The
Fidelity
Law
Journal
published by
The Fidelity Law Association
Volume XIII, October 2007
Cite as XIII Fid. L.J. ___ (2007)
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ATMS AND CHECK FRAUD:
LIFE AFTER INTERIOR CRAFTS AND THE
DEPOSITARY BANK’S OBLIGATION TO HONOR
RESTRICTIVE INDORSEMENTS
Michael J. Weber
Robert K. Grennan
I.
INTRODUCTION
In 2003, the Fidelity Law Association published an article
addressing the issue of whether a depositary bank is liable for failing to
honor restrictive indorsements on checks processed through nonproprietary or offsite ATMs.1 The discussion was by necessity limited to
assumptions as to what a trial court might do in a pending case with
respect to the parties’ pending cross motions for summary judgment
addressing the depositary bank’s liability. Since that time, both an
Illinois trial court and the Illinois Court of Appeals have addressed the
issue. It is the Illinois Appellate Court’s groundbreaking decision in
Interior Crafts, Inc. v. Leparski2 which is addressed in this article.
II.
BACKGROUND
Interior Crafts, Inc. hired Todd Leparski as an assistant
comptroller. Leparski had responsibility to receive and deposit checks
1
Michael J. Weber & Cynthia A. Mellon, ATMs and Check Fraud:
Who’s Watching the Store? IX FID. L.J. 1 (2003).
2
853 N.E.2d 1244 (Ill. App. Ct. 2006).
Michael J. Weber is a partner with Leo & Weber, P.C. with offices in Chicago,
Illinois and New Buffalo, Michigan. Robert K. Grennan is Assistant Vice
President of Bond Claims with Hanover Insurance Company in Worcester,
Massachusetts.
133
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Fidelity Law Association Journal, Vol. XIII, October 2007
from Interior Crafts’ customers. During a relatively short period from
October 2000 through February 2001, Leparski stole approximately
$500,000 from his employer by means of a scheme which, for all intent
and purposes, exploited the banking industry’s methods of processing
checks through ATMs. How was it done?
Leparski took numerous checks received by the company, which
were made payable to Interior Crafts by its customers. Leparski indorsed
the checks with the notation “Interior Crafts—For Deposit Only,” put the
checks into deposit envelopes, and deposited them into an ATM machine
owned by Pan American Bank. Through the use of the Pan American
ATM, Leparski deposited the checks, not into Interior Crafts’ account, as
indorsed, but into a Marquette Bank account he maintained in his
own name. Complying with those instructions, but contrary to the
indorsement on the back of each check, Pan American wired the monies
for deposit into Leparski’s account at Marquette Bank.
It was ultimately Marquette Bank that became suspicious of the
deposits. Marquette, after conferring with Pan American, notified
Interior Crafts that Leparski was depositing checks payable to the
company into his personal account. Even though the checks were made
payable to the company and were indorsed consistent with that
instruction, by avoiding teller interaction Leparski was able to deposit
those checks into his personal account by using his own ATM card and
PIN. Upon discovery of the fraud, not only did Pan American and
Marquette Bank deny liability, but also each bank denied that it was the
depositary bank in the transactions, attributing that role to each other in
an effort to avoid liability for allowing the transactions to occur.
The fidelity bond carrier, American Insurance Company,
ultimately paid the policy limits to Interior Crafts under its commercial
crime coverage policy. What are the subsequent rights, if any, of
American, as assignee and subrogee to Interior Crafts, against the various
banks in the transaction chain? Who is the depositary bank in the
transactions? Should the depositary bank be held strictly liable for
failing to honor Leparski’s restrictive indorsements on the checks? Can
the depositary bank raise employee dishonesty and/or employer
negligence as an affirmative defense to its failed obligation to honor
restrictive indorsements?
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III.
THE LITIGATION
In the Interior Crafts case, Interior Crafts initiated suit against
Leparski, Pan American, and Marquette Bank based on conversion for
monies not recovered. American joined in the suit, and ultimately the
trial court granted summary judgment in favor of American. But, against
which bank? The depositary bank? The answer is, “yes.” The issue on
appeal was whether summary judgment was properly entered against the
depositary bank as to liability for conversion and damages.
It was undisputed that the ATM used by Leparski to deposit the
stolen checks was owned and serviced by Pan American. Bank
employees removed the checks from the ATM and inspected them for
the presence of an indorsement. Because the checks were not deposited
into a Pan American account, the bank asserted that it had no avenue to
verify the authenticity of the indorsement or that the payee matched the
name on the account into which the checks were being deposited. A
bank that owns the ATM does not have information telling it the name of
the owner of an account at another bank into which the check is to be
deposited. The ATM bank is limited to access to the check itself and the
card number of the depositor. Therefore, the Court in Interior Crafts
recognized that the ATM bank has no way of knowing whether the name
on the account at the depositary bank matches the name of the payee on
the check.3 To further complicate matters, as part of the scheme to
defraud, the deposit slips used by Leparski in the ATM did not state the
name of the owner of the account at Marquette Bank, where the funds
were ultimately deposited.
Upon the checks being transported from the ATM to a Pan
American facility, the monies were wire transferred to Marquette Bank
for deposit into Leparski’s account, in accordance with the instructions
on the deposit slips, but in contravention to the restrictive indorsements
on each check. Pan American endorsed each check and sent them
through the channel of collecting banks and back to the drawee banks on
which Interior Crafts’ customers had drawn the checks. Consistent with
3
Id. at 1246.
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136
normal banking procedures, the actual checks sent through the ATM
were never physically in Marquette Bank’s possession.4
In the lower court, Interior Crafts and American moved for
summary judgment against the depositary bank, although Pan American
Bank or Marquette Bank, asserted conversion under section 3-206(c) (2)
of the Uniform Commercial Code, which imposes conversion liability on
a depositary bank for failing to honor a restrictive indorsement.5 The
trial court granted summary judgment, finding that Pan American, not
Marquette Bank, was the depositary bank subject to sections 3-206 and
4-105(2) of the UCC and that in such capacity it was strictly liable to the
payee of the checks.6
IV.
THE REVOLUTION OF ATMs
ATMs have been in existence for forty years.7 ATMs are
computerized telecommunication devices that provide access to financial
transactions without the need for human interaction through the use of a
bank teller. The customer’s plastic card, inserted into the machine,
contains a magnetic strip or a chip that contains security information.8
The security is provided by the customer entering his or her personal
identification number.9
The facts and figures surrounding ATMs are astronomical.
Since 2003, there has been a proliferation of ATMs nationwide. The
ATM Industry Association estimates there are 1.67 million ATMs
4
During the course of the litigation, Marquette Bank disputed any
assertion that it failed to honor the restrictive indorsements on the checks when
it had no opportunity to physically inspect the checks, all monies having been
received by wire transfer from the ATM bank.
5
UCC § 3-206(c)(2) (2003)[hereinafter UCC].
6
853 N.E.2d at 1247.
7
See http://www.greensheet.com.gs_online.php?story_id=196 (July 23,
2007).
8
See Wikipedia, Automated Teller Machine, http://en.wikipedia.org/
wiki/Automated_Teller_Machine (last visited July 21, 2007).
9
Id. [Hereinafter PIN].
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worldwide.10 The American Bankers Association estimates that as of
2006 there were 395,000 ATMs in the United States with in excess of 10
billion transactions taking place annually.11 It is estimated that 362
seconds pass before another ATM is installed somewhere in the world, at
a cost of $30,000-$40,000 per machine.12 In 2007, Bank of America’s
Global Consumer and Small Business Banking organizations report
having 17,000 ATM’s nationwide.13 Chase Manhattan Bank reports
operating 8,500 ATMs throughout the United States.14
Mass marketing campaigns feature banks highlighting their
ability to meet customers’ everyday banking needs through ATMs. In
today’s day and age, it is virtually guaranteed that one can grab a cup of
coffee and do some banking on almost every major metropolitan block.
