Limitations on the Right of Setoff

No setoff against “special accounts”

The law prohibits you from setting off against what is known as a “special” account—if you have knowledge of the account’s special status. A special account is one which the depositor establishes for a specific, limited purpose and over which the depositor has limited control. An escrow account is an example of a special account, as is an account established specifically to pay certain recurring debts, or certain outstanding checks. However, an account such as a payroll account will generally not be considered to be a special account, since, in most cases, the depositor still retains total control over the account even though it is designated for a particular purpose.

If you have knowledge of the special status of the account, you cannot set off against the account. You generally will have knowledge of the nature of the account with most special accounts, such as escrow accounts, since your financial institution will frequently be a party to the agreement that creates the account’s special status. However, not all accounts found to be “special” will clearly be so. The worst example we have seen is the account in the Alabama case of Rainsville Bank v. Willingham, 485 So.2d 319 (Ala. 1986). In this case, a bank officer advised a financially troubled depositor that he should pay off his small bills first. The depositor later deposited an insurance check in his checking account and told the bank officer that the funds were to be used to pay off small bills of the depositor. Sometime later, the bank set off the balance in the account against an overdue loan the depositor had with the bank. The Alabama Supreme Court ruled that because of the advice the bank officer had given the depositor and because of the bank officer’s knowledge of the intended purpose of the funds in the account, the account was a “special” account, making setoff improper. In response to this decision, Alabama passed a law that designated all deposit accounts as general accounts unless the depositor and financial institution agree otherwise in writing.

As you can see from the Willingham case, the line around what constitutes a special deposit is not particularly clear. However, as we said, most special accounts are clearly that and so this rule should not cause you too much trouble. Again, the requirements for special status are that the account be established for a specific, limited purpose; that the financial institution has knowledge of that purpose; and that the depositor’s access to the account is restricted to some extent.

Limited setoff of individual debt against joint account

One of the four prerequisites to setoff is that the deposit account creates a debtor/creditor relationship between the institution and the depositor who owes the debt to the institution. If so, then there is a “mutuality” of indebtedness between the two and setoff can occur. When an individual owes a debt to the institution and the individual is a party to a joint account at the institution, this mutuality may not exist. This is because the individual owing the debt to the institution may or may not have been the owner of the funds deposited in the account. If he or she is not, then the institution does not actually owe him or her any money but, instead, owes the account balance to the person or persons who actually owned the funds when they were deposited. This is true even though all of the depositors may have the right to withdraw the entire account balance. The debtor/creditor relationship exists only between the institution and the depositor or depositors who actually have ownership interests in the account.

So, for example, if C is in default on a loan with you, and C and D have a joint account with you, you can only set off against the joint account to the extent that C has an ownership interest in the account. If C has contributed all of the funds in the account, then the entire account is available for setoff. On the other hand, if C has not contributed any funds to the account, then none of the account can be set off. If C has contributed a portion of the funds, then only that portion is available.

As you can imagine, this means that setting off an individual debt against a joint account is risky business for an institution. Most institutions have no information about the actual ownership interest of each depositor in a joint account. An institution would have to determine each depositor’s contributions, each depositor’s withdrawals, whose contributions were withdrawn against, etc. Obviously, it is an impossible task in most cases.

Fortunately, as we will see in the second section of this chapter, this is an area of the law of setoff that can probably be altered by contractual provisions in your deposit account agreement. Also, a number of states have statutes that say that the institution may presume (absent any proof of net contributions) that each of the depositors has contributed an equal share of the account balance. For example, if A, B, and C are joint owners of an account and the institution wants to setoff against A’s debt, the institution could set off up to a third of the account balance, assuming it has no proof of A’s actual ownership interest.

Limited setoff of debt owed by more than one person against the individual account of one of the debtors

Whether or not setoff is allowed against the individual account of one person who is one of several owing a particular debt depends on the nature of the debt. The law does allow setoff in a circumstance where the debt is the “joint and several” debt of the debtors. The term “joint and several” means that the persons owing the debt owe it both as a group and as individuals. In other words, the creditor can look to all of them, any one of them, or any combination of some of them for repayment of the debt. If the creditor recovers the debt from fewer than all of the debtors, then the debtors who paid can look to the other debtors for reimbursement. Since any one of the individuals, then, is responsible for the entire debt, mutuality of indebtedness exists between the institution and that individual if the individual has a deposit account with the institution. Since there is mutuality, setoff is allowed.

