Tough Financial Times in Agriculture and Lending Clauses – Peril for the Unwary
The farm economy continues to struggle. Of course, certain parts of the country are experiencing more financial trauma than are other parts of the country, but recent years have been particularly difficult in the Corn Belt and Great Plains. Aggregate U.S. net farm income has dropped by approximately 50 percent from its peak in 2011. It is estimated to increase slightly in 2017, but it has a long way to go to get back to the 2011 level. In addition, the value of farmland relative to the value of the crops produced on it has fallen to its lowest point ever. A dollar of farm real estate has never produced less value in farm production, and real net farm income relative to farm real estate values have not been as low as presently since 1980 to 1983.
A deeper dive on farm financial data indicates that after multiple years of declining debt-to-asset ratios, there was an uptick in 2015 and 2016. Relatedly, default risk remains low, but it also increased in 2015 and 2016. Also, there has been a decline in the ratio of working capital to assets, and a drop in the repayment capacity of ag loans. As a financial fitness indicator, repayment capacity is a key. At the beginning of the farm debt crisis in the early 1980s, it dropped precipitously due to a substantial increase in interest payments and a decline in farm production. That meant that land values could no longer be supported, and they dropped substantially. Consequently, many farmers found themselves with collateral value that was lower than the amount borrowed. Repayment capacity is currently a serious issue that could lead to additional borrowing.
While financial conditions may improve a bit in 2017 and on into 2018, working capital may continue to erode in 2017 which could lead to increased debt levels. That’s because average net farm income will remain at low levels. This could lead to some agricultural producers and lenders having to make difficult decisions before next spring. It also places a premium on understanding clause language in lending document and the associated rights and obligations of the parties.
Two clauses deserve close attention. One clause contains “cross-collateralization” language. “Cross-collateralization” is a term that describes a situation when the collateral for one loan is also used as collateral for another loan. For example, if a farmer takes out multiple loans with the same lender, the security for one loan can be used as cross-collateral for all the loans. A second clause contains a “co-lessee” provision. That’s a transaction involving joint and several obligations of multiple parties.
Today’s post takes a deeper look at the implications of cross-collateral and co-lessee language in lending documents. My co-author for today’s post is Roger McEowen of Washburn University’s School of Law. Roger and I have worked together on many presentations through the years on law and taxation.
As noted above, clause language in lending and leasing documents should be carefully reviewed and understood for their implications. This is particularly true with respect to cross-collateralization language. For example, the following is an example of such a clause that appears to be common in John Deere security agreements. Here is how the language of one particular clause reads:
“Security Interest; Missing Information. You grant us and our affiliates a security interest in the Equipment (and all proceeds thereof) to secure all of your obligations under this Contract and any other obligations which you may have to us or any of our affiliates or assignees at any time and you agree that any security interest you have granted or hereafter grant to us or any of our affiliates shall also secure your obligations under this Contract. You agree that we may act as agent for our affiliates and our affiliates may as agent for us, in order to perfect and realize on any security interest described above. Upon receipt of all amounts due and to become due under this Contract, we will release our security interest in the Equipment (but not the security interest for amounts due an affiliate), provided no event of default has occurred and is continuing. You agree to keep the Equipment free and clear of all liens and encumbrances, except those in favor of us and our affiliates as described above, and to promptly notify us if a lien or encumbrance is placed or threated against the Equipment. You irrevocably authorize us, at any time, to (a) insert or correct information on this Contract, including your correct legal name, serial numbers and Equipment descriptions; (b) submit notices and proofs of loss for any required insurance; (c) endorse your name on remittances for insurance and Equipment sale or lease proceeds; and (d) file a financing statement(s) which describes either the Equipment or all equipment currently or in the future financed by us. Notwithstanding any other election you may make, you agree that (1) we can access any information regarding the location, maintenance, operation and condition of the Equipment; (2) you irrevocably authorize anyone in possession of that information to provide all of that information to us upon our request; (3) you will not disable or otherwise interfere with any information gathering or transmission device within or attached to the Equipment; and (4) we may reactivate such device.”
So, what does that clause language mean? Several points can be made:
- The clause grants Deere Financial and its affiliates a security interest in the equipment pledged as collateral to secure the obligations owed to it as well as its affiliates.
- When all obligations (including debt on the equipment purchased under the contract and all other debts for the purchase of equipment that Deere Financial finances) to Deere under the contract are paid, Deere Financial will release its security interest in the equipment. That appears to be straightforward and unsurprising. However, the release does not release the security interest of the Deere’s affiliates. This is the cross-collateral provision.
- The clause also makes Deere Financial the agent of its affiliates, and it makes the affiliates the agent of Deere Financial for purposes of perfection. What the clause appears to mean is that if a financing statement was not filed timely, perfection by possession could be pursued.
- The clause also irrevocably authorizes John Deere to insert or correct information on the contract.
- The clause allows John Deere to access any information regarding the location, maintenance, operation and condition of the collateral.
- The clause also irrevocably authorizes anyone in possession of that information to provide it to John Deere upon request.
- Also, under the clause, the purchaser agrees not to disable or interfere with any information gathering or transmission device in or attached to the Equipment and authorizes John Deere to reactivate any device.
Example. Consider the following example of the effect of cross-collateralization by machinery sellers and financiers:
|Assets||Value||Creditor||Amount||Equity by Item|
|JD 4710 Sprayer 90′ Boom||60,000||JD Finance||84,000||(24,000)|
|JD 333E Compact Track Loader||50,000||JD Finance||35,000||15,000|
|JD 8410T Crawler Tractor||70,000||JD Finance||50,000||20,000|
|JD 612C 12 Row Corn Head||70,000||JD Finance||25,000||45,000|
|Total Value||250,000||Total Liabilities||252,571||(2,571)|
|Equity with Cross Collateralization||(2,571)|
|Equity without Cross Collateralization||80,000|
The equity in the equipment without cross-collateralization is the sum of the equity in the Compact Track Loader, the Crawler Tractor and the Row Corn Head.
