Secured Lenders and Factors tend to go running for the hills when they hear the word PACA.
This is a two part article on a significant topic. For those of you who read WurstCaseScenario on the publication date, Part 2 will be circulated tomorrow (by email, LinkedIn and at www.WurstCaseScenario.com).
The Perishable Agricultural Commodities Act was enacted in 1930 to prevent unfair business practices and to promote financial responsibility in the fresh fruit and produce industry. The Great Depression arrived. Droughts destroyed crops. Bankruptcies were prominent. Farmers were hit on all ends and the food supply chain was at risk.
The purpose of PACA is to remedy this risk through the creation of a statutory trust. PACA products received by a commission merchant, dealer, or broker and any receivables or proceeds from the sale of such products are to be held by the commission merchant, dealer, or broker in trust for the PACA beneficiaries until suppliers, sellers, or agents have received full payment.
In 1984 PACA was amended to prevent secured lenders from defeating the rights of PACA trust beneficiaries. The congressional focus upon the relative rights of these two groups is unmistakable.
PACA permits the comingling of trust assets and permits the PACA trustee to convert trust assets into proceeds. Thus, the transferees of trust assets are liable only if they had some role in causing a breach or dissipation of the trust. If the trustee transfers trust property to a third person without committing a breach of trust, the third person holds the interest so transferred or created free of the trust, and is under no liability to the beneficiary.
The Ninth Circuit Court of Appeals in a February 2017 decision provided some relief for factors.
The Second, Fourth and Fifth Circuit Courts of Appeal have been consistent in their standard that before assessing the commercial reasonableness of a factoring agreement, it is first necessary to examine the substance of the factoring agreement to ensure a true sale has occurred. In the absence of a true sale, superficial indicators and labels surrounding a factoring agreement should be of no consequence. The substance of the transaction matters. If the substance of a transaction reveals a secured lending arrangement rather than a true sale, the accounts receivable remain trust assets. Thus, unpaid trust beneficiaries hold an interest in accounts receivable and their proceeds superior to all unsecured and secured creditors such that the trust beneficiaries should prevail.
The Ninth Circuit, however, did not require a true sale analysis. In its 2001 decision in Boulder Fruit the Ninth Circuit summarized the following scenario:
Farmer sells oranges on credit to Broker. Broker turns around and sells the oranges on credit to Supermarket, generating an account receivable from Supermarket. Broker then obtains a loan from Bank and grants Bank a security interest in the account receivable to secure the loan. Broker goes bankrupt. Under PACA, Broker is required to hold the receivable in trust for Farmer until Farmer was paid in full; use of the receivable as collateral was a breach of the trust. Therefore, Farmer’s rights in the Supermarket receivable are superior to Bank’s. In fact, as a trust asset, the Supermarket receivable is not even part of the bankruptcy estate.
The treatment of true sales and security interests, therefore, is clear. What remains unclear is the analysis to apply when the true nature of the transaction is ambiguous. How should a court treat a transaction if the parties to a factoring agreement label the transaction a sale of accounts but provide substantial recourse for the factoring agent, such as requiring the distributor to “repurchase” non-performing accounts or permitting the factoring agent to withhold payments or otherwise recoup payments already made to the distributor? What if, such labels notwithstanding, the recourse and security provided include a security interest in the accounts receivable? Has a true sale actually occurred?
In the Ninth Circuit’s 2001 decision it did not focus on transfer of risk in finding that a commercially reasonable factoring agreement did not result in a breach of the trustee’s duties. Keep in mind that once a circuit court makes a decision, it is generally bound by the precedent established.
In its February 2017 decision it described the situation as follows:
…the Factoring Agreement involved many hallmarks of a secured lending arrangement, including: security interests in accounts and all other asset classes except inventory; UCC financing statements; subordination of other debts; and substantial recourse for [Factor] against [its client] in the event [Factor] was unable to collect from [Client]’s customers (for example, [Factor] was entitled to force [Client] to “repurchase” accounts that remained unpaid after 90 days, and [Factor] could enforce this right by withholding payments from [Client]).
