Check Clearing for the 21st Century

Check Clearing for the 21st Century Act
Foundation for Check 21 Compliance Training
BACKGROUND
The economics of the check business is changing. Declining check volumes and a largely fixed-cost-based check processing infrastructure have caused banks’ unit costs for processing paper checks to rise. Accordingly, many banks have begun to seek less costly alternatives to sorting paper checks and transporting them physically around the country on a daily basis. For example, some banks have begun to exchange electronic images of checks. However, under current check law, a bank must present the original paper check for payment unless the paying bank has agreed to accept electronic presentment. Because of the large number of banks and the unwillingness of some paying banks to receive checks electronically, it is difficult, if not impossible, for a bank to obtain electronic presentment agreements with all other banks. As a result, banks that want to engage in electronic check exchange on a widespread basis have been hampered in their ability to do so.

The banking industry and consumer groups therefore worked with the Board of Governors of the Federal Reserve System (the Federal Reserve Board), and later with Congress, to develop legislation that would facilitate the ability of banks to exchange checks electronically without requiring any bank to change its check processing methods. This legislation, known as the Check Clearing for the 21st Century Act (Check 21 Act or Check 21 or the Act), was enacted on October 28, 2003, and becomes effective on October 28, 2004. The Check 21 Act authorizes a new negotiable instrument called a “substitute check,” which is a paper reproduction of an original check, and provides that a properly prepared substitute check is the legal equivalent of an original check. The Act facilitates electronic check exchange by enabling banks to sort and deliver checks electronically and, where necessary, to create legally equivalent substitute checks for presentment to banks that have not agreed to accept checks electronically.

INTRODUCTION
It is likely that most financial institutions will, at some point in time, receive a substitute check that is subject to the Check 21 Act and subpart D of the Federal Reserve Board’s Regulation CC, which implements the Check 21 Act. This is true whether or not a financial institution chooses to create substitute checks. Some financial institutions will rapidly migrate toward electronic check exchange. Others will proceed more hesitantly. Regardless, all banks must be prepared to accept a substitute check in place of the original after the Act’s effective date of October 28, 2004. Because the Check 21 Act provides that a properly prepared substitute check is the “legal equivalent of the original check for all purposes,” a bank cannot refuse to pay a check based solely on the fact that it was presented with a substitute check instead of the original check.

One of a bank’s regulatory compliance obligations will be to provide a consumer awareness disclosure to consumer customers who receive canceled checks with their periodic account statements or who otherwise receive substitute checks on an occasional basis. A bank that provides a substitute check to a consumer also must be prepared to comply with the Check 21 Act’s expedited recredit procedure for addressing errors relating to substitute checks. Even if the customer does not receive actual canceled checks in a monthly statement, but instead receives a truncated summary, the individual may eventually receive a substitute check, either in response to a request for a check or a copy of a check or because a check that the consumer deposited was returned unpaid to the consumer in the form of a substitute check. Some increase in the potential for duplicate posting (substitute check and original) may also involve a degree of consumer education and explanation. The regulation provides safe-harbor language for the consumer awareness disclosure and specifies when it must be distributed.

The Act
The Check 21 Act, Pub. L. No. 108-100, 117 Stat.1177, codified at 12 U.S.C. §§ 5001-5018, was signed into law on October 28, 2003, and will take effect on October 28, 2004. The Check 21 Act facilitates check truncation and electronic check exchange by authorizing a new negotiable instrument called a “substitute check.”

The Act provides that a substitute check is the legal equivalent of the original check if (1) it accurately represents all of the information on the front and back of the original check as of the time it was truncated (including payment, identification, and indorsement information), (2) it bears the legend: “This is a legal copy of your check. You can use it the same way you would use the original check,” and (3) a bank has made the Check 21 Act warranties with respect to the substitute check. A bank does not need to affirmatively state that it is making the Check 21 Act warranties; rather, a bank automatically makes the Check 21 Act warranties when it transfers, presents, or returns a substitute check for which it receives consideration.

