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July 27, 1979

Girard Bank, Plaintiff,
Mount Holly State Bank, Defendant, v. Darlene Payung and Penn Mutual Life Insurance Company, Third-Party Defendants.

The opinion of the court was delivered by: BROTMAN

This case presents intriguing questions concerning commercial paper transactions and Articles 3 and 4 of the Uniform Commercial Code. In particular, the court must determine to what extent the negligence of the drawer of a check affects the liability of a depository bank for a forged indorsement under the U.C.C. and common law. The drawee bank has sued the depository bank on its presentment warranty and now seeks summary judgment, while the depository bank defends by asserting the drawer's negligence. The depository bank has also sued the drawer directly in a third-party claim, on which the drawer now seeks summary judgment. The court is asked to hold that certain types of negligence by the drawer, no matter how serious, will not preclude liability of a depository bank or other party taking a check bearing a forged indorsement.

I. Factual and Procedural Background

 Certain facts are not disputed by the litigants. On August 4, 1977, third-party defendant Penn Mutual Life Insurance Company issued its check numbered 377406, dated August 4, for $ 28,269.54 to a Morris Lefkowitz of New York City, as a return of a policy premium. The check was drawn on Penn Mutual's account at plaintiff Girard Bank in Philadelphia. The check, prepared and signed in Philadelphia, was to be sent by mail to Penn Mutual's agency in New York for distribution to Mr. Lefkowitz.

 On August 5, third-party defendant Darlene Payung deposited the check in her account at Mount Holly State Bank of Mount Holly, New Jersey, the defendant and third-party plaintiff. The check bore a forgery of Mr. Lefkowitz's signature as an indorsement; the origin of the forgery is disputed. Ms. Payung also added her signature as an indorsement when she deposited the check. Mount Holly transferred the check through normal banking channels to Central Penn National Bank of Philadelphia, which then presented it for payment to the drawee and payor, Girard. Mount Holly, the depository and a collecting bank, recovered the full amount of the check from Central Penn.

 The facts surrounding the discovery of the forgery are disputed but much of the evidence submitted for these summary judgment motions is uncontroverted. According to a Penn Mutual official, its New York agency first alerted the Philadelphia office that the check had not been received by a telephone call on August 19; the agency had become aware about August 11 that the check might be missing. Deposition of Ronald M. Sherlock at 74-75. Mr. Sherlock further states that both Girard and Mount Holly were notified that the check was missing on the 19th. Id. at 74-75, 86.

 John Hall, executive vice president of Mount Holly, has indicated in his deposition that Mr. Sherlock indeed notified Mount Holly on the morning of the 19th, enabling the bank to freeze the remaining $ 5600 in Ms. Payung's account. Deposition of Hall at 8-9. Most of the proceeds had already been withdrawn by Ms. Payung. Id. at 13-14.

 Mr. Sherlock of Penn Mutual also discussed the check with a Girard Bank officer on August 25, the same day that Mr. Lefkowitz signed an affidavit swearing that the indorsement was forged. Deposition of Sherlock at 86; Plaintiff's Exhibit B. That telephone conversation was confirmed by letter dated August 26 from Penn Mutual to Girard. Affidavit of Robert Torzone P 3 and Accompanying Exhibit A.

 It is not certain how the check was stolen and forged. Mount Holly maintains that several checks had been stolen by Penn Mutual employees prior to August 4, and that the company knew of the problem and unreasonably failed to take proper security measures. The defendant further contends that it can prove at trial that the Lefkowitz check, which was deposited at Mount Holly the day after it was drawn, was stolen by a Penn Mutual employee.

 II. Drawee's § 4-207 Claim

 A. Choice of Law

 Neither party disputes that New Jersey law applies to Girard's claim against Mount Holly. This court must follow the choice of law rule of New Jersey in determining what state's substantive law should apply. Klaxon Co. v. Stentor Electric Manufacturing Co., 313 U.S. 487, 61 S. Ct. 1020, 85 L. Ed. 1477 (1941). Section 4-102(2) of the Uniform Commercial Code, as codified in New Jersey, N.J.Stat. 12A:4-102(2), states in pertinent part:

(2) The liability of a bank for action or non-action with respect to any item handled by it for purposes of presentment, payment or collection is governed by the law of the place where the bank is located.

 The term "liability" in the statute is most logically construed to mean the legal liability of the collecting bank, Mount Holly, on its presentment warranty, rather than the actual loss to the drawee bank, Girard, if its warranty claim is unsuccessful. This construction is supported by Official Comment 2 c. *fn1" Accordingly, the law of New Jersey, where Mount Holly is located, will apply to Girard's claim.

 B. Presentment Warranty

 Girard seeks recovery for Penn Mutual's breach of its presentment warranty under N.J.Stat. 12A:4-207(1)(a). (Further citation to the Code will omit the codification title N.J.Stat. 12A, and titles in other states where an enactment of the Code is construed.) That statute provides in pertinent part:

4-207. Warranties of Customer and Collecting Bank on Transfer or Presentment of Items; Time for Claims.
(1) Each customer or collecting bank who obtains payment or acceptance of an item and each prior customer and collecting bank warrants to the payor bank or other payor who in good faith pays or accepts the item that
(a) he has a good title to the item or is authorized to obtain payment or acceptance on behalf of one who has a good title; . . .

