Volume 42 | Number 3 Summer 2007
Recent International Developments in the Law of Negotiable Instruments and Payment and Settlement Systems
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The Check Payment as an Electronic Funds Transfer1
A. Introduction
By its nature, a check is an order to pay given by a customer to a bank with which the customer maintains an account. It is a paper instrument, embodying an unconditional order in writing, signed by a drawer, instructing a drawee bank to make payment to or to the order of a designated payee, or to the bearer.2 The person to whom a check is payable and who is in possession of the check is its holder.3 A check is issued when the drawer delivers it to the first holder.4 Once issued, a check may circulate from hand to hand, namely be negotiated, by delivery from one holder to another; in the case of a check payable to order, negotiation consists of delivery accompanied by the signature of the holder, called “indorsement.”5 To obtain payment, the last holder is to have the check physically presented to the drawee bank.6
Typically, a holder will not present the check to the drawee bank in person. Rather, the holder is likely to have the check deposited with and collected by a depositary bank, with which the holder maintains an account. The depositary bank will then either present the check directly to the drawee bank, or negotiate it to an intermediary bank. There may be one or more negotiations to one or more intermediary banks. The last intermediary bank will present the check for payment to the drawee. In that process, all banks other than the drawee, namely the depositary bank and each intermediary bank, are collecting banks, the drawee bank is the payor bank, and the collecting bank that presents the check for payment to the drawee bank is the presenting bank.7
The normal process thus entails a series of physical deliveries of the piece of paper embodying the check. First, the check is physically issued by the drawer to the first holder. Second, there may be one or more physical negotiations outside the banking system. Third, there is the physical delivery of the check by the holder to the depositary bank. Fourth, there may be one or more deliveries of the check to intermediary bank(s). Fifth, the process concludes with a physical presentment of the check to the drawee. Following payment, there is possibly a sixth and post-concluding stage, in which the cancelled check is delivered by the payor bank to the drawer, together with the periodic statement containing it. Conversely, where the drawee dishonors the check, the check is returned in a reversed itinerary.
Modern law facilitates variations by agreement; as may be necessary it may further provide for the position of third parties under the law of checks where such variations have been agreed. First, a check may be given as a source of information to be used to initiate a one-time electronic fund transfer, in which case it is often described as an “electronic check.” Second, a check may be remotely created. Third, a check may be negotiated to a collecting bank, whether by its customer the holder, or another collecting bank, by means of electronic transmission. Fourth, a check may be presented for payment electronically. At the same time, no practice of electronic negotiation to non-banks has developed so that no provision for such electronic transmission has been made.
As a source of information, a check may be given to the payee with the authority to convert it to an electronic image. A remotely created check is drawn by the payee, as an agent of the drawer, on the basis of information provided by the drawer to the payee, typically, over the telephone. Both electronic negotiation and presentment consist of the transmission of an electronic image instead of the physical transfer of the paper check. In the United States, inter-bank transmission of check images takes place over dedicated telecommunication channels, provided by both Federal Reserve Banks,8 and the private sector.9
All four procedures involve check truncation, namely a procedure in which the “physical movement of [checks] is curtailed or eliminated, being replaced, in whole or in part, by electronic [transmission of information].”10 Inasmuch as it constitutes the transmission of payment information other than by the delivery of paper check, each of the four procedures results in an electronic funds transfer for the pertinent stage of the check transaction. The ensuing discussion will outline proposed and existing legislative and regulatory frameworks to govern all four procedures. It will commence with the “electronic check,” discuss the remotely created check, move on to the electronic presentment, and conclude with the electronic negotiation, the latter being the most elaborate scheme.
To a large extent, these variations reflect a partial conversion of the check collection process to an electronic funds transfer. To that end, one may roughly describe the process as a whole as the “dematerialization” of the check, or perhaps better, as its immobilization,11 namely the substitution of any stage in its physical transfer, by the transmission of its information or electronic image. By analogy then, the entire transformation of the paper-based payment system into an electronic funds transfer may be viewed as the “decertification” of the check. In the process, the law of checks is being transformed into the law of electronic funds transfers. The ensuing discussion covers developments in the legal framework for each of the four variations outlined above; it does not go as far as to introduce an overall theory encompassing the entire transformation process.
