United States: Mississippi Regulatory Compliance Group February 2018 Quarterly Report Vol. 29 No. 1

Regulation CC Final Rule To Become Effective

At long last, the Federal Reserve Board issued a final rule amending Regulation CC – Expedited Funds Availability and Collection of Checks. Issued in June of 2017, the rule becomes effective July 1, 2018. As everyone knows, Reg. CC implements the Expedited Funds Availability Act of 1987 (EFA Act) and the Check Clearing for the 21st Century Act of 2003 (Check 21 Act) which dealt with prompt funds availability for deposited items and collection and return of paper checks and substitute checks. In this latest rule, the Board modified subparts A, B and C of the regulation to recognize today's environment in which almost all check collection and returns are handled electronically and to encourage all banks to receive, send, and return the few remaining paper checks electronically. In brief, the Board retained the current same-day settlement rule for paper checks, applied Reg. CC's existing check warranties under subpart C to checks that are collected electronically, and adopted new warranties and indemnities related to checks collected and returned electronically and to electronically-created checks. The changes will be particularly helpful in sorting out who is responsible for double presentment when a check is deposited via remote deposit capture (RDC) and (somehow by hook or crook) the original check is also deposited somewhere. In this article, we will provide a little background and then summarize the major changes contained in the new rule.

Background. As a refresher, Reg. CC is divided into subparts. Subpart A contains general information including definitions of terms. Subpart B specifies the times within which banks must make funds available for withdrawal and exceptions to those availability schedules, bank disclosure requirements for their funds availability policies, and payment of interest. Under the Dodd Frank Act, the Fed shares jurisdiction with the CFPB for writing subpart B. Subpart C implements the EFA Act's provisions regarding forward collection and return of checks.

The current provisions of subpart C presume that banks generally handle checks in paper form and include provisions to speed the collection and return of checks, such as the expeditious return requirements for paying and returning banks, authorization to send

returns directly to depositary banks, notification of nonpayment of large-dollar returned checks, standards for check indorsement, and pecifications for same-day settlement of checks presented to the paying bank.

The Check 21 Act, which became effective in October 2004, facilitated electronic collection and return of checks by permitting banks to create a paper "substitute check" from an electronic image and electronic information derived from a paper check. The Check 21 Act authorized banks to provide substitute checks to a bank or a customer that had not agreed to electronic exchange.

Return Requirements. Regulation CC requires a paying bank that determines not to pay a check to return the check expeditiously. Under the current rule, a paying bank must return the check under either the "two-day test" or the "forward-collection test."  A paying bank may send a returned check either directly to the depositary bank or to any bank agreeing to handle the return expeditiously. The current rule also requires a paying bank that decides not to pay a check of $2,500 or more to provide a notice of nonpayment to the depositary bank in a manner so that the notice is received by the depositary bank within the same "two-day test" timeframe for editious return.

Of course, the original rule was written at a time when check processing was almost entirely paper-based. Today, check clearing is almost entirely electronic. The Fed says that by the beginning of 2017, more than 99.99 percent of checks received by Fed. Reserve Banks were received electronically from 99.06 percent of routing numbers and over 99.99 percent of checks were presented to paying banks electronically to over 99.76 percent of routing numbers. A small portion of check returns, however, are still conducted using paper. By the beginning of 2017, Fed. Reserve Banks received 99.63 percent of returned checks electronically from over 99.37 percent of routing numbers and delivered 99.41 percent of returned checks electronically but to only 92.84 percent of routing numbers. I guess there are still a few holdouts.

In the final rule, the Board required all returned checks, both paper and electronic, to satisfy a modified version of the "two-day test." They must be returned in an expeditious manner so that the check would normally be received by the depositary bank not later than 2 p.m. (local time of the depositary bank) on the second business day following the banking day on which the check was presented to the paying bank. The Board also added a new condition for expeditious- return liability, saying that a paying bank and returning bank may be liable to a depositary bank for failing to return a check in an expeditious manner only if the depositary bank has commercially reasonable means in place for receiving check returns electronically, either directly or indirectly through an intermediary or correspondent. The Board believes this will provide incentives to depositary banks to receive electronic returns by preserving their ability to make a claim that a check was not returned expeditiously only if they actually receive electronic returns. The final rule also provides that if a paying bank decides not to pay a check of $5,000 or more (up from the current $2,500 threshold), it must provide a notice of nonpayment in a manner so that the notice would be received by the depositary bank by 2 p.m. (rather than the current deadline of 4 p.m.) on the second business day following the banking day on which the check was presented to the paying bank.

