Check Clearing for the 21st Century Act
Foundation for Check 21 Compliance Training
The economics of the check business is changing. Declining check volumes and a largely fixed-cost-based check processing infrastructure have caused banks’ unit costs for processing paper checks to rise. Accordingly, many banks have begun to seek less costly alternatives to sorting paper checks and transporting them physically around the country on a daily basis. For example, some banks have begun to exchange electronic images of checks. However, under current check law, a bank must present the original paper check for payment unless the paying bank has agreed to accept electronic presentment. Because of the large number of banks and the unwillingness of some paying banks to receive checks electronically, it is difficult, if not impossible, for a bank to obtain electronic presentment agreements with all other banks. As a result, banks that want to engage in electronic check exchange on a widespread basis have been hampered in their ability to do so.
The banking industry and consumer groups therefore worked with the Board of Governors of the Federal Reserve System (the Federal Reserve Board), and later with Congress, to develop legislation that would facilitate the ability of banks to exchange checks electronically without requiring any bank to change its check processing methods. This legislation, known as the Check Clearing for the 21st Century Act (Check 21 Act or Check 21 or the Act), was enacted on October 28, 2003, and becomes effective on October 28, 2004. The Check 21 Act authorizes a new negotiable instrument called a “substitute check,” which is a paper reproduction of an original check, and provides that a properly prepared substitute check is the legal equivalent of an original check. The Act facilitates electronic check exchange by enabling banks to sort and deliver checks electronically and, where necessary, to create legally equivalent substitute checks for presentment to banks that have not agreed to accept checks electronically.
It is likely that most financial institutions will, at some point in time, receive a substitute check that is subject to the Check 21 Act and subpart D of the Federal Reserve Board’s Regulation CC, which implements the Check 21 Act. This is true whether or not a financial institution chooses to create substitute checks. Some financial institutions will rapidly migrate toward electronic check exchange. Others will proceed more hesitantly. Regardless, all banks must be prepared to accept a substitute check in place of the original after the Act’s effective date of October 28, 2004. Because the Check 21 Act provides that a properly prepared substitute check is the “legal equivalent of the original check for all purposes,” a bank cannot refuse to pay a check based solely on the fact that it was presented with a substitute check instead of the original check.
One of a bank’s regulatory compliance obligations will be to provide a consumer awareness disclosure to consumer customers who receive canceled checks with their periodic account statements or who otherwise receive substitute checks on an occasional basis. A bank that provides a substitute check to a consumer also must be prepared to comply with the Check 21 Act’s expedited recredit procedure for addressing errors relating to substitute checks. Even if the customer does not receive actual canceled checks in a monthly statement, but instead receives a truncated summary, the individual may eventually receive a substitute check, either in response to a request for a check or a copy of a check or because a check that the consumer deposited was returned unpaid to the consumer in the form of a substitute check. Some increase in the potential for duplicate posting (substitute check and original) may also involve a degree of consumer education and explanation. The regulation provides safe-harbor language for the consumer awareness disclosure and specifies when it must be distributed.
The Check 21 Act, Pub. L. No. 108-100, 117 Stat.1177, codified at 12 U.S.C. §§ 5001-5018, was signed into law on October 28, 2003, and will take effect on October 28, 2004. The Check 21 Act facilitates check truncation and electronic check exchange by authorizing a new negotiable instrument called a “substitute check.”
The Act provides that a substitute check is the legal equivalent of the original check if (1) it accurately represents all of the information on the front and back of the original check as of the time it was truncated (including payment, identification, and indorsement information), (2) 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,” and (3) a bank has made the Check 21 Act warranties with respect to the substitute check. A bank does not need to affirmatively state that it is making the Check 21 Act warranties; rather, a bank automatically makes the Check 21 Act warranties when it transfers, presents, or returns a substitute check for which it receives consideration.
The Check 21 Act defines “bank” to include insured banks, savings banks, credit unions, savings associations, and anyone else engaged in the business of banking. The U.S.Treasury and the U.S. Postal Service also are banks for purposes of the Check 21 Act to the extent that they are payors of a check (the term check includes U.S. Postal Service money orders). The Act defines a “reconverting bank” as the bank that creates a substitute check or, if a person other than a bank creates a substitute check, the first bank to transfer, present, or return, a substitute check (or, in lieu thereof, the first paper or electronic representation of the substitute check) to another party.
