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McAdam v. Dean Witter Reynolds

filed: February 13, 1990.

THOMAS J. MCADAM, JR., MCADAM ELECTRIC COMPANY, INC., A NEW JERSEY CORPORATION; MCADAM PENSION PLAN, AND MCADAM ELECTRIC PROFIT SHARING PLAN
v.
DEAN WITTER REYNOLDS, INC. AND CLIFFORD B. MURRAY V. HAROLD TYSON AND MIDLANTIC NATIONAL BANK, MARTIN S. WILSON, PHILADELPHIA LIFE INSURANCE COMPANY, PROFESSIONAL BENEFIT CONSULTANTS, INC., MCADAM ELECTRIC COMPANY, THOMAS J. MCDONOUGH, JR., SCOTT A. CONESKY, THERESA CONESKY, EDWARD H. KAY, REGINA A. KAY, MARGARET WHITE, ELMER J. PARSONS, JR., NANCY L. PARSONS, JOHN J. SYKES, JR., ELEANOR DOWNER, S. WHITNEY DOWNER, LUCILLE ROBERTSON, GWENN GRAVES HAMILTON, ROBERT BROWN, BEVERLY A. BROWN AND MARY L. BROWN, DEAN WITTER REYNOLDS, INC., APPELLANT, NO. 89-5250, MIDLANTIC NATIONAL BANK/SOUTH, APPELLANT, NO. 89-5251, MORGAN GUARANTY TRUST COMPANY OF NEW YORK, APPELLEE, NO. 89-5251



On Appeal from the United States District Court for the District of New Jersey, D.C. Civil No. 84-1900.

Becker and Cowen, Circuit Judges; and Weis, Senior Circuit Judge.

Author: Cowen

Opinion OF THE COURT

COWEN, Circuit Judge.

This appeal arises out of a long and complex jury trial. The appellants, Dean Witter Reynolds, Inc. ("Dean Witter") and Midlantic National Bank/South ("Midlantic"), appeal the district court's entry of a judgment against them and in favor of the appellees, Thomas J. McAdam, Jr., McAdam Electric Company, McAdam Pension Plan, and McAdam Electric Profit Sharing Plan ("McAdam"). Midlantic also appeals the district court's entry of a judgment against it and in favor of appellee Morgan Guaranty Trust Company of New York ("Morgan"). Morgan was a defendant below, but was successful in its cross-claim against Midlantic.

The appellants raise numerous issues on appeal relating to their liability, and the award of compensatory damages, punitive damages and prejudgment interest against them. In addition, Midlantic objects to the award of attorneys' fees to Morgan on its successful cross-claim. Because we find no reversible error in the decisions of the district court involving liability, prejudgment interest, compensatory or punitive damages, we will affirm the judgments in favor of McAdam and against Dean Witter and Midlantic. However, because we find that the district court erred in awarding attorneys' fees to Morgan on its cross-claim against Midlantic we will vacate that portion of the judgment in favor of Morgan.

I

BACKGROUND

In 1980, McAdam opened several nondiscretionary investment accounts with Clifford B. Murray ("Murray"), an account executive with the brokerage firm of Dean Witter. These accounts were opened in the name of McAdam, his company, and the company's pension and profit-sharing plans. All of the funds were invested in safe, liquid investments. McAdam received monthly statements from Dean Witter reflecting the transactions made in these accounts.

In the latter part of 1980, Murray informed McAdam of a "special" investment opportunity that Murray said Dean Witter offered only to its preferred customers. Murray represented to McAdam that this "special" investment opportunity offered both a low risk and a high return. Murray also told McAdam that this account would not show up on his monthly Dean Witter statements, but that Murray would personally advise him of its status. Except for an assurance that drug money was not involved, McAdam was never informed of how this "special" account operated nor of its underlying securities. Nevertheless, McAdam testified that over the next few years he wrote out numerous checks to Murray for investment in the "special" account on behalf of himself, his company, and his company's pension and profit sharing plans. These checks were always made payable to Murray and, according to McAdam, totalled approximately $460,000.00.

