Section 362(a) of the U.S. Bankruptcy Code is known as the "automatic stay" provision, which immediately prohibits creditors from collecting on debts when a debtor files for bankruptcy.  By shielding debtors from the reach of creditors, the automatic stay is meant to allow debtors the greatest possible opportunity for successful rehabilitation or orderly liquidation.

 

One type of activity that is "stayed," or prohibited, under the automatic stay provision is the right of creditors to setoff any debt owed to the debtor that arose before the commencement of the bankruptcy case.  Outside of bankruptcy, the right of setoff means that, when A and B both owe each other money, they can apply their mutual debts against one another to avoid the incongruity of making A pay B when B owes A. 

 

A majority of the courts have agreed that a setoff has not occurred until three steps have been taken:

With these three steps in mind, it is easier to see when a creditor might exercise its setoff rights in violation of the automatic stay.  Specifically, staying the rights of setoff once a debtor has filed for bankruptcy (and the automatic stay has been triggered) means that a creditor that owed a larger debt to the debtor than was owed to it by the debtor (prior to filing) may not setoff its debt by netting the mutual debts against each other.  For example, assume that a debtor has a checking account worth $12,000 at a bank, and owes the bank $5,000 on an unpaid loan.  Outside of bankruptcy, the bank would be permitted to setoff its debt (in whole or in part) by netting the mutual debts against each other.  If the bank chose to setoff its debt in whole, this would mean that the bank would only owe the debtor $7,000 ($12,000 less $5,000), instead of $12,000.  However, once the debtor has filed for bankruptcy, the bank is prohibited from exercising its setoff rights.

 

The U.S. Supreme Court has held that a bank does not violate the automatic stay when it places an "administrative hold" on a debtor's bank account.  In other words, the automatic stay is not violated when the bank refuses to pay withdrawals from the account that would reduce the balance below the amount that the debtor owes to the bank on an unpaid loan.  This is because an administrative hold does not constitute a setoff in terms of the three aforementioned requirements.  Specifically, placing an administrative hold on a debtor's bank account does not permanently reduce the balance by the amount of the unpaid loan owed to the bank.