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Business Law Quarterly—First Quarter 2011

First Quarter 2011

Editor’s Column

Welcome to the Business Law Quarterly for 1st Quarter of 2011. We would appreciate hearing from any of our readers who would prefer to receive the BLQ via email, rather than in hard copy. Please let us know if we should email this to you—we’d be happy to do so.

That said, I will admit that I am much more likely to read something if it comes printed on paper. I find it is usually easier to read and more portable. I commute via METRA, so I have several hours a week to read on the train. I can read things on my Blackberry, but I tend to skip the longer messages until I can sit at a computer. Also, once in a while I want to save an article and it’s simple to  tear it out, rather than have to print it. Moreover, email is often distracting. Peter Drucker observes that it is hard to get any real work done unless you have a substantial block of time set aside for it. He points out that two hours worth of work is very difficult to do in installments of 15 minutes interrupted by other activities. It would be nice to hear from any of our readers who have found a way to manage email so that it doesn’t present these problems.

Another topic which we think might be interesting for readers is the subject of water. Most people in the Chicago area aren’t aware that water resources here are beginning to be under stress. We all see Lake Michigan and think we’ve got all the water we’ll ever need, but that isn’t true. Some who live in the suburbs have already experienced water rationing in the form of lawn watering limitations during summer months. If you’d like to hear more on this subject, please let us know.

In March, the fourth annual Reuters HedgeWorld and Dykema Insolvency Outlook Survey was released. The survey showed increasing willingness of hedge funds to provide capital to financially troubled companies, even though the risk profiles of such companies are expected to rise and become riskier. The willingness to provide capital is at least partly due to hedge funds looking to capitalize on higher rates charged to riskier companies. 62 percent of respondents with such investments said they saw them increase in value during 2010. The survey also showed an increase in “loan to own” strategies in which hedge funds make loans to financially troubled companies in pursuit of acquiring equity in the companies. For details and more, please visit click here to access the 2011 Insolvency Survey.

Since I mentioned Peter Drucker, I will recommend his book The Effective Executive. It is not long and an easy to read. An executive, says Drucker, is someone who is a knowledge worker and whose position or knowledge make him or responsible for a contribution that materially affects the capacity of the organization to perform and obtain results. The executive is expected to get the right things done within the organization (or at least his or her part of it). The book is about learning the skills for that.

Andrew Connor, 312-627-2264 


When Does a Remedy Fail Its Essential Purpose?

Article 2 of the Uniform Commercial Code says that in a sales contract, a seller can limit a buyer’s remedies to the repair or replacement of nonconforming goods, but such a limited remedy is said to have “failed of its essential purpose” when the seller can’t, or won’t, fix the goods within a reasonable amount of time or a reasonable number of attempts. When the limited remedy fails, the buyer is free to pursue other avenues of relief under the UCC.

For example, the buyer could then seek breach of warranty damages: i.e., the difference between the value of the goods as accepted and the value that the goods would have had if they had been as warranted. Other remedies under the UCC include incidental and consequential damages. But a seller can disclaim such remedies in the sales contract, and such damages might not be available to a buyer even after the limited remedy has failed of its essential purpose. Unfortunately, judicial application of this part of the UCC has been less than uniform.

One case highlighted in our last issue of the Business Law Quarterly, Turner Envirologic, Inc. v. Griffin Industries, Inc., provides an example of a court deciding to flunk an exclusive remedy of repair or replacement. The seller of certain environmental equipment made only temporary fixes to the equipment and then abandoned its repair attempts altogether less than a year after the sale. Because the seller refused to provide the limited remedy that it promised, the court refused to enforce the seller’s restriction on other remedies. Where the decision left the beaten path was in allowing the buyer to revoke acceptance and recover the full purchase price, rather than granting typical breach of warranty damages.

In addition, the Turner Envirologic court awarded incidental damages to compensate the buyer for its own efforts to repair the defective equipment after the seller stopped trying. Although the seller had disclaimed liability for such incidental damages, that disclaimer was knocked down by the court together with the repair-or-replace remedy that failed of its essential purpose. This approach to dealing with a disclaimer of incidental or consequential damages, i.e., striking it down whenever the underlying limited remedy fails, is called the “dependent” approach.