The "special" account was later revealed to be an elaborate and fraudulent scheme set up by Murray, but not before numerous Dean Witter investors had already transferred sizable funds to Murray based on similar representations.*fn1 The sheer size of this scheme eventually forced Murray to make unauthorized raids on the nondiscretionary Dean Witter accounts of his regular customers, including McAdam. As the "special" account investors became increasingly impatient with the lack of the anticipated return on their investment, Murray began surreptitiously selling off securities in nondiscretionary accounts he managed and causing checks, payable to the account's owner, to be drawn by Dean Witter reflecting the balance from these sales. Murray would then forge his customers' endorsements on the checks and cash them at Midlantic.*fn2 With the proceeds from the forged checks, Murray attempted to mollify impatient "special" account investors by returning what he told them was "principal" on their investment. Incredibly, this financial juggling continued undetected for four years.

Thus, as he did with other "special" account investors, Murray periodically discussed the status of the "special" account with McAdam, always stressing that the account was doing fine and occasionally returning some of McAdam's investment "principal." The amount of the funds returned by Murray is contested by the parties. On direct examination, McAdam testified that Murray returned $162,000. However, the appellants developed evidence from which a jury could have found that a much higher figure had been returned.*fn3

It is clear that both Dean Witter and Midlantic helped facilitate Murray's scheme by failing to follow their own internal policies and procedures. For example, the jury heard evidence that Dean Witter failed to enforce its own policy both that all correspondence between a customer and an account executive must be reviewed by a supervisor and that all account executives must keep a daily diary from which a supervisor is supposed to review an account executive's activities. Furthermore, it was Dean Witter's written policy that any time a check was made payable to a customer and was subsequently handled by an account executive, that account executive must fill out a check receipt form, a supervisor must authorize the transaction, and the account executive must later obtain the customer's signature on the form acknowledging receipt of the check. This procedure was also not followed with regard to Murray and the forged checks.

Likewise, the jury heard testimony that Midlantic's supervisors deliberately broke or disregarded the bank's established rules and regulations concerning check cashing policy whenever a Dean Witter employee was involved in a transaction. Specifically, employees of the bank routinely cashed third-party checks for Murray, even though the checks were not drawn on Midlantic. Most of these third-party checks where quite large, including one for $475,000 payable to a Dean Witter customer's pension plan which, according to Murray, required the use of a suitcase to carry the cash out of the bank. Indeed, there was evidence showing that Murray cashed at least 120 third-party checks at Midlantic over a period of two years, totalling somewhere between $3-4 million. Employees of Midlantic also cashed checks payable to business entities, such as McAdam Electric Company, and pension and profit sharing plans, all in violation of the bank's policies. Such disregard for policy continued even after bank supervisors were warned of Murray's profligate check cashing. All of the forged checks were eventually presented by Midlantic to Morgan for payment.*fn4 The forged checks that belonged to McAdam, but which were cashed by Midlantic and paid by Morgan, totalled $466,992.71.

Evidence was also presented to the jury that once the scheme was uncovered in 1984, the lack of funds in McAdam's Dean Witter corporate accounts led to a dramatic effect on his company's profit picture. Both McAdam and his usual bonding agent, Richard H. Shepherd, testified that once word got out that McAdam and his company had suffered sizable losses due to a fraudulent scheme, it became extremely difficult for McAdam to secure the necessary bonding required for the large contracting projects his company had worked on prior to 1984. McAdam testified that this lack of bonding led to sizable lost business profits because contracting jobs which require no bonding are less profitable and highly competitive.

Thereafter, McAdam brought suit in state court against Murray and Dean Witter. The case was later removed to federal district court and consolidated for trial with another action brought by McAdam against Murray, Dean Witter, Midlantic and Morgan. McAdam's complaint alleged that Murray had committed fraud, breach of contract, breach of fiduciary duty and failed to pay McAdam for checks drawn on McAdam's investment accounts and made payable to him, in violation of N.J.Stat.Ann. § 12A:3-804 (West 1962). The complaint, at least as interpreted by the district court and as submitted to the jury, alleged that Dean Witter was vicariously liable to McAdam for Murray's breach of contract and fiduciary duty, and directly liable to McAdam for fraud, negligent supervision and for violating § 12A:3-804 as well. Morgan and Midlantic were alleged to have converted the forged checks in violation of N.J.Stat.Ann. § 12A:3-419(1)(c) (West 1962). In addition, McAdam charged that Murray, Dean Witter and Midlantic had all violated federal and state securities laws, as well as the federal R.I.C.O. Act, 18 U.S.C. § 1961-1966 (Supp. V 1987). Later in the litigation, Morgan brought a cross-claim against Midlantic for breach of its presentment warranty of good title to the forged checks, in violation of N.J.Stat.Ann. § 12A:4-207(1) (West 1962).*fn5

