U. S. Supreme Court Validates Temporary Freeze of Bankrupt Debtor's Account

November 1, 1995
FINANCIAL SERVICES NEWSLETTER
U.S. SUPREME COURT VALIDATES TEMPORARY
FREEZE OF BANKRUPT DEPTOR'S ACCOUNT

On October 31 the United States Supreme Court ruled that, in certain instances, a creditor does not violate the automatic stay by freezing a bankrupt debtor's deposit account to protect the creditor's right of setoff. The facts of the case, Citizens Bank of Maryland v. Strumpf, demonstrate why this ruling is so necessary and significant.

At the time the debtor filed his bankruptcy petition, he had on deposit with the bank approximately $11,000.00 and owed the bank approximately $3,500.00 as the outstanding balance on a defaulted loan. The bank placed an administrative freeze on a portion of the account approximately equal to the loan balance and filed a motion in the bankruptcy court for relief from the automatic stay to enable the bank to exercise its right of setoff against the account. The debtor retaliated by filing a motion for sanctions and to hold the bank in contempt for violation of the automatic stay. The court first addressed the motion for contempt and ruled that the bank's action violated the automatic stay and ordered the bank to release its freeze on the account. A few weeks later, the court granted the bank's motion for relief, ruling that the bank indeed did have a valid right of setoff against the bank account. Of course, by that time no money was left in the debtor's account.

The case ultimately reached the U. S. Supreme Court, which held that the bank's action did not constitute a setoff in violation of the automatic stay. The bank had not attempted to exercise permanent control over the account when it instituted the administrative freeze, but merely sought to maintain the status quo pending a hearing on its motion for relief. The Court also was persuaded by the fact that the bank did not freeze the entire deposit account, but merely an amount sufficient to satisfy the debt owed to the bank.

The holding of the U. S. Supreme Court in Strumpf will now enable banks to freeze accounts and avoid the risk of having the debtor dissipate all of the funds in the account prior to the bank's obtaining court approval of its right of setoff. The normal requirements applicable to the exercise of setoff obviously still must be applied, a few of which are listed below:

The amount frozen must be limited to the amount of outstanding obligations owed to the bank by the debtor;

The debt owed to the bank and the bank's obligation to its depositor must be mutual obligations owing in the same capacities; in other words, an individual's deposit account may not be used to setoff against corporate debt, unless the individual has guaranteed the debt;

Joint accounts may still be setoff for the obligations of only one of the account holders, with certain limitations and so long as the deposit agreement so provides;

The debt must be "mature," that is, the lender must have accelerated future installments; and

Other restrictions on setoff, such as the inability to setoff against trust funds or IRA funds or to use setoff to satisfy debt incurred in connection with credit cards, still must be observed.

Alabama Supreme Court Clarifies Maximum

Placement of Credit Life/Disability Insurance.

The plaintiff in McCullar v. Universal Underwriters Life Insurance Company purchased an automobile intending to finance the principal amount of $12,748.19. She purchased credit life insurance for a premium of $1,037.10 and credit disability insurance for a premium of $1,306.75, increasing the balance to $15,108.54, and signed a contract to finance that amount, plus precomputed interest, for a grand total of $20,742.00. The credit life and disability insurance sold by the dealer (as agent of the insurer) covered the entire balance of $20,742.00. This appeared to comply with Department of Insurance regulations, which had been interpreted as permitting a lender to sell enough credit life insurance to cover the gross amount of the debt or the total of payments due on add-on/precomputed-interest credit sales transactions.

After defaulting on the loan, the purchaser asserted a fraud claim against the seller, alleging that she was sold an excessive amount of credit life insurance. The basis for the fraud claim was the purchaser's request to obtain only the amount of credit life and disability insurance that she "needed," and that the seller intentionally overstated that amount.

According to the court's decision, including precomputed interest in determining the amount of insurance violates Alabama's "Mini-Code". In such a case, excessive coverage is provided because the actual payoff on a loan is lower than the insurance proceeds at any given time, causing the premium amount to be overstated as well. The court held that the "original face amount" of a specific contract of indebtedness to be insured by credit life insurance "does not include the interest that would be paid under an add-on/precomputed-interest credit transaction." The reasoning behind this holding is that inclusion of precomputed interest is contrary to the consumer protection intent of the Mini-Code and inconsistent with the plain meaning of � 5-19-20(a) of the Code of Alabama and Department of Insurance regulations. The applicable regulation reads: "The amount of Individual Credit Life Insurance written under one or more policies issued by the same lender shall not exceed the original face amount of the specific contracts of indebtedness in connection with which it is written; provided, however, that where the indebtedness is repayable in substantially equal installments, the amount of insurance shall never exceed the approximate unpaid balance of the loan."

Although the McCullar decision is currently being reconsidered by the Alabama Supreme Court, creditors and other parties to sales transactions involving credit life insurance should take care to avoid the result in the McCullar example. Credit life insurance should not be written to cover precomputed interest above the actual unpaid balance of the subject transaction. Additionally, creditors and insurers always must be wary about advising consumers as to what the consumer "needs." We will keep you advised of any developments in the areas affected by the McCullar decision.