Encoding Error Proves Costly - John Burnett

Encoding Error Proves Costly
John Burnett

Have you ever had one of those days when everything you touch goes wrong? In Douglas Companies, Inc., v. Commercial National Bank of Texarkana, recently considered by the U.S. District Court of Appeals for the Eighth Circuit, a seemingly simple check payment to a vendor turned into a comedy of errors with costly results for the bank that happened to mis-encoded the check. As comedies go, this one includes helpful lessons about deposit contracts, the UCC, and "failures to communicate."

Douglas Companies, Inc. (Douglas) was a wholesale supplier of several convenience stores in Arkansas and Texas owned by USA Express (USA). In April 2000, USA issued its $240,000 check to Douglas to pay for merchandise, and Douglas deposited the check to its account with Commercial National Bank of Texarkana (CNB). CNB mis-encoded the check for $24,000 and sent it on to Wells Fargo Bank Texas (Wells Fargo), which held USA's account. Wells Fargo, as luck would have it, missed the encoding error. The result was that Douglas was credited with $216,000 less than the amount of the check.

Delay in Notifying the Bank
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Douglas received its bank statement a few days later, but failed to note the error until November 2, 2000, because one controller had left the company and the new controller fell ill, causing a backlog. When the controller notified CNB of the discrepancy, CNB assured the controller the error would be corrected, and credited the Douglas account the next day. The controller did not inform Stephen Douglas, the company president, of the incident.

First Mis-encoding, Then Mis-routing
The Federal Reserve rejected CNB's adjustment request because it was over six months old. So CNB sent the request directly to Wells Fargo -- but at the wrong address -- on November 7. CNB's adjustments employee testified that she did not inquire of Wells Fargo to verify the correct address. CNB's president admitted in his testimony that the address the employee found in the "big bank book" should have been verified.

A Day Late and $216,000 Short
Wells Fargo transferred the adjustment request to its Southwest Adjustment Center (SAC) in Phoenix, Arizona, where it was logged in on November 14, 2000. The SAC notified CNB of the receipt of the request and indicated it would be worked on in the normal course of business. Wells Fargo's employee worked on the request for two days, but looked in the wrong database and couldn't find a record of the USA check. Wells closed the inquiry without notifying CNB. The USA account at Wells Fargo had sufficient funds to recover the $216,000 error on November 14 (when the check was received by the SAC), but the account was closed on November 15 when Credit Suisse First Boston (CSFB), a creditor of USA, to whom USA had signed over its assets two months earlier, transferred the account balance to Houston Convenience (Houston), formed by CSFB to operate the stores. Houston had assured Douglas that it would bring all of USA's accounts with Douglas up to date, but neither Houston nor Stephen Douglas was aware of the $216,000 hanging in limbo at Wells Fargo's Adjustment Center.

First You Say You Will, and Then You Won't ...
CNB finally learned the fate of its adjustment request in January 2001, when it followed up with Wells Fargo. CNB reversed the April credit of $216,000 it had given Douglas. Steven Douglas convinced CNB to recredit the account and CNB requested reimbursement from Houston, which denied the request and went bankrupt in March 2001. Of course, CNB took back the $216,000 from Douglas's account.

See You in Court!
The predictable court battle ensued. Douglas sued CNB for negligence and breach of contract. CNB denied liability, citing its account agreement requiring Douglas to review its bank statement and notify CNB of errors within 60 days. CNB filed a third-party complaint alleging Wells Fargo had failed to comply with its midnight deadline, failed to exercise ordinary care, and failed to act in good faith. Wells Fargo countered with claims of negligence and violation of the UCC encoding warranty.

CNB lost on all counts at trial and in post-trial motions for a new trial and lost again on the issue of paying attorney's fees for Douglas and Wells Fargo.

Contract Language Failed
The appeals court affirmed the lower court's verdict. As to the deposit contract, the courts both agreed that the language in question addressed customer duties under UCC 4-406, and therefore only covered errors on items debited from the account. In short, had the contract separately dealt with the customer's responsibility to catch errors in deposit amounts, the bank might have prevailed.

"It Happens All The Time!" Didn't Fly
CNB also argued whether it should bear the responsibility for the erroneous encoding. The bank argued that the lower court had erred in putting the question of CNB's negligence to the jury for a decision, because such errors are a matter for Federal Reserve Regulations and Operating Circulars. The appeals court disagreed, saying, "... encoding errors, just like motor vehicle accidents, do not escape the scrutiny of a jury simply because they are known to occur."

Lessons Learned
The matter of the deposit contract is one that banks should review carefully with counsel. Many banks include language in their contracts designed to cut off customers' claims of account errors before the usual one-year statute of limitations. In this case, the appeals court found that the deposit contract language only addressed those matters covered by UCC 4-406, namely signatures and alterations.

There's an old English nursery rhyme that begins, "For want of a nail, a shoe was lost/For want of a shoe the horse was lost," and ends with the loss of the kingdom. What are the horseshoe nails in this case?

• If Douglas's controller had not left in 1999, the error would likely have been identified much sooner, most likely in time to have avoided the loss and ensuing court case.
• Had the new controller not fallen ill in the spring of 2000, there would likely have been a similar happy ending.
• Had Stephen Douglas been notified of delayed discovery of the error, it's possible that Douglas and Houston would have settled the $216,000 error between them.
• Had CNB's adjustment employee simply verified the correct Wells Fargo adjustments address, it's likely the adjustment would have been completed before the USA account was closed.
• If the Wells Fargo adjustments employee had looked in the right database and found the USA check, Wells Fargo might have notified CNB of the fate of its adjustment request in November, rather than January 2001.
• And, of course, the ultimate horseshoe nail: If the encoding error had never occurred in the first place ...

First published on BankersOnline.com 08/23/05