|The Legal Intelligencer
March 1, 2010
In response to technological advancements in check payment practices, Articles 3 and 4 of the Uniform Commercial Code were revised in 1990, and several additional amendments were enacted in 2002. Since that time, further technological advances have taken place in regard to check collection and payment practices.
The banking industry has pushed to eliminate the delay) and expense associated with processing paper checks by developing various means to reduce paper processing, including the truncation of paper checks and the transmission of information electronically (images of checks or MICR line data). As a result, several legal uncertainties have emerged, including issues concerning the application of existing payment rules to the electronic processing of checks.
Much of the uncertainty has been caused by the increased use of electronic imaging and data capture in the collection process. Take, for example, the presentment or return of a check. Under Article 4, a bank is deemed to have exercised reasonable care so long as the bank takes action before its midnight deadline following receipt of the check. However, many banks no longer receive paper checks. These banks may allow customers to provide Magnetic Ink Character Recognition (MICR) line information or an electronic image through a process known as "remote deposit capture." Moreover, banks with several branches may utilize a centralized processing center for all checks within a certain geographic area.
While these developments were intended to increase efficiency and reduce costs, a separate result is that the provision within Article 4 becomes ambiguous in its application because the bank does not actually receive the paper check. Similarly, the transfer and presentment warranties within Articles 3 and 4 are based upon the transfer or presentment of a paper check. Where a customer provides only MICR line information or an electronic image, the warranties would not apply.
Even Article 4, which contemplates electronic presentment agreements, does not clearly address those entities that dealt with the electronic image prior to presentment to the payor bank. UCC Article 4A, governing funds transfers,
imposes liability rules that replace the traditional check warranties, as these might not be suitable for payment items converted from paper checks through electronic imaging or data capture.
The electronic capture itself also results in uncertainty under Articles 3 and 4. While a bank that encodes an item makes an encoding warranty, the UCC does not expressly impose on a bank that captures an electronic image a statutory warranty that the information as captured is accurate, suitable for further processing, or sufficient for the creation of a substitute check.
Moreover, no warranty obligation is imposed for a potential double payment, i.e., payment on both the original paper check and the electronic image. If the electronic capture of information leads to a check being paid twice, the payor bank would have to credit its customer's account for one of the payments, as only one was properly payable. The payor bank might not have express recourse against the bank that captured the information or was involved in processing and forwarding the paper check as there was no substitute check created and there is no contract right between the payor bank and the transmitting bank.
Uncertainty would also exist should a bank capture garbled e1electronic information or should the capture fail to meet other technical standards. Questions arise as to whether a payor bank that receives a garbled or technically deficient electronic presentment should pay the cheek or return it. Should the bank decide to return the check, an issue would arise as to whether the check was being dishonored. Further, would a bank that attempts to correct the garbled or technically deficient information be deemed to fail to exercise reasonable care if, as a result of its downfall, it missed the midnight deadline discussed above?
The use of an electronic image also raises the issue of enforcement of contract liability on the check itself. Article 3 requires that a person seeking to enforce contract liability on an instrument procure an original check unless special circumstances exist that relate to lost or stolen instruments. In the event that the captured image or electronic information is insufficient for the production of a substitute cheek with legal equivalence, or if a bank is unwilling to create a substitute check due to the corresponding substitute check warranties, would it be possible to enforce contract liability on the instrument at all?
Along the same lines, the rules that allow a holder in due course to enforce the instrument also might not apply. If a customer were to transfer an electronic image to its bank, and subsequently the electronic image was dishonored by the payor bank, the bank of first deposit would presumably be unable to recover against its customer, as the "holder in due course" concept set out in Article 3 is limited to paper checks. While it is true that the bank of first deposit could create a substitute check with legal equivalence in order to obtain "holder in due course" status, a potential issue arises as to whether the image its customer created satisfies applicable requirements. And even if a substitute check was created, the bank of first deposit still may not be able to qualify as a holder in due course if at the time it accepted the image it could not qualify, as the concept does not exist with respect to an electronic image.
Ambiguities also arise regarding the allocation of losses stemming from fraud. Determining the type of fraud becomes much more difficult when an electronic image is presented as opposed to a paper check. For example, was the drawer's signature forged or was an otherwise authentic check altered? The loss allocation rules of Articles 3 and 4 depend largely on the type of fraud at issue, with the allocation for a forged drawer signature being different than the allocation for an altered check. The loss allocation rules of Article 4A were designed specifically for electronic funds transfers in which paper copies of checks and other items have not intervened in the process and so those rules do not necessarily apply.
With the increased use of electronic capture, allocation of loss has largely shifted from the ability of the parties to prevent fraud to the applicable burdens of proof in litigation - and this while the various safeguards incorporated in paper checks such as watermarking, safety paper, imprinting and the like. become less and less effective due to the increased use of electronic imaging and data capture.
Apart from the ambiguities relating to electronic imaging and data capture, other issues also exist regarding how to apply the existing rules. Consider, for example, the Check Clearing for the 21st Century Act (the Check 21 Act), which authorizes the recipient of a paper check to produce a digital substitute check in order to dispense with processing the physical document. The regulations promulgated pursuant to the Cheek 21 Act define "check" to include a substitute check, with or without legal equivalence. The term does not include any paper that fails to meet the definition of a substitute check. Now consider that the regulations provide that the VCC applies to substitute checks with legal equivalence.
While it is clear that the UCC applies to substitute checks that have legal equivalence, it is unclear whether the UCC applies to substitute checks that do not have legal equivalence or to any items that do not qualify as substitute checks pursuant to the Check 2I Act regulations. As such, it is impossible to be certain about the rights and obligations of banks and other parties concerning such items.
These considerations raise a primary question: To what extent should Articles 3 and 4 (or, for that matter, Article 4A) be applied to electronic Imaging and data capture? In the interim, some parties within the collection chain have chosen to enter into contracts or agree to be bound by private check-clearing rules in order to limit some of these ambiguities. But such Contracts or rules are inadequate as a comprehensive loss allocation practice because of the lack of privacy among multiple parties involved in the processing chain.
In response to the legal ambiguities surrounding check payment issues, the ULC/ALI Study Committee on Payments
Issues prepared a memorandum last year that set out these uncertainties and several others. The committee is seeking input from industry participants in preparation for a drafting project focused on much-needed revisions to the UCC. Until such time as the various ambiguities are addressed, banks should be cognizant of these potential pitfalls relating to check presentment and payment and should strive to avoid them as best they can.
Reprinted with permission from the March 1, 2010 edition of the Legal Intelligencer, 2010 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited.