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Social Security Benefits and a Bank's Right of Setoff
By: John E. Burrus, Esq.

(Updated as of August 20, 2002)

A recent article circulated by Kansas Bankers Surety Company has prompted questions from a number of IBC members concerning a bank’s right of setoff against deposited Social Security benefits and for advice on approaches which might be taken on overdrafts by Social Security recipients.

The Statute

42 USC §407(a) provides the following with respect to Social Security benefits:

The right of any person to any future payment under this subchapter shall not be transferable or assignable, at law or in equity, and none of the money paid or payable or rights existing under this subchapter shall be subject to execution, levy, attachment, garnishment or other legal process, or to the operation of any bankruptcy or insolvency law.

42 U.S.C. §1383(d)(1) extends these protections to SSI benefits as well.

The Cases

Until 1998, the only two federal cases which had considered the issue held that this statute did not protect Social Security payments on deposit in a bank from being reached by setoff. See Frazier v. Marine Midland Bank N.A., 702 F.Supp. 1000 (W.D.N.Y. 1988); In re Gillespie, 41 BR 810 (Bankr. D.Colo. 1984). These cases rested on a finding that no “legal process” was involved in exercising a setoff right, and thus exercise of that right was not proscribed by the statute. Legal commentators generally agreed. See, for example, Clark, The Law of Bank Deposits, Collections and Credit Cards, paragraph 21.02 (A. S. Pratt & Sons 2001). 

In Tom v. First American Credit Union, 151 F.3d 1289 (10th Cir. 1998), a federal court held for the first time that Social Security payments deposited into a financial institution account were protected from setoff under the above quoted statute. This decision was by the Tenth Circuit Federal Court of Appeals, which includes Colorado within its jurisdiction, and implicitly overruled the contrary holding by the Colorado Bankruptcy Court in In re Gillespie, supra.

Lopez v. Washington Mutual Bank, F.A., 284 F.3d 990 (9th Cir. 2002), followed the Tom decision in holding that Social Security payments deposited into a bank account are protected from setoff. Both Tom and Lopez involved attempts by financial institutions to cover debts arising from the institutions’ covering of overdrafts. Lopez involved accounts with funds derived solely from the direct deposit of Social Security benefits. Tom involved an account which the court stated “consisted entirely of funds [the plaintiff] had received as payments under the Social Security and Civil Retirement Acts.” (The Civil Retirement Acts include protective provisions similar to the Social Security Act provision quoted above.)

Neither case involved accounts which included funds from other sources, and the concurring opinion in Lopez indicates that that judge construes the Lopez holding as being limited to accounts solely funded by direct deposit of benefits. Both cases considered arguments rejected by each court that the benefit recipients had waived any exemption, both by language contained within the deposit agreements and by actions occurring after the overdrafts had been funded.

The Present State of the Law

The following general principles can be said to have been established by the Tom and Lopez decisions:

• Social Security and SSI benefits are protected from a financial institution’s right of setoff, at least when the account consists solely of funds directly deposited or when the financial institution otherwise knows the source of deposit.
• The depositor cannot waive this exemption in the deposit agreement itself because such an advance waiver is also precluded by the statute’s prohibitions on transference and assignment of benefits.
• After the debt has been incurred, the Social Security recipient can use the benefits to pay the debt, but only if that decision includes the “meaningful consent” of the recipient to use the funds for that purpose. Presumably the recipient’s voluntary and uncoerced decision to pay the debt would be final and effective.
• The inability of the financial institution to exercise its right of setoff does not, of course, extinguish the debt.
   

Unanswered Questions

Neither the Tom or Lopez decisions nor any other decision to date has directly addressed the following issues with respect to Social Security or SSI benefits, and these issues must therefore be considered unsettled at this time:

• Lack of knowledge by bank of source of deposits. Under cases involving seemingly analogous situations, it would appear that a bank may exercise its right of setoff if it has no knowledge as to the source of deposits, but may be required to recredit the account if the customer can show that the deposits resulted solely from Social Security or SSI benefits.
• Commingled funds. Case law in related areas indicates that a bank may be entitled to exercise its setoff rights if the account is composed of both exempt and non-exempt funds. It appears that, at a minimum, the customer would have the responsibility to establish both that a portion of the funds are exempt and (through recognized “tracing” rules) that the bank’s setoff was against exempt funds.
   

Available Approaches

In light of these developments, it appears that a bank’s choices are limited to the following:

• Deny overdraft protection to any Social Security or SSI recipients unless an overdraft line of credit can be established which is secured by non-exempt collateral. Since this would be strictly in response to the Tom and Lopez decisions and not based on the age or other attributes of the recipients, this policy should not violate laws precluding discrimination on prohibited bases.
• Continue to follow existing policies on the assumption that the benefits in customer retention will outweigh the likely expense associated with covered overdrafts which are not voluntarily repaid by the customer.
   

It is suggested that a reasonable approach would be to consider a combination of these policies with respect to each particular customer. For example, it may be worthwhile to continue covering overdrafts up to a designated maximum amount, but to cease providing that service for anyone who fails to pay the resulting debt promptly. Each bank will have to make a cost/benefit analysis of its policies in this area in light of these recent developments and its knowledge of its customer base.

UPDATE
 
Since this item was first posted, the Ninth Circuit has withdrawn and reissued the Lopez decision and has, in effect, reversed itself on this issue. The republished Lopez decision (Case No. 01-15303, August 6, 2002) now holds that setoff against Social Security benefits to cover overdrafts is permitted if (i) the deposit agreement contains language whereby the depositor agrees to pay overdrafts and (ii) the depositor continues to deposit or permit the deposit of benefits after the overdrafts have been covered by the bank. 

However, since this matter involves the interpretation of a federal statute, the apparently contrary holding by the Tenth Circuit in Tom v. First American Credit Union will continue to apply in Colorado and other Tenth District states unless and until that decision is overturned either by the Tenth Circuit itself or by the United States Supreme Court. Thus, despite the Ninth Circuit’s change of heart, Colorado banks should not assume that they may lawfully setoff against Social Security benefits to cover overdrafts.

Contact John E. Burrus at jeb@bsblawyers.com

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