Hartford Fire Insurance v. Maryland National Bank, N.A.

MURPHY, Chief Judge. In this case, we determine whether a drawer can bring suit against a depositary bank when (1) it accepts a check with no indorsement for deposit into an account other than that of the named payee or (2) when the depositary bank accepts a check in violation of a restrictive indorsement. I From 1969 to 1993, Eugene Carbaugh served as the head of the accounts payable department of the Prince George’s County Board of Education (the Board). In 1982, Carbaugh began submitting fictitious bills to the Board using names such as “PEPCo” and “Bionomics Product Co.” After checks were issued by the Board to pay the fictitious bills, Carbaugh deposited the checks into bank accounts opened in his name at Maryland National Bank (MNB). 1 Carbaugh’s scheme was not discovered until 1993.

By then, he had stolen about $1.1 million dollars from the Board. The Board recovered most of its losses from the Hartford Fire Insurance Co. (Hartford), its insurance carrier. As subrogee and assignee of the Board’s claims, Hartford brought an action ⁴¹² in the United States District Court for the District of Maryland against MNB seeking to hold MNB liable for the Board’s loss. In July 1995, the district court issued a memorandum of partial decision in which it concluded that MNB had accepted at least eight and possibly as many as fifty checks containing restrictive indorsements, in violation of those restrictive indorsements.

As found by the district court, “MNB violated restrictive indorsements which required MNB to deposit the checks into an account of ‘BIONOMICS PRODUCTS CO INC’ or some variation thereof. Instead, MNB wrongly deposited the checks into the account of ‘Eugene N. Carbaugh.’ ” In addition, the district court found that MNB improperly accepted 35 checks from Carbaugh written to “BIONOMICS PRODUCTS CO INC” or “PEPCo” with missing indorsements; it noted by way of example that “some checks are made out to joint payees but include only one indorsement____ Some of the checks include as a purported indorsement only the stamped or typed words ‘for deposit only to within payee only’ and an account number....” In its memorandum, the district court also found that in accepting checks with missing indorsements and in violation of restrictive indorsements, MNB failed to follow commercially reasonable banking practices. It further concluded that if a drawer can bring an action directly against a depositary bank under Maryland law, MNB would be liable to Hartford for improperly disbursing funds to Carbaugh for those checks with missing or restrictive indorsements. The district court, however, found the question of whether the drawer of a check could sue a depositary bank to be a “significant, debatable and unresolved question[ ] of Maryland law.” To resolve this issue, the district court certified the following two questions to this Court pursuant to the Maryland Uniform Certification of Questions of Law Act, Maryland Code (1995 Repl-Vol.) §§ 12-601 through 12-609 of the Courts and Judicial Proceedings Article and Maryland Rule 8-305: ⁴¹³ 1.

Can the drawer of a check recover from a depositary bank that accepted the check with a missing indorsement? 2. Can the drawer of a check recover from a depositary bank that violated a restrictive indorsement? II A The rights ana duties of drawers and depositary banks are governed by Maryland Code (1975, 1992 Repl.Vol., 1995 Supp.) Titles 3 and 4 of the Commercial Law Article, which are essentially the same as Articles 3 and 4 of the Uniform Commercial Code (UCC). 2 In addition, where the Commercial Law Article does not expressly resolve an issue, “the principles of law and equity ... shall supplement its provisions.” § 1-103. In a case such as this, where Titles 3 and 4 do not directly define or limit a drawer’s right of action, we must look to the structure of rights and duties explicitly imposed by statute and any pre-existing rights and duties under Maryland’s common law.

Under Titles 3 and 4, “[t]o the extent that the forger is unavailable or insolvent, the burden of loss from a forged indorsement is generally placed on the person who dealt with and took the instrument in question from the forger.” George C. Triantis, Allocation of Losses from Forged Indorsements on Cheeks and the Application of § 3-405 of the Uniform ⁴¹⁴ Commercial Code, 39 Okl.L.Rev. 669, 669 (1986). In the typical case, Titles 3 and 4 place ultimate liability for losses resulting from a forged indorsement upon the depositary bank because the depositary bank first accepted the check containing the forged indorsement. Regardless of who is ultimately liable for such losses, the drawer must initially bear the loss “in the form of the debit to his account with the drawee bank.” Id. at 671. The issues in this case focus on the means by which the drawer can seek to shift this loss to the depositary bank.

