FLB 305: BANKING LAW What is Banking Law? Law of Banking comprises common law, rules of equity and statements. It may be defined as the law that governs the operations of banks and banking transactions and relationships that arise therefrom. This may be common or customary law that has evolved over time in commercial world with respect to banking. It includes statutes passed by parliament to control the activities of the bank. Because of the importance of Banks to the health of the nation’s economy, operations of banks are a major concern of governments the world over. This is the main reason for the existence of legislations all over the world for the licensing and monitoring of banking operations. Evolution of Banking Institutions There seems to be no unanimity amongst the economists about the origin of the word ‘bank’. According to some economists, the word ‘Bank’ has been derived from the German word ‘BANC’ which means a joint stock firm. While others say that it has been derived from the Italian word ‘BANCO’ which means a heap. As a matter of fact, at the time of establishment of Bank of Venice in 1157, the Germans were influential and hence, perhaps the word ‘Banc’ or ‘Banco’ was used by Italians to denote the accumulation of securities or money with a joint stock firm which later on with the passage of time came to be known as ‘Bank’. There is still another group of people who believe that the word ‘Bank’ has been derived from the Greek word ‘BANQUE’ which means a bench. In the olden days Jews entered 1 into money transactions sitting on benches in a market place. When a banker was not in a position to meet its obligations, the bench on which he was carrying on the money business was broken into pieces and he was taken as bankrupt. However, the first view of the origin of the ‘Bank’ from the words ‘Banc’ or ‘Banco’ seems to be more convincing since it was used in the establishment of the bank of Venice which is supposed to be the most ancient bank. The business of banking is as old as civilization itself. As early as 2000 BC, the Babylonians had developed a system of banks. They used their temples for lending at higher rates of interest against gold and silver which had been left with them for safe custody. Around the same time, the Greek temples were used as depositories for people’s surplus funds and these were the centres of money lending transactions. The priests of the temples acted as agents till they lost public confidence on account of people’s disbelief in religion. The development of banking in the ancient Rome resembled the Greek pattern. After the death of Emperor Justinian in 565 A.D, the mighty Roman Empire failed resulting in severe damage to the banking business. It was only with the revival of the trade and commerce in the Middle Ages that the lessons of finance were learnt afresh from the beginning. However, during this period, banking was mainly confined to money-lending activities which were largely in the hands of the Jews. The Christians were forbidden by their religion to lend money on interest since it was considered to be sinful activity. However, with the passage of time, the hold of the church on the Christians weakened and with the development of process of trade and commerce around the 13th century, the Christians also started money lending business. They thus started giving competition to the Jews who hitherto, monopolized the business. In the initial stages, the banking largely meant money-lending and it was restricted to selected number of families working as sole proprietary firms. The Bank of Venice founded in Italy in 1157 was the first banking institutions, followed by the Bank of Barcelona in Spain which was established in 1401. The Bank of Geneva was founded in 1407, while the Bank of Amsterdem was established in 1609. All these banks accepted the deposits which could be drawn or demand on transferred from the account of one person to another. In England, the development of banking business can mainly be attributed to the London Goldsmiths during the reign of Queen Elizabeth I. They used to receive their customers valuables and funds for safe custody. The business of Goldsmith suffered a rude set back as a result of the ill treatment of Government of Charles II in 1640. The Goldsmiths used to deposit their funds in the exchequers with the sanction and under the care of the Government. However, King Charles II issued a directive in his regime that no payment would be made to the Goldsmiths and as a result, the Goldsmiths were ruined. The ruin of Goldsmiths proved a turning point in the history of English banking. It led to the growth of private banking and later on establishment Bank of England in 1694. Geoffrey Crowther, a noted economist has identified three ancestors of the present day banker; the merchant, the money-lender, and the goldsmith. The merchant because of his high and widespread reputation on credit. They were able to collect money from their customers and issue documents that were accepted as “titles of money”. The money-lender 3 usually conducted business with his own money. Later, they also started accepting money from clients when they found it profitable to borrow at low interest rates and lend it as higher interest rates. The Goldsmiths which functioned mostly in England received gold and silver for safe custody and the receipts issued by them acknowledging the same were initially used for withdrawals of the deposits made with them. These receipts with passage of time became payable to the bearer on demand and enjoyed considerable circulation. In this way, the ‘goldsmith’ note becomes the fore-runner of modern bank note. Later on when the goldsmiths started transferring the deposits made with them on the basis of letter issued by the depositors, it led to the origin of modern cheque currency. Thus, in a way the goldsmiths can rightly be termed as the fore-runners of the modern banking institutions. Though the banking business in its naïve form was in operation since ancient times the banking in its present form is of recent origin. It was only in the 19 th century that the modern joint stock commercial banking system developed in most of the leading countries, including enactment of laws and regulations to govern the Banking business. Evolution of Banking in Kenya Prior to the establishment of colonial rule in Kenya, there were four different items used as currency • Indian rupee and its coins • The Maria Teresa dollar • Cowrie shells • Beads and cloth Currency was introduced by colonialists because of trade along the East African coast with Arabs, Indians and Europeans. With the establishment of colonial government however, the need arose for a more convenient and standardized form of currency because the major objective of colonialism was the exploitation of the resources in the territory for the advancement of the home country. In 1888 the Imperial British East Africa began its plans to administer Kenya and Uganda and it introduced currency for the two territories. They introduced a silver rupee coin and the continuation of the Indian rupee that was already in circulation. The Indian Rupee was most widely used because of the trade along the coast with British India. In 1922 the East African shilling convertible with the British shilling was introduced as the primary unit of exchange which remained the currency for Kenya till independence. The establishment of the currency system for Kenya had a direct bearing on how banking would evolve. British commercial banks started operating in Kenya in the 1890s and until the attainment of independence these banks had principally the following characteristics: • There was a high degree of concentration in the major towns • There was an exclusive concern with the financing of trade • There was an elaborate system of branch banking • There was a virtual lack of interest in or involvement with the African population. 5 Throughout the advanced period and into the first half of the 1960s Kenya’s banking sector was dominated by the British Banks. The first bank was the National Bank of India which was established in 1896. The bank later changed its name to National Grindlays Bank which is now known as Kenya Commercial Bank. It was joined by Standard Bank of South Africa in 1950 which later became the Standard Bank now the Standard Chartered Bank. Thereafter the National Bank of South Africa came into the country and later merged with two other British Banks to form Barclays Bank which later became Barclays Bank of Kenya. Additional new banks started coming to Kenya, for instance; • In 1951 Nedelandsche • In 1953 the Bank of India and the Bank of Baroda • In 1956 Habib Bank –from Pakistan • In 1958 Ottoman Bank – from Turkey • In 1962 commercial Bank of Africa. Most of these banks had little business with the nature population of Kenya and even when they went into deposit banking they would concentrate on the settler immigrant community. Thus up to 1963 the only institution that helped mobilized African savings was the Post Office Savings Bank which accepted African Savings from 1910. Even when the Commercial Banks started dealing with Africans, these dealings were limited to the acceptance of savings. They did not advance any credit to Africans thus the expansion of credit to Africans would become the major aims for intervention by the independence government in this sector. At independence, the monetary and financial system in place served the colonial interest and hence on independence emphasis was on ensuring that there was proper control of the financial and monetary system to facilitate the attainment of economic, social and political objectives. Thus the independence government set out to rectify the situation in the following ways: a) By establishing a Kenyan Central Bank to take over the control of monetary and financial policy b) The introduction of Kenyan currency separate and distinct from the colonial currency and not shared with any other country. c) Entering into the community banking sector by establishing state owned community banks or buying shares in existing banks. 7 Banking Legislation in Kenya. In Kenya, banking business is regulated by the Banking Act, Cap 488. This Act was enacted in 1989 and it repealed and replaced the Banking Act, 1969. Prior to this, banking in Kenya was regulated under the Banking Ordinance. The Banking Ordinance was a colonial piece of legislation, which was inherited by the government at independence. The Act gave the minister of Finance responsibility of licensing banks and non-financial institutions and to the Central Bank of Kenya the responsibility of inspecting all financial institutions. This Act however, had a lot of legislative deficiencies. The Banking (Amendment) Act, 1985 attempted to rectify these deficiencies, licensing was henceforth to be routed through the Central Bank of Kenya with minister’s approval. Bank failures also led to the establishment of the Deposit Protection Fund (DPF) in 1986. Sources of the Law of Banking in Kenya Laws develop within society in response to the historical evolution of a society, the traditions that inform that evolution and the values that society seeks to enforce. This evolutionary process of law depends on a number of factors in society including the interactions between a specified society and other external influences. In Kenya, developments within the legal system cannot be considered exhaustively without having regard to the intervention of colonialism. All legislation in Kenya is traced to 1897 and the enactment of the East Africa Order in Council of that year which applied the English Law to Kenya whenever that was appropriate. In the context of banking, the formal banking system in Kenya was first introduced by the British, however, after independence the area of banking has continued to suffer from the influence of western imperialism and also globalization. Thus the local law of banking is for the most part a reaction and response to influences that are external to Kenya. This means that in order to place Kenya’s banking law in context there must be an appreciation of the evolution of international finance, the globalization of finance services, and the overall impact of multinational corporations in the Kenyan economy. This however is not to say that local concerns and experiences have no bearing on the evolution of Kenya’s banking law. Therefore local banking law may be said to be a synthesis of global or external influences. The major source of law is derived from the practice of banking in the context of Britain because our practice of banking was introduced by the colonial administration. There is therefore little content in Kenyan banking law that can be said to have come from the customary practice of the Kenyan people with respect to banking. Thus apart from statutes of England, relative to banking, the bulk of the common law governing banking in Kenya is composed of the experiences of British and imperial banking industry. The major sources of banking law for purposes of Kenya are Banking and commercial statutes which are in themselves based for the most part on their British counterparts. The following however are specifically banking legislations for Kenya: 9 • Banking Act Cap 488 • Central Bank of Kenya Act Cap 491 • The Bills of Exchange Act • The Exchange Control Act Cap 113 • The Law of Contract Act Cap 23 This however is not an exhaustive list because a lot of legislation may have relevance to banking depending on circumstances of the particular issue of concern. Thus the companies Act, the Capital Markets Authority Act and the Insurance Act can all be considered among other Banking legislation to the extent that they all have a bearing on banking practice. Banks and their Functions The Banking system in Kenya can be broadly classified into three categories: i) ii) iii) The Banking system proper – e.g. the central bank and the commercial banks. Public Non- Bank Financial Institutions. The Private Non-Bank Financial Institutions. 1. The Banking System Proper a) The Central Bank of Kenya The formation of the central Bank of Kenya was a reaction to the failure of efforts to establish a common central Bank in East African region that would take over the functions of the East African currency Board. It was established in March 1966 and began operations on 14th September 1966. The main objectives of CBK were set out in section 4 of the CBK Act, however it has been sustainability amended by the CBK amended Act of 1996. b) The Commercial Banks There are a number of commercial banks, the number registered by the CBK to do banking in Kenya stood at 53 as at the 30th September 1998. The largest bank in the common banking is the Kenya Commercial Bank which was established in 1970 when the government acquired majority interest National and Gridlays Bank of Kenya ltd. Questions have been raised about the viability of some banks licensed to do business in Kenya is “overbanked”. These arise because in general banking business and operate through a network of branches across the country. Some of the urban centres principally Nairobi, Kisumu, and Mombasa and increasing interest is experienced in Eldoret and Nakuru. A number of banks are specialized while some engage exclusively in international banking by funding import and export trade. 2. Public Non Banking Financial Institution These were established by the government in response to the failure of the general commercial banking sector to address adequately the needs of specific sectors of the economy. Some of these sectors while important to government and the people of Kenya were not sufficiently profitable to warrant the involvement of common profit making banks. 11 Thus these were formed to address such sectors as agriculture, housing and industrial development. Because the agricultural sector dominates the Kenyan economy, a large number of the institutions formed by the government targeted the provision of credit for agricultural development. (a) The Agricultural Finance Corporation This was formed in 1963 and it absorbed and took over the operations of the Land Agricultural bank which had operated exclusively for the benefit of the settler farmers. The corporation was established in order to correct the imbalance with respect to natives access to credit for Agricultural Development. The functions of the AFC are set out in section 3 (2) of the Act as follows: “ To assist in the development of agriculture and agricultural industries by making loans to farmers, co-operatives, groups, private companies, public bodies, local authorities and other entities engaging in agricultural industries.” The current AFC Act became operational on 31st March 1969 and repealed the 1963 Act. Section 3(4) of this Act provides that the AFC shall not be subject to the provisions of the companies Act or the Banking Act. (b) The Agricultural Development Corporation Was established in 1965 by section 3 of the ADC Act cap 444. the functions of ADC are set out in section 12 of the Act as follows: (i) To promote the production of Kenya’s essential agricultural inputs, e.g. seeds, livestock, and bees. (ii) To undertake activities for the purpose of developing agricultural production in specific areas or specific fields of production. (iii) To participate in activities in agricultural productions which are related to its functions and which in its view are commercially viable. Section 13 (2) empowers the corporation to provide credit and finance by means of loans for agricultural undertakings in Kenya. In the housing sector the government formed; i. The Housing Finance Company of Kenya ltd (HFCK) which provides loans to the housing sectors. The HFCK has increasingly moved towards privatization and now functions on the basis of market demands. ii. National Housing Corporation was also established by section 3 (1) of the Housing Act Cap 117. The corporation makes loans to any company, society or individuals for purposes of enabling them acquire land on which to construct dwelling houses. In the industrial sector the major institutions created by the government for purposes of creating credit and finance include: i. The Industrial and Commercial Development Corporation (ICDC) Its functions are set out in section 3 (1) of the Act and includes “Facilitating the Industrial and economic development of Kenya by the initiation, assistance or expansion or by aiding in the initiation, assistance or expansion of industrial commercial or other undertakings or enterprises in Kenya or else where”. ICDC provides credit and finance by means of loans for Industrial Commercial or other undertakings and enterprises. 13 ii. - The Post office Savings Bank Is owned and operated by the Postal Corporation of Kenya. Its objectives were to mobilize Savings from small savers and thereby empower such savers to effectively participate in the economy. In addition there are a large number of public institutions that provide credit and finance e.g. KTDA, KPCU, KFA, etc. 3. Private Non Bank Finance Institutions. These institutions are licensed under the Banking Act. Regulatory inclusion by the Central Bank of its powers over Non-Bank Finance institutions under the amended Banking Act of 1989 has led to the conversion of virtually all non banking financial institutions into banks. Prior to 1989, such financial institutions were classified separately from common banks and their reporting obligations to the Central Bank were less onerous. Following the 1986 crisis, such reporting obligations were strengthened and the differentiation removed. At the height of their operations, these institutions provided medium and long term financing in the areas of mortgage lending, hire purchase and merchant banking. They were either owned or associated with the common banks and they tended to specialized either by economic sector or by economic activities. Functions of Commercial Banks The functions of the commercial banks are now wide and diverse. They have assumed great significance in the role of an agent for social transformation because of their vital role in mobilization of resources as well as deployment for meeting the said objectives. The functions can be classified into: i.Primary functions ii.Secondary functions Primary Functions  Accepting of Deposits Deposits are an important source of banks funds. They are classified in to three categories: a) Savings Deposits: these deposits are of small amounts and are accepted by the banks to encourage person of small means to make savings. Deposits can be made at any time but frequent withdrawals are not allowed. The deposits earn interest b) Fixed Deposits: These are deposits made with the bank for fixed period of time and are repayable on the date of maturity. A customer can use a fixed deposit as security for a loan in same bank or another bank. c) Current Deposits: These deposits are repayable on demand. The banks undertake an obligation of paying all cheques drawn against these deposits by the customers till they have adequate funds of the customer. The banks usually do not pay interest in respect of such deposits. Usually, banks issue monthly statements showing the transactions in the accounts. Deposits are repayable on demand without prior notice. The customer may issue cheques to third parties or may withdraw from counter or via ATM.  Lending of Money 15 The major portion of the deposits received by the bank is lent out. Interest earned from lending is the main income of the bank, however, lending money is not without risk, and therefore, a banker must take precautions in this process. The lending may be in the form of: 4. Loans 5. Cash Credit 6. Overdraft 7. Discounting and Purchasing of the bills. Thus commercial banks fender unique service by tapping savings from a wide spectrum of people and lending to those who really need and use them for various productive purposes. Secondary Functions i.Agency service such as:     Collection of drafts, bills, cheques, dividend, etc. on behalf of customers Execution of standing orders of customers Conducting of stock exchange transactions Functioning as an executor, trustee or administrator of an estate of a customer ii.General utility services such as:    Issuing of letters of credit Issuing of travelers cheques Accepting valuables for safe keeping  Acting as referee as to the respectability and financial standing of the for customers    Providing specialized advisory services to customers Issue of credit cards Providing of information through regular bulletins about general trade and economic conditions  Merchant banking e.g. counseling, sponsor of share issue, investment management, etc. Definition of a Bank The first issue to consider is what constitutes a bank. This is relevant because there are certain rights and obligations attach to a bank at common law e.g. a bank enjoys the rights to exercise the bankers lien and a bank is entitled to protection of statute when paying and collecting cheques. Similarly, a bank is impliedly obliged to observe the duty of confidentiality, for instance they are not compellable to produce their books in court, but may sent copies. A bank is simply an institution authorized under the Banking Act. The common law definition of a bank is provided by United Dominion Trust Ltd vs Kirkwood (1966) which held that there are three essential characteristics of a banking business: a) Accept money from, and collect cheques for, their customers and place them to their credit; b) Honour cheques or orders drawn on them by their customers when presented for 17 payment and debit their customers accordingly, and; c) Keep current account in which the credits and debits are entered. It appears therefore, that all three must be satisfied in order for an institution to be considered a bank at common law. Definition of a Customer A term ‘customer’ has not yet been statutorily defined, however, in common parlance; the term a customer means a person who has an account with the bank. A person becomes a customer of a bank when an account is opened is for him and at the same time a contract is formed (Commissioners of Taxation vs English, Scotish and Australian Bank, 1920). The mere deposit of money with a bank, with instructions to transfer it to another bank, does not itself make the person requesting the transfer a customer of the bank. A person with an account will be a customer even though his/her only connection with the bank was payment into an account opened for the purpose of collecting a single cheque, or if a person is given a cheque book. A bank may also be a customer of another bank, as where a clearing bank regularly collects cheque sent to it by a non-clearing bank on behalf of that banks customer, or where a domestic clearing bank collects cheques for a foreign bank. Old banking experts used to lay emphasis on the duration for which a person maintained an account with the bank. For instance, according to John Paget, “to constitute a customer, there must be recognizable course or habit of dealing in the nature of banking business ------- It is difficult to reconcile the idea of single transaction with that of a customer”. Thus according to the view, a person does not become a customer simply by opening an account with a bank. He should be in the habit of dealing with the bank i.e. there should be some measure of continuity in dealing with the bank. This view point, popularly known as ‘duration theory’ has now been rejected. In the case of Commissioner of Taxation Ns. English Scotish and Australian Bank, Lord Dunedin observed, “the word customer signifies a relationship in which duration is not of essence-------. A person whose money has been accepted by the bank on the footing the bank undertakes to honors cheques upto the amount standing to his credit, is a customer of the bank irrespective to whether his connection is of long or short standing”. Thus inorder to constitute a customer, a person should satisfy two conditions: i He should have an account with the bank, whether fixed, savings, or current. ii The dealings should be of banking nature. These dealings have to be distinguished from other dealings which are of casual nature e.g. occasionally getting a cheque encashed or purchasing stamps, or depositing valuables for safe custody. A person remains a customer, even if he/she is indebted to the bank, or if the bank performs other functions other than holding money for him/her, such as safe keeping of goods or documents, selling securities, giving investment advice, advising on company takeover and mergers, selling insurance services, and all other things which, in an era of financial conglomerates, banks will do for their customers. 