PAYMENT SYSTEMS AND FRAUD LOSS ALLOCATION

Transcription

1 PAYMENT SYSTEMS AND FRAUD LOSS ALLOCATION Terri D. Thomas SVP - Legal Department Director Kansas Bankers Association Topeka, KS tthomas@ksbankers.com August 8-10, 2018

2 PAYMENT SYSTEMS AND FRAUD LOSS ALLOCATION Presented to the Graduate School of Banking-Madison, WI Presented by: Terri D. Thomas, JD-SVP, Kansas Bankers Association 1 OBJECTIVES After successful completion of the course, students will be able to: Understand the legal components of each fraud; Describe the applicable laws, regulations, and rules pertaining to each fraud; Properly allocate the loss resulting from various examples of fraud; Predict how losses from fraud should be allocated as future payment technologies are developed. 2 1

3 GENERAL PRINCIPLES: LOSS ALLOC ATION The crook is always liable. However, collecting a loss from the crook is rarely viable; All other parties are innocent; Laws, regulations, and clearinghouse rules attempts to allocate loss to the party that was in the best position to detect or prevent the problem. 3 TYPES OF FRAUD: Check Fraud: Forged drawer s signature; Forged endorsement; Alteration; Counterfeit check; Remote/Mobile Deposit Capture duplicates; Imaging disputes; Electronically-Created Items; Cashier s check fraud; Unauthorized consumer electronic transfers: Debit card; ACH (including P2P/C2C) and Electronic Check Conversion; Credit Card fraud; Wire transfer fraud. 4 2

4 CHECK FRAUD 5 Is Check Fraud a significant issue for financial institutions? While debit card fraud losses remained consistent with previous surveys, check fraud losses saw their first increase since 2008, surging by 28% to $789 million. -ABA s 2017 Deposit Account Fraud Survey Report 6 3

5 Why? Fraud moves like water trying to find cracks in the system. We have long anticipated that fraudsters would change their tactics once chip card technology was implemented in the U.S. The survey shows attacks have shifted more to other payment platforms like checks and online transactions. -Jim Chessen, ABA EVP and Chief Economist ABA Banking Journal January 24, Legal amount (UCC 3-114) The Drawee [UCC 3-103(a)(4)] (Primarily liable for payment) Must pay or return before lapse of midnight deadline. The Endorsers [UCC 3-415(a)] Contract to pay the subsequent holders if the check is dishonored by the Drawee. Released from liability if check is finally paid. ANATOMY OF A CHECK The Payee (UCC 3-110) The Drawer [UCC 3-103(a)(5)] (Secondarily liable for payment if check is dishonored. Released from liability if check is finally paid by Drawee) Encoded Amount [UCC 4-209] Warranted for accuracy. 8 4

6 Midnight deadline- Midnight of the next banking day after the banking day of presentment. Can be earlier under clearinghouse rules. Deadline for proper dishonor and final payment. UCC 4-104(a)(10) Banking day- UCC 4-104(a)(3) part of a day on which a bank is open to the public for carrying on substantially all of its banking functions. Presentment- UCC is a demand against the party primarily obligated to pay (drawee or maker) a negotiable instrument. 9 ELECTRONIC ITEMS Electronic Checks/Substitute Checks- UCC/Reg CC treat the same as paper checks for purposes of liabilities and warranties; Electronically-Created Item- Not specifically recognized by UCC and only carries a duplicate payment indemnity under Reg CC as of July 1, Federal Reserve and ECCHO will not (knowingly) accept for processing. Will have to be handled through direct presentment. To hold depositor liable, will need contractual terms. Consider dealing with such items in account agreement. 10 5

7 FORGED DRAWER S SIGNATURE 11 CASE STUDY 1 On Monday, August 17, a check that was payable to Jill Dalton, in the amount of $ and drawn on American State Bank was deposited at Big National Bank. The check was sent for payment through the Federal Reserve system and was presented for payment against Ellen Anderson s account on Wednesday, August 19. The check is posted against Ellen s account that night. On Thursday morning (August 20), Ellen calls American State in a panic. Her check book was stolen and she fears that forged checks may be presented against her account. The bank asks her if she wrote the $ check to Jill Dalton and she says no ; 12 6

8 American State tells Ellen that she needs to come into the bank and sign a forgery affidavit, or the bank can t return the check as a forgery. Ellen doesn t come into the bank to sign the affidavit until Friday. Once the affidavit was completed, American returns the check back to Big National Bank as forged; Unfortunately, when Big National Bank attempted to charge the item back against Jill s account, the bank discovered that all of Jill s money on deposit was gone. Should Big National Bank take the loss on this forged item? Why or why not? 13 Rule #1: Passing of Midnight Deadline =Final Payment (UCC 4-302) If the drawee bank does not return (dishonor) a check by its midnight deadline, the check is considered finally paid; Rule #2: After Final Payment, Drawee Bank Recovery Limited to Warranty Claim (UCC 4-208/4-209) Once a check is finally paid, the drawee bank s only option for recovery is a presentment warranty claim. 14 7

