Opinion
MOSK, J.
We here consider the rights of the true owner of a negotiable instrument which has been collected and paid on a forged indorsement. The question has not previously arisen in this state under the Uniform Commercial Code, and has seldom been addressed in other jurisdictions.
The record recounts a typical tale of forgery. Plaintiff Joseph Stell, an attorney, employed one Bernice Ruff as a secretary and bookkeeper. During a period of approximately a year and one-half Ruff purloined some 29 checks intended for Stell and forged the necessary indorsements thereon.
She cashed some of these checks at defendants Union Bank and Crocker Citizens National Bank and deposited the remainder (except one that was cashed elsewhere) to her personal account at the latter bank. The entire amount of such deposits was subsequently withdrawn by Ruff prior to discovery of the forgeries. Certain of the checks were forwarded to and paid by defendants Crocker Citizens National Bank, Security First National Bank, and First Western Bank and Trust Company; the remainder were drawn on payors who are not parties to this action.
Stell and his partners bring this action in conversion against both the collecting and the payor banks to recover the amounts of the instruments handled by them on the forged indorsements. The critical California Commercial Code provision
is section 3419 which establishes that “(1) An instrument is converted when . . . (c) It is paid on a forged indorsement.” Notwithstanding this language, the superior court denied recovery on the basis of section 3419, subdivision (3), which provides: “(3) Subject to the provisions of this code concerning restrictive indorsements a representative, including a depositary or collecting bank, who has in good faith and in accordance with the reasonable commercial standards applicable to the business of such representative dealt with an instrument or its proceeds on behalf of one who was not the true owner is not liable in conversion or otherwise to the true owner beyond the amount of any proceeds remaining in his hands.”
The court concluded that all defendants in the case, including payor
as well as collecting banks, qualified as representatives, had acted in good faith and in accordance with reasonable commercial standards, and had no proceeds remaining in their hands. Thus defendants were held immune from liability. The court also found that plaintiffs had been negligent in failing to discover Ruff’s defalcations by April 1, 1966, approximately six months following their commencement, and that such negligence substantially contributed to the making of the subsequent forged indorsements. On this additional basis it held plaintiffs were “precluded from asserting such forgeries or lack of authorized signatures against any of the respective Defendants herein on checks presented after April 1, 1966.”
We hold that the trial court relied on an erroneous interpretation of section 3419 and that therefore the judgment must be reversed in part. Inasmuch as collecting banks and payor banks raise distinctive issues under section 3419, the application of this section to the two categories of banks will be discussed separately.
Collecting Banks
It is clear, excluding for the moment the issue of plaintiffs’ negligence, that defendant collecting banks are liable for conversion unless they can establish a defense under section 3419, subdivision (3). A careful study of this provision, however, reveals no possible defense in this case after it becomes evident that the court below erroneously held defendant collecting banks had parted with the proceeds of the fraudulently indorsed instruments. The code, unfortunately, fails to define the word “proceeds” in the context of bank collection. Therefore, to fully comprehend the code section we must examine the concept of proceeds as it was understood prior to enactment of the code and to general theory of bank collection found elsewhere in the code and in other parts of the law.
Whether defendant depositary banks have any proceeds of the fraudulently indorsed checks remaining in their hands is resolved through a bifurcated inquiry: first, did they receive any proceeds and second, have they parted with any proceeds they may have received? Each of these queries is more complex than superficially appears. A collecting bank obviously does not receive any proceeds of an instrument unless such proceeds are forwarded to it from a payor bank. Under the dominant theory of bank collection that preexisted the code and which the code has left unchanged, however, the amounts a payor bank remits on
a forged indorsement are not considered the proceeds of the instrument. The explanation for this result lies in the relationship between a payor bank and its customer, the depositor-drawer. The relationship is one of debtor and creditor: the bank is indebted to the customer and promises to debit his account only at his direction. If the bank pays, on an instrument drawn by its customer, any person other than the designated payee or a person to whom the instrument is negotiated, the bank’s indebtedness to the customer is not diminished. If the bank does debit the customer’s account, the customer can compel the bank to recredit the sum. Inasmuch as the full amount of the instrument remains in the account of the drawer when the bank pays on a forged indorsement, the bank manifestly does not part with the proceeds of the instrument but merely remits other funds from its own account.
