September 2025 OBA Legal Briefs

• The Bankers Right of Setoff
• Returning Checks within the Midnight Deadline – Part I

The Bankers Right of Setoff

By Scott Thompson

Introduction: Setoff in the Banking Context

The relationship between a bank and its customer is fundamentally built on mutual obligations. When a customer deposits funds, the bank becomes a debtor to the customer.  When a customer borrows money or incurs fees, the customer becomes a debtor to the bank. The legal doctrine known as the “right of setoff” (or offset) provides a mechanism for banks to manage these mutual debts efficiently and equitably. In essence, setoff allows a bank to apply funds held in a customer’s deposit account against a matured debt that the customer owes to the bank. Instead of the bank paying the customer the full deposit amount and then separately seeking payment for the customer’s debt, setoff permits the bank to “net” those obligations, applying the deposit balance to satisfy the customer’s debt and paying out only the remaining difference, if any. This avoids what courts term “the absurdity of making A pay B when B owes A” and is seen as a crucial tool for fairness and commercial efficiency, particularly if a customer becomes insolvent.

The Foundation of Bank Setoff: Debtor-Creditor Relationship and Legal Rights

A bank’s ability to exercise setoff is rooted in the unique debtor-creditor relationship formed when a customer makes a deposit. Unlike funds held in trust or for a special purpose, money placed in a general deposit account (like a checking or savings account) legally becomes the property of the bank. The bank, in turn, owes a debt back to the depositor for the amount deposited. It is this mutual indebtedness—the bank owing the depositor for the deposit, and the depositor potentially owing the bank for loans, fees, or other obligations—that creates the foundation for setoff.

This right comes into existence through several different legal avenues:

1. Common Law Right of Setoff: Often termed the “banker’s right of setoff,” this is a long-standing, judicially recognized right allowing a bank to apply a customer’s general deposit against a matured debt owed by that customer to the bank. It arises inherently from the debtor-creditor relationship.
2. Oklahoma’s Banker’s Lien (42 O.S. § 32): Oklahoma statute grants a banker a “general lien, dependent on possession, upon all property in his hands belonging to a customer, for the balance due to him from such customer in the course of the business”. While termed a “lien,” Oklahoma courts consistently interpret this statute, when applied to general deposit accounts, as functionally equivalent to the common law right of setoff. This is because a bank cannot technically hold a lien on its own property (the deposited funds it owes back to the customer). Thus, § 32 essentially affirms or codifies the bank’s setoff right regarding deposits.
3. Contractual Setoff Rights: Banks almost universally include explicit setoff clauses in their deposit account agreements and loan documents. These agreements serve to:

• Affirm the bank’s common law and statutory rights.
• Specify which accounts and debts are subject to setoff, potentially including debts personally guaranteed by the customer or debts of one joint account holder against the joint account.
• Outline when setoff can occur (e.g., upon default).
• Include clauses stating the bank is not liable for consequences like dishonoring checks if setoff leaves insufficient funds.
• Some agreements may also grant the bank a consensual security interest in the deposit account itself, bolstering the bank’s position.

The specific terms of the deposit agreement and any relevant loan documents are crucial in defining the exact parameters of the bank’s setoff rights against a particular customer.

Prerequisites for Bank Setoff: Mutuality and Maturity

For a bank to validly exercise its common law or statutory right of setoff, two key conditions must generally be met: mutuality and maturity.

Mutuality of Obligation

The debts must be “mutual,” meaning they exist between the same parties acting in the same legal capacity. This requirement is strictly construed:

• Same Parties: The deposit account must belong to the same legal entity that owes the debt to the bank. A bank generally cannot set off funds in a corporate account to satisfy the personal debt of a shareholder, or vice versa, unless specific contractual provisions (like guarantees) or rare circumstances (like piercing the corporate veil) apply.
• Same Capacity: The parties must hold the debts in the same right. A crucial implication is that a bank cannot typically set off funds a customer holds in a fiduciary capacity (e.g., as a trustee, escrow agent, or in an attorney trust account) against a personal debt owed by that customer to the bank. The funds held in trust are not considered the customer’s personal property for setoff purposes, thus breaking mutuality.

Contractual agreements, such as those allowing setoff against joint accounts for the debt of one owner, aim to establish mutuality by consent.

Maturity of the Debt

The debt owed by the customer to the bank must generally be “mature,” meaning it is due and payable at the time the bank exercises setoff. A bank typically cannot use setoff to collect on a loan before its maturity date or before the customer defaults on payments, unless the loan agreement contains an acceleration clause. Such clauses make the entire loan balance immediately due upon default, thereby satisfying the maturity requirement. Exercising setoff against an unmatured debt without contractual or legal justification can expose the bank to liability. Oklahoma case law provides an interesting perspective on maturity in the context of a customer’s death. In Kasparek v. Liberty Nat. Bank (1935), the Oklahoma Supreme Court permitted a bank to set off funds in a deceased customer’s account against a note that matured shortly after the customer’s death. The court reasoned that since the executor’s lawsuit to recover the deposit was filed after the note had matured, the bank’s right of setoff based on the mutual debtor-creditor relationship could be asserted. The court emphasized the underlying right of setoff for mutual demands and suggested this right existed regardless of the estate’s solvency (though the estate was insolvent in that case). This indicates that, in Oklahoma, the strict timing of maturity might be relaxed when a debtor dies, allowing setoff if the debt matures shortly after death and before the legal proceedings are finalized.

Significant Limitations on the Bank’s Right of Setoff

Despite being a fundamental banking right, setoff is subject to several important limitations designed to protect customers and third parties.

Special Purpose, Trust, and Escrow Accounts

A bank cannot exercise setoff against funds it knows or should know are held in an account for a specific purpose or belong beneficially to a third party. This limitation stems directly from the lack of mutuality – the funds are not the general property of the depositor available to satisfy their personal debts. Examples include:

• Designated payroll accounts.
• Attorney trust accounts (IOLTA).
• Escrow accounts for real estate closings or other specific transactions.
• Accounts known by the bank to hold funds securing obligations to third parties.
• Funds held by contractors under construction trust fund statutes (where applicable).

The crucial factors are the restricted nature of the funds and the bank’s actual or constructive knowledge of that restriction. Oklahoma case law, such as Griffin-Townsend Co. v. First State Bank of Talihina, places the burden on the party claiming the funds are special or trust funds to prove both the restricted nature and the bank’s notice thereof. Clear account labeling (e.g., “Escrow Account”) is vital. Oklahoma’s Special Deposit Act (6 O.S. § 910.1 et seq.) aims to provide a clearer statutory framework for certain multi-beneficiary accounts established for permissible purposes, potentially strengthening protections against setoff for qualifying accounts.

Exempt Funds (Social Security, Government Benefits, Wages)

Federal and state laws protect certain types of funds from seizure by creditors to ensure individuals retain essential resources. This creates a complex area of limitation for bank setoff.

• Federal Benefits (Social Security, SSI, VA, etc.): Federal law, like 42 U.S.C. § 407 for Social Security, strongly protects these benefits from garnishment or levy by third-party creditors. A specific Treasury regulation (31 C.F.R. Part 212) requires banks receiving garnishment orders to automatically protect two months’ worth of directly deposited federal benefits from being frozen or seized by the garnishing creditor. This automatic protection applies only to funds received via direct deposit.
• Bank’s Own Setoff vs. Exempt Funds: The protection of these funds against the bank’s own setoff for debts owed to the bank (like overdraft fees or defaulted bank loans) is much less clear and highly debated. Some argue the broad federal protective language prohibits bank setoff, while many bank agreements explicitly reserve the right to set off against accounts containing such funds, particularly for overdrafts. Oklahoma-specific case law or Attorney General opinions definitively resolving this conflict do not exist, though the issue is acknowledged. In short, this is an unsettled area and banks should be cautious about offsetting such funds.

Payable-on-Death (POD) Accounts

POD accounts allow an account owner to designate beneficiaries who automatically receive the account funds upon the owner’s death, bypassing probate. This creates a significant limitation on setoff:

• Loss of Mutuality: Upon the owner’s death, ownership instantly transfers to the beneficiary. The funds no longer belong to the deceased owner (or their estate), and the beneficiary does not owe the deceased’s debt to the bank. This generally destroys the mutuality required for the bank to set off the deceased owner’s debt against the account.
• Oklahoma Statute (6 O.S. § 901): Oklahoma law governing POD accounts states that the beneficiary is entitled to the funds “only after the death of the last surviving account owner, and after payment of account proceeds to any secured party with a valid security interest in the account”. This clearly protects creditors who hold a perfected security interest (e.g., the account was pledged as collateral).
• Ambiguity for Unsecured Debts: Section 901 does not explicitly address the bank’s right to set off unsecured debts (like overdrafts or unsecured loans owed by the deceased owner) before paying the beneficiary. While the loss of mutuality argues against setoff, the statute’s silence and specific protection only for secured parties create uncertainty. Some banks attempt to address this through contractual clauses in deposit agreements asserting a post-death setoff right against POD accounts, but the enforceability of such clauses against the statutory framework for unsecured debts is unclear under Oklahoma law.

