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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 2002. 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 1882. 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.

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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.

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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 § 229.34(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

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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 § 4-202. 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 § 4-107.

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, 4-208. 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

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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, 210.6. 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 § 4-110 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 § 4-209 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. § 210.5(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. § 210.6(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. § 210.5(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. § 210.6(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. § 210.5(a)(4)(ii). The beneficiary of this

warranty is the Federal Reserve Bank. The Federal Reserve Bank makes a comparable

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warranty to its transferee. Reg. J. § 210.6(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 § 229.52, 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, 3-502. 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 § 229.30(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?

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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 § 3-308 requires the original unless the special circumstances of UCC § 3-309 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 § 229.51), 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)?

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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.

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II. Issues creating uncertainty in risk allocation under current Articles 3 and 42

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

§ 1-103. 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) 3-406 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 § 3-414 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 § 3-405. 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

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underlying obligation to Payee, UCC § 3-310. 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 §

3-302. 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 § 3-405 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 § 4-401. 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 § 3-405

suggests yes, although the Drawer is denied a conversion cause of action for conversion of the

instrument under UCC § 3-420 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 § 3-405. 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 § 3-306 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?

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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 § 3-310. 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 § 3-307 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 § 3-306 provides that a

person with a claim to the instrument or its proceeds can assert a property claim against a person

Page 12 of 22

other than a holder in due course. That section does not specify when those property rights are

created. UCC § 3-420 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 § 3-

306. UCC § 3-307 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 § 3-420 that the drawer does not have conversion claim.

If UCC § 3-307 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 § 3-404 and 3-405 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 13 of 22

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 § 4-103. 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 § 3-406 would not apply). Absent agreement otherwise, the drawer‟s account could not be

charged as the check is not properly payable. UCC § 4-401. 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 § 4-103 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 14 of 22

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 § 4-

214. 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 § 3-416 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), 4-404 (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 § 1-304.

III. Issues that create practical uncertainty about how to apply the existing rules20

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. § 229.2(k) includes a substitute check (with

or without legal equivalence) but does not cover paper that does not meet the definition of a

Page 15 of 22

substitute check. See definition of substitute check in 12 C.F.R. § 229.2(aaa). Regulation CC

only provides that the rules of the UCC are applicable to a substitute check with legal

equivalence. Reg. CC § 229.51(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 § 229.52(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 § 3-404 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 § 3-403 provides “except as provided in this

Article or Article 4" an unauthorized signature is ineffective except as the signature of the

wrongdoer. Because § 3-404 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 § 3-602 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, 4-301. Consider a forged necessary

Page 16 of 22

indorsement on a check which is submitted to a drawee bank. The drawee bank makes final

payment under Article 4 by failing to return the check by the midnight deadline, but has not

“paid” the check under Article 3, § 3-602, as payment has not been made to a person entitled to

enforce. The example in comment 4 to UCC § 3-310 states that in this situation the check has

not been paid or dishonored and thus the underlying obligation remains suspended. However,

under UCC § 4-102, if there is a conflict between Articles 3 and 4, Article 4 controls. So should

this check with the necessary forged indorsement be considered “paid” or not?

In addition, the words “paid/pay/payment” seem to have different meanings, even within

Article 3. Consider UCC § 3-417 presentment warranty. A person presenting a draft for

payment makes a warranty that it is entitled to enforce if the drawee pays the draft. In the case

of the forged necessary indorsement, the drawee has not “paid” the draft for purposes of UCC §

3-602 discharge but has “paid” the draft if there is final payment. In this section, the use of the

word pay or payment is intended to have the Article 4 meaning (otherwise there would never be

a breach of the warranty that the person is entitled to enforce) whereas in UCC § 3-310, paid is

intended to have the Article 3 meaning.

While this different usage of the word paid/pay/payment may seem harmless, as payments

lawyers should be able to figure out when to use the Article 4 meaning and when to use the

Article 3 meaning, the trumping rule of UCC § 4-102 provides some pause to that certainty. In

addition, when courts read a statute with a “plain meaning” approach, different meanings

attached to the same word are troublesome and could lead to bizarre resolutions.

D. Meaning of discharge on an instrument when there is an overdraft

Under UCC § 3-602, an instrument is discharged when there is payment to a person entitled

to enforce by or on behalf of a party obligated to pay. If a payor bank honors an instrument and

in so doing creates an overdraft, has the obligation on the instrument been discharged? This

question has arisen in surety bond litigation where the payor bank seeks to recover on the bond

which covers only in the case of undischarged liability on the instrument.

