Availability of Funds and Collection of Checks

FEDERAL RESERVE SYSTEM

12 CFR Part 229

[Regulation CC; Docket No. R-1034]

Availability of Funds and Collection of Checks

AGENCY: Board of Governors of the Federal Reserve System.

ACTION: Final rule.

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SUMMARY: The Board is adopting amendments to Subpart C of Regulation

CC, which contains rules governing the collection and return of checks.

The amendments to the regulation and Commentary are intended to provide

further clarification as to the extent to which depository institutions

and others may vary the terms of the regulation by agreement for the

purpose of instituting electronic return systems.

EFFECTIVE DATE: December 15, 1999.

FOR FURTHER INFORMATION CONTACT: Louise Roseman, Director, Division of

Reserve Bank Operations and Payment Systems (202/452-2789); Oliver I.

Ireland, Associate General Counsel (202/452-3625), Stephanie Martin,

Managing Senior Counsel (202/452-3198), Legal Division. For the hearing

impaired only, contact Diane Jenkins, Telecommunications Device for the

Deaf (TDD) (202/452-3544), Board of Governors of the Federal Reserve

System, 20th and C Streets, NW, Washington, D.C. 20551.

SUPPLEMENTARY INFORMATION:

Background

In February 1999, the Board requested comment on options for

amending provisions in Regulation CC governing when paying or returning

banks may send notices instead of returning the original

checks.1 The purpose of the proposal was to explore whether

more flexibility is needed to enable check system participants to

experiment with methods to return checks electronically.

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\1\ 64 FR 9105, Feb. 24, 1999.

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The collection and return of checks is governed by both Regulation

CC and state law (Articles 3 and 4 of the Uniform Commercial Code

(U.C.C.)). When a paying bank decides to return a check, the U.C.C. and

Regulation CC require it to send the check or a notice within certain

deadlines.2 The U.C.C. and Regulation CC differ on when a

bank can return a notice rather than the check itself. If a check is

``unavailable for return,'' U.C.C. 4-301(a) allows a paying bank to

charge back the check by revoking its provisional settlement with the

presenting bank based on a notice of dishonor or nonpayment. The

Official Comment to U.C.C. 4-301 states that a check may be considered

unavailable for return if, under a collecting bank check retention

plan, presentment is made by a presentment notice and the check is

retained by the collecting bank. Presumably, therefore, the U.C.C.

would allow a paying bank to return a notice when a check has been

truncated. (It is not clear whether a check would be deemed unavailable

for return under the U.C.C. if the paying bank, rather than the

collecting bank, retains it.)

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\2\ The paying bank must initiate the return by midnight of the

banking day following the day the check was presented (U.C.C. 4-

301). The paying bank must return the check so that it reaches the

depositary bank expeditiously, in accordance with Sec. 229.30(a) of

Regulation CC.

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Regulation CC (Secs. 229.30(f) and 229.31(f)) establishes a

``notice in lieu of return,'' which substitutes for the original check

and carries value. The notice-in-lieu provisions of Regulation CC

provide that the paying (or returning) bank must return the original

check unless the check is unavailable, in which case the bank may

return a notice that meets certain information requirements. The

Regulation CC Commentary states that notice is permitted in lieu of

return only when a bank does not have and cannot obtain possession of

the check or must retain possession of the check for protest. The

Commentary explains that a check is not unavailable for return if it is

merely

[[Page 59608]]

difficult to retrieve from a filing system or from storage by a keeper

of checks in a truncation system.

The primary reason for the difference between the U.C.C.''s and

Regulation CC's treatment of notices is that there is likely to be less

risk for a depositary bank in accepting a notice (instead of the

original check) from a bank it knows than from a bank it doesn't know.

Under the U.C.C., the paying bank returns a check to the presenting

bank, which in turn charges back the check against the prior collecting

bank, and so on back up the forward collection chain until the check

reaches the depositary bank. Therefore, under the U.C.C., the

depositary bank receives returns from the bank to which it had sent the

check for collection and with which it has a previously established

relationship. One of the purposes of Regulation CC was to speed up the

check return system that existed under the U.C.C. Regulation CC

eliminated the requirement that returned checks follow the forward

collection chain. Under Regulation CC, the paying bank may send the

returned check directly to the depositary bank or to any returning

bank, even if that bank did not handle the check for forward

collection. Therefore, under Regulation CC, depositary banks may

receive returned checks from banks with which they have no previous

relationship.

