Memorandum. Fred H. Miller, Chair, Study Committee on Payments Issues Linda J. Rusch, Reporter

Transcription

1 Memorandum From: Fred H. Miller, Chair, Study Committee on Payments Issues Linda J. Rusch, Reporter Date: March 16, 2009 Re: Request for Comments on Issues under UCC Articles 3 and 4. Introduction This is a working document prepared by the ULC/ALI Study Committee on Payments Issues. It constitutes a list of troublesome issues in or related to Uniform Commercial Code (UCC) Articles 3 and 4 identified by attorneys who practice in this area of the law and derived from academic journals and published cases. It has not been submitted to or approved by the Executive Committees of the ULC or the ALI. It will be discussed with payment system participants for their comments and suggestions, and modified accordingly. Any drafting project that may emerge from this process will be subject to limitations on scope and detail imposed by those Executive Committees. Purpose of this Document The Study Committee wishes to receive input from payment system participants on: (1) matters that they perceive could benefit from clarification or updating in or related to payment methods under state law, either by amendments or changes to statutory text or Official Comments, and that result from changes in technology, products, participants, practices, and processes currently employed; and (2) specific comments on the substance and importance of the contents of this document. Previous Revisions Articles 3 and 4 were revised in 1990 (with miscellaneous and conforming amendments to Article 1). A modest set of amendments were adopted in Both efforts were undertaken for the purpose of accommodating modern technologies and practices in payment systems and with respect to negotiable instruments. The Study Committee s current review of issues in or related to Articles 3 and 4 may, not inappropriately, be regarded as the latest effort in the progressive codification of the common law of negotiable instruments that began with the English Bills of Exchange Act enacted by Parliament in The Uniform Negotiable Instruments Law was promulgated by the ULC in 1896, and it in turn was reorganized and modernized by original Article 3 Commercial Paper as part of the UCC jointly promulgated in 1952 by the ULC and the ALI. Revised Articles 3 and 4 in 1990 modernized, reorganized and clarified the law. The 2002 amendments to both articles addressed a small number of specific issues that had arisen since that time. Page 1 of 22

2 Need for Further Revision (a) Developments Related to Improved Technology. Almost 20 years after the 1990 revisions of Articles 3 and 4, the Study Committee is examining whether is it time to further address issues that have arisen under or are related to these UCC Articles in the interim period, during which ambiguities have been discovered, case law interpretations of the statutes have diverged, and perhaps most importantly, new developments have occurred. For example, present Articles 3 and 4 and their predecessors are based upon a paper payment system. Since the revision in 1990, there has been a drive by industry to eliminate the expense and delay in clearing checks in the forward collection process by engaging in various methods of truncation of the paper check and transmitting information electronically (including imagining the check and transmitting the image or merely transmitting the MICR line information). The tragedy of September 11, 2001 demonstrated that moving all this paper was not only costly, but could become impossible. In response to the industry move to speed the processing of checks by engaging in various methods of electronic information transmission and the subsequent decrease in the volume of checks collected end to end by transmitting paper, the Federal Reserve Board has engaged in systemic shrinkage of its paper processing facilities. These developments also implicate the check return system for dishonored items and whether the rules of UCC Articles 3 and 4, and Regulation CC, all of which govern the check return process, are still workable. Present Articles 3 and 4, written for a paper-based system, simply do not adequately address the issues of responsibility and liability as they relate to modern technologies now employed and the procedures required by the current volume of checks. While agreements among parties to particular transactions have provided some relief, such stop-gap measures are increasingly inadequate given the volume of items now processed electronically. One of the issues that is looming is the extent to which parties not in privity with another party in the collection or return chain can enforce indemnity rights or other warranty like rights due to problems in the electronic collection of the item. In particular, it is not clear whether rights under these serial agreements among the processors inure to the benefit of the customers of the bank of first deposit, the customers of the payor bank, or any remote bank in the collection chain that is not a party to the agreement. To illustrate, an intermediary bank may have a contract with the bank of first deposit and another contract with the payor bank, but that does not create any direct rights between the payor bank and the bank of first deposit. (b) Developments leading to segregated sources of law. In addition, as the courts and parties have had almost 20 years of experience with revised Articles 3 and 4 and the Expedited Funds Availability Act (and its implementing regulation, Regulation CC), there have arisen reoccurring litigated issues where the courts approaches have diverged, contributing to uncertainty and inconsistency about how the risks of certain type of behavior relating to checks will be allocated. During that time, an additional federal statue has been adopted (Check 21 and its implementing changes to Regulation CC) to facilitate electronic check collection and creating a new type of negotiable instrument, the substitute check. Further changes have been made to Regulation J and Federal Reserve Operating Circular 3 governing the check collection process. All of these developments have lead to a patch work of statutory requirements and regulations which are difficult to mesh into an easily understandable system with clear risk allocation. Page 2 of 22

