When it comes to personal transactions, the modern-day consumer would be hard pressed to remember the last time they wrote a check. In fact, for many of us, our checkbooks are likely collecting dust in some deep corner of a forgotten desk drawer, if we even have a checkbook at all. However, checks are very much still the go to payment method for many small businesses and insurance companies. While the modern age of technological advancements has provided financial institutions with the ability to replace the expensive and time consuming method of human verification with online automated tools to combat and protect against fraud, the same technological advancements have created new ways for criminals and scammers to manipulate checks to avoid those systems, allowing check fraud to skyrocket. Reports of check fraud nearly doubled from 2021 to 2022, following an already striking 23% increase from 2020 to 2021. With the introduction of more advanced methods of check fraud like check washing, many consumers and small businesses now face anxiety about the financial risk they face in the event they fall victim to this fraud. Who will be responsible for the financial losses sustained by the account holder?
Fraud schemes involving checks come in many different forms. A criminal can submit counterfeit checks, using fake checks to draw money on legitimate bank accounts. A third-party can intercept the check, forge the signature or endorsement, and deposit the funds into their own account. Nowadays scammers can also implement a method of fraud known as “check washing.” Check washing is the removal or erasing of ink on a legitimate check; and then rewriting and altering the check in some way, either by changing the amount of payment or replacing the payee’s name for their own benefit. This type of fraud can be difficult for financial institutions to detect because the altered check will appear genuine. This begs the question, what exactly is a bank’s responsibility in these situations? Do tbanks have to pay for funds lost due to this type of fraud, or are the account holders on the hook because the banks had no reasonable way of detecting and preventing this kind of fraud?
UCC GUIDELINES GOVERNING RESPONSIBILITIES OF BANKS AND ACCOUNT HOLDERS FOR CHECK FRAUD
To answer the questions above, we turn to the Uniform Commercial Codes (UCC), which provides a comprehensive set of proposed laws to govern commercial transactions in the United States. While it is not federal law, most states have adopted their own version of the rules and regulations set forth in the UCC. There are slight variations in the rules from state to state, but most states’ statutes closely mirror the rules proffered by the UCC model. Section 3 of the UCC governs negotiable instruments while Section 4 governs bank deposits and transactions. Sections 3 and 4 of the UCC contain a general framework that can be relied upon to determine the responsibilities of both the Banks and the account holders and allows us to glean which party will ultimately have to bear the loss for the check fraud, and the remedies of each party.
Section 4-401 of the UCC provides that a bank can only charge those items which are “properly payable,” which means that the charge was fully authorized by the person who wrote the check. Accordingly, when the bank pays on a charge against a customer’s account based on a fraudulently altered and/or forged check, the charge cannot be properly payable. You may be wondering if the bank would still have to pay back the loss to the account holder even when the check was difficult or impossible to detect through fraud prevention systems. However, the bank’s responsibility to the account holder is not a negligence standard. Instead, as a general rule, the UCC places a duty on the bank of the payor account to make its account holder whole in the event it pays on a charge made through a fraudulent check. The policy rationale behind placing the initial liability on the drawee bank rests on the belief that the relationship between the bank and the account holder is contractual in nature, and the bank’s paying a charge based on a fraudulent check violates its agreement with the account holder only to pay those properly payable charges.
Now, banks do have some defenses to this general rule. For example, UCC Section 4-406 places a duty on the account holder to discover and notify of a forgery or alteration. The UCC mandates that pursuant to this duty, an account holder must exercise reasonable promptness in discovering and reporting the unauthorized charge but does not define what is considered reasonable promptness. Further, the UCC requires that account holders exercise ordinary in handling the handling of the checks. Under UCC Section 3-406, if a bank can show that the account holder failed to exercise ordinary care, and that failure substantially contributed to an alteration of a check or to the forgery of a signature on the check, that customer may be precluded from making a claim against the bank for reimbursement of that loss. However, the bank has the burden to prove that the customer somehow failed in their duties and contributed to the fraud.
