Tool 2: Understanding Key Statutory and Regulatory Provisions

Tool 2: Understanding Key Statutory and Regulatory Provisions

Key Statutory Provisions

Of Check 21

The purpose of the Check 21 Act is to facilitate check truncation by giving legal status to substitute checks, as well as to foster innovation in the check collection system without mandating receipt of checks in electronic form. The overall goal is to improve the efficiency of the nation’s payments system. The complete Check 21 Act is available at

While the Act was formulated over the period of a few years, Check 21 ultimately cleared the House and Senate with impressive speed and lack of controversy, passing through the House of Representatives unopposed on October 8, 2003. The Senate approved the legislation by unanimous consent seven days later, on October 15, and the President signed the legislation on October 28.

The Federal Reserve Board, which has rulemaking authority under the Act, released for comment their proposed regulations amending Regulation CC on December 22, 2003.

Check 21 takes effect on October 28, 2004.

Summary of the Legislation

Check 21 creates a new negotiable instrument, a “substitute check,” that makes it possible for checks to be truncated at any point in the inter-bank collection process, regardless of state laws or agreements that might otherwise require delivery of the original paper check. A substitute check created in accordance with specific requirements is the legal equivalent of the original paper check, for all purposes.

Banks are not required to truncate checks, but are required to accept substitute checks.

Consumers and financial institutions receiving substitute checks under certain circumstances may be entitled to expedited recrediting of the amount of the check if the item is disputed. When a substitute check is illegible or the original check contains a security feature that did not survive imaging, the original or a better copy of the check must be provided to establish the validity of a transaction. Check images provided by paying banks to customers today (e.g., with account statements) are not “substitute checks” subject to these expedited recrediting provisions.

Substitute Checks

A substitute check is the legal equivalent of its original check, so long as it accurately represents all of the information on the front and back of the original and includes a legend stating: “This is a legal copy of your check. You can use it the same way you would use the original check.” The bank that creates a substitute check from an electronic presentment is called the “reconverting bank.” Reconverting banks must identify themselves on substitute checks.

Bank Warranties

Banks handling a substitute check warrant that the item meets the legal equivalence requirements for substitute checks and is not a duplicate of another check that has already been paid.

Indemnities

The “reconverting bank” and subsequent banks handling the substitute check indemnify against any losses incurred by any recipient of a substitute check if the loss occurred because the substitute check was provided rather than the original.

Expedited Recrediting for Consumers

The expedited recrediting provisions for claims of incorrect charges are similar to those under the Electronic Funds Transfer Act (Regulation E). If a consumer in good faith asserts that (1) a substitute check the consumer received was incorrectly charged to the consumer’s account and (2) the original check or a better copy is needed to determine the validity of the charge, certain requirements kick in for expedited recrediting of the customer’s account. The bank must:

• Produce the original check or a copy that accurately represents the check and demonstrates that the charge is valid, or
• Recredit funds on the first business day following the business day the bank finds the claim valid. If, in the case of a large-dollar item, the bank cannot determine the validity of the claim by the 10th business day, it must recredit the first $2,500; with the remainder due by the 45th day if the claim still cannot be validated.

Exceptions are made for new accounts, repeated overdrafters, and when there’s “reasonable cause to believe” that fraud is involved.

Consumer claims generally must be made within 40 days after the statement is delivered or the date the substitute check is available to the consumer, whichever is later. Longer periods are permitted for extenuating circumstances.

The expedited recrediting provisions do not apply if the check is not a “substitute check” as defined by the statute. For example, the check images banks currently provide customers in monthly statements are not covered by these expedited recrediting provisions because they do not meet the “substitute check” industry standards.

Claims under the expedited recrediting provisions can be made only if the original check or a better copy is needed to determine the validity of the charge. The original check might be necessary, for example, if it included a security feature (such as those found on some cashiers’ checks) that did not survive the image capture process.

As will be discussed in Tool 5, banks could benefit from truncating large-dollar checks in order to present them more quickly to the paying banks. However, banks should weigh the benefits of faster processing against the potential risks of assuming the liability for converting the paper check to an image and potential for expedited recredit on a large-dollar check.

Some large-dollar checks also contain security features that would be lost with imaging. Keep in mind, however, that image-survivable security features are available in the market today.

Special Notice to Consumers

In anticipation of consumers receiving substitute checks, banks need to provide notices to certain accountholders. The notice requirements apply to:

• Existing customers who currently receive original checks with their monthly account statements.

• New account holders, who shall receive notices in their initial disclosures.

• Any customer that might request a check, for example, when establishing a proof of purchase claim.

Expedited Recrediting for Banks

The statute contains corollary recrediting provisions for banks. A bank may make a claim against an indemnifying bank for expedited recredit if the bank has received a claim from a consumer and asserts that the original check or a copy is needed to determine the validity of the charge.

The indemnifying bank may require that the claim be in writing and that it include the consumer’s written claim, if any. Within 10 business days of receiving a claim, the indemnifying bank must (1) produce the check or an accurate copy, (2) recredit the bank, or (3) provide information as to why it determined the claim to be invalid.

Federal Preemption

The Act preempts inconsistent state laws; notably any state law that allows consumers to demand the return of original checks. Some state laws (i.e., New York and Massachusetts) entitle customers to receive original paid checks back with their statement. In these states, substitute checks may be provided rather than the original checks.

AMERICAN BANKERS ASSOCIATION1