Friday, January 11, 2013

Legal tender 101


The trillion dollar coin debate has inspired a lot of chatter about legal tender, not all of it correct. The best source on the meaning of legal tender is Dror Goldberg (the same Dror Goldberg from my Yap Stone post). His paper, Legal Tender is short and concise. Give it a read. This post is largely based off his work.

First off. If someone offers to pay you in legal tender, say a US platinum coin, are you obligated to accept it? The answer is no.

When a medium-of-exchange is denoted as legal tender, that means that it must be accepted in the discharge of certain types of debt. If you are engaged in an exchange with someone that doesn't involve the settling of debts, then legal tender laws don't apply. For example, say you walk into a corner store and offer to pay for cigarettes using legal tender platinum coins. The store owner can legally refuse to accept the coins. After all, the two of you are not settling debts—you're engaging in a spot transaction. The owner is on the right side of the law in requiring payment in, say, peanuts. Either pay him in peanuts or walk out of the store without your smokes.

According to Goldberg, legal tender laws start with non-spot transaction—those transactions in which goods & services are provided prior to final settlement, thereby creating a debt. Legal tender laws require that a creditor accept legal tender as settlement for most types of debt contracts (not all, see next paragraph). What qualifies as legal tender? In the US this includes all United States coins and currency, as well as Federal Reserve notes. In Canada, coins produced by the Royal Mint and notes issued by the Bank of Canada are legal tender (see the Currency Act). Private bank deposits are not legal tender in the US or Canada, nor are traveler's cheques or credit cards. Creditors needn't accept cheques or credit cards.

Creditors can structure contracts to avoid the obligation of accepting legal tender. All it takes is that both parties to a debt contract agree ahead of time that some alternative medium will be used to settle the debt. Say a debtor and creditor have agreed to settle three months from now in bitcoin. If after three months have passed the debtor offers to settle with a legal tender platinum coin, the creditor can refuse to accept the coin since the contract specifies BTC. Private agreement trumps legal tender laws.

Even if no alternative media has been chosen to discharge a debt, in certain situations a creditor can still refuse legal tender. In Canada, for instance, the Currency Act specifies that while $2 coins (toonies) are legal tender, they need not be accepted in the settlement of debts over $40. If a debt is larger than $25, the creditor can refuse twenty-five $1 coins (loonies). In India, a half rupee coin is only legal tender for debts less than ten rupees, which means that a creditor can refuse to accept more than twenty half-rupee coins. (See this RBI page.)

Over the years, governments have set some odd commodities to serve as legal tender. In his book Legal Tender (1903) Samuel Breckenridge notes that in 1631, the governor of Massachusetts declared that corn was to pass in payment for all debts at the market rate, unless money or beaver had been stipulated in the contract. Breckenridge goes on to write:
A little later bullets were ordered to be taken, being rated as equal each to a farthing, though no man was to be forced to take more than 12d in any one payment in this form. In 1643, likewise in Massachusetts, wampum [shell money] was given the debt-paying quality within the value of 40s at the rate of four pieces of black or eight pieces of white to a penny. Similar legislation was enacted in Connecticut and Rhode Island. In Virgina and Maryland tobacco was the commodity most universally desired, and so, in 1633, Virginia enacted that, while contracts, judgements, etc., should be reckoned in English money, they should be paid in tobacco. And a century later Maryland made tobacco a legal tender at a penny a pound, and corn at twenty cents a bushel. In North Carolina corn, pitch, tar, pork were also used at specified rates. Thus, in 1715 any one of seventeen commodities named might be used as a legal tender or in payment of taxes. (Pg 53).
Here I'm obligated to present the alternative view to Goldberg, of which Breckenridge himself provides a decent example. In his book, Breckenridge adopts the common view that legal tender laws applies to all transactions, whether these be time (credit) or cash (spot) transactions. Writes Breckenridge:
in general, it may be said that both gold and silver coins were a lawful tender; that in cash transactions the buyer, in time transactions the debtor, had the right to select the form of money to be employed. In the case of cash transactions it was found necessary to supplement this law by penal legislation and by legislation regulating prices. But in the case of time transactions, the civil power of the courts was an adequate sanction.
Who is right? Here's a quote from the Richmond Fed that settles the matter, at least in its modern US context:
However, no federal law mandates that a person or an organization must accept currency or coins as payment for goods or services not yet provided. For example, a bus line may prohibit payment of fares in pennies or dollar bills. Some movie theaters, convenience stores and gas stations as a matter of policy may refuse to accept currency of a large denomination, such as notes above $20, and as long as notice is posted and a transaction giving rise to a debt has not already been completed, these organizations have not violated the legal tender law.
It would seem that Goldberg is correct. In spot transactions—those in which a debt hasn't been created—legal tender laws don't apply. No one needs to accept your trillion dollar coin or Federal Reserve note. At least not over the counter.