According to the Illinois Supreme Court, a majority of states that have considered the issue take the opposite, “independent” approach, upholding a disclaimer of incidental or consequential damages despite failure of the limited remedy, unless the disclaimer is separately found to be unconscionable (either as written or as applied). In Razor v. Hyundai, the court disparaged the dependent approach for rendering incidental or consequential damage disclaimers utterly pointless: they aren’t needed if a limited remedy works, and they are struck down if the limited remedy fails. Instead, the court reasoned, the limited remedy should be seen as an outer wall of defense against a buyer’s claims, and the disclaimer of consequential and incidental damages as an inner wall, to be confronted after the limited remedy has failed of its essential purpose. The applicable UCC provisions appear to support this view, establishing a separate test of unconscionability, for a buyer to be able to avoid an incidental or consequential damage disclaimer.

The availability of consequential and incidental damages is moot under any approach, however, unless a limited remedy has failed of its essential purpose. So, what constitutes a failure of essential purpose? Certainly, a seller’s refusal to repair or replace non-conforming goods, as was the case in Turner Envirologic, meets the test. But, even if a seller keeps trying to fix defective goods, a court can deem a limited warranty to have failed of its essential purpose if the goods remain non-conforming after a reasonable amount of time or number of repair attempts.

Luckily for sellers, many courts appear willing to cut them slack when diligent repair efforts are made or the underlying goods are relatively complex. For instance, in Computer Network v. AM General, a Michigan court of appeals upheld a limited warranty despite the need for multiple repairs to a vehicle, because the repairs were always made in a timely manner and rarely were repeat repairs. In Delmarva Power & L. v. ABB Twr. T&D, the Delaware Supreme Court refused to hold that two months was an unreasonable amount of time to fix a static excitation system, or “exciter,” that was installed on the rotor of an electrical power generator. The court found that the seller had been “notoriously diligent” in its repair attempts, and that the equipment was too complex to expect it to work immediately, without modification, when it was first hooked up to the generator.

Still, sellers do not have an endless amount of time to fix non-conforming goods, even if the goods are complex or the repair attempts vigilant. In the Ninth Circuit case Milgard Tempering, Inc. v. Selas Corp. of Am., the court found that two and a half years was too long to bring a glass tempering furnace fully online. Although the furnace design was understood by the parties to be complex, even experimental, and although the seller’s attempts to fix the furnace were “intense,” the buyer still did not have an operational furnace almost three years after the sale. That delay, said the court, was unreasonable. The sale contract had contemplated a “debugging” period of only a few months, and although the product was “cutting edge,” the court ruled that the buyer had not paid for the furnace “in order to participate in a science experiment.”

In conclusion, a limited warranty can be effective when a seller takes it seriously. Sellers must be diligent in their repair attempts under contracts that limit buyer remedies. Sellers should also make clear in writing that disclaimers of consequential and incidental damages are independent of the limited remedy to repair or replace defective goods. But at the end of the day, if a product is unfixable and a disclaimer unconscionable under the circumstances, a seller’s contractual ramparts may still come tumbling down.

Sean P. Dudley, 312-627-2298

Records Retention—Time to Review Your Practices

Have you looked at your Record Retention Policy (RRP) lately? If you haven’t looked at it in the past few years, it’s time for an update. Many companies have RRPs that date back years—or decades—but a lot has happened just in the past few years. In 2001, the International Standards Organization issued ISO 15489:2001, which sets a reference standard for information management. ISO 15489:2001 sets out the essential elements of a modern record retention, indexing, and retrieval program. In 2003 and 2004, the Zubulake v. UBS Warburg, 220 F.R.D. 212 (S.D.N.Y. 2003) and Rambus v. Infineon, 220 F.R.D. 264 (E.D. Va. 2004) cases institutionalized the notion of the “litigation hold,” a memorandum that tells employees that an RRP is suspended for certain records (or categories of records). In 2006, the Supreme Court modified the Federal Rules of Civil Procedure to provide safe harbor from discovery sanctions for parties that take reasonable steps to arrest the automatic destruction of electronic data. And from 2006 to the present the number of cases in which litigants attempted to obtain sanctions against other parties has skyrocketed. And even if none of this had happened, the radical shift from paper to electronic communication has rendered older RRPs obsolete.

