A lender’s ability to set off against a borrower’s account can be a valuable tool for lenders, but care must be exercised to safeguard against potential liability.
If setoff is exercised against a checking account, there is a likelihood that checks drawn on the account prior to the setoff (or prior to notice to the depositor of such setoff) will be dishonored, because the account will have been depleted by the setoff. Dishonored checks can expose the depositor to civil liability to third parties and even criminal liability under some circumstances.
In turn, the depositor could challenge the setoff as wrongful. To avoid potential liability for claims of wrongful dishonor of checks where the depositor later challenges the setoff as wrongful (which liability may include punitive damages), lenders should take the following precautions. First, a lender should notify the depositor immediately (e.g., by telephone or e-mail) that the bank is setting off his or her account(s) against the debt owed. More formal notice may be sent by mail for record-keeping purposes. Once the depositor has been notified that the account has been setoff, he or she will be charged with knowledge that any subsequent checks that are written from the account could be rejected.
Second, simultaneously with providing such notice to the depositor, the bank should “flag” the account(s) so that any checks that come in can be scrutinized. “Flagging” the account(s) instead of simply setting it off entirely is recommended because a lender can ascertain whether checks that come in were written (1) prior to when notification was given to the depositor, and (2) to pay a legitimate third-party debt (e.g., rent, utilities). Checks that meet these criteria should be paid from the account in order to reduce any potential liability to the depositor in the event that the account was improperly setoff. Any checks that are written (1) after notice was given to the depositor, or (2) to the depositor or a related party (e.g., the depositor’s company, family or other known affiliate), can be dishonored by the bank.