Overview

Approximately 50 billion checks are written in the United States each year, and significant economic resources are expended in their collection and return. Each night, checks are processed by depositary banks and various intermediaries and then transported for presentment to paying banks across the country. 1 Similarly, checks that, for a variety of reasons, cannot be paid are returned to depositary banks. While the banking industry has applied technology to improve the check collection and return process, the check collection system's legal framework still requires that banks physically present and return checks unless they have obtained agreements to do so electronically. Banks, however, have found it difficult to obtain such agreements on a large scale. In addition, some bank customers still prefer receiving their paper checks after they have been paid and their paper check deposits if they have been returned unpaid. These obstacles have hindered the widespread adoption of check truncation by the banking industry. The Federal Reserve Board has developed a draft Federal law, the proposed Check Truncation Act (the "proposed Act"), that would remove certain legal impediments to check truncation. 2 Removing these impediments would facilitate the use of check truncation and the electronic collection and return of checks. This should lead to overall payments system improvements.

The proposed Act is designed to facilitate check truncation, to foster innovation in the check collection system without mandating the receipt of checks in electronic form, and to improve the overall efficiency of the nation's payments system. In drafting a law to achieve these purposes, the Federal Reserve Board strove to ensure, to the extent practicable, that a bank and its customer would be in the substantially equivalent legal and practical position regardless of whether or not they received the original check. The Board also strove to ensure that the burdens associated with the proposed law did not outweigh the associated benefits for either banks in the aggregate or their customers in the aggregate. The Board used as an additional guiding principle that the proposed law should provide that banks that choose to convert a check to, or receive a check in, electronic form should internalize, to the extent practicable, the costs and risks related to the creation of the substitute check, because they receive most of the associated benefits.

These purposes and guiding principles were intended to guide development of a proposed law that would promote the use of electronics in the collection of checks while acknowledging that some payments system participants may prefer to continue receiving paper checks. While there might be substantial payments system benefits if most or all checks were truncated, certain payments system participants may not be able to achieve sufficient benefits to justify expending the resources required to modify their current processes. As a result, the proposed Act promotes payments system improvements without mandating greater use of electronic processing.

The Federal Reserve Board considered requiring banks to accept checks electronically, but concluded that it is premature to mandate electronic check presentment and return at this time. Today, fewer than one-quarter of checks are presented electronically, using a variety of formats and communications protocols. Mandating electronic check presentment would require significant expenditures and operational changes in check processing practices by thousands of banks. In contrast, the proposed Act facilitates check truncation in a manner that makes significant operational changes optional, rather than mandatory. Banks creating substitute checks will need to make operational changes, but will only do so when they have a business case for creating substitute checks; recipients of substitute checks will process those checks in the same manner as if they were original checks. The Federal Reserve Board believes the proposed Act may help speed the voluntary adoption of electronic check presentment and return. Further legislation to promote electronic check presentment may be appropriate in the future to codify business practices once electronic check exchange agreements become far more widespread.

Highlights of the Proposed Act

Under the provisions of the proposed Act, banks could agree, as they can today, to send check images or information to each other electronically rather than exchanging original paper checks for forward collection or return. Today, these electronic exchange agreements often involve the transmission of payment data taken from the magnetic-ink character recognition (MICR) line of checks and may also involve the delivery or transmission of either the original checks themselves or electronic images of those checks. Under the proposed Act, however, banks could use electronics to streamline the check collection and return process even in cases in which they do not have electronic exchange agreements. The proposed Act facilitates this expanded use of electronics by creating a new type of paper document, called a "substitute check," that can be created from an electronic check image and that would be the legal equivalent of the original check. A legally equivalent substitute check would (1) contain an image 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, (2) contain a MICR line that would permit the substitute check to be processed on standard check-sorting equipment, (3) conform to industry standards for substitute checks, and (4) bear a legend that indicates that it is the legal equivalent of the original check. As a result, banks would be able to take advantage of the latest electronic check processing technologies by sending check images or information electronically to banks with which they have electronic exchange agreements and by sending substitute checks to banks with which they do not have such agreements. Banks that choose to receive checks in paper form would receive either original checks or substitute checks and, therefore, would be able to continue processing checks without modifying their back-office operations.

