Abstract

The February 1, 1988 draft of Article 4A (hereinafter referred to as 4A)1 of the Uniform Commercial Code (UCC) represents a fairly refined product of the drafting effort. It has been preceded by some half-dozen drafts and reflects a growing consensus that began with a December 1985 meeting of those interested in the subject.

I. Introduction

The February 1, 1988 draft of Article 4A (hereinafter referred to as 4A)1 of the Uniform Commercial Code (UCC) represents a fairly refined product of the drafting effort. It has been preceded by some half-dozen drafts and reflects a growing consensus that began with a December 1985 meeting of those interested in the subject.

The project—to write a wholesale electronic funds transfer code—derived from such cases as Evra Corp. v. Swiss Bank Corp.2 and Delbrueck & Co. v. Manufacturers Hanover Trust Co.,3 which made it clear to a dismayed bank audience that no statute governed the electronic transfer of funds. Thus, while Articles 3 and 4 of the UCC prescribe a detailed set of rules for problems that might arise in the checking system, there is no equivalent for electronic transfers. Whether, for example, a bank may suffer consequential damages for the loss of a bargain when it mishandles a funds transfer—the situation in Evra—is currently left to the judgment of the deciding court.4 The banking community did not consider this kind of risk acceptable.5

Proposed Article 4A attempts to answer the Evra problem and the other major problems that were perceived when electronic funds transfers were reviewed. This paper will review the major problems and the present solutions to them contained in 4A.

It must be appreciated that the February 1, 1988 draft of 4A is still subject to revision.* Parties in interest are still being heard from and proposals for change are still being considered. In particular, it is fair to state that the early proposals for 4A came principally from those representing banks and that the present 4A reflects the bankers’ point of view more than the views of users of electronic transfers or, for that matter, of society at large. As the 4A drafts achieve wider circulation, other interests are being heard from. In particular, the large corporate users of electronic banking services have recently become participants in the drafting process and are presenting their views forcefully. Article 4A may undergo some healthy changes before it is finished.

This paper is not intended as an exhaustive treatise on 4A. I have selected the problems that seem most significant to me and have explained 4A’s solutions in general terms. Much more will be discovered in a reading of 4A itself.

II. Basic Definitions and Coverage

Concept of Funds Transfer and Payment Order

Let us assume that a business instructs its bank to wire funds to one (the “beneficiary”) to whom that business is indebted. Normally, the funds will go from that business’s bank, possibly along a route, and into the beneficiary’s bank, which will then pay them to the beneficiary. This entire transaction is defined by Section 4A-104 as a “funds transfer.”

A funds transfer will, however, normally consist of a series of intermediate payment orders; the sender instructs his bank; that bank instructs another bank; and so on until the funds are transferred into the beneficiary’s bank. Under Section 4A-103, each payment order is a separate transaction. To come under 4A, a payment order must involve a bank. Electronic transfers made outside the banking system are not covered by 4A and generally remain subject to the common law. Article 4A is a banker’s code.

Most funds transfers are divisible into two elements. First is the order. This is the instruction to pay that is transferred from the original sending party to its bank and from bank to bank along the route. Second is the payment of that order, which may be accomplished through the creation of book entries among banks, through settlement in clearinghouses, through payment by a central bank (such as the Federal Reserve System), or even perhaps through the delivery of cash. Article 4A distinguishes between an order and the payment of that order. The two events have different legal consequences, and one must be careful, in dealing with 4A, that the correct event is under scrutiny.

Coverage of Article 4A

It was the goal of 4A to cover what bankers referred to as “wholesale wire funds transfers.” Unfortunately, no one could devise a definition that took in “wholesale” transfers and excluded those of a “retail” nature. We now start, under 4A-103, with all payment orders (including checks, which are, of course, orders to pay) covered by 4A. Checks and analogous paper orders are then excluded by Section 4A-103(2)(a). The resulting 4A consequently covers all non-check transfers whether they are made by wire, through the ether, or even with some other paper instrument.

