Maryland Legal Alert for Financial Services

A recent decision from the United States District Court for the Southern District of New York offers useful insight for depository institutions seeking to comply with the Bankruptcy Code (the “Code”) when an individual account holder files a Chapter 7 bankruptcy petition. The case concerns a national bank’s internal policy under which the bank places a temporary freeze on Chapter 7 debtors’ accounts on the date of filing if the accounts have an aggregate value exceeding $5,000.00. After the bank freezes the debtor’s accounts, the bank immediately notifies the Chapter 7 trustee of the freeze and requests the trustee’s direction regarding the disposition of the frozen funds.

In this case, the debtors’ accounts had over $5,000.00 and, on the petition date, the bank froze the accounts and sent its customary notice to the chapter 7 trustee. The debtors had claimed the accounts as exempt under Section 522 of the Bankruptcy Code. Six days later, the bank dishonored a payment demand on the account from a third party due to the account freeze and assessed a $25.00 fee against the debtors. Several days later, the bank released the accounts back to the debtors when it received a letter from the chapter 7 trustee directing the bank to do so. The debtors thereafter sought to hold the bank liable for violating the automatic stay, claiming that the bank’s administrative freeze improperly seized funds claimed as exempt assets. The Bankruptcy Court ruled in favor of the debtors, awarding $25.00 in damages plus nearly $15,000.00 in legal fees and costs.

The District Court reversed the Bankruptcy Court, holding that the bank’s administrative freeze did not constitute a stay violation. The court noted that a tension exists between Bankruptcy Code Section 362(a)(3)’s prohibition on exercising control over property of the estate and Bankruptcy Code Section 542(b)’s requirement that an entity owing a debt that is property of the estate must pay such debt to the trustee. Further complicating matters, creditors have 30 days from the date of the meeting of creditors to object to a debtor’s claimed exemption.  Assuming that exemption deadline passes without objection, the exempt property reverts back to the debtor, is no longer considered estate property, and is no longer protected by the automatic stay.  Adopting the reasoning of a Ninth Circuit case concerning the same administrative freeze policy, the court held that while the accounts remain estate property, the debtors cannot be injured by the bank’s temporary account freeze because the trustee, not the debtors, controls the use of the account. The court determined that the bank’s temporary hold and prompt notice to the trustee did not violate the automatic stay because the bank did not exert control over the funds. Rather, the bank is permitted to temporarily hold the funds (pending the trustee’s instructions) to protect itself against liability and loss. The court also held that the debtors’ exemption claim in the accounts did not change the result. The bank’s refusal to honor the payment request occurred before the 30 day exemption objection period had run and therefore the funds remained estate property subject to the trustee’s control.

In any event, once the property became exempt and removed from the bankruptcy estate, the property was no longer protected by the automatic stay. This opinion is consistent with the majority of cases that have addressed this same administrative freeze policy. Depository institutions may elect to adopt a similar policy to protect against liability for funds used by debtors without trustee authorization. However, such a policy must contemplate prompt notice to the trustee and prompt response to the trustee’s instructions to ensure compliance with the Bankruptcy Code. Please contact Bryan Mull with any questions regarding the topic.