Bank Offsets Against Social Security & V.A. Direct Deposits

by Charles Cheatham
VP and General Counsel
Oklahoma Bankers Association

Subsequent to the writing of this article, the 9th Circuit Court of Appeals withdrew its decision and reversed its opinion. For more details, read "Reversal of Lopez Case on Social Security Offsets"

1. Binding on Oklahoma Banks?
2. The Court's Reasoning
3. Tenth Circuit Case
4. Overdrafts are Loans, Not Just Checks
5. Some Planning Issues
6. Operations Challenges
7. Changed Posting Procedures
8. "Equal Credit" Issues?
9. Some Final Points

Based on a recent decision by the federal Ninth Circuit Court of Appeals in San Francisco, any account that receives direct deposits of either Social Security or V.A. benefits will raise unique problems if the bank pays overdrafts and charges overdraft fees to that account.

The case, Lopez v. Washington Mutual Bank, Inc., concludes that if a bank account has a negative balance resulting from paying overdrafts and overdraft fees, the bank cannot apply a future direct deposit of Social Security or V.A. benefits to make up the deficit balance owed to the bank.

The court analyzed Sections 407(a) and 1383(d)(1) of 42 U.S.C., which prohibit creditors from reaching Social Security or SSI benefits by levies, garnishments, or "other legal process," and decided that these sections do not allow a bank to apply a future direct deposit of Social Security and SSI benefits to cover overdrafts and overdraft fees owed by the customer to the bank on that same account!

Direct deposits of V.A. benefits were not an issue in this case. However, the court made a point of stating in a footnote that 42 U.S.C. Section 5301(a), concerning veterans' benefits, is practically identical to the statutory provisions that protect Social Security and SSI benefits. Therefore, a bank should handle accounts receiving direct deposits of V.A. benefits just like accounts with direct deposits of Social Security or SSI. (A bank should not apply future direct deposits of these benefits to cover outstanding overdrafts or overdraft fees on the account.)

After reviewing the Lopez case in detail, I will outline some changes that banks may need to make in their operations to comply with this ruling.

1. Binding on Oklahoma Banks?
Editor's Note: Since this was originally written for Oklahoma bankers, this section of the article focuses on whether the decision is binding on Oklahoma institutions. The same reasoning would apply to any institution located outside the 9th Circuit.

The Lopez case, which was decided on March 14, is technically "binding authority" only in the western states that are part of the Ninth Circuit - not including Oklahoma. (Oklahoma is within the jurisdiction of the federal Tenth Circuit Court of Appeals in Denver.) For jurisdictions outside of the Ninth Circuit, I am sure this case will be cited quite frequently in arguments; and before very long, lower courts outside of the Ninth Circuit will begin to follow it. One position your bank could take is that this case does not apply in Oklahoma yet, so you prefer to ignore it until it does apply here. However, it's probably best to start making changes to put your bank in compliance with this case's ruling.

During the last two years I have seen several letters addressed to banks in Oklahoma, written by attorneys working for free legal clinics, asserting that it is "illegal" to impose NSF fees or overdraft fees on a checking account containing Social Security funds--and demanding that such charges be reversed. (If you haven't seen such a letter yet, just wait a while! ) With the Lopez case as ammunition, it's probably just a matter of time before someone files a >
2. The Court's Reasoning

In the Lopez case, which was a >
Each plaintiff in the >
The plaintiffs alleged that the bank's application of a later direct deposit to satisfy an earlier outstanding negative account balance (arising from overdrafts and overdraft fees) violated federal prohibitions against seizing Social Security benefits by execution, levy, attachment, garnishment, or other legal process. (42 U.S.C. Sections 407(a) and 1383(d)(1).) The court accepted this argument, concluding that the bank's practice was in fact an impermissible "other legal process," because the bank was "withdrawing benefits from the accounts without consent." (Literally, the bank was only "netting" the deficit balance against the new deposit.)

