such as corn and wheat, or perennial, or “permanent” crops, such as apples and grapes.

Is It Realty or Personalty?

The trees and vines on which perennial crops grow are considered to be affixed to the land, so security interests in them can be established by a mortgage or deed of trust. The products of permanent plantings are clearly personal property once they have been harvested. Issues can arise as to when the transition from realty to personalty occurs. Is it when the tree buds? The apple ripens? The grape is picked? When is a grape no longer a grape and becomes wine? Trees, vines, crops, and their proceeds travel along a continuum of collateral classifications that can be treacherous and need to be carefully managed and documented.

Farm Products Under the UCC

UCC § 9-320 provides that a buyer in the ordinary course of business takes free of a security interest created by the buyer’s seller, other than a person buying farm products from a person engaged in farming operations. The UCC definition of farm products includes crops grown, growing, or to be grown; livestock, born or unborn; supplies used or produced in a farming operation; and products of crops or livestock. Unlike other types of personal property, under the UCC buyers of farm products acquire title subject to the seller’s security interest. Over the years, this led to lots of litigation, frequently over the issue of whether the lender had consented to the sale of the goods. In addition, many states adopted a variety of revisions to the UCC to change the results for some purchasers of farm products. This led to problems and uncertainty in interstate commerce.

Food Security Act

To address the uncertainty in interstate commerce created by the different approaches in states, Congress passed the Food Security Act of 1985 (FSA). In so doing, Congress stated the purpose of the FSA as follows:

(a) . . . (1) certain State laws permit a secured lender to enforce liens against a purchaser of farm products even if the purchaser does not know that the sale of the products violates the lender’s security interest in the products, lacks any practical method for discovering the existence of the security interest, and has no reasonable means to ensure that the seller uses the sales proceeds to repay the lender;

(2) these laws subject the purchaser of farm products to double payment for the products, once at the time of purchase, and again when the seller fails to repay the lender;

(3) the exposure of purchasers of farm products to double payment inhibits free competition in the market for farm products; and

(4) this exposure constitutes a burden on and an obstruction to interstate commerce in farm products.

(b) Declaration of purpose. The purpose of this section is to remove such burden on and obstruction to interstate commerce in farm products.

7 U.S.C. § 1631(a), (b).

The FSA protects buyers of farm products in the ordinary course against the potential of having to pay for goods twice. The FSA provides that a buyer who buys farm products in the ordinary course takes free of a security interest created by the seller even though the security interest is perfected and the buyer knows of its existence, unless the lender qualifies the security interest under the notification and filing procedures of the FSA. Id. § 1631(d). There are two means by which the lender can qualify its security interest under the FSA. First, the FSA provides that lenders can protect themselves by providing buyers with written notice of their security interest that includes:

(I) the name and address of the secured party;

(II) the name and address of the person indebted to the secured party;

(III) the social security number, or other approved unique identifier, of the debtor or, in the case of a debtor doing business other than as an individual, the Internal Revenue Service taxpayer identification number, or other approved unique identifier, of such debtor; and

(IV) a description of the farm products subject to the security interest created by the debtor, including the amount of such products where applicable, crop year, and the name of each county or parish in which the farm products are produced or located.

Id. § 1631(e)(1)(ii).

Alternatively, the FSA provides that states can adopt a central filing system for the registration of security interests in farm products. Id. § 1631(e)(2). In those states, a lender can file an effective financing statement in the central filing system and buyers will take subject to such lender’s security interest if either (1) the buyer has failed to register with the secretary of state of such state before the purchase of farm products; or (2) the buyer receives from the secretary of state written notice as provided in the FSA that specifies both the seller and the farm product being sold by such seller as being subject to an effective financing statement or notice, and the buyer does not secure a waiver or release of the security interest specified in such effective financing statement or notice from the secured party by performing any payment obligation or otherwise. Id.

State Bank of Cherry

How well has this worked out? One example is State Bank of Cherry v. CGB Enterprises, 984 N.E.2d 449 (Ill. 2013). In Illinois, a direct notice state, the State Bank of Cherry loaned money to Lawrence Rogowski, a farmer, and obtained a security interest in Rogowski’s crops and crop proceeds. The bank provided a direct notice of its security interest in Rogowski’s crops by letters sent to CGB Enterprises. Rogowski sold his crops to CGB Enterprises, which in turn sold Rogowski’s crops and delivered the proceeds, some $35,000, directly to Rogowski. CGB made no effort to protect the bank. On April 4, 2005, and June 14, 2006, the bank gave written notice to CGB of its security interest in Rogowski’s crops. The first notice covered crop years 2004 and 2005; the second covered crop years 2005 and 2006. Each notice stated that it was effective for a period of one year after receipt. CGB’s payments to Rogowski took place within the time frames specified in each notice. Each notice contained Rogowski’s name, Social Security number, and address. Each notice identified the bank and the bank’s address. Each notice claimed a security interest in all grain on hand and all growing crops. Neither notice stated the location of the grain or crops. Instead, each claimed a security interest in “the described farm products wherever located.” Id. at 453.