Titles 3 and 4 explicitly provide one means by which the drawer can recover any losses suffered as a result of a forged indorsement. Because a check containing a forged indorsement is not “properly payable,” the drawer can require the drawee bank to re-credit the drawer’s account. See § 4-401(1) (allowing a bank to charge against a customer’s account only those items which are “otherwise properly payable from that account”). The drawee bank can then proceed against the depositary bank for a breach of the depositary bank’s warranty of title under § 4r-207(1)(a). 3 In addition to this remedy, some jurisdictions have allowed the drawer to sue a depositary bank for conversion or to bring suit under other common law causes of action such as money had and received or negligence.

Kelly v. Central Bank and Trust Co., 794 P.2d 1037 (Colo.App.1989) (allowing action for conversion to proceed when depositary bank accepted checks containing missing indorsement); Underpinning, Inc. v. Chase Manhattan, 46 N.Y.2d 459 , 414 N.Y.S.2d 298, 298 , 386 N.E.2d 1319, 1319 (1979) (allowing drawer to bring a conversion action when depositary bank accepted checks containing ⁴¹⁵ forged restrictive indorsements and the checks were accepted in violation of the restrictive indorsement); Sun ’n Sand v. United California Bank, 21 Cal.3d 671 , 148 Cal.Rptr. 329, 346 , 582 P.2d 920, 937 (1978) (allowing drawer to bring a claim of negligence against a depositary bank); Commercial Credit Corp. v. Citizens National Bank, 150 W.Va. 196 , 144 S.E.2d 784 (1965) (finding that “the majority of cases hold that the drawer can sue the collecting or intermediary bank on implied contract for money had and received and omit suing the drawee bank, thus relieving the necessity of circuity of actions”); see also G.F.D. Enterprises, Inc. v. Nye, 37 Ohio St.3d 205 , 525 N.E.2d 10 (1988) (recognizing that “the negligence cause of action is preserved” under the U.C.C., but denying recovery to a drawer in cases involving a forged drawer’s signature). Hartford maintains that “under Maryland law, the drawer of a check who retains title ... may bring an action against a depositary bank that wrongfully pays its proceeds.” Hartford asserts that this result is mandated by our older case law, and that it has not been altered by Maryland’s passage of the Uniform Commercial Code. In contrast, MNB contends that a drawer cannot sue a depositary bank for conversion because the depositary bank never handles the drawer’s funds. Instead, MNB asserts, a drawer must recover its losses from the drawee bank, and the drawee bank is responsible for bringing a claim against the depositary bank.

To hold otherwise, according to MNB, would “eviscerate[ ] the careful allocation of rights and liabilities set forth in the Maryland Commercial Before addressing these contentions, it is necessary to emphasize the differences between the present case and cases involving only forged indorsements. At this time, we need not consider whether a drawer can sue a depositary bank for conversion when the depositary bank accepts a check containing a non-restrictive forged indorsement. That issue is not properly before us for two reasons. First, Title 3 explicitly ⁴¹⁶ precludes Hartford from recovering for any checks accepted by MNB that contained only a forged, non-restrictive indorsement.

In addition, MNB would have failed to act reasonably and to properly obtain title to the checks even if all indorsements on those checks had been genuine. Although a depositary bank generally must bear any loss resulting from its acceptance of a check containing a forged indorsement, § 3-405(1) shifts the loss to the drawer in certain cases of employee embezzlement. Section 3-405(1) provides that [a]n indorsement by any person in the name of a named payee is effective if ... [a] person signing as or on behalf of a maker or drawer intends the payee to have no interest in the instrument; or ... [a]n agent or employee of the maker or drawer has supplied him with the name of the payee intending the latter to have no such interest. Because an indorsement signed by its embezzling employee is “effective” against the drawer, the drawer cannot recover from the drawee or depositary banks, and the drawer must bear any losses resulting from the employee’s embezzlement. 4 For this reason, § 3-405(1) specifically precludes Hartford from holding MNB liable for its acceptance of checks containing indorsements forged by Carbaugh when MNB did not violate any restrictions placed on those indorsements.

In addition to the fact that § 3-405(1) prevents Hartford from recovering from MNB solely on the basis of forged ⁴¹⁷ indorsements, the propriety of MNB’s conduct in this case does not depend upon the validity of the indorsements on any of the checks accepted by it. MNB’s acceptance of checks in violation of restrictive indorsements or despite missing indorsements would have been improper even if none of the indorsements had been forged. Even if all of the indorsements on the checks accepted by MNB had been valid, MNB could not claim the protected status of a “holder in due course” with respect to any of the checks at issue here. Under § 3-206(3), any bank that accepts a check containing a restrictive indorsement “must pay or apply any value given by him for ... the instrument consistently with the indorsement and to the extent that he does so he becomes a holder for value.” To the extent that MNB failed to apply the proceeds of the checks accepted from Carbaugh consistently with the restrictive indorsements on those checks, it failed to become a “holder” regardless of indorsements’ validity.

