Legal Reasons to Implement Positive Pay: Cincinnati Insurance Company v. Wachovia Bank

Wachovia Bank Wins Lawsuit Over Customer That Refused Positive Pay The Legal Rationale to Implement Positive Pay and High Security Checks

Summary

Schultz Foods Company issued a check for $153,856 to Amerada Hess Corporation. Thieves stole the check out of the mail, changed the name of the payee and convinced the new payee (an unwitting accomplice) to endorse the check and deposit it into his bank.

His bank presented the check for payment to Schultz Foods' bank, Wachovia Bank, and Wachovia charged $153,856 against Schultz Foods' account. Before Schultz Foods discovered the fraud, the funds had been wired out, and the money disappeared.

When the fraud was discovered, Schultz Foods reported the altered check to Wachovia and demanded its account be re-credited. Wachovia refused, citing that Schultz Foods had been offered the chance to implement "Positive Pay" after three previous check fraud incidents, but had declined. Instead, Shultz Foods had purchased a check fraud insurance policy from Cincinnati Insurance Co. Positive Pay, however, would have prevented this loss.

Schultz Foods made a $153,856 claim under its policy with Cincinnati, who paid the claim and filed suit against Wachovia to recover its loss. Cincinnati contended that the altered check was not "properly payable" and Wachovia was liable for the loss.

However, the Wachovia deposit agreement signed by Schultz Foods contained a list of precautions that a customer should take to protect their account. The Agreement included a conditional release of Wachovia's liability:

"You agree that if you fail to implement ... products or services [that are designed to deter check fraud], ...you will be precluded from asserting any claims against Wachovia for paying any unauthorized, altered, counterfeit or other fraudulent item ...."

Wachovia had not required Schultz Foods to absorb any losses because of the incidents, even though Schultz Foods never implemented Positive Pay. Cincinnati argued that Schultz Foods "had an expectation that Wachovia would reimburse Schultz Foods' account" for unauthorized charges if Schultz Foods took precautions such as closing its account. However, that expectation was contrary to Wachovia's deposit agreement, which contained an anti-waiver provision, allowing it to waive enforcement of the terms of the Agreement.

Even though Wachovia voluntarily shielded Schultz Foods from past check fraud losses, its deposit agreement protected it from liability created by a precedent.

The Court agreed with Wachovia's argument that the deposit agreement between Wachovia and Schultz Foods required Schultz Foods either to implement Positive Pay or to assume responsibility for any fraud losses caused by its failure to implement Positive Pay.

Complete Court Case and Commentary

Frank W. Abagnale
Abagnale & Associates
(800) 237-7443
abagnale.com

Greg Litster
SAFEChecks
(800) 949-2265

In what may well become a precedent-setting case, Wachovia Bank won a lawsuit against a customer's insurance company after the customer failed to implement Positive Pay and later suffered a $153,856.46 check fraud loss. The bank had repeatedly recommended that the customer use Positive Pay, an automated check matching service, but the customer declined.

Background

On December 1, 2005, Todd's Snax, Inc., dba Schultz Foods Company ("Schultz Foods"), issued a check in the amount of $153,856.46 to Amerada Hess Corporation drawn on Wachovia Bank. Thieves stole the check out of the mail, changed the name of the payee to "Kenneth Payton," and induced Payton (an unwitting accomplice) to endorse the check and deposit it into his account at TCF Bank. Payton was a Protestant minister who had been beguiled by the fraudsters into believing he was helping a refugee family in South Africa. Payton wired out $150,356.46; the benevolent fraudsters allowed him to keep $3,500.

TCF presented the check for payment to Schultz Foods' bank, Wachovia Bank, and Wachovia charged the amount of the check against Schultz Foods' account. By the time Schultz Foods discovered the fraud, Payton had wired the funds to a bank in Singapore, and the thieves had disappeared with the money.

On or about January 13, 2006, the fraud came to light. Schultz Foods reported the altered check to Wachovia, demanding that Wachovia re-credit its account. Schultz Foods claimed that Wachovia must bear the loss because it processed the altered check in violation of § 4-401(a) of the Uniform Commercial Code. Wachovia disagreed, citing the fact that Schultz Foods had declined to implement "Positive Pay," a check-fraud deterrence program that would have identified the altered payee name and prevented the loss. Wachovia refused to pay.

Unbeknownst to Wachovia, in March 2005 Shultz Foods bought a commercial insurance policy from Cincinnati Insurance Company to insure against payment of altered and fraudulent checks. Even as Schultz Foods made a claim against Wachovia, it also made a claim under its policy with Cincinnati. Cincinnati paid the claim and filed suit against Wachovia to recover its loss.

