Basics of Negotiable Instruments

T402 Teller Training Series

Webinar from Verisure, Inc. Moderator: Gregg Bennett

Verisure Inc.
Copyright 2006 by Pivotal Financial Resources

Topics to Cover
Background of the Legal and Regulatory aspects UCC (Articles 3, 4 & 4A) Regulatory Agencies Contracts & disclosures Commercial Paper Checks & Endorsements Deposits, Collections and the collecting bank and depositor duties Electronic Services Deposit agreements Policies, procedures & risk/fraud prevention
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The UNIFORM COMMERCIAL CODE

General contents of the UCC -Articles 3, 4 & 4A are of specific concerns for bank operations
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Article 1 Article 2

General Provisions Sales

Article 2A Leases Article 3 Article 4 Article 5 Article 6 Article 7 Article 8 Article 9 Negotiable Instruments Bank Deposits and Collections Letters of Credit Bulk Transfers and Sales Warehouse Receipts & other docs Investment Securities Secured Transactions Verisure Inc.

Article 4A Funds Transfers

Regulatory Framework
Dual Banking (State, and Federal charters) Federal Reserve Bank Federal Insurance (FDIC) Charter Grantor & Supervisor
State Banking Depts OCC (National Banks) OTS (Thrifts) NCUA (Credit Unions)

FFIEC & NACHA Rules (Regulatory and industry standards organizations) Laws versus Regulations
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Verisure Inc.

Legal Authority & Rules

United States Code, Title 12 (Banks and Banking): The USC is a consolidation and codification by subject matter of the general and permanent laws of the United States. (Title 12 is specific to banking) Code of Federal Regulations The CFR contains regulations issued by executive branch and agencies of the Federal govt. State Banking Laws: Each state has a set of laws or banking code that applies in the state. Especially for State Chartered banks & CUs, but can apply to others. Clearinghouse & Other organizations: Membership in an organization may have other rules that must be followed, such as NACHA, PULSE, VISA & M/C. Verisure Inc.
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Regulator Duties
Type of FI
National Bank

Regulators
OCC* FRB FDIC State FRB* FDIC State FDIC* OTS* NCUA*

State Member Bank With FDIC State non-member, insured bank Thrifts & Savings Banks Credit Union

Purpose of Examinations

* Primary Federal Regulator

True financial condition All laws/regs observed Capital sufficiency Suggest improvements
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Contracts & Disclosures

Customer Signs
Signature Cards
Name and address Account information and number Other demographics Who has signature power and limits Ownership structure TIN Certification and Back-up Withholding Survivorship and beneficiary instructions

Bank Provides
Deposit Agreement
General terms and policies Ownership & beneficiary rules Liability Withdrawal and deposit limits or restrictions Set-off and OD rules Statement review and time limits for claims Stops, stale or post dated items, charge-backs, restrictive legends, ACH, wires, dormant..

OD protection, ATM, Debit, IVR,Internet and other special service agreements

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Reg DD - Truth-in-Savings Reg CC Deposit Availability Reg E EFT Disclosures Reg P Privacy Policy Verisure
Inc.

Commercial Paper Overview

UCC, Article 3 (adopted in 1953) Applies to drafts, checks (a type of draft) and promissory notes Based on N.I.L. Excludes investment securities, documents of title and money Standardized rules for the negotiation and liabilities of parties involved in transfer Negotiation Means transfer of an instrument from one party to another so the latter becomes the holder-in-due course through voluntary delivery.
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Negotiability Requirements

1. 2. 3. 4. 5.

Be written Signed by the maker Words of negotiability Drawee (bank for cks) Payee (or bearer)

6. Sum certain ($ and amount) 7. Specified account 8. Dated or demand (not stale or post for cks)
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Endorsements or Indorsements
The fundamental purpose is to transfer rights & title of an instrument so it can be collected by the next party accepting the item. Types of Endorsements
Blank Special Restrictive Qualified*** (be careful) Has good title Everything genuine and authorized No alterations exist No defense against item No knowledge of problems related to funding of item Verisure Inc.

Warranties of the Endorser

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Holder-In-Due-Course Status
The major purpose of this special status is to extend collection rights protection to any party against adverse circumstances over which they have no control, as long as they acted in good faith when handling an item. (Can over-ride Personal defense challenges, but not Absolute/Real defenses) Qualification Requirements
Received item FOR VALUE Received item IN GOOD FAITH Received item under proper conditions of NEGOTIATION and DELIVERY Received item without notice that is is overdue or has been dishonored Received item without notice of any claim against the instrument of defense against it.
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Defenses Reasons for Nonpayment Absolute or Real: Personal Defenses: Available against Not available against all types of parties Holders-in-due course Types/Examples Types/Examples Essential Fraud
Lack of Title Bankruptcy Forgery Incapacity Illegality (mixed) Alteration (mixed) Simple Fraud Lack of delivery Lack of consideration Undue influence Discharge before maturity Claims or equities of ownership Verisure
Inc.
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Deposits & Collections

Collecting Bank Obligations Collecting bank must exercise ordinary care in promptly Depositor Obligations Endorse/transfer title to collecting bank Assume primary liability Presenting the check or for the check or item item to the payor for deposited or cashed payment; or Assume all warranties Sending the check or item to another qualified of an endorser and allow collecting bank for its the collecting bank to ultimate presentment to become a holder-in-duethe payor course If dishonored by the Make the collecting payor notification to the bank, person or FRB bank whole in the event of the dishonor in a of dishonor of the item
timely manner
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Cash Items vs Non-Cash Items

Cash Items
1. Give depositor immediate provisional account credit 2. Create float (time lag between crediting and collection, except for onus items) 3. Must be payable on demand 4. Must not have documents attached 5. Must not require special handling (no instructions from customer) 6. Are processed in bulk, can be processed using automated systems. 7. Are payable in U.S. Dollars. Example: Checks

Non-cash Items
1. Give depositor deferred (delayed) credit when payment received 2. Do not create float (credit is posted only when collection is completed) 3. May or may not be payable on demand (future/post or stale dated) 4. May or may not have attachments 5. May or may not have customer instructions that require special handling 6. More expensive to handle, may require individual handling. 7. May or may not be payable in Dollars. Examples: Notes, bonds, coupons, drafts with attachments.

