Right of Setoff vs. Perfected Security Interest in Deposit Accounts

We often receive calls from our financial institution clients when they are served with a garnishment (most often from a private-party creditor), or a levy from a taxing authority (most often from the IRS).  The most common question we receive in this scenario is whether the financial institution can exercise a right of setoff against funds in a deposit account when the same account holder has an outstanding obligation to the financial institution (as a borrower under a loan or as a guarantor).  The term “deposit account,” as used in this article, generally refers to any demand deposit account, such as a savings or checking account, that is under the same name and/or tax ID number as the party whose property is being garnished or levied.

This article discusses how, and in what circumstances, a right of setoff may be used to apply funds on deposit to satisfy an account holder’s outstanding loan obligations to the financial institution rather than turning over funds to a creditor pursuant to a garnishment or levy.  This article also compares the right of setoff to the rights associated with having a perfected security interest in a deposit account.

Right of Setoff

Financial institutions generally have a right of setoff over their customers’ deposit accounts.  Most often, a right of setoff is granted pursuant to a provision included in a loan document (promissory note, loan agreement, security agreement, guaranty, etc.), or pursuant to a demand deposit account agreement.  In certain situations, a financial institution may have a right of setoff based on state law even if the customer has never expressly granted one.  This is known as an equitable right of setoff.

A right of setoff allows a financial institution, upon the occurrence of an event of default, to apply funds in a customer’s deposit account to the debts or obligations which are owed to the financial institution by the customer, whether as a borrower or as a guarantor.  Most loan documents allow an immediate right of setoff upon an event of default, meaning that the financial institution does not have to provide the customer with notice of the default prior to exercising its right of setoff.  However, a financial institution looking to exercise a right of setoff should review any applicable loan documents and/or account agreements to ensure the financial institution is following proper procedure.  It is also important to note that the deposit account to be setoff must be under the same name as the obligor.

Perfected Security Interest in Deposit Accounts

The perfection of a security interest in a deposit account is a two-part process.  First, the account owner must execute a security agreement granting the financial institution a security interest in the deposit account to serve as collateral for the obligations of the account owner to the financial institution.  Second, the financial institution must have “control” of the deposit account.  A financial institution is deemed to have control of any deposit account held with the financial institution.  Therefore, upon the execution of a security agreement, perfection of a security interest in a deposit account held with the financial institution is automatic.  Where the deposit account is held at another financial institution, express control of the deposit account must be granted to the financial institution that is perfecting its security interest.  This express control is granted pursuant to an account control agreement executed by both the account owner and the depository financial institution.  It is not necessary for the secured party to file a UCC Financing Statement to perfect its security interest.

Comparing the Right of Setoff to a Perfected Security Interest in Deposit Accounts

Both the right of setoff and a perfected security interest in deposit accounts offer protection to a financial institution as against a private-party creditor.  Upon receipt of a garnishment summons from a private-party creditor, a financial institution may exercise a right of setoff to apply the funds in the deposit account to the outstanding obligations owing to the financial institution before releasing any funds to the private-party creditor.  For a right of setoff to take priority over the garnishing party, however, the financial institution must actually exercise its right of setoff.  The financial institution cannot simply protect the funds by claiming a right of setoff without actually applying the funds to the customer’s outstanding obligations.

Like a right of setoff, a perfected security interest in the subject deposit account has priority over a garnishment from a private-party creditor.  One notable difference between the right of setoff and a perfected security interest is that when a financial institution has a perfected security interest, the funds do not need to be applied to the debt in order to be protected.  Unlike the right of setoff, a financial institution with a perfected security interest in a deposit account can leave the funds in the deposit account to remain as collateral for the debts secured without applying the funds towards the customer’s outstanding debts.  To the extent a financial institution chooses to enforce its security interest and apply funds in a deposit account to an outstanding debt, it must do so in accordance with all applicable documents and laws.

However, when the customer’s deposit account is levied by a taxing authority such as the IRS or a state’s Department of Revenue, a financial institution’s unexercised right of setoff is ineffective.  A tax levy trumps a financial institution’s unexercised right of setoff, and the financial institution is required to release the levied funds to the levying agency.  Only a perfected security interest in a deposit account can provide the financial institution priority in this scenario.  This is because a perfected security interest in a deposit account has priority over all subsequent liens and interests in the deposit account, including a levy issued by a taxing authority such as the IRS or a state Department of Revenue.

It is important to note that a financial institution which has a prior interest in a deposit account, due to a previously-exercised right of setoff or by a perfected security interest, cannot wholly disregard or ignore a garnishment or levy.  For example, in the case of a garnishment from a private-party creditor, a financial institution must still respond properly by completing and returning a garnishment disclosure statement.   Further, as for tax levies, if a financial institution believes its security interest has priority over the interest of the levying authority, the financial institution should contact the levying authority (IRS or state Department of Revenue) to establish its priority of security interest (See IRS Publication 4528 for further instruction on how to respond to the IRS in this scenario).  Upon receiving sufficient proof of the financial institution’s prior security interest, the levying authority will often simply release the levy.  If the IRS does not agree with the financial institution’s claim of priority, the financial institution may have to initiate a wrongful levy action against the levying authority to resolve the priority dispute.  Unless, and until, the levying authority releases the levy, the financial institution is required to strictly follow the laws and procedures governing tax levies.

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