P AYMENT SYSTEMS
E LECTRONIC C ASEBOOK
C HAPTER 3—CHECKS
SECTIONS 6 AND 7
© 2008 by Steven L. Harris
All rights reserved.
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Quaker and Fraud, Quaker should enjoy the right to enforce Empire’s
obligation on the check.
UCC 3–305(c) permits Empire to defend on this basis—“the other
person’s [Quaker’s] claim to the instrument may be asserted by the obligor
[Empire]”—but only “if the other person [Quaker] is joined in the action and
personally asserts the claim against the person entitled to enforce the
instrument [Fraud].” By ensuring that the adverse claimant (Quaker,
whose claim is adverse to Fraud’s) is a party to any suit in which its rights
are determined, the UCC prevents the relitigation of identical issues in
subsequent actions, such as an action brought by Quaker against Fraud. It
also minimizes the possibility that Fraud might be unjustly enriched if it
recovers from Empire but Quaker does not assert its adverse claim.
Comment 4 to UCC 3–305 suggests a more common scenario in which
an obligor on an negotiable instrument might assert jus tertii (the rights
of a third person): When the person entitled to enforce a cashier’s check has
acquired it by defrauding the payee.
S ECTION 6. D EPOSITARY B ANK’S D UTIES WITH R ESPECT TO
D EPOSITED C HECKS
Like the payor bank, the depositary bank plays a central role in the
check-collection process. The process begins when a check is delivered to the
depositary bank. It ends when the depositary bank makes the funds
represented by the check available for “withdrawal as of right.” See UCC
4–201(a)(2). This Section examines the depositary bank’s role in both
settings.
(A) D UTIES ON F ORWARD C OLLECTION
1. DUTY TO APPLY FUNDS PROPERLY
Problem 2.6.1. What result in Problem 2.5.5 if, after indorsing the
Empire check “For deposit only, Quaker Manufacturing Co.,” Quaker
deposited the check with PNC Bank and withdrew $20,000 of the
provisional credit? See UCC 3–206(c), (e).
Problem 2.6.2. Quaker indorsed the Empire check “For deposit only,
Quaker Manufacturing Co.” Before it was deposited in PNC Bank, the check
was stolen by a thief, who deposited it in the thief’s own account with PNC.
PNC then sent the check to Citibank, which obtained payment from The
Bank of New York, and the $22,178.50 ultimately was withdrawn by the
thief. What rights has Quaker against PNC, Citibank, and The Bank of New
York? See UCC 3–206; UCC 3–420. What advantages, if any, does this
indorsement have over “Quaker Manufacturing Co.”? Over “To PNC Bank,
DEPOSITARY BANK'S DUTIES
Quaker Manufacturing Co.”?
NOTE ON RESTRICTIVE INDORSEMENTS
The holder of a check who deposits it for collection often uses the kind
of restrictive indorsement described in UCC 3–206(c)—an indorsement
“using the words ‘for deposit,’ ‘for collection,’ or other words indicating a
purpose of having the instrument collected by a bank.” (The other kinds of
restrictive indorsem ents dealt with in UCC 3–206 are not of great practical
importance.)
Prior to the UCC there was a substantial body of authority for the view
that if a depositor restrictively indorsed a check, the depositary bank could
not become a holder in due course of it. UCC 3–206(e) rejects this approach.
With respect to indorsements by collecting banks, Regulation CC
abandons the UCC’s lackadaisical attitude and imposes strict indorsement
standards. These standards are designed to facilitate easy identification of
the depositary bank and thus the rapid return of checks. The standards
apply to all banks except the payor bank. Appendix D to the Regulation
prescribes the content and location of indorsements.
Prior to Reg CC, banks forwarding checks for collection added language
such as “pay any bank” to their indorsements. This made the indorsement
restrictive so that only a bank could acquire the rights of a holder. See UCC
4–201(b). Reg CC 229.35(c) provides for the same result after indorsement
by a bank, without the need to add any language. In fact, Appendix D to Reg
CC prohibits collecting banks other than the depositary bank, as well as
returning banks, from using a restrictive indorsement of any kind.
2. DUTY TO EXERCISE ORDINARY CARE IN COLLECTING
See Problem 2.5.1, supra.
3. DUTY TO ENCODE CORRECTLY
Problem 2.6.3. PNC Bank mistakenly encodes the Empire check as a
$32,178.50 check, and it is paid in that amount by The Bank of New York.
Shortly thereafter, The Bank of New York dishonors several other checks
drawn by Empire which would have been honored had the mistaken
overpayment not been made. What are the rights of Empire and The Bank
of New York? See Reg CC 229.34(c)(3), (c)(4), (e); UCC 4–209 and Comment
2.
NOTES ON THE DUTY TO ENCODE
As the Prototype transaction explains, a depositary bank normally
encodes the amount of each check in a “field” on the right hand side of the
MICR line. In some cases, the encoding is done by the payee. From the time
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of the encoding forward, every bank that handles the check normally relies
only on the encoded amount. It is easy to imagine a payor bank suffering a
loss as a result of a mis-encoding. (Just look at Problem 2.6.3.)
Regulation CC addresses the mis-encoding problem by creating an
implied warranty that “the information encoded after issue in magnetic ink
on the check . . . is correct.” Reg CC 229.34(c)(3). UCC 4–209(a) creates a
similar warranty. Note, however, that the damages available under Reg CC
for breach of warranty are limited in a way that those under UCC 4–209(c)
are not. Does Reg CC supersede the UCC in this instance? See Reg CC
229.41.
(B) D UTY TO M AKE F UNDS A VAILABLE
As discussed above, the main purpose of the Expedited Funds
Availability Act of 1987 (“EFAA”) is to reduce the hold periods imposed by
depositary banks so that bank customers will have relatively rapid access
to deposited funds. Regulation CC does this directly, by requiring a
depositary bank to make funds available for withdrawal not later than the
times specified in Reg CC 229.10 and 229.12. Reg CC 229.13 provides
exceptions to the mandatory availability times.
Problem 2.6.4. In the Prototype transaction, Quaker deposited the
Empire check on Tuesday, January 26. On Friday, January 29, after The
Bank of New York paid the Empire check, a $12,000 check drawn by Quaker
is presented to PNC Bank for payment. Quaker has in its account, exclusive
of the $22,178.50 credit from the Empire check, only $10,000. PNC Bank
dishonors the $15,000 check and returns it to the payee with a return item
ticket marked “uncollected funds.”
