A Bank's Ability to Set Off Customer Debt From Money Held in Trust

, New York Law Journal

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Scott I. Davidson

Generally speaking, a bank has a right to set off a debt owed by the customer to the bank from its customer's account. In a typical situation, where borrower A owes bank B a debt for a loan, and borrower A has a bank account with bank B, bank B can use funds from borrower A's account to satisfy the debt where there has been a default under the loan. This general rule may not be applicable, however, if the funds in borrower A's bank account are held in trust for another entity. The ability to set off such funds will, absent statutory authority, generally turn on bank B's knowledge of the trust fund nature of the money in the account.

Bank Accounts and Setoffs

Banking institutions "have a long established right of setoff where a borrower is indebted to the institution and also has money on deposit with the institution."1 When a customer deposits funds in a general bank account, the customer parts with title to the funds, and essentially loans the funds to the bank. Conversely, when an account is overdrawn, such overdraft is considered a loan by the bank to the customer. The application of the bank's debt (i.e., the deposit) to reduce the customer's debt (i.e., the overdraft) is a setoff. Because a setoff is any balancing of mutual debts, courts do not distinguish between an active decision to set off funds already in an account against another debt, on the one hand, and an automatic application of deposits to reduce an overdraft, on the other.

A setoff right is premised on mutual obligations. Accordingly, a bank may only reduce a customer's overdraft with funds belonging to that customer, and not with funds belonging to a third party. When funds are deposited into a general, non-trust account, the bank is entitled to presume that the funds belong to the customer; the bank has no duty to inquire into the source of each deposit. That said, the presumption that the funds belong to the customer can be rebutted if it can be shown that the bank had knowledge of the nature of the funds, or adequate notice thereof. Thus, "when a bank is on notice that funds in a depositor's account are owned by a third party, the bank cannot appropriate those funds in order to set them off against a debt of the depositor."2

A bank will be considered to have such notice "when it is aware of facts which would fairly provoke it to inquire as to the true ownership of the funds and such inquiry, if made with ordinary diligence, would reveal the true ownership."3 The nature and characteristics of funds on account, and the bank's knowledge thereof is a fact-intensive inquiry that will depend on the facts of each case. Courts have held that funds that are contractually held in trust for another are third-party funds that are not subject to setoff. This is true even when the bank is not a party to the agreement that establishes the trust funds.

If a bank knows or is on notice that the customer is not the true owner of funds in an account at the time it applies those funds to the customer's debt, the bank may be liable to the true owner for their conversion.4 It is irrelevant whether the bank is aware of the actual amount of trust funds contained in a commingled account. If the bank knows that at least some deposits in an account consist of trust funds, then it may be prevented from applying all deposits to reduce its customer's debt. Thus, if a bank has actual notice that funds are held in trust, the bank will not be able to utilize its setoff rights against such funds.

Courts have held that a bank has actual notice that funds belong to a third party when the bank has received the document creating the third-party ownership. "In most cases where there is a written trust instrument, and the purchaser knows of it, or could have learned of it with reasonable effort, he will be charged with the duty of examining that instrument."5

Absent actual knowledge, a bank may also have constructive or inquiry notice of the nature or characteristics of the funds in an account. For a bank to have constructive notice of trust funds in an account, generally one bank employee should know all of the relevant facts to put the bank on notice.6 Knowledge, however, should not be aggregated; a bank should not be deemed to have constructive notice when the many facts that would prompt inquiry into the funds' ownership are spread out over various different bank employees. Additionally, when a bank receives a check for deposit that appears valid on its face, and the check has an endorsement stating that the payee is the sole and unconditional owner of the funds, the bank will not be required to investigate further.

Knowledge of the nature of the customer's business is relevant, but it probably will not, by itself, be sufficient to establish actual or constructive notice. Other factors that have been held to put a bank on notice of the fiduciary nature of funds are (i) familiarity with the customer's financial affairs and/or (ii) unusual facts surrounding the deposit.

Types of Accounts

In addition to the issue of whether funds deposited into an account are third-party funds, disputes can arise as to whether the account itself is a general account, in which case the bank has a right of setoff, or a special or reserve account where the bank may not have a right of setoff. There is a presumption that an account is general, and New York law considers all of the circumstances of the establishment and maintenance of the account and whether it was the intent of the parties to create a general account or a special or trust account. The party claiming that the funds are special funds has the burden of proving the intent to have the funds kept separate from general funds with the bank.

Whether funds are deposited for a specific purpose is not determinative of whether the account is general or special. Additionally, the labeling of an account as a "special account" alone is not sufficient to put a bank on notice that the funds in that account are trust funds held on behalf of a third party.

Setoffs and Bankruptcy

A bank's right of setoff will generally be preserved in bankruptcy.7 "The rule allowing setoff, both before and after bankruptcy, is not one that courts are free to ignore when they think application would be 'unjust.'"8 The right of setoff should be enforced unless "compelling circumstances" require the disallowance of that right.9

Compelling circumstances may include a real and imminent threat to the debtor, or when a creditor engages in criminal conduct or commits fraud. Compelling circumstances frequently arise in Chapter 11 bankruptcy cases, where the debtor is attempting to reorganize its financial affairs. However, even then, while the right of setoff may be deferred or stayed, it ordinarily will not be completely barred.

Of course, in order to exercise its right of setoff after the filing of a bankruptcy, the bank must request relief from the automatic stay with respect to acts to obtain possession or control over the property of the estate.10 Nonetheless, while the application of a setoff is stayed in bankruptcy, a bank can place an administrative freeze on an account without being in violation of the automatic stay provisions set forth in Section 362 of the Bankruptcy Code.11 That said, the most prudent course of action for a bank to take is to seek relief from the automatic stay to effectuate the bank's right of setoff immediately after placing an administrative freeze on the borrower's account.

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