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March 14, 2018

Best Practices: Deposit Accounts as Collateral – What happens if the account is garnished by a judgment creditor?

by Lyndsay E. Rowland

It is not uncommon for a lender to take a security interest in a deposit account of a borrower as security for a loan. Normally, the lender will maintain the deposit account at their bank and permit the borrower to utilize the account so long as the borrower is not in default under the lender’s loan. However, questions may arise if the lender receives a writ of garnishment from a judgment creditor seeking to take the borrower’s funds in the account to be applied to the judgment. The lender may believe that it has a couple options in that scenario including; asserting its priority interest over the judgment creditor and allowing borrower to continue to use the funds, or asserting its priority interest over the judgment creditor and applying the funds to the loan outstanding to the lender. Either way, most secured lenders believe that their security interest will have priority over a judgment creditor’s garnishment, but that may not always be the case.

First and foremost, lenders who are taking security interests in deposit accounts should ensure that they have perfected their lien in the borrower’s deposit account. Pursuant to Article 9 of the Uniform Commercial Code (“UCC”), a lender who has control of a deposit account, meaning the account is maintained at their institution, has perfected their lien in that account. UCC ยง9-104. Section 317 of the UCC clearly sets forth that the secured creditor should have priority in the property of the borrower provided that its perfected its secured interest prior to the judgment creditor’s interest arising.

However, a borrower may end up with a judgment against it from another creditor who then serves a writ of garnishment on a lender bank that has control over the borrower’s deposit accounts. Case law from across the country reflects that courts have come to different results as to whether the secured creditor or the judgment creditor has priority in the deposit account.

In American Home Assurance Co. v. Weaver Aggregate Transport Inc., 84 F. Supp. 3d 1314 (M.D. Fla. 2015), Florida court applying Illinois law held that a secured creditor with possession of a deposit account that had not declared the borrower in default under the terms of the loan at the time that the writ of garnishment was received by the secured creditor, the judgment creditor was entitled to the funds in the account rather than the secured creditor.

In contrast, the U.S. Court of Appeals for the Eighth Circuit held in, Frierson v. United Farm Agency, 868 F. 2d 302 (8th Cir. 1989), that a secured lender holding an account of a borrower that was subject to a garnishment could take the funds in the account and apply it to their loan because the judgment against the borrower was a technical default under the secured lender’s security agreement. The court went on to say that if the secured lender was not going to apply the funds from the deposit account to its outstanding loan then the money should go to the judgment creditor. This essentially created a “take it or lose it” scenario for the secured creditor.

In yet another interpretation of the law on these facts, the Nebraska Supreme Court held in Myers v. Christensen, 776 N.W.2d 201 (Neb. 2009), that a bank that had a perfected security interest the in the accounts of a borrower, and who could technically declare the loan to be in default pursuant to the terms of the security agreement, and thereby apply the funds from the account to the loan, did not have to do so, could still honor the borrowers checks on the account, and did not have to turn any funds over to the judgment creditor that had garnished the bank accounts. This approach essentially establishes that a secured creditor had an absolute right in a deposit account over the claims of a judgment creditor.

This divergence of results from various courts highlights the need for lenders to review the language of their loan documents in connection with the laws of the state in which loan is being made and pay particular attention to the choice of law provisions in the security agreement. This will not only benefit the lender at the time the loan is closed, but ensure that the lender maintains its priority in the borrowers deposit accounts that it holds in the event of a loan liquidation. For more information regarding garnishments of deposit accounts feel free to contact Lyndsay at 267-470-1154 or at lrowland@starfieldsmith.com.