CUNA Comment Letter

July 31, 2001 Draft of the Check Truncation Act

September 21, 2001

Ms. Louise L. Roseman
Director
Division of Reserve Bank Operations and Payment Systems
Board of Governors of the Federal Reserve System
Washington, D.C. 20551

Re: July 31, 2001 Draft of the Check Truncation Act

Dear Ms. Roseman:

The Credit Union National Association (CUNA) appreciates the opportunity to comment on the draft Check Truncation Act (Act) proposed by the Federal Reserve to promote check truncation among depository institutions. As a national trade association, CUNA represents more than 90 percent of the nation’s 10,600 state and federal credit unions. Our comments reflect the opinions of those credit unions and were developed under the auspices of CUNA’s Payment Systems Subcommittee, chaired by Terry West, President and CEO of Jax Navy Federal Credit Union, Jacksonville, Florida. Our comments reflect our general support for the Act, with some recommended changes, as the Act should encourage the development of further check truncation. CUNA's support for the final Act will depend on the language within the final draft presented to Congress and any further changes that are made by Congress.

The draft Act would still permit depository institutions to convert original checks into electronic items and send those electronic checks to other depository institutions that agree to accept electronic checks. If a depository institution does not agree to accept electronic checks, then the originating depository institution would send a substitute check to that institution. A substitute check is a substitute-paper-machine-readable copy of the check. During the collection and return process, checks would be converted into electronic and paper versions as necessary.

A key issue addressed by the current draft of the Act is the use of substitute checks. Currently, financial institutions that exchange electronic check information and images do so under previously adopted agreements. These agreements would continue to be necessary under this version of the Act. This draft of the Act has been changed so that "reconverting institutions" -- those institutions that reconvert the electronic check back into a substitute check -- would make warranties regarding the accuracy of substitute checks and indemnify other financial institutions that receive those items. Consumers would also have expedited recredit rights for losses incurred as a result of the truncation process, if the loss would not have occurred if the original check had been represented. All parties would be assured by provisions within the Act that a substitute check was the legal equivalent of the original check.

SUMMARY OF CUNA's POSITION

BACKGROUND

Currently, the law requires that paper checks be returned to the issuing institution unless the parties agree to accept check information electronically. The requirement that institutions have a formal agreement in place limits the ability of financial institutions to engage in widespread check truncation.

The Act would permit a financial institution to collect or return electronic checks with other financial institutions that agree to accept electronic checks. If a financial institution does not agree to receive electronic checks, then the originating financial institution would send a substitute check. Any financial institution would be required to accept the substitute check.

This draft law would become effective one year after enactment and it would supersede any law that is inconsistent with it, including federal law, state law, and the Uniform Commercial Code. The Federal Reserve would write the regulations for this law.

Under the draft Act, a substitute check would be the legal equivalent of the original check. These substitute checks must be accurate and legible and bear the legend: "This is a legal copy of your check. You can use it the same way you would use the original check." The reconverting financial institution (a financial institution that converts an electronic check into a substitute check) must ensure that the substitute check has the endorsement of previous institutions that indorsed it. In addition, a substitute check would have to identify the reconverting institution.

The Act would require financial institutions that transfer or present substitute checks and receive consideration for them to make two warranties to subsequent financial institutions and persons who use them. First, they would warrant that the substitute check meets the requirements to be legally equivalent to the original. Second, they would warrant that no institution would be required to pay twice on the same substitute check because of its alternate forms. In the proposal, a reconverting financial institution would indemnify subsequent parties for losses due to receipt of a substitute check instead of the original check. The indemnity amount would include consequential damages for losses caused by a breach of the substitute check warranties. Otherwise, damages would be up to the amount of the check, plus interest. If the loss is partially the fault of the financial institution or person indemnified, then that person would be responsible for a proportionate amount of the loss. If the indemnifying financial institution produces the original check, it is liable only for losses that are incurred up to that time, and all excess money it paid must be returned. Production of the original check would not absolve the indemnifying financial institution from any liability on a warranty that it has given under this Act or other law.

Under the Act, a financial institution's customer could claim that a substitute check cannot be properly charged to the consumer's account or that it breaches a warranty and an original check is needed in connection with the claim. Once a consumer makes a claim, then the financial institution must both produce the original check and show that it was properly payable or recredit the consumer's account. The recredit applied to the account would be for the amount of the check or $2,500, whichever is less, by the business day following the banking day of the claim. The financial institution must credit the remainder, the part over $2,500, within 20 business days following the banking day of the claim. A financial institution must make recredited funds available for withdrawal by the start of the next business day after the recredit is required to be applied to the account. A financial institution may delay availability of the recredit until the twentieth business day following the banking day if the account is less than 30 days old; if the account is frequently overdrawn; if there is a reasonable belief that there is fraud; and if there is an emergency.

