Copyright 2016 by the Electronic Check Clearing House Organization

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1 National Check Payments Certification Program Series Training On Demand Session #1 Check Fundamentals and Check Processing NOTICES This training course may provide an introduction to or summary of various aspects of check payments and the legal and rules framework for check image exchange. Responsibility for compliance with image exchange rules, and/or the legal, operational and regulatory requirements applicable to check image exchange, remains at all times with the financial institution participating in check image exchange and/or the individual or company using a check image exchange service. This presentation and the information contained herein is not intended as legal or compliance advice or recommendation to any person or company. This document could include technical inaccuracies or typographical errors and individual users are responsible for verifying any information found in this presentation and related live webinar or webinar playback. Financial institutions should consult with their legal counsel regarding legal and operational requirements applicable to any check image exchange program they may offer orinwhich they participate. These materials may not be reproduced or published, in whole or in part, without the express permission of ECCHO. (Certain contributed content subject to third party copyrights) 2 1

2 Planning to Register? Free ECCHO / NCP study aids upon registration! JumpStart Reading Program o Links to all program resources NCP Roadmap o Direction on establishing a personalized study plan P.R.E.P. Guide o Training guide, glossary of terms, sample exam Question of the Day & Summary o New daily question & detailed answer to prior day s question with weekly summary Exam Fees: $400 ECCHO member $500 non ECCHO member Not sure about membership? o Check current status at: Enter financial institution name in search box on left 3 NCP P.R.E.P. Guide 300+ pages with suggestions for further study 35 question multiple choice exam Quizzes at the end of each section with Answer Key (example follows): Suggestions for Further Study Use of Check Images By Customers of Financial Institutions (July 14, 2006) The Role of Private Sector Rules and Federal Reserve System Rules in Check Image Exchanges (February 12, CheckImage Collaborative) ANSI X Magnetic Ink Printing (MICR) Part 1: Placement and Location (June 26, 2009) Uniform Commercial Code (UCC) Article 3 - Negotiable Instruments; Article 4 - Bank Deposits And Collections Regulation CC (12 CFR Part 229 Availability of Funds and Collection of Checks Review Questions The following questions are a review of key points covered in this section to be used to further aid in the study of these topics. See Section Four Exhibits ; Exhibit 10 for the Answer Key. Describe the check routing number in fractional form and define each part? The aux on-us field on a check is typically used for what purpose? What do Article 3 and Article 4 of the Uniform Commercial Code (UCC) cover? What does Federal Reserve Regulation CC implement? Register for exam with ECCHO to access the Guide 4 2

3 Session Topics Check Basics Need for Rules Check Payments System Overview Other Payment Systems Note: To prepare for the NCP Exam, it is recommended you review the entire training series Includes 11 sessions plus at least 1 recommended review session o For a complete training program listing, visit ECCHO s website at: 5 Check Basics 3

4 General Check Definitions Section will cover common definitions related to the check including: Amount Bank (general definition) o Collecting Bank o Depositary Bank o Paying Bank (also called Drawee in the UCC) Drawer Payee MICR line o Selected MICR line fields Other definitions discussed in subsequent sessions related to specific topics For additional definitions, see the current NCP P.R.E.P. Guide section titled Glossary of Terms and Common Acronyms P.R.E.P. Guide is included in the NCP exam registration 7 Blank Check Example Consumer Check 8 4

5 Processed Check Example Consumer Check 9 Parts and Parties to the Check Regulation CC Definitions ( 229.2) Bank: Includes ALL depository institutions as defined by: o FDIA Federal Depositary Insurance Act o FCUA Federal Credit Union Act o Includes: Insured commercial bank; Insured credit union; Mutual savings bank; Savings and loan association; or Agency or a branch of a foreign bank as defined in the International Banking Act o Note: Expedited Funds Availability (EFA) Act uses the term depository institution Collecting Bank: Any bank handling a check for forward collection, except the Paying Bank o Federal Reserve is collecting bank for items sent through the Fed; See Regulation J for more information 10 5