Although the Check 21 Act does not require any bank to create substitute checks or to accept checks electronically, certain provisions of the Check 21 Act will affect all banks, even if they choose not to create substitute checks. These provisions involve consumer awareness disclosures, new warranties and an indemnity, and expedited recredit procedures to protect consumer substitute check recipients.
The Final Regulation
On July 26, 2004, the Board of Governors of the Federal Reserve System released its final rule amending Regulation CC (Availability of Funds and Collection of Checks) to implement the Check 21 Act. These amendments detail the requirements of the Check 21 Act that apply to banks, provide a model consumer awareness disclosure and other model notices for educating consumer customers about their rights under the Act, and specify bank indorsement and identification requirements for substitute checks. The final regulations also clarify some existing provisions of the rule and commentary. The final regulations can be found at:
THE SUBSTITUTE CHECK CLEARING PROCESS
Check 21 enables banks to clear checks electronically without having pre-existing agreements between the bank of first deposit and the paying bank. Below is an example of the steps that may be involved in the substitute check clearing process:
A customer indorses an original check and deposits it with Bank 1, the Bank of First Deposit (BOFD). Bank 1 stamps its indorsement onto the back of the original check.
Bank 1 decides to “truncate” the original check and is, therefore, the “truncating bank” Bank 1, therefore, (1) captures an image of the front and back of the original check, (2) captures the magnetic ink character recognition (MICR) line data from the original check, and (3) sends to Bank 2, its correspondent bank, the image and MICR line data in lieu of the original check. Bank 1 also identifies itself as the truncating bank in the electronic records it sends to Bank 2. Note that in order for this scenario to occur, Bank 2 must have previously agreed to accept checks electronically from Bank 1. If Bank 2 had not so agreed, then Bank 1 would need to provide either the original check or a legally equivalent substitute check to Bank 2.
Bank 2 applies its indorsement electronically and transfers the check image and MICR line data to Bank 3. Again, in order for this scenario to occur, Bank 3 must have previously agreed to accept checks electronically from Bank 2.
Bank 3 desires to present the check for payment to Bank 4, the paying bank, but Bank 4 has not agreed to accept checks electronically. Accordingly, Bank 3 uses the information received from Bank 2 to create a substitute check, and Bank 3 is, therefore, the reconverting bank. As part of the substitute check creation process, Bank 3 (1) includes the image of the front of the original check on the front of the substitute check, (2) includes the image of the back of the original check on the back of the substitute check, and (3) applies the MICR line data from the original check to the bottom of the front of the substitute check. Additionally, Bank 3 overlays its own indorsement and the indorsement of Bank 2 onto the back of the substitute check at the time it creates the substitute check. (Bank 1’s indorsement, along with Bank 1’s depositor’s indorsement, is contained within the image of the back of the original check that Bank 3 applies to the back of the substitute check.) Bank 3 also identifies itself as the reconverting bank on the front and back of the substitute check and identifies Bank 1 as the truncating bank on the front of the substitute check. Bank 3 presents the substitute check to Bank 4, the paying bank, for payment.
Bank 4, the paying bank, uses the MICR line data that Bank 3 applied to the bottom of the substitute check to process the substitute check in the same manner as it would have processed the original check. Bank 4 may provide the substitute check to its customer (who wrote the original check) in the customer’s monthly periodic statement.
If there had been insufficient funds to cover this substitute check, the paying bank could return it stamped NSF to Bank 1, the Bank of First Deposit. Regulation CC requires the reason for return to be stamped on the portion of the substitute check that contains the image of the original check. Bank 1 could then charge its customer’s account for the returned item and provide the substitute check with the chargeback notice.
UNIQUE CHECK 21 CONCEPTS
What is a substitute check? [Section 229.2(2)(aaa)]
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 a MICR line containing all the information from the original check’s MICR line, except as provided in ANS X9.100-140, to facilitate the processing of substitute checks;
- Conforms in paper stock, dimension, and otherwise with the industry standard for substitute checks, ANS X9.100-140; and
- Is suitable for automated processing just like the original check.
When is a substitute check the legal equivalent of the original check?
