Course Materials

PAYMENT SYSTEMS AND FRAUD LOSS ALLOCATION

Terri D. Thomas SVP – Legal Department Director

Kansas Bankers Association and

Kansas Bankers Consulting Services, LLC tthomas@ksbankers.com

785-232-3444

August 9-11, 2017

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PAYMENT SYSTEMS AND FRAUD LOSS ALLOCATIONPresented to the Graduate School of Banking-Madison, WI

Presented by: Terri D. Thomas, JD- SVPKansas Bankers Association

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OBJECTIVES

After successful completion of the course, students willbe able to:

Understand the legal components of each fraud;

Describe the applicable laws, regulations, and rules pertaining toeach fraud;

Properly allocate the loss resulting from various examples of fraud;

Predict how losses from fraud should be allocated as future paymenttechnologies are developed.

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TYPES OF FRAUD:Check Fraud:

Forged drawer’s signature; Forged endorsement; Alteration; Counterfeit check; Remote/Mobile Deposit Capture duplicates; Imaging disputes; Cashier’s check fraud.

Unauthorized consumer electronic transfers;Wire transfer fraud;Credit card fraud. 3

BASIC PRINCIPLES OF CHECKS AND CHECK COLLECTION

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ANATOMY OF A “CHECK”

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The Payee (UCC 3‐110)

The Drawee 

[UCC 3‐103(a)(4)]

The Drawer 

[UCC 3‐103(a)(5)John R. Doe

Legal amountUCC 3‐114

Numerical amount

Check Number

Routing Number

Account Number

Encoded Amount

ELECTRONIC IMAGES OF CHECKS RECOGNIZED (UCC AND EFAA-REGULATION CC)

§ 4-110. ELECTRONIC PRESENTMENT. (a) "Agreement for electronic presentment" means an agreement,

clearing-house rule, or Federal Reserve regulation or operatingcircular, providing that presentment of an item may be made bytransmission of an image of an item or information describing theitem ("presentment notice") rather than delivery of the item itself. Theagreement may provide for procedures governing retention,presentment, payment, dishonor, and other matters concerningitems subject to the agreement.

§ 4-104(9) “Item" means an instrument or a promise or order topay money handled by a bank for collection or payment. Theterm does not include a payment order governed by Article 4Aor a credit or debit card slip;

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EFAA Regulation CC- Check 21 Uses check truncation; Creates substitute check as the legal equivalent of

original check; Process check information electronically, and to

deliver substitute checks to banks that want tocontinue receiving paper checks;

Does not require banks to accept checks inelectronic form, nor does it require banks to use theauthority granted by the Act to create substitutechecks.

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CONTRADICTORY TERMS ON A CHECK:

Contradictory terms (UCC 3-114)- Typewritten prevails overprinted. Handwritten prevails over both. Words prevail overnumbers.

Incomplete instruments (UCC 3-115)-

Amount- Enforceable if filled in by payee for authorized amount;

Payee- Payable to bearer, unless completed by holder;

Drawer’s signature- Not authorized because not a writing signedby drawer, unless it meets the definition of “remotely createddraft” or completed by drawer’s authorized agent.

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DEFINITIONS:

Drawee (also known as “payor” or “paying bank”) isprimarily liable for paying a properly drawn draft/check. Liability for payment is under deposit contract (see UCC 4-103

which allows for good faith variation of the UCC byagreement) with drawer and Article 4 (for example UCC 4-402dealing with wrongful dishonor).

Drawer is secondarily liable for paying a draft/check.Drawer’s liability arises when drawee dishonors draft/check(UCC 3-414);

Maker (also known as “Issuer”) has primary liability forpaying a note (UCC 3-412). 9

Midnight deadline- UCC 4-104(a)(10) midnighton a bank’s next banking day following thebanking day on which it receives an item ornotice or from which the time for taking actioncommences to run, whichever is later. Can bevaried by clearinghouse deadlines.

Banking day- UCC 4-104(a)(3) part of a day onwhich a bank is open to the public for carryingon substantially all of its banking functions.

Presentment- UCC 3-501 is a demand againstthe party primarily obligated to pay (drawee ormaker) a negotiable instrument. 10

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PROPERLY PAYABLE [4-401(A)]

A drawee bank is only authorized topay properly payable items from thecustomer’s account;

Authorized by the customer; and

In accordance with any agreementbetween the customer and bank.

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A CHECK IS AUTHORIZED BY CUSTOMER:

Drawn by the customer and issued to anamed payee or the person’s “order”and presented for payment by thatpayee or other person entitled toenforce the check (directly or thru acollecting bank).

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If a check is properly payable and is otherwisepresented in accordance with the depositagreement, the drawee bank must pay thecheck and can charge the customer’s account;

If the drawee bank doesn’t pay when it should, ithas “wrongfully dishonored” the check.

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SIGNATURE/AUTHORIZATION REQUIRED FOR “PROPERLY PAYABLE ITEMS”

Can be manual or by any device or machine;

Can be any name (including trade orassumed name);

Can be any word, mark, or symbol executedor adopted by a person with present intentionto authenticate a writing (must have beenplaced by the person or authorizedrepresentative. 14

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If not authorized, then forged;

If forgery claimed, then victim must specificallydeny the validity of the signature, otherwiseauthenticity is admitted;

If specifically denied, the party enforcing theinstrument has the burden of establishing thevalidity of the signature (with a presumption that itis authentic and authorized).

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SIGNATURE BY A REPRESENTATIVE [3-402(A)]

When a representative signs aninstrument, the principal is liable underlaw of agency;Doesn’t matter which name used;No special form required;Even an undisclosed principal is bound if

agency law would bind.16

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Can a representative be held liable? If explicitly shown to be on behalf of a

represented person, no; If not explicitly shown to be in a

representative capacity: Representative is liable on the instrument to a

HIDC, who had no prior knowledge thatrepresentative was not to be liable;

Representative liable to all other parties unlessthe representative proves that the originalparties did not intend the representative to beliable on the instrument. 17

ENDORSEMENTS REQUIRED FOR PROPERLY PAYABLE ITEMS (UNLESS BEARER INSTRUMENTS)- TYPESBlank- endorsement of payee’s name alone,

with no additional language. Ex: John Doe; or

Special- endorsement that makes the itemspayable specifically to another. Ex: John Doe, pay to the order of Sally Smith;

Blank v. Special- Impacts the futurenegotiation of the check (creates either bearer paper or requires the further endorsement of a specific person for future transfers). 18

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Restrictive- restricts further negotiation of thecheck by limiting the purpose to which theproceeds of an instrument are applied. Forinstance: “For deposit only, John Doe”requires the item to be deposited into anaccount in the name of the endorser;

Qualified- “Without recourse” disclaims theendorser’s liability on the instrument if theinstrument is dishonored (but does not affect“warranty” claims or right of charge backunder 4-214). 19

ENDORSEMENT- HOW MANY DOES IT TAKE? [3-110(D)]

Payable to two or more persons:Joined by “or”= either can endorse;Joined by “and/or”= either can endorse;Joined by nothing= either can endorse;Joined by “and”= both must endorse.

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NO ENDORSEMENT?

Depositary bank warrants that the payee received credit for theitem. (No reason for drawee bank to review endorsements.)

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IF A CHECK IS NOT AUTHORIZED:

Not properly payable;

Should not be paid and payment that iscontrary to the customer’s authorizationis considered “wrongful payment” or“wrongful honor.”

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Dishonor- UCC 3-502. The drawee’s (ormaker’s) refusal to pay a negotiableinstrument before final payment has occurred.

Will occur with: Insufficient funds, account closed, stop

payment, legal hold, not properly drawn (forgeddrawer’s signature), forged endorsement,alteration, and stale-dated.

Will not occur with: Missing endorsement, uncollected funds, and

post-dated checks. 23

Dishonor means:Check was not paid by the drawee’s midnight

deadline;Was returned back through the payment stream,

revoking the provisional settlement (through charge-back) given by each bank to the previous banks;

Will eventually be returned to the depositary bank;Depositary bank then has the right of charge-back

against payee’s account.24

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RIGHT OF CHARGE-BACK- UCC 4-214

Collecting bank’s right to revoke the provisionalsettlement it gave to a prior party due to thedishonoring of the check by the drawee.

It is not affected by the previous use of a credit givenfor the item, or the failure of any bank to exerciseordinary care with respect to the item, but a bank sofailing remains liable.

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REASONS FOR “WRONGFUL DISHONOR” [4-402(A)]

Most common reason is incorrectly determiningthe funds in an account. For example, due to aposting error, a bank posts John’s deposit toJane’s account. The bank then erroneouslyreturns John’s checks drawn on his account dueto insufficient funds. These checks would havebeen paid had the deposit been postedcorrectly.

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LIABILITY FOR “WRONGFUL DISHONOR”

Drawee/payor bank liable to customer(drawer) damages proximately caused by thewrongful dishonor. Liability is limited to actualdamages proved and may include damagesfor arrest or prosecution of the customer orother consequential damages (which is aquestion of fact). [4-402(b)]. The rule neitherprohibits nor provides for non-compensatorydamages, such as punitive damages.