(a) Can Quaker recover from PNC Bank for wrongful dishonor? See Reg
CC 229.13(b), (h).
(b) What result if the amount of the Empire check were only $2,178.50?
Is the Empire check a “local check” or a “nonlocal check”? See Reg CC
229.12; Reg CC 229.21; Reg CC 229.2 (definitions).
Problem 2.6.5. Terry Troy moved from New York to San Francisco.
Troy’s new bank in San Franciso told Terry that it would impose a 15–day
hold on any check deposited in the account during the first 30 days. On the
31st day after Troy opened the account, Troy deposited three checks in the
account: a $4,900 check drawn on Troy’s account at The Bank of New York
New York, a $3,000 check payable to Troy and drawn on the Small Deal
Bank in Frostbite Falls, Minnesota, and a $4,000 check payable to Troy and
drawn by the City of San Diego on The Bank of New York in New York.
(a) What funds must be made available to Troy and at what times? See
Reg CC 229.10; Reg CC 229.12; Reg CC 229.13; Reg CC 229.21; Reg CC
229.2 (definitions).
(b) Suppose the officer who opened the account for Troy is persuaded
DEPOSITARY BANK'S DUTIES
that Troy is a crook. When you ask why, you are told that Troy’s hair is dyed
orange and Troy’s hands were very sweaty when filling out the deposit
agreement. May the bank delay availability on Troy’s three checks? If so, for
how long?
(c) Is the length of time allowed before funds must be made available too
long, too short, or just right?
(d) What is the rationale for the exceptions to the schedule in Reg CC
229.10 and Reg CC 229.13? To what extent does that rationale make sense
in each case?
NOTES ON FUNDS AVAILABILITY UNDER REGULATION CC
(1) The Funds-Availability Problem. The practice of extended hold
periods imposed disadvantages on customers. The first disadvantage is lost
liquidity: While the depositary bank is protecting itself against fraud, the
customer is denied access to the deposited funds. Anyone who has moved to
another city, innocently deposited a personal check in a new account, and
then been compelled to live for the next two weeks in penury will appreciate
the nature of the problem. The second disadvantage is lost interest: While
the bank is lending the credit it received for the customer’s check, it may be
delaying interest payments to the customer on the ground that the
customer’s credit is not final.
Given these disadvantages, one might wonder why customers did not
insist on greater funds availability, and why banks did not compete with
each other by providing it. In fact, this is precisely what occurred for
business customers. Virtually all large businesses, and a number of smaller
ones, have money managers who sweep funds in and out of various accounts
on a daily basis to maximize interest income while maintaining the required
level of liquidity. Banks compete for commercial accounts by offering
competitive terms. Generally speaking, there is no indication that
businesses are at any disadvantage in dealing with banks about these
matters.
The funds-availability problem arose, as might be expected, where
individual consumers are involved. Very few consumers have their own
money managers (those who do are probably not entitled to be called
consumers), and only a few more have the expertise to manage their own
funds as a business does. The vast majority are ignorant about the issue.
They do not know whether their respective banks allow interest to accrue
from the time of provisional credit or rather postpone the accrual of interest
until final payment. Similarly, they are not aware of hold policies until
confronted with an immediate problem of liquidity. They are thus incapable
of evaluating differential bank performance, which gives banks no incentive
to compete or otherwise make concessions to consumer desires. This
phenomenon, of course, is known as a market failure—in this case the
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failure of otherwise competing banks to create a competitive market for
funds-availability services.
(2) The Congressional Solution. During the hearings on the
Expedited Funds Availability Act, the Federal Reserve Board urged
Congress not to impose time limits on availability and instead to speed up
the collection process and leave regulation of availability to state law.
“Unlike disclosures and improvements to the payments system, such as a
return item sharpening, which require uniformity from State to State to be
effective, mandatory schedules may be, or may complicate a localized
problem that can be dealt with at the State level . . . .” The Expeditied
Funds Availability Act, Hearings Before the Subcommittee on Financial
Institutions Supervision, Regulation and Insurance, of the House
Committee on Banking, Finance and Urban Affairs, 99th Cong., 1st Sess.
212–13 (1985) (statement of Preston Martin, Governor, FRB).
Others have proffered an alternative solution, suggesting that banks be
free to determine both the length of the hold period and the manner of
collection but be required to pay interest from the date of deposit at a rate
that is greater than the bank’s cost of funds. Under these circumstances a
bank arguably would have no incentive to delay availability, unless it
thought there was a real problem with the collectibility of a check.
Would either of these approaches have been preferable to the one
Congress adopted?
(3) Have the Maxim um Periods Become the Minimum? At the
Congressional hearings on Reg CC, Board Governor Martin also expressed
concern that “mandatory availability schedules will become the industry
standard, and that those institutions that have better availability will adopt
the specified schedule.” Id. A recent report by the Fed suggests that, at least
over the long run, the maximum hold periods have not become the
minimums. Data from a March 2006 survey indicate that “banks provided
prompter availability than required by the EFAA on about 90 percent of all
consumer deposits of local and nonlocal checks and half of all deposits of
next-day checks.” Board of Governors of the Federal Reserve System, Report
to the Congress on the Check Clearing for the 21st Century Act of 2003 at
3 (April 2007) (“Check 21 Report”).
(4) Shortening the Maximums. The EFTA requires the Fed, by
regulation, to reduce the maximum hold periods for local and nonlocal
checks “to as short a time as possible and equal to the period of time
achievable under the improved check clearing system for a receiving
depository institution to reasonably expect to learn of the nonpayment of
most items for each category of checks.” 12 U.S.C.A. § 4002(d)(1). A
Congressional report accompanying the EFAA suggested, “For example, if
the new system makes it possible for two-thirds of the items of a category of
checks to meet this test in a shorter period of time, then the Federal Reserve
must shorten the schedules accordingly.” Conference Report on H.R. 27 (H.
RECOVERY OF PAYMENTS MADE BY MISTAKE
Rept. 100-261), 100th Congress, 1st session, 179 (1987), pp. H6906-7. A
recent study shows that unpaid checks are not returned to depositary banks
soon enough to meet this benchmark. Check 21 Report, supra, at 2.