Contrary to popular belief, RRPs are not primarily designed to destroy potential future evidence. RRPs are intended to preserve records as long as they need to be preserved—and provide for the retirement of records that either have no usefulness or whose usefulness is outweighed by the costs and risks of storing them. It is tempting to assume that documents will be useful “someday” or to conclude that CDs and DVDs are efficient storage media. But it’s not just the real estate costs. For records to be truly useful, even when compressed into electronic format, they must fit into an indexing and retrieval scheme that allows needed content to be retrieved and used. Many organizations carry large amounts of data in offsite storage—with indexing insufficient to identify contents of various files. From a cost/benefit standpoint, this could be just as bad as throwing things away. And when it comes to regulatory investigations, data that no longer has a business purpose can provoke additional scrutiny and risk.

RRPs consist of a master policy, one or more schedules, a hold mechanism, and corresponding accommodations in IT policies that facilitate (rather than inhibit) the action of the RRP. If you are missing one of these components, you should evaluate whether your policy needs to be reconstructed—whether in part or from the ground up.

  • The master policy sets forth the purpose of the policy, who will enforce the policy, what constitutes a record (and optionally, what does not), and how records will be stored or retired. The schedules set out record types (or functions), a triggering event, and the retention period.
  • Retention schedules are defined by statutes of limitations, audit requirements, regulatory requirements, and in the end, risk-utility balancing decisions. RRPs should be media-neutral—with their focus on content (e.g., items received in email are not “email,” but instead things like correspondence, contracts, etc.). Records should be assigned retention periods based on their usefulness to the business, regulatory requirements, and potential litigation considerations. In addition to specifying retention periods, retention schedules should specify an appropriate record media for the actual record. This serves two purposes: helping employees identify the original record (as opposed to a copy that can be discarded immediately) and specifying a storage method reasonably tailored to how long the information needs to be kept. Setting up schedules is not a cut-and-paste operation; it requires input from various departments, outside financial auditors, and company risk managers. The granularity of these schedules should be tailored to the organization’s need and what information it uses on a day-by-day basis.
  • The hold mechanism is described in the policy and backed with a memorandum that can be distributed instantly to those who need to preserve documents, or who can identify people who need to preserve them. You should have a form memorandum in hand describing what to do with data stored on specific company systems that can be quickly customized for a new matter or investigation.
  • Complementary IT policies are ones that allow users to safely remove records from places where they may be automatically deleted (such as email accounts) in contravention of the prescribed periods. Part of this is examining practices such as time-based auto-deletion and “email jail,” which either automatically destroy potential records or incentivize employees to destroy records. And employees should be able to move items out of their email into storage smoothly and in the regular course of business. IT policies should also exist on the back end to facilitate preservation of data in response to a hold.

Keep in mind that, if handled improperly, RRPs can be hazardous to your business. You could lose (or at least be unable to easily locate) information that you need for your business or to pursue your side of a lawsuit. Also, inconsistency in application could result in claims that you don’t really have an RRP and that you spoliated materials that were relevant to a lawsuit or an investigation.

On the other hand, RRPs are not for everyone. Some businesses don’t have a practical use for them, especially in situations where an organization’s small size, minimal records generation, or low litigation vulnerability put an RRP on the wrong side of a cost-benefit analysis. Some organizations lack the discipline to apply them in a uniform manner—which could lead to claims by litigation opponents that there really isn’t a policy at all. But most businesses in the medium-to-large size range utilize them to prevent information (and storage) overflow and to make information easier to retrieve.