On the other hand, if the debt is joint but not several, then there is no mutuality and setoff is not allowed.

Most standard note forms, including those designed by Wolters Kluwer Financial Services state that multiple borrowers promise to pay the debt “jointly and severally.” Apparently, most states treat debts owed by more than one person as joint and several debts—unless the parties have agreed otherwise. So, for instance, if the debt is an overdrawal of a deposit account and the deposit account agreement does not specify whether the account deficit is a joint debt or a joint and several debt, then the law of most states will treat it as joint and several. However, you should check your own state law since not all states are the same on this issue.

Setoff of partnership debt against individual partner’s account

In some states, setoff is not allowed against a partner’s individual account for a debt incurred by the partnership. This is because in those states the debt of a partnership is owed jointly by the partners but not severally. In other words, the partners are liable for the debt as a group, but none of them, as an individual, is responsible for the debt. Since none of the partners is individually liable for the debt, then there is no mutuality between the debt owed by the institution to the individual partner (the deposit account) and the debt owed by the partnership to the institution. Since there is no mutuality, setoff is not allowed.

You should be sure to check your own state law in this area, however. Apparently, the law as to the nature of partnership debts (whether they are merely joint or joint and several) is changing. Your own state law may have changed making partnership debts joint and several and, thereby, opening the door to setoff of partnership debts against an individual partner’s account.

Setoff of individual partner’s debt against partnership account

An institution normally cannot set off an individual’s debt against the account of a partnership of which the individual is a partner. For example, suppose your institution holds an account owned by “ABC Partnership,” a partnership owned by Mr. A, Mr. B, and Mr. C. Also suppose that Mr. C individually owes money to your institution in the form of an overdue loan. You would normally not be able to set off Mr. C’s debt against the account owned by ABC Partnership.

The rationale here is similar to the rationale for limiting setoff of an individual’s debt against a joint account in which the individual has an interest. In both instances, the extent of the “mutuality” of the debts is doubtful. In our example above, there may be mutuality between Mr. C’s debt to your institution and Mr. C’s interest in the partnership account. But how do you know what Mr. C’s interest in the account is? Without some sort of court determination, you don’t know. Your institution would risk liability to Mr. A and Mr. B by setting off against the partnership account.

This circumstance is, however, one where contract language might be helpful. In the case of Morganfield National Bank v. Damien Elder & Sons, 836 S.W.2d 893 (Ky. 1992), the court disallowed the setoff of an individual partner’s debt against the partnership account because the bank’s signature card/account agreement did not authorize it and the underlying common law did not allow it. The opinion indicates that had the signature card/account agreement contained language giving the bank the right to setoff, the court would have enforced it.

No setoff against an individual retirement account

There are several reasons why we feel the law does not permit a financial institution to set off against an individual retirement account (IRA).

First, all IRAs are either trust accounts or custodial accounts. The financial institution is the trustee on trust accounts and the custodian on custodial accounts. This role as trustee or custodian creates what is known as a “fiduciary duty” running from the financial institution toward the IRA itself and toward the depositor. Someone who has a fiduciary duty toward someone else or toward an account is generally obligated to act in the best interests of that person or account and is prohibited from acting in a way detrimental toward that person or account. Since a financial institution has a fiduciary duty toward the IRA and the depositor of the IRA, the institution is prohibited from taking action that is detrimental to the account and the depositor. Setting off the IRA against a debt of the depositor would certainly be detrimental toward the account and would probably be seen as detrimental toward the depositor as well. In short, setting off against an IRA would be a breach of the financial institution’s fiduciary duty toward the IRA and the depositor.

Second, Section 408 of the Federal Tax Code [26 USC 408] provides that IRAs are not “forfeitable.” This provision has been interpreted to mean that an IRA is not forfeitable to the trustee or the financial institution holding the IRA. This nonforfeitability is inconsistent with the notion that a financial institution can set off against an IRA.

Third, Section 4975 of the Federal Tax Code [26 USC 4975] imposes a tax on a “disqualified person” who participates in a “prohibited transaction.” The tax is 5 percent of the amount involved in the prohibited transaction, or 100 percent of the amount involved if the prohibited transaction is not corrected within one year. Prohibited transactions include, among other things, a “transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan” and an “act by a disqualified person who is a fiduciary whereby he or she deals with the income or assets of a plan in his or her own interest or for his or her own account.” A “disqualified person” includes, among others, a “fiduciary” and a person providing services to the plan. A “fiduciary” is a person who: (1) exercises discretionary authority or control over management of a plan; (2) renders investment advice for a fee or other compensation to the plan; or (3) has any discretionary authority or responsibility in the administration of a plan. A “plan” includes, among other things, an IRA.

