Altered Check: Who Pays?

When a check for more than a half million dollars from Wal-Mart to one of its vendors gets stolen from the mail and undergoes an alteration of the payee, it's not surprising that a lawsuit results as the various parties to the transaction attempt to use the provisions of the Uniform Commercial Code to allocate the loss to the party(ies) in the best position to prevent the loss.

That's what happened in the case of Wachovia Bank, N.A. v. Federal Reserve Bank of Richmond. In an opinion issued on July 29, 2003, the United State Court of Appeals for the Fourth Circuit upheld the district court's decision to grant summary judgment for Wachovia and Wal-Mart against the Federal Reserve Bank of Richmond (FRB) on a claim of breach of transfer and presentment warranties. The appellate court found that FRB, the intermediary bank, did not present evidence to successfully defend against the breach of warranty claims. The Court determined that the drawee bank (Wachovia) paid the check in good faith and the drawer (Wal-Mart) did not substantially contribute to the alteration of the check.

Facts
A $563,288.95 check drawn on Wal-Mart's account at Wachovia was stolen from the mail after Wal-Mart issued it to a vendor. The name of the payee was altered and the check was deposited into the thief's checking account at Asia Bank. The deposit aroused suspicions at the depository bank because at the time of the deposit the thief's account had a balance of $108.55, and the highest balance the account ever held was $8,652.55. The depository bank placed a hold on the deposit and made phone calls to Wachovia regarding the funds.

The check was presented by Asia Bank to the Federal Reserve Bank of New York who presented it to the Federal Reserve Bank of Richmond who presented it to Wachovia. Wachovia's procedures did not require a manual inspection of the item, but it was passed through a Positive Pay system which verified the check number and amount. The Positive Pay system did not compare the original name of the payee with the payee on the item as presented, and thus did not catch the alteration. The check was paid by Wachovia. When the Regulation CC hold placed on the funds by Asia Bank expired, the thief attempted to wire the funds out of the country. He attempted five different transactions, each submitted to a different teller. Asia Bank initially refused to wire the funds. Only after a phone call to Wachovia revealed the check had been paid did Asia Bank release the hold and allow the funds to be wired out.

Subsequently, the true payee contacted Wal-Mart, claiming it had never been paid. At that point, the payee alteration was discovered and Wachovia was contacted. Wachovia sought reimbursement from Asia Bank, who refused. Wachovia then brought suit in North Carolina state court against the Federal Reserve Bank of Richmond for breach of transfer and presentment warranties under Article 4. The FRB removed the case to the U.S. District Court for the Western District of North Carolina and also filed a third-party complaint against Wal-Mart. The district court granted both Wachovia's and Wal-Mart's motions for summary judgment. The FRB appealed to the U. S. Court of Appeals for the Fourth Circuit.

Discussion
When an item is presented for payment to the drawee bank, the entity presenting it warrants under Section 4-208 of the Uniform Commercial Code that the item has not been altered. Wachovia claimed FRB breached this warranty because FRB was a presenting bank, and the check had, in fact, been altered.

In examining the breach of presentment warranty claim, the Court noted that a presenting bank may have a defense if the paying bank lacked good faith or if the drawer of the check is precluded from asserting a claim against the paying bank. The FRB asserted both defenses, claiming Wachovia lacked good faith in paying the check and that Wal-Mart failed to exercise ordinary care which substantially contributed to the alteration.

The FRB specifically argued that the phone inquiries by Asia Bank questioning the validity of the check should have alerted Wachovia to the problem. The Court observed that even though the calls were made prior to the time Asia Bank released its hold, the calls were made after the check was paid by Wachovia. The calls therefore had no bearing on the issue. The language of Section 4-208 warrants the check "at the time of presentment" and acts or failures to act subsequent to presentment are not considered.

The FRB also contended that Wachovia failed to act in good faith by not supplementing the Positive Pay system, which does not detect payee alterations, with a manual review of high dollar checks. The Court noted that the UCC defines "good faith" as (1) "honesty in fact" and (2) "the observance of reasonable commercial standards of fair dealing". The Court concluded that the test was not whether Wachovia acted in accordance with "reasonable commercial standards", but rather whether Wachovia's actions conformed to "reasonable commercial standards of fair dealing". The Court held that the fairness of Wachovia's actions should be considered, rather than any negligence on its part.

