This blog post is the second instalment of our two-part series covering our June 2021 Trade & Export Finance Webinar, "Payments, Problems and Practical Solutions for Trade and Export Finance Transactions".

Following on from our recent coverage of the Revlon loan dispute[1], we briefly consider the nature of payments, as well as the consequences of making an erroneous or late payment. We also address the ways in which parties risk payments being diluted by virtue of forces beyond their control or as a result of common contractual provisions.

What constitutes a payment?

While parties generally understand "payment" to refer to the transfer of money from one party to another to denote the performance or discharge of an obligation to pay, in most instances, payment does not actually involve a physical cash transfer. The reality is that, in most major economies, the exchange of notes and coins comprise just a tiny fraction of the payments made on a day-to-day basis. Instead, large-scale payments typically involve the exchange of credit claims/commitments between commercial banks.

English case law is filled with examples of payment disputes, all of which provide guidance on what constitutes a payment. For instance, a payment required to be made "in cash" has been held to have been satisfied where it was made by bank transfer (as opposed to an actual cash payment).[2] Another factor, held to be relevant by the courts, in determining whether or not a payment has taken place is whether such payment was initially accepted by the payee without objection.[3]

What happens if I make a payment by mistake?

Given parties' general reliance on payment via bank transfer, many will be relieved to hear that where funds are mistakenly transferred, English law generally entitles the payor to recover the money from the payee. This is on the proviso that the payor can demonstrate that:

  1. they did not intend for the payee to have the money;
  2. the money was not paid for "good consideration", i.e. the payee did not provide anything of value in exchange for the payment; and
  3. the payee did not change their position in good faith or otherwise rely on the erroneous payment.[4]

If any of these elements are not satisfied, however, there are grounds for the payor's claim for recovery to fail, for instance where the payment discharged a debt owed to the payee by the payor or a third party authorised to discharge the debt.

In the case of erroneous payments made by a bank without its customer's consent, as a matter of English law, the payment will generally not be held to have discharged the customer's debt, unless the payment is subsequently ratified by the customer. This is on the basis that the payee would be unjustly enriched. (Please see our recent blog post "What happens if you make a payment in error? – The LMA responds to the Revlon loan dispute" for more on erroneous payments.)

What happens if I make a late payment?

It is a basic principle of English law that a failure to pay on time constitutes a default that cannot be cured by late payment, unless the late payment is accepted by the payee. In other words, acceptance/processing of the late payment by the payee's bank merely constitutes an administrative act that can be reversed by the payee instructing its bank to stop the transfer.[5]

Under English common law, where late payment is made, the payee will typically be entitled to damages, the purpose of which is to compensate the injured party for its financial loss (e.g. costs that would not have been incurred but for the breach or forgone profits), not to punish the party in breach.

Parties looking to achieve some contractual certainty might elect for a liquidated damages clause, whereby a fixed sum is payable upon late payment. Including a liquidated damages clause can often provide clarity on how much the innocent party will be entitled to upon a breach and potentially eliminate the need to prove any actual loss was suffered (although it is worth bearing in mind that this may cut the other way with liability being limited to the stipulated sum, even if it is less than the actual loss). Default interest provisions are a subset of liquidated damages and are commonly included in loan agreements. They typically require payment of interest (usually 1% or 2% above the applicable interest rate) in the event of a non-payment and are intended to compensate a lender for costs and losses incurred as a result of the late payment.

Where parties elect to include a default interest provision or some other liquidated damages clause, they will need to ensure that the clause does not inadvertently qualify as a penalty. Penalty clauses impose a detriment on the party in breach that is disproportionate to the legitimate interests of the innocent party, e.g. requiring the party in breach to pay an excessive sum unrelated to the actual harm caused with a view to punishment. The rule against penalties is sparingly used by the courts and considered an exception to the general principle that contracts entered into between sophisticated parties should be enforced in accordance with their terms.

Where a clause is held to be a penalty, it will not be enforced beyond the actual loss suffered by the innocent party. This is a rich area of case law, and ultimately, whether or not a clause constitutes a penalty will turn upon its commercial context. However, parties should aim to ensure that the clause protects a legitimate business interest and that the proposed remedy is not extravagant or unconscionable. To this point, a liquidated damages clause is less likely to be considered extravagant where it represents a genuine pre-estimate of damage calculated at the time the contract is agreed.

The dilution of payments

Parties should also be aware of the various ways in which payments might be reduced, discharged or delayed due to forces beyond their control or as a result of common contractual provisions:

  1. Sanctions – Intended to fight financial crime, terrorist financing and money laundering, sanctions may result in payments being blocked, assets being frozen or a party taking unilateral action to either make partial payment or no payment at all. To ensure that agreements are entered into with eyes wide open, parties should: (i) conduct due diligence internally to ensure that both financial and trade sanctions are adhered to; and (ii) stay up to date on applicable sanctions to avoid contracting with sanctioned individuals or entities. Thought should also be given to any sanctions clauses that might be contained in conditions precedent, representations, compliance undertakings and events of default (to name a few).
  2. Withholding tax – Lenders should be aware that withholding tax may apply to certain claims of payment (such as interest payments), which will result in them receiving less money than expected. One practical solution would be to require borrowers to take on the risk of such a tax applying and to "gross-up" the payment, to ensure that such payments are not reduced, discharged or delayed. Due diligence should be conducted to ensure that "gross-up" provisions are enforceable in any relevant jurisdictions.
  3. Bail-in – Bail-in provisions cover certain types of liability owed by a financial institution (FI). In the event of a restructuring or some other warning sign as to the FI's financial health, the relevant regulator may take action to write down or convert the FI's liability with the result that any payments to be made by the FI will be reduced. While recognition of bail-in has become increasingly prevalent in loan agreements, parties should always undertake sufficient due diligence on finance parties and closely consider the deal structure.
  4. Netting – Netting typically occurs where two parties are liable to each other for payment, with one party's liability being greater than that owed by the other party. A payment netting clause might stipulate that both liabilities are replaced by a single payment obligation on the payor, with the party owing more to pay the excess amount to the other party. Although there are some practical benefits to netting arrangements (and to the related right of set-off), these arrangements may not be suitable or appropriate for all transactions. Parties should consider carefully whether or not such arrangements should be included in their contractual agreements on a case-by-case basis.

It is recommended that parties always conduct the necessary due diligence well in advance of finalising contracts in order to avoid any unwelcome surprises when payment subsequently becomes due.