This article is authored by WLJ Banking Law Team member Johnathan D. Horton.
Arkansas businesses have seen a dramatic rise in check scams. While taking various forms, these scams have real consequences for local banks and businesses because someone is ultimately responsible for the funds taken. However, determining who is ultimately responsible for the loss may be a complicated endeavor.
Most scams begin with stolen mail. Thieves have found creative ways to obtain mail, which they search for cash or checks. Thieves then either deposit the checks themselves, cash them, or sell them to other criminals in an illicit marketplace, often by simply uploading a photo of the check. Enabled by technology that lets them either alter a legitimate check to change the amount, payee, and other details, or that lets them create a counterfeit check containing legitimate account information, the various scams all work because the check looks real. Technology has made it easier for scammers to generate altered or counterfeit checks that are virtually indistinguishable from legitimate checks. Before a bank determines a check is altered or a fake, the scammer has usually disappeared with the money. Numerous variations on the schemes exist. Which scam is involved, however, may impact the rules that apply and may affect who is ultimately responsible. With this background, the basic rules of liability under state law should be examined.
Generally, the bad actor is liable for his or her acts. The UCC allocates losses among three different parties (1) the customer on whose account the check is drawn (the “drawer”), (2) the bank holding the account from which the funds are drawn (the “drawee bank”), and (3) the depository bank, i.e., the bank that accepts the check for payment. The UCC rules place responsibility on a party with the idea that they can then pursue remedies against the bad actor. Unfortunately, in reality the bad actors may be difficult to find, and may not have any assets to be applied to satisfy a judgment, so recovery from a bad actor is far from ideal.
Consider the issue of altered items. A common example is a “washed check,” where a bad actor uses a solvent to remove the ink from the check and rewrites it. An “alteration” is a change made to the check without the drawer’s authority that changes the obligations. So, if a scammer “washes” a check, writes in a new payee, and increases the amount of the check from $40.00 to $400.00, each change is an alternation. Generally, a customer has one year from when the bank makes the account statement available to the customer to discover and report alterations. For purposes of the UCC, a statement is “available” when the statement is sent to the customer. The one-year time limit, however, may be reduced by the agreement between the customer and his or her financial institution. Similarly, repeated wrongdoing by one bad actor may bar recovery by the customer. The UCC provides that if the customer receives a bank statement and should have identified an unauthorized signature or altered item, then the customer may be precluded from making a claim, if the drawee bank can show it suffered a loss and if it paid the item before it received notice from the customer, but after the customer had a reasonable opportunity-not more than 30-days- to review the statement and notify the bank. Similarly, a customer’s negligence may preclude claims for an alternation. The UCC provides preclusion may not apply where a customer can show the bank paid an item without using ordinary care.
If none of the various defenses apply and the drawee bank is liable to its customer, the drawee bank may pursue a depository bank who accepted a check for deposit into the account of its customer—the bad actor–on a breach of warranty claim. Notice of such claims must be given within 30-days after the claimant has reason to know of the breach and the identity of the party making the warranty. When an item is transferred, the depository bank who receives settlement makes warranties to the transferee including that all signatures are authentic and authorized, and the item was not altered. The theory is the depository bank is in the best position to uncover the alteration, so it should bear the loss.
For forged checks, the same analysis as applied to alterations applies to claims between the depository bank and its customer. This rule comes from past practice when a bank compared signatures to a signature card on file to identify forgeries. Today, electronic processing makes that logic inapplicable, but the rule has endured. This rule, however, has exceptions. Examples of exceptions include where the customer benefitted from the proceeds, failed to use ordinary care and that failure contributed to the loss, or where the customer failed to timely identify the loss on their bank statement and allowed it to be replicated. If the check clears through the Federal Reserve Bank, or through an entity that follows the Electronic Check Clearing House Organization (“ECCHO”) Rules, then the Fed’s regulations or the clearinghouse rules may grant additional warranties. These additional warranties may shift the liability that would otherwise apply under state law. Similarly, the UCC provides different rules of loss for a “remotely created item,” i.e. “an item drawn on an account which is not created by the payor bank and does not bear a handwritten or facsimile signature purporting to be the signature of the drawer,” but most forged checks are not remotely created items.
If a check is stolen and the bad actor forges the name of the payee and endorses the check, then a different set of rules applies. Where the endorsement is forged, the customer must make a timely claim after the bank statement is made available to it, or risk bearing the loss. A customer’s negligence may also preclude his or her recovery. This preclusion, however will not apply if the customer can show the depository bank failed to pay the item in good faith. If the customer was negligent in not reviewing statements and reporting, but the bank was also negligent in paying the item and its negligence substantially contributed to the loss, then the UCC says fault may be allocated between the parties. The drawee bank may recover any loss from the depository bank, provided it makes a timely claim, based on a claim under the transfer warranty that the signatures are authentic and authorized. The theory is again that the depository bank is in the best position to uncover a forged endorsement.
That brings the discussion to counterfeit checks. Counterfeit checks are a fairly new vintage of the check scam frauds because technology has only recently permitted widespread creation of passable forgeries. Some jurisdictions treat counterfeit checks under the rules for forged drawee’s signatures. Those states make the drawee bank responsible. In a reported Texas decision, an appellate court declined to apply the rules of altered items to counterfeit checks. There, the Texas court held that counterfeit instruments are not “altered instruments,” because no original instrument exists in the first instance rather the check is entirely a fake. Now pause for a moment and ask the question: what criminal would put his or her own name on the “payable to” blank, knowing the check is likely to be discovered as a counterfeit eventually? Similarly, what criminal will stick around to provide critical testimony over which signatures were forged? A counterfeit check likely involves both a forged endorsement by the purported payee, and a forged signature by the drawer. As a result, one commentator has suggested Arkansas ought to consider whether to apply the forged drawee’s signature rules because generally depository banks are in a better position to avoid the fraud, and if both signatures are forged on a counterfeit, then the transfer warranties related to being a person entitled to enforce should also apply. No reported Arkansas cases appear to have addressed that argument at this time.
As the frequency of these crimes increase, the dollar amounts involved are also increasing. The facts associated with such crimes are complicated, involving multiple parties, banks in multiple states and bad actors who are likely unknown or unavailable. The facts result in cases that cannot be easily distilled to a single reliable rule. Instead, each case is more likely to be resolved on a case by case inquiry, based on the specific conduct involved, and how the fraud occurred in each specific instance. Considering a complicated fact pattern and significant amounts at issue, a financial institution may find that litigation relating to the responsibility for the loss is unavoidable, or possibly in its best interests.