The FSA requires the creditor’s name and address and the debtor’s name, address, and Social Security number or other tax identification number. 7 U.S.C. § 1631(e)(1). It requires a description of the farm products in which the interest is claimed, as well as the amount and the “name of each county or parish in which the farm products are produced or located.” Section 1631(d) provides that, absent compliance with the notice requirements, the security interest is void even for a buyer with actual notice of its existence.

Section 1631(e)(2) describes the requirements for a satisfactory notice of security interest in a central filing state. In general, the requirements are the same as for a direct notice state. Section 1631(c)(4)(H), however, provides that a notice “substantially complies” with the FSA, even though the notice “contains minor errors that are not seriously misleading.” No similar provision appears in the FSA for direct notice states under 7 U.S.C. § 1631(e)(1).

Rogowski defaulted on the loan, and the bank obtained a judgment against him, which had not been satisfied. State Bank, 984 N.E.2d at 452. The bank then sued CGB, claiming that it had actual notice of the bank’s security interest and therefore owed the bank the proceeds of the sale of Rogowski’s crops. The parties filed cross-motions for summary judgment. CGB argued that, in a direct notice state, the FSA requires strict compliance with its terms and that the absence of the location of the farm products made the notice fatally defective. The bank argued that substantial compliance was sufficient and that, because CGB clearly had notice of the security interest, CGB was liable. The trial court agreed with the bank. The court of appeals reversed, and the Illinois Supreme Court affirmed the court of appeals. Id. at 469. It followed Farm Credit Midsouth, PCA v. Farm Fresh Catfish Co., 371 F.3d 450 (8th Cir. 2004), in holding that only strict compliance with the FSA will perfect the security interest in a direct notice state. It disagreed with First National Bank and Trust v. Miami County Co-op. Ass’n, 897 P.2d 144 (Kan. 1995), that substantial compliance would suffice. The Illinois court reasoned that the presence of the substantial compliance language in section 1631(e)(2), and its absence from section 1631(e)(1), meant that Congress intended to treat direct notice states more strictly than central filing states. State Bank, 984 N.E.2d at 465.

It found that Congress could rationally desire to give an advantage to central filing states to encourage the states to adopt that method of perfecting liens. Id. at 464. Because the bank’s notices did not state the location of the farm products in which the bank claimed a security interest, they did not strictly comply with the FSA. Hence, CGB had no liability to the bank despite its knowledge of the bank’s security interest. The moral of the story: include all information required by the FSA in the notice of security interest, including the county where the farm products are located. Being “close enough for government work” will not suffice.

Security Interests in Crop Insurance

Another issue that comes up as to crops is perfecting a lender’s secured interest in crop insurance proceeds. The severe drought of 2012 brought to the forefront the importance of crop insurance to agricultural producers in managing risk. An estimated $12 billion was paid out in crop insurance proceeds for claims arising from the drought of 2012. Lenders need to understand how to perfect their security interests in crop insurance proceeds. An example of the issues is the case of In re Duckworth, No. 10-83603, 2012 Bankr. LEXIS 1219 (Bankr. C.D. Ill. 2012). In this case, David Duckworth, a grain farmer, filed Chapter 7 bankruptcy in fall 2010. Among the assets the trustee was charged with liquidating were the debtor’s growing crop and claim for crop insurance proceeds for 2010. The crop insurance claim had been filed by the debtor before the bankruptcy, but the insurance company denied the claim after the filing. One of the issues in the Duckworth case was who had priority in the crop insurance proceeds (if and when any crop insurance proceeds were approved). The debtor had executed and delivered to the bank a broadly worded security agreement and the bank had properly perfected its security interest with a timely and properly filed UCC-1 financing statement. The bank’s security agreement included crops, farm products, insurance proceeds, and general intangibles as collateral. The debtor in the case had also granted to a crop supplier a security interest and an assignment of the crop insurance proceeds under the policy. The trustee alleged that he was entitled to the crop insurance proceeds ahead of the bank and the crop supplier. The court held that the bank did not have a properly perfected security interest in the crop proceeds because the Federal Crop Insurance Act preempts Article 9 for security interests in crop insurance proceeds. 7 U.S.C. § 1508. The court relied on In re Cook, 169 F.3d 271 (5th Cir. 1999), in which the Fifth Circuit Court of Appeals held that an exclusive means to properly perfect a security interest in crop insurance proceeds is to take an assignment of the federal crop insurance proceeds on the insurance form approved in writing by the insurer.