19 The classical view maintained that a customer is one who has some sort of account and has the habit of engaging continuously over a period of time. The current view, however, provides that duration is not of essence and that relation begins with deposit of first cheque or cash. Banker – Customer Relationship Banking law is not integral and distinctive body of law in itself, but applies a number of general branches of law, such as contract, tort, and trust law, which are given a distinctive character by their operation in the unique context of banking, and some technical branches of law dealing with typically banking aspects, such as law of negotiable instruments and of cheques. Although there are a number of important statutes relating to aspects of banking law, the basic relationship is regulated by the common law of contract. The contract is formed in the usual way, by offer (usually an offer by the customer to open an account) and acceptance. It is also settled that the relationship may be of implied contract, so that the terms of the general contract is not usually written, although nowadays of course the terms of banking contracts relating to specific matter, such as credit cards, availability are. Therefore, the relationship between the banker and the customer is regulated by contract rules, agency laws and banking practice. The General Relationship between a Banker and Customer 1) Debtor – Creditor Relationship The true relationship between a banker and that of its customer is that of a debtor and creditor. The banker when receiving money does not hold money in a fiduciary capacity. Money left with him is at his disposal, subject to the obligation of honoring cheques of the customer up to the amount of any credit in his account, or up to the limit of any overdraft which the banker has agreed to allow. The observations made in Folley Vs. Hill (1848), the learned judge argued that “money when paid in to a bank ceases altogether to be the money of the principal; it is the money of the banker, who is bound to return an equivalent amount by paying a similar sum to the depositor when he is asked for it. The money paid in to the bank is money known by the principal to be places there for the purpose of being under the control of the banker; it is then the banker’s money; he is known to del with it as his own, he makes what profit he can, which profit he retains to himself; paying back only the principal, according to the custom of the bankers in some places, or the principal and a small interest, according to the custom of bankers in other places….. That being established as to be the relative situation of the banker and customer, the banker is not an agent or factor, but a debtor Therefore, it was held that the money paid in by customers is “under the control of the banker; it is then the banker’s money; he is known to deal with it as his own; he makes of it what profit he can, which profit he retains to himself”. Certain important matters flow from this: (i) The bank is free to do what it likes with the money and is not bound to account to its customers for what it does with it. The bank is merely liable to repay the money to the customer when he/she demands it. (ii) Banks may use the money they hold as they see fit – their customers cannot claim the profits from that use. 21 (iii) If the bank fails to repay the money to the customer when he/she demands, the customer ranks only as an unsecured creditor in any claim against an insolvent bank. Implied Terms from Joachimson Vs Swiss Bank Corporation Further implied terms of contract were set out in Joachimson Vs Swiss Bank Corporation (1921) as follows: a) The bank will receive the customers deposits and collect his cheques b) The bank will comply with written orders (i.e. cheques) issued by its customers, assuming there is sufficient credit in the account. c) The bank will repay the entire balance on the customers demand at the account holding branch during banking hours. d) The bank will give reasonable notice before closing a customer’s account, at least if it is in credit. e) The customer will take reasonable care when writing his cheques so as not to mislead the bank or facilitate forgery. Thus the relationship between a banker and its customer is primarily of that of a debtor and a creditor, the respective position being determined by the existing state of account i.e. if the account is overdrawn the banker becomes the creditor. The money deposited with the banker becomes his property and is absolutely at his disposal whether he pays or does not pay interest on it. The customer has no right whatsoever to claim identical coins or notes deposited by him with the banker. The banker can pay in any kind of legal tender money. However, this relationship of debtors and creditor between a banker and its customers differs from similar relationships arising out of ordinary commercial debts in the following aspects: a) Demand for repayment is necessary The general rule that demand for repayment by creditor is unnecessary and applicable in case of ordinary commercial debts, does not apply in case of banks. The customer must make an express demand for repayment to make the debt actually due for payment by the bank. In the case of Joachimson Vs Swiss Bank Corporation (1921), it was held that, it is a banker is not liable to pay the customer the full amount of the balance until the customer demands the payment from the bank. This is because if the banker offers money to the customer without any demand for him, it would amount to summarily closing the customers account without notice. This may damage his customer’s credit on account of possible dishonor of cheques already issued by him. b) Demand should be made at proper Time and Place The demand for repayment should be made during normal working hours of the bank on a working day. Incase a banker makes payment during any other time, it shall not be taken to be a payment in due course and he may be held liable to the customer for loss. Demand can be made at authorized branches if the bank is networked or at a branch in which account is held. c) Demand must be made in proper manner The demand for repayment of money should be made through a cheque or any other 23 written order as per the common usage among the bankers such as withdrawal slip or an ATM. A verbal or telephone demand will not be taken as a proper demand. d) Law of limitation The debt is not subject to limitation period of 6 years from deposit rather from the date of demand. It was held in the Jammu and Kashmir Bank Ltd. vs Chandra Prakash that as far as money of a customer in the hands of a banker payable on demand is concerned, the period of limitation would run from the date of demand for repayment and not from the date of refusal. In the case of deposit accounts subject to notice, the law does not begin to run until the expiry of the stipulated notice of withdrawal given by the customer. In the case of fixed deposit, the law of limitation begins to run from the date at which the depositor is entitled to be paid. It should be remembered that the law does not apply so long as interest is being paid or so long as deposit receipt is renewed. In case a customer has two or more accounts with the same bank, the banker cannot generally combine these accounts unless he obtains prior approval of the customer or has given prior notice to the customer. Similarly, the customer cannot treat two different accounts in the same bank as one. He cannot draw a cheque on one with insufficient balance presuming that the banker will pay it since the balance in the other account is sufficient. 2) Trustee and Beneficiary Trust is a relationship between two persons in which one (trustee) holds property for the benefit of another. The position of the banker as a trustee or debtor depends upon the particular circumstances of each case. This has been viewed in the light of specific instructions given by the customer regarding the purpose or use of the documents or money entrusted to the banker. If specific instructions are given at the time of depositing the money, the banker is taken as a trustee for the money and not as a debtor trustee. For instance, when the money is paid into a bank with special instructions to retain it till further instructions, the banker will be considered as a trustee for the funds and not as a mere debtor. Similarly, when a cheque is deposited with the bank for collection, the banker acts as a trustee for the funds and not as a mere debtor. The banker acts as a trustee of the cheque till it is collected. But once the cheque is collected and proceeds are credited to the customers account, the bank becomes the customer’s debtor. If before the collection of the cheque, the bank goes into liquidation such instrument will not be available for distribution among the creditors of the bank. In New Bank of India Ltd Vs Pyare Lal (1962), the Supreme Court held that in the absence of any other evidence, a person paying into a Bank, whether, he is a constituent of a bank or not may be presumed to have paid the money to be held as a Banker. In other words, when a person dealing with a bank delivers money to the bank, the intention to create relationship of creditor and debtor between him and the bank is presumed, unless this presumption is rebutted. For example, when the money is paid to the bank to pay the same to other person who has no account with the bank and the bank accepts the instructions and holds the money pending instructions from that other person, a trust results and the bank continues to hold the money as a trustee till the 25 instructions for the final disposal of the money are received from such person. 3) Principal and Agent Banker acts as the agent of the customer in those cases where it performs agency functions such as collection of cheques, bills of exchange, purchasing and selling of securities, payments of Insurance premium, etc, on behalf of his customer. 4) Bailor and Bailee The banker acts as a bailee for his customers in those cases where valuables are delivered to the bank for safe keeping. In such cases the customer continues to be the owner of the valuables or securities deposited with the bank and are not available for distribution among the banks creditors in the event of the bank going in to liquidation. Similarly, incase of loss bank is liable for loss. However, incase of a rental of safe deposit box, a bank becomes a mere custodian, and is only liable for negligence leading to loss and not goods being stolen. Obligation of Banker The primary relationship between a banker and his customer is that of a debtor and creditor. This relationship imposes the following special obligation on the banker: 1. Obligation to Honour Cheques A banker must honour customers’ cheque drawn on him provided: (a) The banker has sufficient funds of the customer, (b) The funds are properly applicable to the payment of such cheque, (c) The banker has been duly required to pay. (d) The cheque has been presented within a reasonable time after the apparent date of its issue; (e) No prohibitory order of the court or any other competent authority e.g. tax authority, is standing against the accounts of the customer. (a) Sufficiency of Funds The banker’s obligation to honour the customers’ cheque will arise only when the banker has customer’s funds at least equal to the amount of the cheque. While determining the sufficiency of funds, the customers’ funds which the banker may have in other accounts, the negotiable instruments which have not yet been collected etc are not to be taken into account. The obligation to honour the customer’s cheque may be extended to the extent of the amount of overdraft which the banker may have expressly or impliedly agreed to sanction to the customer. In Mohammed Hussain Vs Chartered Bank, it was held that “if the banks have agreed to give an overdraft, they cannot refuse to honour customer’s cheques, or drafts within the limit of that overdraft” In the absence of an express and implied agreement giving the customer a right to draw cheques against uncleared items, the banker is entitled to return such cheques with the answer “effects not cleared” as was in held in Underwood Vs Barclays Bank Ltd. It should be noted that implied agreement would arise from some established course of business. Thus where the banker in the past had been honouring customer’s cheques to a certain limit in spite of insufficiency of funds 27 and later on asking the customer to make good the deficiency, or on the basis of uncleared effects, the banker should not dishonour the customer’s cheque in a similar case without giving him proper notice, because in such case an implied agreement to grant overdraft will be presumed. (b) Applicability of Funds The funds must be available for the cheque drawn. In case a customer has drawn a cheque against one account, having insufficient funds, the banker cannot debit it to his other account where he has sufficient funds unless the customer asks for it. For instance, a customer having insufficient funds in his current account cannot presume that the cheque drawn by him will be honoured by the bank because he has fixed deposit with the bank. (c) Banker duly required to Pay This means that the cheque is complete in all respects and is presented during banking hours. The cheque should not be post-dated. A banker is also not bound to pay a cheque which does not bear the date of its issue or in the case of joint account; it is not signed by all the joint account holders. e) Presented within a reasonable Time A cheque is meant for immediate payment and, therefore, it should be presented within a reasonable time of its issue. A cheque becomes stale in case it is not presented within six months of its issue. Similarly, the cheque must not be presented before due date in case of post-dated cheques. Consequences for wrongful Dishonour of Cheques • Incase a bank fails to honour a customers cheque, it can be held liable by the customer to pay him the damage. The damages will not only be the pecuniary loss that the customer might have suffered but also to his reputation. • The amount of damages claimed by the customer need not depend on the amount of the cheque. As a matter of fact reverse is true. It means the smaller is the amount of the cheque dishonoured, the greater will be the amount of damages. This is because it is presumed that the dishonour of a cheque of a smaller amount will result in greater loss to the credit of the customer. Stop Payment of Cheques A banker may receive instructions from the drawer of a cheque to stop payment of cheques. The banker should take the following steps when such instructions are received: i.Incase the instructions are received from the drawer himself, the banker should immediately on receipt of the instructions, verify the signatures of the drawer on the letter. If the instructions are in order and the cheque has not been paid, the particulars of the cheque should be entered in “Stopped Cheques Register”. ii.The letter of acknowledgement of receipt of stop payment instructions should be issued to the customer. iii.Proper instructions should be recorded conspicuously in the related account and “Stop Payment” rubber stamp be affixed. iv.When a stopped payment cheque is presented, the word “stop” should be written 29 prominently in red ink across the cheque inorder to prevent the risk of payment through oversight, should the cheque be presented again. v.Instructions received by telephone or from third party must be confirmed in writing by the drawer. 2. Obligation to maintain Secrecy of Accounts It is obligatory for the banker not to disclose the state of the customer’s account with it since such disclosure may adversely affect the customer’s credit and business. The confidential relationship between him and his customer enjoins him to keep secret all matters relating to his customer, discovered in the course of their relationship (Tournier Vs. National Provincial and Union Bank of England, 1935). In the case, a customer of the National Provincial bank drew a cheque in favor ot Tournier who, in turn endorsed it in favour of a third party who had an account with another bank. On return of the cheque to the National Provincial Bank, the manager of the bank wanted to know to whom the cheque was paid. The manager was told the person was a bookmaker. The court held that the disclosure constituted a breach of duty on the part of the National Provincial Bank towards Tournier. This obligation continues even after the customer has closed his account with the banker. However, the duty to maintain secrecy is not absolute but qualified with the following exceptions: Exceptions i) ii) iii) Where the disclosure is a legal necessity, Where the disclosure is permissible on account of banking practices, or Where such disclosure is in public interest. iv) Where there is an express or implied consent of the customer Disclosure as a Legal Necessity In the following circumstances a banker is under statutory obligation to disclose the customer account with him. i) Disclosure under the Income Tax The Income – Tax authorities have been given powers under various sections of the Act to ask the bankers to furnish Information about their clients for assessment purposes. ii) Disclosure under the companies Act, cap 486 Incase the affairs of the company are being investigated, it is the duty of all officers, other employees and agents (including bankers) of the company to present before the inspector all books and papers relating to the affairs of the company. iii) Disclosure under an order of the court The bank will have to disclose information regarding its customer’s account where the court requires it to do so. In order to save the banks from inconvenience in those cases where the bank is not a party to the suit but is required to disclose information about customers account, the bank may produce before the court only certified copy of the entries made in customers account. Such copies shall be treated as sufficient evidence in place of actual presentation of books of account. iv) Disclosure under the Central Bank of Kenya Act Cap 491 According to section 33E (1) (a) every banking company is required to maintain such books, records or other documents and furnish the same to the Central Bank at such time and in such manner as the bank may specify. However, section 33F (1) (c) provides that all information obtained in the course of inspection shall be treated as confidential. 31 Similarly, section 43 (1) provides that every specified bank and specified financial institution shall furnish to the bank, at such time and in such manner as the bank may prescribe, any information and data the bank may reasonably require for the purpose of its functions under this Act. v) Disclosure under the Banking Act According to section 27 (1) the Central Bank may require any institution to furnish to it, at any time and in such a manner as it may direct, such information as the central bank may reasonably require for the proper discharge of its functions under this Act. Disclosure as a Banking Practice Under the following circumstances a banker may disclose the relevant information about his customer as a banking practice: i) Where the customers consent has been obtained The customer may himself direct the banker to disclose the state of his account to his employer or messenger or any person acting as his agent. In such a case the consent is said to be expressed. Where, the customer furnishes the bankers name to the third person for reference or where the customer takes loans from the banker on the basis of a guarantee given, it is implied that the customer has authorized the banker to furnish the necessary information to such third party on his request. ii) Where bankers own interest require Where a banker has to recover money from the customer, the banker can disclose the information regarding the customers account to its lawyers etc. iii) Where credit information is required by other banks The banks exchange credit information about their customers. However, the banker should observe the following precautions while furnishing such information. (a) The information should be based on the record of customers dealing with the banker. (b) The banker should only give a general statement regarding his customer’s financial position without going into figures. (c) The information should be given honestly. Till recently, it was believed that as far as banker’s liability to a third party is concerned, he could not be held liable for any false information given negligently since there was no contractual relationship between the banker and non-customer. But the decision in Hedley Byrne and Co Ltd. Vs Heller and Partners Ltd. indicates that action may be taken for professional negligence if third parties suffer financial loss due to their reliance on the professional skill and judgment of the persons with whom they do not have contractual or fiduciary relationship. According to the facts of the case, before entering in to a transaction with A, the plaintiff sought a reference to A’s standing from A’s bankers. The bankers provided the reference, stating therein that they accepted no responsibility for its accuracy. The reference proved to be misleading and as a result, the plaintiff suffered loss and the bankers were then sued for negligence. The House of Lords held: a) That the bankers could be held liable for negligence contained in a reference but b) That the disclaimer of liability in the reference exonerated them from liability on the particular facts of the case. In the absence of an express authority from the customer concerned, the banker should decline to give any information in response to inquiries from an outsider who is not a banker. 