The following article is reprinted from the June-July 2004 issue of The UCC Filing Flash, a newsletter provided by The UCC Guide Inc. to its subscribers. See the box at the end of the article for disclaimer and other information. It was written by Carl R. Ernst, Publisher. Go to www.ernst.cc for information about publications available from Ernst Publishing Co., LLC.

In an opinion filed March 31, 2004, the Supreme Court of South Dakota rendered an opinion (2004 SD 40) on an appeal of a Circuit Court case, American Bank & Trust et al v. Nathan Schaull and Deborah Schaull, d/b/a/Highmore Auction Sales, Fin-Ag, Inc, Ag Star Financial Services, PCA et al (6th Circuit, Hyde County, #02-20, decided October 1, 2002).

The facts of the case read like a Dan Brown novel, so we will simplify them for the purposes of illustrating a couple of points in this article. The opinion is worth reading for those of our readers who get secret pleasure in learning how the due diligence performed by lenders on both sides of the litigation could be so negligent.

As a result of their negligence, both sides lost lots of money. It looks like the more negligent side lost every cent based on its failure to file as required under UCC law, while the not-as-negligent side lost more in actual dollars.

Massive Negligence

It appears that all the parties to this litigation were either professional farm lenders or professional cattle owners. Still each and every party made some common due diligence mistakes:

1. Nathan Schaull and his companies—They owned cattle and also brokered and cared for other’s cattle. They got into financial trouble, and then claimed to own cattle under their control which they did not own. Later comes the crash.

2. Fin-Ag, Inc.—This cooperative, which used Schaull to care for its cattle and sold him cattle, did everything right until it subordinated its security position in 2001 to American Bank. It was left with $2,000,000 in worthless loans or missing inventory due to American Bank’s due diligence failures.

3. American Bank & Trust—This lender facilitated Schaull’s cattle auction business through a $750,000 line of credit starting in 1999. In 2001 American lent Schaull another $500,000 based on doing a UCC lien search and a cursory inventory of about 1,000 cattle that appeared to be owned by Schaull. It filed properly on Schaull as debtor in 1999 and in 2001. Most of the cattle were, however, not owned by Schaull.

4. Feldman, Jennings and other actual owners of the cattle—None of the owners of the cattle at issue had filed UCC financing statements under Schaull’s name or tagged the cattle as notice of there ownership in herds cared for by Schaull. Unknown to American, most of the cattle were owned by either Jennings (625 cows under a “lease-purchase option”) or by Feldman under a “bred cow agreement.”

5. AgStar—This expert lender had financed Feldman’s cattle purchases and was aware that he boarded them with Schaull. It did not file UCC financing statements naming either Feldman as a debtor or Schaull as a consignee.

If American or Fin-Ag had performed adequate due diligence in 2001, Schaull’s house of cards would have been discovered before the last loan had been made. Schaull and his companies finally went under in the Spring of 2002, leaving the cattle owners and lenders to litigate over who would take ownership of the 910 cows still around.

The Issues Decided

The trial court ruled on all issues in favor of American Bank. On appeal, the Supreme Court of South Dakota affirmed on all three issues it considered:

1. Did American’s security interest attach to the herd?

The court analyzed the facts according to the old Article 9 version of Rev. UCC �9-203. The issue netted down to a question of whether Schaull had sufficient “rights in the collateral” for American’s interest to attach. The court agreed with the trial court that the “bred cow agreement” between Feldman and Schaull by its terms “created a joint venture relationship between Feldman and Schaull “sufficient for attachment of the security agreement.”

Basically, the court let American off the hook even though its due diligence with respect to the ownership of the cattle was way less than adequate; American was not even aware of the “bred cow agreement” because it accepted Schaull’s word that he owned the cattle.

2. Was Feldman estopped from asserting a security interest in the collateral?

In December 2001, after the 2001 American loan, the 625 Jennings cows were bought by Schaull and immediately sold to Feldman. Therefore, most of the remaining herd was owned by Feldman. Feldman claimed that the transaction with Schaull established a bailment, which does not require the filing of a financing statement, but the appeals court agreed with the trial court that the “bred cow agreement” was a form of joint venture, and no bailment was involved. Feldman should have filed something or tagged something.

3. Were the cattle inventory or farm products?

Section 1324 of the Food Security Act of 1985, titled “Protection for the Purchasers of Farm Products,” established a new set of rules for lenders to follow in order to protect their security interests in “farm products,” a form of collateral defined in the act. Because we have done a good deal of research over the years about the interplay of Section 1324 with Article 9 of the UCC, we continue to be wary of the arcane nature of farm-related lending. It is not something for the uninitiated lender to jump into.

Part of the complexity of this case is due to the definition of “farm products”: Like the definition of “fixtures” familiar to real and personal property lenders, the definition of “farm products” depends on context rather than an objective test. As equipment is a fixture if it is affixed to real property, inventory is a farm product if it is goods in the possession of a person “engaged in farming operations.” (Section 1324 and Rev. UCC �9-102(34) agree on this part of the definition.)

If the cattle had been inventory, Feldman would have been considered a holder in due course of 625 cattle remaining in the herd. As such, he would have owned these cattle free and clear. If the cattle had been farm products, on the other hand, American would maintain its interest in the cattle even after the sale. The court determined that the cattle were farm products.

Conclusion

This case illustrates that even farm-lending specialists can get just about everything wrong in dealing with simple due diligence issues, not to mention technical difficulties peculiar to farm operations.

We will narrow our recommendations to cattle collateral, although we suppose it is applicable to other livestock and maybe other kinds of farm product collateral. Here are the due diligence formulas in a nutshell:

Owner Rule

If

(1) you own cattle, and

(2) your cattle are

(a) being held by someone else or

(b) grazing on someone else’s property, then

(1) have a written agreement with the holder or the landlord

(a) allowing you to file a UCC financing statement, and

(b) providing the information necessary under Section 1324 for you, depending on the state where the cattle or located, to either,

(i) file an effective financing statement or

(ii) provide direct notification to possible buyers of your ownership.

Lender Rule

If

(1) you lend against cattle collateral, whether or not the cattle may be inventory or farm products, then

(a) file a UCC financing statement on the owner in the proper filing office,

(b) file an effective financing statement or do direct notification of potential buyers, depending on the state where the cattle are located.

And if

(2) the cattle may not be held by the owner, then

(a) determine where and by whom the cattle are held,

(b) obtain the information about all holders or landlords where the cattle may be located,

(c) make sure that the owner/grazing agreements also authorize you to file UCC financing statements and contain the information required for you to perform Section 1324 procedures with respect to all holders and landlords.

Buyer Rule

If you buy cattle from anyone,

(1) determine whether the seller owns the cattle, and

(2) in case the cattle may be considered farm products, check for any Food Security Act filings under the name of the seller or owner of the cattle.