3 Uncertainty of risk allocation is undesirable because of its effect on undermining the low cost efficiency that is the model of a well functioning payment system. (c) Other Developments. Finally, cases continue to struggle with ambiguities, ģaps, and inconsistencies in Articles 3 and 4. For example, when are common law theories of negligence or breach of contract available to supplement the UCC? Article 1 does not provide clear answers. Also practices have developed which are not easily accommodated within existing Article 3. For example, so called demand drafts or remotely created checks raised concerns for payor banks resulting in non-uniform amendments that made modest inroads on the ancient doctrine of Price v. Neal. Arguably the sponsors of the UCC waited too long to address this development, and as a result this aspect of state law migrated to the federal level through an amendment to the Regulation CC warranty provisions (Reg. CC (d)). Revision of Article 3 and Article 4 to update, improve and maintain the viability of it is believed to be necessary to accommodate these changing practices and modern technologies, the needs of a rapidly expanding national and international economy, the requirement for more rapid funds availability, and the need for more clarity and certainty. Absent such an update, further Federal preemption of state law may likely occur, or a proliferation of non-uniform amendments or divergent case law responses to the same or similar issues. Some may ask, given that the modest amendments to the payment articles of the UCC prepared in 2002 have been slow to be adopted, why not simply federalize payments law (some aspects of that law governing credit and debit devices are existing federal law). Traditionally, the legal structures for payments have been regulated by state law through the Uniform Commercial Code. The virtue of that is several fold and includes: the state law process is open, participatory and transparent, while one is never sure what one is getting through Congress. the UCC is part of state law and as such can better coordinate with it; federal legislation is specific and often coordinates with state law by preemption, a result that adds an additional level of issues on which the outcome is seldom clear. Congress seldom writes a detailed law and generally leaves much to regulation over which there is even less participant control than over the legislation itself. the state law process today can work with the federal level to achieve the maximum success in clear drafting and enactment. In short, the essence of uniform law revision is to obtain a sufficient consensus and balance among the interests of the various participants so that universal and uniform adoption by the legislatures of all 50 states may be achieved. As is the practice of the ULC, announcement of any drafting undertaking for Articles 3 and 4 will be widely circulated. Anyone who so requests will receive notice of all meetings and is invited to attend. Upon request, names can be put on a mailing list to receive copies of drafts as they progress. In addition, the American Bar Association will closely follow the work and widely circulate the drafts. The discussion of the drafts is open for comment by all those who attend. Any work product will be read line for line at the annual meetings of the ULC. In addition, the American Law Institute will circulate the drafts two or three times to its entire membership and drafts will be discussed at the membership annual meeting. Progress reports will be published annually in The Business Lawyer. The consensus, balance and quality achieved in this lengthy deliberative process is a product not only Page 3 of 22

4 of the work of the reporter and the drafting committee, but also the faithful and energetic participation of the advisors and participants to the drafting committee. Responses Solicited The Study Committee is considering the following major issues. Although this is not an exclusive list of issues that may be considered, the explication below is designed to elicit and solicit comments from system participants concerning not only these issues but also to invite submission of other issues and any concerns that should be part of the Study Committee s consideration. The issues are grouped into three major issues. First, what issues are presented under UCC Articles 3 and 4 given the explosion in electronic methods of collecting on checks. Second, what issues are presented under Articles 3 and 4 in practice and by cases which lead to uncertainty regarding the risk allocation in collection of checks. Third, what issues are presented under Articles 3 and 4 where no litigation has yet arisen to a published case, but the current code language or comments create uncertainty about the application of the rules. I. Specific issues regarding electronic methods of collection of checks A. Consolidation of processors In the forward collection or check return chain, each bank has a time for acting in order to act with reasonable care. UCC In facilitation of faster processing methods, many banks have contracted with processors or have aggregated their check processing centers so that the paper checks or electronic information from checks is not processed by each bank. For example, a bank with many branches may provide that all checks in a certain geographic area will be processed by a centralized center. A bank also may image or capture the MICR line information either at the place where the check is deposited or at a centralized processor. In addition, a bank may take only electronic information from its customers in a process referred to as remote deposit capture. In essence, the customer captures the MICR line information or images the check and transmits only the electronic information to its depositary bank. A legal regime that measures whether the bank has acted in a timely manner depending upon when the bank received the check, and that presumes that the banks or branches of a bank are doing the processing, is not a workable regime given modern methods of processing. See UCC B. Presentment and transfer warranties Currently the presentment and transfer warranties in Articles 3 and 4 depend upon transfer or presentment of a physical piece of paper. UCC 3-416, 3-417, 4-207, These warranties inure to the benefit of immediate and subsequent transferees (transfer warranties) or the benefit of the drawee bank or the benefit of a drawer or indorser who pays the check (presentment warranties). These warranties are an integral method of allocating risk from certain types of wrongdoing concerning checks (i.e. that the transferor or presenter is a person entitled to enforce the check, etc.). A transferor or presenter does not make these warranties if what is being Page 4 of 22

