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Thursday, Dec 09, 2004

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Opinion - Accountancy


New image of the old cheque

M. S. Parthasarathy

M. S. Parthasarathy sizes up `Check 21', the new US initiative in cheque collection

ON OCTOBER 28, 2004, a significant piece of legislation came into effect in the US, to facilitate a major change, aided by technological developments, in the mode of collection of outstation cheques (spelt "checks" in the US) within the country.

Check 21, shorthand for the Check Clearing for the 21st Century Act, 2003, permits the creation, through electronic image processing, of a paper document called a "substitute check" from the original cheque deposited for collection.

The substitute cheque (this familiar spelling will be used here), to include all the information contained on the original cheque, is its legal equivalent and can be presented, in lieu of the original cheque, to the drawee bank for payment.

If more than one bank is involved in the collection process, each of the collecting banks can create a substitute cheque and transfer it to the next link in the chain until the final substitute cheque is presented to the drawee bank for payment.

The substitute cheque represents a via media between the physical presentment of the original paper cheque and its electronic presentment to the bank on which it is drawn. Whether presentment is made electronically or through a substitute paper cheque, an electronic process, which has come to be known as "truncation", takes place.

For an electronic presentation, certain vital data on the cheque are electronically captured by a collecting bank and transmitted to the drawee bank for payment. This is equivalent to presentment of the paper cheque itself.

If the drawee bank wishes to see the original cheque itself before deciding on its payment or dishonour, it can ask for it and make the decision after scrutinising the original cheque.

Where a substitute cheque is made and presented, an electronic image of both sides of the original cheque is prepared and reproduced on paper, and the paper document thus created is treated as a substitute of the original cheque and is presented to the drawee bank for payment.

During the last two decades or so, systems and laws providing for electronic instead of physical presentment of cheques have been engaging the attention of legislators and regulators in developed countries. Laws have been amended in the US and UK to permit electronic presentment of cheques after "truncating" them.

However, in the US, where thousands of banks operate, many of them within small geographical areas, universal or widespread adoption of electronic presentment as an alternative to physical presentment of cheques requires application of the required information technology to cheque transactions by such a large number of banks across the country.

While the larger banks may have acquired or developed the requisite technological capabilities, several smaller banks are as yet not ready for the transition.

Moreover, system-wide electronic presentment requires a number of operational agreements between the large number of banks functioning in the country. Without such agreements, electronic presentment is not practicable. Given these constraints, the US authorities have devised the substitute cheque system as an intermediary stage between physical and electronic presentment of cheques.

Legislation permitting the use of substitute cheques (Check 21) was enacted into law in October 2003, to become effective a year later.

Meanwhile, the board of governors of the Federal Reserve system has introduced detailed regulations to facilitate the use of these cheques, after considering comments received from various quarters.

Billions of cheques are issued and cleared in the US every year. Cheques issued and paid within the same city or town constitute the bulk of the cheques handled. The remaining cheques, though they constitute a small percentage of the total number of cheques handled, run into millions, and are drawn on, and therefore require to be presented to, banks in other cities or towns.

This requires physical transportation of the cheques from the cities and towns where they are deposited by the payees with their banks to places where they are payable. Such transportation inevitably consumes time and costs money, apart from running the risk of loss or misplacement during the transit.

The 9/11 in the US two years ago led to disruption of transportation of huge quantities of such outstation cheques, delaying availability and use of the funds for payees entitled to the proceeds of the cheques on collection. The substitute cheque has been devised to drastically cut down the delays in transportation of physical cheques.

Because a substitute cheque is created electronically, it helps eliminate any time lag arising from the transportation of the paper cheque from the depositary bank to the collecting bank, especially when they are at distant locations. Suppose a person in Los Angeles draws a cheque on his bank in Los Angeles and sends it to the payee located in Boston. The payee deposits it with his bank in Boston.

