On occasion a bank will freeze the account of someone who has filed for Chapter 7 bankruptcy protection.  What can be done to prevent, or undo the freezing?  Before answering this question, it’s helpful to understand the automatic stay of 11 U.S.C. § 362(a), and the rationale given by a freezing bank.

I.          The Automatic Stay

A stay in law says:  “Stop!”  The very act of filing bankruptcy papers triggers a special type of stay – nothing else needs to be done – so it is called the automatic stay.  (There is an important exception found in § 362(c):  If the debtor has had one or more previous bankruptcy cases pending during the twelve months prior to filing, then the automatic stay is not automatic.  Discussion of this topic is beyond the scope of the current post.  I’ll cover it in another post in the near future.)

Simply put, the automatic stay stays all actions by the debtor’s creditors against the debtor as a person (in personam), and against the property (in rem) of the debtor and of the bankruptcy estate that is created upon the filing of the papers. 

In practical terms – with a few exceptions listed in § 362(b) – this means that creditors must stop all direct communications with the debtor, all attempts to collect money or other assets from the debtor, all lawsuits against the debtor, and all attempts to exercise control over the debtor’s (or the estate’s) property.  Willful violations of the automatic stay can be expensive mistakes because the debtor who successfully sues in the Bankruptcy Court under § 362(k) can collect damages including costs, attorney’s fees, and punitive damages.

A bank’s freezing of the account of a debtor certainly appears to be an exercise of control over the debtor’s or the estate’s property.  How do banks justify this practice?

II.        A Tale Of Two Arguments

There are two arguments made by banks to justify freezing the account of someone who has filed for Chapter 7 relief:

            A.        Exercise Of The Right Of Setoff

For purposes of this post, a setoff involves a mutual debt where the bank owes the debtor in one context and the debtor owes the bank in another context, so that there is a partial offsetting of one debt by the other:

The right of setoff (also called “offset”) 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.” Studley v. Boylston Nat. Bank, 229 U. S. 523, 528 (1913).

Citizens Bank of Md. v. Strumpf, 516 US 16, 18 (1995).

The automatic stay stays:  “[T]he setoff of any debt owing to the debtor that arose before the commencement of the case under this title against any claim against the debtor . . .” 11 U.S.C. § 362(a)(7).

However, § 553 provides that in some special cases not covered by § 362(a)(7), the bank retains the right of setoff in spite of the debtor having filed for bankruptcy protection.  Therefore, if the bank can successfully characterize the freeze as preserving a right of setoff that falls within the ambit of § 553’s carve-outs, at least until adjudicated by the Bankruptcy Court, the bank will not have violated the automatic stay.  Indeed, that was the holding of the U.S. Supreme Court in the previously quoted case, Citizens Bank of Md. v. Strumpf, 516 US 16 (1995). 

            B.        Preservation Of The Bankruptcy Estate

When someone files bankruptcy papers under any chapter – not just Chapter 7 – a bankruptcy estate is created pursuant to § 541(a).  For the typical Chapter 7 consumer case, the estate consists of everything the debtor owns or has an interest in, with a few exceptions that are listed in § 541(b).  Anything included in the very few exceptions, and anything the debtor can exempt using the appropriate exemption table, the debtor can keep.  Everything else is fair game for the Chapter 7 trustee assigned to the case to liquidate for the benefit of the creditors.

One of the arguments given by banks to justify freezing a debtor’s account postpetition is:  “We don’t know if the money in the account is exempt or not.  If the debtor empties the account and later the trustee asks us for the money, we’re left holding the bag.  Therefore, all we’re doing is preserving the estate for the Chapter 7 trustee.”  Such selfless sacrifice brings a tear to my eye.  What’s that I smell?  Is it burning martyr?

If this really were the case, one would expect banks to uniformly freeze accounts upon learning of bankruptcy filings.  However, account freezing is relatively rare, so I have difficulty believing this claim.  In any event, is a bank justified in using this rationale?

