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Check 21, Remote Deposit Capture and Check Fraud
Frank Abagnale
President, Abagnale and Associates
abagnale.com
Greg Litster
President, SAFEChecks
Canoga Park, CA
greg@safechecks.com
Check Clearing for the 21st Century Act, aka "Check 21" was passed unanimously by the House of Representatives and the Senate in October 2003. It was signed by President George W. Bush on October 28, 2003 and became effective October 28, 2004.
Check 21 allows banks to (1) convert original paper checks into electronic images; (2) truncate the original check; (3) process the images electronically; and (4) create "substitute checks" for delivery to banks that do not accept checks electronically. The legislation does not require a bank to create or accept an electronic check image, nor does it give an electronic image the legal equivalence of an original paper check. Check 21 does give legal equivalence to a "substitute check" that is properly prepared. A substitute check, also known as an image replacement document (IRD), is a new negotiable instrument that is a paper reproduction of an electronic image of an original paper check.
A substitute check must: (1) contain an image of the front and back of the original check; (2) bear a MICR line containing all the information of the original MICR line; (3) conform to industry standards for substitute checks; and (4) be suitable for automated processing just like the original check. To be the legal equivalent of the original check, the substitute check must also (1) accurately represent all the information on the front and back of the original check, and (2) bear a legend that states "This is a legal copy of your check. You can use it the same way you would use the original check." While Check 21 does not mandate that any check be imaged and truncated, all checks except checks drawn on foreign banks1 are eligible to be converted into images and reconverted2 into substitute checks. Bank customers do not have the option to "opt out" of Check 21.
CHECK 21 CONVERSION vs ACH CONVERSION
A check converted into an electronic image and reconverted into a substitute check is not the same thing as a check that is converted into an ACH debit. They are entirely different processing mechanisms and are governed by different rules. A substitute check is governed by the Check 21 Act and the Fed's Final Rule. A check converted into an ACH debit is governed by ACH rules.
WARRANTIES AND INDEMNITY
Check 21 does not require a bank to convert and truncate paper checks. It is entirely voluntary. A bank that chooses to convert a paper check into an electronic image that is then reconverted into a paper substitute check provides two warranties and an indemnity that travel with each substitute check. Companies that convert checks using Remote Deposit Capture may bear the identical risks as banks that convert checks. The two warranties are (1) that the substitute check is properly prepared as described in the paragraph above, and (2) that no bank will be asked to make payment on a check that has already paid (no double debit).
Regarding the indemnity, the Final Rule states a bank "that transfers, presents, or returns a substitute check ... shall indemnify the recipient and any subsequent recipient…for any loss incurred by any recipient of a substitute check if that loss occurred due to the receipt of a substitute check instead of the original check."3 It goes on to say that if a loss " ... results in whole or in part from the indemnified party's negligence or failure to act in good faith, then the indemnity amount …shall be reduced in proportion to the amount of negligence or bad faith attributable to the indemnified party."4
The Fed gives this example.
"A paying bank makes payment based on a substitute check that was derived from a fraudulent original cashier's check. The amount and other characteristics of the original cashier's check are such that, had the original check been presented instead, the paying bank would have inspected the original check for security features and likely would have detected the fraud and returned the original check before its midnight deadline. The security features that the bank would have inspected were security features that did not survive the imaging process. Under these circumstances, the paying bank could assert an indemnity claim against the bank that presented the substitute check.
"By contrast with the previous example, the indemnity would not apply if the characteristics of the presented substitute check were such that the bank's security policies and procedures would not have detected the fraud even if the original had been presented. For example, if the check was under the threshold amount the bank has established for examining security features, the bank likely would not have caught the error and accordingly would have suffered a loss even if it had received the original check."5
The indemnity does not cover a loss that is not directly attributable to the paying bank receiving a substitute check instead of the original check.
The warranties and indemnity are very powerful, and give banks and companies a clear defensive strategy against losses that result directly from an original paper check being converted into an electronic image and the image reconverted into a substitute check. It may also deter banks from converting high-dollar checks because the warranties and indemnity provided by the converting bank continue for one year from the date the injured party first learns of the loss. The Final Rule is very clear that a "…claim shall be brought within one year of the date on which the person's cause of action accrues. …a cause of action accrues as of the date on which the injured person first learns, or by which such person reasonably should have learned, of the facts and circumstances giving rise to the cause of action, including the identity of the warranting or indemnifying bank against which the action is brought."6
It is important to note that the one-year timeframe begins when the injured party learns or should have learned of the loss, not when the loss actually occurred. Thus, the actual risk tail to the converting bank or company is greater than one year.
REMOTE DEPOSIT CAPTURE
Remote Deposit Capture is a service offered by many financial institutions that uses new technology to speed up a company's depositing process. Using a desktop scanner in its office, a company images the checks it normally would send to the bank for deposit. The company transmits the file of check images to its bank, which processes the file and sends the images of the checks for collection to their respective banks. The images are either presented for payment electronically or as substitute checks.