B. The “Electronic Check”: Check as an EFT Authorization
On occasion, a check may not be “issued” so as to give the payee rights thereon to enforce payment in discharge of the underlying obligation;12 rather, contrary to the usual presumption of conditional payment by check,13 a check may be given to the payee merely as a source of information to be used to initiate a one-time electronic fund transfer from the drawer’s account in payment of the obligation. The check is then used as a source document to collect the drawer’s routing number, account number, check’s serial number and the sum payable. In effect, the check is thus converted to a single debit entry which is then input to the ACH (Automated Clearing House) Network. This arrangement is particularly common in consumer transactions. Where the check is mailed to the payee-merchant, the check is converted to an ARC—Accounts Receivables Entry. Where the check is given to the payee-merchant in a face-to-face transaction the check is converted to a POP—Point-of-Purchase Entry. Once converted, the check itself is voided; in a face-to-face transaction it is typically returned to the consumer-drawer.14
The electronic image created by the merchant, usually at the point-of-sale, is often colloquially referred to as an “electronic check.” In fact this is a misnomer; what is generated on the basis of the information derived from the check is not a “check” but rather an ACH debit entry. Payment is then not governed by UCC Articles 3 and 4, but rather is brought into the ambit of Regulation E, issued by the Federal Reserve Board, governing consumer electronic fund transfers.15 Regulation E requires the merchant to “provide a notice that the transaction will or may be processed as an electronic fund transfer, and obtain a consumer’s authorization for each transfer.”16
It should, however, be pointed out that in principle there is nothing to preclude the issue of a paper check by a drawer-buyer of goods or services in payment or discharge of the obligation to the payee-merchant17 and its subsequent electronic presentment to the drawee bank by the merchant through the depositary bank. The banking operation involved may not be different than that of the current “electronic check” collection procedure as outlined above; and yet, it would be governed by the law of checks,18 in which case it is hard to rationalize any disclosure or authorization requirement as under Regulation E. Indeed, the check collection is a regular debit transfer; the “electronic check” collection scenario lends further support to the view that a separate law to govern check collection is outdated.
C. A Remotely Created Check
A remotely created check is typically generated when the drawer authorizes the payee to produce a check drawn on the drawer’s account. The drawer does not sign the check, which generally bears either the drawer’s printed or typed name or a statement as to the issue of the check under the drawer’s authority. The check is deposited by the payee at a depositary bank, under an agreement under which the payee warrants the drawer’s authority. Authorization to the payee is typically given over the telephone; the remotely created check is thus a useful mechanism to make a one-shot “last minute” and yet a timely payment.
The issue or creation of the remotely created check is a matter between the drawer and the payee. Its deposit is a matter to be agreed between the payee and the depositary bank. Obviously however, a customer will not authorize the drawee to honor any remotely created check that merely purports to emanate under that customer’s authority; the customer is not to be charged with checks not actually issued under that customer’s authority. Yet, inasmuch as remotely created checks do not bear signatures or other ready means to verify authority, they are vulnerable to fraud. In the absence of specific protection measures discussed immediately below, a drawee bank that pays a remotely created check thus pays it at its peril, bearing the risk of unauthorized payment out of a customer’s account.
Regulatory and legal response providing protection to the drawee bank against the fraud risk dramatically varies between Canada and the United States. In Canada, the Canadian Payments Association (CPA)19 prohibits the clearing of remotely created checks, or “tele-cheques” in the Canadian terminology.20 In the absence of a pre-existing written and signed authorization by the drawer, fraud, due to the inability of the drawee bank to verify the authority of its customer, is cited as the “key risk associated with a tele-cheque.”21 In short, protection is afforded to the drawee bank in the form of a ban on the practice.
In contrast, the remotely created check is an accepted practice in the United States. To protect the payor bank from the fraud risk, and still facilitate the use of the remotely created check, that otherwise may have not been honored by that bank, both the UCC22 and Regulation CC23 create transfer and presentment warranties. Thereunder, the depositary bank warrants that the remotely created check, which it is transferring or presenting, is authorized by the person on whose account the check is drawn. Loss caused by a check issued without proper authority of the person on whose account the check purports to be drawn thus falls on the depositary bank, which is the bank that dealt directly with the payee, who is the party that created the check.24 It is then up to that bank to shift by contract the risk to its customer, the payee, from whom the bank accepted the check for collection.