It apparently would be irrelevant even if a bank's account agreement specifically granted the right to apply future deposits to satisfy an outstanding negative balance. The problem under the Social Security statutes (and parallel language dealing with veterans' benefits) is that a person cannot legally assign in advance his rights to "any future payment" of benefits. In other words, he cannot be bound by any contractual provision allowing the bank to apply a future direct deposit to satisfy an outstanding negative balance on his account-if that negative balance arose from overdrafts.

How, then, can a bank get paid for a negative account balance on an account receiving these direct deposits of benefits? Citing Nelson v. Heiss, a 2001 case from the Ninth Circuit, the court suggests that the only way an account holder can consent to payment of overdrafts and overdraft fees from an account receiving direct deposits of benefits is to do so after the fact--after he is fully aware of charges that have already been incurred. At that point, the customer can instruct the bank "that payments [to cover what is owed] be deducted from funds which exist in his account at the time that he issues the direction."

In other words, a bank should first tell a customer that he owes for overdrafts and overdraft fees, and that he is obligated to pay them. After this step the customer (1) can then deposit money to make those charges good, or (2) can tell the bank (after his next direct deposit is posted) to pay the charges from the direct deposit. (The bank cannot just "capture" a future direct deposit of benefits that is made to the account, using it to pay outstanding overdrafts on that account. But after a direct deposit is credited to the account, the customer can consent-if he wishes-to apply the direct deposit to pay outstanding charges.)

Washington Mutual argued that each customer, by establishing an account, agreeing to its terms, continuing to leave the account open, and allowing direct deposits to be made to it, had effectively agreed to the payment of overdrafts and overdraft fees from that account. The court disagreed, pointing out that the customers were never told they had a right under federal law not to have their Social Security benefits applied to pay overdrafts.

Interestingly, the Ninth Circuit reaches the opposite conclusion regarding accounts to which a customer deposits a "paper" Social Security check each month. If the customer has been given notice of an overdraft on his bank account and the charging of overdraft fees, and he then voluntarily deposits his Social Security check to that account, he has knowingly consented to payment of the outstanding charges from his Social Security funds--and he will be legally bound. The court noted that "the Social Security beneficiary is clearly exercising control over the benefits and directing the payment" to the bank by depositing that check. By contrast, with direct deposits the bank gains access to the funds before the customer does, and the money is impermissibly applied to overdrafts before the customer can exercise any choice in how the money is spent.

In analyzing the Lopez case it is important to emphasize that paying overdrafts and charging overdraft fees apparently still will not be any problem for accounts to which "paper" Social Security checks or V.A. benefit checks are deposited. It's just the "direct deposit" accounts that will require some major operational changes (as discussed below).

3. Tenth Circuit Case

In my October 1999 article, I discussed a Tenth Circuit case (which is binding authority in Oklahoma) dealing with offset of Social Security deposits to satisfy debt owing to the same financial institution. That case, Tom v. First American Credit Union, 151 F.3d 1289 (10th Cir. 1998), involved a blanket pledge of deposits to secure a loan made by a credit union in New Mexico. The appeals court described this as a "contractual right of setoff."

The Tom case held that the credit union's use of setoff, satisfying the customer's loan balance by applying the customer's deposits that had been received from Social Security (and civil service retirement money) amounted to "other legal process" and violated the Social Security Act's anti-assignment provision in 42 U.S.C. Section 407, as well as a similar provision in 5 U.S.C. Section 8346(a), which protects civil service retirement benefits.

After the Tom case, I thought it remained true that everything a customer has agreed to within an account agreement, affecting his deposit account itself (in contrast to what applies to a separate loan transaction with the same financial institution) is still enforceable, without regard to whether the funds in the account are Social Security benefits. In other words, I have been under the impression that all standard account charges imposed by the bank as part of the account agreement (such as overdraft fees) are specifically consented to, and enforceable--because without agreeing to those standard terms on which a bank establishes accounts, a customer couldn't even open the account.