5 transferred or presented is an electronic image of a check or a transmission of the MICR line information. To deal with this gap in UCC Articles 3 and 4, the Federal Reserve Board amended Regulation J to provide for warranties regarding these electronic items if the transfer is made to a Federal Reserve Bank or by a Federal Reserve Bank. Regulation J, 210.5, But the Regulation J warranties do not cover images collected through another clearinghouse, and do not provide protection to image or electronic information transfers between banks even if the check ultimately is processed through a Federal Reserve Bank. The allowance for electronic presentment agreements in UCC does not clearly govern entities who may have dealt with the image prior to presentment of that image to the payor bank (such as the bank of first deposit). Even if there are agreements between a transferor and its immediate transferee to provide for a warranty similar to the transfer warranty provisions or an agreement between the presenter and the drawee for a warranty similar to the presentment warranty, it is not clear that these types of warranties created by private contract provide any rights against previous transferors that are not in privity, including the customer of the bank of first deposit. Similarly, if the drawer of a dishonored check pays the presenter based upon the electronic image or captured MICR information, the drawer does not get the benefit of the Article 3 or 4 presentment warranties and is unlikely to be covered by virtue of the agreements among bank participants. C. Accuracy of electronic information and double payment The only warranty in either Article 3 or Article 4 concerning capture of electronic information is found in UCC which provides that a party may have an agreement for electronic presentment and the warrant that they follow the agreement. In addition, a party that encodes an item makes an encoding warranty (or if the customer encodes, the depositary bank makes the warranty). Articles 3 and 4, Check 21 or Regulation CC do not address the following issues: $ the entity that captures the electronic information (either in an image, or MICR or other manner) does not warrant that the capture of information is accurate and suitable for further processing. Compare Reg. J (a)(4)(i). The beneficiary of this Reg. J warranty is the Federal Reserve Bank. The Federal Reserve Bank makes a comparable Reg. J warranty to its transferee. Reg. J (b)(3)(i). These warranties do not cover other parties or other methods of processing outside the Federal Reserve system. $ the entity that captures the information does not warrant that the information is suitable for allowing for electronic presentment or for creation of a substitute check with legal equivalence. Compare Reg. J (a)(4)(i). The beneficiary of this Reg. J warranty is the Federal Reserve Bank. The Federal Reserve Bank makes a comparable Reg. J warranty to its transferee. Reg. J (b)(3)(i). These warranties do not cover other parties or other methods of processing outside the Federal Reserve system. $ there is no warranty against double payment (i.e. payment based upon the electronic information and payment based upon a second presentment either in the original paper, or another electronic transmission). Compare Reg. J (a)(4)(ii). The beneficiary of this warranty is the Federal Reserve Bank. The Federal Reserve Bank makes a comparable Page 5 of 22

6 warranty to its transferee. Reg. J (b)(3)(ii). These warranties do not cover other parties or other methods of processing outside the Federal Reserve system. Note the Check 21 warranty against double payment only applies if there is a substitute check created, Reg. CC , and would not apply to double presentments of electronic information or electronic information and the original paper check. Consider a party that engages in remote deposit capture and transmits electronic files to its depositary bank. It creates duplicate files and both files are routed through its depositary bank to the payor bank and the payor bank pays each item. There is no substitute check created and there is no contract right as between the payor bank and the party that initially transmitted the duplicate check or the depositary bank. The payor bank will have to recredit its customer s account as only one item was properly payable but has no clear ability to collect from either the capturing party or the bank of first deposit. To the extent any of these items are handled in privity based contracts between parties, there is no certainty that those rights are enforceable by anyone other than the party in privity, or that the contracts that do exist have adequately guarded a remote party against the risk. D. Garbling and other technical deficiencies Articles 3 and 4 do not contemplate that a presentment will be made with electronic information from which the drawee bank cannot determine whether the item should be honored. Whenever there is capture of electronic information, there is a risk of garbling, or other technical standards not being met. However, if such an electronic presentment is made, the check may be otherwise properly payable, except for the technical issue or garbling. If the drawee bank seeks information in order to determine whether to pay or return the item, is that a dishonor? Compare UCC 4-301, Is the midnight deadline workable to deal with this situation? E. Electronic return In the check return process, the information concerning the item that may be returned could be electronic (under the 2002 amendments to Article 4, UCC 4-301(a)(2)). However, that approach only requires an agreement between the person accepting the return and the payor bank. Should parties who are not party to that agreement be bound to the decision to accept the electronic return? For example, perhaps the agreement is with the presenting bank, not the bank of first deposit. Is the bank of first deposit bound to whatever the presenting bank agreed to? Similarly, Regulation CC appears to require the return of the physical item, not an image of the item, unless the original is unavailable for return. Reg. CC (f). If the original presentment is in paper, does that mean the payor bank must always return the original or does the payor bank have leeway to destroy the original and return a copy? Page 6 of 22

