Dealing With Unauthorized Drafts: Fed Proposes Reg. CC Solution

Dealing With Unauthorized Drafts:
Fed Proposes Reg. CC Solution

John S. Burnett, Associate Editor, BankersOnline.com

You just got off the phone with Tom Smith, one of your "seasoned" depositors. He called to complain about a check he found listed on his checking account statement. He said he couldn't figure out why his account wouldn't balance until he went through the images of his checks and saw it. A check he hadn't signed - in fact no one had. Instead it had wording on it claiming that "your depositor authorized this check." Tom said he had bought something from the company on the check a few months ago, but it turned out to be junk. He had paid them by check back then, and chalked it up to experience. "Could that be how they got my account number?" Tom had asked.

Remotely Created Checks
What Tom just described to you is often referred to as a demand draft, a pre-authorized check, or, in some states, a remotely created check.

Whatever you may call them, these bothersome paper gremlins have been a hot topic on BOL's Bankers' Threads. Remotely created checks are generally issued by the payee on authority given by the holder of a checking account. They often serve legitimate purposes, such as making a payment on a credit card account or other obligation (often just in time to avoid late payment penalties), or completing a telephone purchase when one does not have a credit or debit card.

But the scores of questions about remotely created checks that members of the BOL community have either posted to Bankers' Threads or posed in BOL's Ask a Guru forum, make it obvious that all is not well. Because there is no customer signature on the check, and there is nothing unique in the MICR line to bring the check to a bank's attention, the use of these checks is vulnerable to fraud.

Banks Holding the Bag
The laws covering the rights and responsibilities of people handling checks are called the Uniform Commercial Code (UCC). This is a set of more-or-less consistent laws adopted by the states, dealing with matters of commerce. Some of the specific language varies from state to state. In general, the UCC permits paying banks to return checks they believe are not authorized by their account holders only until midnight of the day following the day of presentment. With "regular" checks, a bank has an opportunity to compare signatures to catch anomalies. In fact, the current UCC provisions reflect a rule adopted in 1762 in England (in the famous Price vs. Neal case). Simply put, the person who can verify a check drawer's signature usually assumes the loss on unauthorized checks.

Remotely created checks include no special identifier (such as a MICR line code) to alert a paying bank of their existence. And even if they had such a "flag," there is no signature for the bank to compare to its records.

Unhappily, when there are problems with remotely created checks, they typically are identified much later than the midnight deadline; often they don't show up until a depositor, like Tom Smith, finds an unfamiliar item in a statement. If, like Tom, the customer makes a claim that the item wasn't authorized within the bank's deadline for statement examination, and the bank cannot determine that the customer actually authorized the charge, the customer is entitled to a refund.

When banks have taken the trouble to research some of these items, they have found that

The payee obtained and recorded an oral authorization for the remote creation of the check and the depositor forgot about it;
The depositor actually authorized the charge, but is now experiencing a form of "buyer's remorse"; or,
The depositor did not authorize the check.

In the first two instances, the depositor's bank is justified in denying its customer's claim since the check was authorized. But in the last instance, it has typically been the paying bank that has absorbed the loss. There is a very low probability that the bank will be able to recover its funds.

A Pathetic Patchwork
Responding to banks' complaints about a perceived increase in fraud, the National Conference of Commissioners on Uniform State Laws and the American Law Institute began in 2002 the agonizingly slow process of revising the 50 plus versions of the UCC to insert added transfer and presentment warranties in Articles 3 and 4. These were written to push the loss for unauthorized remotely created checks back to their payees. According to a recent announcement from the Federal Reserve Board, only 14 states1 have so far adopted the provisions, and not in a uniform manner (different wording, etc.). Some states' versions only apply the warranties to remotely created checks drawn on consumer accounts. Thirty-seven states and the District of Columbia have yet to enact any provision for these checks.

1Those states are California, Colorado, Hawaii, Idaho, Minnesota, Nebraska, New Hampshire, North Dakota, Oregon, Tennessee, Utah, Vermont, West Virginia, and Wisconsin, according to the FRB proposal.

While the goal of the UCC revisions - to provide an economic incentive for the depositary bank to monitor its customers that deposit these items - is laudable, those conducting the fraud have merely to transact business with a financial institution in one of the 30 plus states that haven't adopted the UCC changes, to avoid giving the warranty, or being subject to the sort of enhanced scrutiny the amendments encourage.

Fed Proposes "End Run"
The Fed proposes to use its broad authority received in the Expedited Funds Availability Act to "establish rules regarding losses and liability among depository institutions 'in connection with any aspect of the payment system.'" It would use that authority to define a remotely created check and to add another warranty to those made by banks transferring or presenting these checks -- that the person on whose account the remotely created check is drawn authorized the issue of the check.

The Fed's proposed action would create a national standard on which paying banks could rely to recover on claims paid to their customers on these checks. Claims would be made "without entry." There is nothing in the proposal addressing a need for an affidavit or other statement from the customer, but such a requirement seems reasonable. If the standard "without entry" process fails to obtain results, an aggrieved bank could resort to legal remedies to recover its losses. Note, however, that damages would be limited by Regulation CC to the amount of the check, interest compensation, and "expenses related to the check." As proposed, the warranties would extend to all remotely created checks, although the Fed asks whether it should restrict the warranty to checks drawn on consumer accounts.

Alternatives
The proposal includes three alternatives (the document says there are two, but here are the three listed):

Extending the midnight deadline for return of remotely created checks for perhaps 60 days. This tracks the current process for returning unauthorized consumer ACH transactions, but has some inherent drawbacks, such as making it difficult to determine when final payment for a remotely created check has been made.

Withdrawing the proposal and letting state legislatures work toward adopting the UCC warranty amendments.

This option has its obvious problems, since the patchwork of state laws would do little to deter fraud until almost all the states had adopted the changes.

Adding a mandatory MICR line identifier to remotely created checks (in position 44). The Fed feels that four different digits would be required to identify forward and return originals and substitute check versions of the remotely created check. The Fed suggests this could allow banks to put special verification steps into place for these items, but admits that persons bent on fraud would be unlikely to use the MICR standard.

Assuming that depository banks could be held responsible for affixing the MICR identifier, paying banks would still have the problem of verifying depositors' authorizations by their "midnight deadline." Add to that the need to affix a strip or otherwise put the special code for a return remotely created check, and the returns process becomes needlessly complicated.

Comments
When the Fed floated its trial balloon on this topic in January 2004 it triggered 76 comments, all but two of which supported the concept. Notably, the Permanent Editorial Board for the UCC weighed in as advocating the Fed's idea.

You can read the full proposal on the Fed's Website at http://www.federalreserve.gov/boarddocs/press/bcreg/2005/200503012/attachment.pdf, or review the more compact Federal Register version (published March 4, 2005) HERE. The first page of the document includes five alternatives for submitting comments on the proposal, which will be due by May 3, 2005.

The adoption of the Fed's proposal seems to be a "no-brainer." But to ensure that the Fed takes action, get your comments filed as quickly as possible.

First published on BankersOnline.com 3/9/05