Therefore, although the Tom case prohibited offsetting a deposit account containing Social Security funds to satisfy a delinquent loan payment owed to the same bank, I believed that case had nothing to do with items and charges (such as overdrafts and overdraft fees) pertaining directly to the account that holds the Social Security deposits. Where the Lopez case differs from my previous understanding of the Tom case is that Lopez treats the payment of an overdraft (and the related overdraft fees) as a separate, optional transaction-one that is essentially a loan and that (according to Lopez) should have no different outcome (concerning right of offset) than occurs when a completely separate loan is made by the bank, not flowing through the deposit account.

4. Overdrafts are Loans, Not Just Checks

As I just suggested, the really surprising thing about the Ninth Circuit case (Lopez) is that the court analyzes an overdraft as if it were a transaction separate from (not a necessary part of) the deposit account itself. It is as if the bank has made a loan on the side (which it calls an "overdraft"), although for convenience it accounts for this transaction as part of the deposit account. Then the bank tries to collect for the "loan" by offsetting the account's negative balance (including the overdraft) against future Social Security direct deposits.

The Ninth Circuit, citing the Tom case, makes no distinction between (1) an actual separate loan that the bank is trying to collect by offset, and (2) an overdraft (also a loan) that the bank runs through the deposit account and collects by applying a future direct deposit of Social Security or V.A. benefits. In other words, the Lopez court finds that optional credit extended to the customer is a loan. Calling it an overdraft doesn't make it some higher >
The Ninth Circuit stated, "By paying the plaintiffs' checks when there were insufficient funds in the accounts, the bank essentially extended a loan to the plaintiffs and became a creditor. Washington Mutual then used the self-help remedy of setoff to recoup the plaintiffs' debt to the bank and enforce the contractual account holder agreement, in which the plaintiffs agreed to promptly pay any overdraft." As stated earlier, the court determined that this is "other legal process" and an impermissible forced payment from future Social Security direct deposits.

Interestingly, regulators are also placing increased emphasis on the concept that overdrafts are loans-not just amounts owed on a deposit account. As discussed in my December 2001 article, the OCC wants banks to "develop reasonable loss recognition guidelines and establish loan loss reserve methodologies to ensure timely loss recognition and estimated loss coverage" with regard to overdrafts. Ideally, (1) a bank should have some reasonable credit criteria for determining what overdraft limits will be established on deposit accounts in various categories, just as the bank has criteria for approving loans; (2) it should have policies for writing off unpaid overdrafts promptly; and (3) it should have a loan-reserve component that acknowledges the risk that a certain portion of the bank's overdrafts outstanding at any one time will prove to be uncollectible.

These concepts are somewhat foreign to many banks, because overdrafts traditionally have been handled almost entirely on the operations side of the bank-typically, as a courtesy; sometimes as a deliberate fee-generating activity; but usually never as a "loan-underwriting" activity.

In the past, most banks have not sorted their deposit customers into categories and subcategories, each with possibly different credit-related characteristics, in setting overdraft limits for accounts-as a bank typically would do with different "grades" of loan customers, or for different loan products. But for depositors receiving direct deposits of Social Security or V.A. benefits, banks now will be forced to approach their overdraft procedures and limits differently. This specific category clearly raises unique issues of collectibility, and should be handled with different policies.

In a separate concurring opinion attached to the Lopez case (not the majority opinion of the full court), one of the judges expressed obvious regret about the practical consequences of the decision the court was compelled to reach. He stated, "Holding that a bank cannot touch a directly deposited Social Security check, we make overdraft protection virtually impossible for Social Security recipients." He added that some depositors may even decide to abandon direct deposit of Social Security benefits (returning to receiving benefits by paper checks) in order to retain overdraft protection.

5. Some Planning Issues

Banks should consider a variety of issues in response to the Lopez case. First, "How can the bank collect for overdraft(s) on accounts that receive direct deposits of Social Security and V.A. benefits?"

As in the past, a bank should and will notify the customer about a check that has been paid into overdraft, as well as the amount of overdraft fees. The bank should make demand that these amounts be cleared promptly, as required by the account agreement. The bank can also state (politely) that, based on standard policy, failure to pay the overdraft(s) promptly may result in the account being closed. The difference from previous procedure, however, is that the mere passage of time cannot resolve the overdraft, because, complying with Lopez, the bank is not going to be able to automatically apply the next direct deposit of benefits to clear the overdraft on the account.

