In a recent decision, Judge Paul A. Crotty of the United States District Court for the Southern District of New York denied defendant banks’ motion for judgment on the pleadings in a case involving the alleged wrongful honor of altered checks. The plaintiff filed suit to recover the proceeds of two checks, totaling $85,000, from defendants Wachovia Bank, N.A. (Wachovia) and T.D. Bank, N.A. (T.D. Bank) on the grounds that the checks had been altered prior to the banks accepting them for payment. The defendants moved for judgment in their favor, arguing that the plaintiff’s claims were barred by the intended payee defense. The court was unpersuaded, however, ruling that the intended payee defense was not applicable, choosing instead to let the case proceed past the pleading stage. Roberts v. Wachovia Bank, N.A., No. 09 Civ. 1968 (S.D.N.Y. Sept. 16, 2010).

The Plaintiff’s Claims

The plaintiff, Darren Roberts, was allegedly a victim of fraud. Roberts was approached by a man who identified himself as Michael Howard. Howard allegedly told Roberts that he had advanced funds to Chad Adler, Roberts’ friend and business associate, for the purchase of a defaulted mortgage note. After building a relationship, at Howard’s request, Roberts made two payments to Howard totaling $85,000, based on Howard’s representation that the money would be used to satisfy Adler’s debt to Howard. Roberts wrote two checks payable to “Michael Howard” and “Mike Howard” in the amounts of $80,000 and $5,000, respectively.

Unbeknownst to Roberts at the time, Howard was actually Michael Howard Clott, a felon with multiple convictions for mortgage fraud, who had never loaned any money to Adler. After Clott received the checks from Roberts, he altered them by adding “Clott” to the payee’s name. Clott then endorsed the altered checks and presented them for deposit into his account at Wachovia. Wachovia accepted the altered checks, and then sent them to Roberts’ bank, Commerce Bank, N.A. (Commerce), for payment. Commerce also accepted the checks, and paid Wachovia from Roberts’ account.

Roberts eventually discovered Clott’s true identity, and he and Adler filed suit against Clott in New York state court, which entered a judgment against Clott by confession in the amount of $539,675. Roberts then brought suit against Wachovia and T.D. Bank, as successor in interest to Commerce, to recover the $85,000 and costs and attorneys’ fees, alleging that the alterations on the checks were “materially apparent,” and that his losses would have been prevented had the banks not accepted the checks.

The Intended Payee Defense

The defendant banks moved for judgment on the pleadings pursuant to Rule 12 of the Federal Rules of Civil Procedure. Under this rule, after accepting all the factual allegations in the complaint as true and drawing all reasonable inferences in favor of the plaintiff, the court will dismiss a complaint if it fails to state a plausible claim for relief. In support of their motion, defendants argued that Roberts’ claim was precluded by the intended payee defense.

According to the banks, the intended payee rule provides that whenever the proceeds of a check reach the intended beneficiary, notwithstanding the fact that the check may have been altered or not properly endorsed, the drawer of the check cannot recover these proceeds from the bank which mistakenly accepted the check. Thus, since Roberts admitted he intended to make a payment to Clott, albeit under false pretenses, and Clott did receive the proceeds of the checks, he may not recover his losses against the bank for accepting the altered checks. Essentially, the defendants maintained that Clott’s fraud, and not the banks’ error, caused Roberts’ losses.

Roberts did not dispute this understanding of the intended payee defense, in theory, but argued that the defense does not apply where the plaintiff has alleged and suffered a loss. Roberts noted that, generally, when courts apply the intended payee defense, the drawer of the checks has not alleged that he suffered a loss attributable to the bank. Roberts insisted that his complaint was more precise, as it specifically alleged that he suffered an $85,000 loss, and that the loss would have been prevented had the banks not accepted the checks. Because the complaint alleged a loss attributable to the banks, Roberts contended the defense did not apply.