It seems likely that the setoff by a financial institution of a borrower’s obligation against the funds in his or her IRA would be a “prohibited transaction” by a “disqualified person” under Section 4975. A financial institution would be a disqualified person either because it is a “fiduciary” or because it is a person providing services to the plan. The setoff of the obligation against the IRA funds would probably be a prohibited transaction either because it is a transfer to, or for use by or for the benefit of, a disqualified person of the income or assets of a plan; or it is an act by a disqualified person who is a fiduciary, whereby he or she deals with the income or assets of a plan in his or her own interest or for his or her own account. At least one court has found setoff to be a prohibited transaction by a disqualified person. [In re: Dunn, 5 BR 156 (ND Tex. 1980)]

Fourth, an IRA has some of the characteristics of a “special deposit,” which, as we pointed out earlier, is not subject to setoff. An IRA is established for a specific and limited purpose, that being to provide income for a person after retirement. The depositor has lost some control over the funds in the account in the sense that the depositor cannot withdraw the fund prior to age 59½ without having to pay a tax penalty. The financial institution certainly has knowledge of these special account characteristics. So, in that an IRA is established for a specific purpose, the depositor has lost some control over the funds, and the financial institution has knowledge of these facts, an IRA could be considered a “special account,” immune from setoff. At least one court has so decided. [See First National Bank of Blue Island v. Estate of Philp, 436 N.E. 2d 15 (Ill. App. 1982).]

Finally, Section 408 of the Federal Tax Code [26 USC 408] also prohibits a person establishing an IRA from pledging the IRA as security for a loan. If the person does so, the amount pledged is treated as distributed and the penalty for distributing the funds prior to age 59½ applies. Although no court has come to this conclusion to our knowledge, this prohibition against pledging the account is consistent with the notion that a financial institution cannot set off against an IRA. If the institution could set off against an IRA, then the IRA would function as security for any loans the depositor might have with the institution and the account would be, for all practical purposes, pledged.

No setoff if debt is incurred under a consumer credit card plan

Both the federal Truth-in-Lending Act [15 USC 1601 et seq.] and the implementing regulation of the Federal Reserve Board, Regulation Z [12 CFR Part 226], prohibit a creditor from setting off a deposit account against a debt incurred under a consumer credit card plan. [See Section 169 of the Truth-in-Lending Act and Section 226.12(d) of Regulation Z, 12 CFR 226.12(d).] In order for this limitation to apply, the credit card plan must be subject to Truth in Lending, which means that the borrower must be an individual and the credit must be for personal, family, or household purposes. Also, if the credit exceeds the threshold amount, the plan will be exempt from Truth in Lending unless the plan is secured by real estate. The threshold amount is $54,000 until 12/31/2016 and is adjusted every year. See official comment 12 CFR 1026.3(b) for more information on how this exemption is determined. If the plan is exempt from Truth in Lending, the restriction against setoff does not apply.

For purposes of this rule, a credit card plan includes what you would normally think of as a credit card plan—where the consumer uses a card to make purchases and get cash advances. But, the term also includes overdraft protection plans in which the overdraft feature can be accessed by a debit or cash card. The term “credit card” is defined broadly enough to include both of these sorts of arrangements.

You are prohibited from setting off any sort of debt incurred under a consumer credit card plan—whether the consumer used the credit card to incur the debt or not. For example, if a consumer wrote a check that accessed the overdraft protection feature of his/her account, you could not set off that debt against other deposit accounts if the overdraft plan were a credit card plan because the consumer could access it with a cash card.

If the consumer intends to deposit funds into his/her account, you are prohibited under these rules from immediately applying the funds before they are technically deposited to debt that was incurred under a credit card plan. Truth in Lending says that funds the consumer intended to deposit are to be treated as if they were deposited, and your applying the funds to the debt without depositing them is the same as setting them off.

If you terminate the credit card feature of an account, the setoff rule continues to apply to debt incurred while the plan was a credit card plan. If the debt was incurred after the credit card feature was terminated, the setoff prohibition does not apply.

