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A bank that accepts checks from another bank with forged endorsements cannot be barred from blaming the second bank – even if the signature is illegible – a federal appeals court has ruled. In The Guardian Life Insurance Company of America v. Weisman v. PNC Bank v. Weisman Associates, the 3rd U.S. Circuit Court of Appeals reversed a New Jersey District Court’s ruling that said a drawee bank must verify illegible payee endorsements on checks received from a depositary bank before the drawee bank is entitled to assert the “negligent drawer defense” under Section 3-406 of the Uniform Commercial Code. The lawsuit was sparked by a forgery campaign by Mark Weisman, an insurance agent who routinely routed his customers’ payments through his office, and, over five years, stole 91 checks, which he promptly deposited into his personal bank account after forging the payee indorsements. Since Weisman is now in prison and insolvent, the courts must decide who will bear the loss in the absence of his ability to pay. The lower court concluded that because the banks did not conduct any review of the endorsements, they failed to comply with “reasonable commercial standards” and should therefore be precluded from asserting the drawer’s negligence as a defense. But the 3rd Circuit reversed and held that “as a matter of law drawee banks are not obliged to review payee indorsements on checks received from depositary banks.” Senior U.S. Circuit Judge Robert E. Cowen, writing for a unanimous three-judge panel, wrote: “We think it is reasonable that what review there is of payee indorsements should take place at the depositary bank, which is most likely to have the information available to verify a depositor’s indorsement.” Cowen, who was joined by U.S. Circuit Judges Anthony J. Scirica and Richard L. Nygaard, said the court’s ruling was in line with a leading treatise on the UCC. In 1 James J. White & Robert S. Summers, “Uniform Commercial Code 808″ (3d ed. 1988), the authors wrote: “It is foolhardy to ask collecting banks who are not depositary banks to do any more than pass on instruments in an utterly mechanical way. … Depositary banks, on the other hand, are in the best position to prevent certain kinds of fraud, particularly those involving indorsements.” To understand why it would be a mistake to require drawee banks to review payee indorsements, Cowen said, “it is important to think through what would happen if the payee indorsement is not legible. Since many people do not have a legible signature, the drawee bank cannot simply assume the check is a forgery. Instead, the bank would have to make some further investigation, presumably by contacting the depositary bank.” Having decided that the drawee banks were not required to review the payee endorsements, Cowen said the court’s second task was to consider the insurers’ “fall-back argument” – that under Section 3-406 a drawee bank must prove that both it as well as the depositary bank acted within reasonable commercial standards. Cowen again sided with the banks and held that “only the drawee bank’s conduct is relevant when that bank is asserting the defense.” Finally, Cowen said the court had to decide whether a drawer can maintain an action against a depositary bank for conversion or negligence. On that point, Cowen agreed with the lower court that a drawer cannot. As a result of those holdings, Cowen said the case must be remanded to the lower court “for factfinding to determine whether the insurers were negligent and whether that negligence substantially contributed to the forgeries.” Although Weisman stole 91 checks, most of them were not at issue in the appeal because they were evaluated by the lower court under other provisions in the UCC concerning forgeries committed by a drawer’s employee, or dealing with a drawer’s duty to discover and report forgeries. Cowen said the appeal concerned only “a subset” of the checks drawn on accounts that two of the insurers – The Guardian Life Insurance Company of America and The Guardian Insurance and Annuity Company Inc. – held at Chemical Bank of Delaware and Corestates Bank of Delaware. This subset of checks resulted in liability of $44,587.02 for Chemical and $239,791.28 for Corestates. Applying Delaware law, Cowen found there was no precedential Delaware case interpreting Section 3-406. As a result, he said, the court was forced to rely on the language of the UCC, its official comments and other jurisdictions’ interpretations of the Code. The “negligent drawer defense,” as defined in the UCC, states that “any person who by his negligence substantially contributes to a material alteration of the instrument or to the making of an unauthorized signature is precluded from asserting the alteration or lack of authority against a holder in due course or against a drawee or other payor