Lead Opinion
MOORE, J., dеlivered the opinion of the court, in which COLE, J., joined.
DRAIN, D.J. (pp. 11-14), delivered a separate dissenting opinion.
OPINION
Between 2009 and 2012, Sunshine Heifers, LLC (“Sunshine”) and Lee H. Purdy, a dairy farmer, entered into several “Dairy Cow Leases.” Purdy received a total of 435 cows to milk, and, in exchange, he paid a monthly rent to Sunshine. Unfortunately, Purdy’s dairy business faltered in 2012, and he petitioned for bankruptcy protection. When Purdy , filed this petition, Sunshine moved to retake possession of the leased cattle. Citizens First Bank (“Citi
I. BACKGROUND
Purdy operated his dairy farm in Barren County, Kentucky. In 2008, he entered into a loan relationship with Citizens First, using his herd of dairy cattle as collateral. Purdy refinanced his loan on July 3, 2009, executing an “Agricultural Security Agreement” in exchange for additional principal in the amount of $417,570. R. 20-11 at 1 (2009 Security Agreement) (Page ID #326). As part of the security agreement, Purdy granted Citizens First a purchase money security interest in “all ... Equipment, Farm Products, [and] Livestock (including all increase and supplies) ... currently ownеd [or] hereafter acquired. ...” Id. Three days later, Citizens First perfected this purchase money security interest by filing a financing statement with the Kentucky Secretary of State. R. 20-12 at 1 (2009 Financing Statement) (Page ID #333). Purdy and Citizens Bank executed two similar security agreements in August 2010 and May 2012. See R. 20-13 at 1-7 (2010 Security Agreement) (Page ID # 335-41); R. 20-15 at 1-6 (2012 Security Agreement) (Page ID # 343-48). Citizens First perfected these purchase money security interests as well. See R. 20-14 at 1 (2010 Financing Statement) (Page ID # 342); R. 20-16 (2012 Financing Statement) (Page ID # 349).
Shortly after refinancing his loan with Citizens First in 2009, Purdy decided to increase the size of his dairy-cattle herd. He contaсted Jeff Blevins of Sunshine regarding the prospect of leasing additional cattle. Sunshine was amenable to the idea, and on August 7, 2009, Purdy and Sunshine entered into the first of five contracts, three of which are relevant here: (1) a July 21, 2011 agreement, involving fifty head of cattle; (2) a July 14, 2012 agreement, rolling up two prior agreements and involving 285 head of cattle; and (3) another July 14, 2012 agreement, involving 100 head of cattle. See R. 20-17 (50 Cattle Agreement) (Page ID #351); R. 20-18 (285 Cattle Agreement) (Page ID #369); R. 20-19 (100 Cattle Agreement) (Page ID # 386).
Each of these agreements is titled a “Dairy Cow Lease,” and under their terms, Purdy recеived a total of 435 cattle for fifty months in exchange for a monthly rent. See, e.g., R. 20-17 at 2 (50 Cattle Agreement) (Page ID # 351). The agreements prohibited Purdy from terminating the leases, and Purdy agreed to “return the Cows, at [his] expense, to such place as Sunshine designate[d]” at the end of the lease term. Id. at 2-3 (Page ID # 352).
In the dairy business, farmers must “cull” a portion of their herd every year, replacing older and less productive cows with younger, healthier ones. Many times, dairy farmers will replace the culled cows with their calves. Purdy, in contrast, sold off the calves of Sunshine’s cows and purchased more mature replacеments.
In the fall of 2012, the price of cattle feed rose, and milk production became less profitable. Id. at 534. Purdy responded by selling off cattle, including many bearing Sunshine’s brand, at a faster rate. Unfortunately, Purdy could not keep his operation above water, and on November 29, 2012, he filed a voluntary petition for Chapter 12 bankruptcy relief, and the bankruptcy court issued an automatic stay, preventing the removal of assets from the farm. Id. at 535. A week later, representatives of Citizens First and Sunshine inspected the 389 cattle still on the farm. Of the cows on the property, 289 had white ear tags (indicating that they were covered by Citizens First’s security interest) and Sunshine’s brand, 99 had only white ear tags, and one cow had neither a tag nor a brand. R. 21-22 at 46:2-14 (Hr’g Tr.) (Page ID # 1186). A short time later, another farmer returned forty-three cattle that had been taken in violation of the bankruptcy court’s stay. Id. at 46:13-20 (Page ID # 1186). Sunshine claimed that thirty-nine of those cattle bore Sunshine’s brand. Id. at 101:7 (Page ID # 1241).