General bank collection theory also1 instructs us that the true owner, in bringing an action against a collecting bank for conversion of a check collected on a forged indorsement, is deemed to have ratified the collection of the proceeds from the payor bank. This ratification transmutes the remittance of funds by the payor bank into an authorized act for which it may debit its customer’s account.
In the case at bar, it appears that plaintiffs’ action against defendant collecting banks constitutes such a rati
fication, and these banks, therefore, must.be considered to have received the proceeds of the instruments.
Ratification of collection, however, does not constitute a ratification of the collecting banks’ delivery of the proceeds to the wrong person. The dominant pre-code law established, on the contrary, that the proceeds were held, after collection by the collecting bank, for the benefit of the true owner.
Again resorting to general banking theory, we find that the amounts a collecting bank remits to a person who transfers to the bank a check bearing a forged indorsement do not constitute the proceeds of the instrument. This result is quite clear in the case of an instrument cashed over the counter. At the time the bank takes such an instrument it has obviously not made any prior collection and, thus, has nothing that could be considered proceeds.
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Opinion
MOSK, J.
We here consider the rights of the true owner of a negotiable instrument which has been collected and paid on a forged indorsement. The question has not previously arisen in this state under the Uniform Commercial Code, and has seldom been addressed in other jurisdictions.
The record recounts a typical tale of forgery. Plaintiff Joseph Stell, an attorney, employed one Bernice Ruff as a secretary and bookkeeper. During a period of approximately a year and one-half Ruff purloined some 29 checks intended for Stell and forged the necessary indorsements thereon.
She cashed some of these checks at defendants Union Bank and Crocker Citizens National Bank and deposited the remainder (except one that was cashed elsewhere) to her personal account at the latter bank. The entire amount of such deposits was subsequently withdrawn by Ruff prior to discovery of the forgeries. Certain of the checks were forwarded to and paid by defendants Crocker Citizens National Bank, Security First National Bank, and First Western Bank and Trust Company; the remainder were drawn on payors who are not parties to this action.
Stell and his partners bring this action in conversion against both the collecting and the payor banks to recover the amounts of the instruments handled by them on the forged indorsements. The critical California Commercial Code provision
is section 3419 which establishes that “(1) An instrument is converted when . . . (c) It is paid on a forged indorsement.” Notwithstanding this language, the superior court denied recovery on the basis of section 3419, subdivision (3), which provides: “(3) Subject to the provisions of this code concerning restrictive indorsements a representative, including a depositary or collecting bank, who has in good faith and in accordance with the reasonable commercial standards applicable to the business of such representative dealt with an instrument or its proceeds on behalf of one who was not the true owner is not liable in conversion or otherwise to the true owner beyond the amount of any proceeds remaining in his hands.”
The court concluded that all defendants in the case, including payor
as well as collecting banks, qualified as representatives, had acted in good faith and in accordance with reasonable commercial standards, and had no proceeds remaining in their hands. Thus defendants were held immune from liability. The court also found that plaintiffs had been negligent in failing to discover Ruff’s defalcations by April 1, 1966, approximately six months following their commencement, and that such negligence substantially contributed to the making of the subsequent forged indorsements. On this additional basis it held plaintiffs were “precluded from asserting such forgeries or lack of authorized signatures against any of the respective Defendants herein on checks presented after April 1, 1966.”
We hold that the trial court relied on an erroneous interpretation of section 3419 and that therefore the judgment must be reversed in part. Inasmuch as collecting banks and payor banks raise distinctive issues under section 3419, the application of this section to the two categories of banks will be discussed separately.
