GOVONI & SONS CONSTRUCTION CO., INC., & others [Note 1] vs. MECHANICS BANK [Note 2]; JAMES A. MADDALENA & others, [Note 3] third-party defendants

ARMSTRONG, C.J. These cross appeals concern the proper allocation between a bank and its customers of the loss brought about through a check fraud scheme perpetrated by the customers' accountant. The judge's findings of fact, summarized below, were supported by the evidence adduced at the bench trial.

The customers (the Govonis) are small, family-owned companies, of which Henry Govoni was president and Donald Govoni, Sr., and Donald Govoni, Jr., were the treasurers. For more than twenty years, the Govonis employed James A. Maddalena as their accountant. The Govonis placed their trust in Maddalena, allowing him to keep their financial records, reconcile their checkbooks, and prepare their taxes. When Maddalena requested tax checks from the treasurers, they simply signed checks in the requested amounts and gave them back to Maddalena for routing. They did not supervise, question or audit him, nor did they request receipts or review bank statements or tax returns.

During the period at issue in this litigation, that is, between February, 1988, and December, 1990, the Govonis, guided by falsely inflated tax returns prepared by Maddalena, drew numerous checks to the order of the Commonwealth of Massachusetts or the Division of Employment Security (DES) to pay State taxes (the Commonwealth/DES checks, totaling $147,422.89), and to the order of the defendant Mechanics Bank to pay Federal taxes (the Mechanics Bank checks, totaling $503,352.08) [Note 4]. These checks were drawn on various Govoni accounts

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maintained at the Mechanics Bank. Instead of using them to pay taxes, Maddalena deposited the checks into the account of his own accounting company, A.R. Davis Associates, Inc. (A.R. Davis), which was also maintained at the Mechanics Bank.

Maddalena accomplished his fraud by making deposits to his A.R. Davis account at the bank's branch office in Holden, where he was a known and regular customer [Note 5], during times when the branch was busy. He would bury the Govonis' unindorsed checks in multiple item deposits of checks payable to A.R. Davis. Many deposits had at least eight items, and some had as many as sixty-one. The bank's practice on multi-item deposits was for its tellers to quickly "fan" (i.e., flip through) the checks, scanning the back sides for missing indorsement and returning unindorsed checks to the presenter. However, the tellers were not required to inspect the face of a check to ensure it was indorsed by the named payee. Moreover, depending on the level of activity at the branch, the number of customers waiting in line, and familiarity with the depositor, a teller could entirely dispense with fanning. The judge inferred that in Maddalena's case, because he was a regular customer presenting multi-item deposits during busy times, the tellers did not fan for indorsement and were thus unaware that he had inserted the Govonis' unindorsed checks into the multi-item stacks.

After Maddalena presented a stack of checks, the tellers then entered a provisional credit to the A.R. Davis account for the total amount written by Maddalena on the deposit slip. The checks were next sent to a central processing center for "proofing," a process of checking the amount indicated on each deposit slip against a manual totaling of the individual checks accompanying each deposit slip. Proofing did not include the verification of signatures or indorsement. After proofing, each check was stamped with a Mechanics Bank processing stamp.

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The checks were next sent through an automated sorter. For checks such as these, drawn on one account at the bank and deposited to another account at the bank, the sorting process resulted in the drawer's account being debited and the depositor's account receiving final credit, both as of day's end. The sorting machine diverted individual checks of $7,500 or more for manual review; checks below this amount were stored without further review. Manual review included verifying that the checks were indorsed by the payee. Of the 132 checks fraudulently deposited, twenty-nine Mechanics Bank checks and six Commonwealth/DES checks met the $7,500 threshold and were manually reviewed. The twenty-nine Mechanics Bank checks raised no questions during manual review because the processing stamp administered during proofing was treated as a valid indorsement of the bank, the named payee. Following a bank policy of processing State tax checks despite a lack of indorsement, the six unindorsed Commonwealth/DES checks were also not questioned. The bank's policy was intended to prevent the Commonwealth from assessing interest and penalties for late tax payments against customer/taxpayers.