Article 4A also covers payments both small and large. While it is still often referred to as a “wholesale” code, there is no cutoff as to amount.

It covers wire transfers made through the FedWire facilities of the Federal Reserve System. FedWire is, however, also governed by Federal Reserve Board Regulation J. Since Regulation J is federal law, it would supersede 4A should the two conflict.

Consumer Transactions

The appropriate treatment of consumer electronic transactions has been and continues to be a 4A drafting issue. The issue stems from the following considerations:

(1) Article 4A is designed to be a “wholesale” code. It already covers small transactions. To inject consumer transactions, however, would introduce a constituency that would complicate all drafting issues and undoubtedly delay passage.

(2) Consumer electronic fund transfers are already covered by the Electronic Fund Transfers Act (EFTA).6 This, however, raises another issue, in that EFTA is concerned largely with consumer rights. It does not relate to the kind of financial/commercial issue that is central to 4A. If, for example, we excluded consumer transactions and an issue arose relating to whether an underlying obligation had been paid in a consumer context, it would be resolved by neither 4A (which excludes the consumer transaction) nor EFTA (which does not deal with questions of final payment).

(3) Payment systems like the automated clearing houses (ACHs) increasingly service both consumer and commercial transactions. An ACH has no way of distinguishing between the two. Can there be different legal requirements for the two types of transfers, and what burden does that put upon the existing transfer systems?

The February 1, 1988 draft of 4A approaches the problem through Article 4A-108:

(1) it excludes consumer transactions generally, but

(2) it includes consumer transactions where the system transmitting the order is used primarily for commercial transactions. (Right now, this would seem to apply to the Clearing House Interbank Payment System (CHIPS)—the payments system run by the New York Clearing House Association and used primarily, although not exclusively, for commercial transactions.)

Debit Transfers

Article 4A covers only credit transfers; it does not cover debit transfers. A credit transfer is an order given to one’s bank, by one who wants to pay, for the bank to pay another party. A debit transfer is an order given to one’s bank, by one who wants to be paid, for the bank to pay oneself. For example, an insurance company which receives regular premiums may, by prearrangement with the premium payor, order a bank to pay the insurance company.

Debit transfers are not covered by 4A because they are not as common as credit transfers and are not yet perceived as raising the risks 4A is designed to address. In addition, debit transactions are not understood in the detail that credit transactions are. Resolution of debit-transfer issues has therefore been put off to another day. The volume of debit transfers is increasing, however, and one may wonder whether this deferral is wise.

III. Issue and Acceptance of Payment Order

Unauthorized Transfers

Section 4A-202 prescribes the general rule that a sender is not obligated upon a payment order unless he or someone authorized to act for him has given that order. This principle requires some refinement to protect both customers and banks in view of the potential ability of criminals to break into electronic payments systems.

A bank may, and typically will, adopt a “security procedure,” which is defined in Section 4A-201. Basically, such a procedure must include adequate methods of authenticating payment orders. If a bank has a satisfactory procedure, which it offers to its customers, and an unauthorized order that complies with the terms of that procedure is nevertheless made, the customer is bound by it. The risk that a break-in may occur in the system is borne by the customer. This is not the case, however, if the customer can prove that the break-in occurred because of the bank’s negligence or was carried out by someone who has access to the procedure on the bank’s behalf. Such proof would transfer the loss from the customer to the bank.

Acceptance and Rejection of Orders

If a payment order is made upon a bank, Section 4A-204 provides that any bank other than the bank of the ultimate beneficiary of the wire transfer has an absolute right to accept or reject the order. If it rejects the order, its only obligation is to give appropriate notice to the sender. If it accepts the order, it accepts the credit of the sender that the order will be paid; it acknowledges that the order is correct and authorized; and (Section 4A-302) it incurs the responsibility of sending the order along and paying it. The burdens of an accepting bank are heavy. It is assumed to know and trust the order’s sender. At the same time, its ability to reject (if it is not the beneficiary’s bank) is unfettered.

