Generally speaking, a bank has a right to set off a debt owed by the customer to the bank from its customer’s account. In a typical situation, where borrower A owes bank B a debt for a loan, and borrower A has a bank account with bank B, bank B can use funds from borrower A’s account to satisfy the debt where there has been a default under the loan. This general rule may not be applicable, however, if the funds in borrower A’s bank account are held in trust for another entity. The ability to set off such funds will, absent statutory authority, generally turn on bank B’s knowledge of the trust fund nature of the money in the account.

Bank Accounts and Setoffs

Banking institutions “have a long established right of setoff where a borrower is indebted to the institution and also has money on deposit with the institution.”1 When a customer deposits funds in a general bank account, the customer parts with title to the funds, and essentially loans the funds to the bank. Conversely, when an account is overdrawn, such overdraft is considered a loan by the bank to the customer. The application of the bank’s debt (i.e., the deposit) to reduce the customer’s debt (i.e., the overdraft) is a setoff. Because a setoff is any balancing of mutual debts, courts do not distinguish between an active decision to set off funds already in an account against another debt, on the one hand, and an automatic application of deposits to reduce an overdraft, on the other.

A setoff right is premised on mutual obligations. Accordingly, a bank may only reduce a customer’s overdraft with funds belonging to that customer, and not with funds belonging to a third party. When funds are deposited into a general, non-trust account, the bank is entitled to presume that the funds belong to the customer; the bank has no duty to inquire into the source of each deposit. That said, the presumption that the funds belong to the customer can be rebutted if it can be shown that the bank had knowledge of the nature of the funds, or adequate notice thereof. Thus, “when a bank is on notice that funds in a depositor’s account are owned by a third party, the bank cannot appropriate those funds in order to set them off against a debt of the depositor.”2

A bank will be considered to have such notice “when it is aware of facts which would fairly provoke it to inquire as to the true ownership of the funds and such inquiry, if made with ordinary diligence, would reveal the true ownership.”3 The nature and characteristics of funds on account, and the bank’s knowledge thereof is a fact-intensive inquiry that will depend on the facts of each case. Courts have held that funds that are contractually held in trust for another are third-party funds that are not subject to setoff. This is true even when the bank is not a party to the agreement that establishes the trust funds.

If a bank knows or is on notice that the customer is not the true owner of funds in an account at the time it applies those funds to the customer’s debt, the bank may be liable to the true owner for their conversion.4 It is irrelevant whether the bank is aware of the actual amount of trust funds contained in a commingled account. If the bank knows that at least some deposits in an account consist of trust funds, then it may be prevented from applying all deposits to reduce its customer’s debt. Thus, if a bank has actual notice that funds are held in trust, the bank will not be able to utilize its setoff rights against such funds.

Courts have held that a bank has actual notice that funds belong to a third party when the bank has received the document creating the third-party ownership. “In most cases where there is a written trust instrument, and the purchaser knows of it, or could have learned of it with reasonable effort, he will be charged with the duty of examining that instrument.”5

Absent actual knowledge, a bank may also have constructive or inquiry notice of the nature or characteristics of the funds in an account. For a bank to have constructive notice of trust funds in an account, generally one bank employee should know all of the relevant facts to put the bank on notice.6 Knowledge, however, should not be aggregated; a bank should not be deemed to have constructive notice when the many facts that would prompt inquiry into the funds’ ownership are spread out over various different bank employees. Additionally, when a bank receives a check for deposit that appears valid on its face, and the check has an endorsement stating that the payee is the sole and unconditional owner of the funds, the bank will not be required to investigate further.

Knowledge of the nature of the customer’s business is relevant, but it probably will not, by itself, be sufficient to establish actual or constructive notice. Other factors that have been held to put a bank on notice of the fiduciary nature of funds are (i) familiarity with the customer’s financial affairs and/or (ii) unusual facts surrounding the deposit.

Types of Accounts

In addition to the issue of whether funds deposited into an account are third-party funds, disputes can arise as to whether the account itself is a general account, in which case the bank has a right of setoff, or a special or reserve account where the bank may not have a right of setoff. There is a presumption that an account is general, and New York law considers all of the circumstances of the establishment and maintenance of the account and whether it was the intent of the parties to create a general account or a special or trust account. The party claiming that the funds are special funds has the burden of proving the intent to have the funds kept separate from general funds with the bank.

Whether funds are deposited for a specific purpose is not determinative of whether the account is general or special. Additionally, the labeling of an account as a “special account” alone is not sufficient to put a bank on notice that the funds in that account are trust funds held on behalf of a third party.

