Allocation of Loss in Commercial Payments - Module 5 of 6

Module 5: Allocation of Loss in Commercial Payments

Transferors and Transferees

The role a person plays in any financial transaction determines her legal rights and responsibilities with respect to a transaction.  The Code provides specialized rules for several situations beyond those for drawer and indorser liability.  Recall that the most important aspect of drawers and indorsers is that they only have liability if a check is dishonored.[1]  Therefore, once a payor bank pays a check, shifting the loss to a drawer or indorser will be typically unavailable.  Additionally, only a person who is entitled to enforce an instrument may base a claim on drawer or indorser liability.[2]  Therefore, parties may seek alternate avenues of recovery.  

Sometimes a party may be liable on an instrument but may be able to shift liability to another party in the transaction stream.  Transferring a negotiable instrument for consideration creates certain implied warranties that can form the basis for shifting liability.[3]  A transferee will want to shift his liability on an instrument back to a presenter or transferor if the transferor breaches one of the Code’s implied warranties.  A presenter is a person who presents a check for deposit or payment while a transferor transfers an instrument to another party.  With respect to checks, the drawee of the check is also known as the “payor bank”[4] and it is this bank to which the depositor or check-casher warrants that the check is properly payable upon presentment.  The transferees, which are the collecting banks and their customers, get transfer warranties. 

Certain warranties apply to both presentments and transfers. For example, transferors and presenters both warrant that the person making the transfer or presentment is entitled to enforce the instrument.

A key difference between the presentment and transfer warranties is that a payor bank that pays a check with a forged drawer’s signature has no claim based on a presentment warranty but collecting banks and their customers do have claims based on the transfer warranties.  The challenge, of course, is finding a solvent and responsible party against whom the claim can be made.  The rationale behind this rule dates to the 1762 case, Price v. Neal,[5] where the court reasoned that a payor bank is in a better position than a transferee to be able to recognize the authenticity of a drawer’s signature.[6] 

For example:

Nathan attends a party at Frank’s house.  While Frank is busy with other guests Nathan steals one of Frank’s checks.  Frank’s checking account is at First Bank.  The next day, Nathan forges Frank’s signature on one of his checks, enters an amount of $100, and cashes it at Second Bank.  Second Bank presents the check to First Bank for payment.  First Bank, the payor bank, has no presentment warranty claim and, unless it can locate Nathan, it will have to absorb the loss.

Assume that Nathan also stole a check made out to Shane and Nathan forged Shane’s indorsement.  Nathan then cashed the check at Second Bank, which presented it to First Bank for payment.  First Bank must recredit Frank’s account, but now has a claim against Second Bank based on a presentment warranty.  The forged indorsement meant that Nathan could not pass good title and Second Bank was not entitled to enforce the instrument.  It breached its warranty of good title when it presented the check to First Bank for payment.        

There are two other transfer warranties that are not available to payor banks.[7]  Transferors warrant that there is no applicable defense or claim in “recoupment” against the instrument.  A claim in recoupment is a demand that arises from the same transaction as the plaintiff's claim to eliminate or reduce the claim. Transferors also warrant that they are unaware of any bankruptcy proceeding that may affect any obligors under the instrument.  These provisions are designed to protect the transfer of notes.[8]  Note that presenters do not make these warranties, only transferors.

A presentment warranty provides that all indorsement signatures are valid.  A forged or missing signature means the instrument is not properly payable and the person in possession cannot enforce it. The payor bank will not be able to charge the drawer’s account.  This warranty allows the bank to shift the loss back to the original wrongdoer if that person can be identified.   

Note that the presentment warranty is given at the time of transfer, not at the time of the presentment at the payor bank for payment.  Between the time the instrument is transferred, which is when the presentment warranty is created, and the time that the depositor attempts to cash the check at the payor bank, something, such as a missing indorsement, may render the instrument not properly payable. This, of course, is not covered by the presentment warranty.

The presenter or transferor also warrants that no alteration affects the enforcement of the instrument. [9]  Additionally, a transferor or presenter warrants the authenticity of a telecheck, which is a check created manually over the telephone by a salesperson and authorized by a customer.        

