Payments

Nature

Payment is the unconditional transfer of money. It may be physical cash or, more likely, by the way of credit to a bank account. Obligations under a contract are commonly fulfilled and extinguished by payment.

Payment may take place by delivery of currency notes, whether coins or bank notes, that are legal tender of the currency required under the contract. Payment through bank transfer involves the transfer of claims on a bank in an agreed currency. There is a substitution of the claim of the payer for a claim by the payee against its bank i.e. the relevant credit.

Release of a contractual obligation may also take place by way of set-off or novation. Set-off may be involuntary and is permissible when a person is both creditor and debtor and debts are due in the same currency and with the same maturity.

Novation is the replacement of a payment obligation by another obligation, such as a bill of exchange or promissory note. The substituted obligation may lie from the same party.

Making Payment

The writing of a cheque or endorsement of the bill of exchange is not payment or settlement. It is a conditional discharge only subject to acceptance and fulfilment of the underlying obligations.

Payment is complete and unconditional when value is given in the course of a bank transfer. The creditor must have full disposal rights over the money so that it is an unconditional credit in his account. If, for example, his account may be provisionally credited when a cheque is lodged, but this may be subject to reversal if the check is dishonoured.

The failure to make payment in accordance with the terms of the obligation constitutes a default. The payment duty originates from the debtor. The payment must be accepted. However, in some circumstances, failure to accept where it is tendered would be a default.

In order to introduce more clarity, UNCITRAL has prepared a draft model law on international credit transfers. This follows Article 4A of the (US) UCC.

Money

Money functions as a unit of account and a unit of payment. Money as the unit of account identifies the currency of the obligation.

Where money is the unit of payment, the creditor must have agreed to accept the relevant currency. The origin of the money is irrelevant and money is not subject to title issues in the same way as movable or real property.

Under the gold standard, the major currencies could be converted into gold at a fixed rate. The gold standard was abandoned by most countries in the 1930s and replaced with fiat currency. This is simply backed by the Central Bank and, ultimately, the state.

The remaining obligation of Central Banks is simply upon presentation of a note to make a new note in the same currency. Outside of its borders, the value of the currency may change dramatically and quickly.

In principle, fiat currency may be adjusted politically and could evaporate through inflation or government action. It may be devalued against other currencies and lose its value relative to them quickly.

Most countries legislate that payment in their national currency is legally acceptable. Outside of the country concerned, where mandatory laws may apply, there is no reason a particular currency should be accepted as sufficient payment and discharge unless the contract so provides.

Currency Issues

Many currencies do not allow free convertibility. There may be exchange controls. Currency control was lifted by most of the major states in the late 1980s. The European Union provided the free movement of capital as and from  January 1993. The Irish exchange controls legislation thereupon lapsed

In international transactions, the currency of settlement will be crucial. Convertibility and transferability are key elements of reliable currency for payment. The parties may agree on an internationally strong currency (usually the dollar) for payment, irrespective of the lack of connection with it.

The payee will wish to obtain payments in a currency which is freely transferable and possibly that of his home country. Otherwise, he may bear currency exchange risk and may hedge against this risk.

The IMF’s rules on payment are relevant where currencies are not fully convertible and transferable. Current payments in respect of goods and services must not be subject to restrictions or limitations.

Time of Payment

The identification of the moment of payment may be critical and terms of establishing compliance with the obligation of the contract especially if bankruptcy occurs. Payment could be considered to happen when the payer’s bank accepts the instruction or later at the debiting of the account of the payer.

For the most part,  however, payment is only deemed achieved when the payee can freely dispose of the money so that it is unconditionally credited to his account. Generally, the debtor bears the risk of failure in the payment mechanism.

Electronic Settlement Systems

Modern electronic payment systems have been facilitated by technology. In these systems, orders may be given by telephone or e-mail by the debtor to his banker. The interbank payment then proceeds. Online methods may achieve instant debiting and crediting and immediate payment.

Off-line orders may be stored electronically and netted in a clearing system between the banks. There is a net settlements system which may be multilateral with multiple banks. In this system, payment of a settlement usually takes place within 2 to 3 days.

In the United States, Fedwire maintains a gross settlement system. It operates between the 12 US Federal Reserve Banks for banks holding accounts with the Federal Reserve. The CHIP system in the US maintains the offline net settlement system.

Various Systems

In the UK, CHAPS provides the equivalent system to CHIPS. They operate on a net basis and a multilateral clearing system. In CHAPS, large value transfers may be settled on a real-time basis through the Bank of England, provided that it is put in funds to limit the effect of the immediate payment.

In the euro area, the euro clearing and settlement service, EURO1, is operated by the Euro d Banking Association. It is a privately owned, multinational, cross-border net payment system. It provides same-day value and receives messages via SWIFT. The UK connects through CHAPS Euro.

Large payments go through real gross-time payment systems. In the EU, TARGET is operated through the European System of Central Banks.

Under CHIPS, participants are given a settlement report indicating their net debit or credit positions once a day. If the net debtor does not have sufficient funds in his reserve account, it will draw down balances or lines of credit with banks (the Federal Reserve) or Central Bank.

Risks

The payment system carries risks for participants. There may be a delay in the systems leaving the payee out-of-pocket. One of the obligors may go insolvent. One of the intermediary banks may become insolvent before the process is cleared.

The system runs a liquidity risk if part of one participant becomes a credit risk which may quickly cause a systemic risk. A default in clearing would lead to the unwinding of transactions.

To avoid this, members of the system may guarantee each other’s obligation in advance, effectively taking over the defaulting party’s settlement obligations. In order to avoid liquidity problems, there may be mutual lines of credit. Collateral may be provided by weaker members.

Settlement Finality

The EU Settlement Directive provides that neither the instructions of an insolvent participant nor the law against fraudulent or preferential transfers should disrupt payment or securities settlement systems on any set-off or contractual netting therein. The payment is finally, notwithstanding any invalidity in the underlying transaction.

Limitations are placed on the ability to revoke or amend instructions. Neither the instructions of an insolvent participant in the clearing system nor the laws on fraudulent or preferential transfer should disrupt the payment or settlement or any set-off for contractual netting therein.

Transfer orders given and included in the netting, even in the event of insolvency proceedings against the participant, are binding on third parties. Protection applies unless issued after the other parties did or should have known of the insolvency. Collateral given to the Central Bank is protected against insolvency.

Netting & Set-Off

Set-off may raise complex issues in terms of the finality of payment in the context of bankruptcy. The question arises as to how automatic set-off is. Where there is an immediate need to liquidate a fixed sum debt on either side, the position is generally straightforward. Set-off is not generally automatic unless the sums are immediately due, have the same maturity and are owed to the same beneficial owner.

Difficult questions arise in relation to claims that are potentially the subject of counterclaims in proceedings. There must be a sufficient connection between the claim and the counterclaim. Where one sum is liquidated and another unliquidated, a judicial determination would be necessary in respect of the unliquidated or undetermined sum.

Some countries allow set off of contingent debts while others do not. Civil wrong claims may or may not be allowed. Some states allow unliquidated sums, which need to be assessed to be set off.

Parties may have expanded the scope of set-off by the terms of a contract. They could agree that a wider range of claims that may not have a direct connection are set off. They may abandon the need for a court order in cases which would otherwise require it. These are other techniques are used to contractually accelerate and enhance set-offs which would otherwise exist.