Acceptance occurs either through action or through the passage of time. The action taken by each receiving bank other than the ultimate beneficiary’s bank is the execution of another transfer order, passing the transfer along. The time limit involved is reminiscent of the midnight deadline for checks. It is midnight of the next “funds transfer business day” following the “payment date” of the order, but only if the bank has received funds from its sender to pay the order.

“Funds transfer business day” is defined in Section 4A-106 as the part of the day that the bank is open for funds transfers. “Execution date” is the date, prescribed by Section 4A-301, on which the order is payable.

For the beneficiary’s bank, the rules vary somewhat. An order is accepted when that bank releases funds to the beneficiary, or notifies the beneficiary that funds are available, or itself receives good funds to pay the order. In the last case, the bank’s right to reject is limited, but presumably it should be limited, since the bank has received payment and all it has to do is pay the beneficiary. Section 4A-204 makes clear that this limitation on the right to reject applies only where the ultimate beneficiary has an account with the bank into which the funds will be paid. If the bank has no account relationship with the beneficiary, the right to reject remains.

IV. Execution of Sender’s Order to Receiver

Obligation of Receiver

Upon accepting a payment order, the receiver is obligated by Section 4A-302 to execute it—that is, to send it along—in the manner prescribed by the order. (Prior drafts of 4A had the receiver also give a warranty that the order would be transmitted to the beneficiary’s bank, but this was deleted in the February 1, 1988 draft.) The series of payment orders that make up a total funds transfer are relatively discrete, and no bank is the agent for any other bank.

Erroneous Orders

If a bank receives a correct order and then, in executing it, issues an erroneous order, the following rules apply under Section 4A-303:

(1) If the bank issues an order for a higher amount, it is liable for that amount to the extent that the beneficiary’s bank has paid it to the beneficiary. It may recover only the correct amount from the sender. It may recover the excess from the beneficiary under the law of mistake and restitution.

(2) If it issues an order for a lower amount and corrects its mistake, it may recover the full amount from the sender. If it does not correct the mistake, it is entitled to receive only the lower amount. (Its liability for the error is governed by Section 4A-304, which is discussed below.)

(3) If it issues an order to the wrong beneficiary, the sender need not pay the order to the bank making the mistake. That bank may recover from the wrong beneficiary to the extent provided by the laws of mistake and restitution.

(4) There are a series of rules governing situations where identifying numbers do not match. Reference is made to Section 4A-303(4) and (5).

Liability for Erroneous Transfers

If a bank receives a transfer order, accepts it, and either fails to execute it or executes it erroneously, its damages are specified by Section 4A-304. Basically, its liability is for the amount of the order, plus interest expenses incurred by the originator, plus the originator’s expenses in the funds-transfer process, plus attorney’s fees. Additional (consequential) damages are not recoverable unless there is an agreement to that effect. Damages may not, however, be reduced by agreement.

There is some question as to whether this is the correct level of bank liability. Where a receiver bank has, for example, simply failed to honor an accepted order, it really has no liability at all. It is required to effect the transfer it failed to make in the first instance and to recompense the originator for interest costs (which presumably the bank has itself earned through not transferring the funds) and some basic expenses. The bank liability falls well short, however, of the payor bank’s liability to the drawer for improperly failing to honor a check under UCC Section 4-402, where the damages are measured by a proximate-cause test and generally include consequential damages. The receiver bank’s liability also falls short of the liability of other banks in the check-collection chain, which, under Section 4-103(5), includes consequential damages when bad faith can be proven.