There is no longer a need for consumers to only bank during “normal
banking hours” when in need of services such as cash withdrawals,
account balance information, account transfers, or deposits.
A proprietary ATM is an ATM that meets one of the three
following criteria:
(1)
(2)
(3)
Owned or operated by, or operated exclusively for, the
depositary bank;
Located on the premises, including the outside wall, of
the depositary bank; or
Located within fifty feet of the premises of the
depositary bank, and not identified as being owned or
operated by another entity.15
Regulation CC provides that, if two banks meet the “owned or
operated” test under subsection (1), the ATM will be proprietary to the
10
See http://www.greensheet.com.gs_online.php?story_id=196 (July
23, 2007).
11
Id.
Id.
13
See Wikipedia, Bank of America, http://en.wikipedia.org/wiki/
Bank_of_America (last visited July 23, 2007).
14
See www.chase.com/.../shared/assets/page/findus (2007).
15
Availability of Funds and Collection of Checks (Regulation CC), 12
C.F.R. § 229.2(aa)(2003)[hereinafter Regulation CC].
12
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138
bank that operates the ATM.16 A non-proprietary ATM is defined as an
ATM that is not a proprietary ATM.17 Most ATMs are connected to
interbank networks, which enable the customer to withdraw or deposit
money from an ATM not belonging to the bank where her or she has an
account.18 More often than not, ATM usage fees will be imposed on
users who are not customers of the ATM bank.
It is estimated that sixty-six percent of ATMs are located in retail
or off-premises locations, such as gas stations, restaurants, malls, or
hotels.19 According to the American Bankers Association’s last report on
check fraud, issued in 2004, electronic payments were rising by thirteen
per year.20 In 2003, seventy-five percent of commercial banks incurred
check fraud losses, up from seventy-two percent in 2001.21 In 2003, the
total amount of attempted check fraud against commercial banks’ deposit
accounts was $5.5 billion, up from $4.3 billion in 2001.22 Eighty-eight
percent of the $5.5 billion attempts were caught by banks’ prevention
systems before any losses were incurred.23 For 2003, the incidents
resulted in losses of $677 million, a slight decline from $698 million in
2001.24
One obvious way to avoid the scrutiny of teller interaction is to
use an ATM. Would Leparski have been successful had a teller been in a
position to inspect the check—including the payee, the restrictive
indorsement, and the account to which the funds were being sent? Most
likely not. Would a teller accept checks for deposit from a non-customer
16
Id.
Id. § 229.2(x).
18
See Wikipedia, Automated Teller Machine, http://en.wikipedia.org/
wiki/Automated_Teller_Machine (last visited July 21, 2007).
19
See http://www.greensheet.com.gs_online.php?story_id=196 (July
23, 2007).
20
See Denise Magnell, Check Fraud Increasingly Plague Business
Customers, BOSTON BUS. J. (Nov. 10, 2006), http://boston.bizjournals.com/
boston/stories/2006/11/13/focus8.html.
21
See aba.com, 2004 Deposit Account Fraud Survey Report,
http://www/aba.com/Surveys+and+Statistics/SS_Depositfraud.htm.
22
Id.
23
Id.
24
See Robin Sidel, IdentityTheft-Unplugged (Oct. 10, 2005), http://
www.post-gazette.com/pg/05283/586015.stm.
17
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for a deposit going to another bank? Most likely not. Would a teller
accept deposit slips for a deposit to another bank, which failed to identify
the owner and account number of the account? Most likely not.
The convenience and proliferation of ATMs everywhere add an
ever-expanding dimension to detecting bank fraud. The Illinois
Appellate Court’s ruling in Interior Crafts clearly places the burden on
the depositary bank (in this case, the ATM bank) to comply with
restrictive indorsements regardless that the transactions are carried out
electronically and thus void of human interaction.
The court’s decision in Interior Crafts highlights the increasing
need for banks hosting ATMs and/or performing collection services for
other banks to have agreements in place to allocate liability for ATM
fraud.25 Many large banking networks do not accept deposits for rival
banks at their ATMs. Many of the larger banks perceive the practice,
known as “sharing deposits,” to be too risky, especially with the
increasing burdens on detecting fraud.26 In some markets where States
made the practice of sharing deposits mandatory, it is now optional.27
Some networks allow ATM owners to assess fees for shared deposits.28
Even with increased ATM usage fees, many banks believe the costs
involved to redirect deposits, coupled with the fraud risks, cause the
disadvantages of accepting shared deposits to outweigh the advantages.29
On the other hand, some large banks still accept noncustomer deposits
because they have acquired a bank whose machines take them.30 Some
community banks also have shared deposit arrangements and pool their
25
See Daniel R. Murray & Carter H. Klein, UCC With Illinois Code
Comments, 2A ILL. PRAC. § 5/4-105 (2007).
26
See Jiang Su Qing Hua, ATM Deposits: Why Some No Longer Share
(Sept. 2003), http://www.jsqh.cn/News/en/e_news_detail.asp?id=247.
27
Id.
28
See David Gosselin, ATM Marketplace, ATM Deposits—To Share or
Not to Share? (Aug. 2003), http://www.atmmarketplace.com/article.php?id=
3894).
29
Id. Of interest, the article contains a quotation from the president and
CEO of Pan American Bank after Interior Crafts filed suit that the bank will
continue to accept foreign deposits.
30
Id.
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ATM networks to make banking more convenient or to keep customers
from defecting to larger banks.31
The impact of the Check Clearing for the 21st Century Act on
ATMs is still developing.32 Commonly referred to as “Check 21,” the
Act went into effect on October 28, 2004, and governs check processing
and check clearing. Check 21 allows banks to truncate, or remove, the
original paper checks from the banking system and to process those
checks electronically.33 The aim of Check 21 is a paperless system. It
allows the truncation of the original check at any point in the payment
stream to increase the efficiency of check processing while significantly
decreasing costs by promoting the industry’s ability to process checks
electronically.34
Generally, Check 21 has not been widely used in ATMs,
although several major ATM providers are increasing their deployment
of image deposit capable ATMs.35 Image deposits are being used
primarily to reduce the costs for servicing distant ATMs and the expense
of gathering and sorting checks.36 However, image deposits can also be
used to reduce fraud, particularly in terms of “empty envelope” deposits
which cost U.S. commercial banks more than $240 million in 2004.37
Image capture also makes it easier for new signature analysis programs
to process checks quickly—for example, a single computer equipped
with Mitek’s FraudProtect System can validate two to four checks per
second.38 The FraudProtect System is an automated system that assists
in the detection of counterfeit and signature forgeries, allowing banks to
31
Id.
12 U.S.C. §§ 5001-5018 (2004). For a detailed discussion on the
Check 21 Act, see Michael J. Weber & Dennis E. McDonnell, Check Please?
Check 21 Act and its Impact on Check Fraud Claims, 40 TORT TRIAL & INS.
PRAC. L.J. 941 (2005).
33
Id.
34
Id.
35
See Karen Epper Hoffman, The Few the Proud the Image-Enabled
(May/June 2006), http://www.bai.org/BANKINGSTRATEGIES/2006-MAYJUNE/PaymentsStrategies/ImageEnabled/index.asp.
36
Id.
37
Id.
38
See Theresa W. Carey, Technologies Help Banks with Check 21 (Oct.
2004), http://www.eweek.com/article2/0,1759,1676618,00.asp.
32
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make timely pay or no pay decisions. With electronic image exchanges,
manual check fraud detection will be more difficult. The FraudProtect
System focuses on the image of the original check as it searches for stock
variations or signature irregularities.39
But new technology also opens up new fraud risks. As banks are
now able to treat substitute checks at face value, they may retain the
originals for less time than before. Some experts express concern that
the digital copies will not be sufficiently detailed to reveal evidence of
fraud, which might be more apparent from the original checks.40
Additionally, there might be the unintended consequence of reducing the
bank’s recourse to fraud since the image processing procedure can result
in the destruction of the original paper check, eliminating the evidence of
fraud and increasing the difficulty to prosecute check fraud crimes.41
V.
