Banks have long taken comfort in knowing that if one of their customers files for bankruptcy, the bank can freeze the debtor’s account to preserve the bank’s ability to assert a setoff against the account where the bank has a claim against the debtor. Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 116 S.Ct. 286 (1995). In Strumpf, the Supreme Court reasoned that a bank does not violate the Bankruptcy Code’s automatic stay when it freezes a debtor’s account while the bank takes action (i.e., seeks relief from the automatic stay) to effectuate the setoff.
Strumpf left unanswered, however, the question of whether a bank could place a hold on a debtor’s account when the bank lacks any setoff right. This is a particular concern in Chapter 7 cases where the debtor may be claiming the account monies are exempt property and demanding immediate use of the funds, but the Chapter 7 trustee has not taken a position on the exemption claim or otherwise given the bank any direction on what to do with the monies.
In In re Mwangi, ___ F.3d ___, 2014 WL 4194057 (9th Cir., Aug. 26, 2014), the Ninth Circuit became the first court of appeals to decide the issue and upheld a bank’s freezing a Chapter 7 debtor’s accounts pending resolution of the debtor’s exemption claim in the account funds.
The facts of Mwangi are fairly typical. The debtors held four accounts at Wells Fargo Bank, N.A. with an aggregate balance of $17,075 at the time they filed a joint voluntary Chapter 7 petition. Consistent with its nationwide policy, Wells Fargo placed a “temporary administrative pledge” on the accounts within days after the filing. The bank then promptly sent a letter to the Chapter 7 trustee in the debtors’ case requesting instructions on how the account funds should be distributed. Wells Fargo further informed the trustee that it would maintain the hold on the accounts until the earlier of its receiving direction from the trustee or 31 days after the first meeting of creditors in the debtors’ case. Wells Fargo sent a letter to the debtors’ counsel at the same time explaining that the accounts had been frozen, the bank had asked for instructions from the trustee, and the debtors should contact the trustee to expedite the funds’ distribution.
The debtors responded by amending their bankruptcy schedules to claim the account funds were exempt property under Nevada law. Based on this exemption claim, the debtors requested Wells Fargo lift the hold on their accounts. The bank refused to do so. The debtors quickly sought sanctions against the bank for violating the automatic stay by failing to turn over the account funds to the debtors.
The case has been pending for years. The bankruptcy court initially rejected the debtors’ claim, but the Bankruptcy Appellate Panel for the Ninth Circuit reversed. On remand, the bankruptcy court and then the District Court of Nevada rejected the debtors’ claim, but the debtors’ again appealed, this time to the Ninth Circuit.
The Ninth Circuit concluded the bank did not violate the automatic stay. The court initially noted that the account funds, like all other property of the debtors, became “property of the estate” upon their filing their petition. Hence the funds in the debtors’ accounts were, as of the petition date, subject to the automatic stay’s prohibition of “exercise[ing] control over property of the estate.”
The debtors’ claim of an exemption in the account funds did not change their status as property of the estate. Unless and until an exemption is allowed, the funds remain property of the estate. Under the Bankruptcy Code and Rules, the trustee or creditors have until 30 days after the later of (a) the conclusion of the first meeting of creditors or (b) the filing of an amended exemption schedule to object to a debtor’s claim of exemption. If this period passes without an objection, then the exemption is deemed allowed, ownership of the account funds vests in the debtor, and the monies are no longer property of the estate (and thus are not subject to the automatic stay).
The debtors argued that pending allowance of their exemption, they had an “inchoate” interest in their account funds that was injured when Wells Fargo refused to lift the hold. The Ninth Circuit rejected this argument. The court noted that from the petition date until the 30-day objection period ran on their exemption claim, the funds were property of the estate that the debtors had no right to possess or control. So while the monies were subject to the automatic stay during this period, Wells Fargo did not violate the stay by refusing to allow the debtors access to their accounts. Rather, the Chapter 7 trustee alone had the right to control these monies during this period of time.
Moreover, once the debtors’ exemption in the accounts was deemed allowed with the passing of the 30-day objection period, the funds were no longer subject to the automatic stay. Thus the debtors could not assert the bank violated the stay after ownership of the accounts re-vested in the debtors.
The Ninth Circuit went on to note that Wells Fargo fully complied with its separate obligation under the Bankruptcy Code to “turnover” estate property. While the Bankruptcy Code generally requires parties to “deliver” estate property in their custody or control to the trustee, a bank does not have custody or control of an identifiable pool of money when a debtor has a deposit account with the bank. Rather, the bank is said to owe a debt to the debtor for the sum on deposit with the bank. Under these circumstances, the Bankruptcy Code’s turnover provision requires the bank to “pay such debt to, or on the order of, the trustee.” In Mwangi, Wells Fargo complied with this mandate when it sought instructions from the trustee regarding disbursement of the funds.
After Mwangi, a bank should breathe easier when freezing a debtor’s account at the outset of a Chapter 7 case. But an account hold only preserves the status quo. Like Wells Fargo did in Mwangi, a bank should engage the trustee promptly regarding directions for disbursing the funds. Where the debtor is claiming funds in the account are exempt, the bank should carefully review the debtor’s exemption claim to determine how much of the account balance the debtor is claiming is exempt. If the account balance is greater than what the debtor is claiming as exempt, the bank should seek instruction from the trustee on disbursement of the overage, which will remain property of the estate even after the debtor’s exemption is deemed allowed. Likewise, if the trustee or creditor objects to the debtor’s exemption claim, the bank should await resolution of that claim before lifting the hold.
The Mwangi opinion clarifies the Ninth Circuit’s rule on how a bank may address competing interests of a debtor and the bankruptcy trustee in a fund, and reverses a pesky BAP opinion. But banks should not hold such funds indefinitely, without a policy for resolution of the competing interests, in order to avoid future litigation.