Some check system participants asked the Board to clarify the

interrelationship between the U.C.C. and Regulation CC in order to

provide additional legal certainty for institutions that wish to

experiment with electronic return systems, under which they would

return images or other notices rather than the checks. These

participants were concerned about their ability to bind all relevant

parties to an electronic return arrangement under the variation-by-

agreement provisions of Regulation CC. Regulation CC (Sec. 229.37)

permits the parties to a check to vary the notice-in-lieu provisions;

however, an agreement under Regulation CC cannot affect banks,

customers, or others that are not party to the agreement or otherwise

bound by it. The Regulation CC variation-by-agreement provision differs

from the corresponding language in U.C.C. 4-103 in that the U.C.C.

allows clearinghouse rules (as well as Federal Reserve regulations and

operating circulars) to be effective as agreements whether or not

specifically assented to by all interested parties.3

Regulation CC does not incorporate the U.C.C.''s special treatment for

clearinghouse rules (or for Federal Reserve rules and circulars) but

does not affect the status of such under the U.C.C.

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\3\ The Official Comment to U.C.C. 4-103 (note 3) indicates,

however, that there are limitations on the scope of clearinghouse

rules. The Comment notes that clearinghouses are not authorized to

rewrite the basic law generally and that clearinghouse rules should

be understood in the light of functions the clearinghouses have

exercised in the past.

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This difference in variation-by-agreement provisions exists because

Regulation CC does not govern the relationship between banks, their

customers, and remote parties to the extent that the U.C.C. does. While

Board rules can bind depository institutions, the Board does not appear

to have the authority under the Expedited Funds Availability Act to

bind depositors or payees to an electronic check return system. Section

611(f) of the Act, which authorizes the Board to establish rules

allocating loss and liability in the payments system, applies to loss

and liability among depository institutions only. The Act does not

authorize such allocations to customers of depository institutions.

Although banks would be able to obtain agreement to the terms of an

electronic return arrangement from their customers through account

agreements, under Regulation CC they would not be able to bind remote

parties to the check, such as non-depositor payees. Some check system

participants sought an amendment to Regulation CC that would eliminate

the risk that these remote third parties would bring a claim under

Regulation CC in the event they suffered losses due to the fact that a

check was returned electronically rather than in physical form. A claim

could potentially arise under the following circumstances:

Drawer A writes and delivers a check payable to Payee B. Payee B

negotiates the check to Depositor C, who deposits the check in his

bank. Depositor C's bank presents the check to Drawer A's bank. Both

banks are participating in an electronic return system, and Drawer A's

bank returns an image of the check to Depositor C's bank, which, in

turn, charges Depositor C's account. Depositor C would have to attempt

to collect the funds from Payee B or Drawer A without the physical

check. Assuming that Depositor C has agreed to the electronic return

system through an account agreement, Depositor C would bear the risk

that Payee B or Drawer A would not pay without the original check.

(Payee B or Drawer A may be concerned about the risk of double payment

if the original check is not returned.) If Payee B pays Depositor C in

return for the check image or similar notice, Payee B may still be

unable to collect from Drawer A without the check and could suffer

losses (although Payee B may still have recourse against Drawer A under

the U.C.C. even without the original check). Presumably, an electronic

return arrangement would allow banks or customers to request the

original check within a certain amount of time. If Drawer A becomes

insolvent before the original check is retrieved, Payee B would suffer

losses. If Payee B would have been able to collect from Drawer A had

Payee B originally received the check rather than the notice, then

Payee B's losses would likely be attributable to the electronic return

system.

Regulation CC imposes a duty on banks to exercise ordinary care and

act in good faith in handling checks under Regulation CC. This duty

runs to the depositary bank, the depositary bank's customer, the owner

of a check, or another party to the check. If a bank violates these

duties, resulting in harm to one of these parties, the party may have a

claim against the bank for damages. Therefore, if a bank returned a

notice-in-lieu when the physical check was deemed ``available'' under

Regulation CC, and the return of the notice rather than the physical

check caused a party to the check to incur a loss, the bank potentially

could be liable for damages. The bank sending the notice could be

liable even if it had agreed with the receiving bank to use notices in

lieu of return. The injured party would have to show lack of good faith

or failure to exercise ordinary care.

