The Impact of Contract Laws

Federal regulation of creditors rights

Many times forward grain contracts will contain security clauses which provide that the grain is pledged as security for the grower’s performance of the agreement. The grain buyer may then attempt to secure its interest in the grower’s grain by filing a financing statement with the relevant state’s secretary of state. At this point, the grain buyer may feel fairly comfortable in its belief that if the grower breaches the agreement by selling the grain to someone else, it will be protected because it will still have a security interest in the grain. What many grain purchasers are unaware of is that to fully protect their interests, as a general rule, they must also fulfill the requirements of the Food Security Act. The Food Security Act generally provides that purchasers of farm products, including grain, will take the product free and clear of all security interests unless the secured party provides notice as required by the statute. The notice that must be provided is dictated by whether the state is a central filing state or a notice state. In central filing states, the secured party must simply file the required notice with the central filing agency. If the secured party fulfills the filing requirement, subsequent purchasers of the farm product will take the product subject to the secured party’s security interest.

In notice (non-central-filing) states the secured party must deliver a notice of its security interest to all potential purchasers of the farm product. This can be a difficult process and in some instances will prevent a secured party from attempting to comply with the statute’s requirements. If the secured party elects not to give the required notice, the purchaser will take the farm product free and clear of the secured party’s interest. The secured party, however, will generally have the ability to pursue damages from the grower for the injury it sustains and, depending on state law, may have a security interest in the proceeds that the grower receives from the unauthorized sale.

Impending federal market regulations

Let’s add another layer of complexity to the simple example discussed above. Let’s say that after the processor executes the forward contract with the grower it hedges by and sells the grain through an offsetting futures transaction or enters into a swap through some exchange in order to give itself some price protection. Legislation recently signed into law by President Obama, the Dodd-Frank Wall Street Reform and Consumer Protection Act, has the potential to dramatically alter the law surrounding this secondary transaction. A main theme that runs throughout the legislation is increased transparency and market reliability. It appears transactions executed privately or through other mediums will be subject to increased reporting requirements. Further, it appears that the information reported will generally be made available to the public.

This increased transparency may affect the discovery of prices and the manner in which traders engage in price risk management. Certain over-the-counter (OTC) transactions and commodity swaps that currently go unreported, for example, may be more readily factored into the current and future price of grain. With greater reporting will come, the proponents hope, a better reflection of market prices, and improved convergence between the cash and futures markets.

Additionally, a stated goal of some of the proponents of the Dodd-Frank Act is to limit the impact of excessive speculation on futures markets, and thereby improve the price discovery functions these markets provide. The Act seeks to accomplish this by requiring the Commodity Futures Trading Commission (CFTC) to establish position limits in futures and derivative markets that impact price discovery functions. The law would essentially give the CFTC the power to curb the volume of transactions it determines have the effect of distorting the market.