(5) Which Checks Are Local? One major determinant of the time
when funds must be made available is whether the check is a “local check”
or a “nonlocal check” as defined in the EFTA and Reg CC 229.2. This, in
turn, depends on whether the payor bank and depositary bank are located
in the same Federal Reserve check-processing region. See Reg CC 229.2(r)
(defining “local paying bank”). In February 2003, the Federal Reserve Banks
announced an initiative to reduce the number of locations at which they
process checks from 45 to 32. They announced four further rounds of
restructurings that will reduce the number of full-service check-processing
locations to four by early 2011. The consolidation of check-processing offices
has reduced the percentage of checks considered nonlocal. The Federal
Reserve Board estimates that by early 2008, about 73 percent of all checks
processed by the Reserve Banks could be classified as “local” or “next-day”
for funds-availability purposes. This percentage will continue to increase as
the Reserve Banks further consolidate their check-processing offices.
S ECTION 7. R ECOVERY OF P AYMENTS M ADE BY M ISTAKE
(A) G ENERAL R ULES
Payor banks make mistakes. Sometimes they pay checks that are not
properly payable because the drawer has not authorized the payment.
Examples of an unauthorized payment include a check as to which the
drawer has issued an effective stop-payment order, a check that bears a
forged drawer’s signature, and a check that is paid to a person other than
the person entitled to enforce the instrument (including a check that bears
a forged payee’s indorsement). Generally speaking, a bank that pays a check
that is not properly payable may not charge its customer’s account. See UCC
4–401(a); Section 2, supra. To avoid a loss, the payor bank must seek to
recover the payment from the recipient.
Checks drawn on insufficient funds present another situation in which
a payor bank may pay a check by mistake and seek to recover the payment
from the recipient. Note, however, that not every payment creating an
overdraft is made by mistake. Banks often make a deliberate decision to pay
an overdraft. Indeed, banks frequently offer “overdraft protection,” i.e., they
agree to pay overdrafts, in exchange for the customer’s promise to pay a fee
for the service. As we have seen supra, Section 2, a check that is drawn on
insufficient funds nevertheless may be properly payable. If so, it is
chargeable to the customer’s account, regardless of whether the payor bank
pays it intentionally or by mistake. See UCC 4–401(a). As a practical
matter, such a charge to the customer’s account amounts to little more than
a bookkeeping entry reflecting the customer’s obligation to repay the bank.
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In most cases the customer repays the overdraft voluntarily, or the bank
sets off against subsequent deposits. If it is unable to collect in one of these
ways, the payor bank will need to sue its customer to recover the amount of
the overdraft. A person who draws checks on insufficient funds and fails to
cover the overdraft is not a promising defendant. For this reason, a payor
bank that pays an NSF check may seek to recover the funds from the
recipient of the payment.
UCC 3–418 contains special rules applicable to mistaken payments of
negotiable instruments. In Chapter 1, Section 2(C), we considered the
application of these rules to payment of a negotiable note. Do these rules
apply as well to checks for which “final payment” has occurred under UCC
4–215(a)? They certainly do. As Comment 4 to UCC 3–418 explains, “The
right of the drawee to recover a payment . . . under Section 3–418 is not
affected by the rules under Article 4 that determine when an item is paid.
Even though a payor bank may have paid an item under Section 4–215, it
may have a right to recover the payment under Section 3–418.”
UCC 3–418(b) generally allows a person who pays an instrument by
mistake to recover the payment from the person to whom it was made, “to
the extent permitted by the law governing mistake and restitution.” The law
governing mistake an restitution may afford the recipient a defense against
recovery. Regardless of the defenses available under other law, UCC
3–418(c) provides that the right to recover a mistaken payment may not be
asserted against a person who (i) took the instrument in good faith and for
value or (ii) in good faith changed position in reliance on the payment.
(B) R ECOVERY OF P AYMENT M ADE OVER S TOP O RDER
What is the legal position of a payor bank that overlooks its customer’s
stop-payment order and pays the check by mistake? To put the issue in the
context in which it arises, we first consider the scope of a customer’s right
to countermand the check and obligate the bank to stop payment. We then
turn to the rights of a payor bank that pays a check in violation of an
effective order to stop payment.
Problem 2.7.1. The Bank of New York received a telephone call from
Quaker’s accounts-receivable clerk. Quaker’s clerk told the bank that the
Empire check somehow “went missing”—maybe it was stolen, but probably
it was lost—and directed the bank to stop payment. How should The Bank
of New York respond? See UCC 4–403(a) & Comment 2.
Problem 2.7.2. Empire discovered that the goods delivered by Quaker
did not conform to the contract. Empire’s treasurer, Kim Kaller,
immediately telephoned The Bank of New York and told the bank’s clerk to
stop payment of the Empire check. Kaller gave the clerk Empire’s account
number, the correct amount of the check, but the wrong check number.
RECOVERY OF PAYMENTS MADE BY MISTAKE
(a) The Bank of New York paid the check because its computer, which
was programmed to find checks according to the account and check number,
did not reject it. Empire argues that The Bank of New York was obligated
to dishonor it. Is Empire correct? What additional information might be
relevant? See UCC 4–403(a) & Comment 5.
(b) Assume instead that The Bank of New York’s computer rejected the
check and that the bank properly dishonored it and returned it to PNC
Bank, which properly charged back against Quaker’s account and returned
the check to Quaker. Quaker insists that the goods conform in every respect
to the contract for sale. Advise Quaker. See UCC 3–310(b)(1), (b)(3); UCC
3–414(b).
NOTES ON THE RIGHT TO STOP PAYMENT
(1) The Right to Stop Payment. The inevitable delay between the
issuance of a check and its presentment for payment, coupled with the legal
rule that a check does not of itself operate as an assignment (UCC 3–408),
gives rise to the possibility that a drawer might countermand its order to
the drawee, i.e., that the drawer might order the drawee to stop payment on
the check. The successful exercise of this right may give considerable
leverage to the drawer. For example, having prevented paym ent rather than
having paid, a drawer who issues a check in exchange for the delivery of
goods and then discovers that the goods do not conform to the contract is in
a much stronger position to assert its claim for breach of warranty. Suppose,
however, that the seller is fully entitled to be paid. Enabling the drawer to
stop payment gives the drawer an advantage that some might consider
undeserved.
