Contractual Provisions to Enhance Your Right of Setoff

What we have been looking at so far is the legal right of setoff, or the right of setoff as it exists by operation of law alone. What we are going to look at next are ways in which you can enhance your legal right of setoff by contractual provisions. Institutions generally have some form of deposit account agreement that establishes a contractual relationship between themselves and their depositors. (See the chapter in Part I of this manual for details regarding what ought to be included in such an agreement.) A provision describing the right of setoff, and perhaps expanding the right beyond what is normally allowed under the law, can be helpful.

This provision demonstrates the balance that needs to be struck in drafting a deposit account agreement—the balance between protecting your interests as much as possible on the one hand—and not going too far and ending up with an unconscionable agreement on the other hand. In the first paragraph, we try to expand the legal right of setoff, but in the second paragraph we acknowledge certain limits on the right of setoff.

In the first paragraph, we try to expand the legal right of setoff primarily by attempting to modify the requirement of “mutuality.” We do this by saying that the institution can set the account balance off against any debt owed “…by any of you…” The word “you” is defined elsewhere in the agreement as any account holder. This means that regardless of which account holder actually owes the money, the account is available to the institution for setoff. The requirement of mutuality, as we saw earlier, would ordinarily require that the person or combination of persons owing the debt be the same person or combination of persons holding the account.

So, for example, suppose C owes you money on a note and C, D, and E hold a joint account with you. C, D, and E have all signed an account agreement containing the provision quoted earlier. The rule of mutuality would say that you could only set off against the portion of the joint account that is actually owned by C and not against the entire account. This is because there is mutuality of indebtedness only between C’s debt to you and your debt to C, which is C’s portion of the account balance. No mutuality exists between C’s debt to you and your debt to D and E, which is D’s and E’s portion of the account balance.

Our contractual provision, on the other hand, says that the account balance is available for setoff against debts owed by “any” account holder and so the joint account would be available for setoff by virtue of this provision. Even though B and C do not owe the money, they have signed an agreement to the effect that the account will be available for setoff against A’s debts. We go on to say that if the account is owned by one or more individuals, the institution may set off any funds in the account against a due and payable debt a partnership owes now or in the future, to the extent of the individual’s liability as a partner for the partnership debt. Recall the discussion earlier in the chapter about state laws effecting setoff of partnership debt. Make sure you know your state law in this regard.

Our provision also specifies that you are not required to give prior notice when you set off. However, we still feel it is advisable to give notice at the time of, or as soon as possible after, setoff. And, of course, in the states of New York and California, such notice is required.

The second paragraph of the provision quoted above lists four limitations on your right of setoff. These are limitations we feel cannot be eliminated by contract, and including them in the form gives a more reasonable, less one-sided tone to the setoff provision. Setting off against an IRA, as we have seen, is prohibited. An attempt to change that rule by contract could be seen as an attempt to use the IRA as security for a loan that, in turn, would cause the account to be treated as though it were distributed to the extent it is used as security. Setting off a consumer credit card debt against an account is prohibited, as we pointed out earlier, by Truth in Lending, and the consumer cannot waive protections under Truth in Lending. Accounts held by the debtor in a representative capacity (as a trustee, for example) are not subject to setoff because the person with the real, beneficial interest in the account is not a party to the agreement. Consequently, there is no mutuality of indebtedness. Finally, we exclude set-off if set-off is prohibited by the Military Lending Act. Recall our earlier discussion of the conflicting opinions regarding the MLA and set‑off.

While you probably cannot contract away these restrictions on setoff, expanding your right of setoff in the areas in which our first paragraph does so is probably enforceable. In those situations, no statutory or regulatory provisions are being violated and, more importantly, the persons whose interests are being diminished are parties to the agreement. The joint depositors whose interests in the account are being made subject to setoff against individual debts are all signing the form agreeing to the provisions. Therefore, the provisions ought to be enforceable against them.

A number of cases have determined that contractual provisions of this sort are valid. See Uttecht v. Norwest Bank of Norfolk, 376 N.W. 2d 11 (Neb. 1985) (enforcing a contractual provision authorizing setting off an individual debt against joint account); Craig v. Hastings State Bank, 380 N.W. 2d 618 (Neb. 1986) (recognizing that a contractual provision authorizing set off of an individual debt against joint account is enforceable, but finding no such contractual provision in this case); and Chickerneo v. Society National Bank, 390 N.E. 2d 1183 (Ohio 1979) (enforcing a contractual provision authorizing setting off individual debt against joint account).

Such a provision seems to limit your right of setoff to only a portion of the account balance when you are unsure of each party’s net contribution to the account. (You will almost always be unsure of that.) If there are two parties, you could set off one-half the account balance; if there are three parties, one-third, etc.

