Current Legal Issues Affecting Central Banks, Volume V
Chapter

COMMENT

Author(s):
Robert Effros
Published Date:
May 1998
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Author(s)
JOHN R.H. KIMBALL

Check Truncation

The persistent success of checks as a principal means of noncash payment in countries such as the United States has resulted in efforts almost as persistent to make the collection of checks more efficient. Much efficiency can be achieved in terms of cost savings and speed of collection by the conversion of the paper check to electronic form at an early stage in the collection process, particularly where the banking system is fragmented, and multiple sorts of checks are now necessary. The magnetic ink characters on the bottom of the check are transmitted to the payer’s bank in place of the original check. This process is often called “truncation,” and is distinguished from the mere safekeeping of paid paper checks at the payer’s bank.

The principal difficulty with implementing a check truncation system, at least from the point of view of a lawyer, is the increased risk to the payer’s bank of paying a forged check, defined as a check with an unauthorized or missing payer’s signature. Under most countries’ laws, the payer’s bank is responsible for authenticating the payer’s signature. Existing truncation systems deal with the risk of the payer’s bank in various ways. Most common is a limit on the value of checks that may be truncated; such limits exist in truncation systems in Germany,1 Spain,2 and the United States.3 Because the payer’s bank often does not examine small-value checks today, but assumes the risk of a forgery, truncation would not increase the risk of the payer’s bank, if such limits are set at an appropriate level.

The payer’s bank also has other means of protecting itself in a truncation system. For example, the payer’s bank may require the payer to notify it when the payer draws a check above a certain amount, so that the payer’s bank can reconcile the notice with the truncated check when received (sometimes called a “positive pay” system). This system, of course, detracts from the attractiveness of checks to consumer payers. Another means of reducing the risk of the payer’s bank is for the truncating bank to transmit a digital image of the check itself to the payer’s bank in addition to the magnetic ink information, particularly for larger-value checks. While an image may enable the payer’s bank to feel secure in paying a check in many cases, some payer’s banks say that signature verification or other examination of an image is not a particularly reliable means of authentication and that it is more reliable in authenticating a check to examine the quality of the paper, the nature of the printing, and other details on an original check.

Perhaps the most effective way of protecting the payer’s bank from the risk of forged checks is to shift that risk back down the collection chain to the bank of first deposit and its customer, the payee of the check. This shifting of risk is the effect of systems that use a check guarantee card, such as the Eurocheque system. In such a system, the payer’s bank guarantees to pay a check if the payee compares certain information on the check with information on the card exhibited by the payer. The payee and its bank then may guarantee to the payer’s bank that these procedures have been complied with, and the payer’s bank may later recover from the payee’s bank and the payee if it turns out that the check was forged. As an example of the benefits of such a system, Eurocheques (generally of small value) are truncated and collected by electronic transmission throughout Europe.

Recently, some regional check clearinghouses in the United States have adopted rules that permit the payer’s bank to return a check to another member of the clearinghouse within a stated time, such as 60 days, with an affidavit by the payer that its signature was not authorized. In some cases, these rules are limited to checks that bear only a statement by a third party that the payer has authorized it to issue the check. This type of check is used when a sales firm attempts to obtain an authorization from the payer over the telephone in connection with an attempted sale, and is increasingly common in the United States. These clearinghouse rules shift the authentication responsibility of the payer’s bank to the payee’s bank and the payee, but without giving the payee a ready means, such as a check guarantee card, to protect itself. Such rules also delay the time of final payment of a check, thereby increasing the risk of the payee’s bank in giving prompt availability of funds to the payee for checks deposited. It will be interesting to see if these rules are found to be acceptable to payees and payers, and whether, as a result, payees begin to refuse to accept checks in cases where they cannot readily be authenticated, such as through the mail.

A truncation system must also provide rules for the storage of original checks and copies thereof by the truncating bank, for the return of unpaid checks, and for the retrieval of copies of checks on request by the payer. Payers may need a copy of a check, in addition to a bank statement, in order to prove payment in a particular case or to comply with a variety of laws that require certain categories of payers to keep paid checks for audit purposes. Responsibility for the accuracy of the transmitted magnetic ink information must be determined. A truncation system also must allocate responsibility for complying with postdated and stale-dated checks, and with any legends on a check, such as “not valid for more than___,” because the magnetic ink information does not include information from a check other than the amount and check number, if any. In certain countries, a truncation system must also allocate responsibility for determining the regularity of endorsements.