The jury returned a verdict in the form of special interrogatories. The jury found for the appellants on the fraud, securities violations, and R.I.C.O. counts. However, the jury found Dean Witter directly liable to McAdam for negligent supervision*fn6 and vicariously liable for Murray's breach of contract and fiduciary duty. The jury assessed damages on these counts at $448,247. The jury also found Dean Witter liable on the UCC count and assessed damages on that count at $145,140.*fn7 The jury found Midlantic liable to McAdam for conversion in violation of § 3-419(1)(c) and assessed damages at $466,992.71, the face amount of the cashed forged checks. Based on the jury's factual findings, the district court also found in favor of McAdam on his conversion count against Morgan, but in favor of Morgan on its cross-claim against Midlantic. Finally, the jury found that McAdam was entitled to punitive damages of $800,000 against Dean Witter, and $500,000 against Midlantic.

After rejecting the defendants' post-trial motions, the district court entered a judgment in accordance with the jury's findings: in favor of McAdam and against Dean Witter in the amount of $1,482,070, inclusive of punitive damages and prejudgment interest; in favor of McAdam and against Midlantic and Morgan, jointly and severally, in the amount of $729,694.71, inclusive of prejudgment interest; in favor of McAdam and against Midlantic in the amount of $500,000 for punitive damages; and in favor of Morgan and against Midlantic for $729,694.71, plus an amount for attorneys' fees to be determined by the parties. This appeal followed. We have jurisdiction pursuant to 28 U.S.C. § 1291 (1982).

II

LIABILITY

A. Appellant Dean Witter.

We first consider the appellants' arguments which involve the issue of liability. Dean Witter argues that the district judge erred in refusing to allow the jury to consider its defense of in pari delicto.*fn8 The district court did not allow the defense because it found that McAdam's conduct in this affair did not satisfy the legal requirement for maintaining the defense. Since the resolution of this issue involves the application of a legal precept, our scope of review is plenary. United States v. Adams, 759 F.2d 1099, 1106 (3d Cir.), cert. denied, 474 U.S. 906, 106 S. Ct. 275, 88 L. Ed. 2d 236 (1985).

The common law defense of in pari delicto "is grounded on two premises: first, that courts should not lend their good offices to mediating disputes among wrongdoers; and second, that denying judicial relief to an admitted wrongdoer is an effective means of deterring illegality." Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 306, 86 L. Ed. 2d 215, 105 S. Ct. 2622 (1985) (footnotes omitted). See generally 30 C.J.S. Equity § 94 (1965). The defense derives from the Latin maxim, in pari delicto potior est conditio defendentis, which means: "In a case of equal or mutual fault . . . the position of the party . . . [defending] is the better one." Black's Law Dictionary 711 (5th ed. 1979). See generally 1 Am.Jur.2d Actions § 52 (1962). Unless the degrees of fault are essentially indistinguishable or the plaintiff's responsibility is clearly greater, the in pari delicto defense should not be allowed, and the plaintiff should be compensated. Pinter v. Dahl, 486 U.S. 622, 108 S. Ct. 2063, 2073, 100 L. Ed. 2d 658 (1988).*fn9 The defense is the legal corollary of the equitable unclean hands doctrine which requires not even equal fault on the part of the plaintiff in order to bar the lawsuit. Rothberg v. Rosenbloom, 808 F.2d 252, 256 n. 6 (3d Cir. 1986), cert. denied, 481 U.S. 1017, 95 L. Ed. 2d 501, 107 S. Ct. 1895 (1987).*fn10

Moreover, in order to bar recovery, the plaintiff must be an active, voluntary participant in the unlawful activity that is the subject of the suit. Pinter, 108 S. Ct. at 2073. See also Woolf v. S.D. Cohn & Co., 515 F.2d 591, 604 (5th Cir. 1975), vacated and remanded on other grounds, 426 U.S. 944, 96 S. Ct 3161, 49 L. Ed. 2d 1181 (1976) ("plaintiff must be an active, essential, and knowing participant in the unlawful activity"). "Plaintiffs who are truly in pari delicto are those who have themselves violated the law in cooperation with the defendant." Perma Life Mufflers, Inc. v. Int'l Parts Corp., 392 U.S. 134, 153, 20 L. Ed. 2d 982, 88 S. Ct. 1981 (1968) (Harlan, J., concurring in part and dissenting in part). In determining whether the plaintiff was a participant in the unlawful activity, "a court may look only to conduct associated with the transaction before it, and may not forbid recovery on account of a plaintiff's activities in a separate setting." Tarasi v. Pittsburgh Nat'l Bank, 555 F.3d 1152, 1157 (3d Cir.), cert. denied, 434 U.S. 965, 98 S. Ct. 504, 54 L. Ed. 2d 451 (1977).

