FINANCIAL SYSTEMS: OUTLINE
Commercial Law: Exam #2
THE LAW OF CHECKS
The law of checks is governed by Article 3 and 4 of the UCC.
I. THE BANK CUSTOMER RELATIONSHIP
Negotiable Instrument: UCC 3-104(a): A negotiable draft is an unconditional order to pay a fixed sum of money if it (1) is payable to bearer or order at the time it is issued or first comes into possession of a holder; (2) is payable on demand or at a definite time; and (3) does not state any undertaking or instruction by the person ordering payment to do any act in addition to the payment of money.
Draft: order from one person to another, ordering the second person to pay money as directed
Check. 3-104(f): (I) a draft payable on demand and drawn on a bank.
When a purchaser writes a check, that check is “drawn” on the purchasers account at the bank.
The Bank is then the “drawee” or “payor bank”
UCC 3-103(a)(2) Drawee: Person ordered in a draft to make payments.
The person that directs the payment by writing the check is called the “drawer” or “issuer”
a. UCC 3-103(a)(3) Drawer: person who signs or is identified in a draft as a person ordering payment.
The person to whom the check is “issued” (written) is the “payee.”
If the payee does not have an account at the drawee (payor bank) the process of collecting on the check will involve one or more intermediaries between the payee and the payor bank. For example, the payee is most likely to deposit the check in his bank, which makes his bank the “depository bank.”
a. UCC 4-105(2) Depositary bank: the first bank to tank an item even though it is also the payor bank, unless the item is presented for immediate payment over the counter.
Furthermore, if other banks handle the check before it gets from the depositary bank to the payor bank, they also are “intermediary banks.”
a. UCC 4-105(4) Intermediary bank: bank to which an item is transferred in course of collection except the depositary or payor bank.
Collecting bank. 4-105(5): Bank handling an item for collection, except the payor bank.
A. THE BANK-CLIENT RELATIONSHIP
When a customer opens an account at a bank, he deposits money there. When you deposit money to a bank is a loan to the bank. The bank becomes a debtor that owes you the creditor, the amount of the deposits that you make. The loan that you make is called a “demand loan,” because you can demand the money back at any time.
The bank also agrees to pay part of the debt that it owes to you to any third person whom you direct the bank to make that payment. The bank acts as your agent for purposes of following your directions to pay the payee. Because the bank is your agent, it owes you certain obligations.
B. Two aspects of the bank-client relationship are governed by two types of rules:
The rules that say when the bank may pay out the customer’s money.
The rules that say when the bank must pay out the customer’s money.
Note: When the bank pays a check, it honors the check. When the bank doesn’t pay the check, the bank dishonors the check.
(1) THE BANKS RIGHT TO PAY. When may the bank pay the obligation?
4-401(a): It is proper for the bank to charge a customers account for any item that is properly payable even though the charge creates an overdraft. An item is properly payable if the customer has authorized the payment. (Writing a check, signing it, and delivering it to the payee).
Comment 1: An item containing a forged drawer’s signature or forged indorsement is not properly payable.
A check is properly payable to the payee or to anyone who the payee lawfully authorizes the payment to be transferred. (“Pay to the order of.”)
Issue: What happens if the customer authorizes payment by writing a check, but the account does not have enough funds to cove the check when it arrives at the payor bank?
a. General rule: the payor bank is free to pay the check or dishonor it as the bank wishes (4-401(a)).
b. What amount of fees may banks charge when customers write checks against insufficient funds?
(i) UCC does not regulate the fees itself.
(ii) Too high of fees may violate the obligation of good faith or be unconscionable.
In the checking system, the customer that changes its mind can prevent payment by giving adequate and timely notice to its bank that it wishes to “stop” payment.
There is nothing wrong or illegal or improper as between the bank and the customer to stop payment. A customer has every right to stop payment on the checks. The bank can care less than what third party rights are involved, as the bank is the customers AGENT.
UCC 4-403. Customers right to stop payment
(a) A customer (not necessarily the drawer – anyone who can authorize draw on the account, even though they did not draw) may stop payment by an order to the bank describing the item with reasonable certainty (giving information that is MICR readable) received at a time and in a manner that affords the bank a reasonable opportunity to act on it (before the bank has paid on the check) before any action by the bank with respect to the item described.
(b) A stop payment is effective for 6 months, unless it was oral and a writing was not given confirming it within 14 days.
(c) Customer has burden of proof of harm if the bank pays. The loss resulting from payment of an item contrary to a stop payment order may include damages for dishonor of subsequent items. (A defense to this under 4-407 (below) is that the drawer suffered no loss because it would have been liable to a holder in due course in any event (comment 1)).
Comment 7: However, a payment in violation of an effective direction to stop payment is an improper payment, even though it is made by mistake or inadvertence. Any agreement to the contrary is invalid.