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WRONGFUL PAYMENT A/K/A WRONGFUL HONORPayor bank has paid a check that was not

properly payable under the deposit agreementwith the customer/drawer.

Final payment, even if done wrongfully, effectivelydischarges all the liabilities of endorsers underArticles 3 and 4.

However, the drawee/payor bank is NOT able tocharge the amount against the customer/drawer’saccount if would violate the deposit agreementwith the customer. 28

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REASONS FOR “WRONGFUL PAYMENT”

Paying a forged check (whether the endorsement ordrawer’s signature has been forged);

Paying over a stop payment order (4-303 and 4-403),or when the account has been closed [4-403(a)], orpostdated [4-401(c)], or stale dated (4-404), or thecustomer has died or is incompetent (4-405).

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OVERDRAFTS AND WRONGFUL PAYMENT

A payor/drawee is permitted to either pay or returna check that overdraws the customer’s account. [4-401(a)] If a line of credit has been provided, thepayor/drawee must pay if required by the terms ofthe line of credit agreement.

The typical option to pay or return (at thepayor/drawee’s discretion) is the basis of the“overdraft privilege” product.

A fee may be assessed for the payment or return ofchecks if permitted by contract/regulation. 30

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STALE-DATED CHECKS/DEATH OR INCOMPETENCE OF THE CUSTOMER, AND WRONGFUL PAYMENT

§ 4-404. BANK NOT OBLIGED TO PAY CHECKMORE THAN SIX MONTHS OLD. A bank is underno obligation to a customer having achecking account to pay a check, other thana certified check, which is presented morethan six months after its date, but it maycharge its customer's account for a paymentmade thereafter in good faith.

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§ 4-405. DEATH OR INCOMPETENCE OF CUSTOMER. (a) A payor or collecting bank’s authority to accept, pay, or collect

an item or to account for proceeds of its collection, if otherwiseeffective, is not rendered ineffective by incompetence of a customerof either bank existing at the time the item is issued or its collection isundertaken if the bank does not know of an adjudication ofincompetence. Neither death nor incompetence of a customerrevokes the authority to accept, pay, collect, or account until thebank knows of the fact of death or of an adjudication ofincompetence and has reasonable opportunity to act on it.

(b) Even with knowledge, a bank may for 10 days after the date ofdeath pay or certify checks drawn on or before that date unlessordered to stop payment by a person claiming an interest in theaccount.

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POST-DATED CHECKS § 4-401(c) A bank may charge against the account of a customer a

check that is otherwise properly payable from the account, even thoughpayment was made before the date of the check, unless the customerhas given notice to the bank of the postdating describing the check withreasonable certainty.

The notice is effective for the period stated in Section 4-403(b) for stop-payment orders, and must be received at such time and in such manner as toafford the bank a reasonable opportunity to act on it before the bank takesany action with respect to the check described in Section 4-303.

If a bank charges against the account of a customer a check before the datestated in the notice of postdating, the bank is liable for damages for the lossresulting from its act. The loss may include damages for dishonor ofsubsequent items under Section 4-402.

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STOP PAYMENT ORDERS (4-403)

Who may stop payment- the “customer or any personauthorized to draw on the account.” If the signature ofmore than one person is required to draw on theaccount, any of these persons may stop payment.The payee of a check can not “stop payment” on thecheck. A “reason” is not required.

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Form and Content of Order- May be written ororal and must describe the item “withreasonable certainty”. The deposit agreementmay require the order to be written, or somewill permit oral stop payments, with asubsequent written confirmation.

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Time and Manner of Order- Stop payment must bemade “at a time and in a manner that affords thebank a reasonable opportunity to act on it beforeany action by the bank with respect to the itemdescribed in 4-303 (the priorities rule).

The priorities rule says that certain types ofpayments by the bank can still be made despiteknowledge, notice, or stop-payment order receivedby, legal process served upon, or setoff exercisedby a payor bank.

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Bank accepts or certified the item;The bank pays the item in cash;The bank settles for the item without having a

right to revoke the settlement;The bank becomes accountable for the item

and it would be a late return under 4-302 (themidnight deadline);

The cutoff hour has passed.

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Duration of a stop payment- Oral stoppayment order is effective for 14 calendardays unless “confirmed” in writing. Writtenorders are effective for six months and may berenewed for additional six-month periods.

Confirmation- unclear as to whether thecustomer’s signature is required. Many bankssend “confirmation” indicating that theconfirmation notice is sufficient to make thestop payment order good for six months.

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Damages- Customer has the “burden ofestablishing the fact and amount of lossresulting from the payment of an itemcontrary to a stop-payment order.”[4-403(c)]

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PRIORITY DISPUTES INVOLVING THE ACCOUNT [4-303(A)]

Any of the “four legals” have priority over theregular payment of a check, as long as the bankhas a reasonable time to act (typically for stoppayment, that’s when notice is communicated tothe accounting department and for setoff it’s whensetoff is actually made): Knowledge or legal notice affecting the item, such as

bankruptcy or an assignment for the benefit of creditors; An order stopping payment on the item; Garnishment or levy; Right of setoff.

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THE EXCEPTION TO THE “FOUR LEGALS”:

The bank pays the item in cash; The bank settles for the item without having a right

to revoke the settlement under statute,clearinghouse rule, or agreement;

The bank becomes accountable for the item and itwould be a late return under 4-302; or

The cutoff hour has passed.

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PAYOR BANK’S REMEDIES UPON WRONGFUL PAYMENTSubrogation rights- to prevent unjust enrichment

and only to the extent necessary to prevent loss tothe bank by reason of its payment of the item, thepayor bank is given limited statutory subrogationrights. (4-407)

This means that the drawee can “step into the shoes ofthe payee” and if the payee could enforce payment,the drawee can then enforce payment (i.e. it can sueon the underlying obligation or on the instrument).However, if the customer has a defense againstpayment, the defense would be valid against thedrawee. 42

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HOWEVER, if the check had been transferred from thepayee to a third party who qualified as a HIDC, thedrawee can actually step into the shoes of the HIDCand enforce the drawer’s liability to pay the instrument,free and clear of the drawer’s personal defensesagainst payment.

The drawee bank can even step into the shoes of thedrawer and enforce a drawer’s defenses againstpayment (i.e. lack of consideration) against the payee.

The idea behind all of this is that the drawee bankshouldn’t bear the loss. . .someone should have to paythe drawee bank for the item.

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Warranties- The payor/drawee bank may be ableto recover on the wrongfully paid item byenforcing the warranties provided to it under thepresentment warranties (4-208) or the encodingwarranty (4-209) (Discussed later)

Restitution for Mistaken Payment- If the paymentwas by mistake, the payor/drawee bank mayhave a restitution claim against a person who tookthe instrument for value, but not in good faith, or ina person who took it in good faith, but has notchanged position in reliance on the payment. (3-418)

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MISTAKEN PAYMENT- PRESENTMENT WARRANTY

UCC 4-208 and UCC 4-209- Collecting banks give a“presentment warranty” to the drawee bank. This warrantystates: Good title (all endorsements are valid); No alteration; Encoding is accurate; If remotely-created draft, authorized by drawer; Otherwise, no knowledge that drawer’s signature is unauthorized

(forged). Breach of the warranty gives drawee bank claim against

presenting parties.45

LIABILITIES (CONTRACTS) OF DRAWERS, ENDORSERS, DEPOSITARY BANKS,

AND DRAWEE BANKS

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Contract of drawee bank is to pay a properlypayable item from the drawer’s account inaccordance with the terms of the instrument andthe contract with the drawer. Drawee owes itsduty to the drawer;

Depositary bank’s liability is that of an endorser,taking the check for either cash or for credit to adeposit account of a prior holder.

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LIABILITY ON THE CHECK

Every person who signs is liable on theinstrument in some way (drawer under 3-414and endorser under 3-415);

Drawer is obligated to pay a dishonoreddraft/check according to its terms at the time itwas issued, even if the drawer added words tothe signature purporting to disclaim liability(such as “without recourse”) on the instrument[3-414(e)], when the instrument is a check;

Drawer is liable on the underlying obligation andon the check itself when a check is dishonored;

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(3-415) Endorser is obligated to pay the amountdue on the instrument if it is dishonored,according to the terms of the instrument at thetime it was endorsed or if the endorser endorsedan incomplete instrument, according to its termswhen completed.

The obligation is owed to a person entitled toenforce the instrument or to a subsequentendorser, unless the instrument is endorsed“without recourse”;

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The endorser’s liability under 3-415 is discharged if thecheck is not presented for payment or given to the adepositary bank for collection within 30 days after theday the endorsement was made;

Notice of dishonor must be given to the endorser (3-503) unless excused under 3-504.

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ENFORCING LIABILITY ON A CHECK Drawer’s liability to pay a check when the drawee has

dishonored it runs only in favor of a person who isentitled to enforce the check, or to an endorser whopaid the check [3-414(b)];

A “person entitled to enforce” under 3-301 is: A holder of the instrument; or A nonholder in possession of the instrument who has the rights

of a holder (such as in “subrogation”); or A person not in possession, but has rights to enforce under 3-

309 (lost, destroyed or stolen instrument), 3-418(d) (paid bymistake or payment revoked), or 3-301. 51

WHAT IS A “HOLDER”?

