Check Payments Overview

Defining Payments Terms

• Check Payments Definitions

  • Acronyms and terms defined in this section are grouped by:

    • Financial institutions

    • Industry rules

    • Regulations

    • Standards

    • Check Definitions

• Check Payments Terminology: Financial Institutions

  • Depository Financial Institution (DFI)

    • State or nationally chartered bank, savings, and loan association, savings bank, or credit union

    • Bank of First Deposit (BOFD): Depositary Bank

      • First DFI to which check is transferred; may also be the Paying Bank or Payee

  • Collecting Bank

    • Bank handling an item for collection except the Payor Bank; subsequent bank in forward collection process

      • Example: FRBs are collecting bank

  • Intermediary Bank

    • Bank to which an item is transferred in course of collection

      • Except the Depositary Bank or Payor Bank

  • Presenting Bank

    • Bank presenting an item to the Payor Bank

  • Payor Bank

    • Bank that is the Drawee of a draft; see also Paying Bank definition in Reg CC

• Terminology: Industry Rules

  • ECCHO Operating Rules & Commentary

    • ECCHO, a service of The Clearing House, maintains a national set of Rules for private sector image exchange

      • Rules apply only to exchanges between ECCHO members that agree to use the Rules

  • FRB OC3: Federal Reserve Operating Circular 3

    • Governs the collection of cash items and returned checks through the Federal Reserve Banks (FRBs)

      • References Regulation J for related warranties

• Terminology: State Law

  • Uniform Commercial Code (UCC)

    • Model state law as adopted in a state

    • Provides general business law of a state regulating sale of goods, commercial paper (checks), bank collections, and secured transactions in personal property

    • Articles 3 and 4 relate to negotiable instruments and bank deposits and collections

    • Article 1 includes general provisions and definitions

• Terminology: Regulations/Federal Laws

  • Reg CC or Regulation CC

    • Federal regulation that governs availability of funds deposited in transaction accounts (e.g., demand deposit accounts), the collection and return of checks and substitute checks

  • Reg J or Regulation J

    • Federal regulation that governs collection of checks/other items by FRBs

    • Establishes procedures, duties, and responsibilities among FRBs, senders and payors of checks and other items and senders and recipients of Fedwire fund transfers

• Terminology: Standards:

  • Accredited Standards Committee X9

    • X9 is accredited by the American National Standards Institute (“ANSI”) to develop and maintain open consensus standards for the financial services industry in the US

      • Facilitates creation/administration of standards that improve payments, protect data and interoperability between exchange parties.

    • X9 standard related to payments in this training include:

      • X9.100-140: Specifications for Image Replacement Document - IRD

      • X9.100-160: Magnetic Ink Printing (MICR) Parts 1 and 2

      • X9.100-187: Electronic Exchange of Check and Image Data

      • X9.100-188: Return Reasons for Check Image Exchange and IRDs

  • X9.100-160: Magnetic Ink Printing (MICR) Parts 1 & 2

    • Magnetic Ink Character Recognition (MICR)

      • Descriptive information compromised of numbers and symbols printed at bottom of physical check

      • Generally printed in magnetic ink and designed to be recognized at high speed by automated processing equipment

      • Symbols printed in special font (E-13B)

      • Character set includes:

        

• Terminology: Check - Negotiable Instrument

  • Written order

    • Written order directing a bank to pay money as instructed

      • Designed to transfer amount of money for which it is written on or after the date specified on the check and to specific payee (or to the bearer)

  • Promise to pay

    • An unconditional promise to pay

      • Includes a substitute check and an electronic check/electronic returned check

  • Defined by state & federal law

    • UCC definition:

      • Draft if it is an order to pay;

      • Within this definition it states check is a draft payable on demand

    • Reg CC definition:

      • Check covers several types of instruments including checks, money orders, etc.

