The opinion of the court was delivered by: JOHN F. GRADY
Before the court are the parties' cross-motions for summary judgment. For the reasons explained, plaintiff First National Bank in Harvey's motion is granted in part and denied in part. Defendant Colonial Bank's motion is granted in part and denied in part. Defendant Federal Reserve Bank of Chicago's motion is granted.
Check kiting is a form of bank fraud.
The kiter opens accounts at two (or more) banks, writes checks on insufficient funds on one account, then covers the overdraft by depositing a check drawn on insufficient funds from the other account.
To illustrate the operation, suppose that the defrauder opens two accounts with a deposit of $ 500 each at the First National Bank and a distant Second National Bank. (A really successful defrauder will have numerous accounts in fictitious names at banks in widely separated states.) The defrauder then issues for goods or cash checks totalling $ 3000 against the First National Bank. But before they clear and overdraw the account, he covers the overdrafts with a check for $ 4,000 drawn on the Second National Bank. The Second National account will be overdrawn when the $ 4,000 check is presented; before that happens, however, the defrauder covers it with a check on the First National Bank. The process is repeated innumerable times until there is a constant float of worthless checks between the accounts and the defrauder has bilked the banks of a substantial sum of money.
John D. O'Malley, "Common Check Frauds and the Uniform Commercial Code," 23 Rutgers L. Rev. 189, 194 n.35 (1968-69). By timing the scheme correctly and repeating it over a period of time, the kiter can use the funds essentially as an interest-free loan. Williams v. United States, 458 U.S. 279, 281 n.1, 73 L. Ed. 2d 767, 102 S. Ct. 3088 (1982) (quoting Brief for the United States).
Check kiting is possible because of a combination of two rules found in Article 4 of the Uniform Commercial Code. Under § 4-208(1),
a depositary bank may allow a customer to draw on uncollected funds, that is, checks that have been deposited but not yet paid.
Second, under §§ 4-301 and 4-302, a payor bank must either pay or dishonor a check drawn on it by midnight of the second banking day following presentment. Barkley Clark, The Law of Bank Deposits, Collections and Credit Cards P 5.03 (3d ed. 1990). Thus when a kite is operating, the depositary bank allows the kiter to draw on uncollected funds based on a deposit of a check. The depositary bank presents that check to the payor bank, which must decide whether to pay or return the check before the midnight deadline. The check may appear to be covered by uncollected funds at the payor bank, and so the payor bank may decide to pay the check by allowing the midnight deadline to pass.
A kite crashes when one of the banks dishonors checks drawn on it and returns them to the other banks involved in the kite. Clark, supra. Usually, such a dishonor occurs when one bank suspects a kite. Id. However, an individual bank may have trouble detecting a check kiting scheme. "Until one has devoted a substantial amount of time examining not only one's own account, but accounts at other banks, it may be impossible to know whether the customer is engaged in a legitimate movement of funds or illegitimate kiting." James J. White & Robert S. Summers, Uniform Commercial Code § 17-1 (3d ed. 1988 & Supp. 1994). But each bank is usually able to monitor only its own account, and "there is no certain test that distinguishes one who writes many checks on low balances from a check kiter." White & Summers, supra, § 17-2. Even if a bank suspects a kite, it might decide not to take any action for a number of reasons. First, it may be liable to its customer for wrongfully dishonoring checks. § 4-202. Second, if it reports that a kite is operating and turns out to be wrong, it could find itself defending a defamation suit. White & Summers, supra, § 17-1 (Supp. 1994). Finally, if it errs in returning checks or reporting a kite, it may risk angering a large customer. Id.
This case involves the fallout of a collapsed check kite. Two of the banks involved, First National Bank in Harvey ("First National") and Colonial Bank ("Colonial") are the parties to this litigation. The Federal Reserve Bank of Chicago (the "Reserve Bank"), through whose clearinghouse the relevant checks were processed, is also a party.
Shelly International Marketing ("Shelly") opened a checking account at First National in December 1989. Def. 12(M) P 5.