Thus, the in pari delicto defense in its traditional formulation is limited to situations where the plaintiff, as a direct result of his own actions, bears at least substantially equal responsibility for the underlying illegality. Bateman Eichler, 472 U.S. at 307. While there has been little discussion of the defense in recent cases, the New Jersey courts have given a traditional construction to the defense in earlier actions based on New Jersey law.*fn11 For example, in Pendleton v. Gondolf, 85 N.J. Eq. 308, 96 A. 47 (Ch.Ct. 1915), the court explained that:

In the law courts a similar principle [to the equitable doctrine of unclean hands] is recognized, but in its application cases are to be found in which the courts incline to measure the comparative guilt of the respective parties and extend relief to one who is comparatively innocent; that situation has been usually presented in cases in which the wrongful conduct of the party seeking relief has arisen through undue influence arising from a trust relationship of the parties, through mental weakness, threats, fear, or oppression and like circumstances which have been regarded as sufficient to measurably excuse the wrongful conduct involved. . . . I am unable to find any justification for a court . . . to extend relief to a suitor who has been guilty of conduct involving the degree of moral turpitude of that which is involved in the very transaction which forms the basis of the relief sought when that conduct and the turpitude involved in it have been impelled by the deliberate and intelligent purposes of the rational and normal intellect of a free agent. . . .

Pendleton, 96 A. at 50 (emphasis added). See also Pennsylvania Greyhound Lines v. Rosenthal, 14 N.J. 372, 386, 102 A.2d 587 (1954); Schoharie County Coop. Dairies v. Eisenstein, 22 N.J. Super. 503, 513-15, 92 A.2d 390 (App.Div. 1952) ("there is authority for the proposition that the less guilty party to an illegal transaction will not be considered in pari delicto"); Greene v. Birkmeyer, 8 N.J. Super. 217, 220-21, 73 A.2d 728 (App.Div. 1950); Appell v. Reiner, 81 N.J. Super. 229, 242, 195 A.2d 310 (Ch.Div. 1963), rev'd on other grounds, 43 N.J. 313, 204 A.2d 146 (1964).

Given that the "substantially equal responsibility for the underlying illegality" standard is the one to be applied in this case, we do not find evidence sufficient for reasonable persons to infer McAdam's active and voluntary participation in Murray's fraudulent scheme, i.e., the unlawful activity that is the subject of this suit. See Pinter, 108 S. Ct. at 2073; Pendleton, 96 A. at 50 (in pari delicto defense available when plaintiff's "conduct can only be regarded as having been voluntary and intelligent in its purpose"). The fact that McAdam engaged in off-the-book transactions with Murray -- as did many other defrauded investors -- wrote sizable checks made payable to Murray, and, under Murray's advice, kept secret what McAdam believed to be a preferred customer account that was not open to the public, does not amount to willful, voluntary involvement in an illegal enterprise. There is no evidence that Murray confided in McAdam and thus that McAdam knew of Murray's fraudulent scheme when he "invested" his money. Foolish credulity is not equivalent to culpability for purposes of the in pari delicto defense, see, e.g., Eisenstein, 22 N.J.Super. at 514, and neither is simple greed or a desire to make money. See Rothberg, 808 F.2d at 256-57. Moreover, even assuming that McAdam misrepresented his "special" account investments to his bonding company and the amount of his income to the I.R.S., such fraudulent or illegal conduct is not the underlying illegality which forms the basis of this suit and, therefore, is irrelevant to the determination of whether the defense is available. See Pinter, 108 S. Ct. at 2073.*fn12 Consequently, we will affirm the district court's ruling on the inapplicability of the in pari delicto defense.*fn13

B. Appellant Midlantic.

Midlantic argues that § 3-405(1)(c) of the UCC -- the so-called "faithless employee" defense -- bars McAdam from recovering against it as to the forged endorsement losses. Section 3-405(1)(c) reads in relevant part:

(1) An endorsement by any person in the name of the named payee is effective if

(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.