9 Transfer Warranties (UCC 4-207): Each endorser warrants to subsequent holders that all signatures are authorized, all endorsements are valid and there are no alterations. Allows for item to be passed upstream easily from one holder to a previous holder when fraud occurs. American St. Bank (Drawee Bank) Check paid from Ellen s account Ellen (Drawer) Federal Reserve Bank of Cleveland (central repository) BNB gives presentment warranty to Drawee Check Payable to Jill Big National Bank Depositary Bank (Jill s Bank) Jill deposits the check Check Transaction Transfer warranty Presentment warranty Jill Jill provides a transfer warranty to Big Nat l Bank Presentment Warranties (UCC 4-208/4-209)- Each endorser warrants to the drawee bank: no knowledge that the drawer s signature is unauthorized, all endorsements are valid and there are no alterations. Drawee can easily enforce claim after final payment against an endorser when there is a forged endorsement or alteration. Drawee can NOT easily enforce claim after final payment when the problem is a forged drawer s signature due to knowledge factor. 15 OTHER PRESENTMENT WARRANTIES UNDER THE UCC ARTICLE 4 (AND ALSO GIVEN UNDER EFAA-REGULATION CC): Encoding; Demand draft is authorized by the drawer. *Presentment warranty claims must be brought within 30 days of knowledge. 16 8

10 ENFORCING THE PRESENTMENT WARRANTIES: Regulation CC provides one year for bringing encoding and unauthorized demand draft claims; UCC provides a drawee bank with three years to bring any presentment warranty claim; Federal Reserve Operating Circular 3 provides 6 months to bring an encoding claim, 90 days to bring an unauthorized demand draft claim and 0 days to bring any other presentment warranty claim. 17 ANSWERING THE QUESTION: SHOULD BIG NATIONAL BANK TAKE THE LOSS ON THIS FORGED ITEM? WHY OR WHY NOT? No. Why? Check was finally paid by drawee (midnight deadline had passed); No presentment warranty breach by Big National Bank (depositary bank); Big National Bank should file late return claim. 18 9

11 WHAT IF THE CHECK WERE PROCESSED THROUGH ECCHO? Assume the same facts in Case No. 1, except the check is presented for payment through the Electronic Check Clearing House Organization (ECCHO) and is never processed through the Federal Reserve; Assume there are still funds on hand in Jill Dalton s account at the time it is notified of American State s claim. Will Big National Bank have to accept American State s claim of a forged drawer s signature? 19 Yes, Big National Bank may have to accept a forged drawer s signature (or counterfeit check) claim under ECCHO Rule 9. Why? Under ECCHO Rule 9: In addition to the standard presentment warranties, the depositary bank warrants that: The check does not contain a forged drawer s signature; and The check is not counterfeit. Warranty is valid for 60 days after the drawer s statement is available; Depositary bank may disclaim if the depositor s account is closed or if the claim exceeds the account balance; Depositary bank may opt out of the rule, but will be bound by opt-out for all purposes

12 The problem with the ECCHO rule? Big National Bank may accept the return, but then may find that other presentment warranty claims exist that exceed the balance in the account, with no ability to reject those claims; No right of charge back against depositor/payee. Why? UCC provides for the right of charge back when the check has been properly dishonored by the drawee bank [only up until the time the check has been finally-paid/settled (midnight deadline)]; The bank s deposit agreement may not give depositary bank the ability to debit depositor/payee unless under a right of charge back. 21 LIABILITIES ON FORGED DRAWER S SIGNATURE CLAIMS Presuming the original Case No. 1 facts, is American State stuck with the loss? 22 11

13 FORGERY OF DRAWER S SIGNATURE, CONT. (UCC 3-406/4-406) Drawee can try to pass liability to drawer (customer): Customer s failure to exercise ordinary care substantially contributes to the forgery; Customer failed to report within 30 days (UCC standard) after receiving statement AND the bank can prove delay in reporting caused loss; AND bank exercised ordinary care. Bank followed procedures Procedures reasonable for similarly situated banks 23 FORGERY OF DRAWER S SIGNATURE, CONT. Absolute bar from liability if drawer fails to report within one year of receiving statement. Multiple forgery rule: if same wrongdoer forges checks, then the bank is not liable for checks that are paid after 30 days of statement being issued

14 FORGERY OF DRAWER S SIGNATURE, CONT. Shortening the 1 year and 30 day standards UCC Article 4 can be amended by mutual agreement Can t disclaim good faith, can t limit measure of damages and can t state an unreasonable provision. Could shorten 1 year absolute bar to days and shorten 30 days for the customer to review a statement to around days in most states. For non-consumer customers, consider adding contractual term that requires customer s acceptance of positive pay service as a condition of bank s liability in fraud/forgery claims. 25 USING THE DEFENSES TOGETHER statement sent-customer has 30 days to review- does not thru First forgery Statement sent multiple forgeries occur-customer does not report Customer reports occurs forgeries of thru One year rule will bar forgeries occurring from January 15, 2017 to March 1, Multiple forgery rule bars recovery on all other checks

15 CASE STUDY 2 On a warm summer day, Mary accidently leaves her checkbook in the front seat of her convertible (the top is down, of course). Unbeknownst to her, the checkbook is stolen by Sally, who then writes a $ check, payable to herself and forges Mary s name on the check as the drawer. Big National Bank, the drawee, cashes the check. Mary is now demanding that the bank recredit her account for the forged item. Is the bank liable? Why or why not? 27 CASE STUDY 2 Assume the same facts from the previous question apply, except, Sally forges several checks on Mary s account over a period of three months. Mary is now notifying the bank of the forgeries and demanding that Big National Bank recredit her account. Is the bank liable? Why or why not? 28 14

16 CASE STUDY 2 In the previous discussion question, what might Big National Bank have done to further limit its liability? 29 CASE STUDY 3 Beginning May 15, 2017, Frank Peters forged checks on his employer s checking account using a facsimile signature stamp. Over the next 8 months, Big National Bank paid over 70 of these checks from the employer s account. The employer is now seeking reimbursement from the bank. Assume there are no special contractual provisions controlling the bank s relationship with the customer, and therefore, the standard time periods of the UCC apply. Is Big National Bank liable? Why or why not? 30 15