According to the 4th Circuit Court, in order for the drawee bank to be shown to have failed to act in good faith, the evidence must show that it acted in an unfair or dishonest manner, rather than in a negligent manner. The Court held that no evidence was presented that indicated Wachovia lacked good faith in paying the check.

The Court observed that even though this matter was decided on an analysis of fairness not negligence, Wachovia's check-processing procedures could not be characterized as negligent. The Court stated " under the U.C.C., a bank does not violate ordinary care if it processes instruments by automated means without examining the instruments, unless such a practice violates that bank's prescribed procedures, or the bank's procedures vary unreasonably from general banking usage, or the bank's procedures are otherwise prohibited by the U.C.C."

Next, the Court turned to an examination of the defenses FRB attempted to raise against the drawer of the check, Wal-Mart. The FRB would have a defense to the breach of warranty claims if Wal-Mart failed to exercise ordinary care that substantially contributed to the alteration.

The FRB alleged that Wal-Mart was negligent in not electing to implement precautionary measures, since it had been informed by the Post Office that some checks had been stolen from the Dallas area. The vendor to whom the check was sent was located in Dallas.

The Court observed that the record indicated that Wal-Mart issues 1.6 million checks to vendors annually and approximately 20 Wal-Mart checks are stolen from the mail each year. In the year prior to the theft of the check in question, six Wal-Mart checks were stolen that were addressed to vendors in the Dallas area. The authorities alerted Wal-Mart that these thefts were not part of an organized scheme, but independent acts, and several parties had been apprehended. The Court concluded that the activity did not warrant Wal-Mart sending the checks by courier or making payment by EFT.

In addition, the FRB contended that Wal-Mart employees knew that the check was missing and did not inform Asia Bank. The Court held that the Wal-Mart employees were informed of the problems with the check after the alteration was made. The alleged negligence of the Wal-Mart employees could not have contributed to the alteration of the check.

Decision
The Court determined that the defenses to the breach of warranty claims that were raised by the FRB were not supported by the evidence. The actions of Wachovia met the two prongs of the good faith test of honesty in fact and the observance of reasonable commercial standards of fair dealing. There was no evidence that Wachovia did not act in good faith when it paid the check.

The fact that Wal-Mart did not elect to send payments to vendors in the Dallas area other than via the U. S. postal system was not a failure to exercise ordinary care. The mailing of the check did not substantially contribute to the alteration. The alleged negligence of Wal-Mart employees occurred after the alteration was made, so could not have contributed in any way to the alteration.

The decision of the lower court to granting of the motions of summary judgment to both Wachovia and Wal-Mart was upheld.

The Court noted that FRB's liability, and ultimately the liability of Asia Bank, was consistent with the general scheme of the UCC to shift losses upstream to presenting and depository banks.

Summary
An intermediary bank warrants that an item has not been altered. If the item HAS been altered and a breach of warranty claim is made, the intermediary bank can defend an against it on the grounds that the paying bank lacked good faith when it paid the check in question or that the drawer of the check is precluded from asserting a claim against the paying bank.

The Court held that the good faith analysis must be conducted as of the time the check is presented for payment and any act or lack of action after the fact is not considered. The fact that the bank learned of problems with the check after it had been paid, but prior to the release of funds by the depository bank, had no bearing on the breach of warranty claims.

The failure of the paying bank to manually inspect the check after it was presented did not constitute negligence, even though it was for an amount in excess of $500,000. The use of an automated system was permissible as long as l) the bank's own procedures were not violated, 2) those procedures did not vary unreasonably from general banking usage, and 3) the procedures the bank used were not prohibited by the UCC.

The fact that the drawer of the check elected to deliver it to the named payee via mail rather than an alternative system did not constitute a failure to exercise ordinary care that substantially contributed to the alteration of the check.

First published on BankersOnline.com 08/11/03