Lenders need to obtain the crop insurance carrier’s form of assignment and then properly complete and file that form of assignment. The lender should prepare an assignment each year to make sure that it has a proper assignment, because each policy year is a different policy.

Livestock

Farming operations frequently include a livestock component, which either can be the primary business of the farmer or can be one of several types of productive uses in a multi-faceted farming operation. Some types of livestock are kept in close proximity, largely under shelters, such as chickens or turkeys. Other types of livestock are large and require both shelters and substantial space to move, graze, and roam, such as cattle and horses. The acreage required for these types of large livestock may be owned in fee simple by the farmer or may be used by the farmer under leases or permits issued by various government agencies. This portion of the article will look at the types of state and federal grazing permits and leases that are typically associated with farm and ranch operations. It also will explain how a security interest in a grazing lease or permit is perfected.

Federal Grazing Leases

Grazing leases for publicly owned land are granted by both federal and state agencies. Deborah Buckman, Annotation, Construction and Application of Taylor Grazing Act (43 U.S.C.A. §§ 315 et seq.) and Regulations Promulgated Thereunder, 71 A.L.R. Fed. 2d 197, § 12–13 (2013). Federal grazing leases are issued by the U.S. Department of the Interior’s Bureau of Land Management (BLM). Taylor Grazing Act, 43 U.S.C. § 315m. Federal grazing leases may be pledged as security for loans. 43 C.F.R. § 4130.9. To perfect a security interest in a federal BLM grazing lease, the lender must submit a Lien Holder Notice of Interest in Base Property (this form identifies the lender and borrower, describes the property and the leaseholder, and states the loan number, date of issuance, and project repayment date; it does not include the loan amount) with the applicable BLM district office. Bureau of Land Mgmt., Handbook H-4110, Qualifications and Preference (2008). The notice will be approved and filed as long as the required information is present and accurate. Next, the lender should ask the BLM to send an acknowledgment that the notice is recorded. Once the notice is approved, the BLM will not allow a transfer of grazing preference from the base property without the written consent of the lienholder. In addition, the BLM will inform the lender when proposed grazing decisions may affect the property. Finally, the lender should record the security interest as part of the deed of trust or mortgage in the county in which the property is located. It is unclear whether recording the security interest with the county is necessary, but doing so may provide notice to third parties who do not check the BLM’s records.

State Grazing Leases

Not all states authorize grazing leases on state-owned land, though federal lands in the state may still be leased. States that do authorize grazing leases generally grant regulatory authority to the state’s department of lands or other agencies. For example, the Arizona State Land Department School Trust and Colorado State Land Board lease land for grazing to raise revenue for education in addition to their respective state department of lands. Ariz. Rev. Stat. § 37-132(a)(6); Colo. Const. art. 9, § 9(6). Perfecting a security interest in a state-issued grazing lease generally requires approval from the applicable agency. See N.M. Stat. Ann. § 19-7-37; Or. Admin. R. 141-110-0110(4). The security should also be recorded on the deed of trust or mortgage in the county in which the property is located. For example, the Washington State Department of Natural Resources and Department of Fish and Wildlife prohibit a leaseholder from encumbering any grazing lease without prior written consent. Other states, including Arizona and Wyoming, require the lender to file a notice of security interest with the state land commission. Private grazing leases account for the majority of, and in some cases all, grazing leases in many states, including Missouri, Florida, and Iowa, among others. A security interest in a private grazing lease is perfected by recording a lien in the lease as part of a mortgage or assignment of lease document in the county where the land is located.

Federal Grazing Permits

Grazing permits are revocable licenses. Swim v. Bergland, 696 F.2d 712, 719 (9th Cir. 1983). Federal grazing permits are issued by the BLM or the U.S. Forest Service and are considered personal property. Liens against BLM grazing permits are perfected by providing notice to the BLM and receiving an acknowledgment of the notice. Once perfected, the BLM will not transfer the grazing permit without the security holder’s written permission and will notify the security holder when proposed grazing decisions may affect the property. Bureau of Land Mgmt., Handbook H-4110, Qualifications and Preference (2008).

