BANKS CAN’T HIDE BEHIND CHECK CASHING SERVICES WHEN NEGOTIATING FORGED CHECKS.

Oakland, CA (Originally published, Nov. 10, 2014)  Many businesses face special risk when getting paid – their employees can easily divert incoming checks to their own accounts. Check cashing services provide the bad employee with an easy way of converting the checks to cash. The services can and sometimes do make payment on the diverted checks after the errant employees forge signatures unless the services are careful to verify whether the signatures are valid.

The employer eventually discovers the fraud and seeks to recover its loss. The employee herself is not a promising target. She is now likely unemployed, unemployable, and facing prosecution. So it sues its own bank for making payment, the check cashing service for paying the check, and the banks that accepted the deposits from the check cashing services in an effort to recoup its losses.

The question becomes whether the employer can hold the check cashing services’ own banks for accepting forged checks for deposit. The Fourth District Court of Appeals answered this question in the affirmative last Thursday in HH Computer Systems, Inc. v. Pacific City Bank, GO49028 (Nov. 6, 2014).

In HH Computer Systems, a business’s accounting manager diverted about 300 checks over a period of 18 months, cashing them at several local check cashing services. The check cashing services themselves deposited the forged checks with their own banks – several defendants in the action. The victim employer later sued those defendants for failure to use ordinary care in accepting forged checks from the check cashing services.

The trial court sustained without leave to amend the demurrer of the check cashing services’ banks. They argued that they were mere secondary banks, that the cashing services were the primary banks, and they had a right to rely on the check cashing services under Comm. Code 4207.

The Fourth District rejected this argument. It first provided a highly readable primer on negotiable instruments that is worth the time of any employer worried about employee theft. It noted that the UCC has long imposed on the first bank that accepts a deposit of a check – a depositary bank –a special role under Section 4-207 of the Uniform Commercial Code. See Cal. Comm. Code § 4207.  It noted that the UCC requires depositary banks to ensure the validity of signatures, which the UCC defines as “endorsements.”   It noted the bank does this by verifying identification and authority to cash a check. It noted that many banks manage the risk of employees’ theft of a business checks by requiring the deposit of business checks to a business’s own account. All other banks that participate in the negotiation of a deposited check have the right to rely on the first bank’s acceptance of signatures.

It then noted that check-cashing services are not banks within the meaning of the UCC because they can never fill one role played by banks – that of a payor bank. In other words, as distinguished from true banks, a check cashing service will never be the last bank in the line because they don’t give customers checking accounts. Moreover, functionally, check cashing services don’t engage in one key function of a bank: the acceptance of deposits.

Under the circumstances, the bank defendants are the “first” banks, they have a special duty to use care in accepting deposits, and they are potentially liable to victim employers under Commercial Code section 3405 if they fail to exercise due care. In HH Computer Systems, Inc., the employer argued that ordinary care in the banking industry was for banks to refuse the deposit of company checks into anything other than company bank accounts at least without securing an endorsement guarantee.   The Fourth District found that the victim’s allegations that the banks failed to either reject the check or require an endorsement guarantee adequately alleged a lack of due care under Commercial Code 3405.   The court also observed that, since the employee had use chicken scrawl to endorse the checks, the scrawl was an indicia of fraud that should have alerted the banks.

HH Computer Systems should give businesses an extra layer of protection against bad apple employees – it places on the first bank in the banking system in addition to the check cashing service – the duty to use due care when accepting checks for deposit. As a matter of policy, placing the burden on check cashing companies and their banks to ensure business checks are valid makes a lot of sense: it is extremely easy for them to do and check cashing companies themselves make money from consumers who lack their own bank accounts – not from business theft.

Employers of course should themselves use due care in hiring managerial employees. Yet, as between businesses, which cannot completely mitigate the risk of loss from dishonest employees, and the banking system, which can easily stop employee theft in its tracks, the banking system should bear the risk of loss.

John Claassen practices civil litigation from the offices of Claassen, P.C. in Oakland, California.  For more information about the firm, please click here.  While this blog entry is published for informational purposes, portions of this blog post may constitute "communications" within the meaning of California Rule of Professional Conduct 1-400.  Thus, as a possible "Advertisement" it is not intended to constitute legal advice.  Similarly, no statement made in this blog post is intended as a guarantee, warranty, or promise about the outcome of any litigation matter taken on by the firm.  This Advertisement is not intended for any matter that would require the rendition of legal services outside of the State of California or under the laws of any jurisdiction outside of the State of California. Copyright 2014-15. All rights reserved.