In a sense, a bank that has paid an overdraft on an account receiving direct deposits of benefits is in the same position it would have with any ordinary customer who makes deposits by check: In both cases, the bank's primary method of collecting overdrafts and overdraft fees is its reliance on the customer's decision to pay the amounts owed. (In the case of an ordinary account, the customer would have to deposit more money to clear the overdrafts. For an account receiving direct deposits of Social Security or V.A. benefits, the customer must actually give the bank instructions to pay the overdraft and overdraft fees from new money received in the account by direct deposit after the customer is notified of the charges that have been incurred.)

However, because the ordinary customer's account does not contain Social Security or V.A. benefits, there are possibly two differences, compared to an account with direct deposits of benefits: (1) the ordinary depositor's source of income is not exempt from garnishment (making him possibly more likely to pay), and (2) that depositor's total income may be significantly larger (making him more able to pay).

Pursuing these issues further, a second question is, "How should the bank change its overdraft policies on accounts receiving direct deposits of Social Security or V.A. benefits?" Even if a bank later decides to change nothing, it is desirable to reconsider the bank's overdraft policy in light of the Lopez case. As one possible result, after re-analyzing its policy, a bank might decide to establish a reduced overdraft limit for checking accounts receiving these direct deposits of benefits. Alternative choices would be (1) to change to a "zero overdraft" policy, or (2) (as before) to allocate the same overdraft limit to accounts of all types that have been in good standing for a certain time, without any adjustment for the direct-deposit issue.

Another element to consider in establishing bank policy is that the Lopez case's ruling will apply to overdrafts arising in any manner-certainly overdrafts created by check, but also any deficit resulting from debit card charges or ATM withdrawals that must be posted by the bank even when an account balance is insufficient. "Approved" debit card items can't be bounced when the bank later receives the "memo post" advice in an amount that won't pay, nor can ATM withdrawals be reversed. Overdraft situations involving debit/ATM cards are infrequent, but can arise because debit card and ATM transactions typically rely on an account balance at the close of the previous banking day.

For example, a bank might issue a cashier's check on a Saturday morning against the customer's available account balance, "force paying" the item; but a debit card transaction or ATM transaction occurring that same weekend, relying on the account balance on Friday evening, will also be approved. If on Monday morning the bank receives a "memo post" of debit card items or ATM withdrawals, it has to accept these items; but it also cannot return the "force paid" item that purchased the cashier's check. And so, the account may be overdrawn. (This scenario is equally possible on any other deposit account, but it will create greater operational problems if it occurs on an account receiving direct deposits of benefits.)

To summarize, in reassessing the bank's overdraft policy on accounts that receive direct deposits of Social Security or V.A. benefits, the bank should also re-examine its guidelines for issuing debit cards/ATM cards on such accounts. It may be appropriate to grant a lower daily limit for debit cards/ATM cards issued on these direct-deposit accounts-because debit card/ATM items can also result in overdrafts.

A third issue raised by Lopez, and certainly the hardest to address, is the operational nightmare this case will create: "How can a bank administer direct-deposit accounts receiving benefit payments, so that (1) overdrafts and overdraft fees do not automatically get paid from the next direct deposit that is received, and (2) posted overdrafts and overdraft fees do not reduce the available balance against which items drawn on the account can be paid, after the next direct deposit has been posted?"

Developing a solution to this third question is absolutely necessary. Your first thought might be to attempt to eliminate overdrafts completely on accounts receiving direct deposits of benefits. (However, you might find it difficult to bounce a check for a customer who would be overdrawn by only one penny, or for someone who has had an account at the bank for fifty years and is trying to make a mortgage payment or is perhaps trying to prevent utilities from being cut off.) More likely, you will decide on steps that will greatly reduce the amount of overdrafts that you pay on these direct-deposit accounts (for example, establishing a lower internal (unannounced) overdraft limit; granting no eligibility for an "overdraft protection" plan; providing no "overdraft line of credit" (or a reduced limit); and setting a lower daily limit for transactions by debit cards/ATM cards). In connection with the bank's steps to reduce the number of overdrafts (a result that stops short of eliminating overdrafts altogether), you necessarily will have to develop new operational procedures to deal with the (hopefully) reduced number of overdrafts that will continue to occur.

