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Chapter 24

Banking in the Digital AgeINTRODUCTION

Article 3 and Article 4 of the Uniform Commercial Code (UCC) govern checks. The extent to which any party is either charged with or discharged from liability on a check is established according to the provisions of Article 3. Article 4 is a statement of the principles and rules of modern bank deposit-and-collection procedures. It governs the relationship of banks with one another as they process checks for payment, and it establishes a framework for deposit and checking agreements between a bank and its customers. A check can therefore fall within the scope of Article 3 and yet be subject to the provisions of Article 4 while it is in the course of collection. In the case of a conflict between Articles 3 and 4, Article 4 controls [UCC 4–102(1)].

CHAPTER OUTLINE

I. ChecksA check is a draft drawn on a bank [UCC 3–104(f)]. If any institution other than a bank, as defined in UCC 4–105(l), handles a check for payment or collection, the check is not covered by Article 4.

A. CASHIER’S CHECKSA cashier’s check is a check drawn by a bank on itself; negotiable on issue [UCC 3–104(g)]. A teller’s check is a draft drawn by a bank on another bank, or if drawn on a nonbank, payable at or through a bank [UCC 3–104(h)].

ADDITIONAL CASES ADDRESSING THIS ISSUE —

Cashier’s ChecksCases in which cashier’s checks or other bank checks were at the center of the dispute include the

following.

• Murphy v. National City Bank, 560 F.3d 530 (6th Cir. 2009): (a bank's refusal to cash its teller's check for a payee who was not an accountholder without charging a fee did not violate the bank's obligation under the UCC to pay a dishonored draft—the check was not dishonored because the payee never presented it to the drawee bank for payment).

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2 UNIT THREE: COMMERCIAL TRANSACTIONS

• Transcontinental Holding Ltd. v. First Banks, Inc., __ S.W.3d __ (Mo.App. E.D. 2009): (a bank established lack of consideration as a defense against liability on a cashier's check, and thus was authorized to stop payment on the check, when its purchaser paid the bank for the cashier’s check with a check drawn on a newly-opened account against a provisional credit that was reversed, leaving no funds with which to pay the check the purchaser wrote).

• Lerner v. First Commerce Bank, __ S.W.3d __ (Tex.App.—Houston [14 Dist.] 2009): (a bank customer’s failure to pursue a claim for breach of contract for more than thirty years after the bank refused to honor a cashier’s check that it had issued effectively time-barred the action under the applicable statute of limitations).

B. TRAVELER’S CHECKSA traveler’s check is a check on which a financial institution is both drawer and drawee. The buyer must sign it twice (buying it and using it) [UCC 3–104(i)].

C. CERTIFIED CHECKSA certified check is a check accepted by the bank on which it is drawn [UCC 3–409(d)]. When a bank certifies a check, it immediately charges the drawer’s account and transfers those funds to its own ac-count. This discharges the drawer and prior indorsers [UCC 3–414(c), 3–415(d)].

II. The Bank-Customer Relationship

A. CREDITOR-DEBTOR RELATIONSHIPA creditor-debtor relationship is created between a customer and a bank when, for instance, the customer deposits cash in a checking account or when final payment is received for checks drawn on other banks.

B. AGENCY RELATIONSHIPA principal-agent relationship underlies the check collection process.

C. CONTRACTUAL RELATIONSHIPThe rights and duties of a bank and its customer are contractual and depend on the nature of the transaction.

CASE SYNOPSIS—

Case 24.1: Royal Arcanum Hospital Association of Kings County, Inc. v. Herrnkind

The board of the Royal Arcanum Hospital Association of Kings County, Inc. passed a resolution to require that all corporate checks be signed by two of three officers—Frank Vassallo, Joseph Rugilio, and William Herrnkind. The three were also named as signatories on the firm’s account with Capital One Bank, but the terms of the account did not include the two-signature requirement. After Vassallo and Rugilio died, Herrnkind opened a new account in the corporate name that expressly permitted one-signature transactions. Over the next four years, a series of transactions depleted the account. Royal Arcanum filed a suit in a New York state court against Herrnkind and Capital One to recover the funds, alleging breach. The court dismissed the complaint against the bank. Royal Arcanum appealed.

A state intermediate appellate court affirmed. There was never a two-signature requirement on any of Royal Arcanum’s accounts with Capital One.


CHAPTER 24: BANKING IN THE DIGITAL AGE 3

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Notes and Questions

Did Royal Arcanum meet the requirements for ratification with respect to Herrnkind’s apparent drawdown of the company’s corporate bank account? No, Royal Arcanum did not satisfy the requirements for ratification with respect to Herrnkind’s apparent drawdown of the company’s corporate bank account. Even if Herrnkind did not have the actual authority to write checks and make withdrawals of the funds in Royal Arcanum’s corporate accounts, it might be said that he had the apparent authority to do so based on the circumstances—his express inclusion as one of three corporate officers authorized to approve the issuing of checks on the accounts, for example.

Ratification occurs when a principal affirms an agent’s unauthorized act, thereby binding the principal to the act. But the requirements for ratification include, among other things, the principal’s full knowledge of all material facts and the principal’s affirmation of the agent’s entire act. Here, it cannot be reasonably concluded that Royal Arcanum had full knowledge of all of the facts with respect to Herrnkind’s opening of a second corporate bank account and apparent withdrawal of corporate funds nor can it be concluded that Royal Arcanum affirmed Herrnkind’s actions.

III. The Bank’s Duty to Honor ChecksWhen a drawee bank wrongfully fails to honor a check, it is liable to its customer for damages result ing from the refusal [UCC 4–402]. But the bank’s duty is not absolute: if the bank properly dishonors a check for insufficient funds, it has no liability to the customer.

A. OVERDRAFTSA bank may dishonor a check that, if it were cashed, would create an overdraft in the customer’s account, or the bank may charge the customer’s account for the amount of the check (providing that the customer has agreed in advance) [UCC 4–401(a)]. When a check bounces, the holder can resubmit it (he or she should, however, notify prior indorsers of the dishonor, or they will be discharged). A bank may alternatively agree to honor overdrafts.

B. POSTDATED CHECKSIf a bank charges a postdated check against a customer’s account, despite the customer’s timely notice to the bank of the postdating, the bank may be liable for any damages to the customer as a result [UCC 4–401(c)].