Citizens First argued that Purdy owned all of these cattle and, therefore, that they were covered by the bank’s perfected purchase money security interest. Sunshine contended that it maintained ownership of the cattle, that Purdy had only a leasehold interest in the cattle, and therefore that the cattle fell outside of Citizen First’s security interest. Both Citizens First and Sunshine filed motions in the bankruptcy court for relief from the stay preventing the removal of the livestock.
On January 22, 2013, the bankruptcy court held a hearing on various motions.
The original term of the Lease was for 50 months. Clearly, 50 months is longer than the economic life of the goods [the cows]. Uncontradicted testimony indicated that a dairy herd is culled annually at an approximate rate of 30 percent. Within three years an entire herd is extremely likely to have been entirely replaced and certainly before the end of 50 months. Because [Purdy] met this term of the statute, the transaction is a per se security agreement and the Court’s analysis ends here.
In re Purdy,
Sunshine appealed to the federal district court nine days after the auction sale. R. 1 at 48-55 (Notice of Bankr.Appeal) (Page ID #48-55). Because the cattle had already been auctioned, Sunshine requested a perсentage of the sale proceeds equivalent to its share of the cattle sold. Ultimately, the district court affirmed the bankruptcy court’s decision on September 25, 2013. R. 54 at 1 (D.Ct.Op.) (Page ID # 2287). Sunshine now appeals.
II. STANDARD OF REVIEW
“When reviewing an order of a bankruptcy court on appeal from a decision of a district court, we review the bankruptcy court’s order directly and give no deference to the district court’s decision.” Hamilton v. Herr (In re Hamilton),
III. ANALYSIS
The main question in this case is whether the agreements between Purdy and Sunshine are “true leases” or merely “security agreements.” “ ‘A lease involves payment for the temporary possession, use and enjoyment of goods, with the expectation that the goods will be returned to the owner with some expected residual interest of value remaining at the end of the lease term.’ ” In re QDS Components, Inc.,
In deciding whether these “Dairy Cow Leases” аre true leases or disguised security agreements, we look to the relevant state law. Butner v. United States,
Under Arizona law, “the facts of each case” dictate whether an agreement is a true lease or a security agreement, Ariz.Rev.Stat. § 47-1203(A), and our fact-sensitive analysis proceeds in two steps. First, we employ the Bright-Line Test. According to this test, “[a] transaction in the form of a lease creates a security interest if the consideration that the lessee is to pay the lessоr for the right to possession and use of the goods is an obligation for the term of the lease and is not subject to termination by the lessee, and ... [t]he original term of the lease is equal to or greater than the remaining economic life of the goods.” § 47-1203(B). If the lease runs longer than the economic life of the goods, then the lease is a per se security agreement. See Duke Energy Royal, LLC v. Pillowtex Corp. (In re Pillowtex, Inc.),
A. Bright-Line Test
No one debates that Purdy lacked the ability to terminate the lease. The question is whether the lease term of fifty months exceeds the economic life of the cattle. The bankruptcy court fixated upon Purdy’s testimony that he culled approximately thirty percent of the cattle each year, meaning that the entire herd would turn over in forty months. See In re Purdy,
According to the text of the agreements between Purdy and Sunshine, Purdy had a duty to return the same number of cattle to Sunshine that he originally leased, not the same cattle. See, e.g., R. 20-17 at 2 (50 Cattle Agreement) (Page ID #351) (“Lessee hereby leases from Sunshine ... the number of cows shown above (‘the Cows’), each of which is identified by ... Sunshine’s brand and ear tag ..., whether part of the Lease originally or a replaсement.”); id. at 3 (Page ID # 352); id. at 7 (Page ID #356) (“Lessee shall maintain
B. Economics-of-the-Transaction Test
The precise contours of the economics-of-the-transaction test are rather unclear, but courts have largely focused upon two particular factors: (1) whether the lease contains a purchase option price that is nominal; and (2) “whether the lessee develops equity in the property, such that the only economically reasonable option for the lessee is to purchase the goods.” Phoenix Equip.,
In this case, neither of the above-mentioned factors suggests that these agreements are something other than true leases because the contracts do not contain an option for Purdy to purchase the cattle at any price, let alone at a nominal one. In fact, the agreements explicitly state that Sunshine retains ownership in the cattle throughout the life of the lease and beyond. See R. 20-17 at 3 (50 Cattle Agreement) (Page ID # 352). This lack of a purchase option distinguishes this case frоm others, such as Aoki v. Shepherd Machinery Co. (In re J.A. Thompson & Son, Inc.),
