MANAGING THE RISKS OF PAYMENT SYSTEMS CHAPTER 1 pps

Evolution of Fiat Money New York Clearing House Association 11 How the SWIFT System Works 20 Chapter 3 Checks and the Risk of Fraud 23 Negotiation and Endorsement 32 “Holder in Due Cours

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M ANAGING THE

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Library of Congress Cataloging-in-Publication Data:

1 Electronic funds transfer 2 Payment 3 Risk management 4.

Corporations—Finance I Wunnicke, Diane B II Title.

HG1710.T87 2003

658.15'5 dc21 2002156141

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

Contents

Chapter 1 “We Didn’t Know” Is No Excuse 1

New Frontier in Cyberspace 5

Chapter 2 Payment Systems Survey 7

Evolution of Fiat Money

New York Clearing House Association 11

How the SWIFT System Works 20

Chapter 3 Checks and the Risk of Fraud 23

Negotiation and Endorsement 32

“Holder in Due Course” Doctrine 32

Notice of Fraud or Defenses to Payment 35

Risks to Others Because of the Rights

of a Holder in Due Course 36

Check System in the United States 38

Bank Deposits and Collections:

The Depository Bank—Provisional versus Final Payment of a Check 38 Payor Bank: “Final Settlement”

Basic Rule with Respect to Fraud 41

viContents

Exceptions to the Basic Rule 42

Positive Pay Arrangements 53

Company That Receives Checks 55

Receipt 55

Chapter 4 Wire Transfers: Originator to Its Bank to

Receiving Bank 59

Links in the Funds-Transfer Chain 59

Nonacceptance of Payment Orders 62 Bank’s Right to Reject Orders:

Eliminate Interest Obligation 63 Cancellation and Amendment of Payment

Orders 64 Acceptance and Execution of the Originator’s

Liability for Fraudulent Funds Transfers 81

Notes for Negotiators of Funds-Transfer Agreements 82 Liability for Misdescription of the Beneficiary 83 Interest 83

viiContents

Next Link in the Funds-Transfer Chain:

Sending and Receiving Banks 84

Originating Company’s Money-Back Guarantee 86

Managing Risks in the Links of the Wire Transfer Payment System 86

Sending and Receiving Banks 87

Study of a Bank’s Perspective of Transfer Risk Management: Wire Transfer Systems Lend Money to Customers 88

Funds-Why Do Banks “Lend” Money for Transfers?

What Is the Business Process Behind Daylight Overdrafts? 89 Coping with Corporate Groups 90

Other Side of the Transfer 97

Chapter 5 Wire Transfers: Completing the

Transfer and Rules for Errors 103

Last Link in the Funds-Transfer Chain 103Beneficiary and the Beneficiary’s Bank 104

Payment of the Beneficiary and Discharge of the Underlying Obligation between the Originating Company

Managing Risks in the Links of the Wire Transfer Payment System 120

Beneficiary and the Beneficiary’s Bank 120

General Rule for Customer Errors 121

Misdescription of a Bank 128 Error-Detection Security Procedures 130

Chapter 6 Risks of Automated Clearing

House Payments 141

Origination of ACH Entries 144

Warranties and Liabilities of the ODFI 150

Reversing Duplicate and Erroneous Files 155 Reversing Duplicate and Erroneous Entries 157 Originating Destroyed Check Entries 158 Reinitiation of Returned Entries

Miscellaneous Obligations of Originators 159

Receipt of Entries: RDFIs and Receivers 160

Receipt and Availability of Entries 162 Receiver and Originator: Closing the Loop 164

Returns, Changes, and Acknowledgments 165

Exceptions to the Two-Banking-Day

Refusal to Accept Returned Entries (“Dishonor”) 167

Chapter 7 Commerce and Payments in Cyberspace 185

Revolutions in Payment Systems 185Paperless Transactions and

Uniform Electronic Transactions Act and Electronic Signatures in Global and National Commerce Act 188

Public Key Infrastructure 189

Integrating Risk Management 200

Chapter 8 Management of Corporate

Payment Systems Risks 201

Review of Contractual Risk Allocation 207

Managing Payment Systems Disruptions 208

Contacts 209

Communications 209

Managing Check Payment System Risks 210

Company That Issues Checks 210 Company That Receives Checks 211

xContents

Managing Wire Transfer Payment

In all of these capacities, I have had the good fortune to formlasting and rewarding professional relationships with corporatetreasury and bank executives, counsel to banks, and counsel tocorporate customers It has been interesting to observe thatalthough knowledge and experience are fairly equally repre-sented on both sides of the table in complex negotiations, therisks arising from mundane issues such as fraud, are, from a legalpoint of view, better understood by bankers and their counselthan by corporate treasury executives and their counsel.

It is my hope that this book, which is written for all interestedparties, including bankers, corporate executives, and theirrespective counsel, will make the risks associated with the pay-ment systems better understood by all.