The principals of Shelly also opened accounts at the Family Bank (a nonparty) in the names of Shelly Brokerage and Crete Trading around December 1990. Def. 12(M) P 11. On December 31, 1991, the principals of Shelly opened a checking account at Colonial Bank in the name of World Commodities, Inc. Def. 12(M) P 6. Shelly and World Commodities were related companies, with the same or similar shareholders, officers, and directors. Def. 12(M) P 7. The principals of Shelly and World Commodities began operating a check kiting scheme among the accounts at the three banks in early 1991. Def. 12(M) P 12.
The main events at issue in this case took place in February 1992. The checks that form the basis of this suit are thirteen checks totalling $ 1,523,892.49 for which First National was the depositary bank and Colonial was the payor bank (the "Colonial checks"). Also relevant are seventeen checks totalling $ 1,518,642.86 for which Colonial was the depositary bank and First National was the payor bank (the "First National checks").
On Monday, February 10, Shelly deposited the thirteen Colonial checks to its First National account. Def. 12(M) P 14. First National then sent those checks through the check clearing system. Def. 12(M) P 15. That same day, World Commodities deposited the seventeen First National checks to its Colonial account. Pl. 12(M) P 16.
The next day, Tuesday, February 11, the Colonial checks were presented to Colonial for payment, and the First National checks were presented to First National for payment. Pl. 12(M) P 16; Def. 12(M) P 15. That day, David Spiewak, an officer with First National's holding company, Pinnacle, reviewed the bank's records to determine why there were large balance fluctuations in Shelly's First National account. Pl. 12(M) P 19. Spiewak began to suspect that a kite might be operating. Pl. 12(M) P 19. He did not know whether Colonial had enough funds to cover the Colonial checks that had been deposited on Monday, February 10, and forwarded to Colonial for payment. Pl. 12(M) P 19. Later that day, First National froze the Shelly account to prevent any further activity in it. Pl. 12(M) P 19.
On the morning of Wednesday, February 12, Spiewak met with First National president Dennis Irvin and Pinnacle's chief lending officer Mike Braun to discuss the Shelly account. Pl. 12(M) P 22. Spiewak informed the others of what he knew, and the three agreed that there was a possible kite. Pl. 12(M) P 22. They concluded that further investigation was needed. Pl. 12(M) P 22. The First National officers decided to return the First National checks to Colonial. First National says that the decision was made at this meeting, but Colonial says the decision was actually made the day before. Pl. 12(M) P 22; Def. 12(N) P 22.
On Wednesday, First National returned the First National checks to Colonial. Under Regulation CC, a bank that is returning checks in excess of $ 2,500.00 must provide notice to the depositary bank either by telephone, actual return of the check, or Fed Wire before 4:00 p.m. on the second business day following presentment. Pl. 12(M) P 23. First National notified Colonial by Fed Wire that it was returning the seventeen First National checks. Pl. 12(M) PP 24, 31. Initially, the large item return form indicated that the reason for the return was "uncollected funds," but Spiewak changed that reason to "refer to maker." Pl. 12(M) P 27.
Colonial received the Fed Wire notices at approximately 2:45 p.m. on Wednesday and routed them to its cashier, Joanne Topham. Pl. 12(M) P 32. Randall Soderman, a Colonial loan officer, was informed of the large return, and immediately began an investigation. Pl. 12(M) P 32. He realized that if the Colonial checks were not returned by midnight that same day, Colonial would be out the money. Pl. 12(M) P 33. Returning the Colonial checks before midnight would protect Colonial from liability, but it would risk disappointing the customer. Pl. 12(M) P 34. Anthony Schiller, the loan officer in charge of the World Commodities account, called World Commodities comptroller Charles Patterson and its attorney Jay Goldstein. Def. Add'l Facts PP 11, 12. Both assured Schiller that the First National checks were good and should be redeposited. Def. Add'l Facts PP 11, 12. Ultimately, Richard Vucich, Colonial's president, and Joanne Topham, Colonial's cashier, decided not to return the Colonial checks on Wednesday. They decided instead to meet on Thursday morning with Schiller to discuss the matter. Pl. 12(M) P 47.