The depositary bank may make an electronic image of the cheque and transmit it to its correspondent collecting bank in Los Angeles. The collecting bank may make a paper reproduction of the electronic image and present it to the drawee bank on which the original cheque is drawn and receive payment.

Such a paper image is called a substitute cheque.

To be governed by Check 21, the duplicate cheque should accurately represent the information on both sides of the original cheque, including the magnetic ink character recognition (MICR) data on the original, and include an additional MICR input to show that it is a substitute cheque, as well as a legend saying "This is a legal copy of your check. You can use it the same way you would use the original cheque." The substitute cheque is a negotiable instrument by itself.

If in the above example, more than two banks are involved in the collection process, a substitute cheque may be generated by any of the intermediary banks. There can be more than one substitute cheque in respect of the same original cheque depending upon the links in the collection process.

Thus, if two collecting banks at different or even in the same location are involved, the first may make a substitute cheque and send it to the second, which can create a second substitute cheque based on the first and present the second one to the drawee bank for payment.

Check 21 does not do away with physical presentment of cheques. It is left to collecting banks to create and present substitute cheques. A bank (called "reconverting bank") that creates a substitute cheque from the original cheque may retain the original with it or even destroy it, keeping an image on record.

In the US, banks follow the practice of sending paid cheques or electronic copies of the cheques to their customer-drawers along with periodical statements of their accounts. In future, the paid substitute cheques will also be sent to the customers along with the statement. Banks are required to notify their customers of the practices banks will follow in dealing with substitute cheques.

The creation and use of substitute cheques can considerably short-circuit cheque collection processes and expedite availability of the proceeds to payees.

However, the drawee-bank's willingness to take pay-or-dishonour decisions on substitute cheques would depend upon the clarity of the image of the original cheque carried by the substitute cheque.

If the image is not sufficiently clear in respect of the essential features of the original cheque and any endorsements it carries, the drawee bank may not be able to arrive at an appropriate decision whether or not to pay the cheque.

Hopefully, currently available IT systems can produce sufficiently clear images of the original cheque as would facilitate the drawee bank's decision.

Some bankers have voiced a concern that substitute cheques cannot be effective substitutes of paper cheques because they cannot reproduce the security features imbedded in paper cheques.

Also, it may be difficult to detect fraudulent alterations or forgeries from substitute cheques. Sometimes, pen pressure analysis of the original cheque may give a clue to forgery. A substitute cannot be so analysed.

Some IT experts have expressed fears that this new mode of collection may contribute to frauds through unauthorised access to online cheque images and bank statements of account of the customers concerned. The risk points to the need to ensure that the collection process is carried out in a secure and safe electronic environment, and image-survivable security measures are introduced by banks.

A reconverting bank that generates and issues a substitute cheque undertakes some mandatory warranties with respect to the cheque. Complex legal issues may arise between parties to the original cheque and a substitute cheque. Check 21 anticipates such issues, but more may surface when substitute cheques are widely used.

In India, the Negotiable Instruments Act 1881 was amended in 2002 to provide for electronic presentment (truncation) of cheques. Plans are reportedly afoot for the introduction of a pilot project for implementing electronic presentment of cheques in New Delhi in early 2005.

It should not be surprising if Indian lawmakers and the banking regulator try to keep pace with the US counterparts and soon introduce a law similar to Check 21. Whether we can adopt the US practice would depend upon how well the banking system is, or will soon be, technologically equipped to undertake such a practice.

With India being a major source of IT software to the US, it would indeed be tempting to launch substitute cheques sooner than later. We imported the cheque from the UK and we can import the substitute cheque from the US. However, in order not to be seen as simply importing an alien innovation, we will probably invent a new term for this instrument and make our own indigenous legislative changes.

Hopefully, unlike the 2002 amendments to the Negotiable Instruments Act introducing truncation, these changes will be marked by much needed clarity and precision.

(The author is Chennai-based freelance writer)

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