7th Cir. Rejects Defrauded Bank’s Effort to Recover Counterfeit Check Proceeds from Payee’s Bank, Payee, Federal Reserve

The U.S. Court of Appeals for the Seventh Circuit recently held that a bank that honored a counterfeit check was not entitled to reimbursement from the party who deposited the check, nor from the depositing party’s bank or the Federal Reserve.

A copy of the opinion is available at:  Link to Opinion.

In 2013, an attorney received an email from a person who claimed she wanted to hire him to help her recover money that she said she was owed in a divorce proceeding. The purported ex-wife subsequently told the attorney that after retaining him, her ex-husband settled, and that the attorney should expect a substantial check in the mail to cover his fee plus the amount of the settlement, which he was to pass on to her.

The check that the attorney received was drawn on the account of an Illinois corporation. The check looked like a real check but was counterfeit.

The scammers wrote the counterfeit check on the corporation’s bank account for $486,750.33 to the attorney, which he deposited in his bank. The purported ex-wife told the attorney that she needed the money and the attorney directed his bank to transfer the money to the purported ex-wife.

The corporation lost the entire $486,750.33, which was transferred out of its account by the fraudulent check.

The corporation’s bank reimbursed its defrauded customer — the corporation — and then demanded reimbursement from the attorney and his bank, as well as the Federal Reserve Bank of Atlanta. The attorney’s bank refused, and the corporation’s bank sued the attorney and his bank as well as the Federal Reserve Bank of Atlanta, which was peripherally involved in the transaction.

The trial court granted judgment for all three defendants, and the corporation’s bank appealed.

The corporation’s bank first argued that it was entitled to reimbursement on the basis of breach of warranty.

When the attorney’s bank deposited the $486,750.33 in the attorney’s account, it did so by an electronic rather than paper check, and the electronic check passed through the Federal Reserve Bank of Atlanta en route to the corporation’s bank.

The Federal Reserve Board’s Regulation J, 12 C.F.R. § 210.6(b)(3)(A), provides that when a Federal Reserve Bank presents an electronic check for payment, the electronic image must accurately represent all of the information on the front and back of the original check as of the time that the electronic image was substituted for the original paper check.

Some information that was on the original counterfeit check was missing from the electronic version, but consisted of characteristics of the check, such as watermarks, microprinting, and other physical security features that could not survive the imaging process.  Their absence from the electronic image was not actionable.  See Regulation CC, 12 C.F.R. § 229.51(A)(3).

Among the missing information was a warning box on the back of the check, often designed to resist scanning and so considered by the industry to be a security feature as well.  This missing information, the corporation’s bank argued, was crucial.

The Seventh Circuit disagreed.  Had the corporation’s bank been suspicious of the electronic image that it received from the Federal Reserve Bank of Atlanta, the Court explained that the corporation’s bank could have demanded a substitute check, which is a paper printout that is deemed the legal equivalent of the original paper check.

The Seventh Circuit noted that a demand for a substitute check would have protected the corporation’s bank, because a “bank that transfers, presents, or returns a substitute check or a paper or electronic representation of a substitute check for which it receives consideration shall indemnify the recipient … for any loss incurred by any recipient of a substitute check if that loss occurred due to the receipt of a substitute check instead of the original check.”  See 12 C.F.R. § 229.53(a).  The Court also noted that the corporation’s bank could also have refused to honor the electronic check.

The Seventh Circuit thus rejected the corporation’s bank’s argument, because it did not seek indemnity, and because it did not show that the information on the original check that was omitted from the electronic image would, had it appeared on the electronic image, have aroused suspicions in the corporation’s bank that would have caused it to refuse to send the $486,750.33 to the attorney’s bank.

The corporation’s bank also argued that it was entitled to restitution by mistake, pursuant to the Illinois Uniform Commercial Code, 810 ILCS 5/3-418.

The Seventh Circuit disagreed, noting that although the corporation’s bank was the victim of a mistake, Illinois law provides no remedy for such a victim against a person who took the instrument in good faith and for value.  See 810 ILCS 5/3-418(c).

The Court noted that the lawyer, his bank, and the Federal Reserve Bank of Atlanta reasonably believed that they were engaged in the innocent, commonplace banking activity of forwarding a check to its intended final recipient on behalf of their client and customers. There was no claim or evidence that they knew they were participating in a fraud, or that their conduct fell below reasonable commercial standards of fair dealing, as required by 810 ILCS 5/3-103(a)(4).

The corporation’s bank also argued the attorney’s bank committed negligent spoliation of evidence in alleged violation of Illinois common law, because the attorney’s bank destroyed the original paper check after making the electronic copy that it transmitted to the Federal Reserve Bank of Atlanta.

Again the Seventh Circuit disagreed, holding that a bank has no duty to retain paper checks after an electronic substitute has been made.  The Court noted that otherwise, banks would drown in paper, provided there’s a record of the contents of the paper check.

Lastly, the corporation’s bank argued that the attorney was liable for professional negligence.

Once more, the Seventh Circuit disagreed. Relying on Pelham v. Griesheimer, 92 Ill. 2d 13, 440 N.E.2d 96, 99, 64 Ill. Dec. 544 (Ill. 1982), the Seventh Circuit held that the attorney was liable only to his client, and not to the corporation’s bank, which was not his client.

The Seventh Circuit affirmed the district court’s judgment in favor of the defendant attorney, his bank, and the Federal Reserve Bank of Atlanta.

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