33 Disclosure in the Public Interest The bank should be required to give information regarding the financial position of their customers in the public interest in the following cases: a) When a bank is asked for information by a government official concerning the commission of a crime and the bank has reasonable cause to believe, that a crime has been committed and the information in the bank’s possession may lead to the apprehension of the culprit. b) When bank considers that the customer is involved in activities prejudicial to the interests of the country. c) Where banks books reveal that the customer is contravening the provisions of the law. d) Where sizeable funds are received from foreign countries by a constituent. Consequences of wrongful Disclosures i) Liability towards third parties: The bank will be liable towards third parties for any loss that they may have suffered on account of wrong information supplied to them, such information will arise only when: (a) The banker intentionally furnishes wrong information and, (b) The third party relies on such information, and suffers loss. It is to be noted that mere negligence on the part of the banker will not make the banker responsible towards third parties for the loss they might have suffered since there is not contractual relationship between them and the banker furnishing the credit information. Example: A banker of a company, in response to an inquiry from an advertising company about the company gave its opinion as follows: “the company was a respectably constituted company, considered good for its ordinary business engagements. The banker also added that the opinion was given without responsibility on its part or on the part of its officials. Subsequently, the company went into liquidation. The advertising firm sued the company’s banker for a loss of £ 17,000 on the ground that there was a breach of duty of the banker’s part in giving them information negligently. It was held by the House of Lords that the banker owed no duty to the advertising firm. In general, an innocent and negligent representation gave by itself no cause of action and that there must be something more than mere mis-statement in order to fasten the liability on the person making it. The banker, to whom reference was made, was not expected to make a detailed inquiry and produce a well balanced report. All that was expected was that he should answer honestly the question put to him from what he knew from the books and accounts before him (Hedley Bryne and Co. Vs Heller and Partners Ltd, 1964). ii) Liability towards the Customers: Banker is liable to compensate the customer for any material loss that he might have suffered on account of any wrongful disclosure or expression of extremely unfavourable opinion about him. 3. Obligation to obey Instructions The accounts must be operated as per customers’ instructions. The customers must also obey the Bankers’ rules such as maximum withdrawal per transaction and the authorized signatories or agents attesting the signatures. 35 Garneshee Order Garneshee order is an order that attaches a customer’s money in payment of a debt, for instance, in case a debtor, the latter may apply to court to issue a garnishee order on the debtors’ banker. As a result of this order the debtors’ account with the bank is frozen and the bank cannot make any payment out of the account. When a garnishee order is issued to a banker, he should stop operations on the accounts of the customer. It must remain dormant until the order is discharged. The creditor, on whose request such an order is issued is called the judgment creditor; the debtor, whose account is frozen, is called the judgment debtor and the banker who has the customers account is called the garneshee. Garneshee order is issued in two steps: i) Garneshee Nisi/Order Nisi By this order, the court: (a) Asks the banker to freeze the debtors account, (b) Asks the banker to explain why the funds in the account, so freezed should not be used for payment of judgment creditor. On receipt of such an order the bank should immediately inform the customer so that he may make the necessary arrangement for payments of debts due by him. On the banker failing to show sufficient cause, the order is made absolute. ii) Garneshee Absolute/Order Absolute This order directs the banker to pay either the whole or a part of the funds lying in the account against which ‘Order Nisi’ has been issued to the judgment creditor. The following points are worth noting regarding the garneshee order: (a) Garneshee order may provide for the attachment of the whole or a part of the funds of the judgment debtors account with the bank. The bank should not make payment out of the account so freezed in contravention of the courts order, otherwise it will be in liable for defying the order of the court. Incase only a part of the sum standing to the credit of the judgment debtors account has been attached on account of Garnishee order, the banker may transfer that much of amount to a suspense account and customers account may permitted to be operated with the balance. Incase certain cheques drawn by the judgment debtor were certified as “good for payment” by the banker before the receipt of the garnishee order by the bank, they can be paid inspite of subsequent garnishee order. (b) Incase a banker has a definite claim against the debtor, it can claim the set off of such claim against the customers balance with it inspite of garnishee order. A banker is entitled to all debts due to him on the date of the order from the customer’s credit balance. (c) Garnishee order attaches only that balance which is lying is the customers account at the time when the order is served on the banker. It therefore does not apply to: i. Cheques deposited with the banker for collection but not yet collected. In Fern Vs Bishop & Co. a garnishee order was served on the debtor’s bank 37 for an amount of ₤806. The debtor’s credit balance was ₤4,998, including ₤4,700 representing the cheque paid in for collection but not collected. The bank having deducted the bank charges due to it, opened a new account for the ₤4,700 and left ₤218 to meet the judgment debt. The amount of the cheque was not available at the time of serving the garnishee order and so did not constitute a debt owed by the bank. Underwood Vs Barclays Bank made similar verdict and observed that for uncleared cheques to be a debt there should be a contract express or implied indicating that the customer may draw cheques against uncleared effects. ii. iii. iv. v. vi. vii. Sale proceeds of securities etc of the customer not yet collected. Deposits made subsequent to the serving of the Garnishee order Payments made by the banker before serving of the Garnishee order. Securities lying in safe custody with bank. Money held abroad by the judgment debtor. A joint account is not attached by a garnishee order, provided the order is issued against only one account holders. In Macdonald Vs Tacquash Gold Mines Co., it was held that a debt, legal or equitable, owing by a garnishee order to a judgment debtor, should not be a debt due to him jointly with other persons. viii. A partnership firm’s account is not attached by a garnishee order issued against only one of the partners. ix. In the case of an overdrawn account of a customer, the garnishee order will not attach funds even though the customer has not reached the agreed limit of overdraft when the order is served. Different Types of Accounts and Garnishee Order a) Joint Account A joint account is one which is opened in the names of two or more persons. Such an account can be attached only when all the joint accounts holders are joint judgment debtors. However, incase of a joint debt, the individual accounts of the judgment debtors can be attached since their liability for a joint debt is joint as well as several. b) Partnership Accounts The personal account of a partner can be attached for payment of a firm’s debt. But the firms account cannot be attached for the payment of a personal loan of a partner. c) Trust Accounts Money lying in a trust account though in the trustee’s name cannot be attached for payment of personal liabilities of the trustees. The bank should inform the court that the funds lying in the account are trust funds. Rights of the Banker 1. Right of General Lien Banker has the right of general lien in respect of the amount due to him by the customer. Lien is a right of a person to retain that which is in his possession and which belongs to another, until the demands of the person in possession are satisfied. Lien gives a person only a right to retain the possession of the goods and not the power to sell unless such a 39 right is expressly conferred by the statute or by custom or by usage. There are two kind of lien: (a) Particular lien: This is a right to retain possession over particular goods in connection with which the debt arose. It is restricted to those goods which are the subject matter of the contract and are liable for certain demands of the person in possession of those goods. (b) General lien: Entitles a person to retain possession of goods belonging to another for a general balance of account. It will entitle a person in possession of the goods to retain them until all claims of accounts of the person in possession against the owner are satisfied. The banker’s general lien entitles the banker to retain in his possession securities etc, in respect of the general balance due by the owner of the banker. The right extends to all securities placed in his hands as a banker by his customer which are not specifically appropriated. The bankers lien is a general lien. It has been held in Brandao Vs Barnett that the banker has an implied right to exercise the right of general lien over securities in his possession for the debt due by his customer unless the right has been expressly excluded. The right is available provided the following conditions are satisfied: (i) The property has come into the possession of the banker in his capacity as banker. (ii) The property has not been entrusted for a specific purpose which is inconsistent with the lien. (iii) (iv) The banker should have lawfully obtained the possession of the property. There is no agreement contrary to the lien. Cases where the Banker cannot Exercise his Right of Lien i) Safe custody deposits – The banks generally receive for safe custody customers valuables e.g. Jewellery, documents, etc. these properties are received by the banker not as a banker but as a bailee and that also for a specific purpose. They are not, therefore, subject to banker’s general lien unless contrary is implied. ii) iii) Bills of exchange or other documents entrusted for special purpose. Money deposited for a special purpose – in case a customer has deposited money for a specific purpose with the banker e.g. purchase of securities and the banker has express or implied notice of such deposit, such money will not be subjected to the bankers right of general lien. iv) Documents or valuables left in the banks hands inadvertently- The banker does not have the right to have the right of lien in respect of documents or valuables left inadvertently by the customer with him. Similarly, a banker cannot enforce his right of lien in respect of property which has not been given to it by way of security for a loan which has not yet been granted. However, a banker has a right of lien on securities left with him even after the loan for which the securities were given as collaterals is repaid. By leaving securities with the banker, the customer is supposed to have redeposited them with the banker, as was held by the House of Lords in the case of London and Globe Finance Corporation. v) Amounts not Due- the right of lien is available only in respect of debts which have become due unless the customer has become insolvent. vi) Trust accounts – Incase a customer in operating a trust account to the knowledge of bankers no right of lien will be available to the banker against this account for 41 any amount which the customer otherwise owes him. vii) viii) Where the security is pending grant of a loan No lien arises in case the credit and liability do not exist in the same right. Thus the banker cannot exercise his right of lien over securities of a partner in respect of a debt due from partnership firm. ix) No lien arises over securities for which the customer has no title. 2. Right of Set Off As far as the banker’s right of set-off is concerned, there is a conflict of judicial opinions. In Garnett Vs Mckervan, it was held that in the absence of a special agreement to the contrary, a banker might set-off a customers credit balance against a debt due to him from the customer, and that there was no legal obligation on a bank to give notice to a customer about its intention to combine accounts. But in Greenhalgh and Sons Vs Union Bank of Manchester, the Judge observed: “If the banker agrees with his customer to open two accounts or more; he has not in my opinion, without the assent of the other customer, any right to move either assets or liabilities from one account to the other; the very basis of the agreement with his customer is that the two accounts shall be kept separate” Again in Jinda Ram Vs Central Bank of India Ltd., it was held that where there are two separate partnership firms and these firms have two distinct separate accounts, the bank is entitled to appropriate monies belonging to one of the firms for the payment of the overdraft of another firm. The court observed that although two separate firms were involved, they were not separate legal entities. In view of these conflicting judicial opinions, the banker can exercise this power of setoff subject to the following conditions: i) There must be a contract or agreement authorizing the banker to combine the accounts at any time without notice. The agreement may be express or implied. ii) The customer has been given a formal notice regarding the banker’s intention to exercise the right of set off. iii) The capacity of the account holder in all the accounts must be the same, for instance, a banker cannot set off any credit balance of a partnership accounts against money due from one or more of its partners on their individual accounts. However, incase of a sole trader the accounts in his personal name and that of the firms name are deemed to be in the same capacity. iv) The right can be exercised in respect of debts which have become due and not in respect of future or contingent debts. v) vi) The amount due must be certain. The banker has the option to exercise the right. The customer cannot compel him do so. For the purposes of this right, the different branches of the bank will constitute one entity and the balance standing in the customers account in one branch can be set off against the balance standing in the customers account in the other branch. Case An advocate has three separate current accounts in your bank. (i) Personal account, (ii) Office account, and (iii) Clients account. In expectation of good balance in clients account, your bank had allowed him a clean advance of sh. 250,000 in his personal account. For some reasons, the bank grew unhappy with this arrangement and, therefore, recalled the advance, when the advocate failed to respond to the banks notice to repay, it decided to take recourse against the other accounts for recovery of the outstanding of Ksh.150,000 in his 43 personal account. The bank found that there was a credit balance of Ksh.150,000 in the clients accounts and also a credit balance of Ksh. 20,000 in the office account. The advocate had also safe deposit locker in your bank in the joint names of himself and his wife with operations by “either of survivor”. He also had a fixed deposit of Sh. 50,000 maturity after 4 months. He had also left some shares with the bank, of the approximate value of sh.30,000 with instructions to sell them at or above a fixed price. The shares were still lying unsold. Decision The bank can deal with the balances and securities in the following manner. (i) The office account seems to be in reality the personal account of the advocate. The credit balance of sh.20,000 in his account can, therefore, be set off against the debit balance in his personal account. (ii) The client’s account, as name itself clearly indicates is a trust account. The client has been opened by the advocate to deposit money received by him on behalf of his clients. The personal accounts are not in the same right. The right of set off will not, therefore, be available to the banker against the amount standing to the credit of the clients account. (iii) The Fixed Deposit Receipt of Ksh.50,000 is in the name of the advocate in his personal capacity. It is going to mature after 4 months. The banker cannot, therefore, exercise its right of lien till it matures and thereafter its right of set off. (iv) The relationship between the banker and the advocate in respect of the shares held by it which were left by the advocate with specific instructions to sell, is that of the principal and an agent. The banker cannot, exercise its rights of lien on such shares. (v) Incase of safe deposit locker, the relationship between banker and the customer is that of bailee and bailer. The right of lien on the valuable deposited in the locker is, therefore, not available to the banker. 3. Bankers Right of Appropriation (Clayton’s case) When a customer owes several distinct debts to a banker and makes a payment which is insufficient to discharge his entire indebtedness, there is a problem of appropriating payment. In such a case when money is paid, it is to be applied according to the expressed will of the customer, not the banker. If the party to whom the money is offered does not agree to apply it according to the expressed will of the party offering it, he must refuse it and stand upon the rights which the law gives him. In case there is a current account, and neither the banker nor the customer makes any specific appropriation, then any successive payments will be appropriated in accordance with the rule in Clayton’s case. The following provisions guide the appropriation of payments: (a) Appropriation by the Debtor Where money is paid by a debtor to his creditor with the express or implied intimation that money is to be applied to a particular debts, creditor, of accepts the payment, must apply the money received according to the direction of the debtor. If the debtor owes other debts which are also due and payable and the debtor insists upon applying the money to the debt of his choice, the creditor’s remedy is to refuse to accept the money if he is not prepared to agree with the wishes of the debtor. Appropriation is a right primarily of the debtor and for 45 his benefit. (b) Appropriations by the Creditor If the debtor fails to intimate to the creditor at the time of payment as to the debt towards the payment of which the money is to be applied and where several debts are due, the right of application may be exercised by the creditor, who may applying it to the payment of any lawful debt at his choice including even the time- barred debts. creditors will exercise such a right of appropriation only after the debtor had the opportunity to exercise his right but has omitted to do so. The creditor needs to declare his intentions in express terms. (c) Where neither Party Appropriates Where neither party makes any appropriation, the payment shall be applied in discharge of debts in order of time, whether they are or not barred by the law in force for the time being. If debts are of equal standing payment shall be applied in discharge of each debt proportionately. (d) Payment of Interest In case of a debt carrying interest and the debtor has given specific direction as to the appropriation of money paid, the rule is, to apply money in ordinary cases, first towards payment of interest and then apply the surplus in payment to the principal amount. (e) Right to close the Account The banks may close the account that:  Has no funds    Has dropped below the required minimum Is dormant Has bad debts and is no longer viable to keep running If the bank is of the opinion to close the account, then the banker must notify the customer of the closure. (f) Right to charge interest and commission The banker has a right to charge interest on loans and advances. Such charges must be clearly stipulated in the loan agreement. The banker may also levy charges on credit and debit accounts. (g) Right not to produce Books of Accounts Bankers cannot be compelled to produce books of accounts in any legal proceedings in which it is not a party, however, it may produce certified copies which are normally permissible as evidence. Termination of Relationships between a Banker and a Customer i) Mutual agreement - The customer collects his credit or pays off any debits. ii)  Notice to terminate Customer need not give notice on current accounts – merely withdrawing all his money and requiring them to close down.  For deposits account, must adhere to notice period on contract. 47  Banks must give reasonable notice of any intended closure of account. iii) Death of a customer  Account is normally closed on death, and debts called in or funds held trust for beneficiaries.  Bank must be notified of the death. iv) Insanity  If notified of insanity, the bank must terminate the relationship, otherwise may be held liable for any wrongful honour or dishohour. v) Bankruptcy   By law bankrupts cannot operates accounts. Any credit balance should be forwarded to the receiver, liquidator, or executor. Practice Questions 1. Is the banker entitled to exercise his right of general lien or set off in the following cases; (a) Mr. A deposits a box containing ornaments for safe custody, but later on becomes indebted to the bank. (b) A banker discounts a documentary bill for his customer, X on the dishonour of the bill, X offers payment of the amount of the bill together with interest charges but the banker claims lien on the documents attached to the bill for other debts due form X. (c) When Mr. X, who is indebted to the bank, has a current account jointly with Mr. Y. (d) XY, a partnership firm, of stock brokers, are indebted to the bank and Mr. X, a partner of the firm, carries a large credit balance in his account. Suggested Solution a) The banker cannot exercise his right of the general lien on the box since the box containing the ornaments has been deposited for safe custody and therefore, the banker’s position is that of a trustee. b) The documents have come to the banker in the ordinary course of business and, therefore, the banker can exercise his right of general lien. c) The banker cannot exercise right of set off since the current account is not in the exclusive name of Mr. X. d) The banker cannot set off the debit balance in the account of the partnership firm against the credit balance in the personal account of Mr. X since two accounts are not in the same name and the same right. Negotiable Instruments The law relating to negotiable instruments is contained in The Bills of Exchange Act (Cap 27) and The Cheque Act (Cap 35). These Acts deal with three kinds of negotiable instruments i.e. Bills of Exchange, cheques and promissory Notes. 49 Meaning of Negotiable Instruments The term negotiable instrument literally means a written document which creates a right in favour of some person and which is freely transferable. The word negotiable means ‘transferable by delivery’ and the word instrument means a written document by which a right is created in favour of some other person. Thus a negotiable instrument is a written document transferable by delivery. According to Thomas, a negotiable instrument is one which is, by a legally recognized custom of trade or by law, transferable by delivery or by endorsement and delivery in such circumstances that; a) the holder of it for the time being may sue on it in his own name b) the property in it passes, free from equities, to a bonafide transferee for value, notwithstanding any defect in the title of the transferor” Essential characteristics of Negotiable Instruments: 1. Negotiability The property in a negotiable instrument is freely transferable from one person to another without any formality. The right of ownership in these instruments passes either by endorsement and delivery in case of order instruments or by delivery incase it is payable to bearer, and no further evidence of transfer is required. 2. Title A bonafide transferee of a negotiable instrument for value (also called holler in due course) gets the instrument free from all defects, meaning that the holder in due course is not in any way affected by the defective title of the transferor or any party. A holder in due course means a holder who has accepted a negotiable instrument for value, in good faith and before maturity. Hence a bonafide transferee gets a better title than the transferor which contravenes the general rule of law of transfer which provides that ‘nobody can transfer a better title than that of his own! 3. Recovery A bill, note or a cheque represents a debt i.e. an ‘actionable claim’ and implies that the holder in due course is entitled to sue on the instrument in his own name for the recovery of the amount in case of dishonor without giving notice to the debtor on the fact that he has become a holder. 