THE PARTIES’ ROLES IN ATM CHECK FRAUD
The transaction starts with the drawer,42 otherwise referred to as
the maker or issuer of the instrument (Interior Crafts’ customers).43 The
drawer writes and signs a check against his or her account and gives the
check to his or her creditor as a form of payment.44 The bank where the
39
Id.
See Theresa W. Carey, Experts Fear Check 21 Could Lead to Mass
Fraud (Oct. 2004), http://www.gokis.net/self-service/archives/cat_atm.html.
41
Id.
42
“Drawer” is defined in UCC § 3-103(a)(5) as “a person who signs or
is identified in a draft as a person ordering payment.”
43
UCC § 3-105(a) & (c) define “issue” as “the first delivery of an
instrument by the maker or drawer” and defines “issuer” as “a maker or drawer
of an instrument.”
44
“Check” is defined in UCC § 3-104(f) as “a draft other than a
documentary draft, payable on demand and drawn on a bank.” Section 3-104(e)
defines a “draft” as an order as distinguished from a promise to pay. Section 3104(a)(8) defines “order” as “a written instruction to pay money signed by the
person giving the instruction.” Section 3-104(a) defines “negotiable instrument”
as “an unconditional promise or order to pay a fixed amount of money, with or
without interest or other charges described in the promise or order, if it: (1) is
payable to bearer or to order at the time it is issued or first comes into possession
of a holder; (2) is payable on demand or at a definite time; and (3) does not state
40
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Fidelity Law Association Journal, Vol. XIII, October 2007
drawer maintains the account is the drawee or payor bank.45 The check
is payable to the drawer’s creditor, the payee (Interior Crafts).46 The
payee, upon receiving the check, takes the check to his or her bank, the
depositary bank (Pan American),47 endorses the check and deposits it
into his or her account (Marquette Bank).
The depositary bank is the first bank in the collection chain.48
The depositary bank endorses the check and sends the check through the
chain of banks, eventually back to the drawee/payor bank. Any banks in
between the depositary bank and the drawee/payor bank typically take
the check for value, endorse it, and give it for value to the next bank in
the chain and are referred to as collecting49 or intermediary banks.50
Technically, the depositary bank also is a collecting bank.51 The check
ultimately is presented52 to the drawee/payor bank for payment from the
drawer’s funds on account.53 The perpetrator of the fraud (Leparski) is
ultimately liable for his or her misdeeds under UCC § 3-420 and
common law. However, in the vast majority of cases, the converter
any other undertaking or instruction by the person promising or ordering
payment to do any act in addition to the payment of money . . . .”
45
“Drawee” is defined in §§ 3-103(a)(4) and 4-104 (a)(8) as “a person
ordered in a draft to make payment.” “Payor” bank is defined in § 4-105(3) as
“a bank that is the drawee of a draft.”
46
“Payee” is not a defined term but is functionally defined in
§ 3-110(a) as “the person to whom an instrument is initially payable . . . .”
47
“Depository bank” is defined in § 4-105(2) as “the first bank to take
an item even though it is also the payor bank, unless the item is presented for
immediate payment over the counter.”
48
Id.
49
Section 4-105(5) defines “collecting bank” as a “bank handling an
item for collection except the payor bank.”
50
Section 4-105(4) defines “intermediary bank” as “a bank to which an
item is transferred in course of collection except the depositary or payor bank.”
51
UCC § 4-105(5).
52
UCC § 3-501 defines “presentment” as “a demand made by or on
behalf of a person entitled to enforce an instrument (i) to pay the instrument
made to the drawee or a party obliged to pay the instrument . . . .” Section
4-105(6) defines “presenting bank” as “a bank presenting an item except a payor
bank.”
53
For a discussion of the bank collection process in general, see Roy
Supply, Inc. v. Wells Fargo Bank, N.A., 46 Cal. Rptr. 2d 309 (Ct. App. 1995).
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cannot be found or does not have the money to reimburse the loss, which
places continuing importance on whom else might have ultimate
responsibility for the loss (the banks).54
ATMs can play a role in the life cycle of a fraudulent check,
which differs from a transaction with teller interaction. The ATM can be
an onsite or a remote ATM of the depositary bank, or it can be an onsite
or a remote ATM of a third-party bank.55 If the depositary bank’s ATM
is used, the check will be processed much the same way as if a teller had
been used, except that the scrutiny of a teller at the time of the deposit is
bypassed. If a third-party bank is used, that bank may wire the amount
of the check to the depositary bank for deposit, endorse the check, and
send the check to yet another bank back to the drawee/payor bank.
Under those circumstances, the depositary bank may never directly
possess the instrument.56
In Interior Crafts, the banks denied any culpability while they
looked to shift the focus of responsibility to one another or to Interior
Crafts for not overseeing the actions of Leparski.57 On the other hand,
54
See Perez v. Charter One FSB, 748 N.Y.S.2d 392 (App. Div. 2002).
Regulation CC, 12 C.F.R. § 229.
56
The event of a deposit through a remote ATM at a third-party bank in
effect splits the classic function of a depositary bank. The third-party bank in
such transactions has the opportunity to inspect the instrument and indorse it
before sending it into a chain of collecting banks back to the drawee/payor bank,
which chain cannot be expected to include the bank with which the defrauder
has an account. On the other hand, the bank with which the defrauder has an
account actually is in privity of contract with the defrauder, has an opportunity
to know its customer and his account activity, and is the bank that received the
unauthorized deposit albeit by wire transfer in Interior Crafts. Due to this
functional split, this configuration is attractive for many types of check fraud.
Not surprisingly, the remote, third-party ATM and the bank where the defrauder
maintains an account often disagree about which of them is the depositary bank.
57
See Globe Motor Car Co. v. First Fid. Bank, N.A., 641 A.2d 1136
(N.J. Super. Ct. 1993), aff’d, 677 A.2d 794 (N.J. Super. Ct. App. Div.
1996)(employer that hires thief must suffer the consequences of misjudgment);
Brighton, Inc. v. Colonial First Nat’l Bank, 422 A.2d 433 (N.J. Super. Ct. App.
Div. 1980), aff’d, 430 A.2d 902 (N.J. 1981)(bank loss should fall on employer
because employer is in position to prevent forgery by selection or supervision of
its employees and is in better position to cover loss by fidelity insurance).
55
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144
Interior Crafts and American Insurance Company, as assignee and
subrogee, claimed that either or both banks were negligent by failing to
exercise ordinary care in the handling of the ATM transaction.58
The banks claimed that they never see the indorsement in any
ATM transaction. Marquette Bank denied any negligence for not
inspecting the indorsements because the funds were wire transferred
from the ATM bank into the account. Typically, a drawee bank is liable
for claims involving the drawer’s signature on the face of the check
(because the drawee bank maintains its customer’s signature card),59 and
the depositary bank is liable for claims involving the payee’s
indorsement on the back of the check because the depositary bank is in
the best position to verify the indorsement and has direct contact with the
perpetrator presenting the check.60 Pan American argued it was in no
position to verify the indorsements against the owner of the account to
which the funds were being deposited.
What was alarming in Interior Crafts was the apparent ease with
which Leparski used an ATM to deposit checks into his personal
account, simply by using his bank card and PIN, avoiding any additional
safeguards that were, or should have been, in place to ensure that the
indorsement was proper and that the funds were being credited to the
proper payee. The lack of human interaction by a bank teller should not
act as a facilitator of fraud. The lack of human interaction should not
diminish the bank’s obligations to honor restrictive indorsements.
VI.
THE DEPOSITARY ATM BANK UNDER THE UCC
Article 3 of the UCC imposes certain duties and responsibilities
on the depositary bank. With respect to restrictive indorsement, the
58
See UCC §§ 3-103(a)(9) & 3-206.
See UCC §§ 4-401 & 4-402 (under which drawee bank is responsible
for paying on an instrument that was not “properly payable”).
60
See Donn A. Randall, Massachusetts Check Fraud Law, 83 MASS. L.
