Substitute check
Encyclopedia
A substitute check is a negotiable instrument
used in the United States to represent the digital reproduction of an original paper check
. As a negotiable instrument, a substitute check maintains the status of a "legal check" in lieu of the original check as authorized under the United States law Check Clearing for the 21st Century Act (Check 21 Act
). Instead of presenting the original paper checks, financial institutions and payment processing centers electronically transmit data from substitute checks for settlement through the Federal Reserve System
.
Substitute checks are recognized as legal checks as long as the instruments meet specific requirements. These requirements include the faithful reproduction of the paper check and warranty of the instrument by the reconverting bank—the bank that created the substitute checks or the first bank that transferred or presented them during the check clearing process
. Substitute checks are also subject to the Uniform Commercial Code
(UCC), existing federal and state check laws, and regulations specific to consumer rights that affect the acceptance of these instruments. Although substitute checks are subject to the UCC and existing state and federal check laws, the Check 21 Act takes precedence over these other laws and regulations for substitute checks.
s, traveler's checks and treasury
checks. The Check 21 Act permits any financial institution (such as a commercial bank
or credit union
) that participates in the check collection process to remove or "truncate" the original check from the forward collection or return process without first requiring an existing agreement between the bank of first deposit (BOFD) and the paying bank. The elimination of the original paper checks from the clearing process saves the banking industry the costs of handling, sorting, transporting, storing, guarding, and mailing paper checks. After the bank truncates the original checks in favor of substitute checks, the bank can store or archive the paper checks, return them to its customers according to state law, or later destroy the checks.
Image statements that include pictures or images of the original paper checks and/or substitute checks, photocopies of the original checks, and images of checks posted online are not recognized as the legal equivalents of substitute checks. Unlike a substitute check, a photocopy of a check cannot be presented through the check clearing process for settlement because the photocopy of the check does not adhere strictly to the requirements for substitute checks under the Check 21 Act.
Since substitute checks are considered legal "checks," substitute checks are subject to existing check laws and regulations. Other laws and regulations that govern substitute checks in the United States include the Expedited Funds Availability Act
, Article 3 (Negotiable Instruments), and Article 4 (Bank Deposit
s and Collections) of the Uniform Commercial Code (UCC), along with a variety of state and federal regulatory laws. U.S. federal laws that also affect substitute checks include Federal Reserve regulations that provide for recrediting the amount of the substitute check in the case of fraud and duplicate payments caused by settlement of both the substitute check and the original check used for creating the substitute check. If any state law, federal law, or provision of the UCC conflicts with the Check 21 Act, the Check 21 Act takes precedence to the extent of the inconsistencies among those laws and provisions.
Any financial institution that participates in the forward collection (or return) process can become the reconverting bank if that bank creates the substitute check for transmittal and settlement.
If a substitute check must be returned unpaid because of insufficient funds, the paying bank (Bank 2) stamps the item NSF (non-sufficient funds) as the reason for the return. In this case, Bank 2 encodes a "5" as the EPC on the MICR line, along with the routing number of the depository bank and the dollar amount of the substitute check. Bank 2 encodes this information on a return strip, perforated strip, or carrier document that the bank attaches to the unpaid substitute check. The paying bank then returns the unpaid substitute check through the routing process to the BOFD (Bank 1) for further handling. Once Bank 1 receives the returned substitute check, the bank issues a charge back notice to its customer who deposited or offered the check for settlement.
Negotiable instrument
A negotiable instrument is a document guaranteeing the payment of a specific amount of money, either on demand, or at a set time. According to the Section 13 of the Negotiable Instruments Act, 1881 in India, a negotiable instrument means a promissory note, bill of exchange or cheque payable either...
used in the United States to represent the digital reproduction of an original paper check
Cheque
A cheque is a document/instrument See the negotiable cow—itself a fictional story—for discussions of cheques written on unusual surfaces. that orders a payment of money from a bank account...
. As a negotiable instrument, a substitute check maintains the status of a "legal check" in lieu of the original check as authorized under the United States law Check Clearing for the 21st Century Act (Check 21 Act
Check 21 Act
The Check Clearing for the 21st Century Act is a United States federal law, , that was enacted on October 28, 2003 by the 108th Congress. The Check 21 Act took effect one year later on October 28, 2004...
). Instead of presenting the original paper checks, financial institutions and payment processing centers electronically transmit data from substitute checks for settlement through the Federal Reserve System
Federal Reserve System
The Federal Reserve System is the central banking system of the United States. It was created on December 23, 1913 with the enactment of the Federal Reserve Act, largely in response to a series of financial panics, particularly a severe panic in 1907...