D. Electronic Presentment
Electronic presentment is provided for by UCC Section 4-110. Thereunder, the presentment of a check may be made pursuant to an agreement for presentment. “Agreement for electronic presentment” could be in the form of an agreement, clearing-house rule, or Federal Reserve regulation or operating circular.25 The agreement is to provide “that presentment . . . may be made by the transmission of an image of [a check] or information describing [it] . . . rather than delivery of the [check] itself.”26 The transmission of the image or information constitutes a “presentment notice”; its receipt is the actual presentment. Other elements that may be covered by the agreement for electronic presentment are “procedures governing retention, . . . payment, dishonor and other matters . . . .”27 Arguably, return procedures fall in the ambit of the agreement. An interbank voluntary agreement may be either bilateral or multilateral.28 In any event, per the language quoted above, “agreement for electronic presentment” under Section 4-110 may for example be constituted by means of a regulation or a circular issued by the Federal Reserve and thus may not be entirely consensual; this is however in line with UCC Section 4-103(b) under which “Federal Reserve regulations and operating circulars, clearing-house rules, and the like have the effect of agreements . . ., whether or not specifically assented to by all parties interested in items handled.”29
At the same time, the scheme that was introduced in England in 1996 appears to have stronger compulsory features. Under Section 74B of the Bills of Exchange Act,30 “a banker may present a cheque for payment to the banker on whom it is drawn by notifying him of its essential features by electronic means or otherwise, instead of by presenting the cheque itself.”31 However, in the final analysis, the option is not entirely in the hands of the presenting bank:
if, before the close of business on the next business day following presentment of a cheque under this section, the banker on whom the cheque is drawn requests the banker by whom the cheque was presented to present the cheque itself—(a) the presentment under this section shall be disregarded, and (b) this section shall not apply in relation to the subsequent presentment of the cheque.32
The obligations of a banker making and receiving an electronic presentment that has not been timely rejected are stated to “be subject to the same duties in relation to the collection and payment of the cheque as if the cheque itself had been presented for payment,” except that “[an electronic] presentment need not be made at the proper place or at a reasonable hour on a business day.”33
Along similar lines, a more detailed scheme was recently adopted in Sri Lanka.34 It goes further in containing the following elements. First, it specifically requires the electronic presentment of the check to consist of the transmission of its “image . . . along with . . . stipulated electronic payment information . . . .”35 Second, it limits the right to decline electronic presentment and request a physical one only in the case of technical failure.36 Third, it provides for an “image return document,” stated to “be deemed to be the cheque to which it relates,”37 to be returned to the presenting bank in the case of the dishonor of the check. Fourth, it provides for warranties and indemnities made by the banker making an electronic presentment as well as the banker issuing an image return document.38 Finally, and subject to “rules, directions or instructions issued by the Central Bank,” the scheme authorizes its implementation by means of interbank agreements, “including those in the form of clearing house rules.”39
Electronic check presentment is now on the legislative agenda in Canada. A proposal of the Canadian Payments Association (CPA)40 to amend the Bills of Exchange Act41 follows the English precedent42 and further clarifies43 that electronic conversion does not trigger statutory provisions dealing with lost44 or intentionally cancelled instruments.45 There is however no provision dealing with a “fallback” to physical presentment upon the failure of an electronic presentment or otherwise. An innovative aspect of the Canadian approach is the amendment of the standard definition of a check46 to include
digital data and a display, printout, or other output of that data, provided the digital data, display, printout or other output was created by or from digital imaging of such bill by or on behalf of a bank by a computer system conforming to bylaws, rules or standards of the Canadian Payments Association or from the application of another technology or process conforming to bylaws, rules or standards of the Canadian Payments Association.47
It is submitted that the expansion of the definition of “cheque” is an unsatisfactory aspect of the Canadian proposal. Certainly it is not necessary to attach to the data or its output all the attributes of a “cheque.” And, while the proposed definition is limited to data or output created “by or on behalf of a bank,” it is not limited to its transmission within the interbank check clearing system. A real statutory vacuum will thus be created for the transmission of the data or its output outside the interbank check clearing system.48 Furthermore, within the interbank check clearing system, there is nothing to preclude the use of such data or its output not for presentment, but rather for negotiation, for which there is no provision in the proposal. The treatment of electronic negotiation in the United States, discussed immediately below, is an indication to the further detail and complexity required for a fair statutory treatment of electronic negotiation.
E. Electronic Negotiation
The most elaborate statutory and regulatory scheme is that in the United States covering the electronic negotiation to a collecting bank. The scheme is governed by the Check Clearing for the 21st Century Act (Check 21 Act)49 and implemented by Regulation CC subpart D.50 In essence, the Check 21 Act authorizes a collecting bank to create a substitute check, being a paper reproduction of the original check, for further negotiation or presentment. Upon compliance with specified requirements, the substitute check is to become “the legal equivalent of the original check for all purposes.”51 The Check 21 Act further includes warranty and indemnity provisions, as well as expedited re-credit procedures, designed to protect substitute check recipient.52
In practice, the creation of a substitute check by a collecting bank is predicated upon the existence of two preconditions. First, the creating bank must have received the transmission of an image of the original check instead of the check itself. Second, to receive the substitute check the bank must have not agreed to accept electronic transmission of an image.