As a result of these procedures, which testimony showed to be identical to those of comparable banks in the area (including, at the time of trial, BayBank, Shawmut, and Bank of Boston), Maddalena was able to deposit into his A.R. Davis account 132 checks payable to the bank, the Commonwealth or the DES, which collectively represented $650,774.97 of the Govonis' funds [Note 6].

In December, 1990, the Govonis discovered Maddalena's fraud and in February, 1991, instituted this action against the bank, asserting claims they styled as common law negligence, money had and received, and conversion under the Uniform Commercial Code, as well as claims under G. L. c. 93A, s. 11. The bank brought third-party claims against Maddalena and A.R. Davis for breach of transfer warranties, conversion, fraud, and common law indemnification, and against the two individual Govoni treasurers for indemnification. After a bench trial, with respect to the Mechanics Bank checks the judge rejected the Govonis' conversion and money had and received claims, but

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found the bank negligent, adopting the negligence standard articulated in Sun 'n Sand, Inc. v. United Cal. Bank, 21 Cal. 3d 671, 692-696 (1978). He also found the Govonis twenty-five percent negligent and accordingly reduced the award on the Mechanics Bank checks under the comparative negligence statute, G. L. c. 231, s. 85. The judge found for the bank on all counts as to the Commonwealth/DES checks. Finally, he rejected the bank's claims against the two Govoni treasurers and the Govonis' claims against the bank under G. L. c. 93A. Both the Govonis and the bank appealed [Note 7].

1. Checks payable to the order of Mechanics Bank. Although the Govonis characterized their action as sounding in conversion under the Uniform Commercial Code (see G. L. c. 106, s. 3-419, inserted by St. 1957, c. 765, s. 1) [Note 8], or in money had and received or negligence under the common law, the allegations of their complain [Note 9] are properly characterized as setting out a claim of wrongful debit because the checks were not properly payable to Maddalena under G. L. c. 106, s. 4-401(l), inserted by St. 1957, c. 765, s. 1 [Note 10]. This is a common law claim that was retained under the Uniform Commercial Code. See Stone & Webster Engr Corp. v. First Natl. Bank & Trust Co.,

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345 Mass. 1, 9-11 (1962); Siegel v. New England Merchs. Natl. Bank, 386 Mass. 672, 675 (1982) [Note 11].

As the phrase "properly payable" was left effectively undefined by the original code [Note 12], it is appropriate to ascertain its meaning by reference to the common law. See White & Summers, Uniform Commercial Code s. 18-3, at 878 (3d ed. 1988). While the parties have not cited, and we have not found, a Massachusetts case in which a bank has made payment to an unauthorized bearer on an unindorsed check made payable to the bank itself, there appears to be a general (and perhaps universal) rule in other jurisdictions:

"Where a check is drawn to the order of a bank to which the drawer is not indebted, the bank is authorized to pay the proceeds only to persons specified by the drawer; it takes the risk in treating such a check as payable to bearer and is placed on inquiry as to the authority of the drawer's agent to receive payment [Note 13]."

Bank of S. Md. v. Robertson's Crab House, 39 Md. App. 707, 715 (Ct. Spec. App. 1978), quoting from 9 C.J.S. Banks &

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Banking s. 340, at 683 (1938) [Note 14]. See Dalton & Marberry, PC v. NationsBank, N.A., 982 S.W.2d 231, 234 & n.2 (Mo. 1998), and cases cited. This rule is consistent with the code, and we have found no jurisdiction rejecting it [Note 15]. The results reached in somewhat comparable Massachusetts cases convince us that the rule expresses the law of the Commonwealth [Note 16].

Based on this rule, the Mechanics Bank checks were not properly payable from the Govoni accounts absent inquiry by the bank into Maddalena's authority to receive the proceeds [Note 17].

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See Master Chem. Corp. v. Inkrott, 55 Ohio St. 3d 23, 24 (1990); id. at 29-30 (Holmes, J., concurring). Compare First Natl. Bank of Boston v. Hovey, 10 Mass. App. Ct. 715, 721 (1980) (check paid over unauthorized signature not properly payable) [Note 18]. Because the bank made no such inquiry, we need not decide what depth of inquiry might have been required to discharge the bank's duty before it made any payment on the checks.

