Banker's Dilemma Resolved?: Administrative Freezes and the Automatic Stay

• Publication year: 1996
• Pages: 25
• Citation: Vol. 25 No. 1 Pg. 25

25 Colo.Law. 25 Colorado Lawyer 1996.

1996, January, Pg. 25. Banker's Dilemma Resolved?: Administrative Freezes and The Automatic Stay

---

25

Vol. 25, No. 1, Pg. 25

"Banker's Dilemma" Resolved?: Administrative Freezes and The Automatic Stay

by Tom McNamara

Financial institutions often find themselves on the horns of a legal dilemma at the commencement of a bankruptcy proceeding. The so-called "banker's dilemma"(fn1) develops when a financial institution claims a prepetition right of setoff in a debtor's deposit account. The bank is placed in the untenable position of choosing between: (1) watching its setoff rights disappear as the debtor depletes the account, or (2) risking violation of the bankruptcy automatic stay by placing an "administrative freeze"(fn2) on the debtor's account.(fn3) Since the enactment of the Bankruptcy Code courts have contributed to the banker's dilemma by issuing a confusing and conflicting array of opinions on the propriety of administrative freezes.(fn4)

This article analyzes the relevant statutory framework, case law development and the U.S. Supreme Court's recent contribution to the administrative freeze debate: Citizens Bank of Maryland v. Strumpf.(fn5) In an opinion favorable to financial institutions, the Supreme Court unanimously held that, in order to preserve setoff rights, a bank may temporarily impose an administrative hold on a debtor's deposit account without violating the automatic stay.

Statutory Framework

Analysis of the propriety of administrative freezes in bankruptcy requires familiarity with a patchwork of interrelated Bankruptcy Code(fn6) provisions, including: § 362(a), automatic stay; § 553, setoff; § 542, turnover of property of the estate; and § 363, cash collateral.

The automatic stay imposed by § 362(a) is at the heart of the bankruptcy process. It bars creditors from, among other things, continuing or commencing litigation against bankruptcy debtors. Congress enacted the automatic stay as "one of the fundamental debtor protections" designed to give the debtor a "breathing spell" from its creditors.(fn7) Although the Bankruptcy Code does not specifically reference administrative freezes by financial institutions, the automatic stay explicitly bars: the setoff of any debt owing to the debtor against any claim against the debtor; any act to obtain possession or control of property of the estate; any act to create, perfect or enforce any lien against property of the estate; and any act to collect, assess or recover a claim against the debtor.(fn8) Violation of the automatic stay may subject a creditor to liability for actual damages, attorney fees, costs and punitive damages.(fn9)

In spite of the broad reach of the statute, creditors may obtain relief from the automatic stay, upon notice and a hearing. The court shall grant relief from the automatic stay:

(1) for cause, including the lack of adequate protection of an interest in property ...; or (2) with respect to a stay of an act against property ... if---(A) the debtor does not have an equity in such property; and (B) such property is not necessary for an effective reorganization.(fn10)

Notwithstanding the automatic stay, the Bankruptcy Code expressly allows the creditor's remedy of setoff through § 553(a)(fn11) The right to setoff "allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding 'the absurdity of making A pay B when B owes A.'"(fn12) Administrative freezes are often justified by financial institutions as a mechanism to preserve the right to setoff. Setoff rights also are recognized elsewhere in the Bankruptcy Code. Section 542(b) directs that an entity that owes a matured debt to the bankruptcy debtor shall pay such debt to the debtor "except to the extent that such debt may be offset under section 553 ... against a claim against the debtor."

Finally, § 363(c)(2) also is important in the analysis of administrative freezes in business cases. Pursuant to § 363(c)(2), the debtor may not use cash collateral unless: (1) each entity that has an interest in the cash collateral consents; or (2) the court authorizes such use after notice and a hearing. Arguably, deposit accounts in the banker's dilemma scenario constitute cash collateral that the debtor may not use absent court approval.(fn13)

---

26

Conflicting Case Law

Prior to the Supreme Court's Citizens Bank decision, cases involving the banker's dilemma yielded an array of confusing and conflicting holdings. The Third,(fn14) Fourth,(fn15) Eighth(fn16) and Eleventh(fn17) Circuits held that an administrative freeze of a debtor's account, or other similar action, constituted a violation of the automatic stay. Employing a somewhat narrow interpretation of the Bankruptcy Code, such courts often reasoned that an administrative hold imposed by a financial institution was tantamount to the actual exercise of setoff and, thus, barred by § 362(a)(7).(fn18) Further, some decisions characterized administrative freezes as attempts to obtain possession or control of estate property in contravention of § 362(a)(3).(fn19) The pro-debtor opinions also emphasized a policy basis for their results:

If a bank could freeze the debtor's accounts upon the filing of a petition in...