Check fraud has increased exponentially, skyrocketing through the alleyways of mail theft and the dark web. The Financial Crimes Enforcement Network (“FinCEN”), reports that it received 15,417 reports related to mail theft check fraud between February and August of 2023, totaling more than $688 million in completed and attempted transactions by fraudsters.
The crooks primarily obtain the checks through theft from the mail and commit the fraud or sell the stolen check on the dark web for others to accomplish the fraud. The three main methods by which check frauds are perpetrated are: (1) Altering stolen checks prior to deposit, (2) Creating counterfeit checks using the stolen check as a template, and (3) fraudulently indorsing checks before deposit.
The most common method of check fraud is alteration of stolen checks. FinCEN reports 44% of check fraud involves mail theft of checks that are altered. Alteration of stolen checks differs in sophistication, the least sophisticated being addition of a payee. The more sophisticated, and more difficult to detect, involves “washing” the checks with solvents, even nail polish remover, and making the check payable to the fraudster, and frequently increasing the amount of the check.
Counterfeit checks also vary in sophistication. Sometimes the fraudster simply obtains an account number and routing number, either from stealing a check, or purchasing the information on the dark web. The crook creates a check with that information even though the physical appearance of the counterfeit is grossly different from a real check, deposits the check, and the check goes into the collection system. (Fraud detection software offered by core system providers should detect that type of fraud.) The more sophisticated crook creates an exact replica of a real check down to most of the security features including the use of microprint making it more difficult to detect.
UCC Articles 3 and 4, and Fed. Reg. CC, address how fraud losses are allocated between the depository bank and the drawee bank based on whether the check was altered or counterfeit. The Federal Reserve revised Regulation CC in 2018 to create a presumption of liability for altered and counterfeit checks. For altered checks, the presumption makes the bank of first deposit the warrantor and liable upon the determination of fraud. The presumption of alteration creates a presentment warranty claim in favor of the drawee bank against the bank of first deposit. The rationale is that because of check truncation the depository bank is the only bank that handles the paper item as it accepts the item for deposit and is best positioned to detect the alteration.
Conversely, Reg. CC and the UCC place the liability on the drawee bank in instances involving counterfeit or forged checks. The reason is a counterfeit check does not have an authorized drawer’s signature. Under UCC law, the drawee bank is responsible for making sure it only pays checks with an authorized drawer’s signature and is best positioned to make that determination.
Technology has played a role in the increase in check fraud. Mobile deposits are the fraudsters’ favorite means for the deposit of altered and counterfeit checks. FinCen notes that the fraudsters want to avoid contact with bank personnel when depositing a fraudulent item and mobile deposits make that easy. If a depository bank does not review items accepted by mobile deposit, but electronically routes those items for collection, its risk of accepting an altered or counterfeit check increases. Some banks address this by setting limits on the dollar amount of checks accepted for mobile deposit, or route checks of more than a certain amount for human or electronic review.
Kentucky banks are most frequently the drawee bank in a check fraud transaction. The depository bank’s statutory warranty to the drawee bank is that the item it accepted had not been altered and was properly indorsed. If the depository bank will not make good on its presentment warranty, Kentucky banks can pursue a warranty claim under KRS 355.3-417(2) and KRS 355.4-208(2), which provide a “drawee making payment may recover damages for breach of warranty equal to the amount paid by the drawee.” However, drawee banks are often required to initiate lawsuits to enforce this right. The good news is that beginning January 1, 2025, presentment warranty claimants in Kentucky will be able to recover attorneys’ fees if litigation is required to collect on the presentment warranty.
Most altered checks, particularly for significant amounts, are deposited into newly opened accounts. Depository banks can prevent check fraud losses by following “Know Your Customer” rules to ensure that you are not doing business with fraudsters.
Both the governing board for the Uniform Commercial Code and Federal regulators are beginning to explore legal fixes to help deal with check fraud but those changes will not come quickly. For now, banks need to examine their internal procedures for accepting deposit and paying presented checks and consult with their core system providers on technology solutions.
For more information, please contact John McGarvey.