N.J.Stat.Ann. § 12A:3-405(1)(c) (West 1962). In this case, an employee (Murray) of the drawer (Dean Witter) supplied the drawer with the name of the payee (McAdam) intending that McAdam have no interest in the instrument. Since all of the elements of § 3-405(1)(c) are met, Midlantic argues that it was legal error for the district court to hold that the defense was unavailable to the bank. McAdam counters that § 3-405(1)(c) should either be interpreted so as not to bar suits by payees -- as opposed to drawers such as Dean Witter -- against collecting banks, or not be available to Midlantic because of its bad faith conduct in cashing the checks containing forged endorsements.

In deciding this issue, we are required to apply the substantive law of the forum state, New Jersey. E.g., 13B C. Wright, A. Miller & E. Cooper, Federal Practice and Procedure § 3567.1, at 145 (1971). However, the New Jersey Supreme Court has not addressed the specific questions we now confront. Cf. Brighton, Inc. v. Colonial First Nat'l Bank, 176 N.J. Super. 101, 422 A.2d 433 (App.Div. 1980), aff'd per curiam, 86 N.J. 259, 430 A.2d 902 (1981) (drawer/employer suing collecting and drawee banks); Kraftsman Container Corp. v. United Counties Trust Co., 169 N.J. Super. 488, 404 A.2d 1288 (Law Div. 1979) (drawer/employer suing drawee bank). Therefore, we must predict how the Supreme Court of New Jersey would decide the issue. Pennsylvania Glass Sand Corp. v. Caterpillar Tractor Co., 652 F.2d 1165, 1167 (3d Cir. 1981). Hence, our scope of review is plenary. See Oliver v. Raymark Indus., 799 F.2d 95, 96 (3d Cir. 1986).

We predict that the New Jersey Supreme Court would hold that § 3-405(1)(c) is unavailable in a suit between a payee and an initial collecting bank at least when the bank converts checks with forged endorsements in violation of the good faith requirement of the UCC.*fn14 See N.J.Stat. Ann. §§ 12A:1-203 (1962). Thus, we find that the district judge did not err in holding that the defense was unavailable to Midlantic under the facts of this case.

As part of an attempt to establish uniform rules governing the relationship between banks and their customers, the UCC allocates the losses caused by forged endorsements on negotiable instruments based on the relative responsibilities of the parties to a transaction. Western Casualty & Sur. Co. v. Citizens Bank of Las Cruces, 676 F.2d 1344, 1345 (10th Cir. 1982); Hayes, U.C.C. Section 3-405: Of Imposters, Fictitious Payees, and Padded Payrolls, 47 Fordham L.Rev. 1083, 1083 (1979). See also Hanover Ins. Cos. v. Brotherhood State Bank, 482 F. Supp. 501, 507-08 (D.Kan. 1979). Generally, a drawee bank is not entitled to debit the drawer's account when the bank pays over a forged endorsement, see, e.g., J. White & R. Summers, supra, § 15-1, at 652; Kraftsman, 169 N.J.Super. at 493, because an "unauthorized signature is wholly inoperative as that of the person whose name is signed." N.J.Stat.Ann. § 12A:3-404 (1) (West 1962). See also N.J. Stat. Ann. §§ 12A:4-401 (1), 12A:3-417 Uniform Commercial Code comment 3 (West 1962). However, a drawee bank which has paid over a forged endorsement can shift the loss "upstream" to previous endorsers, e.g., collecting banks, by way of an action for breach of warranty of good title. N.J.Stat.Ann. §§ 12A:3-417(1)(a), 12A:4-207(1)(a) (West 1962). See Western Casualty, 676 F.2d at 1345; Perini Corp. v. First Nat'l Bank of Habersham County, 553 F.2d 398, 404 (5th Cir. 1977); J. White & R. Summers, supra, 15-1, at 653-55.*fn15 Ultimately, the "loss falls on the party who took the check from the forger, or on the forger himself." Perini, 553 F.2d at 404. See also Hayes, supra, at 1085. Thus, the drawer of the check can usually avoid liability on a check with a forged endorsement simply by showing the unauthorized endorsement and the depositary or initial collecting bank will likely suffer the loss. Western Casualty, 676 F.2d at 1345; Perini, 553 F.2d at 404; Harbus, The Great Pretender--A Look at the Imposter Provision of the Uniform Commercial Code, 47 Cinn.L.Rev. 385, 386 (1978).

