ECCHO Insights What s a Rule 8 What s a Rule 9

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1 April 15, 2011 ECCHO Insights What s a Rule 8 What s a Rule 9 Kevin Cranford Vice President BB &T Phyllis Meyerson Executive Vice President ECCHO

2 Background Today s Agenda Price v Neal Clearing House Rules Rule 8 Regulation CC Rule 9 Warranty Opt-Out Process Should you Participate in Rule 9 2

3 Rule 8 & Rule 9 Why are these rules referred to as Rule 8 and Rule 9?? We ll get to that in a minute What Section of the ECCHO Rules contain Rule 8 and Rule 9 Section XIX(N) and XIX(O) respectively 3

4 1762 English Case Price v Neal Ruling by Lord Mansfield Nobody knows the hand of the drawer but the Plaintiff Negligence in the Plaintiff is greater than can possibly be imputed to the defendant Where the loss has fallen, there it must lie One innocent man must not relieve himself by throwing it on another 4

5 Price v Neal Outcome Person who can verify signature assumes loss on unauthorized checks Under UCC paying bank, is holder of signature cards The forger was hanged 5

6 Why Need for Rule Depositor Strong Incentives to take check Merchant in best position to verify identification UCC creates risk free transaction if forged signature since risk is transferred to paying bank Depositor recoups costs, makes profit Depositor decision cause paying bank losses 6

7 Relevance of Old Law As Law Does not reflect how society s payments systems operates Unnecessarily exposes banks (as paying bank) to fraud losses Best defender is party who give value Underlying justification for Price v Neal is essentially obsolete Fraud controls in 1762 England Eyewitness identification Signature verification Extreme punishment No photo ID s 7 No thumbprint signature

8 Current Processing Modern Check Processing MICR encoding checks serve as carrier of electronic data Image only furthered electronification of check Subsequent to BOFD, checks rarely touched by human hand No human eye examines written information Minimum signature verification Signature verification has been made defunct New technologies MICR Image Volume demands of business commerce Definition of Ordinary Care in 1990 version of UCC..does not require a bank to examine an instrument.. 8

9 UCC Warranties Transfer warranties not to Paying bank No forged endorsements No alterations No unauthorized signatures Customer Company BOFD Intermediary/ Collecting Bank Paying Bank 9

10 UCC Warranties Presentment warranties given to Paying bank No forged endorsements No Alterations No knowledge of any unauthorized signatures Paying bank Cannot make claim for counterfeit/unauthorized item after midnight deadline Can make claim for altered item after midnight deadline Intermediary/Collecting Bank Company BOFD 10 Customer Paying Bank

11 Clearing House Rules Fraud personnel worked within clearing houses to move risk Attempted to move risk outside banking industry Clearing House rules can vary UCC In mid 1990 s California paper clearing house Developed rules for unauthorized unsigned draft (Rule 8) Developed claim process that mirrored ACH Worked with state legislator to modify UCC 11

12 Clearing House Rules Texas through its clearing house developed similar rule for signed items (Rule 9) Rule 8 & 9 were implemented in clearing houses all over the country Eventually included in National Uniform Paper Rules Incorporated in ECCHO rules for image exchange 12

13 Rule 8 Remotely Created Checks Initially included in clearing house rules During RFC on Check 21 changes to Reg CC Fed requested input on including RCC warranty in Reg Industry extremely supportive Updated Reg CC for RCC 2006 Regulation CC Definition of Remotely Created Check Check that is not created by paying bank and that does not bear signature applied or purported to be applied, by person on whose account check is drawn 13

14 Rule 8 Definition of RCC does not include Check created by paying bank (e.g. bill payment service) 5 RCC Warranty Claim 1 Bill Pay 4 Company 3 Deposit Unsigned Draft BOFD 3 3 IMAGE IMAGE Intermediary Bank Paying Bank Unauthorized Consumer Customer 14 2 Unsigned Draft

15 Regulation CC Warranty in Section (d) Bank that sends RCC and receives settlement warrants to other banks, that person on whose account RCC is drawn authorized issuance of check in amount stated on check Reg CC did not establish a process for RCC claim Claim process FRB services established adjustment type for RCC sent through Fed Bank has 90 days from settlement of cash letter to make claim Signed affidavit accompany claim No ability to disclaim 15 Rule 8

16 Rule 8 Claim process ECCHO rules Process within ECCHO rules use return mechanism (Section XIX(N)) but is not return Detailed process similar to Rule 9 and discussed later Adjustment process for unauthorized RCC mirrors Fed claim (Section XII and Adjustment Matrix) Similar to Fed Not allowed to disclaim adjustment Rule 8 Definition and warranty in Reg CC Claim process within OC3 and ECCHO Rules 16

