When a forged cheque is encashed on presentation to a bank, what is the liability of the paying bank?

Liability of a Paying Bank on a Forged Cheque — Section 31 and Section 85, Negotiable Instruments Act, 1881

The Concept of Mandate

Every cheque presented to a bank carries with it a mandate — a legal authority given by the account holder to the bank to debit his account and make payment. This mandate is the very foundation on which the banker-customer relationship operates. That relationship, as the Supreme Court affirmed in Canara Bank v Canara Sales Corporation (AIR 1987 SC 1603), is essentially one of debtor and creditor, with the superadded obligation to honour the customer's orders. When a cheque is forged — in any essential particular — there is no such mandate. A forged cheque is not a cheque at all. It is, in the words of established banking law, a mere nullity. The question of the paying bank's liability depends critically on what part of the cheque has been forged — the drawer's signature, or the indorsement.

Situation I — Forgery of the Drawer's Signature

The General Rule — Bank Bears the Loss

When the drawer's own signature on a cheque is forged, the paying bank has no statutory protection whatsoever. The law imposes on every bank the professional duty of knowing its customer's signature. The bank holds specimen signatures of its customers, it transacts with them over time, and its very business requires it to distinguish a genuine mandate from a forged one. If the bank fails in this duty, the loss falls squarely upon the bank — not upon the customer.

The consequence is direct and unambiguous: the bank cannot debit the customer's account with the amount so paid on a forged cheque. Payment made on such an instrument cannot be regarded as a payment in due course within the meaning of Section 10 of the Act, because a forged cheque gives no mandate. The Supreme Court settled this in Bihta Co-operative Development and Cane Marketing Union Ltd v Bank of Bihar (AIR 1967 SC 389), which involved an illegal withdrawal of Rs. 11,000 through a forged cheque. The bank attempted to plead the customer's negligence as a defence — the Supreme Court flatly rejected the argument, holding that a forged signature strips the instrument of any mandate, and absent a mandate, no doctrine of customer negligence can relieve the bank of its liability.

Can the Bank Plead Customer's Negligence?

The Supreme Court firmly answered this question in Canara Bank v Canara Sales Corporation (AIR 1987 SC 1603), a landmark decision that stands as the authoritative statement of Indian law on this subject. In this case, the company's own Chief Accounts Officer had forged 42 cheques over a period of several years, siphoning off Rs. 3,26,047. The bank contended that by failing to examine the monthly statements of account over four years, the company had by its negligence and acquiescence ratified the payments and was now estopped from claiming refund. The Supreme Court emphatically rejected this defence. It held: (i) there is no duty on a customer to examine his pass book and detect irregularities; (ii) the customer has a duty to inform the bank of fraud only after he comes to know of it, not before; (iii) mere inaction for a long period, without knowledge of the fraud, cannot be treated as estoppel or ratification; and (iv) a bank can escape liability only if it establishes the customer's knowledge of the forgery, or a clear unequivocal ratification. The bank could not succeed on any of these counts.

The earlier decision of the Allahabad High Court in L. Prabhu Dayal v The Jwala Bank (AIR 1938 All 374) made this principle memorable in its simplicity — "The banker's obligation is to honour his customer's cheque. To that end he is bound to know his customer's handwriting. If in any way he is deceived without the instrumentality of his customer, he must himself abide the loss." In that case, the customer had negligently left his cheque book in an unlocked box. Yet the court held the bank liable, because the negligence was not the proximate cause of the loss — the bank's own failure to verify the signature was.

The One Exception — Proximate Negligence of the Customer

There is a single, limited exception to the rule that the bank bears the loss. Where the customer's own negligence in drawing the cheque was the proximate and direct cause of the loss, the bank may be exonerated — not because of any statutory immunity, but on the principles of estoppel and contributory fault. The governing rule comes from London Joint Stock Bank v Macmillan and Arthur (1918 AC 777), approved in Indian courts: if a customer draws a cheque carelessly — leaving blank spaces before the amount — and thereby enables a fraudster to interpolate a higher figure, the loss falls on the customer. Similarly, Young v Grote (1827 4 Bing 253) illustrates that a customer who signed a cheque with the amount written so loosely as to admit easy interpolation was held responsible when that space was fraudulently filled.

