Whether you work for a financial institution, develop real estate, invest in real estate, or act as a broker, there is a common thread that ties all aspects of the real estate industry together: You very likely have one or more financial products, such as credit cards, debit cards, savings accounts, auto loans, commercial real estate loans, checking accounts, etc. It may even be that one or more of these products are held with the same bank, credit union, or issuer.
It is very common, especially when it comes to commercial real estate, for lenders to require borrowers to open a checking account as part of the transaction. For this reason, it is important that borrowers are aware of a little-understood, seldom enforced, yet potentially devastating clause found in the typical retail bank deposit account agreement called the “right of offset.”
Definition of right of set-off
You may be wondering what a bank account has to do with a property loan, and that's a fair question, but if you have a loan and a current/savings account with the same bank, it's important to understand how rights of offset work, especially if you default on your loan repayments.
Non-legally, a right of offset gives a bank the legal right to withdraw funds from a checking, savings, or other account without prior notice to repay a delinquent loan, unpaid debt, or other charges. The terms of the right of offset are agreed to when you sign the deposit account agreement and are usually filled with small font and difficult-to-understand language. To illustrate this point, consider the actual legal language in a national bank deposit agreement:
“Unless you have otherwise agreed in writing, any loans, fees, service charges, analysis charges, overdrafts or other obligations or other liabilities now or in the future owed by you to us may be charged in whole or in part to that account, any other accounts in your name or to the accounts of any joint owners and specified individuals, to the extent permitted by law.”
You grant to us a security interest in the Account balance and any other accounts in your name and shall pay all loans, fees, service or analysis fees, overdraft or other obligations or other liabilities that you now or in the future owe to us. In addition, we may exercise our right of set-off without prior notice to you and without consideration of any other rights we may have against you or any other party. Such set-off shall be effective immediately after the occurrence of the event giving rise to the right of set-off, even if we later record the set-off in our books.
Our security interests and rights of set-off have priority over any adverse claims, changes of title, pledges, attachments, seizures, levies, court orders, or other legal process of any kind. In the event of any of these events, we may take any action permitted or required by law.”
Take a moment to understand what it means. By signing a deposit agreement, the account holder is agreeing to allow the bank to freely withdraw funds from any personal account in his or her name, or from any joint account with co-owners or other individuals. Granted, this is rarely enforced, but if it is, it could drive a business or real estate project into bankruptcy.
The Implications of Offset Rights – A Cautionary Tale
At a typical commercial bank, sales staff (usually called relationship managers) tend to lead loans, but are also often responsible for meeting deposit targets. To meet these targets, they use loan approval to require the borrower to open one or more checking accounts with the bank. These could be operational accounts for the business, personal checking accounts, or both. In either case, the relationship manager will urge the borrower to make as many deposits as possible as a condition of loan approval. In most cases, this strategy is perfectly fine, but the following cautionary tale outlines the risks of this approach.
During the market downturn of 2006-2008, I worked as a commercial real estate underwriter for a bank. One of our clients was a well-regarded custom home builder. As the housing market worsened, homes were not selling and the client was finding it increasingly difficult to make necessary loan payments. After a long period of delinquency, failed loan restructurings, and multiple defaults, the bank foreclosed on the outstanding property/loan on the line of credit. In the lead up to the foreclosure, bank officials exercised their right of offset and with little to no advance notice, withdrew six-figure amounts from the borrower's personal checking account. The bank used the proceeds to pay off the delinquent payments on the line of credit.
To say that borrowers were shocked and upset is an understatement. Borrowers had allocated funds as a “rainy day fund,” and their sudden disappearance put a huge strain on their personal finances, their credit scores, and their ability to support their homebuilding businesses. To make matters worse, borrowers had never heard of offset rights, so they had to learn a very harsh lesson.
How to protect yourself
Let's start with the premise that it is not possible to negotiate away your right of set-off in a loan or deposit transaction – it's a fundamental principle that banks are unlikely to budge on. Also assume that not opening an account is not an option either – many banks require you to do so as part of closing the loan.
So commercial real estate borrowers are left with two options to protect themselves from surprise overdrafts by their banks. The first is simple: make required loan payments on time. As long as you do this, the existence of offset rights shouldn't be an issue. If you fall behind on payments, be transparent and realistic with your lender about your plan for getting back on track.
Another option is to always be aware that offset rights exist and manage your cash accordingly. It's a best practice to keep your personal and business checking accounts separate at two different banks, as long as the terms of your loan allow it. Additionally, it can make sense to have your credit card accounts and personal loans at different banks.
Conclusion and Summary
This article is not meant to instill fear in readers, but rather to inform readers that the right of set-off exists with almost all banks. To be clear, the right of set-off is rarely enforced, and friendly banks will give some advance notice before exercising it. However, it is an important concept for commercial real estate borrowers and investors to be aware of in case they default on their loan payments.
Disclaimer: This article is for instructional purposes only and should not be construed as legal advice. For questions regarding your specific loan or deposit situation, it is best to consult with your banker. For legal questions, it is best to consult with a qualified attorney who can provide advice tailored to your situation.
