The recent cyberspace raid on internet bank Egg – the latest in a series of security scares designed to affect the internet banking industry – highlights the need to create a legislative framework with the aim of instilling potential customers with the confidence to take up online banking. The EU has responded to this challenge with a series of directives, one of which, the Electronic Signatures Directive, has recently been implemented in the UK by the Electronic Communications Act 2000.
The aim of the act is to place the legal recognition of digital signatures on a par with that of paper signatures, and to ensure that the regulatory environment is sufficiently rigorous to make this practicable. One way in which it attempts to achieve this is by providing for the regulation of cryptography support services (cryptography being the technique used to provide digital signatures). By using this technique it is possible to ensure that e-commerce communications can only be received by their intended recipients. This makes it more difficult for legitimate transactions to be intercepted and diverted during transmission for fraudulent purposes or for false instructions to be sent to banks.
Comment: The regulation of cryptography service providers should make customers feel more confident about, for example, disclosing their credit card details or other financial information online, and make banks feel more confident about relying on instructions received online.
The Financial Services and Markets Act 2000
Shortly after Labour came to power, the Chancellor of the Exchequer announced that the Government would reform financial services regulation in the UK. The ultimate intention was that the regulatory and registration functions of nine regulatory bodies would be combined under the auspices of one regulator, the Financial Services Authority. The Financial Services and Markets Act received Royal Assent in June 2000, and is likely to come into force towards the end of 2001. Among many other changes, the act will give the Financial Services Authority the power to authorise and supervise a wide range of participants in the UK's financial markets, including banks, building societies, investment firms and insurance companies. Banks have already seen a change in their regulator: under the Bank of England Act 1998, powers to authorise and supervise banks were transferred from the Bank of England to the Financial Services Authority.
Under the act, banks will be required to apply for permission to carry out any number of "regulated activities", which will be defined in secondary legislation. The activities will include deposit taking, as well as many securities-related activities.
Comment: Banks are likely to notice changes, particularly in the style of regulation, which will probably be more intrusive than hitherto. In particular, the changes will include a requirement to obtain approval before appointing individuals to specific posts within the banks.
Changes proposed to capital adequacy framework
In June 1999, in a development that will undoubtedly have a major impact on the international banking community, the Basel Committee on Banking Supervision published a consultative paper on a new capital adequacy framework to replace the 1988 Capital Accord. The new framework proposes three "pillars": revised minimum capital standards, an enhanced supervisory review process and effective use of market discipline.
The Basel consultation paper was followed in November by a consultation document issued by the European Commission, which reviewed regulatory capital requirements for EU credit institutions and investment firms.
The proposed new capital framework is designed to align regulatory capital requirements more accurately with the underlying risks, and proposes a risk weight greater than 100 per cent (new to the UK) for certain low-quality exposures. There is a desire to recognise the improvements in risk measurement and control that have taken place since the capital accord was put in place. Many commentators have pointed out that the risk matrix proposed in the Basel paper still contains too few risk buckets. The use of external rating agencies has caused a degree of concern, and a number of industry participants have suggested that the use of internal risk modelling, with appropriate validation from banking regulatory supervisors, is the best way forward.
The paper includes a proposal that there should be a specific capital charge for operational risk – although no very clear idea is put forward as to how that capital charge will be calculated.
Comment: The enhanced supervisory review process is essentially designed to allow regulators to require banks to hold capital in excess of minimum requirements. This is nothing new in the UK, where the FSA sets target and trigger ratios for individual authorised institutions, which depend on their overall risk profile and strategy. But, for many e-regulators, setting individual ratios will be new.
Consumer law – unfair terms
The Court of Appeal reversed the first-instance decision in Director General of Fair Trading v First National Bank plc. A standard term of the bank's consumer credit agreement provided that interest would accrue on unpaid repayment instalments after, as well as before, judgment, and that the obligation was independent of, and would not merge with, any judgment. Consumers argued that this was unfair: if the court gave judgment for the bank and ordered payment by instalments, even where the borrower repaid those instalments, contractual interest would continue to accrue.
The first question to arise was whether the interest provision fell within regulation 3(2) of the Unfair Terms in Consumer Contracts Regulations 1994 (which excludes the application of the regulations to the "core" terms of a regulated contract). At first instance and on appeal it was held that the provision was not core.