A final consideration of which you should be aware in the area of contractually expanding your right of setoff is the question of whether your deposit account agreement should contain language giving you a “security interest” in the deposit account in addition to your right of setoff. Proponents of such a provision argue that having the depositor sign an agreement stating that you have a security interest in the deposit account will improve your chances of succeeding against some third-party creditors. In particular, the idea is that you will have priority over a federal tax lien when you have a security interest in the account. Remember that our analysis of federal tax liens concluded that if your right of setoff was found to meet the tax code definition of “security interest,” it would have priority over the tax lien if it predated the attachment of the tax lien. The tax code definition of security interest required that the interest be superior to, or enforceable against, subsequent judgment lien holders.

We are not entirely convinced that taking such a security interest in deposit accounts is a good idea. First, to do so by including language in your agreement by which you take a security interest in the money or funds in the account is somewhat contradictory to the notion of setoff. Remember, your right of setoff exists because there is a debtor/ creditor relationship between you and the depositor with respect to the account. This relationship exists because when the depositor makes a deposit, title to the funds deposited actually passes to you and you, therefore, become indebted to the depositor in the amount of the deposit. If you have title to the funds, it is impossible for you to have a security interest in them since one cannot have a security interest in one’s own property. Therefore, by including both a setoff provision and a security interest provision in the same agreement, you are, to some extent, contradicting yourself.

Second, taking such a security interest in deposit accounts is no guarantee that you will actually win out over a federal tax lien, and having such a provision in your account agreement may give you a false sense of security in that regard. Remember, in order to be a “security interest” for purposes of defeating a federal tax lien, the security interest must be enforceable against subsequent judgment creditors. A security interest in a deposit account (other than one evidenced by a certificate of deposit) is not governed by the Uniform Commercial Code (UCC), and so whether such a security interest is superior to a judgment lien creditor is governed by the “common law” (the law of cases decided by judges). The common law in many states says that a security interest in a deposit account is enforceable against a subsequent judgment lien only if the depositor is prohibited from withdrawing from the account or from drawing the account below a specified balance. In these states, therefore, including security interest language in your account agreement would do you no good unless you also restricted the depositor’s access to the funds. Without restricting access, the security interest is the functional equivalent of the right of setoff.

There are cases that go both ways on this issue. As we pointed out earlier, in United States v. Sterling National Bank and Trust Co. of New York, 360 F. Supp. 917 (S.D.N.Y. 1973), rev’d in part, 494 F.2d 919 (2d Cir. 1974), the district court decided that the only sorts of security interests which could have priority over a federal tax lien were security interests subject to the UCC. Since a security interest in deposit accounts was expressly excluded from coverage by the UCC, the right of setoff, even if it was something of a security interest, could not have priority over a federal tax lien. The court also ruled that even if the tax code’s definition of security interest included non-UCC interests, the bank’s right of setoff was not a security interest because it lacked “choateness” and was not superior to subsequent judgment liens. Along the same line is Peoples National Bank v. United States, 608 F. Supp. 672 (W.D. Wash. 1984) in which the court decided that the federal definition of security interest included more than just UCC interests, but did not include setoff because Washington law required that the depositor’s access to the account be restricted before a security interest in a deposit account would be superior to a subsequent judgment lien. However, Trust Co. of Columbus v. United States, 735 F.2d 447 (11th Cir. 1984) went the other way and found that the right of setoff did meet the requirements for being a security interest under the tax code and, therefore, had priority over the federal tax lien. Also see Jefferson Bank and Trust v. United States, 894 F.2d 1241 (1990), and Jersey State Bank v. United States of America, 926 F2d 621 (7th Cir 1991), discussed earlier in this chapter.

While these cases do not involve institutions contracting for a “security interest” in deposit accounts, they are significant in that they reveal the analysis courts will apply to cases where financial institutions claim interests superior to federal tax liens. Those interests must meet the tax code’s definition of “security interest.” This leads us to believe that courts will do the same with interests which are labeled “security interests” but which are not functionally different from the right of setoff. Unless the interest is superior to that of subsequent judgment liens, it will not defeat a federal tax lien.

It is difficult to say whether or how this reasoning is affected by the 1998 revisions to Article 9 of the UCC. As we have pointed out in other contexts in this chapter, the new Article 9 does not exclude security interests in deposit accounts. The drafters do not seem to have any difficulty with the concept of a bank having a security interest in and a right of setoff against a deposit account.

To sum up, we feel that your legal right of setoff can be significantly expanded by contractual provisions in your account agreement. This is particularly true with respect to your ability to set off an individual debt against a joint account. However, not all restrictions against setoff can be done away with by contract. The prohibitions against setting off against an IRA and against setting off a consumer credit card debt against a deposit account cannot be waived by the depositor. Also, contractually doing away with the restrictions against setting off against accounts where the debtor’s rights are only in a representative capacity will probably not be effective.