6. Operations Challenges
With respect to every account receiving direct-deposited Social Security or V.A. benefits, a bank should consider maintaining a related "side account" (possibly a "loan account," if you wish; or a separate deposit account). This "side account" is for you to design. Depending on the capabilities of your deposit account software, you might even set up the two accounts (the main account and side account) as "linked" accounts, with both appearing on the same monthly statement. The purpose of the "side account" (however you approach it) is to provide a place for posting and keeping track of any overdrafts and overdraft fees that have not yet been paid by the customer. These charges cannot legally be posted to the main account (if it receives direct deposits of benefits) until the customer authorizes them to be paid. Posting these charges to the main account before the customer gives consent would impermissibly cause these amounts to be deducted from or "netted" against the next direct deposit.

Nothing in the Lopez case requires a bank to set up side accounts-but Lopez eliminates the possibility of posting these charges to the main account (before the customer gives specific consent), and the entries have to be maintained somewhere, or else charged off.

Smaller banks, if they have very few overdrafts on accounts that receive direct deposits of Social Security benefits, may get by with just a "side list" of unposted overdrafts and overdraft fees for all customers. These charges can never be permanently posted to a customer's direct-deposit account until each customer agrees that the applicable charges can be paid from his account.

Depending on your bank's own system, keeping a "side list" of unpostable charges may be simpler than maintaining "side accounts" for individual customers. The total of this unposted "side list" would need to be reconciled frequently, in order that these amounts can be reflected in a summary manner on the bank's balance sheet. But reconciling any "side list" is an ongoing, tedious task-like reconciling the bank's outstanding cashier's checks.

Furthermore, for accounts with direct-deposited Social Security or V.A. benefits, it will be very time-consuming and tedious to contact customers with overdrafts to get them to come into the bank to pay the amounts owed, or to obtain their specific consent for the bank to pay the overdrafts and overdraft fees from their accounts after the next direct deposit is received. (Each customer's consent will be binding only with respect to overdrafts and fees already outstanding at the time the consent is given.)

(There also will be increased out-of-pocket costs incurred by the bank, as a result of overdrafts on accounts receiving direct deposits of benefits. If a bank actually sets up "side accounts"-as mentioned above-an outside data processor will probably charge a standard monthly fee for maintaining each new "account." A lot of posting adjustments will probably be required (as discussed below) to transfer entries on and off the main account, no matter what approach a bank takes, and a data processor may charge for this increased activity also. Viewed in isolation, the increased costs to the bank would probably justify an increased monthly service charge to the customer for any account that is receiving direct deposits of benefits, and on which overdrafts will be allowed. Unfortunately, it may be a bad marketing decision to impose higher service charges on direct-deposit accounts held primarily by senior citizens. In deciding how to proceed, each bank should carefully balance the possible increased costs of handling overdrafts as required by the Lopez case, versus the possible public relations problem in eliminating or greatly reducing senior citizens' overdrafts on direct-deposit accounts.)

7. Changed Posting Procedures

How can a bank post overdrafts and overdraft fees to a "side account" if the bank's outside data processing system (or internal system) isn't configured to do this? I'm not familiar with the technical capabilities and limitations of various data processing systems, but suggesting some possible approaches to the posting problem (none very attractive) may help your bank choose a "least worst" approach.

