Security Pacific National Bank and Wachovia Bank of North Carolina could lose up to $2.1 million from a botched electronic payment to a financially shaky firm.
The mix-up took place last year and became the source of a little-noticed lawsuit. It enabled Hamilton Taft & Co., a now bankrupt tax-payment processor in San Francisco, to improperly receive the money from a Wachovia account via the automated clearing house network.
Shortly after Security Pacific gave the money to Hamilton Taft, the tax processor was forced into bankruptcy. Federal investigators are pursuing allegations that the firm's owner, Connie C. Armstrong Jr., led one of the largest financial scams in recent history.
Security Pacific, a unit of BankAmerica Corp., must now stand in line with hundreds of Hamilton Taft creditors trying to recover tens of millions of dollars.
And if Security Pacific fails to recover the $2.1 million, as appears likely, it and Wachovia could be stuck with one of the largest losses in the history of the automated clearing house, an electronic payment system started in the 1970s.
Risks Often Underestimated
Observers said the debacle illustrates the risk, often underestimated, that banks take by handling automated clearing house transactions for financially unstable companies or by mishandling failed transactions.
"I think this is important because it points out that there is a risk," said Francis X. Pokorny, senior vice president at First National Bank of Maryland in Baltimore. "Although people have been saying that there haven't been any major losses on the ACH, this is an example of what could become a true loss, for a significant amount of money."
Late last year, First Interstate Bancorp nearly lost $70 million in a fraudulent automated clearing house transaction, but was able to recover the money before it was withdrawn from the receiving bank.
Loss Will Be Shared
Under a settlement crafted in December, Security Pacific and Wachovia agreed to share any losses arising from the Hamilton Taft transaction. Neither company disclosed details of the settlement, or discussed the events that led to the incident.
But details of the case came to light in court documents from more than six months of legal battles between Security Pacific and Wachovia reveal a series of errors that led the financial institutions to improperly release the funds.
The incident began on Friday, March 8, 1991, when Security Pacific, at the behest of Hamilton Taft, sent an order through system to transfer $2.1 million from a Neiman Marcus Group account at Wachovia to a Hamilton Taft account at the West Coast bank.
Before that date, Hamilton Taft had permission to deduct funds from Neiman Marcus's account because the retailer was one of its customers. But, unbeknownst to Security Pacific, on March 7 Neiman Marcus had told Wachovia to revoke Hamilton Taft's permission to debit its account.
So when Wachovia received the transfer order, on Monday, March 11, it tried to halt the transaction by sending a message to Security Pacific through the Federal Reserve's automated clearing house computer network.
But Wachovia, which entered the reversal on Tuesday, March 12, put an invalid code on the message, and it was rejected by the Fed's computers, according to filings by Security Pacific.
Reversal Deadline Passes
Thus on Wednesday, March 13, after the deadline for reversing the transaction had passed, Security Pacific let Hamilton Taft take the $2.1 million out of its account.
Security Pacific didn't find out that the funds transfer was invalid until Friday, March 15. That day, a front-page story broke in the Wall Street Journal saying that Hamilton Taft might have engaged in one of the largest financial scams in recent history -- a Ponzi scheme in which tax payments were delayed and money was diverted to Mr. Armstrong.
Hamilton Taft was forced into bankruptcy on March 20. At that time, $90 million of clients' money was missing.
A court-appointed trustee, Frederick Wyle, has since claimed that Mr. Armstrong diverted at least $55 million to himself and his Dallas companies. Mr. Armstrong has denied any wrongdoing. No charges have yet been filed, though a federal investigation is under way.
Bankers said the debacle illustrates the importance of managing automated clearing house operations properly. One big lesson is that banks must watch their customers carefully. This is because, according to clearing house rules, the bank that originates an electronic transaction guarantees that the funds transfer is valid.
If it turns out that a party to the transaction didn't authorize it, the originating bank can be stuck with the loss.
"You've got to know your customer," Mr. Pokorny said.
Bankers also said that banks must handle exception items in clearing house transactions carefully. Under the rules, a bank that receives an invalid corporate payment is supposed to reverse the funds transfer within 24 hours of the settlement date. If a bank misses that deadline, it or its customer takes responsibility for the funds.
Thus Wachovia was liable for any losses from the Hamilton Taft transaction because it missed the reversal deadline, Security Pacific alleged in court documents.
Industry officials said they would have liked to see the case go to court, to resolve outstanding questions over which bank is ultimately responsible for the mix-ups that occurred in thee Hamilton Taft transaction. But the settlement precluded any definitive decision.
And the banks declined to detail how much of the blame, and loss, each accepted as part of the settlement.
Meanwhile, prospects look dim for Security Pacific and Wachovia to recover all of their money. A lawyer for Mr. Wyle, Patricia Mar of Feldman, Waldman & Kline, San Francisco, said that hundreds of customers, creditors, and landlords have claims pending to recover money from Hamilton Taft.
The bankruptcy proceedings are expected to drag on for years. A Wachovia spokeswoman declined to say whether the bank has written off losses arising from this incident, and a Security Pacific spokesman did not address this issue by press time.