If your organization’s current RRPs and associated policies are cause for concern, please feel free to contact your Dykema relationship manager, or Dante Stella at 313-568-6693.

Guarantor or Surety?

Here’s some typical guaranty wording, taken from a bank form document titled Continuing Unconditional Guaranty:

Guarantor hereby unconditionally and absolutely guarantees to the Lender, irrespective of the validity, regularity or enforceability of any instrument, writing, arrangement or credit agreement relating to or the subject of any such financial accommodation, the prompt payment in full of any and all indebtedness, obligations and liabilities of every kind and nature of the Borrower to the Lender, howsoever evidenced, whether now existing or hereafter created or arising, direct or indirect, primary or secondary, absolute or contingent, due or to become due, joint, several or joint and several, and howsoever owned, held or acquired, whether through discount, overdraft, purchase, direct loan or as collateral, or otherwise. 

Would the average reader (or lawyer, for that matter), take this wording to mean that the guarantor is only “collaterally” liable for the guaranteed obligations—only liable if the borrower is unable to perform? Does it help to know that the guarantor also “unconditionally and absolutely guarantees to the Lender the prompt, full and faithful performance and discharge by the Borrower of each of the terms, conditions, agreements, representations and warranties on the part of the Borrower contained in any agreement with the Lender.” So Guarantor isn’t just guaranteeing of payment, but also guaranteeing performance. To some that suggests that the guarantor is only liable if the borrower doesn’t perform—only “collaterally” liable.

The distinction between being collaterally liable, as against directly or “primarily” liable was central to a recent decision of the Illinois Supreme Court, JPMorgan Chase Bank, N.A. v. Earth Foods, Inc. et al. The case involved a lender (JPMorgan Chase Bank), a borrower (Earth Foods, Inc.) and one of the borrower’s owners, Leonard DeFranco, who personally guaranteed the borrower’s obligations to Chase. The facts were that in April, 2003, DeFranco sent the lender a letter stating that the borrower was depleting the inventory that was the collateral for the lender’s loan and demanding that Chase take action. Ten months later, the borrower stopped making payments to the lender. In late April, 2004, more than a year after DeFranco’s letter was received, the lender sent a notice of default and demand for payment to the borrower. Subsequently, Chase filed suit against the borrower and its three co-owners (including DeFranco), each of which had guaranteed the loan.

DeFranco responded by claiming that his guaranty obligation was discharged under Section 1 of the Illinois Sureties Act (740 ILCS 155/1). The trial court disagreed and granted Chase summary judgment, holding that the Sureties Act does not extend to guarantors. The Illinois Appellate Court reversed, holding that the relevant question was the meaning of “surety” under the Sureties Act, and remanded the case to the trial court. Chase appealed and the Illinois Supreme Court disagreed and reversed the Appellate Court, but also remanded the case to the trial court for further proceedings. 

Section 1 of the Sureties Act states, in relevant part:

When any person is bound, in writing, as surety for another for the payment of money, or the performance of any other contract, apprehends that his principal is likely to become insolvent or to remove himself from the state, without discharging the contract, if a right of action has accrued on the contract, he may, in writing, require the creditor to sue forthwith upon the same; and unless such creditor, within a reasonable time and with due diligence, commences an action thereof, and prosecutes the same to final judgment and proceeds with the enforcement thereof, the surety shall be discharged; but such discharge shall not in any case affect the rights of the creditor against the principal debtor. 

The Court first reviewed the history of this provision, finding that it had not changed in meaning since first enacted in 1819, although it had been updated on several occasions. The Court also noted the principle that statutes are to be construed as they were intended when they were passed.

The Court next reviewed cases and treatises dealing with the distinction between a guarantor and a surety. It found that most cases and treatises have recognized a guaranty as a form of suretyship, but that suretyship is a primary and direct undertaking, while a guaranty is secondary and collateral. A surety is bound with the principal on the contract under which liability is created; whereas the liability of a guarantor is fixed only by the happening of the prescribed condition at a time after the contract is made. Moreover the Court noted, the surety will not be discharged by the creditor’s failing to give the surety notice of the default of the principal or the creditor’s forbearance to act against the principal, whereas a guarantor is often discharged by the indulgence of the creditor to the principal and is usually not liable unless notified of the default of the principal. In sum, said the Court, the protections afforded under Section 1 of the Sureties Act are not applicable to guarantors.

