Ag Lending Update: Revocable Trusts and Perfecting Security Interests
Lending to Revocable Trusts
Agricultural lending is an important and profitable area of banking, but lenders must stay aware if they are to protect their interests. In particular, the use of revocable trusts is on the rise, as farmers are relying on this type of trust as a vehicle for estate planning, managing wealth, and avoiding probate of farmland. Lenders must maintain good lending practices in order to avoid the risks associated with revocable trusts and safeguard their interest in farm collateral.
Primer on Trusts
Trusts are a tool for wealth management and protecting interests in property. In the context of agriculture, trusts have been utilized since the Middle Ages to ensure generational succession of farmland. An agricultural trust has three key parties: (1) the grantor who creates the trust and funds it with property, (2) the trustee who manages the trust and holds legal title to the trust property, and (3) the beneficiary who holds an equitable interest to the property and profits of the trust. Trust property is titled in the name of the trustee.
A revocable trust, also called a living trust, is made during the lifetime of the grantor and can be terminated by the grantor’s power to revoke. In contrast, an irrevocable trust cannot be freely terminated, as the grantor does not have a power to revoke. Oftentimes with a revocable trust, a farmer will act dually as the original trustee and grantor.
Revocable Trust Pitfalls and Best Practices
- Authority of the Trust and Trustee
As the lender, you must know:
- Is the trust authorized to enter into commercial agreements or pledge trust assets?
- Are there special provisions in the trust instrument relating to farmland?
- Who is the trustee and what is the extent of their authority?
If a trustee or the trust itself lacks the authority to enter into a lending agreement, the lender may be left exposed and without recourse.
A lender has two options when it comes to learning the terms of a trust: (1) request the entire trust instrument or (2) obtain a certificate of trust. The trust instrument may be cumbersomely long and contain private and intimate details about the borrower and their trust distribution scheme. In contrast, a certificate of trust is a shorthand document that states the material terms of the trust, including what the trust or trustee is authorized to do. For example, a trustee may be required to obtain the written consent of the grantor before pledging farmland. If a lender has a good relation with the borrower, they can request the full instrument, otherwise the best practice is to obtain and review a certificate of trust.
- Lending to the Asset holder
As the lender, you must know:
- Are the pledged assets titled in the name of the grantor or the trust?
If they are titled in the name of the revocable trust, the grantor can freely revoke the trust and re-title the property back in the grantor’s name.
In a revocable trust, the trust can be treated as the alter ego of the grantor. However, because of the grantor’s power to revoke, the lender must ensure it can still reach the pledged property if the trust is revoked. Thus, the best practice is to lend to the asset holder and obtain a guaranty: If the trust holds the assets, the trust will be the borrower and the grantor should provide a guaranty. If the grantor holds some of the assets, the grantor should act as borrower and the trust will offer a guaranty.
- Naming Considerations
As the lender, you must know:
- What form should the trustee’s signature take?
- How should the revocable trust be addressed on a UCC financing statement?
Even a simple error in the name or signature employed can compromise the enforceability of a lender’s interest in the collateral.
The trustee signs agreements and contracts on behalf of the trust. However, the signature should include the trustee’s name and recognize their official capacity as a trustee. For example, say Jane and John Smith form a revocable trust, naming Jane Smith as the trustee. When Jane Smith is signing in her official capacity as trustee, the signature should model as follows:
Jane Smith, Trustee of the Jane and John Smith Revocable Trust, Dated 1/15/21
When filing a financing statement, the name that should be used for the trust is the name identified within the certificate of trust or trust instrument. If the name is not explicitly stated, then the name of the grantor and the name of the trust that appears on the title page of the trust instrument should be used. When required to list the name of the revocable trust, the best practice is to state the trust’s full and explicit name, in addition to the trustee or grantor’s name where required.
- Change in Circumstance
As the lender, you must know:
- What happens to the revocable trust when the grantor dies?
- What happens if the grantor gets divorced?
Failing to prepare for a change in the borrower’s life circumstances may prevent the lender from safeguarding its interest.
In the event of the death of the grantor, a revocable trust becomes irrevocable—the lender should familiarize itself with the property distribution scheme for when the trust becomes irrevocable and determine what will happen to pledged trust property upon the death of the grantor. If there is a divorce, pledged revocable trust property may be retitled to the ex-spouse—but any lien on the property will follow. Whenever possible, the best practice is for a lender to proactively have borrowers and their spouse waive or release any rights or interests in the pledged revocable trust property. Examples of this include a borrower waiving the homestead exemption when obtaining a mortgage, or a borrower waiving the elective share they are entitled to upon the death of their spouse.
Perfecting Interests in Government Subsidy Programs
Farmers’ reliance on government subsidies has increased significantly in the last few years, resulting from a prolonged trade war and a host of natural disasters. Correlated to this increased reliance on government subsidies is the need for lenders to ensure there are perfecting their security interests in them. Lenders can take certain steps to safeguard their interests in collateralized farm subsidies.
Common Farm Subsidies
- Crop Insurance: the largest subsidy; insurance product that covers nearly all crops and premiums are subsidized by the federal government.
- Agriculture Risk Coverage: payments made directly to farmer if their proceeds per acre fall below a determined threshold.
- Price Loss Coverage: payment issues to farmers if the national average price of a crop dips below a level set by Congress.
- Land Conservation Programs: subsidies distributed to farmers to either conserve land from cultivation or to improve farmland quality.
- Covid-19 Relief: direct relief payments made to farmers.
Best Practices for Perfecting the Lender’s Interest
Covering the Waterfront: An agricultural borrower’s government subsidy classification could take the form of: (1) an account, (2) an intangible, (3) or another type of collateral. Identifying the correct classification for a government entitlement can often create a quandary for lenders. However, diligence in filing is needed, or the lender may lose priority in the collateral as against other creditors. The best practice is to cover the waterfront by using a definition of collateral that is broad enough to encompass all potential forms of classification for government entitlements.
Dragnet Clauses: Some state courts, especially in Iowa, hold a particular disdain for dragnet clauses, or clauses in security or mortgage agreements that allow for collateral used to secure Loan A to be used to satisfy obligations owed to the same lender under Loan B. Common practice for older security agreements was to only reference specific notes or collateral. If a dragnet clause includes language regarding a need for “relatedness” between different security agreements and collateral, a court will not enforce the lender’s attempted cross-collateralization. For a lender, the best modern practice is to draft a dragnet clause that specifically disclaims the need for any “relatedness” between any of the debts and loan obligations.
Changing Government Programs: the USDA currently offers dozens of subsidy programs—some are mainstays like crop insurance but others are temporary, like those related to Covid-19 relief. Many of these programs require that lenders take additional steps to perfect a security interest in the benefits. The most common of these are the “Assignment of Indemnity” for crop insurance and the CCC-36 “Assignment of Payment” form used for various government programs. New benefits to agricultural borrowers may come into existence after a security agreement is executed or a financing statement is filed. A borrower may even submit a new application for an existing benefit that was not covered in the original collateral description. To ensure all applicable government entitlements are covered, the best practice is to require the borrower in the lending agreement to notify the lender of the borrower’s involvement with the subsidy programs and to draft an all-inclusive collateral description that ensnares future entitlements.
For more information on this topic, please feel free to view our on-demand Ag Lending Webinar or contact a member of our banking and finance group.
Author: Matthew L. Roth.
Webinar Presenters: Lynn W. Hartman, Abram V. Carls and Michael J. Neuerburg.
Disclaimer: This information is intended for general information purposes only and is not intended, nor should it be construed or relied on, as legal advice. Please consult your attorney if specific legal information is desired.