17 FACSIMILE SIGNATURE PROBLEMS- Customer is responsible for checks signed with a facsimile signature if customer authorized use of the signature on the account and was negligent in protecting checks and rubber stamp/check machine (drawer s negligence contributed to the forgery); Customer is not responsible for checks that were signed with a facsimile signature if bank was never authorized to accept the facsimile signature; Caution: Imaged signature cards and imaged checks- the Check 21 dilemma. 31 SOME RESOLUTIONS SHIFT ALL RISK OF THE USE OF A FACSIMILE, FOR ANY PURPOSE, ON TO THE CUSTOMER: 32 16

18 OTHER WAYS TO PASS THE LIABILITY ON TO THE DRAWER: RATIFICATION OR ESTOPPEL AS DEFENSES- Prior checks written by forger, but never reported as forged because drawer wanted the checks to be written, will absolve drawee of liability on currently reported forged checks; Checks written by forger which directly benefit the drawer may absolve the drawee of liability; Agency (actual, apparent or implied). 33 FORGED ENDORSEMENTS 34 17

19 CASE STUDY 4 Bob Miller, your checking account customer, has contacted your bank about a check that he wrote to Steve Smith in the amount of $3, The check was paid from Bob s account two weeks ago, but today, Steve has contacted Bob to report that he has not received the check. Bob has looked at the image of the check using his on-line banking access. Even though it appears to have been endorsed by Steve and then paid to the order of Speedy Cash Check Cashing Service, and then deposited at Big National Bank, Steve has asserted that the endorsement is not his, that he did not perform any transaction with Speedy Cash, and he never received any of the check proceeds. The check must have been stolen from the mail. 35 Presuming the endorsement does not belong to Steve, who should take the loss on this forged endorsement item? Why? 36 18

20 Forged endorsement makes an item not properly payable, and therefore it should not have been debited from the drawer s account; The midnight deadline has passed, which means the item has already been finally paid and cannot be returned as dishonored (Note: Drawer does not have duty to discover unauthorized endorsements by reviewing bank statement within a specific period of time. Why? Not in a position to determine if forged endorsement has occurred until payee reports non-payment); Presentment warranty allows drawee to make a claim against the depositary bank (typically for three years after presentment-however Fed won t take it past the midnight deadline); Drawee recredits drawer; depositary bank recredits drawee via the direct claim process. 37 In reality: Depositary bank may ignore the presentment warranty claim from the depositary bank, requiring the depositary bank to sue in order to recover; Depositary bank may raise a valid defense as to why the endorsement should not be considered forged

21 CASE STUDY 5 Carrie is the bookkeeper for Smith Rentals, Inc. She is responsible for reconciling the company s bank statement. She also prepares accounts payable checks for the company s president to sign. One day, she slips in three checks payable to fictitious people, each in the amount of $10,000. The company s president does not notice. He signs the checks. Carrie takes the checks and deposits them into accounts that she has opened in the name of fictitious people. She then removes the money from the accounts and leaves the country. Her employer is now seeking reimbursement from his bank, Big National Bank, claiming that the checks contain forged endorsements. Big National Bank refuses to pay. Who wins and why? 39 FORGED ENDORSEMENT DEFENSES- Defenses that can be raised against recrediting the drawer: Imposter/Fictitious payee defenses- drawer is duped into writing a check to the crook; Padded payroll defense- Employee dupes employer into writing a check. Employee has too much responsibility over employer s payment process. Ratification (previously approved or benefit received)

22 IMPOSTER RULE (UCC 3-404) Drawer is induced to issue an instrument to a thief, who impersonates someone else whom the drawer intends and names as payee. Thief endorses the name of the payee and impersonates that person to induce a third person (depositary bank or drawee bank) to take or pay the instrument; Does not matter how the imposter tricks the drawer; Will be applicable whether the imposter or an associate endorses the instrument; By making the endorsement effective, anyone who takes the instrument becomes a holder (of a bearer instrument), and would probably qualify as a HIDC (presuming no knowledge of the crime). 41 The rule will also apply if the thief poses as the agent of a payee and induces the drawer to issue the check; An endorsement in the payee s name by the supposed agent or anyone else is effective. The defrauded drawer bears the loss

23 FICTITIOUS PAYEE RULE (UCC 3-404) If the drawer gives the thief (albeit unknowingly) the authority to issue checks drawn on the drawer s account, and the thief then draws checks in favor of fictitious parties or third parties, then if the thief endorses the items and negotiates them, the endorsements are considered valid and effective; If the payees named really exist, then this rule would not apply if the checks were validly drawn and then stolen by the thief; The key is what was the intent of the person who actually drew the item at the time the item was drawn? 43 DISHONEST EMPLOYEE RULE (UCC 3-405) The rule is limited to fraud by employees who have been entrusted with the responsibility with respect to an instrument, meaning: Authority to sign/indorse instruments on behalf of the employer; Authority to process instruments received by the employer for deposit to an account; Authority to prepare or process instruments for issue in the name of the employer; Authority to supply information that determines the names or addresses of payees of instruments issued off the employer s account; Authority to control the disposition of instruments to be issued in the name of the employer; or To act otherwise with respect to instruments in a responsible capacity

24 Responsibility does not mean merely having access to instruments, or blank/incomplete instrument forms that are being stored or transported, or are part of incoming/outgoing mail, or similar access. 45 THINGS TO KEEP IN MIND WITH THESE DEFENSES: In the case of employee fraud, and can overlap. In this event, will tend to control because the elements are easier to prove. It covers both endorsements made in the name of the employer and endorsements made in the name of payees of instruments issued by the employer; does not care whether the payees are fictitious or real persons; Why? Employer is in better position to avoid loss by using care in choosing employees, in supervising them, and in adopting other preventative measures (see 3-405, Comment 1)