7 F. Enforcement of contract liability on the check in the event there is only an electronic image or MICR line information Can a person that is attempting to enforce contract liability on the instrument enforce an electronic image, or must that person always procure a substitute check with legal equivalence? UCC requires the original unless the special circumstances of UCC are met for lost or stolen instruments. If the image or electronic information is not sufficient to create a substitute check with legal equivalence or no bank wants to create such a substitute check (a bank that creates the substitute check with legal equivalence must make the substitute check warranties, Reg. CC ), what rights does the person entitled to enforce really have? Similarly the rules that govern holder in due course and rights to enforce the instrument do not seem to apply when the item that is being transferred is merely electronic information. For example, assume a customer images the check (remote deposit capture) and transfers the image to the bank of first deposit. The image is dishonored by the payor bank. If the bank of first deposit is unable to recover against its customer, is the bank of first deposit a holder (and most importantly a holder in due course ) of the image so as to take free of defenses of the drawer (and any indorsers). Because Article 3 and the holder in due course concept is limited to paper checks, the answer appears to be no. Compare Uniform Electronic Transactions Act 16 (not applicable to a check). When collecting against the drawer or indorser, in order to arguably obtain holder in due course rights, the bank of first deposit will have to create a substitute check with legal equivalence. What if the image its customer created is not sufficient to do that? Will the drawer be able to assert all the defenses it would have against the payee against the bank of first deposit because the bank of first deposit cannot qualify as a holder in due course as all it has is the electronic image which is not sufficient to create a substitute check with legal equivalence? Further, the bank of first deposit may not be able to qualify as a holder in due course even with the substitute check, because at the time it took the check image, it could not qualify as a holder in due course as that concept does not exist as to the electronic image. Later, after dishonor, when the bank of first deposit creates the substitute check (and thus has a paper check), it already knows there is a problem with the check, and would arguably not be able to qualify as a holder in due course at that later time. All of the indemnity rights the bank of first deposit has against its customer who created the electronic image will be of no use to the bank as against the drawer of the check. G. Who should warrant the electronic information in a remote deposit capture? When a customer of a bank engages in remote deposit capture (it takes a paper check and creates the electronic image or information file) and transmits merely that electronic file to the bank of first deposit, is it appropriate for the bank of first deposit to be the warrantor if there are warranties imposed on the customer (similar to the encoding warranty)? Page 7 of 22

8 H. Fraud safeguards and the ability to determine the type of fraud In electronic imaging or electronic data capture, many of the safeguards that can be used in paper checks to deter fraud (safety paper, change in color, imprinting, watermarking, etc) are reduced. In addition, with only the electronic image to work with, determining the type of fraud may be impossible (for example, is it a forged drawer s signature or an alteration of an existing check). To the extent the loss allocation rules of Articles 3 and 4 make distinctions based upon the type of loss (i.e. forged drawer liability is different than alteration liability), this type of difficulty will lead to results not based upon the merits, but merely how the litigation is structured and who has the burden of proof on what issue. 1 This partial list of issues indicates that technology and industry practice have outpaced the governing law. The overriding issue is to what extent the construct of Articles 3 and 4 (and Regulation CC) should be applied to electronic information gleaned from checks and used to collect on those checks. These issues are not handled adequately by contracts between parties in the forward collection or return chain because of the privity barrier inherent in the law of contracts. Second, to the extent recovery is limited to the party in privity, multiplicity of lawsuits are encouraged instead of direct actions between the relevant parties. That is, if there is something wrong with an electronic image, the bank initially holding the loss will only be able to go up the chain to its immediate transferor and so on. Even if this is handled through contract assignment when a problem arises, it is still a cumbersome process. Ultimately each party s rights will depend in large part upon the quality of agreements that it did not enter into or have any input into developing. Third, the level of uncertainty here regarding exactly who has what rights regarding these electronic items will also encourage litigation. Finally, another issue which presents broader concerns, is whether the rules of Articles 3 and 4 are the appropriate construct to apply to so-called e-checks which never exist in paper form. While entities such as The Electronic Check Clearing House Organization (ECCHO) have provided private rule sets that govern the parties to that rule set, it is not entirely clear that those rules benefit parties that may handle the electronic item or have rights as to the electronic item who are not parties to that rule set. While the ECCHO rules provide that they are clearing house rules and given effect under UCC 4-103, that is not a matter free of doubt either (but perhaps should be), and even if they are clearing house rules, it is unclear whether those rules can alter some concepts of Article 3 (such as the requirements of holder in due course status). One of the issues that could be addressed in an Article 4 revision is to give clearer guidance on these matters. Any revision of Articles 3 and 4 to address this changed set of collection practices should not seek to duplicate the detail of a rule set such as the ECCHO rule set. Rather, the major issue is whether the existing construct of UCC Articles 3 and 4 is appropriate to apply to electronic images or electronic information captured from checks that would be for the benefit of all participants in the forward collection and return system. A secondary issue is whether there needs to be a discrete number of new rules to deal with specific issues presented by electronic images or electronic information capture that would apply more broadly for the benefit of all participants in the forward collection and return process. Page 8 of 22