A financial institution may make a claim against a bank that indemnified it if a consumer makes a warranty claim related to the substitute check or the financial institution wants to assert such a claim. To recover, the financial institution must have suffered a loss or been forced to pay a consumer recredit and the original check must be necessary to verify the charge. The financial institution has 120 days after the day of the transaction that gave rise to the claim. If a financial institution seeks a recredit, then the indemnifying financial institution must produce the original check or provide expedited recredit rights. The recredit is due within 10 business days. Providing the recredit does not absolve the indemnifying financial institution from liability for additional damages.

CUNA's CONCERNS

CUNA addresses its comments on each section of the Act below in the order in which they appear in the Act. CUNA would like to emphasize that it only supports the Act as long as it allows the current share draft truncation programs of credit unions to proceed without subjecting them to the new requirements in the expedited consumer recredit provisions.

Section 2: Definitions

This section of the Act has been changed significantly in order to reduce the scope of the Act to substitute checks. As a result, the definitions of electronic check, electronic check agreement, and truncating financial institutions have been deleted as the exchange of electronic check information and check images no longer fall within the Act. The financial institution that "reconverts" the electronic image into a check is the institution that takes the responsibility for indemnities, so the reconverter institution is defined.

CUNA is concerned that the draft Act does not make clear that a financial institution, which truncates the original check, is liable under the Act in cases when it is responsible for losses. For instance, it may create duplicate electronic check files and the reconverting financial institution may be held responsible for a charge that is not properly payable to an account. CUNA urges the Federal Reserve to address this issue. The Federal Reserve should describe an example in the Act's commentary that explains how a financial institution may recover from a truncating institution and how that institution is liable under the Act or other laws. This would help clarify for smaller financial institutions that they may recover losses from those truncating financial institutions if they are ultimately responsible for losses. This example would ensure that the payment system remains efficient and effective and that negligent truncation practices are not subsidized. The Act could also be amended to include the terms for the converting financial institution and electronic check so that responsibility for liability is made clear.

CUNA asks that the Federal Reserve amend the Act to make explicit that a paying credit union or paying bank would not become a reconverting financial institution if it creates an image of the check for a statement or other informational purposes.

Section 3: Substitute Checks

This subsection would permit a person to send a substitute check without the agreement of the recipient if a financial institution that created or handled the substitute check provides the requisite warranties. The substitute check would be the legal equivalent of the original and it may be used for negotiating or otherwise if it meets certain requirements and conforms to all industry standards for substitute checks.

In light of the fact that this version of the Act has been modified so that the warranties follow the check through the collection stream, CUNA supports provisions that would require all previous endorsements, physical and electronic, to be included in any subsequent presentment of the item.

The Federal Reserve has asked for comments on whether the identity of the reconverting financial institutions should be in the endorsement so that it will be carried through to all future versions of the check. CUNA supports a requirement that a reconverting financial institution identify itself so that it will be carried through on all versions of the check. This requirement would make it easier for those who want to make an indemnity claim directly on the reconverting financial institution.

Section 4: Substitute Check Warranties

Under this section, any financial institution that transfers or presents a substitute check, and receives consideration for it would warrant that the substitute check meets the requirements for legal equivalence and that payment will not be requested based on a check that has already been paid. These warranties are made to all parties. For example, if a substitute check is deposited, in the case of an item that has been returned unpaid, the credit union of deposit assumes liability for that item. However, the credit union does not have the wherewithal to know whether that item has been paid. In this case, the credit union of deposit should not be held liable for these warranties the reconverting institution should. The Act should be amended so that in this case the depository financial institution does not become responsible for the warranties of the reconverting institution.

Section 5: Indemnity

Under this section, the reconverting financial institution and any institution that transfers or presents a substitute check, and receives consideration for it, must indemnify subsequent parties for losses incurred by the receipt of a substitute check. The loss is indemnified if the loss is due to the receipt of the substitute check rather than the original check. The indemnity provided by the Act, like the warranties, would flow with the substitute check; that is, each financial institution that subsequently handles a substitute check (in electronic or paper form) provides the indemnity.

CUNA urges the Federal Reserve to alter the Act to allow an indemnifying financial institution to limit its liability by supplying an adequate image of the original check, when the image is sufficient for a recredit claim by a financial institution. In many cases, the institution that truncated the check into the electronic image may destroy the original check and there may be no way for subsequent financial institutions to obtain the original. Meanwhile, an image may suffice to resolve the claim. For example, if the first substitute check was blurry, then a good image should resolve the claim. The financial institution should obtain credit if it produces an image that is sufficient to resolve the claim, especially in the case where the original check no longer exists.