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Pre-Check 21 Check Collection Flowchart

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Check 21 Highlights
Check truncation Act provides an optional way to eliminate the physical delivery of ANY check/draft for payment without a prior agreement/arrangement Creates a payment instrument: substitute check New Term: IRD = image-replacement-documents Establishes a set of broad rules under which collecting institutions create an IRD for the original check The IRD is the legal equivalent of the original item Allocates liability to the converting or truncating institution Gives consumers (not businesses) rights to expedited credit when disputes arise about payments made with an item that has become an IRD (substitute check) Presupposes a set of standards (ANSI X9.90)
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Substitute Checks
Substitute Check (IRD) Requirements
Reproduced item must be machine readable and full-field MICR encoded Item must include an image of the front/back of check, plus subsequent endorsements and legend* Conforms, in paper stock, dimensions and otherwise to industry standards Suitable for automated processing

Electronic image of check and Substitute check are granted the legal equivalent of the original check
* Legend: This is a legal copy of your check. You can use it the same way you would use the original check. Verisure Inc.
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Sample Substitute Check

Would need to meet dimension/processing standards
Special Legend Front image

Full MICR
Back image

ANSI X9.90 Specifications for an Image Replacement Document IRD

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Verisure Inc.

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Check 21 - Transitional
Potential transitional Check 21 enabled process:
Original Check or substitute check

mixed processing environment with decreased reliance on transportation

PAPER

or, by agreement: IMAG E CHEC K

PAPER
Original Check and/or by agreement: or substitute check

Check Relay

Federal Reserve

IMAG and/or E ECP

Federal Reserve System

Graphic provided by the FRB

Paying Bank Verisure Inc.

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Check 21 - Future
Potential longer-term Check 21 enabled process:
paper truncation with image and/or substitute check on request, image truncation
Original Check or substitute check or, by agreement:

PAPER

PAPER IMAGE by agreement::

IMAGE and/or ECP

Federal Reserve System

Graphic provided by the FRB

Paying Bank Verisure Inc.

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Electronic Services
ATM and Debit Cards ACH Entries
Direct deposits POS Cash management transfers Internet transactions Telephone initiate transfers PPD (recurring debits) Re-presented checks POP, ARC, WEB, TEL + more Financial EDI & Merchant capture

Voice Response transfers Internet Banking transfers Wire/Telephone transfers

Verisure Inc.
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Reg E, CC & J Changes

Regulation E will include check conversions and payroll cards (POP, ARC, RCK) New merchant signage required by Jan 1, 2007

Remotely Created Checks (unsigned drafts) will shift the liability to the bank of first deposit from the payor bank effective July 1, 2006 (Reg CC & J)
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Transaction Authority & Protection

Authority
Signed authorization or sales slip (ACH and non-PINed debit cards) Application for ATM, Debit card or Internet services PIN associated with card for PINed ATM/Debit card transactions Login ID and password for Internet transactions Account and PIN or passcode for voice response systems recognition/recordings or ID verification for telephone instructions
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Protections
Regulation E (consumer transactions) Bank EFT Disclosures UCC4A Commercial ACH and Funds Transfers Specific service agreements NACHA Rules EFT Switch Rules (like PULSE) Bankcard processing agreement rules UCC forgery or other fraud situations

Verisure Inc.

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Deposit Agreement
Deposit Agreement
General terms and policies Ownership & beneficiary rules Liability Withdrawal and deposit limits or restrictions Set-off and OD rules Statement review and time limits for claims Stops, stale or post dated items, charge-backs, restrictive legends, ACH, wires, dormant..

Reg DD - Truth-in-Savings Reg CC Deposit Availability Reg E EFT Disclosures Reg P Privacy Policy
Verisure Inc.

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Policies & Procedures

Documented policies and procedures will assist in complying with regulations and laws during disputes Logs and standardized response letters help better document research findings and efforts Verbal notifications and actions are extremely difficult to prove. Need to understand disclosures and required response and timeframes
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Resource Material
Basics of Negotiable Instruments summary Reg CC Announcement related to Remotely Created Checks
Verisure Inc.
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26

Questions & Comments

For more information Send emails to
verisure@nyc.rr.com or

Visit our web site at

www.verisure.net
Verisure Inc.
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Verisure Inc.
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FEDERAL RESERVE SYSTEM 12 CFR Parts 210 and 229 Regulations J and CC; Docket No. R-1226 Collection of Checks and Other Items By Federal Reserve Banks and Funds Transfers Through Fedwire and Availability of Funds and Collection of Checks AGENCY: Board of Governors of the Federal Reserve System. ACTION: Proposed rule. SUMMARY: The Board of Governors is requesting comment on proposed amendments to Regulation CC that would define remotely created checks and create transfer and presentment warranties for such checks. The purpose of the amendments is to shift liability for unauthorized remotely created checks to the depositary bank, which is generally the bank for the person that initially created and deposited the remotely created check. The Board is also proposing conforming cross-references to the proposed new warranties in Regulation J. DATES: Comments on the proposed rule must be received not later than May 3, 2005. ADDRESSES: You may submit comments, identified by Docket No. R-1226, by any of the following methods: Agency Web Site: http://www.federalreserve.gov. Follow the instructions for submitting comments at http://www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm. Federal eRulemaking Portal: http://www.regulations.gov. Follow the instructions for submitting comments. E-mail: regs.comments@federalreserve.gov. Include docket number in the subject line of the message. FAX: 202/452-3819 or 202/452-3102. Mail: Jennifer J. Johnson, Secretary, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue, N.W., Washington, DC 20551. All public comments are available from the Boards web site at www.federalreserve.gov/generalinfo/foia/ProposedRegs.cfm as submitted, except as necessary for technical reasons. Accordingly, your comments will not be edited to remove any identifying or contact information. Public comments may also be viewed electronically or in paper in Room MP-500 of the Boards Martin Building (20th and C Streets, N.W.) between 9:00 a.m. and 5:00 p.m. on weekdays. FOR FURTHER INFORMATION CONTACT: Adrianne G. Threatt, Counsel (202/452-3554), or Joshua H. Kaplan, Attorney, (202/452-2249), Legal Division; or Jack K. Walton, II, Assistant Director (202/452-2660), or Joseph P. Baressi, Senior Financial Services Analyst (202/452-3959), Division of Reserve Bank Operations and Payment

