Adams and Reese Partner Scott Jones had his article “Back with a Vengeance: The Challenges of Check Fraud” published in ABA Banking Journal Risk and Compliance.
Below is the article:
Understanding the Rules Surrounding Returns as the Number of Cases Skyrockets
By Scott Jones
Many in financial services continue to predict that checks are dead or will have far less market share of the payments space in the years to come. Unfortunately, however, check fraud continues to soar. There also remains confusion in the industry regarding the obligations of the bank for the deposit customer (bank of first deposit) and the paying bank.
This article summarizes some of the fraud statistics and trends and provides an overview of the competing obligations of financial institutions involved in the process of depositing and paying checks.
The Financial Crime Enforcement Network reports that in 2021, financial institutions filed more than 350,000 Suspicious Activity Reports of potential check fraud, a 23 percent increase over 2020. This upward trend continued into 2022, when the number of SARs related to check fraud reached over 680,000, nearly double the previous year’s filings. This compares to 96,786 suspicious activity check fraud cases reported in 2014.
The reason for the surge? Criminals are becoming more sophisticated and organized across technology and messaging apps, where they can send encrypted messages and conceal their identities through anonymous and untraceable usernames.
The increase in cases is creating many check fraud processing challenges such as backlogs in check warranty claims, availability of funds and the average check value doubling over the last decade. Frank McKenna, chief fraud strategist at Point Predictive, estimates check fraud will reach $24 billion this year.
Most common check fraud schemes
There are numerous, unique deposit channels that present detection challenges and delays, such as via ATM, mail, online remote deposit capture, and tellers. The types and trends of emerging check fraud include stolen checks (washed, altered or forged), counterfeit (difficult to detect across all channels), remote deposit capture (anonymous and easy), and ATM deposit (no real-time interaction and less monitoring).
For example, check washing can be conducted in multiple ways:
- The check is stolen from mailbox, and the name on check erased or “washed” via technology or household chemicals. The payee name on the check and, in some cases, dollar amount are changed, and the check is deposited or cashed under a different account.
- Counterfeit checks are created using real account number but deposited under a fake identity. For instance, across certain messaging apps, like Telegram, criminals advertise for and then hire “walkers” to go to the bank and cash or deposit checks using fake identities that match the name on the check.
According to a 2022 article in the Chicago Sun-Times, a couple reported a $30 donation check to a school stolen, rewritten to someone else and cashed for over $9,000. Also in 2022, the Los Angeles Times reported that 56 people were arrested in a widespread stolen check scheme amassing $5 million from 750 California residents. The suspects were accused of altering stolen checks, depositing them into bank accounts, and withdrawing money from ATMs. They face charges of aggravated white-collar crime, conspiracy to commit grand theft by false pretenses, forgery and money laundering.
On Feb. 27, FinCEN published an alert highlighting the nationwide surge in mail-theft-related check fraud. From March 2020 through Feb. 2021, the United States Postal Inspection Service received 299,020 mail theft complaints, an increase of 161 percent compared with the same period a year earlier.
There has also been a significant increase in armed robberies of and assaults of U.S. Postal Service workers. The target? Their master keys, which can open mailboxes in building lobbies and those on streets. These keys in some instances are being sold online on underground websites.
There have been more than 2,000 assaults or robberies of postal carriers since 2020. If criminals can gain easy access to the mail, they have easy access to checks. And with the 2020 and 2021 surge of government payments to individuals—such as Economic Impact Payments and child tax credit advances—there are ample opportunities for criminals to seize these funds.
Bank of first deposit versus the drawee bank: Who bears the loss?
“Alteration” is an unauthorized change in a check that modifies the obligation of a party. This generally includes a change in the amount of the check or the name of the payee. A “counterfeit” or “forged” check is a fraudulently created check or one that includes a forged drawer signature. Under the Uniform Commercial Code (UCC 4-401), a paying bank may only pay a check that is properly payable. Neither altered checks nor forged/counterfeit checks are properly payable.
