Due Diligence in the Agricultural Loan Transaction: Through the Rearview Mirror

1. H. Edward Hales, Jr. David F. ReidMarch 23, 2012 Due Diligence in the Agricultural Loan Transaction: Through the Rearview Mirror

2. Introduction • Due diligence issues that may not be obvious in an agricultural lending transaction, but which may become important “through the rearview mirror” • Also, recent developments that may affect due diligence practices • Presentation to focus on following topics: • Foreign Investment in Agriculture • NEDC v. Brown: Clean Water Act and Irrigation • Current Use Exemptions and Rollback Taxes • Migrant Labor and Tenant Housing on Farms • Alternative Income Streams: Windmills, Cellular Towers and Hunting Leases • Chemical Trespass: Pesticide Migration • Intellectual Property

3. FOREIGN INVESTMENT IN U.S. AGRICULTURE

4. Foreign Investors in Agriculture • Foreign investors in U.S. real property are subject to various tax difficulties (such as FIRPTA) • Foreign investments in agricultural land and timberland impose additional burdens on the foreign investor • Federal level: AFIDA • State disclosure laws • Additional state burdens • Some laws carry severe penalties and can be a trap for the unwary

5. AFIDA • Agricultural Foreign Investment Disclosure Act of 1978, 7 U.S.C. §§ 3501-3508 (“AFIDA”) • Implemented by regulations at 7 C.F.R. Part 781 • Purpose: To require the disclosure of transfers of agricultural land by foreign persons • Administered by Farm Service Agency, part of USDA • Primary result of AFIDA: Annual report by FSA summarizing foreign holdings

6. Annual Report

7. Filings • Implemented by requiring “foreign person” to make a filing within 90 days following: • the purchase or sale of any interest in agricultural land by a foreign person, • a change in use of any such land that is already owned by a foreign person (e.g., conversion of non-agricultural land to agricultural land), or • a change in the status of a landowner such as becoming a foreign person (e.g., the acquisition of 10% or more of a U.S. company or its parent by foreign entities) • Filings must be made in the FSA office where the property is located, but can be made centrally with USDA with special dispensation

8. Who Is a “Foreign Person”? • Individual who is not a U.S. citizen or permanent resident, • Corporation or other legal entity organized under the laws of a foreign country, • Foreign government, or • U.S. entity in which a 10% interest is held, directly or indirectly, by anyone described above • Special rules apply if no single foreign person owns 10%, but foreign persons own more than 10% in the aggregate

9. What Is an “Interest” in Land? • All interests acquired, transferred or held in agricultural land by a foreign person, except: • security interests • leaseholds of less than 10 years • contingent future interests • noncontingent future interests that do not become possessory upon the termination of the present possessory estate • surface or subsurface easements and rights of way used for a purpose unrelated to agricultural production • interest solely in mineral rights • Although lending transactions are exempt, a foreclosure would constitute a reportable event

10. Consequences • Penalty for failing to file or update or filing an incomplete or misleading report is 25% of the fair market value of the foreign person’s interest in the land • Late filing fees: 1/10th of 1% of the fair market value of the foreign person’s interest in the land per week, up to a maximum of 25% • USDA has discretion to levy lower fines based on circumstances • Penalty is a civil fine, not a tax lien

11. How Is Lender Affected? • Borrowers facing penalties will have difficulty repaying loans • If lender has taken a pledge of interests in an entity, and that entity is a “foreign person,” upon foreclosure lender will succeed to entity’s liability for any failures to make filings • Foreign participant in loan can trigger filing requirements upon foreclosure • Lender should make additional inquiries before selling interests in loan • Lender should seek representations, warranties and covenants in co-lender or participation agreement

12. State Laws Affecting Foreign Investors • States limiting corporate farming: • Iowa Kansas Minnesota • Missouri Nebraska North Dakota • Oklahoma South Dakota Wisconsin • These states’ restrictions on corporate farming make many of the foreign investor concerns moot • It is easier to confirm if individuals or constituent members of family farm entities are “foreign persons” than confirming if an indirect owner makes an entity a foreign person

