Bank With U.C.C. Security Interest In Deposit Account v. Garnishment Creditor: Who Has Priority?

In a commercial loan transaction, a bank is able to (and often does) obtain a perfected Uniform Commercial Code ("U.C.C.") security interest in a deposit account maintained by its borrower at the bank. A bank that has obtained such an interest may not think to worry about what would happen if it receives a garnishment summons from another creditor of that borrower (a "Garnishment Creditor"). In a recent case, however, a federal court ruled that a Garnishment Creditor trumped the bank's security interest in its borrower's deposit account because the bank failed to declare the borrower's loan in default and take affirmative steps to enforce its security interest before it received the garnishment summons. That case, American Home Assurance Co. v. Weaver Aggregate Transp., Inc., 84 F. Supp. 3d 1314 (M.D. Fla. 2015) (herein, "American Home"), concerns Illinois law, but it raises the question of whether the result would be the same under Virginia law.

The American Home Case

In American Home, the borrower's loans from the bank were secured by a deposit account at the bank pursuant to a business loan agreement and commercial security agreement. The bank's security interest was perfected via its control of the account, and the bank also had a right of setoff under the loan documents. Upon receipt of a writ of garnishment from a judgment creditor of the borrower, the bank declared the loan in default and asserted a superior right to the funds in the account by way of its perfected security interest.

The court ruled against the bank and for the Garnishment Creditor, stating that a "key question" in the case was whether the borrower's loan from the bank was in default at the time the garnishment was served on the bank.¹ In this regard, the court noted that the loan agreements stated that if an event of default occurred, then thereafter the bank "shall have all the rights of a secured party under the Illinois Uniform Commercial Code."²The court interpreted this language to mean that the bank "only takes on the rights of a secured creditor under the U.C.C. after a default occurs."³

The bank argued that entry of judgment against the borrower caused the bank to feel insecure and to believe that performance of the loan was impaired, both of which qualified as an event of default under the loan documents. The bank also argued that service of the garnishment was an event of default. The court, at length, dismissed the bank's arguments, focusing for example on (a) the fact that the judgment actually predated the loan, (b) the bank's failure after receiving the garnishment to conduct due diligence as to the borrower's financial condition, and (c) a bank vice president's inconsistent deposition testimony about the steps he did and didn't take after receiving the garnishment summons. The court concluded that -

the Bank's only steps have been to speak to the Bank's president and attorney, and that the Bank declared the loan in default after receiving the writ [of garnishment]. As a result, the Court finds that although the Bank has a prior perfected security interest, it is not entitled to a setoff.⁴

The court believed that its decision was also right as a matter of policy, quoting from another case that a bank cannot -

refuse to exercise its rights under a security agreement, thereby maintaining [the debtor] as a going concern, while it impairs the status of other creditors by preventing them from exercising valid liens.... [T]o do so would fly in the face of all of Article 9 [of the U.C.C.], which is premised on the debtor's ability to exercise rights in the property.⁵

In other words, in the court's view, in order for a bank to preserve its priority with respect to a deposit account, the bank not only has to have declared a default prior to receiving the garnishment, but it must also promptly pursue its default remedies.

We think American Home is wrongly decided both as a matter of policy and of U.C.C. interpretation. The policy argument is obvious when reading the court's concern about the bank "maintaining [the debtor] as a going concern": it's actually a good thing when banks work with their borrowers through difficult times, and a bank should not be put in a position of having to race to enforce its default remedies lest a court later declare that it had not done enough to preserve its priority. The court's approach, on the other hand, would (a) require a bank to undertake an excessive amount of due diligence in order to ensure that it is not caught by surprise with a garnishment summons, (b) incentivize the bank to adopt a hair-trigger approach to declaring defaults and enforcing remedies, and (c) create uncertainty as to just how diligent a bank has to be in declaring default and enforcing remedies, thereby creating more litigation between judgment creditors and banks. Obviously, that is a poor outcome as a matter of policy and could not have been the desire of the drafters of the U.C.C.