MNB also failed to become a “holder” of those checks written to joint payees when it accepted them with the indorsement of only one of the payees. “Holder” is defined as “a person who is in possession of ... an instrument ... drawn, issued or indorsed to him or his order or to bearer or in blank.” § 1-201(20). Under § 3-116(b), an instrument payable to the order of two or more persons “may be negotiated ... only by all of them.” Without proper negotiation, MNB could not perfect its title to the checks. 5 MNB, therefore, could not become a “holder” without the indorsements of all of the joint payees. Finally, MNB could not have become a “holder” of those checks upon which “for deposit only to within payee only” and an account number had been stamped or typed. ⁴¹⁸ Although § 4-205(1) allows a depositary bank to supply a customer’s missing indorsement and “a statement placed on the item by the depositary bank to the effect that the item was deposited by a customer or credited to his account is effective as the customer’s indorsement,” this provision would only allow MNB to supply Carbaugh’s indorsement, since only Carbaugh was its customer. Because MNB could not supply the indorsements of the payees to whom the checks had been written, the checks were never effectively indorsed, and MNB could not become a “holder” of those checks.

Since MNB could not have become a “holder” of the checks accepted in violation of restrictive indorsements or accepted with missing indorsements, MNB could not claim the protection given to a “holder in due course” under Articles 3 and 4. See § 3-302. Under § 3-306, “[u]nless he has the rights of a holder in due course any person takes the instrument subject to ... all valid claims to it on the part of any person....” 6 Even if all of the indorsements on the checks at issue here had been genuine, therefore, MNB would still have failed to perfect its title to the checks, and would be subject to any valid claims against the proceeds that it collected. Ill A As to the issue of when a drawer can sue a depositary bank, “[t]he authorities are hopelessly divided.” Stone & Webster Engineering Corp. v. First National B. & T. Co., 345 Mass. 1, 184 N.E.2d 358, 361 (1962) [hereinafter Stone & Webster ].

For our purposes, three leading decisions will suffice to illustrate and analyze the various approaches that may be taken in this area. ⁴¹⁹ In Stone & Webster, supra, the Supreme Judicial Court of Massachusetts held that a drawer can never bring an action against a depositary bank for conversion of a check containing a forged indorsement. In that case, Stone & Webster Engineering Corp. drafted checks payable to one of its creditors. Before the checks were delivered to the creditor, they were stolen by one of Stone & Webster’s employees. The employee forged the creditor’s indorsement on the back of the check and cashed the checks at the defendant bank.

Id. 184 N.E.2d at 359 . Although some of the indorsements were restrictive, the court made no distinction between those checks that were accepted by the depositary bank in violation of a restrictive forged indorsement and those accepted with a forged indorsement in blank. See id. at 361. The court noted that the depositary bank was not a “holder” of the check because the check could not have been negotiated to the bank when the forged indorsements were “ ‘wholly inoperative’ as the signatures of the payee.” Id.

Accordingly, the court “assume[d] that the collecting bank may be liable in conversion to a proper party____” Because “no explicit provision in the Code purport[ed] to determine to whom the collecting bank may be liable,” however, the court found that whether the drawer was a proper party “must be decided on our own law, which, on the issue we are discussing, has been left untouched by the Uniform Commercial Code.” Id. The court held that the drawer was not the proper party to sue because the drawer had no right to the checks themselves or their proceeds. Since the drawer would have had no right to present the checks for payment, the drawer’s interest in the checks “was limited to the physical paper on which they were written, and was not measured by their payable amounts.” Id. at 362. The drawer similarly had no interest in any proceeds that would have been gained by cashing the checks.

Id. at 360. Thus, the drawer could not sue for conversion of the checks themselves. The drawer’s loss did not follow from its loss of the checks, however, but from the debit of its account by the drawee bank ⁴²⁰ when the checks were accepted from the depositary bank. The drawer, therefore, alleged that the depositary bank wrongfully deprived it of a credit in its bank account with the drawee bank.

Id. at 360. The drawer lost this credit when the drawee bank took funds out of the drawer’s account in order to pay the proceeds of the checks to the depositary bank. Id. The court rejected this argument, finding that any amounts given to a depositary bank by a drawee bank were in fact the funds of the drawee bank.