Federal grazing permits are issued by either the BLM or the U.S. Forest Service. In issuing federal grazing permits, the BLM generally must give preference to persons within or near a grazing district who are landowners engaged in the livestock business, bona fide occupants or settlers, or owners of water or water rights, as may be necessary to permit the proper use of lands, water, or water rights that such persons own, occupy, or lease. 63C Am. Jur. 2d Public Lands § 93. In the permitting of certain lands for grazing purposes, preference also must be given to owners, homesteaders, lessees, or other lawful occupants of contiguous lands, to the extent necessary to permit the proper use of such lands. Id. The lender may only take a security interest in the rights that the borrower has under the permit. The Taylor Grazing Act makes clear that grazing privileges or permits do not create any right, title, interest, or estate in or to the lands. 43 U.S.C. § 315b.

Concerning leases on BLM land, 43 C.F.R. § 4130.9 provides:

Grazing permits or leases that have been pledged as security for loans from lending agencies shall be renewed by the authorized officer under the provisions of these regulations for a period of not to exceed 10 years if the loan is for the purpose of furthering the permittee’s or lessee’s livestock operation, Provided, that the permittee or lessee has complied with the rules and regulations of this part and that such renewal will be in accordance with other applicable laws and regulations. While grazing permits or leases may be pledged as security for loans from lending agencies, this does not exempt these permits or leases from the provisions of these regulations.

State Grazing Permits

State grazing permits are personal property (more specifically, general intangibles) and may sometimes be perfected by filing a UCC-1 financing statement that lists the grazing permit as collateral. The financing statement may need to be filed with the secretary of state in the state where the land is located. See 810 Ill. Comp. Stat. 5/9-501(a)(2); Cal. Com. Code § 9501(a)(2). In addition, states that grant grazing permits typically require that the lender seek approval from the state agency before the permit can be used as collateral. For example, New Mexico, Oregon, South Carolina, Washington, and Wyoming require approval from their respective state grazing agencies. There are nuances and differences in the manner of issuance and steps needed to perfect a security interest in a state grazing permit. Wyoming provides a good example. Grazing and agricultural leasing in Wyoming is controlled by the Board of Land Commissioners. State grazing permits are typically associated with land close to the base property. A Notice of Security Interest must be filed with the Wyoming Board of Land Commissioners whenever a security interest is created or released. The form is available on-line. State of Wyo. Bd. of Land Comm’rs, Notice of Security Interest in State Lease (Dec. 1993), http://slf-web.state.wy.us/surface/assignments/SecurityForm.pdf. The same form is used to both acquire a security interest ($25 filing fee) and to release one (no fee required for release). When a Notice of Security Interest is filed on a state lease, the lease cannot be assigned to a new party without consent of the lender. The lender also is notified if the rental is not paid on or before the due date. Per the specific exemption of leases from the scope of the UCC, the proper location for filing notice of a security interest in a grazing lease is the real property records of the county in which the leased property is located. Although at least one court has ruled something less than a mortgage was sufficient, as a matter of law, to perfect a security interest in a real property lease, the prudent course of action would be to obtain a formal mortgage and record it in the real property records of the county, as well as notify the Board of Land Commissioners of its existence. See Lovelady v. Bryson Escrow, Inc., 32 Cal. Rptr. 2d 371 (Ct. App. 1994); Wyo. Stat. § 34.1-9-109(d)(xi), cmt. 7, exs. 1 & 10. Again, the mortgage should clearly indicate that it is secured only by an interest in the borrower’s leasehold rights. In addition, unless the agreement between borrower and lender contains an assignment clause, on default and foreclosure the leased lands will automatically revert to the state to enter the pool of leases up for assignment and the collateral will essentially disappear. Therefore, the prudent course of action would be to obtain an agreement for assignment of the grazing lease to the secured party on default and foreclosure.

Intercreditor Agreements

Agricultural Financing— Long-Term vs. Operating Debt

The agricultural finance market in the United States is composed of a variety of capital sources whose collateral appetites are very specific. Some agricultural lenders prefer to advance funds on a long-term basis primarily secured by real estate, others function as operating lenders whose loans are secured by farm products and proceeds, while others prefer specific collateral types such as wineries, ranches, dairies, or grain mills.

