Check 21: Frequently Asked Questions

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1 TREASURY SERVICES Check 21: Frequently Asked Questions Check 21 Overview and Benefits What is Check 21? The Check Clearing for the 21st Century Act (H.R. 1474) commonly referred to as Check 21 gives substitute checks the same legal standing as original items. While Check 21 stops short of mandating electronic images, the law represents a radical move toward encouraging and facilitating an electronic check processing environment. When does this Act become effective? Check 21 was passed by both Congressional houses in 2003 and signed into law by President Bush on October 28, It becomes effective October 28, Why was Check 21 passed? The major intended benefits of Check 21 are threefold: To facilitate check truncation by authorizing the use of substitute checks instead of the original checks To foster innovation in the check collection system without mandating receipt of checks in electronic form To improve the overall efficiency of the nation s payment systems How does Check 21 foster innovation in the nation s payment system? Check 21 enables financial institutions to operate in a dual environment wherein they can provide paper clearing documents to institutions that are unwilling or not equipped to receive electronic images without being required to maintain or clear original checks if they so choose. A financial institution may determine that it is in their best interest to convert all checks to images for electronic delivery. This is a check truncation process, and those banks that have entered into an agreement for such exchange can create substitute checks from these images if they are required to process such an item. The many benefits of a check clearing system involving solely image exchange would result in even more savings: the depository institutions would no longer need to transport original physical checks, the costs associated with generating substitute checks would not be incurred, and checks could be converted to ACH items to be cleared through the Automated Clearing House. How will Check 21 affect the current clearing process? Current law allows banks to enter into agreements to collect and return checks electronically with subsequent delivery of the original paper check. If a bank in the chain of payment or return of items has not entered into such an agreement, original checks could be required before payment or further processing of payments or returns could be accomplished. Under Check 21, banks can create electronic images of all of the original checks they process and if any receiving bank has not agreed to accept electronic presentment, then the bank can submit substitute checks. The receiving bank must process the substitute check in lieu of the original paper check. This will reduce the transportation costs associated with clearing (more)

2 2 original paper checks. Although all financial institutions will be required to accept substitute checks for processing collections and returns, they are not required to use the new authority granted by Check 21 to create substitute checks and may continue to process original items that come to them for collection or return processing. How does Check 21 foster an electronic check environment? Check 21 enables financial institutions to operate in a dual environment wherein they can provide paper clearing documents to institutions that are unwilling or not equipped to receive electronic images without being required to maintain or clear original checks if they so choose. A financial institution may determine that it is in their best interest to convert all checks to images for electronic delivery. This is a check truncation process, and those banks that have entered into an agreement for such exchange can create substitute checks from these images if they are required to process such an item. The many benefits of a check clearing system involving solely image exchange would result in even more savings: the depository institutions would no longer need to transport original physical checks, the costs associated with generating substitute checks would not be incurred, and checks could be converted to ACH items to be cleared through the Automated Clearing House. Substitute Checks, IRDs and Electronic Images What constitutes a substitute check under Check 21? A substitute check is a paper image replacement document (IRD) that: Contains an image that accurately represents all of the information on the front and back of the original check as of the time the original check was truncated Bears a MICR line containing all of the information appearing on the MICR line of the original check (except as provided under generally applicable industry standards for substitute checks) and a legend: This is a legal copy of your check. You can use it the same way you would use your original check. Conforms in paper stock, dimension, and otherwise, with industry standards (being developed) for substitute checks Is suitable for automated processing in the same manner as the original check What will be the difference between how a substitute check is processed versus how an electronic image is processed? A substitute check is a paper reproduction of the original check and is cleared as a check item. Alternatively, and by agreement only between the collecting and paying financial institutions, electronic check files with images containing MICR data can be exchanged via electronic delivery systems a process called image exchange without creating a paper document which must be physically delivered through the check clearing process. What is check truncation? Check truncation is the process of removing an original paper check from the collection or return process and creating a substitute check or electronic image to clear the item for payment or return. Unlike converted checks, which result in electronic funds transfer through the ACH system, substitute checks are still cleared as check items under the Federal Reserve board regulation regarding check collection and availability of funds, (Regulation CC) and state law (Uniform Commercial Codes and state regulatory laws).