But DeFranco argued that he was a surety rather than a guarantor. The Court agreed that that would depend on the wording of the document and the intentions of the parties. The Court acknowledged that the use of the term “guarantee” or “surety” in an instrument does not necessarily determine whether the liability created is that of a guarantor or a surety. “Rather,” said the Court “when viewed as a whole along with any other evidence of the parties’ intentions and the circumstances, a written instrument such as the one DeFranco signed may be construed to create a suretyship despite its use of the term ‘guarantee’.”

Since the parties’ intentions were at issue, the Court held that the trial court’s grant of summary judgment was erroneous. Genuine issues of fact existed over whether the parties’ intended DeFranco stand as surety or as guarantor, and the Court remanded the case for further proceedings to let the parties present evidence as to the intent of the parties.

So where does that leave us with respect to the bank form referred to and quoted at the beginning of this article? It’s a tough question, made even tougher by some additional language in the document:

Guarantor hereby expressly and irrevocably waives, to the fullest extent possible, any and all rights at law or in equity to subrogation, reimbursement, exoneration, contribution, indemnification, set off or to any other rights that could accrue to a surety against a principal, a guarantor against a maker or obligor, an accommodation party against the party accommodated, a holder or transferee against a maker, or to the holder of a claim against any person, and which the Guarantor may have or hereafter acquire against any person in connection with or as a result of the Guarantor’s execution, delivery and/or performance of this Guaranty. 

This wording is included in the form guaranty as part of a broad waiver by the guarantor of various rights which might otherwise be applicable, such as rights to notice of default, to require that the lender first seek collection from the borrower, and to require that the lender act against all guarantors and others who might be liable for any of the guaranteed obligations. But it also suggests that the guarantor could be a surety, opening the door to a potantial dispute. In light of Chase v. Earth Foods, we think Illinois lenders would be well served to include a statement in each guaranty in which the guarantor expressly disclaims any rights as a surety under the Illinois Sureties Act.

Andrew Connor, 312-627-2264

Pledges of Stock Issues

As the stock market improves, banks and other lenders are again making loans to officers, directors and 10% stockholders (all of which are referred to in this article as “affiliates”) and other stockholders of public companies secured by stock owned by such persons. In making such loans, banks and other lenders must be aware of two provisions of the law, Federal Reserve Board Regulation U and Rule 144 promulgated by the Securities and Exchange Commission (SEC).

Regulation U

Regulation U provides that a bank or a lender required to be registered under Regulation U (see below), other than a broker-dealer, may not lend more than 50% of the value of “Margin Stock” if Margin Stock is security for the loan. These loans are commonly referred to as “Purpose Credits.” Margin Stock is generally any equity security of a publicly-traded company. Regulation U applies whether the Margin Stock pledged is the Margin Stock which is being purchased with part of the proceeds of the loan or other Margin Stock owned by the pledgor. The percentage restrictions of Regulation U do not apply if the purpose of the loan is not to buy Margin Stock so, for example, a bank can lend in excess of 50% of the value of the Margin Stock pledged if the proceeds of the loan are to be used to buy real estate. Regulation U applies whether or not the pledgor of the Margin Stock is an affiliate of the public company issuing the Margin Stock or a totally unrelated person.

Regulation U differentiates between a bank and a nonbank lender. A bank is always subject to Regulation U when it extends credit secured by Margin Stock. A non-bank lender is subject to Regulation U if it is required to register under the Regulation—that is, it is a lender who “in the ordinary course of business” extends or maintains credit secured, directly or indirectly, by any Margin Stock and in any calendar quarter either the amount of such credit extended is $200,000 or more or the amount of such credit outstanding at any time during that calendar quarter is $500,000 or more.

