Two recent court decisions involve community banks being sued by bankruptcy trustees to claw back transfers the banks received to satisfy check overdrafts from customers who subsequently filed bankruptcy. In one, the bankruptcy court entered a $1.5 million judgment against the bank and came very close to entering a judgment of $61 million. In the other case, the trustee seeks a judgment of over $1.2 million against the bank. The case is still pending, as the federal district court denied the bank's motion to dismiss the lawsuit on the pleadings. These cases highlight a perhaps unexpected risk that comes with overdrafts and the importance of documenting arrangements and following procedures in handling overdrafts.
I. Case #1 – Overdraft Repayment As A Bankruptcy Preference
In the Sarachek case, the $1.5 million judgment against the bank was based on transfers the bank received in the 90-day preference period before the customer's bankruptcy filing to cover overdrafts. The court ruled that the trustee could claw back the transfers as preference payments under Bankruptcy Code § 547. The court ruled that (a) "intraday overdrafts" - i.e., those that are resolved before midnight of the second day of the two-day banking cycle (the "Midnight Deadline"), such as by the customer covering the overdraft or the bank bouncing the check - generally do not constitute extensions of credit by the bank, but (b) overdrafts not resolved by the Midnight Deadline (i.e., "true overdrafts") qualify as extensions of credit and, therefore, may form the basis of a preference lawsuit in a subsequent bankruptcy case. While this is an Iowa case, there is no apparent reason that a bankruptcy court in Virginia could not rule similarly in a case with analogous facts.
The customer operated a large meatpacking and food-processing facility and had an account for daily transactions (the "Operating Account") with the bank for approximately eight years. The customer's overdrafts grew in the year leading up to its bankruptcy filing, at one point creating a negative ledger balance of over $5 million. As the overdrafts grew, the bank asked the customer to open a second account (the "Security Account") and deposit funds into it that the bank could offset against a negative ledger balance in the Operating Account. The customer did so, depositing a total of $1.4 million into the Security Account.
Each day the customer wrote a large number of checks on the Operating Account and generated a number of overdrafts (i.e., a number of checks that would be in an NSF position at the end of the day). The next morning the bank would review the overdrafts and then contact the customer and confirm that a "covering" payment would be made by wire transfer before midnight (i.e., the Midnight Deadline). The covering payment often did not bring the Operating Account to a zero balance. In the bank's view, however, the Operating Account and the Security Account were linked so that if the covering payment brought the Operating Account balance above negative $1.4 million, then there were no true overdrafts. Even considering the two accounts to be linked, however, there were true overdrafts totaling approximately $1.5 during the 90 days preceding the bankruptcy filing. The bank charged the customer over $30,000 in account-management and overdraft fees relating to this flexible arrangement.
After the bank learned that a covering payment was not going to be made, it transferred the $1.4 million in the Security Account into the Operating Account. Eleven days later the customer filed bankruptcy, its collapse precipitated by a government immigration raid. Two years later, the bankruptcy trustee sued the bank to claw back the transfers the Bank received to cover overdrafts during the 90 days preceding the bankruptcy case.
The Legal Positions
The bankruptcy trustee argued that the bank allowed the customer to have special overdraft privileges and that in so doing actually gave the customer a series of short-term loans. The trustee did not distinguish between intraday overdrafts and true overdrafts. In this regard, the trustee asserted that an intraday overdraft was a loan even though it was contingent in nature - i.e., even though it might be paid by the customer or rejected by the bank before the Midnight Deadline - because the Bankruptcy Code's definition of a bankruptcy "claim" includes contingent claims.
The trustee also asserted that (a) there was no evidence of an agreement between the bank and the customer to link the Operating Account and the Security Account for purposes of determining which overdrafts were true overdrafts, and (b) even if there had been such an agreement, the bank did not actually transfer funds from the Security Account to the Operating Account to cover overdrafts. The trustee therefore argued the bank's maximum potential preference exposure for true overdrafts exceeded $61 million, not the $1.5 million posited by the bank under its view of the accounts being linked together.
The bank responded that (a) it had not acted as a creditor providing short-term loans but as a "mere conduit" of the customer's financial transactions, and (b) that there should be an exception to bankruptcy preference law for overdrafts (including true overdrafts) because they are a banking service, not a loan. As to the issue of whether the accounts were linked, the bank relied on the testimony of its officers and the customer, all of whom testified that there was an oral agreement to link (or "net") the accounts for purposes of determining whether there were true overdrafts.