Article 4A thus answers the Evra issue, as did the Seventh Circuit, much to the satisfaction of the banks.7 The banks insist that this limited remedy is appropriate for the cost structure of the electronic-payment system. A typical bank transfer, regardless of its amount, costs somewhere between $8 and $12. Banks maintain that with this modest payment as their sole income from each transaction, they cannot “insure” against consequential damages that can easily amount to millions of dollars. So far, their argument has been accepted.

In Evra, the Seventh Circuit suggested that one reason the Swiss Bank Corporation would not be held responsible for Evra’s loss of the bargain was that the Swiss Bank Corporation was not informed of the risk involved in a failure to pay. In doing this, the court relied on the doctrine of foreseeable consequences laid down in the seminal English case of Hadley v. Baxendale.8 It was suggested to the 4A draftsmen that perhaps a bank should be held responsible for consequential damages if a party to the funds transfer informed the bank of the risks of error. This suggestion was rejected. First, the task of informing the proper person at a large bank with thousands of employees presented problems. But even more significant was the fact that no bank today has any idea of what the proper charge should be for incurring a massive funds-transfer risk. The actuarial basis does not exist.

We may assume that the damages structure of 4A will come under additional scrutiny as the drafting process proceeds.

V. Payment

Payment to Banks

Under Section 4A-402, each bank in the chain of a funds transfer is entitled to receive payment of an order from its preceding bank. A bank that is not the beneficiary’s bank is entitled to payment from the sender when it executes an order (that is, when it sends it along; as previously noted, in the discussion of Section 4A-204, execution is one form of acceptance). The beneficiary’s bank is entitled to receive payment when it accepts an order.

The essential structure of 4A thus becomes clear. A bank generally has an unrestricted right to accept or reject a payment order. If the bank accepts the order, it has a duty to move the order to the next step in the funds transfer and also has a right to receive payment from the sender.

Payment to Beneficiary

Acceptance by the ultimate beneficiary’s bank requires that bank to make payment to the beneficiary. Section 4A-405 describes both when, and the various ways in which, payment may be made. Payment must be made in the manner specified in the order. One assumes that the typical order will direct the beneficiary’s account to be credited. In the absence of a specific direction, the beneficiary’s bank may use any reasonable means, including notifying the beneficiary that funds will be paid to him over the counter.

Liability of Beneficiary’s Bank for Failure to Pay Beneficiary

If the beneficiary’s bank incurs a liability to pay the beneficiary (usually through acceptance of a payment order) and fails to make payment to the beneficiary, its liability is prescribed by Section 4A-407. The general rule is that damages are limited to the principal amount due, plus interest losses and attorney’s fees. This reflects the same point of view toward a beneficiary bank’s place in the payment system that we saw in connection with other banks’ liability for damages; it is not liable for consequential damages. See, in this connection, Section 4A-304.

Section 4A-407 does, however, provide for consequential damages proximately caused if the bank refuses to pay to the beneficiary within a reasonable time after a demand is made. This is the only place that the current draft of 4A imposes upon a bank liability for damages beyond the principal due, interest, immediate costs, and attorney’s fees.

Payment by Originator to Beneficiary and Discharge of Underlying Obligation

The originator of the transaction presumably has an obligation to the ultimate beneficiary. (That is why he is transferring the funds.) The originator starts the funds transfer by ordering his bank to transfer funds to the beneficiary’s bank. Section 4A-408 specifies when the obligation of the originator to the beneficiary is satisfied.

The basic rule is that payment is made when the beneficiary’s bank accepts the order (from whatever bank transmitted the order to it). As we have seen in the discussion of Section 4A-405, such acceptance obligates the beneficiary’s bank to pay the beneficiary. In essence, this entails the substitution of a bank’s obligation for the obligation of the order’s originator. In deeming this to be payment by the originator to the beneficiary, 4A conforms to the pattern of the UCC, according to which a check is only a conditional payment until it is honored by the payor bank. Such honoring may, however, consist of no more than the acceptance by the payor bank of an obligation to pay.9 A difficult theoretical problem is presented when an original sender owes a beneficiary a set amount—say $1,000,000. The sender orders its bank X to pay $1,000,000 to the beneficiary’s bank Z for credit to the beneficiary. The payment order is effected by an intermediate transfer through bank Y, which deducts $10 for its services10 and makes a payment order to Z in the amount of $999,990. Z accepts and pays this amount to the beneficiary. Is the $1,000,000 obligation of the original sender to the ultimate beneficiary consequently satisfied? Section 4A-408 decrees that it is and that the original sender now has a new debt to the beneficiary in the amount of $10.