.
Substitute checks are recognized as legal checks as long as the instruments meet specific requirements. These requirements include the faithful reproduction of the paper check and warranty of the instrument by the reconverting bank—the bank that created the substitute checks or the first bank that transferred or presented them during the check clearing process
Clearing (finance)
In banking and finance, clearing denotes all activities from the time a commitment is made for a transaction until it is settled. Clearing is necessary because the speed of trades is much faster than the cycle time for completing the underlying transaction....
. Substitute checks are also subject to the Uniform Commercial Code
Uniform Commercial Code
The Uniform Commercial Code , first published in 1952, is one of a number of uniform acts that have been promulgated in conjunction with efforts to harmonize the law of sales and other commercial transactions in all 50 states within the United States of America.The goal of harmonizing state law is...
(UCC), existing federal and state check laws, and regulations specific to consumer rights that affect the acceptance of these instruments. Although substitute checks are subject to the UCC and existing state and federal check laws, the Check 21 Act takes precedence over these other laws and regulations for substitute checks.
General
Under the Check 21 Act, payment instruments that are eligible for conversion into substitute checks include consumer (personal) checks, commercial (business) checks, money orderMoney order
A money order is a payment order for a pre-specified amount of money. Because it is required that the funds be prepaid for the amount shown on it, it is a more trusted method of payment than a cheque.-History of money orders:...
s, traveler's checks and treasury
United States Department of the Treasury
The Department of the Treasury is an executive department and the treasury of the United States federal government. It was established by an Act of Congress in 1789 to manage government revenue...
checks. The Check 21 Act permits any financial institution (such as a commercial bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
or credit union
Credit union
A credit union is a cooperative financial institution that is owned and controlled by its members and operated for the purpose of promoting thrift, providing credit at competitive rates, and providing other financial services to its members...
) that participates in the check collection process to remove or "truncate" the original check from the forward collection or return process without first requiring an existing agreement between the bank of first deposit (BOFD) and the paying bank. The elimination of the original paper checks from the clearing process saves the banking industry the costs of handling, sorting, transporting, storing, guarding, and mailing paper checks. After the bank truncates the original checks in favor of substitute checks, the bank can store or archive the paper checks, return them to its customers according to state law, or later destroy the checks.
Legal requirements
A properly prepared substitute check is considered the legal equivalent of the original paper check that can be accepted for payment or proof of payment in the same manner as the original check. Every substitute check must adhere to the following requirements before it can be recognized as the legal equivalent of the original check:- The substitute check must accurately represent all information depicted on the front and back of the original check at the time the financial institution truncates the original check. The information includes the names of the payor and payee, courtesy and legal amounts, endorsements, and encoding information, among other details.
- The substitute check must accurately represent the MICRMagnetic ink character recognitionMagnetic Ink Character Recognition, or MICR, is a character recognition technology used primarily by the banking industry to facilitate the processing of cheques and makes up the routing number and account number at the bottom of a check. The technology allows computers to read information off...
line of the original check. - The substitute check must bear the legend "This is a legal copy of your check. You can use it the same way you would use the original check."
- The financial institution or processor must provide a warranty for the substitute check when it removes or "truncates" the original paper check from the forward collection or return process and converts the paper check into a substitute check.
- The financial institution or processor that truncated the original check must follow ASC X9ASC X9The Accredited Standards Committee X9 - Financial Industry Global Standards, mission is to develop, establish, maintain, and promote standards for the Financial Services Industry in order to facilitate delivery of financial services and products. ASC X9, Inc...
standards in the capture of check images and MICR data when it produces the substitute check.
Image statements that include pictures or images of the original paper checks and/or substitute checks, photocopies of the original checks, and images of checks posted online are not recognized as the legal equivalents of substitute checks. Unlike a substitute check, a photocopy of a check cannot be presented through the check clearing process for settlement because the photocopy of the check does not adhere strictly to the requirements for substitute checks under the Check 21 Act.
Since substitute checks are considered legal "checks," substitute checks are subject to existing check laws and regulations. Other laws and regulations that govern substitute checks in the United States include the Expedited Funds Availability Act
Expedited Funds Availability Act
The Expedited Funds Availability Act was enacted in 1987 by the United States Congress for the purpose of standardizing hold periods on deposits made to commercial banks and to regulate institutions' use of deposit holds. It is also referred to as Regulation CC or Reg CC, after the Federal Reserve...
