This article provides a general overview of liability considerations for various types of check fraud, but it is not intended as legal advice.
A central Ohio man – who had been the quartermaster responsible for safeguarding funds for a not-for-profit Veterans of Foreign Wars (VFW) post in Columbus – was sentenced earlier this month to five years of probation and ordered to repay the more than $35,000 of charitable funds stolen from the VFW post as part of a “check fraud” scheme.
Check fraud is an age-old problem, especially for closely held businesses and not-for-profit organizations. The above case involved fraudulent check issuances as part of an embezzlement from a VFW post. You probably have seen news related to other businesses and organizations over the years. Check fraud has been on the rise and has been in the news a lot these days, recently related to mail theft and related altered checks and forged endorsements. If not, maybe you have seen the 2002 film “Catch Me If You Can,” where Leonardo DiCaprio portrayed Frank Abagnale Jr. as fictionally having cashed thousands of counterfeit checks at various businesses and financial Institutions totaling millions of dollars in the 1960s.
The underlying type of check fraud, the promptness of discovery, and several other factors all have implications on who ends up bearing the liability. The laws and rules that govern check fraud liability are a bit of a maze and include subjectivity, but primary liability is the party who committed the check fraud, and secondary liability is generally that of the party who was in the best position to prevent the loss.
You should consult an attorney with the specific facts and circumstances if you are unsure of liability and trying to decide how to proceed. First, to set the stage for terms, here are types of check fraud and check handling parties:
Five Main Types of Check Fraud
- Alerted check: When details on the front of a check are fraudulently altered after the check was written or printed (e.g., changing the amount or the payee’s name).
- Forged endorsement: When someone other than the listed payee fraudulently endorses the back of a check.
- Forged maker signature: When the issuing signature on the front of a check is forged/signed without authorization.
- Counterfeit check: When a check is fraudulently created leveraging someone’s financial institution routing and account number but was not issued by the account owner.
- Fraudulent issuance (aka embezzlement): When an authorized signer writes a check to divert funds for personal gain or other unauthorized purposes (e.g., the above VFW case).
Five Typical Check Handling Parties, Who Each Have Distinct Roles In the Handling of Checks
- The account holder (aka the financial institution customer or drawer): The party who owns the financial institution account from which a check is drawn.
- The authorized signer: A party who has been authorized to sign checks for a financial institution account.
- The payee (aka the presenter): The party to whom a check is made payable (e.g., the company a check was given to in payment for services).
- The depository financial institution (aka the bank of first deposit or the payee’s bank): The financial institution that receives the check for deposit for the payee.
- The paying financial institution (aka the drawee bank, the drawer’s bank, or the payor bank) is the financial institution from which the check is drawn.
So, Who Bears the Liability?
The person who altered, forged or created the check has primary liability. However, when funds can’t be recovered there, the account holder, the depository financial institution and/or the paying financial institution bear the liability burden. Below are the parties who typically bear the liability for the five types of check fraud outlined above:
Alerted Check: The Depository Financial Institution
Under UCC § 3-416, the depository financial institution warrants that a check has not been altered. Here, the depository financial institution is in the position to identify an altered check from its direct interaction with the presenter. These losses are typically discovered and reported quickly enough to meet the account holders’ deadlines imposed by UCC § 4-406 though.
Forged Endorsement: The Depository Institution
Under UCC § 4-207, the depository financial institution warrants to the paying financial institution that all signatures on a check – including any endorsements – are authentic and authorized. Here, the depository financial institution is in the position to identify a forged presenter endorsement from its direct interaction with the presenter. This endorsement warranty is generally good for three years from the deposit date. This period is shortened or lengthened by state law in some states, though, such as being shortened to one year. Even though the warranty period is longer, once an account holder discovers a forgery suspicion, they only have 30 days to notify the depository financial institution to avoid the risk of the depository financial institution’s liability being decreased to the extent that the loss was increased by the delay.