The risk of a bank becoming liable to a remote third party under

the circumstances described above appears to be low. Nevertheless, some

check system participants stated that they were reluctant to begin

experimenting with electronic check return systems without additional

protection. To flesh out the pros and cons of making regulatory changes

in this area, in February 1999 the Board sought commenters' input on

two options.4

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\4\ 64 FR 9105, Feb. 24, 1999.

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The first option was to amend the Commentary to Regulation CC to

state that banks could send a notice of dishonor or nonpayment in

accordance with the provisions of U.C.C. 4-301 when they return the

notice through the forward collection chain, as contemplated in the

U.C.C. The U.C.C. notices would be subject to the Regulation CC

expeditious return rules. This proposal would clarify that banks could

avail themselves of the U.C.C. rules regarding return of notices to the

same extent that they could before Regulation CC was adopted. The Board

noted, however, that this proposal may

[[Page 59609]]

not provide relief for check truncation or image systems if returns do

not follow the forward collection chain and that it could have

consequences for the depositors or payees of the checks, who may have

difficulty recovering from the drawers without the original checks.

The second option was to delete the Regulation CC Commentary

language that explains when a check is unavailable for return. Instead

of this language, the Commentary would indicate that notices in lieu of

return are permissible whenever they would be permissible under the

U.C.C. The Board noted that this option would liberalize the

circumstances under which banks could use notices in lieu of return and

potentially make it easier for banks to establish electronic check

return mechanisms that feature check truncation, but would force

depositary banks to accept notices from banks with whom they may have

no established relationships. This option could also have consequences

for the depositors or payees of the checks as discussed above under

option one.

The Board also proposed to delete Sec. 229.36(c) of Regulation CC

and its associated Commentary, which states that a bank may present a

check electronically under an agreement with the paying bank and that

the agreement may not extend return times or otherwise vary the

provisions of Regulation CC with respect to persons not party to the

agreement. This provision of the regulation is subsumed by the

variation-by-agreement provisions in Sec. 229.37, and it may be

unnecessary and potentially confusing to retain special provisions

regarding a particular type of variation by agreement. The Board

proposed to add an example to the Commentary to Sec. 229.37, listing an

electronic check presentment agreement as a permissible variation by

agreement under Regulation CC. The Board noted that eliminating

Sec. 229.36(c) and its Commentary would result in no substantive change

to the regulation regarding the validity of electronic presentment

agreements.

Summary of Comments

The Board received 72 comments on its proposed options, classified

as follows:

Banks/Bank holding cos: 32

Thrifts/Thrift holding cos: 2

Credit unions/Corporate credit unions: 9

Trade associations representing--

Banks: 5

Credit unions: 5

Clearing houses: 2

Non-banks: 2

Clearing houses/organizations: 9

Federal Reserve Banks: 2

Non-bank service providers: 4

Problems Raised by Notices in Lieu of Returns

Overall, the commenters were supportive of changes that would

improve efficiency and reduce risk in the check collection and return

system, but were reluctant to support changes that would impose costs

on depositary banks, their customers, and other parties to the check

without their consent. Thirty-five commenters specifically discussed

the problems that would arise if depositors received notices of

returned checks instead of the physical checks. Many of these

commenters echoed the problems stated by the Board in its proposal,

i.e. that customers generally expect checks to be returned to them when

their accounts are charged back and that customers have ownership

rights in the physical checks. Commenters were concerned about whether

their customers would be able to collect from drawers without the

original checks and some noted that the drawer's risk of double payment

needs to be addressed. Some of these commenters stated that the U.C.C.

limits a holder's rights to enforce a check without possession of the

physical item. Several commenters raised concerns about whether a

notice of a returned check would be sufficient evidence of the return

in court, and others noted that law enforcement authorities often

require the original check in order to lift fingerprints from the check

or examine the handwriting. Four commenters, however, stated that even

though the customer, as the legal owner, may have a right to the

original check, there may be no practical consequence if an image or

other electronic return has legal equivalence under the U.C.C. or the

Uniform Electronic Transactions Act.5

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\5\ The Uniform Electronic Transactions Act is a model law

drafted and approved by the National Conference of Commissioners on

Uniform State Laws and recently adopted in California. It does not

provide that a check image or other electronic returned check is

legally equivalent to the original check, except for limited record-

keeping purposes.

