CUNA Regulatory Comment Call


June 25, 2004

(IMPORTANT PAYMENTS PROPOSAL)
Regulation J Proposal to Implement Check 21

EXECUTIVE SUMMARY

Please feel free to fax your responses to CUNA at 202-638-7052; or e-mail them to Associate General Counsel Mary Dunn at mdunn@cuna.com and to Assistant General Counsel Michelle Profit at mprofit@cuna.com; or mail them to Mary and Michelle c/o CUNA’s Regulatory Advocacy Department, 601 Pennsylvania Avenue, NW, South Building, Suite 600, Washington, D.C. 20004. You may also access the proposed rule at http://www.federalreserve.gov/boarddocs/press/bcreg/2004/20040604/default.htm

DISCUSSION

Regulation J governs collection of checks and other items by the Reserve Banks. This subpart includes the warranties and indemnities that are given to the Reserve Banks by parties that send items to the Reserve Banks for collection and return, as well as the warranties and indemnities for which the Reserve Banks are responsible in connection with the items they handle. Regulation J also authorizes the Reserve Banks to issue operating circulars governing the details of the collection of checks and other items and provides that such operating circulars have binding effect on all parties interested in an item handled by a Reserve Bank. The Reserve Bank’s operating circular that is most relevant to the Reserve Banks’ check collection activities is Operating Circular No. 3, “Collection of Cash Items and Returned Checks” (OC 3).

Under existing Regulation J, the term “item” is understood to mean a paper instrument. Although Reserve Banks in some cases accept, transfer, present, or return items in electronic form, the rights and obligations associated with handling items electronically currently are specified in OC 3, rather than in Regulation J.

Once the Check Clearing for the 21st Century Act (the Check 21 Act) takes effect on October 28, 2004, the Board expects that the Reserve Banks will offer a wider variety of services that involve handling items electronically. In addition, the Board expects that the Reserve Banks in some cases will act as “reconverting banks” that create substitute checks and provide the associated substitute check warranties and indemnity in accordance with the Check 21 Act and subpart D of the Board’s Regulation CC.

The proposed amendments to Regulation J primarily are designed (1) to cover the Reserve Banks’ handling of electronic items explicitly under Regulation J, (2) to acknowledge the substitute check warranties and indemnities the Reserve Banks and other banks will make under the Check 21 Act and subpart D when handling a substitute check or a paper or electronic representation of a substitute check, and (3) to include new warranties and indemnities that will apply when Reserve Banks and other banks send an electronic item that is not otherwise covered by the Check 21 Act and subpart D.

The Board will make the following changes to Regulation J:

The Board proposed to amend paragraph (b) of this section to state explicitly that new subpart D of Regulation CC would be binding on all parties interested in an item handled by a Reserve Bank. Although subpart D would apply even in the absence of this reference, the Board believed than an explicit statement in Regulation J promotes clarity.

In paragraph (a), the Board proposes adding to the list of warranties made to each Reserve Bank a new warranty that the item bears all indorsements applied by previous parties that handled the item for forward collection or return. This amendment would facilitate compliance with the requirement under the Check 21 Act that a reconverting bank preserve all previously applied indorsements. This new warranty does not require senders to obtain missing indorsements, but rather parallels the Check 21 Act’s requirement that a reconverting bank preserve the indorsements applied by all parties that previously handled a check in any form. The proposed new warranty would be of particular relevance for items that have been indorsed in electronic form, because a Reserve Bank (or other collecting bank) that handles such an item might convert it to a substitute check and thus have a duty under the Check 21 Act to preserve all previously applied indorsements.