A substitute check is the legal equivalent of the original check if:
- It accurately represents all of the information on the front and back of the original check as of the time the original check was truncated;
- It bears the Check 21 Act’s required legal equivalence legend:
“This is a legal copy of your check. You can use it the same way you would use the original check;” and
- A bank has made the Check 21 Act warranties with respect to the substitute check.
What is included in “all of the information” on the front and back of the original check?
“All of the information” includes the information from the original check that must be present on the substitute check in order for the substitute check to meet the
Uniform Commercial Code’s
(UCC) requirements for a negotiable instrument. This information includes the payment and indorsement information from the original check. A substitute check need not contain watermarks, decorative features, or security features that do not survive the imaging process.
One important point to remember is that substitute checks are checks and are, therefore, subject to existing check law, such as articles 3 and 4 of the UCC.
Substitute Check Warranties [Section 229.52]
Legal equivalence warranty [Section 229.52 (a)]
Beginning with the first reconverting bank in the check clearing process, any bank that transfers, presents, or returns a substitute check or a paper or electronic representation of the operative substitute check, warrants to all subsequent transferees that the substitute check being transferred (or the substitute check from which the paper or electronic representation being transferred was derived) meets the requirements for legal equivalence.
Duplicative payment warranty [Section 229.52 (a) (2)]
The reconverting bank also warrants that no depositary bank, drawee, drawer, or indorser will be asked to make a payment based on a check it already has paid. A “check” includes any of the following items: a substitute check, the original check, or a paper or electronic representation of the substitute check or the original check.
Substitute Check Indemnity [Section 229.53]
Any bank that transfers, presents, or returns a substitute check or paper or electronic representation of a substitute check must indemnify the initial recipient and any subsequent recipient for losses suffered by the recipient because of receiving a substitute check instead of the original check.
An indemnity claim can be originated only by a recipient of a substitute check. By contrast, a recipient of a substitute check or a paper or electronic representation of a substitute check can originate a warranty claim.
Calculating recoverable losses
If the loss only involves a breach of the substitute check warranty, or only involves the indemnity, the claimant is entitled to damages up to the amount of the substitute check, plus interest and expenses (i.e., reasonable attorney’s fees and other expenses of representation).
If the loss involves both a breach of warranty claim and an indemnity claim, the claimant is entitled to damages up to the amount of the substitute check, plus interest and expenses, as well as other proximately caused damages.
Another point to remember is that electronic check conversion (i.e., where information from a check is used to create an automated clearinghouse (ACH) debit) is similar to but separate from the check substitution process authorized by the Check 21 Act. The ACH electronic fund transfers between financial institutions are not considered check transactions and thus are not subject to check law. Rather, they are governed by the rule of the automated clearinghouse that processes the electronic fund transfer. ACH transactions to or from consumer accounts also are subject to the provisions of the Federal Reserve Board’s Regulation E.
The Check 21 Act has implications for consumers and compliance considerations for insured institutions and regulators.
CONSUMER PROTECTION PROVISIONS
Consumer awareness disclosure [Section 229.57]
What is required?
The Check 21 Act requires banks to provide certain consumer customers with a disclosure that describes substitute checks and the rights consumers have when they receive substitute checks. The disclosure must describe 1) how substitute checks are the legal equivalent of original checks and 2) the Check 21 Act’s consumer expedited recredit procedures.
A bank that uses the consumer awareness disclosure language contained in model form C-5A in appendix C of Regulation CC is deemed to have complied with the content requirement(s) for which it used the model language, provided that the model language that the bank uses accurately describes the bank’s policies and practices.
Which consumer customers must receive the disclosure?
A consumer customer is a natural person who deposits a check into, cashes a check against, or draws a check on a deposit account that he or she uses primarily for personal, family, or household purposes.
Disclosure to consumer customers who receive paid checks with periodic account statements
A bank must provide the disclosure to a consumer customer who receives paid checks (which could include paid original checks and/or paid substitute checks) with his or her periodic account statement (1) no later than the bank’s first statement cycle after October 28, 2004, for each consumer who is a customer of the bank on that date; and (2) at the time the customer relationship is initiated, for each customer relationship established after that date.