Where a check is altered, the payor bank is only allowed to charge the drawer’s account for the original amount of the check.  The bank could assert a presentment warranty claim against the depositor and seek to recover its losses that way.  The depositor could then shift the loss back to any responsible transferors under the transfer warranty.  However, the rule is different for incomplete instrument.  In that case, the issuer is responsible for the instrument as completed, even if the entries were not authored by the issuer.[10] For example:

Lydia writes a check to Francine for some landscaping work and leaves the amount blank. She agrees to pay Francine $18 per hour and leaves the amount blank, so Francine can fill in the amount later based on the hours she works.  Francine spends four hours landscaping (entitling her to $72), but enters the amount on the check as $500, and cashes it. Lydia is responsible for the check, not the payor bank, because the instrument was left incomplete by Lydia. 

Forgeries and Alterations: Employers and Employees

The Code addresses two specific situations involving employers and fraudulent indorsements by employees.[11]  The first is when an employer receives a check as payment for goods or services.  An employee who is authorized to indorse checks can properly do so and deposit the check in the employer’s account.  However, if a dishonest employee indorses and cashes it and steals the proceeds, the employer often bears the loss. The Code allows for almost anyone who is involved with the check-issuing process to have the authority to indorse a check, so allowing this sort of access presents some risk for employers. 

Some considerations in determining whether the employer is responsible include the extent to which the employee has access to a company’s check receipts and processing, whether the employee has set up a separate bank account for the purpose of depositing the stolen funds and the if the dishonest employee has engaged in behavior that showed his dishonesty.[12]  The Code uses a comparative negligence approach in determining whether the employer should be liable for the dishonest employees’ actions. For example:

Natalie is a clerk at a large warehouse.  As part of her normal duties, she issues company checks to service-providers and suppliers.  She issues a check to Acme Corporation for motor oil and filters for her employer’s forklift trucks. She then forges Acme’s indorsement and deposits the check into her own account.  The employer is in the best position to avoid the loss, so the Code designates the employer as primarily responsible for the forgery.  However, If Natalie signed the Acme check and it was evident from her signature that she was not an Acme employee, then the bank may share the responsibility for Natalie’s forged indorsement.  Note however, since check processing is largely automated, the courts do not usually hold banks responsible for anomalies in signatures.[13] 

Another situation where an employer may encounter an employee’s dishonesty is when the employer fraudulently indorses the designated payee on the employer’s check or steals a blank check and makes it payable to himself. These are fact-determinative scenarios where the circumstances and actions of the parties determine the degree of any negligence and consequently.     

Forgeries and Alterations: The Imposter Rule and the Fictitious Payee Rule

The Code describes two situations where a party to an instrument uses a deceptive identity.[14]  One is where an “imposter” assumes the identity of another person. The drawer makes a check payable to an imposter, who indorses the check in his own name.  Since the check was not properly payable, the drawer’s bank must recredit the drawer’s account.  However, if a person paid for the instrument in good faith, then the drawer would be unable to recover the loss.  The rationale for the “imposter rule” is that the Code tries to assign any loss to the person best able to avoid it.[15]  Here, the drawer is in the best position to know the identity of the imposter.  The imposter rule may not apply where the depository bank had reason to know of fraudulent behavior and may bear some or all of the loss under the Code’s comparative negligence rules.[16] For example:

Diane writes a check to Lisa, who then deposits Diane’s check.  It is payable not to Lisa, but to “Stephani Germanotta,” which is indorsed with the name “Stephani Germanotta.”  It appears to be a normal transaction so the bank teller processes the check without incident. Here, the imposter rule would apply and the drawer’s bank would be on the hook.  However, if Lisa deposited a check payable to and indorsed by “Lady Gaga,” which is Germanotta’s commonly recognizable stage name, then the teller should be suspicious. Failing to investigate this obviously suspicious check before cashing it may lead to liability of the drawee’s bank because of its negligence.

