Financial Institution Not Required to Examine Checks for Forged Endorsements

As a matter of law, a drawee financial institution does not have a duty to conduct any review of payee endorsements on checks received from a depository bank.

The UCC places the ultimate risk of loss for the payment of checks bearing forged endorsements on the depository bank. It is the first financial institution to receive an item for collection and, thus, is in the best position to detect the forgery and prevent the fraud. Of course, the depository financial institution can look to the forger to recover its loss; however, the likelihood of recovery is slim.

Remember, there are three primary parties to a check. The person who writes the check, called the drawer. The person to whom the check is payable, called the payee. And the financial institution that maintains the account on which the check is drawn, called the drawee. In addition, the first financial institution to receive the check for collection is called the depository bank.

Under the UCC, a check bearing a forged endorsement is not properly payable (Revised UCC . 4-401). If the drawee financial institution pays a check bearing a forged endorsement, then it is obligated to recredit the drawer’s account for the item. Read more

In turn, the drawee financial institution may look to the depository financial institution for reimbursement. This is because the depository financial institution warrants to the drawee financial institution that it had the right to enforce payment of the item at the time it was transferred to the drawee financial institution for collection. Put another way, the depository financial institution warrants to the drawee financial institution that the item does not contain any forged or unauthorized endorsements (Revised UCC . 4-208(a)). If it turns out that the check does bear a forged endorsement, then the depository financial institution has breached its warranty and is liable to the drawee financial institution for the item.

The UCC places the ultimate risk of loss for the payment of checks bearing forged endorsements on the depository financial institution. It is the first financial institution to receive an item for collection and, thus, is in the best position to detect the forgery and prevent the fraud. Of course, the depository financial institution can look to the forger to recover its loss; however, the likelihood of recovery is slim.

Exception
As with any general rule, there are exceptions to the rule that a drawer may recover a loss resulting from the payment of a check over the payee’s forged endorsement. For instance, both the drawee financial institution and the depository financial institution may escape liability for the payment of a check bearing the payee’s forged endorsement if the drawer of the check failed to exercise ordinary care in issuing the check and that failure substantially contributed to the making of the forged endorsement (Revised UCC . 3-406).

For instance, suppose an insurance company issues claim checks after it receives fraudulent payment requests from a dishonest insurance agent. Suppose also that the checks are sent to the agent who forges the payees’ endorsements and then deposits the items into his personal account.

If the insurance company failed to take any steps to verify the legitimacy of the claims, a court or jury could conclude that the insurance company failed to exercise ordinary care in issuing the claim checks and that failure substantially contributed to the making of the forged endorsements. Under these circumstances, the insurance company, the drawer of the checks, could be precluded from asserting the forged endorsements against the drawee bank.

An Exception to the Exception
Under the UCC, even if the drawer is negligent in issuing a check thereby substantially contributing to the making of a forged endorsement, the drawer still may be able to shift a portion of the liability back to the drawee financial institution if the financial institution also failed to exercise ordinary care in paying the item.

For instance, suppose a drawee financial institution pays several checks each bearing an illegible forged endorsement. Can a negligent drawer in this situation divert a portion of liability back to the drawee financial institution by showing that the financial institution was also negligent in paying the items since it failed to detect the illegible endorsements? As illustrated in the following recently decided case the answer to this question appears to be no. The court ruled as a matter of law that drawee banks are not obligated to review payee endorsements on checks received from depository banks.

Guardian Life Insurance Company of America v. Weisman
The Facts. Over a period of five years, Mark Weisman, an authorized agent of three insurance companies, submitted fraudulent payment requests to insurers using various policy holders names. The insurance companies issued 91 checks, which were sent to Weisman’s office. Weisman deposited the checks into his personal account after forging the payee endorsements. To recover its loss, Guardian Life Insurance Company sued the drawee banks. The trial court entered judgment in favor of the Insurance Company and the banks appealed the ruling.

The Arguments. The drawee banks argued that the insurer was negligent in issuing the checks in question and, thus, is precluded from asserting the forgeries against the drawee banks. Guardian Life countered, stating that, since the banks failed to review the endorsements before they paid the checks, they did not act in a commercially reasonable manner and, thus, are precluded from asserting the drawer’s negligence as a defense to its suit. The Court Decision. The Court first pointed out that under the UCC a check bearing a forged endorsement is not properly payable. Therefore, when a check bearing a forged endorsement is paid, the drawee financial institution must credit the drawer’s account for the item. It further observed the UCC exception to this rule that states if a drawer is negligent in issuing a check and that negligence substantially contributes to the forgery, then the drawee financial institution can refuse to credit the drawer’s account for the forged item.

The Court next stated that in this appeal it is primarily concerned with the exception that the UCC creates to the exception making the drawer liable; namely, if the drawee financial institution fails to act with ordinary care in paying the forged check, then all or a portion of the liability for the forged item is shifted back to the drawee bank. Consequently, the Court stated that the issue before it is whether the drawee banks failed to exercise ordinary care in paying the items by not inspecting the endorsements. It then reviewed the trial court’s decision which concluded that the drawee banks did not act in accordance with reasonable commercial standards, placing them within the exception to the exception, because those banks did not determine whether the payee endorsements were legible and matched the named payee on checks received from a depository bank.

The Court found that the decision of the trial court is mistaken for two reasons. First, when a drawee financial institution receives a check from a depository bank, the drawee financial institution receives certain warranties guaranteeing payment. Given these warranties there is little reason for the drawee financial institution to inquire into the validity of payee endorsements. Second, the Court noted that what review there is of payee endorsements should take place at the depository bank, which is most likely to have the information available to verify a depositor’s endorsement.

To require drawee banks to inspect the endorsements on checks would be contrary to the allocation of responsibilities and assignment of risks set forth under the UCC regarding the issuance, collection and payment of checks; prohibitively expensive in light of the millions of checks processed for payment on a daily basis; and, thus, contrary to public policy because of the disruptive effect it would have on the low cost automated check-processing system, an integral part of the nationwide payments mechanism. Based upon its findings the Court ruled as a matter of law that a drawee financial institution does not have a duty to conduct any review of payee endorsements on checks received from a depository bank. Guardian Life Insurance Company of America v. Weisman, No. 99-5397 (NJ 2000).

Protection Points
Although both drawee and depository banks bear the responsibility for the payment of checks over a payee’s forged endorsement, this liability may be avoided if the drawer of the forged check failed to exercise ordinary care in issuing the check that substantially contributed to the making of the forgery.
By Craig W. Smith, J.D., Author, CCH DEPOSIT LAW NOTES.