Check Truncation Comment Letter

Federal Reserve System
Re: Draft Check Truncation Act

September 18, 2001

Ms. Louise L. Roseman, Director
Division of Reserve Bank Operations and Payment Systems
Board of Governors of the Federal Reserve System
20^th and Constitution Avenue, N.W.
Room 4134, Mail Stop 190
Washington, DC 20551

Re: Draft Check Truncation Act

Dear Ms. Roseman:

The Association for Financial Professionals (AFP) welcomes the opportunity to comment on the July 2001 version of the Federal Reserve Board's Draft Check Truncation Act.  The Act is designed to improve the overall efficiency of the nation's payments system and promote the use of electronics in the collection of checks by removing legal impediments to check truncation.

In AFP's April 5, 2001, comment letter on the Federal Reserve's February 2001 version of the draft Act, the Association recommended that efforts to replace original checks in the clearing and return process follow certain general principles.  Most important of these principles was the following:

• The legal equivalence of the original checks and electronic images or paper copies of those checks should be guaranteed.  There should be no question about the acceptability of check images in a court of law and no diminution of legal rights under check law as a result of the legislation and subsequent regulation.

Revisions of the February draft
In a major change from the February 2001 version, electronic checks—digitized reproductions of the original checks—have been omitted from the scope of the Act.  The coverage of the revised Act is limited to substitute checks.  A substitute check is defined as a paper reproduction of the original check which is to be considered the legal equivalent of the original check for all purposes, including federal and state law, and for all persons if it-

• Accurately and legibly represents all of the information on the front and back of the original check as of the time the original check was issued; and
• Bears the legend: "This is a legal copy of your check.  You can use it the same way you would use the original check."

Substitute checks are provided to customers who do not agree to accept electronic images of checks and prefer to have their original paper checks returned.

The revised Act eliminates a section contained in the February draft that provided generally for "variation by agreement" but prohibited bank disclaimers of indemnity, warranty and other obligations to consumers.  As we understand the effect of the elimination of the section, banks can now disclaim their obligations to any user with whom the bank has a contractual relationship.  We believe that all customers—corporates and consumers—should be covered by bank warranties that protect against situations in which a substitute check does not meet the standards for legal equivalence or in which a party receives a duplicate request for payment after the original check has been converted to a substitute check.

"Electronic checks" should be covered
AFP urges the Federal Reserve to restore "electronic checks" within the scope of the Act.  As the Fed points out, banks today exchange electronic check information and images under bilateral or multilateral agreements with each other and by agreement with their corporate customers.  However, the current state of the law continues to leave corporate customers who receive electronic images of their checks exposed to uncertainty regarding the legal acceptability of those images.

With the elimination from the scope of the Act of provisions relating to electronic checks, including the legal equivalence provisions, there can be no assurance that electronic images would not be precluded from acceptance in court under state evidence laws.  Such preclusion could bar an attempt by a payor to prove payment by the introduction of the image of a truncated check or by a payee to prove that a truncated check was returned by the payor bank.  AFP does not believe that the Uniform Electronic Transactions Act (UETA) or the federal E-Sign Act definitively provide that check images satisfy the various state rules of evidence.

AFP urges the Federal Reserve to include in the revised Act that section of the February 2001 draft which clearly provides for legal equivalence—Section 4(b).  Alternatively, the Fed could incorporate Sections 4-214(g)(2) and 4-406(c) of the most recent draft of the NCCUSL revisions to UCC Article 4.  These provisions would enable any corporate in receipt of electronic images to be in "the equivalent legal and practical position" as if the corporate had received the original check, a major objective of the Federal Reserve effort.

The Federal Reserve asserts that business customers can "negotiate agreement terms with their banks that address their rights, responsibilities, and liabilities as part of their overall banking relationship."  However, the state of the law, as outlined above, and the unequal expertise relating to payments law available to the two parties to the agreement both appear to require the statutory confirmation of legal equivalence requested in this comment letter.

Clarification of bank warranty obligations
We would appreciate clarification from the drafters of two additional issues.

First, we believe that a bank is obligated to ensure that a substitute check qualifies as a "substitute check."  The substitute check warranties in Section 4 apply to a "substitute check," which is defined as a check that satisfies the conditions of subsections (1) and (2) of Section 2(m).  Thus, a check that purports to be a substitute check might not qualify as a "substitute check" if, for example, a bank has failed to encode all of the required MICR line information.

The warranties and indemnities of the bank would seem not to apply under these circumstances because they only apply literally to checks that are actually substitute checks as defined.  We know that the warranties and indemnities are intended to apply when the bank is at fault for having failed to ensure that the check qualifies as a substitute check.  As a drafting matter, however, the bank should have an affirmative obligation to ensure that a check that purports to be a substitute check is a "substitute check."  Similarly, the bank should have an affirmative obligation to affix the Section 3(b)(2) legend on the check.

Second, we note that while the indemnity covers any loss that results from the receipt of a substitute check instead of the original check, the bank warrants only that a substitute check "meets the requirements" for legal equivalency.  The warranty is thus narrower than the indemnity. For example, if the user must prevail in court on the equivalency issue, the warranty would not cover the user's litigation costs because the substitute check would be deemed to have met the requirements.  As to litigation costs, this result seems confirmed in Section 5(b), under which the bank's liability is limited to the amount of the check in the absence of a breach of warranty.

A typical contract indemnity applies to "all costs, liabilities, claims, and expenses, including reasonable attorney's fees and costs of litigation or dispute resolution proceedings."  In accordance with the Guiding Principles, it would seem appropriate to broaden the scope of the warranty or broaden the scope of the indemnity, or both.  At the very least, the corporate or consumer user should be entitled to recover its litigation costs.

AFP appreciates the opportunity that the Federal Reserve has afforded our Association to participate in the drafting process, and we would be pleased to answer any questions you may have.

Sincerely,

Donald L. Hollingsworth, CCM
Assistant Treasurer
Ameren Corporation
Chair, AFP Payments Advisory Group

R. Ross Guyer, AAP
Senior Deputy State Auditor
West Virginia State Auditor's Office
Chair, Payments & Technology Task Force
AFP Government Relations Committee

Arlene S. Chapman, CCM
Vice President, Government Relations & Technical Services
Association for Financial Professionals