REV. 114, 115 (1998).
59
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depositary bank is liable in conversion for failing to honor the restrictive
indorsement.61 Section 206(c)(2), Restrictive Indorsement, provides:
If an instrument bears an indorsement . . . in blank or to
a particular bank using the words “for deposit,” “for
collection,” or other words indicating a purpose of
having the instrument collected by a bank for the
indorser or for a particular account, the following rules
apply: . . . A depositary bank that purchases the
instrument or takes it for collection when so indorsed
converts the instrument unless the amount paid by the
bank with respect to the instrument is received by the
indorser or applied consistently with the indorsement.
Official Comment 3 to section 3-206 provides insight into the
provision’s intent, as follows:
The great majority of restrictive indorsements are those
that fall within subsection (c) which continues previous
law. The depositary bank or the payor bank, if it takes
the check for immediate payment over the counter, must
act consistently with the indorsement, but an
intermediary bank or payor bank that takes the check
from a collecting bank is not affected by the
indorsement. For example, suppose a check is payable
to X, which indorses in blank but writes above the
signature the words “For deposit only.” The check is
stolen and is cashed at a grocery store by the thief. The
grocery store indorses the check and deposits it in
Depositary Bank. The account of the grocery store is
credited and the check is forwarded to Payor Bank which
pays the check. Under subsection (c), the grocery store
and Depositary Bank are converters of the check because
X did not receive the amount paid for the check.
The UCC rule would also not protect a depositary bank receiving
a check from a nonbank depositor for collection. In such instances,
banks are in a position to examine indorsements at the time the check is
61
Id.; see also UCC § 3-206.
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deposited or cashed, or to rely on the good faith and credit standing of
the depositor.”62 Under section 3-206, the depositary bank is liable in
conversion unless the forger’s employer as named payee received the
amount of the check or unless the amount of the check was deposited to
an account of the named payee.63 Neither of these things happened in
Interior Crafts, as the amount of the checks was wire transferred by Pan
American to Leparski’s account at a different bank. As such, the remote
ATM bank, as depositary bank, is liable to the named payee or its
assignee/subrogee for conversion.64
Neither Pan American nor Marquette Bank was willing to accept
the role of depositary bank. Section 4-105(2), incorporated by reference
for purposes of Article 3 in section 3-103(c), defines “Depositary Bank”
as “the first bank to take an item even though it is also the payor bank,
unless the item is presented for immediate payment over the counter.”65
To avoid the role of depositary bank, Pan American Bank argued that for
purposes of section 3-206, the UCC definition is the wrong definition
and has been preempted by federal banking Regulation CC which
provides:
Depositary bank means the first bank to which a check is
transferred even though it is also the paying bank or the
payee. A check deposited in an account is deemed to be
transferred to the bank holding the account into which
the check is deposited, even though the check is
physically received and indorsed first by another bank.66
62
See Brady on Bank Checks, The Law of Bank Checks, ¶ 12.04,
(rev’d ed. 2003).
63
UCC § 3-206. See Maley v. East Side Bank of Chicago, 361 F.2d
393, 400 (7th Cir. 1966)(bank cannot avoid liability when handling transaction
in derogation of “for deposit only” restrictive indorsement); see also Davis v.
Committee For First Home Owners, Inc., 692 N.Y.S.2d 882, 884 (Sup. Ct.
1997); New Jersey Steel Corp. v. Warburton, 655 A.2d 1382, 1389 (N.J. 1995).
64
UCC § 3-206.
65
UCC § 4-105(2).
66
12 C.F.R. § 229.2(o) (Availability of Funds and Collection of
Checks).
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We are not aware of any court that has found the UCC definition
of depositary bank to be preempted by Regulation CC.67 While the
Regulation CC definition dates back to at least 1988, courts continue to
rely on the UCC definition.68 Moreover, the language of Regulation CC
itself seems to anticipate and reject Pan American’s argument.69
In our opinion, the drafters of Regulation CC intended to limit
the applicability of the definitions to the substantive provisions of the
Regulation and only to give them preemptive weight in connection with
the substantive provisions found to preempt state law. The stated
purpose of Regulation CC is to implement the Expedited Funds
Availability Act,70 and the Check Clearing for the 21st Century Act.71
Subpart A of Regulation CC, containing definitions including the
definition of “Depositary Bank,” begins with the words: “As used in this
part and unless the context requires otherwise, the following terms have
the meanings set forth in this section, and the terms not defined in this
section have the meanings set forth in the Uniform Commercial Code.”72
This language makes clear at the outset that the definitions contained in
Regulation CC are of terms “[a]s used in this part” and are not intended
to be substituted for different definitions of the same terms without any
consideration of the consequences.
Subpart A of Regulation CC contains no preemption language.
Subparts B and C, which contain substantive provisions, do. Subpart B
in part provides:
67
Interior Crafts, 853 N.E.2d at 1248 (in which the court also agreed
that Pan American failed to cite any authority for the proposition that the UCC
definition of “depositary bank” has been preempted by the federal regulatory
definition).
68
See 53 Fed. Reg. 31290-01; Interior Crafts, 366 (citing Continental
Cas. Co., Inc. v. Am. Nat’l Bank & Trust Co. of Chicago, 768 N.E.2d 352, 359
n.2 (2002)).
69
Interior Crafts, 853 N.E.2d at 1248 (in which the court states: “[In]
reading the federal regulatory scheme in its entirety, it is clear that the definition
of “depository bank” contained in the cited federal regulations, was intended to
be limited in scope and was not intended to preempt the UCC law of negotiable
instruments.”).
70
12 U.S.C. § 4001.
71
12 U.S.C. § 5001 n.31.
72
12 C.F.R. § 229.2(a).
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Preemptive determinations. The Board may determine,
upon the request of any state, bank, or other interested
party, whether the EFA Act and subpart B, and in
connection therewith, subpart A, preempt provisions of
state laws relating to the availability of funds.73
This language undermined Pan American’s proposed use of
Regulation CC’s definition of “Depositary Bank” in lieu of the UCC
definition. First, the Regulation provides an administrative vehicle for
the Federal Reserve Board to determine the extent to which Regulation
CC preempts state law. Second, the words “whether the EFA Act and
subpart B, and in connection therewith, subpart A” make clear that the
definitions of Subpart A can only have preemptive effect in connection
with preemptive substantive provisions and not in isolation. This is
common sense, as substitution of Regulation CC definitions into state
law increases the risks of unintended consequences. Third, the words
“relating to the availability of funds” make clear that the preemption
applies to laws relating to the availability of funds, which is the subject
matter of Regulation CC. Availability of funds was not the issue before
the Interior Crafts’ court.
Another obstacle for Pan American’s reliance on the Regulation
CC definition of “Depositary Bank” in interpreting provisions of the
UCC arises from Subpart C of Regulation CC, which provides:
Indorsement for depositary bank. A depositary bank
may arrange with another bank to apply the other bank’s
indorsement as the depositary bank indorsement,
provided that any indorsement of the depositary bank on
the check avoids the area reserved for the depositary
bank indorsement as specified in Appendix D. The other
bank indorsing as depositary bank is considered the
depositary bank for purposes of Subpart C of this part.74
This language provides that even for purposes of Regulation CC,
where one bank indorses the checks for the depositary bank, as defined
in Regulation CC, and the depositary bank does not indorse the checks,
73
74
12 C.F.R. § 229.20(d).
12 C.F.R. § 229.20(c).
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the indorsing bank is the depositary bank. That is exactly what happened
in Interior Crafts, as Pan American, the remote ATM bank, inspected
and indorsed the checks, even though Marquette Bank held the account
into which the funds were wired. “Preemption cannot occur by accident,
but only by the manifest intent of the federal government acting within
its jurisdiction.”75 “Courts do not . . . lightly attribute to Congress or to a
federal agency the intent to preempt state or local laws. Indeed, ‘we start
with the assumption that the historic police powers of the state were not
to be superseded by the Federal Act unless that was the clear and
manifest purpose of Congress.’”76
We do not believe that the Federal Reserve Board intended
definitions in Regulation CC, in isolation, to be substituted for the
uniform law of negotiable instruments. To the contrary, Regulation CC
is replete with cautionary language, including that it is preemptive only
to the extent state law is inconsistent with Regulation CC, only in the
context of the availability of funds, only as determined by a prescribed
administrative procedure, and its definitions are preemptive only in
connection with its substantive provisions that are preemptive. The
language of Regulation CC supports the conclusion that Regulation CC’s
definition of “depositary bank,” taken in isolation, was not intended to be
read into every state law statutory scheme using that term. The Illinois
Appellate Court in Interior Crafts agreed by stating: “In reading the
federal regulatory scheme in its entirety, it is clear that the definition of
[depositary bank] contained in the cited federal regulations, was intended
to be limited in scope and was not intended to preempt the UCC law of
negotiable instruments.”77
In an effort to avoid the language of section 3-206, Pan
American looked to the language from Official Comment 2 to section
3-205, which states that “[F]or deposit only” followed by the signature of
the payee of a check is a restrictive indorsement. It is also a blank
75
Interior Crafts, 853 N.E.2d at 1248 (citing Fifth Third Bank ex rel.
Trust Officer v. CSX Corp., 415 F.3d 741 (7th Cir. 2005)).
76
See Nat’l Solid Waste Mgmt. Ass’n v. Killian, 918 F.2d 671, 676
(7th Cir. 1990).
77
Interior Crafts, 853 N.E.2d at 1248.
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indorsement because it does not identify the person to whom the
instrument is payable.78
The Illinois Appellate Court rejected Pan American’s argument
that, because a blank indorsement makes a check payable to bearer, a
blank, restrictive indorsement makes a check payable to any account, so
long as it is not cashed. While Pan American argued that it complied
with the instructions on the back of each check, section 3-206
specifically applies to restrictive indorsement “in blank or to a particular
bank,” “for the indorser or for a particular account” and requires in any
event that “the amount paid by the bank with respect to the instrument is
received by the indorser or applied consistently with the indorsement.”79
The language of section 3-206 makes clear that the absence of a
named bank and account of deposit does not make the indorsement any
less restrictive and still requires the amount of the instrument to be
“received by the indorser or applied consistent with the indorsement.”80
As the court in Interior Crafts concluded by its interpretation of UCC
§ 3-206, “a depositary bank is liable in conversion unless the payee
under a restrictive indorsement receives the amount of the check or
unless the amount of the check is deposited in the indorser’s account. It
is undisputed that neither occurred in the instant matter.”81
Pan American also argued that for purposes of section 3-206
Leparski is the restrictive indorser and, therefore, the restrictive
indorsement is honored so long as the check proceeds were wired to his
account and regardless of how the restrictive indorsement is written.82
Certainly the drafters of the UCC did not intend for the depositary bank
to honor the thief’s intentions, even when, in this case, Pan American
was operating on the assumption that the indorser is the named payee. In
essence, was not Pan American’s argument an attempt to take advantage,
after-the-fact, that Leparski was carrying out an illegal scheme as a
means to deflect responsibility for the bank’s failure to honor the
restrictive indorsements, without so much as knowing that Leparski was
78
UCC § 3-205.
Id. § 3-206 (c)(1).
80
Id.
81
Interior Crafts, 853 N.E.2d at 1248.
82
Id.
79
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doing just that? In other words, do we hear the bank saying that it should
not be held accountable because it wired the funds to the restrictive
indorser’s account, dishonest or not? The UCC expressly provides for
liability if payment is made inconsistent with the restrictive indorsement.
“There is no requirement that the restrictive indorsement be made only
by an authorized agent.”83
Although Leparski lacked authority to possess his employer’s
checks or to deposit them into his bank account, in essence the
unauthorized indorsement is not the cause of the loss. Why? The
unauthorized indorsement of the checks did not change the instrument’s
direction payable to Interior Crafts, the named payee. We cannot accept
the bank’s logic that a restrictive indorsement reading exactly as it
should—payable for deposit only to the named payee (although signed
by the wrong individual), is somehow unimportant or overshadowed by
the scheme to defraud. The reality is that, had the depositary ATM bank
followed the instrument’s written instruction as required under UCC
section 3-206, the loss would not have occurred.
In Interior Crafts, Pan American Bank relied on Western
Assurance Co., Inc. v. Star Financial Bank of Indianapolis.84 In Western
Assurance, the court recognized that the corporate agent had authority by
corporate resolution and as signatory on the account signature cards for
both corporate accounts in issue. The lower court held that “the bank’s
conduct, considered in the light of the authorization granted to [the
corporate agent] both in the corporate resolution and in the signature
cards, was commercially reasonable as a matter of law. The appellate
court affirmed.85 However, there is a fundamental distinction between
Western Assurance and the facts of Interior Crafts, which is noted by the
court. Western Assurance is distinguishable because it dealt with the
question of apparent authority to negotiate checks, not whether the
depositary bank was liable for failure to honor a restrictive
indorsement.86
83
Id.
3 F.3d 1129 (7th Cir. 1993).
85
Id. at 1131.
86
Interior Crafts, 853 N.E.2d at 1249 (“Western Assurance is
distinguishable in one salient detail: Western Assurance dealt with the question
84
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It should be pointed out that in Western Assurance the plaintiff
unsuccessfully argued under Indiana law that under former section
3-419(3) the bank was liable for conversion. UCC § 3-419(3), as cited
by the court, read:
Subject to the provisions of this act concerning
restrictive endorsements, a representative, including a
depositary or collecting bank, who has in good faith and
in accordance with the reasonable commercial standards
applicable to the business of such representative dealt
with an instrument or its proceeds on behalf of one who
was not the true owner is not liable in conversion or
otherwise to the true owner beyond the amount of any
proceeds remaining in his hands.
Compare former UCC § 3-419(3) to current UCC § 3-420(c):
§ 3-420. Conversion of Instrument.
(c) A representative, other than a depositary bank, who
has in good faith dealt with an instrument or its proceeds
on behalf of one who was not the person entitled to
enforce the instrument is not liable in conversion to that
person beyond the amount of any proceeds that it has not
paid out.87
By its express terms, section 3-420(c) expressly excepts depositary banks
from any limitation of liability for honoring an unauthorized indorsement
in good faith. Pan American’s reliance on Western Assurance ignored
this revised language.
Finding a bank liable for conversion for depositing checks
restrictively indorsed “for deposit only” into an account other than the
indorser’s, the United States District Court for the Eastern District of
of apparent authority to negotiate checks, not whether the depository bank was
liable for failure to honor a restrictive endorsement.”).
87
UCC § 3-420(c) (emphasis added).
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Virginia in The State of Qatar v. First American Bank of Virginia,88
rejected the decision in Western Assurance, stating:
[T]he portion of Western Assurance dealing with the
legal significance of “for deposit only” is nonetheless
unconvincing here. The Western Assurance panel cites
no authority for its conclusion, nor does it support its
ruling with any significant discussion or analysis. While
it is true that the literal command of the bare words “for
deposit only” is simply that the check be deposited, such
rigid reliance on linguistics in disregard of practical
considerations and plain common sense is both
unwarranted and imprudent. This is especially true
given that the individuals writing and relying upon these
restrictive indorsements are not apt to be well versed in
the subtleties of negotiable instruments law (footnote
omitted). As evidenced by numerous authorities,
[citations set forth under discussion of decision in
Society National below], and common experience, the
unqualified phrase “for deposit only” is almost
universally taken to mean “for deposit only” into the
payee’s account.
