Competition from Third Parties or the Priority of Your Right of Setoff as Against Claims of Third Parties to the Deposit Account

The “majority” rule versus the “equitable” rule

The “majority” rule and the “equitable” rule are two different ways of deciding whether your right of setoff should have priority over the claim of a third party to the account. (The third party is someone other than you or the depositor.) The conflict between these two rules relates to the first of the four prerequisites to setoff—that the funds deposited be the property of the debtor. If they are not, the general rule is that setoff is not permitted. The problem arises when the financial institution does not know who actually owns the funds deposited into the debtor’s account. Is setoff still prohibited, meaning the institution could face liability for wrongful setoff even though it had no reason to know in advance the setoff was wrongful, or does the institution’s lack of knowledge as to the ownership of the funds make setoff permissible?

The “majority” rule, or the rule followed in the majority of states, is that the institution may set off against the account unless it has actual knowledge that the funds do not belong to the debtor, or unless it has knowledge of certain facts that should cause it to make an inquiry whether the debtor owns the funds. The “equitable” rule, on the other hand, says that if the funds are, in fact, owned by someone other than the debtor, the institution cannot set off, even if it has no knowledge of the third person’s interest—unless it has changed its position toward the debtor in reliance on the funds in the account or some other factors exist which make it “equitable” to allow setoff. For example, if the institution makes an unsecured loan to the depositor which it would not have made had the account not existed, then the equitable rule would allow the institution to set off against the account even in the face of a third-party interest. The financial institution has changed its position in reliance on the account in this situation.

It was reported in Article 9 Priority Provisions Do Not Govern Conflict Between Secured Creditors and Banks Exercising Their Right of Setoff, Michael P. Donaldson, 28 South Texas Law Review 689, at 692 (1987), that the states following the equitable rule are: Colorado, Indiana, Michigan, Minnesota, Nebraska, Oklahoma, Pennsylvania, South Carolina, South Dakota, and Texas.

In short, the success of your attempt to set off against an account that turns out to be owned in whole or in part by someone other than the debtor will depend on whether your state follows the majority or the equitable rule. However, under either rule, if you have knowledge of the debtor’s lack of ownership, or you have knowledge of facts that should cause you to inquire regarding the ownership, your setoff will not be allowed, regardless of whether your state follows the majority or the equitable rule. Unfortunately, there is no objective test for determining whether an institution has enough knowledge in this sort of situation to prevent setoff. The courts generally have evaluated the individual circumstances of each case to make the determination and no general rule can be drawn from the cases.

Federal tax liens

Under federal tax law, the U.S. government acquires a lien, or security interest, in any property of a taxpayer who is delinquent in paying taxes. The lien secures the amount of the taxes plus interest and costs. The government can attempt to enforce that lien by levying against (seizing) the taxpayer’s property, including the taxpayer’s deposit accounts. The issue we are interested in is whether a federal tax lien on a taxpayer’s deposit account has priority over a financial institution’s right of setoff and, if so, under what circumstances. In other words, does the existence of a federal tax lien on a depositor’s account prevent you from setting off against that account?

So far, most of the cases ruling on the tax lien v. setoff conflict have favored the Internal Revenue Service (IRS). However, the rationales used by the courts in these cases have not been particularly strong. Therefore, some hope still exists that a financial institution can make an argument in favor of setoff that will be effective. In this section, we’ll try to give you an understanding of the legal issues involved in the tax lien v. setoff conflict and show you how the cases have resolved those issues.

First, you should be familiar with how a tax lien comes into being and how you find out about it. A federal tax lien “attaches,” or comes into existence, at the same time the tax is assessed by the IRS. After the lien attaches, the IRS will file a notice of the lien. This filing is done at an office in each state designated for that purpose by the state. This filing protects the tax lien’s priority against certain other creditors the taxpayer may have. Then, the IRS will levy against (or seize) the property of the taxpayer by serving on persons holding the taxpayer’s property what is known as an “administrative levy.” Persons served with an administrative levy are to turn over to the IRS any of the taxpayer’s property that they hold.

If you set off against the debtor’s account before the attachment of the tax lien, your setoff will likely be successful. This is because the tax lien attaches to all property or rights to property belonging to the taxpayer and, after setoff, the funds set off from the account are not the taxpayer’s property nor does the taxpayer have any rights to the funds.

However, if you do not set off prior to the attachment of the tax lien, your setoff will probably not be successful as against the lien. This means that if you set off after the attachment of the tax lien, and the IRS subsequently serves an administrative levy on you, you will have to turn over the funds you set off to the extent necessary to satisfy the tax lien. It also means that if the administrative levy is served on you before you set off, you will be prohibited from setting off against the account until after you have turned over funds necessary to satisfy the levy.