A “Holder” is someone who takes possession of anegotiable instrument by possession, if it is inbearer form, or by endorsement and transfer, ifpayable to a specific person.

Merely by being a holder of an instrument aperson has a prima facia case for payment fromthe drawer if the instrument has been dishonored.This is better (and easier) than suing on theunderlying obligation.

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TWO DEFENSES AGAINST PAYMENT

If a holder attempts to enforce payment of acheck against a drawer, the holder is typicallysubject to the real and personal defenses thatthe drawer might have against payment;

The holder’s right to enforce payment of acheck against the drawer is dependent uponthe drawer having “signed/ authorized” theinstrument [3-308(b)]

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A DEPOSITARY BANK CAN BE LIABLE FOR A FIDUCIARY’S BREACH OF DUTY IF IT HAD NOTICE:Notice of fiduciary breach (3-307)- IF

An instrument is taken from a fiduciary for paymentof collection or for value;

The taker has knowledge of the fiduciary status ofthe fiduciary; and

The represented person (principal) makes a claimto the instrument or its proceeds on the basis thatthe transaction of the fiduciary is a breach of thefiduciary duty,

Then the following rules apply:54

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In the case of a negotiable instrument payable tothe fiduciary as such, the taker is on notice if it istaken: In payment of or as security for a debt the taker knew

was the personal debt of the fiduciary; Taken in a transaction known by the taker to be for the

personal benefit of the fiduciary; Deposited to an account other than an account of the

fiduciary (in a fiduciary status) or the account of therepresented person (principal’s name).

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If the instrument is issued by either the principal orthe fiduciary, and then made payable to thefiduciary, the taker does not have notice, unless thetaker has actual knowledge; or

If the instrument is issued by the principal or thefiduciary as such, to the taker as payee, the takerhas notice of the breach if the instrument is: In payment of or as security for a debt the taker knew was

the personal debt of the fiduciary; Taken in a transaction known by the taker to be for the

personal benefit of the fiduciary; Deposited to an account other than an account of the

fiduciary (in a fiduciary status) or the account of therepresented person (principal’s name).

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CONFLICT OF GENERAL FIDUCIARY LAWS

If the Uniform Trust Code or Uniform Fiduciary Actdirectly conflicts with the “notice of fiduciarybreach” provisions of the UCC’s 3-307, the UCCcontrols.

However, specific language in the documentcreating the authority can override the liabilityplaced on the depositary bank under 3-307.

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DRAWEE BANK’S DUTY TO ENDORSERS

The drawee bank has a duty to determinewhether to pay or dishonor a check by itsmidnight deadline;

A check that is dishonored and returned afterthe drawee bank’s midnight deadline is a “latereturn” and, generally, prohibited (absent abreach of warranty, discussed later).

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FINAL PAYMENT AND LATE RETURNS(UCC 4-302) There is no right to send back a check (i.e. revoke

settlement) beyond the expiration of the draweebank’s midnight deadline (unless there is a breach ofa presentment warranty, which will be discussedlater);

Sending back a check beyond the midnight deadlineis referred to as a “late return.” It is not legal to do it,but it happens all the time because of the way thecheck collection system works;

By returning an item beyond the midnight deadline,the drawee bank has effectively stolen the final creditthat it gave. 59

FINAL PAYMENT- ON-US CHECKS

A check in which the drawee and depositary bankare the same. (The payee deposits the check into anaccount at the same bank as the check is drawn).

If deposited, then handled like any other deposited item.Drawee will have until midnight deadline to “revoke”provisional settlement given to payee, even if some creditwithdrawn by payee [UCC 4-301(b)] and (UCC 4-302)

If cashed, final payment (UCC 4-215). Drawee bank has untilend of day of presentment to determine whether to pay ordishonor. 60

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WHAT CONTROLS?

UCC Article 4 deals with final payment v.dishonor. Provides for revoking provisionalsettlement and right of charge back, butreally doesn’t provide details of the returnprocess. It acknowledges that federalregulations (such as Regulation J andRegulation CC), and clearinghouseagreements will take priority in thosematters.

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WHAT CONTROLS, CONT.?

Federal Reserve Regulation J deals with howitems are sent through the Federal ReserveSystem and authorizes Operating Circulars tobe issued by the Fed;

Federal Reserve Operating Circulars are moredetailed rules that control the Federal ReserveCheck Processing System. Operating Circular#3 Collection of Cash Items and ReturnedChecks applies to the handling of all cashitems that the Fed accepts for forwardcollection and all returned checks that the Fedaccepts for return. 62

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WHAT CONTROLS, CONT.?

The Expedited Funds Availability Act of 1987-Federal Reserve Regulation CC- providesrules on how a check that has beendishonored is properly returned to thedepositary bank. Why?

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EFAA-REGULATION CC

Purpose was to provide customers with accessto funds deposited with financial institutions.Classifies checks/credits as on-us, cash-like,local or non-local. Each class has a period oftime for which the bank can place a hold onthe deposited funds. There are alsoexceptions to these hold periods that willpermit a bank to extend the hold beyond thenormal statutory periods.

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In order to make the “hold-system” workwithout significant risk for the depositary bank,it was important to establish a procedure thatrequired dishonored items to be returnedquickly (before hold periods expired). Up untilthe passage of EFAA and Regulation CC, therereally wasn’t a law that dealt with “hurrying”the return item process.

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LIABILITY ON THE UNDERLYING OBLIGATIONPayment by check suspends a liability [3-

310(b)], unless the check is certified;Upon dishonor, the suspension ends and the

obligee/payee can sue the obligor on theunderlying obligation [3-310(b)(3)] (i.e. theobligation to pay) OR

The payee can sue on the dishonored checkitself.

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“PERSON ENTITLED TO ENFORCE”

Three ways: Holder; Nonholder in possession who has rights of holder

(dealt with in later chapters); Not in possession, who is entitled to enforce

(dealt with in later chapters).

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A “HOLDER” EXISTS:

By being the payee of an instrument;

By the process of negotiation, meaningtransfer of possession (either voluntarily orinvoluntarily) and endorsement occurred (ifpayable to a specific party); or

If payable to bearer, by transfer of possessionalone. [UCC 3-201(b)] 68

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HOLDER IN DUE COURSEA “Holder” (not just someone entitled to

enforce the instrument);Who takes for value [see 1-204, 3-303(a), 4-

210] (i.e. has given $$$ for the item oracquiring a security interest in it, which isautomatically given to collecting banks);

Who at the time of giving value, had nonotice that: The instrument was overdue (if a check, 90 days

after its date) or had been dishonored or thatthere is an uncured default with respect topayment of another instrument issued as part ofthe same series(3-304); 69

The instrument contains an unauthorized signatureor has been altered;

Of any claim to the instrument; and That any party has a defense or claim in

recoupment (see 3-305);

Who had no reason to question theauthenticity of the instrument (no apparentevidence of forgery or alteration, or is nototherwise so irregular or incomplete as to callinto question its authenticity);

Who took the item in good faith; and70

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Typically, a party who takes the instrumentthrough legal process, by bulk transactionpurchase, or as a successor in interest to anestate will not be a HIDC;

Many times a payee will not qualify as a HIDCdue to the “knowledge” factor.

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WHY SHOULD ONE WANT TO BE A HIDC?

A HIDC takes the instrument free and clearfrom the drawer’s personal defenses againstpayment. However, a HIDC is subject to adrawer’s real defenses against payment.

Why? This allows for negotiable instrumentsto maintain a market place for exchange.

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PERSONAL V. REAL DEFENSESReal defenses:

Infancy; Duress, lack of legal capacity or illegality; Fraud in factum; Discharge in insolvency.

Personal defenses: Lack of consideration; Breach of warranty or other representation; Modification of obligation by separate

agreement; Contract defenses. 73

SHELTER PRINCIPLE A/K/A SHELTER DOCTRINE

A transferee of an instrument may have the rights ofa HIDC without necessarily having the status of aHIDC. The Shelter Principle gives the transferee anyright of the transferor to enforce the instrument. So ifthe transferor was a HIDC, the transferee will also bea HIDC, unless the transferee was a party to anyfraud or illegality affecting the instrument, or who asa prior holder, had notice of a claim or defense [3-203(b)]

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DEPOSITARY BANK SUING ON A DISHONORED CHECK

Right of charge back. But what happens ifthere’s no money in the account?

What if it isn’t endorsed by the payee whentransferred to the depositary bank? 4-214(a)allows depositary bank to obtain a refund fromits customer;

Can sue on the instrument, enforcing either theendorser’s liability (suit against the payee) orenforcing the drawer’s liability. Could drawer’sdefenses against payment be valid against thedepositary bank? Depends upon HIDC status.

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If depositary bank is a HIDC, then it would only besubject to drawer’s REAL defenses against payment.Depositary bank gives value by acquiring a securityinterest as a collecting bank and giving cash for thefunds. If the depositary bank gives provisional creditonly, then it is a HIDC only up to the amount of creditthat was provided. UCC follows the first-in-first-outrule.