Section 3-405(1) (c) creates a limited exception to this general rule when an employee, intending the payee to have no interest in the instrument, causes his employer to draw a check made payable to a customer of the employer. This exception is created because of the differing responsibilities of the parties in such a situation. Banks are shielded from liability because of the

feeling, largely unarticulated, that the loss should be taken by the drawer (employer). His employee, acting within the scope of his authority, caused the loss; he is in the best position to prevent it by supervision and by using care in hiring employees; he has as good a chance as the bank to distribute the risk to all of society through the use of insurance.

N.J.Stat.Ann. § 12A:3-405, New Jersey study comment 1 (West 1962). See also Brighton, 176 N.J.Super. at 112; § 12A:3-405, Uniform Commercial Code comment 4. Thus, the statute was designed to bar suits by drawer/employers against banks on forged endorsements because normally the employer is in a better position, through careful business practices, to prevent such financial abuses by its employees or, at least, ameliorate the consequences. Brighton, 176 N.J.Super. at 112. See also J. White & R. Summers, supra, § 16-4, at 700; McDonnell, Bank Liability for Fraudulent Checks: The Clash of the Utilitarian and Paternalist Creeds Under the Uniform Commercial Code, 73 Geo.L.J. 1399, 1410, 1411 (1985); Hayes, supra, at 1102, 1105, 1110. Cf. National Credit Union Admin. v. Michigan Nat'l Bank of Detroit, 771 F.2d 154, 159-60 (6th Cir. 1985); United States v. Bank of Am. Nat'l Trust and Sav. Ass'n., 438 F.2d 1213, 1214 (9th Cir.), cert. denied, 404 U.S. 864, 30 L. Ed. 2d 108, 92 S. Ct. 54 (1971); New Amsterdam Casualty Co. v. First Pa. Banking and Trust Co., 451 F.2d 892, 897 (3d Cir. 1971) (construing same section under Pennsylvania law).

The rationale for the § 3-405(1)(c) exception, however, does not easily extend to lawsuits brought by payees against initial collecting banks. A payee, unlike the drawer/employer, is not in a better position than the bank to prevent such financial abuses. The faithless employee is not the payee's employee. Consequently, the payee can not prevent such abuses through careful hiring or supervising practices. Nor can the payee spread the risk of forgery losses throughout society by means of fidelity insurance. Importantly, as between the payee and an initial collecting bank, the bank is clearly in a better position both to prevent, or minimize, forgery losses through proper and careful banking procedures, cf. Perini, 553 F.2d at 406 ("such simple expedients as requiring identification . . . may still permit transferees of checks to provide a significant protection against forged indorsements that drawees cannot"); Comment, The Effect of Bank Misconduct on the Operation of the Padded Payroll Preclusion of U.C.C. § 3-405, 26 UCLA L.Rev. 147, 153 n.44 (1979), and to socialize the cost of forgery losses by incorporating insurance costs into its banking charges. McDonnell, supra, at 1428.*fn16

There appear then to be good reasons for allowing payees to sue initial collecting banks despite § 3-405(1) (c), at least when the payee is not simply serving as a litigation front for a drawer/employer who has been the victim of a faithless employee. See Barnett Bank of Miami Beach v. Lipp, 364 So. 2d 28 (Fla.Dist.Ct.App. 1978) (allowing suit under similar facts); Cooter and Rubin, A Theory of Loss Allocation for Consumer Payments, 66 Texas L.Rev. 63, 109-10 (1987) (arguing that the most efficient theory of loss allocation for forgeries would entail scrapping the "complex issues about depositary bank negligence, drawer negligence, reasonable commercial standards, imposters, and fictitious payees" and instead imposing strict liability on payees and drawers for a small, fixed amount and allowing recovery against any financial institution involved for the remainder); Harbus, supra, at 445 (in the author's proposed draft for a new § 3-405, the statute would not bar suits by payees). Yet, at the same time we understand the appeal of Midlantic's counterargument that the symmetry of the Code's liability scheme would, in general, be disrupted if we failed to limit a payee's avenue of recovery for forgery losses, covered by § 3-405(1)(c), to § 3-804 actions against the drawer/employers. Any other result, the bank contends, would allow the loss to be shifted from the employer/drawer to a bank which is less responsible for, and less able to prevent, the forgery. But cf. Girard Bank v. Mt. Holly State Bank, 474 F. Supp. 1225, 1237-42 (D.N.J. 1979) (holding, in an analogous situation, that the New Jersey courts would recognize a cause of action by an innocent depositary bank against a negligent drawer under common law principles even though such an action is not sanctioned by the Code).