Bank Failure

A problem that has bedeviled the 4A drafters from the beginning, and has still not been resolved to the satisfaction of all, is the effect of a bank failure in the payment chain. As we have noted, a wire transfer consists of two basic events: (1) an order to pay, and (2) payment or settlement of that order. An order (formally called a “payment order”) can be made by the original sender to his bank. It may be transmitted from bank to bank and ultimately be accepted by the beneficiary’s bank. This acceptance creates a duty upon that last bank to pay the beneficiary and also discharges the obligation of the sender to the beneficiary. But no money has necessarily changed hands. We have only a series of obligations from party to party. Until payment is made, each party relies upon another’s credit.11

One may evaluate credit wrongly. If a bank accepts a payment order from another bank that subsequently fails before paying the order, the accepting bank has an obligation to the next bank in the chain that accepts the payment order. But the bank may never receive payment from the failed bank. To complicate the problem, the failed bank may—or may not—have received payment from its predecessor. In either event, it probably would not be able to make a payment because of its insolvency.

The basic resolution of the failed-bank problem is contained in Section 4A-409. A failed bank is dropped from the chain of transfers as if it had never, or almost never, existed. Assuming that the failed bank had not yet received payment from the bank whose order it has accepted, the sender of the order to the failed bank is then obligated to pay to the receiver of the order from the failed bank. Payments are, therefore, ultimately made to the beneficiary’s bank.

The foregoing resolution obviously does not, however, solve all problems that may arise. One kind of problem may be created if the sender to the failed bank was not itself a bank and thus could not simply be plugged into the payment system. Another kind of problem may be created if the sender to the failed bank has already made payment to that bank.

In the event of problems such as these (among others),12 Section 4A-409 provides a different approach. Assuming that the beneficiary’s bank has an agreement with its beneficiary to be reimbursed if the beneficiary is not paid, the beneficiary’s bank may revoke its acceptance if either (i) the sender of the order to the beneficiary’s bank was the failed bank or (ii) the sender of the order did not receive payment because the failed bank preceded it in the payment chain.

Revocation of acceptance by the beneficiary’s bank unwinds the transaction under Section 4-402(3). Each bank that has already made payment is reimbursed, and the obligation of the original sender to the ultimate beneficiary is not discharged. The resulting loss would seem to fall upon the bank that paid the failed bank, and the former thus probably could not receive a reimbursement. Since it chose to do business with the (now) failed bank, this may not be an inappropriate result.13

The solution provided by Section 4A-409 has been seriously criticized. It has been called a Russian-roulette procedure according to which a bank that accepted an order from a failed bank—and, correspondingly, gave credit to the failed bank (wrongly, as things turned out)—would have no knowledge of the bank which preceded the failed bank in the payment chain and that is now, by operation of law, required to make the payment.

More fundamentally, the necessity for a solution like that of Section 4A-409 points out an inherent weakness in any private payment system (CHIPS, for example) compared with the public payment system FedWire, which is operated by the Federal Reserve System. When FedWire issues a payment order, it also pays the order. There is no risk to the receiving bank. In a private system, there is a risk of bank failure until all the banks pay.