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HIDC AND FORGED DRAWER SIGNATURES: CASE COMPARISON

ROBERT J. TRIFFIN V. SOMERSET VALLEY BANK AND HAUSER CONTRACTING CO.Issue: You May Be Responsible For Checks You Did Not Issue or Authorize

Hauser Contracting Co. used ADP for payroll services. A thief obtained checkstock that looked identical to ADP’s checks and created 80 counterfeit payrollchecks identical to Hauser Contracting Co.’s, and cashed them all over town.

A retailer who knew Mr. Hauser became suspicious and called him. SomersetValley Bank also called. Mr. Hauser reviewed the checks, which looked justlike his, and confirmed the checks were unauthorized and the payees werenot his employees. The bank returned the checks marked as “Stolen Check -Do Not Present Again.”

Mr. Triffin bought 18 of these checks totaling $8,800 from four check cashingagencies, claimed HIDC status, and sued both Mr. Hauser and his bank fornegligence for not safeguarding the payroll checks and facsimile stamp.Because the counterfeit and authentic checks looked identical, the lowercourt ruled for Triffin. Hauser appealed, but the Federal Appellate Court upheldthe lower court. The Court said the counterfeit check met the definition of anegotiable instrument, and because the check and signature were identicalto an authentic check, the check cashing agency could not have known itwas not authentic. 77

ROBERT J. TRIFFIN V. POMERANTZ STAFFING SERVICES, LLCIssue: High Security Checks May Protect You From Some Holder in DueCourse Claims

Pomerantz Staffing Services used high security checks that included heatsensitive (thermochromatic) ink on the back and a warning banner on thefront that said, “THE BACK OF THIS CHECK HAS HEAT SENSITIVE INK TOCONFIRM AUTHENTICITY.” Someone made copies of Pomerantz’s checks,but without the thermo ink on the back. They cashed 18 checks totaling$7000 at Friendly Check Cashing Company. Friendly’s cashiers failed toheed the warning on the check face, and did not look for the thermo ink. All18 checks were returned unpaid, likely caught by Positive Pay.

Mr. Triffin bought the checks, claimed Holder in Due Course status, and suedPomerantz. Pomerantz counter-sued and won! The judge correctly assertedthat if Friendly had looked for the thermo ink as instructed, they could havedetermined the checks were counterfeit. Because they were provided ameans to verify authenticity and failed to do so, they were not an HIDC andhad no rights to transfer to Mr. Triffin.

This case clearly illustrates the value of check security features, a properlyworded warning band, and a controlled check stock. Pomerantz wasprotected by his checks.

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40

BRINGING IT ALL TOGETHER: Cactus Roofing, Inc. hired Espino Roofing to do a roofing

job for one of its clients. When the work was finished,Cactus Roofing issued a check drawn off its account atSecond Bank to: Espino Roofing and/or TomasHernandez in the amount of $4,700.

Tomas Hernandez cashed the check at Hurst Enterprises(where he had previously cashed checks in the past).

Hurst deposits the check into its account at First Bank. In the meantime, Cactus Roofing receives a complaint

from its customer that the roofing job is not complete.Cactus Roofing places a stop payment on the checkissued to Espino Roofing.

First Bank then presents the check to Second Bank forpayment, which dishonors the check due to the stoppayment and sends it back to First Bank.

The check is charged back to Hurst Enterprises’ accountat First Bank .

79

Hurst sued Cactus (because it had no way of findingTomas Hernandez) alleging it was entitled topayment because it was a HIDC on the checkreceived from Hernandez.

The lower court held that, although Hurst had metthe law and factual requirements to be a HIDC, itdetermined that Hurst was subject to a set-off claimbecause Hernandez/Espino Roofing did notcomplete the job and Cactus Roofing, had tocomplete the job at its own expense.

Hurst Enterprises appealed the decision.80

41

Is Hurst Enterprises a “Holder”?

Is Hurst Enterprises a HIDC?

What type of defense is Cactus Roofingraising? A personal or real defense?

Should Cactus Roofing be able to set-off theamount it had to pay to “complete” theroofing job from the amount of the checkcashed by Hurst?

81

WHAT THE KANSAS COURT OF APPEALS SAID: The lower court was not authorized to reduce the

award to a HIDC when the holder had paid the fullconsideration for the check to the payee.Because Hurst had paid all of the agreed uponconsideration to the payee, it was entitled torecovery of the full amount of the check fromCactus.

-Hurst Enterprises v. Cactus Roofing, 197 P.3d 882, 2008 (Kan. App.)

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42

SOME DEFENSES WILL BE VALID AGAINST ANY HOLDER, EVEN AN HIDC:

83

WARRANTIES SURVIVING FINAL PAYMENT

84

43

CHECK FRAUD LIABILITY AND THE WARRANTIES (UCC ARTICLE 4)-

Transfer Warranties: Each endorser warrantsto subsequent holders that all signatures areauthorized, all endorsements are valid, andthere are no alterations. Allows for item to bepassed upstream easily from one holder to aprevious holder when fraud occurs.

85

Presentment Warranties- Each endorser warrants to thedrawee bank that there is no knowledge that the drawer’ssignature is unauthorized, that all endorsements are valid,and there are no alterations.

This allows the drawee bank to easily return an item back to theendorsers when there is a forged endorsement or alteration.

Does not allow for an item to be easily returned after finalpayment when the problem is a forged drawer’s signature dueto “knowledge” factor.

Additional presentment warranties include remotely-createdconsumer items and encoding (knowledge is not a factor).

86

44

87

John(Drawer)

Check Payable to

SaraSara

Hometown Bank(Drawee Bank)

Big City BankDepositary

Bank(Sara’s Bank)

Sara deposits the check

Check paid from John’s account

Check Transaction Transfer warranty Presentment warranty

Sara provides a transfer warranty to Big City Bank

Federal Reserve Bank of

Cleveland (central

repository)

BCB gives presentment warranty to Drawee

ALLOCATING LOSSES FOR CHECK FRAUD

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45

GENERAL PRINCIPLE: LOSS ALLOCATION

The crook is always liable. However, collecting aloss from the crook is rarely viable;

All other parties are innocent;

Law attempts to allocate loss to the party that wasin the best position to detect or prevent theproblem.

89

GENERAL PRINCIPLE: UNAUTHORIZED SIGNATURES 3-403

Are ineffective as to the purported drawer, but arevalid as to the forger;

Can be ratified by the drawer;

If more than one required, and if only one is obtained,the signatures are unauthorized (risk of two signaturesrequired for withdrawal on signature card).

90

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GENERAL PRINCIPLE: NEGLIGENCE § 3-406. NEGLIGENCE CONTRIBUTING TO FORGED SIGNATURE OR

ALTERATION OF INSTRUMENT.

(a) A person whose failure to exercise ordinary caresubstantially contributes to an alteration of an instrument or tothe making of a forged signature on an instrument isprecluded from asserting the alteration or the forgery againsta person who, in good faith, pays the instrument or takes it forvalue or for collection.

(b) Under subsection (a), if the person asserting the preclusionfails to exercise ordinary care in paying or taking theinstrument and that failure substantially contributes to loss, theloss is allocated between the person precluded and theperson asserting the preclusion according to the extent towhich the failure of each to exercise ordinary carecontributed to the loss. 91

(c) Under subsection (a), the burden of proving failure to exerciseordinary care is on the person asserting the preclusion. Undersubsection (b), the burden of proving failure to exercise ordinarycare is on the person precluded.

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LEGAL LIABILITY FOR FORGERIES-DRAWER’S SIGNATURE-

A check bearing a forged drawer’s signature is not properlypayable;

If drawee discovers by its midnight deadline and dishonors theitem, the depositary bank will bear the loss in most cases (right ofcharge back/contract of endorser);

If drawee does not discover by the midnight deadline, the itemwill be “finally paid” and cannot be returned to prior partiesunless it can prove a prior endorser had knowledge that thedrawer’s signature was forged (presentment warranty).

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FORGERY OF DRAWER’S SIGNATURE, CONT.

Drawee can try to pass liability to drawer(customer):

Customer failed to report within 30 days (UCCstandard) after receiving statement AND thebank can prove delay in reporting causedloss; AND bank exercised ordinary care.

Bank followed procedures;Procedures reasonable for similarly situated

banks.94

48

THE PROBLEM?

How does a bank show that the customer’sdelay in reporting caused the loss?

The loss does not typically occur because ofthe delay in reporting by the customer.

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FORGERY OF DRAWER’S SIGNATURE, CONT.

Absolute bar from liability if drawer fails to reportwithin one year of receiving statement.

Multiple forgery rule: if same wrongdoer forgeschecks, then bank not liable for checks that arepaid after 30 days of statement being issued.

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FORGERY OF DRAWER’S SIGNATURE, CONT.Shortening the 1 year and 30 day

standards

UCC Article 4 can be amended by mutualagreement;

Can’t disclaim good faith, can’t limit measureof damages and can’t state an unreasonableprovision;

Could shorten 1 year to 30-60 days andshorten 30 days to around 15 days in moststates.