Disclosure to consumers who receive substitute checks only on an occasional basis
If a bank provides a substitute check in response to a consumer’s request for a copy of a check, the bank must provide the disclosure at the time of the request, if feasible, and, otherwise, no later than when the bank provides the substitute check. If a bank provides a consumer a returned substitute check, the consumer disclosure must be provided at the time the bank provides the substitute check. A bank must provide the disclosure on these occasional bases even if the consumer previously received the disclosure (for example, because the consumer is a customer who receives paid checks with his or her monthly account statement).
Consumer expedited recredit rights [Section 229.54]
The consumer expedited recredit provision only applies to “consumers” (not business customers) who have received a substitute check and have had a transaction involving a substitute check charged to their account. Because the Check 21 Act defines “account” as a deposit account, the expedited recredit procedures only apply to substitute checks charged to a consumer deposit account. Credit card checks, checks a consumer draws on a home equity line of credit, or checks a consumer draws on a brokerage clearing account would, therefore, generally not trigger the expedited recredit procedures. Such checks could only trigger the expedited recredit procedures if a consumer had deposited such a check into his or her deposit account, the check were returned unpaid, and the bank provided the returned check to the consumer depositor in the form of a substitute check. Note: The UCC provisions that prohibit a bank from making unauthorized charges to the consumer’s account still apply regardless of whether the expedited recredit procedure applies.
To use the expedited recredit procedure, the consumer must be able to assert in good faith that the:
- Consumer’s account was charged for a substitute check;
- Consumer’s account was improperly charged or the consumer has a warranty claim related to the substitute check;
- Consumer suffered a loss; and
- Consumer needs the original check or a “sufficient copy” to determine the validity of the claim.
A “sufficient copy” is defined in Section 229.2 (bbb) as “a copy of an original check that accurately represents all of the information on the front and back of the original check as of the time the original check was truncated or is otherwise sufficient to determine whether or not a claim is valid.”
How does a consumer file an expedited recredit claim?
A consumer must file an expedited recredit claim so that the bank receives it within 40 calendar days from the later of the date that the bank mailed, or delivered by a means agreed to by the consumer, (1) the account statement showing the transaction that gave rise to the claim or (2) the substitute check that gave rise to the claim. (The bank is required to extend the time for making a claim in extenuating circumstances. Additionally, the bank also has the latitude under the final rules to extend the 40-day time period for consumer action, so that it can parallel the 60-day claim period under Regulation E involving claims for disputed electronic fund transfers).
To make a claim for expedited recredit, a consumer must provide:
- A description of why the consumer believes the account was improperly charged or the nature of the consumer’s warranty claim;
- A statement that a loss occurred, including an estimate of the amount;
- The reason why producing the original check or a sufficient copy is necessary to determine the validity of the charge; and
- Sufficient information to identify the substitute check and to investigate the claim.
The bank has a duty to inform the consumer whether his or her complaint is incomplete (and thus is not yet a “claim” for purposes of the expedited recredit procedure) and must identify what information is missing. A bank’s “clock” for responding does not begin to tick until the consumer submits a complete claim.
If a bank requires a written claim and the consumer attempts to submit a claim orally, the bank must, at the time of the attempted oral claim submission, inform the consumer of the written claim submission requirement. The consumer awareness disclosure that the bank distributes also should inform the consumer of the written claim requirement.
If the bank requires the claim to be in writing, the consumer must submit the written claim so that the bank receives it either (1) within 10 business days of the date of notification of the written claim requirement, or (2) within the “basic” 40-calendar-day time period (discussed above) for filing a claim, whichever is later.
If an oral claim is made within the 40-day period and the consumer meets the 10 day written notification requirement, the consumer’s claim is timely even if the written claim is received after the “basic” 40-day period.
Bank options for responding to consumer claims
A bank that receives an expedited recredit claim must take one of the following actions:
- Approve the claim and provide a full recredit no later than the business day after making that determination. In this case, the bank must send a notice of recredit no later than the business day after the banking day on which the bank recredits the consumer’s account;
- Deny the claim and demonstrate to the consumer why the claim is not valid. The bank must send a notice demonstrating that the consumer’s claim is not valid no later than the business day after the banking day on which it makes this determination; or
- If the bank has not taken an action described in (1) or (2) by the tenth business day after the banking day on which the bank received the claim, the bank must provisionally recredit a consumer’s account pending further investigation. The bank must provide notice of the provisional recredit no later than the business day after the banking day on which the bank recredits the consumer’s account.