18 comments:

  1. One thing that's clear is that legal tender means you can use it to pay taxes.

    Which automatically makes $1 of legal tender worth (close to) $1, even if you can't deposit it in a bank.

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    1. It's also clear to me that you can use it to pay off your bond, your credit card bill, or your utility bill. Why is taxation the "one" thing that is clear to you?

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    2. Because there's no issue of what the fine print in the contracts say. It's just a question of public law.

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    3. Ok, I see what you're saying. Not just taxes, I suppose, but any debt one owes to the government, say fees or fines. The existence of any obligation to government means $1 of legal tender = $1

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  2. Another interesting post, JPK. I dare say the precise nature of legal tender laws varies from country to country, but the key point is that such laws generally do not REQUIRE the use of the currency concerned, and therefore do not underpin the value of the currency as much as many suppose. Max should note that, while it may be true that taxation provides an outlet for existing dollars that may support the value of the currency (not necessarily in real terms) that is not the same as saying that the government can pay for what it wants to buy in dollars. A government which abuses its country's currency can still find that the use of that currency dwindles whether it formally levies taxes in that currency or not.

    I was working on a post on this subject eighteen months ago! It's about time I returned to blogging myself.

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    1. Yes Rebel, you need to get back in the saddle.

      "...key point is that such laws generally do not REQUIRE the use of the currency concerned"

      Agreed. Society could easily "hack" around legal tender laws by always specifying alternative settlement media in contracts. Which makes me wonder, why are free-bankerish types like me always complaining about legal tender laws if they're so easy to bypass?

      "...therefore do not underpin the value of the currency as much as many suppose"

      Agreed. I'm still brooding over this and will write something next week about how legal tender laws affect an item's value. My initial hunch is that legal tender laws contribute to the liquidity of an already-valuable item, thereby giving this item an extra premium in the market. Can legal tender laws give an absolutely valueless item (say yellow bits of government paper) value? I'll leave that one hanging.

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  3. I agree that legal tender laws usually do not directly force you to use a particular currency in trades, contrary to what many "blog-austrians" claim.

    However, legal tender laws do have some softer effects which put other currencies at a comparative disadvantage. The more important ones (in my opinion) are laws about accounting, taxation and banking.

    If you are a business, you must conduct your accounting in legal tender (i.e. the laws prescribe your unit of account). This alone does not preclude you from running a separate accounting in a different unit (e.g. for cost-accounting purposes), but it increases the costs of doing so.

    You are also forced to use particular rules when accounting other media of exchange for calculating your profit/loss for tax purposes. Exchange rates you have to use for calculations for most foreign currencies are often prescribed by the central bank, and the profit from exchange rate difference of foreign to local currency is subject to taxation (in the USA, apparently you can't offset losses from forex, but this appears to be an oddity, as in Europe you can do that). This at best diminishes the advantages of using a less depreciating currency (the gains are taxed). You may avoid it by not exchanging foreign currency for legal tender.

    Last but not least, banks give, for one reason or another, preferential treatment to accounts denominated in legal tender. One such example is SEPA. Also, using a debit/credit card denominated in another currency incurs additional forex costs.

    All this increases transaction costs of trading with non-legal tender. Typically this is enough to ensure people don't switch for national transactions (vendor lock-in). But a significant technological advantage (e.g. Bitcoin) might provide a sufficient comparative advantage to motivate a switch.

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    1. Interesting facts. I wasn't aware that there were laws prescribing a business's unit of account. Do you have any links?

      I think we need to differentiate between legal tender laws and the accounting laws you're referring to. Legal tender laws only apply to the discharge of debts. If you are keeping your books in a non-permitted unit of account, you wouldn't necessarily be tried using legal tender law (at least not the laws I've found) since you aren't refusing outright to accept legal tender to settle debts. For instance, say a business always accept legal tender but books that income in a foreign unit of account... in this case the business is not breaking legal tender laws.

