On September 30, 2014, the Alabama Supreme Court issued an important decision regarding which financial institution will bear the burden of a check encoding error under the check-encoding warranty found in Alabama’s U.C.C. Article 4. According to the Alabama Supreme Court, this case is truly a case of first impression as there are no reported cases from “any jurisdiction in the United States applying [the check encoding warranty in] UCC § 4-209.”
In Troy Bank & Trust Co. v. The Citizens Bank, No. 1130040 (Ala. Sept. 30, 2014), the Alabama Supreme Court held that the check encoding warranty in Ala. Code § 7-4-209 shifted liability for a $99,000 encoding error from the payor bank, which it held became liable for the full amount of the check when it paid the under-encoded amount, to the depositary bank, which was responsible for encoding the amount of the check. One of Troy Bank’s customers issued a check to a third-party in the amount of $100,000. That third-party deposited the check into its account at Citizens Bank. Being the depositary bank, Citizens Bank was responsible for encoding the check with certain information, including the amount of the check, using special magnetic ink. Encoding is done manually by bank employees using special encoding machines. Once a check is encoded, the magnetic ink can be read and processed electronically by other parties. Here, Citizens Bank accidentally under-encoded the check at issue for $1,000, instead of $100,000, and presented the check to Troy Bank through the Federal Reserve Board for payment. At the time Citizens Bank initially presented the check to Troy Bank, its customer’s account contained sufficient funds to cover the full amount of the check. However, because of the encoding error, Troy Bank only paid Citizens Bank $1,000. Citizens Bank discovered the mistake a month later and sent an adjustment notice through the Federal Reserve Bank for the remaining $99,000. At the time the Federal Reserve Bank transferred the remaining $99,000 from Troy Bank to Citizens Bank, however, the Troy Bank customer’s account no longer had sufficient funds to pay the full amount of the check.
Troy Bank sued Citizens Bank, claiming that the check encoding warranty in Ala. Code § 7-4-209 protected it from any damage resulting from Citizens Bank’s encoding error. The check encoding warranty provides, among other things, that “[a] person who encodes information on or with respect to an item after issue warrants to any subsequent collecting bank and to the payor bank or other payor that the information is correctly encoded.” Citizens Bank argued that Troy Bank had failed to mitigate its damages because it did not send written notice of dishonor or nonpayment of the adjustment notice before the midnight deadline in Ala. Code § 7-4-301. The trial court agreed and granted summary judgment for Citizens Bank. Troy Bank appealed.
The Alabama Supreme Court reversed, agreeing with Troy Bank that the encoding warranty shifted liability for the encoding error to Citizens Bank. According to the Court, Troy Bank became liable for the full face amount of the check when it paid the under-encoded amount of the check pursuant the final payment rule in Ala. Code § 7-4-215 and did not dishonor the check by the midnight deadline set forth in Ala. Code § 7-4-301. Citizens Bank’s encoding error caused Troy Bank to incur damage based on the insufficient funds in the debited account at the time the $99,000 adjustment notice was paid. As the Alabama Supreme Court noted, “had Citizens Bank properly encoded the check there would have been no damage” because the customer had sufficient funds at the time the check was initially presented to Troy Bank for payment. The Court also rejected Citizens failure to mitigate argument, holding that Troy Bank’s payment of the adjustment notice from the Federal Reserve Bank was inconsequential because Troy Bank became liable for the full face amount of the check when it paid the under-encoded amount.