If the bank provisionally recredits a consumer’s account pending further investigation, the bank is required to recredit the amount of the consumer’s loss, up to the amount of the substitute check or $2,500, whichever is less. The bank must also recredit interest on that amount if the consumer’s account is an interest-bearing account. The bank would recredit any remaining amount (plus applicable interest) on the 45th calendar day after receiving the claim, unless before that time the bank had already made a determination concerning either the validity or invalidity of the consumer’s claim.
If the bank later determines that the claim was not valid, the bank may reverse the recredit (notwithstanding whether the bank’s recredit to the consumer’s account was provided under (1) or (3) above). The bank must provide a notice of reversal of recredit no later than the business day after the banking day on which the bank makes the reversal.
The Federal Reserve Board has provided model notices in appendix C that banks may use in responding to consumer expedited recredit claims under §229.54(e). Unlike the model consumer awareness disclosure form C-5A, however, use of these model notices does not provide banks with a statutory safe harbor.
COMPLIANCE PROVISIONS FOR BANKS
A bank is not required to create substitute checks or to accept checks electronically. However, on October 28, 2004, a bank, at a minimum, should be prepared to receive a substitute check in place of an original check. Banks that choose to create substitute checks will take on additional duties with respect to the substitute check.
Duties for all banks
All banks that transfer, present, or return a substitute check for consideration thereby make the substitute check warranties and indemnities described in Regulation CC. However, in the vast majority of cases, liability for the warranties and indemnity ultimately will flow back to the reconverting bank.
Because a substitute check must be suitable for automated processing in the same manner as an original check, a bank that receives a substitute check will not need to change its equipment and will need to make only minor processing changes if it returns a substitute check.
A bank that returns a substitute check must place the reason for return within the portion of the substitute check that contains the image of the original check; and a bank that qualifies a substitute check for return must encode position 44 of the return MICR line with a “5” instead of a “2.”
Duties of the reconverting bank [Section 229.51]
The Check 21 Act is designed so that losses associated with a substitute check are borne by the reconverting bank.
A reconverting bank is defined in the Check 21 Act as the bank that creates a substitute check; or, if the substitute check is created by a nonbank, the first bank that transfers or presents the substitute check (or in lieu thereof the first paper or electronic representation of that substitute check).
The reconverting bank must:
- Identify itself as a reconverting bank on the substitute check;
- Preserve all previous reconverting bank identifications;
- Ensure that the substitute check bears all previously applied indorsements; and
- Identify the bank that truncated the original check.
Pursuant to the Check 21 Act, the reconverting bank and each bank that subsequently transfers, presents, or returns the substitute check for consideration makes two warranties:
- First, that the substitute check meets the legal equivalence requirements (See above for what these legal equivalence requirements are.), and
- Second, that a paying bank will not be asked to make payment on an item that it has already paid.
Note that the reconverting bank is responsible for the legal equivalence warranty even if a substitute check’s failure to accurately represent the payment information from the original check is the result of the drawer using an ink type or color that does not survive the image capturing process or is the result of receiving a poor image file from an electronic sender. However, a reconverting bank can attempt to further allocate warranty losses by agreement.
Note that the responsibility of the reconverting bank for the duplicative payment warranty and for the indemnity does not depend upon knowledge or fault. Also note that the duplicative payment warranty applies only to charges initiated by check, as opposed to ACH debits.
Interbank expedited recredit rights [Section 229.55]
Interbank expedited recredit rights allow a bank to recover losses associated with a consumer expedited recredit claim from the indemnifying bank that sent the item in question.
The claimant bank can submit a claim to cover losses associated with providing an expedited recredit to a consumer or another bank involved in the collection process. This claim must be submitted by close-of-business on the 120th calendar day after the claimant bank processed the substitute check in question.
The indemnifying bank has 10 days after receipt of the claim to provide: 1) a recredit; 2) the original check, or 3) a “sufficient copy.”
CHECK 21 EXAMINATIONS – COMPLIANCE
In evaluating a financial institution’s compliance with the Check 21 provisions of Regulation CC, examiners should generally focus their evaluation on meeting two objectives:
- Determining the financial institution’s compliance with subpart D notice content and timing requirements (general consumer awareness disclosures regarding substitute checks and notices that respond to a consumer’s expedited recredit claim regarding a substitute check error), and
- Ascertaining whether the financial institution complies with timing requirements for acting on a substitute check expedited recredit claim.