The rule prohibiting setoff against debt incurred under a credit card plan does not, however, prohibit you from taking a consensual security interest in the consumer’s deposit accounts. Such a security interest would usually take the form of a written assignment, pledge, or security agreement. However, such a security interest may not end up being the functional equivalent of the right of setoff. In other words, you cannot simply include in all your deposit account agreements language giving you a security interest in deposit accounts and, thereby, evade the setoff prohibition. The Official Staff Commentary to Regulation Z says that, in order for a security interest to be enforceable under these rules, the following conditions must be met:

[See the Commentary to Regulation Z, section 226.12(d)(2)-1.]

This rule prohibiting setoff against credit card debt also does not prohibit you from arranging with the consumer for the automatic payment of credit card bills from the consumer’s deposit account. The consumer’s authorization for such a payment plan must be in writing and must be signed or initialed by the consumer. The authorization form must clearly indicate the consumer’s option to decline to have payments automatically withdrawn if the consumer has that option. (Note that the Electronic Funds Transfer Act prohibits you from requiring that the consumer make loan payments by automatic transfer, except in overdraft and minimum-balance protection plans.)

Military Lending Act

There are conflicting opinions on whether set-off is prohibited by the Military Lending Act. The regulations provide that it is unlawful for any creditor to extend consumer credit to a covered borrower with respect to which the creditor uses a check or other method of access to a deposit, savings, or other financial account maintained by the covered borrower. [32 CFR 232.8(e)] If not otherwise prohibited by applicable law, a creditor may take a security interest in funds deposited after the extension of credit in an account established in connection with the consumer credit transaction. [32 CFR 232.3(e)(3)] The phrase “other method of access to a deposit, savings, or other financial account” is not clear, but it is written very broadly and we think it certainly could be interpreted to include setoff.

On August 23, 2016 the Department of Defense published an interpretive rule with Q & As that addressed some aspects of this limitation. Q & A 17 states that the prohibition in § 232.8(e) does not prohibit covered borrowers from granting a security interest to a creditor in the covered borrower’s checking, savings, or other financial account after the extension of credit, provided that it is not otherwise prohibited by applicable law and the creditor complies with the MLA regulation including the limitation on the MAPR to 36 percent.

Under 12 U.S.C. 1757(11) federal credit unions may “enforce a lien upon the shares and dividends of any member, to the extent of any loan made to him and any dues or charges payable by him.” Q & A 18 of the interpretive rule states—However, the fact that § 232.8(e)(3) specifies a particular time when a creditor may take a security interest in funds deposited in an account does not change the general effect of the prohibition in § 232.8(e). Therefore, § 232.8(e) does not impede a creditor from exercising a statutory right to take a security interest in funds deposited in an account at any time, provided that the security interest is not otherwise prohibited by applicable law and the creditor complies with the MLA regulation, including the limitation on the MAPR to 36 percent.

We know some observers conclude that the interpretive rule clarifies that exercise of a statutory right of set-off is permissible. We think that position is not unreasonable. However, the opinions we have seen apply to a statutory right of set-off and have not addressed a contractual right of set-off. Many institution’s contractual right of set-off provide for broader rights than created by statute—by providing the ability to set-off all of the funds in a joint account for the debt of only one of the owners. Until there is further clarification, it is advisable to be cautious in dealing with set-off and the Military Lending Act.

Limited setoff against electronic transfer accounts

An electronic transfer account (ETA) is an account with certain characteristics designed to enable lower-income individuals to have a basic, inexpensive, no-frills account at a financial institution in order to receive federal payments electronically. It is a product of the Debt Collection Improvement Act of 1996. This law provided that all federal payments, other than payments under the Internal Revenue Code, must be made by electronic funds transfers after January 1, 1999. [31 USC 3332(a)(1) and (f)(1)] The law authorized the Treasury Department to grant waivers from this requirement [31 USC 3332(f)(2)(A)] and to issue implementing regulations. [31 USC 3332(f)(2)(A)]

