One issue that I discuss with bankruptcy clients more often than you might expect is what happens to the money in their checking or savings account when they also owe money to that same bank.

For example, suppose you have $8,000 in your checking account at a bank and owe that same bank $20,000 on a personal loan. What happens if you file Chapter 7 bankruptcy?

Can the bank simply take the $8,000?

The answer is sometimes—but there are important rules that apply, particularly depending upon whether the debt is a credit card, personal loan, auto loan, or another type of obligation.

This is called the bank’s right of setoff.

I have represented thousands of Michigan consumers in bankruptcy cases, and I always want my clients to understand this issue before we file their bankruptcy petition. Moving money from one bank to another before filing can sometimes prevent a very unpleasant surprise.

What Is a Bank Setoff?

A setoff is essentially a situation where two parties owe each other money.

You have money on deposit at your bank. Legally, the bank owes that money to you.

At the same time, you may owe the bank money because of a credit card, personal loan, auto loan, overdraft, or other debt.

Under circumstances where a valid right of setoff exists, the bank may be able to apply money it owes you against money that you owe the bank.

For example:

You have $10,000 in your checking account.

You owe the same bank $15,000 on a personal loan.

The bank may have a right of setoff against the $10,000 deposit, subject to applicable law and the terms of the account and loan agreements.

The Bankruptcy Code recognizes and generally preserves valid prepetition setoff rights under 11 U.S.C. § 553, although the automatic stay and other bankruptcy provisions place important restrictions on actually exercising those rights after a bankruptcy filing.

The Important Difference: Credit Card Debt Versus a Loan

This is where many people are surprised.

There is a significant federal distinction between credit-card debt and other types of debt.

Federal Regulation Z generally prohibits a credit-card issuer from offsetting a consumer’s credit-card debt against funds that the cardholder has on deposit with that issuer.

The regulation states that a card issuer may not offset a consumer’s credit-card indebtedness against funds held on deposit with the card issuer. The CFPB’s official commentary also explains that simply “freezing” the account can constitute the functional equivalent of an offset and therefore can be prohibited, subject to the regulation’s exceptions.

That means there is an important difference between these two situations:

You owe the bank $10,000 on its credit card.

You have $10,000 in your checking account at that bank.

The bank generally cannot simply take the $10,000 to pay the credit-card debt because of the federal prohibition on credit-card offsets.

You owe the bank $10,000 on a personal loan.

You have $10,000 in your checking account at that bank.

That is a very different situation.

The special Regulation Z credit-card prohibition generally does not protect the account from a setoff based upon an ordinary personal loan, auto loan, or other non-credit-card obligation.

That distinction can be extremely important when someone is preparing to file bankruptcy.

What About Bankruptcy and the Automatic Stay?

People sometimes assume that once they file bankruptcy, the bank cannot touch their money under any circumstances.

The situation is more complicated.

The automatic stay generally prohibits a creditor from actually exercising a prepetition right of setoff after the bankruptcy filing. Section 362(a)(7) specifically addresses setoffs of debts arising before the bankruptcy case.

However, the United States Supreme Court addressed the issue of a bank placing an administrative hold on an account in Citizens Bank of Maryland v. Strumpf, 516 U.S. 16 (1995).

In Strumpf, the Supreme Court held that a temporary administrative hold designed to preserve the bank’s ability to seek a determination of its setoff rights did not itself violate the automatic stay. The bank could preserve the funds while seeking relief from the stay rather than immediately paying itself from the account.

This distinction is important:

A bank may not simply disregard the automatic stay and complete a setoff after the bankruptcy filing. But a bank with a valid setoff claim may be able to place a temporary administrative hold on the funds while it seeks appropriate relief from the bankruptcy court.

Therefore, a debtor can find himself or herself with money in the bank that is temporarily unavailable.

That is obviously a problem if the money is needed to pay the mortgage, rent, utilities, payroll, groceries or other ordinary living expenses.

What About SoFi Bank?

SoFi provides a good modern example of why this issue should be considered before filing bankruptcy.

SoFi’s published materials discuss setoff rights and explain that setoff provisions can appear in loan and bank-account agreements.

SoFi’s current published agreement language also provides for broad setoff rights involving funds maintained with SoFi Bank, subject to applicable law and specific exceptions.

Therefore, if someone has both:

• a SoFi checking or savings account; and
• a substantial SoFi personal loan or other qualifying debt,

I would want to know about that before filing the bankruptcy petition.

The bankruptcy filing does not necessarily mean that the bank can immediately take the money. The automatic stay remains important. But the bank may have a basis for an administrative hold while it seeks to protect its setoff rights.

The practical lesson is simple:

Do not wait until after filing bankruptcy to discover that the bank where you keep your money is also one of your creditors.

What About Credit Unions in Michigan?

Michigan credit unions deserve special attention.

Michigan law specifically provides credit unions with a statutory right of setoff. Michigan Compiled Laws § 490.64 provides that, subject to contractual provisions and other statutory rights, when a party to a multiple-party account is indebted to a credit union, the credit union has a right of setoff against the entire amount of the account.

Credit unions may also have loan documents containing cross-collateralization provisions.

This can create an additional problem.

For example, you might have:

• a $20,000 auto loan with the credit union;
• a $5,000 credit-card balance with the same credit union; and
• $15,000 in your checking and savings accounts at the credit union.

The analysis can become considerably more complicated because of the contractual relationship between the credit union and its member and the language contained in the loan and account agreements.