ADDITIONAL BACKGROUND—

Overdrafts

In a bank-customer relationship, the basic interaction occurs when a customer presents an instrument (a check, for instance) to the right bank in a timely manner, so that the instrument can be paid and all parties’ accounts can be adjusted appropriately.

Payment of an instrument creating an overdraft has caused some controversy. The previous (unrevised)



Article 4 was not clear about whether a bank can create an overdraft without customer authorization [UCC 4–401]. Revised Article 4 clarifies the issue. First, the revised Article 4 defines an item as properly payable “if it is authorized by the customer and is in accordance with any agreement between the customer and the bank.” Thus, a bank can pay an instrument creating an overdraft if the customer has authorized the payment and it does not violate any agreement between the bank and customer [UCC 4–401(a)]. If there is a joint account from which more than one person can draw, however, the bank cannot hold a joint-account customer liable for payment of an overdraft unless the customer has signed the item or has benefited from the proceeds of the item [UCC 4–401(b)]

C. STALE CHECKSA bank is not obligated to pay an uncertified check presented more than six months from its date, but it has that option [UCC 4–404].

D. STOP-PAYMENT ORDERSOnly a customer can order his or her bank to pay a check, and only a customer can order payment stopped, although there are time limits [UCC 4–403(a)].

1. Reasonable Time and MannerThe customer must issue the stop-payment order within a reasonable time and in a reasonable manner for the bank to act on it [UCC 4–403(a)]. A written order is effective for six months. An oral order is effective for fourteen days.

2. Bank’s Liability for Wrongful PaymentIf the bank pays the check over the customer’s order, the bank is liable to the customer for the amount of any actual loss [UCC 4–403(c)].

ENHANCING YOUR LECTURE—

HOW TO USE STOP-PAYMENT ORDERS For a variety of reasons, a drawer should not misuse stop-payment orders. We look at some of those

reasons here.

MONETARY COSTS AND RISKS

One reason is monetary: banks usually charge between $15 and $25 for a stop-payment order, so stopping payment is not cost-effective for a check written for a small amount. Another reason is the risk attached to the issuing of a stop-payment order for any drawer-customer. The bank is entitled to take a reasonable amount of time to put your stop-payment order into effect before it has liability for improper payment. Hence, the payee or another holder may be able to cash the check despite your stop-payment order if he or she acts quickly. Indeed, you could be writing out a stop-payment order in the bank lobby while the payee or holder cashes the check in the drive-in facility next door. In addition, even if a bank pays over your proper stop-payment order, the bank is liable to the drawer-customer only for the amount of loss the drawer suffers from the improper payment.

WHEN YOU CAN STOP PAYMENT



Remember that, to avoid liability, a drawer must have a legal reason for issuing a stop-payment order. You cannot stop payment on a check simply because you have had a change of heart about the wisdom of your purchase. Generally, you can safely stop payment if you clearly did not get what you paid for or were fraudulently induced to make a purchase. You can also stop payment if a “cooling-off” law governs the transaction—that is, if you legally have a few days in which to change your mind about a purchase. Any wrongful stop order subjects the drawer to liability to the payee or a holder, and this liability may include special damages that resulted from the order. When all is considered, it may be unwise to order a stop payment hastily on a check because of a minor dispute with the payee.

CHECKLIST FOR STOP-PAYMENT ORDERS

1. Compare the stop-payment fee with the disputed sum to make sure it is worthwhile to issue a stop-payment order.

2. Make sure that your bank will honor your stop-payment order before the payee cashes the check.

3. Make sure that you have a legal reason for issuing the stop-payment order.

E. DEATH OR INCOMPETENCE OF A CUSTOMER

• If, when a check is issued or its collection has been undertaken, a bank does not know of an ad-judication of incompetence, it can pay the check without liability.

• Once a bank knows of a death, for ten days after the date of death, it can pay or certify checks drawn on or before the date of death (unless a person claiming an interest in that account orders the bank to stop) [UCC 4–405].

F. CHECKS WITH FORGED DRAWERS’ SIGNATURES

1. The General Rule

• A forged signature on a check has no legal effect as the signature of a drawer [UCC 3–403(a)]. If the bank pays on a forged signature, it must recredit the customer’s account unless the customer’s negligence substantially contributes to the forgery [UCC 3–406(a).

• The bank is responsible for determining whether the signature is genuine. The parties may agree that the customer is responsible for losses related to the forgery of “nonmanual” signatures.

2. Customer NegligenceThe customer’s liability may be reduced by any loss caused by negligence on the part of a person paying the instrument or taking it for value (if the negligence substantially contributed to the loss) [UCC 3-406(b)].

a. Timely Examination RequiredA customer must examine monthly statements and canceled checks and report any forged signatures promptly [UCC 4–406(a), (b)]. (If a bank does not send the checks, it must keep them, or copies of them, for seven years.) If a customer fails to do this, he or she is liable for any loss to the bank [UCC 4–406(d)].





b. Consequences of Failing to Detect ForgeriesTo recover for a series of forgeries of the same signature by the same wrongdoer, a customer must report the first item to the bank within thirty calendar days of receipt of the bank statement [UCC 4–406(d)(2)].

3. When the Bank Is Also NegligentIf the bank is also negligent, the bank is also liable on a comparative negligence basis [UCC 4–406(e)]. It is not negligence to fail to examine every signature on every check [UCC 3–103(a)(7)].

a. One-Year Time LimitA customer who fails to report his or her forged signature within a year of the date that the statement was available for inspection loses the right to have the bank recredit his or her account [UCC 4–406(f)].

b. Other Parties from Whom the Bank May Recover

• The bank may recover from the forger—a forged signature is effective as the signature of the unauthorized signer [UCC 3–403(a)].

• The bank may also recover from “the person to whom or for whose benefit payment was made” [UCC 4–207(a)(2), 3–418(a)(ii)].

• The bank may not recover from “a person who took the instrument in good faith and for value or who in good faith changed position in reliance on the payment or acceptance” [UCC 3–418(c)].