E. Restrictive indorsements

UCC § 3-206 provides that if the instrument has a restrictive indorsement, the depositary

bank is a convertor unless the proceeds are received by the indorser or applied consistently with

the indorsement. If a wrongdoer indorses a check with the payee‟s name and a restrictive

indorsement such as “for deposit only,” and the proceeds of the check are deposited into the

wrongdoer‟s account, has the depositary bank converted the instrument under UCC § 3-206?

The wrongdoer is the indorser, but does not happen to be the payee.

F. Double liability

Assume the payee of a check has the check stolen, the necessary payee‟s indorsement is

forged, the wrongdoer deposits the check in a depositary bank, and the check is paid by the

drawee bank. The wrongdoer withdraws the funds from the depositary bank. The payee has a

viable cause of action for conversion against the depositary bank under UCC § 3-420. The

Page 17 of 22

drawer has the ability to recover the amount from the drawee bank as the check was not properly

payable, UCC § 4-401. The drawee bank can recover from the depositary bank for breach of

presentment warranty, as the depositary bank was not a person entitled to enforce. Does the

depositary bank have to pay both the payee and the drawee? Does UCC § 3-420(c) give the

depositary bank a defense? Can payee recover from the drawer on the underlying obligation,

UCC § 3-310? Has the check been dishonored under UCC § 3-502 because there has been no

payment under UCC § 3-602, or has the check been paid, and thus the underlying obligation

discharged, because final payment has happened under UCC § 4-215? Does the payee‟s

recovery on the conversion cause of action from depositary bank extinguish drawer‟s underlying

obligation to payee?

While there is case law asserting that any one plaintiff is not entitled to double recovery (so

perhaps the payee cannot recover both from the depositary bank and the drawer), what if the

plaintiff is not recovering twice, but the defendant has inconsistent and separate liabilities to two

(or more) different plaintiffs and may have to pay twice (or more) (depositary bank‟s liability to

payee for conversion and separate liability to drawee for breach of presentment warranty).

Conclusion

The Study Committee needs your specific advice as to these and other issues or concerns; the

quality of any ensuing product depends on it. Please give us your advice in a record to both the

chair, Fred Miller at fmiller@ou.edu and the reporter, Linda Rusch, at

lrusch@lawschool.gonzaga.edu. Thank you for your consideration and assistance.

Page 18 of 22

Endnotes

1. Wachovia Bank, N.A. v. Foster Bancshares, Inc., 457 F.3d 619 (7th Cir. 2006) (in action for breach of

presentment warranty when it could not be determined whether the check was altered or a counterfeit check, court

presumed it was an alteration, and allowed recovery on presentment warranty); Chevy Chase Bank, F.S.B. v.

Wachovia Bank, N.A., 61 UCC Rep.2d 458, 2006 WL 3522503 (4th Cir. 2006) (held check was not an alteration but

a counterfeit).

2. While this memorandum is focusing on heavily litigated issues in the past few years, there are other issues that get

litigated that could be resolved, although they do not rise to the level of importance of the issues highlighted by this

memorandum. The following list is not exhaustive:

a. UCC § 3-110(d): Does “c/o” in a check mean that the check is made payable to alternative payees? Matson

Intermodal System, Inc. v. Kubis Enterprises, Inc., 895 A.2d 1242 (N.J. Super. Ct. Law Div. 2005) (“c/o” was

ambiguous so payable to either person); Geraldo v. First Dominion Mutual Life Ins. Co., 49 UCC Rep. Serv. 2d

(West) 206 (Ohio Ct. App. 2002) (“c/o” does not indicate alternative payees).

b. UCC § 3-412: Has an issuer of a cashier‟s check dishonored the check when it charges a fee to the payee to

cash the check as it is not paying the check according to its terms as issued? NNDJ, Inc. v. Comerica Inc., 570

F. Supp. 2d 940 (E.D. Mich. 2008).

c. UCC § 3-501: What is reasonable identification that can be demanded to honor a negotiable instrument?

Messing v. Bank of America, N.A., 821 A.2d 22 (Md. 2003) (thumbprint on check was reasonable identification

in addition to identification such as a driver‟s license).

d. UCC § 4-208: Does the word “expenses” regarding recovery for breach of a warranty include attorneys‟ fees?