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USING THE DEFENSES TOGETHER-

98

03-31-16 statementsent-Customer has 30 days

to review- does not.|-----------------------|-----------------|---------------------------|------------------------|--------------------|

01-15-16 01-31-16 03-01-16 thru 12-31-16 03-05-17First forgery Statement sent multiple forgeries occur-customer does not report Customer reports

occurs forgeries of 03-01-16 thru 12-31-16

One year rule will bar forgeries occurring from January 15, 2016 to March 1, 2016. Multiple forgery rule bars recovery on all other checks.

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RATIFICATION AS A DEFENSE-

Prior checks written by forger, butnever reported because drawer‘wanted’ the checks to be written,will absolve drawee of liability oncurrently reported forged checks;

Checks written by forger whichdirectly benefit the drawer mayabsolve the drawee of liability.

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FACSIMILE SIGNATURE PROBLEMS-

Customer is responsible for checks signed with afacsimile signature if customer authorized use of the signature on the account and was negligent in protecting checks and rubber stamp/check machine;

Customer is not responsible for checks that weresigned with a facsimile signature if bank was never authorized to accept the facsimile signature;

Caution: Imaged signature cards and imagedchecks- the Check 21 dilemma.

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SOME RESOLUTIONS SHIFT ALL RISK OF THE USE OF A FACSIMILE, FOR ANY PURPOSE, ON TO THE CUSTOMER:

101

FORGED ENDORSEMENTS- Forged endorsement makes item not properly payable (not paid consistently

with the drawer’s (or subsequent holder’s) order;

Presentment is to be done by the person entitled to enforce the instrument. Ifan endorsement has been forged, subsequent takers do not have “good title”to the instrument;

As such, the instrument has not been properly presented for payment and is notproperly payable;

An item paid that contains a forged endorsement does not “discharge” thedrawer’s liability for the underlying obligation to pay;

The payee can demand the drawer pay a second time to satisfy the underlyingobligation; 102

52

Drawer has to seek reimbursement from the drawee/payor, whoimproperly paid the item;

Presentment warranty allows drawee to return the item to depositary bank(typically for three years after presentment-however Fed won’t take itpast the midnight deadline);

Drawee recredits drawer; depositary bank recredits drawee;

Note: Drawer does not have duty to discover unauthorized endorsementsby reviewing bank statement. Why? Not in a position to determine ifforged endorsement has occurred until payee reports non-payment;

The problem? Endorsers (depositary bank) will try to raise defenses toshow why the forged endorsement should be considered valid. Thesedefenses should be identified by the drawee bank before making anyreimbursement to the drawer.

103

FORGED ENDORSEMENT DEFENSES- Defenses that can be raised against recrediting the

drawer:

Imposter/Fictitious payee defense- drawer is duped intowriting a check to the crook;

Dishonest Employee Rule (Padded payroll defense)-Employee dupes employer into writing a check. Employeehas too much responsibility over employer’s paymentprocess.

Ratification (previously approved or benefit received).

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53

IMPOSTER RULE (3-404)

Drawer is induced to issue an instrument to a thief, who impersonatessomeone else whom the drawer intends and names as payee. Thiefendorses the name of the payee and impersonates that person toinduce a third person (depositary bank or drawee bank) to take orpay the instrument;

Does not matter how the imposter tricks the drawer;

Will be applicable whether the imposter or an associate indorses theinstrument;

By making the endorsement effective, anyone who takes theinstrument becomes a holder (of a bearer instrument), and wouldprobably qualify as a HIDC (presuming no knowledge of the crime).

105

The rule will also apply if the thief poses as the agent of anotherand thereby induces a maker or drawer to issue the negotiableinstrument payable to the alleged principal. Rule states “the ruleapplies when the imposter impersonates “the payee of theinstrument or a person authorized to act for the payee;”

An endorsement in the payee’s name by the supposed “agent”or anyone else is effective. The defrauded drawer bears the loss.

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54

FICTITIOUS PAYEE RULE (3-404)

If the drawer gives the thief (albeit unknowingly) the authority toissue checks drawn on the drawer’s account, and the thief thendraws checks in favor of fictitious parties or third parties, then if thethief endorses the items and negotiates them, the endorsements areconsidered valid and effective;

If the payees named really exist, then this rule would not apply if thechecks were validly drawn and then stolen by the thief;

The key is “what was the intent of the person who actually ‘drew’ theitem at the time the item was drawn?”

107

DISHONEST EMPLOYEE RULE (3-405)

The rule is limited to fraud by employees who have beenentrusted with the responsibility with respect to an instrument,meaning: Authority to sign/indorse instruments on behalf of the employer; Authority to process instruments received by the employer for

deposit to an account; Authority to prepare or process instruments for issue in the name of

the employer; Authority to supply information that determines the names or

addresses of payees of instruments issued off the employer’saccount;

Authority to control the disposition of instruments to be issued in thename of the employer; or

To act otherwise with respect to instruments in a responsiblecapacity.

108

55

“Responsibility” does not mean merely having access toinstruments, or blank/incomplete instrument forms that are beingstored or transported, or are part of incoming/outgoing mail, orsimilar access.

109

In the case of employee fraud, 3-404 and 3-405 can overlap. In thisevent, 3-405 will tend to control because the elements are easier toprove. It covers both endorsements made in the name of theemployer and endorsements made in the name of payees ofinstruments issued by the employer;

3-405 does not care whether the payees are fictitious or real persons;

Why? Employer is in better position to avoid loss by using care inchoosing employees, in supervising them, and in adopting otherpreventative measures (see 3-405, Comment 1).

110

56

COMPARATIVE FAULT RECOGNIZED

3-404 and 3-405 recognize comparative fault (3-406) betweenthe drawee bank/depositary bank/victim. If the draweebank/depositary bank fails to exercise ordinary care, and thefailure substantially contributes to the loss resulting from the fraud,the person bearing the loss may recover from the person failingto exercise ordinary care to the extent the failure to exerciseordinary care contributed to the loss.

111

LIABILITY FOR ALTERATIONS- 3-407/4-401(D)

Drawee/payor is to pay only the original terms of the alteredinstrument, therefore altered information is not properly payable;

If the instrument was left incomplete by the drawer, thendrawee/payor can pay the instrument as completed unless thedrawee/payor has notice the completion was improper;

Under 3-406 (negligence contributing to an alteration), determinelevel of customer negligence in contributing to the alteration;

If no negligence, then drawee will have to recredit the difference;

Presentment warranty places liability on endorser (typicallydepositary bank) since all endorsers warrant that the item is notaltered. 112

57

LIABILITY FOR COUNTERFEITS-

Generally considered the same as “forgeryof drawer’s signature”;

Liability usually on drawee bank if check notdishonored by the midnight deadline;

If cashier’s check, then drawee bank losesafter final payment because the draweebank is also the drawer.

113

DOUBLE FORGERIES (WHERE THE DRAWER’S SIGNATURE AND THE ENDORSEMENT ARE FORGED)-

Law uses a comparative negligencestandard and loss is allocated betweenthe parties (drawee bank anddepositary bank).

114

58

REMOTELY CREATED DRAFTS (DEMAND DRAFTS)

Changes to UCC (adopted on a state-by-state basis)and Regulation CC (effective July 1, 2006) placeliability on the depositary bank for unauthorizeddemand drafts under the presentment warranties(under the UCC) and for one year (under Reg CC)from the date of presentment. The Depositary bankwill be forced to seek reimbursement from thepayee. Can return the item through the Fed for up to90 days after presentment (however Fed will notprocess claims of $25 or less).

115

CHECK 21-SUBSTITUTE CHECKS AND REMOTE DEPOSIT CAPTURE- PAGE 20 UCC warranties survive the imaging process (no matter who does the

imaging) under UCC 4-110 and Check 21;

If loss occurs as a result of creating the IRD or Substitute Check, thenthe law will place responsibility on the “reconverting bank” (the bankthat created the substitute check, not the bank that created theimage);

Contracts executed between participants and Regulation J will placeresponsibility for loss on party originally converting the instrument fromits original state to IRD/Substitute Check;

Consumers have 40 days to report and can receive up to $2500 inprovisional credit at ten business days. 116

59

IMAGING AND CHECK FRAUD-

Wachovia v. Foster Bank- when the check has been imagedand the original destroyed, how can we tell whether it iscounterfeit or altered? Lower court said that “altered” waseasier to believe. Court of Appeals said depositary bank was inbetter position to know of problem.

Wachovia v. Chevy Chase Bank- Court said it was up todrawee to prove check was altered.

117

ECCHO RULE 9; CHANGING COUNTERFEIT AND FORGED CHECK LIABILITIES-

Rule 9 contractually established under UCC Articles 3 and 4, andRegulation CC on drawer forgeries and counterfeit checks;

UCC and Reg CC would typically place liability on paying bank for adrawer’s forgery or counterfeit check that was finally paid (not returnedby the paying bank’s midnight deadline);

Rule 9 allows the paying bank to bring a breach of warranty claimagainst the Bank of First Deposit (BOFD) for up to 60 calendar days fromthe date the customer’s statement is made available;

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60

Only used on electronically cleared checks (under Check 21), that have notbeen submitted through the Federal Reserve check processing system (whichis why ECCHO believes the BOFD rather than the paying bank is in the bestposition to know of a problem with the original item).