G. CHECKS BEARING FORGED INDORSEMENTS

• A bank that pays a customer’s check bearing a forged indorsement must recredit the customer’s account or be liable to the customer for breach of contract (unless the customer fails to report the forgery within three years after the item with it was available to the customer [UCC 4–111]).

• The bank in turn can recover from the bank that sent it the check, and so on up the line to the first party who took the check with the forgery.

CASE SYNOPSIS—

Case 24.2: Michigan Basic Property Insurance Association v. Washington

The Michigan Basic Property Insurance Association (MBP) issued a check for $69,559.06 on its account with Fifth Third Bank to Joyce Washington, Countrywide Home Loans, and T&C Federal Credit Union as co-payees. Washington indorsed the check by signing all the payees’ names but did not share the proceeds. Fifth Third notified MBP of the payment through daily and monthly account statements. MBP did not object until it was forced to issue a second check to Countrywide. MBP then sued Fifth Third for the amount. The court held Fifth Third liable.

On appeal, a Michigan state intermediate appellate court reversed. The check was not properly payable because it had two forged indorsements. When a bank pays a check bearing a forged indorsement, the UCC ordinarily requires the bank to recredit the customer's account. But the UCC allows parties to change their



duties by contract. Here, the account agreement obligated MBP to review its statements and notify Fifth Third of any problems within thirty days. Without such notice, MBP was liable for any forged indorsements.

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Notes and Questions

Why should a customer have to report a forged or unauthorized signature on a paid check within a certain time to recover the amount of the payment? The consequence of a customer’s failure to report a forged or unauthorized signature under these circumstances is the opportunity presented to the wrongdoer to repeat his or her misdeeds.

Would the situation have been different if MBP had handled its account electronically rather than manually? Electronic banking would have made no difference in the outcome in this instance. The liability rules are essentially the same.

What reasonable steps could MBP have taken to have prevented its loss? MBP might have negotiated different terms in its account agreement with Fifth Third. These terms might have included a different assessment of liability for payment on a forged indorsement or a longer time period to review an account statement and notify the bank of any problems. If different terms were not possible, MBP should have more closely scrutinized its account statements within the prescribed time limits to spot the item with the forged indorsements.

ADDITIONAL CASES ADDRESSING THIS ISSUE—

Bank’s Duty to Honor ChecksCases involving the bank’s duty to honor checks include the following.

• Afiriyie v. Bank of America, N.A., __ N.J.Super. __, __ A.3d __, 2013 WL 451895 (2013) (bank was liable for wrongful dishonor when it erroneously caused plaintiff to be arrested for attempting to pass a fraudulent check)

• Compass Bank v. Nacim, __ S.W.3d __, 2015 WL 181721 (Tex.App.—El Paso 2015) (bank was required to recredit customer’s account despite notice of unauthorized transaction more thirty days after bank mailed statement on which transaction appeared—duty to report unauthorized transaction does not begin to run until customer receives mailed statement)

H. ALTERED CHECKSIf the bank pays an altered check, it is liable to its customer for the difference between the check’s original amount and the amount paid [UCC 4–401(d)(1)].

1. Customer NegligenceA customer’s negligence can shift the loss (unless the bank was also negligent) [UCC 4–401(d)(2), 4–406].



2. Other Parties from Whom the Bank May RecoverThe bank can recover from the transferor for breach of warranty (unless the bank is the drawer and the transferor is an HDC) [UCC 3–417(a)(2), 4–208(a)(2)].

IV. The Bank’s Duty to Accept Deposits

A. AVAILABILITY SCHEDULE FOR DEPOSITED CHECKSUnder the Check Clearing in the 21st Century Act, a bank must credit a customer’s account as soon as the bank receives the funds. Under the Expedited Fund Availability Act of 1987 and Regulation CC—

• Any local check must be cleared within one business day from the date of deposit.• Nonlocal checks must be cleared within five business days.• Wire transfers and government checks must be cleared before the next business day.• The first $100 of any deposit must be available on the opening of the next business day.• Exceptions include deposits at nonproprietary ATMs and new accounts.

CASE SYNOPSIS—

Case 24.3: Shahin v. Delaware Federal Credit Union

Nina Shahin deposited a check in the amount of $2,500 into her checking account at the Delaware Federal Credit Union (DelOne). DelOne placed a two-business day “local hold” on the check pending verification. Concerned that the drawer’s signature did not match the handwriting on the rest of the check, the bank placed it on a fifteen-day “non-verified” hold. Meanwhile, a payment from Shahin's checking account to Bank of America was denied for insufficient funds (NSF), and DelOne transferred funds from her savings account to cover other payments. DelOne then imposed two $30 penalties for NSF and transfer fees totaling $6. Shahin filed a suit in a federal district court against DelOne, alleging that the credit union failed to give her proper notice of the extended hold. The court issued a judgment in Shahin’s favor, covering DelOne's NSF and transfer fees plus $1,000, the maximum amount of liability for a notice violation under the Expedited Funds Availability Act. DelOne appealed.

The U.S Court of Appeals for the Third Circuit affirmed the judgment but denied Shahin’s appeal for further damages.

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Notes and Questions

Could Shahin have successfully asserted a claim against DelOne for breach of fiduciary duty, based on the transfer of funds between her accounts without her knowledge or consent? No. The bank/customer relationship is one of creditor to debtor, which does not give rise to a fiduciary relationship.




Availability Schedule for Deposited Checks

The following is part of Regulation CC (12 C.F.R. Part 229), which sets out the availability schedule for deposited checks.

CODE OF FEDERAL REGULATIONSTITLE 12—BANKS AND BANKING

CHAPTER II—FEDERAL RESERVE SYSTEMSUBCHAPTER A—BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM

PART 229—AVAILABILITY OF FUNDS AND COLLECTION OF CHECKSSUBPART B—AVAILABILITY OF FUNDS AND DISCLOSURE OF FUNDS AVAILABILITY POLICIES

§ 229.12 Permanent availability schedule.

(a) Effective date. The permanent availability schedule contained in this section is effective September 1, 1990.