who pays the instrument in good faith and in accordance with the reasonable commercial standards of the drawee’s or payor’s business.” To appreciate how this provision functions, Cowen said, “it is important to remember that ordinarily a forged check is not properly payable … and therefore a drawee bank must credit its drawer’s account for a forged check that the drawee paid.” Section 3-406 “creates an exception to this general rule,” Cowen said. “If the drawer was negligent and that negligence substantially contributed to the forgery, then the drawee bank can refuse to credit the drawer’s account for a forgery that the bank paid.” The Guardian Life appeal, Cowen said, focused on “an exception that Section 3-406 creates to the exception making the drawer liable.” Under the pre-1990 version of the UCC, he said, “if a drawee bank fails to act in good faith and in accordance with reasonable commercial standards in paying a forged check, then the drawee bank will remain liable for the forgery even though the drawer acted negligently and that negligence substantially contributed to the forgery.” The lower court concluded that the drawee banks did not act in accordance with reasonable commercial standard – placing them within the exception to the exception – because those banks did not review whether the payee endorsements were legible and matched the named payee on checks received from a depositary bank. Cowen said the theory of the lower court’s opinion was that, “while a drawee bank typically will not be in a position to verify by itself legible payee indorsements (for the drawee bank very likely will not maintain any accounts with the payee and would not have the payee’s signature on hand), the drawee bank nevertheless should be alerted that there potentially could be a problem if a payee indorsement is illegible or is not in the name of the named payee.” But Cowen said, “This rule is mistaken for at least two reasons.” First, he said, when a drawee bank receives a check from a depositary bank, the drawee bank receives certain presentment warranties from the depositary bank guaranteeing payment. “Given these warranties, there is little reason for the drawee bank to inquire into the validity of payee indorsements, and indeed courts have gone so far as to hold, citing these warranties, that a drawee bank was liable for refusing to accept from a depositary bank a check that completely lacked a payee indorsement,” Cowen wrote. “It would hardly make sense to declare that a drawee bank failed to adhere to reasonable commercial practices by routinely accepting checks with illegible indorsements, while at the same time holding that the bank would be liable for refusing such checks.” Secondly, Cowen said, requiring such review makes no sense in today’s economy. “The procedures banks use for verifying signatures on checks have evolved considerably over the past half-century, a process that has only accelerated in the past two decades. As the size of our economy has expanded, the volume of checks handled daily by banks is, as White and Summers have noted, in the millions. “In light of this massive quantity of checks, as well as the demand for lower transaction costs, it is now common that when a check is deposited, there is often no verification of signatures or at most random sampling for checks below a certain amount.” White & Summers, he said, noted that “to accommodate the explosive growth of checks, banks have automated almost all of the payment process. Except for random examination, most banks look at signatures only on checks above a fixed dollar amount.” In Rhode Island Hospital Trust National Bank v. Zapata Corp., Cowen said Judge Stephen Breyer of the 1st Circuit (now Supreme Court Justice Breyer), held that a bank had exercised “ordinary care” when the bank’s only means for detecting forgeries in checks below a certain value was randomly to select a group for verification. Breyer explained that the system was “used by the majority of American banks,” and noted that the procedure “led to no significant increase in the number of forgeries that went undetected,” while a system where each check was examined imposed very considerable expenses.” Reasonable care, as then-Judge Breyer pointed out, has long been evaluated in terms of a very conventional piece of economics: the cost of a risk-averting procedure should not exceed its expected benefit, where the measure’s expected benefit in this context is calculated by multiplying the harm sought to be averted by the amount the measure reduces the likelihood of the harm occurring. Cowen agreed, saying, “just as one does not spend thousands to buy extra insurance that offers no greater protection, no one would rationally buy a depositary bank’s review of every check, or a fortiori a redundant second review in a drawee bank.”

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