25 OTHER DEFENSES AGAINST FORGED ENDORSEMENT CLAIM Ratification/Estoppel; Agency- (actual, apparent or implied) 47 CASE STUDY 6 Mary is the grantor and trustee of the Mary Doe Trust. She wants endorse a check payable to the trust and deposit it to her personal account. Can she? Why or why not? 48 24

26 NOTICE OF FIDUCIARY BREACH Depositary bank can be liable under the following conditions: It has notice of fiduciary breach (UCC 3-307)- An instrument is taken from a fiduciary for payment of collection or for value; The taker has knowledge of the fiduciary status of the fiduciary; and The represented person (principal) makes a claim to the instrument or its proceeds on the basis that the transaction of the fiduciary is a breach of the fiduciary duty; and either: Check payable to agent (as such) or principal and not credited to the principal; Check drawn on principal s account, payable to bank and not credited to the principal. 49 CONFLICT OF GENERAL FIDUCIARY LAWS If the Uniform Trust Code or Uniform Fiduciary Act directly conflicts with the notice of fiduciary breach provisions of the UCC s 3-307, the UCC controls. However, specific language in the document creating the authority can override the liability placed on the depositary bank under UCC

27 CASE STUDY 7 Michael Jones is a bookkeeper for All-Star Awards and Trophies, Inc. (a Missouri corporation). Michael decides to open an account at a Kansas bank in the name of Michael Jones, d/b/a All-Star Awards. Over the next several months, he steals checks payable to the company and deposits them into the account that he has opened. He then takes all of the money he has deposited (over $100,000) and skips town. All- Star Awards and Trophies, Inc. contacts the various drawers of the checks that were stolen and demands replacement payments. The drawers then demand that their respective drawee banks recredit their accounts. Should the drawee banks be liable? Why or why not? Which party or parties should be ultimately liable for the loss (other than Michael)? 51 NO ENDORSEMENT? Depositary bank warrants that the payee received credit for the item. (Drawee bank has no basis for dishonoring a check with a missing endorsement unless it has knowledge the payee did not receive credit.) (UCC 4-205) 52 26

28 ALTERATIONS 53 Payee changed WHAT IS AN ALTERATION?- CHECK ISSUED BY DRAWER IS CHANGED, WITHOUT AUTHORIZATION Numerical amount inserted Written amount inserted Memo blank changed 54 27

29 CASE STUDY 8 Several weeks after a check was paid against a drawer s account, the drawee bank is notified that the check was originally written in the amount of $50.00, but was altered so that the amount appeared to be $500.00, which was erroneously debited against the drawer s account. Can the drawee bank revoke the settlement it gave to the presenting bank and send the item back to the depositary bank? Why or why not? Can the drawee bank recover its money under any other theory? 55 LIABILITY FOR ALTERATIONS Altered information is not properly payable; (UCC 3-406) Did drawer s negligence in completing the instrument substantially contribute to the alteration? If yes, drawer will take loss (or at least part of the loss if the drawee was also negligent). If no negligence, then drawee will have to recredit the difference; If instrument incomplete when issued, then drawee bank can pay as completed regardless of drawer s intent; Presentment warranty places liability on endorser (typically depositary bank) since all endorsers warrant that the item is not altered

30 COUNTERFEITS 57 WHAT IS A COUNTERFEIT? 58 29

31 LIABILITY FOR COUNTERFEITS- Not defined in the UCC; Generally considered the same as forgery of drawer s signature ; Not authorized by drawer; therefore, not properly payable; Liability usually on drawee bank if check not dishonored by the midnight deadline; If cashier s check, then drawee bank loses after final payment because the drawee bank is also the drawer. 59 DOUBLE FORGERIES (WHERE THE DRAWER S SIGNATURE AND THE ENDORSEMENT ARE FORGED) Law uses a comparative negligence standard and loss is allocated between the parties (drawee bank and depositary bank)

32 UNAUTHORIZED REMOTELY-CREATED DRAFTS (DEMAND DRAFTS) UCC and Regulation CC place liability on depositary bank Three years from the date of presentment under the UCC; One year from the date of presentment under Regulation CC; The depositary bank will be forced to seek reimbursement from the payee; Can return the item through the Fed for up to 90 days after presentment (however, the Fed will not process claims of $25 or less); Regulation CC does not give the depositary bank the ability to hold depositor liable, but liability may exist through the UCC or contract terms. 61 CHECK 21-SUBSTITUTE CHECKS AND REMOTE DEPOSIT CAPTURE UCC warranties survive the imaging process (no matter who does the imaging) under UCC and Check 21; If loss occurs as a result of creating the IRD or Substitute Check, then the law will place responsibility on the reconverting bank (the bank that created the substitute check, not the bank that created the image); Contracts executed between participants and Regulation J will place responsibility for loss on party originally converting the instrument from its original state to IRD/Substitute Check; Consumers have 40 days to report and can receive up to $2500 in provisional credit at ten business days

33 CASE STUDY 9 A customer of Foster Bank named Choi deposited into her account a check for $133,025 that listed her as the payee. The check had been drawn on Wachovia Bank by a company called MediaEdge that had an account with the bank. Foster presented the check to Wachovia for payment. Wachovia paid Foster and debited MediaEdge s account. A couple of months later, MediaEdge notified Wachovia that, while it had issued that check number in the amount of $133,025, the payee of the check was CMP Media. CMP Media had never received the original check. By the time Media Edge made its claim, the original check had been destroyed and all that existed was a computer image of the item. Unfortunately, the image quality was such that it was impossible to tell whether the item paid was altered or counterfeit. Why does it matter? 63 IMAGING AND CHECK FRAUD- Wachovia v. Foster Bank- when the check has been imaged and the original destroyed, how can we tell whether it is counterfeit or altered? Lower court said that altered was easier to believe. Court of Appeals said depositary bank was in better position to know of problem. Wachovia v. Chevy Chase Bank- Court said it was up to drawee to prove check was altered. Proposed change to Regulation CC will presume altered

