A Look at FedNow Liability Allocation and a 4th Circuit Toss-Up

Having laid the groundwork for instant payments with same-day Automated Clearing House, or ACH, transfers, the Federal Reserve took another step toward its goal of ubiquitous instant payments by launching the FedNow service in July of this year.

As a real-time gross settlement system, FedNow payments are all credit transactions "pushed" from the sender's account to the recipient's account, as are ACH credit and wire transfers. Therefore, to the extent that they are business-to-business transactions, Article 4A of the Uniform Commercial Code applies to FedNow transfers.

Article 4A does not apply to any transaction governed by the Electronic Fund Transfer Act, or Regulation E,[1] and therefore most electronic payments to or from a consumer account are governed only by the EFTA/Regulation E — in addition, of course, to the operating rules of the applicable network.

Regulation E also expressly excludes wire transfers. However, the Federal Reserve incorporated Article 4A wholesale into Regulation J, Subparts B and C, governing Fedwire and FedNow transactions, respectively. The net result is that consumer payments processed through FedNow are in the unique position of being governed by both Article 4A of the UCC and Regulation E, a situation likely not contemplated by the drafters of either set of laws.

Legal Requirements Directly Applicable to Common Electronic Payment Methods

Changes to Form I‑9

U.S. Citizenship and Immigration Services (USCIS) revised Form I‑9 to incorporate these key changes:

Regulation J, Subpart C, provides that in the event of an inconsistency between the provisions of Subpart C and the EFTA/Regulation E, the latter shall prevail to the extent of the inconsistency — however, the examples provided make clear that the Federal Reserve's interpretation of what constitutes an "inconsistency" is very narrow.[2]

Under Regulation E, in situations where a consumer properly asserts an error under Title 31 of the Code of Federal Regulations, Section 1005.11, the consumer's financial institution is generally required to either correct the error or provide a provisional credit within 10 business days.

Significantly, the definition of an error giving rise to a right of refund or credit under Regulation E does not line up with the corresponding provisions under Article 4A of the UCC — therefore financial institutions should be mindful that (1) they should incorporate certain notices from their commercial customer terms into their consumer terms to avail themselves of the limitation of liability under Article 4A as incorporated into Regulation J, Subpart C, and (2) they may be precluded from seeking recourse from counterparty financial institutions under Regulation J, Subpart C, even for transactions where they have been obligated to refund or credit a consumer under Regulation E, or vice versa.

Refund/Credit Rights for Common Disputes for FedNow Transactions Under Regulation E and UCC 4A

State Court Interpretations of UCC 4A

Nearly all states and territories have enacted Article 4A of the UCC. However, despite the uniformity in provisions, there is still significant scope for variance in court interpretations, particularly in what constitutes a "commercially-reasonable security procedure" under Sections 202 and 205 and when a recipient's financial institution has "actual knowledge that the name and account number refer to different persons" under Section 207.

Generally speaking, a sender's right of recovery against the recipient's financial institution under Section 4A-207(c)(2) of the UCC has been interpreted very narrowly by courts to preclude recovery in many cases where the sender was defrauded.

In denying recovery, courts have given significant weight to Section 4A-207(b)(1) of the UCC, which entitles the recipient's financial institution to rely on the account number stated in the sender's payment order, unless the recipient's financial institution has actual knowledge that the name and account number refer to different persons.

The associated UCC commentary makes clear that the intent of Section 207(b)(1) was to allow the recipient's financial institution to process the incoming payment in real time through automation, a feature critical to faster payments and essential to instant payments.

It follows that actual knowledge in this context must refer to an existing alert or flag on the payment order or the recipient's account — i.e., one that was already in place at the time the recipient's financial institution received the payment order, rather than an alert generated by the recipient's financial institution's receipt of the payment order — in order for participants in electronic payment networks to reap the benefits of automated payment processing.

The 1st Advantage Decision and Its Implications for FedNow Payments

From this perspective, it seems clear that previous cases interpreting Section 207(b)(1) were correctly decided.

However, a recent ruling from the U.S. District Court for the Eastern District of Virginia in Studco Building Systems US LLC v. 1st Advantage Federal Credit Union[3] goes against such precedent.

The court in 1st Advantage held the recipient's financial institution liable where the sender's payment was fraudulently diverted to a fraudster's account.

In its ruling, the court gave significant weight to the fact that the recipient's, i.e. fraudster's, financial institution's systems generated multiple alerts flagging the mismatch between the name stated in the payment order, i.e., the person that Studco had intended to pay, and the name on the fraudster's account, in response to receiving the payment order from sender Studco's financial institution.

Even though the 1st Advantage decision has its own key implications,[4] the potential impact of this decision increases as the transaction settlement and funds availability window narrows.

With ACH transactions, the one-to-three-day settlement window allows senders to potentially claw back payments if they detect the fraud after a payment has been made but before settlement to the recipient's financial institution is final. With real-time payment or FedNow transactions, the fact that funds are settled and made available to recipients within seconds makes it very unlikely that a fraudulent payment can be recovered if the fraudster or money mule is quick to move payments out of their account, as is generally the case. The 1st Advantage case is currently on appeal at the U.S. Court of Appeals for the Fourth Circuit,[5] and most fellow payments law practitioners we have spoken with agree that it was incorrectly decided and should be reversed on appeal. However, we cannot predict how the Fourth Circuit will resolve the appeals.

The National Automated Clearing House Association and The Clearing House Association LLC have both filed amicus briefs supporting 1st Advantage, while the most recent action by the court was to extend the deadline for both Studco to file its opening/response brief to Dec. 6, and for 1st Advantage to file its response/reply brief to Jan. 8. Oral argument has not yet been scheduled. No decision on the appeal is expected until the first or second quarter of 2024.

This post originally published in Law360 on Dec. 18, 2023.

[1] UCC § 4A-108.

[2] 31 CFR § 210.40(b)(4).

[3] Case number 2:20-cv-00417 (Slip. Op.) (Jan. 12, 2023, E.D. Va.).

[4] https://www.dwt.com/blogs/financial-services-law-advisor/2023/02/business-email-compromise-bec-fraud-studco.

[5] Nos. 23-1148 and 23-1766. 1st Advantage appealed the underlying decision awarding compensatory damages to Studco and Studco cross-appealed the denial of punitive damages. The appeals are consolidated for briefing, argument, and disposition.