• Terminology: Checks

  • Remotely Created Check (RCC)

    • Defined by both UCC and Reg CC as check that is:

      • Not created by the Paying Bank; and

      • Does not bear signature applied, or purported to be applied, by person on whose account check is drawn

    • RCCs are considered unsigned drafts

      • Must be authorized by account holder;

      • Must be printed (a physical item) to meet Reg CC definition

    • RCCs are not created by a Paying Bank or agent of the Paying Bank

Negotiable Instrument

• Negotiable Instrument - Draft/Check

  • UCC 3-104 defines the check within the definition of a negotiable instrument as a draft that is:

    • Written instruction

      • Must be a writing/physical item

    • Signed by the drawer

      • Person giving the instruction

    • Order to pay fixed amount of money

      • Value of instrument

    • Payable on demand

  

• Negotiable Instrument & Drafts

  • UCC divides instruments into two general categories:

    • Drafts and Notes

  • An instrument is a:

    • Note if it is a promise to pay; and

    • Draft if it is an order to pay

  • Draft is further defined in UCC as:

    • Written order signed by the drawer; an unconditional order to pay

    • Checks are drafts

• Check: Demand Draft

  • Reg CC check definition covers several categories of instruments:

    • Negotiable demand draft drawn on:

      • Or payable through or at, an office of a bank;

      • Federal Reserve Bank or Federal Home Loan Bank;

      • US Treasury;

    • Demand draft drawn on:

      • State or unit of general local government not payable through or at a bank;

    • U.S. Postal Service money order;

    • Traveler’s check; and

    • An original check and a substitute check

  • Electronic check/electronic returned check defined as:

    • Electronic image of an electronic information derived from a paper check or paper returned check

    • Must conform with X9.100-187 standard

    • Must have agreement for exchange between sender and receiving bank

• Summary

  • UCC and Reg CC define checks, electronic checks, returned checks, noncash items and electronically created items (ECIs)

    • Check: Defined as a negotiable demand draft

      • Checks include an original paper check and a substitute check

    • Electronic check and electronic returned check: Defined as

      • Electronic image of, and electronic information derived from paper check or paper returned check; that is sent to a receiving bank by agreement; and that conforms to X9.100-187 standard

    • Electronically-created Item

      • Electronic image that has all the attributes of an electronic check or electronic returned check but was created electronically and not derived from a paper check

      • ECI not considered a check under Reg CC

      • Currently not eligible for exchange under ECCHO Rules or Fed Operating Circular 3 (OC3)

Parts of a Check

• Blank Check Example

  

• MICR and MICR Line

  • Magnetic Ink Character Recognition (MICR)

    • Common machine language for automated check handling

      • Descriptive info comprised of numbers and symbols designed to be recognized at high speed by automated processing equipment

      • Printed in magnetic ink according to standards

    • E-13B font

      • For magnetic ink printing in USA, Canada, others

      • Consists of ten numeric characters and four symbols

  • MICR line: Located at the bottom of the physical check; key fields include:

    • Amount: 10-digit field

    • On-Us: Includes drawer’s account number & check serial number

    • Routing Number: ABA assigned identifier

    • EPC: External processing code; optional, single-digit field

  • Definition of MICR also includes:

    • MICR line data in an electronic record

• Processed Check Example

  • Consumer Check (6-inch check)

    • Processed check: completed and signed by drawer

      

    • Note: In UCC and Reg CC, indorsement is spelled with an “I”

      • ECCHO incorporates UCC and Reg CC within the ECCHO rules and maintain that spelling

    • Endorsement with an “E” is a term generally used outside of banking laws and regulations

• Drawer or Maker?

  • Usage of terms Drawer and Maker (see UCC and Reg CC)

    • Drawer: Person who signs or is identified in a draft as a person ordering payment (e.g., person who signs the check)

    • Maker: Person who signs or is identified in a note as a person undertaking to pay (e.g., person to pay on a note)

  • Other check terms:

    • Drawee: Person or bank ordered in a draft to make payment

    • Payor Bank: The bank that is the drawee of a draft

  • Note:

    • UCC defines person to mean an individual, public corporation, or any other legal or commercial entity

    • UCC defines bank as a person engaged in the business of banking

• Paying Bank

  • Paying Bank: A Reg CC definition 229.2 (z)

    • Bank to which check is sent for payment or collection

    • May be designated as a payable-at bank or payable-through bank that is responsible for the expedited return of checks and notice of nonpayment requirements

    • If check is sent for forward collection based on the routing number, bank associated with that routing number in considered the Paying Bank under the regulation

• Federal Reserve (FRB): Cash Items

  • Checks, including postdated checks

  • Government checks, postal money orders

  • Other demand items acceptable to Paying Bank’s FRB

  • Demand items payable outside of a State, acceptable to the last collecting FRB, that are accepted as cash items (foreign cash items)

