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Mitigating Legal Risk in ACH Transactions

2nd Quarter - 2008

By Charla L. Hausler and James E. Michel, Barnes & Thornburg LLP

THIS ARTICLE IS AN INTRODUCTORY ARTICLE IN A SERIES OF ARTICLES THAT WILL DISCUSS LEGAL RISKS A FINANCIAL INSTITUTION FACES WHEN PROCESSING PAYMENTS THROUGH THE AUTOMATED CLEARING HOUSE (ACH) NETWORK AND WAYS A FINANCIAL INSTITUTION CAN MITIGATE THESE RISKS.

Use of the ACH Network for processing payments continues to grow. According to the National Automated Clearing House Association (NACHA), the ACH Network processes over twelve billion payments annually, with this number expected to increase. Although the ACH Network is viewed as a safer and more efficient way of processing payments, financial institutions are subject to liability within the ACH Network.

Increased activity within the ACH Network can expose financial institutions to greater risk. For a financial institution, potential liability can stem from, among other things, fraudulent activity, customers that are not credit-worthy or engaged in disreputable business practices, operational errors, and the failure to have proper agreements in place with customers and third-party senders. Financial institutions, however, can take steps to mitigate risk. Mitigating legal risk begins with understanding the rules and laws governing ACH payments.

Armed with this understanding, financial institutions will be better able to protect themselves from loss. ACH transactions are governed by the National Automated Clearing House Rules (ACH Rules). In addition to the ACH Rules, ACH transactions may be governed by federal and state law, such as Regulation E and Article 4A of the Uniform Commercial Code (UCC). The ACH Rules and applicable laws set out different rights and obligations for financial institutions.
In an ACH transaction, a financial institution may find that its potential liability is quite different than it may expect. This can be especially true, for example, when the ACH transaction involves a converted check.

Check conversion allows companies (Originators) to initiate ACH debits by using a check as a source document. The ACH Rules allow Originators to convert certain eligible checks to one time ACH payments using Point of Purchase (POP) or Accounts Receivable Entry (ARC) transactions. On March 16, 2007, Originators will also be able to convert eligible checks using a Back Office Conversion (BOC) transaction. When a check is converted to an ACH transaction, it is no longer governed by paper check law, such as UCC Articles 3 and 4. Rather, it is governed by the ACH Rules and applicable federal and state laws.

Check conversion can result in a significant shift in liability for a financial institution. An example of this shift is revealed in situations concerning checks that contain a forged drawer’s signature. Assume a merchant takes a check from a customer in the amount of $2,500 for a new TV. Unbeknownst to the merchant, the check contains a forged drawer’s signature. The merchant then deposits the check with its bank (depositary bank). The check is processed as a paper check. If the paying bank (drawee bank) pays the check over the forged drawer’s signature, the paying bank will generally bear the loss under UCC Article 4-401, for paying a check that was not properly payable.

If the check is converted to an ACH transaction, the merchant’s bank becomes the Originating Depository Financial Institution (ODFI). Under the ACH Rules, an ODFI warrants to the paying bank (RDFI) that the transaction has been properly authorized. Liability is placed on the ODFI for unauthorized debit transactions. Therefore, if the forged $2,500 check is converted to an ACH transaction, the ODFI, not the RDFI, will likely bear the loss as between financial institutions. There are precautions an ODFI can take, however, that will prevent it from ultimately bearing the loss.

An ODFI should ensure that it can pass losses to its customer, the Originator. ODFI’s must make sure that proper agreements are in place with their customers. These agreements should bind Originators to the ACH Rules, require Originators to maintain procedures to safeguard against unauthorized transactions, and place responsibility for unauthorized transactions on Originators.

Even with a proper agreement in place, an ODFI may find itself in a position where it is unable to collect from the Originator, such as in cases where the ODFI files bankruptcy. Therefore, ODFIs must also take steps to know their customer. ODFIs should make certain that their customers are credit-worthy and involved in reputable business practices.

Customer relations can also be strained in situations where a loss is incurred from an unauthorized transaction. Many times customers assume that the bank will bear losses from unauthorized transactions. Therefore, ODFIs should take steps to educate their customers on the ACH Rules and the definition of an unauthorized debit. Originators that are educated regarding unauthorized debits will be more willing to protect against losses. The ACH Rules also require ODFIs to establish, monitor and review exposure limits for Originators.

ODFIs should explain policies and procedures regarding their exposure limits to Originators.
At the end of the day, a financial institution can never completely avoid legal risks involved in ACH payments, but there are ways financial institutions can limit their potential exposure for loss. This article series will continue to address potential liability faced by financial institutions in the ACH Network. Through discussions of hypothetical situations that address potential exposure for loss under the ACH Rules and applicable law, your financial institution can become more aware of the liability it faces and be more prepared to prevent
loss.

The articles and content posted on this blog are intended for general informational purposes only and are not to be construed as legal advice or legal opinion on any specific facts or circumstances.