17 Uses of RCCs Should RCCs be Used Recent Fed study says 2% of checks are RCCs Concern in industry over potential fraud with use of RCC Fraudsters known to use RCCs Potential high return rates Regulatory penalties to banks that did not recognize fraudulent RCC use Regulators issued guidance to banks on use of RCCs Use ACH rather than RCC Legitimate uses of RCC Banks that do not accept ACH Transactions not eligible for ACH Desire to maintain as check transaction, including midnight deadline for return Ability to give same day credit for late payments 17

18 Fully Electronic RCC Fully Electronic RCCs RCCs expected to be printed and then imaged for collection as check images But.processors/vendors may skip the print and image steps Format the electronic record as if it were an image of a paper check Results in creation of fully electronic check» Check that never existed in paper form Skipping paper step reduces expense, improves quality and creates a more efficient process Banks cannot easily identify and/or stop these RCC as either BOFD or as Paying Bank 18

19 Fully Electronic RCC Authorization PRINT & CAPTURE CUSTOMER COLLECTING BANK (BOFD) Authorization DEPOSIT 19 CUSTOMER COLLECTING BANK (BOFD)

20 Poll Question Poll Question #1 Does your bank actively participate in Rule 9? Yes No Don t know 20

21 Poll Question Poll Question #2 What area of your bank handles outgoing Rule 9 claims? Adjustments Returns Fraud Customer Service Other 21

22 Poll Question Poll Question #3 What area of your bank handles incoming Rule 9 claims? Adjustments Returns Fraud Customer Service Other 22

23 Rule 9 Forged and Counterfeit Check Warranties Section XIX(O) Generally referred to as Rule 9 Sending Bank (that is BOFD) warrants Signature of purported drawer is not forged or otherwise unauthorized, and Related Physical Check is not counterfeit Warranty only applies to exchanges under ECCHO rules ECCHO rules only cover image exchanges Warranty begins with BOFD and is made to each member in forward exchange If bank accepts deposit from foreign bank, while BOFD under Reg CC, does not make warranty under ECCHO rules Warranty does not apply if non-eccho member exchange Warranty does not apply for exchange through Fed Warranty does not apply to paper exchange Rule 9 may apply to paper exchanges, if exchanged under paper rules that include Rule 9 provision 23

24 Rule 9 Forged and Counterfeit Check Warranties Section XIX(O) Rule 9 is an interbank warranty and does not provide Sending bank with authority to debit its customer s account Authority to debit customer account governed by applicable law including deposit agreement BOFD does not maintain loss, if depositing customer does not have funds in account Sufficiency of funds provision allows BOFD to disclaim if claim exceeds available funds on at least one day Only required to review account once If funds in account, BOFD liable to paying bank for amount even if bank chooses not to charge customer No funds, loss moves back to paying bank 24

25 Opt-Out Participation is default in ECCHO Rules Opt-out permitted Unless member subject to agreement that makes rule mandatory Currently less than ten (10) ECCHO members out of over 3,000 have opted out Opt-out members listed on ECCHO website Process for opt-out Communicate to ECCHO by authorized representative ECCHO to communicate effective date of opt-out If opt-out is cancelled (default back to participation under the rules), cannot elect to opt-out again for 6 months Complete description of process on website 25

26 26 Opt-Out Why allow for Opt-out Still controversy over rule Disagree with shifting liability to BOFD More risk Mixed legal opinions Would like to reverse Price v Neal No funds sufficiency requirement BOFD takes risk Like in ACH and other payments Some believe rule is discriminatory Question ability of clearing house rules to vary this aspect of UCC Finality of payment basic concept in check law and this allows return after midnight deadline BOFD in no position to know signature of paying bank customer

27 27 Mandatory Rule 9 Some Support for Mandatory Rule 9 Rule in effect for over 15 years with no litigation Original premise was paying bank had original check No longer case with image and IRDs Paying bank needs relief, since no longer has original check Paying banks post from MICR data with little to no review of check or check image Original rule was from risk perspective, now should consider operational perspective Rule 9 is pro-image

28 Claim Process Similar timing/process as RCC warranty claim (when using returns process Section XIX(N)) Paying Bank must make claim to BOFD via return process Use return mechanism, but actually adjustment Cannot send these claims through the Fed Return must contain notation of Breach of Warranty and/or Do Not Redposit or Re-Present or similar language Paying Bank may use reason code that reflects item is sent as warranty claim Image standards use return reason of 3 Warranty Breach Claim may be made via Electronic image Paper copy of front and back of electronic image Substitute Check 28