13. State Laws Modeled After AFIDA • Illinois • 765 ILCS §§ 50/1 to 50/8: “Agricultural Foreign Investment Disclosure Act” • Nearly identical to federal AFIDA • Penalties up to 25% of fair market value in aggregate with any penalties under federal AFIDA • Arkansas • Ark. Code Ann. §§ 2-3-101 to 2-3-110: “Arkansas Agricultural Foreign Investment Act” • Similar to AFIDA but shorter 60 day filing requirement • Enhanced penalties: Attorney general or private party can force divestiture; sheriff’s sale if not divested in 2 years

14. Other States With Filing Requirements • Maine • Me. Rev. Stat. tit. 7 §§ 31-35: “Agricultural Land Interest Act” • All corporations and partnerships (foreign or domestic) holding direct or indirect interest in 10+ acres of agricultural land are required to file report upon acquisition or disposition • Federal AFIDA filing can be filed with state • $50/day penalty for failure to file • Ohio • Ohio Rev. Code § 5301.254: Nonresident alien acquiring direct or indirect interest in 3+ acres of real property (or worth $100k) must file with Secretary of State within 30 days • Ohio Rev. Code § 5301.99: Penalty up to 25% of value of property • Ohio Admin Code ch. 111-8-01: includes “security interest” in definition of “interest in real property”

15. Pennsylvania • Pa. Stat. title 68 §§ 41-47: “Alien Acquisition of Agricultural Lands” • Nonresident alien may not acquire interest in more than 100 acres; “alien” and “interest” not defined • Penn. Dept. of Agriculture to monitor AFIDA filings • Penalty: Forfeiture if AG brings suit within 5 years of acquisition • Not clear if law is enforced • Pa. Stat. title 68 § 28: • Aliens may purchase up to 5000 acres • No definitions; not clear if law applies to beneficial interests held by aliens • Enforcement, penalties not clear

16. South Carolina • S.C. Code Ann. §§ 27-13-10 through 27-13-40: • Aliens and corporations controlled by aliens have the right to own land in SC, subject to 500,000 acre limit • SC only has 20,000,000 acres, so applicability is limited • Carveout for foreclosing lender that is an alien • S.C. Code Ann. § 12-43-220(d)(i) • Favorable agricultural assessment of 4% of FMV for taxation purposes for individuals, closely held corporations • Nonresident alien shareholder (among other reasons) causes land to be assessed at 6% of FMV for taxation purposes

17. NEDC v. BROWN

18. NEDC v. Brown • Northwest Envtl. Def. Ctr. v. Brown, 640 F.3d 1063 (9th Cir. 2011): Clean Water Act case • Silvicultural Rule (40 CFR 122.27), adopted by EPA, excludes certain silvicultural activites from the National Pollution Discharge Elimination System (NPDES) "point source" permitting requirements, including “harvesting operations, surface drainage, or road construction and maintenance” from which there is natural runoff. • Silvicultural Rule defines these as “nonpoint sources,” and so any resulting discharges into waters of U.S. do not violate the CWA and do not need permits • 9th Circuit overturned the Silvicultural Rule

19. NEDC v. Brown • Logging Roads: Background • Logging roads, typically temporary, include construction of roadside ditches for drainage • Ditches may lead to discharge of runoff in streams, carrying sediment, logging debris and other substances • States have established “best management practices” (BMPs) to govern logging operations, including road construction • In many states, compliance with BMPs is voluntary, but landowners frequently insist on compliance by loggers to protect their land • Due to sedimentation in Oregon stream, NEDC brought suit to bring logging road construction under NPDES program.

20. NEDC v. Brown: Basis for Holding • “Point source” statutorily includes “any discernible, confined and discrete conveyance, including but not limited to any pipe, ditch, channel . . . ,” with a specific exclusion of “agricultural stormwater discharges and return flows from irrigated agriculture.” Clean Water Act § 502(14) • CWA requires NPDES permitting for discharges of pollutants into waters of U.S. from any point source related to certain uses, including industrial uses. • EPA has no statutory authority to categorically exempt silvicultural activities from CWA.

21. NEDC v. Brown: Basis for Holding • Even if Silvicultural Rule were interpreted to be limited to silvicultural activities producing only natural runoff (without being channelized), logging roads are point sources due to their channelization of runoff. • Court emphasizes statutory element of “discernible, defined and discrete conveyance” in definition of “point source,” de-emphasizes the nature of the activity. • “Natural runoff” is not a point source under this definition • But any ditch used in industrial activity that discharges into waters of U.S. becomes a point source, unless otherwise exempted by statute.

