We recently opened a new business checking account for ABC Inc. We later learned that the business is not in good standing with the Secretary of State, and it is our policy to close such accounts (and we have other misgivings about this particular customer). However, the customer already has deposited a check of several thousand dollars. The check was payable to “Smith and Smith,” but it was endorsed by ABC Inc. and deposited into ABC Inc.’s account at our bank.

The payor bank told us that they confirmed with the check’s drawer that the check is a legitimate payment for painting services and that the drawer wishes it to be paid so that painting will commence. The check itself did not include the drawer’s name or contact information, so we have no way of contacting the drawer directly. The payor bank will not guarantee that they won’t make a warranty claim based on the incorrect endorsement, nor will they return the original check to us. If we close the account, we will have to issue an official check to the customer, leaving us holding the bag if the payor bank later brings a warranty claim. But we don’t want to leave the account open, and if we freeze the account funds, the customer might refuse to begin the paint job and possibly expose us to a claim from the drawer. What should we do?

Feb 14, 2019

—

Unfortunately, the payor bank may have a potential claim against your bank for the proceeds of the check, and without more information about the drawer and the drawer’s account agreement with the payor bank, it might be difficult to determine whether your bank has a valid defense against such a claim, or when the period for making that claim will expire.

Under the Uniform Commercial Code (UCC), your bank could be liable for allowing your customer to deposit this check without a proper endorsement. When your bank sent the check to the payor bank for collection, your bank warranted that it was entitled to enforce the check, which “in effect is a warranty that there are no unauthorized or missing indorsements.”

However, your bank may be able to raise some defenses against this presumption of its liability to the payor bank. For example, your bank could assert an equitable defense against the payor bank based on the fact that the check was paid to “the intended payee for the intended purpose.” Illinois courts sometimes are willing to apply this “intended payee defense” in cases of forged or missing endorsements. To this end, your bank could argue that the drawer confirmed (to the payor bank) that your customer was the intended payee for the check. This defense would become particularly effective after your customer has completed the paint job for the drawer, since in that case the drawer will have suffered no damages, and for a court to rule otherwise would result in unjust enrichment of the drawer.

It also is possible that the payor bank would be precluded from making a claim against your bank if its customer fails to make a timely report regarding the missing endorsement. The general rule in the UCC is that a customer must report an unauthorized payment within one year after a statement reflecting the check is made available to them. However, it is quite possible that the payor bank shortened the customer’s period for reporting unauthorized payments in its account agreement with the customer – many banks shorten this time period to thirty days. Ultimately, your bank would need to access the drawer’s account agreement with the payor bank to determine when the drawer’s window for reporting an unauthorized payment has closed.

For resources related to our guidance, please see:

UCC, 810 ILCS 5/3-417(a)(1) and 810 ILCS 5/4-208(a)(1) (“Presentment warranties. (a) If an unaccepted draft is presented to the drawee for payment or acceptance and the drawee pays or accepts the draft, (i) the person obtaining payment or acceptance, at the time of presentment, and (ii) a previous transferor of the draft, at the time of transfer, warrant to the drawee making payment or accepting the draft in good faith that: (1) the warrantor is or was, at the time the warrantor transferred the draft, a person entitled to enforce the draft or authorized to obtain payment or acceptance of the draft on behalf of a person entitled to enforce the draft . . . .”)

UCC § 3-417 cmt. 2 (“Subsection (a)(1) in effect is a warranty that there are no unauthorized or missing indorsements.”)

UCC, 810 ILCS 5/4-406(c) (“[T]he customer must exercise reasonable promptness in examining the statement . . . If, based on the statement or items provided, the customer should reasonably have discovered the unauthorized payment, the customer must promptly notify the bank of the relevant facts.”)

UCC, 810 ILCS 5/4-406(f) (“Without regard to care or lack of care of either the customer or the bank, a customer who does not within one year after the statement or items are made available to the customer . . . . discover and report the customer’s unauthorized signature on or any alteration on the item is precluded from asserting against the bank the unauthorized signature or alteration.”)

UCC, 810 ILCS 5/4-103(a) (“The effect of the provisions of this Article may be varied by agreement, but the parties to the agreement cannot disclaim a bank’s responsibility for its lack of good faith or failure to exercise ordinary care or limit the measure of damages for the lack or failure. However, the parties may determine by agreement the standards by which the bank’s responsibility is to be measured if those standards are not manifestly unreasonable.”)

Napleton v. Great Lakes Bank, N.A., 408 Ill.App.3d 448, 452 (1st Dist. 2011) (“Here, the parties agree that pursuant to the terms of the Account Agreement, the plaintiff's duty to ‘promptly notify’ the bank of any unauthorized charges was modified to mean 30 days from the date the Monthly Statement was mailed to plaintiff. Although we did not find any Illinois cases directly addressing this issue, decisions from other jurisdictions indicate that such an alteration in the notification period is clearly permissible.”)

Conder v. Union Planters Bank, N.A., 384 F.3d 397, 401 (7th Cir. 2004) (“The [intended payee] rule provides that if a bank transfers a check without a proper endorsement but the transfer is to a person whom the drawer of the check wanted (or would if consulted have wanted) to have the money, the bank is not liable for any loss the drawer may have suffered as a result of the transfer, since the transfer would have gone through even if the bank had insisted that the check be properly endorsed.”)

Sanwa Bus. Credit Corp. v. Continental Ill. Nat. Bank and Trust Co., 247 Ill.App.3d 155, 162, 164–165 (1st Dist. 1993) (“[A] bank may avoid liability for the face value of unendorsed checks if it demonstrates that the proceeds of a check reached the intended payee for the intended purpose. In doing so, the drawee shows that the drawer suffered no loss . . . . We would affirm the circuit court on the basis of ratification as well. In a similar case . . . [o]ur supreme court ruled in favor of the bank because the drawer had received a benefit for the bank’s payment of the check (the promissory note) and had accepted a payment on the note . . . .”)

In re Ostrom-Martin, Inc. v. First Nat’l Bank of Chillicothe, 188 B.R. 245, 255 (B.Ct. C.D.Ill. 1995) (“The intended payee defense is similarly aimed at preventing a drawer from being unjustly enriched by recovering for an improperly paid check when the proceeds of the check in fact were received by the payee intended by the drawer and the drawer suffered no damages caused by the improper payment. The defense ‘is based on the view that the drawer should not be permitted to recover from the drawee bank where he has suffered no loss from the improper payment of a check.’ The intended payee defense is based on the fundamental equitable principle that a defendant should obtain relief from liability when no damage has resulted from his wrongdoing.”)

Kaskel v. Northern Trust Co., 328 F.3d 358, 360 (7th Cir. 2003) (“Mrs. Kaskel argues that had the bank refused to pay Shook he would not have gotten hold of her $250,000, and therefore the bank’s violation of its contract with her was the cause, or more precisely a cause, of her loss. But the premise is incorrect. Had the bank refused to pay Shook it would have returned the check to him and he in turn would have returned it to Forrester for endorsement. Forrester would have endorsed the check to Shook (his authority to do so is not questioned) because he wanted Shook to be able to cash the check. Mrs. Kaskel would have been in exactly the same pickle that she is in today. Not having been harmed by the bank’s breach of contract, she cannot recover damages (beyond nominal damages, which she does not seek) for the breach.”)