So, the key dates are the attachment of the tax lien and when you actually set off against the account. If you set off before attachment of the tax lien, you win, and if you don’t, you lose.

This is the case largely because of the failure of three different arguments made by financial institutions in trying to assert the right of setoff over a tax lien. First, the common law (judge-made law, or law other than statutory or regulatory law) has generally held that in order for a creditor’s interest in the taxpayer’s property to be superior to a federal tax lien, the creditor’s interest must be “choate.” This is true even if the creditor’s interest predates the attachment of the tax lien. An interest is “choate” if it is definite regarding the identity of the lienor (the person claiming the lien), the property subject to the lien, and the amount of the lien. Financial institutions have generally been unsuccessful in arguing that the right of setoff is choate, since an interest in a deposit account to which the depositor has unrestricted access is generally not very definite, due to the constantly fluctuating account balance. In other words, the property subject to the lien and the amount of the lien are indefinite because of the fluctuating balance. Until you actually set off, your right of setoff against a deposit account is generally considered “inchoate.”

If an institution can convince a court that the right of setoff meets the conditions of this definition, the setoff is considered a “security interest” and will have priority over the tax lien—so long as the right of setoff predates the filing of notice of the tax lien. However, judging from the cases dealing with this issue, these conditions are hard to meet. One court has interpreted the term security interest to only include security interests under the Uniform Commercial Code (UCC). Security interests in deposit accounts are not under the UCC (other than those accounts evidenced by a certificate of deposit) and, therefore, are not security interests for purposes of Section 6323 of the tax code under the reasoning of this case. [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).] Another court viewed the term security interest as including more than just UCC security interests, but still ruled against the institution on the grounds that since the taxpayer had unrestricted access to the account, the institution did not have a security interest that would be protected against subsequent judgment creditors under Washington law. [Peoples National Bank v. United States, 608 F. Supp. 672 (W.D. Wash. 1984).] Therefore, the right of setoff was not a “security interest” as defined by the tax code and did not have priority over the tax lien.

However, two more recent cases give hope to financial institutions. In Jefferson Bank and Trust v. United States, 894 F.2d 1241 (1990), the court ruled that a bank did have a security interest sufficient to defeat a federal tax lien. In this case, the promissory note the borrower had signed said that the bank would hold any deposits in the borrower’s accounts as collateral for the loan. Both the promissory note and the borrower’s accounts were in existence before the government filed notice of the tax lien. Also, the bank monitored the account to make sure that the balance in the account was sufficient to cover the loan balance. The court noted that under state law, title to the money deposited in a bank account passed to the bank when the deposit was made. Therefore, a bank account is the equivalent of an assignment, which is a protected security interest under state law. Furthermore, the court said that the security interest was choate since the loan amount was known and the bank monitored the account to make sure the account balance covered it. So, this case represents some hope for institutions with contractual setoff language in their notes that are willing to monitor the borrower’s account balance and, presumably, restrict withdrawals that would result in the account balance being less than the loan balance.

The second case is Jersey State Bank v. United States of America, 926 F2d621 (7th Cir 1991). In this case, the IRS served an administrative levy on the institution and the institution set off when it received the levy. (The IRS apparently never did file a notice of the lien.) The court ruled first that under Illinois law, a bank’s right of setoff was a “security interest” as defined above. Second, the court said that since the institution exercised its right of setoff before notice of the tax lien was filed, there was no problem with “choateness” and the setoff has priority. The court specifically declined to say how this case would have come out had the IRS filed its notice before the bank exercised its right of setoff.

To sum up, this second argument depends first on whether the institution can persuade the court that its right of setoff is a “security interest.” Second, even if that hurdle is cleared, it is not clear whether the institution will win, unless it restricts withdrawals or actually exercises

If the right of setoff is a “security interest” in a “security,” then it will win out over a tax lien, even if the setoff occurs after notice of the tax lien is filed. We just saw the difficulties in arguing that the right of setoff is a security interest as defined by the tax code. To that we have to add the difficulties of arguing that a deposit account is a “security.”

The most tenable argument that a deposit account is a security is that the account is made up of “money.” However, a depositor does not really possess money when he or she opens a deposit account. Rather, the deposit account represents the right to demand money from the financial institution. In that sense, a deposit account is not strictly money and, therefore, is probably not a “security” for purposes of Section 6323. So this argument, that the institution’s right of setoff defeats a tax lien even though the notice of tax lien was filed before the debt was incurred because setoff is a security interest in a security, will also probably fail.

