August 5, 2010

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Court Limits Bank's Administrative Freeze in Bankruptcy

In Strumpf,(1) the Supreme Court held that a bank may place an administrative freeze on a bankruptcy debtor's bank account while the bank pursues relief from the automatic stay to exercise its right of setoff against the account.  In the recent case of In re Mwangi,(2) the Ninth Circuit Bankruptcy Appellate Panel ("BAP") held that a bank cannot place an administrative freeze on the debtor's bank account when the bank does not claim a right of setoff, simply because the bank is unsure what to do with the funds.

In Mwangi, the bank placed a temporary administrative freeze on several bank accounts upon learning of the debtors' Chapter 7 bankruptcy filing.  As part of its normal procedures, the bank then sent a letter to the Chapter 7 trustee requesting instructions as to whom the bank should send the funds.  The trustee never responded.  The debtors demanded that the bank release the funds to them, claiming that the funds were exempt.  When the bank refused to release the funds without the consent of the trustee, debtors sought sanctions for a willful violation of the automatic stay.  The lower court held that the bank did not violate the automatic stay because 1) the funds were exempt and therefore not property of the estate; and 2) the bank was not trying to collect a pre-petition debt.

On appeal, the BAP reversed, holding that the bank violated the automatic stay because it "exercised control" over the account funds when it imposed an administrative freeze.  The BAP observed that the turnover provisions of the Bankruptcy Code are automatic and thus, the bank's failure to turn over the funds to the bankruptcy estate improperly shifted the burden to the trustee to demand the return of estate property.  According to the BAP, a bank must promptly surrender a debtor's bank account to the bankruptcy estate without awaiting instructions from the trustee to do so.  The BAP remanded the case to the lower court to determine whether the bank's retention of the funds in light of the debtors' turnover demand was reasonable and whether the bank should be sanctioned for willfully violating the automatic stay.

The bank faced a dilemma when it received the debtors' turnover demand claiming that the funds were exempt.  If the bank had honored the debtors' demand, the bank may have faced liability to the trustee for turning over the funds.  The BAP response appears to be that a bank cannot simply hold place an administrative freeze and do nothing; it must promptly release the funds to the trustee or seek direction from the bankruptcy court.  The bank's failure to turnover funds in a bank account will constitute an exercise of control of estate property in violation of the automatic stay that may subject the bank to potential sanctions.

For questions regarding the impact and application of the Mwangi holding, please contact a member of our Creditors' Rights and Bankruptcy Practice Group.


1. Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 116 S.Ct. 286 (1995).

2. In re Mwangi, Nos. NV-09-1408-DHPa, 09-24057-BAM 2010 WL 2723204 (9th Cir. BAP. June 30, 2010).