Check 21 and the Non-imaging Bank - Ken Golliher
Check 21 and the Non-imaging Bank
by Ken Golliher, Principal,
Pegasus Educational Services, LLC
Does your bank include original checks in your customers' periodic statements? If the answer is, "Yes," yours will be one of the institutions most heavily impacted by "Check 21." This recent federal legislation creates the legal concept of the "substitute check," a somewhat ingenious stopgap mechanism that facilitates the conversion of paper checks into electronic images.
However, it is the banks that do not make use of imaging; i.e. those that continue to receive and distribute paper checks to their customers, that are most heavily affected by the new law's consumer protection provisions. Those banks:
- will receive increasing numbers of substitute checks and
- accordingly, will have a far greater likelihood of consumer claims for breach of warranty and indemnification in connection with substitute checks and
- will be required to make consumer disclosures that imaging banks do not.
The concept of a substitute check enables depositary banks to truncate a paper check, turn it into an electronic image and send that electronic image through the clearing system. It is the image, not a piece of paper, which moves toward the paying bank. However, no bank is required to accept an electronic image - there must be agreements between transferring banks in order to allow the check to remain in image form for the entire trip from the bank of first deposit to the paying bank. If a receiving bank is unwilling to accept the electronic image, the presenting bank must turn it back into a piece of paper.
For example, assume a depositary bank truncates the original check and creates an electronic image that moves through the clearing system, but the paying bank has chosen not accept images. The presenting bank must turn the item back into a piece of paper; i.e. a substitute check. Check 21 mandates that the paying bank accept the paper substitute check. (Again, no bank is required to accept the electronic image.)
The substitute check will be about the size of a business check and will reflect a copy of the original check (front and back) plus some additional information. It will have physical characteristics that allow it to be handled like a paper check.
When Check 21 takes effect on October 28, 2004 banks will begin receiving substitute checks or images of substitute checks. Since any depositary bank in the chain of presentment may truncate the original check and turn it into an image, a paying bank that has customarily forwarded original checks to its customers will lose control over whether it even receives the original check. It may receive a substitute check instead and will include that item with the customer's statement in lieu of the original. (ABA statistics suggest that 40% of consumers still receive original paid checks from their banks.)
As more and more banks adopt the techniques that Check 21 enables, the bank that refuses to accept imaged items is likely to receive a greater and greater percentage of its inclearing items as substitute checks.
Those non-imaging banks passing on substitute checks to their customers rather than the originals are going to have a lot of explaining to do. Effectively, they have three choices, all of which involve customer communication that should begin well in advance of the effective date. One choice might require a significant capital investment.
First, non-imaging banks can simply explain to customers why and when they can no longer expect to receive some original items back in their periodic statement and what the substitute check is. This scenario reflects the bank's simple acknowledgement of the effects of Check 21.
Second, they can become an imaging bank; i.e. begin providing customers with images of checks rather than the originals in anticipation of Check 21. When the law takes effect, they can accept inclearing items in image form - their opportunities for dealing with substitute checks will be very limited. In this scenario, they can explain to customers why and when they will no longer receive any original items bac
Third, they can eliminate both the original check and the image as enclosures in the periodic statement. While the model version of the uniform commercial code (UCC) requires that banks be able to reproduce customer checks for up to seven years, it does not require banks to provide checks or even images of checks with the periodic statement. (Review your state's version of UCC section 4-406(a) and other pertinent statutes. Some states have statutes that require a much lengthier period.) All the model language requires is that the customer be provided with the item number, amount and date of payment. Again, customer communication will be required, but there is no reason to assume that all customers want either the check or an image of the check. Many banks currently offer successful products where the customer does not receive the check or the image of the check, only the information required by the UCC.
Even some imaging banks continue to provide original checks to a select few customers, usually businesses. They often charge a fee for the service. Those institutions will have to re-evaluate the promise to provide original items in the light of "impossibility" and also begin targeted customer communications. It is doubtful that a customer who was willing to pay to have original checks returned is going to be well satisfied with a substitute check that is only a glorified copy of the original check.
In addition, substitute checks bring other compliance responsibilities that imaged items do not. A paying bank that receives a substitute check makes substitute check warranties when it provides the item to its customer. That paying bank also agrees to indemnify the customer for any loss incurred due to the receipt of the substitute check rather than the original check. Finally, if a bank provides a substitute check to a consumer, there are expedited recrediting provisions if the consumer files a claim recognized by the statute. The warranty and indemnification provisions of Check 21 are the most complex aspects of the regulatory scheme, but they only apply to a paper substitute check, not an image of a check.
If a paying bank simply forwards an image of the item created by the depositary bank to its customer; i.e. it does not insist on receiving the item in paper form, it does not make the substitute check warranties or assume indemnification responsibilities. In addition, the expedited recrediting provisions do not apply.
Finally, banks that provide original checks to customers with periodic account statements are required to make consumer disclosures that imaging banks are not required to make. They must provide a lengthy written disclosure to all existing consumer customers no later than the first regularly scheduled communication with the customer after October 28, 2004. In addition, they are to provide the disclosure for consumer accounts opened after the date existing customers are notified.
The way the law is interpreted by the Federal Reserve (and as clarified in proposed Subpart D of Reg CC), banks that do not provide original checks to consumers (including those that provide images or only the information from the check) are not required to make these disclosures to every consumer customer. An imaging bank's customer that does not normally receive original checks, but who requests and receives a substitute check, must receive the disclosure at that time. For example, an item deposited to a consumer account has been returned for "insufficient funds." If the return item is a substitute check, a consumer depositor would receive the disclosure along with the item.
The consumer protection provisions attached to substitute checks affect all banks. However, as noted above, it is the banks that refuse to accept imaged items that are actually likely to receive significant numbers of substitute checks. Out of necessity, paper based banks will gain the most experience in applying and interpreting Check 21's warranty and indemnification provisions.
The invention of the substitute check and its attendant consumer protection provisions are a sea change for non-imaging institutions. While the regulatory mantra is that Check 21 does not require banks to change their practices, paper based banks must at least realize that their methods trigger substantially greater Check 21 compliance burdens than those borne by imaging banks.
First published on BankersOnline.com 3/3/04