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Did you ever think that a tomato could trump a secured creditor’s ability to recover assets in a bankruptcy proceeding? It may seem absurd, but for lenders involved with grocery stores, supermarkets, restaurants or other purveyors of fruits and vegetables, this is a harsh reality. The Perishable Agricultural Commodities Act can dramatically affect creditors’ recoveries when a retailer or distributor enters into bankruptcy. Indeed, in a bankruptcy proceeding, secured creditors’ liens must yield to assets protected by the statutory trust created under the provisions of PACA. Fortunately, savvy lenders can protect themselves. Historical Perspective PACA was originally enacted in 1930 to protect small farmers and growers from the “sharp practices of financially irresponsible and unscrupulous brokers in perishable commodities.” In re Lombardo Fruit & Produce Co., 12 F.3d 806, 808 (8th Cir. 1993). As noted in In re Snyder, 171 B.R. 532 (Bankr. D. Mary. 1994), PACA’s legislative and regulatory history demonstrate a clear intent to prefer produce sellers to other creditors. Under PACA, an unpaid produce supplier’s rights are superior to all other creditors’ rights, including secured creditors with blanket liens. See, e.g., In re Magic Restaurants Inc., 205 F.3d 108 (3d Cir. 2000). In 1984, Congress broadened the protection afforded by PACA to remedy the burden on commerce caused when purchasers of perishable agricultural commodities, who had not yet paid for the commodities, gave to lenders security interests in inventories and accounts receivable, which enabled the lenders � not the suppliers or sellers of the commodities � to receive payment. Congress found this burden to be “contrary to the public interest.” See Tanimura & Antle, Inc. v. Packed Fresh Produce, Inc., 222 F.3d 132 (3d Cir. 2000), and 7 U.S.C. �499e(c)(1). The 1984 PACA amendments created a floating nonsegregated trust for the benefit of qualified unpaid sellers and suppliers of fresh and frozen produce. The trust consists of the inventories of all perishable agricultural commodities, their products, and any receivables or proceeds derived from their sale. Since PACA creates a bona fide trust, any assets included in the PACA trust are not property of a bankruptcy estate, although bankruptcy courts have consistently held that the PACA trust funds remain subject to the bankruptcy court’s control. Generally then, qualified PACA trust beneficiaries take priority ahead of the claims of secured creditors, administrative claims, and all other priority and general unsecured creditors. PACA protections also have been interpreted to authorize a trust beneficiary to trace and recover trust assets conveyed by the trustee to a third party to whom the trustee dissipated PACA trust funds. See Reaves Brokerage Co. v. Fidelity Factors, LLC, No. 99-cv-2848, 2001 U.S. Dist. LEXIS 16852 at 17-18 (N.D. Tex. Oct. 17, 2001). Protecting a Secured Creditor’s Rights So where does all this leave a properly perfected lender? Notwithstanding the strong presumption toward protecting PACA trust beneficiaries, developing case law evinces a tendency to provide more protection for lenders involved with PACA dealers. Today’s lenders have become more aggressive in contesting PACA claims. This consequence has compelled courts to carefully consider under what circumstances a secured lender’s rights may be superceded by a produce grower or supplier. Courts are more likely to find creative ways to protect “innocent” lenders from receiving no recovery. Because each claim must be viewed on its merits, creditors should be encouraged to carefully scrutinize the validity of PACA claims, as well as protect their own bona fides as a lender. The ‘Bona Fide Purchaser’ Defense In 1992, the 11th U.S. Circuit Court of Appeals decided the landmark case of C.H. Robinson Co. v. Trust Company Bank, N.A., 952 F.2d 1311 (11th Cir. 1992), which gave lenders a great advantage in defending PACA suits. In C.H. Robinson, appellant sellers sold perishable agricultural commodities to a company that failed to pay for the commodities. Subsequently, the appellants filed notices with U.S. Department of Agriculture to preserve their rights under the PACA statutory trust provisions. Within the same time frame, the company made loan payments to their lender banks. Appellants filed a lawsuit to recover the loan payments on the ground that they were made in violation of the trust. Applying general trust principles, the 11th Circuit held that a secured lender may retain trust property received in breach of a PACA trust if it can establish its status as a bona fide purchaser � that it received the property for value and without notice of the trust. A bona fide purchaser takes the proceeds free of the trust. The court found that the defendant-bank was a bona fide purchaser because it had no notice that the property it received was in breach of a PACA trust. Specifically, the bank had never enforced its security agreement, nor had it collected the dealer’s accounts receivables or taken possession of the inventories that were subject to the PACA trust. Rather, the bank merely received cash loan payments without notice that they were made in breach of trust. Consequently, the bank was entitled to keep the loan payments. Lack of Notice C.H. Robinson demonstrates that a popular way to attack a produce seller or suppliers’ PACA claim is to argue that the claimant did not perfect its interest in the commodities by providing notice of the creation of the trust. While a PACA trust is automatically created on delivery of qualified products, in order to preserve the trust, the seller must timely perfect its interest in the trust. 