In the lawsuit, Cincinnati contended that the altered check was not "properly payable" under § 4-401(a) when Wachovia deducted the amount of the check from Schultz Foods' account, and absent an agreement to the contrary, Wachovia was liable for the loss. The problem with Cincinnati's argument was that there was an agreement to the contrary - the deposit agreement signed by Schultz Foods when it opened its commercial checking account at Wachovia. Section 12 of that agreement described several methods by which a customer could safeguard its account from fraud. These methods fell into two categories:

First, Section 12 contained a bullet-pointed list of "precautions" that customers "can and should take to decrease the risk of unauthorized transactions." They included basic measures such as protecting the secrecy of passwords, promptly reviewing bank statements for unauthorized activity, and immediately reporting suspicious activity to the bank.

Second, Section 12 stated that Wachovia may make available to its customers "certain products and services that are designed to detect and/or deter check fraud." These products and services were developed by Wachovia or purchased from third-party vendors by Wachovia and offered to its customers.

Section 12 of the deposit agreement concluded with a conditional release of Wachovia's liability:

"You agree that if you fail to implement any of these products or services, or you fail to follow these and other precautions reasonable for your particular circumstances, you will be precluded from asserting any claims against [Wachovia] for paying any unauthorized, altered, counterfeit or other fraudulent item that such product, service, or precaution was designed to detect or deter, and we will not be required to re-credit your account or otherwise have any liability for paying such items."

Section 25E of the deposit agreement contained virtually identical language. That section began with the customer's acknowledgment that Wachovia had made available "treasury services designed to reduce the likelihood that a fraudulent, unauthorized or altered check or other item will be paid." That section continued with the customer's acknowledgment that its failure to use such "treasury services" could "substantially increase" the likelihood of fraud. Section 25E ended with another conditional release of Wachovia's liability that was virtually identical to the release found in Section 12.

Wachovia argued that under the terms of the deposit agreement between Schultz Foods and Wachovia, Schultz Foods' failure to implement Positive Pay made Schultz Foods liable for the loss. Positive Pay was a "product or service" for purposes of Section 12 and a "treasury service" for purposes of Section 25E. It was "designed to detect" the type of fraud that caused the $153,856.46 loss to Schultz Foods. Wachovia repeatedly made Positive Pay available to Schultz Foods, and Schultz Foods unwisely chose not to implement it.

Prior to this loss, Schultz Foods had been a victim of check fraud on three separate occasions. After the first incident in March 2002 when two fraudulent checks cleared its account, Wachovia recommended that Schultz Foods either close its account or implement Positive Pay. Schultz Foods closed its account but did not implement Positive Pay. After the second incident in October 2003 when a check for $410 was altered to read $3,942.68, Wachovia again covered the loss. After the third incident in September 2004 when Schultz Foods received notice that a fraudulent check drawn on its account had been deposited at an Oklahoma bank - which did not result in any loss to Schultz Foods - Wachovia told Schultz Foods that if its account became compromised, Schultz Foods should either close its account or implement Positive Pay. Schultz Foods closed its account but again did not implement Positive Pay. Instead, Schultz Foods purchased a check fraud insurance policy from Cincinnati Insurance Company.

Wachovia did not require Schultz Foods to absorb any fraud-related losses with any of the incidents, even though Schultz Foods never implemented Positive Pay. Based on these experiences, Cincinnati argued that Schultz Foods "had an expectation that Wachovia would reimburse Schultz Foods' account" for unauthorized charges so long as Schultz Foods took precautions such as closing its account. However, that alleged expectation was contrary to Wachovia's deposit agreement. Section 43 contained the following anti-waiver provision:

WAIVER OF RIGHTS BY THE BANK. We reserve the right to waive the enforcement of any of the terms of this Agreement with respect to any transaction or series of transactions. Any such waiver will not affect our right to enforce any of our rights with respect to other customers or to enforce any of our rights with respect to later transactions with you and is not sufficient to modify the terms and conditions of this Agreement.

Even though Wachovia voluntarily shielded Schultz Foods from past check fraud losses, its well written deposit agreement protected it from any liability created by the illusion of a precedent.

In issuing its Order on July 14, 2010, the Court agreed with Wachovia's argument that the deposit agreement between Wachovia and Schultz Foods required Schultz Foods either to implement Positive Pay or to assume responsibility for any fraud losses caused by its failure to implement Positive Pay. The Order said:

"...the Court finds that, under the deposit agreement between Schultz Foods and Wachovia, Schultz Foods must bear the loss because Schultz Foods failed to implement a fraud-detection program [Positive Pay] offered by Wachovia - a program that would have prevented the loss. The Court thus grants summary judgment to Wachovia."

Points to consider

1. Typically, an altered payee is the liability of the bank of first deposit, in this case, TCF Bank. The attorneys who won this case, William Mohrman and Greg Erickson, Mohrman & Kaardal, in Minneapolis, MN were retained by TCF Bank, not Wachovia Bank. When Wachovia was sued by Cincinnati Insurance, it chose not to hold its customer accountable to the deposit agreement, and expected TCF Bank to pay for the altered check. Under UCC § 3-119, if one party in the legal chain has a good defense, the liable party can assume that party's good defense to defend itself. TCF Bank did precisely that. It took over Wachovia's position and defended itself. This case demonstrates that a customer can have a great relationship with its bank and still lose a check fraud lawsuit.