22. NEDC v. Brown: Result • Silvicultural Rule cannot be relied upon. • Thousands of miles of logging roads subject to NPDES permitting process. • But EPA has not provided any guidance on how permitting process would work for logging roads.

23. NEDC v. Brown: Why should agricultural landowners and lenders worry? • On its face, NEDC v. Brown appears to apply only to timber industry. Consider the following “good facts” for agriculture: • CWA § 502(14) includes statutory exemption of “agricultural stormwater discharges and return flows from irrigated agriculture” from definition of “point source.” • CWA § 402(l)(1) excludes from permitting process “discharges composed entirely of return flows from irrigated agriculture” • In reaching decision regarding EPA’s authority, court expressly contrasts (i) statutory exclusion of certain agricultural discharges and (ii) statutory silence re: timber industry • Temptation for farmers and lenders to rely solely on “agricultural exemption” to avoid NPDES permitting process for the tile systems, ditches, swales and channels that bring irrigation to virtually all large farms and carry away runoff.

24. NEDC v. Brown: Why should agricultural landowners and lenders worry? • Statutory language should still concern ag industry: • Numerous statutory references in CWA to water pollution caused by agricultural activity • “Pollutant” definition includes “industrial, municipal and agricultural waste discharged into water” (emphasis added) CWA § 502(6). • Basis of court’s reasoning should concern ag industry: • Emphasis on channelization vs. natural runoff. • Expansive interpretation of “point source.” • Restrictive interpretation of exclusions and of EPA’s authority to exclude activities from NPDES program. • Emphasis on industrial nature of logging. • Fertilizers and pesticides from farms are a major source of water pollution. • Statute and court’s reasoning may give environmental plaintiffs a “hook” to restrict agricultural exemption in CWA.

25. NEDC v. Brown: Why should agricultural landowners and lenders worry? • Under Clean Water Act, EPA can set water quality standards for states if states fail to do so themselves • EPA recently did so for Florida at 40 CFR Section 131.43. • Standards impose numeric limits on nitrogen and phosphorus in specific water bodies in Florida. • The standards, and a recent court decision regarding a challenge to the EPA’s standards, do not address agriculture specifically, or how it may be impacted by the new standards. • But agriculture is a major contributor of nitrogen and phosphorus; the meaning of the “agricultural exemption” in the statute may become critical to the EPA’s and states’ future decisions regarding agricultural runoff, and to the direction of litigation.

26. NEDC v. Brown: Possible approach of future plaintiffs • To weaken the agricultural exemption, plaintiffs or the EPA could make the following argument: • “Irrigation return flow” not defined in CWA • Little legislative or regulatory history or guidance on scope of term • Little consistent judicial interpretation of term • Following the court’s reasoning in NEDC, plaintiff would focus on method of runoff: • If runoff of irrigation water is natural (without channelization system), then the irrigated agriculture is not a “point source” • As soon as runoff enters a directional channel, it loses the benefit of the exemption • Argument would restrict agricultural exemption to protect only farmers who channelize already polluted water for irrigation, but who then allow runoff to occur naturally. • Moreover, modern farming operations resemble industrial activity, and EPA has discretion under CWA to define what is “industrial”

27. NEDC v. Brown: Recent Activity • Sec. 429 of Omnibus Appropriations Bill passed in December 2011 prohibits EPA from requiring NPDES permits for silvicultural activity through September 30, 2012. • Silviculture Regulatory Consistency Act currently pending in both houses of Congress (HR 2541 and S 1369). If passed, the effect of the legislation will be to overturn the 9th Circuit decision, but focus of the bill is only on silviculture. • Defendant in NEDC v. Brown appealed to Supreme Court. • Supreme Court requested the U.S. Solicitor General to report to the Supreme Court the views of federal agencies, including EPA, USDA, Department of Interior, and the Council on Environmental Quality • Report may be ready by June 2012, with Supreme Court deciding whether to grant certiorari thereafter.

28. NEDC v. Brown: Effect on Lender’s Due Diligence • If upheld and expanded by regulation or litigation, NEDC could ultimately lead to NPDES permitting requirements for irrigated agriculture. • Lender would need to investigate irrigation methods, permits as part of due diligence; and have ongoing covenant of borrower to obtain all necessary permits. • Lender would need to estimate expense of compliance with permitting regime, which would affect underwriting. • Depending on permitting requirements, farms heavily dependent on irrigation may not be operationally profitable.