As for interpretation of the U.C.C., the court in American Home does not take into account all the applicable U.C.C. sections. For example, the court does not even mention U.C.C. section 9-205, which is in force in Illinois, as well as in Virginia (as Virginia Code § 8.9A-205), and provides in relevant part that a security interest -

is not invalid or fraudulent against creditors solely because:

(1) the debtor has the right or ability to:
(a) use, commingle, or dispose of all or part of the collateral...
(2) the secured party fails to require the debtor to account for proceeds or replace collateral.

Yet contrary to section 9-205, the ruling in American Home is that a bank's security interest in a deposit account is effectively invalid as to other creditors for so long as the bank allows its borrower to use the account.

Likewise, the American Home ruling does not consider U.C.C. section 9-104(b), which provides that a secured party can have "control" of a deposit account - i.e., a perfected security interest in the account - "even if the debtor retains the right to direct the disposition of the funds from the deposit account."

In sum, while the opinion in American Home may appeal to a lawyer's mind - with its focus on things like inconsistent deposition testimony and whether a party exercised due diligence - it is inconsistent with the U.C.C., which provides that a bank may allow its borrower to use its account without jeopardizing the priority of the bank's lien on the account.

What Would Happen in Virginia?

There are few reported cases in Virginia that shed light on this issue. The good news is that the few cases that do exist are generally favorable to a bank's position. For example, in C. W. Jackson Hauling Inc. v. Southern Eagle, 12 Va. Cir. 401 (1988), the Caroline County Circuit Court ruled that the bank's security interest in accounts receivable retained priority over a garnishment even though the judgment debtor was not in default to the bank. The court rejected the Garnishment Creditor's argument that because there was no default, the bank could not collect the accounts receivable, and therefore the bank's lien was "not applicable to these funds."⁶ The outcome was the result of the simple fact that the bank's existing security interest held priority over the Garnishment Creditor's lien. The court also rejected the Garnishment Creditor's argument that the bank had waived its lien position by allowing the judgment debtor to collect and use its accounts receivable. On this point, the court cited former Virginia Code section 8.9-205, which is not materially different from the portion of current Virginia Code § 8.9A-205 quoted above in this article.

In Smith v. Akers, 21 Va. Cir. 363 (1990), the Circuit Court for the City of Richmond ruled that a bank prevailed over a Garnishment Creditor with respect to funds in a checking account owned by the judgment debtor, citing "Virginia's rule that a bank has a lien on its depositors' funds."⁷ The court further noted that -

the right of set-off continues even after a writ of attachment or garnishment is served and whether or not the bank has formally "called" the default. Indeed, as the Federal Reserve Bank case implies, it is the DEBT, not the default, which creates the lien giving rise to the right of set-off. Accordingly, the judgment creditor's argument that the bank's right of set-off was lost because of the absence of a default notice is rejected.⁸

While Smith v. Akers is not a U.C.C. case, as the court ruled that the bank no longer had a U.C.C. security interest once a prior loan was extinguished, it nonetheless buttresses the view that a bank's priority position with respect to its borrower's deposit account is not subject to being trumped by a Garnishment Creditor. This view is further supported by Virginia Code section 8.9A-340(a), which in relevant part provides that "a bank with which a deposit account is maintained may exercise any right of recoupment or set-off against a secured party that holds a security interest in the deposit account."⁹ In other words, since section 8.9A-340(a) generally gives the bank's right of set-off priority over a secured party, it stands to reason that the right of set-off also has priority over a Garnishment Creditor's rights.