Schiller, Topham, and Vucich met on the morning of Thursday, February 13. Pl. 12(M) P 48. At the conclusion of the meeting, they decided to return the thirteen Colonial checks to First National. Pl. 12(M) P 48. At about 10:45 a.m., Colonial telephoned First National to say that it intended to return the Colonial checks. Pl. 12(M) P 50. Colonial sent the Colonial checks back through the Reserve Bank as a return in a return cash letter. Pl. 12(M) P 51. The Reserve Bank debited First National's Reserve Bank account in the amount of the Colonial checks. Pl. 12(M) P 51. First National received the returned Colonial checks on Friday, February 14. Pl. 12(M) P 52.
First National then resorted to the Fed's "challenge procedure" to contest the return of the Colonial checks after the midnight deadline. First National prepared and submitted to the Reserve Bank a "Sender's Claim of Late Return" form for each of the Colonial checks. Pl. 12(M) P 55. The Reserve Bank processed the claim forms and credited the Reserve Bank account of First National $ 1,523,892.49 and debited the Reserve Bank account of Colonial in the same amount. Pl. 12(M) P 56. On February 24, Colonial prepared and filed a "Paying Bank's Response to Claim of Late Return" form for each of the thirteen Colonial checks. Pl. 12(M) P 57. As a consequence of the processing of the response forms, the Reserve Bank reversed the credit given to First National and the debit made to Colonial. Pl. 12(M) P 67; Def. 12(N) P 67.
First National then filed this suit against Colonial and the Reserve Bank, alleging that Colonial wrongfully returned the Colonial checks after the midnight deadline and the Reserve Bank wrongfully accepted the late return.
Count I of First National's amended complaint against Colonial alleges breach of warranty under Regulation CC for the late return of the checks. 12 C.F.R. § 229.34. Count II against the Reserve Bank alleges breach of warranty under Regulations CC and J for accepting the late return. 12 C.F.R. § 210.6. Count III against Colonial alleges breach of a duty of ordinary care in Colonial's return of the Colonial checks. Count IV against the Reserve Bank alleges breach of a duty of ordinary care in processing the late return. Count V against Colonial alleges breach of UCC § 4-302 for Colonial's failure to return the checks by the midnight deadline. Count VI against the Reserve Bank and Count VII against Colonial allege breach of contract for each party's failure to comply with the terms of the Reserve Bank's Operating Circular No. 4 ("OC-4").
First National moved for partial summary judgment as to Count V. On August 27, 1993, this court denied the plaintiff's motion. First Nat'l Bank in Harvey v. Colonial Bank, 831 F. Supp. 637 (N.D. Ill. 1993). The parties now have each moved for summary judgment on all counts. Along with deciding the remaining counts, today's opinion reconsiders portions of our earlier ruling on Count V. Avitia v. Metropolitan Club, 49 F.3d 1219, 1227 (7th Cir. 1995).
Summary judgment "shall be rendered forthwith if the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show that there is no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law." Fed. R. Civ. P. 56(c); Celotex Corp. v. Catrett, 477 U.S. 317, 322, 91 L. Ed. 2d 265, 106 S. Ct. 2548 (1986). A "genuine issue of material fact exists only where 'there is sufficient evidence favoring the nonmoving party for a jury to return a verdict for that party.'" Wallace v. Tilley, 41 F.3d 296, 299 (7th Cir. 1994) (quoting Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 249, 91 L. Ed. 2d 202, 106 S. Ct. 2505 (1986)). In considering such a motion, the court must view all inferences in the light most favorable to the nonmoving party. Tolentino v. Friedman, 46 F.3d 645, 649 (7th Cir.), cert. denied, 115 S. Ct. 2613, 132 L. Ed. 2d 856, 63 U.S.L.W. 3906 (U.S. June 26, 1995) (No. 94-1812-CFX). The court will enter summary judgment against a party who does not come forward with evidence that would reasonably permit a finder of fact to find in his or her favor on a material question. McGrath v. Gillis, 44 F.3d 567, 569 (7th Cir. 1995).