Additionally, the fact that there is no purchase option also distinguishes this case from In re Buehne Farms, Inc.,
Finally, whether the parties adhered to the terms of these leases in all facets, in our view, is irrelevant to determining whether the agreements were true leases or disguised security agreements. Neithеr the bankruptcy court nor the parties have sufficiently explained the legal import of Purdy’s culling practices or put forward any evidence that the parties altered the terms of the leases making them anything but what they proclaim to be. Moreover, Arizona Revised Statutes § 47-1203(0 clearly states that the fact that terms of the lease are unfavorable to the lessee, that the lessee assumes the risk of loss of the goods, or that the lease requires the lessee to maintain insurance on the goods is not alone grounds to find that a contraсt is a security agreement. As a result, we hold that Citizens First has not carried its burden of proving that the actual economics of the transaction demonstrate that the leases were security agreements.
IV. CONCLUSION
For the foregoing reasons, we conclude that Citizens First has failed to demonstrate that the “Dairy Cow Leases” were actually security agreements in disguise. Because the bankruptcy court found to the contrary, we REVERSE and REMAND to the bankruptcy court for further proceedings consistent with this opinion.
Notes
. While the dates on which the 'leases” were to commence differ, as do the amounts of the monthly rent and residual guarantee that each agreement requires, the operative terms of the agreements are virtually identical. For the sake of clarity, we refer to the language of the 50 Cattle Agreement — the oldest and best-preserved agreement — in our analysis.
. The bankruptcy court found that Purdy culled approximately thirty percent of his herd per year. In re Purdy,
. "Residual guarantees, in which the lessee promises to make up a shortfall if the leased goods fail to realize a minimum sale price, are considered mechanisms to protect lessors from unusual wear and tear to their goods during the term of the lease.” In re Buehne Farms, Inc.,
. The dissent claims that the record is too thin to hold that the agreements are finance leases under Arizona Revised Statutes § 47-2A103(A)(7). This may be so, but this void in the record is largely irrelevant to our analysis. Citizens First bears the initial burden of proving that the leases are not what they claim to be. WorldCom, Inc. v. Gen. Elec. Global Asset Mgmt. Servs. (In re WorldCom, Inc.),
Dissenting Opinion
dissenting.
In this case, I respectfully disagree with the majority’s decision on the application
A. Bright-Line Test
I agree with the bankruptcy court, and find In re Buehne Farms instructive. That case involved a dairy farmer/debtor who argued his fifty-month cattle leases were disguised as security agreements when his lessors motioned the bankruptcy court to extend the time for the debtor to assume or reject fifty month cattle leases. In re Buehne,
Sunshine argues this case is distinguishable because the leases Purdy signed did not have purchase options. Although this is true, I find this case is instructive because it offers guidance on the econоmic life of dairy cows given a farmer’s culling practices.
We review the bankruptcy court findings of fact under the clear-error standard. B-Line, LLC v. Wingerter (In re Wingerter),
The bankruptcy court in this case heard similar testimony about cull rates and the practices on the Purdy farm. Id. at 537. The bankruptcy court determined that Purdy had a thirty percent cull rate. Id. at 533. This rate causes nearly complete herd turnover after thirty-six months. I agree with the bankruptcy court’s determination that the individual heads of cattle are the good at issue. Each head of cattle was a means of production rather than part of a unit. For Purdy, each cow was a sophisticated piece of equipment that produced a product; milk. The economic life of the individual heads of cattle would not last the term of the lease. Any cows on Purdy’s farm at the end of the lease term would not be the original cows because he would have culled those cows from the herd. In fact, Purdy would have culled nearly all of the cattle from Lease 1 at the time of the petition. Thus, the agreements were for a period longer than the cows’ economic value to Purdy. The lease and Sunshine’s testimony speak to total herd maintenance over the lease term, but this was not important to the parties. The parties did not follow these provisions of the lease. This finding was within the economic life range used by the In re Beuhne Farms court who heard similar testimony regarding culling practices. I find no error in the bankruptcy court’s factual finding of a thirty month culling rate. Therefore, I do not agree with the majority. Unlike the majority, I would hold the Bright-Line Test is met and the leases were per se security agreements.