      I do agree that legal tender laws do create switching costs.

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    2. I recall making similar comments on your medium of account posts. While I don't actually know, it makes sense to me that it should be a legal requirement to express your accounts in legal tender, because this is the best that you can guarantee to receive in settlement of your debt assets, and you would not choose to anything more valuable in settlement of your own liabilities. Any other medium of account does not present a true and fair picture of a business.

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    3. I researched and it looks like in some cases, you may choose to use a different currency than legal tender, but these are of limited applicability (e.g. subsidiary of a foreign company, or non-resident entities). The technical term is "functional currency" and even though I couldn't find it explained explicitly, it looks like it still must be a legal tender in some area (i.e. even if I fulfill the exceptions to local legal tender, I still can't use gold grams or Bitcoin as a unit of account for tax purposes at the moment). Here is the info I found:

      http://www.fasb.org/summary/stsum52.shtml (USA)
      http://www.cra-arc.gc.ca/tx/bsnss/tpcs/crprtns/fnctcrncy/menu-eng.html (Canada, since I recall you live there)

      http://www.ifa-cr.cz/en/documents/foreign_exchange_moudry.pdf (Czech Republic, must use legal tender as a unit of account, I chose this as this is the only example where I found an explicit reference to legal tender)

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    4. It seems that accounting rules (IAS 21) expect, but do not compel, company accounts to be presented in "the currency of the primary economic environment in which the company operates": http://www.hmrc.gov.uk/manuals/cfmmanual/cfm64110.htm

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    5. RebelEconomist, check out http://www.hmrc.gov.uk/manuals/cfmmanual/CFM64120.htm

      "The company must compute its CT profits or losses by reference to its functional currency. The profit or loss is then translated into sterling for tax purposes."

      And as I stated above, you may only use a different functional currency than the local one in exceptional circumstances.

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    6. Thanks for the links. I have a feeling that unit-of-account laws (or the lack thereof) probably varies a lot from country to country, much like legal tender laws.

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    7. I would say that allowing a normal guy to use a different UoA is more an exception than a rule, but alas I do not consider myself an expert in this area. This is what I found:

      http://en.wikipedia.org/wiki/International_Accounting_Standards#Adoption_of_IFRS

      "IFRS are used in many parts of the world, including the European Union, India, Hong Kong, Australia, Malaysia, Pakistan, GCC countries, Russia, South Africa, Singapore and Turkey. As of August 2008, more than 113 countries around the world, including all of Europe, currently require or permit IFRS reporting and 85 require IFRS reporting for all domestic, listed companies, according to the U.S. Securities and Exchange Commission."

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  4. "Legal tender laws require that a creditor accept legal tender as settlement for most types of debt contracts"
    Not quite technically correct. A debtor cannot compel his creditor to accept payment. A debtor may tender the country's legal tender as payment and have the creditor refuse to accept it. The legal significance of having tendered legal tender (rather than say USD) is that if the creditor later sues for payment the creditor will not be entitled to interest for the period following the date when the tender of payment was refused.
    (In the commercial world we sometimes see creditors refusing a tender where the tender is late and the creditor wishes to preserve rights that would disappear if they accepted the payment.)
    Peter in Fiji

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  5. "If after three months have passed the debtor offers to settle with a legal tender platinum coin, the creditor can refuse to accept the coin since the contract specifies BTC. Private agreement trumps legal tender laws."

    If the creditor then sues for breach of contract, would a court compel the debtor to pay in BTC? Or would the damages themselves be denominated in legal tender?

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    1. Good stuff on bitcoin, by the way.

      It seems to me that the court would have to compel the debtor to pay in BTC if the contract stipulated BTC. If not, what would ever be the point of pre-negotiating a private agreement to render a non-legal tender settlement media like BTC? A debtor could always go to court and get the debt re-denominated.

      Note that if you're actually trying to collect on a non-legal tender denominated debt, don't take this blog as your final source for legal advice, best go ask a lawyer. ;)

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  6. Thank you. I certainly had fun writing it.

    I am certain I read somewhere that "U.S. courts will refuse to enforce contracts requiring payment in gold." It was probably written by a gold bug and not, say, a lawyer... But I wonder whether there is any truth to the claim.

    It would be nice to hear from a lawyer on this one, I think.

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