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Twenty-one commenters raised concerns about whether the information

provided on a notice-in-lieu-of-return would be sufficient to allow the

depositary bank to charge back its customer's account. The commenters

listed such necessary information as the indorsement (especially on

third-party checks), the check date, the payee, the amount, the reason

for return, the teller stamp, trace numbers, and the account number.

Some commenters noted that missing information is already a problem for

notices-in-lieu under the current regulation. Some of these comments

were related to concerns about the quality of the photocopy or image

that depositary banks would receive, and others were related to the

sufficiency of information in an electronic notice that did not include

an image of the check. One commenter suggested that if notices-in-lieu

become more permissible, then all of the information requirements of

Sec. 229.33(b) should be mandatory and no questions marks allowed.

Costs and Benefits of Electronic Returns

Thirty-one commenters specifically mentioned the benefits of an

electronic return system. These commenters generally believe that

electronic returns will enable checks to be returned faster and will

allow depositary banks and their customers to protect themselves better

against check fraud. They stated that an electronic return system would

lead to operational savings and make forward check truncation feasible.

On the other hand, eight commenters believed that the costs of an

electronic return system could likely outweigh the benefits. The

commenters noted that costs could take the form of incomplete

information to the depositary bank, potentially resulting in delays in

charging back the customer's account, as well as the expense of

hardware and software to operate an electronic return system.

Six commenters discussed the potential competitive effects of

establishing an electronic return system. These commenters were

generally concerned that community banks and other small depository

institutions may not be technologically prepared for electronic returns

and should not be placed at a disadvantage by any regulatory change.

Option One

Only one commenter expressed a preference for option one. Thirty-

two commenters pointed out specific problems that would arise if the

Board were to adopt option one. Many stated that application of option

one would be too limited in scope to provide sufficient incentive for

experimentation in electronic returns. Several commenters believed that

certain checks may be impossible to return through the forward

collection chain within the expeditious return deadlines. Others

commented that the U.C.C. standards are not clear as to what

information must be included in a U.C.C. notice of nonpayment and were

concerned that the depositary bank would not receive information

sufficient to charge the check back to its customer's account.

[[Page 59610]]

Some commenters believed that adoption of option one would lead to

confusion as to when the U.C.C. applied to a returned check rather than

Regulation CC, and one commenter noted that state-to-state variation in

the meaning of ``unavailable for return'' could lead to confusion with

respect to interstate transactions. Commenters raised other questions

as to the implementation of option one, such as (1) whether the

presenting bank that receives a U.C.C. notice of nonpayment, but holds

the truncated physical check, has the option to either send a notice or

the check to depositary bank and (2) whether the physical check must be

made available to the depositary bank or its customer upon request.

Option Two

Eighteen commenters supported proposed option two, although nearly

all of those commenters raised additional issues that they believed

should be addressed. The Electronic Check Clearing House Organization

(ECCHO) and seventeen other commenters supported option two so long as

the regulation made clear that the depositary bank would have to agree

to receive electronic notices in lieu of return. These commenters

stated that experimentation with electronic notices should be conducted

on a voluntary basis, governed by bilateral or multilateral agreements.

The commenters stated that the depositary bank would need to know from

whom it would be receiving electronic returns and would have to work

out such issues as who would own the returns/images, acceptable quality

standards, who to contact in case of problems, and what procedures to

follow. One supporter of option two, however, did not expect that the

receipt of unexpected electronic returns from unfamiliar banks would be

widespread. This commenter stated that the issue of the quality of

electronic returns from unfamiliar banks would be an operational matter

that would likely be self-regulated between paying banks and depositary

banks and should be left for the banks to police.

Eleven commenters discussed specific problems regarding option two.

Some of these commenters raised issues related to dealing with an

unknown returning bank. They stated that accepting notices from banks

with which the depositary bank has no relationship could pose

significant financial or customer service risk exposure. They also said

that handling returned items could become more complex and time-

consuming if images are received from multiple sources, and the amount

of manual sorting could outweigh the advantages of new technology.

Another concern raised by the commenters was that option two could

increase the use of notices in lieu of returns, placing the burden on

the depositary bank in providing the depositor with the information on

the return item when a charge-back occurs without the physical check.

The commenters also raised other matters that would need to be

addressed under option two, such as (1) Whether the presenting bank

that receives a notice but holds the physical check has the option to

send either the notice or the check to the depositary bank and (2)

whether the physical check must be made available to the depositary

bank or its customer on request.

