Production contracts are becoming commonplace in agriculture today. And a recent consulting project I performed demonstrates what can happen when a contract goes bad.

The scenario
One of my producers, and several other area producers, agreed to grow a specialty crop for the 2002 season for a contractor. The crop was planted in one year and is normally harvested the second year too late to produce a crop in the second year. The contractor provided a letter detailing how the contract payments were to be calculated and tied those payments to production yields reported to the local FSA office.

Payment for 2002 was made when due. However, the payment amount for 2003 was apparently higher than the contractor expected. Even though terms of payment had been specified, the contractor apparently decided they were not to his benefit. One producer received a check for $1,500 less than the terms of his original agreement. Others, including my client, did not receive payment because they wouldn’t agree to the contractor’s new terms. Fortunately, the payment amount falls within the small-claims court rules. The contractor apparently has the resources to make the payments, so I’m sure my client will prevail. However, the contractor has the use of the client’s money — without interest — until the case is resolved.

Protect yourself
How can you avoid becoming a contract statistic? First, do your research. Get references from the contractor and check them out. Call the contractor’s neighbors and other area suppliers. Ask how quickly the contractor pays his bills, and if he or she has had problems with his contracts in the past.

Second, get a written contract and have it evaluated by your attorney and your financial consultant. Get answers to the following questions before you sign:

1.    How and when will you receive payment for the product?

2.    Do the products you are growing have a market other than with your contractor?

3.    Are there quality levels that affect your payment for your product?

4.    Is your contractor the end-user of your product or is he merely a subcontractor responsible to another entity?

5.    If your contractor is selling to another company? What terms and guarantees does he have with that company?

6.    What happens if your crop fails or the livestock that you are producing dies? Are you responsible for completing the contract even if you don’t have the product? 

7.    Is your contractor required to buy your product?

8.    How are disagreements resolved under the terms of the contract? Who is responsible for any legal fees if there is a dispute?

9.    Are you required to buy inputs from specific suppliers?

10.  What is the length of the contract? 

11.  Does the contract require the purchase of capital improvements that may extend beyond the life of the contract?

Don’t be shy about asking for financial data or guarantees from the contractor. His ability to pay is contingent on his financial strength. If the contractor doesn’t have a strong financial position, you may be at risk — especially if no other buyers for the product exist. On large multi-year pro-jects or projects with substantial risk of problems with payments, you may want to secure performance bonds or a stand-by letter of credit.

Some states have passed laws regulating production contracts. Check with your state department of agriculture to determine what guarantees you might have under prevailing state law.

As in all business agreements, if a deal sounds too good to be true, it probably is. Carefully investigate any contract arrangement prior to signing and make sure that you understand the financial risks and rewards.

Darrell Dunteman is an agricultural financial consultant and accountant with offices in Bushnell, Ill.