By Mark W. Powers
Small businesses continue to suffer large losses due to check fraud. In recent years, check fraud schemes have become increasing sophisticated and the legal environment (at least in some jurisdictions) more uncertain, making it essential that banks examine their procedures to safeguard against check fraud and avoid potential liability. This article highlights the prevalence of check fraud, identifies common types of check fraud, provides examples of tactics used to avoid detection, and offers suggestions on how banks should navigate the changing legal environment.
Check fraud remains a significant problem. The average cost per incident is more than $100,000, and more than 20 percent of fraud cases result in losses of more than $1 million. Check fraud often goes undetected due to inadequate internal controls and because the perpetrators of check fraud do not fit the stereotypical criminal profile. The vast majority of perpetrators are first-time offenders. Many are long-term employees or trusted advisors.
In recent years, the perpetrators of check fraud have employed new tactics to avoid detection, thereby resulting in larger financial losses. At the same time, court decisions in some jurisdictions have imposed a legal duty of “inquiry notice” on both collecting banks and drawee banks in connection with their acceptance, negotiation and payment of items in the normal check collection process, even when (in the case of a collecting bank) it had no prior business relationship with the victim. These developments pose challenges to the banking industry.
While it is not yet clear whether these court decisions are mere outliers or part of an unfortunate trend, there is cause for concern. On an operational and even moral level, it seems unfair to impose a legal duty on a bank that had no prior business relationship with the victim of a fraud. This outcome is also inconsistent with the legal principle that liability should generally rest with the party that is in the best position to avoid the loss. In almost all fraud cases, the party in the best position to avoid the loss is the victim of the fraud.
Traditional methods of check fraud include “altering” the payee name or check amount, forging the signature of the drawer (or its agent), and counterfeiting. Applicable law, specifically the Uniform Commercial Code (the UCC), imposes a duty on a bank’s customer to review its bank statements and copies of checks, and to notify its bank of any suspected check forgeries or alterations. The UCC requires a bank to credit its customer’s account if the customer notifies its bank of any forgeries or check alterations within 30 days of receiving its bank statement.
Due to the relative ease by which check alteration or forgery of the drawer’s signature may be detected by the bank’s customer, perpetrators of fraud have developed different tactics to avoid easy detection. Two examples of check fraud from recent cases follow, one committed by a supposedly “trusted employee” and the second by a dishonest financial advisor.
The Trusted Employee
Consider a small business that delegates substantially all of its financial affairs to its long-time employee, an office manager and bookkeeper, who is considered competent and loyal. Over time, the employee decides that he is underpaid and underappreciated, or is under personal financial distress. He devises a scheme to defraud his employer without forging or altering any company checks. In this example, he obtains a personal credit card from the same credit card company that issued his employer’s corporate credit card. He then makes out checks drawn on the company’s bank account for signature by his boss (who is obviously not paying attention), who signs the checks presented to him by the bookkeeper for the stated purpose of paying charges incurred on the company’s credit card account; however, the bookkeeper instead uses that same check to pay his personal credit card bill owed to the same credit card issuer. The bookkeeper perpetrates this scheme without forging the drawer’s signature or altering the check, thereby preventing the employer from detecting the fraud by reviewing copies of statements and checks.
This example presents a host of legal issues. For example, when the credit card issuer receives a check drawn on a corporate account to pay a personal obligation of its customer, should it be on notice of a fraud? Does the answer depend on the size of the bank? Or on the number of checks the bank processes each day? Are there legitimate reasons a company might pay the personal expenses of its employee? What are the rights of the credit card issuer vis-à-vis the victim’s own bank? Does it matter what jurisdiction governs the parties’ contractual relationship?
The Crooked Contractor
Consider a second example taken from another case. A company hires an accountant to maintain its books and prepare its tax filings. The client trusts its accountant implicitly. The accountant instructs his client to pay its tax obligations by drawing checks on the company’s bank account payable not to the taxing authorities directly, but rather to the accountant’s bank. The accountant represents that he will deposit the checks into his bank account and draw against those same funds to pay his client’s tax obligations. The accountant’s bank has no business relationship with the accountant’s client. The accountant then presents the checks drawn on his client’s bank account (made payable to the accountant’s bank) for deposit into the accountant’s personal account at his bank, but instead of paying his client’s tax liability, uses the funds for his personal benefit. Like the first example above, the accountant perpetrates this scheme without forging the drawer’s signature or altering the check.
This second scenario raises many of the same issues as the first. For example, does the accountant’s bank have a duty to contact the accountant’s client to inquire of the intended purpose of the checks even though it had no business relationship with that company? What are the rights and remedies of the banks in the check collection process, each of which accepted, negotiated, and forwarded each check for payment? Does the victim of the fraud have a claim against its own bank for making payment on the checks? Does the victim’s bank in turn have legal claims against the prior collecting banks? Some court will impose a duty on the collecting bank to make inquiry on the drawer of the checks on this example, even though no business relationship existed.
Banks need to remain vigilant against check fraud as the perpetrators of fraud have become more sophisticated and the legal landscape has become increasingly uncertain. Banks should consider undertaking the following steps: reviewing its internal processes for accepting and negotiating checks for deposit, particularly checks presented to a teller that can be physically inspected; identifying any checks made payable to the bank’s order when the bank has no prior business relationship with the drawer of the check (this should trigger further review by senior management); and consulting with experienced bank counsel to navigate the evolving legal landscape and avoid potentially significant legal liability.
Mark W. Powers is a partner in the Worcester office of Bowditch & Dewey. He represents banks, financial institutions, business organizations, creditors’ committees and trustees on a wide range of commercial matters, including out-of-court workouts and in bankruptcy courts across the country. He may be reached at firstname.lastname@example.org.