Sellers that finance the purchase price of the item(s) sold (termed a “purchase money” lender) seem to be using cross-collateralization provisions with some degree of frequency. As noted, the cross-collateralization provisions of the John Deere security agreement will allow John Deere to offset its under-secured status on some machinery by using the equity in other financed machines to make up the unsecured portion of its claims. Other machinery financiers (such as CNH and AgDirect) are utilizing similar cross-collateral provisions in their security agreements.
Can A “Dragnet” Lien Defeat a Cross-Collateralization Provision?
Would a bank’s properly filed financing statement and perfected blanket security agreement be sufficient to defeat a cross-collateralization provision? It would seem inequitable to allow an equipment financier’s subsequently filed financing statement to defeat the security interest of a bank. So far, it appears that when a purchase money security interest holder has sought to enforce a cross-collateralization clause, the purchase money security interest holder has always backed down. For example, in one recent scenario, John Deere Financial sought to enforce its cross-collateralization agreement against a Bank in a situation similar to the one set forth above. The Bank properly countered that its blanket security interest in farm equipment perfected before any of the Deere Financial purchase money security interests were perfected defeated the Deere Financial cross-collateralization. Deere Financial backed down thereby allowing the Bank to have all the equity in the equipment, $80,000, be paid to the Bank by the auctioneer after the liquidation auction.
A “Co-Lessee” Clause
When a guarantee on a loan cannot be obtained, a proposal may be made for “joint and several obligations.” In that situation, the lessor tries to compel one lessee to cover another lessee’s obligations or joint obligations. It’s a lease-sublease structure, with the original lessee becoming the sublessor. While the original lessee/sublessor has no rights to use the equipment (those rights are passed to the sublessee), the original lessee/sublessor remains legally obligated for performance. The sublease can then be assigned as collateral to the original lessor.
While a co-borrower situation is not uncommon, a transaction involving co-lessees is different inasmuch as a lease involves the right to use and possess property along with the obligation to pay for the property. A loan document simply involves the repayment of debt. So, what if a co-lessee arrangement goes south and the lessor tries to compel one lessee to cover another lessee’s joint obligation? What is the outcome? That’s hard to say simply because there aren’t any litigated cases on the issue with published opinions. But, numerous legal and (tax) issues would be involved. For instance, with a true lease, what if the lessees argue over the use and possession of the equipment or the removal of liens or maintenance of the property or the rental or return of the property? What about the payment of taxes? Similar issues would arise in a lease/purchase situation that encounters problems (when a true lease is involved) or the owner/borrowers (in a lease-purchase) dispute the use and possession of the equipment or the parties’ obligations to pay taxes, remove liens, maintain the property, or pay for the rental or return of the property. What is known is that in such a dispute numerous Uniform Commercial Code issues are likely to arise under both Article 2 and Article 9.
The following is an example of John Deere’s co-lessee clause when it has an additional party sign on a lease:
“By signing below, each of the co-lessees identified below (each, a “Co-Lessee”) acknowledges and agrees that (1) the Lessee indicated on the above referenced Master Lease Agreement (the “Master Agreement”) and EACH CO-LESSEE SHALL BE JOINTLY AND SEVERALLY LIABLE FOR ANY AND ALL OF THE OBLIGATIONS set forth in the Master Agreement and each Lease Schedule entered into from time to time thereunder including, but not limited to, the punctual payment of any periodic payments or any other amounts which may become due and payable under the terms of the Master Agreement, whether or not said Co-Lessee signs each Lease Schedule or receives a copy thereof, and (2) it has received a complete copy of the Master Agreement and understands the terms thereof.
In the event (a) any Co-Lessee fails to remit to the Lessor indicated above any Lease Payment or other payment when due, (b) any Co-Lessee breaches any other provision of the Master Agreement or any Lease Schedule and such default continues for 10 days; (c) any Co-Lessee removes any Equipment (as such term is more fully described in the applicable Lease Schedule) from the United States; (d) a petition is filed by or against any Co-Lessee or any guarantor under any bankruptcy or insolvency law; (e) a default occurs under any other agreement between any Co-Lessee (or any of Co-Lessee’s affiliates) and Lessor (or any of Lessor’s affiliates); (f) or any Co-Lessee or any guarantor merges with or consolidates into another entity, sells substantially all its assets, dissolves or terminates its existence, or (if an individual) dies; or (g) any Co-Lessee fails to maintain the Insurance required by Section 6 of the Master Agreement, Lessor may pursue any and all of the rights and remedies available to Lessor under the terms of the Master Agreement directly against any one or more of the Co-Lessees. Nothing contained in the Addendum shall require Lessor to first seek or exhaust any remedy against any one Co-Lessee prior to pursuing any remedy against any other Co-Lessee(s).
Capitalized terms not defined in this Addendum shall have the meaning provided to them in the Master Agreement.”
Clearly, a party signing on as a co-lessee on a John Deere lease is assuming a great deal of risk.
Times are tough for many involved in production agriculture. The same is true for many agribusiness and agricultural lenders. If a producer is presented with a lending transaction that involves either a cross-collateralization or a co-lessee clause, legal counsel with experience in such transactions should be consulted. Fully understanding the risks involved can pay big dividends. Failing to understand the terms of these clauses can lead to the financial failure of the farmer that signs the document.