While the technology is exciting, Remote Deposit Capture is not without financial risk. First, depending on the company's agreement with its bank, the company may need to store the original check in a secure location for a period of time in case it is needed. Second, because banks are likely to protect themselves from potential losses associated with the Remote Deposit Capture process, a company may be held liable for any Check 21 warranty and indemnity loss. The statute of limitations in the law for these types of losses is one year after the cause of action accrues.
CHECK SAFETY FEATURES
The two primary purposes for using many safety features7 in checks are (1) to deter criminals by thwarting the different methods used to alter or replicate checks, and (2) to authenticate an original document. The minimum number of safety features a check should have is eight, and more is better. Among the best safety features are fourdrinier (true) watermarks in the paper, thermochromatic ink, and paper or ink that is reactive to at least 15 chemicals. These safety features cannot be imaged and replicated, which, in an age of desktop publishing, is why they are the best. In addition to their fraud-deterrent value, when an individual or organization uses high security checks that include these safety features that do not survive the image conversion process, they position themselves for a built-in indemnity claim against the converting bank or company. This assumes that the paying bank has a sight review threshold such that the original check would have been examined.
Out of fear of the indemnity, the largest banks in America have been actively looking for check safety features that will survive the imaging process while still being useful, ie. not replicable by forgers. These banks also that have the most to gain from Check 21. Unfortunately, according to Frank Abagnale and The Standard Register Company, there are no check safety features8 that are image survivable that are useful.9 Image survivable check security features can be replicated.
CHECK 21 FRAUD STRATEGIES
In a Check 21 world, the defensive strategies are straightforward:
- Every bank should offer Positive Pay at an affordable price, and every company and municipality should use the service. Most banks charge for Positive Pay; companies deterred by the price should consider the fee an insurance premium that is far less expensive than a check fraud loss or attorney fees. For useful information about Positive Pay, visit PositivePay.net and SafePay123.com.
- Make large dollar payments electronically.
- Every company, municipality and individual should use high security checks with 8 or more safety features. The checks should include a true watermark, thermochromatic ink and at least 15+ chemical sensitivity.
- Avoid using laser checks that can be purchased entirely blank by multiple people and organizations because the stock is not controlled.
- Banks and their service providers should lower their sight review thresholds and re-train inspectors, and encourage their customers to use high security checks and Positive Pay.
1Federal Reserve Board's Final Rule issued July 26, 2004. See Pages 81-82 AAA.229.2(aaa).3 Substitute Check. Visit www.FraudTips.Net to download a copy of the Check Clearing for the 21st Century Act, aka Check 21, and the Federal Reserve Board's Final Rule governing Check 21.
2ibid. Page 11, Footnote 15. "Reconverting" is the statutory term and reflects the fact that the original check is converted to electronic form and then later reconverted back to a paper substitute check.
3ibid. Page 58, Substitute Check Indemnity
4ibid. Page 59, Comparative Negligence
5ibid., pages 99-100, Substitute Check Indemnity
6ibid. Page 67(c) Jurisdiction.
7Frank Abagnale publishes an 18-page color brochure titled Check Fraud, Holder in Due Course, Check 21 and Identity Theft. Check security features are discussed in detail and are shown in color. It is available through his office or through SafeChecks. Copies are free. Call (800) 755-2265 ext. 3303.
8A laser printed security feature called "Secure Seal" is image-survivable and is useful.
9A white paper titled "Check 21 and Image Security" by Frank Abagnale and The Standard Register Company can be downloaded at www.FraudTips.Net. Click on Check 21.
Disclaimer
This article is provided for informational purposes. The authors assume no responsibility or liability for the specific applicability of the information provided. If you have questions regarding the information, please consult an attorney.
About the authors
Frank Abagnale is one of the world's most respected authorities on the subject of forgery, embezzlement, and other forms of fraud. For over 30 years he has lectured to and consulted with hundreds of financial institutions, corporations and government agencies around the world, including the FBI. More than 14,000 financial institutions, corporations, and law enforcement agencies use his fraud prevention materials. He is the author and subject of Catch Me If You Can, a Steven Spielberg movie starring Tom Hanks and Leonardo DiCaprio. Mr. Abagnale can be contacted at (800) 237-7443.
Greg Litster is president of SAFEChecks, and a former 18-year banker. He is an associate of Frank Abagnale, and is editor of Mr. Abagnale's publication, Check 21, Check Fraud, Identity Theft and Embezzlement. SAFEChecks sells high security checks, MICR laser check printing software, and Positive Pay file formatting software. Mr. Litster lectures on check fraud and identity theft across the United States, and provides expert witness services in check fraud cases. He can be contacted at greg@safechecks.com or by phone at (800) 949-2265.
SAFEChecks Boilerplate
SAFEChecks provides check fraud prevention products and services,
including the highly secure Abagnale Supercheck (consumers) and
SuperBusinessCheck, MICR laser check writing software, Positive Pay file
formatting and transmission software, and fraud prevention seminars.
Our checks were designed by Frank Abagnale, and are almost impossible to
replicate or alter without leaving evidence. For more information, visit: www.safechecks.com, call (800) 755-2265 x3311, or email us at info@safechecks.com
First published on BankersOnline.com 10/23/06, with permission from the authors.
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