Comment 1 to UCC 4–403 expresses great support for the right to stop
payment. “The position taken by [UCC 4–403] is that stopping payment . . .
is a service which depositors expect and are entitled to receive from banks
notwithstanding its difficulty, inconvenience, and expense. The inevitable
losses through failure to stop . . . should be borne by the banks as a cost of
the business of banking.” Does the Comment suggest that the UCC prohibits
a bank from charging its customers a fee to stop payment?
As you work through these materials, consider the extent to which
banks actually bear the losses arising from a failure to stop payment.
(2) Effectiveness of Stop-Payment Orders and Automation. To be
effective the stop order must, of course, sufficiently identify the check.
Banks typically handle stop-payment orders by having the computer reject
all checks of the amount of the stopped check until the stopped check is
selected manually from among those rejected. Would the payor bank be
responsible if the computer failed to reject a stopped check for $4,999.99
because the stop-payment order had incorrectly described it as a check for
$4,999.98? In a case decided more than 25 years ago, the court said that the
payor bank “made a choice when it elected to employ a technique which
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searched for stopped checks by amount alone. . . . A bank’s decision to
reduce operating costs by using a system which increases the risk that
checks as to which there is an outstanding stop payment order will be paid
invites liability when such items are paid. An error of fifty cents [“$1,844.48”
for a $1,844.98 check] in the amount of a stop payment order does not
deprive the bank of a reasonable opportunity to act on the order.” FJS
Electronics v. Fidelity Bank, 288 Pa. Super. 138, 431 A.2d 326 (1981).
FJS Electronics was decided under F4–403(1), which required a stop
order to be received “in such manner as to afford the bank a reasonable
opportunity to act on it.” In contrast, UCC 4–403 adds the requirement that
a stop-payment order “describ[e] the item . . . with reasonable certainty.”
Comment 5 explains: “In describing the item, the customer, in the absence
of a contrary agreement, must meet the standard of what information allows
the bank under the technology then existing to identify the item with
reasonable certainty.” Should FJS Electronics be decided differently under
Comment 5? Does the answer depend on the technology that the bank
actually has (e.g., that enables the bank to program its computer to stop
checks that have a stated amount)? Suppose the bank could have purchased
technology that would enable it to all stop checks having an amount within
a range but decided against purchasing it?
In FJS Electronics the bank’s notice confirming the stop-payment order
said “PLEASE ENSURE AMOUNT IS CORRECT.” Would it be to a bank’s
advantage to be explain the importance of providing the correct amount
before a stop order is given? Would a court give effect to the following clause
if it were in the bank’s deposit agreement with its customers:
The bank is not responsible for payment over a stop-payment order
unless the order gives your account number and the number and
exact amount of the check. Otherwise our computer may not be able
to execute your order.
See UCC 4–103(a) and Comment 1 to UCC 4–403.
Stop-payment orders often are given orally, but their period of
effectiveness is limited to 14 days unless they are confirmed in a record
within that period. See UCC 4–403(b). Suppose the clerk who takes an oral
stop order asks the customer for the amount and the customer responds, “I
think it’s around $435.40.” If the bank stops only checks having the exact
amount provided and the clerk doesn’t inform the customer, has the bank
waived its right to claim that the description of the check was not
reasonably certain?
Problem 2.7.3. The Empire check is presented to The Bank of New
York on Wednesday morning. At noon on Thursday the bank receives a
proper stop-payment order from Empire. The bank has fixed a cutoff hour
of 11 a.m. under UCC 4–303(a)(5). Advise The Bank of New York as to its
legal position if it:
RECOVERY OF PAYMENTS MADE BY MISTAKE
a) ignores the stop-payment order and takes no further action with
respect to the check;
(b) promptly reverses the steps that it has just taken, stamps the check
“cancelled in error” and returns it through The Clearing House to Citibank
with a return item stamp with “payment stopped” checked; or
(c) waits until Friday and then takes the steps described in (b).
Problem 2.7.4. Would your advice in the preceding Problem be different
if The Bank of New York had not received the check until 3 p.m. on
Wednesday and had fixed a cutoff hour of 2 p.m. under UCC 4–108?
NOTE ON WHEN A STOP-PAYMENT ORDER COMES TOO LATE
UCC 4–303 fixes the time at which a stop-payment order “comes too
late” to terminate the payor bank’s right to charge its customer’s account for
the check. After one of the events listed in UCC 4–303 occurs, the payor
bank is free to ignore the stop-payment order and pay the check. (Although
we are concerned only with stop-payment orders, UCC 4–303 applies not
only to stop-payment orders but to all of what are known as the “four
legals.” 1 )
By definition, payment of a check cannot be stopped after final payment
has occurred under UCC 4–215 or the payor bank has become accountable
for the amount of the item under UCC 4–302. See UCC 4–303(a)(2), (3), (4).
A stop-payment order also comes too late if the bank has accepted or
certified the check and thus become obligated to pay it. See UCC
4–303(a)(1).
We saw in Section 3 that a payor bank generally has until its midnight
deadline to decide whether to dishonor a check. During that time the bank
can make sure that the customer has not stopped payment on the check. A
payor bank, however, usually processes incoming checks by computer well
before its midnight deadline. Having done so, the bank may not always find
it convenient to reverse the process and stop payment on an individual
check, even if the time for returning the check under UCC 4–301 has not
expired. To accommodate this practice, UCC 4–303(a)(5) permits a bank to
set “a cutoff hour no earlier than one hour after the opening of the next
banking day after the banking day on which the bank received the check.”
1. ”Bankers call the matters handled by section 4–303(1) [revised as UCC
4–303(a)] ‘the four legals’ because four legal questions are answered by determining the
exact point of time at which the drawer loses control of the funds against which he has
drawn his checks: (1) If the drawee (payor) bank becomes insolvent, who takes the loss,
the drawer of the check or its holder?; (2) At what point does the drawer lose his right to
stop payment?; (3) For how long may creditors attach the funds against which a check
is drawn?; and (4) For how long may the bank set off against the drawer’s account the
various claims it holds against him?” 1 W. Hawkland, A Transactional Guide to the
Uniform Commercial Code 399 (1964).
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After that hour, a stop-payment order comes too late.
Do UCC 4–303 and UCC 4–215 create a period during which a payor
bank has discretion either to honor or to ignore a stop-payment order? If so,
is this undesirable? Is UCC 1–304 relevant?
