Check 21 Implementing Regulations Regulation CC, Subpart D Jack Walton Board of Governors of the Federal Reserve System July 28, 2004

1 Check Clearing for the 21 st Century Act The Board submitted proposed legislation to Congress in December Enacted October 28, 2003, the Act becomes effective October 28, The Board published implementing regulations on July 2, –Regulation CC Subpart D (new) –Regulation CC Appendix D (indorsement standard changes) –Other Regulation CC changes, including model consumer notices. – The Board has also published proposed revisions to Regulation J. Comment period closes July 26. Final revisions to be published later this summer. –New services that the Reserve Banks plan to offer in light of the Check 21 Act. –“Check 21-like” warranties and indemnity for electronic items derived from original checks. The Reserve Banks will revise Operating Circular 3 to address the new service options they plan to offer.

2 What Check 21 Does and Does Not Do Check 21 does not require a bank to accept an electronic check image. –Image exchange must still take place under bilateral or multilateral agreements. Check 21 does not give legal equivalence to an electronic check image. Check 21 does create a new negotiable instrument called a “substitute check.” Check 21 gives legal equivalence to a properly prepared substitute check. –By doing so, Check 21 empowers banks to truncate original paper checks, process them electronically, and, where necessary, create substitute checks for delivery to banks that do not accept checks electronically.

3 Comments received on Board’s proposed rule Responses from 168 commenters. Multiple signers of comment letters are reflected separately in the figures at right. One comment letter was signed by 41 organizations, including 17 banks and 15 financial services associations. Banks and bank associations 107 Consumers and consumer groups 35 TPP / vendor / retailer14 Other12 168

4 What is a substitute check? – 229.2(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 MICR line, except….; –Conforms to industry standards for substitute checks (X ); and –Is suitable for automated processing just like the original check.

5 What is a substitute check? – (aaa) Board’s final rule –States that all MICR-line fields from original check must be encoded on substitute check –Leaves permissible MICR-line content variations to ANS X –Indicates that X may vary technical requirements of MICR-line printing, including by not requiring the use of magnetic ink requirement in some circumstances –Clarifies that the Regulation CC encoding warranty applies to MICR-line information encoded on a substitute check Legally-equivalent substitute checks Things that do not meet substitute check definition Purported substitute checks Substitute checks

6 Legal equivalence, reconverting bank duties – A substitute check is the legal equivalent of the original check if –It accurately represents all the information from the front and back of the original check; –It Bears the Act’s legal equivalence legend; and –A bank has made the Check 21 warranties with respect to the substitute check. What does “all the information” mean? –Payment, identification, and indorsement information must survive the imaging process. –Watermarks, microprinting, and other security features need not survive. The reconverting bank must: –Identify itself as such 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 original check.

7 Responsibilities of banks that receive substitute checks A bank that qualifies a substitute check for return must place a “5” instead of a “2” in position 44 of the qualified return MICR line. A bank that qualifies a substitute check for return or that repairs the MICR line of a substitute check does so subject to the Regulation CC encoding warranty A bank returning a substitute check must stamp the return reason code within the image of the original check. A bank that provides substitute checks to consumers should establish procedures for responding to expedited consumer recredit claims. A bank may be part of the Check 21 warranty and indemnity chain.

8 Check 21 Act warranties and indemnity – & Starting with the reconverting bank, any bank that transfers, presents, or returns a substitute check or a paper or electronic representation thereof warrants to all subsequent transferees that –No depositary bank, drawee, drawer, or indorser will be asked to make a payment based on a check that it already has paid This warranty does not apply to ACH debits and does not depend on the warranting bank’s knowledge or fault –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 Reconverting bank responsible for legal equivalence warranty even if poor image the fault of another (for example, drawer wrote payment instructions in ink that did not image)

