Covering Business Credit Logo Home   About Us   Services   Credit Articles   Q&A   Contact  

  Business Credit Law and Regulations  

Check 21 Act

Credit Law Articles
All Articles •  Home

By Scott Blakeley Esq.
Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP

What It Means To The Credit Professional

Executive Summary

  • October 28, 2004 marked the beginning of an evolution in check processing. The Check Clearing for the 21st Century (Check 21 Act), federal legislation affecting all states, changed the method by which checks are processed in the United States, and also changed the technology of check payment and acceptance.

  • What does Check 21 mean to the credit professional and how may it change the way the customer pays for its purchases?

  • Might Check 21 reduce the risk of NSF checks and bust outs?

  • Could Check 21 improve the credit professionalís DSO as check-processing time is shortened?

  • Will payment by check become an even more common payment method in B2B transactions?

  • These and other questions will be answered over time, but this paper will offer some hypothesis.

The electronic credit department has arrived, and is transforming the way credit professionals manage their accounts, including customersí payment methods. Yet even with the ever-increasing use of electronic forms of payment by customers, from ACH to electronic bill presentment to wire transfers and credit cards, payment by check is still the most popular method of payment in B2B transactions.

October 28, 2004 marked the beginning of an evolution in check processing. The Check Clearing for the 21st Century (Check 21 Act), federal legislation affecting all states, changed the method by which checks are processed in the United States, and also changed the technology of check payment and acceptance. What does Check 21 mean to the credit professional and how may it change the way the customer pays for its purchases? Might Check 21 reduce the risk of NSF checks and bust outs? Could Check 21 improve the credit professionalís DSO as checkprocessing time is shortened? Will payment by check become an even more common payment method in B2B transactions? These and other questions will be answered over time, but this paper will offer some hypothesis.

A. Background

In 2000, the Federal Reserve Board began to promote check truncation and electronic check presentment. Check 21 aims at the problem of the considerable time the original check takes to go through the banking system. It is expected Check 21 will eliminate a majority of the 40 billion checks traveling by truck, rail and air each year.

In crafting Check 21, the Federal Reserve and the banking industry sought to decrease the banking systemís dependence on the actual transport of paper checks, by processing the checks electronically. Fostered by the 9/11 terrorist attacks that brought transportation and check clearing to a halt leaving $47 billion worth of checks floating in financial limbo for days, a solution was sought to speed-up the check clearing process. Banks, as well as vendors accepting a customerís payment of goods and services by checks, view the long-established paper process as slow, costly and inefficient. Furthermore, in the event of severe weather conditions, or disasters, the transportation of checks may be significantly delayed. This convinced the Federal Reserve Board to urge the creation of Check 21. Check 21 moves banks away from paper and towards electronic and image exchange.

B. Key Concepts And Terms Of Check 21:
From Paper Based Check Processing To Electronic Image Processing

1. Voluntary Compliance

Check 21 is comprehensive legislation regulating the check collection process, but it does not require banks to truncate or convert checks into an electronic image, nor does it require banks to accept truncated checks. Check 21 does require banks to accept substitute checks as the legal equivalent of the original. Check 21 encourages banks to voluntarily create bi-lateral agreements to accept checks converted into electronic images for collection and the clearing process.

2. Truncation

Check 21 permits the depository bank to truncate the original check. Truncating a check means to take the check out of physical circulation by using a computer scanner to convert the paper check into an electronic image. This electronic image, or IRD, becomes the legal equivalent of the original check, provided it meets the criteria set out in the legislation. Truncating the check permits banks to process it for payment much faster than if the check were paper. As a result of image technology, delays attributable to weather or air travel are gone. It is expected that banks will save millions a year in transportation and storage costs.

3. Substitute Checks or Image Replacement

Check 21 authorizes the creation of a new payment instrument, the substitute check or Image Replacement Document (IRD), which is central to the legislation. The substitute check is a printout or image of the truncated check that is the legal equivalent of the original check when it meets certain requirements. The substitute check must contain images of the front and back of the check, conform to industry standards including MICR and physical characteristics of a check, accurately represent all information on the original check, bear a legend, include the endorsement and be suitable for automated processing in the same manner as the original check.