Systems; for users of Telecommunication Devices for the Deaf (TDD) only, contact 202/263-4869. SUPPLEMENTARY INFORMATION: Background Remotely created checks typically are created when the holder of a checking account authorizes a payee to draw a check on that account but does not actually sign the check.1 In place of the signature of the account-holder, the remotely created check generally bears a statement that the customer authorized the check or bears the customers printed or typed name. Remotely created checks can be useful payment devices. For example, a debtor can authorize a credit card company to create a remotely created check by telephone. This may enable the debtor to pay his credit card bill in a timely manner and avoid late charges. Similarly, a person who does not have a credit card or debit card can purchase an item from a telemarketer by authorizing the seller to create a remotely created check. On the other hand, remotely created checks are vulnerable to fraud because they do not bear a signature or other readily verifiable indication of authorization. Because remotely created checks are cleared in the same manner as other checks, it is difficult to measure the use of remotely created checks relative to other types of checks. However, there have been significant consumer and bank complaints identifying cases of alleged fraud using remotely created checks. Existing Law on Remotely Created Checks A remotely created check is subject to state law on negotiable instruments, specifically Articles 3 and 4 of the Uniform Commercial Code (UCC) as adopted in each state. Under the UCC, a paying bank may charge a customers account for a check only if the check is properly payable. A bank generally must recredit its customers account for the amount of any unauthorized check it pays.2 This obligation is subject to limited defenses.3 In addition, the paying bank may have evidence that the depositor did in fact authorize the check and is suffering buyers remorse and thus does not have to recredit the amount of the check.4 A paying bank may, until midnight of the banking day after a check has been presented to the bank, return the check to the depositary bank if, among other things, the

There is no settled term for these items. The terms remotely created check, telecheck, preauthorized
drafts, and paper draft are among the terms that describe these items. For purposes of this proposal, the
Board refers to these items as remotely created checks.
UCC 4-401.
For example, the paying bank may be able to assert that the customer failed to notify the bank of the
unauthorized item with reasonable promptness (UCC 4-406(c) and (d)).
4 The FTCs Telemarketing Sales Rule prohibits a telemarketer from issuing a remotely created check on a
consumers deposit account without the consumers express verifiable authorization. The authorization is
deemed verifiable if it is in writing, tape recorded and made available to the consumers bank upon request,
or confirmed by a writing sent to the consumer prior to submitting the check for payment. 6 CFR Part 310.

3 2

paying bank believes the check is unauthorized. Once its midnight deadline has passed, the paying bank generally cannot return an unauthorized check to the depositary bank.5 The provisions of the UCC, cited above, reflect the rule set forth in the seminal case of Price v. Neal6 that drawees of checks and other drafts must bear the economic loss when the instruments they pay are not properly payable by virtue of the fact that the drawer did not authorize the item.7 Under the Price v. Neal rule, the paying bank must bear the economic loss of an unauthorized check with little recourse other than bringing an action against the person that created the unauthorized item. This rule currently applies to all checks, including remotely created checks, in most states. The Price v. Neal rule reflects the policy that the paying bank, rather than the depositary bank, is in the best position to judge whether the signature on a check is the authorized signature of its customer. Remotely created checks, however, do not bear a handwritten signature of the drawer that can be verified against a signature card. In most cases, the only means a paying bank would have to verify a remotely created check (and return it if it is unauthorized) is by contacting the customer before the midnight deadline passes. Even if a paying bank wished to verify the authenticity of remotely created checks, however, it must first identify remotely created checks drawn on its accounts. Currently, there is no code or feature of a remotely created check that allows this to be done reliably in an automated manner. For example, remotely created checks bear no machine-readable identifiers that indicate they are remotely created checks. Recent Legal Changes to Address Remotely Created Checks Amendments to the UCC In recognition of the particular problems regarding remotely created checks, the National Conference of Commissioners on Uniform State Laws and the American Law Institute in 2002 approved revisions to Articles 3 and 4 of the UCC that specifically address remotely created checks. The UCC revisions define a remotely created check (using the term remotely-created consumer item) as an item drawn on a consumer account, which is not created by the paying bank and does not bear a hand written signature purporting to be the signature of the drawer.8 The UCC revisions require a person that transfers a remotely-created consumer item to warrant that the person on whose account the item is drawn authorized the issuance of the item in the amount for which the item is drawn.9 Accordingly, in the case of remotely-created consumer items the UCC alters the Price v. Neal rule to provide that the depositary bank and each

See UCC 4-301 and 4-302. In limited cases, the paying bank may be able to recover from the presenting
bank the amount of a check that it paid under the mistaken belief that the signature of the drawer of the
draft was authorized. This remedy, however, may not be asserted against a person that took the check in
good faith and for value or that in good faith changed position in reliance on the payment or acceptance.
UCC 3-418(a) and (c).
6 97 Eng. Rep. 871 (K.B. 1762).
7 See also Interbank of New York v. Fleet Bank, 730 NYS2d 208 (2001).
8 UCC 3-103(16).
9 UCC 3-416(a). A person who transfers an instrument for consideration warrants to the transferee and, if
the transfer is by indorsement, to any subsequent transferee with respect to a remotely-created consumer
item, that the person on whose account the item is drawn authorized the issuance of the item in the amount
for which the item is drawn. See also UCC 4-207(a)(6), 3-417(a)(4), 4-208(a)(4).

intermediary bank warrants to the paying bank that the remotely-created consumer item is authorized.10 These revisions rest on the premise that it is appropriate to impose the burden of ensuring authorization of a remotely created check on the bank whose customer deposited the remotely created check.11 The warranty provides an economic incentive for the depositary bank to monitor customers that deposit remotely created checks and should have the effect of limiting the quantity of unauthorized remotely created checks that are introduced into the check collection system. Amendments to State Laws Fourteen states have amended their Articles 3 and 4 to include provisions similar to those in the UCC.12 No state, however, has adopted the UCC revisions in their entirety and the revisions adopted by the states are not uniform in their scope or requirements. In addition to the state codes, some check clearinghouses have adopted warranties similar but not identical to the revised UCC that apply to remotely created checks collected through the clearinghouse. For example, in California, a person that transfers a remotely created check warrants to the transferee that creation of the item according to the terms on its face was authorized by the person identified as the drawer.13 The California Commercial Code defines a remotely created check as follows:
a writing not signed by a customer that is created by a third party under the purported authority of the customer for the purpose of charging the customer's account with a bank. A remotely created check shall contain the customer's account number and may contain any or all of the following: (1) The customer's printed or typewritten name.
(2) A notation that the customer authorized the draft.
(3) The statement "No Signature Required" or words to that effect.
A remotely created check shall not include a check purportedly drawn by and bearing
the signature of a fiduciary. . . .