(b) Local checks and certain other checks. Except as provided in paragraphs (d), (e), and (f) of this section, a depository bank shall make funds deposited in an account by a check available for withdrawal not later than the second business day following the banking day on which funds are deposited, in the case of—

(1) A local check;

(2) A check drawn on the Treasury of the United States that is not governed by the availability requirements of § 229.10(c);

(3) A U.S. Postal Service money order that is not governed by the availability requirements of § 229.10(c); and

(4) A check drawn on a Federal Reserve Bank or Federal Home Loan Bank; a check drawn by a state or unit of general local government; or a cashier’s, certified, or teller’s check; if any check referred to in this paragraph (b)(4) is a local check that is not governed by the availability requirements of § 229.10(c).

(c) Nonlocal checks—1) In general. Except as provided in paragraphs (d), (e), and (f) of this section, a de -positary bank shall make funds deposited in an account by a check available for withdrawal not later than the fifth business day following the banking day on which funds are deposited, in the case of—

(i) A nonlocal check; and

(ii) A check drawn on a Federal Reserve Bank or Federal Home Loan Bank; a check drawn by a state or unit of general local government; a cashier’s, certified, or teller’s check; or a check deposited in a branch of the depositary bank and drawn on the same or another branch of the same bank, if any check referred to in this paragraph (c)(1)(ii) is a nonlocal check that is not governed by the availability requirements of § 229.10(c).

(2) Nonlocal checks specified in Appendix B-2 to this part must be made available for withdrawal not later than the times prescribed in that Appendix.



(d) Time period adjustment for withdrawal by cash or similar means. A depositary bank may extend by one business day the time that funds deposited in an account by one or more checks subject to paragraphs (b), (c), or (f) of this section are available for withdrawal by cash or similar means. Similar means include electronic payment, issuance of a cashier’s or teller’s check, or certification of a check, or other irrevocable commitment to pay, but do not include the granting of credit to a bank, a Federal Reserve Bank, or a Federal Home Loan Bank that presents a check to the depositary bank for payment. A depositary bank shall, however, make $400 of these funds available for withdrawal by cash or similar means not later than 5:00 p.m. on the business day on which the funds are available under paragraphs (b), (c), or (f) of this section. This $400 is in addition to the $100 available under s 229.10(c)(1)(vii).

(e) Extension of schedule for certain deposits in Alaska, Hawaii, Puerto Rico, and the U.S. Virgin Islands. The depositary bank may extend the time periods set forth in this section by one business day in the case of any deposit, other than a deposit described in § 229.10, that is—

(1) Deposited in an account at a branch of a depositary bank if the branch is located in Alaska, Hawaii, Puerto Rico, or the U.S. Virgin Islands; and

(2) Deposited by a check drawn on or payable at or through a paying bank not located in the same state as the depositary bank.

(f) Deposits at nonproprietary ATMs. A depositary bank shall make funds deposited in an account at a nonproprietary ATM by cash or check available for withdrawal not later than the fifth business day fol lowing the banking day on which the funds are deposited.

[55 FR 50818, Dec. 11, 1990; 56 FR 7801, Feb. 26, 1991; 56 FR 66343, Dec. 23, 1991; 57 FR 36601, Aug. 14, 1992]

PART 229—AVAILABILITY OF FUNDS AND COLLECTION OF CHECKS

Authority: 12 U.S.C. 4001 et seq.

Source: 53 FR 19433, May 27, 1988; 57 FR 36598, 36600, Aug. 14, 1992, unless otherwise noted.

B. THE TRADITIONAL COLLECTION PROCESSCheck collection rules discussed in the text include the following.

1. Designation of BanksA bank can be a depositary bank, a collecting bank, a payor bank, and an intermediary bank.

2. Check Collection between Customers of the Same BankAn item payable by the depositary (payor) bank that receives it—an “on-us item”—that is not dishonored by the opening of the second banking day following its receipt is considered paid [UCC 4–215(c)(2)].

3. Check Collection between Customers of Different Banks

• Each bank in the collection chain must pass a check on before midnight of the next banking day following its receipt [UCC 4–202(b), 4–302, 4–108].



• Deferred posting may push a check’s posted receipt to the next banking day [UCC 4–108].

4. How the Federal Reserve System Clears ChecksThe Federal Reserve System simplifies the check-collection process.

5. Electronic Check PresentmentMost checks are encoded with relevant information, which is thereby warranted as correct to any subsequent bank or payor, and processed electronically.

C. CHECK CLEARING IN THE 21ST CENTURY ACTThe Check Clearing in the 21st Century Act facilitates the use of electronic check processing.

• Under the act, a substitute check (a paper copy of a check) can be created from a digital image. The originals can be destroyed (which saves space and prevents more than one payment on a check).

• Banks can exchange checks digitally (which speeds collection). As check-processing speeds up, the Federal Reserve Board will revise the availability schedule for funds from deposited checks to correspond to reductions in processing time.

V. Electronic Fund Transfers

A. TYPES OF EFT SYSTEMSThere are four principal types of EFT systems—

• Automated teller machines. To initiate a transaction, a consumer uses an access card and a personal identification number (PIN).

• Point-of-sale systems. These systems also sue access cards.• Systems handling direct deposits and withdrawals of funds.• Online payment systems.

B. CONSUMER FUND TRANSFERSThe Electronic Fund Transfer Act (EFTA) of 1978 governs consumer electronic fund transfers. The Federal Reserve Board administers the act through its Regulation E. The EFTA covers financial institutions that offer EFTs for customer asset accounts established for personal, family, or household purposes. Phone transfers are covered only if they are made under a prearranged plan involving periodic transfers.

1. Disclosure Requirements

• If a debit card is lost or stolen, and misused, a customer is liable for (1) $50—if he or she notifies the bank within two business days of learning of the loss; (2) $500—if he or she does not tell the bank until after the second day; or (3) unlimited amounts—if notice is not within sixty days after transfer appears on customer’s statement.

• A customer has sixty days to notify the institution after a transfer appears on the customer’s statement, after which the institution has ten days to respond.



• Banks must provide monthly statements that show the amounts and dates of transfers, the fees, identification of the terminals, names of third parties involved, and an address and phone number for inquiries and error notices.

2. Violations and DamagesAn institution’s failure to comply with the EFTA can result in liability for actual damages, court costs, attorneys’ fees, and punitive damages, as well as fines up to $10,000 and up to ten years in prison.