2. Companies/organizations should review their bank deposit agreements to understand their legal rights and responsibilities. As this case illustrates, a company can do the minimum its bank asked it to do (e.g. close the account), and still lose a lawsuit because (a) of a strongly worded deposit agreement, and (b) it didn't do more.

Based upon this lawsuit, banks will almost certainly be reviewing and re-writing their deposit agreements to include the kinds of provisions Wachovia Bank included in its deposit agreement. Banks that want to strengthen their deposit agreement should consider contacting Bill Mohrman (mohrman@MKLaw.com, 612-341-1074).

3. Companies/organizations should speak with their insurance agent about coverage and loss limits for check fraud and cyber crime losses. Schultz Foods was smart to obtain a high-limit policy that covered its $153,856.46 loss. Many commercial policies cover up to $25,000, which is entirely inadequate for most organizations.

4. Check fraud is rampant across the nation. Companies/organizations should implement Positive Pay with Payee Name match on all checking accounts. If their bank does not offer Payee Positive Pay, customers should request the service in writing. The request should be sent by Certified Mail-Return Receipt Requested. One never knows when that document may become useful.

5. All banks charge for Positive Pay. Banks should charge as little as possible to maximize the number of users, and companies/organizations should think of the fees as "insurance." If Positive Pay fees are considered too expensive, compare it to the cost of legal fees as the alternative. It is no longer a matter of "if" a company will be hit, it is a matter of "when."

6. Wachovia Bank won this lawsuit because it offered Payee Positive Pay and had a well crafted deposit agreement. A bank that does not have Payee Positive Pay can add the technology for as little as $30,000. The technology utilizes X9.37 or TIFF files and works with any bank operating platform. It can interact with existing online banking systems. For more information, contact Greg Litster at greg@safechecks.com or (800) 949-2265.

7. All parties need to know that Payee Positive Pay is not foolproof. Forgers are beating it by adding a new payee name above the original payee name. A check with an added payee name can pass through Payee Positive Pay undetected.

8. A "secure name font" helps prevent added payee names. The font is available through SAFEChecks. It is illustrated in Frank Abagnale's fraud bulletin, Check Fraud, Identity Theft, Holder in Due Course and Cyber Crime, Volume 9, Page 7, A Primer on Laser Printing, and also on Page 14, Secure Software. To receive a check printed with a secure name font, contact Robin Johnson at (800) 755-2265 x3311 or robin@safechecks.com. Mr. Abagnale's bulletin can be downloaded at safechecks.com/services/fraudbulletin.html.

9. Technology-challenged companies/organizations that lack the IT capability to format and send its check issue file to the bank can buy software from SAFEChecks to do so. To assist understaffed accounting departments, the software can be programmed to automatically send the check issue file to the bank after every check run. The software includes a secure name font to prevent added payee names, a secure number font, and an encrypted, image-survivable barcode. The barcode contains the maker, payee, dollar amount, check number, account number, issue date, routing/transit number, the X,Y coordinates of each piece of data, the time and date the check was printed, the printer used to print the check, and the operator. The barcode is like Payee Positive Pay on-board the check. If a bank has the technology to decrypt the barcode (starting at $30,000), the customer does not need to send a check issue file. The entire file is in the barcode on the check, and carries through to the image if the check is converted.

10. High security checks are a critical component in check fraud prevention. Organizations cannot fight check fraud and ignore the quality of the check. When Schultz Foods' check was altered, apparently there was no visible trace of the alteration. Using high security checks such as the SuperBusinessCheck (www.supercheck.net), discussed on Page 11 of Frank Abagnale's fraud bulletin, would likely have left some telltale signs of the alteration. Contact Robin Johnson (robin@safechecks.com) for a sample.

11. Use a 14 point font for the Payee Name and address. A larger font makes physical alterations more evident. Also, use good quality toner, not cheap toner. Cheap toner can be peeled off with tape without damaging the physical paper check. Finally, make sure the laser printer is hot. The hotter the printer the better the toner bonds to the check. This is discussed in detail in Frank Abagnale's bulletin, Page 7, A Primer on Laser Printing.

12. Readers that want to know how challenging it can be when a bank's attorney takes a company to the woodshed over the company's internal failings will want to read selected excerpts from Wachovia Bank's Memorandum in Support of Defendant Wachovia Bank's Motion for Summary Judgment.

The case is:
UNITED STATES DISTRICT COURT
DISTRICT OF MINNESOTA
CINCINNATI INSURANCE COMPANY,
as Subrogee of Todd's Snax, Inc., d/b/a Schultz Foods Company,
Plaintiff,
v.
WACHOVIA BANK, NATIONAL ASSOCIATION,
Defendant.
Case No. 08-CV-2734 (PJS/JJG)

This Article and the Court Order can be downloaded on our PDF library page here.