Several states use the same warranty language as California, although they define a remotely created check slightly differently, omitting the California statutes requirement that a remotely created check contain the customers account number. Vermont generally follows the California language; however, Vermont law includes an exception to account for conflict of law rules.14 The state-by-state approach to the adoption of remotely created check warranties complicates the trail of liability for remotely created checks collected across state lines, as the bank that presents a check may not be subject to the same rules as the paying bank.

Normally, the transferor must warrant only that it has no knowledge that the instrument is
unauthorized. UCC 3-417(a)(3).
11 UCC 3-416, Official Comment, paragraph 8. The Official Comment notes that the provision
supplements FTCs Telemarketing Rule, which requires telemarketers to obtain the customers express
verifiable authorization.
12 Those states are California, Colorado, Hawaii, Idaho, Minnesota, Nebraska, New Hampshire, North
Dakota, Oregon, Tennessee, Utah, Vermont, West Virginia, and Wisconsin.
13 Cal. U. Com. Code 3416 (2004).
14 9A V.S.A. 3-416(e).

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Proposed Rule The Expedited Funds Availability Act (the EFA Act), Pub. L. 100-86, 101 Stat. 635 (codified at 12 U.S.C. 4001 et seq.), authorizes the Board to establish rules regarding losses and liability among depository institutions in connection with any aspect of the payment system.15 As noted above, the check collection and return system operates nationally. As a result, in order for the remotely created check warranties to be effective and to prevent conflicts among warranties as they apply to banks, the warranties must apply uniformly and nationwide. In connection with its proposed amendments to Regulation CC to implement the Check Clearing for the 21st Century Act (the Check 21 Act), the Board requested comment on whether it should develop a proposal to amend Regulation CC to adopt the UCC warranties for remotely created checks.16 Seventy-six commenters responded to the Boards request for comment on this issue, and all but two supported the proposal,17 including the Permanent Editorial Board for the UCC.18 In publishing the final amendments to Regulation CC to implement the Check 21 Act, the Board noted its intent to issue a separate proposal regarding remotely created checks.19 The Boards proposal defines remotely created check as a check that is drawn on a customer account at a bank, is created by the payee, and does not bear a signature in the format agreed to by the paying bank and the customer. This definition would include checks that are created by remote payees or their agents to enable payors to make a payment by check.20 Unlike the UCC amendments, the Boards proposed definition would apply to remotely created checks drawn on either a consumer or a non-consumer account. Although most remotely created checks are believed to be drawn on consumer accounts, these checks could be drawn on business or other accounts as well. In either case, the depositary bank would appear in the best position to address the potential for fraudulent check writing. A remotely created check often contains a statement that the customer authorized the check, the customers printed or typed name, or a similar notation. Generally, a paying bank and its customer agree to a form of authorization for checks drawn on the
The Board is authorized to impose on or allocate among depository institutions the risks of loss and
liability in connection with any aspect of the payment system, including the receipt, payment, collection, or
clearing of checks, and any related function of the payment system with respect to checks. Such liability
may not exceed the amount of the check giving rise to the loss or liability, and, where there is bad faith,
other damages, if any, suffered as a proximate consequence of any act or omission giving rise to the loss or
liability. 12 U.S.C. 4010(f).
16 69 FR 1470, 1482, Jan. 8, 2004.
17 One commenter argued that it would be inappropriate for the Board to adopt the UCC warranty for
remotely created checks because it has not yet been adopted by all states. The other commenter stated that
it is neither in favor nor opposed to incorporating the UCC warranty but is unsure how such a warranty in
Regulation CC would be enforced.
18 The Permanent Editorial Board for the UCC stated that the lack of uniform state law creates a problem
that a remotely-created-items warranty in Regulation CC would resolve. Under the existing non-uniform
state of play, a company creating large numbers of these items could avoid the new uniform [UCC] transfer
and presentment warranties and continue to insulate itself and its depositary banks by selecting depositary
banks in states that have not adopted these warranties.
19 69 FR 47290, 47306, Aug. 4, 2004.
20 The proposed Commentary would provide that a check created by the payees agent would be deemed to
be created by the payee. Therefore, if a telemarketer hired a service provider to create checks drawn on the
accounts of the telemarketers customers, those checks would be covered by the definition.

15

customers account. These agreed-upon formats most often take the form of a handwritten signature or a specific type of machine-applied signature. The proposed definition covers remotely created checks that do not bear a signature in the format agreed to between the paying bank and its customer. Accordingly, a check that is created by someone other than the drawer and on which the drawers signature is applied using the authorization format agreed to by the paying bank and its customer (such as a handwritten signature), is not a remotely created check under the proposal. For example, a typical forged check, such as a stolen personal check fraudulently signed by a person other than the drawer, is not covered by the proposed definition of a remotely created check. In this regard, the existing system of warranties appears suitable for those types of situations because the paying bank can monitor the format and the signatures it has agreed to with its customer. The Board proposes to create transfer and presentment warranties that would apply to remotely created checks that are transferred or presented by banks to other banks. Under the proposed warranties, any transferor bank, collecting bank, or presenting bank would warrant that the remotely created check that it is transferring or presenting is authorized according to all of its terms by the person on whose account the check is drawn. The proposed warranties would apply only to banks and would ultimately shift liability for the loss created by an unauthorized remotely created check to the depositary bank. A paying bank would not be able to assert a warranty claim under the Boards proposed rule directly against a nonbank payee that created or transferred an unauthorized remotely created check. The proposed transfer and presentment warranties differ in this respect from the UCC provisions, which apply to any person that transfers a remotely created check. However, the bank would likely have a claim under other law against such a payee. The Boards proposal also differs from the UCC provisions to the extent that the Boards proposed warranties cover all of the terms of the check while the UCC provisions cover only authorization of the issuance of the check in the amount for which the check is drawn. The Board is also proposing conforming cross-references to the proposed new warranties in Regulation J. The Board requests comment on all aspects of the proposed definition of a remotely created check and the scope of the proposed transfer and presentment warranty. In particular, the Board requests comment on how best to distinguish remotely created checks, to which the proposed warranty would apply, from other fraudulent checks, which would not be subject to the proposed warranty. The proposed definition of remotely created check attempts to make this distinction by stating that the check does not bear a signature in the format agreed to by the paying bank and the customer. A payee that creates an unauthorized remotely created check could circumvent this requirement, however, by applying a handwritten signature purporting to be the signature of a consumer. Similarly, a traditional forged check that contains a signature in a different format than that agreed to by the paying bank and the customer could be subject to the proposed warranty. There are few statistics or other quantitative data on remotely created checks; therefore, the Board also seeks comment on the prevalence and uses of remotely created checks generally. The Board also requests comment on the general characteristics of remotely created checks, including the manner by which such checks typically reflect the account-holders authorization. In addition, the Board invites comment on whether it is