9 II. Issues creating uncertainty in risk allocation under current Articles 3 and 4 2 A. The relationship between common law principles (primarily negligence) or other state statutes and UCC Articles 3 and 4. An issue that creates a significant amount of litigation year after year is whether there are negligence causes of action that supplement the causes of action within the UCC structure. UCC Articles 3 and 4, unlike Article 4A, does not have a clear signal as to what common law rights of action are supplementary and what common law causes of action are displaced. The major questions in this area are: Are there common law causes of action outside the code structure that supplement the UCC-based causes of action? Do UCC 3-404(d), 3-405(b), or (in particular) create affirmative negligence causes of action against persons who take or pay instruments bearing forged indorsements or are they loss sharing rules that should apply only within the context of other code-based actions concerning instruments? 3 Are negligence claims assertable even against a taker that otherwise qualifies as a holder in due course (i.e., even if a party is negligent, are they still a good faith taker without notice of claims and defenses so as to qualify as a holder in due course under UCC 3-302)? How does this potential negligence liability relate to the issue of liability for conversion under UCC 3-420, or contract liability on an instrument under UCC or 3-415? A related and important issue, to the extent negligence principles have a role to play, is what counts as ordinary care of the parties in this age of technology? If the banks do not have to examine signatures, should they have to employ other means to determine if checks are properly payable, such as to control for duplicate check numbers? Do customers have to use positive pay services or other sorts of controls in order to be not negligent in issuing and paying checks? The following examples illustrate the problem, but are not intended to be exhaustive. Scenario1. Drawer issues a check to Payee. Drawer s employee steals the check and forges Payee s indorsement. Assume Drawer s employee has responsibility with respect to the instrument within the meaning of UCC Employee deposits the check with Depositary Bank and in due course Drawee Bank honors the item. Payee sues Depositary Bank for conversion. Payee s conversion cause of action is dismissed because Payee never had possession of the check. UCC 3-420(a). Does Payee have a negligence cause of action against Depositary Bank or Drawee Bank under UCC 3-405(b) if it does not have a conversion cause of action? 4 Did Payee suffer a loss (assuming Depositary Bank or Drawee Bank was negligent)? It has not received the funds it was supposed to from Drawer. Arguably, the payment of the check effects a discharge of the Drawer s obligation on the check (UCC 3-602) because the forged indorsement is deemed effective under UCC 3-405(b) and that discharge on the check also discharges Drawer s Page 9 of 22

10 underlying obligation to Payee, UCC On the other hand, perhaps the forged indorsement is not deemed effective under UCC 3-405(b) to deal with the rights as between Drawer and Payee and thus Payee has not suffered a loss by virtue of the Depositary Bank s or Drawee Bank s actions and thus would not have a negligence cause of action. Assume further that Depositary Bank would qualify as a holder in due course under UCC Does that qualification, which would bar claims to the instrument or its proceeds under UCC 3-306, and would bar defenses to indorser s or drawer s liability, UCC 3-305, have any effect on this negligence cause of action between the Payee and the Depositary Bank? The comments to UCC do not deal with Payee s rights in any of the illustrations. Now consider the same scenario and the Drawer s rights. Drawer would seek to have Drawee Bank recredit its account because it paid a check that was arguably not properly payable. UCC Drawee Bank would resist that based upon the argument that the indorsement was deemed effective under UCC 3-405(b). As the comments illustrate, for purposes of the properly payable rule, the indorsement is deemed effective (cmt. 3, Ill. 5). 5 However, if Drawee Bank was negligent, the loss would be shared with Drawer to the extent of the relative negligence of the parties. Can Drawer, in addition, assert an affirmative cause of action for negligence against the Depositary Bank to the extent that Drawer has suffered a loss? Comment 4 to UCC suggests yes, although the Drawer is denied a conversion cause of action for conversion of the instrument under UCC against Depositary Bank. Is Depositary Bank or Drawee Bank liable to both Payee and Drawer for negligence? Would this result in either Bank potentially having double liability? Scenario 2. Drawer issues a check to Payee. Payee s employee steals the check and forges Payee s indorsement. Assume Payee s employee has responsibility with respect to the instrument within the meaning of UCC The employee deposits the check to its Depositary Bank, either into the employee s account or in an account in the name of a fictitious person. The check is paid in due course by Drawee Bank. When Payee discovers the problem, Payee seeks to recover from both Depositary Bank and Drawee Bank. Because the indorsement is made effective by virtue of the rule UCC 3-405(b), the Payee is unable to recover based upon conversion of an instrument with a forged indorsement under UCC 3-420, although given that the first sentence of subsection (a) preserves the right to recover for conversion under common law principles, it is not entirely clear that the Payee s common law conversion action is precluded. The Payee certainly has a claim to the instrument and its proceeds within the meaning of UCC and thus if Depositary Bank is a holder in due course, it would take the check free of that claim. The effect of deeming the indorsement effective is to make Depositary Bank a holder, and thus possibly a holder in due course if it took the item in good faith and without notice of claims and defenses. Does the comparative negligence analysis in UCC 3-405(b) override the ability of a holder in due course to take the item free of claims and defenses? Does the comparative negligence analysis in UCC 3-405(b) trump the Drawee Bank s argument that it has not converted the check due to the indorsement being deemed effective? Page 10 of 22