The Check 21 Act defines “bank” to include insured banks, savings banks, credit unions, savings associations, and anyone else engaged in the business of banking. The U.S.Treasury and the U.S. Postal Service also are banks for purposes of the Check 21 Act to the extent that they are payors of a check (the term check includes U.S. Postal Service money orders). The Act defines a “reconverting bank” as the bank that creates a substitute check or, if a person other than a bank creates a substitute check, the first bank to transfer, present, or return, a substitute check (or, in lieu thereof, the first paper or electronic representation of the substitute check) to another party.

Although the Check 21 Act does not require any bank to create substitute checks or to accept checks electronically, certain provisions of the Check 21 Act will affect all banks, even if they choose not to create substitute checks. These provisions involve consumer awareness disclosures, new warranties and an indemnity, and expedited recredit procedures to protect consumer substitute check recipients.

The Final Regulation
On July 26, 2004, the Board of Governors of the Federal Reserve System released its final rule amending Regulation CC (Availability of Funds and Collection of Checks) to implement the Check 21 Act. These amendments detail the requirements of the Check 21 Act that apply to banks, provide a model consumer awareness disclosure and other model notices for educating consumer customers about their rights under the Act, and specify bank indorsement and identification requirements for substitute checks. The final regulations also clarify some existing provisions of the rule and commentary. The final regulations can be found at:

http://www.federalreserve.gov/boarddocs/press/bcreg/2004/20040726/default.htm

THE SUBSTITUTE CHECK CLEARING PROCESS
Check 21 enables banks to clear checks electronically without having pre-existing agreements between the bank of first deposit and the paying bank. Below is an example of the steps that may be involved in the substitute check clearing process:

Step 1
A customer indorses an original check and deposits it with Bank 1, the Bank of First Deposit (BOFD). Bank 1 stamps its indorsement onto the back of the original check.

Step 2
Bank 1 decides to “truncate” the original check and is, therefore, the “truncating bank”[1] Bank 1, therefore, (1) captures an image of the front and back of the original check, (2) captures the magnetic ink character recognition (MICR) line data from the original check, and (3) sends to Bank 2, its correspondent bank, the image and MICR line data in lieu of the original check. Bank 1 also identifies itself as the truncating bank in the electronic records it sends to Bank 2. Note that in order for this scenario to occur, Bank 2 must have previously agreed to accept checks electronically from Bank 1. If Bank 2 had not so agreed, then Bank 1 would need to provide either the original check or a legally equivalent substitute check to Bank 2.

Step 3
Bank 2 applies its indorsement electronically and transfers the check image and MICR line data to Bank 3. Again, in order for this scenario to occur, Bank 3 must have previously agreed to accept checks electronically from Bank 2.

Step 4
Bank 3 desires to present the check for payment to Bank 4, the paying bank, but Bank 4 has not agreed to accept checks electronically. Accordingly, Bank 3 uses the information received from Bank 2 to create a substitute check, and Bank 3 is, therefore, the reconverting bank. As part of the substitute check creation process, Bank 3 (1) includes the image of the front of the original check on the front of the substitute check, (2) includes the image of the back of the original check on the back of the substitute check, and (3) applies the MICR line data from the original check to the bottom of the front of the substitute check. Additionally, Bank 3 overlays its own indorsement and the indorsement of Bank 2 onto the back of the substitute check at the time it creates the substitute check. (Bank 1’s indorsement, along with Bank 1’s depositor’s indorsement, is contained within the image of the back of the original check that Bank 3 applies to the back of the substitute check.) Bank 3 also identifies itself as the reconverting bank on the front and back of the substitute check and identifies Bank 1 as the truncating bank on the front of the substitute check. Bank 3 presents the substitute check to Bank 4, the paying bank, for payment.

Step 5
Bank 4, the paying bank, uses the MICR line data that Bank 3 applied to the bottom of the substitute check to process the substitute check in the same manner as it would have processed the original check. Bank 4 may provide the substitute check to its customer (who wrote the original check) in the custome