The Treasury Department issued implementing regulations on September 25, 1998. [Federal Register for September 25, 1998, at page 51489] These regulations restated the basic rule that all federal payments other than those under the Internal Revenue Code must be made by electronic funds transfers. [31 CFR 208.1 and .3] The regulations also established a number “waivers,” (i.e., situations where federal payments could be made in ways other than electronic funds transfers). For example, if the individual receiving the payment claims that receiving the payment by electronic funds transfers would cause certain hardships, that individual can receive payments in other ways. [31 CFR 208.4(a)] Other waivers are: (1) where the payment is going to a foreign country that is lacking the capability of receiving electronic funds transfers, (2) where the payment is going to a declared disaster area, (3) where the payment is to be made during time of war or similar circumstances, (4) where the national security is threatened or an individual’s safety is endangered or a law enforcement action would be compromised, (5) where the payment is nonrecurring, and (6) where the agency making the payment is purchasing goods or services and circumstances dictate payment by some other means. [31 CFR 208.4(b) – (g)]

One more waiver exists, and this is where ETAs come in. Treasury recognizes that many people who receive federal payments are unable to receive their payments electronically because they do not have an account at a financial institution. One reason why people don’t have accounts is that accounts allowing low balances are sometimes expensive because of maintenance fees, per-check charges, and the like. So the regulation gives people who do not have an account a waiver, but it also tries to encourage them to open an account. The encouragement takes two forms: (1) Treasury induces financial institutions to offer ETAs, which, as we pointed out earlier, are accounts with certain characteristics designed to enable lower-income individuals to have a basic, inexpensive, no-frills account at a financial institution. (2) Treasury puts a time limit on the waiver—the waiver expires when Treasury determines that an ETA is “available” to the person receiving the federal payment. [31 CFR 208.4(a)] An ETA is “available” when the federal agency making the payment notifies the individual of a local financial institution that offers ETAs. [31 CFR 208, Appendix A]

The September 1998 regulations do not list the characteristics of an ETA. Instead, Treasury issued the characteristics in a Notice released in July of 1999. See our chapter in this manual entitled “Types of Deposit Accounts” under the heading “Electronic Transfer Accounts” for details on the characteristics of an ETA.

[Federal Register, July 16, 1999, at page 38513]

No setoff against unmatured debts unless debtor insolvent

This rule relates to the four prerequisites we listed earlier. Before an institution can exercise its right of setoff, the debt must be matured, or “then due and owing.” This means the debt must be such that the creditor has the authority to demand immediate payment. In the case of a note, the maturity date has to have passed or else the borrower has to be in default so that the creditor is authorized under the terms of the note to accelerate the balance and demand immediate payment.

The law in some states allows you to setoff against an unmatured debt if the debtor is insolvent. However, exactly what constitutes insolvency is not clear. This issue is not that important, though, since in many cases the circumstances that would constitute insolvency also constitute a default on a promissory note (assuming the default provisions on the note are drafted broadly). Therefore, the note balance could be accelerated and the setoff justified by arguing that the note is, in fact, mature.

Setting off against an account of a bankruptcy debtor

Federal bankruptcy law [11 USC s.101 et seq.] affects a creditor’s right of setoff in three ways. First, in some circumstances, it simply prohibits a creditor from setting off by creating an “automatic stay” against any creditors taking any action to collect debts from the debtor. Second, it gives creditors whose right of setoff has been blocked by the automatic stay a somewhat improved position in the bankruptcy proceeding. And third, in certain cases, it enables the bankruptcy trustee to recover from creditors amounts that the creditors have already set off before the filing of the bankruptcy petition. Let us now take a closer look at each of these three ways in which your setoff right is affected.

The automatic stay. First, you are prohibited from setting off once a petition in bankruptcy concerning your debtor is filed. The filing of a petition in bankruptcy is what starts the bankruptcy process, and once that petition is filed, an “automatic stay” is imposed on all of the debtor’s creditors. The automatic stay prohibits creditors from taking any action to collect the money owed them by the bankruptcy debtor. It prohibits, for example, initiating or continuing any lawsuits against the debtor, enforcing any judgments against the debtor or the debtor’s estate (the debtor’s property), and repossessing any property of the debtor. It also prohibits setting off against any accounts of the debtor. The automatic stay goes into effect the moment the bankruptcy petition is filed. So, once the petition has been filed, you cannot exercise your right of setoff.

