Clayton’s Rule

When there are several debts to one person, and the debtor makes an insufficient payment to discharge all his debts, it is essential to understand how the payment will be adjusted. This article will discuss what Clayton’s rule is, what is right to appropriation, appropriation by the debtor, creditor, and law, and Clayton’s rule applies to which type of loan accounts.

What is Clayton’s Rule?

Clayton’s rule is based on the maxim “Quicquid solvitur, secundum modum solventis” meaning whatever is paid, is paid according to the intention or manner of the party making payment. Therefore, when the debtor makes a payment, they may direct how the money should be appropriated, and the creditor has no right to alter it without the debtor’s consent. It was first laid down under the Devaynes Vs. Noble case.

As per Clayton’s Rule, each withdrawal made in a cash credit account is considered a new loan, and each deposit made to repay the loan will be applied in the order of the loan taken.

In simple words, the first debit in the account will be discharged by the first credit deposited, and likewise, other entries will be released in chronological order. Hence, it is also called the first-in, first-out principle. In India, this rule is applicable based on the Indian Contract Act, 1872. However, now bankers close the operation of accounts in case of insolvency or death of a partner/ joint account holder/ guarantor.

Devaynes Vs. Noble (1816) 35 ER 781

In this case, Mr Clayton had an account with a partnership banking firm named Devaynes, Dawes, Nobel, and Co. One of the partners, named William Devaynes, died. The amount due to Mr Clayton was £1,717. After that, the surviving partners paid more than the said amount to Mr Clayton. Later, Mr Clayton also further deposited with the firm. The banking firm had gone bankrupt. Mr Clayton had also claimed the money.
The learned Judge Sir William Grant, Master of the Roll, held that the deceased partner’s estate would not be liable to Mr Clayton. The payment that the surviving partner made was more than the amount due and would be considered as a discharge of liability of the firm at the time of death of a partner.

The court had laid down the following rules –

a) Where the debtor owes the creditor, the debtor has the right to appropriate the payment to discharge any debts.
b) If the debtor at the time of payment does not expressly or impliedly directs the appropriation of payment, then the creditor has the right to appropriate the payment.
c) If the debtor or creditor fails to indicate any appropriation of payment, then appropriation is made as per law, according to the entries made in the account. The first entry on the debit side is the entry discharged or reduced by the first entry on the credit side.

What is the right to appropriation?

Appropriation means the application of payments.

Clayton’s rule’s applicability in India is based on Section 59-61 of the Indian Contract Act, 1872, which lays down the principle for applying the payment to a particular debt.

Appropriation by the debtor – Application of payment where debt to be discharged is indicated – section 59

If a debtor owes several debts to one person, make payment to him, express or implied, under certain circumstances indicating that the payment should be applied to discharge a particular debt. Therefore, the payment received should be applied accordingly. Under this principle, the right of appropriation is given to the debtor. Once the appropriation is made, it cannot be reversed.

Example: A owes B several debts, of which he owes Rs 4000 upon a promissory note to be paid on 1st August. A pays B Rs. 4000. Now, there is only one debt of that amount. Therefore, the payment will be applied to the discharge of the promissory note.

Appropriation by creditor – Application of payment where debt to be discharged is not indicated – section 60

If the debtor owes several debts and fails to intimate or indicate which debt has to adjust with the payment made while paying his debts. Then, the creditor has the discretion to apply the payment to any lawful debt that is due and payable by the debtor, irrespective of whether any suit of limitation bars the recovery. Under this principle, the right to appropriation is given to the creditor.

Suppose Mr. A has four loan accounts in a bank. He gives the banker Rs. 1Lakh to be deposited in his account but did not indicate which version he wanted the amount to be deposited. In the absence of any direction given by A, the banker deposits the said amount in account No.3. Later, A insisted that the amount should be deposited in account No. 1. As per the principle, the creditor has the right to use its discretion to deposit the amount in the absence of any direction given by the creditor.