To disregard this common
understanding in support of an illogical construction is to
elevate form over substance. [The bank’s] argument to
the contrary is a little like saying that a store reading
“shirts and shoes required” does not restrict a trouserless man from entering the store.89
Pan American also relied upon the decision in Grand Rapids
Auto Auction, Inc. v. National City Bank of Indiana90 for the proposition
that “a bank has not violated the terms of a for deposit only restrictive
indorsement, if the bank deposits the proceeds of a check according to
the request of an authorized signator.” Similar to the facts of Western
Assurance, Grand Rapids Auto dealt with the question of the indorser’s
apparent authority to negotiate checks, not whether the depositary bank
was liable for failing to honor a restrictive indorsement. Regardless of
88
885 F. Supp. 849 (E.D. Va. 1995).
Id. at 854.
90
No. 01-147, 2003 U.S. Dist. Lexis 2448 (W.D. Mich. Feb. 20, 2003).
89
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whether Pan American was privy to Leparski’s authority, or lack thereof,
to negotiate checks, the bank cannot avoid the duties of vigilance
imposed on depositary banks by section 3-206 and other sections of the
UCC.
Pan American’s reliance on a California appellate decision in
Spencer v. Sterling Bank91 also was misplaced. In Spencer, the court
found that an indorsement with the payee’s purported signature along
with the words “for deposit only” is a restrictive indorsement under
section 3-206. However, in that case, the indorsement also contained an
additional stamp indorsement over to an estate’s attorney’s client trust
fund account. The court found that the first indorsement did not restrict
further negotiation of the checks. Spencer, however, is irrelevant
because the ATM bank in Interior Crafts received no further
indorsement instruction to deposit the funds into any account other than
the named payee. In Spencer, the additional stamp indorsement made by
the attorney converted the instrument into a specially indorsed
instrument, which allowed for the checks to be negotiated by the person
to whom the instrument is made payable.92
The Court’s rationale in Interior Crafts is consistent with the
Ohio Supreme Court decision in Society National Bank v. Security
Federal Savings and Loan.93 In Society National, an authorized agent of
two companies placed a blank restrictive indorsement on a check payable
to one of the companies but deposited the check with the use of a
separate deposit slip into the second company’s account, while receiving
a portion of the check in cash for himself. A successor bank (secured
party on note) to the first company payee subsequently brought suit to
recover the monies improperly deposited into the second company’s
account.
The Ohio Supreme Court, citing multiple jurisdictions in
support, affirmed the Ohio Appellate Court decision stating:
We today hold that, pursuant to this statute (UCC), a
depositary bank presented with a check bearing a blank
91
74 Cal. Rptr. 2d 576 (Ct. App. 1998).
Id.
93
643 N.E.2d 1090 (Ohio 1994).
92
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restrictive “for deposit only” indorsement made by or on
behalf of the payee acts inconsistently with the
indorsement in cashing or crediting the amount of the
check to any account other than one held in the name of
the payee.94
Furthermore, the Ohio Supreme Court in Society National held
that the check indorsed “For Deposit Only” was a restrictive indorsement
on behalf of the payee, and thereafter, the check could only, consistent
with the restrictive indorsement, be deposited into an account held by the
named payee.95 “When the [depositary bank] credited an account of a
separate legal entity . . . it thereby converted the check by acting in
express contravention of the restrictive indorsement.”96
In the context of the discussion of Interior Crafts, the court in
Society National fittingly recognized that the issue before them is not
94
Id. at 1093 (citing Mid-Atlantic Tennis Courts, Inc. v. Citizens
Bank & Trust Co. of Md., 658 F. Supp. 140, 143 (D. Md. 1987), for proposition
that depositing a check’s proceeds into the payee’s account is “the only
treatment consistent with a ‘for deposit only’ restrictive indorsement made by,
or (even purportedly) on behalf of, a named payee”); see also AmSouth Bank v.
Reliable Janitorial Serv., Inc., 548 So. 2d 1365, 1367 (Ala. 1989); cf. O’Petro
Energy Corp. v. Canadian State Bank, 837 P.2d 1391 (Okla. 1992); see also
Underpinning & Found. Constructors, Inc. v. Chase Manhattan Bank, 386
N.E.2d 1319 (N.Y. 1979). Accord 4 HAWKLAND & LAWRENCE, UCC SERIES
§ 3-205:05, at 366 (1999) (“When an instrument is indorsed ‘for deposit’ the
holder has signified that the proceeds obtained from payment of the instrument
can only be used to credit a bank account. Taken literally, this would permit the
proceeds to be credited to any bank account, although the clear purpose of the
indorsement is to limit the application of the proceeds to deposit in the holder’s
bank account.”); 2 HART & WILLIER, BENDER’S UNIFORM COMMERCIAL CODE
SERVICE § 3A.02, at 3A-5 (“[W]hen an instrument is indorsed ‘For Deposit’ the
indorsee, almost always a bank, is obligated to put any money received for the
instrument in the indorser’s account.”); 1 LAWRENCE, COMMERCIAL PAPER AND
PAYMENT SYSTEMS § 3.6[3], at 3-37 (1990) (“A payee who indorses a check
‘for deposit only’ provides notice to the depository [sic] bank that the check is to
be credited to the payee’s account. [T]he bank cannot credit the check to any
account other than the payee’s or apply the check to an outstanding
indebtedness.”).
95
Society Nat’l, 643 N.E.2d at 1094.
96
Id.
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whether the dishonest individual had legal authority to modify the
indorsement by his subsequent use of a deposit slip (analogous to the
ATM envelope in Interior Crafts), which directed the instrument into an
account different from the named payee. The court in Society National
stated:
The issue is whether his act of preparing a deposit slip
on behalf of [company 2] instructing payment of the
check in a manner contrary to the indorsement he had
previously made on behalf of [company 1] was an act
sufficient to accomplish a modification of that
indorsement. We find no statutory authority for the
proposition that a depositary bank may disregard a
restrictive indorsement based on the content of a deposit
slip which is facially inconsistent with that restrictive
indorsement. On the contrary, the law compels the
opposite conclusion. A deposit slip, which is neither
attached to nor incorporated into the check itself, does
not constitute an allonge, nor can a writing contained on
a deposit slip serve as a restrictive indorsement, or a
modification of a restrictive indorsement.97
The deposit slip in Society National was an insufficient basis for
the depositary bank’s failure to honor the restrictive indorsement. In that
regard, it is no more compelling to allow a depositary bank to disregard a
restrictive indorsement based on the content and writing on an ATM
deposit envelope. Remote ATM banks typically inspect indorsements
and further indorse the instrument before sending it through a chain of
collecting banks back to the drawee/payor bank for payment from the
issuer’s account. A depositary bank that honors anything but the
restrictive indorsement does so at its own risk for conversion.
VII.
THE INAPPLICABILITY OF ARTICLE 3 AFFIRMATIVE
DEFENSES TO § 3-206
Pan American asserted as affirmative defenses Interior Crafts’
comparative negligence under section 3-405 (Employer’s Responsibility
97
Id.
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for Fraudulent Indorsement by Employee),98 and under section 3-406
(Negligence Contributing to Forged Signature or Alteration of
Instrument).99
When applicable, these sections arguably offer
protections to the depositary bank from strict liability for conversion
under section 3-420 (Conversion of Instruments).100 These affirmative
defenses substitute a “comparative fault” analysis for strict liability,
which focuses on the conduct of the depositary bank and that of the
employer, whether that conduct was negligent and the extent to which
any negligent conduct by both parties contributed to the loss.
As stated by the Court in Interior Crafts, sections 3-405 and
3-406, while relieving the depositary bank’s strict liability under section
3-420 for paying over the forged indorsement, do not relieve the
depositary bank’s strict liability under section 3-206 for simply failing to
honor the restrictive indorsement.101
Section 3-420, Conversion of Instruments, provides in pertinent
part:
The law applicable to conversion of personal property
applies to instruments. An instrument is also converted
if it is taken by transfer, other than negotiation, from a
person not entitled to enforce the instrument or a bank
makes or obtains payment with respect to the instrument
for a person not entitled to enforce the instrument or
receive payment . . . . A representative, other than a
depositary bank, who has in good faith dealt with an
instrument or its proceeds on behalf of one who was not
the person entitled to enforce the instrument is not liable
98
UCC § 3-405(a).
