By STEVE JOHNSON

ISU farm management specialist

What are the legal options if farmers cannot fulfill their contracts in a drought year?

Many Iowa farmers have entered into forward cash or hedge-to-arrive contracts with grain merchandisers. These are agreements between the buyer and seller of grain for delivery of a certain quality and quantity of grain at a specified time and price.

These contracts are legally enforceable agreements, thus farmers who fail to deliver or are forced to delay delivery may face some serious penalties under the terms of the contract.

Not all grain contracts are the same. Each grain merchandiser uses different language and provisions when contracting with sellers.

However, most grain contracts in Iowa are governed by Iowa’s Uniform Commercial Code. The Statute of Frauds, found in Article 2, requires contracts for the sale of goods over $500 should be in writing to be enforceable in Iowa.

Contract terms

If sellers doubt their ability to perform under the forward cash contracts, they should first look to the terms of the contract to see if it addresses the potential for default or excuses delay of delivery under certain conditions.

While it is not very common, a contract may have what is termed a “force majeure” clause allowing a party to delay or suspend performance under the contract due to an “act of God” or “event that can be neither anticipated nor controlled,” so long as the party used its best efforts to perform on a contract.

In the likely event that a contract does not contain such a clause, a producer fearing default may also want to see if the contract contains a clause dealing with “underdelivery.”

The National Grain and Feed Association, a non-profit trade association whose members include elevators, feed mills, cash grain merchandisers, grain processors and biofuels producers, has published a sample grain contract on its website at www.ngfa.org. The sample NGFA contract contains a clause called “Settlement for Underdeliveries.”

Work with buyers

In short, the clause provides that if a seller of grain discovers that he/she will not be able to deliver the contracted amount and quality of grain, then it is the duty of the seller to advise the buyer immediately. The buyer may elect to agree to an extension of time for the seller to deliver or cancel the contract all together-requiring the seller to essentially compensate the buyer for the buyer’s losses with the difference between the contract price and the replacement value of the commodity.

A few examples include:

• A farmer forward contracted 2012 corn earlier this year when the December corn futures price was $6 a bushel. Now, the market has jumped to $8 a bushel and the farmer wants to get out of the $6 contract. The farmer will have a reduced crop, but is still going to produce enough corn to be able to deliver on the $6 contract.

Legal outcome: The farmer, in this case, lacks the requisite good faith required for the defense of “commercial impracticability.” Generally, there is no excuse, under the law, for defaulting on the contracts in this situation. Some courts have held that breaching a contract for “trivial and insubstantial” reasons as an excuse for release from a contract constitutes “bad faith.”

• A farmer forward contracted corn from the 2012 crop, but now the drought has severely reduced the farmer’s 2012 production to the point that he/she isn’t able to deliver that amount.

Legal outcome: Once the farmer realizes he/she cannot deliver all the bushels contracted, they should work with the grain merchandiser on a strategy to make up the shortfall in bushels or pay the replacement value of those bushels. The solution will vary by grain merchandiser and whether a cash-forward contract or hedge-to-arrive contract was used. Generally, the farmer would have the option of buying out the missing bushels at the current market price.

Given adequate notice, the merchandiser will attempt to replace the contracted bushels by purchasing bushels elsewhere.

However, the farmer who contracted those bushels should still expect to pay the replacement value for those bushels. That is the difference between the CME futures price at the time the contract was initiated subtracted from the CME futures price at the time of settlement.

In addition, a small cancellation fee will likely be charged. So, if the CME price at the time of the contract for corn was initiated was $6 per bushel and the futures price at settlement is $8 per bushel, the difference is $2 per bushel plus a 10-cent service fee, which equals $2.10 per bushel total cost.

Revenue protection

The vast majority of Iowa’s row crops are insured using revenue protection. This coverage provides for any shortfall in revenue guaranteed bushels at the higher of the harvest price or projected price.

Since the harvest price will be higher in 2012, revenue protection losses will be known approximately Oct. 31. If not done prior to this date, settlement for the replacement value of undelivered bushels should be negotiated at that time, regardless if bushels were to be delivered at a later date.

Since the farmer will likely have other bushels to be delivered to this grain facility, the merchandiser will simply subtract the replacement cost of $2.10 per bushel from the total sales receipts.

Delaying settlement beyond early November leaves the farmer in a speculative position for those bushels that they were unable to deliver. Should the futures price move even higher beyond this time frame, the replacement cost would increase.

Regardless, the need to work with the merchandiser is critical if a grain grower falls short on contracted bushels.