Article 4 of the Uniform Commercial Code adopts a policy of "final payment"; that is, a check is considered to be finally paid at some specific and identifiable point in time. § 4-215 Comment 1. Final payment is the "end of the line" in the check collection process. Id. Section 4-301 sets up the "midnight deadline" in the process: a payor bank which intends to return a check presented to it must do so before midnight of the next banking day following receipt of the check. §§ 4-301(a), 4-104(a)(10). If a payor bank fails to return a check before the midnight deadline, final payment occurs. Los Angeles Nat'l Bank v. Bank of Canton, 229 Cal. App. 3d 1267, 280 Cal. Rptr. 831, 836 (Ct. App. 1991); see Rock Island Auction Sales, Inc. v. Empire Packing Co., 32 Ill. 2d 269, 204 N.E.2d 721, 722-23 (Ill. 1965); Templeton v. First Nat'l Bank, 47 Ill. App. 3d 443, 362 N.E.2d 33, 37, 5 Ill. Dec. 720 (Ill. App. Ct. 1977).
Section 4-302 spells out the payor bank's liability for its late return of an item, that is, return after the midnight deadline:
(a) If an item is presented to and received by a payor bank, the bank is accountable for the amount of:
(1) a demand item, other than a documentary draft, whether properly payable or not, if the bank . . . does not pay or return the item or send notice of dishonor until after its midnight deadline . . . .
§ 4-302 (emphasis added). The operative word in this section is "accountable." Courts interpreting this section have nearly unanimously concluded that § 4-302 imposes strict liability on a payor bank for failing to adhere to the midnight deadline, and makes the measure of damages the face amount of the check. In an early decision, the Illinois Supreme Court held that "accountable" means "liable" for the amount of the item. Rock Island Auction Sales, Inc. v. Empire Packing Co., 32 Ill. 2d 269, 204 N.E.2d 721, 723 (Ill. 1965). The Rock Island court contrasted the "accountability" language in § 4-302 with the language used to specify the measure of damages in what is now § 4-103(e).
Section 4-103(e) makes a bank liable for failing to exercise ordinary care in the handling of a check in "the amount of the item reduced by an amount that could not have been realized by the exercise of ordinary care." § 4-103(e). The Official Comment to this section explains: "When it is established that some part or all of the item could not have been collected even by the use of ordinary care the recovery is reduced by the amount that would have been in any event uncollectible." In other words, § 4-103(e) imposes liability in the amount of the loss caused by the negligence, while § 4-302(a) imposes strict liability in the face amount of the check.
The Rock Island court reasoned that the special role of the payor bank in the check collection system justifies the imposition of liability regardless of negligence. The midnight deadline requires the payor bank -- the bank in the best position to know whether there are funds available to cover the check -- to decide whether to pay or return the check:
The role of a payor bank in the collection process . . . is crucial. It knows whether or not the drawer has funds available to pay the item. The legislature could have considered that the failure of such a bank to meet its deadline is likely to be due to factors other than negligence, and that the relationship between a payor bank and its customer may so influence its conduct as to cause a conscious disregard of its statutory duty.
Rock Island, 204 N.E.2d at 723.
The overwhelming majority of courts that have considered the meaning of § 4-302(a) have followed the Rock Island court in concluding that the liability of a payor bank that fails to return a check by the midnight deadline is strict and is in the face amount of the check. See, e.g., Starcraft Co. v. C.J. Heck Co., 748 F.2d 982, 986 (5th Cir. 1984); Chrysler Credit Corp. v. First Nat'l Bank & Trust Co., 746 F.2d 200, 201 (3d Cir. 1984); American Title Ins. Co. v. Burke & Herbert Bank & Trust Co., 813 F. Supp. 423, 426 (E.D. Va. 1993), aff'd, 25 F.3d 1038 (4th Cir. 1994); Bank Leumi Trust Co. v. Bank of Mid-Jersey, 499 F. Supp. 1022, 1024 (D.N.J. 1980), aff'd, 659 F.2d 1065 (3d Cir. 1981); Los Angeles Nat'l Bank v. Bank of Canton, 229 Cal. App. 3d 1267, 280 Cal. Rptr. 831, 838 (Ct. App. 1991); Citizens Fidelity Bank & Trust Co. v. ...