Given the number and difficulty of these legal issues, not to speak of issues relating to technology and pricing, it is not surprising that truncation has not yet become more widespread. Yet the challenge remains to reduce the costs and increase the speed and security of check collection. The following hypotheticals raise issues concerning check collection and truncation.

Hypotheticals

Hypothetical Number 1: Collecting Bank Liability

The following hypothetical raises problems that could arise during the collection of a check.

Your bank (Your Bank) acts as an intermediary collecting bank in handling checks for collection. You receive a letter from a lawyer for the bank of first deposit (Bank 1) demanding credit and other damages for a check in the amount of $27,500 received by Your Bank from Bank 1 and later charged back to it by Your Bank. The letter recites the following facts:

  • January 5: check deposited in Bank 1 by payee; check sent to Your Bank by Bank 1; credit given to Bank 1;

  • January 29: photocopy requested from Bank 1 by Your Bank because original was reported lost by paying bank (Bank 3);

  • February 16: photocopy supplied by Bank 1;

  • March 4: photocopy returned and credit charged back to Bank 1 by Your Bank; only $10 left in payee’s account;

  • March 13: Bank 1 sends form to Your Bank claiming late return by Bank 3; credit given to Bank 1;

  • April 15: Bank 3’s denial of late return charged back to Bank 1 by Your Bank.

Information from Bank 3 states:

  • February 21: photocopy received by Bank 3;

  • February 29: photocopy returned by Bank 3; notice of nonpayment not given by telephone or wire.

The lawyer for Bank 1 alleges:

  • negligence by Your Bank in not giving prompt notice of nonpayment or loss after January 5;

  • breach of warranty of timely return by Bank 3;

  • negligence of Your Bank in losing check;

  • negligence by Your Bank in not reversing credit for late return claim promptly after March 13; and

  • unfair and deceptive acts and practices (treble damages).

After you ask for help from your Operations Department, it researches the matter, expresses supreme satisfaction with its handling of the check, confirms the above dates, and adds:

  • January 8: Your Bank sends check to Bank 3;

  • January 22: Bank 3 requests credit for January 8 cash letter (bundle of checks) not received.

How do you respond?

Hypothetical Number 2: Truncation

The following hypothetical raises issues concerning the introduction of a check truncation system:

A city check clearinghouse wishes to promote check truncation to save its members processing costs. The clearinghouse has as members most of the banks in the city, both large and small. The Truncation Committee of the clearinghouse proposes a rule that would require all member banks to present checks to other members by electronic transmission of magnetic ink information on the bottom of the check by the 10 a.m. clearing time. The paying bank would be required to pay based on this information. The rule would require the presenting bank to store the original check for 90 days and a copy for 6 years, and to supply the original or a copy to the paying bank on request at a set fee.

The proposed rule is controversial. The smaller banks complain that they are not operationally ready to process checks based solely on the magnetic ink information or to store checks, and that their customers will demand the original check in many cases because they fear not being able to prove payment without the original. The smaller banks request that the originals be delivered to the paying bank later on the day after transmission so that the checks can be supplied with the statement to their customers.

The larger banks support the proposal for small-value checks (the vast majority of checks by number), but object to the proposal for large-value checks because they are unable to verify the authenticity of a check from the magnetic ink information. If a forged check is paid, the paying bank will be required to recredit the customer’s account, and may not be able to recover its mistaken payment from the forger. The larger banks demand that the presenting bank be required to guarantee the validity of the check writer’s signature on checks over a certain amount. They argue that the presenting bank or its customer (the payee) is in the best position to determine whether a check is valid when it accepts the check in payment.

The Truncation Committee of the clearinghouse (dominated by technicians from the larger banks) insists that the savings in processing costs from truncation will outweigh some increased risk of paying forged checks and will convince customers to accept a statement showing only check number, amount, and date of payment. It argues that the savings from truncation will be much greater when city clearinghouses begin exchanging magnetic ink information between each other in place of original checks. However, in deference to the lawyers from the smaller banks, the Committee agrees to modify the proposal to be implemented in phases. Phase 1 would begin with the truncation of smaller-value checks (60 percent by total number of checks in the clearing), and one of the larger banks would provide the service for other banks of storing checks and supplying copies on request. Phase 2 would require the presenting bank to guarantee the validity of checks over a certain amount and would provide for truncation of all checks.

When news of the proposed rules leaks out, a coalition of consumer groups protests the changes as contrary to the check statute and the check writer’s ownership of a paid check. In addition, a coalition of retailers protests that presenting and paying banks will attempt to return forged checks to payees long after they have been finally paid, contrary to the check statute.

What do you advise the central bank that regulates the banks and the check system?

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