CBA Publications >> CBA Regulatory Compliance Bulletin >> Vol 2004 No.3
February 27, 2004

Vol 2004 No. 3 February 27, 2004

Check 21 Primer

Background. The manner of processing checks today, which still largely involves physical shipment of checks across the country, is costly to the industry both in dollars and time. The Check Clearing for the 21st Century Act (hereafter, "Check 21" or the Act), reduces these costs and inefficiencies by creating a new instrument-a substitute check-which is a reproduction of the original check that is treated as the legal equivalent of the original check. Because a substitute check may be produced from an electronic image, a substitute check may be "delivered" among banks and processors almost instantaneously.

What Check 21 does. The stated Congressional purposes of Check 21 are to facilitate check truncation, foster innovation in the check collection system without requiring banks to receive checks in electronic form, and to improve the efficiency of the payment system.

Check 21 permits any person to deposit, present, send for collection, or return a substitute check rather than the original check. Unlike electronic presentment, which is subject to bank-to-bank agreements, substitute checks may be transferred and presented without an agreement. Check 21 does not require any bank to produce substitute checks. However, all banks are required to accept them. But because of the mandatory physical characteristics of a substitute check (and because Check 21 does not require a bank to accept an image of a check in lieu of paper), a bank could process and otherwise handle a substitute check in the same manner as an original check using existing bank equipment.

An original check may be truncated and turned into a substitute check at any stage in the collections and returns processes. The earlier the truncation occurs, the greater the potential savings in time and transportation costs. A bank may elect to truncate only selected items, such as high dollar checks, and process other checks in their original form.

For example, a bank on the West Coast receiving a check for deposit could create an image of the check, electronically transfer the image to a processor (a Federal Reserve branch or a private vendor) on the East Coast, which then creates a substitute check for presentment to the paying bank. Conceivably, the bank of deposit could get the item finally paid on the same day the check was deposited. On the return side, a paying bank can return a substitute check to upstream banks immediately in the same manner, cutting days from the return cycle and improving the odds of collection.

This Bulletin is a summary of the Act, and includes selected provisions of the Federal Reserve's proposed rules. Those rules are expected to become final later this year.

Key definitions and principles.

Substitute check. A substitute check is a paper reproduction of the original check that:

contains an image of the front and back of the original check;
bears the same MICR line as the MICR line of the original check, with the addition of an additional identifier;
conforms, in paper stock, dimensions, and otherwise, with standards to be established for substitute checks; and
is suitable for automated processing in the same manner as the original check.

In proposed Federal Reserve regulations, additional information regarding banks handling the check must also be shown on the substitute check, such as the identity of the reconverting bank.

Reconverting bank. Reconverting bank refers to the bank that creates a substitute check, or if not created by a bank, the first bank that transfers the substitute check.

Legal equivalence. The cornerstone of Check 21 is the mandatory acceptance of a substitute check as the legal equivalent of the original check, and usable in all respects as the original check. A substitute check is the legal equivalent if (i) it accurately represents all of the information on the front and back of the original check as of the time it was truncated (including endorsements), and (ii) 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." The Federal Reserve believes that Check 21 requires a bank warranty (see below) as an additional prerequisite of legal equivalence.

Effect on state law. While a substitute check is subject to state and federal laws and regulations as applied to original checks, Check 21 also supercedes all inconsistent laws. For example, specific claims procedures apply to substitute checks, superceding UCC claims provisions applicable to original checks.

Preparing for Check 21. Substitute checks will be introduced into the payment system after October 28, 2004. Therefore, whether or not a bank intends to produce substitute checks, every bank must train tellers and front-line personnel on substitute checks so they can identify them, answer customer questions about them, and manage the special claims and expedited recrediting procedures. Banks are also required to deliver new disclosures to consumers informing them about substitute checks. The Federal Reserve may issue model form disclosures.

Customers need to know that original cancelled checks will no longer be available, and that a substitute check may be used in the same manner as the original check for all purposes. (Note, however, that whether banks actually furnish customers with substitute checks is subject to agreement. As will be discussed below, certain rights apply only when a customer receives a substitute check).

Check 21 will abrogate any rights consumers have to receive original checks whether under state law or pursuant to account agreements. Because checks may be truncated at any number of points in the payment system, a paying bank will have no right as a matter of course to retrieve them and return them to their customers. Customers also need to learn about the new claims and expedited recrediting provisions that may apply.