The following is an example of how Regulation U works. Mr. Jones wishes to purchase 500 shares of stock in XYZ corporation whose stock is selling for $100 a share. XYZ stock is Margin Stock. The total purchase price of the stock is $50,000 and Mr. Jones wishes to use a loan from a bank to purchase the stock. Under Regulation U, Mr. Jones can borrow up to $25,000, 50% of the market value of the stock being purchased, but will have to pay the remainder of the purchase price from other funds.

Regulation U requires a Form U 1 be completed and executed by the borrower if the borrowing is in excess of $100,000. The Form must be accepted by the bank in “good faith,” which generally means the banker has done an investigation necessary to assure himself or herself that the borrower has correctly stated the use of the loan proceeds. The form has two sides, the front side requires information on the amount of the loan and the purpose of the loan and the back side requires information on the Margin Stock used as collateral. The form is not filed with any governmental agency but must be retained by the bank and is one of the reports which bank examiners look for in their review. The front side of a Form U 1 must be completed in any transaction in which Margin Stock is pledged, even if the purpose of the loan is not to purchase Margin Stock. If a registered non-bank lender extends credit in any amount that secured by Margin Stock, then it must obtain from the customer a Form G-3. Form G-3 is substantially similar to Form U-1 except that the requirement for registered nonbank lenders to obtain Form G-3 is not subject to a $100,000 threshold.

Regulation U, at first glance, appears simple. However, it is not. It not only applies to equity securities (e.g., common stock) as noted above, but debt securities convertible into equity securities, warrants, options, indirectly secured arrangements (such as negative pledges), and mutual funds invested in equity securities. The Regulation has provisions dealing with multiple loans, only a portion of which are secured by Margin Stock, revolving credit agreements, loan extensions and transfers of credits from one bank or other registered non-broker dealer lender to another and calculation of maximum loan value. Therefore, Regulation U and the extensive related Federal Reserve Board interpretations must be reviewed in each case before any loan is made involving securities.

There are other Federal Reserve Board regulations applicable to loans secured by Margin Stock. Regulation T applies similar restrictions as Regulation U to margin loans
from broker-dealers. Regulation X closes the loop and applies the Regulation U and Regulation T restrictions to borrowers.

Rule 144

Unfortunately, at times a borrower who pledges stock as collateral for a loan defaults on the loan and the lender must foreclose and sell the stock. If the borrower is not an affiliate of the company issuing the stock and the borrower acquired the stock on the open market or in a transaction registered under the Securities Act of 1933, as amended (“’33 Act”), the lender generally will not have any securities law issues in selling the pledged stock.

However, if the borrower is an affiliate of the issuer of the stock pledged or if the borrower received the stock in an transaction not registered under the ’33 Act, the stock cannot be sold absent registration under the ’33 Act or exemption from such registration.

The most common registration exemption is Rule 144 adopted by the SEC in the early 1970s. Under that Rule, stock owned by an affiliate (“Control Stock”) or stock acquired in a transaction not registered under the ’33 Act (“Restricted Stock”) can be sold, provided that:

  1. generally, the stock has been held for at least 6 months if the stock is Restricted Stock (there is no holding period for Control Stock),
  2. public information is available on the issuer of the stock,
  3. the amount of stock that can be sold in any three month period is limited to the greater of 1% of the outstanding shares of stock of the issuer and the average weekly trading volume of such stock over the past 4 weeks before sale,
  4. stock may only be sold in brokerage transactions; and
  5. a form describing the sale (Form 144) is completed and filed with the SEC.

Lenders must understand that they are subject to these same restrictions on resale in situations in which Restricted Stock or Control Stock is pledged and the pledgor defaults. Rule 144 contains several provisions dealing with pledges:

  1. A lender can “tack” its holding period onto that of the pledgor, provided the loan is a recourse loan (that is, the pledgor is fully liable for the debt regardless of the value of the stock pledged).
  2. Sales by the pledgor and the lender must be aggregated within the six month period after default.
  3. In cases involving two or more pledges, so long as the pledgees (e.g., the lenders) are not acting in concert, if a pledgor defaults, each pledgee may sell the stock pledged to it in the amount permitted by the volume limitations, without having to aggregate sales by the other pledgees.