6 Parts and Parties to the Check Regulation CC Definitions ( 229.2) (continued) Depositary Bank: First bank to which check is transferred even though it may also be Paying Bank of payee (Reg CC definition) o Depositary Bank or Bank of First Deposit (BOFD) and Paying Bank may be the same bank for on us items Paying Bank: Bank by which check is payable, to which it is sent for payment or collection o Federal Reserve Bank (FRB) / Federal Home Loan Bank (FHLB) by which check is payable; or o Bank through which a check is payable, if check is not payable by a bank; or o State or unit of local government on which a check is drawn and to which it s sent for payment or collection 11 Parts and Parties to the Check UCC Definitions (Sections 3 103, 3 104, 4 104, 4 105) Amount: Part of definition of a negotiable instrument o Negotiable Instrument: Means an unconditional order to pay a fixed amount of money o Should appear twice on the check: Courtesy amount: Amount written in numbers May also be referred to as convenience amount Legal amount: Amount written in words Bank: Includes a savings bank, savings and loan association, credit union, or trust company Drawer: Person who signs, or is identified in a draft, as the person ordering payment Drawee: Bank or person ordered in a draft to make payment Item: An order to pay money that is handled by a bank for collection or payment o Does not include a payment order governed by Article 4A (Wire Transfer) 12 6

7 Parts and Parties to the Check UCC Definitions (continued) Depositary bank: First bank to take an item even though it is also the payor bank Payor bank: Bank that is the drawee of a draft o Bank ordered in a draft to make payment Intermediary bank: Bank to which item is transferred in course of collection o Except the depositary or payor bank Collecting bank: Bank handling an item for collection, except the payor bank o Federal Reserve Banks are collecting banks Presenting bank: Bank presenting an item, except a payor bank. 13 Parts and Parties to the Check Correspondent Bank: Financial institution that provides services on behalf of another financial institution Can conduct business transactions, accept deposits and gather documents on behalf of other financial institutions they serve under the correspondent agreement (respondents) o Example: Banker s bank (correspondent) and their members (respondents) 14 7

8 Processed Check Front 15 Processed Check Back Indorsers Depositary Bank DO NOT WRITE, STAMP OR SIGN BELOW THIS LINE 16 8

9 What is MICR? Magnetic Ink Character Recognition (MICR) 1956 Descriptive information comprised of numbers and symbols Magnetic ink printed characters that can be recognized at high speed by automated processing equipment E 13B Font Used in magnetic ink printing in USA, Canada and several other countries o Consists of ten numeric characters and four symbols MICR line at the bottom of physical check 17 MICR Line of a Check Six inch check Generally used for consumer checking accounts DRAWER NAME STREET ADDRESS CITY, STATE Payee s Name One hundred twenty-three and 45/ Drawer s Signature External Processing Code Field Optional 1 digit ABA Routing Number 9 digits, no spaces bounded by transit symbols Account Number and Serial Number 10 DIGITS 18 9

10 MICR Line Key Fields Six inch check Amount: 10 digit field On Us o Drawer s account number o Check serial number Routing Number o ABA assigned routing number for Paying Bank EPC External processing code o Optional, single digit field Provides information for handling or routing of the check or check data to financial institutions and other processors o New EPC code value added (effective 2015) for the remotely created check (RCC) identifier EPC value = 6 19 MICR Line of a Check Large check (longer than six inches) Generally used for business checking accounts 20 10

11 MICR Line Key Fields Business sized check Same fields as smaller six inch check Includes Aux On Us (optional field) o To the left of the Routing Field on the MICR line Used for: o Consecutive check serial numbers; or o Account control information; or o Product codes/information 21 Routing Number Used for all financial institutions in the U.S. Each FI has a unique number Some have more than one Two forms found on checks: MICR form Fractional form Both forms appear on most checks, although only MICR form is used in automated item processing 22 11