7 U.S.C. 499e(c)(2) & (3). Perfection requires the unpaid supplier or agent provide written notice of the intent to preserve the benefits of such trust to the merchant, dealer or broker. Generally, with some exceptions, the notice must be given within 30 days of the invoice payment date. Alternatively, a supplier can perfect a security interest in a PACA trust by printing boilerplate language on its ordinary and usual billing or invoice statements. That printing must give notice of the intent to preserve the trust. Even when the seller meets these formal notice requirements, however, courts will not automatically require secured lenders to disgorge loan payments received in breach of a trust. Rather, courts generally permit secured lenders to retain trust funds if they had no actual notice of the breach after a “substantial inquiry,” when (1) dealing with a trustee and/or (2) dealing with a set of circumstances that suggest the trustee may be committing a breach of the trust. See, e.g., Consumers Produce Co., Inc. v. Volante Wholesale Produce, Inc., 16 F.3d at 1374 (3d. Cir. 1994). The Third Circuit addressed the issue of notice and what constitutes a substantial inquiry in Consumers Produce. The court held that, under certain circumstances, a secured lender could retain loan payments made in breach of trust. In Consumers Produce, the debtor transferred PACA trust assets in breach of the PACA trust to a bank in the form of loan repayments in the ordinary course of business. The court held that such loan payments were “for value,” as the consideration provided to the bank was money. Instructively, the court reasoned that: The transfer of trust assets in satisfaction of a pre-existing debt is normally not for value; however, an exception exists where the trust property transferred is a negotiable instrument or money. This exception arises from the necessity for practical business transactions that the payee of money in due course of business shall not be put upon inquiry at his peril as to the title of the payer. Because [the bank] received PACA trust assets in the ordinary course of business as monetary loan repayments, the transfer was for value. The court recognized that the bank had made a substantial inquiry into whether the dealer was acting in breach, but due to the produce dealer’s deception, had failed to discover the breach. The court found that the bank knew or should have known that it was dealing with a PACA trustee based on the fact that the borrower’s principal business was the purchase and resale of produce on credit. This finding was tempered by a second finding that the borrower had prevented the bank from discovering certain other critical facts, such as the dealer’s failure to pay produce suppliers and the dealer’s financial difficulties. Because the bank was unaware of these early warning signals, the bank could not have known that the dealer was breaching the PACA trust by making the loan repayments. Accordingly, the bank was not required to disgorge the loan payments received in breach of trust. More recently, the Second Circuit also addressed the issue of notice and the scope of inquiry required in Albee Tomato, Inc., et al. v. A.B. Shalom Produce Corp. et al., 155 F.3d 612 (2d Cir. 1998). In this case, the court held that the secured lender was not entitled to judgment as a matter of law based on a bona fide purchaser defense. Rather, it found that the lender had not conducted a proper inquiry in light of the fact that the line of credit and account reflected a consistently negative balance. Self-evident cash-flow problems of a PACA trustee, the court reasoned, made bona fide status available to a lender only if it makes “the kind of inquiry as to debts owed by the trustee to PACA beneficiaries that a reasonably prudent lender would make as to debts owed by a similar borrower to a prior creditor who had rights superior to those sought by the lender.” Absent that type of inquiry, a lender cannot qualify as a bona fide purchaser. Lack of ‘Value’ Even if a secured lender meets the first prong of the bona fide purchaser defense by showing that it had no notice of the breach, in order to keep the trust funds, it must also prove that it received the trust property “for value.” In A&J Produce v. C.I.T. Group Factoring, Inc., 829 F. Supp. 651 (S.D.N.Y. 1993), the court held that the secured lender, CIT, was not a bona fide purchaser for value. In deciding the case, the court made a critical distinction between the facts in the present case and in the facts of C.H. Robinson: CIT advanced loans and, in return, took over the accounts receivable of the company that did business with the dealers of the perishable goods; in C.H. Robinson, the bank had received cash loan payments. The court considered this distinction decisive. It reasoned, “when secured lenders use their security agreement to foreclose on property or otherwise enforce their contractual rights, they essentially force the transfer of trust property in satisfaction of an antecedent debt.” The court went on to conclude that any such transfer, including transfers of negotiable instruments and money, through the exercise of rights under a security agreement, is not for value. Thus, the Second Circuit held that CIT did not receive the trust funds for value and must disgorge the funds received in breach of the PACA trust. Machinery and Equipment Exclusion The Consumers Produce court said the PACA trust provision “effectively vitiates a lender’s security interest in trust assets held by produce purchasers vis-�-vis unpaid produce suppliers.” Despite this powerful advantage, however, as