Other Comments on Options.

Seventeen commenters opposed both options. Most of these commenters

stated that the proposals would make the return process more

complicated, particularly in connection with reconcilement, without a

comprehensive all-electronic approach. They stated that the Board

should address other issues related to electronic returns before

adopting either option. One commenter favored either option, stating

that either would accomplish the goal of reconciling Regulation CC with

the U.C.C. as to when a check is available for return.

Most of the commenters suggested additions or enhancements to the

two options proposed by the Board:

Variation by Agreement.

Nine commenters stated that the Board should permit clearing house

rules to vary Regulation CC in same way as they vary the U.C.C. The

commenters stated that this would avoid the need to change Regulation

CC to accommodate innovations and would put private-sector banks on a

more equal footing with non-banks and Federal Reserve Banks.

The Federal Reserve Bank of Atlanta (FRB Atlanta) believed that the

concern as to whether Sec. 229.37 of Regulation CC limits the ability

of an agreement to bind remote parties is ameliorated by at least two

factors: (1) FRB Atlanta stated that the only remote party right under

Regulation CC is the right to receive a notice of return, which can be

met by an image of sufficient quality to permit the depositary bank to

identify its customer; other remote party rights arise under the U.C.C.

and can be addressed in the context of agreements under the U.C.C.; and

(2) At least one court decision 6 held that the depositary

bank, as the collection agent for its customer, can enter into

agreements on behalf of the customer without prior consent as long as

agreement is reasonable. FRB Atlanta stated that accepting an image

return (with the paper check to follow) seems to be reasonable. FRB

Atlanta suggested, as an alternative to the proposed options, that the

Board revise the Commentary to Sec. 229.37 to provide that depositary

bank may agree with paying or returning banks to accept images or other

notices of dishonored checks as notices in lieu of return and that

those banks may be responsible under other applicable law to parties

interested in the check for any losses caused by the handling of check

returns under such agreements (except to the extent addressed in

effective agreements with those other parties).

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\6\ Graubert v. Bank Leumi, 399 N.E. 2d 930 (Ct. App. N.Y.

1979).

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U.C.C. Availability Requirement.

Three commenters stated that the proposal's reference to U.C.C. 4-

301 is not sufficient because it is not clear what types of check

programs are encompassed by the U.C.C.'s Official Comment to 4-301

regarding ``availability'' of checks for return. The commenters

suggested that the Regulation CC Commentary should specifically permit

notice in lieu of return when a check is difficult to retrieve from a

filing system or from storage pursuant to a truncation, image or other

check electronification program, provided the receiving bank has agreed

to accept notices in lieu of return in such circumstances.

Two commenters raised other questions concerning what sorts of

truncation arrangements are contemplated by U.C.C. 4-301(a). These

comments reflected the uncertainty as to whether it matters which bank

in the collection or return chain is the truncating bank in determining

if a check is unavailable for return under the U.C.C.

Three commenters suggested that the Board allow a bank to provide a

notice-in-lieu at will, rather than only when the original check is

unavailable for return. These commenters noted that such returns may

not be permissible under the U.C.C., but they anticipated that the

U.C.C. or its state variations may become less restrictive in the

future as technology changes.

Address Legal Status of Images.

Five commenters requested that the Board address the legal status

of images to provide comfort that an image or electronic notice legally

replaces the original check. Some of these commenters suggested that

the

[[Page 59611]]

Commentary should explicitly state that images are acceptable in the

U.S. check collection and return system to bolster banks' ability to

convince customers to accept images in lieu of the original check.

Establish Standards.

Fifteen commenters asked the Board to establish standards for an

electronic return system. The commenters expressed a need for standards

in areas such as image quality, standardized return reason codes, data

communication, procedures to verify system integrity and compatibility,

and indorsements. Some of these commenters stated that the Board should

set time limits for the returning bank to provide the depositary bank

with the paper check and procedures for request and retrieval. One

commenter stated that the Board should provide for migration to more

image-friendly check stock. Another commenter stated that a new

regulatory infrastructure is necessary to address detailed issues, even

more specifically than the Board's same-day settlement provisions in

Regulation CC.

Address Return Deadlines.

