Remotely Created Checks Linked to Image Exchange Stoke Fraud Fears

Regulators seeking to rein in so-called remotely created checks aren't going far enough to contain the risk these payment devices pose?particularly when they are processed electronically, says one payments expert. “I think they should ban them,” says George F. Thomas, chief executive at Radix Consulting, Oakdale, N.Y., and a former executive with The Clearing House Payments Co. Ltd., New York. “That's the ultimate solution.” Concern about demand drafts, or remotely created checks (RCCs), has been building for several years, but now some regulators and observers fear that electronic clearing processes brought on by the Check Clearing for the 21st Century Act (Check 21) could exacerbate the problem. Often used by phone marketers, RCCs are checks created by merchants on behalf of customers, who give marketers their account and bank-routing numbers online or over the phone. Customers don't sign the checks, but merchants are supposed to get explicit authorization before submitting the items for payment. In an unknown number of cases, the items turn out to be fraudulent. Last year, the federal office of the Comptroller of the Currency ordered banking giant Wachovia Corp. to pay up to $144 million in connection with a case in which telemarketers were using accounts at Wachovia to deposit RCCs that ended up bilking millions of dollars out of thousands of unsuspecting consumers, many of them elderly. The settlement, which included a $10 million fine, $8.9 million for consumer education, and up to $125 million in restitution, was the second-largest penalty ever imposed by regulator. Cases like this, coupled with the electronic image-exchange capabilities fostered by Check 21, have regulators worried. With electronic processing, marketers can turn online payment instructions from consumers into electronic files. These in turn can be formatted electronically into files acceptable to image-exchange networks, resulting in faster clearing and settlement than is possible with paper RCCs. Indeed, with these electronic items, no paper ever existed. That process has alarmed the Federal Reserve Banks. Last week, the Reserve Banks' Retail Payment Office notified depository financial institutions that the Reserve Banks will hold financially responsible banks sending electronically processed RCCs that were not imaged from paper originals and that result in fraud losses. The new policy, technically a change in the Banks' Operating Circular 3, takes effect July 15. In effect, in cases of such fraud, the Reserve Banks are stepping out of the warranty chain that normally controls the processing of check images from banks of first deposit through networks like the Fed's to paying banks, says Rich Oliver, executive vice president at the Federal Reserve Bank of Atlanta. Without a paper item backing up the image, says Oliver, “that [RCC] shouldn't have been a Check 21 item in the first place.” While a July 2006 change to Regulation CC, the set of rules that govern the checking system, shifted liability for fraudulent RCCs to banks of first deposit, the Reserve Banks' policy change specifically targets RCCs that never existed as paper items. It also means that when such items turn out to be fraudulent, the Fed will step out of the claims process stipulated by Reg CC, Oliver says. “The bank of first deposit will have to fight it out with the paying bank,” he says. But large fines and liability shifts don't go far enough, says analyst Thomas. Remotely created checks, he argues, are too dangerous to allow, he argues, because banks too often fail to perform due diligence on merchants and because no automated method exists to track the items. Indeed, even the Fed doesn't know how many RCCs are flowing through the checking system. “I haven't the faintest idea,” says Oliver. “I've actually asked that question and the folks [at the Atlanta Fed] can't tell me.” Only when manually examining certain items returned for technical reasons recently did the Fed realize the items were electronic RCCs, says Oliver. “We realized someone was creating an electronic image of a check from a template?they all looked alike,” he says. With another set of returns, it became apparent, he adds, that some of the items originated from marketers that had been denied transaction privileges by the automated clearing house system, an electronic payment network that can track returns by reason codes and by originator. Some experts fear that criminals chased out of the ACH are migrating to the check system by means of electronic RCCs, a factor that makes it even more crucial for banks to check out merchants. “Nobody wants to do the due diligence,” says Thomas, who advocates banning RCCs in an article in the upcoming July issue of Digital Transactions magazine. “You've got to know your customer's customer.”