Understanding and preventing payment fraud.

• Author: Fletcher, Michael M.

Until the last 10 years, the primary exposure of governments to payment fraud was the dishonesty of their own employees. Sophisticated check fraud required special skills and an investment in expensive printing equipment. And since sole responsibility for fraudulent check stock and signatures rested with the banks, losses from external sources were not considered important enough to warrant serious attention.

Times have changed. With the advent and proliferation of inexpensive personal computers, desktop publishing software, laser printers, and blank check stock, almost anyone can alter or counterfeit checks. Indeed, payment fraud has blossomed into a $10 billion dollar industry. At the same time, changes in the Uniform Commercial Code have distributed the liability for payment fraud among banks and their customers. As a result, public entities are more vulnerable to payment fraud than ever before. This article provides tips on how governments can mitigate the risks and lower the costs of payment fraud.

ON THE HOOK

Historically speaking, financial institutions have been responsible for losses resulting from payment fraud. However, the legal liability for check fraud losses has now shifted to depositors. This section describes the changes that precipitated this increased liability and highlights specific issues that governments should be aware of.

Changes in the regulatory environment. Following the deregulation of the banking industry in the 1980s, banks began to aggressively manage the amount of time they could control a customer's funds. By delaying remittance only a few days, a bank could earn substantial additional revenue. In 1992, however, the Federal Reserve Board modified the rules to allow customers more rapid access to their deposits. Banks were required to make deposits available to depositors even before the check clearing process had been completed. The new regulation actually facilitated check fraud by giving criminals more time to complete fraudulent transactions.

Changes in the Uniform Commercial Code. The Uniform Commercial Code, which governs financial transactions in all 50 states, was modified in the mid 1990s, shifting some liability from the banking industry to depositors under the concepts of "ordinary care" and "comparative negligence." Consider UCC Section 3-103:

Ordinary care in the case of a person engaged in business means observance of reasonable commercial standards, prevailing in the area in which the person is located, with respect to the business in which the person is engaged. In the case of a bank that takes an instrument for processing for collection or payment by automated means, reasonable commercial standards do not require the bank to examine the instrument if the failure to examine does not violate the bank's prescribed procedures and the bank's procedures do not vary unreason ably from general banking usage. In other words, check issuers may be precluded from recovering check fraud losses from their banks if their business practices contributed to the fraud. Notice that the code does not require banks to examine every check. This is a significant departure from the past.

Bank Contracts. Section 4-102(a) of the UCC allows banks to contractually modify to some extent their liability for payment fraud. The contract may also attempt to define the "reasonable commercial standards" of the area. Within the last year, customers of one of the country's largest banks received a certified letter informing them that the bank's definition of ordinary care included the use of positive pay on all checking accounts. The subsequent failure to implement positive pay has resulted in government customers absorbing fraud losses.

Governments need to pay particularly close attention to contractual provisions on the use of facsimile signatures and on bank reconciliation. A Florida court, for example, recently sided with a bank in disallowing the recovery of $4 million worth of counterfeit checks that passed using an exact replica of the...