Importantly, the SEC has afforded lenders, in certain situations, some relief from the restrictions of Rule 144. A lender which has not been an affiliate of the issuer of the pledged stock during the three months preceding any sale of the stock may resell the Restricted and Control securities immediately pursuant to Rule 144 so long as there is current public information on the issuer and, if the securities are Restricted Securities, the six-month holding period is satisfied (the tacking provision mentioned above is helpful here).

Summary

In any loan secured by stock of a publicly-held company, the lender should know whether the proceeds will be used to purchase Margin Stock, whether the stock being pledged is Restricted Stock or Control Stock, and whether the issuer is current in its periodic SEC reports. In addition, the lender should also review the daily trading volume of the stock to determine how long it would take to sell the pledged stock in case of a default.

Robert Smoller, 312-627-2500

Bank Setoff and the "Use It or Lose It" Rule

Generally, under the Uniform Commercial Code, if two creditors both have security interests in an item, either one can foreclose. Suppose Bank A makes loans to a borrower and obtains a blanket security interest in all of borrower’s assets. Then an equipment seller sells the borrower a stamping press on credit and takes a security interest in the press. If borrower defaults on the equipment loan, the equipment seller can foreclose its security interest, even though Bank A has a prior security interest covering the press. Bank A’s prior claim stays in place unless it is paid off (or Bank A voluntarily releases its lien). So the proceeds of the sale will go to Bank A except to the extent, if any, that proceeds exceed Bank A’s claim. Obviously, if the proceeds don’t exceed Bank A’s debt, the equipment seller won’t get anything from the sale—but Bank A has no right to block the equipment seller from taking action.

Suppose Bank A’s collateral includes borrower’s bank account at Bank A. And suppose that that borrower defaults on its lease and the landlord sues and gets a judgment. Landlord then serves a garnishment notice on Bank A seeking the funds in Borrower’s bank account. (Garnishment is a means by which a judgment creditor seeks to reach property of a debtor in the hands of a third person, so that the property may be applied in satisfaction of the judgment.) Bank A ignores the garnishment and lets borrower go on using the bank account, making deposits and writing checks on the account. Can landlord force liquidation of the account?

Once landlord has a judgment and serves a garnishment on Bank A, landlord is a judgment creditor with a claim on the bank account similar to a perfected security interest. Bank A’s interest was perfected first, however. If the account is liquidated, Bank A gets the money until it is paid in full. But, as with the equipment seller, the existence of Bank A’s interest doesn’t invalidate landlord’s claim—it just means that Bank A is entitled to first dibs on the money. So it would seem that Bank A cannot stop the garnishment, but will be entitled to the funds in the account until its claim is paid.

Curiously, a recent Fifth Circuit case, applying Indiana law, came to the opposite conclusion. Old, McGuire & Shook (OMS) maintained deposit bank accounts with Fifth Third Bank (Fifth Third). It borrowed over $1.5 million from Fifth Third and granted to Fifth Third a security interest in all of its assets, including any deposit accounts with Fifth Third. OMS subsequently defaulted on its loans with Fifth Third and also defaulted on a lease agreement with PNB. PNB filed suit and received a judgment against OMS in the amount of $63,689.50. PNB then attempted to collect on its judgment by garnishing funds in OMS’ Fifth Third deposit account. Fifth Third put a freeze on the account in the amount of $150,000 and initiated an action to collect on OMS’s defaulted loans and to enforce its security interest in OMS’ collateral, including its deposit account and proceeds held therein, eventually getting a judgment against OMS. But while this was pending, Fifth Third continued to honor OMS’ checks drawn on the deposit account, subject to the frozen $150,000 not being accessible.