The Bankruptcy Code does provide a procedure for obtaining relief from the automatic stay. You can ask the court to either lift the stay completely or modify it in some way. The Code provides that the court can do so for either of two reasons: (1) “for cause”; or (2) if the creditor wants to take some action against property of the estate and the debtor does not have equity in the property, and the property is not necessary to an effective reorganization. “Cause” is not defined in the Code but, presumably, you would have to show that unless you are allowed to set off immediately, your interest would somehow be unfairly harmed. The second reason does not seem particularly applicable to the setoff situation since it requires that the debtor not have equity in the property. Presumably, the debtor would, in most cases, have equity in his or her deposit accounts. In short, relief from the automatic stay may very well be hard to come by for a creditor wanting to set off against a depositor’s account.

Without receiving the bankruptcy court’s relief from the automatic stay, an outright setoff is not available. However, something less than setoff may be. In the case of Citizens Bank of Maryland v. Strumpf, the U.S. Supreme Court ruled that an “administrative hold,” imposed by the bank pending the resolution of it motion for relief from the automatic stay was not a setoff and did not violate the automatic stay. The crucial difference, according to the court, between setoff and the administrative hold imposed in this case was the institution’s intent: a setoff is a permanent settling of accounts; the administrative hold in this case was a temporary refusal by the institution to pay the debt it owed the debtor.

A couple of cautionary notes. First, an institution imposing an administrative hold will have to evidence in some way its intent that the hold be temporary since the temporary nature of the hold is what distinguishes it from a setoff. Promptly filing a motion for relief from the automatic stay is one way. In this case, the bank filed its motion for relief five days after imposing the administrative hold. The institution would also express its intent by not taking actions usually associated with setoff—namely, some action accomplishing the setoff and the recording of the setoff. The institution might also evidence the temporary nature of the hold through a notice to the debtor stating its temporary nature.

Second, the court in the Strumpf case specifically refused to rule on whether the administrative hold was wrongful because the bank imposed the hold on an amount larger than what the debtor owed the bank. The court ruled only that the administrative hold did not violate the automatic stay. So, institutions should not read this case as carte blanche authority to impose an administrative hold on any and all amounts in the debtor’s account.

Institution’s improved position in bankruptcy proceeding. The second way in which the bankruptcy laws affect your right of setoff is to improve your position in the bankruptcy proceeding because of your right of setoff. What really happens is that a creditor with a right of setoff is treated as a secured creditor to the extent of the right of setoff and as an unsecured creditor for the remainder of the creditor’s claim. For example, if your claim against the debtor is for $10,000 and your right of setoff is $8,000, you will be treated as a secured creditor as to $8,000 of your claim and an unsecured creditor for the rest. The benefit of being treated as a secured creditor is that the secured creditor’s claim is protected up to the value of its collateral, which, in the case of a creditor with the right of setoff, would be the amount of the right of setoff as determined by provisions in the Code. So, in our example, you would be protected up to $8,000 of your claim and the remaining $2,000 of your claim would be thrown in with the claims of the other unsecured creditors to share whatever is remaining of the debtor’s assets after the secured creditors are satisfied.

How is your right of setoff measured for purposes of determining your protection? It is measured by the same rules that determine how much the trustee in bankruptcy can recover from you in the event you set off before the filing of the petition. Remember that the third way in which bankruptcy affected your right of setoff is to enable the trustee in some circumstances to recover amounts you set off before bankruptcy. The rules that determine when and how much the trustee can recover also determine the extent of your right of setoff for purposes of determining your secured status in the bankruptcy proceeding. Let’s look at those rules now.

Trustee’s ability to recover prior setoffs. Section 553 of the Bankruptcy Code [11 USC 553] spells out these rules and puts the following limits on your right of setoff. First, both your claim and your debt to the depositor (the deposit account) must have preexisted the bankruptcy filing. If either the deposit account or your claim came into existence after the filing, no right of setoff exists.

Second, if your claim is “disallowed,” or invalidated, then your right of setoff regarding that claim is not recognized. A claim might be disallowed, for example, because it is based on a loan transaction found to be usurious.

Third, if your claim was transferred to you either after the bankruptcy petition was filed, or within the 90-day period prior to filing and the debtor was insolvent during that period, then you will have no right of setoff as to that claim. For example, suppose the debtor owes money to Joe’s Hardware and has a deposit account with you. It might seem like a good idea for Joe’s Hardware to sell that debt to you since you have a right of setoff while Joe is unsecured. However, if Joe’s Hardware sells or transfers that debt to you within the 90-day period preceding the filing and while the debtor was insolvent or at any time after the filing, you will have no right of setoff regarding that debt. The debtor is presumed to be insolvent during this 90-day period, which means the burden would be on you to prove that he or she was actually solvent during the period in order to justify your setoff.