Collecting Banks
It is clear, excluding for the moment the issue of plaintiffs’ negligence, that defendant collecting banks are liable for conversion unless they can establish a defense under section 3419, subdivision (3). A careful study of this provision, however, reveals no possible defense in this case after it becomes evident that the court below erroneously held defendant collecting banks had parted with the proceeds of the fraudulently indorsed instruments. The code, unfortunately, fails to define the word “proceeds” in the context of bank collection. Therefore, to fully comprehend the code section we must examine the concept of proceeds as it was understood prior to enactment of the code and to general theory of bank collection found elsewhere in the code and in other parts of the law.
Whether defendant depositary banks have any proceeds of the fraudulently indorsed checks remaining in their hands is resolved through a bifurcated inquiry: first, did they receive any proceeds and second, have they parted with any proceeds they may have received? Each of these queries is more complex than superficially appears. A collecting bank obviously does not receive any proceeds of an instrument unless such proceeds are forwarded to it from a payor bank. Under the dominant theory of bank collection that preexisted the code and which the code has left unchanged, however, the amounts a payor bank remits on
a forged indorsement are not considered the proceeds of the instrument. The explanation for this result lies in the relationship between a payor bank and its customer, the depositor-drawer. The relationship is one of debtor and creditor: the bank is indebted to the customer and promises to debit his account only at his direction. If the bank pays, on an instrument drawn by its customer, any person other than the designated payee or a person to whom the instrument is negotiated, the bank’s indebtedness to the customer is not diminished. If the bank does debit the customer’s account, the customer can compel the bank to recredit the sum. Inasmuch as the full amount of the instrument remains in the account of the drawer when the bank pays on a forged indorsement, the bank manifestly does not part with the proceeds of the instrument but merely remits other funds from its own account.
General bank collection theory also1 instructs us that the true owner, in bringing an action against a collecting bank for conversion of a check collected on a forged indorsement, is deemed to have ratified the collection of the proceeds from the payor bank. This ratification transmutes the remittance of funds by the payor bank into an authorized act for which it may debit its customer’s account.
In the case at bar, it appears that plaintiffs’ action against defendant collecting banks constitutes such a rati
fication, and these banks, therefore, must.be considered to have received the proceeds of the instruments.
Ratification of collection, however, does not constitute a ratification of the collecting banks’ delivery of the proceeds to the wrong person. The dominant pre-code law established, on the contrary, that the proceeds were held, after collection by the collecting bank, for the benefit of the true owner.
Again resorting to general banking theory, we find that the amounts a collecting bank remits to a person who transfers to the bank a check bearing a forged indorsement do not constitute the proceeds of the instrument. This result is quite clear in the case of an instrument cashed over the counter. At the time the bank takes such an instrument it has obviously not made any prior collection and, thus, has nothing that could be considered proceeds. The money paid over the counter is, consequently, the bank’s own money. Upon collection of the instrument, the proceeds become merged with the bank’s general' funds and are therefore retained by the bank. (See Advanced ALI-ABA Course of Study on Banking and Secured Transactions under the Uniform Commercial Code (ALI 1968)
supra,
p. 56.)
A bank that accepts an instrument for deposit likewise ultimately retains the proceeds of that instrument. Such a bank is initially considered to be an agent of the person who delivers the instrument to it for collection. When, however, the bank receives a final settlement for an item it has forwarded for collection, the agency status typically ends, and the bank becomes a mere debtor of its customer. As a mere debtor, it becomes entitled to use the proceeds as its own.
The foregoing view was expressed by Justice Cardozo for the United States Supreme Court in the following terms: “Whether a fiduciary relation continues even afterwards [when the collecting bank has completed the business of collection] upon the theory that the proceeds of the collection until remitted to the forwarder are subject to a trust, depends upon the circumstances. In the absence of tokens of a contrary intention, the better doctrine is, where the common law prevails, that the agency of the collecting bank is brought to an end by the collection of the paper, the bank from then on being in the position of a debtor, with the liberty, like debtors generally, to use the proceeds as its own.”
(Jennings
v.
U.S.F. & G. Co.
(1935) 294 U.S. 216, 219 [79 L.Ed. 869, 872, 55 S.Ct. 394, 99 A.L.R. 1248].)
