A Horse of a Different Color Problems of Classification Under Article 9 of the UCC
Classification of collateral is critical to questions of perfection and priority under Article 9 of the Uniform Commercial Code (UCC).1 A filing effective to perfect a first-priority purchase-money security interest in equipment, for example, might be insufficient if the collateral in question is properly characterized as inventory.
When the collateral in question is indisputably "goods," under the Article 9 definition,2 classification should be a straightforward proposition. It's not. Rather than an objective definition (i.e., one that looks merely at the nature of the goods in question), Article 9 employs a subjective definition of goods: the classification of goods as inventory, equipment, consumer goods or farm products will depend on the use to which they are put.3 See UCC §9-102 cmt. 4(a); First Colo. Bank & Trust N.A. v. Plantation Inn Ltd., 767 P.2d 812 (Colo. Ct. App. 1988) (furniture and personal items used in motels and restaurants classified as equipment). Therefore, knowing how to effectively perfect requires the lender to know what the debtor intends to do with the goods.
These distinctions are not merely academic. A recent bankruptcy court decision from Florida illustrates the importance of proper classification of collateral. A lender financed some 1,200 vehicle leases for a car dealership and noted its lien on the certificates of title. The bankruptcy court found that the vehicles were inventory (not equipment), and that under §9-302 of the UCC, a lien on them could be perfected only through the filing of a UCC-1 financing statement. The notation of lien on the vehicle titles was ineffective, and the lender was left with an unsecured claim. In re Carcorp Inc. (Carcorp Inc. v. Bombadier Capital Inc.), 272 B.R. 365 (Bankr. S.D. Fla. 2002).
Horses provide another excellent illustration of the problem. Depending on its use, a horse may be classified as a farm product, consumer good, inventory or equipment.
A given item can, over the course of its life, constitute different forms of collateral at different times.
A common-sense approach to classification might suggest that horses are farm products. However, the Article 9 definition of farm products is very limited.
"Farm products" means goods, other than standing timber, with respect to which the debtor is engaged in a farming operation and which are:a. crops grown, growing or to be grown...
b. livestock, born or unborn...
c. supplies used or produced in a farming operation, or
d. products of crops or livestock in their unmanufactured states.
UCC §9-102(34) (emphasis added).
While horses may be livestock, they will be classified as farm products only in the hands of a debtor engaged in farming operations. See UCC §9-102 cmt. 4(a) ("Goods are 'farm products' if the debtor is engaged in farming operations with respect to the goods."). The Article 9 definition of farming operations is "raising, cultivating, propagating, fattening, grazing or any other farming, livestock or aquacultural operation." UCC §9-102(35).4
Accordingly, a racehorse that is not raced, but is only used in breeding operations, is a "farm product." See North Ridge Farms Inc. v. Trimble, 37 UCC Rep. Serv. 1280, 1983 WL 160534 (Ky. Ct. App. 1983), aff'd., 700 S.W.2d 396 (Ky. 1985) (fractional interest in race horse as a farm product where "at the time the transactions described in this opinion were entered into, it was contemplated that the stallion would be retired from racing and utilized in breeding operations for the remainder of his life").
Where the owner of the horse is not engaged in farming operations, the horse cannot be a farm product. See In re Butcher (Martin v. Landers), 43 B.R. 513, 521-22 (Bankr. E.D. Tenn. 1984) (where the horse is intended to be leased out for stud services, but the owner is not engaged in farming operations, the horse is either "equipment" or "inventory."); see, also, North Ridge Farms, 37 UCC Rep. Serv. 1280, 1983 WL 160534 ("Had the stallion continued to be used in connection with racing, it would not have been a farm product as defined in the statute.").
While it may seem counterintuitive, a horse may constitute consumer goods if it is held by the debtor as a pet. The Article 9 definition of "consumer goods" is "goods that are used or bought for use primarily for personal, family or household purposes." UCC §9-102(23). Therefore, the family horse is properly classified as "consumer goods." See Press v. Purks, 41 Va. Cir. 539, 1997 WL 823549 (Va. Cir. Ct. 1997) (parties stipulated that quarter horse owned by individual was consumer goods). This will be so even if the family keeps the horse on the family farm, so long as the family is not engaged in farming operations "with respect to" the horse.
Held by a broker for resale, a horse can constitute inventory. Under the UCC,
"Inventory" means goods, other than farm products, which:a. are leased by a person as lessor,
b. are held by a person for sale or lease or to be furnished under a contract of service,
c. are furnished by a person under a contract of service, or
d. consist of raw materials, work in process or materials used or consumed in a business.
Horses that are held for sale (instead of some other use), but that do not satisfy the definition of farm products, are "inventory" under UCC §9-102(48). Cf. In re Rex Group Inc. (Amvest Funding Co. v. Rex Group Inc.), 80 B.R. 774, 782 (Bankr. E.D. Va. 1987) (horses held for breeding, training, showing and racing, and not for resale, are not inventory). This conclusion is supported by the official comments to §9-102 of the UCC, which point out that:
Crops, livestock, and their products cease to be "farm products" when the debtor ceases to be engaged in farming operations with respect to them. If, for example, they come into the possession of a marketing agency for sale or distribution or of a manufacturer or processor as raw materials, they become inventory.