The sender of the transmission of the original check image could be either a customer, the payee-holder of the check, or a collecting bank. Either way, the creating bank is a collecting bank; it is the depositary bank where the sender is the customer, and an intermediary bank where the sender is a prior collecting bank. On its part, the bank to receive the substitute check is typically a small bank that does not have the required processing equipment. It could be either a subsequent intermediary bank or the drawee bank.53
Stated differently, the Check 21 Act does not require banks to accept electronic transmission of check information or image. Rather, it requires a collecting bank that agreed to accept the electronic transmission, whether from its customer or a prior collecting bank, to issue a substitute check, to be processed onward as if it were the original check. A bank, either a subsequent collecting/intermediary bank or the drawee bank, must accept the substitute check as the equivalent of the original check. By the same token, a customer who received original checks with the periodic statement cannot object to receiving substitute checks in lieu of original checks that have been so truncated in the collection process.54
In practice, by truncating the paper check, the Check 21 Act eliminates long-distance transport of physical checks, though effectively it does not eliminate or bypass intra-city or local transportation for paper. The following hypothetical example will demonstrate the circumstances governed by the Check 21 Act. Suppose Drawer has a bank account with a Payor (drawee) Bank in New York. Drawer sends a check drawn on that account to Payee in California who deposits the check in Payee’s account with a California Depositary Bank. The latter is a large institution that has equipment for the transmission of the image of the check. At the same time, Payor (drawee) Bank is a small institution that does not have processing equipment capable of receiving the electronic transmission of a check. There is nothing in the UCC, the Check 21 Act, or anywhere else, to force Payor (drawee) Bank to accept electronic transmission; hence, electronic presentment is not an option for Depositary Bank. Rather, Depositary Bank may transmit the image of the check to an Intermediary Bank in New York, which is capable of accepting such transmission.55 In effect, this is an electronic negotiation of the check. Having agreed to accept the electronic transmission, the New York Intermediary Bank is now required under the Check 21 Act to create a paper substitute check. The Act further requires Payor (drawee) Bank to accept the presentment of the substitute check as if it were the original check. Finally, any requirement, either by statute or agreement, to provide the canceled check, as under the contract between Drawer and Payor (drawee) Bank, is to be satisfied, under the Check 21 Act, by providing the substitute check.
In that hypothetical example, coast-to-coast physical transportation was eliminated; only local delivery of the substitute check in New York was not avoided.
A substitute check is a paper production of the original check that contains the image of the front and back of the original check, bears a MICR line containing information appearing on the MICR line of the original check, conforms, particularly in paper stock and dimension, with generally applicable for substitute checks, and is suitable for automated processing in the same manner as the original check.56 To be the legal equivalent of the original check, a substitute check must “accurately represent . . . all of the information on the front and back of the original check as of the time the original check was truncated” and bear the legend: “This is a legal copy of your check. You can use it the same way you would use the original check.”57
As in the example above, a substitute check is typically created by a collecting intermediary bank. It, however, can also be created by the depositary bank, where it agreed to receive the deposit of the check from the payee by means of electronic transmission. Furthermore, a substitute check may be created even by the payee/holder; such would be the case for a large organization that receives checks in various locations but would rather deposit them in one place. The organization may then arrange for the electronic transmission of check images to one place where substitute checks will be created for deposit. In general, a check could be transformed from electronic form to substitute checks form several times in the course of the collection and return process.
In connection with a substitute check, the Check 21 Act provides for warranties and an indemnity. The warranties are, first, that the substitute check meets the requirements for legal equivalence, and second, against double payment on the original check or any other representation of it.58 The indemnity is “to the extent of any loss incurred . . . due to the receipt of a substitute check instead of the original check.” Other than for costs, expenses, and reasonable attorney’s fees, the amount to be indemnified is to the extent of loss proximately caused by the breach of warranty. In the absence of a breach of a warranty amount of indemnity is limited though to the amount of the substitute check. Either way, amount of loss to be indemnified is reduced by amount representing loss resulting “from the negligence or failure to act in good faith on the part of an indemnified party.”59 An example of loss incurred notwithstanding the lack of any breach of warranty is the case where forgery, proof of which would have allowed a purported drawer to avoid liability, cannot be proved on the substitute check, but allegedly could have been proved on the original.
