Picture this: A bank makes a loan to a borrower, and the bank’s collateral includes a security interest in the borrower’s deposit account maintained at the bank. All necessary loan paperwork is executed and filed, and the loan officer sleeps well knowing the funds in the borrower’s deposit account will go a long way toward satisfying the outstanding loan balance.
Fast forward: The borrower pays as promised for a few months. Then, the bank receives garnishment paperwork from a judgment creditor of the borrower. The paperwork identifies the bank as a garnishee defendant and instructs the bank to freeze the funds in the borrower’s deposit account so the same may be used to satisfy the judgment. Not only that, but the paperwork indicates if the bank does not act as instructed, it may be liable for the payment of the judgment. Now the loan officer is losing sleep over what she thought was a problem-free loan.
The loan officer should rest easy. As long as the bank takes appropriate steps in response to the garnishment paperwork, the bank’s perfected security interest in the deposit account will defeat any interest asserted by the judgment creditor. Why is that the case?
First, consider the bank’s interest. Article 9 of the Uniform Commercial Code governs the perfection of security interests in deposit accounts, indicating that such security interests may be perfected only by “control.” Indiana Code § 26-1-9.1-312. One way a bank can obtain control of a deposit account is by ensuring the deposit account is maintained at the bank. I.C. 26-1-9.1-104 and 26-1-9.1-314. Such perfection by control exists even if the depositor has the right to make withdrawals from the account, and even if the associated control agreement requires the bank to certify that a default has occurred before it can seize funds from the account. See id. A security interest held by a bank having control of a deposit account has priority over an interest held by a party that does not have control. I.C. 26-1-9.1-327.
Next, consider the interest of the judgment creditor seeking garnishment. Generally, a garnishment proceeding is a means by which a judgment creditor tries to reach property of its judgment debtor in the hands of a third person in order for that property to be applied to satisfy the judgment. See Freidline v. Thomalla, 852 N.E.2d 17, 20 (Ind. Ct. App. 2006). It is well-settled under Indiana law that a judgment creditor acquires an equitable lien on funds owed by a third party to the judgment debtor from the time the third party receives service of process in the garnishment proceeding. See Radiotelephone Co. of Indiana, Inc. v. Ford, 531 N.E.2d 238, 240 (Ind. Ct. App. 1988) (citing Butler v. Jaffray, 12 Ind. 504 (1859)). Accordingly, a third-party garnishee may be liable for paying out funds in a manner inconsistent with the judgment creditor’s lien. Id. at 241.
In the aforementioned hypothetical, the interests of the bank and judgment creditor are in direct conflict. If the bank must pay out funds from the deposit account, its prior perfected security interest is nullified. On the contrary, if the bank can use its perfected security interest as a shield to garnishment, the judgment creditor will be out of luck. So who wins?
The Court of Appeals of Indiana answered this question in Fifth Third Bank v. Peoples National Bank, 929 N.E.2d 210 (Ind. Ct. App. 2010). There, the trial court had ordered the bank to turn over deposited funds to the judgment creditor, ignoring the bank’s prior perfected deposit account security interest. See Peoples National Bank, 929 N.E.2d at 213. The bank appealed, arguing that its security interest trumped the judgment creditor’s equitable lien. Id. The Court of Appeals agreed with the bank, finding that “[a] garnishing creditor has no greater rights in the judgment debtor’s assets than does the judgment debtor.” Id. at 216. Since the judgment debtor’s rights were subject to the bank’s security interest, so too was any lien obtained by the judgment creditor. Id.
The Court of Appeals offered helpful guidance when explaining its decision. Specifically, it confirmed Indiana recognizes that the bank had a right to “set off” any amounts owed to it with funds in the deposit account, even after receiving the judgment creditor’s garnishment paperwork. Id. at 214-15. Practically, this means a bank does not lose its prior perfected security interest in a deposit account through a lack of control if it allows its depositor access to funds as part of a larger strategy to secure repayment of the depositor’s loan. Id. at 216. In Peoples National Bank, that meant the deposit account was not subject to garnishment, even though the depository bank did not immediately seize and apply its depositor’s funds after receiving the garnishment paperwork. See id. at 217.
The reasoning underpinning Peoples National Bank gives banks holding perfected deposit account security interests substantial deference in disputes with judgment creditors seeking to garnish such accounts. But banks should not get complacent. They can still put their perfected security interests, and their right to set off against deposited funds, in jeopardy if they fail to take proper action after receiving garnishment paperwork.
The case of Old Plank Trail Community Bank N.A. v. Mattcon General Contractors, Inc., 137 N.E.3d 308 (Ind. Ct. App. 2019), shows how it can go wrong for a bank that does not effectively assert its deposit account security interest. There, the Court of Appeals explained that in a garnishment proceeding, a judgment creditor has the initial burden of proving that funds are available for garnishment. Old Plank Trail, 137 N.E.3d at 311. The court clarified that once that burden is satisfied, the garnishee defendant must demonstrate a countervailing interest in the property or assert a defense to the garnishment. Id. The court also noted that a garnishee bank may waive its senior priority position if it remains silent or fails to act when there is a duty to do so in relation to the rights it seeks to assert. Id.
Unfortunately, the bank’s garnishment responses in Old Plank Trail did not reference any relevant loan documents, payment histories, statements of outstanding balances or notices of default underlying the set-off right it generically claimed. Id. Not only that, but the bank failed to appear at a garnishment hearing to present and prove its claimed set-off defense, despite being ordered to do so by the trial court. Id. at 311-12. The Court of Appeals thus determined the bank “had the duty, knowledge, and opportunity to present and prove the claimed defense,” but it failed to do so. Id. Under such circumstances, the Court of Appeals affirmed the trial court’s conclusion that the bank had waived its set-off right and thereby forfeited its prior perfected security interest in the account. Id. at 312.
So what is a bank to do if it receives garnishment paperwork aimed at garnishing funds held in a deposit account that is subject to the bank’s perfected security interest? The bank should feel confident that its security interest will overcome the judgment creditor’s equitable lien; however, the bank also should make sure to submit evidence of its security interest and attend any scheduled garnishment hearing to present and prove its set-off defense. Once these steps are taken, the loan officer can again rest easy.•
David Jurkiewicz is a partner at Bose McKinney & Evans. Opinions expressed are those of the author.