Michigan bankruptcy cases have recognized that credit unions can possess setoff rights against a member’s account, and the Bankruptcy Code generally preserves valid setoff rights subject to the bankruptcy rules.

Banks Have Setoff Rights Too

There is sometimes a misconception that only credit unions can take money from an account to satisfy a loan.

That is not correct.

Banks can also have setoff rights.

Michigan law recognizes the importance of setoff rights, and bank deposit agreements commonly contain contractual provisions addressing the bank’s ability to apply deposits toward debts owed to the bank.

Michigan case law has recognized a bank’s right to use funds on deposit as a setoff against obligations when that right has not been waived.

So I do not tell my clients:

“It’s a bank, so you’re safe.”

And I do not tell them:

“It’s a credit union, so they will automatically take your money.”

Instead, I want to know exactly what institution holds the money, exactly what debt is owed to that institution, and what the applicable agreements provide.

Why I Often Recommend Using a Different Bank

When someone is preparing to file bankruptcy, one of the things I consider is whether the debtor’s everyday checking account should be moved to a completely unrelated financial institution.

For example, if you owe Bank A $30,000 and have $12,000 sitting in your Bank A checking account, there is an obvious concern.

If you instead have your checking account at Bank B, where you have no debt, there is generally no creditor-debtor relationship between you and Bank B that would give Bank B a right of setoff for Bank A’s debt.

That does not mean money can simply be moved around to conceal assets or defraud creditors. Bankruptcy requires complete disclosure of assets, accounts and financial transactions.

But there is nothing inherently improper about maintaining your checking account at a financial institution where you do not owe money.

What Should You Do Before Filing Bankruptcy?

If you are considering bankruptcy and have money deposited at a bank or credit union where you also owe money, I recommend addressing the issue before the bankruptcy is filed, rather than waiting until afterward.

Depending upon the circumstances, that may include:

1. Open an account at an unrelated financial institution.

If you owe money to your present bank or credit union, consider whether a different institution should be used for your ordinary household banking.

2. Redirect your direct deposit.

If your paycheck or other income is deposited directly into an account at a creditor bank, consider changing the account before filing.

3. Cancel unnecessary automatic withdrawals.

If loan payments are automatically drafted from the account, those arrangements should be reviewed before filing.

4. Allow legitimate outstanding transactions to clear.

You do not want checks, debit-card transactions or other legitimate payments unexpectedly bouncing because an account has been frozen.

5. Tell your bankruptcy attorney about all accounts and all debts.

This is extremely important.

Do not assume that a particular account is irrelevant because it contains only a few thousand dollars. Your attorney needs to know where the money is and whether you owe that financial institution money.

What If the Money Is Needed for Living Expenses?

This is one of the biggest practical problems with a bank hold.

Imagine that you have $6,000 in your checking account because you are preparing for bankruptcy and need the money to pay your mortgage, car payment, utilities, groceries and other household expenses.

You file bankruptcy.

The bank sees that you owe it $25,000 on a personal loan.

The bank places an administrative hold on the account.

Suddenly, the $6,000 you thought was available to pay your household expenses may not be immediately accessible.

That can create a very serious cash-flow problem.

The bankruptcy attorney may need to communicate with the bank and, depending upon the circumstances, address the issue with the bankruptcy court.

This is why I would much rather identify the problem before the bankruptcy is filed.

What If You Owe the Bank on a Credit Card?

This is one of the better situations from the standpoint of the deposit account.

If the debt is truly a consumer credit-card obligation covered by Regulation Z, the federal offset prohibition is significant.

The bank cannot simply say:

“You owe us $10,000 on your credit card, and you have $10,000 in your checking account, so we’re taking the checking account.”

Federal Regulation Z generally prohibits that type of offset.

But you need to be careful about assuming that every product described as a “credit line” or “card” falls within exactly the same rules.

An overdraft line, personal line of credit, secured obligation or other product may involve different legal considerations.

The exact nature of the debt matters.

The Bankruptcy Code Does Not Erase Every Setoff Right

Another misconception I sometimes encounter is that bankruptcy eliminates the bank’s setoff rights.

That is also not quite correct.

Section 553 of the Bankruptcy Code generally preserves a creditor’s prepetition right of setoff, subject to the statutory limitations contained in the Bankruptcy Code.

The important distinction is between the existence of the right and the ability to exercise the right after bankruptcy is filed.

The automatic stay can prevent the actual setoff.

Strumpf demonstrates that a temporary administrative hold can nevertheless be permissible while the creditor seeks to protect its setoff position.

This is one of those areas of bankruptcy law where a seemingly small detail—whether the debt is a credit card or a personal loan, and where your money is deposited—can make a very large practical difference.

Bottom Line

If you are considering filing Chapter 7 or Chapter 13 bankruptcy and you owe money to the same bank or credit union where you keep your checking or savings account, tell your bankruptcy attorney before filing.

The answer can be very different depending upon whether you owe the institution:

• a credit card;
• a personal loan;
• an auto loan;
• a home-equity loan;
• an overdraft;
• a line of credit; or
• another type of obligation.

Credit unions in Michigan have specific statutory setoff rights, but setoff is not limited to credit unions. Banks can also have setoff rights.

And while the automatic stay is extremely powerful, it does not necessarily mean that your bank must immediately release every dollar in an account after you file bankruptcy.

The safest approach is to identify the issue before the petition is filed, review the particular debts and account agreements, and make sure your bankruptcy attorney knows exactly where your money is located.

If you are considering bankruptcy in Michigan and have both a bank account and a debt with the same financial institution, this is something I would want to discuss with you before we file your case—not after your account has been frozen.