Southwest Update - Legacy Bank v. Fab Tech Drilling Equipment

Texas Court upholds interest of Senior Secured Creditor against Garnishment by Junior Creditor

In Legacy Bank v. Fab Tech Drilling Equipment, Inc, 2018 WL 6928971 (Tex.App. – Eastland), in an issue of first impression, the Court of Appeals of Texas evaluated whether garnishment of a debtor’s accounts receivable by a junior judgment lien creditor would trump a secured creditor’s first-priority lien against the same assets. 

The junior judgment lien creditor, Fab Tech Drilling Equipment, Inc. (“Fab”), was a trade creditor of the debtor, Canyon Drilling Company (“Canyon”). Fab obtained a default judgment against Canyon in the amount of $1,661,399.45 for unpaid services.  The senior secured creditor, Legacy Bank (“Legacy”), had a revolving line of credit with Canyon, which was secured by, among other things, Canyon’s accounts receivable. When Fab attempted to collect on the judgment by filing a writ of garnishment against certain of Canyon’s accounts receivables, Legacy filed a plea in intervention asserting that it held a properly perfected security interest in the accounts receivable which would be superior to Fab’s judgment lien. 

At trial, a jury determined that, due to Legacy’s failure to exercise rights to collect on its collateral, Legacy had waived its rights to recover against Canyon, and therefore the trial judge awarded the proceeds of the accounts receivable to Fab. On appeal, Legacy argued that its perfected first priority security interest on the accounts receivable had priority over Fab’s subsequent lien. Fab acknowledged the prior attachment of Legacy’s lien on the accounts receivable, but argued that, because Legacy had allowed Canyon to remain in default on its loan for several years without exercising remedies, Legacy had in effect waived its security interest, and therefore the proceeds of the accounts receivable should belong to Fab.

In analyzing the issue at hand, the court considered case law from other jurisdictions, including the “trace and recapture” approach advocated by the Oregon Court of Appeals and the “waiver” approach advocated by a line of federal cases from the Northern District of Illinois. Under the “waiver” approach, unless a secured party has taken affirmative steps to exercise remedies upon default, it could be deemed to have waived its rights in the collateral vis-a-vis a judgment lien creditor, and therefore the judgment lien creditor would be entitled to take the garnished assets free from the secured party’s security interest. Under the “trace and recapture” approach, in contrast, while a garnishor would be entitled to take collateral, such collateral would remain subject to a secured party’s interest, even if the secured party had not exercised remedies with respect to such collateral. The secured party could then trace and recapture such collateral as and when it elected to exercise remedies.  The court then concluded that the “trace and recapture” theory was more consistent with the Uniform Commercial Code’s approach to determination of priority, continuation of a security interest and tracing the identifiable proceeds of collateral.  It further noted that, if the “waiver” theory were adopted, secured parties would be required to act immediately to realize on collateral or risk losing their interest. The “trace and recapture” approach, in contrast, would allow secured parties flexibility to work with a troubled debtor without fear of losing lien priority. Lastly, the court noted that since the law of garnishment permits a garnishor to step into the shoes of its debtor with respect to the garnished accounts receivable, the appropriate outcome would be for Fab’s judgment lien to remain subject to Legacy’s first priority security interest in the accounts receivable at issue.  The court then concluded that, because there was no evidence that Legacy had expressly waived its rights in the accounts receivable, the garnished funds should be awarded to Legacy rather than Fab.

Summary courtesy of Andrew Thomison of Baker Botts.