Liberty Bank v. De-Marty, 2008 WL 1800009 (Conn. Super. Ct. 2008) (holding no, rejecting the comment

suggestion); First Atlantic Federal Credit Union v. Perez, 918 A.2d 666 (N.J. Super. A.D. 2007) (rejecting the

comment suggestion).

e. UCC § 4-301: May a payee assign/sell its right to recover against the payor bank for late return of the item after

the midnight deadline in UCC § 4-301? Triffin v. TD Banknorth, 920 A.2d 649 (N.J. 2007) (holding no).

f. UCC § 4-402: May payee bring an action for wrongful dishonor against drawee when the drawee charges a fee

for over the counter presentation/payment? Johnson v. First Banks, Inc., 889 N.E.2d 233 (Ill. App. Ct. 2008)

(holding no); Kronemeyer v. U.S. Bank National Ass’n, 857 N.E.2d 686 (Ill. Ct. App. 2006) (same). If action is

against a national bank, the OCC has stated that charging a fee is permissible under the national banking

statutes and preempts any contrary state law. Murphy v. National City Bank, 2008 WL 834376 (E.D. Mich.

2008). Should state law differ?

3. Halifax Corp. v. Wachovia Bank, 604 S.E. 2d 403 (Va. 2004) (holding section 3-406 does not create a negligence

cause of action); Gina Chin & Assoc., Inc. v. First Union Bank, 500 S.E.2d 516 (Va. 1998) (allowing direct

negligence action under UCC § 3-404 or § 3-405); Auto-Owners Ins. Co. v. Bank One, 879 N.E.2d 1086 (Ind. 2008)

(ordinary care for purposes of 3-405 does not include ordinary care in opening accounts in name of employer, rather

it just relates to ordinary care in taking or paying an instrument; assumed 3-405 created a negligence cause of

action). But see Official Comments to UCC §§ 3-404 and 3-405.

4. See e.g., Ramsey v. Hancock, 79 P.3d 423 (Utah Ct. App. 2003) (non customer payee who sues depositary bank

who took checks with forged payee indorsement does not owe a duty of care to that payee, employee of drawer

forged payee‟s indorsement and deposited checks at depositary bank).

5. At least one case has held that the deemed effective indorsement rule of UCC § 3-405(b) does not make the check

properly payable. ALG, Inc. v. Estate of Eldred, 35 P.3d 931 (Kan. Ct. App. 2001). See also Kaskel v. Northern

Trust Co., 45 U.C.C. Rep. Serv. 2d 827 (N.D. Ill. 2001) (raising issue as to whether payment is proper to a person

entitled to enforce even if not a holder, but not deciding the issue); Govoni & Sons Const., Co. v. Mechanics Bank,

742 N.E.2d 1094 (Mass. Ct. App. 2001) (item not properly payable when drawn by drawer‟s dishonest employee

and made payable to the payor bank).

Page 19 of 22

6. Bryant v. Community Choice Credit Union, 160 P.3d 266 (Colo. Ct. App. 2007) (duty of ordinary care in dealing

with deposit accounts when on notice that depositor was fiduciary for principal and fiduciary drained principal‟s

deposit account); Lerner v. Fleet Bank, 459 F.3d 273 (2d Cir. 2006) (allowing negligence action); Chicago Title Ins.

Co. v. Allfirst Bank, 905 A.2d 366 (Md. 2006) (same); New Properties, Inc. v. Newpower, 60 UCC Rep. Serv. 2d

(West) 1373 (Mich. Ct. App. 2006) (same); Traveler’s Casualty and Surety Co. of America v. Wells Fargo Bank,

N.A., 374 F.3d 521 (7th Cir. 2004) (depositary bank owed duty of care to drawer when the check is made payable to

the depositary bank and person uses that check to open an account in a name other than the name of the drawer);

YF Trust v. JP Morgan Chase Bank, N.A., 2008 WL 821856 (D. Ariz. 2008) (allowing drawer‟s negligence cause of

action against depositary bank as the depositary bank allowed embezzling employee of drawer to open multiple

accounts in fictitious payees‟ names); Chicago Title Ins. Co. v. Allfirst Bank, 905 A.2d 366 (Md. 2006) (negligence

action allowed); Gil v. Bank of America, N.A., 42 Cal. Rptr. 3d 310 (Cal. Ct. App. 2006) (negligence action not

allowed); Conder v. Union Planters Bank, N.A., 384 F.3d 397 (7th Cir. 2004) (negligence action not allowed).

