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

Re: Draft Check Truncation Act

Dear Ms. Roseman:

The Association for Financial Professionals (AFP) welcomes the opportunity to comment on the draft of the Federal Reserve Board's proposed Check Truncation Act, which would remove current legal impediments to the non-return of original checks to the makers of the checks.

If enacted by Congress, the law would permit electronic images of checks or machine-readable paper copies of the checks, called substitute checks, to replace physical checks in the clearing and return process. The electronic checks and the substitute checks would be the legal equivalent of the original checks, acceptable in a court of law as proof of payment. The proposed legislation would encourage banks to eliminate paper from the check system at the earliest possible point in the process. It is designed to increase the efficiency of the check system, cut costs and improve availability. Given the continued predominance of checks as the primary payment method in the U.S., the resulting increase in productivity should bring substantial benefits to the economy. To have the desired results, all users of the payment system should benefit from check truncation -- businesses, consumers and banks.

AFP has supported the concepts underlying the Check Truncation Act and understands the benefits of replacing original checks with electronic images of those checks or with machine-readable paper copies. We anticipate that such a landmark change in check processing would have a substantial impact on AFP's members. Our members are employed by many of the Fortune 1,000 companies and the largest of the middle market companies. They have direct responsibility for check disbursements, collections, reconciliation, and funds transfers generally. AFP members' companies, with their higher check volume, larger check size and greater exposure to fraudulent practices, have a significant stake in the outcome of this initiative.

While recognizing the benefits of check truncation, AFP members believe that efforts to replace original checks in the clearing and return process should follow these general principles:

• 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.
   
• The check-related services provided to companies by banks -- such as controlled disbursement and positive pay -- should not be harmed.
   
• Check truncation should not increase already substantial losses due to check fraud.
   
• The development of standards and the identification of a rule-making authority should precede implementation of check truncation.

AFP's comment will address our concerns in each of these areas.

Legal equivalence of electronic images and substitute checks

1. Disclaimer of warranties
   AFP's members consider that legal acceptability as proof of payment in a court of law is the most important requirement for electronic images of checks and substitute checks. However, the draft permits a bank to disclaim, with respect to non-consumers, the provision of the act that warrants that the electronic check or the substitute check "meets all the requirements for legal equivalence."
   
   Section 3 of the draft act deals with variation by agreement. Section 3(b) states that "A bank may not disclaim, with respect to consumers, its warranties under sections 5 and 7…."   In effect, banks are free to disclaim those warranties through provisions in agreements with their business customers.
   
   Section 5 states that a bank that transfers or presents an electronic check…warrants…that "the electronic check meets all the requirements for legal equivalence under section 4(b)." Section 7 makes the same warrants for substitute checks. Both sections also warrant that relevant parties will not be asked to make payment based on a check that has already been paid, i.e., on a duplicate check.
   
   Section 4(b) is the basis for legal equivalence for electronic checks; Section 6(b) provides the same basis for substitute checks. They state that an electronic check or a substitute check is "the legal equivalent of the original check for all purposes, including federal and state law, and for all persons…."
   
   We point out that in Uniform Commercial Code (UCC) Sections 3-416(c), 3-417(e), 4-207(d) and 4-208(e), the bank cannot disclaim its check warranties, whether the warranty is made to a consumer or a non-consumer. The limitation on disclaiming the benefits of the warranties should be non-disclaimable as to all customers, not just consumer-customers, as they are in UCC Articles 3 and 4.
    
2. Definition of "legal equivalence"
   In explanatory notes accompanying the text of the draft act, the Federal Reserve states that "report language could clarify that ‘legal equivalence' includes, among other things, the ability to use the electronic check as proof of payment." AFP suggests that this places too much of a burden on the report language. In addition, the act, rather than the report, should clearly state that the holder of a dishonored electronic or substitute check should be able to enforce the check against the drawer to the same degree as would be possible with the original check. These provisions would parallel provisions in planned revisions to UCC Articles 3 and 4.
    
3. Inflexibility of legal equivalence provision
   The draft provision requiring an accurate representation of the information on the check appears to be inflexible because it denies legal equivalence in cases of harmless error. For example, legal equivalence would be denied if an electronic or substitute check shows the check as having been drawn on Jan….y 10 instead of January 10 because the image was blurred. The same result would obtain in a harmless misspelling of the legend, "This is a legal copy of your check…" required by Section 6 (b)(4). Should legal equivalence be denied for errors that do not prejudice any of the parties?

Expedited re-credit provisions for substitute checks

AFP recommends that banks not be permitted to disclaim their responsibility under Section 8 to indemnify a company for losses incurred due to the receipt of the substitute check instead of the original check.

