June 24, 2019

Tenth Circuit: Debt for Principal Residence Arises out of Farming Operation if It is Directly and Substantially Connected to Activities Constituting a “Farming Operation” Within 11 U.S.C. § 101(21)

The Tenth Circuit Court of Appeals published its opinion in First National Bank of Durango v. Woods on Wednesday, February 19, 2014.

Debtors were a husband and wife who purchased farmland in Colorado on which to ran their hay-farming operation. Until they filed for bankruptcy, they accumulated various debts, some of which were related to their farming operation and others of which were not. One such debt was a $480,000 loan Debtors obtained from First National Bank. Approximately $284,000 of this loan was used to pay off a loan from another bank that was obtained to purchase Debtors’ farmland. The parties did not dispute that this portion of the debt “arose out of” a farming operation; nor did they dispute that the majority of the remaining loan proceeds—what we called the “construction loan”—were used to construct Debtors’ principal residence on the farmland.

It was the construction loan that was the primary focus. This was because Debtors petitioned for Chapter 12 relief as family farmers. From the outset of this case—and again on appeal—First National Bank maintained that, if the construction loan was excluded from the debt total because it did not “arise out of” a farming operation, less than fifty percent of Debtors’ aggregate noncontingent, liquidated debts “arose out of” a farming operation, which would preclude Debtors from qualifying as family farmers. And, if Debtors were not “family farmers,” they could not seek relief under Chapter 12.

The bankruptcy court concluded that the construction loan should be included in the debt total under § 101(18)(A) because it arose from farm operations. The BAP agreed with the bankruptcy court that the construction loan arose out of a farming operation. The Bank appealed.

Although First National Bank raised several issues on appeal, the Tenth Circuit only reached the first: whether Debtors were permitted to seek relief under Chapter 12 as “family farmers.” In deciding this issue, the court was presented with a question of first impression for the Tenth Circuit — namely, when does a debt “for” a principal residence “arise[] out of a farming operation”? See 11 U.S.C. § 101(18)(A).

The Tenth Circuit concluded that a debt so arises if it is directly and substantially connected to any of the activities constituting a “farming operation” within the meaning of 11 U.S.C. § 101(21). More specifically, when the debt at issue is loan debt, as here, the court concluded that an objective “direct-use” test serves as the optimal vehicle for discerning when the direct-and-substantial-connection standard is satisfied. That is, if the loan proceeds were used directly for or in a farming operation, the debt “arises out of” that farming operation. This was not the test applied by the bankruptcy court (or the BAP).

Because the court concluded that the bankruptcy court did not apply the proper legal standard and test in its analysis of Debtors’ eligibility for Chapter 12 relief, the Tenth Circuit VACATED the bankruptcy court’s judgment and REMANDED the case to the bankruptcy court for further proceedings.