It is common in the agricultural finance market for a single farming operation to obtain credit from more than one source, making intercreditor agreements both necessary and typical. Agricultural collateral can include a lien on property that is of unclear character. For example, irrigation equipment may be a fixture or it may be personal property depending on the jurisdiction and how it is installed. Because of the nature of certain equipment and property common to farming, the characterization of property as personal or real property is often open to interpretation. A wide variety of types or classes of collateral is involved in agricultural financing.

Mortgage Financing and Operating Lender Documentation

First mortgage loan transactions involving agricultural financing involve the typical set of loan documents: a note setting forth the indebtedness, which is secured by a first mortgage lien on the property involved in the transaction; and an assignment of leases and rents, guaranty, an environmental indemnity agreement, and a loan agreement that sets forth the terms of the loan (unless sufficiently set out in the note and mortgage). When multiple sources of financing are contemplated, the real estate agricultural loan agreement or mortgage will typically include an acknowledgment that (1) the existence of the operating loan does not violate the transfer and encumbrance covenant and (2) any foreclosure of the operating lender under its loan documents will not require the mortgage lender’s consent or violate the transfer restrictions. Furthermore, the mortgage financing loan documents should include an acknowledgment that the operating loan constitutes permitted indebtedness under the mortgage loan.

Operating lender documentation will focus on personal property as collateral. It will typically include a loan agreement, note, security agreement, and a UCC financing statement. The personal property description will depend on the nature of the personal property being pledged as collateral.

Intercreditor Agreement

The terms between the operating lender and mortgage lender may be incorporated into the loan documents or in an intercreditor agreement. The key terms of an intercreditor agreement in the agricultural context should (1) identify each lender’s collateral, (2) provide clear priority of loans on each lender’s respective collateral, (3) provide for the operating lender’s release of liens on collateral to be sold or discharged by the mortgage lender, (4) provide for the mortgage lender’s release of liens on collateral to be sold or discharged by the operating lender, and (5) provide for the operating lender’s right to protect its collateral in the event of foreclosure (for example, right of entry on land to cultivate and harvest existing crops).

The intercreditor agreement should carefully define the collateral on which each lender has a lien and then set out the priorities of each lender to that collateral in the event of default.

Although operating lenders may be given senior priority to the operating lenders’ collateral, as that term is defined in the intercreditor agreement, term lenders would similarly be given senior priority to the term lenders’ collateral, also defined in the intercreditor agreement. For existing crops, the intercreditor agreement provides that the operating lenders generally have senior priority. On the occurrence of a foreclosure, the operating lenders are granted a non-exclusive right to enter and use the land to cultivate and harvest the existing crops to ensure a return on their senior priority lien. The operating lenders’ senior priority lien extends only to existing crops and not to permanent plantings or future crops, and the operating lenders’ right to the existing crops ends at the end of the crop year, as that term is defined in the intercreditor agreement.

The intercreditor agreement also can provide that if either lender seeks to sell or dispose of collateral in which both a senior and junior lien are present, the junior lienholder must cooperate to sell the collateral by releasing its lien on the collateral. This is encouraged by allowing for the junior lender’s lien to attach to the proceeds of such sale or disposition in the same order of priority as before.

Intercreditor Agreement Default and Remedy Provisions—Courts Generally Enforce the Contract

One of the key purposes of an intercreditor agreement is to provide clarification of each party’s rights in the event a default on the applicable loan should occur. The drafter of these agreements needs to be very clear about these provisions. By their nature, intercreditor agreements are likely to be between two sophisticated parties, each likely represented by counsel. The courts, in interpreting intercreditor agreements, have predominantly enforced their terms as written.

Courts have addressed intercreditor agreements within the context of both a bankrupt borrower and a defaulted loan. Specifically, in the context of a defaulted loan, in 2002 a Delaware court ruled against a borrower who was claiming that because the mortgage lender had offered an extension, the mezzanine lender had an obligation to match that extension. Vornado PS, L.L.C. v. Primestone Inv. Partners, L.P., 821 A.2d 296, 313 (Del. Ch. 2002). In finding that the mezzanine lender had no such obligation within the terms of the intercreditor agreement, the court also affirmed the right of the mortgage lender to exercise its remedies against the borrower when the borrower defaulted on the mezzanine loan, through enforcement of a cross-default provision. Id. In addition, the court upheld a provision against enforcement by third parties and ruled that no fiduciary duty was owed to the borrower by the mezzanine lender. Id. at 312.