The proposed Act governs substitute checks but not checks in electronic form. Today, banks that present or return checks electronically do so under bilateral or multilateral agreements. These agreements would continue to be necessary under the proposed Act. Excluding electronic checks from the proposed Act's scope allows the banking industry to address liability and technical issues related to electronic exchanges through agreements, which the Board believes is preferable to broader legislative coverage that might hinder the adoption of new technologies in the future.

The proposed Act creates a warranty structure to protect against the risk of increased losses associated with the use of substitute checks. Like the current Uniform Commercial Code (U.C.C.) transfer warranties, the proposed Act's warranties are designed to "run with the check," that is, to follow the substitute check in any form, just as they would with an original paper check. As discussed in more detail in section 4, the new warranties are given by the bank that creates a substitute check and by each bank that subsequently handles the check, whether in paper or electronic form, and receives consideration for it. The warranties are intended to protect against situations in which a substitute check does not meet the standards for legal equivalence or in which a party receives a duplicate request for payment after an original check has been truncated and converted to a substitute check.

The proposed Act also creates an indemnity structure, discussed in section 5, that is designed to address losses resulting from receiving a substitute check rather than the original check. These losses could occur because of a breach of warranty (such as the receipt of an illegible substitute check) or under other circumstances (such as in certain forgery cases when it is necessary to examine the handwriting on the original check for pen pressure or similar analysis). Like the warranties under the proposed Act, the indemnity would be given by the bank that creates a substitute check and by each bank that subsequently handles the check, whether in paper or electronic form, and receives consideration for it. The indemnity is intended to put parties in the position in which they would have been had they received the original check rather than the substitute check. Therefore, the indemnifying bank may satisfy the indemnity either by paying the amount of the indemnity, as described in section 5, or by producing the original check (or, in certain cases, a combination of both). A bank that creates substitute checks may arrange to share warranty or indemnity liability with other banks that are part of its electronic exchange agreement.

The proposed Act also provides an expedited recredit procedure for consumer accounts (discussed in section 6). Current law generally permits consumers to make claims against their banks for improper charges to their accounts. Banks have an incentive to resolve these claims quickly to avoid wrongful dishonor or other liability. Nevertheless, consumer groups have noted that banks do not always resolve problems promptly. They have stated that erroneous account charges can be particularly harmful to low-income consumers who cannot maintain sufficient funds in their accounts to cover such charges. The expedited recredit procedure is intended to mitigate the effects on consumers of any potential problems associated with the receipt of substitute checks. The proposed Act requires a bank to recredit a consumer, within a specified period, when a consumer makes a good faith claim that a loss has been incurred because the consumer's account was debited improperly for a substitute check that was provided to the consumer. The expedited recredit is available only if production of the original check is necessary to determine the validity of the claim. (If the claim's validity can be determined from the substitute check, then the consumer is in no worse a position than if he or she had received the original check.)

The proposed Act also provides an expedited recredit procedure for banks (discussed in section 7). This procedure permits a bank to obtain expedited recredit from a previous indemnifying or warranting bank when the bank is obligated to provide expedited recredit to a consumer.

Finally, the proposed Act has four special provisions for Treasury checks, to meet the particular needs of the Treasury Department (discussed in section 13). The first provision allows banks to truncate Treasury checks, but requires banks that do so to send the originals of those checks to a Federal Reserve Bank for safekeeping. The second provision specifies that a bank that truncates a Treasury check warrants that it has sent the original to a Federal Reserve Bank for safekeeping. The third provision allows the Secretary of the Treasury to write regulations with respect to Treasury checks to implement the provisions of the proposed Act to further the proposed Act's purposes. The fourth provision specifies that the Secretary of the Treasury has the authority to extend the effective date of the proposed Act with respect to Treasury checks.