34 MOBILE/REMOTE DEPOSIT CAPTURE AND DUPLICATE CHECKS WEST DIVERSEY CORP V. JP MORGAN CHASE (2016) Who takes the loss when duplicate entries occur? Depositary Bank (Check Cashing Service Bank) Original check was presented and dishonored as a duplicate MB Financial Bank (Drawee Bank) Hotel (Drawer) Imaged check paid from Hotel s account Check Payable to Employee JPMorgan Depositary Bank (Employee s Bank) Employee first deposits the check via Mobile Deposit Capture Employee Check Cashing Service A few weeks later, Employee cashes the original check at Check Cashing Service Key: 1 st Transaction 2 nd Transaction 65 Federal Reserve and Electronic Check Clearing House Organization adjustment procedures available for six months after presentment. Drawee Bank may bring claim against either Depositary Bank, however if the Drawee Bank doesn t pay both checks, there s no reason to bring a claim; Drawer appears to be liable to a Holder in Due Course (HIDC), which could be both of the Depositary Banks or Check Cashing Service; Effective July 1, 2018, Regulation CC was amended to create a new indemnity that generally places liability on a depositary bank providing the mobile deposit capture service, unless the original check was endorsed with a restrictive endorsement ( For Deposit Only to Account #... or For Mobile Deposit Only ) so that the bank subsequently taking the original item is on notice; Amendments state that the depositary bank cannot automatically hold customer liable under Regulation CC, but may use UCC or other contracts to create liability

35 DOES REGULATION CC SOLVE THE REMOTE DEPOSIT CAPTURE PROBLEM? Case Study: You are reviewing deposits made by remote deposit capture on the bank s system. Would this be an acceptable deposit to absolve your bank from indemnity liability under Regulation CC if the original check were negotiated by the payee with another party? 67 ELECTRONIC CHECK CONVERSION 68 34

36 ELECTRONIC CHECK CONVERSION Electronic check conversion occurring on consumer accounts covered under Regulation E. Under Regulation E, the drawee bank will be responsible for providing the same provisional credit as would be required under unauthorized ATM, ACH and POS transactions on consumer accounts. 69 CASH EQUIVALENT INSTRUMENTS 70 35

37 C AN NEGOTIABLE INSTRUMENTS (I.E. CHECKS) HAVE THE SAME EFFECT AS C ASH? UCC 3-310(a) Certified check Cashier s check G/L checks; Loan proceeds checks; Expense checks Teller s check Discharge the obligation the same as cash. Therefore, these are recognized by the law and bank regulations as cash equivalents. It is virtually impossible to dishonor or stop payment on these items. 71 CERTIFIED CHECK (UCC 3-409) Payment accepted and guaranteed by Home Town Bank, USA By: Jane Jones, SVPJohn R. Doe 72 36

38 CASHIER S CHECK- [UCC 3-104(G)]- DRAWN BY AND DRAWN ON THE SAME BANK (SAME BANK IS DRAWER AND DRAWEE) Remitter- person who provided the funds to the bank for the cashier s check. TELLER S CHECK- [UCC 3-104(H)]-CHECK DRAWN BY BANK EMPLOYEE (TELLER OR OFFICER) ON THE BANK S ACCOUNT AT ANOTHER FINANCIAL INSTITUTION. 73 CASE STUDY 10 Yesterday, Bill obtained a cashier s check payable to Sara from Big City Bank. The bank allowed Bill to purchase the check using uncollected funds in his checking account? The bank has just found out that a check Bill deposited is being returned to the bank as account closed. Once charged-back to Bill s account, it will be overdrawn. Big City Bank would like to put a stop payment on the cashier s check and put the money used to purchase the cashier s check back into Bill s account to cover the returned item. Can it? Why or why not?

39 THE STOP PAYMENT PROBLEM To encourage cash-like treatment there is a limited ability to issue a stop payment on a cashier s check. Right to stop pay is held by the issuer (financial institution) not the remitter (purchaser). Any holder in due course has the right to enforce payment against the issuer, unless the issuer has a real defense against payment. Issuer is liable to a holder in due course for improperly placing a stop payment on a cashier s check. 75 PERSONAL V. REAL DEFENSES Real defenses (valid against paying a cashier s check): Infancy; Duress, lack of legal capacity or illegality; Fraud in factum; Discharge in insolvency. Personal defenses (NOT valid against paying a cashier s check): Lack of consideration; Breach of warranty or other representation; Modification of obligation by separate agreement; Contract defenses

40 IF A HIDC COULD EXIST: During the first 90 days after issuance, no stop payment should be placed unless either no HIDC or a remitter indemnifies the bank (provides an indemnity bond, indemnity agreement, or grants other security for replacement of the check); After 90 days from the date of issuance, UCC permits the payee or remitter to issue a Declaration of Loss for LOST, STOLEN or DESTROYED cashier s check. 77 DECLARATION OF LOSS FORM: 78 39