11 When the indorsement is deemed effective, what effect does that have on the obligation of Drawer to Payee on the check and on the underlying obligation? Arguably, Drawee Bank s payment to Depositary Bank was payment to a person entitled to enforce (because the indorsement is deemed effective) and thus the Drawer s obligation to Payee on the check was discharged, UCC 3-602, and the underlying obligation Drawer owed to Payee was discharged, UCC The Drawer would lose to the Drawee Bank on an argument that the check was not properly payable under UCC 4-401, because the indorsement was deemed effective. On the other hand, the rule in UCC 3-405(b) limits its effect on making the indorsement effective for the purpose of determining the rights and liabilities of a good faith taker or payor, and does not deal with the rights of other parties on the check. To follow this statement through its logical implications, Drawer would not be able to get its account recredited under the properly payable rule, as that involves the rights of the payor, but the indorsement is not deemed effective for purposes of the rights of Payee and Drawer (i.e. Drawer s liability has not been discharged, and there is no discharge of the underlying obligation to Payee). If this is the meaning of this section, then Drawer is out the money (debited from its account) and still owes an obligation to Payee. Payee cannot recover from Depositary Bank or Drawee Bank, and would still have the ability to recover from Drawer (unless the check is considered neither paid or dishonored in which case the underlying obligation is suspended indefinitely). This may, in effect, put the liability for Payee s employee s fraud on Drawer. As between the Drawer and Payee, the comparative negligence analysis has no effect at all. Should the Drawer be able to defend against the Payee s attempt to collect from the Drawer based upon the Payee s negligence in supervising its employee? Scenario 3. Fraudfeasor has authority to sign checks on behalf of Drawer and issues such a check to Payee (other than Fraudfeasor). What are the Drawer s rights when a check is used by an employee to steal from Drawer s bank account with Drawee Bank? The cases are remarkably inconsistent regarding the Drawer s ability to recover. 6 The Drawer usually attempts two avenues of recovery, one against the Fraudfeasor s Depositary Bank or the creditor who took the check to pay an obligation of the Fraudfeasor and the second against the Drawee Bank. Under the principle of UCC 3-405, any indorsement in the name of the Payee is deemed effective in litigation with a taker or payer of the instrument in good faith and for value. Fraudfeasor deposits the check to Depositary Bank. As discussed above, Depositary Bank (or a creditor of Fraudfeasor who took the check) could be liable to Drawer for potential negligence but not for conversion of the instrument. However, some would argue that the Depositary Bank or Fraudfeasor s creditor is liable for conversion of the credits from the Drawer s bank account (not the same thing as conversion of the instrument) and that UCC recognizes that fact (and, actually authorizes recovery for conversion) because it recognizes that a represented person who issues a check will make a claim to the proceeds of the check based upon the fiduciary s breach of duty. Again, the cases are remarkably inconsistent. 7 This is not surprising given the mixed signals that Article 3 gives regarding property based claims to the proceeds of an instrument. UCC provides that a person with a claim to the instrument or its proceeds can assert a property claim against a person Page 11 of 22