The Board also proposes that paragraph (a) explicitly acknowledge the warranties and indemnities that a sending bank makes under Regulation CC subject to the terms of that regulation. Proposed paragraph (a)(3)(i) would list the settlement, encoding, and offset warranties in § 229.34(c)(2)-(4) of Regulation CC. Proposed paragraph (a)(3)(ii) would acknowledge explicitly that a sender makes the warranties and indemnity specified in subpart D of Regulation CC (which implements the Check 21 Act) when sending an item in the form of a substitute check or a paper or electronic representation of a substitute check. Although senders would make each of these warranties as provided in Regulation CC even if the warranties were not listed in paragraph (a), the Board believes that the meaning of the rule is clearer if paragraph (a) specifically acknowledges these warranties. These changes also conform the list of senders’ warranties in § 210.5(a) of Regulation J to the list of the Reserve Banks’ warranties in § 210.6(b) of the regulation.

Proposed paragraph (a) would supplement the warranties that are given under other law by including new warranties that a sender would give only under Regulation J to each Reserve Bank that handles an electronic item that is not a representation of a substitute check and thus is not subject to the Check 21 Act warranties. The Reserve Banks anticipate that most electronic items they receive will fall into this category and that the Reserve Banks or subsequent parties might later use such electronic items to create substitute checks. A recipient of an electronic item that is not subject to the Check 21 Act (i.e., an electronic item created directly from an original check) would not receive the Check 21 Act warranties from the sending bank. However, that recipient would itself make the Check 21 Act warranties if it subsequently used the electronic item to create a substitute check that it transferred for value. The proposed new warranties in Regulation J thus are designed to allow the recipient of an electronic item to pass back liabilities incurred under the Check 21 Act but for which the recipient did not receive corresponding Check 21 Act protections. The proposed new electronic item warranties therefore closely track the substitute check warranties contained in the Check 21 Act. The proposal would include a one-year statute of limitations for their claims.

The amendments described in the analysis of § 210.6(b) would explicitly acknowledge the Reserve Banks’ responsibility for the new Check 21 Act indemnity to be implemented in § 229.53 of Regulation CC and would add a new indemnity that Reserve Banks would give for electronic items that are not subject to § 229.53. The Board therefore proposes to add two new paragraphs to newly redesigned § 210.5(a)(5) that would allow the Reserve Banks in certain circumstances to pass back to the sender losses the Reserve Bank incurs in connection with these indemnities. Specifically, new § 210.5(a)(5)(iv) would require a sender who sent a substitute check (or a paper or electronic representation of a substitute check) to indemnify the Reserve Bank for losses that the Reserve Bank incurred as a result of an indemnity that it made under §§ 210.6(b)(2) and 229.53. Similarly, new § 210.5(a)(5)(v) would require a sender who sent an electronic item to indemnify the Reserve Bank for losses that the Reserve Bank incurred because it made an indemnity for that electronic item under § 210.6(b)(3). The Board also proposes that newly redesigned § 210.5(c)(3) (currently § 210.5(b)(3)) specify that the Reserve Banks’ recovery rights under newly redesigned § 210.5(c) extend to any indemnity that the Reserve Banks provide under § 210.6(b).

The warranties in the proposal do not negate the warranties that a sender gives under other laws. The Board proposes to amend paragraph (b) along the same lines as § 210.5(a) so that the protections that the Reserve Banks give when they handle an item for forward collection parallel the protections that the Reserve Banks receive from senders. Specifically, the Board proposes to add a new paragraph (b)(1)(iii), to provide that Reserve Banks handling an item for forward collection would make the same warranty regarding preservation of previously applied indorsements that a sender would give under proposed § 210.5(a)(2)(iii). Similarly, paragraph (b)(2) would parallel § 210.5(a)(3) by explicitly acknowledging the Reserve Banks’ responsibilities under subparts C and D of Regulation CC, including the warranties and indemnity that Reserve Banks would give when handling a substitute check or a paper or electronic representation o a substitute check. Paragraph (b)(3) would parallel the new warranties in § 210.5(a)(4) that flow with the transfer of an electronic item that is not subject to the Regulation CC warranties. Paragraph (b) (3) also would add a new indemnity that Reserve Banks would make if an electronic item they sent later were converted to a substitute check that was subject to an indemnity claim under § 229.53 of Regulation CC.