7. Travelers Casualty & Surety Co. of America v. Northwestern Mutual Life Ins. Co., 480 F.3d 499 (7th Cir. 2007)

(defalcating fiduciary embezzled funds by using employer drawn checks to personal debt payees, allowed action by

drawer‟s insurer against payee to recover amounts of check); Borg v. Chase Manhattan Bank USA, N.A., 247 Fed.

Appx. 627 (6th Cir. 2007) (drawer‟s signature was forged by home health care aide, and drawer‟s conversion action

barred against payee); Mid-Continent Specialists, Inc. v. Capital Homes, L.C., 106 P.3d 483 (Kan. 2005) (drawer‟s

conversion action against payee barred when drawer‟s employee issued unauthorized checks drawn on drawer‟s

account to the payee); Cascade Falls, L.L.C. v. Henning, 2008 WL 934074 (Wash. Ct. App. 2008) (distinguishing

conversion of credits from conversion of the check, allowing drawer‟s action against payee when partner in the

drawer partnership used check to divert funds).

8. Mutual Service Casualty Ins. Co. v. Elizabeth State Bank, 265 F.3d 601 (7th Cir. 2001).

9. Siemens Building Technologies, Inc. v. PNC Financial Services Group, Inc., 226 Fed. Appx. 192 (3d Cir. 2007).

10. For example, courts have recognized misrepresentation causes of action based upon either the depositary bank‟s

or the drawee bank‟s statements that the check is “good.” Holcomb v. Wells Fargo Bank, 66 Cal. Rptr. 3d 142 (Cal.

Ct. App. 2007) (misrepresentation claim against depositary bank possible); City Check Cashing, Inc. v.

Manufacturers Hanover Trust Co., 764 A.2d 411 (N.J. 2001) (misrepresentation claim against drawee bank possible

but not in this case); Gossels v. Fleet National Bank, 876 N.E.2d 872 (Mass. App. Ct. 2007) review granted 884

N.E. 2d 522 (Mass. 2008) (based upon interpretation of 4-202 obligation of ordinary care and duty of good faith,

held that collecting bank was liable for negligent misrepresentation and conversion of funds when it failed to

indicate how a check drawn on a foreign bank in euros would be paid in dollars, the need for an indorsement, the

conversion rate and the bank fees; bank was also liable for unfair and deceptive trade practice under applicable

consumer law); Valley Bank of Ronan v. Hughes, 147 P.3d 185 (Mont. 2006) (collecting bank may be liable for

negligent misrepresentations regarding check collection process even though it is did not breach its obligation of

ordinary care under UCC 4-202 in the actual collection of the check; alleged negligent misrepresentation was that

the check was “good” and it was a counterfeit check in a Nigerian funds scam). On this, see Official Comment 1 to

UCC § 3-408.

Arguments have also been made that a bank has an independent duty to be not negligent in handling items for

collection. See Shelby Resources, LLC v. Wells Fargo Bank, 160 P.3d 387 (Colo. Ct. App. 2007) (collecting bank

that mishandled payable through check; common law claim for negligence preempted as governed by 4-202; thus

claim for consequential damages governed by 4-103 and because no bad faith, no consequential damages available).

11. Willowglen Academy-Wisconsin, Inc. v. Connelly Interiors Inc., 746 N.W.2d 570 (Wis. Ct. App. 2008) (allowed

recovery by drawer whose employee embezzled by writing unauthorized checks to payee under UFA, stating that

the UFA cause of action was not the same as a conversion cause of action); C-Wood Lumber Co. v. Wayne County

Bank, 233 S.W.3d 263 (Tenn. Ct. App. 2007) (holding UCC rules controlled over contrary rule from the UFA);

Page 20 of 22

Bradley v. First National Bank of Walker, N.A., 711 N.W.2d 121 (Minn. Ct. App. 2006) (holding that section 3-307

preempted cause of action under UFA § 8 and thus shorter 3 year statute of limitations of the UCC applied in action

against payor bank by represented person).

12. Douglas Companies, Inc. v. Commercial National Bank of Texarkana, 419 F.3d 812 (8th Cir. 2005) (rejecting

argument that bank customer agreement is allowed to shift liability for bank‟s encoding error to customer if the

customer does not report the error within time specified in bank/customer agreement); Union Planters Bank, N.A. v.