12 other than a holder in due course. That section does not specify when those property rights are created. UCC provides that the drawer of the check does not have a conversion claim as to the instrument, but does not consider the issue of a claim to the proceeds. Compare UCC UCC provides that a taker of an instrument has notice of a breach of fiduciary duty if an instrument issued by the fiduciary or the represented person is taken in certain situations, if the represented person makes a claim to the instrument or its proceeds, thus implying that the represented person (the drawer) has a property claim to the proceeds in spite of the contrary implication from UCC that the drawer does not have conversion claim. If UCC is used to imply a conversion like claim to the proceeds of the check (as opposed to a negligence claim based upon UCC 3-405(b)) as against the taker of the check from the fiduciary, there is no comparative negligence principle as provided in UCC 3-405(b) to share the loss based upon the relative degree of negligence. It is also not clear what is the difference in responsibility with respect to an instrument and a fiduciary with respect to an instrument. Now consider the rights of Drawer against Drawee Bank. If the check is deposited and collected in the ordinary course, the Drawer would assert either the properly payable cause of action or the negligence cause of action as discussed in the previous example. However, in the event the Drawee Bank happens to be the payee of the check, and the Drawer does not owe the Drawee Bank any obligation, the Drawee Bank has been held to have a common law duty to Drawer not to merely give value for the check to Fraudfeasor. That common law duty could be based upon a negligence principle or could be based upon an interpretation of the duties of the Drawee Bank under its contract with the Drawer. 8 In this scenario, again, there is no loss sharing using comparative negligence principles and the Drawer is able to obtain full recovery against Drawee Bank. Scenario 4. Do the negligence-based loss sharing rules discussed above apply if an employee of either the depositary bank or the drawee bank is in on the scheme with Fraudfeasor to embezzle from the drawer? At least one court has held that the loss sharing rules in UCC and do not apply in that circumstance as they apply only when the bank is negligent and not when one of its employees engages in fraud (which is outside the scope of the employee s duties). 9 In this court s view, the loss was thus left where it lay, on the employer, even though arguably both employers were negligent in supervising their respective employees. These scenarios do not exhaust the issues regarding the interface of common law principles and Articles 3 and 4. They are illustrative of a bigger problem. Experience makes it clear that to reduce unnecessary litigation Articles 3 and 4 need to deal in a more direct way with their relationship with common law, 10 particularly, but not exclusively, in the context of employee fraud using checks. Consideration also needs to be given to the question of the intersection of Article 3 and 4 with other statutory law that may govern the issue. For example, should the liability allocation scheme under Articles 3 and 4 yield to contrary principles under the Uniform Fiduciaries Act or other state statutory law when it comes to employee fraud? Again the cases are divided. 11 Page 12 of 22

13 As illustrated above, the ability of either the Drawer or Payee to recover will vary depending upon whether the court recognizes a negligence or conversion cause of action, exactly how the employee perpetrated the fraud, and the theory on which the drawer or other party brings its case. In addition, the injection of comparative negligence principles and the deeming effective of an indorsement has created uncertainty regarding how the Code based liabilities play out, leading to courts willingness to consider common law principles as supplementary. A drafting effort that resulted in a clear scheme for allocating loss from employee fraud and providing that it was exclusive and not to be supplemented by common law principles would cut down on a significant amount of litigation regarding check fraud. B. The ability to vary the effect of principles of UCC Article 4 and UCC Article 3 Article 4 provides that the effect of provisions in Article 4 may be varied by agreement except that the bank s obligation of good faith or failure to exercise reasonable care cannot be disclaimed or the measure of damages for such failure may not be limited. UCC There are many rules in Article 4 that do not depend upon the bank s good faith or duty of reasonable care. Applied literally, this provision would allow the parties to alter the effect of such rules. Some of these rules are critical to the allocation of risk from error and wrongdoing and there has been litigation concerning the ability of the parties to alter the effect of those rules. 12 To give an example of how alteration of these rules would upset the allocation of risk, consider a forged drawer s signature case. The drawer is not negligent (so the preclusion rule of UCC would not apply). Absent agreement otherwise, the drawer s account could not be charged as the check is not properly payable. UCC Nonetheless, the agreement between the drawer and drawee provides as follows: Drawee Bank assumes no responsibility for detecting forgeries or unauthorized drawer s signatures. Customer agrees that in the event there is a forgery or an unauthorized drawer s signature, the item is properly payable from the Customer s account. Is that an acceptable variation by agreement under UCC so that the drawer s account can be charged? 13 If the agreement does not provide for charging the account as stated above (by altering the meaning of the properly payable rule), but instead provides that all unauthorized charges to the account must be reported within 15 days after making the information available to the customer, is that an enforceable alteration of the effect of the UCC 4-406? 14 The time period for making objections is not stated under subsection (b), just that the customer must act with reasonable promptness. The cases have considered the issue of a limited time period under subsection (f), (shortening the one year period for making objection), and have allowed shortening that time period to as few as 15 days. Is the time period stated ever tolled by circumstances such as incapacity, fraudulent concealment or other types of circumstances that would toll the running of a statute of limitations? 15 Does subsection (f) require that bank pay item in good faith in order to be able to use the preclusion? 16 Under UCC 4-406, the bank must make available to the customer a statement of account and the customer s duty to respond is triggered by that availability. In these days of on-line banking, is the bank making the customer s account statement continuously available so as to trigger the customer s duty to respond? This issue is presently in litigation, and there also is a case in this regard under Article 4A. 17 Page 13 of 22

