International trade presents the perfect challenge—exporters will not ship without guaranteed payment, and importers will not pay without guarantee goods are shipped. Of the solutions innovated in response, the letter of credit has become a faithful mainstay. The importer’s bank makes an irrevocable promise to pay the exporter’s bank if certain conditions are met. This promise can be cash-backed or made on the strength of a separate promise by the importer to repay the bank within certain timelines.
To mitigate risk, banks often prefer to have the cash to pay the exporter before issuing the letter of credit. In some cases, even though the arrangement was made on credit basis, the bank may offer a discount to the importer for prepaying the sums eventually payable to the exporter. This win-win can turn complicated as the Kenya Deposit Insurance Corporation (KDIC) and SBM Bank recently found in a Chase Bank related case.[1]
What happened here?
Chase Bank received discounted pre-payment for a letter of credit it then issued on behalf of an importer. However, before it honoured the letter of credit, the Bank was placed in receivership under KDIC. Meanwhile, the exporter’s bank honoured payment to the exporter and upon maturity of the letter of credit requested reimbursement. Chase Bank was unable to pay, and after several extensions, was sued.
The High Court found there was a resulting trust established in favour of the exporter’s bank because the following conditions were met:
- Intention to Create a Trust – where funds are paid into a separate account for a designated purpose clearly communicated to the recipient, a trust is created in favour of the depositor and the intended beneficiary;
- Priority of Trusts – ordinary creditors have no claim over trust property. Where money is deposited for a specific purpose which then fails, those funds are trust property in favour of the original depositor. They are not part of the recipient’s assets in liquidation, and must be accounted for separately; and
- Traceability and Segregation of Funds – where trust property is misappropriated, the beneficiary (or settlor, where the original purpose failed) is entitled to trace and recover the trust property.
Banks and your money: debtors or trustees?
The divergence arises from whether banks are trustees for deposits or debtors to depositors. Ordinarily, when you deposit money in a bank you are entitled to claim an equivalent amount back, just not the exact same cash you deposited. This lets banks utilize deposits to lend and invest on their undertaking to return them on demand. As a result, ordinary deposits pass ownership of funds to banks. This facilitates circulation and growth of money supply in an economy.
In some cases, ownership will not pass to the bank which will instead hold funds in trust. This ultimately comes down to the reason why the funds were paid to the bank. Money paid to you to pay over to another—much like property handed over for safekeeping—does not belong to you. It becomes traceable and unique property that can only be transferred to its intended recipient, or failing this, its original owner.
Where did this concept originate?
The Quistclose trust arose from a fight over who was entitled to funds borrowed to pay dividends which failed when the company went into liquidation.[2] A company borrowed money to pay dividends, but went into liquidation before it had paid the dividends it borrowed to finance.
The company’s bank was owed money by the company and saw a quick recovery opportunity. Since the funds earmarked for the dividend were not used, it made no sense to let that go to waste. The bank, minding its cents, claimed these funds to recover its debt. However, the lender who provided the funds was of a contrary view. The bank was aware this financing was specifically provided to finance pay the dividend, and therefore its role was to keep the money safe until this was done. Since the intended use failed, it was only right that the funds be returned to the lender.
The English Courts eventually agreed with the lender and ordered the bank to repay the funds. In doing so, they established the principle that where funds are paid over for a specifically disclosed use, they can take on the form of trust property. Accordingly, such funds can only be put to the intended use or returned.
Banks often hold property in trust for its owners, the most common example of this being items stored in their vaults. Such items are not part of a bank’s assets, as it is only keeping them safe for their owners who retain complete ownership over them. Similar to a trustee going into liquidation, the liquidator is required to segregate trust property from the trustee’s assets, trace its owners and return it.
Why does this matter to you?
This decision is an important reminder of the intricacies of dealing with designated funds, and applies to anyone who receives and holds property for another’s benefit. In such circumstances, notwithstanding there was no express discussion on creating a trust, a trust can result by operation of the law. Courts will imply trusts where it is necessary to protect the interests of innocent parties.
Therefore, when receiving assets earmarked for a specified purpose, it is important to segregate them from your general assets. In the unfortunate event you go into insolvency, it will be necessary to trace these trust assets and either apply them to their intended purpose or return them to the original owner.
Lastly, it is important to remember trusts are a creation of the law of equity, and can override written law. Equity is a creation of the pursuit of justice, meant to ensure innocent parties do not suffer injustice because of the limitations of written law. Where the limitations of statute law might result in someone receiving and keeping an unfair benefit, equity will step in.
DISCLAIMER:
This alert highlights legal matters, legislative and policy changes for general use only. It does not create an advocate-client relationship between the sender and its receiver or reader. It is neither legal advice nor legal opinion. You should not act or rely on this briefing without consulting an advocate.
[1] Union De Banques Arabes et Francaises vs. Chase Bank Kenya Limited (In Receivership) and SBM Bank Kenya (Milimani HC. Comm/206/2019)
[2] Barclays Bank Ltd v Quistclose Investments Ltd [1968] UKHL 4
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