CBA Publications >> CBA Regulatory Compliance Bulletin >> Vol 2005 No.8
December 6, 2005

Vol 2005 No.8 December 6, 2005

Federal Reserve Adopts Federal Standard for Demand Drafts

CBA wishes to thank Gene Elerding of the law firm, Manatt Phelps & Phillips for contributing to this Bulletin, and to Ted Kitada of Wells Fargo Bank.

The Federal Reserve Board has adopted an amendment to Regulation CC, with conforming changes to Regulation J, to establish federal standards in the treatment of what in California is known as "demand drafts." What the new rules call "remotely created checks" are deposited items that do not bear the signature of the maker, but purported by the payee to be authorized. As with demand draft legislation in California, the amendments shift liability for an unauthorized remotely created check from the paying bank to the bank of deposit.

CBA had sent a comment letter to the Federal Reserve supporting adoption of federal rules that are patterned after California's demand draft legislation, which has also been adopted in a number of other states. Most of the least conforming elements of the proposal were not adopted, but the new rules are not altogether consistent.

Background

While remotely created checks-known variously in different jurisdictions as demand drafts, tele-checks, preauthorized drafts, and paper drafts-provide some convenience to customers and retailers, such items are vulnerable to fraud because they do not bear the drawer's signature. Several states and clearing house associations have adopted changes to the uniform commercial code and to clearing house rules, respectively, to address this problem by creating an exception to the long-held rule that the paying bank bears the economic loss of an unauthorized item. Under these laws and rules on remotely created checks, it is the bank of deposit that bears the loss for this variety of unauthorized items because the bank is in the better position to detect the fraud and avoid a loss. California was one of the first jurisdictions to adopt demand draft legislation in 1996.

The revised rules created a national standard because they supersede state laws to the extent that they are inconsistent with the federal rules. The clearing house associations, under the auspices of NACHA, contemplate making minor conforming amendments to Rule 8, which covers demand drafts, some time early next year.

Amendments

Definition. Regulation CC (which implements the Expedited Funds Availability Act) adds a new definition of remotely created check, which is a check that is not created by the paying bank and that does not bear a signature applied, or purported to be applied, by the person on whose account the check is drawn. The commentary states that the term "applied by" refers to the physical act of placing the signature on the check. For purposes of this definition, "account" includes a credit or other arrangement that allows a person to draw checks that are payable by, through, or at a bank. The commentary also specifies that the definition covers a substitute check (under Check 21) created from a remotely created check.

The California Commercial Code defines a demand draft as a writing not signed by a customer that is created by a third party under the purported authority of the customer for the purpose of charging the customer's account with a bank. Rather than a signature, a demand draft may include the customer's printed or typewritten name, a notation that the customer authorized the draft, or the statement "No Signature Required" or words to that effect.

The federal rule differs from California law in a few respects. The federal rule by its terms does not apply to items created by the paying bank, while the California rule does. Also, California law does not cover checks that a drawer created but neglected to sign (because, among other things, it is not created by a "third party"), but the federal rule does (because it does not bear the drawer's applied signature). Both rules apply to consumer and non-consumer accounts, and both carve out forged signature items, as neither a demand draft nor remotely created check contains a signature. A new comment to Regulation CC clarifies this point.

Warranty. A bank that transfers or presents a remotely created check and receives a settlement or other consideration warrants to the transferee bank, any subsequent collecting bank, and the paying bank (i) that the person on whose account the remotely created check is drawn authorized the issuance of the check (ii) to the payee (iii) in the amount stated. Unlike the California law, the federal warranty is made only by and among banks, so California banks should ensure that their account agreements give the bank recourse against a depositor of a remotely created check. Otherwise, the coverage of the federal rule is consistent with the California warranty, which covers the terms on the face of a check.

Defenses to warranty. The revised rules allow for a defense based on the paying bank's failure to assert its own defense against its customer for failing to discover and report unauthorized checks with reasonable promptness under Commercial Code Section 4406. The rule's reference to the availability of a Section 4406 defense with respect to remotely created checks may help clear up an uncertainty in this area, as it has not been clear whether the defense is available since a demand draft does not actually include a signature. The federal rule does not contemplate a contributory negligence defense of a warranty claim under Section 3406, while the California law does.

Limitation period. The limitation period for a Regulation CC warranty is one year, as opposed to three years under the UCC. It is likely that the longer state limitation period is preempted as it is inconsistent.

The new rules are effective July 1, 2006.