A final case worthy of note is National Acceptance Co. v. Virginia Capital Bank, 491 F. Supp. 1269 (E.D. Va. 1980). In that case, the bank, ironically, was in the position of the subordinate lienholder and had used a setoff to obtain money from the debtor's account. The superior lienholder, Mitsubishi - which held a U.C.C. security interest - argued that its lien precluded the setoff.¹⁰ The bank, similar to a Garnishment Creditor, argued that Mitsubishi (a) "had no right to any of the ... [account holders] property or proceeds thereof" because there had been no default under Mitsubishi's loan documents, and therefore the debtor retained the right to use its property, and (b) Mitsubishi had waived its security interest in the funds at issue by allowing the debtor to use them in the ordinary course of business. The court rejected the first argument as follows:

Under the UCC, a secured creditor clearly may not enforce his interest in collateral until such time as the debtor defaults. However, this is not to say that, until the debtor defaults, a secured party has no rights in the collateral sufficient to defeat the claims of other creditors to the collateral. The secured party's rights against conflicting claims to the collateral are determined not by the default of his debtor or his recognition thereof, but by the extent of his compliance with the various provisions of Article 9 governing the attachment and perfection of security interests and the priority of conflicting interests. ... Mitsubishi would, therefore, have acquired a continually perfected security interest in these proceeds at the moment ... [the debtor] acquired rights in them, whether or not the debtor was in default. Under these circumstances, this perfected security interest would be sufficient to defeat the claims of unsecured creditors to these proceeds, including the Bank's right of set-off, regardless of whether we find that this determination is governed by the UCC or Virginia common-law.¹¹

The court rejected the bank's second argument by citing former Virginia Code section 8.9-205, stating that "we find no waiver of Mitsubishi's security interest arising from its action in permitting ... [the debtor] to retain possession of the collateral, including proceeds, and to use them in the ordinary course of its business."¹²

Finally, the court in effect noted the benefit of its ruling from a policy perspective, stating as follows:

The priority of a perfected security interest is not affected by the fact that a secured party, in order to assist the debtor and to enhance the likelihood of satisfaction of any indebtedness, agreed not to declare the debtor in default. A secured creditor does not owe any duty to those holding subordinate interests to proceed to enforce his remedies. To hold otherwise would place an undue burden, not imposed under the UCC, upon debtors and creditors alike. Moreover, the rule which we adopt enhances the position of both prior and subordinate creditors. As the Bankruptcy Act itself recognizes, it is often in the best interest of all creditors that a financially unsound debtor continue in business with his assets intact, thereby generating revenues in excess of the value of the collateral to which both secured and unsecured creditors may look to satisfy their debtor's obligations.¹³

Therefore, while the bank lost to Mitsubishi, the case can be a valuable aid to a bank who in the future faces a challenge to its lien on a deposit account from a Garnishment Creditor.

Conclusion

The American Home case seems wrongly decided under the reasoning of Virginia cases interpreting the U.C.C., and we therefore think American Home is unlikely to be followed by a court applying Virginia law. Nonetheless, in a scenario involving a financially-troubled borrower that has significant funds flowing through an account on which the bank holds a lien, prudence may dictate that the bank take proactive measures in order to avoid the kind of judicial second guessing that the American Home court engaged in. These proactive measures might include, for example, stepped-up monitoring of the borrower's condition - especially whether the borrower is being sued by other creditors - and placing the borrower into default if allowed by the loan agreements.

[1] American Home, 84 F. Supp. 3d at 1320.
[2] Id. at 1326.
[3] Id.
[4] Id. at 1327 (emphasis in original).
[5] Id. at 1326.
[6] C. W. Jackson Hauling Inc., 12 Va. Cir. at 402.
[7] Smith, 21 Va. Cir. at 366.
[8] Id. at 366 n.3 (emphasis added).
[9] Under section 8.9A-340(c), the general rule that a set-off right has priority over a security interest does not apply if the secured party has perfected its security interest by becoming the bank's customer with respect to the deposit account.
[10] National Acceptance predated Virginia Code section 8.9A-340(a).
[11] National Acceptance, 491 F. Supp. at 1272-73 (citations omitted).
[12] Id. at 1273-74.
[13] Id. at 1276 (citation omitted)