The Check 21 Act: Changes Ahead for Investment Companies

Abstract

The Check Clearing for the 21st Century Act (the Check 21 Act) took effect October 28, 2004. This legislation permits anyone in the check collection system to convert an original check into a "substitute check" and deposit, present or send the substitute check for collection, instead of the original check. The Check 21 Act is intended to speed up the collection of checks and to prepare the system for electronic check processing, without at this time requiring banks to receive checks electronically. The effect on mutual funds' substitute checks will be adverse. The Check 21 Act is a step toward electronic check processing. The transition is bound to be bumpy and both consumers and businesses who write and receive checks should prepare for this change in the check processing and collection system. Mutual funds will want to review their agreements with their transfer agents or service providers who receive and inspect investment checks.

The Check Clearing for the 21st Century Act (the Check 21 Act)1 took effect October 28, 2004. This legislation permits anyone in the check collection system to convert an original check into a "substitute check" and deposit, present or send the substitute check for collection, instead of the original check. The Check 21 Act is intended to speed up the collection of checks and to prepare the system for electronic check processing, without at this time requiring banks to receive checks electronically.2

The Board of Governors of the Federal Reserve System (the Board) has adopted regulations (in Regulation CC) to implement the Check 21 Act, as authorized by Section 15 of the Act.3 In the general pattern, the regulations track the statute.4 However, there is at least one point where the Board has made an unmandated decision contrary to the interests of mutual funds that provide checkwriting services.

Mutual funds and their transfer agents receive checks in volume-primarily from investors, but also from brokers, other mutual funds (making account transfers), pension plans and others. They issue checks. Also, they operate checkwriting programs for their shareholders. The Check 21 Act will affect mutual funds in all these capacities. The effect on their checkwriting programs, particularly, will be adverse.

Substitute Checks

A substitute check is a paper reproduction of the original check, suitable for processing as a check, showing the front and back of the original check. The Check 21 Act will permit a bank of first deposit, for example, to transmit an image of the original check to an agent located near the payor bank, so that the agent may print the image and create a substitute check for presentation, thus avoiding the physical transportation of the original check. This shortcut will not require the payor bank that receives the substitute check to do anything differently from what it does now; it will receive a paper check that can be processed in the same way as the original check. This is how the Check 21 Act is a step toward electronic check processing.

Standards and Equivalence for Substitute Checks

There are standards for the creation of substitute checks, of course. The statute defines a "substitute check" as 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 appearing on the MICR line of the original check, except as provided under generally applicable industry standards for substitute checks to facilitate the processing of substitute checks;

* Conforms, in paper stock, dimension, and otherwise, with generally applicable industry standards for substitute checks; and

* Is suitable for automated processing in the same manner as the original check.5

Regulation CC fills in important detail, but (for present purposes) does not alter this definition fundamentally.6

No permission is needed to use a substitute check. Certain warranties go with such use, as discussed below, but these are a matter of law rather than contract. A proper substitute check is the legal equivalent of the original check for all purposes and all persons, so long as it is accurate and complete and bears the legend "THIS IS A LEGAL COPY OF YOUR CHECK. YOU CAN USE IT THE SAME WAY YOU WOULD USE THE ORIGINAL CHECK." Among other things, it may be returned to the drawer in lieu of the original check.

Warranties

A bank that transfers, presents or returns a substitute check warrants to the transferee bank and all subsequent transferee banks, as well as the depositary bank, the payor bank, the drawer, the payee, the depositor and all endorsers:

1. That the substitute check satisfies the applicable standards, and

2. That no depositary bank, payor bank, drawer or endorser will receive presentment or return of the substitute check or the original check, or a paper or electronic copy of either of them, and be asked to make a payment based on the check that the depositary bank, payor bank, drawer or endorser already has paid.

The latter warranty is intended to shift one of the risks raised by the creation of a substitute check to the party that creates it. The problem is that a substitute check, unlike an original check in the present payment system, is easily reproduced. With sufficiently lax security, a check could be reproduced several times and presented more than once to the payor bank. There may be some question as to whether the legal right under this warranty is adequate compensation for an actual loss of the size typical in check fraud, which often is too small to permit vigorous pursuit of a claim.

