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In re Schmaling

February 7, 1986

IN THE MATTER OF: LELAND G. SCHMALING AND MARY F. SCHMALING, DEBTORS. APPEAL OF: ESTHER J. SCHMALING, LELAND G. SCHMALING AND MARY F. SCHMALING


Appeal from the United States District Court for the Northern District of Illinois, Western Division. No. 84 C 20180-Stanley J. Roszkowski, Judge.

Author: Cudahy

Before CUDAHY and POSNER, Circuit Judges and GRANT, Senior District Judge.*fn*

O P I N I O N

CUDAHY, Circuit Judge. In this case, we consider whether corn received under the federal government's Payment-in-Kind ("PIK") program-under which farmers receive surplus grain in exchange for an agreement not to plant their intended crop-constitute crop "proceeds" under the Uniform Commercial Code. The Bankruptcy Court for the Northern District of Illinois determined that PIK payments are proceeds and the District Court affirmed. We reverse.

Leland and Mary Schmaling (the "Schmalings" or the "debtors") are farmers in Jo Daviess and Carroll Counties, Illinois. On May 5, 1982, the Schmalings and the First National Bank of Freeport (the "Bank") entered into a security agreement. The agreement covered the following collateral:

All of the farm machinery and equipment, livestock and the young and products thereof, corn and all other crops grown or growing, and the feed, seed, fertilizer, and other supplies used in connection with the foregoing which are now owned or existing, and which are now located on the [Schmalings'] real estate ..., together with all property of a similar nature or kind to that therein described which may be hereafter acquired. . . .

In 1983, the Schmalings entered into a contract to participate in the United States Government's PIK program. Under that program, a farmer agrees to remove a specified percentage of his farm's acreage base and designated crops from production. He also agrees to follow certain soil conservation procedures. If the farmer takes these steps, the government transfers to him a commodity equal in quantity to a percentage of what his diverted or nonproducing acreage would normally yield. 7 C.F.R. § 770 et seg. (1984).

The debtors assigned their PIK rights to three parties: Esther Schmaling, the Carroll Service Company and the State Bank of Pearl City. Esther Schmaling was assigned the right to receive 22,960 bushels of PIK corn. In reliance on this assignment, she loaned the debtors $47,537.92 in 1983. The State Bank of Pearl City loaned the debtors $12,000 in 1983 for operating and rent expenses and received the right to 6,612 bushels of PIK corn as collateral. Later, Pearl City loaned the debtors an additional $3,300, using the PIK corn as collateral. Carroll Service Company sold the debtors supplies for the 1982 farming season worth over $40,000. By September 1983, the debtors still owed $13,972.44 on their 1982 bill and assigned Carroll Service 6,200 bushels of PIK corn toward payment. Later, expenses from the 1983 season came due and the debtors owed Carroll Service $32,196.03.

In October 1983, Esther Schmaling presented the document entitling her to the PIK corn to Johnston's Feed Service for payment. Payment was denied on the basis of a claim by the Bank of Freeport stating that it was entitled to the PIK payment because of its security agreement with the Schmalings. Thereafter, upon agreement of the parties to the dispute, the total amount of the proceeds that the debtors were entitled to receive under the PIK program-$99,343.44-was deposited in a trust account with the debtors' attorneys pending resolution of the respective priorities of the parties.

On March 9, 1984, the Schmalings filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. 11 U.S.C. § 1100 et seq. On March 30, 1984, they filed a complaint in the Bankruptcy Court for the Northern District of Illinois under § 544(a) of the Bankruptcy Code*fn1 to set aside a lien against them in favor of the First National Bank of Freeport. Esther Schmaling, the Carroll Service Company and the State Bank of Pearl City intervened as parties plaintiff.

The Bankruptcy Court found for the Bank. It concluded that, "although the agreement did not contemplate the not-as-yet-commenced Payment-in-Kind program and its coverage was intended to be broad so as [sic] cover all of the debtor's farm-related assets."

The United States district court affirmed. It found that because PIK payments are based on debtors' prior growing history, participants in the program in essence "'exchanged' their own corn for the PIK corn," thus making the PIK payments "proceeds."*fn2 A contrary result, the court found, would create a potential for fraud, as farmers could avoid a security agreement in crops merely by abandoning their farming activities and participating in a Payment-in-Kind program. We disagree.

I.

Because the Bankruptcy court found the Schmalings' intent to grant the Bank a security interest in all farm-related assets to be clear, it eschewed engaging in a "hypothetical bout over the meaning of the word 'crops.'" Schmaling v. First National Bank of Freeport, Mem. Op. No. 84-A-2037 (Bankr. N.D. Ill. 8/1/84). However, a security interest granted by a debtor to a creditor is limited strictly to the property or collateral described in the security agreement. See Allis Chalmers Corp. v. Staggs, 453 N.E.2d 145, 148, 117 Ill. App. 3d 428, 432, 72 Ill. Dec. 840 (1983); In re Martin Grinding & Machine Works, Inc., 42 Bankr. 888 (Bankr. N.D. Ill. 1984); R. Anderson, 8 TREATISE ON THE UNIFORM COMMERCIAL CODE § 9-203:15 at 668 (a "security agreement is not effective beyond its terms")(3d ed. 1980). Here, the security agreement does not refer to all farm-related assets. Rather, it grants the bank of a security interest in certain specific assets pertaining to the debtors' farm, including "corn and all other crops grown or ...


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