12 Routing Number MICR Form Called the ABA Routing Number May be referred to as: o ABA Number, Routing Transit (RT), Routing Transit Number (RTN) First two digits: Fed District location of Paying Bank and Type of Institution 3rd and 4th digits: Specific Fed bank or branch serving paying institution 5th through 8th digits: ABA number for paying bank 9th digit is RT number validation (Check digit) 23 Routing Number Fractional Form May be printed in one of two forms as shown here: OR 91 03/1221 Numerator Includes a city (1 49) or state (50 99) prefix followed by the ABA institution identifier Denominator is the Federal Reserve Routing Symbol ABA and Federal Reserve numbers match corresponding numbers in MICR form without leading zeros Additional letters or numbers may be printed if paying bank chooses 24 12

13 Example: Fractional RT ABA routing number: In MICR form, shown on the check s MICR line: 91-03/ Example Fractional RT To convert ABA routing number to fractional form: Drop check digit last number in ABA routing number Pick up city or state prefix 91 o Assigned by ABA ABA institution identifier 0003 o Drop leading zeroes o Separate with dash 1221 Federal Reserve routing symbol o Separate with slash / / / 1221 Generally pre printed on the check in upper right near the check serial number 13

14 Need For Rules Clearing Paper Checks UCC & Reg CC Provisions [Statutory and Regulatory] UCC, Reg CC & Payee s Deposit Agreement UCC & Reg CC & Correspondent Agreement UCC, Reg CC & Check Writing Agreement Payee (Merchant) Paper Check BOFD Paper Check Paying Bank Paper Check Drawer 28 14

15 Paper Check Law Applicable Laws and Regulations Impose warranties on financial institutions when transferring and presenting checks Together with case law form boundaries for most aspects of check processing Complemented by large body of court interpretations Provide guidance and understanding in check payment disputes 29 Recognized Role of Rules UCC [4 103(b)] Recognizes role of check clearinghouse rules and Federal Reserve Operating Circulars o May set forth additional provisions for paper check collection by financial institutions Reg CC [229.37] Recognizes role of check clearinghouse rules and Federal Reserve Operating Circulars o May vary some provisions of laws and regulations However may not fail to act in good faith or exercise ordinary care 30 15

16 Clearing Images Not Covered Under UCC or Reg CC What Rules or Agreements Apply? What Rules or Agreements Apply? What Rules or Agreements Apply? Remote Deposit Payee (Merchant) IMAGE IMAGE BOFD Key Considerations: Are the images authorized payments? When does legal presentment occur? Can the images be dishonored? Who is responsible for duplicates? Who is responsible for data security? What are the rights of the payee and drawer? Paying Bank IMAGE Drawer 31 UCC Updates UCC anticipated electronic check truncation/ image exchange 1990 revision ( 4 110) permits electronic presentment of items pursuant to an agreement for electronic presentment Agreement may be in the form of: o Check clearing house rules and/or o Federal Reserve regulation or Operating Circular 32 16

17 What Did Check 21 Do? Successfully encouraged and supported the rapid image exchange evolution by removing a key barrier to check truncation No longer required to obtain agreements from all parties to the transaction o Provides for replacement of paper check with substitute paper check o Allows unilateral decisions to truncate checks Does not mandate the receipt of electronic (image) transactions Only applies to the substitute check, but... Encourages image exchange Use image technology to create substitute check 33 Paper Check vs. Images Regulations vs. Rules UCC and Reg CC provide statutory and regulatory definitions for a paper check, but... No default definition of image in current check law Where is the image of a check defined? 34 17

18 Need for Rules There Are No Laws To Cover Exchange of Check Images Exchanging images in the absence of agreements exposes financial institution to an indeterminately large amount of risk o Potential for consequential damages Check Image Exchange Need agreements for exchanges through: o Federal Reserve or o Private sector 35 Check Rules, Regulations and Agreements Uniform Commercial Code (UCC) Developed with efforts towards uniform laws for sales and other commercial transactions in all 50 states Detailed Code Addressing Most Aspects of Commercial Law o Set of standardized state laws that govern financial contracts o Establishes general duty standards for parties to act in Good Faith and exercise Ordinary Care Organized as Articles o Each deals with a different subject area Article 3 covers negotiable instruments Article 4 cover bank deposits and funds transfers 36 18

