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The Right of Setoff – What is Exempt?

June 7, 2014

by Drew. M. Edwards, Esq.

The right of setoff is one of a credit union’s best collection tools. Basically, the right of setoff enables a credit union to use the balance in a member’s deposit accounts to pay that member’s delinquent loan balance. This is often a quick and easy way for the credit union to recoup at least some of its losses when a member defaults on a loan. However, there are certain cases in which the right of setoff is not so simple, and important exceptions where it does not apply at all.

What is the right of setoff?

What we generally call “setoff” is really three different legal rights, each of which is sufficient by itself to enable a financial institution to offset a debt using the debtor’s deposit accounts:

1) The first component is the common-law “right of setoff,” where the concept gets its name. This is the common-sense concept that if a borrower defaults, a lender can satisfy the debt out of any assets that the lender holds on the borrower’s behalf. This is a very old concept, which has survived from English common law.

2) The second component to the right of setoff is a statutory lien. For a Federal credit union, this is contained in 12 USC 1757(11), which gives the credit union the power “to impress and enforce a lien upon the shares and dividends of any member, to the extent of any loan made to him and any dues or charges payable by him.” State credit unions will have a corresponding power in the state’s credit union act or banking law. When the member defaults, the credit union can enforce this statutory lien.

3) The third component to the right of setoff is a consensual lien contained in the credit union’s loan documents. Virtually all credit union loan documents contain language specifically allowing the credit union to setoff the member’s shares in the event of a default (if your loan documents don’t contain such a provision, they should).

Having three separate legal rights to setoff may sound good, but there are some important situations in which you won’t be able to use some or all of these rights to apply your members’ deposit account balances to their delinquent loans. Three important areas where you will probably not be able to use your right of setoff are consumer credit cards, social security funds, and retirement accounts.

Consumer Credit Cards

Section 12 CFR 1026.12(d) of the Truth in Lending regulations nullifies the common law right of setoff and any statutory liens for consumer credit cards. This regulation specifically allows a consensual lien on consumer credit card accounts, but only if certain special requirements are satisfied. In the commentary to this section, the agency speaks at length about what a creditor must do to obtain an enforceable consensual lien in the context of a consumer credit card account. The requirements are onerous:

1. Security interest—limitations. In order to qualify for the exception stated in §1026.12(d)(2), a security interest must be affirmatively agreed to by the consumer and must be disclosed in the issuer’s account-opening disclosures under §1026.6. The security interest must not be the functional equivalent of a right of offset; as a result, routinely including in agreements contract language indicating that consumers are giving a security interest in any deposit accounts maintained with the issuer does not result in a security interest that falls within the exception in §1026.12(d)(2). For a security interest to qualify for the exception under §1026.12(d)(2) the following conditions must be met:

i. The consumer must be aware that granting a security interest is a condition for the credit card account (or for more favorable account terms) and must specifically intend to grant a security interest in a deposit account. Indicia of the consumer’s awareness and intent include at least one of the following (or a substantially similar procedure that evidences the consumer’s awareness and intent):

A. Separate signature or initials on the agreement indicating that a security interest is being given.

B. Placement of the security agreement on a separate page, or otherwise separating the security interest provisions from other contract and disclosure provisions.

C. Reference to a specific amount of deposited funds or to a specific deposit account number.

ii. The security interest must be obtainable and enforceable by creditors generally. If other creditors could not obtain a security interest in the consumer’s deposit accounts to the same extent as the card issuer, the security interest is prohibited by §1026.12(d)(2).

These requirements are very strict, and there have been several cases involving credit unions in which the judge ruled that generic language in the credit union’s card agreement was insufficient to allow a right of setoff. For example, language like the following has been held insufficient to create a valid consensual lien for a credit card account when placed in the “fine print” of an account information booklet: “you pledge and grant as security for all obligations you may have now or in the future, except obligations secured by your principal residence, all shares and dividends and all deposits and interests, in any, and all accounts you have with us now and in the future.” If your card agreement is not specifically tailored to fall within the narrow exception above, you can’t apply a member’s shares to a delinquent credit card account.

Social Security

Social Security funds are also exempt from the right of setoff. This exemption arises from Section 207 of the Social Security Act (42 USC 407): “The right of any person to any future payment under this title shall not be transferable or assignable, at law or in equity, and none of the moneys paid or payable or rights existing under this title shall be subject to execution, levy, attachment, garnishment, or other legal process, or to the operation of any bankruptcy or insolvency law.” Based on this, the courts have decided that a financial institution cannot offset Social Security benefits against any other debts held by the financial institution. However, this exception also has its own exception: a financial institution can use Social Security funds to offset a debt only if the debt arose from the account in which the Social Security benefits are placed (i.e., an overdraft). This means that you can offset an overdraft with a future deposit of Social Security funds into the same account, but you cannot apply Social Security funds in a member’s share account to a separate delinquent loan account.

Retirement Accounts

The Federal statute creating IRAs states that in order for an account to be an IRA, the account documents must provide that “the interest of an individual in the balance in his account is nonforfeitable.” In addition, remember that an IRA account is not technically an account in the member’s name; instead, it is a trust created for the benefit of the member. Considering these two factors, courts have held that IRA accounts are not subject to setoff.

As you can see, our courts and our legislature have found plenty of ways to complicate something as simple as the right of setoff. If you have any questions about using your right of setoff, be sure to contact your credit union attorney.

DISCLAIMER: The foregoing is provided for informational purposes only, and does not constitute legal advice. It is not a substitute for legal or professional advice. Any legal advice should be tailored to specific clients and their specific needs. No attorney-client relationship is created by any use of this website. You should not act on the information contained in any of the materials on this website without first consulting a competent attorney licensed to practice in your jurisdiction.

From → Credit Unions

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