UCC §9-102 cmt. 4(a); see, also, Cooperative Fin. Ass'n. Inc. v. B&J Cattle Co., 937 P.2d 915 (Colo. App. 1997) (cattle classified as inventory, not farm products, where debtor intended to resell cattle, and was not equipped to raise, fatten and graze cattle).
Equipment, though it may seem an unlikely classification for an animal, will often constitute the correct Article 9 classification for a horse. Under Article 9, "'Equipment' means goods other than inventory, farm products or consumer goods." UCC §9-102(33).
"Equipment" is a catch-all category for goods that are not farm products, consumer goods or inventory. Horses that are held for racing and not for breeding purposes are equipment, not farm products. In re Bob Schwermer & Assoc. Inc., 27 B.R. 304, 308 (Bankr. N.D. Ill. 1983); Rex Group, 80 B.R. at 782 (grand prix horses held for breeding, training, showing and racing classified as equipment). Horses that are used as work animals will likely also constitute equipment, so long as the debtor is not engaged in farming operations with regard to horses.5
Implications for Lenders
Understanding the treatment of collateral under Article 9 requires not only an understanding of the collateral, but of its intended use. A given item can, over the course of its life, constitute different forms of collateral at different times. One horse can, over time, fall into each of the four categories of "goods." Born on a farm owned by one who breeds and raises horses for a living, a horse is a farm product. That same horse, when sold to a broker who intends to resell it, becomes inventory. Sold to a stable that owns horses exclusively to race them, the horse becomes equipment. When its racing career is over, and the horse is sold to an individual as a pet and a family riding animal, the horse becomes consumer goods.
A creditor seeking to perfect a purchase-money security interest in the horse must know how it will be used (and therefore classified for Article 9 purposes) in order to protect its priority. A purchase-money security interest in goods other than inventory or livestock has priority over a conflicting security interest in the same goods, so long as it is perfected within 20 days of the debtor's receipt of the collateral. UCC §9-324(a). Special priority rules apply to livestock that are farm products. UCC §§9-324(d) and (e).6
The practical effect can be significant. If the debtor purchased the horse for use in farming operations, such that it will be classified as a farm product, then a purchase-money security interest will have priority only if perfected when the debtor receives possession and if certain notice requirements are satisfied. UCC §9-324(d). On the other hand, if the debtor purchased the horse to race it, it will be classified as equipment, and the purchase-money security interest will have priority over a prior perfected security interest in the debtor's assets, so long as the purchase-money security interest was perfected within 20 days of delivery. UCC §9-9-324(a).7
The subjectivity of this analysis seems to suggest a quagmire for the lender: How can the lender know what the debtor will do with the collateral? What if the debtor says it will race the horse, but instead uses the horse to begin farming operations? If the lender relied on the equipment classification, will its priority be lost?
Two principles offer some certainty to the lender. First, a court will generally look to the debtor's intentions at the time of the transaction. See White and Summers, 4 Uniform Commercial Code §31-15 (4th Ed. 1995). This can provide a measure of insulation to a creditor when the debtor changes its mind about how to use the collateral. A careful lender will require representations and warranties from its borrower regarding the intended use of the collateral.
Second, in this as in many other contexts when dealing with Article 9, the creditor's philosophy should be "when in doubt, play it safe." File financing statements early and often to protect the lender from any adverse consequences should the collateral be classified in an unexpected way.
In the world of Article 9, if it looks like a duck, walks like a duck and quacks like a duck, then it might or might not be a duck. It depends.
1 The 1999 revision to Article 9 of the UCC is currently in effect in every state and territory of the United States (with the exception of Puerto Rico). References to Article 9 of the UCC in this article are to Revised Article 9. While the 1999 revision contains significant changes to Article 9, the provisions relevant to this article have not changed substantially, and cases decided under pre-revision Article 9 remain relevant. Return to sender
4 Note that the goods in question will be classified as farm products only if the debtor is engaged in farming operations "with respect to" those goods. This means that a horse will not be a farm product, even if it lives on a farm, if the debtor is not engaged in "raising, cultivating, propagating, fattening [or] grazing" horses. A horse that is used as a work animal on a farm (such as a horse used on a ranch in the management of cattle) would likely be classified as equipment. Return to sender
6 The UCC does not contain a definition for "livestock." However, the official comments to §9-324 explain that §9-324(a) "states a general rule applicable to all types of goods except inventory and farm-products livestock..." UCC §9-324 cmt. 3 (emphasis added). In light of this comment, and in light of the fact that the special priority rules set forth in §9-324(d) expressly apply to "livestock that are farm products," as well as the inclusion of "livestock" in the definitions of "farm products" and "farming operation," it appears that animals that are not "farm products" as defined in UCC §9-102(34) are not considered "livestock" for purposes of UCC §9-324(a). Return to sender
7 Trade associations have instituted systems of registration for some types of racehorses. See, e.g., United States Trotting Ass'n. v. Chicago Downs Ass'n. Inc., 665 F.2d 781, 784 (7th Cir. 1981) (discussing USTA registration certificates). While such registration systems may provide a convenient system for the identification of ownership or liens, they do not constitute a "certificate-of-title" system pursuant to UCC §9-311(a) (unless the jurisdiction has formally recognized such a registration system in its statutes). Accordingly, noting a lien on a horse's registration certificate will generally be ineffective as a means of perfection. Return to article