Problem 2.7.5. Before the Empire check has been presented to The
Bank of New York, Empire offers to return the cans to Quaker and stops
payment on the check, in the belief that they are defective and that it is
entitled to refuse to pay for them. The Bank of New York mislays the
stop-paym ent order, pays the check, and charges Empire’s account.
(a) What are the rights of The Bank of New York, Empire and Quaker?
Does it make any difference whether Empire is correct in its belief? See
UCC 4–403; UCC 4–407.
(b) Would it make any difference if the stop-payment-order form
contained the following clause:
Should you pay this check through inadvertence or oversight, it is
expressly understood that you will in no way be held responsible.
Problem 2.7.6. Suppose, in Problem 2.7.5(a), that Empire insists that
the cans are defective and Quaker insists that they are not. Before The
Bank of New York has a chance to investigate, a second check drawn by
Empire is presented for payment. Empire’s balance is insufficient to pay the
second check, but the balance would be sufficient if the $22,178.50 check
payable to Quaker had not been charged to Empire’s account. Advise The
Bank of New York whether to pay the second check. See UCC 4–403; UCC
1–201(b)(8); UCC 4–407; Siegel v. New England Merchants National Bank,
infra; Notes on Payment in Violation of a Stop Order, infra.
The following case, which was decided under the pre-1990 version of
Article 4, concerns payment of a postdated check (i.e., a check that bears a
date later than the date on which it is written). The substantive rules
governing postdated checks have changed since the opinion was written, see
UCC 4–401(c), but they are not our concern here. Rather, our focus is on the
court’s analysis of UCC 4–403 and UCC 4–407.
Siegel v. New England Merchants National Bank*
Supreme Judicial Court of Massachusetts, 1982.
386 Mass. 672, 437 N.E.2d 218.
O H ENNESSEY, Chief Justice.
We are called upon to define the respective rights of a bank and its
*.
[The court’s citations are to the applicable pre–1990 version of the UCC.]
RECOVERY OF PAYMENTS MADE BY MISTAKE
depositor when the bank has paid a post-dated check before maturity and
deducted the amount of the check from the depositor’s account. Applying the
Uniform Commercial Code, we conclude that the bank must recredit the
depositor’s account, but may then assert against the depositor any rights
acquired by prior holders on either the instrument or the transaction from
which it arose. In the course of this opinion, we shall describe the parties’
responsibilities of proof with respect to the bank’s subrogation claim. We
remand for a further hearing on the question of subrogation. . . .
The plaintiff’s decedent, David Siegel, maintained a checking account
with the defendant, New England M erchants National Bank. On September
14, 1973, Siegel drew and delivered a $20,000 check to Peter Peters,
post-dated November 14, 1973. Peters immediately deposited the check in
his own bank, which forwarded it for collection. The defendant bank
overlooked the date on the check, and, on September 17, paid the item and
charged it against Siegel’s account. Siegel discovered the error in late
September when another of his checks was returned for insufficient funds.
He informed the bank that the check to Peters was post-dated November 14,
and asked the bank to stop payment of the check. Later, he requested that
the bank return the $20,000 to him.
When the bank refused to restore the $20,000, Siegel brought this action
for wrongful debit of his account. The bank denied liability, raised defenses
of waiver, estoppel, and ratification, and filed counterclaims asserting rights
on the instrument and rights of subrogation. . . . The bank also impleaded
Peters, the payee . . . .
After a trial, jury-waived, the judge found that the check was post-dated
by agreement between Peters and Siegel, without fraudulent purpose, and
that Siegel had acted with reasonable speed to inform the bank of the error.
He also found that Peters had paid no money to Siegel since receiving the
check. The judge ruled that (1) the check was a negotiable instrument; (2)
the check was not payable until November 14; (3) the bank was negligent in
paying it before that date; (4) the bank had no right to debit Siegel’s
account; (5) Siegel had not waived his rights or ratified the bank’s action
and was not estopped from demanding the $20,000; and (6) the wrongful
debit caused Siegel a loss of $20,000. He also rejected the bank’s
counterclaims as having no merit. He then entered judgments for Siegel
against the bank in the amount of $20,000, for Siegel on the bank’s
counterclaims, and for the bank against Peters for $20,000. The bank
appealed, and we transferred the case to this court on our own motion. We
vacate the judgment and remand the case for further consideration of the
bank’s subrogation claims.
1. Wrongful Debit and Subrogation.
The parties agree that the bank should not have paid the check when
Peters presented it on September 14, and had no right at that time to charge
it against Siegel’s account. G.L. c. 106, §§ 3–114, 4–401(1). [This result no
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longer obtains. See UCC 4–401(c).] Their differences center instead on
whether the bank’s wrongful action caused Siegel any loss, so as to entitle
him to damages. Siegel contends, and the judge ruled, that his loss must be
$20,000 because that amount was debited from his account. The bank
contends that there was no loss, because Siegel drew the check with the
intention that it eventually be paid, and the bank could rightfully have
charged it against his account on November 14. We believe that the drafters
of the code anticipated disputes such as this, and provided a logical system
for their resolution.
We begin with G.L. c. 106, § 4–401(1), which governs bookkeeping
between depositor and bank. A bank may charge any “properly payable”
item against its depositor’s account. Implicitly, the bank may not charge
items, such as post-dated checks, that are not properly payable. If the
charge is unauthorized, it follows that the depositor has a valid claim to the
amount of the charge by virtue of the account itself. Cf. Stone & Webster
Eng’r Corp. v. First Nat’l Bank & Trust Co., 345 Mass. 1, 5, 184 N.E.2d 358
(1962) (relationship of bank and depositor as debtor and creditor).
As the bank points out, the depositor’s realization of this claim may
produce unjust enrichment. Even when an item is not properly payable, due
to prematurity or a stop payment order, the bank’s payment may discharge
a legal obligation of the depositor, or create a right in the depositor’s favor
against the payee. See G.L. c. 106, §§ 3–601(1)(a), 3–603(1), 3–802(1)(b). If
the depositor were permitted to retain such benefits, and recover the
amount of the check as well, he would profit at the bank’s expense.
