Imagine it. You’re barely making it paying the bills for your business - much less your loan payments - and then you log in to find that your operating account balance has been swallowed by your bank. Wait a minute: is that legal? If you’re using the same bank that gave you your business loan, it very well may be. Here is how it works (and what its limits are).
Short answer: yes, if the lender is also the bank holding your accounts. Ordinarily, a commercial lender will require that you keep operating and other deposit accounts with the lending bank. If you default, those deposits become an extra source of recovery for the bank. The legal right to do so is called the right of setoff.
Setoff is worth understanding, because it’s not the same as a security interest. A right of setoff does not require the borrower to grant a security interest over its property. Setoff is a “canceling out” of two competing debts: you owe the bank the money it loaned you, and it owes you the money you deposited. The two cancel each other out. It applies regardless of whether the commercial loan is secured or unsecured. (It may not apply to consumer transactions.)
Where Does the Right Come From?
Where does the right come from? Start with your paperwork: the loan documents typically address the issue and it’s their terms that will control whether and when the bank can do that, how much notice it has to give and what the extent of the setoff right is. If the loan documents say nothing, then the bank might have to look to the account-opening forms you signed for a contractual right of setoff. And if the bank can’t find any such contractual right, it can look to the common law.
Still, the bank can’t act whenever it likes. There are two conditions.
- First, your obligations must be mutual (that means the depositor and the borrower have to be the same party).
- Second, the debt you owe the bank must be in default or mature, and any grace period must have expired.
But keep in mind, the bank’s common-law right of setoff is also subject to the rule that if the bank already has other collateral sufficient to fully repay the debt, leaving no shortfall, it won’t be able to use the setoff right either.
State law can add its own rules. Massachusetts, for instance, has a statute that says that, promptly after the setoff, the bank must send written notice of the setoff by first-class mail to the depositor named on the account at its last known address. A bank that fails to do this runs the risk of some liability.
Fortunately, you’re not at the bank’s mercy. It can’t touch funds held in a payroll account, for example, or in another special-purpose account - say, a specially designated escrow account. And if you file for bankruptcy, the automatic stay suspends the bank’s right to setoff; it can’t exercise that right without the Bankruptcy Court’s approval.
When You’re Current on the Loan
Setoff can also come into play when you’re current on the loan. If another creditor sues you and serves your bank with an order attaching money from your bank account (called a Summons to Trustee in Massachusetts), your loan documents may provide that being served with an attachment or a garnishment itself constitutes an event of default. Once that happens, the bank has a decision to make: set off the money for itself as a result of the default, or freeze part of your money for the other creditor in accordance with the court’s order.
If you’ve got a revolving line of credit with the bank, you’re in luck. The bank can set off the funds that are attached and later re-advance them to you. But things get dicey if you have a term or demand loan instead, you’re in good standing, a good customer, and the bank really doesn’t want to declare a default. In that case it becomes really important that the bank gets in touch with you the second it finds out about the attachment and listens closely as you explain what happened.
Once the garnishment order arrives, the bank will have to report in 20 days (that’s the Massachusetts rule) to the court and the attaching creditor how much of the money in the bank account is subject to the attachment. But by reporting that the funds are attached, the bank risks its ability to change its mind later in the game and use its right of setoff. Why? Because to change its reporting and let itself use the setoff right, the bank would have to file an Amended Answer undoing its initial answer, and the more time that has passed, the less likely a court is to grant that request and allow the bank to change course.
Start with the Paperwork
If you’re behind on a loan with the bank that holds your accounts, start with the paperwork. Dig out the agreement you signed when you got the loan, and the one you signed when you opened your accounts. Find the setoff clause and the clause telling you what notice the bank has to give. Assess whether you have in fact defaulted on the loan, and if so, whether the grace period for that default has expired. Know whether any of your accounts with that bank are for payroll or holding property in escrow. Don’t forget to pay attention to any guarantees you personally signed because the guarantors may be required to maintain accounts with the lender too.
Setoff may look routine, but a good bank looks at the whole picture before pulling a trigger like that, and talking with the bank about your economic circumstances is the most important thing an owner can do in that situation. Don’t just disappear. Reach out to your lender, let them know what’s going on, and work with them to negotiate before everything gets swept away.