A substitute check may be found in: periodic statements from a bank; when viewing check images while performing online banking; when a customer requests a copy of the paid check from the bank; or, as a deposited check that is returned unpaid.

Check 21 does not require banks to return to the customer the original check. Check 21 also does not impose any minimum time period for banks to keep the original check. This is consistent with Article 4 of the Uniform Commercial Code, which states that an original check may be destroyed at any time, as long as the bank has the capacity to provide a legible copy of the check for seven years. As required by Check 21, banks have been notifying customers who still receive canceled checks in their statements that they soon may begin seeing substitutes once the change takes effect.

Under Check 21, no drawer, bank or other party can insist on receiving the original or a copy of the original check. Rather, when the original check is requested, a bank may issue a substitute check. As Check 21 makes a substitute check the legal equivalent of the original check, other laws regulating checks, such as the Uniform Commercial Code, apply to substitute checks to the extent consistent with Check 21.

3.a. Substitute Check Warranties

When a paper check is truncated and a substitute check is provided, the bank makes warranties to the accuracy and legal standing of the substituted check. Check 21 provides certain rights to receive an expedited recredit to an account based on two grounds.

One ground for an expedited recredit is a breach of a Check 21 warranty; the other ground is that the check was not properly charged. The significance of a breach of a Check 21 warranty is that this may lead to a recovery for damages. Damages under Check 21 are limited to the amount of the substitute check. When a party breaches a Check 21 warranty, the damaged party may also seek consequential damages and recovery for other losses related to the substitute check.

Check 21 provides that any bank that transfers, presents, or returns a substitute check and receives consideration for the check, warrants that the substitute check meets the requirements for legal equivalence. This warranty is made to the following entities: all other banks to whom the substitute check is transferred; the drawer; the payee; the depositor; and any other endorser.

C. Check 21's Impact On The Credit Department

1. Farewell To the Float

A major benefit to suppliers with Check 21 is the end of the float, especially with out of state checks. A customer may count on a few days of check processing delays from the time they issue a check to give them time to collect funds to cover the check. As of October 28, 2004, customers who attempt to gamble the float are likely to find themselves in an overdraft and facing bad check fees and payment demands from creditors. A check to a supplier can be scanned by the creditorís bank and sent electronically to the customer's bank for payment. Customers must have sufficient funds to cover payment when a check is issued. Potentially, Check 21 will allow checks to be cleared in hours rather than days, even with out of state checks.

2. Check 21 And NSF Checks

a. Bad Check Law

Notification of NSF checks may change significantly. Pre-Check 21, a supplier may not be notified of the NSF check for days, with the original check returned days, and sometimes weeks afterwards. With Check 21, a creditor may learn promptly that a check has not cleared.

Each bank may set its own standard as to the redeposit procedure, after the initial attempt fails. A bank may issue a substitute check stamped "Returned due to NSF." The substitute check is the legal equivalent of the original, and therefore may be used for reporting to the police authorities.

b. More NSF Checks?

In the short term, customers that had juggled the check float may issue more NSF checks as they deal with the loss of float time. The credit professional needs to be vigilant that in the short term they may need to deal with NSF checks. The creditors may consider advising customers that they are using a Check 21-compliant financial institution that may result in a loss of float.

c. Stopping Goods In Transit

UCC 2-702 and 2-703 provides that if the supplier has not yet shipped goods that the customer ordered on credit and the supplier discovers that the customer is insolvent or in bankruptcy, the supplier may refuse to deliver the goods. Given the more prompt notice that a supplier may receive of an NSF check with Check 21, the supplier may have an opportunity to exercise its rights to stop the goods in transit.

d. Reclamation Demands

UCC 2-507 and 2-511 provides a vendor selling goods on COD the right to reclaim goods when the customerís check is returned NSF. Bankruptcy Code section 546(c) recognizes a vendorís reclamation right where the customer is in bankruptcy and the cash sale was in the ordinary course of business.