4. Presumptions Certain presumptions apply to all negotiable instruments. These assumptions may be that every negotiable instrument: (i) (ii) (iii) Was made, drawn or accepted for consideration; Was made or drawn on the date appearing on the instrument; Was accepted within reasonable time after being made and before maturity (iv) Was endorsed in the same order in which they appear, etc. The Bill of Exchange Act (Cap 27) recognizes negotiable instruments as consisting the following; i) ii) iii) Bill of exchange Cheques Promissory notes 51 Bills of Exchange Section 3(1) of the Bills of Exchange Act defines the bill of exchange as “an instrument in writing containing an unconditional order, 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 certain sum of money to or to the order of a specified or to bearer.” Characteristics of a bill of exchange i) ii) iii) iv) v) vi) It must be in writing It must be signed by the drawer The drawer, drawee and payee must be certain The sum payable must be certain It should be properly stamped It must contain an express order to pay money and money alone. A mere request to pay on account will not amount to an order. vii) The order to pay must be unconditional. This means that there must be no condition attached to the payment. A bill expressed to be payable out of a particular fund will be conditional and invalid because it may not be certain whether the fund will be in existence or prove to be sufficient where the bill becomes payable. viii) If it is not payable on demand then the time of payment must be fixed or determined. Specimen of a bill payable on demand Specimen of a bill payable on expiry of a specified period. The three parties in the bill are as follows: ‘2’- is the drawer David –Payee ‘Julius’- The drawee Advantages of Bills of Exchange 1. A bill of exchange is a double secured instrument. If the bill is dishonoured by the accepter, the holder or the payee may look to the drawer for payment. 2. Incase of immediate need of money, a bill can be discounted with a bank by the payee. 53 3. Two separate trade debts can be discharged by a bill of exchange. Hence, where A buys goods on credit from B for sh. 5,000 to be paid there after date and B buys goods on credit from C on similar terms for similar amounts, an order by B to A pay the sum of sh.5,000 to C will discharge two separate trade debts. CHEQUES A cheque is defined as “a bill of exchange drawn on banker payable on demand” (section 73(1)). It is a bill of exchange drawn on a specified banker and not expressed to be payable otherwise than on demand. A cheque is a bill of exchange containing two additional qualification. a) It is always drawn on a specified banker b) It is always payable on demand Thus all cheques are bills of exchange but all bills of exchange are not cheques. Difference between a Cheque and Bills of Exchange 1. A bill of exchange is usually drawn on some person or a firm while a cheque is always drawn on a bank. 2. A cheque is always payable on demand while a bill of exchange may be payable on demand or on expiry of a fixed period. 3. In the case of a bill, three days of grace is allowed, while no grace is given in the case of cheques. 4. The notice of dishonour of a bill is necessary but no notice is necessary in the case of a cheque. 5. A bill of exchange must be properly stamped, whereas a cheque does not require any stamp. 6. Unlike a cheque, a bill of exchange cannot be crossed. 7. Unlike bills of exchange, cheques are usually not intended for circulation but for immediate payment. 8. The rules relating to acceptable do not apply to cheques. It is essential that a bill of exchange must be accepted before its payment can be claimed. A cheque does not require any such acceptance. Promissory Notes Section 84(1) defines a promissory note as “an unconditional promise in writing made by one person to another signed by the maker, engaging to pay, on demand or at a fixed or determine future time, a sum certain in money, to, or to the order of, a specified person or to bearer”. It is an instrument in writing containing an unconditional undertaking, signed by the maker, to pay a certain sum of money only to or to the order of, certain person, or to the bearer of the instrument. The essential characteristics of a promissory note include: i) It is an instrument in writing –meaning that verbal promise to pay is not a promissory note. ii) It is a promise to pay –there must be an express undertaking to pay. A mere 55 acknowledgement of the debt will not suffice, for instance “I promise to pay B or order sh.5,000”. However the following will not amount to a promissory note; “Mr. B, I am liable to pay you sh. 1,000” or Mr. B, I.O. U, Sh, 5,000. iii) In a case of Balmukand Vs Mannalal Ramjilal and others (1978) It was held that before a document can be treated as a promissory note, it should be promissory note both in form and intent. If indebtedness is acknowledged in a document in a defined sum of money payable on demand that is enough to make a document a promissory note and the document need not necessarily say that the debtor promises to repay the amount. The absence of the ‘I promise to pay’ makes no difference in the nature of the instrument provided it fulfils other conditions of a promissory note. iv) The undertaking to pay is unconditional. The payment should not depend upon contingencies which may or may not happen, because uncertainty badly affects the business and commerce. promissory note: • • • v) vi) vii) “I promise to pay B sh.1000 after marriage with C”. “I promise to pay as soon as possible a sum of sh.1,000.” “When able I promise to pay B or order a sum of sh.1000, value received”. Thus the following cannot be termed as a It should be signed by the maker The maker must be certain The payee must be certain. The instrument must point out clearly the person to whom the promise has been made. viii) The amount should be certain. The following instruments cannot be termed as promissory notes: • • ‘I promise to pay B sh. 5,000 and all other sums which become due” ‘I promise to pay B sh.5,000 first deducting there from any amount which he owes to me”. Specimen of a promissory note Parties to a Negotiable Instrument Parties to a bill of exchange • • • Drawer – The maker of the Bill Drawee – The person directed to pay the money by the drawer. Payee- The person named in the instrument to whom or to whose order the money is directed to be paid by the instrument. He is the real beneficiary under the instrument. • Indorser – when the holder transfers or indorses the instrument to any one else, the holder becomes the endorser. • Endorsee-The person to whom the bill is indorsed 57 • Holder- A person who is legally entitled to the possession of the negotiable instrument in his own name and to receive the amount thereof. Parties to a Promissory Note • Maker – Is the person who promises to pay the amount stated in the note, he is the debtor. • Payee – Is the person to whom the amount of the note is payable i.e. the creditor. • Holder- He is either the payee or the person to whom the note may have been indorsed. Parties to a Cheque • • • Drawer – Is the person who draws the cheque Drawee – is the drawer’s banker on whom the cheque has been drawn. Payee –Is the person who is entitled to receive the payment of the cheque. Holder The Bills of Exchange Act defines a holder as “the payee or endorsee of a bill or note who is in possession of it or the bearer thereof” A holder means a person: (a) Who is entitled in his own name to the possession of the instrument, and (b) Who has also the right to receive or recover the amount due thereon from the parties thereto. The Act draws a distinction between two types of holder; i) ii) Holder for value Holder in Due course Holder for Value A holder for value is a payee or endorsee in possession of a bill, or a bearer of a bill, who has furnished valuable consideration for it. Holder in Due Course A holder in due course is defined as a holder who has taken a bill, complete and regular on the face of it, under the following conditions (Sect 29); o That he became the holder of it before it was overdue and without notice that it had been previously dishonored, if such was the fact; o That he took the bill in good faith and for value, and that at the time the bill was negotiated to him he had no motive of any defect in the title of the person who negotiated it. Hence a holder in due course is any person who: i) ii) For valuable consideration Becomes the possessor of a negotiable instrument payable to bearer or the endorsee or payee thereof, iii) Must become holder of a negotiable instrument in good faith. Good faith means 59 that he should not have accepted the instrument after knowing about defects in the title to the instrument. Under conditions of sufficient indications showing the existence of a defect in the title of the transferor, the holder will not become a holder in due course even though he might have taken the instrument without any suspicion or knowledge of such defects. iv) Holder in due course must take the negotiable instrument complete and regular on the face of it. Presentment of a Negotiable Instrument Presentment means placing before the drawee a negotiable instrument for any of the following purposes: i. For acceptance ii.For sight iii.For payment Presentment for Acceptance   It is only a Bill that can be presented for acceptance. Acceptance may be general or qualified acceptance. General acceptance means unqualified acceptance , for instance, “accepted payable at Equity Bank” or a bill drawn payable three months after date is accepted as follows “Accepted, payable four months after date”. Qualified acceptance means an acceptance in which the drawee accepts the bill subject to certain conditions, for instance, “accepted, payable when my ship docks at Mombasa safely”.   A person entitle to demand acceptance can present the bill for acceptance. The bill should be presented for acceptance to the person who can accept the bill, for instance, to the drawee, to the legal representative incase the drawee is dead, to the official receiver incase the drawee has become insolvent, and to an acceptor for honour. Presentment for Payment  A Promissory Note, a Bill of Exchange, and a Cheque must be presented for payment to the maker, acceptor, or drawee.  Incase of death or insolvency of the maker, acceptor, or drawee, presentment should be made to his legal representative.  A note or a bill drawn or accepted payable at a specified place must be presented for payment in that specified place.  The presentment for payment should be made during the usual business hours and incase of a bank, during the usual banking hours.  All instruments which are payable otherwise than on demand must be presented for payment on maturity.  A cheque should be presented for payment within a reasonable time of its issue. Negotiation Negotiation means transfer of an instrument from one person to another person so as to constitute that person the holder of the instrument. It involves the transfer of right, title, and interest of a person in a negotiable instrument to another so as to give a good title to the 61 transferee and make him the holder thereof. Modes of Negotiation Negotiation may be effected by transferring a negotiable instrument with or without endorsement to another person. Instruments payable to bearer can be transferred by mere delivery, while instruments payable to the order of a person are transferable by delivery and endorsement.  Delivery: Is the voluntary transfer of the possession of the instrument. It should be given voluntarily and with the intention of transferring ownership of the instrument to the person to whom it is delivered.  Endorsement: Means writing of a persons name on the back of the instrument for the purposes of negotiation. When the maker or holder of a negotiable instrument signs his name, otherwise than such maker, for purposes of negotiation, on the back or the face thereof or on a slip of paper annexed thereto he is said to have endorsed the instrument. Kinds of Endorsement Endorsement may be of any of the following kinds: i.General or blank endorsement ii.Special or Full endorsement iii.Partial endorsement iv.Restrictive endorsement v.Conditional endorsement: (a) ‘Sans recourse’ (b) Facultative endorsement (c) ‘Sans frais’ (d) Liability dependent upon a contingency o General or Blank Endorsement: In the case of an endorsement in blank, the person making it signs on the back of the negotiable instrument his name only. He does not make any mention of the name of the endorsee. Such an endorsement makes an order on the instrument to be payable to the bearer and the property in it can be transferred by mere delivery. o Full or Special Endorsement: It is an endorsement in which the person signing adds direction to pay the amount to or to the order of a specified person, for instance, a bill is payable to the order of Nyagol. Nyagol signs on the back of the bill thus: ‘Nyagol’. This is an endorsement in blank. However, if in the above case Nyagol signs after putting these words ‘Pay to Korir’, it becomes an endorsement in full. o Partial Endorsement: A partial endorsement is invalid because a negotiable instrument cannot be endorsed for a part of its value. However, where an instrument has been paid in part the fact of the part payment may be endorsed on the instrument and it may then be negotiated for the residue e.g. ‘Pay A or order being the unpaid of the residue of the bill’. For instance, A is the holder of a bill for sh. 1,000. He writes on it ‘Pay B shs. 500. The endorsement is invalid. A, the maker of a bill for sh. 1,000, pays sh.500 to the holder and the fact is noted on the 63 instrument. The bill can be negotiated for sh.500. o Restrictive Endorsement: This endorsement prohibits the endorsee from further negotiation of the instrument. For instance, ‘Pay C only’ o Conditional Endorsement: Conditional endorsement limits or negatives the liability of the endorser. It differs from restrictive endorsement which restricts the negotiability of the instrument but does not in any way limit or negative the liability of the endorser. A conditional endorsement may be in any of the following forms: • Sans recourse: In this case the endorser expressly excludes his own liability for dishonour of the instrument towards the endorsee or any other subsequent holder. This can be done by writing the words ‘sans recourse or without recourse to me’ after the name of the endorsee. • Facultative: If the endorser, by express words increases his liability or gives up some of his rights under the negotiable instrument, the endorsement is termed facultative. For instance, ‘Pay C or order. Notice of dishonour waived’ • ‘Sans frais’: Where the endorser does not want the endorsee or any subsequent holder of the instrument to incur any expense on his account on the instrument, the endorsement is known as ‘sans frais’. • Liability dependent upon a contingency: The endorser may make the endorsement in such a way that his liability is depends upon happening of a specified event which may never happen. For instance, ‘Pay C or order on his marriage with B’. it becomes the duty of the drawee in such a case to see that the instrument is paid to C or his order when the specified event has happened . Negotiation of Lost Instruments and Instruments obtained by unlawful means • Lost Instruments The holder of a lost instrument should give notice of the loss to all parties through public advertisement The finder of a lost instrument is not entitled to sue thereon in his own name The true owner can recover the instrument from the finder if it is with him but if he has parted with the instrument and has received payment thereon and cannot return the instrument to the owner, he must compensate the owner. An acceptor, maker, or drawee who makes payment in due course of a lost instrument gets a valid discharge for it. If the instrument is payable to the bearer, and the finder negotiates to a bona fide transferee for value, the transferee will get a better title against the right owner. • Stolen Instruments The thief does not get any title to the instrument, but if the instrument is payable to the bearer and it is negotiated to a holder in due course; he will get a good title to it not only against the thief but also against any party prior to him. • Instruments obtained by Fraud Valid contracts must be brought about by the free consent of the parties competent to contract. Therefore, the person guilty of fraud not only gets no 65 valid title to the thing obtained, but also liable to damages. The person who gets possession of the instrument by means of fraud or coercion cannot recover payment because his title happens to be defective. Where the document lands in the holder in due course, the plea of a defective title cannot be set up against such a holder because it is not a case of the absence to title (as in case of theft) but only a case of defective title, hence once the instrument comes in to the hands of a holder in due course, it is purged of all its defects. • Forged Instruments Forged instruments in the eyes of law have no existence whatsoever. It is a nullity. There is complete absence of the title from the very beginning and a forged signature is altogether inoperative. Even if it lands in the hands of a holder in due course, it cannot be cured of the defects because there is no defect of title which can be cured, but there is no title from the very start. Thus a title which never came in to existence cannot be improved by commercial custom. Discharge of Parties Following are the various ways in which discharge may take place: i.By Payment: All rights of action on a negotiable instrument are extinguished when payment or money due thereon is made to the person legally entitled to receive it. ii.By Cancellation: holder may deliberately cancel the name of any of the parties liable under a negotiable instrument with intent to discharge them from the liability thereon. iii.By Release: the holder of a negotiable instrument may grant, by an agreement, release to the person liable to pay the amount due thereon. Substitution of the old instrument by the new one will also discharge the parties concerning the old instrument from liability. iv.By default of the Holder: All parties will be discharged from liability when any of the following are committed: a. When he fails to give notice of dishonour of the negotiable instrument to all parties b. When he fails to present the instrument for payment or acceptance on the specified date or within a reasonable time unless such has been waived c. When the holder of a cheque fails to present it before the relations between the drawer and the banker is altered v.By Material Alteration: Material alteration is that change in the negotiable instrument which causes it to speak a different language in legal effect from that which it had originally spoken. Instances of material alteration include: a. Alteration in the date of the instrument. b. Alteration of the sum payable. c. Alteration in time of payment. d. Alteration in the place of payment. e. Alteration in the rate of interest. f. Alteration by the addition of a new party. g. Alteration of an order instrument in to a bearer instrument. A material alteration shall discharge all parties who are liable in the instrument at the time 67 of alteration and who do not consent to such alteration. Liabilities of a Banker • Liabilities as a Paying Banker: As mentioned earlier, the relation between the banker and the customer is that of a debtor and a creditor. Therefore the money deposited will always belong to the customer, hence, the drawee of a cheque having sufficient funds of the drawer in his hands, properly applicable to the payment of such cheque must pay the cheque when dully required to do so, and in default of such payment, must compensate the drawer for the any loss or damage caused by such default. Hence, the following precautions must be taken by the paying banker: i.Precautions regarding the form of the cheque: the cheque must be in proper form. ii.Precautions regarding date: the banker should refuse to honour an undated cheque which has been presented for payment. In case of post dated cheques, the bank should honour it only on or after the date mentioned on the cheque. In case a bank honours post-dated cheque, it runs the following risks:  The drawer may countermand payment before the date mentioned on the cheque and the banker will not be entitled to debit the customers account  The drawer may make the banker liable for dishonouring of other cheques on account of insufficiency of funds resulting because of the post-dated cheque  In case of insolvency or death of the drawer before the date mentioned on the cheque, the banker shall not be entitled to debit the customers account, if it has already made payment of the cheque.  The payment of a post-dated cheque shall not be considered to be a payment of in due course and, therefore, the banker shall not be entitled to any statutory protection if the payment is made to the wrong person. iii.Precaution regarding amount: The banker should see that the amount mentioned both in words and figures are the same. In case they differ, the amount stated in words may be taken as correct and the banker may make the payment. In such cases also, the bank return the cheque for reference to the drawer. In case the amount has been stated in words only and not in figures the banker should pay the cheque. But where the amount has been stated in figures only and not in words, the banker should return the cheque. iv.Precautions regarding the ‘Funds’ of the customer: There should be sufficient funds in the account of the customer for payment of the cheque. Cheque has to be paid in full and not in part and, therefore, inadequacy of funds will result in dishonour of the cheque. The cheques should be paid in chronological order of their receipt by the bank. Therefore, in case of inadequacy of funds, the cheques will be paid in the order in which they are received by the bank to the extent the funds permit and the rest will be dishonoured. Where cheques are received at once, the usual practice is to honour the cheque of bigger amount. Where the cheques are of equal amounts, the banker has the discretion to honour any of them to the extent the funds of the drawer permit. v.Precaution regarding material Alteration: in case a cheque is materially altered and the banker makes the payment, he shall be discharged from liability only 69 when he proves the following;  The alteration could not be detected with reasonable care, prudence and scrutiny  The payment has been made in due course. vi.Precaution regarding the Drawers Signature: The banker is expected to know the signature of the customer, therefore, if the signature is forged, and the banker makes payment it shall not be entitled to debit the customer’s account. It is also expected from customers to remain reasonably vigilant and render all possible assistance to the bank when asked by it. vii.Precautions regarding Mutilated Cheques: A cheque is said to be mutilated when it is torn into two or more pieces. Such a cheque should not be paid unless the banker is satisfied that the mutilation was unintentional and it also obtains confirmation of the drawer. viii.Precaution Regarding Banking Hours: The banker should make payments of only such cheques which have been presented to it for payment during its banking hours. Any payment of cheque which was presented to it for payment after banking hours will not be taken as a payment in due course and the banker will be entitled to debit the customers account. ix.Precautions Regarding Crossing: If the cheque is a crossed one, it should not be paid on the counter but through a collecting banker. Instances when a banker may refuse to honour a Customers Cheque i. When the balances to the credit of the customer is insufficient to meet the cheque. ii. iii. Notice from the customer to stop payment (countermanding payment). When funds are not properly applicable to the payment of the cheque, e.g. when the account was opened for a purpose other than that for which the cheque has been drawn, i.e. personal cheques cannot be drawn on trust accounts. iv. After receiving the notice or information of death, the banker should stop payment of all cheques drawn against his account. The account will cease to be operative till the successor or legal representative produces to the bank the succession certificate or a letter of administration. v. vi. When the customer has been informed of the loss of a cheque When the bank comes to know of the defect in the title of the person presenting the cheque vii. When the bank comes to know that the customer is applying the funds in breach of trust viii. When the customer closes the account before the cheque is presented for encashment ix. When the cheque is post-dated and is presented for payment before the due date. x. xi. Notice of customer’s insolvency or bankruptcy Notice of garnishee order Answers in case of Dishonoured Cheques Incase a cheque is dishonoured, the bank is should return it with a slip disclosing the reason 71 for dishonour. Most banks have slips called ‘return memos’ printed and the banks ticks the appropriate answer. Some of the reasons for dishonour include: 1. Return to Drawer (RD): This means the holder should refer to the drawer for payment. The bank puts a note in those cases where the drawer does not have sufficient funds with the bank or there is reasonable ground for suspecting that the cheque has been tempered with. 2. ‘Not Sufficient’, ‘No Effects’ or ‘No Funds’: In actual practice, however, the words ‘Refer to Drawer’ is used. 3. Not Arranged For: it is used in cases where payment of cheque will result in overdraft which has not been approved by the bank. 4. Endorsement Irregular: this is used when endorsement is not in order, e.g. the spelling of the payee’s name as given on the face the cheque differs from that in the endorsement. 