Id. § 3-406.
100
Id. § 3-420.
101
Interior Crafts, 853 N.E. 2d at 1249 (“The affirmative defense of
comparative negligence is available where the indorsement is forged, not as in
the instant matter, where the depository bank simply fails to honor the restrictive
indorsement.”).
99
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in conversion to that person beyond the amount of any
proceeds that it has not paid out.102
This language imposes liability for conversion on a depositary
bank that pays an instrument over a forged indorsement unless either
section 3-405 or section 3-406 applies. Section 3-405 (Employer’s
Responsibility for Fraudulent Indorsement by Employee), provides in
pertinent part:
For the purpose of determining the rights and liabilities
of a person who, in good faith, pays an instrument or
takes it for value or for collection, if an employer
entrusted an employee with responsibility with respect to
the instrument and the employee or a person acting in
concert with the employee makes a fraudulent
indorsement of the instrument, the indorsement is
effective as the indorsement of the person to whom the
instrument is payable if it is made in the name of that
person.103
If the indorsement is effective as the indorsement of the person
to whom the instrument is payable, i.e. the employer/payee, then the
instrument may be enforced by anyone who comes into its possession,
including the employee/forger, and the depositary bank is not strictly
liable for conversion under section 3-420. The funds paid by the
depositary bank, however, are still not “received by the indorser or
applied consistent with the indorsement”104 when it is wire transferred to
the forger’s and not the employer’s account, and conversion liability
exists under section 3-206.105 The language of section 3-405(b), making
the forged indorsement effective as the indorsement of the payee, does
not mollify the depositary bank’s obligations to honor a restrictive
indorsement as required by section 3-206.
102
UCC § 3-420(a) & (c).
Id. § 3-405(a).
104
Id. § 3-206(c)(2).
105
Id. §§ 3-206 (c)(2) & 3-405(a).
103
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We draw a similar conclusion coming from a different direction
under section 3-406 (Negligence Contributing to Forged Signature or
Alteration). Section 3-406 provides in pertinent part:
A person whose failure to exercise ordinary care
substantially contributes to . . . the making of a forged
signature on an instrument is precluded from asserting
the . . . forgery against a person who, in good faith, pays
the instrument or takes it for value or collection.106
If the person asserting the preclusion fails to
exercise ordinary care in paying or taking the instrument
and that failure substantially contributes to loss, the loss
is allocated between the person precluded and the person
asserting the preclusion according to the extent to which
the failure of each to exercise ordinary care contributed
to the loss.107
If applicable, section 3-406 would preclude the employer/payee,
who fails to exercise ordinary care, from asserting the forgery against a
depositary bank who in good faith paid the instrument. Or, at a
minimum, liability would be allocated based on the extent each party’s
failure to exercise ordinary care contributed to the loss. It would
therefore avert the bank’s strict liability for conversion under section
3-420 for paying the instrument to the forger.
The preclusion is asserting the forgery against a bank exercising
ordinary care which pays on an instrument in good faith, and is not in
place to assert a bank’s failure to honor a restrictive indorsement. The
protection provided by section 3-406—the preclusion to assert the
forgery based, in part, on the payee’s failure to exercise ordinary care—
does not allow a depositary bank to escape conversion liability under
section 3-206. A forgery is fundamentally different from a restrictive
indorsement in that a depositary bank can honor a restrictive indorsement
under any circumstances regardless of a scheme to defraud. In the
context of restrictive indorsements, the depositary bank is hard pressed to
acknowledge anyone as the indorser other than the named payee without
106
107
Id. § 3-406(a).
Id. § 3-406(b).
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violating its obligation of good faith required under sections 3-405 and
3-406. “[T]he beneficiary of a depositary bank’s duty to make that
inquiry [that the check proceeds are applied consistently with a
restrictive indorsement] is any party harmed by the bank’s failure to do
so.”108 Common sense dictates that section 3-206 was not adopted to
protect the dishonest employee applying the restrictive indorsement nor
as a shield for a depositary bank that fails to honor the restrictive
indorsement.
Under this factual scenario, the depositary ATM bank will likely
pursue an affirmative defense based on the definition of “ordinary care”
under section 3-103(a)(9), which provides:
Ordinary care in the case of a person engaged in
business means observance of reasonable commercial
standards, prevailing in the area in which the person is
located, with respect to the business in which the person
is engaged. In the case of a bank that takes an
instrument for processing for collection or payment by
automated means, reasonable commercial standards do
not require the bank to examine the instrument if the
failure to examine the instrument does not violate the
bank’s prescribed procedures and the bank’s procedures
do not vary unreasonably from general banking usage
not disapproved by this Article or Article 4.109
It is our opinion that it is not the intent of section 3-103(a)(9) to
act as an affirmative defense to section 3-206 for a depositary bank’s
failure to honor a restrictive indorsement. The definition of ordinary care
is expressly incorporated by reference in a comparative fault analysis
under section 3-405 or section 3-406. As held by the court in Interior
Crafts, both affirmative defenses, however, are inapplicable to section 3206.110 It necessarily follows that the definition of ordinary care is also
inapplicable.
Absent a statutory defense, conversion involves
108
Underpinning & Found. Constructors, Inc. v. Chase Manhattan
Bank, 403 N.Y.S.2d 501, 502 (App. Div. 1978).
109
UCC § 3-103(a)(9).
110
Interior Crafts, 853 N.E.2d at 1249
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intentional, wrongful conduct.111 The UCC definition of ordinary care,
to the extent it supports a bank’s failure to inspect instruments, “when
taking them for processing for collection or payment by automated
means,”112 arguably applies only to payor/drawee banks, and not to
depositary banks.113
The Illinois Appellate Court in Continental Casualty Co. v.
American National Bank,114 addressed the scope of the revised standard
of care for banks processing instruments. In that case, the unfaithful
employee caused his employer to sign nine checks over time, each in the
range of $40,000 to $50,000, made out to the depositary bank, as payee.
The employer was told by its employee that the checks were for payroll
taxes. The employee deposited the checks in separate transactions at an
ATM of the depositary bank, with deposit slip instructions to deposit the
checks to the employee’s personal account at the depositary bank. The
depositary bank was not owed any payment from the employer and
deposited the checks, pursuant to the employee/depositor’s instruction, in
the employee’s account. When the fraud surfaced, the employer sued the
depositary bank for breach of contract and an implied duty of ordinary
care. The complaint was dismissed for legal insufficiency and the
employer appealed.
The appellate court reversed and remanded the case, concluding
that the employer had stated a cause of action for breach of contract
against the bank.115 The court concluded that the allegations of the
complaint, if proven, constituted bank negligence as a matter of law.
The court reasoned that a bank named as payee when it is not owed a
debt by the drawer has a duty to determine the appropriate disposition of
the funds and that on the face of the transaction the diversion to the
111
See, e.g., In re Thebus, 483 N.E.2d 1258 (Ill. 1985); Colonial
Funding, LLC v. Am. Empire Surplus Lines Ins. Co., 719 N.E.2d 1098 (Ill. App.
Ct. 1999).
112
UCC § 3-103(a)(9).
113
See Continental Cas. Co. v. Am. Nat’l Bank &Trust Co. of Chicago,
768 N.E.2d 352 (2002).
114
Id.
115
Continental Cas., 768 N.E.2d at 359.
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employee’s account of employer funds payable to the bank puts the bank
on notice of potential foul play.116
On appeal, the bank argued that its failure to inquire and
examine the checks did not amount to negligence because the
employee/depositor “did not deposit the checks with a human bank teller
who could obtain knowledge in a face-to-face transaction but, rather,
deposited the checks at an ATM, where they were processed by
automated means.” The bank relied on the language in section
3-03(a)(9).117 The court rejected this argument outright, adopting the
conclusion that the new language of section 3-103(a)(9) only applies to
payor banks, stating:
We cannot agree with ANB’s [the bank’s]
argument. Section 3-103(a)(7) does not provide
protection to ANB under the facts in this case, because
this provision of the UCC applies specifically to payor
banks, which under certain circumstances are excused
from visually inspecting the signatures on checks drawn
by their customers. Section 3-103(a)(7) was amended to
protect payor banks from having to visually inspect
drawer signatures, since these banks could fully process
checks by electronic information encoded on a MICR
[magnetic ink character recognition] line and therefore,
no visual inspection was necessary.