DIGITAL FUNDS PROVIDE

NEW OPPORTUNITIES FOR MONEY LAUNDERING Money laundering occurs when profits obtained from illegal activities, such as drug trafficking, are

processed through various financial transactions in an effort to conceal their illegal source. This is how criminals make illegitimate funds appear legitimate. Money laundering has been going on for many years, but in the past criminals had to physically transport the cash. The advantages of digital cash—in particular the fact that it can be exchanged anonymously—have provided an avenue for more effective money laundering (sometimes referred to as cyberlaundering). Today, terrorist groups and criminal enterprises can use two types of electronic cash to transfer funds and evade detection by law enforcement: prepaid ATM cards and ATM cards offered by online gaming companies that convert virtual cash to real cash.

REPORTING REQUIREMENTS FOR CASH TRANSFERS

Federal law requires reporting of any financial transactions or funds transfers that involve more than $10,000.a According to estimates of the White House Office of National Drug Control Policy, the sales of illicit drugs in the United States produce more than $65 billion a year in revenue.b Internationally, the amount of proceeds from drug trafficking that are laundered globally are somewhere between 2 and 5 percent of the world’s gross domestic product (GDP), or about $600 billion annually.c To avoid detection by the government for transferring amounts in excess of $10,000, drug traffickers have had to rely on moving cash a little at a time in numerous transactions (or smuggle bundles of cash across borders). This effectively limited the amount that could be laundered through more traditional means, such as wiring funds through Western Union. This limitation also deterred terrorist groups from transferring large amounts of cash to various locations or cells for the purpose of funding terrorist activities.

ADVANTAGES OF PREPAID ATM CARDS

As discussed in the text, ATM cards normally are issued by banks and connected online to a customer’s account. Because the government strictly regulates banks, however, this type of ATM card leaves a paper trail that can be investigated if the customer is suspected of criminal or terrorist activity. Also, as just mentioned, banks and other regulated financial institutions are required to the report financial transactions involving amounts above the $10,000 threshold.

Prepaid ATM cards, in contrast, are not linked to a bank account like a regular debit or ATM card. They are essentially a stored-value card (defined later in this chapter) in which the purchaser pays a specific



amount and that amount is loaded onto the card. The user can then access those funds from anywhere in the world. These cards are convenient for students or travelers because a person does not need to show identification or have a bank account to access the funds. Moreover, they provide a safe substitute for carrying cash to those individuals who are part of the estimated 75 million people in the United States who do not have bank accounts.

Perhaps most importantly, prepaid ATM cards can be purchased anonymously at retail and check-cashing stores across the nation—locations that are not subject to the government’s reporting requirements. This enables drug traffickers (and terrorists) to move funds to and from foreign locations without having to smuggle cash past customs agents.

MONEY LAUNDERING THROUGH VIRTUAL GAMING CURRENCY

The dramatic increase in virtual gaming also opens the door up for cyberlaundering. Online gaming has become extremely popular in the United States and elsewhere. For years, gamers who participated in these virtual worlds (using digital personas, or “Avatars”) have been selling their digital monies, goods, or properties, for real-world compensation. A number of Avatars have managed to create wealth for the persons controlling them by selling (or taxing) assets in the virtual world.

In the beginning, players were only able to convert their virtual dollars or credits to real-world cash by selling them on online auction sites. (Gamers could always do the reverse and use real cash or credit cards to add monies to their online accounts.) Soon, Web sites developed at which gamers could exchange virtual currency. Then, in 2006, the makers of Entropia Universe—a giant in the virtual gaming industry that transacted over $165 million of business in 2005—began offering real-world ATM cards.

These new ATM cards allow gamers to instantly convert their Avatar’s virtual world assets into physical currency and withdraw “real” cash from any Versatel brand ATM machine in the world. Inessence, one can generate and hold significant financial assets anonymously in the virtual world without paying taxes or having to report it to the government. In addition, these assets can be purchased, transferred, and accessed from any place in the world and are completely unregulated and unreported. Once the funds are withdrawn from a virtual account, they are “clean” and cannot be traced to an identifiable source. What more could a criminal or terrorist ask for? The anonymous virtual world holds great appeal for those who want to hide their assets from governmental view and transfer funds internationally without risking detection.

FOR CRITICAL ANALYSIS

Should only banks and regulated financial institutions be allowed to issue ATM cards? Why or why not? How else might the government regulate digital funds to reduce the potential for cyberlaundering?

a. These laws were set forth in the Bank Secrecy Act of 1970, and amended by the Money Laundering Control Act of 1986. See 18 U.S.C. 1956-1957; and 31 C.F.R. Section 103.22(a)(1), which comprise the Bank Secrecy Act of 1970.b. Lewis, Adrienne, “Drug, terror rings find new ways to launder money,” USA Today, January 12, 2006.c. This statistic was taken from the Web site of the United States Department of Justice, www.usdoj.gov/dea/programs/money.htm.


Electronic Fund Transfers



The Electronic Fund Transfer Act (EFTA) of 1978 was passed “to provide a basic framework es tablishing the rights, liabilities, and responsibilities of participants in electronic fund transfers.” The EFTA provides the following definition for electronic fund transfer at 15 U.S.C. Section 1693a(6).

TITLE 15. COMMERCE AND TRADECHAPTER 41—CONSUMER CREDIT PROTECTIONSUBCHAPTER VI—ELECTRONIC FUND TRANSFERS

§ 1693a. Definitions

As used in this subchapter—

* * * *

(6) the term “electronic fund transfer” means any transfer of funds, other than a transaction originated by check, draft, or similar paper instrument which is initiated through an electronic terminal, telephonic instru-ment, or computer or magnetic tape so as to order, instruct, or authorize a financial institution to debit or credit an account. Such term includes but is not limited to, point-of-sale transfers, automated teller machine transactions, direct deposits or withdrawals of funds, and transfers initiated by telephone.

* * * *

(Pub.L. 90-321, Title IX, § 903, as added Pub.L. 95-630, Title XX, § 2001, Nov. 10, 1978, 92 Stat. 3728.)


Unauthorized Electronic Fund Transfers

Under some circumstances, a customer can be liable for an unauthorized electronic fund transfer. In other circumstances, a financial institution may be liable. The Electronic Fund Transfer Act of 1978 provides the following definition for unauthorized electronic fund transfer at 15 U.S.C. Section 1693a(11).

