Freezing a Chapter 7 Debtor’s Bank Account Doesn’t Violate the Automatic Stay

Persuaded by a Ninth Circuit opinion, a district judge in New York held that a bank does not violate the automatic stay by imposing a temporary freeze on the account of an individual who files a chapter 7 petition.

The bank had an internal policy of allowing chapter 7 debtors to continue drawing funds from their accounts if the accounts held an aggregate of less than $5,000 on the date of filing. On the other hand, the bank would temporarily freeze the accounts if they held more than $5,000 in total.

In the case at bar, the debtors had more than $5,000 in their accounts on the filing date, so the bank froze everything. On the same day, the bank notified both the chapter 7 trustee and the debtor’s counsel about the temporary freeze and sought instructions from the trustee about the disposition of the account.

One week after filing, the bank dishonored a $75 check the debtors had drawn on the account and imposed a $25 fee.

Ten days after filing, the trustee instructed the bank to release all funds in the account to the debtors, presumably because the funds were exempt assets. The bank immediately complied.

Later, the debtor sued the bank for violating the automatic stay under Section 362(a). Eventually, the bankruptcy court ruled that the bank had violated the stay by exercising control over estate property. The court awarded the debtors $25 in damages and attorneys’ fees of almost $15,000.

The bank appealed and won a reversal in an April 25 opinion by District Judge Kenneth M. Karas of White Plains, N.Y.

Judge Karas explained that two provisions of the Bankruptcy Code are “in tension.” Section 542(b) requires an entity owing a “debt” that is property of the estate to pay the “debt” to “or for the benefit of” the trustee. On the other hand, he said, Section 362(b)(3) prohibits an exercise of control over estate property.

Judge Karas noted how Bankruptcy Rule 4003(b) imposes a 30-day deadline after the first meeting of creditors for objecting to the debtor’s claimed exemptions. Once the deadline passes without objection, exempt property reverts to the debtor, is no longer an asset of the estate and is not protected by the automatic stay.

In Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 19 (1995), the Supreme Court held that a bank did not violate the automatic stay by placing an administrative freeze on a debtor’s bank account, to the extent the bank had a right of setoff. Judge Karas said that subsequent courts “applied [Stumpf’s] reasoning to temporary holds placed on bank accounts even where the bank had no setoff rights.”

Judge Karas said he was persuaded by the Ninth Circuit’s “reasoning” in In re Mwangi, 764 F.3d 1168 (9th Cir. 2014), where the bank had placed an administrative freeze on the debtors’ bank account after they filed a chapter 7 petition. The debtors had sued, alleging a violation of the automatic stay.

The Ninth Circuit found no stay violation before the deadline for objecting to exemption claims, because the debtors had no right to possession of the funds and thus suffered no injury. After the exemption deadline, the appeals court likewise found no stay violation because the account was no longer estate property and thus was not protected by the automatic stay.

Judge Karas cited Section 362(k), which allows the recovery of damages by an individual who is “injured by any willful violation” of the stay. He agreed with “the overwhelming majority of courts” holding that a debtor has not been injured — and thus has no right to recover damages — before the exemption deadline when the debtor has no right to possess the property.

There was no stay violation on a second ground, according to Judge Karas. Because the bank immediately sought instructions from the trustee after imposing the temporary freeze, he said that the bank had not exercised control over the property and therefore did not violate the stay.

Observation: The opinion seems to mean that the bank would not violate the stay by freezing accounts with less than $5,000. By allowing debtors to draw against accounts with less than $5,000, the bank is exposing itself to potential liability if a debtor withdraws funds for an improper purpose. Evidently to maintain good relations with customers, the bank’s policy gives debtors more rights than those to which they are entitled by strict application of the Bankruptcy Code, as interpreted by Judge Karas.