The bank raises several defenses to avoid liability for paying these checks, which were not properly payable, to the A.R. Davis account. We discuss these in turn.

A. The "fictitious payee" (or "padded payroll") rule.

The fictitious payee rule, G. L. c. 106, s. 3-405(l)(c), inserted by St. 1957, c. 765, s. 1, provides that "[a]n indorsement by any person in the name of a named payee is effective if . . . (c) an agent or employee of the maker or drawer has supplied [the maker or drawer] with the name of the payee intending the latter to have no such interest." "This section places the loss on the drawer when an employee supplies him with the name of the payee intending that the named payee have no interest in the check and an indorsement is forged in the name of the named payee" (emphasis supplied). McCarthy, Kenney & Reidy, PC. v. First National Bank of Boston, 402 Mass. 630, 634 (1988). The effect of the rule is to treat certain fraudulent indorsement as genuine.

The bank argues that the rule applies because Maddalena never intended the bank to have an interest in the checks and because the bank, the named payee, subsequently indorsed the checks. The checks, however, were never fraudulently indorsed. Maddalena presented the checks designating the bank as payee

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to the bank without any indorsement. The bank accepted these unindorsed checks and provisionally credited the proceeds to Maddalena's account. The bank subsequently stamped each check with a Mechanics Bank processing stamp. The parties dispute whether the stamp constituted an indorsement. The dispute is immaterial because the stamp, if regarded as an indorsement, was genuine, the bank being the named payee. "[T]he benefit of [the fictitious payee rule] runs to those who acquire an interest subsequent to the forgery of the indorsement; it does not improve the status of the named payee or of the person who actually executes the indorsement." Federal Ins. Co. v. Groveland State Bank, 44 A.D.2d 182, 185-186 (N.Y 1974) (citing Pacific Indem. Co. v. Security First Natl. Bank, 248 Cal. App. 2d 75 [1967]), modified on other grounds, 37 N.Y.2d 252 (1975). Because the Mechanics Bank checks contained no forged indorsement, the fictitious payee rule does not apply [Note 19]. See Federal Ins. Co. v. Groveland State Bank, supra (fictitious payee rule not applicable where improperly paid checks contained only the genuine indorsement of the named payee). See also State of Qatar v. First Am. Bank of Va., 880 E Supp. 463, 468 (E.D. Va. 1995) (rule does not apply to checks containing no indorsement); Pacific Indem. Co. v. Security First Natl. Bank, supra at 92-94 (rule inapplicable where unindorsed check was in fact delivered to named payee bank, which paid check to depositor without verifying his authority to receive funds); Wright v. Bank of Cal., 276 Cal. App. 2d 485, 489-490 (1969) (rule inapplicable where bank paid check without any indorsement) [Note 20].

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B. Estoppel.

The bank argues that the Govonis' negligence in failing to supervise their accountant estops them from asserting the bank's wrongdoing in the first instance. Even if the Govonis were negligent, the bank's contention lacks merit under both the code's provisions and the common law.

We consider first the estoppel-like affirmative defense provided by G. L. c. 106, s. 3-406, inserted by St. 1957, c. 765, s. 1, which precluded a party whose "negligence substantially contributes to a material alteration of the instrument or to the making of an unauthorized signature . . . from asserting the alteration or lack of authority" against the bank if the bank paid the check "in good faith and in accordance with . . . reasonable commercial standards." This preclusion is unavailable to the bank for two reasons. First, the provision is irrelevant because, as noted earlier, the Govonis do not assert an alteration or unauthorized signature, but an improper disbursal of the check proceeds. See Bank of S. Md. v. Robertson's Crab House, 39 Md. App. at 722.