§ 1693a. Definitions

As used in this subchapter—

* * * *

(11) the term “unauthorized electronic fund transfer” means an electronic fund transfer from a consumer’s account initiated by a person other than the consumer without actual authority to initiate such transfer and from which the consumer receives no benefit, but the term does not include any electronic fund transfer (A) initiated by a person other than the consumer who was furnished with the card, code, or other means of access to such consumer’s account by such consumer, unless the consumer has notified the financial institution involved that transfers by such other person are no longer authorized, (B) initiated with fraudulent intent by the consumer or any person acting in concert with the consumer, or (C) which constitutes an error committed by a financial institution.

(Pub.L. 90-321, Title IX, § 903, as added Pub.L. 95-630, Title XX, § 2001, Nov. 10, 1978, 92 Stat. 3728.)



C. COMMERCIAL TRANSFERSUCC Article 4A, which most states have adopted, covers transactions not subject to the EFTA or other federal or state law. Typically, these are transfers of large sums between commercial parties.

VI. Online Banking and E-Money

A. ONLINE BANKING SERVICESOnline banking services include bill consolidation and payment, transferring funds among accounts, and applying for loans.

B. STORED-VALUE CARDS AND SMART CARDS

• Stored-value cards are plastic cards embossed with magnetic stripes containing magnetically encoded data. Using a stored-value card, a person buys goods and services offered by the issuer.

• Smart cards are plastic cards containing microchips that can hold more information than a magnetic stripe. For this reason, these cards are more versatile that stored-value cards, are less prone to error, and carry and process security programming (such as a digital signature).


SMART CARDS A fundamental innovation in recent years has been the development of smart cards, which have

embedded microprocessor chips that store “cash” balances. When the holder of a smart card uses the card to purchase goods from a retailer, the amount of the purchase is deducted from the card and credited to the retailer. The retailer can store its digital cash in special point-of-sale terminals and later transfer accumulated balances to its bank by means of telephone links.

There is no actual “cash,” or “legal tender,” in a smart card, just as there is no actual currency in a checkbook. Instead, the balance of funds recorded on a smart card represents a balance of funds deposited with a financial institution.

SECURITY PROGRAMMING

Because of microchip technology, a smart card can do much more than maintain a running cash balance in its memory or authorize the transfer of funds. A smart card carries and processes security programming. This capability gives smart cards a technical advantage over stored-value cards. The microprocessors on smart cards can also authenticate the validity of transactions. Retailers can program electronic cash registers to confirm the authenticity of a smart card by examining a unique digital signature stored on its microchip.

DEPOSIT INSURANCE FOR SMART-CARD BALANCES

Normally, all depository institutions—including commercial banks and savings and loan associations—offer $100,000 of federally backed insurance for deposits. The Federal Deposit Insurance Corporation (FDIC) offers this insurance.



The FDIC has said that most forms of e-money do not qualify as deposits and thus are not covered by deposit insurance. If a bank becomes insolvent, an e-money holder would then be in the position of a general creditor. This means that he or she would be entitled to reimbursement only after nearly everyone else who is owed money is paid (except for other general creditors). At that point, there may not be any funds left.

LEGAL PROTECTION FOR SMART CARDS

Some laws that extend to e-money and e-money transactions. The Federal Trade Commission Act of 19141 prohibits unfair or deceptive practices in, or affecting, commerce. Under this law, e-money issuers who misrepresent the value of their products or make other misrepresentations on which e-money consumers rely to their detriment may be liable for engaging in deceptive practices.

General common law principles, discussed in Chapter 1, also apply. For example, the rights and liabilities of e-money issuers and consumers are subject to the common law of contracts. This means that the parties’ relationships are affected by the terms of the contracts to which they agree. On the whole, however, it is unclear how existing laws will apply to e-money.

Even without legal protection, e-money payment systems could be safer than cash and checks. Encryption (encoding) may solve some of the problems associated with e-money and with unprotected online exchanges. For example, the theft of encrypted e-money would be a waste of time because without the code a thief could not use the money. The failure of a merchant to give a customer a receipt may not matter if the e-money payment system provides proof of a transaction. Digital signatures could eliminate the problems associated with forged and bounced checks. Digital signatures can also increase the enforceability of contracts entered into online.

IMPLICATIONS FOR THE BUSINESSPERSON

1. For businesspersons involved in global transactions, e-money may provide a number of benefits. This is because smart cards and other devices allow payments to travel through cyberspace quickly and without encountering any of the barriers that otherwise could discourage trade across national boundaries.

2. Businesspersons must realize that there are some disadvantages to using e-money. For example, counterfeiting and theft are potential problems with digital cash, just as they are with physical currency. There is also the potential for monetary breakdowns caused by power outages or hardware malfunctions, as well as security problems, such as the threat of infection by computer viruses.

FOR CRITICAL ANALYSIS

1. The federal government imposes bank-reporting requirements designed to limit money laundering. Do smart cards allow persons to avoid these requirements? In other words, will the use of smart cards make it easier to “launder” money obtained through illegal activities?

2. In what ways might bank fraud be easier to perpetrate using smart cards and online banking methods instead of traditional banking practices?

115 U.S.C. Sections 41–58.





TEACHING SUGGESTIONS

1. Commercial banks want to protect themselves against fraud and encourage the free flow of commerce. Ask students to discuss whether they believe that the commercial banking system should be more concerned with facilitating commercial transactions or preventing fraud. Do the cases reflect a judicial preference for one principle over another? Ask the students if there is some way in which these competing values can be satisfactorily balanced.

2. Ask students to discuss the ramifications of widespread electronic fund transfers. Are we moving from a “checkless” as well as a “cashless society” to one dominated by electronic transactions? How will this change affect the ways in which commercial transactions are ordinarily conducted? Will the financial system itself become more vulnerable to fraud and disruption? What sort of safeguards might be adopted to reduce the potential for unauthorized electronic transfers of funds?

3. Ask students to discuss any electronic fund transfer problems they have either personally encountered or heard about and to indicate how these problems were resolved. Did the EFTA apply?

4. To lend substance to the subject of this chapter, bring “physical” items to class that relate to the topics. These might include examples of the different types of checks mentioned in the text, receipts and statements for electronic transactions, both consumer and commercial, and relevant Federal Reserve documents.