The Court’s Ruling

In his opinion, Judge Crotty first clarified that, while New York law did not specifically acknowledge the intended payee defense by name, it recognized it under the rubric of unjust enrichment. In Tonelli v. Chase Manhattan Bank, N.A., 363 N.E.2d 564 (1977), the New York Court of Appeals—the state’s highest court—had affirmed an “equitable defense . . . based on the view that the drawer should not be permitted to recover from the drawee bank where he has suffered no loss from the improper payment of a check.”

Although receptive to the concept of the intended payee defense, the court found that the question of whether the rule applies depended largely on the circumstances of the case, and is more “nuanced” than the brightline rules suggested by the parties. As the court explained: “Defendants’ understanding of the defense is too broad; Plaintiff’s too narrow. The intended payee’s receipt of the proceeds of an altered check does not ipso facto immunize banks from liability for improper payment. Nor does a loss by the drawer necessarily preclude banks from avoiding liability when the intended payee has received the proceeds of an altered check. The inquiry is more nuanced.” According to the court, the most significant issue when analyzing the application of the intended payee defense is causation. The “focus of the intended payee rule is not on the acts of the intended payee or third-parties, instead . . . the focus is on the extent to which the improper payment of the check contributed to the loss suffered by the plaintiff—even if the originating cause of the loss is the intended payee or a third-party.”

The court briefly reviewed some of the caselaw cited by both parties to demonstrate the importance of causation. For example, while the defendants argued that banks can never be held liable when the intended payee receives the funds, the court referred to previous cases holding banks liable, even when the intended payee receives the money, if the alterations on the check defeated the drawer’s specific purpose. The court noted a situation whereby the drawer had marked a check to reflect a desire to pay money into a designated account. Where the intended payee alters the checks to defeat the drawer’s intent, deposits the money into a general account and it is then misappropriated, banks do not automatically avoid liability based on the fact that the intended payee received the money, since they could have prevented the drawer’s loss.

Similarly, the court found that Roberts’ contention that the intended payee defense cannot apply if the drawer suffers and alleges a loss to be an overstatement. The court noted that, in cases of fraud, the drawer always suffers a loss; even if the drawer did intend to pay a fraudster, he has still lost the money. Thus, according to the court, the important issue is the extent to which the bank contributed to the loss. Judge Crotty cited a New York case that applied the intended payee defense despite a clear loss by the drawer. In that case, unendorsed checks were improperly deposited into a business account, and the proceeds were misappropriated by an officer of the company. The business filed suit against the banks for accepting the unendorsed checks, but the case was dismissed. Although the plaintiff had suffered a loss and the banks should not have accepted the unendorsed checks, the loss was attributable to the fact that the business had failed to establish separate bank accounts or procedures to limit account access, leaving it exposed to misappropriation. The court also discussed a case involving a Ponzi scheme. After losing money, the victim filed suit against a bank, which had accepted his checks even though the Ponzi scheme operator had failed to endorse them. Although the victim had lost money, the court dismissed the case by noting that, even if the checks were not accepted, the Ponzi scheme operator would have simply been asked to sign the checks and redeposit them. Thus, the loss was attributable to the fraud and not the bank’s mistake.

In the current case, by focusing on the element of causation, Judge Crotty determined that the intended payee defense did not apply, and denied the defendants’ motion for judgment on the pleadings. The court explained that, if Roberts’ allegations were accepted as true, the alterations were “clearly apparent,” and the banks should have never accepted the checks. And without the banks’ mistake, Clott would not have received the $85,000, his scheme would have been foiled and Roberts’ losses would have been avoided. “[T]he improper payment was a substantial factor in causing plaintiff’s loss, and therefore Defendants cannot avoid liability— at least on the well-pleaded facts in the Complaint— based on the intended payee defense.” While surviving dismissal, to prevail on his claims Roberts must now prove that the banks’ mistakes were indeed a “substantial factor” in his loss to recover.

Implications

Roberts v. Wachovia Bank demonstrates that, at least under New York law, the intended payee defense may not be an automatic bar against potential claims based on the use of altered checks. Many courts will not mechanically apply the test, but rather will undertake a detailed analysis to determine whether the particular circumstances of the case warrant its application. The court’s opinion here suggests that the analysis may turn on the precision with which the plaintiff alleges causation.