The Board proposes to amend paragraph (b) to parallel the proposed amendments to § 210.4 by including the Administrative Reserve Bank of the bank to which a Reserve Bank returns a check in the chain of parties deemed to have handled a check. Proposed amendments to paragraphs (c) and (d) parallel the proposed amendments to §§ 210.5 and 210.6 by making the return warranties and indemnities given by paying and returning banks and Reserve Banks correspond to the forward-side warranties given by senders and Reserve Banks, respectively, and by including a returning or paying bank’s responsibility for indemnifying a Reserve Bank for indemnities it pays for returned checks. The proposed amendments would move existing language from § 210.12(c)(2) about preservation of other warranties and liabilities to a separate paragraph (d), paralleling the creation of new § 210.5(b) with respect to preservation of forward warranties and indemnities.


1 The Board expects that the Reserve Banks will amend OC 3 to address the operational details associated with new check processing services following the Board’s adoption of final amendments to Regulation CC and Regulation J.

QUESTIONS REGARDING THE PROPOSAL

The proposed amendments would provide that each bank that sends an electronic item to a Reserve Bank for forward collection or return would make warranties and an indemnity for that item. The proposed new warranties and indemnity in Regulation J are similar to the warranties and indemnity that apply to substitute checks under the Check 21 Act. The proposed amendments would apply to all depository institutions that collect checks through a Federal Reserve Bank.

  1. The proposal extends the coverage of Regulation J, so that it covers electronic items as well as paper items. Do you support this change? Please explain.
















  2. The proposal also acknowledges the substitute check warranties and indemnities the Federal Reserve Banks and other banks will make under the Check 21 Act and subpart D when handling a substitute check or a paper or electronic representation of a substitute check. Does your credit union support the addition of these clarifications in Regulation J? Please explain.
















  3. The proposal includes new warranties and indemnities that will apply when Reserve Banks and other banks send an electronic item that is not otherwise covered by the Check 21 Act and subpart D. For example, it would make each sender of an electronic item that is not a representation of a substitute check provide the Check 21 Act warranties to recipients of those electronic items that later convert the item into a substitute check and incur a loss. Thus, these new warranties would allow the recipient of an electronic item to pass back liabilities incurred under the Check 21 Act but for which the recipient did not receive Check 21 Act protections. A recipient could incur these liabilities if the recipient converted the item into an electronic item. Do you support this expansion of the substitute check warranties under Regulation J?
















  4. Regulation J would require a sender who sent an electronic item to a Reserve Bank to indemnify the Reserve Bank for losses that the Reserve Bank incurs when it makes an indemnity for an electronic item that it subsequently converts to a substitute check. Do you support the extending of these warranties to those entities that send electronic items to the Reserve Banks? Please explain.
















  5. Similarly, in the proposal the Reserve Banks would give during the forward collection of an item the same protections that they receive from senders. As a result, Reserve Banks would give a warranty that flows with an electronic item that is not subject to the Regulation CC warranties. Finally, this section would add a new indemnity that Reserve Banks would make if an electronic item the Reserve Banks sent were later converted to a substitute check that was subject to an indemnity claim. Do you support this change? Please explain.
















  6. The Board also proposes that the Regulation specify that the Reserve Banks’ recovery rights extend to any indemnity that the Reserve Banks provide under this regulation. Do you support this proposal? Please explain and provide examples.
















  7. Do you have any additional comments on proposed changes to Regulation J?
















  8. Please submit your name, address, and phone number.
















Eric Richard • General Counsel • (202) 508-6742 • erichard@cuna.com
Mary Mitchell Dunn • SVP & Associate General Counsel • (202) 508-6736 • mdunn@cuna.com
Jeffrey Bloch • Assistant General Counsel • (202) 508-6732 • jbloch@cuna.com
Catherine Orr • Senior Regulatory Counsel • (202) 508-6743 • corr@cuna.com