9 Check 21 Act warranties and indemnity – & Any bank that transfers, presents, or returns a substitute check or paper or electronic representation thereof also must indemnify a subsequent recipient for losses that are due to any person’s receipt of a substitute check instead of the original check A bank that truncates an original check and sends it in electronic form does not make the warranties and indemnity –Reconverting bank that accepts electronics can further allocate warranty and indemnity losses by agreement Losses recoverable under warranties and indemnity Either warranty or indemnityUp to amount of substitute check, plus interest and expenses Both warranty and indemnity Up to amount of substitute check, plus interest and expenses, plus all other proximately caused damages

10 Check 21 Act warranties and indemnity – & A warranty claim may be based on receipt of a substitute check or a paper or electronic representation thereof An indemnity claim must be based on a loss that was due, directly or indirectly, to the receipt of a substitute check instead of the original check Recipients of a paper or electronic representation of a substitute check cannot “originate” an indemnity claim Example Truncating Bank Reconverting Bank Collecting Bank Paying Bank Drawer Electronics Substitute check Electronic representation of substitute check Image statement containing image of substitute check In this example, neither the paying bank nor the drawer could make an indemnity claim, but either could make a claim for breach of a substitute check warranty Original check

11 Consumer expedited recredit – Consumer expedited recredit applies only to substitute checks that are provided to a consumer and charged to a consumer account –Consumer receipt of account statement alone does not trigger right –Checks that are not drawn on consumer accounts (such as a credit card check or a check a consumer draws on a brokerage clearing account) would be subject to the procedure only if returned to the consumer in the form of a substitute check and consumer’s account charged for that item A consumer must file an expedited recredit claim such that the bank receives it within 40 days of the later of the date that the bank mails or delivers the consumer’s periodic account statement showing the relevant transaction or the substitute check

12 Incomplete complaint does not constitute a claim –Bank must inform consumer of incompleteness and identify what information is missing If bank requires written claim and consumer attempts to submit orally, then bank must at that time tell consumer of the requirement to submit the claim in writing –Consumer must submit written claim such that bank receives it within 10 business days of notification of the requirement to submit the claim in writing –If oral claim is within the 40-day period and the consumer meets the 10-day requirement to submit the claim in writing, the consumer’s claim is timely even if written claim is beyond the 40-day period A bank can provide more generous protections than the Act requires Consumer expedited recredit –

13 No later than the 10 th business day after the banking day on which the bank received the claim, the bank must do one of the following: –Determine that a claim is valid and provide a full recredit no later than the business day after making that determination –Determine that the claim is not valid and demonstrate to the consumer why –Recredit the amount of the consumer’s loss, up to the lesser of the substitute check or $2,500 on day 10 (the bank then would recredit any remaining amount on the 45 th calendar day after receiving the claim, unless the bank before that time determined that the claim was or was not valid as described above) A bank can reverse a recredit if it later determines the consumer’s claim is not valid Regardless of what action a bank takes, it must notify the consumer –The Board has provided model notices to help banks comply with this notice requirement; use of these models is not a statutory safe harbor Consumer expedited recredit –

14 Interbank expedited recredit – Interbank expedited recredit allows a bank to recover losses associated with a consumer expedited recredit claim from the bank that sent the problematic item –Covers losses associated with providing an expedited recredit to a consumer or to another bank –Covers losses associated with a substitute check that was not charged to a consumer’s account but that would have been subject to a consumer expedited recredit claim if so charged –Claimant bank must submit its claim by the end of the 120 th calendar day after it settled for the problematic substitute check –The indemnifying bank has 10 days after receipt of the claim to provide a recredit or provide the original check or a sufficient copy

15 Consumer awareness disclosures – Banks must distribute consumer awareness disclosures to: –Accountholders who receive cancelled checks with their monthly account statements, no later than the first statement cycle after October 28, 2004 –Consumers who receive substitute checks on an ad hoc basis Consumers who receive a substitute check in response to a request for a copy Consumers to whom a bank provides a returned substitute check The time at which a bank must provide an ad hoc disclosure is at the time of request if feasible, otherwise no later than when a bank provides the substitute check The final rule provides that a consumer who receives a substitute check on an ad hoc basis should receive the disclosure, regardless of whether he or she has received it previously.