It is significant that the Commercial Code does not make a collecting bank accountable to its customer for the
proceeds
of an instrument but only for “the
amount
of the item.” (§ 4213, subd. (3); italics added.) Justice Cardozo’s conception of the post-collection status of collecting banks is clearly preserved: “[I]f a collecting bank receives a settlement for an item which is or becomes final, the bank is accountable to its customer for the amount of the item. One means of accounting is to remit to its customer the amount it has received on the item. If previously it gave to its customer a provisional credit for the item in an account its receipt of final settlement for the item ‘firms up’ this provisional credit and makes it final. When this credit given by it so becomes final, in the usual case
its agency status terminates and it becomes a debtor to its customer for the amount of the item.”
(§ 4213, com. 9; italics added.)
As suggested by Justice Cardozo, the parties can by mutual agreement extend the agency relationship until the amount of an instrument is received by the customer. Under such an agreement the proceeds would be maintained as a separate fund until paid over to the customer.
The ordinary banking transaction, however, contains no such agreement, and it is apparent that there was none in the present case. Defendant collecting banks, on the contrary, became debtors, and the proceeds of the instruments were completely merged with the banks’ own funds. The effect of this commingling is that the banks retain the proceeds of the instruments even though amounts set forth in the instruments, in the banks’ own money, were remitted to Ruff. This conclusion is derived by reference to the law of constructive trusts. The cases in that area establish that money received by a bank and mingled with the bank’s funds is traceable by a proper claimant into those funds. This result is unaffected by withdrawals so long as the amount of the cash on hand is not diminished below the amount of the claimant’s money that has been mingled with the fund.
Since it is obvious that no such severe diminution of funds occurred in the present case, de
fendant collecting banks must be deemed to retain the proceeds of the instruments transferred by Ruff, regardless of whether those instruments were cashed or accepted for deposit.
Our conclusion that defendant collecting banks did not part with the proceeds of the instruments in making the various payments to Ruff is reinforced by several additional factors. To begin with, had the draftsmen of the Commercial Code intended to absolve collecting banks from liability by virtue of such payments, it seems probable they would have employed language more explicit than that of retaining or parting with proceeds. Instead, the words “for value” could have been employed. The collecting banks in this case are in a situation comparable to that of a holder in due course under the Commercial Code or a bona fide purchaser under the law of constructive trusts inasmuch as they took property and in return gave consideration to the transferor. With respect to a holder in due course or a bona fide purchaser, however, this consideration is termed “value.” (§ 3302; 5 Scott on Trusts,
supra,
§§ 474-475, pp: 3454-3456.) The fact that different terminology is contained in section 3419, -subdivision (3), suggests that the ambiguous language of this provision was not intended to refer to the giving of such consideration. If the draftsmen and the Legislature had intended to protect collecting banks that had merely given value for an instrument, it may be assumed they would have clearly said so:
Secondly, an examination of the law existing prior to the enactment of the Uniform Commercial Code reveals a nearly unanimous agreement among the jurisdictions that the true owner of an instrument collected on a forged indorsement could recover in a direct suit against a collecting bank even though the bank had acted in good faith and with the highest degree of care and even though it had remitted the amount of the instra
ment to a prior party.
Since the rule had apparently operated satisfactorily, there is no reason to believe the code draftsmen or the Legislature would have wished to modify it to- make direct suits extremely difficult. As discussed below, the payor bank is in effect strictly liable to the true owner if it pays an instrument on a forged indorsement. The collecting banks that handled the instrument for collection are, in turn, strictly liable to the payor bank for breach of warranty of good title. (§ 4207.)
Because liability ultimately rests with the first collecting bank, it is unlikely that such a bank was intended to have a ready defense in a direct suit by the true owner. Requiring cumbersome and uneconomical circuity of action
to achieve an identical result would obviously run contra the code’s explicit underlying purposes “to simplify, clarify and modernize the law governing commercial transactions.” (§ 1102, subd. (2) (a).)