Setoffs and Bankruptcy

A bank’s right of setoff will generally be preserved in bankruptcy.7 “The rule allowing setoff, both before and after bankruptcy, is not one that courts are free to ignore when they think application would be ‘unjust.’”8 The right of setoff should be enforced unless “compelling circumstances” require the disallowance of that right.9

Compelling circumstances may include a real and imminent threat to the debtor, or when a creditor engages in criminal conduct or commits fraud. Compelling circumstances frequently arise in Chapter 11 bankruptcy cases, where the debtor is attempting to reorganize its financial affairs. However, even then, while the right of setoff may be deferred or stayed, it ordinarily will not be completely barred.

Of course, in order to exercise its right of setoff after the filing of a bankruptcy, the bank must request relief from the automatic stay with respect to acts to obtain possession or control over the property of the estate.10 Nonetheless, while the application of a setoff is stayed in bankruptcy, a bank can place an administrative freeze on an account without being in violation of the automatic stay provisions set forth in Section 362 of the Bankruptcy Code.11 That said, the most prudent course of action for a bank to take is to seek relief from the automatic stay to effectuate the bank’s right of setoff immediately after placing an administrative freeze on the borrower’s account.

While setoff rights will generally be preserved in bankruptcy, there are exceptions. For example, Section 553(a)(2) of the Bankruptcy Code provides an exception to the general right of setoff where the claim that is subject to setoff was transferred, by an entity other than the debtor, to the bank either (a) after the commencement of the case, or (b) within 90 days of the bankruptcy filing while the debtor was insolvent. Additionally, Section 553(a)(3) of the Bankruptcy Code provides that a setoff may not be asserted where: (i) the debt owed to a creditor is incurred within 90 days of the bankruptcy filing; (ii) while the debtor was insolvent; and (iii) for the purpose of obtaining a right of setoff.

In effect, Section 553(a)(3) is a restriction on preferential payments made by a debtor to a deposit bank. Deposits made in the ordinary course of business are generally not deemed to have been made for the purpose of obtaining a right of setoff. Nevertheless, if it can be shown that a debt was incurred for the purpose of obtaining a setoff right, Section 553(a)(3) of the Bankruptcy Code may disallow the setoff.12


While a bank generally (inside and outside of bankruptcy) will be able to set off funds its customer has on deposit against a debt that its customer owes the bank, the nature of the funds on deposit and the bank’s knowledge (actual or inquiry) of same could affect the bank’s ability to apply a setoff. As a setoff can only be accomplished if there are mutual obligations, if the funds in the customer’s account are trust funds­—and, thus, not the property of the customer but of a third party—a setoff could be found to be improper and amount to conversion of the third party’s funds. The fact-intensive inquiry will turn on the bank’s knowledge of the true owner of the funds. Banks should be aware of this issue so as to minimize the possibility of being sued for conversion by third parties that have fiduciary relationships with their customers.

Scott I. Davidson is counsel in the financial restructuring group at King & Spalding in New York City. Gary A. Ritacco, an associate at the firm, assisted in the preparation of this article.


1. In re Catalano, 352 B.R. 361, 362 (Bankr. W.D.N.Y. 2006).

2. Daly v. Atl. Bank of N.Y., 614 N.Y.S.2d 418, 419 (1st Dept. 1994).

3. Id.

4. See, e.g., Schreibman v. Chase Manhattan Bank, 224 N.Y.S.2d 977, 977 (1st Dept. 1962) (“‘It is universally conceded that knowledge upon the part of a bank that deposits made by a debtor of the bank in his own name belonging to a third person absolutely precludes the bank from applying such funds to the individual indebtedness of the depositor to it’” (citation omitted); upholding conversion claim).

5. George Gleason Bogert, George Taylor Bogert & Amy Morris Hess, Bogert’s Trusts And Trustees §894 (3d ed. 1979 & supp. 2012).

6. See Gerrity Co. v. Bonacquisti Constr., 525 N.Y.S.2d 926, 929 (3d Dept. 1988).

7. See 11 U.S.C. §553(a) (unless otherwise provided, the Bankruptcy Code “does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case…”).

8. New Jersey Nat’l Bank v. Gutterman (In re Applied Logic), 576 F.2d 952, 957-58 (2d Cir. 1978).

9 . Id.

10. See 11 U.S.C. §362(a)(7) (“[A] petition filed under section 301, 302, or 303 of this title…operates as a stay…of…the setoff of any debt owing to the debtor that arose before the commencement of the case under this title against any claim against the debtor”).

11. See Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 19 (1995).

12. Limitations on the amount of a setoff are discussed in Section 553(b) of the Bankruptcy Code.