Cyberlaw Link

Is private electronic “cash” legal? To what extent should private authorities be liable when a fraud is perpetrated in the context of an electronic transfer of funds via the Internet? Is the current law sufficient in this regard? If not, what changes need to be made?

DISCUSSION QUESTIONS

1. What is a check? A check is a special type of draft drawn on a bank, ordering the bank to pay a sum of money on demand. The person who writes the check is the drawer and is usually a depositor in the bank on which the check is drawn. The person to whom the check is payable is the payee. The bank or financial insti tution on which the check is drawn is the drawee.

2. What is an overdraft? When a commercial bank provides checking services, it agrees to honor the checks written by its customers with the usual stipulation that there be sufficient funds in the account to pay each check. A bank may properly dishonor a check for insufficient funds and incur no liability to the customer unless it has made special arrangements with the customer to accept overdrafts—checks that are paid from that account even though the account contains insufficient funds to cover the checks. A bank that dishonors overdrafts after having agreed to such an arrangement may be liable to its customer for any proximate damages.

3. When does a check become stale under the UCC? A check outstanding for longer than six months is a stale check. The UCC gives the bank the option of paying or not paying on a stale check. A bank will usually consult with



the customer before paying on a stale check but a bank that pays in good faith without consulting its customer normally has the right to charge the customer’s account for the amount of the check.

4. Who has the right to order that payment on a check be stopped? Only a customer—or, if a customer is de-ceased, any person claiming an interest in the account—can order the customer’s bank to pay a check or stop payment on a check. This right does not extend to holders—payees or indorsers—because the drawee bank’s contract is only with its drawers. Moreover, a customer has no right to stop payment on a check that has been certified or accepted by the bank.

5. Who is liable when a customer’s bank pays an altered check? Because the customer’s instruction to the bank is to pay the exact amount on the face of the check to the holder, the bank is required to examine each check before making final payment. If it fails to detect an alteration, it is liable to its customer for the loss because it did not pay as the drawer-customer ordered. The loss is the difference between the original amount of the check and the amount actually paid. The bank may recover the difference from the party who presented the check for payment on the ground of breach of the presentment warranty that the instrument has not been altered.

6. What role does the Federal Reserve System play in clearing checks? The Federal Reserve System serves as the central bank of the nation by transferring funds, handling government deposits, and supervising and regulating banks. The twelve Federal Reserve banks act as clearinghouses and agents in the col lection of checks and other instruments, thus greatly simplifying the clearing of checks (the methods by which checks deposited in one bank are transferred to the banks on which they were written).

7. How might Check 21 affect the potential for banking fraud? Fraud may be more difficult to accomplish, in part because the “float,” which contributes to the effective commission of a “check-kiting” scheme, is eliminated. Fraud may be no more difficult to commit, however, because much “bank fraud” consists of forgeries that occur before items are presented to banks for payment. Are there circumstances in which y a copy of an original canceled paper check could be demanded? No. After the effective date of the Check Clearing in the 21st Century Act (Check 21), as noted in the feature, financial institution customers can no longer successfully demand an original canceled check. They are entitled to receive a “substitute check” only.

8. What types of financial institutions are covered by the EFTA? The EFTA governs financial institutions that offer electronic fund transfers involving customer (consumer) accounts. The EFTA defines “financial institutions” to include banks, savings and loan institutions, credit unions, and any other business entities that directly or indirectly hold accounts belonging to consumers. Security brokerage houses that permit consumers to make electronic transfers to and from money market fund accounts are also included.

9. Are there legal safeguards for the privacy of a user of e-money against the issuer? An issuer of e-money may be subject to the Right to Financial Privacy Act of 1978. Although it is yet unclear if this act applies to e-money issuers (credit-card issuers and other financial institutions are covered), this act may apply if the issuer is deemed to be (1) a bank by virtue of its holding customer funds or (2) an entity that issues a physical card similar to a credit or debit card. Also, the Financial Services Modernization Act (Gramm-Leach-Bliley Act) of 1999 may apply to an issuer of e-money. Under this act, all financial institutions must provide their customers with information on their privacy policies and practices. This act proscribes the disclosure of financial institutions’ customer data without notice and an opt-out opportunity.

10. Should only banks and regulated financial institutions be allowed to issue ATM cards? Yes, because limiting the issuers of ATM cards to regulated financial institutions reduces the number of methods by which terrorists



and other criminals can anonymously transfer money or launder illegally obtained funds. No, the financial-reporting provisions should be extended to currently unregulated entities, because doing otherwise would only offer an opportunity to develop other methods for criminals and terrorists to conceal their activities. How might the government regulate digital funds to reduce the potential for cyberlaundering? Laws could be passed to cover the current and future owners and operators of financial exchanges of all types.

ACTIVITY AND RESEARCH ASSIGNMENTS

1. Although the bank-customer relationship is contractual in nature and arises from the contract executed by both parties, this relationship is also governed in large part by the UCC. Ask the students to obtain form agreements for opening checking accounts from local banks. The students should then review their respective forms and attempt to identify the provisions that seem to be purely contractual in nature and those provisions that are taken from or heavily influenced by the UCC so as to appreciate the extent to which there is a merger of the UCC and contract law itself in such agreements.

2. Obtain copies of electronic fund transfer agreements from local banks and ask the class to compare the similarities and differences of the agreements with each other. Ask the students to identify the provisions that appear to be purely contractual in nature and the provisions that are modeled on the EFTA. Do any of the agreements contain provisions that appear to be unreasonable? How might these provisions be redrafted to make them more reasonable while still protecting the interests of the bank?

3. Ask students to research the changes to the banking and financial industry caused by the Internet and those changes caused by different federal and state laws and regulations. Do consumers understand the different “hats” that banks now wear? Will consumers embrace online banks?