A supplier selling goods on cash shortly before the customerís bankruptcy may find the check returned NSF, even with Check 21ís accelerated clearing. Given this, the supplier needs to make a reclamation demand within the time periods provided by the Bankruptcy Code. A form reclamation demand letter concerning cash terms is attached as Exhibit C.

The supplier should assume that the customerís check will be returned NSF and send its reclamation demand immediately upon learning of the customerís bankruptcy filing. With Check 21, perhaps the check will clear prior to the customerís bankruptcy filing; however, the reclamation demand may protect the supplier from the risk that the time periods for making a reclamation demand would run out prior to the supplierís receipt of confirmation that the customerís check had been dishonored. Again, due to Check 21, the supplier should receive prompt notification that the check has been dishonored.

e. Cash In Advance – CIA

Cash In Advance typically affords a supplier one of the least risky methods of selling to a customer with a poor credit standing. However, one of the obstacles to CIA terms has traditionally been the pressure put on the credit professional by the customer, and often the supplierís own salespeople, to release merchandise being held waiting for the check to clear the bank. Check 21 will speed up the process of releasing the goods, providing better customer service, quicker inventory turn and more satisfied salespeople.

f. NSF Check And Flash Reports

An industry groupís flash report of a memberís notice of an NSF check will have even greater value to industry group members. Since a supplier will be promptly notified that a check has not cleared, that supplier will notify the industry group leader who may immediately send out a flash report. Given that the supplier is learning of the NSF check much earlier, especially with out-of-state checks, the flash report may become more valuable by assisting suppliers in deciding what action to take with their pending orders.

g. Personal Liability Of Check Signer May Be Easier To Establish

Where an individual signs a check on behalf of the corporation and the corporate check does not clear, may the signer of the check be personally liable? The general rule is that a person signing in a representative capacity, such as ìABC Corp. by Francis Smith, Treas.î protects that individual from personal liability. However, when the person who signs the checks knows that the company does not have funds on hand to cover the checks, there may be personal liability in certain states.

This fraud exception requires the vendor to establish that the signer intended to defraud the vendor. With Check 21, it may be easier for the vendor to establish this intention, as the signer may not be able to argue the float as a defense. Check 21 compliant banks are warning that funds must be on hand when checks are written, given the shortened processing time.

h. Importance Of Sending NSF Demand Letter May Be Minimized

4 Under most bad check statutes, a vendor must send a demand letter to the customer requesting grounds for the check not clearing, such as stopping payment because of the vendorís quality, e.g., for the vendor to be entitled to treble damages. Exhibit D is an example of this form of letter. With Check 21, a customer likely will not have an opportunity to have a stop payment issued as it will not have had an opportunity to inspect the goods prior to the check clearing. With Check 21, the demand letter will actually be directed at the NSF check.

3. Reduced Risk of Bust outs?

A common way for an unscrupulous businessperson to take advantage of a vendor is a bust-out scheme. A bustout scheme is devised to defraud vendors of their merchandise through the use of planned bankruptcies and business failures. Bust-out schemes are usually orchestrated in two stages.

In the first stage, the usual practice of bust-out operators is to create a fake corporation, establish a credit account with one or more vendors, place small purchases, and pay within invoice terms on the limited credit provided. In this way, the bust-out operator establishes good credit (i.e., credit worthiness) with vendors.

In the second stage of the bust-out, the execution, the operator places large orders on open account with as many suppliers as possible. He or she then sells the merchandise at steep discounts in return for cash, and often merely disappears. Traditionally the best way for credit executives to avoid a bust-out scheme was conducting a thorough investigation of the company. Check 21 will substantially thwart efforts of unscrupulous businesspersons.

With Check 21, suppliers may be able to confirm whether the check is good prior to releasing the shipment, or while the goods are in transit. With Check 21, the credit professional may find receiving a check akin to a customer paying by credit card. While a payment by check will not result in a simultaneous transfer of funds, with Check 21 it may allow the supplier to avoid being ensnared in a bust out.