The bankruptcy court ruled that "intraday overdrafts, standing alone, are not extensions of credit provided they are covered or reversed before the midnight deadline of day two," but they become true overdrafts and extensions of credit - thereby making the repayments of them potentially subject to claw back if the customer subsequently files bankruptcy - if they "'are not cured or zeroed' out by the midnight deadline." The court added that intraday overdrafts can also constitute extensions of credit if "there is an agreement specifying that the Bank is obligated to honor overdrafts," but that under Iowa law such an agreement would need to be in writing (and in the case there was no evidence of such a document between the bank and the customer).
With respect to true overdrafts, the court rejected the bank's arguments that it was a "mere conduit" of the customer's financial transactions, not a creditor, and that the bankruptcy preference law should not cover overdrafts. The court relied on the fact that the bank had charged the customer over $30,000 in account-management and overdraft fees, stating that such fees "functioned much like interest" and could have been used, had the court chosen, to characterize even the intraday overdrafts as extensions of credit. The court added that there is no "banking" exception in the bankruptcy preference statute. Accordingly, the court entered a $1.5 million judgment against the bank based on the transfers to repay the true overdrafts.
The court also found that the two accounts were linked, relying on the testimony of both the bank and the customer that there was an oral agreement to that effect, as well as the parties' course of conduct in managing the accounts. The court characterized the arrangement as a "small town banking relationship," but it noted that the trustee's arguments on the issue had "great logical and technical appeal" and that the weight of the evidence in the bank's favor was "ever so slight." In short, it appears the bank narrowly avoided a $61 million dollar judgment and would have been much better served by a written agreement linking the two accounts.
II. Case #2 – Overdraft Repayment As An Avoidable Transfer Under State Law
In the pending case, the $1.2 million lawsuit against the bank is based on transfers the bank received from its customer to cover overdrafts in the four years before the customer's bankruptcy filing. The bankruptcy trustee asserts that the customer was engaged in a massive check-kiting scheme involving a number of banks and that the overdrafts the customer incurred at the defendant bank constituted loans. The trustee alleges that the transfers used to repay those loans can be clawed back as actually or constructively fraudulent transfers under Florida law.
The bank filed a motion to dismiss the trustee's complaint, arguing among other things that there were no true overdrafts - i.e., there were only intraday overdrafts - because the trustee's complaint demonstrates that the customer deposited checks into its overdrawn account to cover the deficit within the two-day banking cycle. The court declined to dismiss the complaint on that ground, stating that the bank was presenting a factual issue that could not yet be decided. In so ruling, the court seems to suggest that the supposed intraday overdrafts might have become true overdrafts if the checks deposited into the overdrawn account to cover the deficits were themselves overdrafts.
The bank also argued that it was a "mere conduit" for the customer's funds and therefore cannot be held responsible for any fraudulent activity of the customer. The court ruled that this issue also could not be decided on the pleadings, but it added that the bank's position "depends on its assertion that it was not under a duty to investigate routine banking services" and that "[e]ven though overdraft services may now be common within the banking sector, I am unable to conclude on the present record that it constitutes a 'routine banking service' for purposes of the mere conduit rule."
The facts of the two cases discussed above are very different. In the first, it is clear that the bank was providing significant flexibility to a major customer and was well aware of the customer's significant overdrafts. In the second case, the bank denies having knowledge of the customer's alleged scheme, and it is not clear that the bank even had a duty to investigate the customer's account activity. Nonetheless, in each case the customer's bankruptcy filing gives rise to a significant lawsuit against the bank that was probably very much unexpected - the bank saw itself as providing a service to its customer by not rejecting NSF checks, not as making a loan that could expose it to claw-back litigation in the event of a bankruptcy. Banks should keep this additional risk in mind when considering their policies relating to overdrafts.
 The case is Sarachek v. Luana Sav. Bank (In re Agriprocessors, Inc.), 2015 Bankr. LEXIS 1366 (Bankr. N.D. Iowa Apr. 20, 2015).
 Because this case is still in litigation, the author has not included the citation.