19 Check Rules, Regulations and Agreements Code of Federal Regulations (CFR) Codification of the general and permanent rules published by the executive departments and agencies of the Federal Government Title 12 Banks and Banking o Part 229 Availability of Funds and Collection of Checks (Regulation CC) Reg CC implements legislation relative to: o Funds availability (EFAA) o Substitute checks (Check 21 Act) Awaiting updates to Reg CC at this time Following review of industry responses to two RFC proposals in 2011 and Check Rules, Regulations and Agreements Federal Reserve Regulations Regulation J Subpart A: Collection of Checks and Other Items by Federal Reserve Banks o Purpose is to provide rules for collecting and returning items and settling balances via the Federal Reserve Banks o Referenced by Fed OC3 Industry Image Rules FRB Operating Circulars o OC 3: Collection of Cash Items and Returned Checks o OC 5: Electronic Access Private sector clearing house rules (such as the ECCHO rules) Rules and regulations will be discussed in detail in other sessions 38 19

20 Image Exchange Rules Items defined as checks under Reg CC and items under UCC eligible for image exchange Covered by Fed OC3 and private sector rules such as ECCHO s rules US savings bonds now transmitted via image exchange Noncash items not eligible for exchange ECCHO Rules permit imperfect image to be exchanged Foreign items currently not eligible Canadian items may be exchanged by agreement o ECCHO Rules updated 2015 to facilitate image exchange of Canadian items within U.S. prior to delivery to Canadian financial institution 39 Summary Warranties/Indemnities Come From Different Sources Federal regulations State Laws Rules and agreements To determine what rules apply, is the item: Original physical check, a substitute Check (IRD), or an image For images, determine the presentment/clearing channel Through the Fed Reg J and OC3 apply Through a clearinghouse clearinghouse rules (i.e. ECCHO) Direct bank to bank (Clearinghouse rules or agreements) Generally, warranties start at first bank that deals with substitute check or image 40 20

21 Check Payments System Overview Check Collection Process Day in the Life of a Check Forward Collection On Us Items Image Image Individual Payor or Individual Payee Image Clearing Banks /Correspondent Image Corporate Payor Merchant or Corporate Payee Image Bank of First Deposit (BOFD) Image Federal Reserve Image Paying Bank 42 21

22 Clearing Payments Various channels to move payments through system to final collection May use clearing bank, correspondent or Fed to present to Paying Bank Depositary Bank wants to collect funds quickly and at reasonable cost Depositary Bank collects funds it has provisionally credited to its depositor s account 43 Clearing Payments Clearing Exchange of payment instruction data between financial institutions Moves checks from banks where they are deposited to banks where they are drawn Clearing process includes: Data collected from multiple transactions Sent to FI s core processing system Affects accounts of the FI s customers 44 22

23 What is Settlement? Settlement Exchange of value between financial institutions for payments As shown in previous example: o Clearing involves exchange of payment instructions (data) between two financial institutions Settlement: Exchange of funds o Separate event based upon agreement between the two exchanging parties 45 Settlement Federal Reserve Settlement typically occurs at the Federal Reserve Bank All banks designate accounts for settlement at the Federal Reserve Bank May have their own Fed account May use the settlement account of a correspondent o Some banks utilize both and designate which types of settlement occurs at each account 46 23

24 FRB National Settlement Service Owned and operated by Federal Reserve Banks Service is offered to depository institutions that: Settle for participants in clearing houses Financial exchanges Other clearing and settlement groups Settlement agents electronically submit settlement files to Federal Reserve Banks Files are processed on receipt Entries are automatically posted to depository institutions' Federal Reserve Bank accounts 47 Designated Settlement Accounts Checks, Credit Cards, ACH Wires, TT&L, Treasuries +/ $ +/ $ Federal Reserve 48 Bank A s Fed Account Bank Bs Correspondent Account at Bank A 24

