Good Times for Bad Paper

Check fraud is everywhere--and customers are stuck with most of the tab

Business Week - August 13, 2001

Last September, Allen Farrell, CEO of vitamin maker Meta-Sure Health, knew he had a problem. He thought his company had been paying its bills on time. But Meta-Sure's suppliers, credit-card issuers, and even the Internal Revenue Service had received no payments for months--though Farrell had gotten back undoctored, cancelled checks made out to them.

Farrell ultimately discovered he had been the victim of a brazen fraud that slipped under the radar of more than 20 banks that processed nearly 60 of his checks, totalling some $92,000. Figuring out how it happened was just the start of Farrell's problems, though. Ten months later, he's still struggling to get his money back from banks that processed the checks.

Although Farrell's experience may be extreme, it's not unique. Bank customers write some 65 billion checks a year.

Illegal activity, including fake checks, counterfeiting, and check kiting--but not checks that bounced for lack of funds--grew 25% in 2000 (chart), according to the Treasury Dept. "The problem is certainly not getting any better," says J. Mark Batts, head of the FBI's financial institution fraud unit. "In fact, [check fraud] is much easier than it used to be" because it's easier to print checks from computers.

SLOW BANKS. And because of a set of rules modeled after British laws dating from the 1890s, consumers and small businesses are getting hit the hardest. By some estimates, fraudulent checks will cost the economy $10 billion this year. Banks will only bear about one-tenth of the losses, sticking customers such as Farrell with the rest.

Meta-Sure's problems were traced to an employee who intercepted checks written both by Farrell to pay bills and to Meta-Sure from would-be investors in the company. Without altering them, the employee sent them with her credit-card payment slips. Without exception, the card companies credited them to her account. In turn, the checks were paid by the bank they were drawn on--though they were clearly payable to someone else. Farrell's employee, now serving 16 months in prison for the fraud, used the cards to pay for, among other things, a trip to the Cayman Islands.

Banks say there's not much they can do to stop such frauds because nearly all checks are processed by machine. "If there's a payment coupon attached to a check, it automatically gets credited to that account," no matter who it's written out to, says Mark Lowenthal, chief privacy officer at credit-card issuer Providian National Bank. "Most banks don't look at every line" on a check, says Nessa Feddis, senior federal counsel for the American Bankers' Assn. trade group. "It's just not cost-effective." Instead, banks use software to flag exceptionally large amounts, out-of-sequence checks, and ones printed on non-check stock--and of course, to make sure the payer's account has enough funds. But they can't pick up misappropriated checks.

The banks are slow to compensate fraud victims, as well. The Uniform Commercial Codes lay down how much responsibility banks have to their depositors. They were last updated by a committee of attorneys--not state or federal regulators--in 1990, when banks were relieved of full responsibility for payouts on fraudulent checks. "It used to be pretty cut-and-dried. If the banks allowed the checks to be paid against the wrong account, they were 100% liable," says Eugene Seitz, a Federal Deposit Insurance Corp. examiner. "Now the customer has some of the responsibility." Farrell says his bank, City National in Beverly Hills, Calif., argued that he should have taken more care in his hiring. City National said in a statement that it is "deeply sympathetic" to Farrell's plight, and that it immediately credits customers like Farrell when it receives funds from the other financial institutions. So far, Farrell has recovered just 25% of the $92,000 he lost.

Mark Meckle, owner of computer retailer Appel & Cook Systems Inc. in Towson, Md., is in the same position. He says he's out more than $80,000 because of fraudulent checks cleared by his bank, First Mariner in Baltimore. Meckle says he took an order from a Nigerian customer last year but waited until the check cleared before he shipped any goods. Two months later, he accepted a check and shipped a second order to the same customer. A month later, First Mariner told him the checks were fraudulent, and removed the amount of the checks from his account. First Mariner attorney Eugene A. Friedman says the bank is "doing whatever it can" to recover Meckle's money, but adds, "businesspeople have to be aware of who they are dealing with."

Litigation is often a bank customer's only recourse, says Maryland Assistant Attorney General Tom Gounaris. As a result, "lawsuits [are] flying around the country," says Edward L. Rubin, a professor at the University of Pennsylvania Law School. Consumers lose out, though, because it's "economically impossible for a consumer to sue a bank over a $5,000 check because the legal fees will be more than that."

Some relief may be coming. A committee that includes consumer representatives was set up early this year to review the Uniform Commercial Codes. But when it will be meeting isn't clear, says Chairman Edward Smith, a Boston attorney. Alas, it may be too late to cure Farrell's "incredible headache."

By Heather Timmons in New York

Copyright 2001, by The McGraw-Hill Companies Inc. All rights reserved.