5. Effects not Cleared: this is used in those cases where the drawer has given certain cheques, drafts, etc., for collection and the same have not been collected yet and, therefore the banker is not in a position to meet the cheque drawn on account of insufficiency of funds in the drawers account at the moment. 6. Drawer Deceased: where the banker receives information that the drawer is dead, it will return the cheque on the same account. 7. Words and figures differ: this is used where the reason for dishonour is differing of amounts of cheque in words and figures. Bankers’ Liability in case reply is not appropriate A banker should take utmost precaution while sending its reply in respect of a dishonoured cheque. In case the banker states an inappropriate reason which injures the reputation of the drawer unnecessarily, the drawer can make the banker liable. In those cases where a bank wrongfully refuses to honour a valid cheque drawn upon it by its customer, who had sufficient amount to his credit in the bank, the drawee may bring about a suit for damages against the bank for breach of contracts as well as for loss of reputation or injury caused to his credit. A customer is expected to be reasonably careful while issuing cheques so that it does not mislead the bank. If a cheque is drawn so negligently that it may facilitate forgery by alteration of the amount payable, any loss caused by such alteration will fall on the customer of the bank, provided the bank made payment of the cheque in due course. Payment of a Cheque by Mistake: Incase the payment of a cheque has been made by the drawee bank under a mistake; it can recover from the payee provided that the payee’s position has not been altered to its prejudice before detection of the mistake. Payment of a Forged Cheque Payment must be in good faith and without negligence. Although the rules of the bank require the customer to keep the cheque book under lock and key, and that the bank will not be liable for any loss otherwise, it will not relieve the bank of liability. In Bihta Cooperative Development and Cane Marketing Union Vs Bank of Bihar and others, it was held that leaving the cheque book carelessly would afford no defense to the bank that the customer was negligent. Again in Canara Bank Ltd. and Canara Sales Corporation, the decision was in favour of the customer in a case involving payment on certain forged cheques by the bank. In this case the Chief Accounts Officer of the Canara Sales Corporation who was the custodian of cheques forged the signature 42 times and withdrew 73 a colossal sum of money. On discovery of the forgery, the corporation wanted the bank to recredit its account with the amount in question. The bank refused to comply and the company sought legal redress. The court passed a decree in favor of the company. The bank went on to appeal on the following grounds: a) The corporation was estopped from its claim because it had not objected to the payments which were brought to its notice through monthly statements b) The corporation was negligent in entrusting the custody of cheque books to the Accounts Office c) The suit was time barred since the company had not objected to the payments for a period of 4 years The appeal was dismissed owing to the following reasons: i. ii. A cheque on which the drawers signature was forged was not a cheque at all The failure on the part of the customer to detect the forgery and to inform the banker of the payment made on a forged cheque was not sufficient reason to deprive the customer of his right to recover the amount paid on the forged cheque, since there was no duty on the part of the customer to check cheques and inform the bank of payments made on a forged cheque. Additionally, the company brought the facts to the attention of the bank as soon as the forgery was detected. iii. The fact that the cheque book was entrusted to the Accounts Officer did not constitute negligence on the part of the corporation since it is the normal practice of any concern to entrust the cheque book to the custody of the head of accounts section. iv. The suit was not time barred The decision was similar in Wealden Woodlands (Kent) Ltd. Vs National Westminster Bank Ltd. According to this decision, a bank which pays forged cheques cannot resist the customer’s request for the amount to be recredited on the grounds that the customer had failed to note the payment from his bank statement. In this particular case, a director had forged the signature of another director on 23 cheques over a period of 9 months. The learned Judged observed that the customer was under no obligation to examine his bank statements, and that failure on the part of the customer to draw inferences from those statements would not constitute negligence on his part, so that he could be estopped from claiming the amounts paid on forged cheques from the bank. The banks defence may be available if the customer was in a way culpable. • Liabilities as Collecting Banker A bank undertakes to collect customers cheques as an agent and incur a fiduciary responsibility to account for and pay the money to his principal or any one else according to his direction. The Banker shall continue to act as an agent of its customer till the amount of the cheque is actually paid off. Duties of a Collecting Banker A Banker entrusted by his customer with the collection of a cheque is bound to act according to the directions given by the customer, and in the absence of such direction, according to the usages prevailing at the place where the banker conducts his business. Thus a collecting banker has the following duties towards its customers: 75 i.Due care and diligence in the collection of cheques- A collecting banker should present them for payment within a reasonable time to the drawee bank and duty not to pay out of the customers account without authority. A banker must honour his customer’s cheques as long as there is sufficient and available credit balance (Foley Vs Hill, 1848). The bankers’ authority to pay is determined or revoked by either countermand (stoppage) of payment or by notice of the customers’ death (Section, 75). The authority to pay may also be revoked by either circumstances such as notice of the customers’ mental incapacity or bankruptcy. In a case of Consultant Surveyors and Planners Vs Standard Bank (U) Ltd. (1984) it was observed that “a bank owes a contractual duty to its customers and in the discharge of that duty a bank must take reasonable care in honouring cheques especially open cheques to be paid on the counter. A bank must ensure that the drawer’s signature on the cheque strictly conforms with the specimen signature given when the account was opened. When the drawers signature on the cheque differs from the specimen signature, the payment should be refused with comments like “signature differs”. The Facts of the Case The plaintiff operated a current account with the defendant bankers. They had three signatories two of whom would sign the cheques and draw money. Their specimen signatures were given to the defendant at the time of opening of the account. Their rubber stamp was supposed to appear on their cheques whenever they drew money from the account. The cheque book was always kept under lock and the keys were kept by two persons only. A thief stole a leaf from a plaintiff’s cheque book and, using the rubber stamp that was different in letter and ink forged the signatures of the two of the plaintiff’s signatories. The forged signatures differed from the specimen signatures given to the defendants. The payee had signed twice at the back of the cheque but both signatures differed from each other and from that in his identity card. The defendant paid to the thief sh. 496,000 and debited the plaintiffs account on the basis of the forged cheque. It was held that: 1. The primary cause of the loss of sh 496,000 was the neglect of the defendant bank to counter check the signatures appearing on the cheque with the one given when the account was opened. 2. The defendant was found liable and had to credit the plaintiff’s account with the same amount and were in addition, to pay general damages of sh. 5,000 for breach of contract. ii.Duty to serve notice of dishonour- In case the cheque is dishonoured, the collecting banker must within a reasonable time give notice to the customer so as to enable him to take action against the prior parties. In case the banker fails to serve notice of dishonour to the customer, it will be liable to the customer for any loss that the customer might have suffered on account of such failure. iii.Banker’s duty to maintain accurate accounts- A bank owes a duty to its customers to record accurately each entry of the debit and credit in the customer’s account. 77 Duties of the Customer The duty of Care: A customer has a duty of care in drawing a cheque. He is bound to take reasonable precautions to prevent forgery. In London joint Stock Bank vs. Macmillan (1918), a cheque for £2 was drawn in such a way that a gap was left between the £ symbol and 2, with a blank in the space for the amount in words. After the drawer had signed, his confidential clerk inserted “1” and “0” respectively in the said gaps, so that the figure now read: £120. He then wrote his new figure in words in the space that had been left, and received £120 from the bank. Held: the customer’s banker was entitled to debit his account with £120, and the customer was to bear the loss. Crossing of Cheques A cheque may be classified as: (a) An open cheque: This is a cheque which can be presented for payment by holder at the counter of the drawees bank. (b) A crossed cheque: Is a cheque which can be paid only through a collecting banker. Crossing Defined A cheque is said to be crossed when two transverse parallel lines with or without any words are drawn across its face. A crossing is a direction to the paying banker to pay the money generally to a particular banker and not to the holder at the counter. Crossing of cheques affords security and protection to the true owner since payment of such cheque has to be made through a banker. Cheques are crossed in order to avoid losses arising from open cheques falling in to the hands of wrong persons. Modes of Crossing Crossing can be either be: i General crossing ii Special crossing General Crossing Section 76(1) provides that where a cheque bears across its face and an addition of: a) the words such as ‘and company’ or any other abbreviation e.g. ‘& co.’ between two parallel traverse lines, either with or without words ‘not negotiable’; or b) Two transverse parallel lines, either with or without the words “not negotiable” Then it constitutes a crossing called general crossing and in this case, the banker upon whom the cheque is drawn will make the payment only to some other bank. Special Crossing Section 76(2) provides that where a cheque bears across its face an addition of the name of a banker with or without the words ‘not negotiable’, that addition constitutes a crossing special crossing. When a cheque has been specially crossed, the banker upon whom it has been drawn will make the payment only to that banker in whose favour it has been crossed. A cheque is therefore specially crossed if it is crossed in any othe following forms: The basic ingredient of crossing is the two transverse lines across the face of the cheque 79 which must be present in order to constitute a crossed cheque. The cheque will not be taken as crossed if this has not been done. Who may Cross a Cheque? Section 77 provides that a cheque may be crossed by the drawer, the holder, or a banker concerned with the cheque. Where the cheque is uncrossed, the holder may cross it generally or specially; where it is crossed generally, he may cross it specially; and where it is crossed generally or specially, he may add the words “not negotiable”. Liability of a banker on Crossed Cheques The paying banker should make payment of crossed cheques only through the collecting banker. In case of special crossing, the payment of the cheque should be made only to the banker whose name has been mentioned between the two transverse lines. Incase the banker contravenes these rules; its liability will be as follows:  The paying banker will have to reimburse the true owner for any loss that he might have suffered on account of payment being made to the wrong person.  The paying banker shall not be entitled to debit his customers account with the amount of payment in case payment has been made to the wrong person since it has not followed the mandate of the customer. Practice Questions 1. Write short notes on the following: a) Noting b) Protesting a bill c) Negotiation d) Effect of crossing 2. Explain what is meant by the terms “holder in due course” and “holder for value” of a bill of exchange, and outline their legal rights. 3. Explain the statutory provisions affording special protection to: (a) The paying banker (b) The collecting banker 4. XYZ bank Ltd. has installed a computer system. Due to a defect in the computer programming, a number of cheques drawn by the banks customers have been dishonoured and returned to payees marked “Refer to Drawer”. The customers are contemplating court proceedings against the bank for the damage caused to their credit worthiness. Advice the bank as to its liability. 5. Explain the circumstances under which a collecting banker gets protection in collection of cheques under Negotiable Instruments Act. 6. “A banker’s obligation to drawn by his customers is not absolute”. Discuss. What are the consequences of the wrongful dishonour of a cheque? 81 Customers Accounts Customers can maintain several types of accounts as follows:  Fixed Deposit Accounts These are known as term deposits. They are deposits which are made with the bank for a fixed period specified in advance and a fixed deposit receipt is issued for acknowledgement for the amount deposited. A fixed depositor is not legally entitled to draw cheques against fixed deposits. The bank offers higher rate of interest for such deposits. To open such an account the depositor has to fill in an application form wherein he/she mentions the amount of deposit, the period for which the deposit is to be made and the name(s) for which the fixed deposit is to be issued. In case of a deposit in joint names, the banker also takes the instructions regarding payment of money on maturity of the deposit, i.e. whether payable jointly, or any of them. The banker takes the specimen signature of the depositor(s). A fixed deposit receipt is then issued for the sum of money mentioned therein. It also contains the rate of interest and the date on which the deposit will fall due for payment. The customer can grant advance against fixed deposit receipts. A banker may receive a request from a customer to change the name in a Fixed Deposit Receipt or making an addition or deleting a name therein. The banker has to be very careful in this respect and should comply with the customer’s request only after examining the legal position in each case. In case the receipt was issued in the names of unmarried lady who now wants her name changed on account of marriage, the banker should comply with such a request since this is a genuine case. In case the request have been received from the customer to add the name of any other person in the fixed deposit receipt, the banker should have no objection to adding of such name since he has the mandate of the customer. However, in case the receipt is in the name of two or more persons, the banker should comply with the request for adding the name only when all the depositors make such request in writing. Fixed deposit is attachable by a garnishee order since the order attaches funds due or accruing. Current Deposit Accounts In case of a current or demand deposits, the bank undertakes the obligation of paying all cheques drawn against it by the customer till it has adequate funds of the customer with it. The current account is a running account designed to save big customers from the risk of handling cash. The bank levies charges to manage such accounts and do not earn interest. To open such an account the customer need to fill an application form which is in a prescribed form, provide photographs, be introduced by an existing customer or some other person known to the bank by signing on the application form. The customer should also provide the specimen signature, and in case the customer desires to have his account operated by another person, the bank will obtain the mandate in writing to that effect as well as specimen signature of the person in whose favour the mandate is given. After observance of all these formalities, the bank opens an account in the name of the customer. The bank then provides a cheque book to facilitate withdrawal and payments to third parties by the customer. Closing of a bank Account A customer’s account with the banker may be closed in the following circumstances: i.The customer may inform the banker in writing of his intention to close the account. 83 The banker cannot ask for his reasons of such closure. It should immediately ask the customer to return the unused cheques and close the account. ii.The banker may itself ask the customer to close the account when then banker finds that the account has not been operated for a long time. A notice to that effect can be given to the customer. iii.A banker can also close the account if it finds the customer not being desirable, e.g. customer is found guilty of having forged cheques or flouting rules of operating the account. In that case the banker may by notice in writing, informs the customer of its intention to close the account. However, the banker should follow the following procedures: a. The banker should give a reasonable time notice to the customer for making alternative arrangements b. In case the customer does not come forward to close the account in spite of getting the notice for closure of such account from the banker, the banker should give a second notice to him stating clearly that in case he himself does not close his account by a specified date, the banker itself will close that account. c. In case the customer fails to close the account by the specified date, the banker should by a draft send to him the money lying in his account. iv.In the following cases, the banker should suspend all payments from the customer’s account till the matters are finally settled: a. When the banker receives notice of the customer’s death or insanity. b. When the customer becomes insolvent or in case of a company, goes in to liquidation. c. When the banker receives a garnishee order d. When the banker receives a notice from the customer regarding assignments of the balance standing to the credit of his account by him to a third party. The banker in such a case is bound to pay money to the third party. Dormant Accounts Dormant accounts are those accounts which are without any customer created transactions. The law has not prescribed any period after which account should be treated as a dormant account because of the absence of any transactions by the customer in his account. However, every bank has its own policy in this respect. There are many reasons for an account becoming a Dormant account, for instance, the customer might have moved from one place to another without notifying the bank, or in some cases the customer might have died without bank’s knowledge. In case of active accounts, there is some measure of control because of periodic reviews by the customer, for instance in case of current accounts the bank submits the statements of accounts to the customer at regular intervals, however, such controls are non-existent in case of Dormant Accounts. In the absence of customer’s checks, the Dormant Accounts can easily be manipulated by cheats. To control frauds in Dormant Accounts, the bankers transfers all such accounts in to one ledger. This ledger should list all the dormant Accounts and the amounts shown against each account. In case the depositor whose account has been taken to the ledger wants to operate such an account, the entry must be initialed by a responsible official before the account is permitted to be operated upon. 85 Legal considerations Varying with the type of Customers Every person who is competent to contract can open an account with a bank provided the bank is satisfied regarding his bonafides and is willing to enter in to necessary business relations with him. But there are certain types of persons whose capacity to enter in to valid contracts is subject to legal restrictions as follows: Minors In Kenyan laws, a person who has not completed the age of 18 is considered to be a minor. Since an agreement made with a minor is absolutely void (except for necessaries), a bank has to extra cautious while entering in to business dealings with a minor. The following points should be kept in mind by the banker in this connection: 1. The banker may open a savings bank account: It will not be advisable to a current account of a minor since in case of an overdraft, the minor does not have any personal liability. The savings bank account may be opened in a number of ways: a. In the name of minor himself b. In the joint names of the minor and his/her guardian c. In the name of the guardian in the following way “ABC, a natural guardian of X” In the case of (a), the account can be operated by the minor himself. He will be bound by the withdrawals made by him and the bank can legally debit his account. The account can be continued on minors attaining the age of majority. In the case of (b), the minor can operate the account jointly with the guardian, while in (c), the account is to be operated by the guardian on behalf of the minor. In cases (a) and (b) above the minor must have attained the age of at least 12 years and should be in a position to read or write. 2. Recording the Date of Birth: The banker should record the date of birth of the minor as disclosed by his or her guardian at the time of opening the account. 3. Death of the minor: In the event of death of a minor, the money will be payable to the guardian. Lunatics All contracts made by lunatics are void except those made during lucid intervals. Therefore, no banker would knowingly like to open an account in the name of a person of unsound mind because it would involve him, “in the difficulty of choosing between the risk of unjustifiably dishonouring the customers cheques on the one hand and of being held to have debited his account without adequate authority on the other” a customer may become a lunatic after opening the account with the bank. In such a case the bank will not be held responsible if it honours a cheque dully drawn, accepted or endorsed by the lunatic unless it is proved that the banker knew of his lunacy at the time of honouring or dishonouring the cheque. The bank should therefore suspend all operations on the account of the person who to its knowledge has become lunatic till it receives a proof of his sanity or gets an order of the courts to that effect. The banker should take the following steps on receiving notice of customer’s insanity: i.It should return all cheques on customer’s account with the words “Refer to Drawer” and not “customer insane”. 