Rogers, 912 So. 2d 116 (Miss. 2005) (rejecting argument that continued use of the account was agreement to

arbitration clause contained in purported amendment to deposit account agreement; may have been influenced by

court wanting a clear waiver of right to sue in court); In re Bank One, N.A., 216 S.W.3d 825 (Tex. 2007) (arbitration

agreement enforceable when incorporated by reference through account signature card); Lema v. Bank of America,

N.A., 826 A.2d 504 (Md. 2003) (court enforced deposit agreement that expanded right of chargeback).

13. See Lor-Mor/Toto Inc. v. 1st Constitution Bank, 871 A.2d 110 (N.J. Super. A.D. 2005) (not a clear agreement to

alter properly payable rule).

14. May a bank state an explicit time period shorter than 30 days for reporting forgeries or alterations under

subsection (c)(2) governing repeat forgeries or alterations by same wrongdoer? Union Planters Bank, N.A. v.

Rogers, 912 So. 2d 116 (Miss. 2005) (upholding a time period of 15 days).

May a bank reduce the one year period in subsection (f)? Peters v. Riggs National Bank, N.A., 942 A.2d 1163

(D.C. 2008) (can shorten time period (60 days ok)); Freese v. Regions Bank, N.A., 644 S.E.2d 549 (Ga. Ct. App.

2007) (can shorten time period, 30 days ok); National Title Insurance Corp. v. First Union National Bank, 559

S.E.2d 668 (Va. 2002) (can shorten time period, 60 days ok); Stowell v. Cloquet Co-op Credit Union, 557 N.W.2d

567 (Minn. 1997) (can shorten time period, 20 days ok).

15. Peters v. Riggs National Bank, N.A., 942 A.2d 1163 (D.C. 2008) (not subject to statute of limitations tolling

arguments).

16. Pinigis v. Regions Bank, 997 So. 2d 446 (Ala. 2007) (good faith not required); Halifax Corp. v. First Union

Nat’l Bank, 546 S.E.2d 696 (Va. 2001) (same); Falk v. Northern Trust Co., 763 N.E.2d 380 (Ill. App. Ct. 2001)

(good faith required).

17. See Regatos v. North Fork Bank, 838 N.E. 2d 629 (N.Y. 2005) (court rejected the argument that under UCC §

4A-505 that notice of a funds transfer was available merely because customer could request the information).

18. Kidney Cancer Assoc. v. North Shore Community Bank and Trust Co., 869 N.E.2d 186 (Ill. Ct. App. 2007)

(cause of action accrued when check with forged indorsement deposited at bank); New Jersey Lawyers’ Fund for

Client Protection v. Pace, 892 a.2d 661 (N.J. 2006) (when the instrument was “negotiated” (the court means

transferred, as a check with a forged necessary indorsement cannot be negotiated) to the defendant depositary bank);

C & L Const. Co. v. BB & T Corp., 2005 WL 2792401, 60 UCC Rep. Serv. 2d 230 (S.D.W.Va. 2005) (applying

discovery rule); Rodrigue v. Olin Employees Credit Union, 406 F.3d 434 (7th 2005) (rejecting discovery rule and

collecting cases).

19. Friendly Check Cashing Corp. v. Dolphin LLC, 2007 WL 2033134 (N.J. Super. A.D. 2007) (failure to follow

state law regulating check cashers meant that check casher who took check payable to a corporation without a

corporate resolution authorizing the check cashing was not in good faith); Buckeye Check Cashing, Inc. v. Camp,

825 N.E.2d 644 (Ohio Ct. App. 2005) (check cashing business taking a post dated check without verifying that the

check is “good” is not acting according to „reasonable commercial standards of fair dealing‟); Bay Shore Check

Cashing Corp. v. Landscapes by North East Const. Corp., 776 N.Y.S. 2d 742 (N.Y. Dist. Ct. 2004) (check cashing

business that took post dated check and failed to verify its authenticity did not act in good faith); Any Kind Checks

Cashed, Inc. v. Talcott, 830 So.2d 160 (Fla. Ct. App. 2002) (cashing a large check for a unfamiliar customer without

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authenticating it with drawer did not met reasonable commercial standards of fair dealing); Maine Family Credit

Union v. Sun Life Assurance Co. of Canada, 727 A.2d 335 (Me. 1999) (depositary credit union did not act in accord

with reasonable commercial standards of fair dealing when it allowed immediate availability of funds from large

checks drawn on out of state banks); MidWisconsin Bank v. Fosgard Trading Inc., 668 N.W.2d 830 (Wis. Ct. App.