Forged Maker Signature: The Paying Financial Institution
Under both UCC § 4-207 and when Clearing House Rule 9 applies, the depository financial institution warrants to the paying financial institution that the purported drawer’s signature is not forged or otherwise unauthorized; however, most losses related to forged maker signatures are not discovered and reported quickly enough for the paying financial institution to make a return before the deadline imposed by UCC § 4-301, the midnight on the following business day. These losses are typically discovered and reported quickly enough to meet the account holder’s deadlines imposed by UCC § 4-406 though.
Counterfeit Check: The Paying Financial Institution
Under UCC § 4-207, the depository financial institution warrants that all signatures on a check are authentic and authorized. When Clearing House Rule 9 applies, the depository financial institution warrants to the paying financial institution that a check is not counterfeit. However, the majority of losses related to counterfeit checks are not discovered and reported quickly enough for the paying financial institution to make a return before the deadline imposed by UCC § 4-301, midnight on the following business day. These losses are typically discovered and reported quickly enough to meet the account holder’s deadlines imposed by UCC § 4-406 though.
Fraudulent Issuance: The Account Holder
Plain and simple for this one. Authorized drawer signatures on checks bind the account holder.
Of course, there are exceptions to these generalizations. For example, if an account holder leaves their checkbook or check stock in a place where it is very likely to get stolen, they may have liability due to the account holder needing to apply “ordinary care” as outlined within UCC § 3-406. Also, a financial institution may – to retain an account holder and protect reputation among other reasons – assume liability beyond that it is legally obligated.
How Can You Be Proactive?
Even better than trying to navigate liability from check fraud is taking steps to proactively prevent losses from occurring in the first place. Below are several ways you can help protect yourself and your organization from check fraud:
You and Your Organization
- Avoid mailing checks when possible.
- Individuals and organizations should typically seek to make payment through alternative methods, avoiding the need to mail a check.
- Organizations can encourage vendors to transition to electronic payment methods, such as ACH. Electronic payment methods also inherently come with risk, but internal controls like account owner validation leveraging third-party data sources and verifying deposit account changes through trusted sources and methods can be implemented to significantly reduce those risks, as well.
- If a check needs to be mailed, consider dropping the mail off at the mail provider’s physical location (e.g., within the post office).
- If a check needs to be mailed, consider the costs and benefits of paying extra to require the recipient’s signature for delivery.
- Leverage high-security check stock: Although there is still risk in the creation of new checks to alter check details like payee and amount, leveraging high-security check stock reduces check fraud risk. Features like watermarks, microprinting, holograms and chemical sensitivity make checks more difficult to successfully alter.
Your Organization
- Leverage positive pay: While generally not available for personal financial accounts, positive pay has been around for decades but has stood the test of time. This process helps organizations verify the checks they issue against those presented for payment, flagging identified discrepancies as exceptions for the drawer’s review. Although not bulletproof or without cost of its own, positive pay is a best practice to help protect organizations against altered and counterfeit checks. In fact, an organization not leveraging features made available by its financial institution like payee positive pay could be considered negligence for not applying “ordinary care” under UCC § 3-406 contributing to a check payee alteration.
- Segregate duties among employees: Fraudulent check issuance is typically harder for organizations to protect against, but segregating duties such as check writing and cleared check review and reconciliation can help deter and sooner detect fraudulent issuances. Segregation of duties can be difficult for not-for-profits like the VFW post referenced above that leverage volunteers and closely held businesses that don’t have many employees, but there should always be some level of oversight of check writing.
- Know Your Customer (KYC): For those who work at a financial institution, insufficient new account opening identity verification can cause your organization to become a target for people who steal and fraudulently alter or endorse checks. KYC processes can help your financial institution avoid unnecessary check fraud losses.
- Contact Schneider Downs: If your organization needs assistance in implementing a fraud risk management strategy, assessing the maturity and/or effectiveness of your fraud risk management practices, assessing your fraud risk to help prioritize efforts, developing awareness content or procedures, or finding a litigation expert witness related to fraud, contact James Rumph in our Columbus office or Tom Pratt and Brian Webster in our Pittsburgh office.
About Schneider Downs Business Advisory
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