Same-Day Settlement. Currently, Reg. CC a paying bank to provide same-day settlement for checks presented in accordance with reasonable delivery requirements established by the paying bank and presented at a location designated by the paying bank by 8 a.m. (local time of the paying bank) on a business day. A paying bank may not charge presentment fees for checks—for example, by settling for less than the full amount of the checks—that are presented in accordance with same-day settlement requirements. In its final rule, the Board retained the current same-day settlement rule, with only minor technical changes.

Electronic Check Collection and Returns. Currently, Subpart C applies only to paper checks, so the provisions regarding acceptance of returned checks, presentment, and warranties do not apply to electronic images of checks ("images") or to electronic information derived from checks ("electronic information"). Presently, the collection and return of images and electronic information are governed by agreements between the banks which may be in the form of the Federal Reserve Banks' operating circular, for items cleared through the Fed, or a clearinghouse agreement, like the ECHHO rules. The agreements often include, among other terms, warranties for electronic checks similar to those made for substitute checks under the Check 21 Act ("Check-21-like warranties").

In the final rule, the Board amended subpart C to create a regulatory framework for the collection and return of electronic images and electronic information. The Board defined the terms "electronic check" and "electronic returned check" as an electronic image and electronic information derived from a check or returned check. The Board also applied the provisions of subpart C to banks that send and receive these items by agreement as if they were checks, unless otherwise agreed by the sending and receiving banks. So, subpart C will generally apply to all electronic checks,but clearinghouse rules may still override it.

The Board also applied existing paper-check warranties and the Check-21-like warranties to electronic checks and electronic returned checks. The existing paper-check warranties include the returned-check warranties; the notice of nonpayment warranties; the settlement amount, encoding, and offset warranties; and the transfer and presentment warranties related to a remotely-created check. The Check-21-like warranties include warranties that a bank will not be asked to pay an item twice and that the electronic image and electronic information are sufficient to create a substitute check. These warranties ensure that a bank that receives a check for collection, presentment, or return receives the same warranties regardless of whether the check is in paper or electronic form.

The Board also added new indemnities for electronically-created items, which are check- like items created in electronic form that never existed in paper form. Electronically created items can be difficult to distinguish from electronic images of paper checks. The final rule defines "electronically-created item" to mean an electronic image that has all the attributes of an electronic check or electronic returned check but was created electronically and not from a paper check. Under the final rule, a bank transferring an electronically-created item indemnifies each transferee bank, any subsequent collecting bank, the paying bank, and any subsequent returning bank against any loss, claim, or damage that results from the fact that the image or information was not derived from a paper check. The rule also limits the amount of the indemnity to the amount of the indemnified bank's loss, not to exceed the amount of settlement or other consideration received by the indemnifying bank plus interest and expenses of the indemnified bank

(including costs and reasonable attorney's fees and other expenses of representation). The Board also adopted new indemnities for losses due to the fact that: (1) the electronically-created item was not actually authorized by the account holder, or (2) a subsequent bank pays an item that has already been paid. The Board believes that these indemnities will provide basic protections for banks handling electronically-created items that are unauthorized or presented more than once.

Finally, the Board added a new indemnity for remote deposit capture that would indemnify a depositary bank that takes an original paper check for deposit which is then returned unpaid because the check was previously deposited using a remote deposit capture service and the image was paid by the paying bank. The Board believes this places the risk on the bank that is in the best position to prevent multiple deposits of the same item, namely, the bank taking the imaged deposit via RDC. The indemnity is limited to the consideration received by the indemnifying bank plus interest and attorneys fees and expenses. The Board added an exception to this indemnity that will prevent an indemnified bank (the bank taking the original paper check for deposit) from making an indemnity claim if the paper check it accepted contained a restrictive indorsement that is inconsistent with deposit of the physical check, such as an indorsement "for mobile deposit only." Banks utilizing remote deposit capture will want to be sure they have appropriate provisions in their customer agreements and procedures in place for making sure that before sending the image to the bank, the RDC customer indorsed the original check in a way that will help prevent deposit of the original paper check.

We will discuss these changes and more at the quarterly meeting.

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