Second, we conclude that the payment of the checks violated "reasonable commercial standards [Note 21]," which strips the bank of

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the ability to invoke the provision even if it were relevant [Note 22]. See First Natl. Bank of Boston v. Hovey, 10 Mass. App. Ct. at 723-724. There is ample authority finding a failure to comply with "reasonable commercial standards" in these circumstances. Although adherence to such norms is often a question of fact, see First Natl. Bank o Boston v. Hovey, supra at 721-724; Bank of S. Md. v. Robertson's Crab House, supra at 714, certain conduct has been considered so unjustified as to be commercially unreasonable as a matter of law. For example, the following situations, quite similar to the case at bar, "have involved clearly unreasonable conduct on the part of the bank: payment of checks with missing indorsement, failure to respect restrictive indorsement, failure to inquire into the authority to sign of one purporting to be an agent, and allowing deposit of a check indorsed by a corporate payee into a personal account" (footnotes omitted). White & Summers, Uniform Commercial Code s. 15-5, at 761-762 (3d ed. 1988) (collecting cases). "Two other examples of obviously negligent conduct include payment of checks bearing irregular or incorrect indorsement and honoring a check on which the name of the payee has been visibly altered." Id. s. 16-7, at 807 n.1 (citations omitted). Likewise, other courts have specifically found that the payment of a check by a payee bank to an unauthorized third party without inquiry by the bank is commercially unreasonable as a matter of law. See, e.g., Bullitt County Bank v. Publishers Printing Co., 684 S.W.2d 289, 291-293 (Ky. Ct. App. 1984); Bank of S. Md. v. Robertson's Crab House, supra at 722; Master Chem. Corp. v. Inkrott, 55 Ohio St. 3d at 25. See also Olean Area Camp Fire Council, Inc. v. Olean Dresser Clark Fed. Credit Union, 142 Misc. 2d 1049, 1062 (N.Y Sup. Ct. 1989) ("In charity we will withhold characterizing such conduct as 'abject stupidity' and call it merely negligence of the grossest kind"). The bank's showing that other area banks, following identical procedures, would also have allowed payment of these checks cannot alone make those procedures reasonable in contemplation of law. An entire industry may behave unreasonably. "[A]lthough the bank ha[s] established that the procedures it ha[s] followed in paying

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the check[s] were common among banks, it ha[s] failed to show that such procedures were reasonable." First Natl. Bank of Boston v. Hovey, supra at 723, citing Perley v. Glastonbury Bank & Trust Co., 170 Conn. 691 (1976).

The bank argues that the vast number of checks a modem bank must rapidly process [Note 23] makes it practically impossible for it to examine all presented checks for such information as the identity of the named payee. While forcefully made, the substance of this argument is called into question by a recent report of the Federal government's Check Fraud Working Group. [Note 24] The report instructs banks to confirm the identity of customers presenting checks [Note 25], to record identification information on the back of each check [Note 26], and to train tellers to look for telltale signs of check fraud, including attempts to deposit checks payable to corporations into the accounts of individuals [Note 27]. If for the sake of efficiency banks feel that they must forgo these prudent safeguards, they should also appreciate that they must bear the losses that result as a cost of doing business.

We next consider common law estoppel. Without deciding whether the code has displaced common law estoppel, we conclude that even if not displaced it would not assist the bank. In the context of bank-customer relations, the test for estoppel by negligence was stated in Jordan Marsh Co. v. National Shawmut Bank, 201 Mass. 397, 408 (1909): "[N]egligence of the maker is immaterial unless it is of a kind that directly and proximately affects the conduct of the banker in the performance of his duties." The Govonis' failure to oversee Maddalena did not directly cause the bank's failure of inquiry, and it has no common law estoppel defense.

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C. Holder in due course status.

A holder in due course takes an instrument free from all claims and from all defenses of any party to the instrument with whom the holder has not dealt, except certain so-called "real" defenses. See G. L. c. 106, s. 3-305, inserted by St. 1957, c. 765, s. 1. The bank asserts that it qualifies as a holder in due course and is therefore protected from liability to the Govonis. We disagree.