87 ii.It should make a careful not of the lunacy order as and when received from the court. iii.It should allow the operation of the account only as per the lunacy order. iv.It should not allow the customer to operate the account until he is certified by the courts to be sane. Drunkards A person who is so drunk that he cannot understand the terms of the contract about its effects cannot contract while such drunkenness lasts. Thus a contract by a drunken person is void. However, ordinary drunkenness is not sufficient to make a contract void. He must be intoxicated as to be incapable of understanding the nature and effects of the contract on his interests. Hence, when a customer presents a cheque across the counter when drunk, the banker, to be on the safe side should ensure that the payment is witnessed. Illiterate Person An illiterate person may open an account with the bank. The banker should take the following steps: i.Thumb Impression: The thumb impression of the depositor should be obtained on the account opening form and specimen signature sheet. ii.Photographs: Passport size photographs of the depositor should be obtained. iii.General: The implication and conditions for operation of the account should be explained to the depositor by an authorized official. Joint Accounts A banker should keep in view the following provisions while opening account in joint names: i.The account should be opened only on receiving applications signed by all persons interested in the account. ii.The banker should know how the account is to be operated or conducted not only so far as withdrawals are concerned, but also as regards other maters such as advances are concerned. The banker should obtain specific instructions as to whether one or more of the joint account holders shall operate the account. If no such directions are given the banker should honour only those cheques which are signed by all the joint account holders. The clause regarding the operation of a joint account may be worded in several forms depending on the intention of the parties. The banker generally insists for clear instructions while opening the account including the mandates to operate the account. In Catalin Vs Cyprus Finance Corporation (London) Ltd. a joint account was opened by a husband and wife and the mandate clearly specified “both to sign”. The bank negligently allowed the husband to transfer funds from the joint account to his personal account without the wife signing the transfer instructions. Thereupon, the wife proceeded to sue the bank for breach of mandate instruction and for restoration of funds in the joint account. The bank argued that because the contract with the bank relating to the joint account was with the husband and wife, then both should sue the bank and so the wife could not sue by herself because of the joint rights. This argument was not accepted and it was held that the bank had an obligation to honour withdrawal instructions which provided for both to sign. Joint Account in the name of Husband and Wife The position in the case of a joint account in the name of husband and wife is different. 89 Where an account is opened by the husband for his convenience, the balance cannot be claimed by the widow but has to be brought to the estate of the deceased. But where the intention of the husband by opening a joint account was to make the provision for his wife in case of untimely death, the widow would receive the money as was held in Marshall Vs Coutwell. If the banker has been given express instructions to pay the balance to the survivor, his position would be more secure. So it is advisable for the bankers to take written directions regarding disposal of the balance in case of death of either party. However, if the wife dies first, and even if the intention of the parties was not clear, the banker is justified in paying the balance to the husband. Executors and Administrators Executors and administrators are persons appointed to settle the accounts of a person after his death. An executor is appointed by the deceased himself, while the administrator is appointed by the courts. A banker should observe the following precautions while dealing while dealing with executors and administrators: i.The bank should examine the ‘letter of Probate’ i.e. letter of official confirmation in case of executors and a letter of administration in case of administrators to acquaint itself with the powers and functions of executors and administrators. ii.An account in the name of executors and administrators may be opened. iii.In case of joint executors and administrators, the banker should get clear instructions from them regarding the executors and administrators who will operate the account. Partnership Firm A bank should take the following precautions in the course of having business dealings with the firm; i.The banker should open an account in the name of the partnership firm only when one or more partners make an application to that effect. ii.The banker should ask for a copy of a partnership agreement and thoroughly get acquainted with its clauses. iii.The banker should take a letter signed by all partners containing; the names and addresses of all partners; the nature of the firms business; and the names of the partners authorized to operate the account in the name of the firm. iv.The banker should not credit a cheque in the firms name to the personal account of a partner without enquiring from other partners. In case the banker fails to so, it shall be liable to the other partners for wrongful conversion of funds. v.When a partner retires from partnership firm, he will not be liable to the banker for liabilities incurred by the firm after his retirement. Similarly, other partners will not be liable to the banker for his liabilities after his retirement. vi.In case of insolvency of one partner, a firm ordinarily stands dissolved. The insolvent partner ceases to be a partner on the date the order of adjudication is made. Therefore, a cheque signed by the insolvent partner before the date of adjudication should not be paid by the banker until without confirmation from other partners. The solvent partners may continue to operate the account for the purpose of winding up the firm’s business. It is proper for the banker to close the account of the old firm on the declaration of a partner as an insolvent and open an account in the name of the reconstituted firm. 91 vii.In case of death of a partner, a partnership firm stands dissolved. In case the firm continues to carry on the business, the estate of the deceased is not liable for any act of the firm after his death. The bank may continue with the account of the firm after the death of the partner but the cheques signed by the deceased partner before his death should not now be honoured by the bank without getting confirmation by the surviving partners. The banker should always close the account of the firm on the date of death of a partner and open a new account in the name of the firm. Joint Stock Companies A banker should take the following precautions before opening an account in the name of the company: i.The banker should thoroughly acquaint itself with the following documents; memorandum of association, articles of association, certificate of incorporation, certificate of commencement of the business, and in case of existing companies, it will be appropriate for the banker to ask for copies of annual accounts. ii.The banker should ask for a copy of board of director’s resolutions appointing it as the banker of the company. The resolutions must be signed by the chairman and countersigned by the secretary of the company. It should specify the names of the persons who have been authorized to operate the bank account on behalf of the company. Exercise 1. What are the precautions to be taken by the banker before it opens an account in the name of: a. A minor b. Partnership firm c. Joint accounts Securities for Advances and Guarantees Securities continue to be one of the most important factors which determine to a significant extent the banker’s willingness to lend money. The banker cannot afford to take the risk of non-recovery of money lent. In case of the borrower’s inability to pay, the bank must have tangible asset to fall back upon. The banker, therefore, must tries to get some charge created on the asset of the borrower in his favour. Such charge makes the asset charged available to the banker when needed in satisfaction of the advances made by him. Some of the important modes by which such charges can be created are: i.Lien ii.Pledges iii.Hypothecation iv.Mortgage v.Assignments vi.Guarantees Bankers Lien Lien is the right of a person to retain that which is in his possession and which belongs to 93 another, until the demands of the person in possession are satisfied. Lien gives a person only a right to retain the possession of the goods and not the power to sell unless such a right is expressly conferred by statute, custom or usage. There are two types of lien; particular lien, and general lien. Particular Lien: it is attached to some specific goods. It is a right to retain possession over those particular goods in connection with which the debt arose. It is restricted to those goods which are the subject matter of the contract and are liable for certain demands of the person in possession of these goods. General Lien: a general lien entitles a person to retain possession of the goods belonging to another for a general balance of account. It will entitle a person in possession of the goods to retain them until all claims of the person in possession against the owner of the goods are satisfied. A banker is entitled to general lien, and hence can retain all securities etc. in his possession till all his claims against the concerned person are satisfied. Pledge Pledge is the bailment of goods as security for payment of a debt or performance of promise. In the contract of pledge, pawnor must deliver the goods pledged to the pawnee. Originally, only a person who is the original owner of the goods can make a valid pledge, however in the following cases, pledge can be made by non-owners: Pledge by an agent Pledge by a co-owner in possession Pledge by a seller or buyer in possession after sale Rights and duties of Pawner i.Right to repay the loan ii.Right to receive goods upon settlement of the loan Rights and duties of the Pawnee i.Right to receive payment of the debt together with interest ii.Right of particular lien- pawnee has no right to retain his possession over the goods pledged for any debt other than the debt for which they were pledged, unless otherwise provided by the contract. iii.Right to receive expenses incurred for the preservation of the goods pledged. iv.Pawnees rights in case of default of the pawner a. Right to bring a suit on the debt and can retain the goods pledged as a collateral security b. Right to sell the goods pledged after giving reasonable notice of sale to the pawner. v.Pawnee must take reasonable care of the goods pledged. Hypothecation Hypothecation is a mode of creating an equitable charge against a property, for payment of a debt which continues to be in possession of the debtor. It is different from pledge because the asset pledged remains in the possession of the lender. However, the hypothecation deed provides that the banker will have the power to take the goods hypothecated in its possession if the need arises. In case the banker exercises such power the hypothecation will take the form of a pledge. Lord Macnaghten has characterized hypothecation as “being 95 ambulatory in nature, hovering over and so to speak, floating with the property until some event occurs or some act is done which causes it to settle and fasten on the subject on the subject within its grasp”. Hypothecation is particularly useful in those cases where it is almost impossible or impracticable to give possession of the goods to the lender. For example, where money is borrowed on the basis of goods lying in the retail showroom or the security of a motor vehicle which is to be used by the customer for purposes of his business. Granting of loans on the basis of hypothecation of assets is quite risky because the borrower may fail to give possession of the asset hypothecated when demanded by the bank or may sell the asset without paying the money. In order to safeguard itself against all such risks, a banker should take the following steps: • The banker must thoroughly verify the three C’s of banking before granting the loans i.e. character, capacity, and capital. Thus this facility should be advanced to genuine, honest, and financially sound parties. • The borrower should be asked to submit the statement of stocks held by him under the hypothecation to the banker. • An undertaking should be obtained from the borrower that he shall not charge the same goods to some other person. • • • The goods should be insured against fire, theft, and other risks. The banker should get the charge registered. The banker should ensure that the borrower is not enjoying similar hypothecation facilities on the same stocks from some other banks. • Incase the borrower is enjoying hypothecation facilities from different banks, he should be asked to earmark his stocks in such a way that a clear distinction can be made regarding specific stocks hypothecated with different banks. The borrower should also be asked to keep distinct record of stocks relating to each bank. Mortgage A mortgage is the transfer of an interest in specific immovable property for the purpose of securing the payment of money advanced or to be advanced by way of loan, existing or future debt or the performance of an engagement which may give rise to a pecuniary liability. The transferor is called a mortgagor the transferee a mortgagee, while the instrument by which the transfer is effected is called mortgage deed. The main characteristics of a mortgage can be put as follows: i) The mortgagor does not transfer the ownership of the property to the mortgagee. He transfers only some of his rights as an owner e.g. he cannot sell the property without the consent of the mortgagee. ii) Mortgage relates only to immovable properties. Properties mortgaged should be specified by the mortgagee in the mortgage deed. Such specification can be done by mentioning the name, location or size of the properties. iii) The object of mortgaging the property is to give security for the loan to be taken or already taken for performance of an engagement giving rise to the pecuniary liability. Transfer of property for any other purpose e.g. in satisfaction of a loan, 97 will not amount to mortgage. iv) v) The mortgage need not always given the actual possession of the property. The mortgagor gets back all his rights regarding the mortgaged property on repayment of loan with interest due thereon. Types of Mortgages 1. Simple Mortgage: A simple mortgage is one where without delivering possession of the mortgaged property, the mortgagor binds himself personally to pay the mortgage money and agrees expressly or impliedly that in the event of his failure to pay according to his contract, the mortgagee shall have a right to cause the mortgaged property to be sold and the proceeds of sale to be applied so far as may be necessary in the payment of the mortgage money. Thus, in simple mortgage, the mortgagee has two-fold security for the debt: i) ii) The personal obligation of the mortgagor, The property. However, the mortgagee cannot directly sell the property. The sale must be through the intervention of the Court. The mortgagee will have to obtain first a degree from the court for sale of the mortgaged property since the words used are “cause the mortgaged property to be sold”. 2. Mortgage by Conditional Sale Mortgage by conditional sale is one where mortgagor ostensibly sells the mortgaged property on the condition that: a) On default of payment of the mortgage money on a certain date the sale shall become absolute , or b) On such payment being made the sale shall become void, or c) On such payment being made the buyer shall transfer the property to the seller. The following are the essential characteristics of such a mortgage: a) It is an ostensible sale and not a real sale b) The ostensible sale is subject to a condition: i) The ostensible sale will ripen into real sale in case the mortgagor defaults in payment, or ii) In case the mortgagor makes payment, the mortgagee will retransfer the property to the mortgagor. c) The possession of the property continuous with the mortgagor. d) The fact that transaction is a mortgage should be specified in the document of sale. e) The mortgagor does not have any personal liability; therefore, in case the mortgaged property is not sufficient to pay off the mortgagees claim, he cannot recover the balance out of any other property of the mortgagor. 3. Usufuctuary Mortgage An usufuctuary mortgage is one where the mortgagor delivers or agrees to deliver the possession of the mortgaged property to the mortgagee and authorizes him: i) ii) To retain such possession until payment of the mortgage money. To receive the whole or any part of the rents and profits accruing from the property, and 99 iii) To appropriate such rents profits (a) in lieu of interest or (b) in payment of the mortgage money or (c) partly in lieu of interest and partly in payment of the mortgage money. 4. English Mortgage English Mortgage has the following characteristics:i) The mortgagor makes a personal promise to repay the mortgage money on a certain day. ii) iii) The property mortgaged is transferred to the mortgagee absolutely. The transfer is subject to this condition that the mortgagee will retransfer the property to the mortgagor upon making payment of the mortgage money as agreed. 5. Mortgage by Deposit of Title Deeds or Equitable Mortgage Where a person delivers to a creditor or his agent documents of title to immovable property, with the intention to create a security thereon, the intention to create a security thereon, the transaction is called a “mortgage by deposit of title deeds” 6. Anomalous Mortgage A mortgage other than any of the mortgages explained above. Such a mortgage includes a mortgage formed by combination of two or more types of mortgages as explained in the previous pages. Legal Mortgage and Equitable Mortgage On the basis of transfer of title in the mortgaged property, mortgages can be classified into two categories. i) ii) Legal Mortgage Equitable Mortgage In a legal mortgage, the mortgagor transfers to the mortgagee the legal title to the property and must be registered. On repayment of the loan, the mortgagee transfers the title to the mortgagor. In case of an equitable mortgage, the mortgagor deposits the title deeds with the mortgagee with the intention of giving the mortgagee an equitable interest in the property. It does not require registration. Advantages of an Equitable Mortgage i) It does not require registration; therefore, stamp duty is saved. It is thus economical. ii) iii) No witness is required. It is simple as no elaborate drafting of mortgage deed is required. Disadvantages of an Equitable Mortgage i) Property mortgaged can be realized, when required, only through the courts orders. ii) The mortgagee has to be extra-cautions. In no case he should part with the title deeds. In case the mortgagee hands over the possession of documents to the mortgagor, a subsequent mortgagee who has in good faith accepted the 101 documents will have a prior claim. Rights of the Mortgagor 1. Right of redemption if he pays the mortgage money on the due date at the proper place and time. 2. Transfer to third party. The mortgagor can ask the mortgagor to transfer the to a third party the mortgaged property instead of retranference to the mortgagor. 3. Inspection and production of documents. 4. Additions to property. Right of the Mortgagee 1. Right to foreclosure: Foreclosure means debarring the mortgagor from exercising his right of redemption. It can be exercised by obtaining decree from the court to that effect. 2. Right of suit for sale: The mortgagee may bring a suit for sale in place of a decree of foreclosure. 3. Right to spend money. A mortgagee may spend money on the property for purposes such as; preservation of mortgage property from sale, insuring the property; renewal of lease; etc. 4. Right possession. Charge Where in a transaction for value, both parties evidence an intention that property existing shall be made available as security for payment of a debt and that creditors shall have a present right to have it made available, there is a charge. Types of Charges A charge may be classified as: i.A fixed charge ii.A floating charge Fixed Charge A charge is said to be fixed if it is made specifically to cover definite and ascertained assets of a permanent nature e.g. charge on land and building, or heavy machinery. Floating Charge It is a charge on property which is constantly changing e.g. stock. The company can deal with such property in normal course of its business until it becomes fixed on the happening of an event. Thus, it is the charge on the assets of the company in general. Assignment Assignment means transfer of an existing or future right, property or a debt by one person to another. The transferor is known as assignor and the transferee is called assignee. Usually assignments are made of actionable claims such as book debts, insurance claims, etc. Assignment may be: i.Legal ii.Equitable 103 A legal assignment is one where: a) Assignment deed is in writing duly signed by the assignor b) The transfer of actionable claim is absolute, and c) The assignee informs the assignor’s debtor about the assignment and also gets the balance confirmed from him. An equitable assignment is one which does not fulfill all the above requirements, for instance, where a debtor issues an order in favour of his creditor, on his debtor asking to pay such funds to his creditor it will result in creation of an equitable charge. Guarantee It is the act of promising to discharge the liability of a third party in case of his default. The person who gives the guarantee is called the ‘surety’ while the person in respect of whose default the guarantee is given is called the ‘principal debtor’ and the person to whom the guarantee is given is called the creditor. Types of Guarantees Guarantees may be: i.Specific ii.Continuing Specific guarantee means a guarantee for one specific transaction. In this case the liability of the surety extends only to a single transaction. A continuing guarantee on the other hand is one which extends to a series of transactions. Revocation of Guarantees A continuing guarantee is revoked by any of the following ways: i.By notice ii.By death Nature of Surety’s liability Where the parties do not specifically agree as to the extent of the liability or the surety does not put any limit on liability at the time of entering in to the contract, the liability of the surety will be co-extensive; meaning that the obligations of the surety will be the same as that of a principal debtor. The liability of the surety arises immediately on the default of the principal debtor but the creditor is not bound to give any notice of default of the principal debtor to the surety. Discharge of the Surety Surety will be discharged from his liability in the following cases: i.By Notice or Death: a contract of continuing guarantee may be terminated at any time by notice to the creditor. The death of the surety also brings an end to continuing guarantee. No notice of death need to be given to the creditor. The surety will not be responsible for acts done after his death. ii.Variation in the Terms of the original Contract between the Principal Debtor and Creditor: If the contract between the creditor and the principal debtor is materially altered without the consent of the surety, the surety is discharged as to transactions subsequent to alteration. Even the alteration beneficial to the surety would entitle the surety to claim a discharge. 