Seven commenters stated that the Board should clarify how an

electronic return system would affect return deadlines. For example,

one commenter suggested that the Board should clarify when the return

clock starts if checks are presented electronically and the physical

item is necessary to create a return. Other commenters suggested that

the Board amend Regulation CC to provide that, if a bank sends image

returns under a truncation arrangement where the check was presented

electronically, it would not be required to meet the U.C.C. return

deadline. The commenters stated that this rule would nurture the

development of electronic check presentment and would enable the paying

bank to examine the physical check and create an image return without

violating the U.C.C. midnight deadline.

Representment.

Eleven commenters stated that the Board should address how a

depositary bank could represent a check that had been returned

electronically. They said that representment of checks returned

electronically would pose technical and operational challenges,

including the form of the represented check and what would replace the

indorsement audit trail. One commenter suggested that the Board

establish redeposit rules allowing for prompt representment of

electronic returns to protect consumers from the potential loss from

dishonored checks.

Depositary Bank Protections.

Thirteen commenters requested that the Board take steps to protect

depositary banks under electronic return systems. Several commenters

suggested that the depositary bank should be able to send back an

electronic return and require return of the physical check instead.

Other commenters suggested providing warranty protection for the

depositary bank by requiring the bank that sends an electronic return

to indemnify a depositary bank that charges back its customer based on

the electronic return. One commenter also stated that the depositary

bank and its customers should receive guarantees that the original

check will not be returned.

Allow Images Only.

Ten commenters suggested that the Board limit electronic return to

images only. One of these commenters stated that the regulation should

reflect a preference in favor of check imaging rather than the

transmission of a detailed accounting of the check. Another commenter

stated that the regulation should discourage the proliferation of

written notices, which are often incomplete and expose the depositary

bank to undue risk.

Address Coordination Issues.

Two commenters suggested that the Board should address various

issues related to the interaction of an electronic return system with

other electronic payment initiatives. One commenter asked for

clarification as to how a paying bank could return an image if it is

receiving check presentment electronically. This commenter also asked

how a depositary bank could create ACH returned-check entries (RCKs)

without the physical checks. Another commenter suggested that the Board

should provide a statement authorizing use of a notice in lieu of

return when the check has been processed electronically and returned to

its owner at the point of sale. The commenter stated that this would

encourage increased experimentation with electronic check truncation at

the point of sale.

Comprehensive Approach.

Seven commenters believed that the Board should take the lead in

working with the industry on a comprehensive approach to structuring an

all-electronic return process. One commenter stated that electronic

returns need to be part of a new regulatory approach for overall check

electronification. Another commenter stated that the Board should

express its willingness to consider and act on appropriate regulatory

changes on an ongoing basis during the transition to electronics in

check processing. Another commenter suggested that the Board fund a

nationwide education and marketing campaign to ensure consumer and

corporate acceptance of images in lieu of checks. Finally, one

commenter stated that the current return rules hold the check system

hostage to the needs of a few payees, and the Board should endorse the

notice-in-lieu process more enthusiastically rather than merely

condoning it.

Implementation Date.

Seven commenters made statements regarding the implementation date

of any rule change. Most of these commenters favored implementation as

quickly as possible, but one commenter asked for at least one year lead

time to allow for updating of internal systems.

Amendments to Secs. 229.36 and 229.37.

Seven commenters explicitly supported the proposed amendments to

Secs. 229.36 and 229.37 regarding electronic presentment agreements.

One commenter suggested that the restriction on the expansion of check

return deadlines should be retained explicitly.

Board staff invited all of the public commenters to participate in

a meeting on July 26 to discuss issues related to the proposed

amendments. Twenty-eight commenters attended the meeting.

Discussion

As indicated in the comment summary, overall, most commenters were

open to the idea of an electronic return system but were very concerned

about the effects of such a system on depositary banks and their

customers. Many commenters were reluctant to support regulatory changes

without knowing the details of how an electronic return system would

work and how they and their customers would be protected. This concern

prompted many commenters to suggest that the Board, in cooperation with

banks, establish more detailed rules and standards that would govern

such a system. The Board continues to believe that practices and

standards would be developed most efficiently through commercial

practice and market experimentation rather than by regulation. The

Board believes that its appropriate role is to facilitate

experimentation by determining whether its rules create barriers to

experimentation and if so, whether

[[Page 59612]]

those rules can be changed without creating undue adverse affects.

