CBA Publications >> CBA Regulatory Compliance Bulletin >> Vol 2004 No.5
April 8, 2004

Vol 2004 No. 5 April 8, 2004

Managing Fraud in the Check 21 Environment

This is the second CBA Bulletin in an occasional series on Check 21, and is presented to readers who already have a basic knowledge of Check 21. The first bulletin, A Primer on Check 21, may be obtained from CBA's website at www.calbankers.com.

Introduction

It is anticipated that the Check Clearing for the 21st Century Act ("Check 21" or "Act") will finally launch the check payment system inexorably toward full electronic check presentment. Whether the legislation was intended to bring about this result or not is not as important as the marketplace forces it will unleash.

By conferring legal equivalence to substitute checks and thus eliminating the need to return cancelled original checks, Check 21 removes one of the major barriers to the broader use of electronic presentment. Presently, banks have to enter into separate agreements with other banks or join electronic exchange networks in order to present checks electronically, and in some cases still had to follow electronic presentment with delivery of original checks. Under Check 21, any bank may produce a substitute check without an agreement with a collecting or paying bank (or with the depository bank as to returned checks), and all banks must accept substitute checks.

Banks that already truncate and process checks electronically will seek to achieve further efficiencies by capitalizing on new opportunities to truncate checks both in the forward collection and return processes. Bank customers themselves may demand the option of depositing checks electronically.

Banks that will continue to process paper checks, over time, may find themselves becoming relatively less efficient, and declining paper check volumes may make it unprofitable to continue investing in existing infrastructures. Collecting and presenting banks that transfer electronic images will bear the costs of producing substitute checks for banks that do not receive them, a situation that creates pressures that will gradually nudge the entire industry toward the path of full conversion.

But well before that time arrives-indeed, even before October 28 arrives-all banks will have to think through how Check 21 will affect the way they manage fraud and certain exceptions. The outlook is mixed. Shorter, more efficient clearing of checks will help thwart kites and other check fraud schemes. In time, automated fraud filters applied to electronic check images will vastly improve how checks are reviewed. Products are already available today that automatically verify signatures, compare the legal and numeric check amount fields, and automatically confirm geographic characteristics of checks (relative location of date line to signature line, distance of logo to edge, etc.). As check clearing moves more decisively into the digital age with imaging, all the possibilities of the evolving technology will become available in the fight against check fraud.

Until then, many of the traditional security measures now used that are based on the physical characteristics of checks may no longer be effective as applied to substitute checks. The good news is that, for an indeterminate period after the effective date of Check 21, most checks in the system will still consist of original paper checks. Therefore, banks will continue to handle paper-based check fraud and exceptions under their normal procedures. This Bulletin looks primarily at the challenges of handling substitute checks.

Handling Substitute Checks

Paying banks. In some ways, banks in their capacity as the paying bank are likely to be in the better position to avoid fraud losses under Check 21. On the one hand, a paying bank will face the challenge of having to make a payment decision without being able to examine the physical characteristics of the original check. This could make it more difficult to detect alterations, chemical spotting, or other abnormalities. Security features such as micro-printing, specialty printing, and artificial watermarks-those that, by intention, are not easily replicated-may not survive the process of creating substitute checks.

However, the paying bank's risks will be ameliorated by the Check 21 warranty and indemnification provisions provided downstream by the reconverting bank and any intermediate bank transferring a substitute check for consideration. The indemnity against losses arising from the use of a substitute check instead of the original check is provided in addition to the existing warranties available under the UCC.

Paying banks could also continue to take advantage of procedures like positive pay, where items received for payment are checked against the maker's list of issued checks prior to posting. The receipt of substitute checks should not significantly impair the effectiveness of positive pay. At least one bank service provider offers a product where, at the time of creating a check, the issuer can encode information on a data strip or data matrix contained on the check itself as a means of verifying the information on the issued check. The encoded information is designed to remain viable after imaging, and offers the similar kind of protection that is available with positive pay but without the need to submit an issued check list to the bank.

Paying banks will also continue to benefit from "Rule 9," adopted by several clearing house associations, including WesPay covering California that permits members to return forged maker and counterfeit checks received for payment for up to 60 days rather than within the midnight deadline. Generally, the claim can be satisfied only if the affected account at the depository bank contains sufficient funds at the time of the claim. This expanded right to return may turn out to be very helpful if, as expected, substitute checks are returned more frequently.

Depository banks. All this will put more pressure on the bank of first deposit to examine very closely those items that will be converted into substitute checks and transferred for collection. Note that, even if a depository bank decides not to produce substitute checks for collection, the bank will have no control whether an intermediate collecting bank or the paying bank will convert the check at some point in the forward collection or return processes.

If the depository bank is also the reconverting bank (generally, the bank that produced the substitute check), it may see more checks being returned than usual because the reconverting process has hampered paying banks' ability to examine items carefully. Greater returns may also result generally from the production of poor quality images. (See also discussion below on expedited recredit).

Banks that accept deposits from customers (or customers' vendors) in the form of electronic images or substitute checks may face heightened risks from processing the deposits without the benefit of handling the original items. It is anticipated that businesses that handle numerous checks will demand banking services that allow them to deposit checks by transmitting electronic or substitute checks rather than originals. Such a service would help the business avoid making frequent trips to the bank, and could also save the bank itself from incurring the costs of truncating the checks.