The other situation that involves a deceptive identity is where a check’s payee is not a real person at all - the “fictitious payee rule.”[17]  The rule also applies to real payees to whom the writer does not intend to have any interest in the instrument. The intent to steal must be contemporaneous with the fraudulent activity.[18] The fictitious payee rules operates similarly to the imposter rule.

For example, Samantha works as a treasurer for Apex Corporation and makes a check drawn on First Bank and payable to SupplyCo., which is a fictitious company.  She deposits the check in her account at Second Bank.  The fictitious payee rule makes any indorsements effective and thus protects First Bank and Second Bank from loss.  Apex would bear the loss because it is in the best position to detect and prevent the fraud. 

Note that negligence can preclude a person from asserting forgery or alteration as a defense against a party who pays or gives value for an instrument taken in good faith.[19]  While a drawer is normally responsible for a check as originally drafted, a poorly written check can be considered negligence and compromise her claims. The negligence must “substantially contribute” to a loss for that person to be precluded from using forgery or alteration as a defense.

For example, in an old English case[20] the drawer of a check wrote the word” fifty” in the middle of the amount line and left a space between the pound sign, used to denote English currency, and the number “50.”  A thief added the words “three hundred” to the amount line and added a “3” to the numbers, effectively making the check payable for 350 pounds.  While under today’s Code the payor bank would be limited to charge the drawer to the original amount of 50 pounds, in the actual case the court found that the drawer’s negligence made her liable for the loss.   

Forgeries and Alterations: Telechecks

The presentment and transfer warranties allow banks to pass a loss back to the presenting bank and previous transferors in the case of telechecks. A telecheck is a check created by a telemarketer over the internet or phone on a customer’s behalf.[21]  Where a telemarketer creates checks not authorized by the customer, the customer’s bank will have to recredit her account.  The customer’s bank, which is the payor bank, would have a claim against the presenting bank based on the presentment warranty and that bank would in turn have a claim against the telemarketer or prior transferors, based on the transfer warranty.  The ultimate target would be the unscrupulous telemarketer if he can be located.  Telemarketers are required to verify for a bank, upon the bank’s request, a customer’s authorization for the creation of a telecheck under the Federal Trade Commission’s Telemarketing Sales Rule.[22]   

Forgeries and Alterations: Bank Statements

The Code imposes a duty upon a bank’s customers to examine bank statements and failure to comply with this duty give banks a defense against claims made by customers asserting forgeries and alterations.[23]  The duty arises when the customer’s bank statement gives sufficient information to reasonably identify the checks paid from the account.  To comply, the bank may return the customer’s canceled check, an image of the check or a statement with the check number, amount, and date of payment.  The bank has the burden to show that an unauthorized signature or alteration caused it a loss and the customer breached the duty to examine the returned items or statement.   

Moreover, the customer is also liable for forgeries or alterations if the customer had a canceled check for thirty days or more that should have prompted the customer to notify the bank of wrongdoing.[24]  In some states, the customer may even be required to notify the bank in less than thirty days if a forgery or alteration is evident.  A customer must, according to the Code, notify the bank of any alteration or authorized signature within one year after the bank has made the bank statement or canceled check available.  After one year, the customer cannot make an unauthorized signature or alteration claim. 

While the Code does not impose a similar time restriction for forged indorsements, because they are more difficult to detect, some states have done so.  One commentator has observed that these notice provisions of the Code are among the most controversial because of the burden they place on consumers.[25]  Some states have shortened the time limitations customers have to notify their banks of anomalies in their bank statements and canceled checks.

The customer may be able to shift the loss to the bank if the bank was negligent or failed to act in good faith.  If the customer fails to notify the bank for a year after the appearance of the anomaly, then the customer loses the right to his claim.[26]

While the customer must notify the bank within one year of any suspected forgery or alteration, it does not require that suit be brought within that time.  The Code provides that any claim brought under Articles 3 and 4, which governs the provisions in this presentation, must be brought within the three-year statute of limitations period.[27]  Under tort law a limitations period can be “tolled,” or suspended, until a person should have reasonably discovered an injury.

In our last module, we’ll turn to letters of credit, which are issued between banks to guarantee payments under some conditions.