Looking Behind the Label: The Ninth Circuit Rules on Purported Factoring and the Perishable Agricultural Commodities Act

On February 22, 2018, the Ninth Circuit Court of Appeals – sitting en banc – issued an opinion, S&H Packing & Sales Co., Inc. v. Tanimura Distributing, Inc., where the court analyzed competing rights and obligations related to the Perishable Agricultural Commodities Act (“PACA”) and purportedly secured transactions. The court held that labeling an accounts receivable transfer as a “factoring agreement” does not ultimately determine whether the accounts receivable were actually sold for the purposes of applying the PACA statutory trust. Rather, a court is obligated to look behind the label and study the substance of the transaction, including the important issue of whether the transferee assumed the risk of non-collection. The PACA statutory trust provides powerful protection to produce growers, allowing them to collect in full even where there are insufficient funds to pay secured creditors. While the S&H Packing case did not involve a bankruptcy filing, the decision has significant implications for creditors in a bankruptcy case of a purchaser or producer of fresh fruits and vegetables.

PACA is a federal law creating a “nonsegregating floating trust” in favor of produce growers. By operation of the statute, purchasers of wholesale-quantity fresh fruits and vegetables hold proceeds for the sale of produce in trust for the benefit of growers. Trust law provides that money held in trust is the property of the trust beneficiary, and if the party holding the money (the trustee) disposes of the money in breach of the trust, the trustee is liable to the beneficiary for damages. The distinction between being a creditor versus a trust beneficiary takes on great significance when there are insufficient funds to pay all creditors. A PACA trust beneficiary can successfully argue that the debtor is holding property (that is, the proceeds of the produce sales) actually belonging to the trust beneficiary, and that the property must be handed over to the beneficiary. In contrast, a creditor can make demands to be paid, but cannot argue that the debtor is holding property belonging to the creditor. Ownership of the property likewise has implications on the rights of secured creditors. If the proceeds belong to the growers – by virtue of the PACA trust – the proceeds do not belong to the debtor. It follows that any lien held by a secured creditor cannot attach to the proceeds. For these reasons, PACA trust beneficiaries are entitled to be paid in full before secured creditors. In addition, if the debtor breached the PACA trust by using PACA proceeds to pay a secured creditor, the PACA beneficiary (under certain circumstances) is entitled to demand payment of such misdirected funds from the secured creditor.

Courts have recognized that produce purchasers (i.e., PACA trustees) are entitled to sell PACA trust property under certain circumstances without breaching the PACA trust. It is well-accepted that if a PACA trustee sells produce on credit, the resulting accounts receivable become PACA trust assets. It is also well-accepted that if such accounts receivable are sold to a third party (a factor) for cash at a discount, the transaction is not a breach of the PACA trust. In that situation, the factor takes the accounts receivable free and clear of the PACA trust, which attaches to the proceeds of the accounts receivable sale. The situation changes, however, if the factor is deemed a lender who provided money to the PACA trustee and took a security interest in the accounts receivable to secure re-payment of the loan. Such accounts receivable remain subject to the PACA trust. The difference between a factor and a secured lender, and the resulting implications under PACA, were the issues presented to the court in the S&H Packing court.

In the S&H Packing case, certain growers sold produce on credit to distributor Tanimura Distributing, Inc. Tanimura sold the produce on credit to third parties, thereby generating accounts receivable. The accounts receivable were transferred by Tanimura to AgriCap Financial under an agreement labeled a “Factoring Agreement.” Pursuant to the Factoring Agreement, AgriCap provided cash to Tanimura at a significant discount from the face value of the accounts receivable. The transaction had other indications that, considered in the aggregate, indicated it was more than a mere factoring arrangement. AgriCap took a security interest in the accounts receivable and in all other assets of Tanimura, with the exception of inventory. In addition, AgriCap was entitled to force Tanimura to “repurchase” the accounts receivable in the event AgriCap was unable to collect.

Tanimura’s business later failed and it was unable to pay the growers in full. The growers sued AgriCap, arguing that the Factoring Agreement was actually a secured lending arrangement rather than a “true sale,” and that the accounts receivable therefore were subject to the PACA trust. AgriCap responded by citing to a 2001 Ninth Circuit case – Boulder Fruit Express & Heger Organic Farm Sales v. Transportation Factoring, Inc. – where the court held that a PACA trustee may remove assets without breaching the trust as long as the transaction was commercially reasonable. The Boulder Fruit case was notable because it did not require an analysis of whether a true sale actually occurred before analyzing whether the transaction was commercially reasonable. This was in contrast to decisions in the Second, Fourth, and Fifth Circuits where the courts required such an initial true sale analysis.

Based on its commercially reasonable argument, AgriCap prevailed on summary judgment at the district court and at a three-judge panel of the Ninth Circuit. The growers requested that the Ninth Circuit hear the matter en banc, based on the circuit split in the law. The Ninth Circuit agreed and the matter was heard before eleven Ninth Circuit judges. The court noted the Boulder Fruit decision, but determined that “the weight of authority and reasoning” required that true sale and transfer of risk “considerations should be assessed before considering the commercial reasonableness when considering the propriety of a transfer of trust assets.” The court set forth a multi-step analysis that is illustrated by the following flow chart:

The court cited to the following factors for analyzing the transfer of risk: “(1) the right of the creditor to recover from the debtor any deficiency if the assets assigned are not sufficient to satisfy the debt, (2) the effect on the creditor’s right to the assets if the debtor were to pay the debt from independent funds, (3) whether the debtor has a right to any funds recovered from the sale of assets above that necessary to satisfy the debt, and (4) whether the assignment itself reduces the debt.”

The majority of the S&H Packing court (eight judges) concluded that such a true sale analysis must be conducted prior to analyzing the commercial reasonableness of the transaction, thus overruling the Boulder Fruit decision and aligning the Ninth Circuit with the Second, Fourth, and Fifth Circuits. The matter was remanded back to the district court to conduct the analysis.

Factors, asset-based lenders, and other creditors should each take heed of the required analysis in the S&H Packing case and the potential implications if a PACA trustee files bankruptcy. The absolute priority rule is a fundamental tenet of bankruptcy law and requires that higher priority creditors must be paid in full before any money flows down to junior creditors. The claim priority hierarchy is: secured claims (up to the value of the collateral), administrative expense claims, priority claims, general unsecured claims, and equity interests. As discussed above, trust fund law allows a trust beneficiary to sidestep the entire claim priority hierarchy and demand payment based on the argument that the debtor/trustee is holding the beneficiary’s property. Secured creditors who believed that the value of the collateral exceeded the loan balance may in fact find there is much less non-trust cash to make them whole. General unsecured creditors may discover that, although the debtor appears to be a going concern enterprise, it lacks the assets to pay anything at all on their claims. In the case of a factoring agreement, this important issue will not turn on the words in the title of the agreement. Rather, the matter will turn on the substance of the agreement, and whether the accounts receivable were truly sold.

For more information on PACA and statutory trust fund claims in bankruptcy, please see the full-length law review article co-authored by Jason Binford, Farmer Favoritism: Statutory Protections for Creditors in Agricultural Bankruptcy Cases, 46 Tex. Tech. L. Rev. 337 (2014).