Substitute check warranties are given by each bank “that transfers, presents, or returns a substitute check and receives consideration for the check.”60 In turn, indemnity liability is incurred by “[a] reconverting bank and each bank that subsequently transfers, presents, or returns a substitute check in any electronic or paper form, and receives consideration for such transfer, presentment, or return . . . .”61 A “reconverting bank” is defined as “the bank that creates a substitute check” or where “a substitute check is created by [the depositor], the first bank that transfers or presents [the] substitute check,” namely, the depositary bank.62 Surprisingly, the reconverting bank is not listed as one of the warrantors; it can hardly be described as a “bank that transfers . . . a substitute check,” unless “transfer” is to include the first delivery or issue; this indeed appears to be the view of the Federal Reserve.63 In any event, the reconverting bank is listed as one to become liable to indemnify for loss caused by the breach of warranty.
As indicated, a substitute check need not necessarily be created by a bank; rather it may be by a person other than a bank, typically a large organization-payee. In such a case warranties and indemnity liability emanate under the Check 21 Act not from the payee, the creator in fact of the substitute check, but rather from the first bank that transfers or presents such substitute check; such a bank, being the depositary bank, is then considered to be the “reconverting bank” in the collection process.
Both substitute check warranties and the indemnity are stated to run to the benefit of the transferee, any subsequent collecting or returning bank, the depositary bank, the drawee, the drawer, the payee, the depositor, and any endorser.64 Since a check could be transformed from electronic form to substitute checks form several times in the course of the collection and return process, it is possible that there could be multiple substitute checks, and thus multiple reconverting banks, with respect to the same payment transaction. A subsequent participant may thus benefit from warranties and indemnity of more than one reconverting bank. As well, a collecting bank receiving an electronic representation of a substitute (rather than original) check will both receive and pass on the reconverting bank’s Check 21 Act warranty and indemnity protections.
The Check 21 Act further contains provisions covering expedited re-credit for consumers65 and banks. First, Section 7 permits a consumer to challenge a debit for a substitute check either where the check was not properly charged to the consumer’s account or where the consumer has a warranty claim. In each case the consumer must have suffered a resulting loss and the production of the original check or a better copy of it is necessary to determine the validity of the challenge or claim. Second, Section 8, governs a claim by a bank that is obligated to provide an expedited re-credit to the consumer or that has otherwise suffered loss, in circumstances where “production of the original check . . . or a better copy of [it] is necessary to determine the validity of the charge to the customer account or any warranty claim connected with such substitute check.”66 The claim is a claim for indemnity from another bank that incurred the indemnity liability to the claimant bank under Section 8.67
The Check 21 Act allocates losses only among banks that handle a substitute check. However, it is possible that the problem giving rise to liability under the Check 21 Act was created prior to the creation of a substitute check; for example, electronic information derived from the check may have consisted of a poor image of the original check, which would preclude the reconverting bank from creating a legally equivalent check, and thus caused it to be in breach of a substitute check warranty. Or else, a substitute check created by the payee and deposited at the depositary bank may have been deficient in one way or another. At the same time, neither warranties nor indemnity liabilities are provided in the Check 21 Act in connection with the electronic transmission of check image or information. Similarly, no warranties or indemnity liability are fastened on a payee that creates a substitute check. Responsibilities of transmitters of electronic information and depositors of substitute checks are thus to be provided by their respective contracts with the immediate recipients of electronic information and substitute checks. This indeed is quite consistent with the overall position under the Check 21 Act, under which no bank is to be required to receive electronic transmission of check data and no depositary bank is under an obligation to accept for deposit substitute checks. Having nevertheless agreed to accept such information or substitute checks, it is up for the collecting banks to do so under contractual arrangements that provide them with adequate protections.
However, contract is not the exclusive source of regulating responsibilities outside the Check 21 Act; under Regulation J, a sender of an electronic item derived directly from the original check makes two sets of warranties for the electronic item. First, the sender makes transfer warranties as if the item was a paper check governed by the UCC. Second, the sender makes warranties as if the item were a substitute check governed by the Check 21 Act.68 For checks handled by Reserve Banks governed by Regulation J an end-to-end combined UCC and Check 21 liability structure is thus provided.69
In the final analysis, however, by reconverting an electronic image to a new piece of paper, Check 21 Act is a step backward in the process of the “immobilization” of the check.70 Rather, the Act implements the “materialization” or “certification” of the electronic image. The Act reflects a legislative policy of not forcing banks either to have their check processing facilities automated, or to outsource or contract out the function of automated processing, whether to a large bank, or a third-party processor. The result is a move away from an EFT payment, at the additional cost of a complex piece of legislation with no counterpart anywhere else in the world.