(1) A bank might code all accounts receiving direct-deposited benefits so that zero overdrafts are allowed (although the bank does intend to allow some amount of overdrafts). This will cause all NSF items to be kicked out by the data processor as return items that won't pay from the main account. The bank itself can then make the entries to post to a "side account" each NSF item that the bank chooses to pay into overdraft for that customer (within whatever dollar limit the bank has set), also including the related overdraft fees. In this approach, the data processor would still post NSF fees to the customer's main account, for each item that won't pay within the available balance. However, for every return item that the bank "overrides" the next morning by paying it into overdraft on the side account, the automatic "NSF fee" to the main account will need to be reversed, and a corresponding "overdraft fee" will need to be posted to the side account. (This approach is very labor intensive. And the customer's statement on the main account, reflecting NSF charges that are made and reversed, will look messy and confusing.)

(2) To simplify the previous procedure (resulting in a "cleaner" customer statement) the data processor could impose in the first step no NSF charges on a main account held by a direct-deposit customer, although the account would still be coded for zero overdrafts, and all overdrafts would kick out as if they are being returned. (There is no need for any later reversal of posted NSF fees that are charged to the main account, if no NSF charges are imposed on that account in the first step.) As under the first procedure, the bank would then manually post overdrafts to the side account (within the customer's limit), as well as overdraft fees. The bank then could go back to post (manually) an NSF charge on the main account for each actual return item that the bank does not pay into overdraft by posting to the side account.

(3) Still another variation would be to code the main accounts to allow a fixed dollar amount of overdrafts. In this approach, the data processor would post overdrafts and overdraft fees to the main account (just as has been done up until now.) The next morning, the bank would make adjusting entries to reverse from the main account each of the overdrafts and each of the related overdraft fees (but not the NSF fees). These "reversed" overdrafts and overdraft fees would then be posted manually to a "side account." For this approach to work, it must be true that the bank can identify daily every item that is paid into overdraft on the main accounts, not just return items that exceed the overdraft limit. (I am assuming that the data processor's temporary posting to the main account of overdrafts and related overdraft fees would not cause any additional checks to bounce.) If a data processor cannot do anything differently from what it is already doing, this third approach adjusts from that point. However, this alternative creates a messy series of charges and reversals on the statement for the customer's main account.

8. "Equal Credit" Issues?

The O.C.C. has determined that any overdraft is "credit," whether that overdraft is approved on a case-by-case basis, or a part of an "overdraft protection" plan or overdraft line of credit. Therefore, Regulation B (Equal Credit Opportunity) applies to overdrafts. The relevant question then becomes, "Is there a violation of Regulation B, in reducing or completely eliminating the amount of overdrafts on accounts receiving direct deposits of Social Security or V.A. benefits?"

Section 202.6(b)(2) of Reg B states, "Except as permitted in this paragraph, a creditor shall not take into account an applicant's age . . . or whether an applicant's income derives from any public assistance program." The Reg B Commentary to Section 202.2, at subpart 3 of Paragraph 2(z), defines "public assistance program" to include, among other things, "Social Security and Supplemental Security Income." Therefore, to state our question somewhat differently, "Would the denial or limiting of overdraft privileges on direct-deposit accounts amount to impermissible discrimination-because the customer is receiving Social Security benefits?"

Fortunately, the Reg B Commentary to Section 202.6, at subpart 6 of Paragraph 6(b)(2), provides an answer: "When considering income derived from a public assistance program, a creditor may take into account, for example . . . whether the creditor can attach or garnish the income to assure payment of the debt in the event of default." This precisely meshes with the "other legal process" prohibition imposed in the Lopez case. The court concluded that overdrafts and overdraft charges can be posted to accounts that receive deposits of Social Security or V.A. benefits by check, but cannot be posted and paid on accounts receiving direct deposits of these types of benefits, without the customer's consent. If a depositor has no significant income other than by direct deposit of benefits, a bank's ability to collect for overdrafts would depend almost entirely on the borrower's willingness to pay. On this basis, I think it is very legitimate for a bank (1) to decide not to pay overdrafts, or (2) to decline to extend "overdraft protection," or (3) to assign a reduced overdraft limit, on any account receiving direct deposits of Social Security or V.A. benefits. The bank also may want to tell the customer what he can do differently to be considered more favorably: If he will switch back to