25 Settlement Clearing House Data Data Data Clearing House Data Each member financial institution presents payment instructions to clearing house Clearing house facilitates presentment to each paying bank for clearing Settlement occurs as a separate event 49 Gross vs. Net Settlement Gross Settlement Exchange of value for a single payment Net Settlement Exchange of value for multiple payments Net effect of all payments is settled to each financial institution 50 25

26 Gross Settlement For the value of a single payment; one financial institution receives credit and other receives debit DFI sending wire receives a debit on FRB books; DFI receiving the wire receives the credit Debit Bank A s Account on Books of the Federal Reserve $ +$ Credit Bank B s Account on Books of the Federal Reserve Federal Reserve Bank A s Fed Account Bank B s Fed Account 51 Net Settlement Multiple payments are grouped together Net effect settled to the designated accounts on books at Federal Reserve Net settlement Exchange of funds between participating banks in a clearing network +/ $ Federal Reserve +/ $ +/ $ +/ $ All debits/credits are combined for single bank; Net effect reflected on the designated settlement account at the Fed Bank A s Account Bank B s Account Bank C s Account Bank D s Account 52 26

27 Float Overview Float Time between the deposit of a check and final collection and funds availability to the customer o Dollar value of cash balances created by the time lag in processing unpaid checks Checks outstanding in the process of collection o Conditional credits in a depositor's checking account until the checks are collected/paid 53 Float Overview Float Banks receive checks for deposit and provisionally credit the account of the check depositor Timing of clearing Collection and settlement of funds from drawee the Paying bank o Where the check is drawn Check clearing results in checks in process of collection appearing briefly in accounts of both Depositary Bank and Paying Bank 54 27

28 Types of Float Bank Float May be referred to as incurred float Non earning asset created through delay in collection of deposited funds Correlates to calendar days elapsing between: o Posting of customer ledger credit; and o Bank s receipt of usable funds Customer Float May be referred to as assigned or allocated float Sum of dollars credited to a demand deposit account but not available for immediate withdrawal or earnings credit Correlates to calendar days elapsing between: o Posting of customer ledger credit; and o Funds made available to customer 55 Positive and Negative Float Negative float occurs when: Customer Float (assigned or allocated) is greater than Bank Float incurred o Negative position from customer s point of view o Positive for the bank Bank has use of funds prior to funds availability to the customer Positive float occurs when: Bank Float incurred is greater than Customer Float (assigned or allocated) o Positive position from customer s point of view o Negative for the bank Customer funds available made available for use prior to the bank s collection and final settlement 56 28

29 Other Payment Systems Multiple Channels / Options Check Can Be Cleared via Multiple Channels As a physical check As an image Convert image to substitute check (IRD) As an ACH debit (if check is eligible for conversion) o ARC Accounts Receivable entry o POP Point of Purchase entry o BOC Back Office Conversion entry 58 29

30 Automated Clearing House (ACH) Funds transfer system governed by NACHA Rules Provides for inter financial institution clearing of electronic entries for participating financial institutions General terms: ACH transactions may be debits or credits Examples include: o Direct Deposit of payroll, government and Social Security benefits o Mortgage, insurance or other bill payments ACH Operators: Two central clearing facilities o Federal Reserve and o The Clearing House Originator Individual, corporation or another entity that initiates either a deposit or payment transaction ODFI: Originating Depository Financial Institution RDFI: Receiving Depository Financial Institution ACH generally considered batch and forward payment system where: o Day 1: Files are originated o Day 2 or beyond: Files are settled 59 Ineligible Items ACH Following Checks Do Not Qualify for Conversion to ACH Transactions: Checks containing aux on us field Greater than $25,000 Third Party checks/share drafts/money orders Demand drafts/3rd party drafts with no signature HELOC checks Money market checks Financial institution obligations o Traveler s checks, official checks, cashier s checks State/local government checks Checks/money orders in a foreign currency 60 30