Bankruptcy Proceedings

If a customer files for bankruptcy, the bank’s ability to exercise setoff is significantly impacted by the U.S. Bankruptcy Code:

• Automatic Stay (11 U.S.C. § 362): Upon filing, an automatic stay immediately prohibits most collection actions, including setoff. A bank must obtain permission (relief from the stay) from the bankruptcy court before exercising setoff against a debtor’s pre-petition deposit balance for a pre-petition debt. Unauthorized setoff violates the stay and can lead to penalties.
• Section 553 Limitations: Even if a setoff right exists under state law, 11 U.S.C. § 553 imposes further restrictions in bankruptcy:

o    Requires pre-petition mutuality (both debts arose before bankruptcy filing).

o    Bars setoff if the bank’s claim against the debtor is disallowed.

o    Restricts setoff using claims acquired from third parties or debts incurred by the bank shortly before bankruptcy (within 90 days while the debtor was insolvent) for the purpose of obtaining setoff.

o    Includes an “improvement in position” test allowing the bankruptcy trustee to potentially recover amounts set off by the bank within the 90 days before bankruptcy if the setoff improved the bank’s net position relative to other creditors.

Bank Setoff vs. Other Claims in Oklahoma

A bank’s right of setoff often interacts with the rights of other creditors or legal processes involving the customer’s account. Oklahoma law provides some specific rules:

• Secured Parties (12A O.S. § 9-340): Oklahoma’s Uniform Commercial Code (UCC) addresses the priority conflict between a bank’s setoff right and a third party’s perfected security interest in the deposit account. Generally, the bank can exercise setoff even against a secured party. However, a crucial exception exists: the bank’s setoff is ineffective against the secured party’s interest if the secured party becomes the bank’s customer with respect to the account and the set-off is based on a claim against the debtor (the customer that granted the security interest).
• Garnishment/Levy Timing (12A O.S. § 4-303): The UCC also specifies when a bank’s right or duty to pay an item (like a check) becomes final, cutting off the effectiveness of subsequent legal processes or setoff attempts against that specific item. This occurs if the bank has already accepted/certified the item, paid it in cash, settled for it without a right to revoke, or completed the process of posting it to the customer’s account.
• Oklahoma Employment Security Commission (OESC) Levy (40 O.S. § 3-509): Oklahoma statute explicitly states that when the OESC levies a customer’s bank account for unpaid unemployment taxes, the levy is subject to the bank’s prior banker’s lien or right of setoff. The bank can satisfy its own claims first before remitting funds to the OESC.
• Effect of Prior Judgments (Citizens State Bank of Hugo v. Hall): If a court has previously issued a final judgment determining that a bank holds only the status of a general creditor without priority regarding specific funds, that judgment can preclude the bank from later asserting its setoff right against those same funds. The prior judgment effectively settles the bank’s rights concerning those funds.

Conclusion

The right of setoff is an integral aspect of the relationship between a bank and its customer, providing banks with a vital self-help remedy to recover matured debts by applying funds held in the customer’s general deposit accounts. Rooted in common law, affirmed by Oklahoma’s Banker’s Lien statute (42 O.S. § 32), and often explicitly detailed in contractual agreements, this right hinges on the core principles of mutuality and maturity.

However, both banks and customers must recognize the significant limitations surrounding setoff. Funds held in special purpose, trust, or escrow accounts are generally protected. The application of setoff against federally exempt funds like Social Security remains ambiguous and contentious. Payable-on-Death accounts present unique challenges after the owner’s death due to the immediate transfer of ownership, with Oklahoma law offering clear protection only for secured creditors against P.O.D. funds. Furthermore, bankruptcy law imposes strict procedural and substantive limitations.