2003) (rejecting the rationale of Maine Family case). In an exceedingly poorly reasoned case (for a whole host of

issues), the court found that a lender was not in good faith for purposes of the holder in due course status if the

lender did not search under the debtor‟s name and the roots of that name to find a filed financing statement, relying

in part on comment 5 to UCC § 9-331. In re Jersey Tractor Trailer Training, Inc., 2008 WL 2783342 (D.N.J. 2008).

20. There are other issues in Articles 3 and 4 that could be addressed either by statutory text or comment if a

drafting effort was undertaken. Without being exhaustive, some of the issues are as follows:

a. What is the relationship of Article 4 to adverse claims statutes (see e.g. Ind. Code § 28-9-1-1 through § 28-9-5-

3), particularly UCC § 4-303 and the rules of part 4 of Article 4?

b. Is it time to repeal Price v. Neal which places liability for a forged drawer‟s signature on the payor bank?

Remotely created items are governed by warranties in Reg. CC, § 229.34(d). Does the experience under that

provision indicate that it is time to place the liability for forged drawer‟s signature on someone other than the

payor bank?

c. UCC § 3-305(e) refers only to rights of a holder being subject to claims and defenses of the issuer. It should

also refer to claims in recoupment of the issuer. This appears to be a drafting error.

d. UCC § 3-305(a)(3) refers to the rights of a holder being subject to claims in recoupment that arise against the

original payee. There could be claims in recoupment that arise out of subsequent transactions (i.e. the original

payee could have a claim in recoupment against its transferee) and thus this section should not be so limited.

e. UCC § 3-302(e) addresses the rights of a person who only has a security interest in the instrument. It states that

the person may enforce rights as a holder in due course up to the amount of the unpaid obligation secured if the

obligor has asserted a defense to payment. However, a secured party cannot by definition be a holder in due

course as it will always have notice that someone else has a property based claim to the instrument, that of the

debtor. The granting of a security interest in an asset does not extinguish the debtor‟s property interest in the

asset. So is UCC§ 3-302(e) instructing us to “pretend” the secured party is a holder in due course?

f. UCC § 3-419 assigns accommodation party status only when the instrument is “issued” for accommodation.

That fails to account for an instrument that is negotiated for accommodation. Consider a check that is payable

to a payee. Payee wants to negotiate the check to a taker, but the taker won‟t take the check unless payee gets

another indorser. Under section 3-419, the anomalous indorser does not fit the definition of accommodation

party in subsection (a) as the instrument is being negotiated for accommodation instead of issued for

accommodation.

g. Under UCC § 3-504, if presentment is excused, is notice of dishonor also excused? Section 3-504(b) refers

only to “waiver” of presentment, not excuse of presentment. Under former 3-511, any excuse of presentment

was also an excuse of notice of dishonor. Was there an intent to change law here?

h. If a check payable to order is transferred to a person without the required indorsement so that the person in

possession may be a nonholder in possession with the rights of the holder and thus a person entitled to enforce,

can the drawee refuse to pay the nonholder in possession with the rights of a holder for lack of a necessary

indorsement without a dishonor under UCC § 3-501(b)(3)?

i. UCC § 3-310(b)(4) states that if obligee on the underlying obligation no longer has the check, that obligee

cannot enforce the underlying obligation “to the extent the obligation is suspended.” The obligation is

suspended until the check is paid or dishonored. However, if the underlying obligation is no longer suspended

because the check has been dishonored, and the obligee on the underlying obligation is not a “person entitled to

enforce” the obligations on the check because it is no longer in possession of the check, the obligee should not

be able to enforce the underlying obligation. The only cause of action that should remain is the holder‟s cause of

action on the check. See comment 3 which states the right rule. The text should be conformed to the comment.

j. In UCC § 3-602(e)(2), is there an intent to have a different rule apply if the instrument is a “lost” instrument as

opposed to a stolen instrument? Compare UCC § 3-305(c) last sentence (obligor does not have to pay a person

that is not a holder in due course if the instrument is a lost or stolen instrument).

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k. When there is an obligation to act within a reasonable time, is that the same as acting with ordinary care for

purposes of UCC § 4-103(e)?

l. Should UCC § 4-407 have a provision similar to UCC § 3-418(d) (deeming the instrument to be dishonored)?

To enforce the check against either the drawer or to enforce the underlying obligation against the drawer or

payee, the check must have been dishonored. However, the payor bank has paid the check (usually because of

the final payment concept) and is seeking to recover using the subrogation right, which requires pretending the

check has been dishonored.