....
In the present case, because ANB was the bank
of first deposit rather than the payor bank and because
the alleged breach of contract claim related to the failure
to verify the named payee rather than drawer signatures,
section 3-103(a)(7) does not provide ANB with a
defense in this case. Continental Casualty at 359-60
(relying in part on Clark, note 47, ¶12.05[7], at 12-160
(rev. ed. 1999) (stating that presently, the “automated116
Id.
Note that at the time of the court’s decision the definition of
“ordinary care” was found under § 3-103(a)(7).
117
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processing” defense and the industry wide standard now
codified in the revised UCC protect payor banks in
drawer signature verification cases, but not depositary
banks in ATM deposit cases).
The Continental Casualty case leaves uninterrupted a line of
cases under the original UCC and the revised UCC that have found
depositary banks negligent as a matter of law for choosing as a matter of
procedure to forego inspection of certain types of instruments or all
instruments under certain circumstances.118
VIII.
LIFE AFTER INTERIOR CRAFTS
The fraud scheme in Interior Crafts was, in part, “successful”
because Leparski avoided interaction with a human bank teller. The
restrictive indorsements in the name of the payee sounded no alarms. A
teller who inevitably inspects the instruments after deposit, before
indorsement by the bank, would have no reason to question the
restrictive indorsements on their face. With the money gone, the pivotal
question was which of the banks, if any, in the transactions is the
depositary bank, subject to the duties imposed by Article 3 of the UCC.
Articles 3 and 4 of the UCC govern check fraud cases. The
rationale under the UCC is to place the loss on the party that could most
easily have prevented that loss.119 In Interior Crafts, Pan American, the
remote ATM bank, argued it had no relationship with the depositor.
Marquette Bank, Leparski’s bank, argued it had no relationship with the
deposit or the instrument. Pan American relied upon the federal banking
regulations definition of depositary bank, while Marquette Bank relied
upon the definition found in the UCC. Throughout the litigation, the
respective banks were pointing at each other, denying any culpability or
118
See Mutual Serv. Cas. Ins. Co. v. Elizabeth State Bank, 265 F.3d
601 (7th Cir. 2001); Govoni & Sons Constr. Co. v. Mechanics Bank, 742 N.E.2d
1094, 1104 (Mass. App. Ct. 2001); Medford Irrigation Dist. v. Western Bank,
676 P.2d 329 (Or. Ct. App. 1984); see also Wilder Binding Co. v. Oak Park
Trust & Sav. Bank, 527 N.E.2d 354, 358 (Ill. App. Ct. 1988), rev’d, 552 N.E.2d
783, 788 (Ill. 1990).
119
See Underpinning & Found. Constructors, 386 N.E.2d at 1323.
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denying they were the depositary bank in the transactions. At some
point, the finger pointing had to end.
If and when a depositary bank is identified, that bank will
interpose a number of legally and factually complicated defenses to
liability. By resort to section 3-405 (Employer’s Responsibility for
Fraudulent Indorsement by Employee)120 and section 3-406 (Negligence
Contributing to Forged Signature or Alteration of Instrument),121 the
depositary bank will attempt to focus on the employer’s negligence in the
hiring and supervision of the forger. This defense benefits from 20/20
hindsight and, if allowed, can shift liability back to the employer or, at a
minimum, result in liability sharing under a comparative fault analysis.
In addition, the depositary bank will likely raise a defense based
on the definition of “ordinary care” contained in section 3-103(a)(9)122
and the relaxed standard of care for bank’s processing instruments by
automated means. With the proliferation of ATMs, the check deposit
and collection process has become ever faster and less personal. All
being said, in the end, the groundbreaking ruling in Interior Crafts
identifies the remote ATM as the depositary bank and holds the
depositary bank strictly liable under section 3-206 for failing to honor
restrictive indorsements.123 Moreover, affirmative defenses applicable to
forgery in general do not apply to the failure to honor the restrictive,
although forged, indorsement. The issue facing the depositary bank is
not necessarily whether it has a duty to physically inspect every check
passing through its system, but whether it is prepared to accept the
economic risk if it chooses not to.124 That said, while there is an
economic risk to not employ a system of checks and balances, the
decision ultimately falls to the banks based on industry standards and the
law; however, the bank’s decision should not prejudice an innocent
consumer.
120
UCC § 3-405.
Id. § 3-406.
122
Id. § 3-103(a)(9).
123
Id. § 3-206.
124
Arguably, a bank performs its own cost/benefit analysis when it
determines, among other things, whether to charge ATM fees and how much to
charge, presumably with the intent to cover not only administrative expenses,
but also to reduce the economic risks resulting from fraud.
121
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Where does this leave the depositary bank under our ATM check
fraud scenario? A depositary bank will be strictly liable for taking for
deposit or cash a fraudulent instrument unless the payee is fictitious or an
impostor, unless the payee as an employer negligently authorizes a
faithless employee with respect to the instrument, and unless any other
person’s negligence contributed to a forgery or alteration. In these cases,
the depositary bank avoids strict liability but remains subject to a duty of
ordinary care.125
The depositary bank’s liability differs from that of a
drawee/payor bank. If the depositary bank is not expressly authorized to
process ATM transactions without inspection of the instrument under the
revised UCC’s definition of ordinary care, the depositary bank will be
held to a reasonable community standard of ordinary care. Courts have
tended to take a dim view of depositary banks choosing to forego
inspection in the processing of instruments, often finding them negligent
as a matter of law.126 The essence of the problem is the depositary
bank’s disregard of the restrictive indorsement and allowing the check to
be deposited into the employee’s account. Following the decision by the
Illinois Appellate Court in Interior Crafts, the depositary bank will be
125
See Nat’l Accident Ins. Underwriters, Inc. v. Citibank, F.S.B., 243
F. Supp. 2d 769 (N.D. Ill. 2003) (finding that “strict liability” does not eliminate
all affirmative defenses); Leeds v. Chase Manhattan Bank, N.A., 752 A.2d 332
(N.J. Super. Ct. App. Div. 2000)(finding depository bank was strictly liable to
payees for conversion after customer altered the check to make himself payee as
attorney for payees, reasoning the bank made payment with respect to the
instrument for a person not entitled to enforce the instrument or receive
payment).
126
See Mutual Serv. Cas. Ins. Co. v. Elizabeth State Bank, 265 F.3d
601 (7th Cir. 2001); Govoni & Sons Constr. Co., 742 N.E.2d at 1104; Medford
Irrigation Dist. v. Western Bank, 676 P.2d 329 (Or. Ct. App. 1984)(bank does
not have to adopt particular procedure of review to comply with statutory
mandate, but procedure used must reasonably relate to detection of unauthorized
signatures to be considered an exercise of ordinary care or reasonable
commercial banking standards); see also Wilder Binding Co., 527 N.E.2d at 358
(court recognizing that, while examination of signature cards to determine
genuineness of endorsements may not be entirely practical under modern
banking methods, failure to do so did not relieve banks of risk of loss on forged
checks), rev’d, 552 N.E.2d 783, 788 (Ill. 1990).
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held strictly liable and liable for negligence for failing to honor a
restrictive indorsement.127
127
Interior Crafts, 853 N.E.2d at 1244; see also Underpinning &
Found. Constructors, Inc. v. Chase Manhattan Bank, 403 N.Y.S.2d 501 (App.
Div. 1978), aff’d, 414 N.Y.S.2d 298 (N.Y. 1979); see also Rutherford v.
Darwin, 622 P.2d 245 (N.M. Ct. App. 1980).
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