Understanding the interplay between the bank’s setoff rights, contractual terms, statutory provisions (including Oklahoma’s UCC and specific statutes like those discussed above), and judicial interpretations is crucial for financial institutions managing risk.

Returning Checks within the Midnight Deadline – Part I

By Pauli Loeffler

As the paying bank, you must understand what reasons are available for returning a check after the bank’s midnight deadline which will be covered in a future article), and also the longer list of check-return reasons that can only be used before the midnight deadline some of which will be covered here..  The timing for returning a check based on a particular reason is determined by statutes and regulations and cannot be varied.

The rules outlined in the UCC and Regulation CC allocate check losses very clearly, either to the depository bank (and its depositor) or to the paying bank.  The emphasis on certainty and finality, not “fairness” to either bank, as such.  The system creates a predictable event, “final settlement.”  After that point in time, the paying bank is stuck with a loss if it has not returned a bad item, and the depository bank can safely give its customer available funds without risk that the item will later be returned unpaid—except for claims involving “breach of warranty.”

I will cover various topics as these relate to reasons for returning checks within the midnight deadline.

 Bulk Filing

The vast majority of banks use “bulk filing.”  As a result, a bank examines only those items in the cash letter that either (1) are large, or (2) will not pay from a combination of the customer’s available funds on deposit plus the account’s overdraft limit.  However, checks presented to a teller to be cashed are also manually examined, but “on us” checks presented in another customer’s deposit may not be examined by anyone, except in verifying the deposit total and encoding the item.

If a customer has a good balance in his account and a bogus check is received in the bank’s cash letter or in a deposit by another customer of the same bank, if the check is below the dollar amount that triggers manual examination, the bad check will pay automatically.  No one will notice the bad item until the customer receives his statement in the mail, or when some items presented later overdraw the account.  By that time,  the midnight deadline for returning the item will have passed.  The paying bank must re-credit the unauthorized item to its customer’s account (unless the customer is extremely slow in examining his statements or has otherwise contributed to the loss.  The midnight deadline will prevent the paying bank from returning the item (except for “breach of warranty” claims), and the paying bank loses.

Bankers lament this requirement as “unfair” since there is no chance to avoid the loss on a fraudulent check without manually examination all items. This is prohibitively expensive and time-consuming.  A bank doing bulk filing makes an economic decision that it is cheaper to take losses on bad checks below the dollar amount that requires manual examination to avoid the expense of manually examining those smaller items.  If the bank is taking too many losses on bad checks, it can consider lowering the dollar amount that triggers manually examination—but this will increase the bank’s time spent examining checks.  Lowering the dollar level at which checks are manually examined would only help if a substantial number of the checks that are causing the problem are above the lowered dollar amount.

Having a Valid Reason for Return

Section 229.30(d) of Regulation CC states, “A paying bank returning a check shall clearly indicate on the face of the check that it is a returned check and the reason for return.”  A notice of nonpayment of large items, as required by Section 229.33 of Regulation CC, also must include the “reason for return.”  If a particular reason for return is one that cannot be used after the midnight deadline, the bank must return the item before that time, or else the bank no longer has a valid reason for return.

When a paying bank returns a check outside of its midnight deadline and uses a return reason that doesn’t apply after the midnight deadline, the depository bank should bounce the check back to the paying bank as a “late return.”  Of course, the paying bank does not want to take the loss, but if the paying bank is in a position where it must stand the loss as being outside of the time period for using a particular reason to return the check, the bank accomplishes nothing in attempting to return the check to the depository bank anyway.

More importantly, when a paying bank returns a check outside of its deadline, it breaches a warranty under Section 229.34(a) of Regulation CC.  (Any paying bank making a return automatically warrants that it is returning the check within its deadline.)  The bank also violates the Federal Reserve’s Operating Circular No. 3, Section 17.1, which allows a paying bank to return a cash item “only if it returns the item within the deadline of Section 210.12(a) of Regulation J, Section 229.30 of Regulation CC and the Uniform Commercial Code.”

Reasons Limited to the Midnight Deadline

A paying bank has many available reasons for returning a check to the depository bank within the midnight deadline.  Most of these are based on some provision in the UCC or contract law that also specifically gives the paying bank the right not to pay the item under the circumstances and that does not result in liability to anyone for “wrongful dishonor” of the item.