Even if the institution convinces the court that its interest is a security interest in a security, the institution must also lack notice or knowledge of the tax lien. [See Section 6323(b), quoted earlier.] However, the burden of proof on the knowledge and notice issue is with the IRS. In other words, the IRS must prove that the institution had notice or knowledge of the lien in order to defeat the institution’s claim, assuming the institution has successfully argued that it has a valid security interest in a security.

While institutions have generally not been successful making the arguments we have just listed, there has been some success with an argument that so long as setoff occurs before the institution is served with an administrative levy, the setoff should be successful. The argument is that after setoff, the institution does not possess “property or rights to property” belonging to the taxpayer. Once setoff occurs, the funds that have been set off belong to the institution, not the taxpayer.

This argument was successful in the case of Pittsburgh National Bank v. United States, 657 F.2d 36 (3d Cir. 1981). However, this case seems to deviate from the rationale we have seen in other cases where the priority of the tax lien versus setoff is decided not by when the administrative levy is served, but rather by when the tax lien attaches. Therefore, this case is a somewhat questionable authority.

For a more detailed examination of the issues and cases we have presented here, see Note, Taxation: Federal Tax Liens and Levies and the Bank’s Right of Setoff, 39 Oklahoma Law. Review 337 (1986).

Secured parties with a UCC security interest in proceeds

The National Conference of Commissioners on Uniform State Laws completed work in July 1998 on a new version of Article 9 of the Uniform Commercial Code. Article 9 governs “secured transactions” (i.e., transactions that are secured by personal property). Although every state and the District of Columbia have adopted revised Article 9, it may be instructive to review old Article 9 before analyzing new Article 9.

Old Article 9

The Uniform Commercial Code (UCC) provides that if a debtor who has given a security interest in certain collateral to a secured party sells that collateral without the authorization of the secured party, the secured party retains a security interest in both the collateral and the proceeds of the sale. [Section 9-306(2)] If the debtor deposits those proceeds into a deposit account, then the secured party’s security interest in the proceeds could come into conflict with the financial institution’s right of setoff. This section will discuss the legal analysis that goes into settling this conflict.

The analysis that ought to be applied is the “majority rule/equitable rule” analysis we presented earlier. Again, under the majority rule an institution’s setoff against an account in which a third party has an interest is effective, in spite of the third party’s interest, so long as the institution does not have actual knowledge that the funds do not belong to the debtor or knowledge of certain facts which should cause it to make an inquiry as to whether the debtor owns the funds. The equitable rule says that if a third party has an interest in the funds in the account, the institution cannot set off unless it has changed its position toward the debtor in reliance on the funds in the account.

A secured party with an interest in proceeds deposited in an account should be treated as a third party under the majority and equitable rules and the conflict ought to be decided by those rules. However, courts have not always done so. Some confusion exists in this area because of the fact that the security interest in the proceeds held by the secured party is a security interest under the UCC. The UCC has its own priority rules (rules governing which parties with security interests have “priority” regarding collateral) that can produce a result different from what would be the case under the majority or equitable rules. While the security interest in proceeds is a UCC security interest, the right of setoff is not; the UCC expressly excludes the right of setoff from its coverage. [Section 9-104(i)] So, the issue is whether a conflict between the right of setoff and a UCC security interest ought to be settled under the UCC priority rules or under either the equitable or majority rule, whichever applies in a particular state.

The majority of states that have ruled on the issue have decided that the UCC exclusion of the right of setoff means that any conflict between the right of setoff and a UCC security agreement is to be decided by non-UCC rules—either the equitable rule or the majority rule. What difference does it make? Well, you already know how the equitable and majority rules work. The UCC rules say that conflicting security interests rank according to priority in time of filing or perfection. If the conflicting security interests are not perfected, then the first to attach has priority. [Section 9-312(5)] So suppose that a creditor has a perfected security interest in a borrower’s automobile. The borrower sells the automobile and deposits the proceeds in his/her deposit account at your institution. The creditor will likely have a perfected security interest in those proceeds. [See Section 9-306 of the UCC for how a security interest is perfected.] Your interest in the funds, your right of setoff, is not perfected and, in fact, cannot be perfected under the UCC. In this situation, the creditor’s security interest would win over your right of setoff if the UCC rules were applied. However, if the majority rule were applied, you could set off against the account—as long as you did not have actual knowledge of the secured party’s interest or knowledge of facts that should cause you to inquire about a third party’s interest. The UCC rules would bring about the opposite result.

