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Under common law, a bank may set off the balance of an obligation owed to it by its depositor (e.g., a loan) against a general deposit made by the depositor (e.g., the balance of a checking or savings account) which has been accepted by the bank in good faith and in the ordinary course of business. This is true because, technically, sums on deposit in a checking or savings account are debts owed by the bank to its depositor, which the bank is required to pay to the depositor or to the order of the depositor upon demand (that is, the presentment of a check or withdrawal request). In addition to this common law right, most account agreements and many loan documents contain specific provisions providing for the right of setoff by the bank, and may even grant contract rights that are more extensive rights than those available under the common law.
The right of setoff may be exercised without prior notice, so long as the conditions permitting setoff are met. These conditions include:
(1) both debts must be due (e.g., the loan has matured and there is money in the account);
(2) the parties on both debts must be identical (that is, the borrower has to be the same party as the depositor, and the bank must be the same party as the lender); and
(3) the sums on deposit must constitute a general deposit (e.g., the account is not an escrow account and does not contain exempt funds).
Lenders do need to be careful in order to safeguard against liability to the depositor for wrongful setoff and to third parties if an error is made with respect to identity of parties. The right of setoff can be a valuable tool for lenders, but can be disastrous for a debtor. One moment your deposit could be safely sitting in you bank account and the next moment it could be gone.