The bank of first deposit (the financial institution for the customer depositing the check) warrants to the paying bank (the drawee bank), among other things, that: the check has not been altered; there are no forged or unauthorized payee endorsements; the warrantor is a person is entitled to payment and to enforce the check; and the depositary bank has no knowledge that the check contains a forged drawer signature.
If a check is a counterfeit check or contains a forged drawer’s signature, there is no presentment or transfer warranty and the paying bank must return the item to the bank of first deposit before the midnight deadline under UCC 4-302, which is midnight on the next banking day following presentment of the check to the paying bank (UCC 4-104(10)).
So, what action is required?
If the drawee bank claims the check is counterfeit or contains a forged drawer’s signature, it must return the item by the midnight deadline (in addition to satisfying the time requirements of Federal Reserve Regulation CC). If the check is altered or contains a forged payee endorsement, then the drawee bank has a breach of warranty claim against the bank of first deposit (which may be up to three years, depending on the form of UCC adopted in the applicable state).
A conflict occurs when the depositary bank claims the check is counterfeit and the drawee bank claims alteration. Who bears the loss in this situation?
In 2018, Regulation CC was amended to create a presumption of alteration if the original check is not available for inspection. Thus, there is a presumption of alteration when there is a conflict as to whether a check was altered or is counterfeit. The presumption is applicable only to substitute checks or electronic checks where the original check is not available. The presumption is applicable to depository financial institutions only, is not applicable if contrary to federal statute or regulation, and is rebuttable if other evidence exists.
A persistent problem
There was a recent case highlighting a growing problem. In the 2021 case of Provident Savings Bank v. Focus Bank, Focus Bank was the drawee bank, and Provident Bank was the bank of first deposit. Provident Bank’s customer deposited a check for more than $150,000. Provident Bank presented the check to Focus Bank for payment through the Federal Reserve Bank, and Focus Bank honored the check and paid it.
After the midnight deadline expired, the drawer of the check alerted Focus Bank the check was fraudulent. Thus, Focus Bank returned the check through the Federal Reserve to Provident. Provident Bank filed suit against Focus Bank claiming that Focus Bank’s failure to timely return the forged check within the midnight deadline made Focus Bank strictly liable under the UCC.
The court distinguished between altered and counterfeit checks: “The bank on which a check is drawn warrants to the presenting bank that the check is genuine, [and]hence not forged, while as we know the presenting bank warrants that the check hasn’t been altered since its issuance.”
The evidence in the case established that the check deposited at Provident Bank was electronically duplicated because a second check was discovered on the Focus Bank’s customer’s account that was nearly identical to the check at issue (but with a different payor). So was it an alteration or a counterfeit? The court noted: “The depositary bank has an opportunity to examine the check free of the time pressures which prevent collecting banks from giving checks more than a cursory glance. Perhaps more important, the depositary bank is in the unique position of being able to examine both the depositor and the check.”
Ultimately, however, the court concluded that the evidence was insufficient to establish that the check was altered: “Focus Bank does not cite any case to support the proposition that a digitally altered copy of a genuine check, modified and then printed on commercially available check stock, is an ‘alteration’ under the UCC.” Accordingly, the court said that Provident Bank did not breach the presentment warranty because “[t]he evidence does not establish a genuine issue of material fact as to whether the check was altered.”
Check fraud is back with a vengeance. Every financial institution can expect to face both sides of the challenge, so be a good citizen! Banks must work together on check fraud prevention methods and also resolve disputes over bad checks in a timely and proper manner. We must also be more vigilant with monitoring check activity and considering good and effective fraud prevention tools (like positive pay) to help mitigate against criminals who are always looking for opportunities.
Scott Jones is a partner at Adams and Reese. He works with financial institutions on payment systems, payments fraud and bank operations, including treasury management services, wire transfers, ACH transactions, Internet banking, mobile banking, checks and emerging payment systems. He participated in a recent ABA webinar on check fraud.