The Banker's Dilemma: A Tale Of Two Cases

The U.S. Supreme Court in Citizens Bank of Maryland v. Strumpf, 516 U.S. 16 (1995) made clear that a bank which has setoff rights against a borrower/depositor may place an administrative hold on, or "freeze," a borrower's bank account without fear of violating the automatic stay imposed under section 362 of the United States Bankruptcy Code. 11 U.S.C. §§101-1532 (“the Code").  However, may a bank impose a freeze with impunity when there is no right of setoff, especially in a case filed by an individual Chapter 7 debtor?
 
Section 542(b) of the Code directs a party which owes a debt which is property of the estate to pay such debt to the trustee unless there is a valid right of setoff.  This would include a bank account, which constitutes an obligation of the bank to the account owner.  On the other hand, section 362(a)(3) automatically stays any party from taking any action to exercise control over any property of the bankruptcy estate.  If a bank is compelled by section 542(b) to pay such obligation to the trustee, and the bank prevents a debtor from accessing funds in the debtor's bank account until this can be accomplished, is it violating the section 362 stay?  Two recent cases involving Wells Fargo Bank addressed this question and reached opposite results.  In both cases, Wells Fargo followed its policy of imposing an administrative pledge or freeze on all funds in any account with a balance in excess of $5,000 upon learning of the filing of a bankruptcy petition.  Under the policy, the freeze continues until the bank receives instructions regarding disposition of the funds from the bankruptcy trustee.
 
In In re Mwangi, 764 F.3d 1168 (9th Cir. 2014), after learning of the debtor's petition, Wells Fargo instituted a freeze on the debtor's account containing approximately $17,000, and contacted the trustee seeking instructions.  Five days later, the debtor filed schedules claiming 75% of the funds in the account as exempt under Nevada law, and requested that the freeze on the account be lifted.  The bank, which had not received instructions from the trustee, refused to lift the freeze.  In response, the debtor filed a motion seeking sanctions for the alleged stay violation.  The bankruptcy court denied the motion for sanctions, but the Ninth Circuit Bankruptcy Appellate Panel reversed, ruling that Strumpf did not apply where there was no right of setoff and that the debtor's claimed exemption of the account under section 522 of the Code bestowed standing on the debtor to pursue violation of the section 362 stay. 
 
The debtor then filed an adversary proceeding in bankruptcy court for sanctions, which the bankruptcy court dismissed with prejudice, concluding that only the trustee had standing to protect property of the estate and that the debtor did not allege any injury as a result of the freeze.  The debtor appealed to the district court which affirmed the bankruptcy court's decision.  The debtor then appealed to the Ninth Circuit. 
 
The court began by discussing the applicable statutory framework, including the provisions of sections 362, 522 (dealing with exemptions), 541 (defining property of estate) and 542 of the Code.  In re Mwangi, 764 F.3d at 1173.  The court concluded that the funds became property of the estate upon the filing of the petition and that the debtor had no right to possession or control at that point.  Continuing, the court concluded that the monies remained property of the estate during the 30-day period in which parties in interest may challenge any property claimed as exempt under Federal Rule of Bankruptcy Procedure 4003(b)(3). Id. at 1176.
 
Given the language of section 542(b), it was reasonable, said the court, for the bank to seek instructions from the trustee, as it promptly did. Id. at 1178. Once the 30-day period within which objections to exemptions may be filed ran and the funds in the account became exempt, the funds ceased to be property of the estate and the provisions of section 362(a)(3) did not apply. Id. at 1179. Because section 362(a)(3) applies only to acts relating to property of the estate, the debtor could therefore not allege a plausible injury arising from violation of that section.  Id.
 
The bankruptcy court in In re Weidenbrenner, 521 B.R. 74 (Bankr. S.D.N.Y. 2014) came to a very different conclusion on very similar facts.  There, after it learned of the petition filed by the debtor and his wife, Wells Fargo placed an administrative pledge, or freeze, on accounts containing slightly over $6,900.  That day, the bank sent notice of the freeze to the trustee and requested instructions.  However, unaware of the freeze, the debtors wrote checks against the account.  One of the checks bounced and the debtors were assessed a $25 penalty.  The debtors filed a motion alleging that Wells Fargo violated the stay by placing the freeze on the account. In re Weidenbrenner, 521 B.R at 78.
 
The court began by discussing the automatic stay under section 362.  Finding that the funds in the account were property of the debtors' estate, the court concluded that the administrative freeze placed on the account constituted improper control over the account in violation of section 362. Id. at 79. This was especially true, said the court, because of the bank's unilateral policy to only freeze accounts with balances in excess of $5,000. Freezing the account was not "…mandated by the Bankruptcy Code, ordered by the Court, or requested by the chapter 7 trustee.  Wells Fargo simply decided to place a freeze on property of the estate and unilaterally determine who was allowed to access it." Id. at 79-80.
 
The court then dismissed Wells Fargo's claim that section 542(b) mandated the freeze as "grandstanding."  The court read section 542(b) to require the bank to turn over all property of the estate.  Even if it could comply with section 542 by sending notice of the freeze to the trustee, because under Wells Fargo's policy the freeze is only applied to accounts with balances of $5,000 or more, and because section 542 contains no dollar limit, Wells Fargo's actions were completely arbitrary. Id. at 80. The court also rebuffed the bank's argument that Strumpf supported the freeze, agreeing with the Mwangi court that Strumpf is applicable only in instances where the bank is a creditor with a right of setoff.  Id at 80-81.
 
The court acknowledged the banker's dilemma created by the clash of the automatic stay under section 362 and the turnover requirements of section 542:
 
While the Court is sympathetic to Wells Fargo's argument that it has a duty under §542(b) that could cause it to violate §362(a), it can avoid this problem by simply waiting for the chapter 7 trustee to ask for the balance of any deposit accounts to be turned over.  Once the petition is filed, debtors continue to eat, drive to work, and take care of children; they may not receive a post-petition paycheck for days or weeks.  Wells Fargo's policy of freezing funds upon filing makes it more likely that debtors will squirrel away secret stashes of cash prior to filing so that they can continue to meet their everyday needs.
Id. at 82.
 
Finally, the court determined that the penalty of $25 imposed upon the debtors for the bounced check gave it standing to assert the stay violation, and found the bank liable for $25 plus costs and attorney's fees. Id. at 84.
 
The banker's dilemma is put into stark relief by these decisions.  In jurisdictions such as New York, policies which impose a freeze on a debtor's accounts may result in a successful claim that the automatic stay was violated and sanctions are warranted.  While the damages imposed in Weidenbrenner were minimal, one can imagine a court imposing a much more severe penalty.  In other jurisdictions, such as the Ninth Circuit, lenders who don't freeze accounts are open to claims from trustees that they violated section 542(b).  Regrettably, these decisions offer little guidance to lenders on which risk to take. 
 
Peter C. Blain is the head of the Corporate Reorganization Practice Group of the Milwaukee, Wisconsin law firm of Reinhart Boerner Van Deuren, s.c.  He is a Fellow in the American College of Bankruptcy and has been included in Best Lawyers in America since 1987.  He has served as past Co-Chair of the Bankruptcy Subcommittee of the Eastern District of Wisconsin Bar Association, Chair of the Bankruptcy Insolvency and Creditors Rights Section of the Wisconsin Bar Association and Chair of the Bankruptcy Section of the Milwaukee Bar Association.  Mr. Blain frequently speaks and writes on bankruptcy topics.