Leland Chan

The information contained in this CBA Regulatory Compliance Bulletin is not intended to constitute, and should not be received as, legal advice. Please consult with your counsel for more detailed information applicable to your institution.

Text of amendments

PART 210-COLLECTION OF CHECKS AND OTHER ITEMS BY FEDERAL RESERVE BANKS AND FUNDS TRANSFERS THROUGH FEDWIRE (REGULATION J)
1. The authority citation for part 210 continues to read as follows: Authority: 12 USC 248(i) and (j), 12 USC 342, 12 USC 464, 12 USC 4001 et seq., 12 USC 5001-5018.

2. In § 210.5, revise paragraph (a)(3) to read as follows:
§ 210.5 Sender's agreement; recovery by Reserve Bank
(a) * * *
* * * * *
(3) Warranties for all electronic items. The sender makes all the warranties set forth in and subject to the terms of 4-207 of the U.C.C. for an electronic item as if it were an item subject to the U.C.C. and makes the warranties set forth in and subject to the terms of § 229.34(c) and (d) of this chapter for an electronic item as if it were a check subject to that section.
* * * * *
3. In § 210.6, revise paragraph (b)(2) to read as follows:
§ 210.6 Status, warranties, and liability of Reserve Bank
* * * * *
(b) * * *
(2) Warranties for all electronic items. The Reserve Bank makes all the warranties set forth in and subject to the terms of 4-207 of the U.C.C. for an electronic item as if it were an item subject to the U.C.C. and makes the warranties set forth in and subject to the terms of § 229.34(c) and (d) of this chapter for an electronic item as if it were a check subject to that section.
* * * * *
4. In § 210.9, revise paragraph (b)(5) to read as follows:
§ 210.9 Settlement and payment
* * * * *
(b) * * *
(5) Manner of settlement. Settlement with a Reserve Bank under paragraphs (b)(1) through (4) of this section shall be made by debit to an account on the Reserve Bank's books, cash, or other form of settlement to which the Reserve Bank agrees, except that the Reserve Bank may, in its discretion, obtain settlement by charging the paying bank's account. A paying bank may not set off against the amount of a settlement under this section the amount of a claim with respect to another cash item, cash letter, or other claim under § 229.34(c) and (d) of this chapter (Regulation CC) or other law.
* * * * *
PART 229 AVAILABILITY OF FUNDS AND COLLECTION OF CHECKS (REGULATION CC)
5. The authority citation for part 229 continues to read as follows:
Authority: 12 U.S.C. 4001 et seq., 12 U.S.C. 5001-5018.
6. In section 229.2, add a new paragraph (fff) to read as follows:
§ 229.2 Definitions
* * * * *
(fff) Remotely created check means a check that is not created by the paying bank and that does not bear a signature applied, or purported to be applied, by the person on whose account the check is drawn. For purposes of this definition, "account" means an account as defined in paragraph (a) of this section as well as a credit or other arrangement that allows a person to draw checks that are payable by, through, or at a bank.
7. In § 229.34, redesignate paragraphs (d), (e), and (f) as paragraphs (e), (f), and (g), and add a new paragraph (d) to read as follows:
§ 229.34 Warranties
* * * * *
(d) Transfer and presentment warranties with respect to a remotely created check.
(1) A bank that transfers or presents a remotely created check and receives a settlement or other consideration warrants to the transferee bank, any subsequent collecting bank, and the paying bank that the person on whose account the remotely created check is drawn authorized the issuance of the check in the amount stated on the check and to the payee stated on the check. For purposes of this paragraph (d)(1), "account" includes an account as defined in § 229.2(a) as well as a credit or other arrangement that allows a person to draw checks that are payable by, through, or at a bank.
(2) If a paying bank asserts a claim for breach of warranty under paragraph (d)(1) of this section, the warranting bank may defend by proving that the customer of the paying bank is precluded under U.C.C. 4-406, as applicable, from asserting against the paying bank the unauthorized issuance of the check.
* * * * *
8. In § 229.43, revise paragraph (b)(3) to read as follows:
§ 229.43 Checks Payable in Guam, American Samoa, and the Northern Mariana Islands
* * * * *
(b) Rules applicable to Pacific islands checks. * * *
* * * * *
(3) § 229.34(c)(2), (c)(3), (d), (e), and (f);
* * * * *
9. In Appendix E to part 229:
a. Under paragraph II., § 229.2, paragraph (OO) is revised and a new paragraph (FFF) is added.
b. Under paragraph XX., § 229.34, redesignate paragraphs D., E., and F. as paragraphs E., F., and G., and add a new paragraph D.
APPENDIX E TO PART 229 - COMMENTARY
* * * * *
II. Section 229.2 Definitions
* * * * *
OO. 229.2(oo) Interest Compensation
1. This calculation of interest compensation derives from U.C.C. 4A-506(b). (See §§ 229.34(e) and 229.36(f).)
* * * * *
FFF. 229.2(fff) Remotely Created Check
1. A check authorized by a consumer over the telephone that is not created by the paying bank and bears a legend on the signature line, such as "Authorized by Drawer," is an example of a remotely created check. A check that bears the signature applied, or purported to be applied, by the person on whose account the check is drawn is not a remotely created check. A typical forged check, such as a stolen personal check fraudulently signed by a person other than the drawer, is not covered by the definition of a remotely created check.
2. The term signature as used in this definition has the meaning set forth at U.C.C. 3-401. The term "applied by" refers to the physical act of placing the signature on the check.
3. The definition of a "remotely created check" differs from the definition of a "remotely created consumer item" under the U.C.C. A "remotely created check" may be drawn on an account held by a consumer, corporation, unincorporated company, partnership, government unit or instrumentality, trust, or any other entity or organization. A "remotely created consumer item" under the U.C.C., however, must be drawn on a consumer account.
4. Under Regulation CC (12 CFR part 229), the term "check" includes a negotiable demand draft drawn on or payable through or at an office of a bank. In the case of a "payable through" or "payable at" check, the signature of the person on whose account the check is drawn would include the signature of the payor institution or the signatures of the customers who are authorized to draw checks on that account, depending on the arrangements between the "payable through" or "payable at" bank, the payor institution, and the customers.
5. The definition of a remotely created check includes a remotely created check that has been reconverted to a substitute check.
* * * * *