Following are some examples:  “Deceased”; “stop payment”; “account closed”; “signature irregular” (or “forgery”); “counterfeit”; “no account” “not on us”; “unauthorized signature”; “signature missing”; “stale dated”; “postdated”; “insufficient funds” (or “NSF”); “uncollected funds” (or “funds not available”); or “two signatures required.”  These reasons can’t be asserted outside of the midnight deadline.

“Refer to Maker”/” Kiting”

“Refer to maker” as a reason for return is nearly no reason at all.  Basically, the paying bank is saying we intend to dishonor the check but doesn’t convey any information.  It says, “Don’t ask us why.  Go ask our customer.”  This reason for return should be used sparingly, when no other reason for return will fit.

The best use of “refer to maker” is in connection with kiting. The issue with using “kiting” as a reason for return is that accuses a customer of a criminal offense when the customer has not been convicted or even charged with that offense. If the paying bank has misinterpreted what’s happening on the account, or if the facts are not strong enough for the district attorney to file charges for kiting, the paying bank could potentially be sued by its customer for libel.

Using “funds not available” for a return reason (another possible choice) after the paying bank places an extended hold to collapse the kit, is at least minimally adequate from the paying bank’s standpoint.  It’s not false but neither is it a full warning to the depository bank of the seriousness of the problem.  “Funds not available” signals that by waiting a few days before trying again, the check might pay.  However, with a kite the paying bank places an extended hold to try to get itself back to a positive “collected funds” balance with the intention to close the account as soon as it can.  The check is probably never going to pay.

“What does ‘refer to maker’ really mean?”  Telling the depository bank to “refer to maker” is usually not to be taken literally.   If a maker is actually involved in questionable transactions on his bank account, it’s unlikely that the depository bank will receive a truthful or accurate explanation from the maker.  Saying “ask the maker” is almost like suggesting that someone should talk to a brick wall.

Although the paying bank uses “refer to maker” as a return reason, the paying bank is free to call the other bank at any point to warn that apparent kiting is going on.  Equally, a depository bank that holds a check that has been returned for this reason is free to call the paying bank, to attempt to learn more.  One of the exceptions under the privacy regulation allows information to be provided between financial institutions, in the case of fraud or to prevent fraud.

Every kite involves writing checks on funds that don’t exist and eventually will cause loss to one financial institution or the other. In a suspected kiting situation, a paying bank can and should file a suspicious activity report (SAR), and can attach to the SAR a list of the items that are involved, or copies.  Once the SAR with this information is mailed, the bank is protected from liability under federal law if it provides a copy of the SAR to law enforcement.

“Account Closed”

A check written on a closed account meets the definition of a “false or bogus check” under Title 21, O. S., Section 1542.4.  A merchant who gets a returned check with the reason “account closed” is very likely to take it to the local district attorney for prosecution.  Depending on the facts, the customer may have done nothing bad deliberately.  The true circumstances can eventually be established—perhaps after some unpleasantness–but it’s easier to avoid a return reason that may cause the payee and the district attorney to make mistaken assumptions about an innocent customer.

Sometimes a customer closes an account because of identity theft, and the bank knows this.  The customer doesn’t intend to defraud a payee holding a several-months-old outstanding check; rather, the customer is afraid of unauthorized items that might hit the account.

Another situation is when the customer’s checkbook is lost or stolen, the bank insists that the account be closed, and the customer decides he doesn’t want to open a new account.  Another possibility is a new account is opened, but the customer fails to list all of the outstanding items on the old account, when he authorizes the bank to pay those items on the new account.  He leaves one check out by mistake, and it is returned “account closed.”

If a check actually written by the customer is presented to the paying bank after the account is closed, and the check is less than six months old, the bank probably must use “account closed” as a reason for return.  But it could state “account closed after identity theft,” or “account closed after checkbook stolen” which would prevent a district attorney from concluding there was wrongful intent.

A bank can also help a customer while closing an account, by preparing an affidavit of identity theft, or affidavits of forgery, which the customer can use as evidence of intent if the payee on a check overreacts.

If a check is presented on a closed account and the check is seven months old (stale dated), there are two possible reasons for return, either of which is adequate.  I suggest the bank should return the check as “stake dated” because this creates no possible basis for a criminal charge against the customer but still permits the payee to still sue on the check in small claims court, to obtain a judgment against the maker for the money owed.