4. Reduced Risk of Check Fraud?

White-collar criminals continue to seek loopholes in the check processing system. They "float" checks knowing the checks will not clear, or they write checks against bogus accounts. Check 21 may eliminate paper trails that often lead to convictions. It may become more difficult to spot and prove forgeries and check alterations.

When a check is deposited, the bank that first received the check will truncate the check and electronically send the check to other banks. The banks that receive the truncated checks will not even question the authenticity of the check. There is evidence held on a paper check, everything from DNA to ink print to latent printing. There is a high evidentiary value to an original document. The substitute check may be all that is available for investigation and prosecution.

Some bank and technology industry observers say digital images are more secure because the paper is not floating around and the process is more automated. Relying on check images instead of paper checks should make it less likely that a potential fraudster will come into possession of the personal finance information located on the check.

The original check is taken out of the processing stream, and the security of electronic channels limits human contact with your financial information. In addition, bankers believe that the system will actually help fight fraud because the process allows for faster processing. The faster processing times leave less getaway room for check forgers.

A criminal who had three to four days between the time a check was cashed in, say, Los Angeles, and presented in New York, could find that cut to one day. Any process that reduces the time between an act of fraud and the point at which it is identified as fraud is an advantage. Business customers shoulder most of the losses, an estimated $8 billion a year. Banks will now have access to check images as soon as the items enter the collection stream, which means banks, and bank customers can identify potential fraud early in order to take immediate steps to prevent losses.

5. Eve of Chapter 11 Check Payment

Check 21 may reduce the risk of a customer loading up on inventory and filing bankruptcy. A too common tactic of a financially struggling debtor is to write checks to vendors to obtain product on COD terms, only to file bankruptcy within days of issuing the checks. Prior to Check 21, the check would not clear because of the bankruptcyís automatic stay, especially with the delay of clearing out-of-state checks. Even if the check cleared post-bankruptcy, the payment could be recaptured as an avoidable post petition transfer. Check 21 may result in checks clearing prior to the customer filing bankruptcy, even with out-of-state checks.

6. Bankruptcy Preference

With an earlier clearing of checks, a vendor may find that it may avoid a preference demand where a customer later files for bankruptcy. The bankruptcy preference laws provide that a debtor may recapture payments to vendors within 90 days of the bankruptcy filing, subject to defenses. Under the preference laws and payment by check, a preferential transfer is measured by the date the check clears the customerís bank. With Check 21, a check may clear earlier, and, therefore, may miss the 90-day reach back from when the customer files bankruptcy.

7. Effect on Credit Card and Other Electronic Payments

A vendor may find that with Check 21 payment now has more appeal given the check clearance time when compared with credit cards, due to the fact that transaction costs with credit cards are much steeper than the handling costs with checks. Likewise, customers may consider payment by check preferable, even with the reduced float time, as credit cards become more expensive due to rising interest rates.

Check 21 may lead to a customerís willingness to pay electronically (ACH, EFT, EIPP) as the float advantage they previously enjoyed by paying with paper checks has been eliminated.

8. Effect on DSO and Cash Flow

Unfortunately Check 21 may have a negative impact on DSO as those customerís who typically play the cash flow game will be compelled to withhold payments several days to compensate for the loss of check float. However, an obvious advantage to Check 21 could be an acceleration of cash flow.

9. Your Customerís Stop Payment Strategy May Be Ineffective

A supplier may have language in a credit application or vendor agreement that the customer has a duty to inspect goods within a specified period. If the customer fails to object within the period, the customer has waived its right to challenge the goods. In the context of payment by check with Check 21, the customer will likely not have an opportunity to inspect the goods, object, and then issue a stop payment by check.

10. Race to the Bank

With Check 21 in place, the race to the bank for checks to clear, especially for out-of-state checks, may be significantly shortened, but be aware, other forms of payment will usually win the race. Automated Clearing House (ACH) transactions, for example, occur instantly; money is taken out of the customerís account electronically. Most wire transfers will clear the same day they are requested, especially if the transfer is a regularly scheduled transfer and the wire transfer is not from an out-of-state bank. With Check 21, the truncated check will still have to be batched and presented for payment.