Thus, the depositary bank had no funds that belonged to the drawer. If the drawee bank 'wrongfully debited the account of the drawer, the drawer would have to recover them from the drawee bank, not the depositary bank: [w]hen the defendant [depositary bank] ‘cashed’ checks with its own funds, no legal harm befell the plaintiff---- The harm which befell the plaintiff was the charging of its account by the drawee bank. As has been noted above, the drawer has a cause of action, possibly subject to defenses, against that bank. Id. at 364; see also id. at 360-61.

If we adopt the reasoning used in Stone & Webster, therefore, Hartford will be unable to recover from MNB for any of the checks because any losses suffered by the Board are attributable to the drawee bank, not MNB. Other courts have allowed a drawer to bring suit against a depositary bank in only a few, very specific situations. In Underpinning, Inc. v. Chase Manhattan, 46 N.Y.2d 459 , 414 N.Y.S.2d 298, 298 , 386 N.E.2d 1319, 1319 (1979), the New York Court of Appeals allowed a drawer to sue a depositary bank for conversion when it “accepts [a] check and pays out the proceeds in violation of a forged restrictive indorsement.” In that case, one of the drawer’s employees had created false invoices purportedly from firms with which the drawer did business. The employee prepared checks to pay the invoices and obtained the appropriate signatures from the drawer’s officers.

The employee then forged indorsements on the checks using stamps similar to those used by the named payees. The stamps contained restrictive indorsements such ⁴²¹ as “for deposit only.” The checks were then either cashed by the employee or deposited in savings accounts opened at various depositary banks in names other than those of the named payee-indorsers. After discovering the scheme, the employer brought suit against the depositary banks. Id. 414 N.Y.S.2d at 299 , 386 N.E.2d at 1320 .

At the outset of its discussion, the court enunciated the same view of a drawer’s interest in the money debited from its account that was applied in Stone & Webster: Simply stated, the reason why a drawer is normally held to have no cause of action against a depositary bank which wrongfully paid over a forged indorsement, is that the depositary bank is not deemed to have dealt with any valuable property of the drawer.... In the typical forged indorsement case, the indorsement will be ineffective, and thus the check will not authorize the drawee bank to pay it from the drawer’s account. Absent such authority, the drawee may not charge the drawer’s account—and any payment made on the check is deemed to have been made solely from the property of the drawee, not the drawer.... Since the money received by the depositary bank from the drawee is the property not of the drawer, but rather of the drawee alone, nothing’the depositary bank does with those funds can be considered a conversion of the drawer’s property.

Id. 414 N.Y.S.2d at 300 , 386 N.E.2d at 1321 . The court also applied the rationale used in Stone & Webster to explain why the drawer had no interest in the checks themselves: [SJince the drawer is not a holder, and could not present the check for payment, the drawer is normally considered as having no interest in the check. Moreover, since the check cannot be paid over a forged indorsement, the drawer is viewed as having no valuable interest in whatever right the check might otherwise be seen as transferring to the payee and to subsequent holders, for the simple reason that there exists no such right. ⁴²² Id. In New York, therefore, a drawer could not sue a depositary bank for payment of a check containing a forged indorsement when that indorsement was ineffective to transfer title to the check and the proceeds could not have been properly debited from the drawer’s account by the drawee bank.

In Underpinning, however, the forged indorsement was considered to be “effective” under § 3-405(l)(c) of New York’s Commercial Code, which provided that “[a]n indorsement by any person in the name of a named payee is effective if ... an agent or employee of the maker or drawer has supplied him with the name of the payee intending the latter to have no such interest.” Id. 414 N.Y.S.2d at 301 , 386 N.E.2d at 1322 (quotation omitted). Because the indorsement was “effective,” the check was negotiable and the drawee bank acted properly in disbursing the funds to the depositary bank and debiting the drawer’s account. Therefore, “the drawee is in fact paying out funds in which the drawer does have an interest and which may serve as the basis for an action against a depositary bank which has wrongfully obtained that money.” Id. Noting that the UCC “places liability solely upon the bank which first takes the check with the restrictive indorsement,” the court found that “[t]he depositary bank ... was responsible for checking all restrictive indorsements, and is liable for payment made in violation thereof.” Id. 414 N.Y.S.2d at 301 , 386 N.E.2d at 1322 .

Under the reasoning in Underpinning, MNB could be held liable for all of the checks accepted from Carbaugh in violation of a restrictive indorsement. As we discussed above, § 3-405(1) of our Commercial Law Article makes Carbaugh’s signature effective as an indorsement in this case. Therefore, the drawee bank properly charged the drawer’s account, and the drawer may sue the depositary bank for its