The following scenario has become all too common for community banks in recent years:

• A bank customer reports an inaccurate account balance resulting from an unknown check drawn on the customer’s account.
• The bank completes a preliminary investigation and determines that the check charged to the customer’s account is fraudulent.
• The bank restores the funds to the customer’s account, either because the bank wants to make its customer whole or because it is legally required to do so.
• Because the customer report came days or weeks after payment of the fraudulent check, the bank’s “midnight deadline” for returning the check has already passed.¹ The bank cannot recover the funds through that channel.
• The bank investigates further and determines that the fraudulent check was deposited in an account at a much larger financial institution over 1,000 miles away. The fraudster’s account was opened online shortly before the fraudulent check was deposited into it.
• The bank also learns that the fraudster’s account has been closed or drained of funds. Both the fraudster and the money are gone.

At this point, the bank whose customer was defrauded will want to recover the funds from the other bank whose customer committed the fraud. Common sense may suggest that the other bank should be responsible because it was the only one that had any contact with the fraudster. Unfortunately, the legal result is not that simple.

Uniform Commercial Code Articles 3 and 4

The defrauded bank’s ability to recover from the second bank will depend, in large part, on Articles 3 and 4 of the Uniform Commercial Code (UCC). Specifically, when funds cannot be recovered from the fraudster, the question of “which bank takes the loss” will depend on whether the check was “properly payable” by the customer and the application of the “presentment warranties” for negotiable instruments and bank checks included in Articles 3 and 4 of the UCC.

In the scenario described above, the UCC refers to the bank whose customer was defrauded as the “payor bank.”² The UCC refers to the bank whose customer committed the fraud as the “depositary bank.”³

Potential Recovery: Breach of Presentment Warranties

Under the UCC, when the depositary bank introduces the fraudulent check into the payment system as the bank of first deposit, the depositary bank makes the following presentment warranties:

• Entitlement to enforce. The depositary bank warrants that it is a person entitled to enforce the check or authorized to obtain payment on behalf of a person entitled to enforce the check.⁴
• No knowledge of unauthorized drawer signature. The depositary bank warrants that it has no knowledge that the drawer’s signature on the check (the defrauded customer) is unauthorized.⁵
• No alteration. The depositary bank warrants that the check has not been altered.⁶

If any of these warranties is false, the payor bank is legally entitled to recover from the depositary bank, notwithstanding the fact that the “midnight deadline” has passed.⁷

The first two presentment warranties rarely provide a basis for the payor bank to recover. The first warranty (entitlement to enforce) requires an unauthorized or missing endorsement, which is uncommon on fraudulent checks. The second warranty (no knowledge of unauthorized drawer signature) requires proof that the depositary bank had actual knowledge of the forgery. This standard is difficult to satisfy, as there is rarely evidence that the depositary bank actually knew of the fraud. As a result, the third warranty (no alteration) is the critical one in most cases.

Altered, Forged and Counterfeit Checks

The third presentment warranty (no alteration) generally provides the best chance of recovery for the payor bank. “Altered” checks have a specific meaning under the UCC, and “altered” checks differ from “forged” and “counterfeit” checks. Thus, when a payor bank seeks to collect from a depositary bank for a fraudulent check, the payor bank normally will succeed only if it convinces the depositary bank (or a court) that the check was “altered” and not “forged” or “counterfeit.”

The determination of whether the check was “altered,” “forged” or “counterfeit” likely will determine which bank takes the loss:

• “Alteration” means (1) an unauthorized change in a check that purports to modify in any respect the obligation of a party, or (2) an unauthorized addition of words or numbers or other change to an incomplete check relating to the obligation of a party.⁸ Old-fashioned check-washing may lead to any of the following “alterations” to a check: (i) changing the payee name, (ii) an increase or decrease in the amount payable and/or (iii) completing an incomplete check other than as authorized. If the check is “altered,” the payor bank should recover from the depositary bank.⁹
• A “forged” check includes an unauthorized signature that was made without actual, implied or apparent authority.¹⁰ An example of “forgery” that leads to this result is a stolen checkbook, in which the thief uses the blank checks to forge the customer’s signature. If the check is “forged,” the payor bank likely will not recover from the depositary bank.¹¹
• A “counterfeit” check is a wholly fabricated check rather than a modification to an existing check. For example, a fraudster may use a bank’s routing number and a customer’s account number to create (or order) new checks that resemble the customer’s actual checks. Counterfeit checks are generally treated the same as forged checks. Thus, if the check is “counterfeit,” the payor bank likely will not recover from the depositary bank.

At the time the UCC was adopted, these outcomes reflected an allocation of risk that matched the technology of the era. A payor bank was believed to be best positioned to detect forgeries and counterfeits by comparing checks against its customers’ check stock and signature cards. A depositary bank, on the other hand, was believed to be in the best position to detect check-washing, erasures and other alterations.

These assumptions, and the resulting outcomes, have not kept pace with modern technology. In the modern era, checks can be imaged, electronically manipulated and remotely deposited into accounts established online. The checks are then processed through a highly automated settlement system involving little to no review of physical checks by actual people. In this environment, the rationale for the outcomes dictated by the UCC can be difficult to discern, and the distinctions between “altered,” “forged” and “counterfeit” become exceedingly difficult to draw in practice.¹²

The Board of Governors’ Modernization

In 2018, the Federal Reserve Board of Governors amended Regulation CC and adopted a rebuttable presumption of alteration.¹³ Under the new provision, when a dispute arises between banks as to whether a substitute check or electronic check is “altered,” “forged” or “counterfeit,” and the original paper check is not available for examination, there is a rebuttable presumption that the check was altered.¹⁴ Virtually all checks today are processed electronically, and the original paper check is rarely available by the time a fraud dispute surfaces. Thus, this presumption will apply in the vast majority of cases.

The presumption established in 2018 will be quite helpful to a payor bank if its dispute with a depositary bank ends up in court. In that event, the practical effect will be significant: The presumption shifts the burden to the depositary bank to prove by a preponderance of evidence that the check was either forged or counterfeit. If the depositary bank cannot carry that burden, the payor bank’s warranty claim should succeed. On the other hand, prior to litigation (when most of these disputes are resolved), the presumption’s practical effect is less significant. In the absence of clear rulings from courts establishing the distinctions between “altered,” “forged” and “counterfeit” checks, payor banks continue to argue that the right kind of electronic manipulation of imaged checks, or a sufficient number of different changes to the same imaged check, renders the check “counterfeit” instead of “altered,” even when Regulation CC’s presumption applies.¹⁵

Conclusion

For community banks that learn their customer is the victim of a fraudulent check scheme, and if the bank is facing the scenario described at the outset of this article, the combination of the UCC’s presentment warranties and Regulation CC’s presumption of alteration provides a potential path to recovery from a depositary bank. The payor bank should be prepared to argue and prove that the check was not only fraudulent but also “altered.”

The facts and legal issues will vary in every case. Banks are encouraged to contact counsel when dealing with particular challenges or complications related to fraudulent check schemes.