appropriate to cover all remotely created checks or to follow the UCC approach of covering only remotely-created consumer items. Additional Requests for Comment There are other approaches to addressing the risks associated with remotely created checks. The Board invites comment on whether a different approach to addressing this issue is more appropriate. In particular, the Board requests comment on two alternatives. Extension of the Midnight Deadline Under the proposal described above, a paying bank would recover its losses caused by an unauthorized remotely created check by making a warranty claim outside of the check collection and return system. As an alternative, the rule could potentially allow such a paying bank to return the unauthorized remotely created check through the check system by extending the UCC midnight deadline for a period of time (such as 60 days). Such a rule could reduce the cost of recovering losses suffered in paying unauthorized remotely created checks and is similar to the return scheme for unauthorized ACH transactions. However, the rule would extend the midnight deadline considerably, and thereby delay finality of payment and discharge of the underlying obligation with respect to remotely created checks. Commenters that favor the extension of the midnight deadline are encouraged to explain their preference for this approach, including how such an approach would be implemented under the current check collection process. Allow the State Legislatures to Adopt the UCC Amendments The Board could refrain from or delay acting on the remotely created check issue and allow the states to adopt the UCC warranty, or some variation thereof, on their own. Check law traditionally has been the province of state law, although a substantial number of federal laws and regulations apply to the check collection system as well. The pace at which the states have adopted the UCC changes has been slow and that might be an indication that consensus has not been reached on whether there should be a change to the warranties for remotely created checks. MICR Line Identifier Regardless of whether the Board provides a special warranty or return rule for remotely created checks, it may be useful to have a means of identifying these checks so that banks can better protect themselves and their customers against fraud. Identifying remotely created checks could be accomplished by assigning digits in the External Processing Code (EPC) Field (commonly referred to as Position 44) of the MICR line to remotely created checks. Four digits would appear to be necessary to identify a forward and return original remotely created check and a substitute check version. The practical utility of a MICR line code for identifying fraudulent checks may be low in practice, however, because a person depositing an unauthorized remotely created check would be unlikely to place an EPC identifier in the MICR line. Furthermore, requiring a payee, rather than a bank, to encode in position 44 of the MICR line may lead to inconsistent results and operational problems. Paperwork Reduction Act In accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3506;

5 CFR 1320 Appendix A.1), the Board has reviewed the proposed rule under authority delegated to the Board by the Office of Management and Budget. The proposed rule contains one collection of information pursuant to the Paperwork Reduction Act. In addition to the proposed rule, the Board requests comment on whether banks should be required to ensure that a remotely created check includes identifying digits in the MICR line. The MICR line requirement would be deemed a collection of information, however, the Board believes that the paperwork burden associated with such a requirement would be minimal. The Board invites comment on the paperwork burden associated with the MICR line requirement. Regulatory Flexibility Act In accordance with the Regulatory Flexibility Act (RFA), an agency must publish an initial regulatory flexibility analysis with its proposed rule, unless the agency certifies that the rule will not have a significant economic impact on a substantial number of small entities. (5 U.S.C. 601-612.) The Board believes that, if adopted as proposed, the rule would not have a significant economic impact on a substantial number of small entities. The RFA requires agencies to examine the objectives, costs and other economic implications on the entities affected by the rule. (5 U.S.C. 603.) Under section 3 of the Small Business Act, as implemented at 13 CFR part 121, subpart A, a bank is considered a small entity or small bank if it has $150 million or less in assets. Based on December 2004 call report data, the Board estimates that there are approximately 13,666 depository institutions with assets of $150 million or less. The proposed amendments to Regulation CC create a definition of a remotely created check and warranties that apply when a remotely created check is transferred or presented. The proposed amendments would require any bank that transfers or presents a remotely created check to warrant that the person on whose account the remotely created check is drawn authorized the issuance of the check according to the terms stated on the check. The purpose of the proposed amendments is to place the liability for an unauthorized remotely created check on the bank that is in the best position to prevent the loss. By shifting the liability to the bank in the best position to prevent the loss caused by the payment of an unauthorized remotely created check, the Board anticipates that the proposed amendments will reduce costs for all banks that handle remotely created checks. Banks seeking to minimize the risk of liability for transferring remotely created checks will likely screen with greater scrutiny customers seeking to deposit remotely created checks. The Board believes that the controls that small institutions will develop and implement to minimize the risk of accepting unauthorized remotely created checks for deposit likely would pose a minimal negative economic impact on those entities. The Board invites comment on the economic impact of the proposed warranties on small institutions. The RFA requires agencies to identify all relevant Federal rules which may duplicate, overlap or conflict with the proposed rule. As noted above, the Boards Regulation J includes cross-references to the warranties set forth in Regulation CC and the proposed rule would amend such cross-references to include the proposed warranties. As also noted above, the proposed rule would overlap with 14 state codes which presently provide warranties for remotely created checks. The RFA also requires agencies to describe any significant alternatives to the proposed rule. The alternatives are discussed above and comment is requested on the proposed alternatives.

