Mandate final Report
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5. Legal Evaluation5.1.1 Legal Structure1. The aim of the legal structure is to provide a framework under which differing national legal requirements can be satisfied whilst at the same time fulfilling the commercial requirements of users. 2. The research has been conducted from a basis of English law (and recent and imminent caselaw developments are reviewed in detail) but a pan-European perspective has been adopted throughout. 3. Due to uncertainties over the requirement of “writing”, the “electronic cheque” does not easily fit into the detailed legal provisions which apply to negotiable instruments and which date mainly from the nineteenth century. Therefore a new commercial instrument must emerge which fulfils the same function as a cheque. 4. The way this is done is by interlocking contractual arrangements between all relevant participants. 5. The main demands of participants are: security (which is dealt with in the technical parts of the project) “liquidity” - described below as the “main functionality”, namely the ability to defeat a counterclaim in the event of dishonour or the “as good as cash” rule (which is dealt with in the contractual structure envisaged and which the judiciary appear to be supporting1). 6. National laws are thought to be capable of fulfilling such demands. Legal structure is based on commercial functionThe electronic negotiable instrument must reflect and, preferably, improve the functionality of the traditional paper based payment methods. So it follows that the legal structure must be based on accepted principles and build upon them to respond to the challenges of novelty or unfamiliarity. At the same time legal structure is never created in a vacuum. It is always a response, however imperfect, to commercial demands. It is therefore important to look at why a system of cheques has come into widespread commercial use. The proposed contractual structure can then look at the fundamental requirements of the relevant parties and provide for them. There are two sets of parties: the customers and the bankers. 5.1.2 Reasons for using cheques: the requirements of the commercial partiesIf SME A provides goods or services to SME B, it will create an asset for itself in the form of a receivable, a right to be paid. Its ultimate aim is that that claim against B will be converted into cash to fund the production and value-generation process. There are two reasons why it is inconvenient for A to insist on immediate cash payment from B:
The role which banks have developed and which is facilitated by the cheque system provides a solution to both these problems: the banks look after the parties’ cash and they provide credit by meeting cheques under agreed overdraft facilities. Thus the banks provide a service (and make a profit). At the same time the banks incur risks and require protection from liability. As Goode points out (Commercial Law, second edition 1995): “The sheer volume of cheque transactions, leading to the computerisation of account systems, has made it necessary to enact legislation for the protection of bankers in order to relieve them of the liabilities which would otherwise fall upon them. In the result, the greater part of the law relating to negotiable instruments is concerned with particular problems in relation to cheques.” So, the legal structure for electronic cheques must provide for the interests of customers and protect the interests of banks in the same way as the paper system. The analysis must therefore be made under two headings: (A) Fulfilment of customers’ requirements and (B) protection of bankers. A Fufilment of customers’ requirementsThe Bill of Exchange was developed through accepted commercial practice, confirmed by common law and ultimately codified in the Bills of Exchange Act 1882. Section 3(1) of that Act defines a bill of exchange as follows: “An unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand, or at a fixed or determinable future time, a sum certain in money to or to the order of a specified person, or to bearer.” The attraction of the Bill of Exchange was that the drawer could obtain its acceptance by a financially stronger party. The instrument could then be traded on the credit of the acceptor. The holder in due course had a number of advantages:
The bill of exchange was thus a tradable commodity: in other words a negotiable instrument. The role of bankers as facilitators of trade and provider of credit sometimes required bills to be accepted by banks. On other occasions it was sufficient for it to be involved in the transaction solely as drawee. In this event, the supplier’s credit risk remained with the drawer (in this case the recipient of goods or services) and the holder was able to use the banking system (via his own bank as collector) to obtain value. This is the origin of the cheque system. Why a cheque is different from a classic bill of exchangeAs provided by section 73 of the 1882 Act, a cheque is: “.. a bill of exchange drawn on a banker payable on demand”. The combined effect of the two quoted sections produces the following full definition of a cheque: “An unconditional order in writing addressed by one person to a bank signed by the person giving it requiring the bank to pay on demand a sum certain in money to or to the order of a specified person or to bearer” The essential differences between the classic bill of exchange (where the seller draws on the buyer and sells it on) and the cheque (where the buyer draws on his bank and gives it to the seller who tests the bank’s preparedness to pay through the collection system) are that:
To achieve (2), he would need to put in place credit insurance, obtain a third party guarantee or seek an additional contractual relationship with the bank. This is effectively what is now achieved in consumer transactions with cheque guarantee cards. It has also been overtaken by use of debit cards and the even more universal electronic funds transfer at point of sale, also activated through the mechanism of a debit card. To require the bank to accept the cheque and impose traditional bill of exchange liability would be otiose and commercially impractical. To achieve (3), the seller is more likely to utilise invoice discounting rather than assignment of the instrument of payment. It is of course theoretically possible to endorse or negotiate a cheque in order to gain discounted value from a third party, but the modern conventional use of crossings “a/c payee only” tends to preclude this. The Cheques Act 1992 specifically amends the 1882 Act to make such a cheque non-transferable.
