Check 21, NSF Checks and Flash Reports

A new era in protecting industry group members from fraud?

Industry credit groups have served vendors needs for reliable credit information for decades. Indeed, the U.S. Supreme Court has recognized that industry group members may exchange credit experience information. Many industry credit groups also serve their members by providing them with alerts or “flash reports” when a member receives notice of an NSF check. These flash reports are used by industry groups to alert members that there may be a risk of even accepting payment by check from a customer, of being ensnared of a bust out given that a member has not been paid.

Flash reports, however, have not realized their potential as an early warning system for the vendor who is the target of a bust-out or fraudulent transaction. The reason is that the member is not promptly notified that the customer’s check has not cleared, which means that the vendor cannot promptly notify the industry group leader of the bounced check. Often a vendor must wait several days before receiving notice of the bounced check, especially with an out-of-state checks. That delay by the bank in notifying of the bounced check provides the bust-out artist with the window for which they may load up on inventory from other vendors.

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 that 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, they are expected to clear in hours, not days. Indeed, a vendor may be promptly notified by the bank of an NSF check, even with an out-of-state check. May the arrival of Check 21 make flash reports an effective “red flag” and allow the vendor from being ensnared in the bust-out or fraud? bad check laws? What steps does a vendor take to enforce the bad check in light of Check 21?

Overview of Check 21

Approximately 75 percent of trade credit transactions are conducted by check. Check 21 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.

Fraud and Bust-Outs In Action

A bust-out is a scheme 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. The first stage may be characterized as laying the groundwork for the bust-out and the second stage as execution.

In the first stage, the usual practice of bust-out operators is to create a fake corporation and establish a payment historycredit account with severalone or more vendors. With, make small purchase orders, and pay within invoice terms on the multiple trade historylimited credit provided. In this way, the bust-out operator establishes good credit (i.e., credibility) with vendors. Bustout operators have found that having a Fortune 500 company as a reference can go a long way towards avoiding thorough credit checks.

Vendors become unwitting participants to a bust-out when they do not conduct thorough credit checks of new customers. A vendor’s resources to do so often limited, while increasing competition in many fields has pushed large numbers of vendors to relax their credit standards. Unsuspecting companies of any size, including Fortune 500 companies, are vulnerable to bust-out schemes.

Some large companies have sophisticated credit departments, yet even some of these become lax when an order involves five-digit or six-digit amounts. The bustout operator takes possession of the goods, then sells it at a steep discount -- often to legitimate businesses. The cash from the sale is used to pay for prior orders, until it is time to execute the bust-out.

In the second stage of the bust-out, the execution, the operator places large orders on open account with as many vendors as possible. Where the vendor demands payment by check from the customer at the time they release the goods, the bust-out operator is counting on the float time to load up on inventory from other vendors. Once the vendor receives notice of the NSF check and reports this to the industry group leader, the bust-out operator has already obtained the inventory from other vendors.

The bust-out operator then sells the goods at steepbig discounts in return for immediate cash, and files for bankruptcy liquidation or merely disappears. Far from being experienced businessmen who have stepped over the line in their business decisions, bustbut -out operators are usually members of criminal rings that operate for the sole purpose of defrauding vendors.

Notification of NSF checks may change significantly post-Check 21. Post- Check 21, a vendor may learn promptly of an NSF check because the float time is less and most banks will offer notice of NSF checks via email or on-line. Each bank may set up its standard for immediately notifying vendors of bounced checks.

Check 21 and NSF Checks

At this point, it appears that banks may set their own standards for the redeposit procedure, after the initial attempt fails. The bank may redeposit the check without returning the check to you, based on your instructions to them. Or, the bank may issue a substitute check stamped "Returned due to NSF" and return the check to you. The substitute check is the legal equivalent of the original, so you may use this for reporting to the police authorities.

Flash Reports

NACM/Chicago-Midwest flashreporting services, over the last two years has evolved meet the needs of today’s savvy credit professional even more efficiently. Web access now allows critical account information to be delivered via our secure site and distributed as an alert to industry credit group members within 24 hours. Once submitted, the information is transmitted to NACM/Chicago-Midwest where it is screed by trained personnel ensuring confidentiality and compliance for Antitrust. Only then is it distributed to participating group members in an email. This enhancement gives credit managers a valuable resource with which to base their credit decisions on more real-time information. Further, this information is reflected both regular flash reporting cycles as well as on the group’s credit exchange report so it can be used as a reference and a benchmarking tool.

NSF Checks and Flash Reports

An industry group’s flash report of a member’s notice of an NSF check will have even greater value to industry group members with Check 21. As a vendor will be promptly notified that a check has not cleared, that vendor will notify the industry group leader who may immediately send out a flash report. Given that the vendor is learning of the NSF check much earlier, especially with out-of-state checks, the flash report may become more valuable by assisting vendors in deciding what action to take with their pending orders.

A common way for an unscrupulous businessperson to take advantage of a vendor is a bust-out scheme. A bust-out 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 pay ing 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.

There are several steps credit executives can take to protect themselves. These steps include: keep the vendor=s credit functions and sales functions separate; visit the new customer during business hours and observe sales behavior; visit the customer when the business is closed; ask for a personal guarantee; and discuss the account with other vendors in the industry group.

Check 21 and Flash Reports Help the Vendor

When the business failure includes a bankruptcy filing, a vendor=s legal remedies are also limited. The vendor may be able to convince the bankruptcy trustee of the failed business to pursue the buyers of the discounted merchandise under a fraudulent conveyance theory. The trustee would, however, need funding to pursue such litigation. A vendor may attempt to block the discharge of its claim in the bankruptcy by filing a complaint to determine the dischargability of its debt where the operator has filed an individual bankruptcy. In either situation, the vendor still faces the problem of locating the operator=s assets.

Flash reports will become more effective as a result of Check 21, given that the vendor will be promptly notified of the NSF check, even with the out-of-state check. Provided that the vendor immediately notifies the industry group leader of the NSF check, the flash report can be that red flag that prompts other industry group members to hold orders and insist on certified funds before releasing the goods.

Even with the arrival of Check 21, credit professionals must be vigilant for red flags indicating a risk of fraud or a bust out. Although Check 21 may allow the industry group leader to promptly send out a flash report that may serve as an early warning of an NSF check, if the goods have been shipped and cannot be reclaimed, the vendor will likely be unable to recover the goods in a fraudulent transaction.

Natalie Wriston is Manager of Group Services for NACM/Chicago-Midwest with a staff responsible for credit reporting services and planning business meetings for over 40 industry credit groups. Her email address is natalie@nacmchicago.org.