List of Subjects in 12 CFR Parts 210 and 229 Banks, Banking, Federal Reserve System, Reporting and recordkeeping requirements. Authority and Issuance For the reasons set forth in the preamble, the Board is proposing to amend parts 210 and 229 of chapter II of title 12 of the Code of Federal Regulations as set forth below: PART 210-COLLECTION OF CHECKS AND OTHER ITEMS BY FEDERAL RESERVE BANKS AND FUNDS TRANSFERS THROUGH FEDWIRE (REGULATION J) 1. The authority citation for part 210 continues to read as follows: Authority: 12 USC 248(i) and (j), 12 USC 342, 12 USC 464, 12 USC 4001 et seq., 12 USC 5001-5018. 2. In section 210.5, revise paragraph (a)(3) to read as follows: 210.5 Senders agreement; recovery by Reserve Bank (a) * * * ***** (3) Warranties for all electronic items. The sender makes all the warranties set forth in and subject to the terms of 4207 of the UCC for an electronic item as if it were an item subject to the UCC and makes the warranties set forth in and subject to the terms of 229.34(c) and (d) of this chapter for an electronic item as if it were a check subject to that section. ***** 3. In section 210.6, revise paragraph (b)(2) to read as follows: 210.6 Status, warranties, and liability of Reserve Bank ***** (b) * * * (2) Warranties for all electronic items. The Reserve Bank makes all the warranties set forth in and subject to the terms of 4207 of the UCC for an electronic item as if it were an item subject to the UCC and makes the warranties set forth in and subject to the terms of 229.34(c) and (d) of this chapter for an electronic item as if it were a check subject to that section. ***** 4. In section 210.9, revise paragraph (b)(5) to read as follows: 210.9 Settlement and payment ***** (b) * * * (5) Manner of settlement. Settlement with a Reserve Bank under paragraphs (b)(1) through (4) of this section shall be made by debit to an account on the Reserve Bank's books, cash, or other form of settlement to which the Reserve Bank agrees, except

that the Reserve Bank may, in its discretion, obtain settlement by charging the paying bank's account. A paying bank may not set off against the amount of a settlement under this section the amount of a claim with respect to another cash item, cash letter, or other claim under section 229.34(c) and (d) of this chapter (Regulation CC) or other law. ***** PART 229 AVAILABILITY OF FUNDS AND COLLECTION OF CHECKS (REGULATION CC) 5. The authority citation for part 229 continues to read as follows: Authority: 12 U.S.C. 4001 et seq., 12 U.S.C. 5001-5018. 6. In 229.2, add a new paragraph (fff) to read as follows: 229.2 Definitions ***** (fff) Remotely created check means a check that is drawn on a customer account at a bank, is created by the payee, and does not bear a signature in the format agreed to by the paying bank and the customer. 7. In 229.34, redesignate paragraphs (d), (e), and (f) as paragraphs (e), (f), and (g), and add a new paragraph (d) to read as follows: 229.34 Warranties ***** (d) Transfer and presentment warranties with respect to a remotely created check. A bank that transfers or presents a remotely created check and receives a settlement or other consideration warrants to the transferee bank, any subsequent
collecting bank, and the paying bank that the person on whose account the remotely
created check is drawn authorized the issuance of the check according to the terms stated
on the check.
*****
8. In 229.43, revise paragraph (b)(3) to read as follows: 229.43 Checks Payable in Guam, American Samoa, and the Northern Mariana Islands *****
(b) Rules applicable to Pacific islands checks. * * *
*****
(3) 229.34(c)(2), (c)(3), (d), (e), and (f);
*****
9. In Appendix E to part 229: a. Under paragraph II., section 229.2, paragraph (OO) is revised and a new paragraph (FFF) is added. b. Under paragraph XX., section 229.34, redesignate paragraphs D., E., and F. as paragraphs E., F., and G., and add a new paragraph D. APPENDIX E TO PART 229 COMMENTARY

10

*****
II. Section 229.2 Definitions ***** OO. 229.2(oo) Interest Compensation 1. This calculation of interest compensation derives from UCC 4A-506(b). (See 229.34(e) and 229.36(f).) ***** FFF. 229.2(fff) Remotely Created Check 1. A remotely created check may be drawn on a consumer account or an account held by a corporation, unincorporated company, partnership, government unit or instrumentality, trust, or any other entity or organization. In accordance with principles of the law of agency, an agent of a payee is deemed to be the payee for purposes of the definition of remotely created checks. 2. A check authorized by a consumer over the telephone, which is created by the payee, and which bears a legend on the signature line such as Authorized by Drawer is an example of a remotely created check. A check that bears the signature of the customer or a signature purporting to be the signature of the customer in the format agreed to by the paying bank and the customer is not a remotely created check. For example, the agreed-upon format is often a handwritten signature, or in the case of corporate checks, a machine-applied signature. In these cases, a check that bears a handwritten or machineapplied signature (regardless of whether the signature was authentic) would not be a remotely created check. A typical forged check, such as a stolen personal check fraudulently signed by a person other than the drawer, is not covered by the definition of a remotely created check. 3. The definition of a remotely created check includes a remotely created check that has been reconverted to a substitute check. ***** XX. Section 229.34 Warranties ***** D. 229.34(d) Transfer and presentment warranties 1. The transfer and presentment warranties for remotely created checks supplement the Federal Trade Commissions Telemarketing Sales Rule, which requires telemarketers that submit checks for payment to obtain the customers express verifiable authorization (the authorization may be either in writing or tape recorded and must be made available upon request to the customers bank). 16 C.F.R. 310.3(a)(3). 2. Any transferring bank, collecting bank, or presenting bank warrants that the remotely created check that it is transferring or presenting is authorized according to all of its terms by the person on whose account the check is drawn. The warranties are given only by banks and only to subsequent banks in the collection chain. The warranties ultimately shift liability for the loss created by an unauthorized remotely created check to the depositary bank. The depositary bank cannot assert the transfer and presentment warranties against a depositor; however, it would likely have a claim under other laws against that person or could choose to transfer the liability by contract. The transfer and presentment warranties differ from the UCC warranty provisions, which are given by any person that transfers a remotely created check including a nonbank, apply only to

11

remotely created consumer checks, and cover authorization of the issuance of the check in the amount for which the check is drawn. 3. The transfer and presentment warranties for a remotely created check apply to a remotely created check that has been reconverted to a substitute check. ***** By order of the Board of Governors of the Federal Reserve System, February 28, 2005.

