I. INTRODUCTION
Since ancient times, the law has generally recognized the right of a creditor to “set-off” amounts owed to the creditor by a debtor against property of the debtor that is in the creditor’s possession. This right for a commercial bank arises out of the debtor-creditor relationship between the bank and its depositor. If a customer is in default on its obligation to the bank, the bank is entitled to immediate satisfaction by “setting-off” against the customers deposit accounts (even without advance notice to the customer) thereby extinguishing mutual debts between the parties.
Set-off is a common law equitable right which permits a bank to apply the general deposits of a depositor against the matured debts of the depositor. Funds on general deposit with the bank become property of the bank. In essence, the depositor is the bank’s creditor with respect to demand and time deposits in the same fashion that the bank is the depositor’s creditor with respect to overdrafts, loans and other indebtedness.
II. ELEMENTS OF SET-OFF
In order to exercise the self-help right of set-off, the following elements must be satisfied:
A bank must exercise the remedy of set-off with caution. In the event a set-off is improper, due to lack of mutuality or maturity of debt, or for any other reason, the bank may incur significant liability. In such a case, the bank may be liable for wrongful dishonor under § 4-402 of the Uniform Commercial Code if the depositor’s checks are returned unpaid or the bank may be subject to a lawsuit for conversion based upon a wrongful appropriation of the depositor’s account.
A bank also needs to be very careful when exercising set-off in situations where the deposit is not general and unrestricted. While most cases may be easily distinguished, the tougher cases involve those where a debtor has a right to an account which may be limited.
Examples of accounts which would require close scrutiny prior to exercising set-off would be accounts where the depositor is acting as agent, personal representative, guardian, conservator, broker, commission agent, attorney, public official, trustee, receiver, stock broker, contractor, partner or joint tenant or similar types of accounts.
III. REQUIREMENT OF MUTUALITY
A determining factor in many cases regarding a bank’s right to set-off involves the satisfaction of the mutuality requirement (elimination of mutual debts). Nebraska court cases have settled many set-off disputes by determining whether an account was a “general” or a “special” deposit. The presumption under Nebraska law is that a deposit is general and not special and the party claiming special deposit status has the burden of proving that the account was intended to be kept separate from the general funds of the bank and to be retained for a special purpose.
If the bank has actual knowledge of a difference in identity between the debtor and the true owner of an account, set-off would be improper (e.g., a bank cannot appropriate the individual account of a single partner to satisfy partnership debt). In the absence of actual knowledge by the bank of the lack of mutuality, a bank’s right to set-off may still be precluded, if circumstances are such that the bank should know that a deposit is to be held for a special purpose (e.g., independent knowledge that a customer’s account held trust funds or a special designation on the account).
The mutuality requirement often comes into play when a bank attempts to exercise set-off against a joint account. If A and B open a joint account and A later defaults on a personal loan from the bank, the bank may desire to set-off against the entire account. The Nebraska Supreme Court has approved of this practice as long as the bank has by contract obtained a right to set-off the full amount of a debt owed the bank by one of the parties to a joint account. It is therefore important for the bank’s deposit agreement to include language that both joint tenants consent to set-off against a debt of either, irrespective of their mutual contributions to the account.
IV. EXERCISING SET-OFF
In order to properly complete the Act of set-off, a bank must take the following steps:
1. The bank must intend and decide to exercise the right of set-off;
2. Some act must be carried out which completes the set-off; and
3. The bank must have a record which verifies that the set-off has occurred.
V. COMPETING INTERESTS
A. Writ of Garnishment
Generally, a bank will prevail as against a competing writ of garnishment. If the depositor’s indebtedness is mature, set-off may be exercised even after service of the garnishment writ. While it is not necessary that book entries be made before the garnishment arrives at the bank, it is important that the bank promptly complete its set-off without allowing the debtor to draw on the account in order to avoid losing its priority.
B. Federal Tax Liens
Ordinarily, if a bank exercises set-off following the receipt of notice of a tax lien, the bank’s rights with respect to the deposit account will be subordinated to the IRS. It is advisable, therefore, for a bank to exercise set-off prior to receipt of the IRS notice.
C. Claims by Secured Creditors
When a bank’s right to set-off is in conflict with a secured lender claiming a perfected security interest in the deposit account as proceeds under § 9-327 of the Uniform Commercial Code, the secured creditor will normally prevail over the bank.