This case held that a credit union’s “freeze” on a bankrupt members’ account violates the bankruptcy court’s automatic stay if the member’s loan secured by the deposit is not in default.

In this case, the debtors previously borrowed funds from the credit union and granted to the credit union a security interest in their deposits at the credit union.

The credit union “froze” the members’ deposits upon receiving notice of their filing for bankruptcy.

Pursuant to the loan documentation, the credit union also applied the deposit balance to the members’ loan balance and discontinued all member privileges to these debtors, which included dis- honoring outstanding drafts on the members’ account. The credit union classified this as an “administrative freeze”.

All three courts to which this case was presented found that the credit union’s “freeze” on the members’ account was in contravention of the bankruptcy court’s automatic stay. In fact, the credit union violated the Bankruptcy Code prohibition against discrimination of a bankrupt debtor.

Specifically, the credit union applied the members’ deposit to the loan balance, suspended all privileges to the member, dishonored outstanding drafts issued by the members and deprived the members of control over their deposits; additional deposits to the debtors’ account were also refused.

The credit union’s policy directed that any member who was causing a loss to the credit union would be denied all privileges of membership.

In this case, however, the credit union had not yet suffered a loss since the debtors’ payments on the loan were current when the credit union chose to set-off the loan balance with the members’ deposit. It is also significant that the loan documentation only permitted that the credit union apply the deposits to the loan balance as the payments became due.

The courts held that in order for the credit union to exercise its right to set-off, as was done in this case, the creditor must first apply for relief from the bankruptcy court’s automatic stay. The creditor must also be able to prove that it has a legitimate claim against the members’ deposits. Here, the credit union made a unilateral determination that it had a legitimate right of set-off against the members’ deposit pledged as collateral.

If the credit union had not exercised its right of set-off, the funds on deposit may have been dissipated by the debtors. Nonetheless, the courts found that the credit union ought to have immediately filed a motion pursuant to the Bankruptcy Code to permit application of the members’ deposits to the loan debt. In this situation, the credit union may only have 24 to 48 hours to file an ex-parte petition and order with the court to protect its interests.

The court held that creditors in this position have an alternative remedy and need not freeze debtors’ accounts. The credit union could have filed a motion under Section 362(f) or 363(e) of the Bankruptcy Code to preserve the credit union’s application of the deposits.

In addition, the court found that the loan documentation itself did not authorize the credit union to transfer any more from the members’ account than would be necessary to maintain current payments; since the members were current with their payments, the credit union had no right to transfer any funds from their deposit accounts.

In conclusion, the credit union’s freeze of the members’ account, as well as their refusal to honor membership privileges, constituted a violation of the bankruptcy stay and discriminated against the debtors for having filed bankruptcy. B.F. Goodrich Employees Federal Credit Union v. Fred C. Patterson & Mary Patterson (U.S. Court of Appeals, 11th Cir., No. 91-7669).

EDITOR’S COMMENT

The case above specifically states that it does not change the position that any creditor should not be forced to continue conducting business with a debtor who causes a loss to the creditor, however, this credit union acted before a loss was incurred and they acted by setting-off the members’ account without application to the bankruptcy court.

Credit unions previously prevailed in Brown v. Pennsylvania State Employees Credit Union, 851 F.2d 81 (3rd Cir.), by disallowing services to credit union members who caused a loss to the the credit union, however, the decision above is of great concern for the daily operation of a credit union when the member(s) file bankruptcy.

Author: Charles R. Harroun, Attorney at Law