the court noted in In re United Fruit & Produce Co., 242 B.R. 295 (Bankr. W.D. Pa. 1999), the produce supplier is only entitled to funds derived from the corpus of the trust: Although the PACA language imposing a trust is powerful and invasive, it imposes the trust only upon a limited and defined collateral. The corpus of the trust consists of the produce and any receivables and or proceeds from their sale. It does not include vehicles and equipment. Thus, according to the United Fruit & Produce court, courts have found that “it is necessary to balance the public’s interest in preserving the stability of commercial transactions with the interest of the PACA trust beneficiaries in assuring that sufficient funds are maintained in the trust.” In United Fruit & Produce, secured lenders and PACA trust creditors disputed who was entitled to proceeds received from the sale of the debtor’s vehicles and equipment. The court ruled that despite an unpaid produce supplier’s superior right to the corpus of the PACA trust fund, the intent of PACA is not violated by recognition of the liens of lenders who provide financing and take a security interest in those assets which they have financed. The court found that the security interests and payments received by the vehicle and equipment lenders were “nothing more than regular loan transactions in the ordinary course of business.” Given the lender’s lack of actual or constructive notice of the debtor’s breach of the PACA trust, the court ruled the lender was entitled to the sale proceeds. Fruits, Vegetables and Products Not Covered by PACA Another method of challenging a PACA trust claim is to segregate items not subject to the PACA trust because they don’t fall within the definition of a protected PACA product. A protected PACA product or a “perishable agricultural commodity” is defined as fresh fruits or fresh vegetables of every kind and character (whether or not frozen or packed in ice), and cherries in brine. 7 U.S.C. 499(a)(4). Additional explanations in 7 C.F.R. 46.2(u) give the sellers protected rights under the trust if the seller merely changes the form of the perishable produce by slicing, freezing or adding a preservative chemical. However, if the produce has been transformed into an essentially different product, the seller loses the right to PACA trust protection. Note the following examples from different cases: � potato products treated with oil are not entitled to PACA trust protection; � frozen onion rings, breaded cauliflower, pickles and other products whose fresh ingredients constitute less than 90 percent of their weight do not qualify for PACA protection; � dried fruits. Of course the only way to raise these challenges requires a careful line-by-line review of each invoice submitted by a seller or supplier as to whether each item is subject to the trust. Because sellers and suppliers typically invoice their PACA eligible goods with noneligible goods, noneligible items will often find their way into a PACA trust claim. Careful review, therefore, will permit a diligent creditor to challenge improperly included items. Leveling the Field As with any financing agreement, the onus is on the lender to perform due diligence in assessing the risk associated with the loan. A lender should be extremely cautious with any produce seller; obviously, borrowers with a history of defaulting on payments to growers should be avoided. Similarly, during the life of the loan, the borrower’s payment consistency to both suppliers and the bank should be closely watched. This is key. If the borrower is not paying the lender, it is quite possible that it is not paying the grower. Or, more critically, the borrower may be paying the bank out of trust. However, if a lender is faced with a bankruptcy situation involving a PACA trust, all is not lost. It is possible to mitigate exposure. One defense is for lenders � and trust claimants � to require the debtor to keep a minimum amount, either held in reserve or in the form of inventory, to cover eligible PACA claims. In this way, so long as the debtor either has funds on hand or funds stemming from the sale of the grower’s produce to cover the claims of PACA claimants, the lender will be able to recover as a secured creditor from the assets deemed not related to produce sales. Another line of defense, to the extent practicable, requires the lender to analyze and differentiate between the debtor’s assets that derive from the sale of produce and those that are derived from other sources. On its face this will identify the assets that immediately fall into the PACA trust. For example, if a lender funds start-up costs, the purchase of machinery and equipment could not have derived from the sale of produce. The sale of those assets, consequently, may not be subject to a PACA trust. Finally, the lender should carefully review whether the products of the grower have been transformed into unprotected products, thus eliminating ineligible assets from the PACA trust – that is, processed foods, nuts and so on. By doing so, a lender can preserve the remaining assets in the estate for the benefit of all creditors. It is easy to see why it is important for lenders to take the time to research PACA and the protections it affords PACA claimants. Once the rights of these claimants are understood, a lender can take appropriate steps to protect its interests, and level a seemingly lopsided playing field. Freedman is counsel, Martin is an associate and Laskowski is a senior paralegal in the bankruptcy, reorganization and creditors’ rights practice group at Porzio, Bromberg & Newman of Morristown.

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