As noted above, under Regulation CC, the inability to bind remote

parties to an interbank agreement could lead to liability on the part

of banks for relying on electronic returns. Some participants in the

July 26 meeting reiterated that it is this potential liability they

would like to avoid. ECCHO and various others suggested in their

comment letters that the Board adopt option two but permit an

electronic return only if the depositary bank agrees to accept it.

ECCHO restated its proposal at the July 26 meeting, laying out a 3-part

plan for revising option two: (1) All of the banks involved, including

the depositary bank, would have to agree to participate in any

electronic check return program, (2) a notice in lieu of return,

whether specifically permitted under Regulation CC or permitted as part

of an interbank agreement on electronic check returns, would satisfy

the requirements of Regulation CC to the same extent as the return of

the original paper check for all bank and non-bank parties to the

check, and (3) banks that are parties to an electronic return agreement

may be liable under other law to non-bank parties unless that liability

is covered by other agreements.

Most of the discussion at the July 26 meeting focused on the cut-

off of rights under ECCHO's point (2), which would shield participating

banks against claims by remote parties under Regulation CC but would

not operate as a shield against claims under other law. (Presumably,

ECCHO and others would rely on their ability to bind remote parties by

clearinghouse rules under the U.C.C. to address these potential

claims.) The Board's proposed option two would have cut off Regulation

CC rights, but those rights would have been cut off for both banks and

non-banks. The ECCHO proposal would allow banks to opt out of the

electronic return arrangement but would not allow their customers or

other parties to the check to do so. Supporters of the ECCHO proposal

reasoned that this distinction was justified because depositary banks

would have to make operational changes to be able to accept electronic

returns, but depositors and others would not necessarily need to make

such changes.

Meeting participants were unable to quantify the risk presented by

the possibility that non-assenting parties may assert Regulation CC

rights if an electronic return program caused them to incur losses. In

general, participants agreed that, because banks can generally obtain

assent from their customers through deposit agreements, the most

serious risks would be from potential claims by remote third parties,

such as non-depositor payees, unless those rights are cut off. ECCHO

and some of the bank representatives stated that the uncertainty as to

the size of this risk was preventing banks from investing in pilot

electronic return programs. Without quantifying this risk, some banks

stated that they are unable to judge whether the benefits of an

electronic return system outweigh the risks, although some bank

representatives said that they had not made a focused attempt to

determine the magnitude of the risk. At the close of the meeting

representatives from ECCHO and certain banks stated that they would

take a closer look at the risks of claims from non-assenting parties

under Regulation CC to determine whether those risks are actually

outweighed by the perceived benefits to banks of electronic returns.

In a subsequent letter to the Board, ECCHO reiterated its support

for a Regulation CC amendment that would incorporate its proposal as

outlined at the meeting.7 In its letter, ECCHO argued that

its proposal would result in increased efficiency in the check return

system that would benefit banks as well as depositors in terms of

protection against check fraud. ECCHO believes that customer service

incentives will lead banks to make the original paper checks available

to customers within a reasonable window of time and that banks that are

not comfortable with the arrangement can opt out.

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\7\ The Board received five other follow-up letters from

organizations that attended the July 26 meeting. The letters

supported the ECCHO proposal in general, but some stated that the

Board should seek additional comment before adopting the ECCHO

proposal.

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ECCHO's proposal would eliminate the risks of potential Regulation

CC claims against banks that participate in electronic check return

systems. The risk would, in effect, be shifted from depositary banks to

their customers and remote third parties. Those who favor this proposal

have not demonstrated the magnitude of this risk. They state that the

risk is significant enough to prevent banks from experimenting with

electronic returns. On the other hand, they state that shifting the

risk to non-bank parties is justified by the efficiencies and cost-

savings that an electronic return system would bring. The Board's

proposed option 2 would also, in effect, shift this risk to non-bank

parties to the check, as well as to depositary banks. The Board

believes that the risk of Regulation CC claims by remote third parties

is quite low and finds it difficult to justify shifting that risk to

the remote third parties to benefit banks that have agreed among

themselves to return checks electronically. The barrier that the

current regulation presents to electronic check return does not appear

to be significant enough to warrant shifting risks to non-assenting

parties. Further, the commenters indicated that proposed option one

would not be useful in many situations where checks are not returned

back through the forward collection chain.

