Claim for forged checks covered under forgery coverage of Financial Institution Bond No. 24 because checks were “finally paid” under Michigan Uniform Commercial Code

by Chris Graham and Joseph Kelly

Seaway Community Bank v. Progressive Casualty Insurance Co., Case No. 11-2575 (6th Cir. Aug. 8, 2013)

A customer of Seaway Community Bank deposited three checks payable to him via a Canadian bank over a span of four months. Seaway cashed the checks – but the checks were fraudulent as the original payee on the checks was deleted and Seaway’s customer’s name was added as payee.

Seaway submitted a proof of loss to Progressive and sought coverage under Insuring Agreement D which provides coverage for:

Loss resulting directly from the Insured [Seaway] having, in good
faith, paid or transferred any Property in reliance on any Written,
Original (1) Negotiable Instrument . . . which . . . is altered, but
only to the extent the alteration causes the loss.

Progressive denied coverage based on Exclusion O which excludes coverage “loss resulting directly or indirectly from payments made or withdrawals from a depositor’s account involving items of deposit which are not finally paid for any reason, including but not limited to Forgery or any other fraud. . .”

The District Court granted summary judgment in favor Seaway and the Sixth Circuit affirmed. The Sixth Circuit outlined the process of check cashing generally and under Michigan law, stating in pertinent part:

  • The check-collection process begins when a customer deposits a check for collection in a “depository” bank, defined as “the first bank to which an item is transferred for collection even though it is also the payor bank.”
  • Here, Seaway was the depository bank. Seaway paid its customer, and then it sought payment on each check he had deposited by transferring each of them through one or more “intermediary” banks, defined as “any bank to which an item is transferred in the course of collection except the depository or payor bank.”
  • Each bank in the collection process “settles” for a check by various means, including by paying cash.
  • Giving credit to the prior intermediary bank is the most common method of settlement.
  • In other words, each intermediary bank that transfers the check to the next intermediary bank receives a provisional credit from the transferee, with the penultimate intermediary bank in the collection chain receiving its provisional credit from the bank upon which it was drawn, called the “payor” bank, which means “`a bank by which an item is payable as drawn or accepted.'”
  • Here, the payor bank for each of the checks was a Canadian bank.
  • To revoke a settlement, the payor bank must return the item before its midnight deadline, defined as “midnight on its next 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.”
  • If the payor bank decides not to finally pay the check—perhaps because it is fraudulent—then these provisional credits are reversed. Whether the payor bank decides to finally pay the check or dishonor it, under Article 4 of the Uniform Commercial Code, the payor bank must take action before midnight on the next banking day following the banking day on which the payor bank receives the check. This is known as the “midnight deadline” rule.
  • Under the midnight deadline rule, if the payor bank receives a check and does nothing by midnight on the following banking day, then the bank must pay the check.
  • Here, the checks from the Canadian payor bank were “finally paid” as that phrase is defined in the Uniform Commercial Code. Progressive states that the Uniform Commercial Code, and the midnight deadline rule, do not apply to Canadian banks. Therefore, the Canadian payor bank in this case could—and did—decide days after receiving the checks from the collecting bank that it was going to dishonor the checks because they were fraudulent.
  • The Canadian bank reversed the provisional credits all the way down the chain to Seaway. Because the fraudulent checks at issue in this case could never be “finally paid,” Progressive argues, they fall under Exclusion (o), which provided that Progressive did not have to pay Seaway for losses incurred on checks not “finally paid.”
  • The phrase “finally paid” has a clear meaning within the banking industry: it means when the midnight-deadline rule applies under the Uniform Commercial Code.

In conclusion, the Sixth Circuit held:

  • The Exclusion does not say whether or not checks drawn on Canadian banks are to be exempted from Michigan’s version of the Uniform Commercial Code’s definition of “not finally paid.” Applying the Uniform Commercial Code, the checks were finally paid. Therefore, Exclusion (o) could not apply, and Progressive must indemnify Seaway.

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