Section 6: Expedited Recredit Procedures for Consumers

The Act permits consumers to obtain expedited recredit in some cases for the amount of a substitute check that is erroneously charged to their account. These provisions apply only to consumers and only in cases where the consumer suffers a loss because the substitute check was charged to their account and the original check is necessary to determine the validity of the charge.

The expedited recredit provisions apply only with respect to substitute checks that are provided to the consumer. The expedited recredit provisions would not apply when a consumer has agreed with his or her financial institution that he or she will not receive canceled checks in his or her statement. The expedited recredit provisions do not apply in such cases because the consumer in those cases would be in the same legal position regardless of whether original checks or substitute checks had been presented for payment. Although these consumers would not be eligible for expedited recredit under the Act, they could nevertheless make warranty and indemnity claims under the Act.

CUNA strongly commends the Federal Reserve for adding a clarification that the expedited recredit provision would not apply to consumers who have agreed with their financial institutions that they will not receive canceled checks in their statements. Credit unions have truncated the share drafts of their members for years, and it is an integral part of their low-cost services. The Federal Reserve should not hinder that aspect of their service, by introducing unnecessary rules to a process that currently works well. Without this provision, CUNA would not support this Act.

CUNA urges the Federal Reserve to allow financial institutions to reverse recredits when the circumstances indicate that the consumer was not entitled to the recredit. Currently, the circumstances delineated under the Act for a reversal of a recredit are too narrow. The Act states that "[t]he bank may reverse the recredit to the consumer's account when it provides the original check to its consumer, if the check was properly charged to the account." If the financial institution can prove that the charge was properly payable, then the financial institution should be able to reverse the charges even if it cannot obtain the original check. CUNA requests that the Act be amended to allow the financial institution to reverse the recredit if the financial institution can show that the consumer did not have a loss or the original check is unnecessary for determining the validity of the original claim.

CUNA commends the Federal Reserve for adopting changes to the Act that enhance security in the payment systems. CUNA supports the Federal Reserve for reducing the amount of the recredit that must be immediately paid from $5,000 to $2,500. This reduces the amount that a financial institution would have to give before it has a chance to thoroughly investigate a claim. In addition, CUNA commends the decision of the Federal Reserve to allow institutions to place holds on expedited recredit funds in certain circumstances. These holds give financial institutions time to verify claims. As a result, they should allow institutions to protect themselves from fraud.

Within this section, the Federal Reserve refers to 30-day, 60-day, and 120-day time periods, but does not clarify if these are business days or calendar days. CUNA suggests that the final draft include these distinctions.

Section 7: Expedited Recredit Procedures for Financial Institutions

A financial institution is entitled to expedited recredit for a claim against a previous indemnifying institution if the following three conditions are met. First, the financial institution must either assert an indemnity or warranty claim related to a substitute check or must have received a claim for expedited recredit from a consumer. Second, the financial institution or its consumer customer must have suffered a resulting loss and the original check must be necessary to determine the validity of the warranty claim or of the charge to the consumer’s account. Third, the financial institution must have submitted the claim to the indemnifying financial institution within 120 days after the date of the transaction that gave rise to the claim. Within 10 business days after receiving a claim, the indemnifying financial institution must produce the original check or recredit the indemnified financial institution.

CUNA supports amendments by the Federal Reserve that would make it explicit that the ten day turnaround time for resolution of claims among financial institutions applies to indemnity breaches under section 5 and not just expedited recredits that are described in sections 6 and 7. Within all sections of the Act, financial institutions should be required to provide recredits and/or original checks in a timely manner.

Section 11: Regulations

CUNA supports this new provision within the Act that grants the Federal Reserve the authority to prescribe regulations it deems appropriate to carry out the Act. This provision should support the nationwide accessibility of the payment system.

Section 12: Effective Date

CUNA supports a one-year delay of the effective date for the Act. This date should provide sufficient lead-time to establish standards and train credit union staff.

CUNA has heard reports that the Department of the Treasury may opt out of this proposal. CUNA asks the Federal Reserve to work with the Treasury so that it complies with the Act. Treasury's participation would ensure that one set of rules applies to substitute checks. This would eliminate unnecessary extra training and processing caused by inconsistent rules.

CONCLUSION

For all the reasons stated above, CUNA remains generally supportive of the current proposal and recommends changes that would make the proposal stronger. If you have any further questions, please contact Michelle Profit at (202) 682-4200.

Sincerely,

Michelle Q. Profit
Assistant General Counsel