Such a modification would also create a significant potential for injustice. In cases involving forged indorsements collecting banks are generally the most feasible defendants. A forger typically transfers instruments bearing forged indorsements to only one or two banks for collection. Often the banks are located near the true owner. Thus it would be practical for him to bring a suit against such banks. The payors, by contrast, may be situated in many and distant states or in foreign countries, and the drawers may be equally geographically diverse. Even though the collecting banks would be ultimately liable after initial suits were brought in all the various fora, the expense and difficulty of bringing such suits would have the actual effect of freeing the collecting banks from any responsibility. The true owner would be required to shoulder the loss that should have been that of the banks; thus the banks would receive a windfall. That section 3419, subdivision (3), was intended to produce this unjust result is highly doubtful.
Had such substantial and controversial deviation from prior law been intended, moreover, it could be expected that the official commentary to section 3419 would have so stated and would have included extensive explanation of the reasons for the change. Neither the California nor the uniform comment to this section, however, contains any such discussion. The comments, on the contrary, are brief and state that section 3419, subdivision (3), is merely a codification of prior decisions (U.Com.Code, com. 5) and is entirely consistent with prior California law (Cal. com. 5).
The prior decisions to which the Uniform Commercial Code comment makes reference are presumably a line of cases primarily involving defendants that had acted as investment brokers and had marketed negotiable securities, remitting the consideration received to their customers.
The relationships between the representatives and their customers in those cases appear to have been true agency relationships that did not merge into debtor-creditor relationships upon collection of the proceeds. Unlike the ordinary bank collection transaction, in which the collecting bank and its customer have tacitly agreed a debtor-creditor relationship will emerge upon collection, the ordinary agency transaction gives rise to no> such debt when the agent receives funds intended for the principal. Such funds,, instead of being mingled, must be kept separate from the agent’s own
funds and identified as the property of the principal.
Thus, when the true agent remits the amount of an instrument to his customer, the agent actually does part with the proceeds. It is to this kind of situation, rather than to the typical bank collection transaction, that section 3419, subdivision (3), appears to be addressed.
Defendant collecting banks are, therefore, liable to plaintiffs for the amounts of those instruments received by them as of April 1, 1966. Plaintiffs’ negligence, however, bars them from recovering for conversion of instruments received after that date. Plaintiffs do not dispute the trial court’s finding that their negligence substantially contributed to the conversion of these instruments, and it appears, viewing the evidence in the light most favorable to the judgment, substantial evidence existed to justify such a finding. Stell had been retained by Ruff in 1963 because of her insolvency and because of litigation instituted against her by several creditors. She had informed Stell at that time that her financial difficulties were primarily due to considerable gambling losses she had sustained. A short time thereafter he hired her as a secretary and bookkeeper. He exercised practically no supervision over her, never reviewed the books, and never checked the bank reconciliation of deposits on the accounts she handled. Only during an annual examination made for tax return purposes by one of Stell’s partners were Ruff’s records reviewed, and even then, despite the suspicious absence of an entry, her accounts were accepted without checking for accuracy or veracity.
Section 3404 provides: “Any unauthorized signature is wholly inoperative as that of the person whose name is signed unless he ratifies it
or is precluded from denying it. . .
.” (Italics added.) The Uniform Commercial Code comment to this section adds the following explanation: “The words ‘or is precluded from denying it’ are retained in subsection (1) to recognize the possibility of an estoppel against the person whose name is signed, as where he expressly or tacitly represents to an innocent purchaser that the signature is genuine;
and to recognize the negligence which precludes a denial of the signature.”
(§ 3404, U.Com.Code, com. 4; italics added.) The preclusion language of section 3404 is essentially the same as that of section 23 of the Negotiable Instruments Law (former § 3104 of the Civ. Code). This language had been interpreted to provide for equitable estoppel in order to avoid, an unconscionable result.
We conclude that the doctrine
must be invoked in the present case. Plaintiffs’ negligent failure to discover Ruff’s patent defalcations was directly responsible for defendant depositary banks’ detrimental change of position in paying Ruff the amount of the instruments. Defendants acted entirely in good faith, and, though their conduct with respect to certain of the instruments may have fallen somewhat below reasonable commercial standards, it was not sufficiently egregious to shift the balance of the scales in plaintiffs’ favor.