31 ACH Process Example ORIGINATOR ODFI Originating Depository Financial Institution RDFI Receiving Depository Financial Institution ACH OPERATOR Federal Reserve or The Clearing House RECEIVER 61 Other Payment Systems Debit Card Generally uses the shared ATM networks that offer payment services associated with a financial institution s DDA systems Credit Card Issued by a company to allow the user to purchase goods and services from merchants who accept the card Wire Electronic payment service for transfer of funds Characteristics include: o Large dollar transactions o Immediate availability o Irrevocable payments 62 31

32 Recommended Resources CheckImage Central Website: White paper on Need for rules : esecrulesandfrsrules.pdf ECCHO website: Federal Reserve website: Uniform Commercial Code (UCC) o Article 3 Negotiable Instruments o Article 4 Bank Deposits and Collections X9 Standards: 63 Appendix A What is a Check? 32

33 Payments Teaser Is this paper check a check? Yes a paper check is a check This example has all the elements of a check o Date o Signature of drawer o Payee name o Amount both in words and numbers 65 Is This Large Check a Check? Hint: Assume this check has a MICR line Could be considered a negotiable instrument under the UCC definition Has same elements as our last example: o Date, signature of drawer, payee name, amount and a MICR line But it is not a check based on regulations Under Reg CC a check must be able to be processed by automated check processing equipment 66 33

34 Is This A Check? If this is a check, what type of check is this? Substitute check or IRD (image replacement document) Yes, assuming this is a properly prepared substitute check, it is considered a check under check law o Considered a legal equivalent of the original check 67 Is This A Check? Hint: This cloud illustrates an image of a check. Is this a check? No default definition for this Not defined by current regulations This is only a check by agreement between the exchanging parties No law or other regulation makes the image of the check a check 68 34

35 Is This A Check? This is a MICR line from a check Is this a check? The MICR line is not a check. By agreement exchange partners may agree to accept only this information to clear an item (to make the item processable) but... It would not be defined as a check 69 Is This A Check? Hint: It is being sent directly from a mobile device? 70 35

36 Mobile RDC Example An image on the phone (prior slide) is not a check by default. However, If by agreement an exchange partner accepts this information to clear the item, it may be accepted for exchange Example: Customer has the original check and is under a Remote Deposit Capture agreement o Image exchange process via the mobile device would be similar to any other image channel for exchange o But this is still done only by agreement 71 Is This A Check? Hint: This is created and sent from an online bill pay/accounting software? 72 36

37 Online Software Example Currently, a check must begin as a physical item a tangible writing according to the Uniform Commercial Code See the check illustrated on the prior slide If electronically created and transmitted from an online software system, but not printed first and then imaged, it is not considered a check under current check law May be considered an electronic payment order or an EPO, but not a check 73 Negotiable Instrument & Check Two Concepts Two Definitions Negotiable instrument and check defined in UCC Check considered a demand draft Check also defined in Reg CC To be considered a check (not a noncash item) o Item must qualify for handling by automated check processing equipment In prior examples the large donation check would be considered a negotiable instrument but... Even with all elements of negotiable instrument: o Would not qualify for automated processing o Would not meet definition of a check under Reg CC 74 37

38 Summary Negotiable Instrument Defined in UCC as a draft Written order signed by the drawer o Unconditional order to pay: a fixed sum of money on demand or at a definite time to a named payee or to bearer Check Negotiable Demand Draft Defined in Reg CC 229.2(k) as drawn on: o or payable through or at a bank; o the Federal Reserve Bank o Federal Home Loan Bank; o US Treasury; o a state or unit of local government; Does not include a noncash item 75 Additional Information For additional details regarding terms defined in these materials, please see: UCC Articles 3 & 4 Regulation CC Availability of Funds and Collection of Checks 76 38

39 Thank You! For more information about this or other on demand training options, contact: ECCHO 3710 Rawlins Street; Suite 1075 Dallas, Texas Direct: NOTICE This document contains copyrighted materials of its publisher. These materials may not be reproduced or published, in whole or in part, without the express permission of ECCHO 39