The United States bankruptcy code provides the honest debtor with the ability to attain a fresh start. Provided that a debtor meets all applicable rules and standards of bankruptcy, he or she can first stop collections through the automatic stay and upon completion of the bankruptcy process, be discharged of debts owed. The automatic stay during the bankruptcy process and the discharge of debt upon the completion of the bankruptcy process are the hallmarks of the American bankruptcy system.

Nonetheless, like almost every rule, there are exceptions. One significant exception to this rule is the right of set-off. In simple terms, a set-off occurs when two parties owe mutual debts to each other. The creditor will subtract the amounts owed from the amounts that the creditor is obligated to pay. The new number represents the obligations from one party to another, which is applicable during a bankruptcy.

Set-off Example

A common example is a debtor who borrows money from Bank X while Bank X holds a bank account for the debtor. When a bank customer deposits money in an account, the account is called a demand deposit. If a customer has $1,000 in the account, in reality, the bank owes the customer $1,000, which the customer can demand at any time. To put it another way, a bank account is an IOU from the bank to the customer. Therefore, if a debtor borrows money from Bank X and has a bank account with Bank X, both owe each other money. If the debtor files for bankruptcy, Bank X is a creditor while simultaneously owing money to the debtor. Bank X, under the US bankruptcy code, has the right to set-off what is owed to it against what is due to the debtor.

In this example, Bank X can have a common law right to set-off outside of the bankruptcy context. If the depositor has a debt to Bank X and the debt becomes due, the bank has the common law right to seize the depositor’s bank account in satisfaction of the debt. California law recognizes this right. It is also known as a banker’s lien.

Set-off in Bankruptcy

As noted above, the right to set-off is not strictly a bankruptcy law. However, it can be used during a bankruptcy even though the debtor, through filing bankruptcy, has the protection of the automatic stay. Section 553 of the Bankruptcy Code specifically preserves a creditor’s right to set-off against mutual obligations between the debtor and creditor. Note that Section 553 does not create a right to set-off; it merely preserves the state law right to set-off. In a state that does not provide for the right to set-off, then the automatic stay will prevent a creditor from exercising such action. Bankruptcy and Appellate Courts have clarified this matter that there is no Federal right to set-off during a bankruptcy; instead, it is a preserved state right.

In debt? Facing financial pressure? Bankruptcy can get you the fresh start you need. Contact the law firm of Melanie Tavarre, an experienced Bay-area debt relief attorney.