Fourth, if your debt to the debtor (the deposit account) was incurred within the 90-day period preceding the filing and while the debtor was insolvent and for the purpose of obtaining a right of setoff against the debtor, then your right of setoff is reduced by the amount of debt which meets these conditions. For example, suppose you and your debtor devise a plan in which the debtor deposits all of his or her cash into an account with you in order to give you the right of setoff and a preferred position in bankruptcy and then declares bankruptcy. If the debtor declares bankruptcy within 90 days of making the deposit, then your right of setoff does not apply to that deposit. (Again, for purposes of this rule, the debtor is presumed to be insolvent during the 90-day period preceding filing of the bankruptcy petition.)

And fifth, the Bankruptcy Code limits your right of setoff by what is known as the “improvement in position” rule. This rule, put very basically, says that the trustee can recover from you the amount by which you improve your position, with respect to setoff during the 90-day period preceding the bankruptcy filing. More specifically, the rule says the trustee can recover from you the amount by which the “insufficiency” when you actually set off is less than the “insufficiency” on the later of 90 days prior to filing or the first day during the 90-day period preceding filing on which there was an “insufficiency.” An “insufficiency” is the amount by which your claim against the debtor exceeds the debtor’s claim against you (the deposit account balance).

So, for example, suppose that 90 days prior to filing the debtor owes you $10,000 and has deposit accounts with you of $8,000. This is an insufficiency of $2,000. Then, two weeks later, the debtor deposits $500 into his account. You set off at that point, when the deficiency is $1,500. Under the “improvement in position” rule, the trustee could recover $500 from you. If there had been no insufficiency at the beginning of the 90-day period prior to filing, then the insufficiency at setoff would be compared with the first insufficiency that did occur during the 90-day period prior to filing. So, in our example, suppose that instead of only an $8,000 deposit account balance, the debtor had a $12,000 balance 90 days before filing. Then, two weeks later, he/she withdrew $3,000. This would leave an insufficiency of $1,000 (the $10,000 debt to you, minus the $9,000 balance) two weeks into the 90-day period. The insufficiency at the time of setoff would then be subtracted from this $1,000 insufficiency to determine whether you had improved your position or not.

Another way in which the trustee could recover from you under the improvement in position rule is if the debtor makes a payment on the debt during the 90 days preceding filing. For example, if the insufficiency 90 days before filing is $2,000 and the debtor makes a $500 payment on the debt two weeks later, the insufficiency has decreased by $500 and the trustee could recover that $500 from you if you set off while the insufficiency was $1,500. So your position can improve by the debtor either making a deposit or making a payment on the debt during the 90-day period.

That concludes our review of your right of setoff in the context of a debtor in bankruptcy. Again, remember that bankruptcy affects your right of setoff in three ways. First, it prevents you from exercising your right after a petition in bankruptcy has been filed. Second, it gives you secured-party, or protected, status regarding your claim to the extent that you have a right of setoff and unsecured-party status for the remainder of your claim. And third, it enables the trustee in bankruptcy to recover from you, in certain circumstances, amounts you have already set off.

When the account contains social security and supplemental security income

Cases interpreting this provision are not consistent with each other. In Tom v. First American Credit Union, 151 F.3d 1289 (10th Cir. 1998), the Court approved a judgment in favor of a credit union customer that Section 407 prohibited the credit union from applying social security deposits to the customer’s debt.

On the other hand, the Federal Circuit Court of Appeals for the Ninth Circuit, ruled the other way, saying that Section 407 does not prohibit a financial institution from setting off a debtor’s overdrafts against social security benefits directly deposited to the debtor’s account. [Lopez v. Washington Mutual Bank, Inc., 2002 U.S. App. LEXIS 15658.] But, the opinion we just cited is the Ninth Circuit’s reversal of its own original opinion in this case, which went the other way. In other words, the court first ruled that the law prohibited the financial institution from setting off, then reversed itself, and withdrew its original opinion.

Even after the Ninth Circuit’s self-reversal, at least one court viewed Section 407 as still prohibiting setoff. See In Re: Brewer, U.S. Bankruptcy Court for the Southern District of Illinois, 2002 Bankr. Lexis 992 August 15, 2002.

In short, we don’t know whether Section 407 limits an institution’s right of setoff if the account contains social security funds. Financial institutions should stay alert for new cases