Agricultural Production Contracts

Phillip L. Kunkel, Attorney
Scott T. Larison, Attorney
Hall & Byers, P.A.
St. Cloud, MN

Copyright ©  2008  Regents of the University of Minnesota. All rights reserved.

Contracts are an increasingly important aspect of agricultural production and marketing. Such contracts may take the form of leases, contracts for deed, production contracts, or marketing contracts. Some of the legal issues surrounding such contracts are discussed in other fact sheets in this series, including Contracts, Notes and Guarantees, Mortgages and Contracts for Deed, and Farm Leases. This fact sheet deals with the legal considerations involved in agricultural production contracts.

Introduction

An agricultural production contract is a contract by which a producer (sometimes called a "grower") agrees to (1) sell or deliver all of a designated crop raised in a manner set forth in the agreement to a contractor (sometimes called a "processor") and is paid according to a formula established in the contract; or (2) agrees to feed and care for livestock or poultry owned by the contractor until such time as the animals are removed, in exchange for a payment based on a formula typically tied to the performance of the animals. A production contract usually specifies in detail the production inputs to be supplied by the contractor, the quality and quantity of the particular commodity involved, the production practices to be used, and the manner in which compensation is to be paid to the producer.

While significant attention has recently been focused on production contracts with large, corporate agricultural processors, farmers themselves can be contractors. For example, a dairy farmer may contract with a neighbor for the raising and/or breeding of heifers. A swine farmer may simply operate a farrowing business for surrounding farmers.

Agricultural production contracts are not new. Seed contracts, vegetable contracts, and even hog contracts have been used in agriculture for several years. However, contracting has been a growing part of U.S. agriculture since at least 1960. According to estimates of the United States Department of Agriculture, about 32 percent of the total value of U.S. agricultural production in 1993 was produced under contract arrangements. Contracts are most common in the poultry industry, although they are becoming more standard in other livestock operations.

There are several potential advantages for producers who may consider a production contract. Such contracts may provide a more stable income for the producer by reducing traditional marketing risks. Such contracts may allow a producer to benefit from technical advice, managerial expertise and access to technological advances provided by the contractor. An agricultural production contract may provide the producer with a guaranteed market, provided that the commodities are produced in accordance with the contract. Finally, such contracts may allow a producer to increase the volume of his or her business with limited capital since the contractor may often supply the necessary production inputs. However, by entering into a production contract that establishes a formula for compensation, the producer may lose the potential for increased profits due to market conditions. In addition, since such contracts are often very specific in their requirements and in limiting the producer's interest in the commodities produced, the producer may become a mere provider of production services for a fee.

From the contractor's perspective, production contracts may provide an orderly flow of uniform commodities so as to allow the contractor to control production costs. And such contracts may allow contractors to better respond to changing market conditions. The use of such contracts may allow a contractor to protect its investment in genetics and other intellectual property associated with a particular commodity.

Alternative Legal Relationships
Agricultural production contracts take various forms, depending upon the commodities to be produced, the economics of the transaction, and local custom. The manner in which such contracts are structured will affect the legal relationship between producer and contractor.

Production contracts may be structured as sales contracts, especially those for typical crops. Such sale contracts may be very similar to a standard forward contract for the sale of crops. Under such contracts the producer owns the crop to be produced and agrees to sell the crop on harvest to the contractor. Such contracts will generally be subject to the provisions of the Uniform Commercial Code (UCC) relating to sales contracts. The UCC provides various remedies for sellers of goods in the event a purchaser breaches the sales contract.

A production contract may be considered a personal service contract. Such contracts generally provide that the producer is to provide services, rather than commodities, to the contractor. Under such contracts, the producer will not typically "own" any of the commodities which are the subject of the contract. Rather, he will be providing services and management to the contractor. The UCC provisions relating to sales of commodities will not be applicable to a personal sales contract.

Some production contracts, especially those involving seed and vegetables, may be bailments. A bailment is the legal relationship which exists when someone else is entrusted with the possession of property, but has no ownership interest in it. A classic example of a bailment is a grain storage contract. The elevator which stores a farmer's grain does not have an ownership interest in the stored grain. Rather, it merely holds the grain for the farmer. Crop production contracts structured as bailments provide the contractor with additional protection against the unauthorized distribution of seeds and crops which may be the result of extensive genetic inputs by the contractor. Under such contracts, the contractor retains full ownership to the seed and crop to be produced.

Finally, some production contracts may be leases of facilities, especially if the contracts relate to the production of livestock.

Regardless of the legal relationship created by a production contract, most contracts will contain provisions that specify that the producer is an independent contractor and not an employee or agent of the contractor. Such provisions are designed to limit the liability of the contractor for the actions or omissions of the producer. Similarly, such contracts typically declare that no joint venture or partnership between the producer and contractor is intended.

Risks Associated with Production Contracts
Before a producer enters into any production contract, he or she should carefully assess the risks associated with such a contract.

Frequently, such contracts may require substantial long-term capital investments. For example, if a producer is entertaining a proposal to raise hogs under contract, a significant improvement to existing facilities may be necessary to comply with the contract. This may mean a long-term obligation to a lender to finance the costs of such improvements. Certain crops may similarly require specialized equipment in order to raise and harvest the crop. Before entering into any such contract, the producer should pay especially close attention to the provisions of the contract specifying the term of the agreement and the ability of the contractor to terminate the agreement. If a substantial investment is required to perform the contract, the producer should ensure that the contract provides sufficient safeguards to allow recovery of investment. As discussed below, Minnesota law has addressed these concerns.

The manner in which the producer is to be paid should be clearly understood. Often, production contracts include formulas which base such payments upon a comparison of the performance of the livestock that are the subject of the contract to other similar livestock. Such a formula should be analyzed carefully before a contract is signed.