41 IF A STOP PAYMENT IS PLACED AND THE ORIGINAL CHECK IS PRESENTED BY A HIDC FOR PAYMENT: Within 90 days of issuance- issuer must pay on original (even if a replacement has been issued) unless there is a real defense against payment (valid against HIDC); 90 days or after- issuer can refuse to pay without liability to a HIDC; Be careful, though: If the issuer fails to stop the item by its midnight deadline, the cashier s check will be finally paid and the issuer will take the loss; If check was stolen without a valid endorsement of the payee, stop payment can usually be placed because there will not typically be a HIDC. 79 DECISION TO PLACE STOP PAYMENT IS THE ISSUER S, NOT THE REMITTERS: Helpful language for the deposit agreement or purchase documents: Stop payment orders on cashier s checks, certified checks or money orders are generally not permitted, although the financial institution will accept a declaration of loss and issue a replacement for a cashier s check on or after 90 days have passed from the date of issuance if the check has not otherwise been presented for payment

42 WHAT IF ISSUER HAS A DEFENSE AGAINST PAYMENT? Still liable to a HIDC if the reason for stop payment is a personal defense against payment (such as the remitters failure to pay for the cashier s check); However, won t be liable for expenses or consequential damages. 81 THE DANGER OF COUNTERFEIT CASHIER S CHECKS? With a regular forged drawer s signature on a check or a counterfeit check, if the midnight deadline has passed, the drawee might have the ability to recover its loss from the drawer; With a counterfeit cashier s check, if the check is finally paid, the drawee is also the drawer and therefore, has no ability to pass the loss on to another party

43 Case Study 11 Bob Burnett is a local attorney. He was recently hired by a new client, Independence Manufacturing to collect past due account receivables. Bob sends a demand letter to one of the debtors (Greentree Retail Corp.) and demands payment of $250,000 that is past due and owed to his client. Greentree sends a cashier s check drawn on Bank of the East in the full amount of $250,000, with a letter explaining that it does not want to get involved in litigation over the account, and therefore, is paying the account in full. 83 Bob calls his client with the great news. The client instructs Bob to go ahead and deposit the cashier s check into his law firm account and take his collection fee (30%=$75,000) from the proceeds. He should then wire the remaining amount to the client. He deposits the check on Wednesday, September 10, into his account at First Bank. Because it s a cashier s check, First Bank allows Bob to go ahead and wire the money to Independence Manufacturing s account at Big City Bank on the same day

44 On Friday morning, September 12, the Bank of the East calls First Bank with notice that the $250,000 cashier s check is being returned as counterfeit. First Bank immediately calls Bob to tell him the news. Bob calls his client, only to find that the phone number provided has been disconnected. First Bank calls Big City Bank to find out if the funds wired are still in Independence Manufacturing s account. Big City Bank reports that the funds have been removed and the account is closed. Bob calls Greentree Retail Corp, and finds that it, too, has disappeared. Further investigation reveals that neither Greentree nor Independence Manufacturing ever existed. 85 First Bank receives the counterfeit check back from the Federal Reserve on Monday, September 15. -Can First Bank charge back the $250,000 counterfeit check against Bob s account? Why or why not? -Can Bob or First Bank sue Bank of the East for returning the cashier s check? Why or why not? 86 43

45 THE PROBLEMS? Counterfeit cashier s checks are hard to verify. A financial institution s refusal to verify the legitimacy of a cashier s check may not be reasonable cause to doubt collectability; Some counterfeit cashier s checks are not drawn on valid financial institutions or institutions in the United States. Other countries are not subject to the Regulation CC rules (including expeditious returns or the UCC midnight deadline). 87 THE PROBLEMS CONT. Alterations v. counterfeits- A cashier s check may be altered rather than counterfeit. A depositary bank warrants that no alterations have occurred on the instrument for three years under the Presentment Warranties of the UCC (4-208). Therefore, if the item has been altered the depositary bank will be liable for the item, regardless of the midnight deadline

46 THE PRACTIC AL PROBLEM? The payee/holder has already spent the money because a hold was not placed on the deposited cashier s check. As a result, the charging back of the fraudulent item causes an overdraft; or The payee/holder participated in the scam and the payee/holder, as well as the money, is gone. 89 THE DEPOSITARY B ANK SOLUTIONS? Don t take a questionable item for deposit; Instead, consider sending the item for collection; If already accepted for deposit, determine the minimum threshold that should receive further investigation. If investigation concludes the item is counterfeit after it has already been processed, a Regulation CC exception hold can be placed on the funds deposited

47 WHAT IS THE COLLECTION ITEM PROCESS? Not subject to regular check processing rules, such as presentment, dishonor, and the midnight deadline ; Not considered an item taken for deposit under Regulation CC; In essence, the payee/holder does not get credit until the depositary bank gets credit. Shifts the risk of loss from the depositary bank to the payee/holder. 91 HOW? Must get consent from the payee/holder to send the item for collection; Must prepare instructions for the drawee bank on how the collection item should be handled, including: How payment should be remitted; How long the check should be held; How fees should be collected

48 SAMPLE COLLECTION INSTRUCTIONS: 93 WHAT IF THE CHECK SENT FOR COLLECTION IS COUNTERFEIT? Typically, the drawee bank will send the item back and ask that a fee be remitted. That is usually a sign that the check is counterfeit; If the check is valid, the drawee bank will pay the check, deduct a collection fee and send the remaining funds back to the depositary bank as instructed in the letter

49 PRACTICE TIP: CHANGES TO DEPOSIT ACCOUNT CONTRACTS Need to incorporate language that provides for the depositor s liability for any return or claim that is filed regarding: Demand drafts; Remote/mobile deposit capture items; Electronically-created items; ECCHO Rule 9 claims. 95 ELECTRONIC FUNDS TRANSFER ACT- (CFPB) REGULATION E BCFP 96 48

