Chief Judge Cecelia G. Morris of the Bankruptcy Court for the Southern District of New York decided that banks may not place an administrative freeze, even a temporary one, on the bank account of an individual who files for bankruptcy.

In In re Weidenbenner,1 the joint Chapter 7 debtors filed a bankruptcy petition on March 7, 2014 listing four deposit accounts at Wells Fargo Bank as exempt personal property. On March 12, the Bank implemented an administrative freeze on all four accounts pursuant to the Bank’s internal policy. At the same time, the Bank contacted the Chapter 7 trustee to request instructions concerning the estate funds in the accounts. On March 17, at the trustee’s instruction, the Bank cancelled the account freezes. During the five-day period that the accounts were frozen, one of several checks issued by the debtors bounced and triggered a $25 penalty. On March 23, the debtors filed a motion alleging that Wells Fargo Bank violated the automatic stay by freezing the accounts.

In response, the Bank argued that the account funds ceased to be property of the debtors when they filed for bankruptcy protection, becoming property of the estate. Under Section 542(b) of the Bankruptcy Code, parties that hold “property of the estate” as defined under Section 541 are required to turn over that property to the Chapter 7 trustee. The Bank argued that it was acting in compliance with this provision when it placed the freeze and simultaneously requested instructions from the trustee concerning the funds in the accounts. Moreover, the Bank noted that if it failed to place the freeze and the debtors subsequently withdrew funds from the account, it might face liability under the turnover provisions of Section 542 for any decrease in estate funds.2 To that end, the administrative freeze was designed to facilitate the trustee’s role to determine the merits of claimed exemptions and avoid the risk of the Bank incorrectly guessing whether a claimed exemption is valid or not.3

Chief Judge Morris rejected these arguments, finding that the Bank “clearly” exercised control over property of the estate by placing the administrative freezes, violating the automatic stay provisions of Section 362. The court noted that account freezes are not required by law, and Congress did not include freezes among the statutory exceptions to the automatic stay. Further, the turnover obligations of Section 542 were not applicable because the bank never turned over the funds in the account to the trustee. In fact, the trustee instructed the bank to release all funds to the debtors.

The court took a particular interest in the Bank’s internal policies for administrative freezes when individual account holders file for bankruptcy. The court set an evidentiary hearing so it could take testimony from a “high ranking policy person from Wells Fargo” regarding the bank’s policies. At that hearing, a Bank operations manager testified that upon receiving notice of an individual account holder’s Chapter 7 filing, the Bank determines whether account funds are owed to the estate and freezes any such accounts with a balance exceeding $5,000. The court did not take comfort in the Bank’s policy, describing the $5,000 cut-off as “completely arbitrary.” Rather than take unilateral action to comply with its turnover obligations under Section 542(b), the Bank could “simply wait[] for the Chapter 7 trustee to ask for the balance of any deposit accounts to be turned over.”

As a policy matter, the court noted that administrative freezes make it more likely that debtors will hide funds before their accounts are frozen, and more difficult for the court to determine the debtors’ true financial situation, needs, and spending habits during the bankruptcy case.

The court did take note of one exception:  When a bank asserts a setoff claim against the account in question, a freeze is appropriate.4 In addition, case law in the Ninth Circuit permits an account freeze until the deadline for objections to a debtor’s exemptions.5

The amount at stake in Weidenbenner was relatively small — $25 (plus a significantly larger amount for attorneys’ fees). However, the decision opens the door for debtors and trustees to challenge administrative freezes of bank deposits and other accounts in individual bankruptcy cases where the asserted damages may be much higher — if, for example, the debtor’s lack of access to account funds results in the debtor’s inability to work or some other emergency.

Conclusion

Chief Judge Morris’ Weidenbenner decision provides much-needed guidance to banks on how to deal with trustees and account holders in bankruptcy. Frequently, banks place administrative freezes on debtor accounts because the debtors list banks in their bankruptcy schedules for two reasons: i) for notice purposes only; and ii) to advise trustees of the location of their assets. This places banks in the difficult and uncertain position of being depositories of debtor property that could be claimed by a trustee. Banks often worry that if the debtor funds are used by debtors, it may result in the dissipation of estate assets and thereby create liability for the banks.

In other words, banks are concerned that if they do not place administrative freezes on accounts, it will allow debtors to withdraw and dissipate funds. Moreover, because it is unlikely that a trustee could ever recover those funds directly from the bankrupt debtor, the easier litigation target is simply the bank that permitted the withdrawal of the funds in the first place.

As unfair and unreasonable as it may seem, it is easy to imagine a scenario where a trustee might commence an action for turnover against a bank for allowing a debtor to withdraw funds that amount to property of the estate. Indeed, in the Fourth, Seventh, and Ninth Circuits, a party may still be liable for the value of the property, even if it no longer has the property, as long as it had the property at some point during the bankruptcy case.6 The Bankruptcy Appellate Panel for the Tenth Circuit has also endorsed this view.7 In contrast, in the Eighth Circuit, the party that transferred the property is not liable because it no longer has possession of the property.8 A handful of bankruptcy courts have agreed with the Eight Circuit approach, but it is clearly the minority view. The conflicts among these courts underscore the concern and uncertainty related to this issue and the practice of placing administrative freezes on accounts.

Weidenbenner gives credence to the view that banks do not have unspecified fiduciary obligations to trustees in the individual bankruptcy cases of their account holders.Weidenbenner may even protect against a trustee’s efforts to hold a bank responsible when a debtor withdraws account funds. Undoubtedly, many banks will welcome the Weidenbennerdecision, but this is unlikely the last time these issues will arise. Weidenbenner is currently on appeal in the District Court for the Southern District of New York.