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Alabama Supreme Court Holds Bank of First Deposit Must Bear Liability for Under-Encoded Check

On September 30, 2014, the Alabama Supreme Court issued an important decision with wide-ranging implications for depositary institutions.  In the case of Troy Bank and Trust Co. v. The Citizens Bank, 2014 WL 4851511 (Ala. 2014), the Court held that a bank that "under-encodes" a check is strictly liable for any loss caused by such an action under the Uniform Commercial Code.  

At the heart of the dispute between Troy Bank and Trust Co. ("Troy") and Citizens Bank ("Citizens") was a $100,000 check issued by Ronnie Gilley Properties, LLC ("RGP") to Cile Way Properties, LLC ("CWP"), drawn on RGP's account at Troy.   The payee CWP deposited the check in its account at Citizens.  Typically, when a depositary bank receives a check, it encodes the check with certain information--including the amount of the check--using magnetic ink character recognition technology to enable a machine to automatically process the check.  When Citizens received the $100,000 check in question, it inadvertently "under-encoded" the check in the amount of $1,000, and credited $1,000 to the CWP account.  Id. at *1.  Citizens then presented the check for payment through the Federal Reserve Board, and RGP's account at Troy was only debited $1,000 because of the inadvertently under-encoded check.  Id.  CWP discovered the error weeks later and Citizens filed an adjustment of $99,000 through the Federal Reserve Board, which was immediately paid by Troy to Citizens to credit the account of the payee.  Id.  

The trouble arose when Troy discovered that RGP had withdrawn its money from its account at Troy, and no longer had the funds to cover the additional $99,000 debit to its account.  Id.  Troy then sued Citizens to recover the damages caused by the encoding error.  Troy relied on Section 4-209 of the Uniform Commercial Code, which has been adopted by Alabama, and which provides that a person or bank who "encodes information on or with respect to an item after issue warrants to any subsequent bank and to the payor bank or other payor that the information is correctly encoded," and that the subsequent bank who suffers damages may recover from the initial bank for breach of that warranty.  Citizens moved for summary judgment, and alleged that Troy had failed to mitigate its damages by challenging the adjustment notice within a 20-day deadline prescribed by a Federal Reserve Board operating circular.  Id. at *1.   The Alabama trial court agreed with Citizens and granted summary judgment, holding that the challenge procedure established by the Federal Reserve Board governed and Troy was precluded from recovering from Citizens for the inadvertent under-encoding because of its failure to follow that procedure and its own alleged negligence.  Id. at *4-5.

The Alabama Supreme Court reversed, and held that though Troy could have challenged Citizens' adjustment claim by responding to its notice of adjustment, it was entitled to process the adjustment and sue for damages under the UCC warranty clause, Section 4-209.  Id. at *11.  The Court noted that the encoding warranty "operates to shift the liability" for an encoding error to the bank that makes the error, and precluding recovery by Troy would eviscerate the legislatively enacted protection for subsequent banks.  Id. at *11.  

The Alabama Supreme Court's decision in Troy is an important result for banks, as it ensures that strict liability will attach to the bank who has incorrectly encoded a check, and a "downstream" bank will not be liable for the initial error.  Fitch Law Partners LLP will continue to monitor developments in this important area throughout the country.

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