105 iii.By Release or Discharge of the Principal Debtor: The surety is discharged by any contract between the creditor and the principal debtor, by which the principal debtor is released or by any act or omission of the creditor the legal consequences of which is the discharge of the principal debtor. iv.Compounding by the Creditor with the principal Debtor: A contract between the creditor and the principal debtor, by which a creditor makes a composition with, or promises to give time to, or not to sue the principal debtor discharges the surety unless the surety assents to such contract. v.Loss of Security: If the creditor loses or without the consent of the surety, parts with any security given to him at the time of the contract of guarantee, the surety is discharged from the liability to the extent of the value of the security. vi.By invalidation of the Contract of Guarantee: A contract of guarantee becomes invalid if guarantee was obtained by fraud or concealment of material facts. Special Types of Guarantors i.Minors and Lunatics: Contracts made with minors and persons of unsound mind are absolutely void. The banker should not, therefore, accept guarantees from such persons. ii.Undischarged Insolvent: The undischarged insolvent is also incompetent to enter into a contract, and therefore, the guarantee given by such a person is void and unenforceable. iii.Partnership Firms: A partner of a partnership firm cannot bind his co-partners by giving Guarantees for loans given by a bank to other parties, however, he can do so in the following circumstances; if it part of the ordinary business of the firm to give guarantees, or definite authority has been give by other partners to give such guarantee. iv.Limited Companies: in case of a guarantee executed by a limited company, the banker has to be extra cautious. The banker must verify from the company’s memorandum and articles of association, whether the company has been expressly given such power. Practice Questions 1. What is a banker’s lien? Explain with examples general lien and particular lien. 2. What is equitable mortgage? What is the procedure for creating such mortgage? What precautions would you take before accepting equitable mortgage as a security? 3. Describe the various types of charging securities and methods of charging them to cover bank advances. 4. A borrower desired to have a short term advance against the security of his property and suggested that the bank should grant to him against the equitable mortgage of his residential house inherited from the family. He had therefore no documents of title but only certified copies of the last conveyance which was held by one of the family members. The branch manager suggested that he preferred a legal mortgage. Please discuss briefly the advantages and disadvantages, if any, of each of these types of mortgage. The property is free of any encumbrances as certified by the bank’s approved lawyer. 107 Suggested Answer Legal mortgage is preferred to equitable mortgage, where the original documents of title of the property are not available, since equitable mortgage cannot be created by way of deposit of copies of title deeds. 5. A junior trainee officer in advances department of a branch said that when goods are hypothecated to a limited company, the possession is with the borrower. The borrower may borrow against the same goods from another bank. There will be double finance against the same goods. However, when the goods are pledged to a bank, the bank is fully secured as the goods are in possession of the bank. i.Do you agree with him ii.State what advice you will give as to how a bank protects itself from the possibility of double finance. The trainee officer further queried as to how the ‘search’ is carried out at the office of companies. Please explain step by step, how the ‘search’ is carried out. Suggested Solution The banker should be careful while granting advances on the basis of fixed or floating charge over the assets of a company. The banker should satisfy himself that no prior charge is in existence over the security by carrying out search in the office of the registrar of companies. The banker may dispute a legal counsel to inspect the register of charges maintained by the registrar of companies to ensure that there are no prior encumbrances on the property. In case the banker is satisfied after such a search it should get the documents executed and get the bank charge against the assets of the borrower registered with the registrar. Types of Securities 109 The previous discussion was on the different modes of charging security, however, this section dwells on the different types of securities and the precautions a banker should take while advancing money against them. The different types of securities which may be offered to the banker are as follows: i. ii. Immovable properties Movable properties: a. Goods b. Documents of title to goods c. Stock exchange securities d. Life insurance policies e. Fixed deposit receipts Before looking at each of these securities, the following principles should be kept in mind by the banker while granting advances on the basis of these securities: • Adequacy of Margin: In banking terminology, margin means the excess of the market value of the security over the advance granted against it. For instance, if the market value of the security is Sh. 5,000 and the advance granted against it is Sh. 4,000, margin is Sh.1,000. A banker must keep adequate margin while granting loans because the market value of the security is subject to fluctuations, and secondly, the security remains the same while advance against the borrower may go on increasing on account of non-payment of interest and charges. • Ready Marketability: A banker should accept those securities which are easily marketable without much loss in their value. • Documentation: The banker should see that proper documentation such as mortgage deed, or pledge agreement containing all terms and conditions of the mortgage or pledge are executed. This should be done to avoid future disputes. • Realization of Advance: The banker has to see that the loans advanced are realized on their becoming due. On default, the banker may sell the securities after giving notice to the borrower and use the money towards payment of the loan. In case the debt is not fully satisfied by sale proceeds of the security, suit may be filed against the borrower for the recovery of the balance before it becomes time barred. Advances against Immovable Property Banks usually do not prefer to advance money on the security of immovable property because of the following reasons: Difficulty in ascertaining the title to the property Not readily realizable Restrictive laws- immovable property is subject to various restrictive laws particularly with regard to agricultural land. Precautions In case the banker decides to lend money on the security of immovable property, it should take the following precautions: i. The borrower should be financially sound and the business for which money is borrowed should be economically viable. Valuation problem Legal formalities 111 ii. iii. The borrower should have a clear title to the property to be given as security. The property should be properly valued and the valuation work given to qualified valuers. The value normally depends on the ownership right, the location of the property, the type of the construction, the size, structure and layout, and the rental value. iv. v. vi. Proper margin should be kept The property should be fully insured. In case of legal mortgage, the mortgage deed should be registered. Advances against Goods Banks can advance money against the security of goods which include industrial raw materials, plantation products, manufactured articles, etc. Goods have distinct advantages over other forms of securities because: They are easily realizable on account of their having a ready market. Their value can easily be ascertained from the market. Loans against commodities are of a seasonal character; hence, it does not lock up funds. In case of commodities which are necessaries of life, there is not much of price fluctuation. However, such goods have the following limitations: Effective supervision over the goods may not be possible when they are hypothecated. Dishonest persons may cheat the banks. Quality of the goods may be difficult to verify. Goods deteriorate in quality with the passage of time. Precautions The bank should keep in mind the following points while advancing money on the security of goods as follows: i. Selection of the borrower: the banker should satisfy himself regarding the character, capacity and capital of the borrower. ii. Selection of commodities: commodities should be such which have fairly stable prices. iii. Charging the security: the banker should ensure that the goods are deposited by way of security either in the form of pledge or hypothecation. iv. Storage of goods: the following points should be taken in to account while storing the goods; the godown should be safe from water, fire, etc. and is located in a good location, in case of hypothecated goods, the borrower should give an undertaking that he will allow the inspection of the goods, and that the goods should be insured for full value. Advances against Documents of Title Documents which in the ordinary course of trade, are regarded as proof of the possession of the goods are called documents of title. They authorize the holder thereof to transfer or receive goods which are mentioned therein. Granting advances against documents of title involve the risk of frauds especially if say the transporter or consignor may mention in the forwarding note 10 bags of sugar but in actual sense it was 10 bags of sand. The bill of lading or the railway receipt will indicate 10 bags of sugar though actually 10 bags of sand was received. 113 Precautions i. The advances against documents should be made only to trusted and reliable borrowers. ii. The borrower should be asked to submit the complete set of documents such as bill of lading or the railway receipt. iii. The borrower should be asked to sign an agreement with the bank pledging the documents with the bank. The principal documents of title include; the bill of lading, ware house receipts, railway receipts, among others. Stock Exchange Securities Stock exchange securities can be classified in to government securities, corporate bonds and shares. In comparison with other forms of securities, stock exchange securities have the following merits: Reliability: it is easier for the banker to verify the title of the borrower of such securities. Liquidity: they are easily realizable as compared to other securities such as land. Price stability: such securities do not have so much price fluctuation, hence, the banker can be more sure of recovering his funds if the need arises. Easier valuation: since such securities are listed in the stock market, the banker can ascertain their value easily. Transferability: the ownership of such securities can be easily transferred as compared to other securities. However, it has the following demerits: Forgery: the banker may suffer loss on account of forgery committed by the borrower. Fluctuations in prices: the banker may suffer loss in case of fluctuations in the value of the securities. Precautions i. Selection of securities: while selecting the securities to be used in lending, the bank should consider the nature of company’s business, company’s management, past-working results, and market trends in the value of shares. ii. Valuation of the securities: valuation of securities dealt with in the stock exchange can be done on the basis of daily stock exchange quotations; however, the bank should calculate the break up value. iii. Creation of charge: the banker should finally get securities charged in its favour. Such charge can be created by giving a legal title, or by creating an equitable title. In case of a legal title, the securities are transferred by the borrower to the bank in its name. The name of the bank replaces the name of the borrower in the company’s records, while in case of an equitable charge; the borrower transfers the equitable title to the securities in favour of the bank by depositing securities with it. The securities continue to be in the borrowers name in the company’s records. The equitable charge may be created by any of the following methods; by mere deposit of securities; by memorandum of deposit, wherein the securities are deposited with the banker and the bank is entitled to 115 sell securities in the event of default; by blank transfer; and by the power of the attorney. Precautions to be taken in case of Equitable Mortgage i. ii. The banker should accept securities which are under the borrower’s name. The bank should give a notice to the company intimating about its charge over the company’s securities. This will help the bank know about any prior charge, and also prevent the company from issuing duplicate share certificate to the borrower. iii. The bank should obtain in the memorandum power of selling the securities in case the need arises. iv. The banker should obtain the borrower a mandate addressed to the company directing it to pay dividends to the bank in respect of the shares over which it has an equitable charge. Advances against Life Insurance Policies A life insurance policy is a contract in which on party (the insurer) agrees to pay a certain sum upon the happening of a certain event or on the maturity of the policy. Life insurance policy is considered by banks as one of good securities on account of the following reasons; the policy can be easily assigned in favour of the bank; the valuation of the policy can easily be done; the value of the security increases with time as more and more premiums are paid; and the security can be easily realized. Precautions A banker should take the following precautions while accepting life insurance policy as a security: i. The banker should have a thorough scrutiny of the policy to determine the terms and conditions under which the policy has been issued. ii. The banker should see that the insured had insurable interest in the person whose life has been insured at the time of when the contract was effected. iii. The banker should prefer endowment policies to whole life policies, as there is definite maturity date. iv. v. vi. The banker should ensure there is no prior charge or encumbrance against it. The banker should get the policy assigned in its favour. The banker should ensure that payment of premium is being made regularly by the borrower after giving the policy as security to the bank. Advances against Fixed Deposit Receipts A fixed deposit is payable after the expiry of a fixed period. The encashment of a fixed deposit before its maturity results in loss of interest. A depositor may therefore, borrow money against the fixed deposit receipt to meet his urgent needs. A fixed deposit receipt issued by the same banker is the safest form of security; however, the banker should take the following precautions: i. The loan should be advanced to the same person in whose name the fixed deposit receipt stands. In case the receipt has been issued in the name of two or more persons and the loan is sought by one them, the bank should ask for a letter of authority signed by all depositors authorizing the intended borrower to borrow money against the receipt. 117 ii. The bank should obtain from the borrower the deposit receipt duly discharged by signing on the back of it across a revenue stamp, and a memorandum of pledge authorizing the bank to utilize the proceeds of the deposit on maturity towards repayment of the loan. iii. In case the receipt stands in the name of a minor no advance should be granted against such a receipt. iv. On maturity of the deposit, the money due to the customer on account of the deposit will be credited to then current or savings account of the depositor. In case the loan is repaid in full before maturity, the lien and discharge noted on the receipt will be cancelled and the receipt will be handed over to the depositor after obtaining acknowledgement. A banker should not normally grant loans against fixed deposit receipt issued by other banks. However, in exceptional cases, loans may be advanced subject to the following precautions in addition to those given above: i. The banker should obtain a letter from the depositor addressed to the bank which issued the deposit receipt, requesting it to pay the principal and interest to it. ii. The banker should also send a notice to the bank which issued the receipt intimating about advancing money to the depositor. iii. The bank should not affix its stamp on the deposit receipt issued by another bank. iv. On the maturity date, the bank should sent the deposit receipt together with the authority letter to the bank which issued the deposit with the request that the money due under the deposit receipt should be paid to it. On receipt of such money, the banker should adjust the proceeds against the loan and the balance if any should be credited to the savings or current account of the borrower. Practice Questions 1. State the precautions that must be taken and the practice that is generally followed in advancing money against the life insurance policies. 2. Explain the risks banks in Kenya undertake in making advances against documents of title to goods. Discuss the documents of title to the goods and the safeguards banks take in accepting them as security for the advances. 3. Mr. Korir, your valued customer, approaches you to grant an overdraft facility up to Sh. 150,000 in his current account. He offers the following securities: i.1,800 shares of East African breweries Ltd. of shs. 150 each standing in the name of his wife. ii.A fixed deposit receipt for sh. 270,000 standing in the name of his wife and son jointly issued by another branch of your bank. iii.His own life insurance policy for sh. 290,000 maturing after two years. Which of the securities would you accept and why? What precautions would you take and what documents would you obtain for the advance? Suggested solution The first two securities are not in the name of the borrower. They should not, therefore, be preferred to the third security i.e. life insurance policy which is on the life of the borrower. 119 Moreover, the policy’s surrender value should be near about Sh.150,000 twice the amount Mr. Korir wants to borrow. The banker should get the surrender value of the policy determined; ensure that the age of the insured has been admitted by the Life Insurance Company. A memorandum of deposit signed by the policy holder should also be obtained by the banker. The Central Bank of Kenya Central Bank of Kenya is also known as Banki Kuu ya Kenya and is created by section 3 cap. 491 of the Central bank of Kenya Act which states that (1) there is hereby established a bank which shall be known as the Central Bank of Kenya and which shall also be known by the alternative corporate name of the Banki Kuu ya Kenya. Section 3 also gives the bank a legal capacity i.e. section (2) provides that the bank shall be a body corporate with perpetual succession and a common seal. The bank is at the apex of the financial and monetary system of Kenya. It is the regulatory authority vested with powers to register, inspect, monitor and control the operations of commercial banks and financial institutions in Kenya with a view to ensuring that the banking and the financial sector serves the economic and development institutions in Kenya. Section 3 (3) of Cap 491 provides that the Central Bank of Kenya “shall exercise any type of banking functions unless specifically excluded under the act, and shall enjoy all the prerogatives of the Central Bank”. It is provided in section 3(5) that the Central Bank of Kenya shall not be subject to the companies Act or The Banking Act. The powers and functions of the Central Bank are spelt out in the CBK Act and the Banking Act. The former spells out the role of the Central Bank and its regulatory duties with respect to other financial institutions. The latter specifies the conditions governing the establishment and operations of commercial banks and their relationship with the Central Bank. Functions of Central Bank 1. Issuing of currency Every country in the world identifies itself with reference to its own currency. The CBK Act cap 491 section 4A (f) provides that the bank shall issue currency notes and coins. Central Bank enjoys the monopoly of issuing currency. Such monopoly is vital because it gives uniformity to the currency issue. Similarly, monopoly gives the Central Bank control over other banks in the matter of credit creation, since it is the cash reserves which constitute the ultimate limit of such expansion. 2. Banker of the Government Section 4 A (e) provides that the Bank shall act as a banker and advisor to, and as fiscal agent of the government. Meaning that all balances of the government are kept with the Central Bank. Central Banks everywhere operate as bankers of the government not only because it may be more convenient and economical to the government, but also because of the intimate connection between public finance and monetary affairs. Central Banks provide short term credit to the government which is usually done through discounting the governments treasury bills to enable the government meet its financial obligations. 121 3. Banker’s Bank Central Bank acts as a banker’s bank in three capacities; i.As custodian of cash reserves of commercial banks; ii.As the lender of the last resort; iii.As a bank of central clearance, settlement and transfers.  Custodian of the cash reserves of commercial banks The practice of commercial banks keeping their cash reserves with the Central Bank helps in pooling reserves, and in the process facilitates more efficient use of cash. Similarly, it enables commercial banks to increase their reserves by discounting bills with the Central Bank.  Lender of last resort The Central Bank is the lender of the last resort to the commercial banks. When the commercial banks have exhausted their own resources and have failed to supplement their funds from the usual outside resources, the Central bank is called upon to function as the lender of the last resort. It acts in this capacity mainly through its rediscount operations.  Clearing and Settlement According to section 4 A (d) Central Bank shall formulate such policies as best promote the establishment, regulation and supervision of efficient and effective payment, clearing and settlement systems. Since banks keep cash reserves with the Central Bank, settlements between them can be easily effected by means of debits and credits in the books of the Central Bank. 4. Credit Control The control of credit means the regulation and control of bank advances. The nature and volume of bank advances have a bearing on the state of the economy, for instance, there is a time when the business community requires funds but the commercial banks may feel shy to lend especially after the economic recession experienced in 2008. Therefore, the Central Bank must step in to stimulate bank advances. At other times, the banks lending may assume undesirable proportions or they may be flowing into undesirable channels. It is the duty of Central Bank to curb these undesirable tendencies by regulating and controlling credit creation by banks. 5. Control of financial institutions In order for the country to have control of its monetary and financial policy, it must have an institutional framework for registration, inspection, monitoring, and general restriction of its financial sectors whose main players are banks and non bank financial institutions. These are institutions whose sole objectives is to make profit. In order for the profit making objectives not to compromise the main economic interests there must be a regulatory institution to keep them in check. This function is provided by section 4 A (c) which states that Central Bank shall license and supervise authorized dealers. 6. Manage Foreign Exchange Reserves Section 4A (b) provides that central Bank shall hold and manage its foreign exchange reserves. The reserves are the backbone of a country’s credit worthiness at international 123 level. The Central Bank administers these reserves to ensure the country’s capability to purchase foreign goods and services for effective participation in the international economy. The administration of foreign reserves involves the control of foreign currency i.e. the control of the flow of foreign currency in to and out of the country. This is to ensure the country’s wealth is not exported to the detriment of the national economy. 7. Section 4 A (a) provides that Central Bank shall formulate and implement foreign exchange policy. 