Fortunately, we need not decide whether all conversion claims by payees involving "faithless employees" are proper in resolving the case before us since we believe Midlantic's symmetry concerns are not paramount when an initial collecting bank has acted in callous disregard of the payee's rights. As we have discussed, § 3-405(1)(c) is intended to allocate the losses resulting from forgeries based on the relative responsibilities of the parties. Rather than utilizing the general rule of the Code and imposing liability on the depositary bank, the "faithless employee" liability rule is supposed to achieve a more socially desirable result by encouraging employers to make prudent personnel decisions.

But clearly the attempt both to achieve the most socially desirable result and to create the proper incentives is frustrated when a bank's commercially outrageous conduct is insulated from legal consequences under § 3-405(1)(c) in order to encourage an employer to be more careful in hiring and supervising its employees. Such extraordinary misconduct simply cannot go undeterred and we will not find that the New Jersey legislature so intended.*fn17 Section 3-405(1)(c) was not designed to allocate forgery losses when parties act outside commercially foreseeable norms. Cf. Chartered Bank v. American Trust Co., 47 Misc. 2d 694, 697-98, 263 N.Y.S.2d 53 (N.Y.Sup.Ct. 1965) (interpreting the Fictitious Payee Amendment to the previous statute, § 9(3) of the Uniform Negotiable Instruments Law, to the same effect).

Therefore, we predict that the New Jersey Supreme Court would decide that "the fictitious payee rule is not intended to provide an absolute defense," but instead hold that in order to successfully assert the effectiveness of a forged endorsement under § 3-405(1)(c), the bank must have acted in good faith when paying the instrument. City of Phoenix v. Great West. Bank & Trust, 148 Ariz. 53, 712 P.2d 966, 970 (Ct.App. 1985). Although there is no specific standard of care set forth in § 3-405, banks are obligated to act in good faith with respect to all their contracts and duties under the Code. N.J.Stat.Ann. § 12A:1-203 (1962). The UCC comments suggest that this includes the § 3-405 context. See N.J.Stat.Ann. § 12A:4-406, Uniform Commercial Code comment 6 (1962) ("under the rules relating to imposters and signatures in the name of the payee (Section 3-405) certain forged endorsements on which the bank has paid the item in good faith may be treated as effective notwithstanding such discovery and notice") (emphasis added).

Courts in other jurisdictions have interpreted § 3-405 to require that a bank must have acted with at least good faith in order to assert the defense. Western Casualty, 676 F.2d at 1347 ("it is clear that banks must observe this standard of good faith . . . to invoke the protection of § 3-405") (dictum); Prudential Ins. Co. v. Marine Nat'l Exchange Bank, 371 F. Supp. 1002, 1003 (E.D.Wis. 1974) ("to the extent that a cashing bank is subject to the 'good faith' requirement . . . its defense under [§ 3-405] is, of course, not absolute") (dictum); City of Phoenix, 712 P.2d at 970; Fair Park Nat'l Bank v. Southwestern Inv. Co., 541 S.W.2d 266, 270-71 (Tex.Civ.App. 1976) ("the drawer cannot avoid the defense provided in [§ 3-405] without a showing of bad faith"); Hicks-Costarino Co. v. Pinto, 23 U.C.C.Rep.Serv. (Callaghan) 680, 682-84 (N.Y.Sup.Ct. 1978).*fn18 Cf. Travelers Indem. Co. v. Center Bank, 202 Neb. 294, 275 N.W.2d 73, 76 (1979) ("in the absence of any allegation that the bank either had actual notice or facts sufficient to put it on constructive notice, or in some manner acted in a commercially unreasonable manner," § 3-405 is a valid defense); McConnico v. Third Nat'l Bank in Nashville, 499 S.W.2d 874, 886 (Tenn. 1973) (while holding that § 3-405 was applicable, the Court found that the bank was nevertheless liable because it "had notice of an irregularity on the face of the instrument"). See generally J. White & R. Summers, supra, § 16-5, at 710 ("we think it appropriate ...


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