Destination: BLJJun2004

06/10/2004 Buffalo Law Journal: Check-clearing rules adapt to 21st-century technology

Check Clearing Adapt for the 21st Century

At Congress’ direction, the Board of Governors of the Federal Reserve System established the Check Clearing for the 21st Century Act ("Check 21") "in 2003 for both financial services customers and the financial services industry, to reduce costs, improve efficiency in check collections, and expedite funds availability for customers." (12 U.S.C. § 5001(a)(3)). Check 21 will become the law of the land on October 28, 2004. Check 21 will allow banks to "foster innovat[ive] check collection . . . without mandating . . . checks in electronic form," and does not apply to all electronic checks. Fundamentally, Check 21 allows a person to convert an original check into a substitute check without an agreement provided the reconverting bank accepts the warranties and indemnifications under to Check 21.

The passage of Check 21 does not necessarily mean that customers will receive "substitute checks" instead of original checks in their monthly statements. In New York, section 9-m of the Banking Law provides that "[a]ny banking institution . . . which offers consumer accounts . . . which can be accessed by check . . . shall offer a customer account on which the cancelled check . . . drawn on that account are returned to the customer with a periodic statement of the account." (N.Y. Banking Law § 9-m (McKinney 2002)). Banks should consider, however, revising their account agreements with their customers to account for the substitute check to not run afoul of other applicable laws. But for agreements between banks, Check 21 may not be varied by agreement. (12 U.S.C. § 5013).

When the substituted check accurately represents all information from the front and back of the original check at the time the original check was truncated, and bears the legend on legal equivalence, a substituted check is deemed the legal equivalent to the original check for all purposes. A substitute check is subject to Regulation CC, the UCC, and any other applicable federal or state law "as if such substitute check were the original check, to the extent such provision of law is not inconsistent with this chapter." (12 U.S.C. § 5003(e)).

To account for the new liabilities and warranties that Check 21 imposes to facilitate check truncation, reconverting banks should revise agreements that such banks have with other banks to address collection or presentment of substitute checks. A "reconverting bank" is obligated to maintain all the identification on a substitute check "so as to preserve any previous reconverting bank identification." (12 U.S.C. § 5003(d)). The reconverting bank must ensure that the substitute check bears all endorsements applied by parties that previously handled the check (whether in electronic form or otherwise). (12 U.S.C. § 5003(c)).

A recipient’s loss resulting from a substitute check (as opposed to an original check) depends upon whether there was a breach of a warranty. When a warranty has been breached, the recipient is entitled to the loss proximately caused by the breach together with reasonable attorneys’ fees. Check 21 further provides that any loss incurred by a recipient may be reduced by the comparative negligence of the party indemnified.

There are new expedited recredit rights for consumers and banks under Check 21. A consumer may claim an expedited recredit of a charge to the consumer’s account if the consumer, in good faith, asserts that the item is either (1) not properly payable or (2) there is a breach of warranties and (3) production of the original check or better copy is required to validate the consumer’s claim. A recredit claim, which the bank could require be in writing, must be made within 40-days of the improper charge to consumer’s account.

The bank is required to reclaim the consumer’s account no later than the end of the business day following the business day that the bank validates the consumer’s recredit claim. The bank may also conduct a recredit investigation. Even prior to finding the recredit claim valid, the bank is required (on the 10th business day after the submission of the recredit claim) to credit the consumer’s account the lesser of either the amount of the substitute check or $2,500.00. Unless the bank finds the recredit claim invalid, the bank must recredit the remaining amount of the substitute check 45 days "following the business day on which the consumer submits the claim." The recredit funds must be made available for withdrawal on the next business day after the day of recredit, except that availability of a recredit made pending an investigation can be delayed until the 45th calendar day following the business day on which the claim was submitted for (1) new accounts (less than 30 days old); (2) repeated overdrafts (negative balance on 6 or more days during past 6 months); (3) prevention of fraud losses (reasonable grounds to believe claim is fraudulent). (H.R. Rep. No. 108-291, 108th Cong. §7(d)).

A bank may reverse a recredit if it determines the substitute check was properly payable and notifies the consumer. Only the recredit procedures of Check 21 between banks may be modified by agreement. Triggered by a consumer recredit claim and subject to similar rules, a recredit claim between banks should be brought against the indemnifying bank within 120 days of the date of the transaction that was the cause for the consumer recredit claim. The claimant bank is responsible for ensuring that the substituted check that may be sent in association with the recredit claim is not considered by the indemnifying bank as an actual live item. This may be something that the reconverting banks should address in their inter-bank agreements.

Upon receipt of the recredit claim, prompt action is required by the indemnifying bank. Within 10 business days from receiving the recredit claim from the claimant bank, the indemnifying bank is required (A) to produce original check (or sufficient copy), (B) to recredit the claimant bank account up to the amount of the substitute check; or (C) to explain why the indemnification bank is not required to produce the original check (or copy) or recredit the account.

If the claimant bank received credit for the wrongfully charged item, the claimant bank is required to refund the indemnifying bank. If the indemnifying bank produces the original check (or sufficient copy), the indemnifying bank looks to section 6(d) of Check 21 for a refund. Under section 6(d),

the indemnifying bank shall (A) be liable under this section only for losses covered by the indemnity that are incurred up to the time that the original check or copy is provided to the indemnified party, and (B) have a right to the return of any funds it has paid under the indemnity in excess of those losses.

Section 6(d) also notes the indemnifying bank will not be absolved of any liability by producing the original check.

A number of important issues are raised by the enactment of Check 21. The substitute check warranties are entirely new. There are new fraud risks created by the recredit and indemnity provisions of Check 21. How will the courts deal with Check 21 when the drawer demands the original check to obtain a float? Banks should recognize that, as with any new legislation, Check 21 will mean increased litigation costs. Does Check 21 create any unintended consequence when Articles 3 and 4 of the UCC are applied to substitute check issues? What special concerns are raised particularly in New York by not adopting the revised Articles 3 and 4? With a substitute check and original check co-existing it would appear that multiple holder in due course issues are created. How will courts deal with such issues? Another rather puzzling consequence to be seen is whether Check 21 overrules the long established principles of Price v. Neal, which in 1762 propounded the principle that a drawee who accepts or pays an instrument on which the signature of a drawer is forged is bound on its acceptance and cannot recover back its payment.