CHIPS and FedWire now compete for the business of those who make electronic funds transfers. It remains to be seen whether this disadvantage of the private system will be viewed as innate, possibly driving users to the greater safety of FedWire; whether CHIPS and another private system, the Society for Worldwide Interbank Financial Telecommunication (SWIFT), will dominate international transfers, leaving FedWire to handle domestic transfers; or whether the private payment systems will improve their safety, perhaps putting the credit of the entire system behind each transfer.

VI. Miscellaneous Provisions

Variation by Agreement

Consistent with Articles 3 and 4 of the Uniform Commercial Code as they affect the checking system,14 the rules of 4A may generally be varied by agreement. Section 4A-501 provides that agreements of parties and the rules of payment systems to which the relevant transactions are subject will supersede 4A.

Also, with or without Section 4A-501, although that section makes it specific, Regulation J of the Federal Reserve System, which governs the operation of FedWire, is federal law and, as such, is superior to 4A as state law.

The present comment to Section 4A-501 provides that provisions of 4A “that relate to the basic structure of Article 4A and those that are designed to provide basic rights” may not be varied by agreement. While this comment makes good sense, it is not reflected in the draft statute itself. Possibly it means that certain provisions in 4A15 which specifically provide that they may not be varied by agreement mean what they say and that the remainder of 4A may be so varied.

Addendum

Some of the changes made between the February 1, 1988 draft of Article 4A and the final draft are as follows:

(1) Definitions. The definitions in Section 4A-103 of the Code discussed in this paper have been almost entirely recast in form. No major changes have, however, been made in substance.

(2) Consumer Transactions. The approach of the final draft in Section 108 is to exclude from the coverage of Article 4A all transactions that are covered by the federal Electronic Funds Transfer Act. This is the case whether or not the particular issue involved is covered by EFTA. It should be noted that, pursuant to EFTA itself, funds transferred through Fed-Wire, even if consumer in nature, are excluded from EFTA. They therefore would be covered by 4A.

(3) Unauthorized Transfers. The matters to be proved for a bank to be held liable for an unauthorized transfer when it complied with an appropriate security procedure have been changed in the final draft. Now, the customer must prove under Section 4A-203 that an interloper did not get his information through the customer rather than (as in the February 1, 1988 draft) that he got them through the bank.

(4) Acceptance and Rejection of Orders. Although the substance of the change in the final draft from the February 1, 1988 draft is not significant, the approach has been altered. A payment order is not now accepted after the passage of time. If not specifically rejected, Section 4A-210(b) provides that interest now accrues in favor of the sender on any of its funds with the receiver until the order is canceled. It is rejected by operation of law under Section 4A-211(d) after five days.

(5) Obligation of Receiver. The warranty of a receiving bank referred to in this paper has evolved into what is now generally called a “money back guaranty” made by the banking system to the originator. This is accomplished by a combination of Section 4A-402(c) and (d), excusing a sender from making payment if the funds transfer is not accepted by the beneficiary’s bank and requiring a refund if the payment has been made.

(6) Liability for Erroneous Transfer. The liability of a receiving bank has been refined. (See new Section 4A-305.) The most significant change is that the measure of liability has been varied between that applicable to a funds transfer that is merely delayed and one that does not occur at all. (The basic answer to the Evra issue described in the main text of this paper remains unchanged.)

(7) Liability of Beneficiary’s Bank for Failure to Pay Beneficiary. The imposition of consequential damages, now under Section 4A-405(a), now requires the beneficiary to give not only a demand for the funds but also notice of particular circumstances that will give rise to the consequential damages.

(8) Bank Failure. The risks of a bank failure are handled with less particularity in the final draft than they were in the February 1, 1988 draft. Basically, the failed bank is given a right to net its accounts with the next bank in line. Presumably, this will reduce the amount at risk. The remainder of the risk can be dealt with through advance planning and a continuing evaluation by every bank of its risk position. The issues are dealt with in Section 4A-403(b) and (c).

*

The 1989 official text (incorporating the final draft) of Article 4A appears in Appendix III of this volume.