Fraud and Check 21: More efficiency may open door to more risk

Northwestern Financial Review, Sep 1-Sep 14, 2004 by LaFontaine, Michael

As an attorney focusing much of my practice in the bank fraud area, I have been particularly interested in the effects Check 21 will have on the world of check fraud, both positive and negative. Like many, I am optimistic that Check 21 will notably decrease a number of prevalent types of check fraud. Still, banks and businesses should carefully consider some of the negative implications for check fraud detection and prosecution that flow from Check 21.

In a perfect post-Check 21 environment, where most banks participate in the electronic exchange of check images (keeping in mind that this requires an agreement either between banks or between banks and an intermediary processor), the collections process will decrease from two to three days to a few hours and float will fade away. Thus, check kiting will decrease dramatically and payor banks and their customers will have more immediate access to checks to determine their legitimacy. With earlier fraud identification, fraudulently procured funds could be retrieved from the bank of first deposit before they are released to the perpetrator. This is the tangible benefit of decreased float.

On another front, image exchange will push fraud detection from a paper environment to a more efficient, perhaps more reliable, electronic image-based fraud detection platform. However, as banks consider the expense associated with wholesale check imaging, image quality is typically the first cost-cutting casualty. Herein lies the problem.

The Federal Reserve's imaging standards under Check 21 require no more than a binary black and white check image for the creation of a substitute check - not grayscale and certainly not color. As a resuit, watermarks, coloring, bleed-through ink and other common check stock security features will be lost in the imaging process. Thus, check imaging presents a fraud detection risk and a new liability risk to a reconverting bank under the Check 21 Act. A hypothetical:

A substitute check drawn on the account of ACME, Inc., is presented to ACME's bank, which pays the item and sends the substitute check to ACME. The check was altered, and certain security measures on the original check would have alerted ACME and ACME's bank to the alteration, but the security measures did not survive the imaging process. ACME has a statutory indemnity claim against the reconverting bank. This is a statutory liability for the reconverting bank that didn't exist prior to Check 21.

Perhaps just as troubling, there is mounting sentiment among prosecutors that they will be less likely to prosecute check fraud cases where an original check is not available. Prosecutors worry that wholesale truncation and shorter timeframes for destruction of original checks will seriously hinder law enforcement's ability to request and secure original checks before they are destroyed. Without the ability to use the original check for fingerprinting, check stock comparison and other evidentiary purposes, some prosecutors feel that their ability to convict will decrease and/or the cost for pursuing a conviction (i.e. having to hire handwriting experts) will be unrealistic for smaller fraud matters.

So what can banks and businesses do?

Focus on fraud prevention - Fraud prevention efforts should begin to focus on identifying and implementing image survivable check security features, employing more sophisticated automated fraud detection platforms, integration of imaging systems and corporate security efforts, and real-time information sharing among banks and businesses to prevent repeat offenders. Finally, while it is not fraud proof, positive pay services remain one of the best methods for detecting and preventing fraud losses.

Find alternative methods to deter fraud - Deterrence is crucial. If prosecution of check fraud offenders begins to lag due to unavailability of original checks, the onus will fall on banks and businesses to seek out offenders and send the message that fraud will not be tolerated. A shift would necessarily occur from criminal prosecution and restitution to civil enforcement and collections efforts. The voice may change out of necessity, but the message must remain the same.

Identify and manage risk tolerances - Finally, as with any risk of loss, it is important that banks and businesses identify the check fraud risks associated with Check 21 and make a calculated business judgment based on their tolerance of those risks. If, for example, a bank is willing to accept the risk associated with the above hypothetical, but only up to $100,000, a bank may not want to convert the original or image of a six-figure check to a substitute check, thus foregoing the statutory indemnification that flows from creating substitute checks. This, however, is a calculation that only the bank or business can weigh.

Michael LaFontaine is an attorney with Halleland, Milan, Lewis, Sipkins & Johnson, P.A. in Minneapolis.