  • Electronic checks that conform to Operating Circular 3 and FRB technical requirement

  • Substitute checks

  • Certain redeemed savings bond (see OC3 Appendix C)

  • Noncash items FRB has agreed to handle

    • Agreement or authorization required before sending noncash items

• Noncash Items

  • Would otherwise be checks except for:

    • Attachments or special instructions

    • Printed on more than a single thickness of paper - don’t qualify for automated check processing

    • Not preprinted or post-encoded in magnetic ink with routing number of Paying Bank

  • Key takeaways:

    • Determining if item is a check or noncash item

      • Does the item qualify for handling by automated check processing equipment?

      • Does the item have the routing number of the Paying Bank pre-printed or post-encoded in magnetic ink?

Check Processing Overview

• Level Set: General Processes

  • Cashing a check

    • Process by which check is negotiated by the holder for cash

  • Depositing a check

    • Process by which check is negotiated by the holder to the DFI for credit to the depositor’s account

  • Remote Deposit Capture (RDC)

    • Banking service which allows a user to scan checks and transmit the scanned images to a financial institution for posting and clearing

      • RDC described in FFIEC guidance as a transaction delivery system

    • Images may be created using a scanner or via a mobile device app

• General Check Payment Processes

  • Clearing a Check

    • Process by which check moves through payment systems from DFI where it was deposited to Payor/Paying Bank (institution on which it’s drawn)

      • Note: May involve one or more collecting banks in the process

  • Collection of a Check

    • Process by which Depositary or Collecting Bank transfers a check to another collecting bank or presents it to the Paying Bank for payment

      • Presentment of a check:

        • Exchange of value for the amount of that check

  • Return of a Check

    • Process by which Paying Bank may determine not to pay for check presented due to NSF, Stop Pay, or other reasons

      • Must be returned timely to be a return

      • Return timing based on UCC and Reg CC requirements

  • Claim Adjustment

    • Process by which a bank may send/receive a claim to adjust settlement for a paid check

      • Must be for a valid reason

        • Adjustments are by agreement

• Check Collection Process

  • Simple image exchange process (forward) with three banks

    • Depositary Bank (BOFD) = Bank A

    • Intermediary (Correspondent or FRB) = Bank B

    • Paying Bank = Bank C

    

• Check Processing

  • Detailed example with paper check then image exchange

    • Paper processes shown from individual/corporate Payor → Payee → Depositary Bank → through clearing network → Paying Bank

    • Overlay with image exchange: Medium changes (from paper check to electronic check) but general processes are the same

  

  • Daily cycle includes various steps - Processes and timing differ for:

    • Depositary Bank; Intermediary or Collecting Bank and Paying Bank

  • Sources of work: Where are checks cashed, deposited, or used for purchase or other payments?

    • ATM

    • Vault

    • Lockbox

    • Bank branch

    • Merchants

  • Capture process: Collecting check info via either physical or electronic (virtual) cycle

  • Reject/repair re-entry: Correcting errors (if possible) to get an item back into the processing cycle

  • Imaging: Create digital image of front and back of check

    • Required by standards to capture all info from both the front and back of the physical check to create an electronic check

    • Virtual (electronic process) to capture the check info

      • May also use some form of physical scanning of paper checks

  • Dispatch process: Sending out checks drawn on other banks for collection and final settlement

    • Majority sent electronically (no paper transportation today)

  • Clearing process: Process, prepare and release data files to move check data forward from point of deposit for collection

    • May go through intermediaries before final presentment to Payor/Paying Bank

  • Settlement process: Exchange of funds for the value of cash letters sent/received

    • May be net or gross settlement via clearinghouse, provider, or the FRB

  • Exception handling: Processing/resolution of returns or adjustments

    • Determine not to pay a check presented - based on timing

      • Return check with proper reason code or send as an adjustment

Exceptions and Check Fraud

• Exceptions - Returns

  • Exception: An error or an exception to the normal operational process

    • Any paper or electronic check that requires further investigation before disposition can be determined

    • Exceptions deal with both returns and adjustments

    • Timing is a primary determining factor in whether an item is handled as a return or must be handled as an adjustment

  • Returns: Governed by statutory and regulatory requirements

    • UCC midnight deadline (UCC 4-301)

