When it comes to unsecured loans, the one word that will strike fear into a bank or other creditor’s heart is “bankruptcy.” Based on any bank or credit union’s experiences with bankruptcy, being an unsecured creditor generally means getting in line behind the priority and secured creditors and getting the crumbs, either pennies on the dollar or nothing at all. One often overlooked source of payment could be lurking at the very financial institution that is owed the previously thought unsecured debts – the right of setoff.

The right of setoff arises under common law, but many states now have statutes that address this important right. In Florida, for example, a bank has a common law right to set off a debt due the bank against a deposit balance. Furthermore, most financial institutions include in their contracts with their customers a contractual right of setoff.

The Legal Relationship

When a customer deposits funds into his account at a bank, the legal relationship is that of the bank as a debtor and the customer as its creditor. The bank takes title to the money and owes a debt to its customer totaling the amount of the deposit. Article 9 of the Uniform Commercial Code also allows a secured creditor to take a security interest in a deposit account without affecting its setoff rights. See UCC 9-340(2), cmt. 3.

However, setoff rights may not be generally applicable to a special deposit or an account set up for a specific purpose such as a trustee account. Some federal laws may also somewhat restrict a bank’s setoff rights. For example, Regulation Z also has prohibitions on a bank’s right of setoff absent a consensual security interest (i.e., no setoff rights for debts arising from a consumer credit card transaction). See Reg. Z, § 226.12(d). Despite these potential limitations, setoff rights are a powerful tool for financial institutions.

The Bankruptcy Code gives a creditor with a right of setoff at least two advantages. First, under Section 506(a), the creditor’s claim is secured to the extent of the debt owed to the bank. Second, Section 542(b) exempts the bank from the requirement that debts owed to the debtor that become property of the bankruptcy estate be paid to the bankruptcy trustee. Section 553 of the Bankruptcy Code specifically deals with setoff in bankruptcy, and setoff rights under state law remain intact in bankruptcy.

Filing Timing

Pursuant to Section 553, the obligation between the debtor and creditor must arise before the bankruptcy petition was filed, and it must have accrued before the 90 day period immediately prior to the filing. If the debt was within the 90 day period immediately prior to filing, it will likely be subject to the “improvement in position” test contained within Section 553(b).

Upon receiving a bankruptcy notice, a bank with a wholly or partially unsecured debt should first ascertain whether the debtor has a general deposit account with the bank. If such an account is found, a bank should first seek relief from the automatic stay to exercise its setoff rights. If a bank were to exercise its setoff rights without permission from the bankruptcy court, it would violate the automatic stay, specifically Section 362(a)(7).

But if a debtor realizes what a bank intends to do, wouldn’t the debtor simply withdraw the funds? Is it a violation of the bankruptcy automatic stay to place an administrative hold on the funds? The U.S. Supreme Court, in Citizens Bank of Maryland v. Strumpf, 516 U.S. 16 (1995), found that placing a temporary administrative hold on funds subject to a bank’s setoff rights pending the disposition of the relief from stay motion did not violate the automatic stay.

Protecting Setoff Right

However, creditors beware; other decisions have found that an indefinite or permanent administrative hold, or a temporary administrative hold on funds in excess of the amount subject to setoff are violations of the automatic stay.

Based on this decision, rather than watching its only chance of being paid disappear in front of its eyes, a bank may protect its setoff right by placing a temporary administrative hold while it files a motion for relief from stay to exercise its setoff rights.