MICR: Magnetic Ink Character Recognition.
WHAT ARE THE REMEDIES FOR A BANKS IMPROPER PAYMENT?
General rule: The remedy for an improper payment is that the bank should reverse the improper transaction. Thus, the bank should recredit the customers account with funds improperly paid out, so that the balance in the customers account will be the same as it would have been if the bank had not made the improper payment. (This is not in Article 4, but this is still the general rule).
4-402(b): A payor bank is liable to its customers for damages proximately resulting by the wrongful dishonor of an item. Liability is limited to actual damages proved and may include damages for an arrest or prosecution of the customer or other consequential damages (if consequentials are proved in that case).
(2) THE BANKS OBLIGATION TO PAY. When must the bank pay the check?
4-401(a): Bank has an obligation to pay checks that are properly payable and where there will be no overdraft, or the bank has agreed to pay for any overdraft. Should they not fulfill this obligation, they wrongfully dishonor it.
1. When are funds available for payment?
General rule: If the account has funds available to cover the item, the bank no longer has an option to pay the item, but instead has an affirmative obligation to its customer to pay the item.
2. Wrongful dishonor: What happens if the bank refuses to pay.
When a bank violates its agreement with its customer by failing to pay a properly payable check “wrongful dishonor.” 4-402(a).
4-402(b): A payor bank is liable to its customers for damages proximately caused by the wrongful dishonor of an item. Liability is limited to actual damages proved and may include damages for an arrest or prosecution of the customer or other consequential damages.
Traditionally, courts could not properly pay a postdated check. However, because of the MICR machine, Article 4 has stated that postdated checks are properly payable.
a. Exception: 4-401(c): A postdated check is properly payable unless the customer has given notice to the bank of the postdating describing the check with reasonable certainty. The notice must be received at such time and in such manner as to afford the bank a reasonable opportunity to act on it before the bank takes any action with respect to the check.
(i) Reasonable certainty: bank has to be able in some way as it comes through the MI
midnight deadline, may revoke the settlement if it
4-301(a)(1): returns the check; or
4-301(a)(2): sends written notice of dishonor if the check is unavailable for return.
(1-201(38): Send = mailing the item.)
If the payor bank does not do this by its midnight deadline, then the payor bank has finally paid the check. This is how final payment occurs in most case. (4-215(a)(2) (“An item is finally paid when the payor bank . . . settled for the item without having a right to revoke the settlement)
4-301(b): If the payee already has withdrawn the money from the account, the payor/depositary bank can sue him to recover the money. In that case, the payee may then sue the drawer for breach of contract, or on the instrument under 3-310.
Note: Any settlement that is not made in cash is a provisional settlement.
4-104(a)(10): Midnight deadline—midnight of the banking day following the banking day on which it receives the relevant item or notice or from which the time for taking action commences to run, whichever is later.
Note: the bank might say that anything that is received after 2 is going to be considered the next banking day, which means they have bought themselves an add on to the midnight deadline.
4-104(11) settlement: to pay in cash, by clearing house settlement, in a charge or credit or by remittance, or otherwise agreed. A settlement may be provisional or final [final is only when the check is cashed.]
B. OBTAINING PAYMENT THROUGH INTERMEDIARIES (Presentment through banking channels)
When the payee cannot cash the check or deposit it at the payor bank, the payor must deposit it at his bank. In order to get payment, there must be two separate steps: (1) check goes from payee to depositary bank and (2) what happens when the check goes from the depositary bank to the payor bank.
1. WHEN THE BANK IN THE NORMAL SITUATION DECIDES TO HONOR THE CHECK.
When the customer deposits the check into his account (1) the bank where the customer has deposited the check (depositary bank) agrees that it will obtain payment for the customer from the payor bank—it is then a collecting bank (acts as an agent). (2) While it is attempting to obtain payment, the depositary bank ordinarily gives the customer a provisional settlement for the item (credit for the amount of the check)
This is provisional because the depositary (collecting) bank has the right if the payor bank does not honor the check to revoke the settlement and take the money back out of the customers account (charge back the provision credit), or obtain refund by the customer. (see 4-214)
When the midnight deadline passes, the payment becomes final.
2. WHAT HAPPENS WHEN THE BANK DECIDES TO DISHONOR THE CHECK
In this case, the depositary bank gives provisional settlement to its customer and the bank passes the check on to payor bank, but there is insufficient funds.
The payor bank may dishonor the check so long as by its midnight deadline the bank returns the check to the depositary bank. This avoids final payment.
When the depositary bank gets it back, it has until midnight of its next banking day to charge back the account (it debits the account) 4-214(a). It also returns the check to the payee. This is dishonor and it avoids final payment. Under the UCC all the bank ahs to do is return the check.