Banks and their commercial customers often enter loan agreements which give the bank the right to set-off or “swipe” the customer’s account if the customer defaults on a loan. The boilerplate loan documents will typically list as a default event, a judgment creditor of the customer attempting to attach the account funds.
The loan and security agreement will also give the bank “first dibs” on those funds: the bank can liquidate the account and apply the funds to the customer’s outstanding loan balance. This creates a classic priority dispute: the judgment creditor wants the customer’s account (because that is likely the only hope for recovering any monies) while the bank wants the same funds so it can salvage its loan rights.
One CW, LLC v. Cartridge World, 661 F.Supp.2d 931 (N.D.Ill. 2009) involves a priority dispute in a franchise suit. The plaintiff, a prospective franchisee, sued and obtained an arbitration award against the seller and entered the judgment (about $360K) in Federal court. The plaintiff then issued a third-party citation against the defendant/seller’s bank and sought turnover of over $81K held in the defendant’s bank account. The bank claimed priority to the entire funds pursuant to both a UCC filing against the defendant’s assets and under Code Section 12-708 which governs a third party citation respondent’s set-off rights. 735 ILCS 5/12-708.
In finding for the plaintiff creditor, the Court harmonized the various Illinois Code sections and some cases that govern post-judgment or supplementary proceedings. See 735 ILCS 5/2-1402 (governs citation proceedings); SCR 277 (same). The key rules:
– a judgment lien is created in a judgment debtor’s nonexempt assets upon proper service of a citation. Section 2-1402(m);
– citations may be served upon the judgment debtor or a third party (usually a bank) that has personal property of the debtor in its possession. 2-1402(m)(2);
– the citation lien that’s created upon service of a citation doesn’t affect the rights of citation respondents in property prior to service of the citation. 2-1402(m);
– a third party who violates the citation restraining provision (by not freezing the account, e.g.), can have judgment entered against it for – lesser of – unpaid judgment amount or in the amount of any property transferred. 2-1402(f)(1);
– a third-party citation respondent has a right to clam all set-offs against the judgment creditor that it could assert against the debtor and must hold, subject to court order, any non-exempt property of the debtor in the respondent’s possession. 12-707(a);
– the third-party respondent must also file a written answer (to the garnishment interrogatories) under oath, that states any property or indebtedness due or to become due the debtor in the third party’s possession or control. 12-707(b);
– a third-party respondent can exercise its set-off rights and deduct from a debtor’s deposit account amounts owing on a note even if the note is not yet due;
– the bank does not have to first proceed against an account holder’s collateral securing the loan before exercising its set-off rights.
Applying these rules, the Court found that the third-party respondent bank failed to properly assert its prior security interest rights by unfreezing the debtor’s assets without court approval and by taking no action to foreclose on its security interest in the debtor’s bank account.
The Court also held that the bank lost its set-off rights by failing to comply with the third-party citation. The Court pointed out that the bank failed to take any steps to exercise its set-off rights such as accelerating the debtor’s defaulted loan and also failed to properly freeze the debtor’s account as required by the text of the third-party citation order and Section 2-1402(f)(1) and 2-1402(m).
Creditor’s counsel should be leery of Section 12-708’s set-off provision and the caselaw’s expansive application of a third-party’s set-off rights. If a bank has a prior loan to an account holder/debtor, it can likely claim a set-off in the amount in default. It seems the best you can do as a creditor attorney in this situation is to have the bank prove that it is swiping the debtor’s funds and actually crediting the funds against the loan balance.
From the third-party respondent/bank’s vantage point – it should exercise all security interest rights by taking possession of a debtor’s collateral and applying the account funds to the outstanding loan balance. The responding bank should also timely and properly answer a creditor’s garnishment interrogatories and immediately assert its set-off rights in the debtor’s account funds.