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 responds appropriately to the garnishment paperwork, the bank’s 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. Under the Uni form Commercial Code, security interests in deposit accounts may be perfected only by “control.”1Ind. 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.2Ind. Code §§ 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 a loan default must occur before the bank can seize funds from the account.3See 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.4Ind. Code § 26-1-9.1-327
Next, consider the interest of the judgment creditor seeking garnishment. Through garnishment the judgment creditor is trying to reach funds of its judgment debtor in the hands of the bank in order for those funds to be applied to satisfy the judgment.5See 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.6See 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.7Id. 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?
This question was answered 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.8See Peoples National Bank, 929 N.E.2d at 213 The bank appealed, arguing that its security interest trumped the judgment creditor’s equitable lien.9Id. 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.”10Id. 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.11Id. As such, 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.12Id. at 214-15
Despite this favorable precedent, banks must be prepared to take action to assert their rights. 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 after a judgment creditor establishes there are funds available for garnishment, the garnishee defendant must demonstrate a countervailing interest in the property or assert a defense to the garnishment.13Old Plank Trail, 137 N.E.3d at 311 If a garnishee bank does not do this, it may waive its senior priority position by remaining silent or failing to act when there is a duty to do so in relation to the rights it seeks to assert.14Id.
Unfortunately, the bank’s garnishment responses in Old Plank Trail did not reference any loan documents, payment histories or notices of default underlying the set-off right it generically claimed.15Id. 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.16Id. at 311-12 Under such circumstances, the bank was found to have waived its set-off right, and thereby forfeited its prior perfected security interest in the account.17Id. at 312
So, what is a bank to do if it receives garnishment paperwork targeting 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 must 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.
This article exists for informational purposes only, and none of its contents should be construed or used as legal advice on any specific facts or circumstances. You should consult with an attorney admitted to practice law in your state regarding your specific legal issues.