Indemnity

A substitute check will not be as useful as the original check in detecting or proving forgery, alteration, forged endorsement or other forms of check fraud. A condition of converting an original check to a substitute check is that the converting bank or, if the substitute check is created by a person who is not a bank, the first bank to transfer the substitute check (in either case, the "reconverting bank" under the statute and the regulations) and each bank that transfers the substitute check subsequently, must indemnify the transferee bank and all subsequent transferee banks, as well as the depositary bank, the payor bank, the drawer, the payee, the depositor and all endorsers-against a loss that is due to receipt of the substitute check rather than the original check. The reconverting bank must identify itself on the substitute check. An indemnifying bank may cut off the indemnity by producing the original check.

Expedited Recredit-for Consumers

This indemnity may be satisfactory legally as a remedy for the loss of access to the original check when a check has been forged or altered, but it can hardly be a practical remedy for an individual who no longer can obtain the original check in order to show his or her bank that the check has been forged or altered. The Check 21 Act addresses this problem by granting a consumer the right to make a claim against his or her payor bank for expedited recreait of the account if the payor bank has charged the account for a substitute check and the charge was improper or the consumer has a claim for loss under a warranty related to the substitute check. The consumer must submit a claim for expedited recredit within 40 days after the later of receipt of the relevant account statement or receipt of the substitute check. The consumer's bank must recredit the account for the amount of the substitute check (unless it has provided the original check) within the earlier of 10 business days or one business day after determining that the consumer's claim is valid.7

A "consumer" is an individual who draws a check on a "consumer account," which is a bank account used primarily for personal, family or household purposes. Banks must provide their consumer customers with notices that explain substitute checks and expedited recredit rights.8 At least two important groups of checkwriters who are not "consumers" will not enjoy expedited recredit rights: those who are not individuals and those who draw checks against accounts that are not consumer accounts.

Checks Drawn by Mutual Funds

The first group of non-consumers includes corporations, partnerships, limited liability companies, trusts, and even associations and clubs, as well as sole proprietorships. It includes mutual funds, which draw a lot of checks. Currently, when a check drawn by a mutual fund is altered, the fund can obtain the original check, examine it, and determine whether it has been altered and whether the fund has a claim against its bank. Now it will need to rely on its records to convince the bank that the check it wrote was different from the check presented to the bank. It will not have a right of expedited recredit."

Forged endorsement does not present much risk to drawers of checks. Those who deposit checks with forged endorsements normally bear the resulting losses, because they warrant to everyone downstream in the collection system that existing endorsements are valid. It is the bank of initial deposit that has the opportunity to detect a forged endorsement-the last endorser is its customer-and that bank will handle the original check, not a substitute check, at least initially. The Check 21 Act will not change the position of a mutual fund that writes checks with respect to forged endorsements.

This legislation should not affect mutual funds particularly in their capacity as drawers of checks.

Checkwriting Programs

The second group of non-consumers includes shareholders who participate in mutual fund checkwriting programs. (Checkwriting programs offered by securities brokerage firms are similar and these comments apply to them also.) These programs generally employ omnibus accounts held by agents of the mutual funds for their customers. Customer checks10 are presented each day to the mutual fund's service provider, which debits shareholder accounts and pays the Checkwriting bank the amount necessary to pay the checks. The shareholders who participate in these programs write checks on omnibus accounts that are not their accounts and are not consumer accounts, according to the Board, and so they will not have expedited recredit rights." When their mutual fund accounts are charged for checks they did not write, or for checks that have been altered, these shareholders will have to satisfy the mutual fund that they did not write the checks, or that the checks were altered. They will not have original checks to help them. Even when they are successful, they may be without funds for extended periods of time.

This interpretive conclusion is not required by the statute. Under Section 3(8) of the Check 21 Act, a "consumer account" is an "account used primarily for personal, family or household purposes."12 Regulation CC defines the term in the same way.13 The Board could have viewed the omnibus account in a checkwriting program as a consumer account, at least to the extent it was limited to personal, family or household purposes. The definitions do not require that the account be in the consumer's name, nor that the acceptable purposes exhaust the goals of every party involved-the Board could have viewed the omnibus account as established to be used by consumers for personal, family or household purposes. The Board could have determined that the consumer quality of the account would "flow through" the omnibus account, as deposit insurance does, so that the account would qualify as a consumer account when a consumer wrote checks on it, and that consumer would have expedited recredit rights (to be exercised through the omnibus accountholder).

As consumers become aware that they have expedited recredit rights for checks they write in their bank accounts, they will become aware that they do not have these rights for checks they write in checkwriting programs of mutual funds. Indeed, in order to avoid confusion, mutual funds may wish to provide their shareholders who participate in checkwriting programs with notices that explain briefly the nature of substitute checks and inform shareholders that expedited recredit rights are not available in those programs. This is bound to be perceived by consumers as a disadvantage associated with such programs.

