We received notice from ABC Bank that we owe it $1,000 on a $1,600 check that ABC Bank sent to our bank for payment over a year ago. We paid only $600 of the $1,600 check to ABC Bank, which now is requesting a cashier’s check for the remaining $1,000. We think that an encoding error on the MICR line caused the underpayment. Can ABC Bank seek payment on a check that is over one year old? Are we required to pay the balance of this check?

We believe that your bank is liable to ABC Bank for the remaining $1,000 to be paid on the check, provided that your bank can withdraw that amount from your customer’s account. However, if your customer’s account does not contain sufficient funds to cover the remaining $1,000, your bank may be able to offset its liability to ABC Bank due to the encoding error on the check.

As a general rule, a payor bank is liable to the depositary bank for any check retained beyond the midnight deadline, even if the depositary bank presented the check with an encoding error. And it appears that ABC Bank has brought its claim within the applicable three-year statute of limitations under the Uniform Commercial Code (UCC).

However, the depositary bank (ABC Bank) also warranted that the check was correctly encoded when it presented the check to your bank. Because the encoding understated the check amount, ABC Bank evidently has breached its encoding warranties under both the UCC and Regulation CC. Due to its warranty breach, ABC Bank is liable to your bank for your “loss suffered as a result of the breach, plus expenses and loss of interest.”

As explained in the UCC commentary, a payor bank’s loss may be mitigated if its customer has sufficient funds in its account to cover an under-encoding error. In other words, if your customer has $1,000 or more in its account, your bank must withdraw $1,000 and pay those funds to ABC Bank — and your bank has not experienced a loss. But if your customer’s account lacks the funds to cover the shortfall, your bank has experienced a loss, which it may assert as a defense against ABC Bank’s claim for the remaining $1,000.

For resources related to our guidance, please see:

UCC, 810 ILCS 5/4-302(a) (“If an item is presented to and received by a payor bank, the bank is accountable for the amount of: (1) a demand item, other than a documentary draft, whether properly payable or not, if the bank, in any case in which it is not also the depositary bank, retains the item beyond midnight of the banking day of receipt without settling for it or, whether or not it is also the depositary bank, does not pay or return the item or send notice of dishonor until after its midnight deadline

UCC, 810 ILCS 5/4-111 (“Statute of limitations. An action to enforce an obligation, duty or right arising under this Article must be commenced within 3 years after the cause of action accrues.”)

Regulation CC, 12 CFR 229.34(c) (“(c) Settlement amount, encoding, and offset warranties. . . . (3) Each bank that presents or transfers a check or returned check warrants to any bank that subsequently handles it that, at the time of presentment or transfer, the information encoded after issue regarding the check or returned check is accurate. For purposes of this paragraph, the information encoded after issue regarding the check or returned check means any information that could be encoded in the MICR line of a paper check.”)

UCC, 810 ILCS 5/4-209(a) (“A person that encodes information on or with respect to an item after issue warrants to any subsequent collecting bank and to the payor bank or other payor that the information is correctly encoded. If the customer of a depositary bank encodes, that bank also makes the warranty.”)

UCC, 810 ILCS 5/4-209(c) (“A person to whom warranties are made under this Section and who took the item in good faith may recover from the warrantor as damages for breach of warranty an amount equal to the loss suffered as a result of the breach, plus expenses and loss of interest incurred as a result of the breach.”)

UCC Official Comments, § 4-209, Comment 2 (“If a drawer wrote a check for $25,000 and the depositary bank encoded $2,500, the payor bank becomes liable for the full amount of the check. The payor bank’s rights against the depositary bank depend on whether the payor bank has suffered a loss. Since the payor bank can debit the drawer’s account for $25,000, the payor bank has a loss only to the extent that the drawer’s account is less than the full amount of the check. There is no requirement that the payor bank pursue collection against the drawer beyond the amount in the drawer’s account as a condition to the payor bank’s action against the depositary bank for breach of warranty.”)