Warranties and indemnities. While banks are not required to produce substitute checks, banks cannot avoid accepting, transferring, presenting, and returning them. Additionally, when a bank receives consideration for a substitute check (or, under the proposed rule, any paper or electronic representation of a substitute check) upon its transfer, presentment, or return, it warrants as a matter of law to the recipient that (i) the substitute check meets all the requirements for legal equivalence (faithful copy, legend requirement), and (ii) the item will not be presented for subsequent payment; that is, another copy or the original will not be presented again. The bank also indemnifies subsequent transferees against losses occurred due to the receipt of a substitute check instead of the original check.

Under the proposed rule, receipt of consideration includes a bank's charging, having the right to charge, or otherwise receiving value for a substitute check (or paper or electronic representation of the substitute check) that the bank transfers. However, consideration is not received upon a transfer solely in response to a claim related to that substitute check.

The proposed rule clarifies that warranties are made not only to the transferee of the substitute check but also to any subsequent recipient, which could include a collecting or returning bank, the depositary bank, the drawer, the drawee, the payee, the depositor, and any indorsers. The warranties flow forward, not backward. However a person that initially handled only the original could become a warranty recipient if that person later received a returned substitute check (or paper or electronic representation derived from the original check).

Expedited recrediting for customers. Check 21 establishes expedited recrediting procedures that may apply when a consumer claims that a payment represented by a substitute check was erroneously paid and the original check or a better copy is necessary to determine the validity of the claim. The purpose of these procedures, which have no counterpart in the UCC, is to address the specific circumstance where a customer is in an inferior position because of the use of a substitute check rather than the original.

Note that expedited recrediting procedures apply only to consumers (not business customers), and only if a consumer actually receives a substitute check. Where substitute checks are not returned, the existing UCC claims procedures continue to apply. Note that images of checks that many banks presently provide to their customers with statements are not substitute checks and would not trigger Check 21 responsibilities applicable to substitute checks.

To make a claim for expedited recredit, a consumer must provide:

a description of the claim;
a statement that a loss occurred, including an estimate of the amount;
the reason why producing the original check or a better copy is necessary to determine the validity of the charge; and
sufficient information to identify the substitute check and to investigate the claim.

The claim must be made in good faith (and in writing, if required by the bank), within 40 days from the date the bank delivers the relevant statement or the date the substitute check is made available, whichever is later. (As proposed, the 40-day period is calculated using the postmark on the envelope). A longer period to submit a claim is available under extenuating circumstances preventing the consumer from submitting a claim with the 40-day period.

A bank is then required to recredit a customer's account on the first business day that it determines a consumer claim to be valid. Recredited amounts must be available for withdrawal no later than the start of the business day after the day of recredit.

Provisional credit pending investigation. If validity of the claim cannot be determined within 10 business days, the bank must recredit the amount charged (with interest for interest-bearing accounts) up to $2,500 by the end of the 10th business day after the claim is made. The remaining amount, if any, must be recredited (with interest, if applicable) pending investigation within 45 calendar days. A credit may be reversed if a claim is determined to be invalid. (Check 21 is silent on whether credited interest may be reversed; the Federal Reserve is seeking comment on this point). As proposed, a bank must provide the recredit pending investigation for each substitute check for which claim submitted, even if the consumer submitted multiple check claims in the same communication.

Additional time is available with respect to new(1) or frequently overdrawn(2) accounts, or if fraud is suspected.(3) In these situations, a bank may comply with only the 45 calendar day full recredit provision as to the entire amount of the claim. However, when applying one of these "safeguard exceptions," the bank may not impose any overdraft fees during the 5 days after the bank sends a notice of delayed availability to the consumer.

Denial of claim. If the bank determines that the claim is not valid, it must provide the customer no later than the business day after the determination:

the original check or sufficient copy that either accurately represents all of the information on the front and back of the original check (as of the time it was truncated), or that is otherwise sufficient to determine the validity of the claim; and
an explanation of why the claim is denied, including a statement that the consumer may request copies of any information or documents relied upon.
Under the proposed rules, a bank is not required to provide the original check or copy if it is providing a denial notice electronically and the consumer has agreed to receive that type of information electronically.

Notice of recredit. If a bank recredits an account, it is required to send by the next business day notice of the amount of the recredit and the date the recredited funds will be available for withdrawal (e.g., the start of the business day following recredit).

Reversal of recredit: If a bank determines that a substitute check for which it had recredited a consumer's account was in fact properly charged, the bank may reverse the recredit. The bank must send, by the business day after the recredit, the notice required when a claim for recredit is denied, plus a notice of the amount of the reversal and the date the recredit was reversed.

Providing a recredit does not absolve a bank from liability for any claim made under any other law, such as a UCC claim for wrongful dishonor.

