Bankruptcy And The Frozen Bank Account: Keep Your Money On Deposit Safe
When deposit account holders write a check or make a withdrawal, they may believe that they are accessing their own money, but that is not precisely true, for important reasons. What is actually happening is that the account holder is making demand upon the bank to pay over sums up to the amount on deposit. Viewed in this light, the bank balance really represents a debt owed by the bank to the account holder. Banks hold plenty of cash, but if every deposit holder were to withdraw all their funds at the same time the banks may not have enough to satisfy all these demands. Recognizing that banks can’t maintain such 100% liquidity, the law has developed this debtor/creditor approach to deposit accounts.
This approach becomes vitally important when viewed under the doctrine of setoff (also called offset). Setoff happens when two people or entities owe each other debts. Instead of requiring one side to pay the other and then collect the money back, either of the debtor/creditors can simply say “you don’t have to pay me all you owe; I’m setting off what I owe against your debt to me.” The other party usually can’t protest when the right of setoff is being exercised if the right is built into the transaction or under the law.
The classic setoff relationship is when a depositor owes money to their bank, under a mortgage, credit card or line of credit. When that happens, if the depositor is in default under the debt, under the right of setoff the bank can seize any money in the bank account and apply the funds taken to reduce the debt. This right of setoff will usually happen without any warning or notice to the account holder.
It doesn’t take much imagination to see that when the bank exercises its setoff rights the result is usually great inconvenience or hardship to the account holder. If there’s a default the depositor is usually insolvent or facing other financial distress. Losing access to cash on deposit may mean that other bills or necessary expenses can’t be paid. Even though these results may seem severe, the bank is completely within its rights to exercise this setoff. This is why clients seeking financial advice must be mindful to inform their advisors that they are holding money in banks who are their creditors. It is also why banks will exercise their setoff rights promptly if they believe their customers may be getting ready to prefer other creditors with the cash on deposit.
Debtors cannot seek protection from their banks by filing for bankruptcy. The Bankruptcy Code specifically preserves setoff rights and the US Supreme Court has ruled unanimously that applying an administrative freeze to prepare for setoff does not violate the automatic stay in bankruptcy. As a result, immediately upon learning of the bankruptcy filing by an account holder, a bank may administratively freeze a bank account. Under the debtor/creditor approach to bank accounts, this means that the bank will refuse to honor an account holder’s demand for payment of a check or withdrawal of funds. This refusal to pay on a debt is not by itself considered a setoff. That won’t happen until the bank files a motion for relief from the automatic stay and the bankruptcy court grants that motion. Once that happens, the bank will make a book entry by (1) reducing the amount considered on deposit and (2) applying that amount to reduce the debt owed to the bank. At that time, the funds are forever removed from the reach of the account holder.
Insolvent debtors need to understand the perils of leaving money on deposit with their creditor banks. They should expect that a bank can and will exercise their setoff rights and deprive them access to their cash, usually at a time they can least afford it.
On the other hand, banks and credit unions should anticipate that their debtor customers will seek legal advice that will result in depletion of their bank accounts to defeat their setoff rights. The best way to protect these rights is to closely monitor customers’ payment patterns to better understand whether a pattern of late payments is developing. If so, an early exercise of setoff rights may preserve a collection opportunity that may soon be lost forever.