The process: Drawer files a Written Statement Under Penalty of Perjury (WSUPP) with paying bank within

60 calendar days of statement being sent;

Paying bank files a claim within 15 business day;

BOFD either has to disclaim or request a copy of the WSUPP within 15 business days;

If a copy of WSUPP is requested, paying bank has 15 business days to provide;

BOFD then has 5 days to disclaim or process claim.

BOFD Disclaimer permitted when the account is closed or if the claim exceedsthe account balance.

119

The risk?

What if the money in the account is from other fraudulent items?Did the bank clear all checks through ECCHO? Are there otherclaims that could be brought against the account that the BOFDwill not have the right to disclaim?

BOFD may not have the right to charge the item back to thepayee-depositor’s account. Under the UCC, the right to chargeback only exists as long as the check has not been finally paid.After that, the only way for the BOFD to collect from the payee-depositor is to enforce a transfer warranty claim. The problemarises because UCC wouldn’t recognize the legitimacy of theoriginal warranty claim by the paying bank. Therefore, how can theBOFD enforce the transfer warranty on the payee-depositor?

120

61

Opt-out may be available to BOFD- however, bank wouldnot be able to bring a warranty claim under Rule 9 if itopted-out;

Opt-out may not be an option based on othercorrespondent agreements;

Make sure to review customer account agreements toensure that the bank has the ability to hold the payee-depositor liable for a Rule 9 claim;

WARNING- If the depositary bank doesn’t participate inECCHO, the rule doesn’t apply, even if the drawee banktries to make a claim.

121

MOBILE/REMOTE DEPOSIT CAPTURE AND DUPLICATE CHECKS- 1409 WEST DIVERSEY CORP V. JP MORGAN CHASE (2016);

122

Hotel(Drawer)

Check Payable to Employee

Employee

MB Financial Bank

(Drawee Bank)

JPMorganDepositary Bank

(Employee’s Bank)

Employee first deposits the check via Mobile Deposit Capture

Imaged check paid from Hotel’s account

Check Cashing Service

Depositary Bank (Check Cashing

Service Bank)

A few weeks later, Employee cashes the original check at Check Cashing Service

Who takes the loss when duplicate entries occur?

Original check was presented and dishonored as a duplicate

1st Transaction 2nd Transaction

62

Federal Reserve and Electronic Check Clearing HouseOrganization adjustment procedures available for six monthsafter presentment. Drawee Bank may bring claim against eitherDepositary Bank, however if the Drawee Bank doesn’t pay bothchecks, there’s no reason to bring a claim;

Drawer appears to be liable to a Holder in Due Course (HIDC),which could be both of the Depositary Banks or Check CashingService;

Effective July 1, 2018, Regulation CC will be amended to createa new indemnity that will generally place liability on depositarybank providing the mobile deposit capture service.

123

ELECTRONIC CHECK CONVERSION-

Amendments formally bring electronic checkconversion occurring on consumer accountsunder The Electronic Funds Transfer Act- CFPBRegulation E.

Drawee bank will be responsible for providingthe same provisional credit as would berequired under unauthorized ATM, ACH and POStransactions on consumer accounts.

124

63

CASH EQUIVALENT INSTRUMENTS

125

CAN NEGOTIABLE INSTRUMENTS (I.E. CHECKS) HAVE THE SAME EFFECT AS CASH?

UCC 3-310(a)

Certified check Cashier’s check Teller’s check

Discharge the obligation the same as cash.  Therefore, these are recognized by the law and bank regulations as “cash equivalents.”  It is virtually impossible to dishonor or stop payment on these items.

126

64

CERTIFIED CHECK (UCC 3-409)

127

Payment accepted and guaranteed by Home Town Bank, USABy: Jane Jones, SVPJohn R. Doe

CASHIER’S CHECK- [UCC 3-104(G)]- DRAWN BY AND DRAWN ON THE SAME BANK (SAME BANK IS DRAWER AND DRAWEE)

Teller’s Check‐ [UCC 3‐104(h)]‐Check drawn by bank employee (teller or officer) on the bank’s account at another financial institution. 128

Remitter-person who provided the funds to the bank for the cashier’s check.

65

WHAT DO ALL THREE HAVE IN COMMON?

The bank is substituting it’s money for the money of itscustomer or the remitter/purchaser of the item;

Why does this matter?

What makes these items unique are the restrictions ondishonoring and stop payment, which will bediscussed later.

129

130

THE “CASHIER’S CHECK” DILEMMA:

A cashier’s check has traditionally been considered to be thelegal equivalent of cash and is treated as such under law andregulation.

Cashier’s check fraud is calling in to question the legitimacy of allcashier’s checks.

66

IF A CHECK DELIVERED FOR PAYMENT ISN’T CERTIFIED? The underlying obligation is suspended until the check is

either dishonored, paid, or certified. [UCC 3-310(b);

If dishonored, if the person entitled to enforce is theobligee, then can enforce either the instrument or theobligation against the drawer/issuer;

If the person is not the obligee, then can only enforceinstrument as long as obligation is suspended;

If instrument is lost, stolen, or destroyed, the obligation is stillsuspended. Enforcement can be only on the instrument(resulting in stop payment and replacement) of the item. 131

132

THE STOP PAYMENT PROBLEM

To encourage “cash-like” treatment there is a limitedability to issue a stop payment on a cashier’s check.Right to stop pay is held by the issuer (financialinstitution) not the remitter (purchaser).

Any holder in due course has the right to enforcepayment against the issuer.

Issuer is liable to a holder in due course forimproperly placing a stop payment on a cashier’scheck.

67

133

During first 90 days after issuance, no stop paymentshould be placed unless a remitter indemnifies thebank (provides an indemnity bond, indemnityagreement, or grants other security for replacementof the check);

After 90 days from the date of issuance, UCC 3-312permits the payee or remitter to issue a “Declarationof Loss”.

IF A HIDC COULD EXIST:

134

DECLARATION OF LOSS FORM:

68

135

IF A STOP PAYMENT IS PLACED AND THE ORIGINAL CHECK IS PRESENTED BY A HIDC FOR PAYMENT:

Within 90 days of issuance- issuer must pay on original (even if areplacement has been issued);

90 days or after- issuer can refuse to pay without liability to a HIDC;

Be careful, though: If the issuer fails to stop the item by its midnightdeadline, the cashier’s check will be “finally paid” and the issuer willtake the loss;

If check was stolen without a valid endorsement of the payee, stoppayment can usually be placed because there will not typically be aHIDC.

136

DECISION TO PLACE STOP PAYMENT IS THE ISSUER’S, NOT THE REMITTERS:

Helpful language for the deposit agreement or purchasedocuments:

Stop payment orders on cashier’s checks, certifiedchecks or money orders are generally not permitted,although the financial institution will accept adeclaration of loss and issue a replacement for acashier’s check on or after 90 days have passed fromthe date of issuance if the check has not otherwise beenpresented for payment.

69

WHAT IF ISSUER HAS A DEFENSE AGAINST PAYMENT?

Still liable to a HIDC if the reason for stop payment is a personal defense againstpayment (such as the remitters failure to pay for the cashier’s check);

However, won’t be liable for expenses or consequential damages.

137

138

COUNTERFEIT CASHIER’S CHECK-DRAWEE/DRAWER ISSUES

When a counterfeit cashier’s check is presented for payment atthe named drawee institution, the item is handled just like anyother counterfeit check.

The law generally looks at counterfeit checks the same aschecks containing a forged drawer’s signature.

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139

COUNTERFEIT CASHIER’S CHECK-DRAWEE/DRAWER ISSUES CONT.

Just like any other check containing a forged drawer’s signature,the financial institution (as drawee) has until it’s midnightdeadline to refuse payment and return the check back to thebank of first deposit. After the midnight deadline has passed, ifthe drawee has not returned the check, the check is consideredto be “finally paid”. The drawee is prohibited by the UCC andRegulation CC from returning the item after the midnight deadlinehas passed.

140

WHY ARE CASHIER’S CHECKS DIFFERENT?

With a regular forged drawer’s signature on a check, if themidnight deadline has passed, the drawee might have the abilityto recover its loss from the drawer;

With a counterfeit cashier’s check, the drawee is also the drawerand therefore, has no ability to pass the loss on to another party.

71

141

DEPOSITARY BANK ISSUES:

A cashier’s check that is accepted for deposit is just like anyother check accepted for deposit. It is subject to theprovisions of the Expedited Funds Availability Act (RegulationCC).

142

REGULATION CC AND CASHIER’S CHECKS

§229.10 (c)(v)- Generally receives next business day availability aslong as the following conditions are met: Deposited into account of payee (otherwise treated as local); Deposited in person to an employee (otherwise two-day hold); A special deposit slip/envelope is used if required by the depositary

bank (otherwise treated as local).

72

143

EXCEPTIONS TO THE NEXT-DAY AVAILABILITY RULE: New account (account with new customer opened for less than 30

calendar days) and only amounts over $5,000 can be extended to 9business days;

Large aggregate deposit (amounts over $5,000);

Redeposited checks (except for missing endorsement and post-dateditems);

144

EXCEPTIONS CONT.

Repeated overdrafts- six or more banking days in past six monthsor two or more banking days of $5,000 or more;

Reasonable cause to doubt collectability- can not be basedupon a “class” of check or “class” of persons. Reason must bewell-grounded;

Emergency conditions.