Expedited recredit provisions for banks. A consumer claim for expedited recredit starts a chain of claims for expedited recredit among banks handling the substitute check, a process also set forth in detail by Check 21. As discussed above, a bank that transfers a substitute check and receives consideration for it also indemnifies the transferee and subsequent parties for certain losses. A bank may make a claim for expedited recredit against the indemnifying bank if:

the claimant bank (or bank that claimant bank in turn has indemnified) has received a claim for expedited recredit from a consumer, or would have been subject to such a claim if the account had been charged;
the claimant bank is obligated to provide expedited recredit or otherwise has suffered a resulting loss; and
producing the original check or sufficient copy is necessary to determine validity of the claim.

The claim must be made by the end of 120th calendar day after date of the transaction giving rise to the claim. The time period is intended to allow time for multiple banks to bring a claim.

To make a claim, the bank must send to the indemnifying bank information that parallels what a consumer provides in making a claim, namely:

a description of the claim, explaining why the substitute check cannot be properly charged, or stating that it is a warranty claim;
a statement that the bank has suffered a loss or is obligated to recredit the consumer's account, with an estimate of the amount of the loss or recredit;
the reason why producing the original check (or other copy) is necessary to determine the validity of the claim; and
information sufficient for the indemnifying bank to identify the substitute check and to investigate the claim.

The proposed regulation adds that the claimant bank may be required to provide a copy of any written claim provided by the consumer, as well as a copy of the defective substitute check. In such instance, the claimant bank must take reasonable steps to ensure that the copy would not be mistaken for the legal equivalent of the check, or sent or handled by any bank for forward collection or return.

The indemnifying bank has 10 business days in which to respond to a bank's claim for expedited recredit in one of three ways:

recredit the claimant bank up to the amount of the substitute check (plus interest, if applicable);
provide the verifying check and explain why the claim is denied; or
explain why it is not obligated to provide a verifying check or to recredit.

If a bank that had been indemnified subsequently reverses a re-recredit or otherwise receives a credit or recredit, it must "promptly" refund amounts advanced by the indemnifying bank. Note that providing a recredit does not absolve a bank from liability for claims brought under any other law or under other provisions of the Act.

Risks of using substitute checks. Because a substitute check is a reproduction of the information on the original check, characteristics and security features on the original check may not be available for inspection. For example, a person handling a substitute check would not have an opportunity to check for a perforation on the original check. An alteration on a substitute check may be more difficult to detect. On the other hand, fraud detection procedures based on rules-based systems, automated signature verification, and positive pay would continue to be effective, if not more effective. Also, because the time needed to clear a check could be greatly reduced, frauds such as kiting would be more difficult to complete successfully.

As discussed above, the bank that creates a substitute check bears the risk of loss incurred by the receiver because a substitute rather than the original check was provided. For example, if a paying bank would not have paid a check if it had the opportunity to examine the original check's watermark, it could be subject to an expedited recredit claim.

Customer awareness. Check 21 requires every bank to provide "a brief notice" regarding substitute checks and re-crediting procedures to existing customers and new accountholders who receive (or will receive) original or substitute checks. The notice, which is expected to be provided in model form by the Federal Reserve, is to be provided to existing consumer customers no later than the first regularly scheduled communication after the effective date of the Act, which is October 28, 2004. New accountholders must be given the notice at the time of account opening.

Note that, while in California a bank is not required to provide customers with original checks or, under Check 21, substitute checks along with regular account statements, there may be instances in which a customer is given one, for example, in the event of a returned item that had been converted into a substitute check. The decision whether to provide the notices must consider these possibilities.

As banks begin to learn and then prepare to implement Check 21, CBA will continue to offer guidance to its members through a variety of means, including more detailed analysis of special problems and through education. Check 21 will be covered in a number of CBA educational events, including the Bank Counsel Seminar from May 13 to 15 at the Hyatt Huntington Beach Resort, at CBA's Regulatory Compliance Seminar at the La Costa Resort from October 6-8, and a special joint CBA/State Bar meeting tentatively scheduled for this summer.

If you have any questions about Check 21, please contact Leland Chan at 415-284-6999 x214.

1) A new account is defined as one that has been opened for 30 days or less.
2) An account is deemed to experience repeated overdrafts if on at least 6 business days during the 6-month period prior to the customer's claim (or at least 2 business days in the case of a negative balance of $5000 or more), the balance in the account was negative, or would have become negative if checks or other charges to the account had been paid.
3) A bank's suspicion of fraud must be based objectively on the facts presented, meaning that the facts would "cause a well-grounded belief in the mind of a reasonable person that the claim is fraudulent."