Our bank underpaid a check issued by a customer due to an encoding error, and the collecting bank has sent us a Federal Reserve adjustment to collect the remaining amount. However, in the time between paying the check and receiving the adjustment, our customer (the payor) died. The customer’s account was payable on death (POD), so we distributed the funds to the designated beneficiary and closed the account. The POD beneficiary then used the funds to open a new deposit account at our bank. Can we use funds from the beneficiary’s deposit account to pay the remaining amount?

No, we do not believe you may charge the beneficiary’s account to cover the underpayment, as the funds in that account belong to the beneficiary, and the beneficiary did not authorize your deceased customer’s check.

Under the Illinois Trust and Payable on Death Accounts Act, a POD beneficiary becomes the sole owner of a POD account on the death of the last surviving holder of the account, and banks must distribute POD account proceeds to the designated beneficiary on the death of the last holder of the POD account. Because the POD account holder has died and you have distributed the POD account funds to the designated beneficiary, those funds now belong solely to the beneficiary.

The Illinois Uniform Commercial Code (UCC) provides that a bank may charge a customer’s account for an item that is “properly payable.” An item is properly payable if it is authorized by the customer and in accordance with any agreement between the customer and bank. Since the POD beneficiary did not authorize the POD account owner’s check, we do not believe the check is a properly payable item for which you can charge the POD beneficiary’s account.

We note that you might have a claim against the collecting bank for breach of its encoding warranty. The Illinois UCC states that “a person that encodes information on or with respect to an item after issue warrants to . . . the payor bank . . . that the information is correctly encoded.” Additionally, “a person to whom warranties are made . . . 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.”

The UCC’s Official Comments further explain that “[a] payor bank’s rights against the depositary bank depend on whether the payor bank has suffered a loss,” and “the payor bank has a loss only to the extent that the drawer’s account is less than the full amount of the check.” As the payor bank, your bank ordinarily may be able to mitigate its loss for an underencoded check if the drawer has sufficient funds in their account to cover the under-encoding error. However, because the drawer’s account has been closed and the funds distributed to a POD beneficiary, your bank cannot mitigate its loss. As such, your bank might have a claim against the depository bank for the remaining amount of the check.

For resources related to our guidance, please see:

Illinois Trust and Payable on Death Accounts Act, 205 ILCS 625/4(c) (“ . . . unless otherwise agreed in writing between the person or persons opening or holding the account and the institution: . . . (c) Upon the death of the last surviving holder of the account, the beneficiary designated to be the owner of the account . . . shall be the sole owner of the account. . . .”)

Illinois Trust and Payable on Death Accounts Act, 205 ILCS 625/10 (“Upon the death of the last surviving trustee or holder of the account, the institution that maintains the account shall distribute the proceeds to the beneficiary or beneficiaries designated in the agreement controlling the account without further liability. No institution, however, shall be required to distribute the account proceeds until the institution receives (i) legal evidence of death of all trustees or holders of the account, (ii) identification from each beneficiary then living, or business records evidencing the lawful existence and parties authorized to collect on behalf of each beneficiary not a natural person, and (iii) written direction from each beneficiary to close the account and distribute the proceeds in a form acceptable to the institution. . . .”)

Illinois UCC, 810 ILCS 5/4-401(a) (“A bank may charge against the account of a customer an item that is properly payable from that account even though the charge creates an overdraft. An item is properly payable if it is authorized by the customer and is in accordance with any agreement between the customer and bank.”)

Continental Cas. Co., Inc. v. Am. Nat. Bank and Trust Co., 329 Ill.App.3d 686, 698 (1st Dist. 2002) (“[W]hen a bank makes an improper payment . . . the drawer can bring an action for improper payment under section 4-401(a) and have its account recredited.”)

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 (“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.”)

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.”)

Regulation CC, 12 CFR 229.34(c)(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(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 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.”)