Combatting Check Fraud

Over the last several months, banks all across Iowa have dealt with an increasing volume of fraudulent checks. The typical situation involves fraudsters intercepting a business customer’s check to a vendor. The fraudster then either (1) creates a counterfeit check, (2) alters the check’s payee, or (3) fraudulently endorses the check. The fraudster then deposits the check at a financial institution in another state.

To the business customer checking the bank statement, it appears that the vendor cashed the check. However, within a couple of weeks the vendor is calling about payment, and the customer realizes the cashed check was not the one the business customer wrote. By the time the customer is aware of the problem, it is too late to return the check and the funds are often gone.

What can banks do? There are a lot of factors to consider, and this blog does not address every issue. However, there are some steps that every bank should consider taking in these situations.

Return the Check

If the bank catches the fraudulent check before the Federal Reserve’s deadline for returning checks, then the bank should send the check back through the Federal Reserve.

Often this is not an option, however, because the deadline is past. If the deadline is past, then banks should not return the check through the Federal Reserve. Federal Reserve Operating Circular No. 3: Collection of Cash Items and Returned Checks, (November 15, 2021) (“Circular No. 3”), § 20.13 provides:

“A bank must not attempt to recover on a warranty or indemnity claim by including the item in a paper or electronic cash letter or return letter after the return deadline.” (emphasis added).

After the deadline for return expires, the bank should deal directly with the depository bank where the fraudster deposited the check.

Try to Recover the Funds

Banks should next try to recover the funds from the fraudster’s account. If the bank acts quickly, it can request that the depository bank freeze the account and return the remaining funds.

Often the depository bank will request indemnification. That means the bank requesting return agrees to defend the depository bank against claims by the account holder that the funds should not have been returned. The depositor would have difficulty succeeding in such a claim, because there should be sufficient evidence that the check was fraudulent.

There are some commonly used forms for providing indemnification, such as the Bankers Association for Finance and Trade (“BAFT”). If you are lucky, the funds will be sitting in the depository bank’s account.

Presentment Warranty Claims

If the funds are not sitting in an account at a depository bank, then banks should consider whether they have a presentment warranty claim. Uniform Commercial Code (“UCC”) § 4-208, which has been adopted by all states, requires banks to make a warranty to every bank involved in collection of a check that (1) the check is not altered, and (2) the check is properly endorsed.

If the fraudulent check is an altered check or has a forged or inappropriate endorsement then a bank may be able to demand the depository bank reimburse the amount of the check. This will not work for counterfeit checks, however, as there is no presentment warranty for a counterfeit check.

If necessary, banks can file a lawsuit against the depository bank to recover the amount of the check. Some states have even held that under the UCC the bank filing suit can recover attorneys’ fees from the depository bank.

Allocate Responsibility

For all counterfeit checks, and for checks where the bank has not been able to recover funds, the final step in the analysis is to consider the apportionment of responsibility between bank and its customer.

Many customers decline security features such as positive pay based on a belief that their bank will cover any losses. This assumption is misguided, however.

Under the UCC, banks are required to act with “ordinary care” in the handling of checks. In general, automated check processing systems meet this standard. In that case, depending on the language of their deposit account agreements with their customer, banks may be able to allocate some or all of the liability for the unauthorized check to their business customers.

Conclusion

Check fraud is a serious problem for banks and customers. Features such as positive pay can reduce the potential for fraud. Some customers, however, need to be educated about the benefits of security features, and the risks of check fraud. Banks can even require customers to adopt certain security procedures, or require that the customer acknowledge waiving use of these procedures.

Banks should also evaluate the language in their deposit account agreements to determine if the account agreement provides banks with the rights necessary to allocate liability to their customer, especially if the customer has declined features such as positive pay.

Whether a bank ultimately holds customers liable is a complicated decision that involves both legal rights and business considerations. However, banks should at least make sure they have all options for dealing with the problem available, so the only option is not just taking the loss.