Preliminary review of documents that demonstrate the financial institution’s compliance with the notice requirements can include, but are not limited to:
- Consumer awareness notice(s)
- Sample (test) substitute checks, if available
- Direct mail correspondence, statement stuffers, et. al. describing Check 21/substitute check implementation to consumer customers
- Notices relating to expedited recredit claims:
- Notice of valid claim and refund
- Notice of provisional refund
- Denial of claim
- Reversal of refund
Review of the financial institution’s training manual, procedures manual, internal audit reports, and board meeting minutes can reveal the extent to which the financial institution’s compliance risk management program has responded to the Check 21 provisions. Additionally, interviews with key staff members, including new accounts personnel and deposit operations, can identify how effectively the institution’s management has communicated its response to this new regulation to the individuals responsible for ensuring compliance.
The FFIEC has approved examination procedures that discuss the steps examiners should follow to evaluate a financial institution’s effective use of the consumer awareness notice and handling of any consumer claims of Check 21-related losses. Those examination procedures can be found on the Examination Procedures link above.
As we wrap up our Check 21 training, the most important learning you need to come away with is fairly simple.
Check 21 Does Not
- Require banks to accept check images (image exchange must still take place under agreements)
- Give legal equivalence to check images
- Mandate check truncation
- Mandate destruction of original checks
- Exclude business or U.S. Treasury checks
- Pertain to checks that are converted to ACH transactions
Check 21 Does
- Create a new negotiable instrument (called a substitute check)
- Provide that a properly prepared substitute check is the legal equivalent of the original check
- Provide that any check is eligible to become a substitute check
- Require banks to accept legally equivalent substitute checks
The Law – Check 21 Act
Authorizes substitute checks and defines the look, format and other features
No person or entity is required to issue a substitute check. However, a properly prepared substitute check is the legal equivalent of the original check. Therefore, a paying bank must receive a legally equivalent substitute check just as it would the original check.
Protects recipients of substitute checks
- Warranties and Indemnity
- Two warranties
- Legal equivalence warranty
- No double debit warranty
- Indemnity against losses due to the receipt of a substitute check in lieu of the original check
- Expedited recredit for consumers
- Expedited recredit for banks
Requires consumer awareness
All existing consumer customers who routinely receive canceled checks in their periodic statement must be provided a disclosure no later than the first statement after October 28, 2004.
After that date, all new consumer customers who receive canceled checks or substitute checks must be provided a disclosure when the new account is opened.
This disclosure must:
- Explain that a substitute check is the legal equivalent of the original check, and
- Describe the consumer’s rights for recredit for substitute checks not properly charged to the consumer’s account.
Model disclosure for banks to use – Appendix C, form C-5A of Regulation CC.
Consumers who receive substitute checks on an occasional basis (e.g., consumers who request a copy of a check and receive a substitute check or who receive, in the form of a substitute check, a previously deposited item that has been returned unpaid) must also be provided the disclosure.
- When the consumer contacts the bank to request a copy of a check (where possible), the bank should provide the model disclosure at the time of the request.
- If that is not feasible, the disclosure should be provided no later than when the substitute check is provided.
- When a substitute check is provided as a returned deposited item, the disclosure should be included along with the substitute check.
This concludes our Check 21 training. Please visit our Resources page located above on this FFIEC Web site. You will also find other Web links and additional information there.
Under § 229.2(ddd), “truncate means to remove an original check from the forward collection or return process and send to a recipient, in lieu of such original check, a substitute check, or, by agreement, information relating to the original check (including data taken from the MICR line of the original check or an electronic image of the original check), whether with or without the subsequent delivery of the original check. Under § 229.2(eee), a “truncating bank” is defined as follows: “(1) The bank that truncates the original check; or (2) If a person other than a bank truncates the original check, the first bank that transfers, presents, or returns, in lieu of such original check, a substitute check or, by agreement with the recipient, information relating to the original check (including data taken from the MICR line of the original check or an electronic image of the original check), whether with or without the subsequent delivery of the original check.”
 American National Standard Specifications for an Image Replacement Document – IRD, X9.100.