Within the context of a bankrupt borrower, significant issues regarding enforcement of intercreditor agreements may arise. Specifically, the enforceability of intercreditor agreement provisions assigning a junior lender’s bankruptcy voting rights to the senior lender is in question. The U.S. Bankruptcy Court for the Northern District of Illinois would not enforce an intercreditor agreement to affect the transfer of the voting rights of the subordinated lender to the first mortgage lender. In re 203 N. LaSalle St. P’ship, 246 B.R. 325 (Bankr. N.D. Ill. 2000). The court reasoned that, although the language of the subordination agreement governs the outcome of the senior lender’s right to repayment, the Bankruptcy Code governs the determination of voting rights. The court turned to Bankruptcy Code § 1126(a), which provides that the holder of a claim may vote to accept or reject a plan under Chapter 11. The court found that the junior lender was entitled to vote its claim even though the intercreditor agreement provided that the senior lender could vote its claim. On the other hand, in a bankruptcy action in which a creditor filed a motion requesting declaratory judgment of his voting rights, valuation of collateral, and ballot casting allowances, the U.S. Bankruptcy Court for the Northern District of Georgia held that, by the express terms of the agreement, the lender had the right to vote on the creditor’s claims. See Blue Ridge Inv’rs v. Wachovia Bank, N.A. (In re Aerosol Packaging, LLC), 362 B.R. 43 (Bankr. N.D. Ga. 2006). The Aerosol Packaging court analyzed the North LaSalle Street Partnership court decision and disagreed. The Aerosol Packaging court found that the subordination agreement effectively transferred the subordinate creditor’s voting rights to the mortgage lender under Bankruptcy Code § 510(a), which provides that a “subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law.” Aerosol Packaging, 362 B.R. at 46. The Aerosol Packaging court stated that, although “Section 1126(a) grants a right to vote to a holder of a claim, it does not expressly prevent that right from being delegated or bargained away by such holder.” Id. at 47.

In a 2008 case, a Montana district court granted the defendants’ motion to dismiss two counts of the plaintiffs’ complaint and the defendants’ motion to strike portions of the complaint because of provisions in the intercreditor agreement that clearly covered the issues in dispute. See Smith v. Bull Mountain Coal Properties, Inc., No. CV-06-169-BLG-RFC-CSO, 2008 WL 1736047, at *11 (D. Mont. Mar. 7, 2008) (enforcing intercreditor agreement and holding that the “express terms” of the intercreditor agreement dictated lien priorities and precluded equitable subordination and marshaling).

The U.S. District Court for the Eastern District of Pennsylvania upheld and enforced an intercreditor agreement in the context of a bank seeking declaratory relief and damages because a financial corporation with which it had dealings was refusing to comply with the express terms of the parties’ intercreditor agreement. See The Marian Bank v. Pan Am. Fin. Corp., No. 85-0850, 1986 WL 15002, at *1 (E.D. Penn. Dec. 31, 1986). Pan American Financial Corporation argued that its intercreditor agreement with Marian Bank should not be enforced because it was entered into without consideration and because it relied on a material misrepresentation by Marian. The court rejected both arguments and held (1) because each party compromised its claim, the agreement had adequate consideration and (2) any misrepresentation made by Marian did not induce Pan American to enter into the agreement, so it should be enforced in accordance with its terms. The Marian Bank, 1986 WL 15002, at *1–2.

And, in an action brought by a minority lender to compel majority lenders to exercise acceleration and foreclosure under a syndicated loan agreement, the U.S. District Court for the Southern District of New York held that the credit agreement was unambiguous in its terms and would be enforced as written. See New Bank of New England, N.A., v. Toronto-Dominion Bank, 768 F. Supp. 1017 (S.D.N.Y. 1991). The agreement in this case expressly stated that the creditors have no liability to each other beyond what was provided for in the loan agreement, so the court held that the minority lender could not sue on theories of breach of fiduciary duty, negligence, willful misconduct, or an implied covenant of good faith and fair dealing. Id. at 1021. An unambiguous credit agreement, like any other contract, will be accepted by courts on its face.

Conclusion

Today’s agricultural finance markets present a wide variety of financing vehicles and collateral types. It is more and more common for borrowers and business operations to secure financing from multiple capital sources. These lenders frequently look to different types of collateral, have different appetites for risk, and view protection of their positions in land, crops, water, livestock, and equipment differently from each other.

By John P. McNearney

John P. McNearney is a shareholder in the St. Louis, Missouri, office of Polsinelli PC and vice-chair of the Continuing Legal Education Committee.