XX. Section 229.34 Warranties
* * * * *
D. 229.34(d) Transfer and presentment warranties
1. A bank that transfers or presents a remotely created check and receives a settlement or other consideration warrants that the person on whose account the check is drawn authorized the issuance of the check in the amount stated on the check and to the payee stated on the check. The warranties are given only by banks and only to subsequent banks in the collection chain. The warranties ultimately shift liability for the loss created by an unauthorized remotely created check to the depositary bank. The depositary bank cannot assert the transfer and presentment warranties against a depositor. However, a depositary bank may, by agreement, allocate liability for such an item to the depositor and also may have a claim under other laws against that person.
2. The transfer and presentment warranties for remotely created checks supplement the Federal Trade Commission's Telemarketing Sales Rule, which requires telemarketers that submit checks for payment to obtain the customer's "express verifiable authorization" (the authorization may be either in writing or tape recorded and must be made available upon request to the customer's bank). 16 CFR 310.3(a)(3). The transfer and presentment warranties shift liability to the depositary bank only when the remotely created check is unauthorized, and would not apply when the customer initially authorizes a check but then experiences "buyer's remorse" and subsequently tries to revoke the authorization by asserting a claim against the paying bank under U.C.C. 4-401. If the depositary bank suspects "buyer's remorse," it may obtain from its customer the express verifiable authorization of the check by the paying bank's customer, required under the Federal Trade Commission's Telemarketing Sales Rule, and use that authorization as a defense to the warranty claim.
3. The scope of the transfer and presentment warranties for remotely created checks differs from that of the corresponding U.C.C. warranty provisions in two respects. The U.C.C. warranties differ from the § 229.34(d) warranties in that they are given by any person, including a nonbank depositor, that transfers a remotely created check and not just to a bank, as is the case under § 229.34(d). In addition, the U.C.C. warranties state that the person on whose account the item is drawn authorized the issuance of the item in the amount for which the item is drawn. The § 229.34(d) warranties specifically cover the amount as well as the payee stated on the check. Neither the U.C.C. warranties, nor the § 229.34(d) warranties apply to the date stated on the remotely created check.
4. A bank making the § 229.34(d) warranties may defend a claim asserting violation of the warranties by proving that the customer of the paying bank is precluded by U.C.C. 4-406 from making a claim against the paying bank. This may be the case, for example, if the customer failed to discover the unauthorized remotely created check in a timely manner.

5. The transfer and presentment warranties for a remotely created check apply to a remotely created check that has been reconverted to a substitute check.
* * * * *