Financial Services FLASHPOINTS January 2023

Michael L. Weissman, Levin Ginsburg, Chicago
312-368-0100 | E-mail Michael L. Weissman

Bank Not Liable for Honoring Fraudulently Endorsed Checks

Navigators Specialty Insurance Co. v. California Bank & Trust, Case No. 8:17-cv-0991-JLS-KES, 2021 WL 4929554 (C.D.Cal. Sept. 27, 2021), arose on a bank’s effort to avoid being held liable for checks it honored that bore fraudulent endorsements. It was successful, with the court basing its decision on California law.

A general contractor entered into a subcontract with a subcontractor under which the general paid the subcontractor’s suppliers and sub-subcontractors via a joint check procedure. The procedure called for the subcontractor to obtain a lien waiver from its supplier and deliver it to the general. Then, the general would issue a check drawn on the general’s account at its depository bank that named both the subcontractor and its supplier as payees. The subcontractor was to endorse the check and hand it to its supplier.

In January 2016, the subcontractor began forging the lien waivers and submitting them to the general. Unsuspecting, the general continued to issue checks on its depository bank. When the checks reached the subcontractor, the subcontractor endorsed them, forged the supplier’s endorsement, and deposited the checks in the subcontractor’s own account.

Months later, the general discovered the fraud, made a claim with its insurer under its crime and fraud policy, and was paid. The insurer then sued the bank that honored the fraudulent endorsed checks.

The case was in its second go-around, having been considered earlier by the Ninth Circuit Court of Appeals and remanded to the district court because the bank had not been given an opportunity to present an important defense the first time around.

That defense was §3405 of the California Uniform Commercial Code §1101, et seq., the California version of UCC §3-405. But first, what lead to that defense: To begin, the court cited Cal.Com. Code §4401, which plainly states that a bank may charge against its customer’s account only “an item that is properly payable from that account.” But the court also noted an exception in circumstances in which a bank, “in good faith, pays an instrument” when “an employer entrusted an employee with responsibility with respect to the instrument and the employee or a person acting in concert with the employee makes a fraudulent indorsement of the instrument.” 2021 WL 4929554 at *3, quoting Cal.Com. Code §3405(b).

The bank contended that the exception meant the fraudulent endorsements on the checks were effective and that the bank was not liable. Not so fast, said the court. There were a couple of hoops the bank still had to jump through.

First, there was the question of whether the subcontractor was the general’s “employee.” For that, the court turned to the California Labor Code. The Code defined the term “employee” to include an independent contractor. The court found the subcontractor to be an independent contractor because the general retained control over the performance of the job the sub was hired to do but not the means by which the subcontractor might accomplish the result. So, because the subcontractor was an independent contractor, it was an employee under California law.

Next, the question was whether the subcontractor was a “ ‘responsible’ employee.” California decisions, said the court, hold that a separate entity, or the employee of a separate entity, may serve as an employee or agent for purposes of Cal.Com. Code §3405.

Continuing, the court said even though the subcontractor did not operate within the framework of the general — as a traditional employee might — the general nonetheless had solely authorized the subcontractor to supply the information used to prepare the checks.

Thus, the subcontractor fell under the classification of an employee, even though it was an independent contractor, and was a responsible employee because of its role in the preparation and distribution of the checks bearing the fraudulent endorsements.

The public policy reason for UCC §3-405 was explained as follows: “Section 3-405 is based on the belief that the employer is in a far better position to avoid the loss by care in choosing employees, in supervising them, and in adopting other measures to prevent forged indorsements.” 2021 WL 4929554 at *5, quoting UCC §3-045, cmt. 1.

The conclusion: UCC §3-405 made the forged endorsements of the checks legally effective, and the general and its insurers must bear the loss. The bank is not liable under UCC §4-401. NOTE: The result would be the same in Illinois under 810 ILCS 5/3-405(a)(3).

For more information about financial services, see COMMERCIAL AND INDUSTRIAL LOAN DOCUMENTATION (IICLE®, 2018). Online Library subscribers can view it for free by clicking here. If you don’t currently subscribe to the Online Library, visit

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