The question of whether a creditor can freeze the accounts of bankrupt debtors in order to protect the rights of offset has long since been in debate. Technically, the automatic stay provisions of Bankruptcy Code §362 (a) (7) prohibits a creditor from exercising its right to set off any pre-petition debt owing to the debtor against any claim it has against the debtor. The most common of the matters arising under this subsection in consumer cases is that of a bank or credit union seeking to satisfy a pre-petition claim with the funds the debtor has on deposit. However, there are ways to accomplish the set off with judicial approval. There are several cases which help answer the question. Creditors must be careful to distinguish action based upon the facts and the Chapter of the bankruptcy, however.
In regard to Chapter 7 cases, previously the Fourth Circuit Court of Appeals upheld a bankruptcy court order assessing punitive damages and attorney's fees against a creditor bank which placed a "freeze" on a bankrupt's checking account because he had defaulted on a consumer loan. The Court held that the freeze violated the automatic stay. Although previous decisions upheld findings of violations and upheld awards of attorneys fees, this was the first federal circuit case upholding a punitive award. Based upon this state of the law, creditors, although having the right to take money in an account as a set off for unpaid debts (this is allowed under Bankruptcy Code §553), in order to offset, must first obtain court relief from the automatic stay. This puts the creditor in a dilemma, because once the debtor finds out that the creditor is seeking relief from the stay, the debtor can simply remove the funds from the account. Some courts took this dilemma into consideration and allowed banks to freeze an account while the motion to lift the stay was pending; these courts reasoned that a freeze on an account is not the same thing as actually taking the money, and so the stay is not violated. In the previously referenced Chapter 7 case, the Fourth Circuit, however, held that despite the obvious dilemma, ruled that the Bankruptcy Code does not authorize such action. The Court stated that "[A]n administrative hold is tantamount to the exercise of a right of set off and thus violates the automatic stay of Bankruptcy Code §362(a)(7).”
Although some Bankruptcy and Circuit Courts have previously held that the freeze violates the Bankruptcy Code's Automatic Stay, and in doing so these courts found the creditor in contempt of court, the United States Supreme Court ultimately resolved the issue. In the case of Citizens Bank of Maryland v. Strumpf, the Supreme Court ruled that bankruptcy law allows a creditor to temporarily freeze a bankrupt debtor's account while seeking authorization to use the money to offset a debt the bankrupt debtor owes the creditor. In Strumpf, the Supreme Court ruled that the freezing of the debtor's account was not a set off (which would violate the automatic stay) because the creditor did not intend to permanently reduce the debtor's balance by the amount of the defaulted loan. Instead, the administrative hold was temporary, pending a determination by the bankruptcy court on the creditor's Motion for Relief from Automatic Stay and for Set off, which was filed within five (5) days of the placement of the hold, and that it was not an attempt to set off permanently the amounts in the debtor's account against the remaining balance of a loan on which the debtor was in default. The Supreme Court recognized that the temporary administrative hold would protect the creditor's right of set off while the bankruptcy court decided its merits. There is an important distinction to keep in mind. "Freezing" an account is not the same as application of the funds to the debtor's outstanding balance. Application of the funds to the debt constitutes a set off. Court permission and an order lifting the automatic stay are necessary before this step can be taken.
There are two approaches that I recommend that you take when facing a freeze problem in Chapter 7 cases. First, creditors can ask the bankruptcy court for an "ex parte temporary restraining order" on the account pursuant to Bankruptcy Code §105. This order would place the account on hold until the Court could rule on the creditor's motion for relief from the stay. Second, if it is likely that the debtor will consent to the offset given the situation, place the freeze on with instructions not to bounce any checks. Then, immediately write the debtor’s counsel and advise him of the situation, and request consent to offset. If consent is denied, file the motion for relief from the stay. Improper procedures in protecting your collateral can yield bad results. A good example of this is the case of In Re: Joann L. Marcussen. In Marcussen, the debtor's credit union administratively "froze" her bank account. The "freeze" was achieved by transferring funds from the debtor's checking account to her savings account, and then freezing that account even though the debtor was current on her loans from the credit union at the time she filed her Chapter 7 petition. The Bankruptcy Court ruled that this administrative freeze violated the automatic stay in bankruptcy, and the credit union was held liable to the debtor for damages. The debtor in Marcussen testified that as a result of the freeze, she incurred damages totaling $300.00, consisting of overdraft charges in the amount of $135.00, returned check fees in the amount of $140.00, unanticipated attorney's fees and a $25.00 cable television re-connection fee. In addition, the debtor testified that the credit union's actions made it difficult for her to continue in her day-to-day payments and activities, and it caused her embarrassment. The debtor also testified that one creditor even threatened her with a potential criminal warrant and possible repossession of her automobile. The credit union argued that the administrative freeze did not violate the automatic stay because the freeze merely protected its right of set-off. The Court found that the credit union did not merely freeze the funds of the debtor and leave the accounts "intact", it transferred funds from a non-freezable checking account to a freezable savings account. The Court ruled that this was an attempt to "exercise control over the property of the estate" in violation of 11 U.S.C §352(a)(3). The Bankruptcy Court granted judgment for the debtor in the amount of $300.00 plus interest, as well as $1,786.00 in attorney's fees and $59.00 in expenses. The lesson of Marcussen is this: before taking any action against the accounts of debtors in bankruptcy, ensure that there is a statutory right to do so, and that proper procedures are followed. If questions arise, seek legal review.
In a few weeks we will examine whether a creditor can freeze the accounts of bankrupt debtors in order to protect the rights of offset if a debtor is in a Chapter 13 bankruptcy.