[Client]’s business later failed, and Growers did not receive payment in full from [Client] for their produce. Growers sued [Factor] alleging: (1) the Factoring Agreement was merely a secured lending arrangement structured to look like a sale but transferring no substantial risk of nonpayment on the accounts; (2) the accounts receivable and proceeds remained trust property under PACA; (3) because the accounts receivable remained trust property, [Client] breached the PACA trust and [Factor] was complicit in the breach; and (4) PACA-trust beneficiaries such as Growers held an interest superior to [Factor], and [Factor] was liable to Growers.
Relying on Boulder Fruit and describing the cited cases as a circuit split, the district court granted summary judgment. The district court noted the Ninth Circuit in Boulder Fruit expressly addressed the commercial reasonableness of a factoring agreement but implicitly rejected a separate, transfer-of-risk test. Further, the court noted the factoring agreement in Boulder Fruit transferred even less risk than the Factoring Agreement in the present case—in Boulder Fruit, the factoring agent enjoyed unrestricted discretion to force the distributor to repurchase accounts. The court therefore held that, even if Boulder Fruit could accommodate the transfer-of-risk test, the facts of Boulder Fruit controlled and precluded relief for Growers. Finally, the court concluded that the Factoring Agreement was commercially reasonable because [Factor] paid to [Client] 80% of the face value of the accounts as an up-front payment and ultimately paid to [Client] an even greater percentage of the face value of the transferred accounts.
Further, because the Factoring Agreement in the present case transferred a small degree of risk of non-payment, at least when compared to the agreement at issue in Boulder Fruit, we agree that Boulder Fruit would preclude relief to the Growers even if it were possible for our panel to adopt the transfer-of-risk test.
Although the judge writing the majority opinion did not focus on who assumed the risk for non-payment, a concurring decisiondid:
In contrast, the Fourth, Fifth, and Second Circuits considered it necessary to examine the rights and risks transferred between the parties to a factoring agreement. ….. As the Fourth Circuit stated, “[I]f the accounts receivable were not sold but rather were given as collateral for a loan, then the accounts receivable would have remained trust assets, subject to [the factoring agent’s] security interest.”
In this decision the Ninth Circuit provided a safe harbor for factors who had not assumed the risk of non-payment. But in rendering its decision it recognized that “subsequent panels are bound by prior panel decisions…” and cautioned that “under the doctrine of stare decisis a case is important only for what it decides—for the ‘what,’ not for the ‘why,’ and not for the ‘how.’
Although the February 2017 decision was the law in the Ninth Circuit it was not the “law of the land.” Other circuits have looked, not only on the commercial reasonable standard, but also at the transfer of risk. The Second Circuit (New York, Connecticut and Vermont) has held that
Where the lender has purchased the accounts receivable, the borrower’s debt is extinguished and the lender’s risk with regard to the performance of the accounts is direct, that is, the lender and not the borrower bears the risk of non-performance by the account debtor. If the lender holds only a security interest, however, the lender’s risk is derivative or secondary, that is, the borrower remains liable for the
debt and bears the risk of non-payment by the account debtor, while the lender only bears the risk that the account debtor’s non-payment will leave the borrower unable to satisfy the loan.
In other words the same facts in a New York case, for example, would have given a different result. The Fourth and Fifth Circuits appear to have aligned with the Second.
S&H Packing & Sales Co., Inc. v Tanimura Distributing, Inc. 868 F3d 1047 (2017 9th Cir)
 A concurring decision is in addition to the majority decision and is by one or more of the judges giving different or additional reasons for joining with the majority.
 Meaning: to stand by things decided. This is the legal doctrine that the US Supreme Court explained “promotes the evenhanded, predictable, and consistent development of “ the law