Therefore, § 4–407 provides that upon payment, the bank is “subrogated” to
any rights prior holders may have had against the drawer-depositor, on
either the check or the initial underlying transaction, and to any rights the
drawer may have against the payee or other holders. G.L. c. 106, 4–407.5
Thus, the code fixes the rights of the bank and the depositor by a two
part adjustment. The depositor has a claim against the bank for the amount
improperly debited from its account, and the bank has a claim against the
depositor based on to the rights of the payee and other holders. The bank
may assert its subrogation rights defensively when its depositor brings an
action for wrongful debit.
Here, the bank asserted a subrogation claim based on the rights of
Peters, the payee. Neither party, however, introduced evidence concerning
Peters’s rights against Siegel. A question then arises as to what matters
each party was obligated to prove in order to prevail.
5. . . .
At the time a bank asserts subrogation rights, the check will of course have been
paid, and prior holders will have no rights against the drawer. See G.L. c. 106, §§
3–601(1)(a), 3–603(1), 3–802(1)(b). Therefore, we understand § 4–407 to refer to rights
existing prior to the payment.
RECOVERY OF PAYMENTS MADE BY MISTAKE
Section 4–403(3) of the code provides that when the problem is one of
improper payment over a stop order, the “burden of establishing the fact and
amount of loss . . . is on the customer.” G.L. c. 106, § 4–403(3). Here, of
course, the bank’s liability is for premature payment rather than for
payment over a stop order. Nevertheless, these two forms of improper
payment have in common the problem of unjust enrichment, and we believe
that § 4–403(3) is a source of useful analogy.
The rule of § 4–403(3), that a depositor must prove his loss, may at first
seem at odds with our earlier conclusion that § 4–401(1) provides the
depositor with a claim against the bank in the amount of the check, leaving
the bank with recourse through subrogation under § 4–407. See Mitchell v.
Republic Bank & Trust Co., 35 N.C.App. 101, 104, 239 S.E.2d 867 (1978);
Thomas v. Marine Midland Tinkers Nat’l Bank, 86 Misc.2d 284, 288-289,
381 N.Y.S.2d 797 (N.Y.Sup.Ct.1976); J. White & R. Summers, supra at
684–691. We believe, however, that § 4–403(3) was intended to operate
within the process of credit and subrogation established by §§ 4–401(1) and
4–407. See G.L. c. 106, § 4–403, comment 8. When a bank pays an item
improperly, the depositor loses his ability to exercise any right he had to
withhold payment of the check. His “loss,” in other words, is equivalent to
his rights and defenses against the parties to whose rights the bank is
subrogated-the other party to the initial transaction and other holders of the
instrument. Section 4–403(3) simply protects the bank against the need to
prove events familiar to the depositor, and far removed from the bank,
before it can realize its subrogation rights. The depositor, who participated
in the initial transaction, knows whether the payee was entitled to eventual
payment and whether any defenses arose. Therefore, § 4–403(3) requires
that he, rather than the bank, prove these matters. Cf. Knowles v. Gilchrist
Co., 362 Mass. 642, 651-652, 289 N.E.2d 879 (1972) (when goods are
damaged in the hands of a bailee, bailee, who is best informed, must
establish due care).
This view of the three relevant sections of the code suggests a fair
allocation of the burden of proof. The bank, which has departed from
authorized bookkeeping, must acknowledge a credit to the depositor’s
account. It must then assert its subrogation rights, and in doing so must
identify the status of the parties in whose place it claims. If the bank’s
subrogation claims are based on the check, this would entail proof that the
third party subrogor was a holder, or perhaps a holder in due course. This
responsibility falls reasonably upon the bank, because it has received the
check from the most recent holder and is in at least as good a position as the
depositor to trace its history.
The depositor must then prove any facts that might demonstrate a loss.
He must establish defenses good against a holder or holder in due course,
as the case may be. If the initial transaction is at issue, he must prove either
that he did not incur a liability to the other party, or that he has a defense
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to liability. Thus the bank, if it asserts rights based on the transaction, need
not make out a claim on the part of its subrogor against the depositor.
Responsibility in this area rests entirely with the depositor, who
participated in the transaction and is aware of its details. Further, the
depositor must establish any consequential loss.8
A further hearing is necessary to determine the question of subrogation
in the present case. The judge ruled that the check was a negotiable
instrument, and the evidence at trial fairly indicated that Peters was a
holder. Thus the burden, under the rules we have set out, was upon Siegel
to prove a defense good against a holder of the instrument. However, the
trial record makes clear that neither the parties nor the judge was
proceeding with these rules in mind. Indeed, the judge excluded, at the
bank’s strenuous request, evidence offered by Siegel concerning the
transaction between Siegel and Peters. We believe, therefore, that Siegel’s
executrix should have an opportunity to present evidence that Siegel
suffered a loss.
2. Other Claims and Defenses.
Several other arguments offered by the bank to escape or counteract its
liability can be disposed of quickly. First, the bank asserts a claim against
Siegel in its own right, contending that it is a holder in due course of the
check. This argument is without merit because the check has been finally
paid and is not in the bank’s possession.
The bank also argues that the judge erred in rejecting its affirmative
defenses of waiver, estoppel, and ratification. [The court rejects this
argument.]
In sum, Siegel had a valid claim against the bank for premature
payment in the amount of the item paid, but the bank was entitled to assert
the rights of prior holders on the check and on the transaction from which
it arose. We vacate the judgment and remand for a further hearing to
determine those rights. At the hearing, the bank must establish the status
of its subrogor. Siegel’s executrix must establish any defenses to liability on
the instrument as well as the absence of rights or presence of defenses on
the underlying transaction.
So ordered.
8. Several courts have harmonized § 4–403(3) with §§ 4–401(1) and 4–407 in terms
of shifting burdens of production and persuasion. “Simply because a bank pays a check
over a stop payment order does not entitle the customer to recover damages against the
bank, but it does establish a prima facie case for the customer. The bank must present
evidence to show absence of loss, or the right of the payee of the check to receive
payment. Then the customer must sustain the ultimate burden to show why there was
a defense to payment of the item.” Southeast First Nat’l Bank v. Atlantic Telec, Inc., 389
So.2d 1032, 1033 (Fla.Dist.Ct.App.1980). Although our analysis will often have the same
result as that of the cited cases, it may in some cases give greater force to § 4–403(3).
