Court Mishandled Cows After Farm Bankruptcy

(CN) - After a Kentucky dairy farmer went bankrupt, his 435 leased cows were improperly sold to settle a bank's security interest, the 6th Circuit ruled.

Sunshine Heifers LLC leased 435 milk cows to Lee Purdy from 2009 to 2012 when his dairy farm in Barren County failed.

Purdy tried to keep his business afloat by selling hundreds of his animals and reducing his herd from approximately 750 to 432, but ended up voluntarily filing for chapter 12 bankruptcy in November 2012.

When Sunshine tried to get its cattle back, Citizens First Bank claimed it had a superior interest in all the animals thanks to a 2008 loan in which Purdy used his livestock and farm equipment as collateral.

Sunshine argued that Purdy did not own its cattle but was simply leasing them, meaning that they were not included in the bank's security interest. Citizens First countered that the lease agreements were really "disguised security agreements."

The bankruptcy court found in March 2013 that Purdy's 50-month leases with Sunshine functioned as per se security agreements because dairy herds are culled by approximately 30 percent each year, and Purdy would likely have replaced the entire herd within three years, long before the leases expired.

Citizens First foreclosed on the herd and sold them at auction for $402,353.54, which it applied to Purdy's outstanding debt on his loan.

Sunshine appealed the decision nine days after the auction, demanding its fair percentage of the cattle sold. It also appealed the September 2013 affirmation by a federal judge in Bowling Green of the bankruptcy court's decision.

The 6th Circuit reversed, 2-1, on Thursday, finding that the bankruptcy court erred in emphasizing the economic life of individual cows rather than that of the entire herd.

Applying Arizona law, as required by choice-of-law provision of the leases, the Cincinnati-based appellate court found that the dairy cow leases are true leases not security agreements.

The majority noted a specification in the leases that "Purdy had a duty to return the same number of cattle to Sunshine that he originally leased, not the same cattle." (Emphasis in original.)

"It made little difference to Sunshine whether it received the exact same cows that it originally leased to Purdy," Judge Karen Nelson Moore wrote for the court. "In line with this understanding, the agreements took into account industry practices, such as culling, by requiring Purdy to replace any unproductive cows that he sold. Sunshine protected its interests in the herd by inspecting Purdy's operation, requiring Purdy to carry insurance, and creating a 'residual guaranty,' which stated that the actual cattle returned would be worth at least a set amount. Given these provisions and the testimony of the parties, it is clear to us that the relevant 'good' is the herd of cattle, which has an economic life far greater than the lease term, and not the individual cows originally placed on Purdy's farm."

Sine the leases did not include an option for Purdy to buy the cows outright, they cannot be characterized as disguised security agreements, according to the ruling.

"Here, even if Purdy had wanted to purchase the cattle at $300 per cow, there is nothing in the agreements that obligates Sunshine to sell to him," Moore wrote. "Sunshine could have retaken possession of its cows and leased them out to Purdy's competitor under the same terms, and there would have been nothing Purdy could have done under the agreement. In our view, this state of play is consistent with a lease."

It is also of note that Purdy had no purchase option, and his rental payments could not be construed as installment payments because he had to return the same number of cows as he leased when his leased expired, according to the ruling.

Since the herd sold for $309,000 at auction, "ownership of this herd - in our view - is a significant asset, and thus, we hold that Sunshine retained a meaningful revisionary interest," Moore wrote.

The court also found no evidence that Purdy's culling rate altered the leases into security agreements.

U.S. District Judge Gerswhin Drain, sitting on the panel by designation from Detroit, took issue with this finding in his four-page dissent.

"Each head of cattle was a means of production rather than part of a unit," Drain wrote. "For Purdy, each cow was a sophisticated piece of equipment that produced a product; [sic] milk. The economic life of the individual heads of cattle would not last the term of the lease. Any cows on Purdy's farm at the end of the lease term would not be the original cows because he would have culled those cows from the herd. In fact, Purdy would have culled nearly all of the cattle from lease 1 at the time of the petition. Thus, the agreements were for a period longer than the cows' economic value to Purdy. ... Unlike the majority, I would hold the Bright-Line test is met and the leases were per se security agreements."

Drain also chided the majority for finding that Citizens First did not meet its burden to prove the economic realities of the transaction, stating that the court should have focused on factors other than the existence of a reversionary interest.

He pointed to the ruling in In re Phoenix Equpment Co. Inc., in which an Arizona bankruptcy judge found that "the nature of the transactions showed that the debtor did not need a lease agreement, but needed capital to continue operating."

Here, Sunshine apparently loaned Purdy the necessary money to buy cows for his farm in three of the lease agreements and maintained a lien on the cows he ultimately bought rather than directly leasing its own cows to him, the dissent notes.

"Purdy purchased the cattle, and there is no indication in the record Purdy approved or saw a contract or any warranties or promises the third-party buyer would have given to Sunshine," Drain wrote. "Sunshine only has invoices and bills to indicate it paid for cattle that Purdy already had on his farm. Sunshine has not shown its leases meet the statutory requirements of the finance lease."

"It was not error for the bankruptcy court to rely on the fact that Purdy acquired the cattle from third parties and Sunshine reimbursed those parties," he added. "This arrangement was tantamount to Sunshine financing the acquisition of cattle for Purdy's diary operation. Moreover, Sunshine failed to come forward with evidence it actually owned the cattle delivered by the third party buyers, which calls into question the leases [sic] status as finance leases. I would hold the economics of the transaction support a finding that the parties entered into security agreements for the cattle rather than leases."

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