14 These are but two examples, other provisions of Article 4 that may be the subject of attempted alteration through agreement are the right to stop payment, UCC 4-403, bank liability for wrongful dishonor, UCC 4-402, and an expanded right of chargeback, UCC These rights and obligations do not depend upon the bank s reasonable care or good faith and thus could be within the ambit of UCC 4-103(a). C. Accrual of causes of action in continuing fraud schemes In an ongoing fraud scenario, the courts have considered when the cause of action accrued for conversion of the instrument or its proceeds. Some courts have used a discovery rule and other courts have used a time of transfer rule. 18 While Article 3 gives a time the cause of action accrues for warranty claims under UCC and 3-417, it does not do so for conversion. Some clarification could be useful here. D. Good faith When Articles 3 and 4 were amended in 1990, the new definition of good faith was adopted which requires both honesty in fact and adhering to reasonable commercial standards of fair dealing. The question of what is good faith for purposes of being a holder in due course has gained increasing attention in the courts, with the court s grappling with the degree to which the taker of the check has to investigate the circumstances in order to be in good faith or has discretion to follow alternative courses of action and chooses what appears to be a riskier course of action. 19 To the extent the risk allocation rules in Articles 3 and 4 depend upon holder in due course status which requires good faith, or requires the bank to act in good faith, this rise in litigation is troublesome, particularly where it requires investigation on the part of the actor in order to be in good faith. For some important sections that rely on good faith actions of a bank, see UCC 4-401(d) (payment of an altered item), (payment of a stale check), 4-406(e) (asserting a preclusion against the customer), 4-207(b), (c) (transfer warranties), 4-208(a), (d) (presentment warranties). In addition, one could argue that a bank has a general duty of good faith in the performance and enforcement of its contract with its customer concerning the bank account. See UCC III. Issues that create practical uncertainty about how to apply the existing rules 20 In current practice, issues arise that create uncertainty about the meaning of UCC provisions. While to the best of the Study Committee s knowledge these issues have not yet been litigated, and the following list is not exhaustive, these examples indicate that if a drafting project was commenced, there could be some useful clarification of how questions like these should be resolved so as to avoid almost certain future litigation. A. Uncertainty created by the substitute check structure of Check 21 The definition of check in Reg. CC, 12 C.F.R (k) includes a substitute check (with or without legal equivalence) but does not cover paper that does not meet the definition of a Page 14 of 22

15 substitute check. See definition of substitute check in 12 C.F.R (aaa). Regulation CC only provides that the rules of the UCC are applicable to a substitute check with legal equivalence. Reg. CC (c). Thus there are three categories of paper contemplated in the Check 21 structure: (i) substitute checks with legal equivalence which are treated for all purposes as checks under the UCC; (ii) substitute checks without legal equivalence, which are treated as checks under Regulation CC, but it is unclear if they are to be treated as checks under the UCC; (iii) pieces of paper which do not qualify as substitute checks, where the paper is not treated as a check under Regulation CC, and it is unclear whether the paper should be treated as a check under the UCC. What are the banks and customers rights and obligations as to pieces the pieces of paper in the second two categories under the UCC? To illustrate, assume that the piece of paper that purports to be a substitute check does not contain the exact MICR line of the check at the time it was imaged. That would preclude the check from qualifying as a substitute check. That paper is presented to the drawee bank and honored. Does the drawee bank have its rights under Article 4 to charge the customer s account? Is the item properly payable? Have the presenting banks and prior transferors made presentment warranties to the drawee bank? The warranty against double debiting does not apply as it is not a substitute check. See Reg. CC (a). This is just one of many issues that arises from the Check 21 Act and its corresponding provisions in Regulation CC, Subpart D. B. Deeming an indorsement effective Under UCC and 3-405, an indorsement of the payee is deemed effective for purposes of the rights of a good faith taker or payor of the check. Under either section, the payee could be a real entity, and the wrongdoer has impersonated the real entity ( 3-404) or the wrongdoer (an employee with responsibility as to the check) has taken a check that belongs to the payee, a real entity ( 3-405). What does it mean to deem the wrongdoer s indorsement as effective as the payee s indorsement? Does that mean that if the check is dishonored, the real payee is liable on the indorser s contract? UCC provides except as provided in this Article or Article 4" an unauthorized signature is ineffective except as the signature of the wrongdoer. Because and 3-405, deem the indorsement effective, a plain reading of the code could lead to the wrong answer, that is, that the payee is liable on the indorser s contract of a forged indorsement. C. The meaning of paid in Articles 3 and 4 The use of the concept of pay/paid/ payment in Articles 3 and 4 have varying meanings depending upon the context. The right meaning may not be readily apparent to judges asked to resolve issues where that word is pivotal. The following two examples are given for illustration, but the problem is pervasive. UCC details that in most circumstances to have a discharge of the contract obligation on the instrument through payment, payment must be made to a person entitled to enforce. Under Article 4, if a drawee bank fails to return a check by its midnight deadline, the drawee bank will have made final payment. UCC 4-215, Consider a forged necessary Page 15 of 22