A New Year’s Eve (yes, December 31) decision came down from the Court of Appeals of Texas that is worthy of your consideration and a few minutes of your time.  The case concerns whether the secured creditor waived its priority rights to collateral by failing to declare a default or take an affirmative action to foreclose on collateral prior to the judgment-lien-creditor foreclosing on the same collateral through garnishment.

In October, 2011, Legacy Bank entered into a secured revolving line of credit facility with Canyon Drilling Company. In December, 2012, two trade creditors obtained judgments against Canyon and soon thereafter filed a writ of garnishment. Upon learning of the garnishment, Legacy appeared and intervened asserting that it held a properly perfected security interest in the garnishees’ accounts due and owing to Canyon and that its interests were superior to those of the judgment creditors.

Legacy subsequently provided a formal notice of default to Canyon on July 19, 2013. Despite Canyon’s default, Legacy continued to advance funds to Canyon hoping for a successful turnaround. However, Legacy ultimately exercised its foreclosure rights against Canyon after the note became due in April, 2014.

At trial the judgment creditors argued that Legacy waived its security interest by (1) allowing Canyon to remain in default for several years without making demand, accelerating the debt, liquidating collateral, or otherwise enforcing its security interest; (2) not demanding payment until a year after the judgment creditors obtained their judgment and more than six months after Canyon filed the writ of garnishment; and (3) making a “nominal, halfhearted demand on Canyon solely to save face” before loaning Canyon more than $2 million in additional funds. In advancing this argument the judgment creditors asserted that they are not bound by the terms of the contracts executed by Legacy and Canyon to define the terms by which Legacy could waive its security interest. Instead they asserted that they were entitled to establish a waiver under equitable principles.

The jury agreed and awarded judgment in favor of the judgment creditors.  Legacy appealed.

This was a case of first impression in Texas and accordingly, the Texas Court of Appeals turned to a recent decision from Oregon in a similar situation.  The Oregon Court, also lacking precedent in its state, turned to a group of decisions from the Northern District of Illinois.

The Texas Court stated:

The Oregon court determined that, taken together, the cases from the Northern District of Illinois impose three preconditions on a secured creditor attempting to enforce its interest in garnished collateral funds under the waiver theory: (1) a default has to occur; (2) the secured party must declare a default; and (3) the secured party must take an “affirmative step” to exercise its rights (such as acceleration). **** If any of the preconditions remain unsatisfied as of the time the lien creditor garnishes funds, “the secured party is deemed to have constructively waived its priority vis-à-vis the lien creditor, and, thus, cannot trace and recapture its collateral from the garnishor.” ****. [This] waiver theory has been characterized as a “use-it-or-lose-it” approach. *** [T]his characterization of the waiver approach is accurate.

Conversely, under the trace and recapture approach, “before and until a secured party declares default and acts on its right to collateral, a garnishor is entitled to take the collateral; however, in doing so, the garnishor takes traceable collateral subject to the secured party’s interest.” ***. “Thus, unlike the waiver approach, the secured party maintains its security interest, despite a period of inaction after default and before a judgment creditor takes the funds.” *** In other words, a security interest under the trace and recapture approach is not lost if it is not used.

The Court also looked to the UCC for guidance noting that the official comments to Section 9-610 expressly support the trace and recapture approach.  Comment No. 5 to Section 9-610 provides that “the disposition by a junior [creditor does] not cut off a senior’s security interest.” Rather, “[t]he holder of a senior security interest is entitled, by virtue of its priority, to take possession of collateral from the junior secured party and conduct its own disposition.”

The Court reversed the trial court concluding:

Legacy’s security interest in the collateral could not be waived under equitable principles or by operation of law by not being enforced prior to the garnishment. Instead, the UCC affords Legacy the opportunity to trace and recapture its prior perfected security interest in the garnished funds even though it did not exercise those rights prior to the garnishment. That is not to say that it was impossible for Legacy to waive its security interest because, under Texas law, waiver is a valid defense to an action to enforce a security interest

OK.  So do we think that this is a win for the good guys or did they just dodge the bullet?

The concern I have with this case arises out of Legacy’s continued advances – some $2 million over a period of several years – following the judgment creditors obtaining their judgments and having commenced enforcement proceedings.  Although this conduct may now be sanctioned in Texas, we cannot suggest that secured lenders be cavalier in their secured position when confronted with the execution of a judgment against their borrowers-debtors.

Legacy Bank, v. Fab Tech Drilling Equipment, Inc. and Impulse Electric, Ltd., 2018 WL 6928971 (Texas, 2018)

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