How Food Contamination Could Spoil Your Security Interest

a. The Food Safety Modernization Act

The U.S. Food and Drug Administration Food Safety Modernization Act (“FSMA”) was enacted in order to better protect public health by strengthening the food safety system. The FSMA significantly broadens the FDA’s authority to regulate and oversee the growing, production, transportation, and distribution of food products. Although originally enacted in 2011, the first of the final rules were submitted for publishing at the end of August 2015.

The FSMA provides the FDA with the authority to suspend a food facility’s registration and the authority to recall food. Before the FSMA was enacted, a food facility always had the opportunity to recall its product voluntarily. However, under the new regulations, the FDA may order a mandatory recall if it believes that an article of food may be contaminated or misbranded or the product may cause serious adverse health consequences or death. Additionally, the new regulations give the FDA the power to order an administrative detention, whereby the FDA may detain an article of food for up to 30 calendar days until it decides to either release or seize the product.

Often times in a recall, the food facility is required to use an authorized method of destruction of the product. Other times, food facilities may be ordered to “recondition” the product, which allows the facility to break down the item into smaller parts so non-defective parts may be reused.

b. How the Food Safety Modernization Act Affects Lenders

The Act and the newly issued final regulations raise the issue of what may happen to a lender’s security interest if the FDA issues a mandatory recall or imposes an administrative detention on a food facility debtor’s inventory.

Traditionally, if collateral is damaged or destroyed but covered by an insurance policy, a secured party should be entitled to payments made under the policy either as “proceeds” of its security interest or as an additional named beneficiary under the policy. On the other hand, if the collateral is not insured and has no salvage value that can be realized, the secured party would be unable to look to the collateral to satisfy the debt. Therefore, if the FDA were to order the destruction of a food facility debtor’s product, a lender may have to rely on the insurance proceeds, if any, to apply to the outstanding loan, rather than on the proceeds that otherwise might have been realized on a sale of the collateral. Thus, the lender may find that what it thought was a well-collaterized loan in fact may become under secured.

Since any proceeds that result from the sale of collateral should constitute “proceeds” of such collateral, if there is any salvage value to a reconditioned product, a lender may recover the “proceeds” of its security interest. This, at least, may somewhat mitigate the adverse impact on the lender and its security. Further, the lender should investigate whether payments are available under any applicable insurance policy for the partial loss in value.

In evaluating the risk of lending to certain food facilities, a lender may want to review FDA warning letters issued to a facility to determine the potential risk of recall or detention. Although not a guarantee, it is probable that facilities with frequent and serious offenses are more likely to be subject to a recall or detention than those with no prior offenses.

In order to protect its security interest in the collateral, lenders should also (1) consider requiring a food facility debtor to insure its inventory and reviewing the policy to determine whether mandatory recalls or administrative detentions are insured events, and (2) confirm that its security agreement contains language that specifically references the right of the lender to receive all proceeds of the insured inventory. Although lenders have no control over the future actions of the FDA under the Act and its regulations, with the proper precautions a lender may lessen the risks to its security interest in the event of a mandatory recall or administrative detention.

If you have any questions or need assistance, please contact one of Woods Aitken's Banking and Financial Institutions attorneys. For additional banking and financial news, tips, and updates, we encourage you to view our Financial Institution E-Brief archives.