A holder in due course under the original code was a holder who took an instrument for value, in good faith, and without notice that it was overdue, had been dishonored, or was subject to any defense or claim to it on the part of another. See G. L. c. 106, s. 3-302(l), inserted by St. 1957, c. 765, s. 1. Generally under the Uniform Commercial Code, "[a] person has 'notice' of a fact when (a) he has actual knowledge of it; or (b) he has received a notice or notification of it; or (c) from all the facts and circumstances known to him at the time in question he has reason to know that it exists." G. L. c. 106, s. 1-201(25), inserted by St. 1957, c. 765, s. 1 [Note 28]. Specific to the holder in due course context, under G. L. c. 106, s. 3-304(l)(a), inserted by St. 1957, c. 765, s. 1, a party was regarded as having notice if "the instrument is . . . so irregular as to call into question its validity, terms or ownership or to create an ambiguity as to the party to pay [Note 29]." Here, the bank had reason to know that the checks it received designated it as payee, and it failed to discharge its duty to inquire into the presenter's authority to receive the proceeds. See Bank of S. Md. v. Robertson's Crab House, 39 Md. App. at 722. The checks on their face left unanswered the critical question whom to pay and thus put the bank on notice of the Govonis' claim against the checks. Cf. Medeiros v. Fellsway Motors, Inc., 326 Mass. 656, 658 (1951) (holder charged with notice of what appears on face of instrument); First Natl. Bank of Cape Cod v. North Adams Hoosac Sav. Bank, 7 Mass. App. Ct. 790, 795-796 (1979). The bank therefore does not qualify as a holder in due course, and in so deciding, we join a number of other courts reaching the same

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result on similar facts. See, e.g., Sun 'n Sand, Inc. v. United Cal. Bank, 21 Cal. 3d at 689-690; Douglass v. Wones, 120 111. App. 3d 36, 45-46 (1983); Allis Chalmers Leasing Servs. Corp. v. Byron Center State Bank, 129 Mich. App. 602, 607-609 (1983); Dalton & Marberry, PC v. NationsBank, N.A., 982 S.W.2d at 235 [Note 30].

D. Comparative negligence and indemnification.

After finding the bank liable in negligence on the Mechanics Bank checks, the trial judge also found the Govonis to have been twenty-five percent negligent in failing to oversee their accountant, and applied the comparative negligence statute, G. L. c. 231, s. 85, to reduce the defendant's liability to seventy-five percent of the total. The bank argues that this allocation was clear error, and that the Govonis were over fifty percent negligent, which under the statute places all of the loss on the Govonis. However, we agree with the Govonis that the statute is inapplicable.

First, a claim for wrongful debit of items not properly payable under G. L. c. 106, s. 4-401, is one of strict liability. See Ambassador Financial Servs., Inc. v. Indiana Nati. Bank, 605 N.E.2d 746, 751 (Ind. 1992); Pamar Enters., Inc. v. Huntington Banks of Mich., 228 Mich. App. 727, 736 & n.6 (1998); Woods v. MONY Legacy Life Ins. Co., 84 N.Y.2d 280, 283 (1994), citing Putnam Rolling Ladder Co. v. Manufacturers Hanover Trust Co., 74 N.Y.2d 340, 345 (1989); Medford Irr. Dist. v. Western Bank, 66 Or. App. 589, 595 (1984). It is settled that the comparative negligence statute does not apply to strict liability claims. See Correia v. Firestone Tire & Rubber Co., 388 Mass. 342, 353 (1983).

Second, the comparative negligence statute is "displaced by the particular provisions" of the code. G. L. c. 106, s. 1-103. Cf. Arkwright Mut. Ins. Co. v. State St. Bank & Trust Co., 428 Mass. 600, 604-606 (1998). Against the strict liability of the wrongful debit action retained by s. 4-401, the code provided

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affirmative defenses that incorporated concepts of negligence. See McCarthy, Kenney & Reidy, P.C. v. First Natl. Bank of Boston, 402 Mass. at 633. For example, as discussed above, s. 3-406 allowed a bank that followed "reasonable commercial standards" to preclude a plaintiff whose negligence substantially contributed to the making of a material alteration or unauthorized signature from asserting the alteration or lack of authority against the bank. Similarly, G. L. c. 106, s. 4-406(3), inserted by St. 1957, c. 765, s. 1, denied a bank that failed to use ordinary care the defense that the plaintiff customer failed to exercise reasonable care in examining periodic statements of account. These provisions expressed a form of contributory negligence whereby the bank, if at all negligent, may have been liable regardless of the plaintiff's own negligence. See First Natl. Bank of Boston v. Hovey, 10 Mass. App. Ct. at 723; White & Summers, Uniform Commercial Code s. 16-7, at 806-807 (3d ed. 1988). The original code's dual reliance on notions of strict liability and contributory negligence in allocating liability between drawer and drawee left no room for a comparative negligence standard. See Federal Ins. Co. v. NCNB Natl. Bank of N.C., 958 F.2d 1544, 1550-1552 (11th Cir. 1992) (applying Florida law); Putnam Rolling Ladder Co. v. Manufacturers Hanover Trust Co., supra at 348 ("[t]he importation of comparative negligence into the UCC - which was drafted before widespread acceptance of comparative fault - is not without its advocates . . . but has generally been rejected by both courts and commentators"), citing White & Summers, supra s. 16-7, at 809 n.6 [Note 31].