Jennifer J. Johnson Jennifer J. Johnson Secretary of the Board.

(signed)

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Negotiable Instrument Basics

FUNDAMENTALS OF NEGOTIABLE INSTRUMENTS The guidelines and rules that govern negotiable instruments are described by several legal documents, but most importantly in the Uniform Commercial Code. The UCC was adopted in 1953 by most States, (Louisiana has some exceptions to the UCC), and is based on the predecessor called the Negotiable Instruments Laws (NIL). The UCC is divided into sections that focus on specific types of legal documents, and Negotiable Instruments are addressed in Article 3. Rules that apply to bank deposits and the collection of negotiable instruments are contained in Article 4 and there are some special requirements related to Funds Transfers in Article 4A. The information shown below will highlight some of the basic information about the negotiable items that are customarily handed by financial institutions. In the ordinary course of business, an employee will be called upon to handle many kinds of instruments. It is imperative that they know and recognize each kind so that they will know what treatment is expected for each. By far, the most common negotiable instrument is what is known as a check. Other common types are drafts, coupons, bonds, and money orders. CHECKS: A check is a written order by a depositor directing his bank to pay a certain sum of money from collected funds that he has on deposit. Checks may be payable to an individual, corporation, or an association or they may be payable to the bearer or cash. Checks are thought of as three party agreements. They are: 1. Maker: The person or firm who is ordering the money paid. The maker's signature will usually be located in the lower right hand corner of the check. 2. Payee: The person or firm to whom the check is payable. The payee will usually follow the words "Pay to the order of...". 3. Drawee Bank: The bank on which the check is drawn. The name of the bank will normally appear in the lower left hand corner of the check, across the top of the check, or in another prominent spot on the face of the check. A check must meet five characteristics as set forth by the Uniform Commercial Code to qualify as a LEGAL negotiable instrument. The five characteristics include the following: 1. The Check must be in writing (written longhand, typed or printed) and signed by the maker. Note: A properly drawn check WRITTEN IN PENCIL is negotiable. However, it is NOT considered good practice to accept such a check for cashing and it is not a policy of this institution to cash checks written in pencil. 2. The check must name the bank or financial institution on which it is drawn (the drawee). 3. The check must contain an unconditional order to pay definite sum of money. 4. The check must be payable on demand or at a fixed or determinable date. 5. The check must contain Words of Negotiability: bearer...", or similar words. "Pay to the order of...", "Pay to the

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TYPES OF CHECKS The most common checks routinely encountered are described below: Personal Checks: A personal check drawn against an individual or joint checking account. Company Checks: A company check is one where the maker is a company or corporation. Such checks will be signed by one or more persons who are authorized to sign on behalf of the company. Voucher Checks: This is a type of check used by some companies. It contains a detachable portion at the bottom or side of the check that is a receipt or explanation of the purpose of the check. There are two things you must remember about voucher checks: a. It is rare, but some of these require that the voucher portion remain attached to the check while others direct the payee to detach the voucher before cashing. b. Watch for special instructions for endorsing the check. These instructions may be found on the back of the check or the voucher portion. Because voucher checks vary, it is important that you read all instructions on both the check and the voucher portion. Government Checks: These checks are issued by the U.S. government to pay Federal employees, pay its debts, pay pensions, social security, and other legal obligations. NOTE: Because these checks are easily stolen, a teller should be particularly cautious when accepting them. ALWAYS IDENTIFY THE CUSTOMER. Customers presenting these checks must be identified by an account number or referred to an officer. Traveler's Checks: Traveler's checks are sold to the public for a fee by certain companies and banks. Their purpose is to provide a simple means of identifying the holder, who will normally be trying to cash them in places where they are not known. The purchaser must sign their name once on the face of the check at the time they buy them and a second time in THE PRESENCE OF THE TELLER or business person who is considering cashing them. Cashier's Checks: A Cashier's check is normally defined as a check that a financial institution draws on itself; that is, the maker and the drawee are the same. Such checks are sold to customers for cash. Lost or stolen checks issued required an indemnity bond prior to the reissue or voiding a check. (Sometimes called Teller or Official Checks). Money Orders: Bank or personal money orders are drawn on a bank's own funds. These checks have indicated on them a maximum amount they can be negotiated for and are issued for small amounts.

DRAFTS: A draft is a negotiable order to pay a definite sum of money, either on demand or at some future date. The draft is addressed to the person or firm who is being asked to pay. Compare this definition with that of a check and you will note the primary difference. 1. The drawee of a check is always a financial institution, but the drawee of a draft may be any person or company. 2. Checks may be charged to the maker's checking account without further notice to or approval from the maker. Drafts, on the other hand, are never automatically chargeable to a checking account, but must be presented to the maker. They are then Pivotal Financial Resources Page - 2

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free to refuse payment or may pay in cash or any other manner. Since institutions have no way to determine without presenting to the maker whether any drafts will be paid, tellers would not pay out cash for a draft without the approval of a supervisor or officer. TYPES OF DRAFTS: Some of the more common drafts are listed below: Sight Drafts: A sight draft is simply any draft that is to be paid immediately upon viewing by the drawee. A sight draft and a demand draft are both the same. Time Drafts: A time draft is any draft that has been drawn payable at some future date. This may be expressed as a specific future date, or in terms of a specific lapse of time after the date of the draft of after presentation to the drawee. Time drafts are principally used to extend credit to a purchaser of goods or to allow for arrival from distant points. Insurance Drafts: Many insurance companies pay policy claims with a draft rather than with a check. The normal reason is that in order to provide fast claim service; they permit many of their agents to sign and deliver claim drafts. Each agent then sends the claim report to the home office, which will have the opportunity to examine it before making payment on the draft. If the agent was in error, the company can refuse to pay the draft. No such opportunity would exist if checks were used. Most insurance companies will print on their claim drafts "Payable through" or "collect through" a named bank. Thus, those instruments which appear to be drawn on a bank, but which read "through" the bank, are not checks but drafts. Discretion should be used when paying drafts, depending on status of customer, many are sent for collection; therefore, immediate credit is not always given. BOND COUPONS: A bond coupon is a special type of draft payable to the bearer on a specified date. The issuer of the bond has coupons attached to it that pay interest as they become due. Any owner of the bond may clip the maturing coupon and so collect his interest. Most bond coupons are sent to the collection area for further credit to the customer. SAVINGS BONDS: Savings bonds are issued by the U.S. Government to raise revenue. These bonds earn interest every month and reach maturity after a specified number of years.