29. CURRENT USE EXEMPTIONS; ROLLBACK TAXES

30. Current Use Exemptions; Rollback Taxes • Almost all states have a form of ad valorem real property tax assessment that gives preference to agricultural use. • In exchange for agreeing to limit the use of the property to agriculture, a property owner receives reduced property taxes. • Breach of requirements results in penalties in the form of “rollback taxes” • Appears in various forms: • Zoning • Restrictive covenants filed in real property records • Entry maintained on tax rolls in assessor’s office

31. General Concept of Current Use • Landowners’ and lenders’ general concept of current use exemption: Continued agricultural use = lower property taxes Non-agricultural use = penalties, higher taxes • Ag lenders’ underwriting likely assumes continued preferential assessments. • Problem: General concept is frequently undermined by quirks of state current use regimes.

32. Example: Georgia • OCGA § 48-5-7.1: “Bona fide agricultural use property” • Property qualifies if its primary use is “good faith commercial production from or on the land of agricultural products” • Allows for assessment at 75 percent of value at which other real property is assessed • OCGA § 48-5-7.4: “Bona fide conservation use property” • Various uses qualify property, including “raising, harvesting or storing crops” • Allows for assessment at 40 percent of current use value

33. Example: Georgia • Both statutes contain similar structures and provisions • Both statutes contain the following expected elements: • 10 year commitment to agricultural use • Covenant of property owner/applicant is maintained in public records (but not necessarily the real property records) • Breach of covenant results in rollback taxes in the form of penalties, interest • Penalties and interest attach to property as a first priority lien, similar to other property taxes

34. Example: Georgia • Problem 1: Identity of landowner • Both statutes require ownership by natural person or family-farm entity • Ownership by any other entity is breach of covenant • Carve-out from most penalties for foreclosing lender, but lender still must pay current year’s regular taxes (plus interest), and must pay the higher rate going forward as long as it owns the property • Problem 2: Acreage caps • Each statute has independent statewide cap of 2,000 acres per direct or indirect landowner • Taxes are assessed individually by counties, and no statewide registry exists to date

35. Example: Georgia • Threat to lender: Changes to landowner’s composition • Tax assessor likely has not followed transfers of interests in family-farm entity since the time of enrollment • Upper tier transfer after making loan, even if approved by lender, could result in breach of covenant, rollback taxes • Threat to lender: Over-enrollment by landowner • Borrower, or persons holding an interest in borrower, may breach covenant by enrolling too many acres, including in other counties • Statutes are unclear whether the breach affects only acres in excess of 2000, or all acres enrolled by landowner • Threat to lender: Foreclosure • Lender is not a natural person or family farm; foreclosure removes property from eligibility • Higher taxes for current year and going forward • All penalties, increased taxes and interest will be superior to lender’s lien!

36. Rollback Taxes: Other Examples • Georgia is not alone; many states present unique risks • Examples: • Rhode Island: Annual filing required to maintain exemption (R.I. General Laws § 44-27-3) • Tennessee: Cap of 1500 acres per beneficial owner per taxing jurisdiction (Tenn. Code Ann. § 67-5-1001 et seq.) • Texas: Sale of enrolled land subjects it to rollback taxes, including by foreclosure; statutes govern lender’s attempts in loan documents to protect itself from rollback taxes (Tex. Tax Code Ann. §§ 23.42, 23.47)

37. Rollback Taxes: Protection of Lender • Review the state’s current use regime! • Include representations and warranties by borrower. • Include specific covenants in loan documents tailored to the state’s program; allow for foreclosure if breach detected by lender but not by taxing authority. • Many states have lender protection provisions if breach results solely from foreclosure. • No protection for lender if rollback taxes assessed against borrower. • Make breach a liability guaranteed by guarantor. • Ask borrower’s counsel to address rollback taxes in legal opinion.

38. MIGRANT LABOR ANDTENANT HOUSING ON FARMS

39. Migrant Labor on Farms • Federal Migrant and Seasonal Agricultural Worker Protection Act, 29 USC §§ 1801 et seq. applies to farm labor. • Applies to farmers employing laborers directly and to third party providers of farm labor (“farm labor contractor” under the law) • In addition, farm labor contractors must register with the Department of Labor; farmers must use a registered farm labor contractors if they do not employ farm labor directly. • Civil and criminal liability can attach for violations.

40. Tenant Housing on Farms • Tenant Housing may be difficult to discover: • Survey of large farm is likely only a boundary survey, and will not reveal improvements. • Old surveys may not reveal existence of tenant housing. • Site visits likely will not cover every acre of farms, especially in portfolio transactions • Third party contractor may be responsible for providing housing to labor, and might do so on the property, exposing landowner to liability. • And landowner’s agreement with contractor likely has been collaterally assigned to lender.

41. Tenant Housing: Risks • Residential Landlord-Tenant Law • State-specific residential tenant protection legislation • Notice requirements • Mandatory lease terms • Statutory damages • Implied warranty of habitability – by statute or common law • Health and Safety • Health code • Building code • Zoning code

42. Tenant Housing: Risks • Utilities • Electricity, water, sewage must be provided to residences • If not on municipal system, a well and septic system must be feasible • Environmental considerations • Well water: Must meet certain criteria as to quality; wells must conform to state well standards • Farm pesticide, herbicide, fertilizer usage • May endanger well water • Proximity of residence to fields where chemicals are applied • Different permissible concentrations of hazardous substances for residential vs. non-residential land. Has Phase I ESA been performed to appropriate standard?

43. ALTERNATIVE INCOME STREAMS: WINDMILLS, CELLULAR TOWERS AND HUNTING LEASES

44. Alternative Income Streams: Wind Farms and Cellular Towers • Farm may be good candidate for wind turbines and cellular towers, which can be an important income stream for landowner and for lender’s underwriting. • Has landowner granted lease or permanent easement to operator? • Operator will require access and utility easements to the site over the farm. • Has the lease limited the easements to defined areas? • Or are they blanket in nature?

45. Alternative Income Streams: Wind Farms and Cellular Towers • Both uses can pose a nuisance to neighbors, or result in liability for the landowner. • Concern over health effects of cell towers • “Strobe effect” of windmills • What indemnities does the lease provide? • What is the credit quality of the lessees? • Environmental issues • Wind farms kill birds. Does this pose an Endangered Species Act problem for landowner? • Cell towers often have on-site back-up generators, which include large amounts of diesel fuel sitting on the property.

46. Alternative Income Streams: Hunting Leases • May be used for supplemental income during or after growing season • Duck blinds • Quail, turkey and other bird hunting • Other game on non-arable portion of property • Required insurance of lessees to cover potential injuries from hunting accidents • Lease should include indemnity, but… • Lessees are typically groups of individuals without deep pockets, so insurance is a must. • Lease should include overriding provision for normal farm operations: Right of landowner to kick out hunters for planting, harvesting, etc.

47. Alternative Income Streams: Hunting Leases • Termination provisions: • At will of landowner? • With 30 days’ notice? • Immediately upon conveyance? • Environmental issues: • Use of lead shot for bird hunting. • Operation of vehicles on property. • Harm to endangered species.

48. CHEMICAL TRESPASS: PESTICIDE MIGRATION

49. Neighboring Property Uses: Pesticide Migration • Minnesota Court of Appeals case is the latest to confirm that chemical pesticide drift can constitute a trespass to neighbor’s land. • Johnson, et al. v. Paynesville Farmers Union Cooperative Oil Company, 802 N.W.2d 383 (Minn. Ct. App. 2011) • Typically, as in this case, plaintiff landowner is an organic farmer, and defendant adjacent farmer is not • USDA “certified organic” standards prohibit pesticides above certain thresholds • USDA can require “tainted” land to be removed from production for 3 years

50. Neighboring Property Uses: Pesticide Migration • Minnesota case is not the first to recognize the theory of trespass by chemical pesticide • Leading case is from Washington: Langan v.Valicopters, 567 P.2d 218 (Wash. 1977) • Part of broader “chemical drift” trespass theory applicable to industrial emitters of chemicals • States and localities may have laws and ordinances regarding application of pesticides • May prohibit application within certain distance of structures • Remedies: • Money damages for impact on crops • Trespass violates a property right, meaning that an injunction may be an appropriate remedy