    • Reg CC expeditious return requirement (221.31(b))

  • Return of a check unpaid:

    • Items that are being sent back by the Paying Bank

    • Must state it is a return and the reason for the return

    • Must meet timing requirements or may be considered a late return

• Exceptions - Adjustments

  • Adjustments: Handled by agreement of parties

    • FRB OC3; The Clearinghouse/ECCHO Rules

    • Errors that occur during item processing generally require some research to resolve; depending on timing and type of adjustment, may adjust settlement for a paid check either:

    • With entry (with financial settlement)

    • Without entry (without immediate financial settlement)

  • Must state specific adjustment type for each case

    • Adjustment types, timing and related requirements may differ depending on adjustment provider and adjustment rules:

      • FRB, Viewpointe, The Clearing House/ECCHO Rules, etc.

• What is Fraud?

  • Fraud exists in all payment systems

  • Occurs when following elements exist:

    • Intentional untrue representation about an item, fact or event

    • Untrue representation is believed by the victim

    • Victim relies upon and acts upon the untrue representation

    • Victim suffers a loss of money and/or property as a result of reliance on untrue representation

  • Check fraud:

    • Refers to a category of criminal acts that involve making the unlawful use of checks in order to illegally acquire funds that do not exist within the account balance or account holder’s legal ownership

Other Payment Systems

• Multiple Channels/Options

  • Checks can be cleared via multiple channels

    • Different channels (FRB vs. private sector): different rules may apply

  • Check can be cleared in different forms:

    • As a physical check

    • As an electronic check

    • As a substitute check (IRD)

    • As an ACH debit (if check is eligible for conversion) using appropriate SEC code:

      • ARC - Accounts Receivable entry

      • POP - Point of Purchase entry

      • BOC - Back Office Conversion entry

• Automated Clearing House (ACH) - Simple Overview

  • Funds transfer system governed by Nacha Rules

    • Provides for interbank clearing of electronic entries for participating financial institutions

  • ACH transactions: Debits or credits

    • Examples include:

    • Direct deposit of payroll, government, and social security benefits

    • Scheduled payments for mortgage, insurance, or other bill payments

  • Participants in ACH exchange

    • Originator: Individual, corporation or another entity

      • Initiate either a deposit or payment transaction

    • ODFI: Originating Depository Financial Institution

    • RDFI: Receiving Depository Financial Institution

    • ACH Operators: Two central clearing facilities:

      • FRB

      • The Clearing House (EPN)

• Sample ACH Process Example

  • ACH credits may be consumer or corporate payments:

    • Interest payments

    • Payrolls

    • Social security payments

    • Government vendor payments

    • Pensions

    • Dividends

    • State tax payments

    • Annuities

  • Originator initiates payment instructions to move funds into a Receiver’s account

    • Common use: Direct deposit of payroll

• Other Payment Systems

  • Debit Card: May use term bank card or check card

    • Generally, uses shared ATM networks that offer payment services associated with a financial institution’s DDA system

    • Similar to a credit card, but unlike a credit card, the money comes directly from the user’s DDA account

  • Credit Card: Issued by a company to allow a user to purchase good/services from merchants who accept the card

    • Major networks include:

      • American Express, Discover, MasterCard, and Visa

    • Merchants generally pay fees to accept credit cards

      • Card-issuing banks receive part of the fees as revenue

    • Card Processing: When the card is used, card-holder is technically using the bank’s money instead of their own to pay for a product or service

      • Over time must repay with interest

  • Wire: Electronic payment service for transfer of funds

    • Characteristics of large dollar transactions, immediate availability, and irrevocable payments

    • To wire funds is to make a funds transfer from one bank to another with almost immediate availability

      • Credit transfer (crediting funds)

      • Contrast to checks which are debits

  • Funds transfer defined in UCC 4A-104 as:

    • Series of transaction, beginning with originator’s payment order, for purpose of making a payment to beneficiary of the order

    • Term includes payment order issued by originator’s bank, or an intermediary bank, intended to carry out originator’s payment order

    • Completed by acceptance of payment order by the beneficiary’s bank for the benefit of the beneficiary

  • Wires governed by provisions in UCC 4A and:

    • Regulation J for Fedwire

    • Rules and procedures for Clearing House Interbank Payment System (CHIPS)