50 WHAT IT DOES DO AND WHAT IT DOESN T DO: Applies only to consumer accounts; Does not establish loss allocation procedures between financial institutions or between financial institutions and third parties (other than with the International Remittance Transfer rules); Loss allocation established by NACHA rules for ACH (including converted checks and ACH POS transactions); Network rules control debit card/pin transactions; VISA/Mastercard rules for credit/signature transactions. Does establish rules between a financial institution and its consumer customer with regards to electronic funds transfers, such as in the area of unauthorized transfers and liability limits. 97 CASE STUDY 12 Sally has a checking account in the name of her sole proprietorship (Sally Jones d/b/a Simply Sally s Catering) at Community Bank. She also has a savings account in her individual name, Sally Jones. On August 1, Sally realized she misplaced her ATM card. She was pretty sure she left it in the pocket of her jeans that are now in the laundry. Today, August 10, she discovers that two ATM withdrawals were performed for $1000 each against her checking and savings accounts on August 3. She is now reporting those withdrawals as unauthorized. What would be Sally s maximum liability for these unauthorized transactions? 98 49

51 Community Bank discovers, in the course of its investigation, that Sally had written her PIN on her debit card (so she wouldn t forget the number). Does this discovery affect Sally s maximum liability for the unauthorized withdrawals? Why or why not? 99 Unauthorized Electronic Funds Transfers; Regulation E Liability Limits- Unauthorized EFT- transfer initiated by a person other than the consumer without actual authority to initiate the transfer and from which the consumer receives no benefit. Includes a transfer initiated by a person who obtained access device through fraud or robbery; Includes ATM transfer if consumer has been induced by force to initiate transfer

52 Unauthorized EFT does NOT include an EFT initiated: By a person who was furnished an access device by the consumer AND granted authority to make transfer and exceeds the authority given, unless the consumer has notified the bank that person is no longer authorized; Unclear as to what the level of liability is if the card was given voluntarily to agent and then agent returns card, but continues to use information from card to perform unauthorized transactions. With fraudulent intent by the consumer or any person acting with the consumer; or By the bank or its employees. However, a consumer has no liability for erroneous or fraudulent transfers initiated by an employee of a bank. 101 Liability of Consumer for Unauthorized Transfers Using an Access Device (i.e. Debit Card) Bank must provide the required disclosures and access device must have been accepted by the consumer for the consumer to have any liability whatsoever; State law that is more beneficial than Regulation E controls. Negligence by the consumer can NOT be used as a basis for imposing greater liability than is permissible. For example, writing PIN on debit card will not affect the consumer s liability for unauthorized transfer (per Regulation E Official Staff Commentary)

53 If the consumer notifies bank within two (2) business days after learning of the loss or theft of the access device, the consumer s liability shall not exceed the lesser of $50 or the amount of the unauthorized transfers that occur before the notice to the bank. If the consumer fails to notify the bank within two (2) business days after learning of the loss or theft of the access device, the consumer s liability shall not exceed $ If the consumer fails to report after 60 days from the periodic statement, the bank is still going to be liable beyond the $500 limit, but the consumer is responsible for the unauthorized transactions that occurred after the 60 day period, as long as bank establishes that the unauthorized EFTs would not have occurred had the customer notified the bank during the 60 day period. Liability may be $0 if underlying agreement says so. VISA/Mastercard contracts promote $0 liability for unauthorized use, unless cardholder (consumer/small business) is negligent. Merchants and bank issuers agree to these terms as part of offering (or accepting) VISA/Mastercard services

54 Liability of Consumer for Unauthorized Transaction Not Involving an Access Device Consumer is not liable for any portion of an unauthorized EFT within the 60 day period after the statement is transmitted showing the first unauthorized EFT. Consumer is liable for any after the 60 day period. Common mistake- Consumer does not report in 60 days and bank tries to pass all liability back onto consumer. Regulation E requires bank to investigate. Bank does not have to provide provisional credit, but bank is still liable based on the consumer limits described above during the first 60 days after the statement is transmitted. 105 CASE STUDY 13 On November 1, Sara receives her October 31 monthly bank statement and discovers that $1000 in unauthorized ACH debit transactions have hit her account at Community Bank of the Midwest in the month of October. She looks back at prior statements (that she hadn t had time to review) and finds that there have been unauthorized transactions since April 1 as follows: In April- $1000 In May- $1000 In June-$1000 In July-$1000 In August-$1000 In September-$1000 In October $

55 WHAT COULD BE SARA S MAXIMUM LIABILITY FOR THESE UNAUTHORIZED TRANSACTIONS? WHY? Regulation E- $4000 (July-October); NACHA Rules- May relieve Sara from $2000 or the $4000 liability as September/October may be sent back to the ODFI as unauthorized. 107 Sara has also discovered that there were several withdrawals done from Sara s account over the Internet. Further inquiry reveals that Sara had given her check (debit) card account number and the card code to her daughter so that she could buy school supplies in January. However, she never authorized her daughter to do the additional withdrawals from her account. Under Regulation E, would the bank be liable to Sara for these withdrawals? Why or why not?