The true function of cheques: the security of cash equivalenceAs between SME’s therefore, the cheque is used because it avoids the risks and drawbacks of cash, it is part of a well-used and traditional structure under which both parties are likely to have relationships with banks who will provide the collections and current accounting services required and the ability to post date or delay delivery of the cheque ensures that maximum use can be made of commercial credit periods. Proposition 1: in this context, the negotiability function of the cheque is of relatively little importance. However, the cheque does have a further important advantage, derived from commercial usage. The recipient of the cheque may bear the risk that bank will decline to pay because the drawer has insufficient funds but a rule has developed whereby he does not bear the risk of disputed cross-claims. Proposition 2: the important function of the cheque is to provide a secure right of action against the drawer. The Courts look on a cheque as being as good as cash and it is no answer to claim on a cheque to assert that the goods or services in question were defective and have caused loss. The cheque must be paid and any counterclaims pursued separately and a stopped cheque can be sued upon and summary judgment obtained. Authority for this rule derives from a number of nineteenth century cases but a recent focal point is the decision of the House of Lords in Nova (Jersey) Knit Limited v. Kammgarn Spinnerei GmbH [1977] 1W.L.R. 713, where Lord Wilberforce said: “I take it to be clear law that unliquidated cross-claims cannot be relied upon by way of extinguishing set-off against a claim on a bill of exchange...As between the immediate parties, a partial failure of consideration may be relied upon as a pro tanto defence, but only when the amount involved is ascertained and liquidated....English law (and German law appears to be no different) does not allow cross-claims, or defences, except such limited defences as those based on fraud, invalidity or failure of consideration, to be made. I fear that the Court of Appeal’s decision, if it had been allowed to stand, would have made a very substantial inroad on the commercial principle on which bills of exchange have always rested ” The main functionality: liquidity This rule can be identified as the main functionality of the cheque in present day commerce and it is important to replicate it in the MANDATE™ legal structure. The receiver of a cheque has a procedural advantage in the English Courts against the drawer. Thus if one is seeking to persuade a commercial customer that he ought to take advantage of the facility which his bank proposes to afford him of using electronic cheques contained in a MANDATE™, he will need to be convinced firstly that security issues will not adversely affect him and secondly that he will be able to maintain his right to treat a cheque as being “as good as cash”. Extension of the main functionalityThe English Courts have recently demonstrated that they are prepared to afford the benefits attaching to cheques to other payment mechanisms if that is what is required by modern commercial practice. This is highly relevant to the marketability of MANDATE™ and the setting up of the underlying contractual structure. In Esso Petroleum Co. Limited v. Milton [1997] 2 All ER 593, the English Court of Appeal (Thorpe LJ and Sir John Balcombe, Simon Brown LJ dissenting on this point) held that modern commercial practice is to treat a payment by direct debit in the same way as payment by cheque and, as such, the equivalent of cash. In general, a payment by direct debit for goods or services received should preclude a defence of set-off. The facts were that Mr Milton, the licensee of two of Esso’s service stations determined that by reason of the ever more stringent financial conditions imposed by Esso, he could not continue to operate profitably and so he cancelled his direct debit mandate given to his bank. Esso sought summary judgement for the price of outstanding deliveries and Mr Milton sought to raise his counterclaim for future losses as a set-off. According to Lord Justice Thorpe: “Whilst I am conscious of the difficulties and dangers involved in such an extension, I believe that it is consistent with the principle stated by Lord Wilberforce in the Nova (Jersey) Knit case. Where goods are effectively sold for cash, the seller should have the security that cash brings where, for mutual convenience, the parties have adopted the banking mechanism in general usage for the transfer of cash from one account to another. Twenty years ago, that was still by cheque....The modern mechanism for handling what are effectively large scale cash sales on that scale is the direct debit system. So it seems to me that it is a natural evolution rather than an extension of the Nova Knit principle to hold that the seller of goods transferred by the direct debit mechanism should be in no worse position than if he had accepted a cheque on delivery.” It would be part of the function of the banker/customer agreement (and any customer/ customer agreement) in relation to MANDATES that set-offs would be precluded (save for cases of failure of consideration). The intention would be that, following the Esso case, electronic cheques would be given the same recognition as paper cheques. Without that, one of the main attractions of the cheque as a means of payment will be lost. NB Expected developments relating to the Esso caseIt is understood that the House of Lords gave Mr Milton leave to appeal and therefore the issues raised in the case will shortly be the subject of consideration by the highest Court in the United Kingdom. It is to be expected that further judicial pronouncements on the issues raised will be made which will assist those involved in the MANDATE project in gauging the likely extent of judicial reaction to the extension of traditional financial practices to fit relatively new ones. B Protection of bankersThere are normally two bankers involved in a cheque transaction: the collecting banker and the paying banker. The collecting bankerThe legal risks which the collecting banker faces are as follows:
Statutory protection in respect of traditional chequesIn respect of (3), parliament has stepped in to protect bankers and to enable them to carry on business efficiently. Section 4(1) of the Cheques Act 1957 provides as follows: “Where a banker, in good faith and without negligence, (a) receives payment for a customer of an instrument to which this section applies; or (b) having credited a customer’s account with the amount of such an instrument receives payment thereof for himself; and the customer has no title, or a defective title, to the instrument, the banker does not incur any liability to the true owner of the instrument by reason only of having received payment thereof” Subsection (3) provides: “A banker is not to be treated for the purposes of this section as having been negligent by reason only of his failure to concern himself with absence of, or irregularity in, endorsement of an instrument” Clearly then, an important issue is the extent to which a banker acts “without negligence” and a considerable body of case law has developed in relation to this issue. The assumption on which the MANDATE project has proceeded is that it is not safe to presume that an electronic cheque is an instrument “to which this section applies”. Equivalent protections must therefore be put in place in the contractual structure under which the MANDATE™ system operates. The paying banker A paying banker is liable if the drawer’s signature is forged or unauthorised. He must re-credit the drawer’s account. He will have a defence if the customer has acted so as to facilitate fraud or forgery or has not warned the bank following a discovery of suspicious circumstances. The banker is protected by statute (section 1 of the Cheques Act 1957) in the case of a forged or fraudulent endorsement. Once again, therefore, equivalent protections must be put in place in the contractual structure under which the MANDATE™ system operates. 5.1.3 Summary of Mandate I conclusions on legal structureThe effective conclusion was that a fully electronic instruments could not, in English law be guaranteed. It would be necessary for there to be legislation amending section 3 of the 1882 Bills of Exchange Act 1882 in order for it to be unequivocally clear that an electronic form of negotiable instrument fell squarely within the ambit of that legislation. Until such legislation is passed it seems likely that the use of electronic negotiable instruments will have to depend upon the establishment of private contractual relationships between the parties handling the electronic negotiable instrument. Any party who agreed to handle an electronic negotiable instrument could be asked to acknowledge that any person who subsequently obtained titled from a trusted third party would be deemed to have acquired full title and the transferor could then estop himself from denying the truth of such good title. Each party to an electronic cheque (either in the constitution of the corporate entity or in their contract with their own bank) that they will treat an electronic instrument precisely as if it were a paper based equivalent and will, therefore, waive any point they could otherwise raise regarding the inadequacy of the passage of title to a subsequent holder of the instrument. This waiver will be an express term of the condition of issue of the mechanism by the user's bank and will, in consequence, be a term of the dealings between drawer, drawee, endorser and payee of the electronic cheque. 5.1.4 The MANDATE contractual structureThere are effectively 3 levels of contract
A further contractual relationship for which provision must be made is that between the participating bankers and the TTP. 6. ConclusionsMany projects looking at PKI issues have developed a key management infrastructure first and then tried to find an application to fit into it, which has not always proved a simple task. This project took a different approach, it took and developed an application which could be implemented and used in a commercial environment and then went on to define the key management infrastructure and techniques needed to support this application. The conclusions that can be drawn from the pilot project are: 6.1 CommercialFrom a commercial perspective Mandate needs to be integrated into current systems on the banking side, but more particularly into the business software applications of those customers using electronic cheques for it to become a serious commercial offering. It is clear that in such a way Mandate as a payment mechanism could offer added value, increased efficiency and more security to the user. Integration with bank systems would also be necessary, particularly the system by which value would be transferred, whether this follows current clearing practices or develops new mechanisms. Whilst the banks are involved in major IT development projects such as Year 2000 and the Euro they are unlikely to begin looking at new payment mechanisms and systems, unless there is a strong demand from the customer for them to do so. However, the technical concept was tried and stood up to the tests of the pilot and showed that it is a technology which could be used in the electronic payment systems of the future. 6.2 TTPThe pilot showed clearly that there was a need for a key management infrastructure to support a Mandate system. The need to have the public encryption key of the person to whom you are sending the cheque may be seen as an obstacle to this becoming a totally open system, but easy access to this key through a generic type of key management system would certainly go some way to countering this problem. How open does the system in fact need to be? In the paper world it is necessary to have a certain amount of information about the person to whom the cheque is being sent – such as his address. How much more difficult is it to access the public key through an electronic directory service? Certainly, if the Mandate system is to offer the ability to recover cheques from a lost or broken hardware token (which is in fact offering an additional functionality over the paper-based system), a key recovery system will have to be implemented and this raises the question of who should keep copies of these keys and how they should be stored. 6.3 Legal conclusionsIn view of the further research reflected above, it appears that negotiability for the electronic cheque is not its primary function or attraction. The above provisions can be incorporated into the contractual structure but need not cause particular concern as to whether any vulnerability they possess under various European legal systems should affect the overall marketability of the project. 1Although it is understood that there may be imminent case law developments: see discussion of Esso v. Milton below 24/02/98 |