Fed Helps Cancel Fraudulent Paper Drafts

by John S. Burnett, BOL GuruGuru Bios

Your valued customer, Florence Smythe, calls with a complaint. "How could you?" she asks, as you brace yourself for bad news. "You let them take my money, without my permission!" As Florence continues her tale of woe, you scramble to pull up her last statement on your screen, where you find an image of the item that's got Florence ranting about a phone call from a high-pressure sales type. "Yes, I guess I must have given him my account number. But I caught myself, and I told him to make sure he didn't send me that contraption he was selling. I said it was too much money, and I wasn't interested. How can you let them take money from my account when I told them not to?"

Nineteen states have adopted some form of UCC amendments to create warranties of authorization for remotely created drafts:
Arkansas, California, Colorado, Hawaii, Idaho, Iowa, Main, Missouri, Minnesota, Nebraska, New Hampshire, North Dakota, Oregon, Tennessee, Texas, Utah, Vermont, West Virginia, and Wisconsin. Two days later, one of your back office staff asks you to take a look at something. He has a half-dozen white check-sized items in his hand. "We have to do something about these things, Sam," he says. "We've been fielding a lot of complaints from customers about unauthorized checks with legends on them reading something like 'No signature required. This check has been authorized by the customer.' And from the earful I've been getting from these customers, Sam, there's no way they've all forgotten about telling someone it's OK to charge their accounts." You learn that the staff found a way to identify some of the items in the thousands that were processed last night, and he shows you two hundred of them that they culled out. He says lots of them are legitimate, but he'd bet that at least 10% of them aren't.

Those Darned Drafts
Some bankers call them "consumer drafts." Others call them "telechecks," "preauthorized drafts," or simply "paper drafts." Most bankers have stronger names for them. That's because along with the thousands of legitimate unsigned paper drafts that are paid every day, there are significant numbers of fraudulent drafts, created by fly-by-night thieves that prey on consumer lack of awareness, obtaining bank routing and account numbers dishonestly, and printing official-looking drafts with appropriate MICR characters. These scam artists know that they can strike quickly, glean a few thousand dollars and move on before anyone's the wiser.

Your customers are victimized, unless they realize they have a defense against unauthorized payments. What you don't know is how many of your customers have quietly been hit by these thieves, but have failed to complain.

Banks are the real victims of this fraud, however. Most banks don't have the ability to detect these unsigned paper drafts in their automated processing environments. Unless one of these items is "flagged" for some other problem -- an overdraft, for example -- the items are usually paid and stay "under the radar" until a customer finally detects them in her bank statement. As more statements drop paid checks in favor of images, even consumers become less likely to find these bogus checks. But when they are found, the customer is entitled to reimbursement, since the bank cannot in most cases pay items not authorized by its customer.

The Fed Acts
Starting July 1, 2006, amendments to Regulations CC and J announced by the Federal Reserve Board will go a long way toward eliminating this weakness in the payment system. The Fed acted on November 21, 2005, to create a federally-mandated warranty in the payment system that will supplement a patchwork of amendments to individual states' versions of the Uniform Commercial Code (UCC), The goal of those amendments (both the state UCC changes and the Fed's action) is to shift the liability for unauthorized "remotely created drafts," as the Fed calls them, to the bank whose customer created the drafts and deposited them.

In its announcement of the amendments, the Fed said that only nineteen of the states had so far passed UCC amendments creating transfer and presentment warranties covering paper drafts. According to the Fed, there is such a lack of uniformity in the various states' amendments that the legal positions of the players are doubtful. Further, several of the UCC amendments address only those paper drafts drawn on consumer accounts (the Fed's action applies to paper drafts on accounts of all customers).

A one-year warranty
The Fed's action will create a new warranty, made only by banks that transfer or present "remotely created checks." They will warrant to the transferee bank, subsequent collecting banks and the paying bank that the person on whose account the check is drawn authorized its issuance in the amount on the check and to the payee stated on the check. This warranty will apply not only to remotely created checks on deposit accounts, but also on other arrangements allowing checks, such as credit card or home equity plans.

The paying bank can file suit for breach of warranties under Regulation CC within one year from the time of the violation.

Shifting the Burden
With the implementation of the new warranty in 2006, bankers will be able to reimburse customers like Florence, knowing that there is recourse against the depository bank. To protect themselves, depository banks will both revise their deposit contracts to allow them to charge back any offending drafts, and improve their customer due diligence efforts to prevent the use of unauthorized drafts in the first place.

The Fed's action should effectively close the loophole in the payment system that thieves have fraudulently exploited for the last several years.

Keeping it simple
The Fed stopped short of taking other action it had listed as "possible" in its March 4, 2005, proposal for amendments. Among the options discarded in favor of simply adding the warranty were an extension of the midnight deadline, a delay in Fed action in favor of letting the states take action to update the UCC, and adding a MICR line identifier to these items.

Read the complete text of the Fed's November 21, 2005, Federal Register notice.

First published on BankersOnline.com 11/22/05