October 2012

The following is an increasingly frequently occurring scenario.  A farmer ("Debtor") carries on the business of producing and selling one or more crops ("Crops").  To finance the Debtor's operations, the Debtor obtains a revolving operating line of credit from a Canadian chartered bank ("Bank").  The Debtor utilizes this credit to obtain various goods and services which it requires in order to conduct its operations, in particular, to grow, to harvest and to sell its Crops.  These include such items as seeds, fertilizers and pesticides ("Primary Inputs"), servicing and obtaining parts for the Debtor's production equipment (including the acquisition of fuel for same), consumption of electricity and payments made to farm employees/workers.  As security to better assure the Debtor's payment of its obligations arising out of such credit, the Bank obtains a general security agreement ("GSA") from the Debtor which, by its very nature, covers all of the from time to time existing personal properties, both tangible and intangible, of the Debtor, including the Debtor's Crops.  The Bank perfects its GSA security under the applicable Personal Property Security Act ("PPSA") by registering a financing statement in the Personal Property Registry ("PPR"), thereby establishing the priority of the Bank's security against, amongst other things, the Debtor's Crops.  Additionally, and to protect the Bank's security against real estate interests, the Bank files a PPSA Crops Notice against the title(s) to the Debtor's farmland on which the Debtor's Crops are to be/are growing.  For argument's sake, assume that at this point in time, no one has priority over the Bank with respect to the Bank's security against the Debtor's Crops.

Subsequently, the Debtor, decides that it needs more Primary Inputs than it has acquired via the Bank's financing.  It also concludes that it would be less expensive for it to acquire such additional Primary Inputs from an agricultural products supplier ("Primary Inputs Supplier").  So the Debtor acquires one or more of seeds, fertilizer and pesticides from a Primary Inputs Supplier on credit.  The Primary Inputs Supplier takes a security interest in the Primary Inputs which it has sold on credit to the Debtor plus a security interest in the Crops being grown/about to be grown by the Debtor.  The Primary Inputs Supplier promptly perfects its security interest. 

Can the Primary Inputs Supplier, in effect, retroactively, achieve priority over the Bank's security?  Consider these arguments which the Primary Inputs Supplier might make to support its claim for priority over the Bank's security:

1. The Primary Inputs Supplier has a purchase money security interest in the Crops.  In Section 1 of the PPSA (Manitoba), "purchase money security interest" is defined (insofar as a credit seller is concerned) to be "a security interest taken or reserved in collateral, other than investment property, to the extent that it secures all or part of its purchase price".  It is doubtful that the Primary Inputs Supplier could successfully argue that its security covers all of or any part of the "purchase price" of the Crops.  What the Primary Inputs Supplier does have is a purchase money security interest in the Primary Inputs themselves which it has sold on credit to the Debtor.  But it does not (likely) hold a purchase money security interest in the Crops.
2. The Primary Inputs Supplier's purchase money security interest in the Primary Inputs attaches to the Crops (with the same priority that its purchase money security interest had in the Primary Inputs themselves) on the basis that the Crops are "proceeds" of the Primary Inputs.  Section 1 of the PPSA (Manitoba) defines "proceeds" to include "identifiable or traceable personal property, fixtures and crops (i) derived directly or indirectly from any dealing with collateral or the proceeds of collateral, and, (ii) in which the debtor acquires an interest".  Clearly, the Crops are a species of personal property and clearly, the Debtor acquires an interest in them when they start growing.  But there are two problems for the Primary Inputs Supplier in making this argument.  First, it may be difficult to "trace" the Primary Inputs Supplier's Primary Inputs to the Crops themselves, bearing in mind that some of the Primary Inputs utilized by the Debtor to create the Crops (in the above example) were financed with value provided by the Bank.  Second, can it really be said that the Crops are "derived" from the Debtor's "dealing" with the Primary Inputs?
3. The Primary Inputs Supplier has obtained a perfected security interest in the Crops which "enables (the Debtor) to produce the Crops".  The quoted words come from the PPSA (Manitoba) Section 34(10) which states: "A perfected security interest in crops or their proceeds given for value to enable a debtor to produce the crops and given while the crops are growing crops or during the six months immediately before the time the crops become growing crops, has priority over any other security interest in the same collateral given by the same debtor".  There can be no doubt that provision of credit to the Debtor of the Primary Inputs by the Primary Inputs Supplier does "enable" the Debtor to "produce the crops".  But doesn't the Bank also provide value to the Debtor which enables the Debtor to produce the Crops?  In the example given here, the Bank assists the Debtor to produce the Crops by enabling the Debtor to acquire some (although only some) of the Primary Inputs required to produce the Crops.  So the situation is that both the Bank and the Primary Inputs Supplier have enabled the Debtor to produce the Crops.  There are two problems or questions which arise here: (i) where the financing provided by the Bank is utilized, not only to enable the Debtor to obtain some of the Primary Inputs required to produce the Crops, but also to enable the Debtor to generally carry on its crop production business (as described above), is the financing of the Debtor's acquisition of such other non-Primary Inputs costs and expenses just as much "value to enable (the Debtor) to produce the Crops" as the utilization by the Debtor of the Bank's financing to acquire some of the Primary Inputs for the Crops?, and, (ii) if both the Bank and the Primary Inputs Supplier can be said to have enabled the Debtor to produce the Crops, what rule in the PPSA resolves the priority dispute?  As to the latter question, one cannot look to the rule that provides, in effect, that in a competition between a seller's purchase money security interest and a lender's purchase money security interest, the seller's security interest holds priority over the lender's security interest.  Arguably, the Bank's and the Primary Inputs Supplier's security interests in the Crops are security interests governed by Section 34(10) and not "purchase money security interests" at all.  If that is the case, then one must fall back on the "residual" priority rule in the PPSA which provides that in a competition between two perfected security interests, priority is determined by who has perfected (in this case registered) first (Section 35(1) of the PPSA (Manitoba)).  In the example given here, that would put the Bank 100% ahead of the Primary Inputs Supplier insofar as the Crops are concerned.

