Subrogation
To be “subrogated” means being able to assert the rights of another person as if they were your own. If A is subrogated to the rights of B, then A can assert B’s rights against the rest of the world. In effect, A can step into B’s shoes.
- If a payor bank has paid an item over the order of the drawer or
maker to stop payment, or after an account has been closed, or
otherwise under circumstances giving a basis for objection by
the drawer or maker, to prevent unjust enrichment and only to
the extent necessary to prevent loss to the bank by reason of
its payment of the item, the payor bank is subrogated to the
rights:
(1) of any holder in due course on the item against the drawer or maker;
(2) of the payee or any other holder of the item against the drawer or maker either on the item or under the transaction out of which the item arose; and
(3) of the drawer or maker against the payee or any other holder of the item with respect to the transaction out of which the item arose.
The most common circumstance in which the subrogation rules help a payor bank is when the bank has accidentally paid a check in spite of a valid and timely stop-payment order. For example, suppose A writes a check in payment for a new washing machine. After A takes the washing machine home, he decides he cannot afford it after all. He phones in a stop-payment order to his bank, but never gets around to returning the washing machine. The seller of the washing machine deposits the check in Straight Arrow Bank which presents it for payment to Last Best Bank, the drawee. Last Best pays the check. Two weeks later when he gets his bank statement, A finds out the check was paid and insists that his account be recredited.
As we learned at the beginning of the chapter, Last Best has made a mistake. The check is not “properly payable” and Last Best has no business paying it, even though A never returned the washing machine. Furthermore, as we also learned, Last Best cannot return the check anymore since it has been finally paid. But if Last Best is forced to recredit A’s account, A will have a windfall; he will have a new washing machine without having paid for it. Last Best will have suffered a loss.
The subrogation rules will help Last Best in this situation. The thinking behind the rules is that a payor bank should not suffer a loss if someone else would consequently enjoy a windfall, even though the bank made a mistake in paying a check. In our example, Last Best can rely on either Subsections (1) or (2 ). Subsection (1) subrogates Last Best to the rights of a holder in due course. Straight Arrow Bank is likely to be a holder in due course, and Last Best can say to A, “You must view us as if we were Straight Arrow Bank and the check had not been paid. Since we are a holder in due course, you must pay us the amount of the check. Therefore, we need not recredit your account.” Subsection (2) subrogates Last Best to the rights of the payee or any other holder. Last Best can say to A, “You must view us as if we were the seller of the washing machine (the payee on the check) and the check was not paid. You have no defense on the sale transaction and you also have an obligation as drawer of the check to pay it if it is dishonored and you have no defense against that obligation. Therefore, we need not recredit your account.”
But what if A does have a defense? What if, for example, the washing machine seller had agreed to deliver the machine but never had? Now A has not enjoyed a windfall, but someone else has (the seller of the washing machine, who has been paid but has delivered no machine). In this case, Subsection (2) of 4-407 is of no help to Last Best since Subsection (2) subrogates Last Best to the rights of the payee or a holder. The rights of the payee or a holder (who is not a holder in due course) are subject to any defenses the drawer might have. Since A has a defense, those rights are of no value to Last Best.
But Subsection (1) is still available to Last Best. Subsection (1) subrogates Last Best to the rights of a holder in due course and, fortunately for Last Best, there is one on this check. Straight Arrow is a holder in due course, and Last Best can say to A, “You must view us as if we were Straight Arrow Bank and the check had not been paid. Since we are a holder in due course, you must pay us the amount of the check. Therefore, we need not recredit your account.”
Now A has suffered a loss, but A has the right to recover that loss from the seller of the washing machine. If the seller is gone or has no resources, A loses. But Articles 3 and 4 view A as the appropriate party to lose in this situation since A dealt with the seller and was in the best position to determine the seller’s trustworthiness.
Subsection (3) of 4-407 subrogates the payor bank to the rights of the drawer of the check against the payee or any other holder with respect to the transaction out of which the check arose. This might be the most attractive choice to Last Best in our example above in which A has a valid defense against the seller of the washing machine. Last Best might be reluctant to take on its own customer. It might prefer to recredit A’s account, then turn to the seller of the washing machine and say, “You must view us as A since we are subrogated to the rights of A. We paid for a washing machine which we never received. We want our money back.” If Last Best feels recovering from the seller is likely and won’t be too expensive, this might be a better business decision than refusing to recredit A’s account. This choice involves evaluating the merits of A’s defense, however, and consequently involves some risk.
To sum up subrogation, if you pay a check which is not properly payable and, as a result, someone is enjoying a windfall while your institution is suffering a loss, think of the subrogation rules as a possible remedy. You will be entitled to put your institution in the position of a holder in due course (if there is one in the particular circumstance), the payee, any other holder, or the drawer of the check.