In State of Gujarat Vs. Bank of Baroda, 1997, the debtor fails to indicate which loan he wants to appropriate the payment while making payment to the bank. The court had held that the appropriation by the bank was held to be proper under section 60.

Appropriation by law – Application of payment where neither party appropriates – section 61

If the person has more than one loan account, neither party (debtor or creditor) makes an appropriation; the payment will be used to discharge the debts in order of the time they were made. Suppose the debtor has debts of equal standing or value. In that case, the payment should be applied to the setting of each debt proportionately. Any payment that the debtor makes will be first applied to clear the interest and later towards the principal amount unless it is agreed to the contrary.

This section can be broken down into three parts to grasp it more clearly –

i. Payment will be discharged in order of the time they were made means –

If X owes three loans to Y, namely – Rs. 1000 taken on 1st July, Rs. 500 taken on 20th July, and Rs. 1,500 taken on 1st August. Suppose X pays Rs 2000 without stating where to apply for the payment. In that case, the payment shall be appropriated to the first and second loans, and the remaining amount (Rs, 500) will be used towards the third loan.

ii. The money the bank receives will be used to set off against the interest. We can understand this with the help of an example –

Suppose a person has Rs 1000 as the principal amount (initial debit entry) having an interest amount of Rs 100 when the debtor deposits a credit entry of Rs 500. Then, the bank will adjust the interest amount from the credit entry, and the debt will be appropriated accordingly. Therefore, 500 – 100 = 400. Rs 400 will be used against the principal amount (Rs 1000).

iii. Setting of each debt proportionately can be understood clearly with the given example –

X has two loan accounts, and both accounts have an equal number of dues, let’s suppose, Rs 10,000 each. X makes a credit entry of Rs. 5000, and the interest rate is Rs. 100. So, 5000 – 100 = 4900. Then in such a case, both accounts will be adjusted equally, i.e., Rs 2450 each.

However, suppose the person has only one loan account, and such person regularly deposits and withdraws money from it. In that case, the order to set off credit entry against debit entry is in chronological order. Then, in such a situation, the first-in, first-out (FIFO) principle will apply, which is called Clayton’s rule.

Clayton’s rule applies to which types of loan accounts

Clayton’s rule applies to current accounts like cash credit and overdraft (OD) accounts or limit accounts, based on the First in-First out principle. This means the first debit entry will be adjusted with the first credit entry.

How is Clayton’s rule applied?

A Cash Credit (CC) account customer is given the power to withdraw even if there is no credit in his account.

If G has a CC account and is given a 1Lakh DP limit;

Here, from the 500 Credit entry, the first withdrawal of Rs 1000 will be adjusted. Hence, Clayton’s rule of the first in-first out principle will be applied.

Let us take another example:

If XYZ partnership firm is given a DP/ CC limit of 1Lakh.

ABC bank goes for recovery from XYZ firm. Now, the question arises as to who has the liability to pay the amount. All the partners have the liability to pay the bank. The total to be paid is 75,000. So, 75,000 divide by 3 = 25,000 each. Here, X died, and the remaining partners deposited Rs. 37,500. This credit amount would be used to set off the first debit according to the FIFO principle. The balance amount of Rs. 37500 was left to be paid. The balance amount of 37,500 would be divided among 3 to discharge debts per the Clayton rule.

Conclusion

Clayton’s rule deals with appropriation of payment for discharge of debts. Under the Indian Contract Act, the debtor has the right to appropriate the payment in case there is more than one debt due to the creditor. The debtor making payment has the right to direct the creditor to appropriate the payment to discharge his debts. If the debtor fails to direct the creditor, then the creditor has the right to appropriate the debt payment. If the debtor and creditor fail to direct the appropriation of payment, then the appropriation can be made by law. Clayton’s rule is based on the first-in, first-out principle, where the first credit entry made is used to discharge the first debit entry.