For similar reasons, the bank is not entitled to common law indemnification from the Govoni treasurers. The code's carefully devised allocation of liability must be seen to displace common law indemnification just as it displaces comparative negligence [Note 32].

2. Checks payable to the Commonwealth or the DES.

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The defendant for similar reasons is also liable for its improper disbursal of the proceeds of the Commonwealth/DES checks. Maddalena was not entitled to payment on those checks because they were not "drawn, issued, or indorsed to him or his order or to bearer or in blank." G. L. c. 106, s. 1-201(20), as amended by St. 1983, c. 522, s. 3. See generally 9 C.J.S. Banks & Banking s. 342 (1996) ("Where a check designates a payee, the bank generally may charge the customer's account only if payment is made to such payee or the payee's indorsee"); id. s. 343 ("[t]he payment of such a check to one other than the payee, without a valid indorsement of the payee, is at the risk of the bank") [Note 33].

At trial the bank successfully invoked the defense of commercial reasonableness under s. 3-406. The judge found that the Govonis' negligence in dealing with their accountant substantially contributed to the fraudulent scheme, and that the bank followed "reasonable commercial standards" in paying the checks. The latter finding was based on the policy of the bank, identical to that of comparable local banks, of paying out tax checks made to the order of the Commonwealth or the DES, even without payee indorsement, to protect customers from late tax payment penalties. Were the checks in fact presented by the named payees, this practice would not expose the bank to liability. See Gordon v. State St. Bank & Trust Co., 361 Mass. 258, 260-261 (1972) (payment over forged indorsement not basis for recovery by drawer where intended payee received payment). But here the bank failed to conduct even the most basic of inquiries into whether the checks were in fact presented by an agent of the Commonwealth or deposited to an account of

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the Commonwealth. This failure invites fraud against both the Commonwealth and the bank's depositors, and is commercially unreasonable as a matter of law [Note 34].

3. The Govonis' chapter 93A claims.

The Govonis' claims under G. L. c. 93A, s. 11, that the bank engaged in unfair or deceptive acts, were properly rejected by the judge. Even if the bank is characterized as negligent, this by itself does not amount to a chapter 93A violation. See Glickman v. Brown, 21 Mass. App. Ct. 229, 234 (1985). The bank was merely following procedures that, although resulting in improper payment, were widely utilized by similar banks in the area. No act of the bank fits within a common law conception of unfairness or was "immoral, unethical, oppressive, or unscrupulous." Levings v. Forbes & Wallace, Inc., 8 Mass. App. Ct. 498, 504 (1979), quoting from 29 Fed. Reg. 8325, 8355 (1964).

4. Summary.

We conclude that the bank wrongfully debited plaintiffs' account when, without any inquiry into Maddalena's authority, it paid to him the proceeds of the Mechanics Bank checks. The bank's defenses based on the "fictitious payee" rule, estoppel, holder in due course status, and common law indemnification are all without merit. Moreover, the trial court erroneously applied the comparative negligence statute to reduce the Govonis' recovery. The bank is fully liable to the Govonis for the Mechanics Bank checks, which totaled $503,352.08. The bank is also liable to the Govonis for improperly debiting their account for the Commonwealth/DES checks, which totaled $147,422.89. The Govonis' chapter 93A claims are without merit.

Accordingly, the trial court's amended judgment is to be modified by eliminating the prefatory paragraph that includes the reference to the reduction for the plaintiffs' comparative

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negligence, by striking the figure $384,514.06 and inserting in its place the figure $650,774.97, and by making appropriate adjustments in interest. As so modified, the judgment is affirmed.

So ordered.