What businesses should know about Check 21.

Spurred by the shutdown of the air transportation system after 9/11 that left hundreds of billions of dollars worth of checks sitting idle at airport tarmacs, Congress last year passed a law to modernize the nation's check payment system.

The Check Clearing for the 21st Century Act was enacted to facilitate check truncation (i.e., conversion), foster innovation and improve the efficiency of the payment system, particularly by promoting the transition from paper to electronic check processing.

Ultimately, banks, businesses and consumers will all benefit from Check 21 because checks will clear faster and the banking industry will reduce its reliance on a system of clearing checks that wastes money, burns fuel and clogs the transportation system. To many small businesses, Check 21 will mean little more than getting used to going without original cancelled checks for record-keeping purposes. For larger companies that issue or receive large numbers of checks, the changes present both opportunities and challenges.

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BACKGROUND

In its wisdom, Congress did not require banks to abandon their vast and long-standing investment in paper check processing all at once. Instead, it created a new, check-like instrument called a "substitute check," and requires all banks, businesses and consumers to accept it.

Think of a substitute check as a two-sided paper copy of the front and back of a check that, like the original, can be processed by high-speed sorters. The advantage is that a substitute check could be created from an electronic image, which means the image could be "delivered" anywhere almost instantaneously before being reconverted into a substitute check.

Of course, if the paying bank were equipped to process the check electronically, there would be no need to convert the image to a substitute check at all. But most banks have not converted, thus the need for substitute checks.

Substitute checks are expected to be used only during the industry's transition to electronic processing. The transition is inevitable because electronic processing is both faster and cheaper, and because declining paper volumes will force holdouts to upgrade. But even during the transition, clearing times will improve with the use of substitute checks.

Checks drawn on banks located on the other side of the country could be cleared on the next day after deposit rather than four or five days.

WHAT BUSINESSES CAN EXPECT

Because of Check 21, the original check is no longer required to follow the transaction. Among other things, this means that bank customers are no longer entitled to receive original cancelled checks with statements. This should be of no concern because a substitute check is the legal equivalent of the original check. Whether true substitute checks or other images are returned, they should be sufficient for purposes of proving payments.

Bank customers should be aware that shorter clearing times make it more risky to issue checks before sufficient funds are available. In particular, banks, for various reasons, are more likely to use substitute checks to clear large dollar items. Clearing an item more quickly means reducing negative float. Expedited clearing also allows a bank to determine sooner whether an item is legitimate.

If a business has experienced check fraud and uses checks bearing security measures such as micro-printing, specialty printing and artificial watermarks--features that, by intention, are not easily replicated--bear in mind that these features may not survive imaging. This could make it more difficult for account personnel to detect alterations, chemical spotting or other abnormalities.

Businesses that are concerned about check fraud should talk with their bank about fraud deterrence tools such as "positive pay." With a positive pay program, banks only pay those checks that appear on a list that the maker submits at the time the check is written.

Companies that handle large volumes of incoming checks may have opportunities under Check 21 to reduce clearing times and improve funds availability. Note, however, that banks are not legally required under Check 21 to shorten funds availability schedules, though the Federal Reserve is required to reconsider the present schedules by 2007.

Businesses also may have the opportunity to work with their banks to capture check images at their own locations and deposit them electronically. Companies in multiple locations, in particular, could eliminate the need to carry checks to multiple bank branches to make deposits.

Before taking advantage of electronic deposits, businesses should be prepared to manage the risks inherent in the fact that, unlike bank personnel, company employees may have little experience in processing checks. Precautions must be taken, including adequate staff training, to avoid encoding errors and creating duplicate items, and so forth.

Staff may be less sensitive to the need to safeguard, store and destroy checks, and they may not have the appropriate systems and procedures, including internal controls, necessary to protect against computer intrusions, unauthorized deposits or other compromises of data systems. From the crooks' perspective, businesses could be viewed as the weak link in the payment chain.

Also, be aware that, because the images on a substitute check are smaller than on the original, substitute checks are less susceptible to handwriting, fingerprint and chemical analysis and many other processes incident to a check fraud investigation. Thus, law enforcement agencies and prosecutors, many of whom already refuse to take cases on original checks without a clear, inkless fingerprint, may be reluctant to accept fraud cases based on substitute checks and other images.

On the other hand, as processing inevitably migrates into the digital world, technology also will be the key to controlling fraud, with all the tools of the digital age at the ready.

SAFEGUARDS

The ability of banks--and customers--to negotiate a check by delivering a copy of a check creates risks of copying errors and a single item being presented for payment more than once. Congress recognized these risks and enacted three separate safeguards to protect customers from losses arising from the use of substitute checks.

Generally, banks warrant that a substitute check contains a faithful copy of the original and that the item will not be presented more than once for payment. If this warranty is breached, the bank is liable for any resulting damages that the customer suffers. For example, if through an encoding error on a substitute check, a customer's account is debited $800 rather than the correct amount of $300, and three subsequent checks are bounced, the bank would be liable for the following: the $500 difference in the face amount; the three NSF fees charged by the bank; any returned check fees and penalties charged by the payees of the returned checks; interest (if the account is interest bearing); and any other damages caused by the error. Warranty damages are not capped.

In addition to the warranty, banks also must indemnify customers for any losses--up to the face amount of the check--incurred because the customer received a substitute check rather than the original. Finally, consumers, but not businesses, are entitled to have their account re-credited within 10 days of making a claim if a loss occurred because of a warranty violation or the receipt of a substitute check and the original check or a better copy is necessary to prove the claim.

For more information on Check 21, go to www.federalreserve.gov/paymentsystems/truncation/default.htm.

Leland Chan is general counsel for the California Bankers Association. He can be reached at [e-mail].