The critical qualifier, however, is that this negligence must be intimately connected with the transaction itself and must be the proximate cause of the bank's loss. General negligence in keeping a cheque book or in not examining account statements is categorically insufficient, as the Supreme Court confirmed in Canara Bank and the Allahabad High Court held in Prabhu Dayal.

In Bank of Maharashtra v Automotive Engineering Co. (1993 2 SCC 97), the Supreme Court also held, importantly, that a bank is not negligent merely because it did not subject a cheque to ultraviolet ray scrutiny, so long as no forgery could be detected on careful visual examination. The standard required of a paying bank is that of reasonable visual care — not the deployment of advanced technology on every cheque.

Situation II — Forgery of the Indorsement on an Order Cheque

The Statutory Protection Under Section 85(1)

The law strikes a different and more protective balance when the forgery is not of the drawer's signature but of the payee's indorsement. Section 85(1) of the Negotiable Instruments Act, 1881 provides: "Where a cheque payable to order purports to be indorsed by or on behalf of the payee, the drawee is discharged by payment in due course."

This section grants the paying bank a statutory discharge even if the indorsement subsequently proves to be a forgery, provided the bank has paid in due course. The rationale is entirely practical — the sheer volume of daily banking transactions makes it impossible for a bank to verify the genuineness of every indorsement on every cheque presented. Section 85, therefore, allocates this risk away from the bank, on the condition that the bank exercises good faith and reasonable care.

The practical illustration provided by the law is clear: if a cheque payable to B is stolen, B's indorsement is forged, and the drawee-bank pays the cheque in good faith after reasonable scrutiny, the bank is fully discharged. It may debit the drawer's account — and the true owner's remedy is not against the paying bank but against the person who perpetrated the fraud.

Conditions for Claiming Protection Under Section 85

Three conditions must cumulatively be satisfied before the bank can claim the shield of Section 85(1):

• The cheque must be payable to order (not a bearer cheque, which is separately governed by Section 85(2))

• The cheque must purport to be indorsed by or on behalf of the payee — there must be an indorsement that appears, on its face, to be the payee's

• The payment must be in due course within Section 10 — in good faith, without negligence, according to the apparent tenor, to a person who does not appear to be unauthorised

Where these conditions are met, the bank is discharged even though the indorsement is proved to be a forgery. As the Calcutta High Court stated in Pranendu Mohan Das v Central Bank of India (AIR 1978 Cal 55), the bank is protected if it pays in accordance with the apparent tenor of the instrument, in good faith and without negligence, under circumstances not affording a reasonable ground for doubting the presenter's authority.

Negligence Defeats the Protection

Where the bank has been negligent, the Section 85 shield falls away. In Woodbriar Estate Ltd v Catholic Bank of India (AIR 1958 Ker 316), two demand drafts payable to the plaintiff company were indorsed by its managing director and deposited with the defendant bank for collection. The bank, instead of crediting the company, paid the amount into the managing director's personal account, from which he misappropriated the money. The indorsements on the drafts clearly disclosed they were payable to the company and to no one else. The court held that the bank's failure to heed this warning made it guilty of negligence — the protection under Section 85 was lost.

Similarly, in Central Bank of India v Gopinathan Nair (AIR 1970 Ker 74), a demand draft was drawn in favour of a sole proprietary concern with which the drawee branch was entirely familiar. The forged indorsement was not in the form that the proprietor customarily used, and was made out to a third party — circumstances that ought to have aroused suspicion. The Kerala High Court held the paying bank negligent for proceeding without inquiry.

The onus of proving that payment was made in good faith and without negligence lies upon the bank claiming the protection. This is well settled by Woodbriar Estate Ltd v Catholic Bank of India and confirmed in the principles laid down under Section 131.

The Governing Principle

Underlying all these rules is a single equitable principle, expressed by the Supreme Court in Canara Bank v Canara Sales Corporation (AIR 1987 SC 1603): "If there are two innocent parties, the one whose negligence led to the ultimate loss is primarily responsible." Where the bank fails to recognise a forged signature, it is the bank whose negligence caused the loss. Where the customer carelessly enabled the fraud in the very act of drawing the cheque, it is the customer. And where a forged indorsement is paid by a careful, good-faith bank on an order cheque, the law through Section 85 deliberately shifts the risk away from the bank — because the bank is not, and cannot reasonably be expected to be, an insurer against every species of fraud perpetrated by third parties.