Instead, the Board has taken a different approach, similar to that

suggested by FRB Atlanta. The Board has revised the Commentary to

Sec. 229.37 to clarify that depositary banks may agree with paying or

returning banks to accept images or other notices in lieu of returned

checks even when the checks are available for return under Regulation

CC. Except to the extent that other parties interested in the checks

assent to or are bound by the banks' agreements, banks entering into

such agreements may be liable under Regulation CC or other applicable

law to other interested parties for any losses caused by the handling

of returned checks under such agreements. This revision leaves the

rights of depositary banks, depositors, and remote parties intact under

both Regulation CC and the U.C.C., avoiding the potential consumer

issues of the proposed options and the ECCHO proposal.

Given the Board's action, the final analysis of any electronic

return system will be driven by a cost decision on the part of the

banks involved. If the cost savings of an electronic return system will

be as great as some check system participants expect, then the risk of

Regulation CC claims by non-assenting remote third parties may be

outweighed by those savings and could be absorbed by participating

banks. The Board notes that banks have taken on these risks in other

contexts. For example, the banks that are participating in the Federal

Reserve electronic return pilot in Montana have agreed to assume the

risk of claims by non-assenting parties.8

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\8\ In other electronic payment experimental programs, banks

have been willing to assume risks that appear to be more significant

than the risk presented in this instance. For example, under

recently adopted National Automated Clearing House Association rules

that allow check payees to collect the funds from the checks through

the automated clearing house (ACH) under certain circumstances, the

bank that originates the ACH transaction warrants that all

signatures on the check are genuine and that the underlying paper

check will not be presented, even though the bank itself may not

have possession of or control over the check.

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The Board believes that the best long-term solution to this

particular electronic return issue, as well as other

[[Page 59613]]

issues related to the electronic collection and return of checks, would

best be addressed in a coordinated effort to bring subpart C of

Regulation CC and the U.C.C. into conformance. The Board is pursuing

this solution with the National Conference of Commissioners on Uniform

State Laws.

In addition, as proposed, the Board has removed the electronic

presentment agreement provisions from Sec. 229.36(c) and its related

Commentary and added a corresponding example to the Commentary to

Sec. 229.37. These amendments will not have any substantive effect.

Regulatory Flexibility Act Certification

In accordance with section 605 of the Regulatory Flexibility Act,

(12 U.S.C. 605), the Board certifies that the amendments to Regulation

CC and its Commentary will not have a significant economic impact on a

substantial number of small entities. The amendments will clarify the

extent to which banks may agree to vary the terms of Regulation CC by

agreement to experiment with electronic return systems, but will not

affect any entities who have not agreed.

List of Subjects in 12 CFR Part 229

Banks, banking, Federal Reserve System, Reporting and recordkeeping

requirements.

For the reasons set forth in the preamble, 12 CFR Part 229 is

amended as set forth below:

PART 229--AVAILABILITY OF FUNDS AND COLLECTION OF CHECKS

(REGULATION CC)

1. The authority citation for part 229 continues to read as

follows:

Authority: 12 U.S.C. 4001 et seq.

Sec. 229.36 [Amended]

2. In Sec. 229.36, paragraph (c) is removed and reserved.

3. In Appendix E, under section XXII, paragraph C. is removed and

reserved.

4. In Appendix E, under section XXIII, new paragraphs C.9. and

C.10. are added to read as follows:

Appendix E to Part 229--Commentary

* * * * *

XXIII. Section 229.37 Variations by Agreement

* * * * *

C. * * *

9. A presenting bank and a paying bank may agree that

presentment takes place when the paying bank receives an electronic

transmission of information describing the check rather than upon

delivery of the physical check. (See Sec. 229.36(b).)

10. A depositary bank may agree with a paying or returning bank

to accept an image or other notice in lieu of a returned check even

when the check is available for return under this part. Except to

the extent that other parties interested in the check assent to or

are bound by the variation of the notice-in-lieu provisions of this

part, banks entering into such an agreement may be responsible under

this part or other applicable law to other interested parties for

any losses caused by the handling of a returned check under the

agreement. (See Secs. 229.30(f), 229.31(f), 229.38(a).)

* * * * *

By order of the Board of Governors of the Federal Reserve

System, October 27, 1999.

Robert deV. Frierson,

Associate Secretary of the Board.

[FR Doc. 99-28580 Filed 11-2-99; 8:15 am]

BILLING CODE 6210-01-P