RECOVERY OF PAYMENTS MADE BY MISTAKE
NOTES ON PAYMENT IN VIOLATION OF A STOP ORDER
(1) Consequences of Payor Bank’s Failure to Stop Payment. UCC
4–403(a) gives the customer the right to stop payment of a check. The
caption to the section refers to the “Customer’s Right to Stop Payment,”
Comment 1 leaves no doubt about the existence of this right: “stopping
payment . . . is a service which depositors expect to receive and are entitled
to receive from banks notwithstanding its difficulty, inconvenience and
expense. The inevitable losses through failure to stop . . . should be borne by
the banks as a cost of the business of banking.”
The certainty surrounding the existence of the customer’s stop-payment
right is matched by the murkiness of the provisions governing the
consequences of the bank’s failure to stop payment. Two important
questions have arisen. The first concerns the time when the bank is
obligated to reverse the charge to the customer’s account. The second
concerns the evidentiary burdens borne by the customer and the bank if the
issue goes to trial.
At first blush, the answer to the first question seems simple. A properly
countermanded check is not properly payable, and the bank has no right to
charge the check against the customer’s account. See UCC 4–401(a); UCC
4–403, Comment 7. It would seem to follow that the customer’s balance
should not be affected by the bank’s wrongful payment. Thus, if the bank
fails to pay checks that are subsequently presented because the book
balance in the account is less than the “real” balance, the bank would be
liable for wrongful dishonor. See UCC 4–402. The reported cases, however,
generally have rejected this approach. The notes that follow explain why.
(2) Payor Bank’s Rights of Subrogation. In many case, the UCC’s
rules concerning payment of a negotiable instrument by mistake will not
enable a bank to recover the amount paid in violation of a stop-payment
order. A drawee that pays a check under the mistaken belief that payment
had not been stopped may recover the amount of the check from the person
to whom, or for whose benefit, payment was made, regardless of whether the
law governing mistake and restitution would permit recovery. See UCC
3–418(a). But recovery ordinarily may not be had from a person who (i) took
the instrument in good faith and for value or (ii) in good faith changed
position in reliance on the payment. See UCC 3–418(c).
UCC 3–418(c) does not limit a payor bank’s remedies under UCC 4–407.2
Among the cases the latter section addresses is payment of a check in
violation of the drawer’s stop-payment order. UCC 4–407 gives the payor
bank certain rights of subrogation that may allow it to recover against
2. UCC 3–418(c) also doesn’t limit a payor bank’s remedies under UCC 3–417,
dealing with warranties that are made upon presentment for payment. These warranties
primarily affect checks that have been altered or bear a forged indorsement or drawer’s
signature. See Section 8, infra.
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either its customer or the payee, depending on the facts relating to the
underlying transaction between the two of them (UCC 4–407(2) and (3)) and
on the rights of third parties (UCC 4–407(1)).
Subrogation often is referred to as an “equitable assignment.” When, to
prevent unjust enrichment, one person is subrogated to another’s rights
with respect to an obligation, the result is essentially the same as if the
latter had assigned those rights to the former. Suppose A owes B $100. C,
mistakenly believing that C owes this debt to B, pays B $100. C is entitled
to be subrogated to B’s claim against A in the amount of $100. Or, as people
often say, C, the subrogee, “stands in the shoes” of B, the subrogor.
(3) The Custom er’s Burden of Proof. The payor bank’s right to
subrogation under UCC 4–407 may be disputed, as it was in the Siegel case.
May the payor bank maintain the charge to its customer’s account in the
interim, until the dispute is resolved? Or must it recredit its customer’s
account during that period?
UCC 4–403(c) puts on the customer the “burden of establishing the fact
and amount of the loss resulting from the payment” of a check over a
stop-payment order. The meaning of this language, which also appeared in
F4–303(3), has been the subject of considerable dispute among courts and
commentators.
Former Article 4. Even the drafters of former Article 4 seem to have been
uncertain about what F4–403(3) means. The 1952 edition of the UCC
contained a Comment 9 to section 4–403: “When a bank pays an item over
a stop-payment order, such payment automatically involves a charge to the
customer’s account. Subsection (3) imposes upon the customer the burden
of establishing the fact and amount of loss resulting from the payment.
Consequently until such burden is maintained either in a court action or to
the satisfaction of the bank, the bank is not obligated to recredit the amount
of the item to the customer’s account and, therefore, is not liable for the
dishonor of other items due to insufficient funds caused by the payment
contrary to the stop payment order.”
The Study of the Uniform Commercial Code made by the New York Law
Revision Commission in 1955 had this to say about Comment 9:
“Subrogation to a right to enforce is not the same thing as a right to charge
the customer’s account. However, Section 4–403, providing for the right to
stop-paym ent, provides that the burden is on the customer to establish the
fact and amount of loss resulting from payment contrary to a binding
stop-paym ent order, and Comment 9 to that section states that until such
burden is maintained the bank is not obligated to recredit the customer’s
account. It is not clear that the rule indicated in this Comment 9 does result
from the text of Section 4–403(3).” 2 N.Y.L. Rev. Comm. Study of UCC 339
(1955).
In 1955 the UCC’s Enlarged Editorial Board stated, “We . . . believe that
RECOVERY OF PAYMENTS MADE BY MISTAKE
Comment 9 is consistent with Section 4–403(3) and should stand.” Supp. No.
1 to the 1952 Official Draft 145 (1955). The text of F4–403(3) remained the
same, but when the revised Comments to the UCC appeared early in 1958,
Comment 9 had been dropped without explanation.
Subsequent judicial opinions had no greater success in interpreting the
troublesome language of F4–303. Several adopted Siegel’s approach or a
variant thereof. Others, like Hughes v. Marine Midland Bank, 484 N.Y.S.2d
1000 (N.Y. Civ. Ct. 1985), took a different approach:
[A] bank may not defend a U.C.C. § 4–403 violation by pleading that the
payee of the check, which was the subject of a valid stop order, was
justly entitled to the money. Further, the [payee’s] entitlements, if any,
are not a part of the plaintiffs’ prima facie case. This Court now holds
that the plaintiffs meet their burden to prove loss both under the
common law, and under the code, if they show that the bank has paid
out from the depositor’s account a sum of money over a valid stop order,
and the loss, both prima facie, and at trial, is that sum so paid out.
