By Daniel C. Knox
In response to technological changes in check payment practices, Articles 3 and 4 of the Uniform Commercial Code (the UCC) were revised in 1990, and several additional amendments were enacted in 2002. Since then, check collection and payment processes have become more technologically advanced. The banking industry has pushed to eliminate the delay and expense associated with processing paper checks. Banks have developed 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, new legal uncertainties have emerged, including several issues concerning the application of the existing payment rules to the speedier processing of checks.
The increased use of electronic imaging and data capture in the collection process has caused much of the uncertainty. Take as an 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 either utilize a centralized processing center or they allow customers to provide MICR line information or an electronic image through a process referred to as “remote deposit capture.” The result of these developments – intended to increase efficiency and reduce costs – 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. The warranties would not apply where a customer provides only MICR line information or an electronic image. 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 or suitable for further processing or that the information is 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, and might not have express statutory recourse against the bank that captured the information or was involved in processing and forwarding the paper check. Uncertainty would also exist should a bank capture garbled electronic 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 check 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 efforts, 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 check 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.
Ambiguities also arise regarding the allocation of losses stemming from fraud. When an electronic image is presented as opposed to a paper check, determining the type of fraud becomes much more difficult. 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 have been designed specifically for electronic funds transfers in which paper copies of checks and other items have not intervened, and so those rules do not necessarily apply. With the increased use of electronic capture, allocation of loss has largely migrated from the ability of the parties to prevent such loss to the applicable burdens of proof in litigation – and this while the various safeguards incorporated in paper checks (watermarking, safety paper, imprinting and the like) become less and less effective due to the increased use of electronic imaging and data capture.
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 privity among multiple parties involved in the processing chain.
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 Check 21 Act define “check” to include a substitute check, with or without legal equivalence. Moreover, 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 UCC 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 21 Act regulations. As such, it is impossible to be certain about the rights and obligations of banks and other parties concerning such items.
In response to the numerous ambiguities surrounding check payment issues, the ULC/ALI Study Committee on Payments Issues prepared a memorandum earlier this year that set out these uncertainties and several others. The committee is seeking input from payment system 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 aware of these potential pitfalls relating to check presentment and payment, and should work to avoid them as best they can.
If you have questions about the issues raised in this article, or if you would like more information on how the UCC, the Check 21 Act, Federal Reserve regulations or interchange rules apply in these types of ambiguous situations, please contact Nicholas Deenis at 484.323.1351, Daniel C. Knox at 215.564.8067 or any other member of the Banking and Financial Services Practice Group.
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