Historical basis of right of setoff

The right to setoff has existed since Roman times (then known as “compensatio”) and automatically existed between mutual obligors as a matter of common law. Historically, the object of the compensatio was to prevent unnecessary suits and payments by ascertaining to which party a balance was due. In current times, “setoff” is the term used for the cancellation of mutual obligations involving unrelated transactions, and often occurs when a bank seizes the funds of one of its depositors in order to satisfy the debt owed by the depositor to the bank. Set‐off is classified as a self‐help remedy for creditors that can be accomplished outside of court at their election. It is a doctrine that allows entities who owe money to each other to cancel out or apply their mutual debts against each other thereby avoiding the “absurdity of making A pay B when B owes A.” See Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 18 (1995). Therefore, use of set‐off is relied upon by creditors as an efficient method for settling debts where the parties have mutuality by setting off one claim against the other.

“Under common law a bank has the power to apply the deposit to the payment of such depositor’s indebtedness only when there are mutual demands and debts between the parties and this right of setoff arises at the time the depositor’s indebtedness to the bank has matured.” SeeSelby v. DuQuoin State Bank, 223 Ill.App.3d 104, 107, 584 N.E. 2d 1055, 1057 (5 Dist. 1991).  Under federal law, “the relation existing between banks and their depositors is that of debtor and creditor, out of which the right of setoff arises.” See U.S. v. Butterworth-Judson Corporation,267 U.S. 387, 394-395. In NewYork County Nat.Bank v. Massey, the US Supreme Court stated that “in all cases of mutual debts or mutual credits between the estate of a bankrupt and a creditor, the account shall be stated and one debt shall be set off against the other and the balance only shall be allowed or paid.” See New York County Nat. Bank v. Massey, 192 U.S. 138, 144 (1904). In Studley v. Boylston Nat. Bank of Boston, the Court went on to say that “What the old books called a right of stoppage-what business men call setoff-is a right given or recognized by the commercial law of each of the states, and is protected by the bankruptcy act if the petition is filed before the parties have themselves given checks, charged notes, made book entries, or stated an account whereby the smaller obligation is applied on the larger.” Studley v. Boylston Nat. Bank of Boston, 229 US 523, 528 (1913). 

Illinois basis of Right of Setoff

Illinois law reflects the well-established right to setoff. A general depository account is a debt from a bank to its depositor. Under Illinois law, a bank “may apply its depositor’s account for a debt he owes to the bank.” See Selby, 223 Ill.App.3d at 107, 584 N.E. 2d at 1057. A bank has a right of setoff where mutuality can be established. Such mutuality can be established “when the individual who is both depositor and debtor stands in both of these characters alike, in precisely the same relation and on precisely the same footing toward the bank.” See International Bank of Chicago v. Jones, 119 Ill. 407, 410, 9 N.E. 885, 886 (1887). Illinois has adopted a specific statute that provides a procedural road-map for a garnishee attempting to assert a claim against indebtedness. The statute governing deductions and setoffs of a garnishee states, in relevant part:

“The garnishee is entitled to assert against the indebtedness due to the judgment debtor offsetting claims against either or both the judgment creditor and the judgment debtor, whether due at the time of service of the garnishment summons or thereafter to become due …. To the extent that other property belonging to the judgment debtor or in which the judgment debtor has an interest is pledged to or held by the garnishee in good faith as security or that the garnishee has other just claim against the other property, the garnishee is entitled to retain the other property. The garnishee is liable for the balance of the indebtedness due to the judgment debtor after the offsetting claims are adjusted and for the balance of other property after deducting property to which the garnishee has just claim.”  735 ILCS 5/12-708.

General vs. special deposits

A bank account is presumed to be a general deposit unless there is an agreement to the contrary. Bieze v. Coca, 54 Ill.App.3d 7, 16, 11 Ill.Dec. 652, 369 N.E.2d 106, 112 (1977). The well-established common law rule provides that “a bank has the right to setoff funds on general deposit against a matured debt owed by a depositor to the bank.” See Tri State Bank of East Dubuque v. Colby, 141 Ill.App.3d 807, 811; 490 N.E.2d 1037, 1039; Ill.App. 2 Dist.,1986.

Under the UCC a “deposit account” is defined as “… a demand, time, savings, passbook, nonnegotiable certificates of deposit, uncertificated certificates of deposit, nontransferrable certificates of deposit, or similar account maintained with a bank. The term does not include investment property or accounts evidenced by an instrument.”  (810 ILCS 5/9-314). If an account is a deposit account, then Under Section 9-314 of the UCC, “A security interest in investment property, deposit accounts, electronic chattel paper, letter-of-credit rights, electronic documents, or beneficial interests in Illinois land trusts may be perfected by control of the collateral.”  (810 ILCS 5/9-314). Further, “a bank with which a deposit account is maintained may exercise any right of recoupment or setoff against a secured party that holds a security interest in the deposit account.” (810 ILCS 5/9-340(a)). With respect to a deposit account, in most instances a garnishee’s right of setoff is superior to a judgment creditor’s claim. The Illinois garnishment statute establishes that the garnishee is only liable for the balance of the indebtedness due to the judgment debtor after the offsetting claims are adjusted.  See735 ILCS 5/12-708.  “If mortgaged or pledged property is in the possession of a garnishee, or property is held for the payment of a debt to the garnishee, the judgment creditor may, under order of court, pay or tender the amount due to the garnishee; and the garnishee shall thereupon deliver the property to the officer holding the certified copy of the judgment for the enforcement thereof against the judgment debtor.” See735 ILCS 5/12-714. As a “garnishee,” the Bank “has a right to all demands and setoffs, as against the judgment creditor, that it would have against the judgment debtor.” SeeObergfell v. Booth,218 Ill.App. 492, (1^st Dist.1920) applying 735 ILCS 5/12-708.

Under 810 ILCS 5/9-327, as between a depositary bank’s security interest in a deposit account and one held by another secure party, the depositary bank’s security interest is senior. (Official Comments to UCC, 810 ILCS 5/9-101). Although in general, Article 9 of the Uniform Commercial Code does not apply to rights of setoff, 810 ILCS 5/9-340 applies with respect to the effectiveness of rights of setoff against deposit accounts. (810 ILCS 5/9-109). Specifically, under 810 ILCS 5/9-340, a depositary bank’s right of setoff is generally senior to a security interest held by another secured party. However, if the other secured party becomes the depositary bank’s customer with respect to the deposit account, then its security interest is senior to the depositary bank’s security interest and right of setoff. (Official Comments to UCC, 810 ILCS 5/9-101; 810 ILCS 5/9-340). 810 ILCS 5/9-315 and 810 ILCS 5/9-322 apply to deposit accounts as proceeds and with respect to priorities in proceeds with respect to both consumer and non-consumer transactions. 

Unlike a general deposit, a special deposit is the delivery of either money or chattel to a bank under a “special agreement, or under circumstances sufficient to create a trust.” See People ex rel. Auditor of Public Accounts v. West Side Trust & Savings Bank of Chicago, 376 Ill. 339, 342, 33 N.E. 2d 607, 609 (1941). When money is deposited for a special purpose, it is held in trust for the depositor, rather than owed to the depositor. See US v. Butterworth–Judson Corp., 267 U.S. 387, 395 (1925). As it relates to the right to setoff, “where the liability of the one claiming a setoff arises from a fiduciary duty or is in the nature of a trust, the requisite mutuality of debts does not exist, and such person may not setoff a debt owing from the debtor against such liability.” See Klapmeier v. Flagg, 677 F.2d 781, C.A.Hawaii, 1982, citing 4 Collier on Bankruptcy P 553.04(3) (15 ed. 1981). This special account exemption from setoff applies when a debtor deposits funds for some special purpose, which are thereby held in trust for the debtor.In re Ben Franklin Retail Store, Inc., 202 B.R. 955, 957 (1996). Under the general rule of special deposits, the special deposit may not be setoff by bank for payment of general balance or for payment of other claims. See Filosa v. Pecora, 44 Ill.App.3d 912, 915, 358 N.E. 2d 1213, 1217 (1^st Dist. 1976).

Exception to the special deposit setoff exemption rule

Importantly, the special account exemption from the right of setoff is subject to the following contract exception established by the Illinois Appellate Court in Filosa v. Pecora:

“The disposition of escrow property is governed by the terms of the escrow agreement. Unless the agreement specifically provides that the escrow funds be returned to the money-lender, such funds will be returned to the depositors.”  See Id. at917-918; 1217. (emphasis added)

In Hannafan and Hannafan, Ltd. v. Eric Bloom, et al., 2011 IL App (1^st) 110722, 959 N.E. 2d 1280 (1^st Dist. 2011), the judgment creditor filed a motion to compel a third party (a law firm) to turn over funds paid to him by the judgment creditor (a client of the law firm). The funds had been paid to the law firm pursuant to a written retainer agreement. The judgment creditor argued that the agreement didn’t meet the requirements to establish an advance payment retainer agreement – which would transfer title to the funds on deposit to the law firm immediately when deposited, rather than leave the funds available for attachment by a citation or other collection proceeding. Noting that such retainers should be used “only when necessary to accomplish some specific purpose,” the court went on to look at the agreement, read as a whole, to determine the parties’ intent. See Id. at 1283, 959 N.E. 2d at 550.

In Hannafan, the Illinois Appellate Court stated that “In construing a contract, a court’s primary objective is to ascertain and give effect to the parties’ intent as evidenced by the plain language used in the agreement.”  Id. at 1285, 959 N.E. 2d at 553. The result was that the retainer agreement provided that the funds became the property of the law firm upon payment by the client and were not held by the firm as security for the payment of future bills. Had the agreement provided otherwise, the unused retainer would have been subject to Bloom’s garnishing creditor. 

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.

Client Alert authored by: Ronald N. Primack, Of Counsel