3 3 If an original check had a security feature that did not survive when the substitute check was created and a loss occurred due to the lack of that feature, who is liable? A substitute check need not capture other characteristics of the check, such as watermarks, micro-printing, or other physical security features that cannot survive the imaging process, or decorative images, in order to meet the accuracy requirement. Conversely, some security features that are latent on the original check might become visible as a result of the check imaging process. For example the original check might have a faint representation of the word void that will appear more clearly on a photocopied or electronic image of the check. Provided the inclusion of the clearer version of the word on the image used to create a substitute check did not obscure the required information listed above, a substitute check that contained such information could be the legal equivalent of an original check. What is image on demand? When financial institutions enter into contractual relationships for image exchange, they can create additional efficiencies by sharing an image archive. Under such circumstances, the depository bank can choose to provide a file with payment details rather than images, so the paying bank can retrieve images from the image archive on an as needed basis. This process is known as image on demand. Who makes the decision to generate an electronic check image and why? Any financial institution in the clearing chain can truncate original checks at any point in the clearing process. However, in choosing to do so, that financial institution must have the capability to provide a substitute check when required to do so or have a contractual relationship with another entity that can create the substitute check on their behalf. Check 21 and ARC What is Accounts Receivable Conversion (ARC)? Accounts receivable conversion, known as ARC, is the electronic conversion of consumer checks at a retail lockbox, and it is the fastest growing segment of the ACH services network. Check images can be used for conversion of items to ARC, if eligible. What is check conversion? Check conversion is the process of converting an original paper check to an electronic funds transfer through the Automated Clearing House. In check conversion, your check is used as a source of information, including your check number, account number and the number that identifies your financial institution (ABA number) to create a different type of payment, taking your payment out of the check environment. What happens to ARC after Check 21 takes effect? Check 21 creates ideal circumstances for image exchange and ARC to co-exist with synergistic benefits. Because Check 21 promotes large-scale image exchange, many industry leaders are exploring remote image capture whereby check images are captured in the branch or ATM, at the point of sale, or in a corporate back office to allow for end-to-end processing. As remote image capture becomes more widespread, clients may look to banks with the capability to decision the best route for clearing items image exchange or ARC rather than maintaining or managing these processes themselves. Neither check truncation nor check conversion is likely to trump the other because corporations have varying needs that require alternative solutions with considerations toward speed of debit, return item risk and notification, fraud prevention, etc. Some will choose to go the ARC route while others will use image exchange. Plus, not all check payments are ARC eligible because ARC can only be used to clear retail checks (not corporate checks) that meet specific criteria.

4 4 What Financial Institutions and Businesses Can Expect from Check 21 How will Check 21 impact financial institutions? The Act provides the legal framework for substituting electronic images for original paper checks, but more important, it forces financial institutions to rethink their check processing operations. For example, banks that reject image exchange agreements, choosing instead to accept original checks or substitute checks only, may seriously compromise their competitive advantage. When Check 21 becomes effective, they may be more willing to enter into these image exchange agreements with more banks. Also, those that invest in technology to reap the benefits of electronic transfer will enjoy savings by eliminating float and transportation costs associated with the physical transportation of original checks. As a third option, banks that find the technology to be costprohibitive may look to outsource their clearing operations to achieve savings by leveraging large-scale clearing organizations that have invested in new technology. Are financial institutions obligated to accept substitute checks? Yes, once Check 21 becomes effective, all financial institutions will be required to accept and be able to process substitute checks as if these were the original items as long as the substitute check conforms to the standards and requirements under the Act. Are financial institutions obligated to accept electronic images? No. Financial institutions that are not under a written agreement can insist upon paper presentment, forcing the depository bank to provide either the original paper item or a substitute check. Just as before Check 21, financial institutions can voluntarily enter into agreements to accept electronic images via image exchange, however, they will be able to clear these items without also processing paper. How soon will financial institutions reap the benefits of Check 21? The true benefits of Check 21 will be realized when there is widespread adoption of image exchange for clearing since many payments will then be able to clear more timely and efficiently, eliminating the costly expense of transporting physical items. In this environment, banks will not have to manage the dual processes for clearing checks (paper and image). Furthermore, from a contingency standpoint, electronic images offer a safety net. In the aftermath of the 9/11 tragedy, when planes were grounded and the physical transportation of original checks was brought to a screeching halt, payments were backed up for days. Using image exchange mitigates this type of risk because payments can continue to be processed in the wake of this type of transportation crisis or other backlogs. How will Check 21 impact businesses that receive check payments? Under Check 21, businesses can optimize their check processing operations. For example, a company may manage multiple lockboxes around the country and utilize local banking relationships to clear those items. When Check 21 becomes effective, that same business could consolidate all of its check deposits with one bank that may not necessarily be located within their local footprint. In this instance, they could take advantage of electronic imaging to clear items faster and cheaper. The business is no longer dependent on local banks nor does it have to manage multiple banking relationships or physically transport original paper checks to banks for deposit. Also, the use and storage of check images will provide additional support for disaster recovery and contingency planning operations.