It is important to note that the laws in each state are not an exact reflection of the UCC model rule. Therefore, issues such as what amount of time is considered reasonably prompt when complying with the duty under 4-406 or the standard used to determine whether an account holder failed to exercise ordinary case under 3-406, will vary from state to state. Because every state has adopted their own version of the model UCC rules, it is important to ensure that you seek out counsel familiar with the relevant state’s version of the UCC that will apply to your specific fraud claim.
REMEDIES UNDER THE UCC
In a perfect world, we’d be able to catch every bad guy and law enforcement would bring charges against the scammer and a lawsuit would be able to be brought against the scammer to hold them responsible for repayment. Realistically, however, scammers that are committing advanced levels of fraud such as check washing are likely not strolling into the bank with their legal, government issued ID, and depositing the funds into an account easily traceable back to the responsible party. Further, the rise of mobile banking makes it even less likely that these scammers can be identified. Therefore, the chances of recovering the money from the scammer are often negligible.
Importantly, the general rule placing initial responsibility on the drawee bank is not a steel cage placing all of the financial burden on the drawee. The UCC was drafted with the intent to address all possible scenarios, and to distribute the burden amongst the parties to the check clearing process, i.e. the customer, drawee dank, and depository bank, based on the duties between those parties, with allowances for deviation in the event of negligence of some kind. The UCC then provides each party with remedies based on that system.
In the event that none of the enumerated defenses discussed above are available to the drawee bank, therefore making the bank liable to its customer, the UCC provides the drawee bank with a remedy against the financial institution that accepted the proceeds of the check for deposit, the depository bank. Under UCC Section 4-207(a), the depository bank warrants that the check is authentic and authorized and is free from any alterations. UCC Section 4-207(c) allows the drawee bank to recover the loss it was forced to pay its account holder from the depository bank, under the rationale that the depository bank was in the best position to avert the wrong and discover the fraud.
SUBROGATION IMPLICATIONS
When a business falls victim to check fraud and makes a claim for reimbursement against their bank for those lost funds; the bank, despite having no evidence of negligence on behalf of the business, may deny the claim and refuse to reimburse the business. The business may then turn to its insurance carrier to pay for the loss under theft and fraud coverage. In many cases, this situation may provide the insurance carrier full subrogation rights against the drawee bank for reimbursement of the funds paid on the claim. The carrier’s right of recovery may be impacted by language in the insurance policy. There is also a risk that there is some state law or public policy prohibiting subrogation in this instance. Finally, the carrier’s insured may have failed to comply with its own duties and obligations under the UCC, precluding the carrier’s ability to pursue the claim. Therefore, it is important to contact subrogation counsel early on in the process to ensure that there is a viable claim.
For more information on subrogating damages incurred by check fraud, contact Brianna Law or Jim Busenlener at briannalaw@mwl-law.com or jbusenlener@mwl-law.com.
James T. Busenlener is an insurance trial lawyer and managing partner of Matthiesen, Wickert & Lehrer, S.C.’s New Orleans branch office. Jim is licensed to practice law in Louisiana, Texas, and Pennsylvania, as well as numerous federal district and appellate courts. Jim received his Bachelor of Arts degree from Washington & Lee University in Lexington, Virginia in 1990, his Juris Doctor degree from Tulane University School of Law in New Orleans, Louisiana in 1993. For many years, Jim served as MWL’s local subrogation counsel in Louisiana. Jim has nearly three decades of experience representing insurers in coverage, professional liability, subrogation and defense litigation, and also practices in the areas of maritime and commercial litigation. He has extensive experience representing domestic and foreign insurers, including the London Market, in complex, multi-party insurance coverage, indemnity and casualty defense issues arising out of pipeline ruptures, maritime allisions, well blowouts and industrial accidents. He also has a great deal of experience litigating large loss property and casualty subrogation cases. He has represented excess insurers and re-insurers in disputes with large corporate insureds and primary insurers. Jim handles MWL’s large case load of workers’ compensation, health, Longshore (LHWCA), maritime, auto, and oilfield subrogation in Louisiana and Texas.
Brianna M. Law is a litigation associate with Matthiesen, Wickert & Lehrer’s New Orleans, Louisiana branch office. She is licensed to practice law in Louisiana. Brianna’s practice focuses on the handling of automobile, maritime, property and casualty, and workers’ compensation subrogation cases throughout the country, out of the New Orleans office.
