Check 21 and fraud: say goodbye to bust-outs?(credit column)(Check Clearing for the 21st Century Act of 2003)

A frustrating aspect of a credit professional's job is being ensnared in a planned insolvency or bust-out. Even a sophisticated credit professional who may sense credit risk with a particular account, and sells only on COD, may find a debtor's check bounce and that the goods delivered to the debtor vanish (along with the proceeds from the sale of the goods). While payment by check is viewed as a cash sale, a check can bounce and the goods have already been delivered. Unfortunately, the credit professional who is being pressured to release goods with payment by check may have to wait days for the check to clear. The recent enactment of a federal law may change this.

On October 28, 2004, the Check Clearing for the 21st Century (Check 21 Act), federal legislation affecting all states, went into effect. Check 21 changes the method in which checks are processed in the United States, as well as changes the technology of check payment and acceptance. With Check 21, financial institutions may process checks electronically, instead of transporting the paper checks. With checks being processed electronically, checks are expected to clear promptly, not in clays. Indeed, a vendor may be promptly notified by the bank of an NSF check. What is the impact of Check 21 and reducing the risk of a bust-out?

Overview" Of Check 21

Approximately 75 percent of trade credit transactions are conducted by check. This act focuses on the delay caused by a paper check being transported through the banking system.

Check 21 permits the depository bank, if it so chooses, to "truncate" the original check. Truncating a check means to take the check out of physical circulation by transforming it, using a computer scanner, into a digital image, also known as a substitute check. This digital image 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 the digital image for payment in hours rather than days. As a result of image technology, delays attributable to weather or air travel are gone.

The Bust-Out

A company establishes credit with a supplier by paying promptly for a small initial order, and then places additional orders for product. As the invoces start becoming past due, the proprietor starts stalling credit managers. Meanwhile, the unpaid merchandise is removed and the principal abandons the business completely, or files for bankruptcy. This is known as a bust-out. Bust-out schemes are usually orchestrated in two stages. The first stage may be characterized as laying the groundwork for the bust-out and the second stage as execution.