5 5 Check 21 and the Customer Experience How will Check 21 impact bank customers? There are several potential impacts that Check 21 may have on bank clients. Let s use the example of the customer who regularly writes checks on Wednesday hoping they won t clear until after his paycheck is direct deposited on Friday. This habit becomes much riskier after Check 21 becomes effective. As images become more widely used to clear check payments, the delay caused by transporting original physical items will be lost. Customers should be cautioned about potential consequences, such as returned checks and penalty fees for overdrafts in their accounts, as a result of reduced float time. Also, clients who reside in regions where they currently can require their paid original checks be returned with their bank statements will no longer be able to require receipt of the originals. Instead, they will receive only Substitute Checks for items that are truncated. What will happen to customers check security features? Certain check security features do not survive the imaging process. Examples of security features that do not survive the imaging process include void pantograph (usually in the paper background if copied), lock icon, security features in borders, etc. As a result, if customers do not currently use Positive Pay, they should consider doing so. What is the effect of Check 21 and image exchange on customers ARP and Positive Pay account? Check 21 and image exchange should not have an effect on our customers ARP and Positive Pay service. Regardless of how customers checks clear (check, IRD or image), JPMorgan will integrate the transaction into our customers services. Must financial institutions obtain customer approval to generate a substitute check? No. The decision rests solely with the depository bank or any financial institution in the chain of processing of an item for collection or return, not the customer. After Check 21, can certain consumers insist on receiving their original checks with their bank statements? Under certain state or local rules and regulations, customers are entitled to receive their original paid items with their statements. Under Check 21, such customers would have to accept receipt of a substitute check instead of their original item. Banks may choose to provide any of the following along with bank statements: original checks if they are in possession of such originals, substitute checks if they receive a substitute check from a prior bank in the chain of processing the original check or if they are truncating original checks themselves, and/or electronic images. Once a check is truncated to a substitute check, however, the customer is no longer entitled to demand receipt of their original paid check. The substitute check is the legal equivalent of their original item. If non-consumer customers currently receive their original checks in their statements, will they begin to receive cancelled checks, IRDs, or both? Possibly both. Customers who currently receive their checks in their checking account statement may be asked to re-evaluate the need for this service. Under Check 21, JPMorgan cannot guarantee the return of the original checks to customers as these items could have been converted to IRDs. JPMorgan is exploring options to increase the customers use of image-based services (which our customers find easier and more convenient than check return) and to reduce the amount of paper documents returned to the customers.

6 6 What is the effect of Check 21 and image exchange on customers Controlled Disbursement accounts? With Check 21 and image exchange, customers may experience a decrease in their clearing float. Check 21 could result in a decrease in clearing float driven by the fact that larger value checks will likely be the first items converted to IRDs. These IRDs could be presented faster than traditional checks as they bypass certain transportation delays and allow for inclusion in High Dollar Group Sorts or Same Day Settlement windows. Current image exchange models are similar to Electronic Check Presentment models, whereby, controlled disbursement accounts are usually excluded from the day-of-presentation debiting by the paying bank, therefore we do not anticipate any initial impacts. We will also be diligent in keeping our reporting times and quality unaffected. JPMorgan Response to Check 21 What image-based solutions does JPMorgan offer? JPMorgan offers several image-based disbursement solutions, inlcuding Ad Hoc Check Image Retrieval and i-vault SM. Ad Hoc Check Image Retrieval retrieves images of paid checks through a single access point, using a browser. You can see a check image immediately, without waiting for a photocopy or CD-ROM. i-vault electronically loads, stores and retrieves virtually any kind of document. Documents and data are accessible online and copies can be pasted in customer correspondence. What is JPMorgan doing about developing new offerings in support of Check 21? JPMorgan has a holistic strategy to meet the needs of clients in the operating environment after Check 21 takes effect. First and foremost, JPMorgan will continue to champion image exchange agreements with other financial institutions to offer clients the full array of financial services that Check 21 promotes, including check conversion and the migration to electronic processing. In support of that initiative, we re developing a multi-channel payment engine a decision system that will automatically determine for our clients the most timely and efficient manner to clear payment information that we receive. For example, when a deposit is provided via remote image capture from our client, the payment engine will automatically determine if the item is ARC eligible and, if so, it will be cleared through the Automated Clearing House. Payments that are not ARC eligible will automatically clear via the check clearing network using image exchange or a substitute check. At a minimum, non-arc payments may be truncated to be cleared more expeditiously. Additionally, although Check 21 is U.S. focused, we are looking to leverage image technology for cross-border U.S. dollar transactions. More Information For more information or to discuss how Check 21 may impact your business, contact your JPMorgan Treasury Services representative. Copyright 2004 JP Morgan Chase & Co. All rights reserved.