Fraud risks also arise from the fact that businesses, unlike banks, are less adept at safeguarding, storing, and destroying checks, and may not have appropriate systems and procedures, including internal controls, necessary to protect against computer intrusions, unauthorized deposits, or other compromises of data systems. From the crooks' perspective, businesses may be viewed as the weak link.

Banks can manage some of these risks by applying "know your customer" principles to prevent against unauthorized issuance of electronic images or substitute checks, by ensuring that transmission channels use encryption, and by entering into agreements with customers to maintain standards and allocate losses. The agreements may include, for example, the kinds of warranties that would be appropriate between a bank that transmits electronic check images (the truncating or converting bank) and one that produces a substitute check from the image (the reconverting bank), namely, that the image accurately reflects the front and back of the check, including the MICR line, and includes appropriate endorsements. Remember that if the bank receives the deposits in the form of substitute checks, it is deemed to be the reconverting bank under Check 21.

Investigations and prosecutions. In the pre-Check 21 environment, checks normally follow the transaction. A party that has taken a loss on a check may enforce the instrument or use it as a basis for investigation or prosecution. A substitute check, which is a paper copy of a check, is the legal equivalent of the original check, but as a practical matter, may be of little forensic value.

Check 21 does not require any bank to retain the original item or to produce it for any reason. As already discussed, a depository bank transferring an original check for payment may get it returned in the form of a substitute check with no rights to demand the original. A bank paying a substitute check of a counterfeit check may never have the opportunity to see or take possession of the actual counterfeit check.

A bank that is responding to a Check 21 warranty or indemnity claim may be required to produce a better copy of the check or of a substitute check, but it is not required to return the original. As a cost-savings matter, it is anticipated that banks will be inclined to retain originals no longer than necessary, and it is uncertain to what extent the possibility of being responsible on a warranty or indemnity claim will induce banks to keep originals for longer periods of time.

Under existing rules issued by the Electronic Check Clearing House Organization (ECCHO), a membership organization devoted to electronic check presentment, original checks must be retained for only a day or so after payment. It may behoove banks to analyze the types and characteristics of transactions that are susceptible to fraud and to decide whether, in specific instances, they should retain the original items for longer periods of time.

The decreased availability of original checks will make it difficult for banks, investigators, and prosecutors to handle check fraud cases using existing procedures. Because a substitute check is a reduced reproduction of the original, it would be much less susceptible to handwriting analysis, chemical analysis, examination for latent or inkless fingerprints, and many other processes incident to a check fraud investigation. Law enforcement agencies and prosecutors, many of whom already refuse to take cases on original checks without a clear, inkless fingerprint, will be reluctant to accept cases based on substitute checks.

Expedited recredit. Check 21 provides consumers who are provided with returned substitute checks a right of expedited recredit if a loss has occurred because of the receipt of a substitute check instead of the original check. A claim could be made, for example, if a bank purportedly debited the wrong amount based on an error in encoding or reading a substitute check. The warranty also applies where a payment involving a substitute check is debited twice. But aside from these obvious examples, the legal standards governing the availability of expedited recredit are not entirely clear.

Both paying and depository banks may be subjected to abusive recrediting claims. As to consumers who receive substitute checks, banks will generally have 10 days to respond to a claim for expedited recredit. If the claim cannot be resolved, then up to $2500 must be recredited after the 10th day, with the remainder recredited no later than the 45th day. As with fraudulent claims made under Regulation E with respect to electronic funds transfers, banks should expect to see abusive recrediting claims under Check 21.

Adding to the uncertainty is that, at present, there are no quality standards established for substitute checks, other than the statutory requirements. This means that even banks will almost certainly have disputes among themselves whether a particular claim is valid-that is, the claiming bank will assert that the poor quality of the substitute check led to an improper charge, while the indemnifying bank will claim that the quality is acceptable and had nothing to do with the loss.

Looking ahead

The prospect of a national, highly efficient payment system based on the electronic exchange of checks may finally become a reality with the passage of Check 21. Checks can be processed, paid, and returned as fast as technology will allow. Technology will also be the key to controlling fraud in the image environment, with all the tools of the digital age at banks' disposal.

As with all changes, the transition is the hardest part. Check 21 is a bridge that allows banks to utilize their existing systems to handle paper checks for the time being. How long the transition will take is anyone's guess. One thing is certain though-the crooks will make the transition along with the industry.

If you have any questions, you may direct them to Leland Chan of CBA at lchan@calbankers.com.

1)The Financial Services Technology Consortium (FSTC), an organization consisting of financial services and technology companies, is currently conducting a study to determine which check security features are likely to survive imaging. Results of the study are expected to be available in mid-2004. See www.fstc.org.
2)Under the WesPay rule, banks are covered under Rule 9 only if they opt in.
3)As discussed in more detail in CBA's previous Bulletin, the Check 21 warranty and indemnity flow forward from the reconverting bank, which is the bank that creates or first handles a substitute check. A depository bank that does not itself transfer a substitute check does not provide the warranty or indemnity.
4)Those standards are that the substitute check contains an image of the front and back of the original check, bears a correct MICR line, conforms to "industry standards" for substitute checks, and is suitable for automated processing in the same manner as an original check.