DIANE B WUNNICKE

As a veteran corporate finance manager, I came to know the risks

of corporate payment systems These systems and their risks werefirst introduced to me in the 1970s when I worked on the first on-line systems for a large savings and loan and its multiuser dataprocessing service company I came to understand the structure,requirements, and risks of banking payment systems as weinstalled our on-line customer systems, including single andmulti-institution ATM machines and ACH payment processing.During the 1980s through the mid-1990s, I was finance and cashmanager for a global energy company We sought out every newcash management product that would help our domestic andinternational multicurrency payment operations I arranged forour office to beta test new payment systems products and report-ing We all welcomed the Treasury Management Association andits successes for both corporate treasury departments and banks

I hope that this book’s practical explanations of the issuesand management of corporate payment systems risks will be ahelpful guide Much longer books on specific topics and laws areavailable, and a lot of information is now timely updated andavailable on the Internet (See References section.) I hope thatthe format of this book and its content provide the convenient,basic desk reference so often needed

* * *

We both thank James Caldarella, former head of systems opment for payment systems with a major global bank, for hisinsights into the risks of corporate payment systems and his per-spectives as a highly experienced senior banker

devel-xivPreface

M ANAGING THE

R ISKS OF

1

“We Didn’t Know” Is No Excuse

This book is about the risks that business entities are likely to encounter in their use of the payment systems employed in the United States

This chapter emphasizes that corporate managers who are responsible for the management of payment risks should understand how the law governing liability for fraudulent checks and funds transfers determines whether the company or the bank is liable for fraud losses and, in addition, should understand whether the wording

of the company’s agreements with its bank would make the company liable for a loss even though the law would otherwise make the bank liable for it

Ignorance of the law is not an excuse for poor agement of payment systems risks.

man-WHAT IS A PAYMENT SYSTEM?

By “payment,” we mean generally the process by which a debtordischarges indebtedness to a creditor Of course, a payment can

be used for family, charitable, or other strictly consumer poses, but this book is about business uses By “system,” we mean

pur-an arrpur-angement of national or international scope by whichdebts may be discharged Payment systems typically also includethe processes by which the payors and participating financialinstitutions settle with each other

PAYMENT SYSTEMS

There are primarily three kinds of payment systems:

1 Payment in the national currency (e.g., U.S dollar billsand coins),

2 Payment by check, and

3 Paperless payments

The paperless payment is a relatively new device as comparedwith payment in currency and payment by check Paperless pay-ments today are typically made by electronic means, and pay-ments made by electronic means are commonly referred to as

“wire transfers.” The electronic funds-transfer systems in theUnited States include:

• The Fedwire system of the Federal Reserve Banks

• CHIPS (Clearing House Interbank Payment System) of the

New York Clearing House Association and participating banks

• SWIFT (Society for Worldwide International

Telecommu-nications)

• The ACH (automated clearing house) system of the

National Automated Clearing House Association, usingthe processing facilities of the Federal Reserve system The Fedwire system and CHIPS are called “wholesale” funds-transfer systems because they normally involve the business-to-business transfer of very large sums SWIFT is an internationalmessage transmission system SWIFT differs from the other sys-tems described in this book in that it does not provide settlementservices for its participants

The ACH system is generally used for transfers in relativelylower amounts than are transferred in wholesale transfers Asthese terms are generally used, ACH transfers, although elec-tronic, are not called “wire” transfers The ACH system is theonly system described in this book that supports both credit and

debit transfers In an ACH credit transfer, the payor instructs its

bank to send funds to the payee’s bank, whereas in a debit

trans-fer, the payee instructs its bank to cause funds to be transferred

from the payor’s account into its own (the payee’s) account ACH debit transfers have been used in innovative ways, such as

in the transfer sometimes called an “electronic check.” This type oftransfer begins as a conventional paper check and ends as an ACHdebit to the account of a consumer In one form of electroniccheck, for example, a merchant captures the information on thecheck presented at the point of purchase and uses that information

to initiate an ACH debit to the consumer’s account (See Chapter

6 for a discussion of ACH debit entries to consumer accounts.)Chapter 2 of this book contains a broad survey of the variouspayment systems, including the check system and the Fedwire,CHIPS, SWIFT, and ACH systems Subsequent chapters discuss each

of these systems in greater detail The advent of the Internet has had

an enormous impact on commerce; commerce in cyberspace andpayment-related aspects of cyberspace commerce are discussed inChapter 7 Chapter 8 concludes the book with suggestions for themanagement of risks, including a discussion of transactional riskand the risk of system disruptions, as well as the risks directly associ-ated with each of the payment systems discussed in this book

LIABILITY FOR FRAUD LOSSES: THE LAW AND

THE CONTRACT WITH THE BANK

Among the risks discussed in this book, special emphasis is given

to the risk of fraud We believe that corporate management isbetter able to manage the risk of fraud if management has a basicunderstanding of how the law determines liability for fraudamong the parties involved in a payment transaction

3Liability for Fraud Losses

When a fraudulent check or funds transfer is paid and thewrongdoer has escaped, which party is liable for the loss? Thecompany whose account has been charged? The paying bank? Abank that acted as an intermediary bank? This book is not a legaltreatise, but is intended to help the reader understand broadlyhow the law allocates liability for fraud losses to the parties inpayment transactions

The law governing checks, bank deposits, and collections iscontained in Articles 3 and 4 of the Uniform Commercial Code(U.C.C) The law governing wire transfers is contained in U.C.C4A Automated clearing house (ACH) transfers are also gov-erned by the ACH Rules of the National Automated ClearingHouse Association These laws and rules are discussed inChapters 3 through 6 of this book

An understanding of the U.C.C and ACH rules, however, isnot sufficient The treasury manager should know that theserules can be varied by the agreement of the parties In otherwords, the rules generally allow the parties to agree to their own,different rules

Bank Shifting Its Statutory Liability

to the Customer: Examples

Banks typically offer their customers blanket agreements ing all of the services they provide and additional agreementsthat cover particular services, such as a funds-transfer agreementand an ACH Agreement The customer should be aware thatthese agreements commonly impose rules that are differentfrom the statutory rules, and that these differences are unfavor-able to the customer The differences, moreover, are typicallyworded indirectly and thus not clearly evident to the reader Consider the following examples Note the effect as to cor-porate payment risk management

cover-Example 1, as to checks:A provision stating, “The Bank shallhave no liability unless the Bank’s conduct shall have constitutedgross negligence or willful misconduct,” may sound innocuous

4

“We Didn’t Know” Is No Excuse