Check 21

Originally published: Aug-19-2004

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Its Impact on U.S. Businesses

On October 28, 2004, the Check Clearing for the 21st Century Act, more commonly referred to as Check 21, will go into effect. Enacted by the U.S. Congress in October 2003, Check 21 is designed to increase the efficiency of the check clearing process and mitigate the risks of potential threats or disasters effecting the nation’s transportation system. Although it speaks directly to banks and financial institutions, as the provisions of Check 21 are implemented businesses across the board will be impacted.

Purpose and Provisions of Check 21

One result of the terrorist attacks of 9/11 was a disruption in air travel. Since check processing relies heavily on the transfer of paper documents via the transportation system, this caused a significant delay in check payments across the United States. This not only effected commerce but the delay in clearing checks also opened the doors for increased check fraud. Check 21 is, in part, a response to an apparent weakness in the current system revealed by the attack.

The Check 21 bill (H.R. 1474), drafted by the Federal Reserve and supported by the American Bankers Association, has three main purposes:

1. To improve the overall efficiency of the Nation’s payment systems;
2. To facilitate check truncation by authorizing substitute checks;
3. To foster innovation in the check clearing system without mandating the use of electronic checks.

It attempts to achieve these ends by:

1. Permitting checks to be truncated at any point in the check clearing process; and
2. Authorizing a new negotiable instrument called a "substitute check".

Truncating a check refers to stopping the movement of the paper check through the banking system and converting it into an electronic image which then becomes the legal equivalent of the original check. Thus, eliminating the reliance on road and air transportation and moving the check through the system much faster.

In the industry, the electronic version of the check is called an IRD (image replacement document). The substitute check is a paper reproduction of the IRD. Under the provisions of Check 21, substitute checks are the legal equivalent of the paper check if they meet certain requirements. They must:

• Contain images of the front and back of the original check.
• Conform to industry standards and physical characteristics of a check, including providing the MICR (magnetic ink character recognition line).
• Accurately represent all information on the original check.
• Bear the legend: "This is a legal copy of your check. You can use it in the same way you would use the original check."
• Include all endorsements.
• Include the identification of the party creating it.

The substitute check will look similar to the original, but does not have to look exactly like it. For instance, it would not include the background colors or images on the original check and may not be the same size.

Check 21’s Impact on Businesses

Checks will clear more rapidly. This should translate into improved notification of NSF checks. Keep in mind that accounts payable and payroll accounts will see a much quicker outflow of cash. And, although faster processing should result in your company having access to its incoming funds more quickly, this may not necessarily be the case since the law does not reduce the holding period on funds credited to your account.

You will not have access to your original check. Check 21 disallows any party from insisting on receiving the original paper check. Because it is a federal law, it preempts state laws that allow account holders to insist on the return of their original check. Also, the only electronic version of your check that has the same legal effect as the original is the substitute check. You should, therefore, request your bank return substitute paper checks with your monthly statement of accounts.

Some means of fraud protection and detection will be lost. Fraud detection features, such as watermarks and microprinting will not survive the conversion from original to image to substitute. And, handwriting experts will not be able to utilize the substitute for examination of pen pressure, etc.

Banks fees may increase. Although banks should save on processing fees by utilizing electronic processing, they are not required to pass on the savings to consumers. And, service fees for providing substitute checks have not been capped.

Internal payment, record keeping and control processes should be evaluated. Lea Strickland, President of F.O.C.U.S. Resources, lists 10 areas that should be addressed before Check 21 goes into effect in her article "How Will Check 21 Impact Your Business?"

1. What controls currently exist for issuing checks?
2. Are you using duplicate (or triplicate) checkbooks?
3. Who can sign checks?
4. What is the procedure for verifying the amount of the check to the invoice?
5. How will you monitor your account between bank statements?
6. If you don’t request substitute checks with your statements: (a) How will you provide proof of payment in a dispute? (b) How will you monitor transactions for payment errors between statements?
7. What process will you use to minimize the risk of fraudulent transactions in your payment system? (Remember you have no control of the original paper check for detecting alteration or forgery.)
8. What will be your record keeping processes to support taxable transactions?
9. What will the bank account reconciliation process look like? (You may have a mix of electronic transactions, substitute check transactions, and original paper transactions.)
10. What will the impact be on your cash flow? Payments clearing more quickly, receipt of cash not increasing.

The U.S. financial world will not dramatically change at 12:00 a.m. on October 28, as some financial institutions are already converting paper checks into electronic transfers and others may take time to implement the new procedures. (Note that banks are not required to truncate checks, although they are required to accept substitute paper checks.) However, change is coming soon. Start making preparations now to reduce your risk under the new law.

Sources of In-Depth Information on Check 21

H.R. 1474 - Bill Summary and Status for the 108th Congress

Consumers Union (Nonprofit Publisher of Consumer Reports), "Questions and Answers About the Check Clearing for the 21st Century Act"

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