B. Economic Realities of the Transaction
The majority finds that the leases fail the Bright-Line test. A lease agreement can fail the Bright-Line test, which is inevitable when the herd is the relevant good, and the court can still find that an agree
The UCC and its Arizona adaptation offer very little guidance to courts on how to analyze the economics of a transaction. A common factor courts use is whether the lessor has a reversionary interest in the leased goods or an option to purchase. Id. Courts are not limited to these factors. In re WorldCom, Inc.,
In re Phoenix Equipment Co. Inc. is distinguishable from this matter bеcause it also involves a purchase option. Id. at *11. The In re Phoenix Equip. Co., Inc. leases did not provide for an option in the language of the lease, but the court inferred the option by analyzing the parties’ course of dealings. Id. When the parties could not establish whether the purchase price on the option was nominal, the In re Phoenix Equipment Co., Inc. court focused on the structure and effect of the parties’ transactions. Id. (stating the court must consider the agreements within the context of the parties’ relationship). The debtor needed capital in order to run his operation and entered into transactions in which he transferred title of equipment to his creditor in exchange for the capital. Id. The court concluded the nature of the transactions showed that the debtor did not need a lease agreement, but needed capital to continue operating. Id. at *12.
In the three relevant leases, third parties sold cattle to Purdy. Sunshine reimbursed Purdy for the cost of the cattle. Sunshine knew Purdy did not adhere to the replacement cattle provisions in its agreements, but chose to ignore his noncompliance. Sunshine was awаre of Citizens’ lien at the time it entered into the transactions and filed its statements. The facts of the case at the time of the transaction indicate that Purdy needed money to place cows on the farm. Sunshine, by the way it forwarded funds to Purdy, appears to have supplied Purdy with funds rather than the actual cattle. Sunshine received a lien on the cattle whose acquisition it financed. These facts indicate the parties entered into three financing transactions rather than three lease transactions.
Furthermore, the reimbursement sheds doubt on Sunshinе’s characterization of the leases as finance leases under Article 2A. Under Arizona’s adaptation of the UCC, finance leases have three characteristics. A.R.S. 47-2A103(A)(7). First, the lessor does not select, manufacture, or supply the goods. Id. at (a). Second, the lessor acquires the goods or a right to possess and use of the goods in connection with the lease. Id. at (b). Purdy selected the cattle, and the cattle were branded in accordance with Exhibit B of the lease, which creates a presumption of ownership. Third, one of three events involving the lessee must occur. Id. at (c). The lessee must, before signing the lease, receive a copy of the contract by which the lessor
Purdy purchased the cattle, and there is no indication in the record Purdy approved or saw a contract or any warranties or promises the third-party buyer would have given to Sunshine. Sunshinе only has invoices and bills to indicate it paid for cattle that Purdy already had on his farm. Sunshine has not shown its leases meet the statutory requirements of the finance lease. Thus, the bankruptcy court did not err by relying on the parties’ post lease conduct in reaching its conclusion. Testimony reveals Sunshine acquiesced in Pur-dy’s decision to sell the cattle, and use the funds to either purchase more cattle or deposit the sale proceeds in his Citizens’ account. It was not error for the bankruptcy court to rely on the fact that Purdy acquired the cattle from third parties and Sunshine reimbursed these parties. This arrangement was tantamount to Sunshine financing the acquisition of cattle for Pur-dy’s dairy operation. Moreover, Sunshine failed to come forward with evidence it actually owned the cattle delivered by the third party buyers, which calls into question the leases status as finance leases. I would hold the economics of the transaction support a finding that the parties entered into security agreements for the cattle rather than leases.
For these reasons, I respectfully dissent and would affirm the bankruptcy court’s decision.
. Sunshine argues that the herd is a perpetually self-renewing asset.