Common sense precludes involving banking institutions in litigation
among their customers and those with whom their customers deal. The
bank’s contract obligations with their customers are separate and
distinct from the commercial transactions which the customers may
have with others. In granting subrogation rights to any bank which has
sustained a loss due to a wrongful payment over a valid stop order, the
Legislature in U.C.C. § 4–407, gave a method of mitigating such losses,
if a bank chose to exercise such rights. The analogy to an insurance
subrogation—where the carrier must pay the insured upon the event of
loss—is apposite and comparable. The carrier can sue the guilty
party—and it frequently does; but that option bears no relationship to
the carrier’s duty to pay its insured under its insurance contract on a
proper proof of loss.3 Here the debtor-creditor contract between the
Hughes and the bank governs the bank’s liability. The bank’s
subrogation rights, after it has experienced a liability for its breach of
that debtor-creditor contract, are irrelevant.
The Hughes court acknowledged in a footnote that it is in the minority:
Contrary judicial interpretations of U.C.C. § 4–403, subdivision (3)
are the rule, however, not the exception . . . .
...
This Court’s decision, in the instant case, does not stem from any
animadversions to North Carolina, M assachusetts, or Florida courts.
3. While large banks may be self-insurers, many smaller banks insure themselves
against both forgeries and collection losses. In those cases, the insurance subrogation
process is more than an analogy, it is a fact, as the carrier who pays eventually winds up
as the subrogee under § 4–407.
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The predicates for the instant holding are two-fold: (1) [pre-UCC and
UCC cases decided by the New York Court of Appeals] all eschew
involvement with the underlying transaction either as part of plaintiff’s
damages, or as an affirmative defense, and all three cases bind this
Court; and (2) absolutely nothing in the official comments to U.C.C. §
4–403, nor in the language of subdivision (3), itself, constrains so bizarre
and cumbersome an interpretation.
484 N.Y.S.2d at 1005, n.6.
The 1990 Amendments. The 1990 amendments did not clarify what it
means for the customer to have the “burden of establishing the fact and
amount of the loss resulting from the payment” under UCC 4–403(c) or the
relationship of that section to UCC 4–407.
In the initial revisions of Article 4, section 4–403 was modified. The
reporters provided that the bank must recredit the customer’s account
and would then have the burden of proving that no loss to the customer
had resulted from its error. Since the bank is subrogated to the
customer’s rights against the merchant-payee in this situation, by virtue
of existing section 4–407, it would not necessarily absorb the loss. If the
customer was justified, and the bank was required to reimburse her, it
could assert her rights in a suit against the payee. The customer was
required to cooperate with the bank in such a suit by providing an
affidavit about the reasons for stopping payment of the check, and that
doing so would be a precondition to obtaining the recredit. But the
banks objected to this revision; they argued that they usually recredit
a customer’s account anyway, so no legal requirement was necessary.
This position prevailed and the revision now continues [F4–403(3)]
essentially unchanged.
Rubin, Efficiency, Equity and the Proposed Revision of Articles 3 and 4, 42
Ala. L. Rev. 551, 578 (1991).
The 1990 amendments did, however, add a sentence to UCC 4–403(c),
which makes clear that the loss from payment of an item contrary to a
stop-payment order may include damages for wrongful dishonor of
subsequent items. Under what circumstances would UCC 4–403(c) entitle
a customer to damages for wrongful dishonor of a subsequent check that the
bank returns for insufficient funds? Does your answer depend on whether
the court adopts the approach in Hughes or the approach in Siegel?
(4) Validity of Stipulations. Prior to the UCC banks frequently
printed on their stop-payment-order forms clauses like the following:
“Should you pay this check through inadvertence or oversight, it is expressly
understood that you will in no way be held responsible.” There was a conflict
of authority on the validity of such clauses. Some courts held them invalid
on the ground of public policy, at least in so far as they purported to relieve
the bank of liability for its negligence. Other courts held them invalid on the
basis of lack of consideration, since a bank was bound to observe a
RECOVERY OF PAYMENTS MADE BY MISTAKE
stop-payment order and gave up nothing in exchange for the clause.
The UCC prohibits disclaimer of a bank’s responsibility for “failure to
exercise ordinary care.” UCC 4–103(a). Does this mean that an exculpatory
clause on a stop-payment order is of no effect under the UCC? Comment 7
to UCC 4–403 explains:
A payment in violation of an effective direction to stop payment is an
improper payment, even though it is made by mistake or inadvertence.
Any agreement to the contrary is invalid under Section 4–103(a) if in
paying the item over the stop-payment order the bank has failed to
exercise ordinary care. An agreement to the contrary which is imposed
upon a customer as part of a standard form contract would have to be
evaluated in the light of the general obligation of good faith. Sections
1–203 and 4–104(c).
Under UCC 4–403(b) an oral order to stop payment is effective for
fourteen days, a written order for six months. What would be the effect
under the UCC of a clause on the signature card requiring stop-payment
orders to be in writing and on a form provided by the bank? What risk
inherent in an oral stop-payment order might a bank seek to avoid by such
a clause?
Even where it is against public policy for a bank to limit its liability for
negligent payment, might it not be advantageous to a bank to put such a
clause on its stop-payment order form? Would the inclusion of such a clause
come within Rule 1.2(d) of the American Bar Association’s Model Rules of
Professional Conduct (2007), which states: “A lawyer shall not counsel a
client to engage, or assist a client, in conduct that the lawyer knows is
criminal or fraudulent . . . .” The final draft of that rule contained additional
language that was deleted: “. . . or in the preparation of a written
instrument containing terms the lawyer knows are expressly prohibited by
law. . . .” The following comment was also deleted: “Law in many
jurisdictions expressly prohibits various provisions in contracts and other
written instruments. Such proscriptions may include usury laws, statutes
prohibiting provisions that purport to waive certain legally conferred rights
and contract provisions that have been held to be prohibited as a matter of
law in the controlling jurisdiction. A lawyer may not employ expressly
prohibited terms. On the other hand, there are legal rules that simply make
certain contractual provisions unenforceable, allowing one or both parties
to avoid the obligation. Inclusion of the latter kind of provision in a contract
may be unwise but it is not a violation of this Rule, nor is it improper to
include a provision whose legality is subject to reasonable argument.”
Can you draft a clause that would meet this standard under UCC
4–103(a)? Would the same reasoning apply to a clause which was
unenforceable because of lack of consideration?
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