Set-Off Versus Garnishment: Rights To And Priorities In Deposit Accounts

Fifth Third Bank v. Peoples National Bank, 210 Ind. App. LEXIS 952 (Ind. Ct. App. 2010) (.pdf) outlines a plethora of legal principles related to judgment enforcement generally and garnishment proceedings specifically.  The opinion analyzes a priority dispute between one lender, which had a judgment lien in a checking account, and a second lender, which had a security interest in the same account.

The parties and the account.  An accounting firm, OMS, opened a checking account with Fifth Third.  Fifth Third also loaned OMS approximately $1.5MM, secured in part by the same account.  Years later, Peoples obtained a judgment against OMS in the amount of $64,000.  About the same time, OMS defaulted on the Fifth Third loan.  Fifth Third did not initially freeze the OMS checking account.  Meanwhile, Peoples initiated proceedings supplemental against OMS and named Fifth Third as a garnishee defendant.  Although Fifth Third did not at first disclose to Peoples that OMS had the account, it subsequently identified the account and froze it.  In a separate suit, Fifth Third soon thereafter got its own judgment against OMS.

Competing interests.  The Court in Fifth Third noted that, under Indiana law, a judgment creditor (here, Peoples) acquires an equitable lien “on funds owed by a third party [here, Fifth Third] to the judgment debtor [here, OMS] from the time the third party receives service of process in proceedings supplemental.”  The third party (here, Fifth Third) may be “liable for paying out funds in a manner inconsistent with the judgment creditor’s lien.”  On the other hand, Indiana recognizes a right of depositary bank (here, Fifth Third) to set-off any amounts owed to it with funds from its “indebted depositors’ [here, OMS’s] account after receipt of notice of garnishment proceedings.”  The pivotal rule proved to be:  a garnishing creditor (here, Peoples) “has no greater rights in the judgment debtor’s [here, OMS’s] assets than the judgment debtor does.” 

General rule of priority.  In Fifth Third, the “first in time is first in right” rule applied.  Fifth Third, a secured creditor with a perfected prior security interest in the deposit account, had rights that were superior to Peoples, a subsequent judgment (unsecured) creditor.  At the time of the loan default, OMS owed Fifth Third in excess of $470,000, which was the account balance at the time in question.  Once OMS defaulted, Indiana law entitled Fifth Third to exercise the remedy of self-help in order to apply the balance of the deposit account to the indebtedness owed under the security agreement.

Compelled to set-off?  Peoples asserted various equitable arguments against Fifth Third’s position.  Peoples contended that, by not immediately exercising the right to set-off, Fifth Third lost its superior priority status and should have been foreclosed from attempting to belatedly enforce its right to the account.  Under the UCC, a secured party holding a perfected security interest in a deposit account “may set-off or apply the balance of the deposit account to the loan obligation secured by the deposit account.”  Again, Peoples, the garnishing creditor, had no greater rights in OMS’s assets than did OMS.  OMS owed Fifth Third in excess of $1MM.  The OMS deposit account contained only $470,000.  As such, OMS’s rights in the deposit account “were extremely subject to” Fifth Third’s security interest.  According to Fifth Third, a failure to exercise set-off will not result in a subordination of those rights to the rights of a garnishing creditor.

Compelled to freeze?  Peoples also claimed that Fifth Third lost its superior priority status when Fifth Third continued to honor checks drawn on the deposit account after the OMS loan default.  Fifth Third’s security interest was automatically perfected by its “control” over the account.  Ind. Code § 26-1-9.1-104 provides that the requisite “control” over the account exists even if the debtor retains the right to direct the disposition of the funds in the account.  Fifth Third’s decision to allow OMS to reach the funds was not inconsistent with the required “control” for purposes of automatic perfection.  Banks have “the latitude to allow their indebted depositors to have reasonable access to funds, which may enable them to continue to operate and generate revenue that may be applied to their existing indebtedness.”  Under circumstances like those in Fifth Third, the failure to freeze an account that is subject to set-off will not permit a garnishing creditor to assume senior status.