11. Greater Risk of Identity Theft Through Check Fraud

One area that the credit professional must consider with Check 21 and the effect of checks clearing faster is that it may encourage fraudsters to consider check fraud. This may impact the credit professional that takes checking account information from a sole proprietor or personal guarantor and stores this information electronically.

In an effort to protect customers from the risk of identity theft, California passed legislation that creates a duty for companies to protect electronic personal information from being disclosed, and requires companies to notify customers when their electronic personal information has possibly been misused, so they can take steps to protect their assets, including closing their checking accounts. With Check 21 and the more prompt clearing of checks, even fraudulent checks, the credit professional must ensure that a customer's private financial information is secure, including checking account information.

12. Documenting Payment By Check

Record keeping and internal document controls for checks and verifications of payments will need to be improved to address that the original paper check will no longer be available. Vendors should evaluate their procedures for verifying the amount of the check to the invoice before shipping goods and how to monitor accounts between statements. Vendors should also be conscious that the bank account reconciliation process will look significantly different. There will be a mix of electronic transactions, substitute check transactions and original paper check transactions.

One negative effect of Check 21 may be an increase in bank fees. While banks will be saving money on processing fees due to electronic processing, they are not required to pass on those savings to the customers. Check 21 does not place any cap on the fees a bank may charge for providing substitute checks.

Check 21 Benefits to the Credit Department

For many of the foregoing reasons Check 21 will benefit the credit professional. It will help to thwart those who commit fraud, and those who just make good faith mistakes by not having enough money in their accounts to cover the checks they have written. Check 21 will also reduce the need for litigation to recover goods or payment. The credit professional will have a much stronger position when extending credit and making collections.

Scott Blakeley is a principal of Blakeley & Blakeley LLP where he practices creditorsí rights and bankruptcy law. His e-mail is

The Credit Research Foundation will perform a follow-up survey in about 6-months to attempt to validate the impact of Check 21 on the receivable management process.

EXHIBIT C [Page 1 of Reclamation Demand Letter]


Re: Reclamation Demand by (Vendor)

Dear Sir/Madam:

Demand is hereby made upon you pursuant to Sections 2-507, 2-511 of the Uniform Commercial Code, and Section 546(c) of the United States Bankruptcy Code, for the return of goods that the undersigned had sold to you on cash terms and for which the check(s) tendered in payment for the goods were dishonored, which goods were received during the applicable reclamation periods. This demand specifically includes, but is not limited to all goods described in the Schedule annexed hereto.

Please contact the undersigned for instructions for return of the goods. You are further notified that all goods subject to our right of reclamation should be protected and segregated by you and are not to be used for any purpose except those authorized following notice and a hearing by the Bankruptcy Code.

Very truly yours,

[Page 2 of Reclamation Demand Letter]


Invoice No.

Invoice Date

Invoice Amount










Exhibit D Bad Check Demand Letter




Re: Vendor v. Buyer

Dear [Buyer]:

[Vendor] is the payee of a check you wrote for [$________ ]. The check was not paid because you stopped payment, and [Vendor] demands payment. You may have a good faith dispute as to whether you owe the full amount. If you do not have a good faith dispute with the [Vendor] and fail to pay the payee the full amount of the check in cash, a service charge of an amount not to exceed $25 for the first check passed of insufficient funds, and $35 for each subsequent check. You could be sued and held responsible to pay at least the following:

(1) The amount of the check;

(2) Damages of at least $100, or three times the amount of the check up to $1,500.

If the court determines that you have a good faith dispute, you will not have to pay the service charges and treble damages.

Yours very truly,

© Copyright 2004 by the Credit Research Foundation
All rights in this paper are reserved
No part of the paper may be reproduced in any manner whatsoever without written permission
Printed in the United States of America
Credit Research Foundation
8840 Columbia 100 Parkway
Columbia MD 21045

Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley LLP

Share |

Business Credit Articles
Send to a Friend
Ask A Credit Question
Questions & Answers
Business Credit News
Your Privacy
Site Map