The risks assigned to the producer under the contract should similarly be understood. The extent to which the producer must bear the risk of casualty losses, crop failure, disease, or adverse weather conditions should be considered by the producer. The contract should clearly set forth the risks to be assumed by the contractor and absorbed by the producer.

As in any contractual relationship, a producer will always be subject to the risk of nonpayment by the contractor. While state law may provide for a limited bond for grain purchasers, there may be no similar protection for a producer who raises certain crops or livestock under contract. Rather, in the event the contractor's business fails, the producer may be an unsecured creditor of the contractor. The rights of unsecured creditors are discussed in another fact sheet in this series, Rights of Unsecured Creditors. Should the contractor's business completely fail, a producer who has acquired facilities or equipment in order to perform under a contract may lose any meaningful ability to generate sufficient income to pay for such facilities or equipment.

The best way for a producer to address the risk of nonpayment is to contract with financially responsible contractors. However, state or federal law may provide some relief, depending upon the nature of the contract and the commodity produced. For example, a producer who custom feeds livestock may be provided with a lien by Minnesota law.

Generally, any person who keeps, feeds, pastures, or otherwise cares for domestic animals is entitled to a lien on the animals for all charges associated with such care. This lien may have priority over the security interest of another party. A producer who delivers perishable fresh fruits and vegetables, milk and cream, or poultry or poultry products may be protected, at least in part, by a bond which must be posted by dealers in wholesale produce. Finally, an agricultural producer may be entitled to a lien for the contract price or the fair market value of the commodities delivered to a buyer. However, such a lien is not available if federal law allows the buyer of such commodities to acquire them free of any such lien.

Regulation of Production Contracts
Minnesota has adopted significant legislation regulating certain aspects of agricultural production contracts. The legislation generally provides as follows:

1. Dispute Resolution
   Every contract for an agricultural commodity must contain a provision providing for resolution of disputes by mediation or arbitration. For purposes of this law, "agricultural commodity" is broadly defined and includes crops, livestock, seeds, oilseeds, poultry, and poultry products.
   
   
2. Recovery of Investment
   If a contract requires a producer to make a capital investment in buildings or equipment having a useful life of five or more years and which cost $100,000 or more, the producer may not cancel or terminate the contract until: (1) the producer has been given written notice of at least 180 days and (2) the producer has been reimbursed for damages incurred by an investment in buildings or equipment that was made for the purpose of meeting the requirements of the contract.
   
   
3. Notice of Termination
   Except in the case of abandonment of the "contract relationship" with the contractor or conviction of an offense directly related to the business conducted under the contract, a contractor must give a producer written notice at least 90 days before termination of a contract if the producer breaches the contract if it meets the capital investment standard of $100,000. In such a case, the producer must be given 60 days to cure the breach of the contract.
   
   
4. Parent Company Liability
   Parent companies of subsidiaries licensed to purchase agricultural commodities are liable to a seller for the unpaid amount of any claim under the contract if the contractor fails to pay or perform according to the terms of the contract.

Minnesota has also enacted legislation directed specifically at purchasers of perishable fresh fruits and vegetables, milk and milk products, and poultry and poultry products. Such purchasers must provide a bond to protect producers of such commodities. Such a bond is required even if the "purchaser" is the owner of the commodity which is produced by another. Thus, a vegetable processor which obtains raw product through bailment contracts is subject to the bonding requirements of this law. However, any person claiming to be damaged by a breach of a contract must submit a claim to the Commissioner of Agriculture within 40 days after the due date in order to assert a claim against the bond. The purchasers of such products are also subject to civil and criminal penalties for violations of the law.

In addition to state regulation, the federal Packers and Stockyards Act (PASA) and Perishable Agricultural Commodities Act (PACA) may provide additional protection for producers. PACA, in particular, provides significant protection for unpaid producers. Under PACA, a buyer of commodities subject to the act (generally fresh fruits and vegetables) must hold all inventories, receivables or proceeds received from the sale of the perishable commodities in trust for the benefit of unpaid sellers (i.e., producers) until full payment is made.

Conclusion
The decision by a producer to enter into a production contract should be carefully considered. While such a contract may provide the producer with several advantages, the terms of the contract and the underlying economics of the contract should be carefully assessed. State and federal laws may provide limited protection to producers. However, the law does not provide complete protection.

To order other publications in this series, contact the University of Minnesota Extension Store, 20 Coffey Hall, 1420 Eckles Avenue, St. Paul, MN 55108-6069, e-mail: shopext@umn.edu or credit card orders at 800-876-8636 or (612) 624-4900 (local calls).

• Security Interests in Personal Property (FO-7292).
• Mortgages and Contracts for Deed (FO-7293).
• Termination of Contracts for Deed (FS-7294).
• Bankruptcy: Chapter 7 Liquidations (FO-7295).
• Bankruptcy: Chapter 11 Reorganizations (FS-7296).
• Mortgage Foreclosures (FO-7297).
• Termination of Security Interests in Personal Property (FO-7298).
• Rights of Unsecured Creditors (FO-7299).
• Tax Considerations in Liquidations and Reorganizations (FO-7300).
• Bankruptcy: Chapter 12 Reorganizations (FO-7301).
• Agricultural Production Contracts (FO-7302).
• Financing the Farm Operation (FS-2589).
• Contracts, Notes and Guaranties (FS-2590).
• Farm Leases (FS-2593).
• Bankruptcy: The Last Resort (FO-2598).

The fifteen publications are also available as a package: Farm Legal Series (PC-7291).

This publication is designed to provide accurate information in regard to the subject matter covered. It is published with the understanding that the authors and the University of Minnesota are not engaged in rendering legal, accounting or other professional services. If legal advice or other professional assistance is required, the services of a competent professional should be sought.

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