So, to sum up, conflicts between your right of setoff and a secured party’s security interest in funds in the account will be settled according to either the majority rule or equitable rule (whichever applies in your state) if your state does not apply the UCC priority rules to the case. In such a state, you would win under the majority rule, unless you had actual knowledge of the secured party’s interest or knowledge of facts that should cause you to inquire as to a third party’s interest. You would not win under the equitable rule, regardless of your knowledge or lack of knowledge, unless you had changed your position in reliance on the deposit account.

If your state does apply the UCC rules, then the secured creditor will win if its security interest is perfected. If the secured creditor’s interest is not perfected, then the outcome will depend on whose interest (your right of setoff or the creditor’s security interest) attached first. A security interest under the UCC generally attaches when the security agreement is signed and the creditor gives value. [See UCC Section 9-203.]

New Article 9

Having control of a deposit account is the way a creditor “perfects” a security interest in a deposit account. “Perfecting” a security interest means establishing your priority in the property by putting the world on notice of your security interest. One way of having control of the account is to become the bank’s customer. “Customer” is defined in Section 4-104(a)(5) as “…a person having an account with a bank or for whom a bank has agreed to collect items, including a bank that maintains an account at another bank.”

In short, under the new Article 9 rules, your right of setoff is not affected by a third party creditor’s security interest in the account—unless the creditor has control over the account by becoming your “customer.” Exactly how a creditor becomes a customer of yours is a little unclear, but it may mean having the debtor transfer ownership to the creditor, giving the creditor authority to make deposits and withdrawals, etc.

Garnishers and other lien creditors

The courts have generally held that you can exercise the right of setoff after you have been served with a notice of garnishment or levy on a judgment debt. The rationale is that the garnisher or judgment creditor has no more rights than the debtor—your depositor—would have. Since you could refuse a depositor’s withdrawal request and, instead, set off against the account (assuming the prerequisites to setoff are met), then, you can also refuse the garnisher’s and judgment creditor’s demands for the funds and set off against the account (again assuming the prerequisites for setoff are met). To put it another way, the garnisher and judgment creditor merely “step into the shoes of the debtor” and have no more rights than the debtor would have.

Checks drawn on the account

Suppose you have a borrower with a loan that is questionable, but you have not yet decided to set off against the borrower’s deposit account. Then, another bank presents to you a check drawn by your borrower on his/her account. The amount of the check is large enough to almost completely deplete his/her balance. This makes you very nervous about the loan, and you decide to set off against the account and return the check unpaid. Does the law allow you to do this, even though your decision to set off was not made until after presentment of the check?

Let’s take a closer look at some of these provisions.

“Accepting” or “certifying” an item occurs when you, as the paying institution or drawee, sign the item and thereby engage yourself to honor it.

“Paying the item in cash” means just what it says. You pay for the item in cash. This occurs, for example, when someone presents a check over the counter and you cash it.

To “settle for an item” is to pay for it in cash, by clearinghouse settlement, in a charge or credit, or by remittance, or otherwise as instructed. Doing so without having the right to revoke is called “final settlement.”

“Becoming accountable for the amount of the item” means: (1) provisionally settling (settling while retaining the right to revoke settlement) for an item and failing to revoke the settlement by the midnight deadline or some other deadline established by clearinghouse rule or agreement; or (2) retaining past the midnight deadline an item presented to you and failing to settle for it by the midnight deadline (unless you are also the depositary bank) or failing to pay it, return it, or send notice of dishonor until after the midnight deadline. The midnight deadline is midnight of the first banking day following the banking day the item was presented.

Finally, item (5) above refers to the passing of a cutoff hour after which your right to set off the funds represented by the check will expire. Looking at this strictly in the context of setoff, it seems you would want this cutoff hour as late as possible. However, this cutoff hour also establishes the time at which a stop-payment order comes too late. Some institutions want the cutoff as early as possible to limit their liability for paying over a stop-payment order. You need to balance these two considerations in deciding what your cutoff hour should be. (For more details on how this cutoff hour works in the context of stop-payment orders, see the chapter in this manual on stop-payment orders.)

If any of these things occur before you exercise your right of setoff, then you are too late. You have paid the check and your right of setoff is limited to whatever balance is remaining in the account after the amount of the check has been deducted.

But, at exactly what point have you exercised your right of setoff? Does setoff occur at the point at which the appropriate person at your institution decides to set off, or is more required? This is significant in this context since the act of setoff must occur prior to one of the events listed earlier or else the setoff will not be effective.

So, again, if these three things have happened prior to any of the payment occurrences listed above, your setoff will be effective as against a check drawn on the account. This, of course, assumes that the setoff was proper in all other respects.