Introduction: A Financial Institution's Right of Setoff

This section will describe the scope of your right of setoff, or offset as it is sometimes called. Basically, the right of setoff is the right of a financial institution to deduct from a depositor’s account balance an amount equal to the amount the depositor owes the financial institution on a debt of some kind, such as a loan or an overdrawn account. The idea is that the deposit account itself represents a debt owed by the financial institution to the depositor, and the law has traditionally allowed parties with mutual debts to set the debts off against each other, with the difference between the two debts being the only amount actually owed. In the case of setoff, the financial institution is setting off its debt to the depositor—the deposit account balance—against whatever debt the depositor owes to the financial institution.

The scope of a financial institution’s right of setoff has been the subject of much litigation. In addition, some state statutes and federal laws and regulations affect the right of setoff. In short, there is an incredible amount of law that governs the right of setoff. Unfortunately, not much of this law clarifies whether a financial institution and its depositor can contractually agree to a broader right of setoff for the institution than would normally be allowed under the law. In other words, the law establishes all sorts of limits on an institution’s right of setoff, as we will point out in this section. But the law says very little about whether or not an institution can get around those limitations by having the depositor sign an account agreement waiving those limitations.

So where does that leave us? Because of the ambiguity about the effectiveness of contractual setoff provisions, a prudent financial institution will, it seems to us, do two things: (1) it will educate itself about the law of setoff and all of its limitations; and (2) it will have a carefully worded setoff provision in its deposit account agreement, which attempts to expand the scope of the setoff right as much as reasonably possible. In other words, it will acknowledge the need for both an understanding of the limits of the law and a good contractual provision.

This section is organized along the lines of this approach. The first section will attempt to give you an overview of the general right of setoff absent any contractual provision. We will refer to this as the “legal” right of setoff. The next section will review the sorts of things you might want to include in a contractual provision defining your right of setoff. As we will see, not all of the legal limitations on the right of setoff can be contracted away.

But, before we look at the legal right of setoff, we want to caution you against relying on the information we set out in this section to determine whether you set off in a particular situation. The law on the right of setoff varies somewhat from state to state. Also, some states have simply not dealt with some of the issues we discuss. Consequently, while what we will say is true in most states, it may not necessarily be true in yours. Because of the overall ambiguity in the law of setoff, we encourage you to consult with your legal counsel before actually setting off. Use this information as a general overview of the law of setoff. Do not use it to determine whether you should set off in a given situation.

Note to credit bureau

All federal credit unions and many state credit unions have a “lien” on the balances in members’ accounts. Functionally, this is the equivalent of a bank’s right of setoff in that it enables the credit union to apply the balance in a member’s account to debt the member owes the credit. Technically, however, there is a difference between a lien and a right of setoff. When a person makes a deposit to a bank account, a creditor-debtor relationship comes about. The bank now owes the depositor the amount of the deposit. But when a member puts money in a share account at a credit union, the member is purchasing an ownership interest in the credit union—i.e., the member is buying “shares.” There is no creditor-debtor relationship. Recall that the right of setoff is the right of two people with mutual debts to set the debts off against each other, with the difference in amount being the only debt owed after the setoff.

Credit unions that offer share accounts have, instead of a right of setoff, rights under a “statutory lien” on the member’s shares. (Some state credit unions are authorized to offer deposit accounts and, presumably, have the right of setoff equivalent to that of other institutions.) The statute creating the lien may impose conditions the credit union must meet in order to enforce the lien. For example, federal credit unions must give notice of the statutory lien to the member. They can give this notice in the member’s account agreement, loan documents, or through a credit union by-law or policy of which the member is given notice. [12 CFR 701.39]

Credit unions with rights under a statutory lien should look to the statute and any implementing regulations for details.