PNB sued Fifth Third, arguing that its garnishment forced liquidation of the account and that Fifth Third’s allowing OMS to continue to use the account instead of setting off and applying the account funds to its claim constituted a waiver by Fifth Third of its interest in the account. The trial court agreed and held that PNB was entitled to recover the amount required to satisfy its $63,689.50 judgment. Fifth Third appealed, arguing that OMS’ deposit account should not have been subject to attachment since Fifth Third had a perfected security interest in the account before PNB obtained its judgment. Therefore, Fifth Third’s perfected security interest took priority over PNB’s judgment lien. PNB argued that Fifth Third waived its security interest in the deposit account when it failed to exercise its right of set-off.

Surprisingly (at least to us), the appeals court reversed the trial court’s order in favor of PNB and remanded with instructions to enter judgment in favor of Fifth Third. The court found that under Indiana Code section 26-1-9.1-104, Fifth Third’s security interest in OMS’ deposit account was perfected and also cited to a comment to this section that provides that a secured party’s decision to allow the debtor to access the funds in its deposit accounts does not affect the secured party’s automatic perfection of the accounts. The court reasoned that allowing such access allowed the debtor to continue to operate and generate revenue that may be applied to the existing indebtedness.

Using the same reasoning, the court went on to hold that Fifth Third did not fail to properly exercise its right of set-off by freezing only a portion of OMS’ deposit accounts. The court observed that Fifth Third had imposed a $150,000.00 freeze on the funds in OMS’ accounts, which amount was sufficient to satisfy PNB’s judgment.

We think that the court misread the UCC. If the collateral were an item of equipment, could Fifth Third take possession of the equipment and thereby prevent the judgment creditor from enforcing its judgment lien? No. Could Fifth Third affirmatively authorize the borrower to continue to use the equipment and thereby prevent the judgment creditor from enforcing its judgment lien? No.

Not surprisingly, this situation has been presented to various courts over the years. Also not surprisingly, most jurisdictions allow a bank to set-off any amounts owed to it from the funds in their debtor’s accounts after a notice of garnishment is received. But the majority view (including in Illinois) is that when the judgment creditor garnishes the bank account, the bank must “use it or lose it”—either set-off the funds in the account and apply them to the debt, or turn the funds over to the judgment creditor. Failure by the bank to set-off results in losing its priority.

Perhaps the Fifth Third court thought that freezing the account was the equivalent of setting off (at least to the amount of the freeze), thereby meeting the “use it or lose it” requirement? But the freeze didn’t reduce the senior debt—Fifth Third did not apply the funds in the account to the debt of OMS, which is what set-off requires.

We think the better position is the majority one, that the bank loses its priority as to the garnished account. To hold otherwise is to give a senior secured creditor the ability to block a junior creditor from garnishing a bank account by freezing enough of it to settle the junior creditor’s claim. Such a freeze gives the junior creditor no assurance of payment, however, because the senior bank’s claim is senior up to the full amount of its debt, which means that the frozen funds may never be available to junior creditor. Given that the borrower has already defaulted to the junior creditor, allowing the borrower to continue to operate may result in increased losses and adversely impact the junior creditor’s prospects of getting paid. A junior creditor should not be forced to stand by and watch a failing borrower continue to operate, using up assets that could be applied to pay the creditors, just because there are senior liens on those assets which have to be paid first.

Andre Connor, 312-627-2264

For more information about any of the material contained in the Business Law Quarterly, please contact the author or the editor or one of the Dykema attorneys with whom you work.


As part of our service to you, we regularly compile short reports on new and interesting developments in our business services program. Please recognize that these reports do not constitute legal advice and that we do not attempt to cover all such developments. Rules of certain state supreme courts may consider this advertising and require us to advise you of such designation.Your comments on this newsletter, or any Dykema publication, are always welcome. © 2011 Dykema Gossett PLLC.

As part of our service to you, we regularly compile short reports on new and interesting developments and the issues the developments raise. Please recognize that these reports do not constitute legal advice and that we do not attempt to cover all such developments. Rules of certain state supreme courts may consider this advertising and require us to advise you of such designation. Your comments are always welcome. © 2018 Dykema Gossett PLLC.