Federal Crop Insurance Act Pre-empts Security Interests in Crop Insurance

January 23, 2012 | Erika Eckley

This case involved several issues that arose during the administration of a farmer’s Chapter 7 bankruptcy surrounding the security interest of multiple lenders. A key factor was that the debtor had taken out two loans from a bank and a third loan from another Company.

The bankruptcy trustee held the proceeds from the farmer’s post-petition equipment and crop sales as well as crop insurance proceeds. The trustee brought a declaratory judgment action seeking guidance on how to disburse the proceeds. The bank filed a summary judgment motion to declare it had first priority in the proceeds. The trustee filed summary judgment seeking to avoid the bank’s security interest.

The undisputed facts are that the farmer signed a promissory note for a revolving line of credit. The loan was dated December 15, 2008. The debtor also signed an Agricultural Security Agreement (ASA) dated December 13, 2008 that identified the loan date as December 13, 2008. Several boxes at the top of the form identifying the principal, maturity, loan number, and call were left blank. The box for “Account” included the same number as the one on the promissory note. The ASA described the collateral as “All Inventory, Chattel Paper, Accounts, Equipment, General Intangibles, Crops, Farm Products, Livestock (including all increase and supplies) and Farm Equipment.” The farmer was permitted to sell his crops as long as the proceeds were made immediately available to the bank in the form of a joint check and the debtor provided a list of the buyers of the crop. Other documents were generated, including a UCC Financing Statement, Notice to Buyer of Security Interest Farm Products directed to the identified buyers, and an agreement to provide insurance.

A second loan between the debtor and the bank was entered into in January 2010 and due in July 2010. This was also a revolving line of credit for “farm operating expenses only”. Collateral was addressed with the following phrase, “Borrower acknowledges this Note is secured by SECURITY AGREEMENT DATED DECEMBER 13, 2008.” 

The farmer then granted a security interest to another company in November 2010 granting security interest to secure “all debts”. The collateral description included crops and proceeds from crop insurance. “All debts” was not defined and no documents were attached to the agreement. On the same day, the farmer assigned his rights to the proceeds of two crop insurance policies to the company by signing several documents. The policies were purported to cover the 2010 crop year.
In their motion, the trustee and the Company argued that the Banks’ ASA was invalid because it referenced a loan dated December 13, 2008, which did not exist. The bank presented evidence that the bank closed the loan on December 15, 2008 and disbursed the $1.1 million note.  It stated the discrepancy in the date was due to a “clerical error.”

Under Illinois law, the requirements for a security interest to be enforceable against a borrower and third parties are:  (1) value must be given; (2) the debtor must have rights in the collateral;  and (3) either the debtor has authenticated a security interest, the collateral is not a certified security interest, the collateral is a certified security in registered form, or the collateral is electronic or investments under the secured party’s control. Of these three requirements, the parties agreed the only issue was whether value had been given.  

The trustee and Company argued that the court could not look beyond the ASA in deciding the manner. The court reminded the parties that parol evidence was admissible to determine proof of the debt because Illinois law allows parol evidence to be admitted when a dispute regarding the meaning of a contract is raised by a third party. In this case, the trustee and the company raised the issue, so the Bank’s evidence of disbursing the funds was considered.

After reviewing the extrinsic evidence presented by the Bank, the court held that despite the mistake in the date on the ASA, the bank did disburse $1.1 million. Because value was given, the ASA was enforceable and a mistake in the description of the secured debt did not render it unenforceable. Because of this, the Bank had a first security interest in collateral securing the first loan.

The Bank argued the ASA also secured the second note in January 2010. The court found no dragnet clause securing future debts was included in the provisions of the ASA. Failure to include a future advances or dragnet clause in a security agreement cannot be cured by referring to the agreement in a different contract in order to prevent “secret liens”.  Because there was no dragnet clause in the ASA, the court held that the reference to the ASA in the January 2010 note was ineffective and the second note was not secured.

The next issue the court addressed was whether the Bank had an enforceable security interest in the crop insurance proceeds. The ASA’s collateral description included reference to crops, proceeds, and insurance proceeds.  The crop insurance policies had been assigned by the farmer to the Company granting the November 2010 loan.  Both policies included a provision that required assignments to be on the insurer’s form or approved in writing by the insurer. Therefore, the question of whether an assignment accepted by the federal crop insurer is the exclusive method by which a creditor can obtain an interest in insurance proceeds was raised. If, so, this would mean the Federal Crop Insurance Act (FCIA) pre-empts UCC Article 9 concerning security interests in crop insurance.

This issue had not yet been decided in the Seventh Circuit. The court, therefore, adopted the reasoning of a decision of the United States Court of Appeals for the Fifth Circuit, In re Cook, 169 F.3d 271 (5th Cir. 1999), where the court addressed the same issue. In Cook, the 5th Circuit examined the language of FCIA and determined the statute expressly pre-empted security interests in the following specific ways: in the imposition and enforcement of liens; expressly stating that an interest in an insured crop existing by virtue of an existing lien does not entitle the lienholder to any benefit under the insurance contract; and an assignment may be made to the proceeds, but must be on the insurer’s form and will not be effective until approved in writing by the insurer.

As a result, the court held the Bank had no interest in the crop insurance proceeds because the only valid method for assigning the proceeds was the authorized procedure outlined in FCIA. Because this procedure was not followed, the mere mention of crop insurance proceeds within the description of collateral was insufficient to create a security interest in the proceeds.

Therefore, lenders should be aware of whether future advances or dragnet clauses can be enforceable to protect future loans to the same individual and utilizing the same collateral. Also, in order to have a valid interest in crop insurance proceeds, lenders must comply with the process of assigning the rights to crop insurance as outlined in the FCIA. Merely including crop insurance within the description of collateral may not be effective to create an interest in the proceeds.  In re Duckworth, No. 10–83603, 2012 Bankr. LEXIS 1219 (Bankr. C.D. Ill. Mar. 22, 2012).

In further proceedings, a bank sought first priority security interest in the proceeds remaining from the sale of farm equipment. The trustee sought to avoid the bank’s security interest. The debtor signed a promissory note with the bank dated December 15, 2008. The ASA, however was dated December 13, 2008 and identified the Note as being dated on the 13th. The court held that the ASA secured the Note because all statutory prerequisites for effectiveness of the security agreement had been conceded by the trustee, and it was merely a scrivener’s error that the trustee sought to use to render the ASA ineffective. The court also found the trustee’s argument that the incorrect date on the ASA would relieve any subsequent lender from further inquiry and be justified that the ASA secured no debt was unreasonable.  In re Duckworth, No. 10-83603, 2013 Bankr. LEXIS 223 (Bankr. C.D. Ill. Jan. 18, 2013).