In essence, I would argue that my analysis in paragraph #3 above is correct provided that a Court held that:

(a)          the Debtor's Crops are not "proceeds" of the Primary Inputs; and

(b)          the non-Primary Inputs acquired by the Debtor utilizing the Bank's funds are just as much inputs which "enable (the Debtor) to produce the (Crops)", as are the Primary Inputs themselves.

In support of my argument that the non-Primary Inputs should be considered to perform the same function as the Primary Inputs, I would ask readers to review Section 34(11) of the PPSA (Manitoba) which provides a limited priority for those taking security interests in animals to secure obligations arising out of the secured party's provision of value to the animals' owner to acquire "food, drugs or hormones to be fed to or placed in the animal(s)".  Section 34(11) specifies types of inputs for animals, but Section 34(10) does not specify types of Primary Inputs.  The expression "Primary Inputs" has been made up by the writer for illustrative purposes only and no such expression appears in the PPSA (Manitoba).

Assume that a Court disagreed with the writer's analysis of the above-described fact scenario. What could be done to protect the Bank?  Consider the following:

(A)          The Bank could take a Bank Act, Section 427 security assignment covering the Debtor's Crops.  If the Primary Inputs Supplier (which presumably is not another chartered bank) takes security in the Crops, it will undoubtedly be governed by the PPSA.  In a contest between a Bank Act, Section 427 security assignment and a PPSA governed security interest, the priority rules found in the Bank Act will determine priority.  If the Bank has taken and properly registered notice of its taking of its Bank Act, Section 427 security before the Primary Inputs Supplier has taken and properly registered its PPSA governed security, the Bank will prevail.  Section 4(k) of the PPSA (Manitoba) provides that the PPSA does not apply to Bank Act, Section 427 security where, as is the case with the Bank Act, the federal legislation spells out the rights and priorities of competing claimants against commonly charged collateral.

(B)          If, for whatever reason, the Bank chooses not to take Bank Act, Section 427 security, or, as might well be the case in the future, chartered banks are no longer able to obtain security under the Bank Act, then, absent a legislative solution to sort out priorities in the above-described fact scenario (ie, an amendment to the PPSA), the Bank could obtain a covenant from the Debtor to the effect that the Debtor is not to obtain additional credit (or at least additional secured credit) from any Primary Inputs Supplier without first obtaining the written consent of the Bank.  That way - and assuming that the Debtor honours its covenant - when the Debtor approaches the Bank and requests permission to obtain (secured) credit from a Primary Inputs Supplier, the Bank can then make a reasoned decision as to what to do.  The Bank may well agree to permit the Debtor to obtain some additional (secured) credit from a Primary Inputs Supplier, but only if the Primary Inputs Supplier enters into an intercreditor agreement with the Bank spelling out the Bank's and the Primary Inputs Supplier's respective priorities regarding the Debtor's Crops.

Note that in order to narrow a potential priority dispute down to one whereby the Bank and the Primary Inputs Supplier are the only meaningful competing claimants to the Debtor's Crops, both the Bank and the Primary Inputs Supplier will have to be mindful of certain "time restrictions" imposed on them by the PPSA (Manitoba).  Assume that the Bank is relying on PPSA security rather than Bank Act Section 427 security.  First, Section 13(2)(a) of the PPSA (Manitoba) provides that as a general rule, in order for a creditor's security interest to attach to crops at all, the crops must start growing no later than one year after the "security agreement is entered into".  Second, as noted above, Section 34(10) of the PPSA (Manitoba) requires that a creditor wishing to have as high as possible a security interest in crops must ensure that the security interest arises during a period of time commencing six months before the crops start growing, and continuing down to when the crops are threshed.  The need to have the security agreement signed no more than one year before the crops start growing is subject to an exception; where the security in the crops is given "in conjunction with…a mortgage of land…". Then if the parties so agree, the creditor's security interest in the crops will "attach to (the crops) to be grown on the land during the term of the…mortgage…".  In the above-described scenario, I have assumed that the Bank and the Primary Inputs Supplier have, in effect, "complied" with the aforementioned "time restrictions".