Regulation CC does not require mutual funds (or securities brokerage firms) to provide notices to their shareholders (or customers) who participate in checkwriting programs.

Checks Received by Mutual Funds

Mutual funds not only write checks and offer checkwriting programs, they also receive checks from investors. Currently, they are at risk for receiving and depositing checks with forged endorsements, to the extent they accept third-party checks, because as depositors they warrant the validity of existing endorsements. They are less at risk, however, for receiving altered and forged checks because their transfer agents or other service providers have an opportunity to detect alterations by examining the checks they receive. After the Check 21 Act takes effect, a mutual fund's transfer agent will have the same opportunity as now to examine each check it receives. If it fails to detect an alteration in the course of the necessarily routine and cursory examination of a check received in the mail, then, later, when the substitute check of the altered check it did not notice is returned, the mutual fund and the transfer agent will be at a disadvantage in determining whether the altered check should have been detected in the first place. Without the original check it will be more difficult to see that someone has changed Three to Thirty or added a word to the payee's name or otherwise altered a check to his or her advantage, and it may be impossible to determine how obvious the alteration was on the original check. On a substitute check an alteration that would be obvious on an original might be undetectable and the subtlety of the alteration impossible to judge.

In order to see how this will affect a mutual fund, consider an example. ABC Funds receives a check drawn by Telephone Company for the benefit of John Doe and payable to ABC Funds in the amount of $30,000. The check is accompanied by a proper order for shares. The mutual fund's Transfer Agent examines the check routinely, finds nothing amiss, and endorses and deposits it. The depositary bank converts the check to a substitute check, destroys the original check, and presents the substitute check to the payor bank, which pays it. Telephone Company discovers that it did not write a check in the amount of $30,000 to ABC Funds (but wrote a check of the same number and date in the amount of $3,000 to ABC Foods). It has never heard of John Doe. Telephone Company obtains the substitute check and, using its records, demonstrates to its bank that the check must have been altered and should not be charged against its account. The payor bank recredits the account and returns the check to the depositary bank, which debits the ABC Funds account and notifies Transfer Agent of the alteration. John Doe has redeemed his shares by this time and cannot be found.

The alteration, being done well, is impossible to detect on the substitute check. The question for ABC Funds is: was the alteration reasonably detectable on the original check? If so, ABC Funds will hold Transfer Agent accountable for its error in failing to detect the alteration; if not, ABC Funds will have to accept the loss. However, ABC Funds cannot get the original check and, without it, ABC Funds cannot make a rational determination.

ABC Funds can assert against the depositary bank (which is the likely reconverting bank) a claim under the indemnity against a loss that is due to receipt of the substitute check rather than the original check. Or can it? Whether the mutual fund will be able to prove, and whether it can afford to prove, that it has incurred a specific loss by being deprived of the original check is an interesting question. This is a new hurdle-ABC Funds is merely trying to ascertain whether its transfer agent erred in not catching the alteration. The Check 21 Act provides that, when there is no claim under one of the warranties described above, the reconverting bank's indemnity covers "the amount of any loss, up to the amount of the substitute check," along with reasonable attorney's fees, costs, interest and other expenses. The loss suffered by ABC Funds due to the unavailability of the original check is the loss of the opportunity to determine whether its transfer agent made a mistake in not detecting the alteration in the course of a reasonable routine inspection. Whether such a loss will be covered by the reconverting bank's indemnity and whether it will be feasible to make the claim for this loss are questions that remain to be answered.14

Summary

The Check 21 Act took effect October 28, 2004. Consumers and shareholders who still receive original checks with their account statements will begin to find some substitute checks among them. Undeniably, these will not be as helpful as the originals. This legislation is a step toward the electronic collection of checks; the transition is bound to be bumpy and both consumers and businesses who write and receive checks should prepare for this change in the check processing and collection system.

Mutual funds will want to review their agreements with their transfer agents or service providers who receive and inspect investment checks. Under the Check 21 Act it will be too late to allocate responsibility for a loss on an altered check once the altered check has been deposited and a substitute check has been created.

Mutual funds will need to decide whether to provide notices to their shareholders who participate in checkwriting programs (which notices are not required). If they decide to provide notices, they must give some thought to framing them. Their consumer shareholders, unlike consumer customers of banks, will not enjoy expedited recredit rights under the Check 21 Act.