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FUNCTIONS OF ENDORSEMENTS In order to process checks intelligently and safely, one must learn about the most common types of endorsements and the rules and regulations that govern each. The most common meaning of "endorse" is to give one's name or support to someone. When you sign your name on the back of your paycheck (or any other check made out to you) so that you can cash it, you are also guaranteeing (to the person who cashes it for you) that the check is genuine. Thus, the first function of an unqualified endorsement is to guarantee that the check is genuine and good. Endorsements actually perform four main functions: 1. To guarantee that the check is genuine. 2. To guarantee that all previous endorsements are genuine. 3. To transfer title to another person or organization. 4. To warrant that there is no knowledge of any claim, notice of default, insolvency, fraud or other reasons that would result in the dishonor of the item. Additionally, the endorser received the item in good faith and consideration. NOTE: For an endorsement to be acceptable, the endorser must sign his name EXACTLY as it appears on the face of the check. If the payee's name is misspelled on the face of the check, he must first sign the check EXACTLY as it appears on the face, then underneath he must sign his name again, using his correct legal signature. TYPES OF ENDORSEMENTS: Since the manner in which an endorsement is made will determine to whom ownership is being transferred and under what conditions, it is imperative that a teller understand the meaning of each of the various types of endorsements. Several types of endorsements will render a check unsuitable for cashing, while other types will allow "deposit only" to a specific account. INDIVIDUAL AND JOINT ENDORSEMENTS: The most common type of endorsement you will see is the individual endorsement (the signature of one person). When you endorse your payroll check, for example, that is an individual endorsement. On occasion, however, you will encounter joint endorsements involving two signatures. When a check is made payable to two persons, both must ordinarily endorse it. ENDORSEMENT BY MARK: On a very rare occasion, a teller may encounter a situation in which the payee of a check cannot write his endorsement, either because he is illiterate and does not know how to write his name, or because he is ill and is unable to write. In such cases, the payee may endorse the check by mark, which must be witnessed by two literate people. The witness must give their full name and address. The payee must be positively identified and the fact that he cannot write must be verified. If you encounter a situation involving an endorsement by mark, you should refer it to your supervisor. BLANK ENDORSEMENT: When the payee is cashing the check, a blank endorsement includes ONLY the payee's signature on the back of the check. When the payee is not the one getting the money, a blank endorsement includes the payee's signature plus the check casher's signature. A check endorsed in a blank becomes bearer paper and can be cashed upon presentation. Since such a check, if lost or stolen, is negotiable by anyone (bearer), the teller should be sure to identify the person cashing it. Pivotal Financial Resources Page - 4

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SPECIAL ENDORSEMENTS: When the endorser wants to protect himself from loss (in case the check is lost or stolen), he endorses the check so that it is payable to and negotiated by a specific person or organization. This consists of such words as "Pay To" a designated person followed by the signature of the holder. Such a check cannot be further negotiated with out the endorsement of that designated person. RESTRICTIVE ENDORSEMENT: A restrictive endorsement limits the use to which the person acquiring the check can make use of the proceeds. A check endorsed "For Deposit Only" and signed by the holder can only be credited to a financial institution account in the name of the endorser. Not only must the next holder of such a check be financial institution, but also a restrictive endorsement cannot be followed by any other endorsements except those necessary to collect the check from the drawee bank. Thus, after crediting the endorser's account, a bank could not endorse the check over to any other person outside the check collection channels. The key word on a restrictive endorsement is the word "only". CONDITIONAL ENDORSEMENT: A conditional endorsement is one that prescribes certain conditions to be met before ownership of the check is to be transferred. Often it is impossible to determine whether the conditions have been met simply by examining the check. Such conditions usually refer to the completion of a certain job or the happening of some other event. If a conditional endorsement on a check is presented to a teller, the holder must be referred to a supervisor. QUALIFIED ENDORSEMENT: When a person wants to cash a check, but does not want to assume liability in case the check is dishonored, he uses a qualified endorsement. In most cases, such an endorsement is used by the original payee to convey title of the check to another party. For example, a check has been drawn payable to a lawyer when the funds were really meant to be paid to one of his clients. The lawyer might endorse the check to his client without recourse, who would then provide an endorsement that did make the usual guarantees. The words "Without Recourse" will always appear on a qualified endorsement and should be referred to your supervisor. MULTIPLE ENDORSEMENTS: Any check which has been passed from one holder to another several times before it is placed into the banking system will bear a number of endorsements which track its chain of title. There is no limit to the number of endorsements in blank that may appear on a check, so long as each is followed by the endorsement of the person specified in the preceding endorsement. Unless each endorsement is dated, it might be difficult to tell in which sequence they had been made. Thus, custom has dictated that each subsequent endorsement be placed directly beneath the preceding one. In deciding whether any check has been acceptably endorsed for cashing or for deposit, the last endorsement should govern. ACCOMMODATION ENDORSEMENTS: An accommodation endorsement is an endorsement in blank written by a person who has no interest or title to the check, but who has lent the weight of his name to an endorser who could not have otherwise cashed the check. For example, if a total stranger attempted to cash a check drawn on another institution, we should decline to do so unless this person could induce a person whose financial responsibility is known to us or who has an account with our institution, and is willing to endorse the check being presented. We may hold our customer's funds in his account with us until the check clears, as he is responsible for the check if he gives an accommodating endorsement. You always want to remind our customer that he will be responsible for the check if Pivotal Financial Resources Page - 5

Negotiable Instrument Basics

he endorses it as an accommodation. Many customers do not realize that if the check is returned it will be deducted from their account. RUBBER STAMP ENDORSEMENTS: Many companies use a rubber stamp to affix their endorsement since they handle hundreds of checks daily. Most rubber stamp endorsements are restrictive, but even if not, no check which bears a rubber stamp endorsement without a manual (handwritten) signature should ever be cashed.

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