 The forged indorsement prevented Mount Holly, the depository and collecting bank, from obtaining good title to the check, and Mount Holly therefore breached its warranty. See § 3-417, Comment 3; § 4-207, Comment 1; J. White & R. Summers, Uniform Commercial Code 510 & n. 37 (1972). *fn2" The overriding scheme of the Code is to place liability on the person who takes from the forger, which is often the depository bank. The rationale is that this party is normally in the best position to detect the forgery and prevent the fraud. See, e.g., Perini Corp. v. First National Bank of Habersham County, 553 F.2d 398, 405 (5th Cir. 1977). This has long been the policy of negotiable instruments law. See, e.g., Standard Accident Insurance Co. v. Pellecchia, 15 N.J. 162, 189, 104 A.2d 288, 302-03 (1954).

 This policy is reflected throughout Articles 3 and 4 of the Code. Various sections indicate that a check bearing a forged indorsement is not "properly payable" within the terms of § 4-401(1). See Perini, 553 F.2d at 403 & n. 7. That section indicates that, absent cognizable negligence on the part of the drawer, the drawee bank may not charge the drawer for a check that is not "properly payable." However, the drawee which has paid the check may seek recovery against prior banks in the collection chain for breach of presentment warranty under § 4-207. The depository bank may also sue the prior transferring party under a similar warranty provided in § 3-417. In the instant case, Mount Holly, if found liable to Girard, may be able to shift the loss back to the prior transferor, Ms. Payung. However, it is often the case that a depository bank will be unable to recover from a prior party and will ultimately bear the loss.

 While the Code essentially presumes that the depository bank (or prior party) was negligent in accepting the check and should be held liable, that bank can sometimes shift the loss to the drawer or drawee if those parties were negligent. Mount Holly does not deny the applicability of § 4-207 here, but raises various negligence defenses under several Code provisions.

 C. § 4-207(4) Defense

 Mount Holly first contends that it is relieved of liability on its warranty by subsection (4) of § 4-207, which states:

(4) Unless a claim for breach of warranty under this section is made within a reasonable time after the person claiming learns of the breach, the person liable is discharged to the extent of any loss caused by the delay in making claim.

 Mount Holly argues that there is a genuine issue of material fact precluding summary judgment as to whether Girard asserted its claim within a reasonable time.

 While reasonableness has been held to present a fact question, Phoenix Assurance Co. v. Davis, 126 N.J.Super. 379, 391, 314 A.2d 615, 622 (Law Div. 1974), the court finds there is nothing in the record to show that Mount Holly suffered a loss as the result of any delay by Girard in making its claim against Mount Holly. Mount Holly's vice president stated in his deposition that the bank was notified of a problem the morning of August 19, and immediately froze the remaining proceeds of the check. Uncontroverted evidence also indicates that Girard was first notified of the problem on August 19. Therefore any delay in Girard's noticing Mount Holly could not possibly have caused any loss since all proceeds of the check were frozen the same day Girard first learned it had a claim against Mount Holly. There is no factual issue here, and this defense can be precluded as a matter of law. See Twellman v. Lindell Trust Co., 534 S.W.2d 83, 99 (Mo.App.1976).

 D. § 3-405 Defense

 Mount Holly next asserts that § 3-405 of the Code precludes Girard's warranty claim. This section provides:

3-405. Impostors; Signature in Name of Payee.
(1) An indorsement by any person in the name of a named payee is effective if
(a) an impostor by use of the mails or otherwise has induced the maker or drawer to issue the instrument to him or his confederate in the name of the payee; or
(b) a person signing as or on behalf of a maker or drawer intends the payee to have no interest in the instrument; or
(c) an 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.
(2) Nothing in this section shall affect the criminal or civil liability of the person so indorsing.

 The section does not explicitly place liability on the drawer; rather it renders a forged indorsement "effective," thereby precluding liability of a collecting bank on a § 4-207 warranty and liability of a drawee bank to its customer under § 4-401, thus shifting the loss to the drawer. See White & Summers, Supra at 541-43. These provisions can be invoked against a drawer which has been defrauded in certain specified ways. Mount Holly believes that § 3-405(1)(c) is applicable here. Paragraph (1)(c) refers to the padded payroll situation where the drawer is defrauded by its employee before or during preparation of its checks. See White & Summers, Supra at 542-44. The Code drafters have explained the policy behind this paragraph in Comment 4:

The principle followed is that the loss should fall upon the employer as a risk 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.

 Taking Mount Holly's contentions as true, the most it could show at trial is that a dishonest Penn Mutual employee had stolen a properly prepared check. There is no evidence whatsoever indicating that an employee added Mr. Lefkowitz's name to a list of payees intending him not to receive the check. It is undisputed that the company intended to pay the true Mr. Lefkowitz.

 The New Jersey Appellate Division, in an opinion affirmed by the supreme court per curiam, has held that simple conversion of checks by a dishonest employee through theft and subsequent forging of indorsements is not within the meaning of paragraph (1)(c). Snug Harbor Realty Co. v. First National Bank of Toms River, 105 N.J.Super. 572, 253 A.2d 581 (App.Div.), Aff'd, 54 N.J. 95, 253 A.2d 545 (1969). The court noted that the payees were bona fide creditors of the company. 105 N.J.Super. at 574, 253 A.2d at 582. The Third Circuit Court of Appeals, applying Pennsylvania's § 3-405, has also held that paragraph (1)(c) is inapplicable where ...

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