Footnote

NOTES

1. Pub. L. No. 108-100, 117 Stat. 1177 et seq. (2003).

2. See H. Rep. No. 108-291, at 19 (2003). The Check 21 Act is expected to reduce the volume of paper checks being transported through the clearing system. The cost of imaging should drop, and the quality should improve. The Federal Reserve check processing business should contract. See B. Ely & K. Hoover, "Check 21 Spells the End of Fed Check Processing," American Banker, May 21, 2004.

3. 69 Fed. Reg. 47290 (2004). The regulations constitute a new Subpart D, as well as other changes and additions, in Regulation CC (Availability of Funds and Collection of Checks, 12 C.F.R. Part 229).

4. In the details, there arc important differences; see, e.g., discussion of the definition of "substitute check," supra.

5. Pub. E. No. 108-100, § 3(16), 117 Stat. 1177, 1180 (2003).

6. Under Regulation CC 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 that, except as provided under ANS X9.100-140 (unless the Board by rule or order determines that a different standard applies), contains all the information appearing on the MICR line of the original check at the time that the original check was issued and any additional information that was encoded on the original check's MICR line before an image of the original check was captured;

* Conforms, in paper stock, dimension, and otherwise, with ANS X9.100-140 (unless the Board by rule or order determines that a different standard applies); and

* Is suitable for automated processing in the same manner as the original check.

C.F.R. 229.2(aaa). The regulation adds at least three details. First, the "generally applicable industry standards" for a substitute check will be ANS X9.100-140. This is a standard (Specifications for an Image Replacement Document) to be published by the American National Standards Institute through its Accredited Standards Committee X9, Financial Services. (At the time of writing the standard is in the draft stage and is titled DSTU X9.90; a press release of the Accredited Standards Committee X9 dated May 12, 2004, indicated that final approval was expected in July; a current page on the Committee's Web site states that DSTU X9.90 is expected to be finalized in September. At mid-October the catalogue at the Committee's store (http://www.x9.org/store.shtml) lists DSTU X9.90 for sale at $25; ANS X9.100-140 is not yet available.)

Second, the Board can countermand ANS X9.100-140, and it does not have to adopt a regulation to do it. Third, the statute requires that the substitute check's MICR line contain all information on the MICR line of the original check (except as provided under "generally applicable industry standards for substitute checks to facilitate the processing of substitute checks"); the regulation tells us, again, that the applicable standard for exceptions is ANS X9.100-140 and that the information required is the MICR information on the original check when issued plus information that was encoded on the MICR line on the original check "before an image of the original check was captured" (which may or may not be the same thing as the conversion of the original check to a substitute check).

7. This 10-day period is shorter than the investigation period currently allowed under the Uniform Commercial Code.

8. section 229.57 of Regulation CC requires banks to provide notices to their customers who are consumers explaining briefly what substitute checks are and what consumers' expedited recredit rights are. Model C-5A of Appendix C of Regulation CC sets forth a model notice for this purpose.

9. The Check 21 Act has the potential to facilitate check fraud. Without original checks, law enforcement will be handicapped severely in investigating forged and altered checks and forged endorsements. see W. Wade, "Check 21's Unintended Side Effect," American Banker, April 27, 2004.

10. The checks may be regular checks or payable through drafts; the difference is unimportant here.

11. A Regulation CC commentary includes the following on the definition of "consumer account:"

A clearing account maintained at a bank directly by a brokerage firm is not a consumer account, even if the account is used to pay checks drawn by consumers using funds in that account. The bank's relationship is with the brokerage firm, and the account is used by the brokerage firm to facilitate the clearing of its customers' checks.

12 C.F.R. Part 229 Appendix E II, Paragraph N. Brokerage firm checkwriting arrangements do not differ materially from mutual fund checkwriting arrangements; it is clear that this commentary applies to both.

12. Section 3(8) refers to the definition of "consumer account" in Section 602(10) of the Expedited Funds Availability Act, 12 U.S.C. §4001(10).

13. 12 C.F.R. 229.2(n).

14. The Conference Report for Check 21 (H. Report 108-291, 108th Cong., 1st Sess.) is silent on the question as to whether the indemnity covers such a loss, as is Regulation CC. New sections of the commentary for Regulation CC also do not address this question. An example in the commentary makes clear that a bank that issues a cashier's check that is altered and then converted into a substitute check has an indemnity claim if it can show that its fraud detection procedures could have detected the alteration of the original check, but could not detect the alteration as depicted on the substitute check. In our example, however, ABC Funds is trying to determine whether its transfer agent's fraud detection proceduresroutine examination of every check received-should have detected the alteration. This is a different question.