56 CREDIT CARD LOSS ALLOCATION 109 CASE STUDY 14 Pam has a MasterCard credit card from Big City Bank. It has a $10,000 limit. One day, Pam gave the card to her husband so that he could fill up her car with gas and pick up a pizza for supper (which he did). A few weeks later, Pam s husband borrowed the card and maxed out the credit line. He purchased a new computer for his business in the amount of $2,500, two men s suits in the amount of $1,000, his and her watches in the total amount of $2000 and the rest he spent at the local casino. What is Pam s maximum liability for each of the transactions? 55

57 Would your answers change if her husband had called Big City Bank without Pam s knowledge and asked them to issue him a card in his name on Pam s account, which it did, and that was the card that was used for the transactions? CONSUMER CARDHOLDER S LIMITED LIABILITY FOR UNAUTHORIZED USE Differs for credit and debit card transactions. Reg Z controls credit cards. The Electronic Funds Transfer Act (Federal Reserve Regulation E) regulates debit cards or transactions that are blended. This can be difficult for customer s (and issuers) to understand due to confusion of VISA/Mastercard logos on cards. Credit card transactions run through the VISA/Mastercard network and are typically signature based; Debit card transactions run through NACHA system and are typically PIN based

58 GENERALLY, FOR UNAUTHORIZED CREDIT CARD TRANSACTIONS: Losses between the card issuer and consumer cardholder are settled pursuant to Truth in Lending-BCFP (CFPB) Regulation Z, as well as VISA/Mastercard that can be more consumer friendly; Losses between the card issuer and commercial cardholders are settled by VISA/Mastercard rules and contract. These rules will look at customer s negligence; 113 TIL-REG Z UNAUTHORIZED USE LIABILITY LIMITATIONS ( ): Applies to consumers and some business cards (if cards are issued to fewer than 10 employees). Otherwise, law allows the bank to contract for other liability limits against the company (but not as to the individual cardholders); Generally limits the liability of cardholder to $50; Liability can be $0, unless:

59 Credit card has been accepted by the cardholder; The liability does not exceed $50; The issuer gives adequate notice of potential liability; The issuer provides a description of means to report loss or theft of card; Unauthorized use occurs before the cardholder has notified the issuer of the loss or theft; and The issuer has provided a means to identify the cardholder (signature or photograph). However, if the identification means were not used in the transactions (i.e. phone or Internet), cardholder can not be held liable. This is why CVC numbers are now used on these purchases. 115 Liability may be $0 if underlying agreement says so. VISA/Mastercard contracts promote $0 liability for unauthorized use, unless cardholder is negligent. Merchants and bank issuers agree to these terms as part of offering (or accepting) VISA/Mastercard services. $0 liability may require that customer was not negligent, where Regulations Z and E will not take negligence into account

60 EXCEPTIONS TO THE LIMITATION OF LIABILITY: Cardholder voluntarily and knowingly allows another to use the card and that person exceeds the authority. Authority can be actual, implied, or apparent authority for such use. Cardholder s express limitations on authority are not effective against the issuer; If used by someone not having authority, cardholder can be liable for unauthorized use if cardholder received a benefit from the transaction; Cardholder must notify issuer that authorization has been withdrawn (so that issuer can block card); Unclear as to what the level of liability is if the card was given voluntarily to agent and then agent returns card, but continues to use information from card to perform unauthorized transactions. 117 Most contracts also create joint account liability where joint applicants for credit card agree to be liable for each other s transactions on the card, even if there is no approval or benefit. Burden of proof is on the card issuer to show a reportedly unauthorized transaction was actually authorized by the cardholder, or that the cardholder received benefit from a transaction

61 WHO IS LIABLE IF CARDHOLDER IS NOT? Criminal (unjust enrichment), although this is unlikely to ever happen; May be charged back to merchant if merchant failed to follow required verification procedures (EMV liability shift would apply); Issuer will take loss if merchant followed required verification procedures. 119 PAYMENT ORDERS (DEBIT/CREDIT/ACH)- CONTRACTUAL LOSS ALLOCATION

62 HOW ARE CLAIMS BETWEEN FINANCIAL INSTITUTIONS AND THIRD PARTIES ALLOCATED? Not controlled by laws or regulations; VISA/Mastercard transactions (POS/credit card) settled under rules between participants in the respective systems. VISA Claims Resolution process (effective April 2018); EMV liability shift, but does not have to be consistent between card companies. NACHA rules for ACH transactions; Other debit cards- Network rules. 121 EMV LIABILITY SHIFT ENCOURAGES BANKS TO ISSUE, AND MERCHANTS TO INSTALL, EMV TECHNOLOGY (LIABILITY SHIFTS TO THE PARTY WITH THE LESSER TECHNOLOGY AND IF THERE S A TIE, THE ISSUING BANK TENDS TO LOSE) Transaction No EMV Chip Card/No EMV Chip Reader EMV Chip Card/No EMV Chip Reader No EMV Chip Card/EMV Chip Reader Counterfeit EMV Chip Card/EMV Chip Reader Loss Allocation Issuing bank typically takes the loss Merchant takes the loss Issuing bank takes the loss Issuing bank typically takes the loss

63 NACHA Operating Rules ODFI warrants that Originator s ACH entry is authorized; Imposes strict liability that a debit entry is authorized by the Receiver; Warranty lasts beyond the RDFI s return claims (in network) process time frame (60 days from settlement for consumer/2 days for non-consumer); ODFI s liability for a warranty breach is controlled by state law statute of limitations for breach of contract (usually 5 to 7 years); Rules violations may be submitted to NACHA within 90 days of the occurrence of the alleged violation. 123 RECALLING ENTRIES; WHAT IS THE RISK TO THE RDFI? Does the ODFI have the ability to force an RDFI to return an ACH credit when fraud has occurred? Generally, no. Procedures available are under NACHA rules: Recall- Neither the ODFI, nor an Originator, has the right to recall an entry or file, to require the return or adjustment to an entry, or to stop the payment or posting of an entry, once the entry or file has been received by the Originating ACH Operator, except for Reversing Files, Reversing Entries, and Reclamation Entries and Written Demands for Payment. Reversing Files and Reversing Entries, Reclamation Entries and Written Demands require ODFI to indemnify RDFI; also have very limited and strict time frames;