Greenberg Traurig Alert

Two Recent U.S. Supreme Court Decisions Benficial to Banks and Other Lenders

March 5, 1996

I. "Bankers' Dilemma" Resolved . . . in Favor of the Bankers!

Resolving a long-standing dilemma for banks and their counsel, the Supreme Court has held that a bank owed a debt by a depositor who files bankruptcy may protect its right to set off that deposit against the debt by temporarily withholding payment of the deposit, without violating the automatic stay. Citizens Bank of Maryland v. Strumpf, 116 S.Ct. 286 (1995).

The "bankers' dilemma" arises each time that a depositor who is also a creditor of the bank holding the deposit files bankruptcy. The bank then faces the thorny issue of whether to freeze the account and risk sanctions for violating the Bankruptcy Code's automatic stay, or to risk the loss of its setoff right by withdrawing funds from the account.

In Strumpf, the Chapter 13 debtor was in default on the remaining balance of a $5,000 loan. Upon the filing of the bankruptcy petition, the bank placed an "administrative hold" on the debtor's checking account, so as to block withdrawals which would reduce the balance below the amount due on the loan. Five days later, the bank filed a motion for relief from the automatic stay and for setoff of the account. The debtor responded with a motion to hold the bank in contempt, claiming that the administrative hold on his account violated the automatic stay.

The bankruptcy court first ruled on the debtor's motion, holding that the administrative hold constituted a setoff in violation of the stay, and assessed sanctions against the bank. Several weeks later, the bankruptcy court granted the bank's motion for relief from the stay, and authorized it to set off the remaining account balance against the unpaid loan. Not surprisingly, the debtor had already emptied the account, leaving the bank with a hollow victory and nothing to set off.

On appeal, the district court reversed, holding that the bank had not violated the automatic stay. The court of appeals reversed again, ruling that the administrative hold was a violation of the automatic stay.

In reversing the court of appeals, the Supreme Court first noted "the absurdity of making A pay B when B owes A." The Court then went on to rule that the administrative hold was not a setoff within the meaning of the automatic stay: the bank "refused to pay its debt, not permanently and absolutely, but only while it sought relief under ¤ 362(d) [of the Bankruptcy Code] from the automatic stay." Although the Court did hold that the bank's administrative hold was not an improper setoff, it declined to rule on whether the administrative hold was otherwise proper (e.g., whether the bank had frozen too much money).

It is now the law of the land that a bank may preserve its right to setoff by putting a temporary hold on a debtor's account. Nevertheless, banks should develop a standard policy and a set of appropriate forms with outside counsel in order to comply strictly with the ruling in Strumpf, and preserve the right of setoff while avoiding any risk of sanctions.

II. Supreme Court Rules on Extent to Which Lenders May Rely on Borrowers' Representations

Every day, lenders require that borrowers provide them with certain information and representations in order to obtain credit. But lenders often fail to consider the extent to which they must verify the information in order to prevent a discharge of the debt in the event the information turns out to be false and the borrower files for relief under the Bankruptcy Code.

The Bankruptcy Code provides that the discharge available under Chapters 7, 11, and 13 of the Bankruptcy Code does not discharge an individual debtor from, among other things, any debt for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by:

1. false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor's or an insider's financial condition; or
2. use of a statement in writing;
   1. that is materially false;
   2. respecting the debtor's or an insider's financial condition;
   3. on which the creditor to whom the debtor is liable for such money, property, services, or credit reasonably relied; and
   4. that the debtor caused to be made or published with intent to deceive.

11 U.S.C. ¤ 523(a)(2).

With respect to a written financial statement, the Bankruptcy Code makes clear that the lender must have "reasonably relied" on such statement in order to have the debt excepted from discharge. Therefore, if the bankruptcy court determines that a reasonable person in the position of the lender would have taken greater steps to verify the financial information, the debt may be discharged notwithstanding the fact that the debtor intentionally misrepresented his financial condition to obtain the credit.

The Bankruptcy Code is silent on the standard for determining a lender's right to rely on representations other than those respecting the debtor's financial condition. Until now, courts generally applied the same "reasonable reliance" standard, based on the assumption that the legislature intended the same standard to apply. In Fields v. Mans, 116 S.Ct. 437 (1995), however, the Supreme Court ruled that the lower standard of "justifiable reliance," is required for written financial information.

What is the difference between reasonable reliance and justifiable reliance? According to the Supreme Court, reasonable reliance requires that the court make a determination as to whether a "reasonable person" would have relied on the information provided; while the justifiable reliance standard requires that the court consider the "qualities and characteristics of the particular plaintiff" and "the circumstances of the particular case."

The lenders in Fields v. Mans were two individuals who took back a purchase money mortgage as part of the payment for real estate sold to a corporation. The note was guaranteed by Mans, a principal of the corporation. Several months after the sale, the borrower conveyed the property to a third party without the lenders' consent, in violation of the mortgage deed. The day after the transfer, Mans wrote the lenders a letter requesting a waiver of the due-on-sale clause in the mortgage deed without advising lenders of the conveyance, ostensibly for the purpose of avoiding complications with adding a new principal to the corporation. The lenders agreed to the waiver based on the false representations in the letter.

Three years later when Mans filed for bankruptcy, the lenders argued that the debt due under the guaranty had been accelerated at the time of the transfer and was nondischargeable because of the false representations made by Mans. The bankruptcy court found that Mans did make false representations and that the lenders relied on the representations in extending credit. However, the bankruptcy court held that a reasonable person would have checked for conveyances at the time the credit was extended, and therefore granted the debtor's discharge. On appeal, both the district court and First Circuit Court of Appeals affirmed.

The Supreme Court reversed the decision, holding that the proper standard was "justifiable reliance," and remanded the case for further proceedings under the proper standard.

The decision in Fields v. Mans may prove of little benefit to banks and other institutional lenders. In considering the "qualities and characteristics of the particular plaintiff," courts are likely to apply a higher standard to lending institutions engaged in the business of evaluating and extending credit, than to individual lenders like the plaintiffs in Fields who may be unfamiliar with the credit decision process.