Is Overdraft Safe? A Favorable Ruling in California's Miller Case Removes a Major Threat, and Could Persuade Judges in Cases in Other State Jurisdictions

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It's convenient. Most customers love it. It prevents the embarrassment and potential expense associated with bouncing a check.

And until the California Supreme Court took action last month, it was a potentially massive litigation liability for your bank if you did business in the Golden State.

Hidden danger in overdraft

While virtually all banks offer an overdraft protection product, most give little thought to the source of the funds being deposited into the account. Institutions in California, however, became all-too-aware of an unexpected potential downside associated with overdraft protection. This came after a trial court in San Francisco awarded depositors at Bank of America nearly $1.1 billion in restitution and damages.

Like any other bank with an overdraft program, Bank of America had debited the overdrawn account (and charged an NSF fee) and looked to subsequent deposits into the account to satisfy the indebtedness. The key difference in this instance, however, was that the accounts in question were being used by their customers as repositories for their Social Security or other similar government benefits.

On June 1, after five years of closely-watched litigation, the California Supreme Court ruled in Miller v. Bank of America that overdraft protection programs do not violate state law that normally shields funds such as Social Security or other similar benefit programs from collection actions by creditors. While the decision has, at least for the moment, settled the issue in California, the decision in Miller may do little to dampen a growing national debate over how best to protect government benefits, and balance the burden that is often placed on banks to determine whether or not a customer's account contains protected funds.

Understanding the Miller case

The Miller litigation was filed in 2004 in the San Francisco County Superior Court on behalf of 1.1 million Bank of America account holders who had overdrawn accounts containing Social Security and other government benefits. The plaintiffs argued that the practice of debiting overdrafts from benefit payments that were subsequently deposited into the account (usually via automatic electronic payment from the benefit provider) violated state law protecting such benefits from normal collection efforts.

Banking law practitioners recognized from the start that the case had the potential to be very significant; an adverse ruling would impose large monetary liability on virtually all banks doing business in California.

Equally daunting were the likely operational and customer-relations problems that would have been created by an adverse decision. According to Leland Chan, General Counsel for the California Bankers Association, a decision in favor of plaintiffs "would have required banks to develop the capability to detect the presence of benefit funds in transaction accounts on an automatic basis and systematically withhold overdraft services from those accountholders."

Chan found that most banks that have considered this option "found it to be either impossible or prohibitively expensive to develop." Adopting a policy of categorically refusing to honor overdrawn items of benefit recipients was not a palatable option because, as Chan notes, it "would hurt customers and likely result in greater costs to them in the form of retailer bounced check fees, late fees, cancelled services, and negative credit reports."

The litigation also attracted the interest of the federal Social Security Administration. The agency saw a ruling against Bank of America as posing a threat to the government's preferred mechanism for delivering Social Security benefits-automatic direct deposit. The Social Security Administration recognized that if the California courts ruled that banks could not automatically debit an account that receives Social Security payments or other protected government benefits when an overdraft occurs, many banks would restrict the types of products available to accept direct deposit, making it a less-attractive option for benefit recipients. …