Not according to the Bankruptcy Appellate Panel for the Ninth Circuit (BAP) in In re Mwangi, 432 BR 812, 825 (B.A.P. 9th Cir. 2010):

The bankruptcy court erred when it determined that Wells Fargo did not exercise control over property of the estate when it placed its administrative freeze on Appellants’ account funds. Appellants have standing to seek sanctions against Wells Fargo pursuant to § 362(k) for willful violation of the stay with respect to their interest in estate property.

Therefore, if the bank places an administrative freeze on a debtor’s account – other than to preserve legitimate setoff rights – and the case comes before a judge that follows the Mwangi holding, the bank will regret the mistake.

III.       Prepetition Solution:  An Ounce Of Prevention

One way to avoid the problem of account freezing is to have little or nothing in the account at the time of filing.  Then if the bank freezes the account the debtor isn’t left out in the cold. 

Earlier I stated that banks don’t uniformly freeze accounts.  Indeed, in my case load it is somewhat unusual.  Therefore, if the debtor is not risk averse, he/she can keep the account as is and hope the bank doesn’t freeze it.  However, if the debtor owes money to the bank, it increases the likelihood of a freeze – especially because of the potential right of setoff.  Therefore, in this situation, even if the debtor is not risk averse it is probably better to drain the account prepetition.

Although draining the account is a sure way of preventing any problems associated with freezing, it has the drawback of forcing the debtor to live on a cash basis, perhaps for several months – at least until the bar date for objections to exemptions has passed (see Fed. R. Bankr. Proc. 4003 (b).  This means that the debtor will have the inconvenience of having to make mortgage/rent and utility payments by money order rather than by check.  However, this inconvenience is better than being unable to make the payments at all due to an account freezing.

IV.       Postpetition Solutions

How can a freezing be undone?

            A.        Enlist The Trustee’s Help

The debtor can always ask the Chapter 7 trustee to tell the bank to unfreeze the account.  Unfortunately, it may be difficult to get the trustee to relinquish claims against the asset without having first completed the investigation.  After all, if the money turns out to be nonexempt the trustee will have lost it by telling the bank to release it.  Moreover, the trustee may be unmotivated to do anything for the debtor because of the obvious “What’s in it for me” sentiment.

            B.        Seek Relief In The Bankruptcy Court

If the freezing isn’t done to preserve the right of setoff the debtor can seek sanctions against the bank by appealing to the Mwangi decision. 

Unfortunately, this approach doesn’t guarantee success because bankruptcy judges are not necessarily bound by BAP decisions.  Some bankruptcy courts have ruled that BAP decisions do not bind them.  See, e.g., In re Locke, 180 B.R. 245, 254 (Bankr. C.D. Cal.1995), while others have reached the opposite conclusion.  See, e.g., In re Barakat, 173 B.R. 672, 676-80 (Bankr. C.D. Cal. 1994), aff’d on other grounds, 99 F.3d 1520 (9th Cir.1996).  In In re Silverman, 616 F. 3d 1001 (9th Cir. 2010) the Ninth Circuit held:

[W]e have never held that all bankruptcy courts in the circuit are bound by the BAP. See, e.g., Bank of Maui v. Estate Analysis, Inc., 904 F.2d 470, 472 (9th Cir. 1990) … Nevertheless, we treat the BAP’s decisions as persuasive authority given its special expertise in bankruptcy issues and to promote uniformity of bankruptcy law throughout the Ninth Circuit.

SCIF v. Zamora, at 1005 and at fn. 1.

Thus, the better view is that BAP decisions have persuasive, but not stare decisis force in the Ninth Circuit.  Therefore, the success of an appeal to In re Mwangi will rest on its persuasive power with the judge.

In sum, the safest bet is to drain the account prepetition and live on a cash basis until the bar date for objections to exemptions has passed.