For the purposes of this case, therefore, plaintiffs are precluded from denying the forged signatures are operative indorsements. Ruff is then deemed to be a “holder,” which the code defines as “a person who is in possession of a document of title or an instrument or an investment security drawn, issued or indorsed to him or to his order or to bearer or. in blank.” (§ 1201, subd. (20).) Good faith payment or satisfaction to file holder of an instrument discharges a party to the extent of his payment or satisfaction, even though the holder may have acquired the instrument by theft. ( § 3603, subd. (1).) Defendant collecting banks are thus discharged on the instruments received by them after April 1, 1966.
Payor Banks
All but three of the instruments paid by defendant payor banks had been transferred for collection by collecting banks that are also parties to this suit. As indicated above, plaintiffs ratified the collection of these instruments by bringing this action against the collecting banks. This ratification retroactively validates the payor banks’ remission of proceeds and provides a defense to an action for conversion. With respect to these instruments, therefore, no liability exists as to any payor bank. Two of the instruments on which this action is based, however, were presented by Ruff directly to the payor, Crocker Bank. The one remaining instrument was collected through banks that are not parties to this action and was also paid by Crocker. With respect to these three instruments no ratification occurred, and we must therefore consider whether Crocker is hable for their conversion.
The conclusion of the court below that section 3419, subdivision (3), shields defendant payor banks from liability is erroneous.
Even if
we assume arguendo that section 3419, subdivision (3), was intended to apply to payor banks, the provision would afford them no protection in cases such as this. As we stated above, the amounts a payor bank transfers to a collecting bank on a forged indorsement do not constitute the proceeds of the instrument, unless the true owner ratifies the collection. It follows that, absent such ratification, the proceeds remain in the hands of the payor bank. The payor bank is, consequently, liable for the full amount of the instrument notwithstanding section 3419, subdivision (3).
It is not now necessary for us to undertake an extensive analysis of the applicability of section 3419, subdivision (3), to payor banks. Inasmuch as the three instruments that concern us were all transferred by Ruff after April 1, 1966, plaintiffs’ negligence stands as a bar to recovery. Section 3406 states that “Any person who by his negligence substantially contributes to a material alteration of the instrument or to the making of an unauthorized signature is precluded from asserting the alteration or lack of authority against a holder in due course or against a drawee or other payor who pays the instrument in good faith and in accordance with the reasonable commercial standards of the drawee’s or payor’s business.”
The record contains substantial evidence to support the trial court’s finding that Crocker acted in good faith and in accordance with reasonable commercial standards in handling the three instruments. Ruff held an account with Crocker, and at the time the account was opened, she had been introduced to the bank by one of its established customers. Nothing on the face of the instruments would have led the bank to suspect they were irregular in any way. A single branch of a large bank, as the testimony indicated, may handle several thousand instruments bearing third
party indorsements in a single day. Considering this burden, it would be commercially unreasonable to expect payor banks to undertake foolproof efforts to verify ostensibly valid indorsements. Crocker’s diligence with respect to the check received through bank collection channels is, of course, particularly evident, inasmuch as Crocker apparently received the instrument with all prior indorsements guaranteed by the collecting banks. Having acted in good faith and in accordance with reasonable commercial standards, Crocker is therefore entitled to invoke the defense of section 3406.
Conclusion
We conclude that defendant collecting banks are liable for the amount of any instrument received by them prior to April 1, 1966. The record reveals that only 7 of the 23 misappropriated checks were received by that date, and each of them was taken for collection by defendant Union Bank. The total amount of these seven checks is $2,791.11. The judgment is therefore reversed with directions to enter judgment against Union for $2,791.11 plus the appropriate interest due on the amounts of each of the seven checks. With respect to the other defendants the judgment is affirmed. The parties shall bear their own costs on appeal.
Wright, C. J., McComb, J., Tobriner, J., Burke, J., Sullivan, J., and Files, J.,
concurred.
Appellants’ petition for á rehearing was denied April 19, 1973.