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145

IF AN EXCEPTION:

Can extend for a reasonable period of time (except for new accountswhere first $5000 is on next-business day and remainder is on ninthbusiness day). For cashier’s checks, the check is treated as local and areasonable time is to be added to the local check schedule (due toconsolidation of the Federal Reserve’s check processing regions,generally seven business days total).

146

THE PROBLEMS?

Counterfeit cashier’s checks are hard to verify. Afinancial institution’s refusal to verify the legitimacy ofa cashier’s check may not be reasonable cause todoubt collectability;

Some counterfeit cashier’s checks are not drawn onvalid financial institutions or institutions in the UnitedStates. Other countries are not subject to theRegulation CC rules (including expeditious returns orthe UCC midnight deadline.

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147

THE PROBLEMS CONT.

Alterations v. counterfeits- A cashier’s check may be altered ratherthan counterfeit. A depositary bank warrants that no alterationshave occurred on the instrument for three years under thePresentment Warranties of the UCC (4-208). Therefore, if the itemhas been altered the depositary bank will be liable for the item,regardless of the midnight deadline.

148

THE RIGHT OF CHARGE BACK-

A depositary bank has the right to charge an unpaid itemback to the payee/holder under UCC 4-214;

Payee/holder warrants under the Transfer Warranties (UCC4-207) that all signatures on an item are authentic andauthorized, there are no alterations, that there are nodefenses to payment. Liability for the warranty can not bedisclaimed by the payee/holder (i.e. “without recourse”endorsements do not work).

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149

THE PRACTICAL PROBLEM?

The payee/holder has already spent the money because a holdwas not placed on the deposited cashier’s check. As a result,the charging back of the fraudulent item causes an overdraft.

Or, the payee/holder participated in the scam and thepayee/holder, as well as the money, is gone.

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THE DEPOSITARY BANK SOLUTIONS?

Don’t take a questionable item for deposit;

Instead, consider sending the item for collection;

If already accepted for deposit, out source the item forfurther investigation. If it is discovered to be counterfeitafter it has already been processed, an exception hold canbe placed on the funds deposited.

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WHAT IS THE COLLECTION ITEM PROCESS?

Not subject to regular check processing rules, such as presentment,dishonor, and the “midnight deadline”;

Not considered an item taken for deposit under Regulation CC;

In essence, the payee/holder does not get credit until the “depositary”bank gets credit. Shifts the risk of loss from the depositary bank to thepayee/holder.

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HOW?

Must get consent from the payee/holder to send the item forcollection;

Must prepare instructions for the drawee bank on how thecollection item should be handled, including: How payment should be remitted; How long the check should be held; How fees should be collected.

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SAMPLE COLLECTION INSTRUCTIONS:

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WHAT IF THE CHECK IS COUNTERFEIT?

Typically, the “drawee” bank will send the item back and askthat a fee be remitted. That is usually a sign that the check iscounterfeit;

If the check is valid, the drawee bank will pay the check, deducta collection fee and send the remaining funds back to thedepositary bank as instructed in the letter.

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ELECTRONIC FUNDS TRANSFER ACT-CFPB REGULATION E

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WHAT IT DOES DO AND WHAT IT DOESN’T DO: Applies only to consumer accounts;

Does not establish procedures between financial institutions or betweenfinancial institutions and third parties (other than with the InternationalRemittance Transfer rules;

Does establish rules between a financial institution and its consumercustomer with regards to electronic funds transfers, such as in the area ofunauthorized transfers and liability limits.

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Unauthorized EFT- transfer initiated by a person otherthan the consumer without actual authority to initiatethe transfer and from which the consumer receivesno benefit. Includes a transfer initiated by a person who obtained access device

through fraud or robbery;

Includes ATM transfer if consumer has been induced by force to initiatetransfer.

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Unauthorized Electronic Funds Transfers; Regulation E Liability Limits-

Unauthorized EFT does NOT include an EFT initiated:

By a person who was furnished an access device by the consumer ANDgranted authority to make transfer and exceeds the authority given, unlessthe consumer has notified the bank that person is no longer authorized;

With fraudulent intent by the consumer or any person acting with theconsumer; or

By the bank or its employees. However, a consumer has no liability forerroneous or fraudulent transfers initiated by an employee of a bank.

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Liability of Consumer for Unauthorized Transfers Using an Access Device(i.e. Debit Card)

Bank must provide the required disclosures and access device must have been“accepted” by the consumer for the consumer to have any liability whatsoever;

State law that is more beneficial than Regulation E controls.

Negligence by the consumer can NOT be used as a basis for imposing greaterliability than is permissible. For example, writing PIN on debit card will not affect theconsumer’s liability for unauthorized transfer (per Regulation E Official StaffCommentary).

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If consumer notifies bank within two (2) business daysafter learning of the loss or theft of the accessdevice, the consumer’s liability shall not exceed thelesser of $50 or the amount of the unauthorizedtransfers that occur before the notice to the bank.

If the consumer fails to notify the bank within two (2)business days after learning of the loss or theft of theaccess device, the consumer’s liability shall notexceed $500.

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If consumer fails to report after 60 days from the periodicstatement, the bank is still going to be liable under the $500 limit,but the consumer is responsible for the unauthorized transactionsthat occurred beyond the 60 day period, as long as bankestablishes that the unauthorized EFTs would not have occurredhad the customer notified the institution during the 60 day period.

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Liability of Consumer for Unauthorized Transaction NotInvolving an Access Device Consumer is not liable for any portion of an unauthorized EFT within

the 60 day period after the statement is transmitted showing the firstunauthorized EFT. Consumer is liable for any after the 60 day period.

Common mistake- Consumer does not report in 60 daysand bank tries to pass all liability back onto consumer.Regulation E requires bank to investigate. Bank does nothave to provide provisional credit, but bank is still liablebased on the consumer limits described above during thefirst 60 days after the statement is transmitted.

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HOW ARE CLAIMS BETWEEN FINANCIAL INSTITUTIONS AND THIRD PARTIES ALLOCATED?

Not controlled by laws or regulations;

ACH and debit transactions settled under NACHA rules/clearinghouserules;

VISA/Mastercard transactions (POS/credit card) settled under rulesbetween participants in the respective systems.

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FUNDS TRANSFER FRAUD LOSS ALLOCATION- FUNDS TRANSFERS NOT

SUBJECT TO REGULATION E

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GENERALLY

Wire transfers are not specifically covered under Regulation E, except inso far that they are consumer international remittance transfers;

Otherwise, wire transfers and commercial funds transfers are subject toUniform Commercial Code Article 4a and network rules (Fedwire/SWIFT),which are not regulations or laws, but are rules adopted by the system,governing use of the system.

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FUNDAMENTALS- RIGHTS, DUTIES, AND PAYMENT 4A-209

Rights and obligations arise upon the “acceptance” of a payment orderby the receiving bank. “Acceptance” occurs when receiving bank“executes” the payment order of the sender by sending a payment orderto some other bank (intermediary or beneficiary’s bank) with the intentthat it carry out the payment order received by the receiving bank.

Basic terminology: Sender- party transferring out the money; Receiving bank- sender’s bank; Beneficiary bank- bank that receives the transferred funds; Beneficiary- party for whose benefit the transfer was sent. 166

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Receiving Bank is not required to accept a sender’spayment order request unless the bank makes anagreement (before or after issuance) to accept it, oracceptance is required by a funds transfer system rule4a-209;

If there is a contract or a rule requiring the ReceivingBank to accept and execute a payment order, a breachof that agreement or rule will only result in actualdamages (not consequential damages, unless theagreement specifically allows for them) 4a-305;

If there is no contract, but the sender’s account issufficient to cover the order, the receiving bank mustgive timely notice of rejection of the payment order, orbe liable for interest if the notice is untimely 4a-210. 167

When a payment order is accepted, the sender must pay theamount of the order to the receiving bank 4a-305(d);

If beneficiary’s bank accepts a payment order, thebeneficiary’s bank is obligated only to the beneficiary (not tothe sender);

The obligation is paid (discharged) when the beneficiary bankaccepts the payment order and becomes obligated to paythe beneficiary 4a-406;

Beneficiary’s bank is required to promptly credit thebeneficiary when the payment order is accepted, otherwisemay be liable for consequential damages 4a-404.

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If the payment order is not completed, sender has no obligation topay receiving bank. If sender has already paid, it is entitled to arefund;

All parties (except for the beneficiary’s bank) are obligated to thesender when accepting a payment order for processing 4a-209 and4a-302;

Payment orders can be dated for a future payment or execution date.If no payment or execution date is set, it is to be paid immediately4a-301;

Absent a special contract term, consequential damages are notavailable to the sender for a receiving bank’s failure to complete anaccepted payment order, or the bank delays processing anaccepted payment order or fails to execute a payment order 4a-305.

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STOP PAYMENT 4A-211 Referred to as “cancellation”;

Effective only if verified under any applicable security procedure or thebank agrees to the cancellation; and

Is received at a time and in a manner affording the receiving bank areasonable opportunity to act on the communication before the bank“accepts” the order;

If already “accepted,” it can only be cancelled if receiving bankagrees or a funds transfer rule allows for cancellation without receivingbank’s agreement;

Practically, there is very little time for a sender to amend or cancel apayment order, unless the order is a recurring order or beneficiary’sbank accepts cancellation request.