29 29 Disclaim - Rule 9 Sending Bank may disclaim warranty claim for Account closed Claim amount exceeds funds in account Claim was not made timely as defined in rules Sending Bank is not first bank to which check was transferred Opt-out in effect Other defenses as provided by other applicable law

30 Rule 9 Claim Process Rule 9 Claim Section XIX (O) Available $ to Cover Warranty Claim? Charge Customer -or- Disclaim Back to Paying Bank Statement Deposited Check IMAGE IMAGE Bank X Depositing Customer BOFD BOFD Requests Copy of WSUPP Within 15 Business Days of receipt of claim Paying Bank Sub Check or Paper Copy or IMAGE 30 Warranty Claim made directly to BOFD Within 15 Business Days of receipt of WSUPP Image, Paper Copy (front/back) or Sub Check Banks are all ECCHO Members

31 Rule 9 Decision Table Customer Claim Paying Bank If < 61 Days Send Affidavit To Paying Bank No E Yes If < 16 Days Send Claim to BOFD No E Yes BOFD If < 16 Days No Yes D Or Or A B C BOFD Paying Bank A Send Request for Affidavit to Paying Bank No Or Yes B C If < 11 Days Send Affidavit To BOFD No Yes Or C B C 31

32 Rule 9 Decision Table C BOFD Send disclaimer to Paying Bank Paying Bank Receives disclaimer E Paying Bank retains loss B BOFD If $s in Customer s Account Yes Or BOFD Debit customer & avoid loss (if claim received without entry, settle with Paying Bank) Customer not debited No C D BOFD has loss 32

33 Depositing Customer BOFD Disclaimer Or Request Copy Paying Bank Send Copy Drawing Customer 1 Rule 8 & 9 Timeline 60* Customer files statement within 60 calendar days Claim Deadline for breach of warranty claim 15 Business Days after receipt of customer statement. Settlement within 2 Business Days of claim Deadline for receipt of BOFD disclaimer or request for copy - 15 Business Days Deadline to provide copy 15 Business Days Claim Deadline to file disclaimer or request for copy of customer statement 15 Business Days after receipt of claim Deadline to file disclaimer may be extended 5 Business Days. If not received Dr customer s account Rule 8 Dr customer s account if account balance equals or exceeds amount of check Rule 9 Dr customer s account (Rule 8) if balance sufficient (Rule 9) 1 60* Time in Days 33 *60 days from availability of customer s statement 110

34 Challenges For Image Paying Bank Claim must be made to BOFD as return Claim cannot be made through Fed If bank returns through Fed, no mechanism to make claim Claim made through Fed may be rejected as late return Original rule required stamp to tell BOFD Rule 9 claim Stamp not practical in image, so allowed for return reason Return reason as either customer or administrative return of 3 Warranty Breach (includes Rule 8 & 9 claims) 34

35 Challenges For Image Disclaim process, still needs work Rules developed in local clearinghouses where exchanges typically in person and in reasonable proximity to one another When need to disclaim was exchanged between members Today with national image exchange environment members no longer in same geographic location Image exchanged through multiple banks and/or networks Rule 9 claim and disclaim cannot be made to intermediaries or Federal Reserve Claim must be made directly to BOFD How to disclaim to appropriate party 35

36 Challenges For Image ICL ICL Rule 8 /9 Warranty Claim $$ Receive Funds How & When?? Warranty Claim SWITCH $$ BOFD Dishonor Claim How?? Correspondent Paying Bank 36

37 Risks vs Benefits Banks typically act as both Paying Bank and BOFD Both banks have opportunity to make claim or claim made to it Balanced and fair rules to share risks by all members Paying bank Able to recover some money from the BOFD that would have previously been a loss Rules do not change way bank decides to reimburse customers for forged or counterfeit checks BOFD try to recover money from depositing customer for Paying bank Balance risk of customer relationship in charging back customer for Rule 9 claim Customer service impact has been negligible Recovering of funds paid from fraudulent item very positive 37

38 Risks vs Benefits Process For paying bank claim is outgoing items For BOFD claims are incoming items Returned deposited items for customer Average amount of items about $350 Millions of dollars savings based on Rule 9 claims over the years Only about 5% or less are disclaimed by BOFD Much greater chance item will be disclaimed if payable to individual Fraud has occurred at both Paying Bank and BOFD 38

39 Additional Information Will be Distributed after Session Exhibits from ECCHO Rules Disclaimer Form: Rule 8 and 9 Explanatory Charts for Rule 8 and 9 Process Events Timing Decisions Model Customer Written Statement for Warranty Claim under Rules 8 and 9 Coming Soon Document on Rule 8 and 9 by ECCHO 39

40 40 Questions?

41 April 15, 2011 Thank You! Kevin Cranford Phyllis Meyerson