08.05.2020 | Articles

Why Do We Care About a Lender’s Right of Setoff?

By Richard E. Gentilli, Brian F. Plunkett
Commercial Real Estate

In the context of a commercial loan, the lender ordinarily will require that operating and other depository accounts of borrowers (and perhaps guarantors) be maintained with the lending bank.  Regardless of why the accounts are held at the lending institution, depository accounts can potentially serve as valuable additional sources of recovery for the bank in a defaulted loan scenario.

This is because in a commercial setting a lender ordinarily has the right to set off funds of a borrower it is holding to pay down defaulted obligations owed to the bank.  (Note, the right of setoff may not exist in regard to consumer transactions.) The right of setoff applies whether a commercial loan is secured or unsecured.  The right of setoff is different than a security interest.  It essentially is a “setoff” of competing obligations.  The borrower owes the lender the funds loaned.  The lender owes the borrower the funds deposited with it. The two obligations off set each other.

Since the ability of a lender to set off funds is typically addressed in the loan documents executed by a borrower, the terms of the loan documents will then govern the availability, notice requirements and the extent of the lender’s right to set off funds.  If the right of setoff is not specifically referenced in the loan documents, the lender should double check the bank’s account opening forms establishing the depository relationship for any other contractual rights of setoff.  However, even in the absence of a specific loan term permitting setoff, a lender may be able to rely upon its common law right (i.e. rights established by legal case law) to set off funds held on deposit against a defaulted loan obligation.

A bank can only exercise its right of setoff if (a) mutual obligations exist between the bank and the depositor/borrower (i.e., identity of depositor and obligor), and (b) the loan is in default or has matured. (In this regard the lender must be certain a default has occurred and any applicable grace periods have elapsed before it can set off an obligor’s funds).  To complicate matters further, the common law right of setoff may not be available to a lender where the bank holds other collateral that is adequate to provide for repayment of the debt (i.e., where there is not likely to be a deficiency).

In Massachusetts, the right of setoff is also governed by statute.  See G.L. c. 167D, §§ 16, 17. The statute requires that promptly upon set off by the lender, written notice be sent by first class mail directed to the last known address of such depositor whose name the account is in.  Failure to do so could potentially result in some manner of liability on the part of the lender.

There are limitations to the right of setoff. For example, a lender cannot set off funds held in a payroll or other “special purpose” account such as a specially designated escrow account.  In addition, in the event of a bankruptcy, the right of setoff is subject to an automatic stay, and may not be exercised absent Bankruptcy Court approval.

The question of whether a bank should set off funds often arises when the bank is served with a Summons to Trustee from another creditor attaching some amount of an account holder’s funds on deposit with the bank. If that occurs, the lender is faced with a dilemma.  Assuming the loan documents provide that service of an attachment or garnishment writ constitutes an event of default, the lender must decide whether to (i) exercise its rights, declare a default and set off the funds, or (ii) freeze a portion of its depositor’s funds for the benefit of the attaching creditor in accordance with the writ served upon it.  In the situation where the depositor has an existing revolving loan facility with the lender, this may be an easier decision by the lender as it may be possible for a lender to set off the funds in the attached account and then later re-advance the funds to the borrower.  The question becomes more complicated if the loan is a term or demand loan, the borrower is in good standing and a good customer and the lender does not wish to declare a default under the customer’s loan obligations.  In this situation, it is very important that the lender be in immediate contact with its borrower to review the circumstances for the issuance of the attachment or writ.   A lender is required to answer (i.e. report to the court and the attaching creditor) within 20 days the amount of funds in the deposit account subject to the attachment.  If a lender does not set off funds and reports that a certain amount of funds have been attached, it is difficult, if circumstances then change, to later declare a default and exercise the right of setoff against the previously attached funds, since this involves the filing of an Amended Answer of Trustee which seeks to undo or reverse the earlier report.  The more time that has passed since the filing of the original Answer, the less likely a Court is to permit the filing of an Amended Answer and allow the bank to then set off the attached funds.

While the exercise of setoff rights can seem routine, as with so many defaulted loan remedies, it is important to assess the full picture for a borrower before exercising rights.  Communication with the customer and an understanding of its economic situation are key elements to an effective setoff of funds. 

This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.

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