How a right of set-off led to a fight against creditors


A recent decision from the North Carolina Court of Appeals teaches a valuable lesson about how a creditor with the upper hand over another creditor should behave to avoid squandering their advantage and getting bogged down in litigation.

The decision involves a fight between two creditors. In one corner: a custodian bank with the right of compensation. In the other corner: a judgment creditor with a garnishment order. The price? Several hundred thousand dollars in two bank accounts belonging to a company that owed both creditors.

KLO Acquisition, LLC maintained an operating account and a cash collateral account at Chase Bank. Chase Bank had loaned KLO more than $12 million and KLO was in default. KLO had also been sued by Guy M. Turner (GMT) for breach of contract. GMT obtained an order of seizure, garnishment and notice of levy from a North Carolina state court regarding KLO’s accounts at Chase Bank. GMT served Chase Bank with the garnishment order. In response, Chase Bank cleared the collateral account with cash, applying more than $328,000 to its defaulted loans.

But Chase Bank neither cleared the operating account nor remitted the funds to GMT. Instead, he sent GMT a form letter that read, “JPMORGAN CHASE BANK HAS TAKEN THE CLEARING RIGHT. FUNDS NOT AVAILABLE.” But Chase Bank continued to allow the borrower access to the operating account, debiting nothing and letting millions slip through despite the garnishment order.

Needless to say, GMT was not happy. Chase Bank now had to pay lawyers not to collect the money KLO owed them, but to defend the lawsuit GMT had filed against it. In the first round, a North Carolina trial court ruled in favor of GMT against Chase Bank, awarding them more than $209,000 (the operating account balance when Chase received the garnishment order and the direct debit notice). In the second round, the North Carolina Court of Appeals overturned, in a split decision, giving Chase Bank the win. Now it looks like the case is heading to the North Carolina Supreme Court for the rubber match.

It should have been a first-round knockout. Chase Bank, like all banks that offer deposit accounts, had a perfect security interest in the accounts. You perfect a security on the accounts in management, and the maintenance of the account with your bank is governed. Chase Bank also had a deposit account agreement with KLO which gave it the right to set off accounts in the event of default. As long as the operating account and the cash collateral account were open before GMT received its garnishment order (and they were), there was no way for GMT to prevail over ChaseBank. Unless Chase Bank, by its conduct, has waived its rights as senior creditor.

And that’s exactly what GMT argued – Chase Bank waived its set-off rights by not enforcing them and allowing KLO unfettered access to the operating account for months after receiving the seizure order. -stop. The trial court accepted GMT’s argument, but two members of the Court of Appeal determined that Chase Bank did not have to assert its set-off rights to preserve them. It was enough to invoke them in the standard letter they sent to GMT. In other words, a custodian bank is not required to actually exercise its rights of set-off so long as it asserts them to oppose its superior security against a creditor holding a second lien.

Chase Bank is victorious – until what happens in the North Carolina Supreme Court. But he has a permanent self-inflicted wound. It shouldn’t be like this. Chase Bank could have triggered the operating account and applied the funds to delinquent loans. GMT could only watch. Chase Bank may have intended KLO to use the operating account because it increased the likelihood that it would generate income to repay its loans. But if that was Chase Bank’s goal, given the garnishment order, it had to do more than send a form letter. Chase Bank should have hired a lawyer to negotiate a three-party agreement with GMT and KLO that would preserve Chase Bank’s rights and end future litigation from the start. Maybe each month a percentage of the funds could have gone to GMT, Chase and KLO for operations. Chase Bank had full power to offer a “take it or leave it” deal with GMT. If GMT refused, Chase Bank could have triggered the account. Although Chase Bank may have wanted to negotiate the loan with KLO, had it known it would be sued by GMT, it might have acted differently.

The narrow decision of the North Carolina Court of Appeals is that a mere assertion of set-off rights by a depository bank will preserve the right, even without effective enforcement. But the biggest lesson of this ongoing saga is that creditors need to be more careful and careful when challenged by another creditor desperate to collect from the same borrower.

© 2022 Ward and Smith, PA For further information regarding the issues described above, please contact Lilian L. Faulconer or Lance P. Martin.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or factual situation. No action should be taken on the basis of the information contained in this article without obtaining the advice of an attorney.

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