, Article 3 (Negotiable Instruments), and Article 4 (Bank Deposit
Deposit account
A deposit account is a current account, savings account, or other type of bank account, at a banking institution that allows money to be deposited and withdrawn by the account holder. These transactions are recorded on the bank's books, and the resulting balance is recorded as a liability for the...
s and Collections) of the Uniform Commercial Code (UCC), along with a variety of state and federal regulatory laws. U.S. federal laws that also affect substitute checks include Federal Reserve regulations that provide for recrediting the amount of the substitute check in the case of fraud and duplicate payments caused by settlement of both the substitute check and the original check used for creating the substitute check. If any state law, federal law, or provision of the UCC conflicts with the Check 21 Act, the Check 21 Act takes precedence to the extent of the inconsistencies among those laws and provisions.
Clearing process
Each substitute check processed for forward collection is encoded with a "4" as the External Processing Code or "EPC" in position 44 of the MICR line. An example of the forward collection process for substitute checks involves the following steps:- The payee endorses the original paper check and presents it to the depository bank or bank of first deposit.
- The bank of first deposit or "BOFD" (Bank 1) stamps its endorsement on the rear of the original check.
- Bank 1 captures an image of the front and back of the original check and the MICR line data from the front of the check. Bank 1 then removes or "truncatesCheque truncationCheque truncation is the conversion of physical cheque into electronic form for transmission to the paying bank. Cheque truncation eliminates cumbersome physical presentation of the cheque and saves time and processing costs.-History:To settle a cheque it has to be presented to the drawee bank...
" the original check from the clearing process and uses the check image, MICR data, its own electronic endorsement, and the electronic endorsements to create a substitute check. - Bank 1 electronically transmits the check image and the MICR line data captured from the original check to the paying bank (Bank 2) for settlement. If no agreement exists between Bank 1 and Bank 2 to exchange check images and data, Bank 1 must provide either the original check or the legal equivalent of the substitute check to Bank 2.
- As the paying bank, Bank 2 uses check image and MICR data or information from the substitute check received from Bank 1 to process the item during the normal course of settlement.
- After the settlement process, Bank 2 provides a copy of the substitute check to the customer who wrote the original check or includes information about the substitute check in that customer's monthly or periodic statement.
Any financial institution that participates in the forward collection (or return) process can become the reconverting bank if that bank creates the substitute check for transmittal and settlement.
If a substitute check must be returned unpaid because of insufficient funds, the paying bank (Bank 2) stamps the item NSF (non-sufficient funds) as the reason for the return. In this case, Bank 2 encodes a "5" as the EPC on the MICR line, along with the routing number of the depository bank and the dollar amount of the substitute check. Bank 2 encodes this information on a return strip, perforated strip, or carrier document that the bank attaches to the unpaid substitute check. The paying bank then returns the unpaid substitute check through the routing process to the BOFD (Bank 1) for further handling. Once Bank 1 receives the returned substitute check, the bank issues a charge back notice to its customer who deposited or offered the check for settlement.
See also
- Check (cheque) truncationCheque truncationCheque truncation is the conversion of physical cheque into electronic form for transmission to the paying bank. Cheque truncation eliminates cumbersome physical presentation of the cheque and saves time and processing costs.-History:To settle a cheque it has to be presented to the drawee bank...
- Remote depositRemote depositRemote deposit refers to the ability to deposit a check into a bank account from a remote location, such as an office or home, without having to physically deliver the check to the bank...
- French check processing fee controversy of 2010French check processing fee controversy of 2010In 2010 the French government's Autorité de la concurrence fined eleven banks €384,900,000 for colluding to charge unjustified fees on check processing, especially for extra fees charged during the transition from paper check transfer to "Exchanges Check-Image" electronic transfer...
(French banks were fined hundreds of millions of Euros for colluding to charge unnecessary fees on electronic check exchange)
External sources
- Accredited Standards Committee (ASC) X9 Financial Industry Standards: Statement on Check 21 adoption (October 23, 2004)
- Anatomy of a substitute check. (2004). Federal Reserve Financial Services.
- Ways to Use Check 21. (March 2004). Electronic Check Clearing House Organization (ECCHO)
(diagram of the check clearing and return processes for a substitute check) - Substitute Checks: Development of Processing & Quality Standards. Electronic Check Clearing House Organization (ECCHO)
(callouts to identify parts of a substitute check from the forward collection and return processes included at the end of the document)