July 13, 2010 | By Adam Hertzke & Todd Langel

The Impact of Contract Laws

Grain Licensing, Contracting and Financial Regulations: A Glance at the Laws Affecting Your Contracts and the Markets

The world of forward grain contracting boiled down to its most basic elements is relatively simple. A grower and processor agree, for example, that the grower will deliver a certain quantity of grain at some definite time in the future for a price determined today. A major benefit to the grower is that it knows the price it will receive for its grain and can plan its operations accordingly. Conversely, the processor knows both the quantity of grain it will receive and the price that it will pay and can, likewise, plan accordingly. The complexity of most forward grain contracts reflect this relative simplicity. The entire forward agreement is usually only a page or two in length and is usually written in a way most non-lawyers understand. The first page of the agreement generally lays out the basic terms — the commodity, the price and the delivery date. The second page (or back of the first page) is usually made up of standard contractual language.

Given the relative simplicity of the underlying transaction, few growers and producers appreciate the degree to which the law governs or can otherwise affect their transaction. This article briefly addresses the various ways in which state regulation of grain contracts, the requirements of the Food Security Act and the impending Dodd-Frank Wall Street Reform and Consumer Protection Act can weave their way into the parties’ agreement.

State Regulation of Forward Contracts

Many agricultural state legislatures have established statutory schemes designed principally to protect farmers and agricultural producers. Aside from this general theme, however, consistency of the requirements from state-to-state is not typical. Generally, most states that regulate grain contracts require that certain grain purchasers become licensed. Usually, state grain dealer’s licensing statutes require the licensee to maintain a certain level of working capital, or other indications of financial health. Depending on the state, and the financial strength of the licensee, states may require periodic financial reporting in order to maintain a license, and may require the posting of a surety bond, letter of credit, or other assurance that the licensee can make good on its contracts.

Often, as part of the licensing scheme, purchasers are required to pay into a state-administered grain indemnity fund that will protect unpaid cash sellers of grain in the event the purchaser defaults, files bankruptcy, or is placed in receivership. In some instances, states regulate substantive terms of forward grain contracts, even under the simple example discussed above. Usually, if a state regulates standard forward agreements it does so by dictating the information that must be found in the agreement. For example, a statute may require that forward contracts contain such standard terms as the date of execution, quantity contracted for, price, and the grade of the grain. Often, state statutes mandate the date by which a producer must be paid following delivery.

Fundamental changes in the grain industry have drawn additional attention to licensing requirements in recent years. Price volatility, trends of increasing farm size and contract exposure, together with the influx of industrial (biofuels) grain purchasers have caused state legislatures to begin to reevaluate the nature and level of protections afforded agricultural producers. These changes have resulted in increases in indemnity funds and assessments required to fund them, as well as increased scrutiny on licensing standards.

As the terms of the forward contract start to deviate from the simple example discussed above — perhaps through delayed pricing or delayed payment terms — the level of regulation tends to increase. Often when an agreement contains such terms buyer are required to include certain notices in the agreement usually explaining that the agreement is not covered by a grain indemnity fund.

In general, contracts between more sophisticated commercial entities, such as between grain elevators or cooperatives and end-users carry fewer requirements than contracts calling for sales by individual farmer-growers. Again, the with the central goal being the protection of unpaid cash sellers (producers) of grain, states recognize that producers are not well-positioned to evaluate the financial stability of the buyer or processor. Regulations are the states’ attempt to level the field for producers faced with standard contract terms, while facilitating the exchange of grain by keeping transactions costs low.

Federal Regulation of Creditors Rights with Regard to Grain Contracting

Many times forward grain contracts will contain security clauses which provide that the grain is pledged as security for the growers 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 grain free and clear of all security interests in the farm product 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 Regulation of Derivatives and Commodity Markets

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 currently in committee, the Dodd-Frank Wall Street Reform and Consumer Protection Act, has the potential to dramatically alter the law surrounding this secondary transaction. The specific parameters of the legislation have yet to be finalized and in any event are beyond the scope of this article. A main theme that runs throughout the legislation, however is increased transparency and market reliability. It appears that 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 potential 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 current draft of the bill 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.

Opponents of the bill, which include futures industry groups, and institutional investors, believe the regulations will stifle investment in the commodity markets, and reduce the liquidity provided by speculative trading. As you can expect, the current draft of the proposed legislation is extremely voluminous, at over 2,300 pages. Further complicating the matter is the fact that much of the bill simply authorizes the CFTC to enact regulations, which will be many months down the road. Give n the level of controversy surrounding the bill, it is no surprise that many commentators are predicting the ultimate impact of the legislation will be determined by federal courts. For the grain industry, Title VII is the portion of the bill to watch. Needless to say, participants in the industry often overlook the degree to which the trading of grain and other commodities are impacted by state and federal law. The new era of market volatility, spurred by dynamic shifts in supply and demand, federal energy policy, the flow of capital into and out of commodities, and to an increasing extent, the global economy, has changed the legal landscape for buyers and sellers.

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