The second question was whether, since the provision was not core, it was unfair within the meaning of regulation 4. The Court of Appeal, overturning the first-instance decision, held that it was. The provision meant that the bank could obtain judgment and an order for payment by instalments without the court considering whether to make a time order or an order to reduce the contractual rate of interest. The court was of the view that the bank, with its strong bargaining position as against the relatively weak position of the consumer, had not adequately considered the consumer's interests in that respect.
Comment: This is the first case in which the Office of Fair Trading has sought to exercise its powers under the Unfair Terms in Consumer Contracts Regulations 1994 (which have recently been replaced by the Unfair Terms in Consumer Contracts Regulations 1999).
Security over book debts
In re CIL Realisations Ltd, the High Court considered whether a charge over book debts created a fixed or a floating charge. The debenture purported to create a fixed charge over book debts and provided for the payment of proceeds into an account with the lender. The lender, however, told the borrower in a side letter to pay the proceeds into an account with another bank. The debenture also contained a floating charge over all assets not subject to a fixed charge.
The borrower went into receivership and the lender was paid in full out of the proceeds of sale of the borrower's business and assets, including the book debts. It subsequently went into creditors' voluntary liquidation. By section 40 of the Insolvency Act 1986, if the book debts were subject to the floating charge, they had to be paid to the borrower's preferential creditors in priority to all other creditors.
It was held that, as a matter of construction, the debenture and the side letter gave the borrower the freedom to deal with the proceeds of debts paid into the third-party bank account, and thus the charge operated as a floating charge.
Comment: Although this case adds nothing new to existing case law on the treatment of book debts, it confirms the need for careful drafting if a fixed charge over book debts is required. The debenture in this case did not attempt to separate the book debts from the proceeds of realisation, and so the decision in New Bullas Trading was not considered. However, the case indicates clearly that, if the borrower is to have free use of the proceeds of book debts, the debenture should draw a clear distinction between the fixed charge over the book debts and the floating charge over their proceeds.
Duty of receivers
Receivers were appointed to run a pig-farming business. The proprietor of the business sued them, alleging breaches of their duty of good faith and of an alleged duty of care in that they had failed to obtain the usual discount (obtained by him before the receivers' appointment) on supplies of pig feed. In Medforth v Blake the receivers appealed to the Court of Appeal on the basis that their duties were limited to a duty of good faith.
The Court of Appeal held that a receiver owes duties to the mortgagor, and to anyone else with an equity of redemption. Those duties include, but are not limited to, a duty of good faith. Whether or not they owe any additional duty will depend on the facts of the particular case. If the receivers do carry on the business that was previously run by the mortgagor, they should take reasonable steps to do so profitably. In this case, the failure to obtain a discount which had been freely available to them would constitute a breach of the receivers' duty of care.
Comment: Until the decision of this case, it was thought that a receiver's duties to a mortgagor were limited to a duty of good faith. This case establishes for the first time that there may well be additional duties.
Letters of credit
Two cases that were heard last year, Banco Santander v Banque Paribas and Czarnikow-Rianda Sugar Trading Inc v Standard Bank, indicated that the practise of discounting a deferred payment letter of credit may be fraught with risk.
In the Santander case, Paribas, at the request of its customer, issued a letter of credit under which payment was deferred for 180 days. Santander added its confirmation to the letter of credit.
The beneficiary presented confirming documents to Santander and requested Santander to discount the letters of credit and pay the proceeds to the beneficiary's bank, RBS. Seven days after Santander had done so, it emerged that the documents submitted by the beneficiary were in fact false.
The question was: did the discovery of fraud relieve Paribas from liability to reimburse Santander at maturity? The Court of Appeal held that it did because Santander had chosen to discount the credit prior to its maturity, without being authorised to do so by Paribas.
Since the obligation of Paribas to reimburse Santander could only arise on payment of the letter of credit at maturity, and no such payment had been made, it followed that Paribas had no obligation to reimburse. If, on the other hand, Paribas had requested or authorised Santander to discount the letter of credit, then Santander would have been entitled to reimbursement.
Comment: It is clear from these cases that the only safe course for a confirming bank wishing to discount a deferred payment letter of credit is to obtain the express authorisation of the issuing bank.
isda Master Agreement (amount payable on early termination)
Peregrine Fixed Income Ltd v Robinson Department Store Public Co Ltd concerned a swap transaction between the two companies, documented under the 1992 ISDA Master Agreement.
