In Tripp & Co. Inc. v. The Bank of New York (Del.) Inc. n/k/a. BNY Mellon Trust of Delaware, N.A., and Citibank (South Dakota) N.A., 2010 WL 2836999 (Sup. Ct. N.Y. Co.) (Jul. 14, 2010), a case decided in the Commercial Division of the New York State Supreme Court, the court dismissed all of the claims brought by plaintiff Tripp & Co., Inc. (“Tripp”) against defendants Citibank, N.A. (“Citibank”) and The Bank of New York (Del.), Inc. (“BNY”) in connection with a fraudulent check scheme perpetrated by Tripp’s employee, Michael Axel. The eight claims brought by Tripp sounded in conversion, gross negligence and negligence. In dismissing the conversion claims, the court relied upon Section 3-405 of the Uniform Commercial Code (“UCC”), also known as the “imposter rule,” which shifts the risk of loss from depositor or drawee banks to the drawer of the checks. The common law claims for negligence and gross negligence were dismissed because of the existence of applicable UCC provisions.

Background

As a small brokerage firm, Tripp engaged clearing service Pershing, LLC (“Pershing”) to maintain its customers’ assets in a brokerage account. When Tripp needed to issue a check to one of its customers, Tripp would make a request to Pershing and Pershing would issue checks payable to Tripp’s customers from Pershing’s account. Pershing’s account was managed by defendant BNY. As part of Axel’s employment at Tripp, he was authorized to make check requests to Pershing on behalf of Tripp’s customers. Axel’s authority to make those check requests is what enabled him to perpetrate his fraudulent scheme. Specifically, Axel would make check requests to Pershing on behalf of Tripp’s employees, inscribe on the check “Pay to Michael Axel,” forge the payees’ names, and then cash or deposit the checks into his personal bank account at defendant Citibank. Citibank accepted the deposits and made payments on the checks and BNY accepted and cleared the checks.

Axel made 220 fraudulent check requests over five years, resulting in the misappropriation of over $624,000. Through receipt of funds from its insurance company and a plea agreement with Axel, Tripp was able to recover $624,000 and reimburse its customers. Ultimately, however, Tripp was unable to recover from the customer disruption caused by Axel’s fraud and went out of business.

The General Rule v. The Imposter Rule

In general, for improper payment of a forged indorsement, the risk of loss is imposed upon the drawee bank. Tripp, 2010 WL at *2, citing UCC §1-201[43] (McKinney 2010); UCC §3-401 (McKinney 2010). Applied to the facts of this case, that general rule would have imposed liability on BNY, as drawee (or even Citibank, as depositor). Section 3-405 of the UCC, also called the imposter rule, however, shifts the risk of loss from the banks to the drawer of the checks. Section 3-405 provides that “[a]n indorsement by any person in the name of a named payee is effective if . . . the 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.”

The principle behind the imposter rule is that the drawer of the check is in a better position to detect a fraud by one of its agents or employees than the drawee or depositor bank. Moreover, businesses can purchase insurance coverage to protect against losses caused by their employees’ commission of a fraud. The Official Comment to Section 3-405(i)(c), cited by the court, provides:

The principal followed is that the loss should fall upon the employer as a result of his business enterprise rather than upon the subsequent holder or drawee. The reasons are that the employer is normally in a better position to prevent such forgeries by reasonable care in the selection or supervision of his employees, or, if he is not, is at least in a better position to cover the loss by fidelity insurance; and that the cost of such insurance is properly an expense of his business rather than of the business of the holder or drawee.

In this case, the drawer of the check was non-party Pershing. The fact that Axel was employed by Tripp and not by Pershing, however, was not an impediment to the court’s application of Section 3-405. Instead, the court reasoned that Axel was an agent of Pershing, the drawer of the checks, thus making the imposter rule applicable. The court held:

Pershing and Axel had a ‘well-established course of dealing’ lasting for at least five years, in which Axel supplied the payee information so that Pershing could simply draw the checks. [T]he action of supplying payee information on behalf of a brokerage firm to its clearinghouse is very much ‘normal business practice’ of an employee. Axel, as an agent of Pershing (the drawer), supplied the names of the payees, intending the latter to have no such interest, such that the imposter rule applies and the indorsements are legally effective.

Although the court’s application of the imposter rule focused on the relationship between Axel and Pershing and the well-established course of dealing among the parties, the court did not lose sight of the fact the fraud was covered by an insurance policy. The court held: “The facts here make application of the rule reasonable. Tripp was in a position to prevent the fraud in its hiring and monitoring of Axel and actually collected on an insurance policy that covered Axel’s fraudulent conduct—an insurance policy that is properly a business expense of Tripp’s rather than of the holder or drawee.”

No Duty of Care Owed by Banks

Characterized as a “banker’s provision,” the imposter rule not only shifts the risk of loss from the depositor or drawee bank to the drawer (or employer), but the rule will render fraudulent indorsements legally effective even if the depositor or drawee bank acted in a commercially unreasonable manner. Put simply, “Section 3-405 imposes no duty of care.” As such, according to the court, Tripp’s suggestion that “the quantity and double-indorsed nature of the checks, frequency of deposits, and amount and duration of the fraud” should have caused the defendants to investigate, was insufficient as a matter of law. Indeed, the court noted that while the imposter rule does not protect banks from claims of commercial bad faith, i.e. knowing participation in a fraudulent scheme, “‘wary vigilance’ [or] even ‘suspicious circumstances which might well have induced a prudent banker to investigate,’ would be insufficient to state a cause of action against a depositary bank.”

Common Law Claims Pre-Empted by UCC Claims

The court dismissed Tripp’s common law claims for negligence and gross negligence because of the existence of applicable provisions of the UCC, noting that

“[a] plaintiff may not ‘sidestep’ the UCC by merely attempting to restate a failed UCC claim as a common law cause of action.” The sole exception to that rule, as explained by the court, applies when a bank neglects a restrictive indorsement provision, for example, an indorsement “for deposit only.” Finding that defendants Citibank and BNY “deposited and withdrew the checks in full compliance with the drawer’s instructions,” that narrow restrictive indorsement exception did not apply.