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Beneficiary’s bank may accept cancellationrequest without automatic liability to thebeneficiary if (4a-211): Unauthorized payment order; or Mistake of sender resulted in:

Duplicate payment; Beneficiary not entitled to receive payment; Amount ordered was greater than amount beneficiary was

entitled to receive.

If beneficiary is to receive payment order thatbeneficiary is not entitled to, parties can seek aninjunction or seek remedy under unjustenrichment/restitution 4a-503. 171

UNAUTHORIZED PAYMENT ORDERS

4a-202 encourages sender and receiving bank toestablish verification procedures for authenticatingpayment order requests. If payment order is authorized by a person identified

as sender (or an agent), then payment order isconsidered effective.

If verified by an authentication system/procedure,then considered valid if authentication system iscommercially reasonable and bank accepts thepayment order in good faith and in compliance withthe system/procedure. 172

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4a-203- If receiving bank accepts a payment order under an“authentication procedure” and it is not really authorized by sender, itcan have an express written agreement that can limit the extent towhich it is entitled to enforce or retain payment of the order;

However, receiving bank is not entitled to enforce or retain paymentof the payment order if the sender proves that the order was notcaused, directly or indirectly, by a person: Entrusted with duties to act for sender; or By a person who obtained access to transmitting facilities of sender, or

who obtained from a source controlled by the sender, without authorityof the receiving bank, information facilitating breach of the securityprocedure, regardless of how the information was obtained or whetherthe customer was at fault. Information includes any access device,computer software or the like.

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4a-204 If payment order is not authorized or verified under 4a-202 or 4a-203, then receiving bank that accepts the order willbe liable for payment order amount and interest to sender forunauthorized payment order;

4a-204 Sender not entitled to interest unless reported within areasonable time not exceeding 90 days after the senderreceived notification of the payment order’s acceptance;

4a-204 The reasonable time can be fixed by agreement, butthe receiving bank’s liability can not be varied by agreement;

4a-505 Sender must notify receiving bank of error within oneyear after notification was received by sender (this rule appliesto all debits against the sender’s account for payment orders).

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MISTAKES IN PAYMENT ORDER- 4A-205

Erroneous could be that the payment order contained: Wrong beneficiary; Wrong amount; Duplicate.

If the order was not transmitted to a security/authenticationprocedure, sender takes the loss and must act on its own torecover from the beneficiary under law of mistake and restitution;

If order was transmitted pursuant to security procedures, andsender can prove it complied and that had the receiving bankcomplied, the error would have been detected, then the followingrules apply: 175

If wrong beneficiary or duplicate payment order, sender is notobliged to pay the order and the receiving bank will have topursue the money from the beneficiary;

If wrong amount, sender is not obliged to pay more than whatwas actually intended to be paid by the sender. Receiving bankmust pursue the difference from beneficiary;

Sender must bring claim within 90 days after receivingnotification. If fails to do so, then liable to receiving bank foramount the bank can prove it lost as a result of the sender’sfailure to notify in a timely manner.

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THE KEYS FOR BOTH UNAUTHORIZED TRANSFERS AND MISTAKES:

Must have a written agreement that incorporatessecurity/verification procedures;

To be insured, need written agreements with call-backverification procedures (or verification procedures that havebeen approved by the insurance underwriter).

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MISDESCRIPTION OF BENEFICIARY- 4A-207

Where name, bank account number, or otheridentification of beneficiary refers to a nonexistentor unidentifiable person or account, no person willhave rights as beneficiary and acceptance of theorder can not occur. If payment order identifies the beneficiary by both

name and account number, and the name andnumber identify different person, the following rulesapply:

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If beneficiary’s bank does not know that the name andnumber refer to different persons, it may rely on thenumber as the proper identification. Beneficiary’s bankneed not determine whether the name and number referto the same person;

If the beneficiary’s bank pays the person identified byname and knows that the name and number identifydifferent persons, no person has rights as beneficiary,except the person paid by the beneficiary’s bank if thatperson was entitled to receive payment from the senderof the funds transfer. If no person has rights asbeneficiary, acceptance of the order can not occur;

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If the payment order is accepted and the order described thebeneficiary inconsistently by name and number, and the beneficiary’sbank pays the person identified by number, rather than by name, thefollowing rules apply:

If the sender is a bank, the sender is obliged to pay the order; If the sender is not a bank, and it proves the person identified by number

was not entitled to receive payment from the sender, the sender is notobliged to pay its order unless the receiving bank proves the sender,before acceptance of the payment order, had notice that the payment ofthe payment order might be based upon the bank account number, evenif the person named is different.

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RECALLING ENTRIES; WHAT IS THE RISK TO THE RDFI?

Does the ODFI/Receiving Bank have the ability to force anRDFI/Beneficiary Bank to return an ACH credit/wire transfer when fraud hasoccurred?

Generally, no. Procedures available are under NACHA rules: Recall- Neither the ODFI, nor an Originator, has the right to recall an entry or

file, to require the return or adjustment to an entry, or to stop the payment orposting of an entry, once the entry or file has been received by the OriginatingACH Operator, except for Reversing Files, Reversing Entries, and ReclamationEntries and Written Demands for Payment.

Reversing Files and Reversing Entries, Reclamation Entries and Written Demandsrequire ODFI to indemnify RDFI; also have very limited and strict time frames;

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ODFI/Receiving Bank Request for Return used in most cases.RDFI/Beneficiary Bank may, but is not obligated, to return theentry. ODFI/Receiving Bank indemnifies RDFI/Beneficiary Bankfor this process, but there is significant risk if entry should not havebeen returned.

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CREDIT CARD LOSSES

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GENERALLY:

Losses between the card issuer and consumer cardholder aresettled pursuant to Truth in Lending-CFPB Regulation Z;

Losses between the card issuer and commercial cardholders aresettled by VISA/Mastercard rules and contract;

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CONSUMER CARDHOLDER’S LIMITED LIABILITY FOR UNAUTHORIZED USE

Differs for credit and debit card transactions. Reg Zcontrols credit cards. The Electronic Funds TransferAct (Federal Reserve Regulation E) regulates debitcards or transactions that are “blended”.

This can be difficult for customer’s (and issuers) tounderstand due to confusion of VISA/Mastercardlogos on cards. Credit card transactions run throughthe VISA/Mastercard network and are typicallysignature based; Debit card transactions runthrough NACHA system and are typically PIN based.

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TIL-REG Z UNAUTHORIZED USE LIABILITY LIMITATIONS (1026.12):

Applies to consumers and some business cards (ifcards are issued to fewer than 10 employees).Otherwise, law allows the bank to contract forother liability limits against the company (but notas to the individual cardholders);

Generally limits the liability of cardholder to $50;

Liability can be $0, unless:186

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Credit card has been accepted by the cardholder; The liability does not exceed $50; The issuer gives adequate notice of potential liability; The issuer provides a description of means to report loss

or theft of card; Unauthorized use occurs before the cardholder has

notified the issuer of the loss or theft; and The issuer has provided a means to identify the

cardholder (signature or photograph). However, if theidentification means were not used in the transactions(i.e. phone or Internet), cardholder can not be heldliable. This is why CVC numbers are now used on thesepurchases. 187

Liability may be $0 if underlying agreement says so.VISA/Mastercard contracts promote $0 liability for unauthorized use,unless cardholder is negligent. Merchants and bank issuers agree tothese terms as part of offering (or accepting) VISA/Mastercardservices.

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EXCEPTIONS TO THE LIMITATION OF LIABILITY:

Cardholder voluntarily and knowingly allows another to use thecard and that person exceeds the authority. Authority can beactual, implied, or apparent authority for such use. Cardholder’sexpress limitations on authority are not effective against theissuer;

If used by someone not having authority, cardholder can beliable for unauthorized use if cardholder received a benefit fromthe transaction.

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Notification that authority has been withdrawn may not be legallyeffective against the issuer either (courts differ as to whethercardholder’s liability is limited). However, practically, if thecardholder notifies issuer of revoked authority, issuer will blockand cancel the card so that it can not be used;

If issuer fails to block and cancel card once reasonable noticehas been given, issuer may be liable to cardholder for thecontinued misuse of the card;

Unclear as to what the level of liability is if the card was givenvoluntarily to agent and then agent returns card, but continues touse “information” from card to perform unauthorized transactions.

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Most contracts also create joint account liability where jointapplicants for credit card agree to be liable for each other’stransactions on the card, even if there is no approval orbenefit.

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Burden of proof is on the card issuer to show a reportedlyunauthorized transaction was actually authorized by thecardholder, or that the cardholder received benefit from atransaction.

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WHO IS LIABLE IF CARDHOLDER IS NOT?

Criminal (unjust enrichment), although this is unlikely to ever happen;

May be charged back to merchant if merchant failed to followrequired verification procedures;

Issuer will take loss if merchant followed required verificationprocedures.

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THE END!

ANY QUESTIONS?

THANK YOU!

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