Peregrine performed all of its obligations under the agreement but subsequently took steps to appoint a provisional liquidator. This constituted an event of default, causing the automatic early termination of the agreement. As the non-defaulting party, it fell to Robinson to determine the "settlement amount". This was defined as the US-dollar equivalent of the market quotations for the terminated transaction, or the party's loss for the terminated transaction where a market quotation "can not be determined or would not (in the reasonable belief of the party making the determination) produce a commercially reasonable result".
Peregrine challenged the market quotation measure used by Robinson on the grounds that it did not produce a commercially reasonable result, because it grossly undervalued what Robinson had gained as a result of the termination of the transaction. Robinson countered that, even if the loss measure was used, issues such as Robinson's poor credit rating should be taken into account for the purpose of calculating the value of Robinson's obligation to Peregrine.
The judge upheld Peregrine's challenge. Applying an approach similar to that used in the judicial review of discretionary decisions, he held that the market quotation measure had not produced a commercially reasonable result and that, by applying the market quotation measure, Robinson had not acted reasonably and was in breach of the agreement. Furthermore, he held that there was nothing in the definition of loss to suggest that account should be taken of Robinson's credit standing or ability to perform.
Comment: It is generally accepted that the market quotation and loss measures are intended to achieve broadly similar results. Facts peculiar to this case – Peregrine's performance of its obligations before the default and Robinson's poor credit rating – caused a significant discrepancy between the two. Interestingly, ISDA's 2000 definitions (updating the provisions of the 1998 supplement to the 1991 definitions) use market quotation in certain "cash settlement" methods, but there is an assumption that the party requesting quotations is of the highest credit standing, and the fallback, where fewer than three quotations are obtained, is for the calculation agent to determine the cash settlement amount (and the definitions impose a general duty on the calculation agent to act reasonably and in good faith). Meanwhile, a draft annex to the 1992 Master Agreement proposes a new concept of "replacement value", the calculation of which would take into account such factors as market prices, actual losses, funding costs and current creditworthiness.
In Bank v A Ltd & ors the High Court held that a bank which had taken legal action against a customer suspected of money laundering was liable for legal costs and a possible action for damages by the customer, who was exonerated of any wrongdoing.
The bank took action following the deposit of nearly £1.41m in a company's account by two of the defendants within a short period of time after the account was opened. The bank suspected that the money had been obtained through fraud. It was concerned that if it allowed funds to be withdrawn it might become liable as a constructive trustee for the beneficiaries. On the other hand, it was concerned that, if it raised the issue with the first defendant, that might amount to "tipping off", in contravention of the Criminal Justice Act 1988. It applied to the High Court seeking direction, and the court ordered the firm's accounts to be frozen. However, Justice Laddie found that the court did not have any material on which to justify the freezing order. Permission for the case to be taken to the Court of Appeal was granted.
Comment: The case is a good illustration of the dilemmas that a bank may face in complying with its obligations under anti-money-laundering legislation, while protecting its position under the civil law.
Can a bank convert a materially-altered cheque?
Smith v Lloyds TSB Group concerned a cheque payable to the Inland Revenue that had been stolen. The name of the payee was altered and the cheque was paid into the fraudster's account with Lloyds TSB. The drawers tried but failed to recover the full amount of the cheque from Lloyds as damages for conversion. Mr Justice Blofeld found that, by virtue of section 64 of the Bills of Exchange Act 1882, the alteration rendered the cheque void. All that had been converted was a worthless piece of paper, and the drawers of the cheque were entitled to recover nominal damages only.
The drawers' appeal to the Court of Appeal was heard with another case that raised the same issue, Harvey Jones Ltd v Woolwich plc. The Court of Appeal unanimously ruled in favour of the banks. The effect of section 64 is to render a fraudulently-altered cheque or draft worthless for all purposes, including a conversion claim. The fact that the proceeds of the cheque or draft had been paid to the fraudster's account did not alter this.
Comment: Unless there is a further appeal to the House of Lords, it seems that the Court of Appeal has now finally put to rest the long debate concerning the status of a fraudulently-altered cheque. For the banking community at large, the decision provides helpful clarification, but no reason to rejoice. The Lloyds and Woolwich cases were unusual in that the frauds did not give rise to breach of mandate claims against the paying banks. In most cases they do, and therefore it is still the banks that pay the price for cheque fraud.
With new leglisation and case law, banking is in a constant state of flux. Anthony Bonsor highlights ten of the most significant developments to hit banking in the past eighteen months
Anthony Bonsor is a partner in the banking and finance department of Denton Wilde Sapte.