Padded Payroll Rule
by G. Bradley Hargrave, Esq.
As a general rule, a drawee bank may not debit a depositor's account when it pays a check over a forged indorsement, as a forged indorsement is equivalent to an unauthorized signature and thus is "wholly inoperative to negotiate an instrument" (UCC 3-404(1)). However, there is an exception to this rule of which every employer should be awareóthe "padded payroll" rule (UCC 3-405(1)(c)).
The rule states that "an indorsement by any person in the name of a named payee is effective ifÖ an agent or employee of the maker or drawer has supplied him with the name of the payee intending the latter to have no such interest." This rule is engaged when an employee deceives his employer into issuing a check to an undeserving, or fictitious, person and thereafter indorses the item in the name of the named payee for deposit into his personal account. The employee might accomplish this misappropriation of his employer's funds by adding a fictitious name to the payroll, by preparing a bogus check requisition form, or by falsifying a list of creditors.
Regardless of the specific ruse used, the employer, and not its bank, bears the loss. Moreover, the bank is released from liability even if the employer can establish that it's bank acted in a negligent or commercially unreasonable manner. Of course, the faithless employee remains subject to criminal and/or civil liability, but in all likelihood the misappropriated funds are unrecoverable from this source.
The drafters of the UCC believed that employers should suffer these losses as they are in the best position to institute safeguards to guard against the fraudulent conduct of their employees. Employers are warned, therefore, to take whatever steps are necessary to establish adequate internal controls over their checking accounts.