Moreover, all users of the check system -- not only consumers -- should be entitled to the expedited re-credit provisions of Section 9 of the act. Section 9 allows consumers to make a claim against the bank and receive expedited credit if the bank improperly debited the consumer's account, the consumer suffered a resulting loss, and the original check is necessary to determine the validity of the charge. The amount of the re-credit would be up to the amount of the check or $5,000, whichever is less, and would be made no later than the business day following the banking day the consumer makes the claim. If the claim is valid, the remainder of the amount is credited. If the original check shows that the check was properly debited, the bank may reverse the re-credit.

Large companies and small businesses alike frequently encounter excessive delays when seeking re-credit for improperly charged checks and lack the ability to expedite the process. The potential for an increase in improper charges as a result of check truncation will make the problem even worse.

If Section 8 or Section 9 is not modified, the act should specify, at minimum, that language dealing with rights to damages under the act -- or the lack thereof -- must appear clearly and specifically in all account agreements between banks and their non-consumer customers. If the Federal Reserve and the banks intend the use of substitute checks to become widespread, users of the check payment system should clearly understand the limitations on their rights. To retain the public's confidence in the safety and reliability of the check payment system, we strongly believe that the Federal Reserve has an obligation to protect non-consumer and consumer users of the check system alike.

Impact on controlled disbursement, positive pay and fraud prevention

Controlled disbursement services are widely used by businesses as an important cash  disbursement report enables treasury managers to borrow and invest at the more favorable rates generally available only earlier in the day. Federal Reserve regulations that carry out provisions of this act, if adopted, should not extend the current check presentment deadlines until later in the day. AFP has previously recommended that the Fed take no action that would reduce the usefulness of controlled disbursement. We strongly reiterate that position as it relates to possible consequences of the check truncation act.

Positive pay is the single best method for preventing check fraud. Corporates must view positive pay exception items to make pay or return decisions. The use of electronic images or substitute checks should facilitate and expedite, not impede, this process.

When a check is converted into an electronic image, it will not reflect the color or the background designs on the check. Fraud prevention safety devices may not be visible on the image. Opportunities to examine the original check during the clearing and return process will be reduced and corporate exposure to increased instances of fraud may result. The Federal Reserve and the banking industry should cooperate to develop new fraud prevention measures that counter the potential increase in exposures resulting from the check truncation process.

Standards and rules

The development and enforcement of standards and rules are critical to the widespread adoption and use of electronic services. Standards must be adopted for the image format, the size of the substitute check, and the length of time for check storage. A number of promising electronic initiatives have foundered because of the existence of multiple, proprietary formats or processes. We encourage the Federal Reserve to take an active role in creating a consensus on establishing these standards. Check truncation should not be implemented until the underlying framework has been put in place.

The Federal Reserve should have the responsibility to establish the rules implementing the check truncation act. It is important that representative user groups -- including the corporate community -- be included in the rule-making process.

Timeliness of the Assertion of Claims

AFP recommends that the Federal Reserve clarify the provisions of the act dealing with timely assertion of claims as they relate to each other and to the "reasonable time" and 30-day reporting requirements of UCC Section 4-406. According to draft Sections 4(c), 6(d) and 13, the UCC would apply to substitute and electronic checks except to the extent that it is inconsistent with the Act.

Specifically, the Federal Reserve should clarify whether the reporting requirements of UCC Section 4-406 would apply in addition to the requirements listed below:

• Under Section 9(a)(2), a consumer must submit a claim for a re-credit within 60 days after receipt of the bank statement.
   
• Under Section 9(b)(1) the consumer must submit detailed information, presumably within the same 60-day period.
   
• Under Section 9(b)(2), the bank may require that the consumer's submission be in writing, but the Section does not specify by when the bank may assert the requirement and by when the consumer must comply.
   
• Under Section 12(b), a claimant must give notice to the indemnifying bank within 30 days after the claimant has reason to know of the claim.

Another timeliness issue arises under Section 8(d), whereby a bank is relieved of indemnity liability when it produces the original check regardless of its delay in producing the check. If the customer has, pursuant to a judicial determination or otherwise, been compelled to pay the payee a second time, the bank should not be relieved of its indemnity obligation and should not be entitled to a refund when it is able to produce the check at a later date.

AFP appreciates the opportunity that the Federal Reserve has afforded our Association to participate in the drafting phase of the Check Truncation Act. We would be pleased to answer any questions you have about this comment letter, and we look forward to participating in the May 17 meeting on the issue.

Sincerely,