Most lawyers in the equipment financing business in urban areas have never handled a deal involving animals, such as livestock. Although businesses lease guard dogs and labs may lease animals for scientific research, leases of dairy cattle are more common and sometimes end up in bankruptcy-related litigation.

Commentators have pointed out the advantages of cattle leasing for both owners and farm operators. See  http://www.agriculture.gov.sk.ca/cow-calf_lease_agreements (last visited July 3, 2014). For example, the lessor of dairy cows and the lessee may find it mutually advantageous to agree to transfer cows to the lessee’s farm so that the lessee can make best use of existing assets, such as livestock buildings and pasture.

Lessors of cattle also point out the tax benefits of leasing cattle and in the 1980s, tax shelters involving cattle were common. At that time, the tax benefits available in these deals included the investment tax credit, depreciation deductions, the deductibility of cattle maintenance expenses, and the deduction of interest expense paid pursuant to promissory notes used to finance the cattle lease.

A recent Michigan Bankruptcy Court explained all you want to know about leasing dairy cattle. In re Moohaven Dairy, LLC, No. 13-10319 (Bankr. E.D. Mich. April 16, 2014), the court addressed the often-litigated issue of whether a lease of dairy cows is a true lease or a disguised secured transaction.

The case arose after a Michigan dairy farmer filed a voluntary Chapter 11 proceeding. The court said that the debtor’s business failed because of a number of factors, including the recession. According to the court, the dairy farmer’s business failed because his herd suffered a high cull and death rate as a result of sickness, which reduced his herd’s milk production. A downturn in the economy and rapidly declining milk prices also hurt the debtor’s business. The debtor also failed to achieve a herd size necessary to meet the financial results he had projected.

During the bankruptcy proceeding, the trustee developed a detailed Revised Amended Plan, which the bankruptcy court confirmed, to enable the debtor to increase his milk production to meet revised financial projections. Quoting from the debtor’s Plan, the court said that the debtor and trustee were working to enable the debtor to operate the dairy operation at a profitable level and pay his creditors in full.

An essential element of the Plan was the debtor’s intention to lease 200 additional head of cattle. To accomplish that objective, the debtor entered into a post-petition lease with Sunshine Heifers. Sunshine Heifers and Moohaven Dairy entered into a cow leasing agreement in January 2012. Moohaven signed the lease, but Sunshine did not sign. The lease provided that Sunshine would lease 240 cows to Moohaven for $13,056 per month for 48 months, according to the court. Moohaven had no right to terminate the lease.

At the expiration of the lease or on default, Moohaven agreed to return the cows to Sunshine, the court said. Moohaven also agreed to maintain the herd at 240 cows at all times and guaranteed that each cow would have a residual value of at least $240. The lease contained an Arizona choice of law clause. The lease also included a merger clause, making the lease the entire agreement between Sunshine and Moohaven and prohibiting any oral modifications.

Like most states that have adopted provision 1-203 of the UCC,  Arizona’s statute provides as follows:

a “transaction in the form of a lease creates a security interest if the lease is not subject to termination by the lessee, and any one of the following applies: (1) the original term of the lease is equal to or greater than the remaining economic life of the goods; (2) the lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods; (3) the lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or for nominal additional consideration on compliance with the lease agreement; or (4) the lessee has an option to become the owner of the goods for no additional consideration or for nominal additional consideration on compliance with the lease agreement.”  Ariz. Rev. Stat. Section 47-1203(B)(1)-(4).

Applying this provision to the facts of this case, the court found that the express terms of the lease prohibited early termination by the lessee. The court also concluded that the lease was not subject to any of the factors described in elements (2) through (4) of section 1-203.

But the court devoted a substantial part of its opinion to whether the original term of the lease was equal to or greater than the remaining economic life of the heifers. In particular, the court noted that another bankruptcy court concluded a 50-month lease was clearly longer than the economic life of the cows. In re Purdy, 490 B.R. 530 (2013).

In Purdy, the court noted that the original lease term was 50 months. Uncontradicted testimony in that case was that a dairy herd is culled annually at an approximate rate of 30 percent.

Applying a 30 percent annual reduction rate, the court inferred that a heard of 1,000 cows would be reduced by 300 cows (or 30 percent of the initial herd) each year. In other words, a herd of 1,000 cows would be reduced to 700 after one year, 400 after two years, 100 after three years, and zero cows after three years and four months (or 40 months).

The court in Purdy, concluded that “within three years an entire herd is extremely likely to have been entirely replaced and certainly before the end of 50 months.” The Purdy court concluded that because the first factor of the applicable UCC section applied to the dairy farmer’s agreement with Sunshine Heifers, the transaction was a security agreement rather than a true lease.

In contrast, In re Moohaven Dairy, LLC, reached the opposite conclusion regarding whether the value of the lease was equal to or greater than the remaining economic life of the heifers. Applying a different mathematical approach, the court found that the herd would be reduced by 30 percent of the remaining number of cows each year.

Under this approach, the court inferred that 30 percent of the herd would be culled and 70 percent of the cows would be milkable at the end of one year. So, under this model 1000 cows would be reduced to 700 cows at the end of one year; 70 percent of 700 cows would leave 490 cows after two years; 70 percent of 490 cows would leave 343 cows after three years; and 240 cows after four years.

Accordingly, the court concluded that although a substantial proportion of the herd would have been culled by the end of 48 months, its calculations demonstrated that the term of the lease did not exceed the economic life of the cows.

In its opinion, the court cited a government website that explains the lactation cycle of dairy cows. See http://www.epa.gov/oecaagct/ag101/dairyphases.html (last visited June 24, 2014). According to that site, cows average 2.5 lactations of 12-14 months each, with 60 days between lactations. On average, therefore, average cows are retired or culled after about three years. But the court also cited industry journals for the proposition that many cows will continue to produce milk after a four year period.

In view of the factual dispute between the Purdy and Moohaven courts over the useful life of heifers, an attorney involved in a cattle leasing transaction would be well advised to include in the lease provisions that clarify whether or not the cattle have an economic value that exceeds the term of the lease.

For example, the parties could agree, as in Moohaven, that the lessee will ensure that herd size remains stable throughout the term of the lease. And to avoid a battle of experts, the lease should specify an agreed basis for estimating, at the beginning and end of the lease, whether the heifers are likely to be productive for a period of time that exceeds the term of the lease.