Benefits

The proposed Check Truncation Act may result in substantial payments system benefits, depending on the extent to which banks take advantage of provisions of the proposed Act to expand the use of electronics in the collection and return of checks. The proposed Act should result in faster collection and return of checks and lower costs in the long run; in addition, the proposed Act would reduce banks' reliance on air and ground transportation for collection and return of checks. The more rapid check collection and return process could be accomplished in many ways, with benefits likely accruing to both banks and their customers.

There are numerous ways a bank could take advantage of the proposed Act to streamline its check processing operations. For example, consider a bank that needs to present or return checks to a distant bank that does not accept check images or information electronically. Under the proposed Act, the bank would be able to use electronic processing throughout its operations and transmit the electronic check information and images to an intermediary, located near the distant bank, with whom it has an agreement to do so. The intermediary would print substitute checks for physical delivery to the distant bank. Thus, the sending bank would be able to take advantage of faster collection and other benefits of electronic processing, while the receiving bank would be able to continue processing paper checks because substitute checks could be processed the same way original checks are processed.

A bank could use substitute checks not only to present or return checks but also to improve its own internal operations. For example, a paying bank could run its returned check file against its image system to create substitute returned checks. Doing so would eliminate the need to run all the checks presented on the previous day through its sorters to pull the small number of checks that must be returned unpaid. A bank might also be able to restructure its branch network to significantly reduce its infrastructure costs. A bank's branch and ATM networks would no longer need to be tied geographically to its processing centers, because information and images on checks could be transmitted electronically to processing centers to create substitute checks. A bank would be able to selectively use electronic check processing and substitute checks when it is cost-effective to do so, and could transport original checks using less time-critical (and potentially less frequent) transportation options. As a result, a bank could reduce its operating costs, with savings passed on to shareholders in the form of higher returns or to customers in the form of lower fees.

The branch and ATM network restructuring noted above could benefit customers as well. For example, banks could offer customers broader deposit options or extended deposit cutoff hours for certain checks. Such changes could result in some checks being credited one day earlier, some checks clearing one day earlier, and interest accruing one day earlier for some checks deposited in interest-bearing accounts. Banks may also be able to provide more timely information to both depositors and drawers. For example, banks may be able to provide customers with access to on-line images of deposits and payments before the delivery of paper statements or provide printed copies of checks deposited at ATMs on ATM receipts.

The proposed Act gives banks authority to create and use substitute checks in the forward collection and return processes, but does not require them to do so. Each bank may decide whether to make use of this new authority, according to its own internal business case analysis. The outcome of a given bank's analysis is likely to depend on the bank's technology infrastructure and technology strategy. A few banks have already begun to use substitute checks, even though the formal legal structure is not yet in place. Many other banks may take advantage of the new authority given by the proposed Act shortly after it becomes effective. Some banks, however, may find that in the short run, it is not profitable to do so, but that it is profitable in the long run as technology and banking practices change. Because each bank will take advantage of the new authority only if its benefits outweigh its costs of doing so, the Board has not estimated the aggregate and sectoral net benefits of this authority. Further, because each bank's decision on how to make use of the new authority will be based largely on the bank's own proprietary information, it would be extremely difficult to develop a reliable estimate of the aggregate level of banks' adoption of the new authority at any time or the net economic benefits to be derived, even if such an analysis were desired.

Law Enforcement Considerations

While the proposed Act may result in an increase in the number of checks being truncated, the Federal Reserve Board believes that the proposed Act will not significantly affect law enforcement efforts involving fraudulent checks. Currently, under a typical check truncation arrangement, the original paper check is generally destroyed shortly after being truncated. By the time fraud is discovered and law enforcement has become involved for investigation or prosecution of cases related to fraudulent checks, often the originals of checks that are currently truncated have already been destroyed. Thus, the Federal Reserve Board does not expect the proposed Act to significantly affect law enforcement's existing ability to investigate and prosecute cases related to fraudulent checks. Moreover, to the extent the proposed Act speeds the collection of checks, it may reduce opportunities for some forms of check fraud by enabling its more rapid discovery.

This information was obtained from: http://www.federalreserve.gov/