8. The handling of external financial relations. Kenya is a member of both the Word Bank and IMF, the two institutions which are the apex of the international financial system. The country’s participation and interaction with these institutions is spearheaded by the Central Bank. Apart from these international financial institutions, the country has to deal with both bilateral and multilateral donor organizations. 9. The CBK is also the institution enjoined with the role of hastening the development of capital and money market in Kenya. In this connection the bank works closely with and monitors the operations of the Capital Markets Authority and the Nairobi Stock Exchange. The Act creating Central Bank of Kenya i.e. Central Bank of Kenya Act came in to force on 24th march 1966 and with it the first Kenyan currency notes were issued. However, the Act has been amended as the need and new challenges arose, for instance, the new banking system has been designed to safeguard the interest of the depositors who became victims of a major financial crisis which occurred in Kenya in the 1980’s. The crisis put the banks regulatory system to its greatest test since the creation of the CBK. The failure by the CBK to notice the weakness within the non bank financial system in advance and therefore check check the collapse of those institutions illustrated a major weakness of the regulatory system then in force. The major cause of crisis and the failure of the CBK in that crisis were: • • Failure to maintain a safe cash reserve ratio Poor lending policies- most loans were advanced on the basis of political patronage or to directors and shareholders without any sufficient security. • • • Inadequate credit analysis and administration Under capitalization Excessive risk concentration- banks lending to one sector of the economy or one group of people. The financial crisis of 1986 forced the government to re-examine the policy and the legal framework for the regulation of the banking sector. This resulted in a considerable amendment and the consolidation of the Banking Act which was then passed as the Banking Act of 1989. The act established stricter regulation of the licensing and inspection of commercial banks by the CBK. It also increased the power of the Minister for Finance to restrict the operation of the financial institutions and it and it created the deposit protection fund to protect the interests of depositors in the event of collapse.\ Upon the creation of the deposit protection fund the government in consultation with the World Bank and the International Development Association IDA, established the Consolidated Bank of Kenya as a state owned financial institution which then took over the 125 assets and liabilities of failed financial institutions. The institutions whose assets were taken over were; The Estate Finance Ltd.; Estate Building Society; Citizen Building Society; Home Savings and Mortgage; and Business Finance Co. Ltd. later, two other companies were added; Nationwide Finance Co. Ltd; and Union Bank Ltd. The Central Bank of Kenya Act The CBK Act is described as an Act of Parliament to establish the Central Bank of Kenya and to provide for the operation thereof and establish the currency of Kenya and for matters connected therewith and related thereto. The Act is divided in to 9 parts as follows: Part 1 Part 2 Part 3 Part 4 Part 5 Part 6 Part 7 Part 8 Part 9 Preliminary Establishment, constitution and objects Capital and Reserves Management Currency External Relations Relations with specified Banks Relations with public entities Miscellaneous provisions Part2 Establishment, Constitution and Objects The Act was first passed in 1966, however, it has undergone major revisions with the latest being amendment No. 9 of 2007. Among the amendments are the objects which have been amended and expanded to read as follows:  Section 4 (1) to formulate and implement monetary policy directed to achieving and maintaining stability in the general level of prices.  Section 4 (2) to foster the liquidity, solvency and proper functioning of stable market based on financial system.  Section 4 A provides that without prejudice to the generality of section 4, the bank shall: a) Formulate and implement foreign exchange policy b) Hold and manage its foreign exchange reserves c) License and supervise authorized dealers d) Promote the smooth operation of payments, clearance and settlements systems. e) Act as a banker and advisor to and as fiscal agent of the government f) Issue currency notes and coins. The significance of the amendment to the objects of the CBK is that the banks are now the central authority for the management of the monetary and financial system and of the economy. In order to facilitate this expanded function at the policy level, the bank has given more power and substantially delinked from the government in terms of policy formulation. Previously, CBK assisted the government in the administration in financial and monetary policy but now the bank formulates that policy. Although the bank consults with the government, it is not bound any longer to follow the directives of the government. 127 A new provision introduced by the amendments (Section 4 B) enjoins the bank to submit to the Minister at intervals of not more than 6 months a monetary policy statement for the next 12 months which shall: a) Specify the policies and the means by which the bank intends to achieve the targets b) State the reasons for adopting such policies and means c) Contain a review and progress of the implementation by the Bank of monetary policy during the period which the preceding policy statement relates. Every monetary policy shall be laid before the committee of the National Assembly appointed to investigate and inquire into matters relating to the monetary policy, not latter than the end of the session of parliament subsequent to its submission to the minister. Both the monetary policy statement and the Bank’s balance sheet shall be published in the Kenyan Gazette. Section 4 (3) (b) provides that the Bank shall disseminate key financial data on the monetary policy to the public. A further amendment (section 4 C) provides that there shall be a regular consultation between the minister and the Bank on the monetary policy. However, in exceptional circumstances and after consultation with the Bank the Minister is of the opinion that the monetary policy adopted by the Bank is inconsistent with its principal objective of the Bank, the Minister may, upon resolution by the Cabinet, direct the Bank in writing to adopt such monetary policy as the Minister may specify for a period of 6 months or for such shorter period as the Minister may specify. If so directed, the Bank shall adopt such policy notwithstanding any othjer provision in the Central Bank of Kenya Act. Sub section (3) provides that any such directive shall be published in the Kenyan Gazette. Following such amendments, the Central Bank has been made more powerful, transparent and accountable. The transparency relates to the duty to avail information to the public on an ongoing basis. The accountability is reflected in the duty to consult regularly with the Minister and the submission of its monetary statement to a committee of National assembly. The purpose of these amendments is to create a participatory and consultative process to ensure the involvement of the Kenyan people in the evolution of the monetary and the financial system and the process of the economic development. A further amendment of 2007 (section 4D (1) provides that there shall be a committee of the Bank, to be known as the Monetary Policy Committee of the Central Bank, which shall have the responsibility of formulating the monetary policy within the Bank. The committee shall consist of the Governor who shall be the chairman, the Deputy Governor, who shall be the Deputy Chairman, two members appointed by the governor from among the staff, and four other members who have knowledge, experience and expertise in matters relating to finance, banking and fiscal and monetary policy, appointed by the Minister. Of the four members appointed by the Minister, at least 2 of them shall be women. Such members shall hold office for a period of 3 years and shall be eligible to be reappointed for one additional term. Section 5 provides that the bank shall have its head office in Nairobi, but during a time of national emergency, the Bank may, unless the President otherwise directs, establish its head office temporarily or permanently in any other place within Kenya. The Bank can also open or close branches in any place within Kenya and may, with the approval of the Minister, open or close branches outside Kenya. 129 Lastly, section 7 (1) provides that the Bank shall not be liable to any taxation imposed by any law in respect of income or profits. Subsection (2) states that no duty shall be chargeable under Stamp Duty Act in respect of any instrument executed by or on behalf of or in favour of the Bank. Part3 Capital and Reserves The Bank was established with an initial capital of Ksh.26 million, however, by the Act of No. 9 of 1996 the Banks authorized capital has been increased to Ksh.5 billion. This amount may be increased by such amount as shall be determined by the Board in consultation with the minister. Section 8 (2) of the Central Bank Act vests the capital of the Bank in the permanent secretary to the treasury who is said to have ownership of the entire capital. Section 8 (4) provides that the share capital of the bank shall not be reduced. It may however be increased by such an amount payable out of the general reserve fund as the board shall direct having regard to the amount assets exceed it liabilities. Section 9 (1) provides that the bank shall establish land maintain a fund designated as the ‘General Reserve Fund’, to which it shall be transferred at the end of each financial year at least 10% or any other amount as the board, in consultation of the minister, may determine of the net annual profits of the bank. Management of Central Bank of Kenya Central Bank of Kenya is run by the Board of Directors of the Bank. The Board shall consist of the following section 11 (1): a) The Governor, who shall be the chairman. b) The Deputy Governor, who shall be the deputy chairman. c) The permanent secretary to the Treasury who shall be a non voting member. d) Five other non-executive directors. Sub section (2) provides that all but the permanent secretary shall be appointed by the president (permanent secretary gets automatic appointment) and shall hold office for terms of 4 years each but shall be eligible for re-appointment. The governor and deputy governor shall each hold office for not more that two terms. Sub section (7) provides that a person shall be eligible to be appointed to the board of: a) He is a citizen of Kenya. b) He is knowledgeable or experienced in monetary, financial, banking and economic matters, or other disciplines relevant to the functions of the bank. The appointment of the board members is staggered in-order to ensure continuity. Subsection (4) provides that a member of the board may resign by writing to the president and such resignation shall take effect one month from the date of receipt of letter of resignation by the president. Any vacancy in the office of the Governor, deputy Governor or director that occurs before expiry of term shall be filled by the president by appointment of a replacement. Where the Governor, Deputy Governor or a Director is unable to perform the functions of 131 his office on account of temporary incapacity which is likely to be prolonged, the president has powers to appoint a person to act in his place during his time and shall have full power of the replaced member. Section 14 (1) lists the following persons not to qualify for appointment to the board:a) Sitting Member of Parliament. b) Salaried employee of any Public body (except on secondment basis) c) A director, officer or employee of any Bank of Financial Institution. d) A sitting Councilor whether nominated or elected of any local authority. Section 14 (2) outlines the conditions under which the president shall terminate the appointment of Governor, Deputy Governor or a director as follows: a) If any of them become a subject of the disqualification under section 14 (1) above. b) Is adjudged bankrupt. c) Is convicted of an offence involving dishonesty or fraud or moral turpitude. d) Is found to be of unsound mind. e) Is absent, for any reason, in capable or incompetent of properly performing the functions of his office. The appointment of the Governor shall not be terminated under this section until the question of his removal from office has been referred to a tribunal appointment by the president. The tribunal has to recommend to the president that the Governor ought to be removed for incapability or incompetence. The Governor The Governor is an appointee of the president and he is the chair of the Board and CEO of the Bank. As CEO of the Bank, the Governor shall subject to the Central Bank policy guidance of the Board: i) ii) Be responsible for the management of the Bank. Be responsible for the organization, appointment and dismissal of the staff of the bank. iii) Have authority to incur expenditure for the Bank within the budget approved by the board. iv) Be a principle representative of the Bank in its relations with other bodies and persons. v) Represent the bank in legal proceedings to which the bank is party either directly or by the counsel. vi) Sign contracts, bank notes, and security reports, balance and security reports, balance sheets and other financial statements, correspondents and documents of the bank. The Act does not stipulate any qualification for appointment as governor save for qualification under section 11 (7) that relate to the governor as a Director of the Bank. This omission is intended to give the president a free hand in making the appointment. However, given the increased powers of the central Bank and its new role in the management of the national economic and the emergence of a globalized financial system, there is a clear need for setting clear qualification criteria for the Governor. Once appointment governor can be removed from office for same reasons as those that 133 apply to Directors under section 14 (2). Part 4: Currency Section 19 (1) of the Central Bank of Kenya Act establishes the Kenyan shilling as the country’s unit of currency. Prior to the amendment by Act No. 9 1996, the value of the shilling was to be determined by the president an advice by the Central Bank of Kenya. Following the amendment, section 20 of the Act now reads, “the external value of the Kenyan shilling shall be determined by the market” this means the shilling has to find level on the international market relative to the value of Kenyan exports into that market. Section 22 of the Act vests the power to issue notes and coins in Kenya to Central Bank and that those notes and coins shall be legal tender in Kenya. The Bank also has powers to withdraw any notes or coins issued by the Bank subject to following the right procedure with respect to notice, time and exchange at face value. Section 24 provides that the Bank shall not be obliged to exchange any note or coin which is mutilated defaced, soiled or otherwise defective, and the condition subject to which the Bank as a matter of grace exchange any such note or coin shall be within the absolute discretion of the Bank. The Central Bank of Kenya is the primary authority for the issuance of bills of exchange but section 25 recognizes the right of other persons and or institutions to issue such bills. Part 6: External Relations External economic relations are pegged to the capacity of the country to deal and transact the country to deal and transact in international markets. This capacity is in turn determined by the level of the country’s foreign researches on external assets and holdings. The creation and maintenance of these reserves and holdings is a major functions of the Central Bank of Kenya. By section 26 the Central Bank is enjoined to ensure that at all times the country shall have external assets in an aggregate amount of not less than the value of 4 months imports recorded and averaged for the last 3 proceeding years. These assets shall consist of: a) Gold; b) Convertible foreign exchange in the form of; (i) Demand or time deposit with foreign Central Banks, or with Bank’s agents or correspondents outside Kenya; (ii) Documents and instruments customanly used for decision making of payments or payments or transfers in International transactions; (iii) Notes and coins; c) Convertible and marketable securities of, or guaranteed by, foreign governments or international financial institutions. To enable the Central Bank build up external assets and research, it is empowered by section 27 of the Act to trade in gold and foreign exchange and to invest its foreign currency holding in short term foreign securities. 135 The bank may engage in foreign exchange transaction with any of the following institutions:1. Specified banks. 2. Public entitles. 3. Foreign Central Banks or foreign financial institutions. 4. Foreign governments or agencies of foreign governments. 5. International financial institutions. 6. Any other person or body of persons whom the minister on the recommendation of the Central Bank may by notice on the Kenyan Gazette prescribe for this purpose. The Central Bank is also empowered to: a) Open and operate accounts for foreign Central Banks, foreign Banks and foreign financial institutions. b) Administer any law relating to exchange control in Kenya. c) Administer any payment agreement entered into by Kenya, and for this purpose the bank shall be consulted by the government in negotiating any payment agreement. d) Be the fiscal agent for all government transactions with international transactions with international financial institutions of which Kenya is a member or with which it is in association. e) Be the depository of Kenyan Currency holdings owned by international financial institutions of which Kenya is a member or with which it is in association. Part 7: Relations with Specified Banks Section 2 of the Central Banks Act “a licensed bank within the meaning of Cap. 488 which is specified by the Central Bank of Kenya for the purposes of this Act”. In effect therefore all Banks operating in Kenya are specified Banks under the Central Bank of Kenya Act. Section 33 (1) provides that Central Bank shall open account for and accepts deposit from collect monetary claims for and on account of instructions and generally act as banker to institutions. The bank may provide additional services or facilities it considers desirable including facilities for clearing financial instruments to institutions operating in Kenya (section 34 (2). The bank may grant loan or advances for fixed periods not exceeding 6 months to specified banks which pledge treasury bills or other Government securities specified by the bank (section 36 (1)). The bank may determine the general terms and conditions under which it extends credit to specified banks, and in particular, the Bank shall determine and announce the rates of interest it shall charge for granting loans or advanced to specified banks and may determine different rates for different classes of transactions. The Bank shall publish the lowest rate of interest it charges on loans to banks and that rate shall be known as the Central Bank Rate. Section 38 (1) provides that the Bank may from time to time require institutions to maintain minimum cash balances on deposit with the Bank as reserves against their deposit and other liabilities. Subsection (4) provides that the Bank may impose on any institution which fails 137 to maintain the sufficient minimum cash balances required, a penalty interest charge not exceeding one percent per day on the amount of deficiency or ten thousand shilling, which ever is higher. To facilitate the Banks supervision and regulation of specified Banks, section 43 (1) provides that every specified bank and specified financial institution shall furnish to the bank at such time and in such manner as the bank may prescribe, any information and data, the bank may require for the proper discharge of the functions of the Bank under this Act. Section 43 (2) indicates that the Bank may publish in whole or in part, at such times and in such manner as it may decide, any information or data furnished under this section provided that no such information shall be published which would disclose the financial affairs of any person or undertaking unless prior consent in writing has been obtained by the bank. Part 8: Relations with Public Entitles The Bank shall act as a fiscal agent of and banker to the government. It may also perform the functions of fiscal agent and banker for any other Public entity in accordance with, and within the scope determined by any special arrangements made between the bank and the public entity concerned. According to section 45, the Bank in its capacity as fiscal agent and banker to any public entity may, subject to the instructions of that public entity: a) Be the official depository of the public entity concerned and accept deposits and effect payments for the account of that public entity. b) Maintain and operate special official accounts in accordance with arrangements made between the Bank and the public entity concerned. c) As an agent of the government, administer the public debt including the assurance of payment of interest on and redemption of bonds and other securities of the Government. d) Pay, remit, collect or accept for deposit or custody of funds in Kenya or abroad; e) Purchase, sell, transfer or accept for custody cheques, bills of exchange and securities; f) Collect the proceeds, whether principal or interest, resulting from the scale for, or accruing to the interest of, a public entity of securities or other property. g) Purchase, sell, transfer or accept for custody gold or foreign exchange. Section 46 (1) provides that the Bank may make direct advances to the government for the purpose of offsetting fluctuations between receipts form the budgeted revenue and payments of the government. Subsection (2) notes that each advance made by the government shall: a) Be secured with negotiable instruments issued by the government which mature within 12 months, b) Bear interest at market rate; c) Be made solely for the purpose of providing temporary accommodation to the Government. Section 46 (3) maintains that the total amount outstanding at any time of advances shall not exceed 5 per cent of the gross recurrent revenue of the government as shown in the 139 Appropriation Accounts for the latest year for which those Accounts have been audited by the Controller and Auditor – General. The Central Bank’s prohibited from extending any Credit directly or indirectly to any Public entity (section, 49). The functions of the Central Bank as advisor to the Government are spelt out in section 50. The Bank has the duty to advice which in its opinion is likely to affect the achievement of the principal objects of the Bank as specified in section 4. The Bank may provide such advice on its own on any matter which the Bank is concerned or at the request of the minister. Such advice may include any particular measures, situation or transactions, or on monetary, banking and credit conditions in or outside Kenya, and the Banker shall give its advice accordingly. Part 9: Miscellaneous Provisions Section 52 outlines prohibited operations and provides that the Bank shall not: a) Save, engage in trade, own or acquire any direct interest in any commercial, agricultural, industrial or similar undertaking, except in the course of obtaining satisfaction for any debt due to the Bank, and such interest shall be disposed of at the earliest suitable opportunity; b) Purchase, acquire, or at least immovable property for commercial purpose or as an investment, except for its own business employees; c) Draw or accept bills payable otherwise than or demand; or d) Guarantee any loan, advance, or investment. requirements or for the use of its Section 53 determines the financial year of the Bank being the same as the Governments financial year and the accounts of the Bank shall be closed at the end of each financial year. Within 3 months after the close of the financial year the bank shall submit to the minister a report on the Bank’s operations throughout that year, together with the balance sheet and the profit and loss account as certified by auditors appointment by the Bank and approved by the minister. *******************************END********************************* 141
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