EXPLANATIONS OF SELECTED FOOTNOTES IN THE TEXT

Footnote 7: Wulf worked for Auto-Owners Insurance Co. He opened a checking account at Bank One in the name “Auto-Owners, Kenneth B. Wulf.” Over an eight-year period, he deposited $546,000 in Auto-Owners’ checks that he stole and endorsed with a stamp that said “Auto-Owners Insurance Deposit Only.” When the scam was discovered, Auto-Owners filed a suit in an Indiana state court against Bank One, contending that the defendant failed to exercise ordinary care in opening Wulf’s account because it did not ask for documentation to show that he was authorized to open an account in the name of Auto-Owners. The courts ruled in the defendant’s favor. Auto-Owners appealed. In Auto-Owners Insurance Co. v. Bank One, the Indiana Supreme Court affirmed, finding that Bank One’s conduct did not “substantially contribute” to bringing about Auto-Owners’ loss. The major reason for Auto-Owners’ loss was its weak monitoring of its own files and the lack of controls in the handling of checks. The bank breached no duty by opening Wulf’s checking account.

In circumstances such as those in the Auto-Owners case, should a customer have the burden of proving a lack of ordinary care on the part of its bank, or should the bank have to show that it exercised ordinary care? The burden of demonstrating lack of ordinary care falls on the person or entity that is asserting the lack. In this case, of course, that was the plaintiff customer.

Why should a customer have to report a forged or unauthorized signature on a paid check within a certain time to recover the amount of the payment? The consequence of a customer’s failure to report a forged or



unauthorized signature under these circumstances is the opportunity presented to the wrongdoer to repeat his or her misdeeds.

Would the situation have been different if Wulf had handled his account electronically rather than manually? Electronic banking would have made no difference in the outcome in this instance. The liability rules are essentially the same.

What reasonable steps could Auto-Owners have taken to prevent such internal fraud? Spot audits of the check handling process would have uncovered the scam. This was not rocket science. It was uncovered, as such things often are, when Wulf was on vacation and another employee handled some of his files. To allow this to go on for eight years shows negligence in the design of the audit process at Auto-Owners.

Would the outcome in this case have been changed if Auto-Owners had never given Wulf (and other staff members) the authority to deposit checks to its bank account? It would not likely have changed the court's holding in this case because the UCC section involved in this case, UCC 3–405(b), does not mention a bank’s responsibilities when opening an account for a new customer. Instead, that UCC section requires that a bank exercise ordinary care in the “paying” or “taking” of an instrument. The court in this case reasoned that Auto-Owners had not proven that Bank One was negligent in taking the checks. The court also found that even if Bank One had been negligent in opening the account, Auto-Owners had not shown that the bank’s conduct “substantially contributed” to its losses. Therefore, even if Auto-Owners had never given Wulf the authority to make deposits, the bank would not be liable (unless it had reason to know about the lack of authority and its conduct had substantially contributed to Auto-Owners’ losses.

Footnote 8: Bank of America (BOA) issued a check for $300 to Ama Afiriyie, a BOA customer. On attempting to cash the check at a BOA branch office in a Pathmark Supermarket in South Orange, New Jersey, Afiriyie was erroneously accused of criminal conduct—the branch manager told the police that the check was fraudulent—and was briefly arrested. Afiriyie filed a suit in a New Jersey state court against BOA, alleging wrongful dishonor. A jury awarded Afiriyie $710,000 in damages. BOA appealed the court’s denial of BOA’s motion for summary judgment, claiming that it never dishonored the check. In Afiriyie v. Bank of America, N.A., a state intermediate appellate court affirmed, concluding that “BOA cannot, on the one hand, cause plaintiff to be arrested for attempting to pass a fraudulent check, and, on the other hand, claim that they never dishonored that check.”

Why did the bank argue that UCC 4–402 did not apply in this case? UCC 4–402 concerns a drawee bank’s wrongful dishonor of checks payable from a customer's own account. In the Afiriyie case, Bank of America disputed whether the check at issue was payable from its customer’s (Afiriyie’s) account. The check was drawn on an account in the bank’s name. But correspondence from the bank to Afiriyie accompanying the check refers to the bank account as her account. And the amount of the check represented a refund of her security deposit that the bank had held under the terms of a secured credit card agreement. In other words, the funds originated with the bank’s customer to secure her own account. The bank controlled the funds and their dispersal, and decided when a refund was appropriate.

The court determined that “in light of this correspondence from the bank, it is reasonable to regard the refund check in this case * * * as the functional equivalent of funds coming from plaintiff's own account. * * * We conclude that the distinctive circumstances of this matter can support plaintiff's statutory claim for wrongful dishonor.”

On what basis did the court reason that the bank may have wrongfully dishonored the check? When Bank of America refused to honor its check, Afiriyie filed a suit against the bank for wrongful dishonor. On the bank’s appeal of the court’s denial of a motion for summary judgment, the bank contended that there was no wrongful dishonor because under UCC 3–501(b)(4) it had until the day after Afiriyie came to the bank to process her request for payment. The appellate court reasoned that this argument “does not work” because Bank of America’s actions



between the time that Afiriyie presented the check for payment and the bank’s authentication of it were “inconsistent with the benign ordinary processing of a check.” During this time, Diane Lowe, the bank’s branch manager, called the police. She told them that the check was fraudulent, and they arrested and charged Afiriyie with forgery and attempted theft by deception based on Lowe's statements. The court reasoned, Bank of America “cannot, on the one hand, cause [Afiriyie] to be arrested for attempting to pass a fraudulent check, and, on the other hand, claim that they never dishonored that check. * * * In sum, the trial court did not err in declining to grant summary judgment dismissing [Afiriyie’s] claim of wrongful dishonor.”

During the trial, Lowe admitted that she made a mistake when she did not ask Afiriyie whether she was a bank customer. How might this simple question have changed the facts? When a teller at a branch office of Bank of America perceived a problem with the check that Afiriyie presented for payment, branch manager Diane Lowe did not ask Afiriyie whether she was a customer of the bank but only asked her where she had gotten the check. Afiriyie told Lowe that the bank had issued it to her, and Lowe responded that the bank did not issue checks like that. Unable to immediately verify the validity of the check, Lowe told Afiriyie that she could not cash it, and she (Lowe) was not allowed to give it back to Afiriyie.

If Lowe had asked Afiriyie whether she was a bank customer, as of course she was, Lowe could have simply had her deposit the check into her account at that time, so it could be verified in the normal course of the bank collection procedure. This step would likely have avoided the subsequent events that formed the basis for this suit.


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