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A negotiable instrument is a specialized type of "contract" for the payment of money that is unconditional and capable of transfer by negotiation. Common examples include cheques, banknotes (paper money), and commercial paper.

Differences from a contract

A negotiable instrument is not a contract, as contract formation requires an offer, acceptance,consideration,none of which is an element of a negotiable instrument. Unlike ordinary contract documents, the right to the performance of a negotiable instrument is linked to the possession of the document itself (with certain exceptions such as loss or theft).The rights of the payee (or holder in due course) are better than those provided by ordinary contracts as follows:

  • The rights to payment are not subject to set-off, and do not rely on the validity of the underlying contract giving rise to the debt (for example if a cheque was drawn for payment for goods delivered but defective, the drawer is still liable on the cheque)


  • No notice needs to be given to any prior party liable on the instrument for transfer of the rights under the instrument by negotiation


  • Transfer free of equities—the holder in due course can hold better title than the party he obtains it from


Negotiation enables the transferee to become the party to the contract, and to enforce the contract in his own name. Negotiation can be effected by endorsement and delivery (order instruments), or by delivery alone (bearer instruments). in addition, it includes the rule of a derivative title which does not allow a property owner to transfer rights in a piece of property greater than his own.

Classes

Promissory notes and bills of exchange are two primary types of negotiable instruments.

Promissory note

A promissory note is a written promise by the maker to pay money to the payee. Bank note is frequently transferred as a promissory note, a promissory note made by a bank and payable to bearer on demand. A maker of a promissory note promises to unconditionally pay the payee (beneficiary) a specific amount on a specified date.

A promissory note is an unconditional promise to pay a specific amount to bearer or to the order of a named person, on demand or on a specified date.

A negotiable promissory note is unconditional promise in writing made by one person to another, signed by the maker, engaging to pay on demand, or at fixed or determinable future time, sum certain in money to order or to bearer. (see Sec.194)

A promissory note, briefly stated, is a promise to pay a sum of money.

Original parties to a promissory note.

There are originally two parties in a promissory note. The one who makes the promise and signs the instrument is called the "maker" and the party to whom the promise is made or the instrument is payable is called the "payee"

Bill of exchange

A bill of exchange or "draft" is a written order by the drawer to the drawee to pay money to the payee. A common type of bill of exchange is the cheque (check in American English), defined as a bill of exchange drawn on a banker and payable on demand. Bills of exchange are used primarily in international trade, and are written orders by one person to his bank to pay the bearer a specific sum on a specific date. Prior to the advent of paper currency, bills of exchange were a common means of exchange. They are not used as often today.

A bill of exchange is an unconditional order in writing 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 fixed or determinable future time a sum certain in money to order or to bearer. (Sec.126)

It is essentially an order made by one person to another to pay money to a third person.

A bill of exchange requires in its inception three parties--the drawer, the drawee, and the payee.

The person who draws the bill is called the drawer. He gives the order to pay money to third party. The party upon whom the bill is drawn is called the drawee. He is the person to whom the bill is addressed and who is ordered to pay. he becomes an acceptor when he indicates his willingness to pay the bill. (Sec.62) The party in whose favor the bill is drawn or is payable is called the payee.

The parties need not all be distinct persons. Thus, the drawer may draw on himself payable to his own order. (see Sec. 8)

A bill of exchange may be endorsed by the payee in favour of a third party, who may in turn endorse it to a fourth, and so on indefinitely. The "holder in due course" may claim the amount of the bill against the drawee and all previous endorsers, regardless of any counterclaims that may have disabled the previous payee or endorser from doing so. This is what is meant by saying that a bill is negotiable.

In some cases a bill is marked "not negotiable". In that case it can still be transferred to a third party, but the third party can have no better right than the transferor.

In the Commonwealth

In the commonwealth almost all jurisdictions have codified the law relating to negotiable instruments in a Bills of Exchange Act, e.g. Bills of Exchange Act 1882 in the UK, Bills of Exchange Act 1908 in New Zealand, The Negotiable Instrument Act 1881 in India and The Bills of Exchange Act 1914 in Mauritius. The Bills of Exchange Act:
  1. defines a bill of exchange as: 'an unconditional order in writing, 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 sum certain in money to or to the order of a specified person, or to bearer.
  2. defines a cheque as: 'a bill of exchange drawn on a banker payable on demand'
  3. 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 determinable future time, a sum certain in money to or to the order of a specified person or to bearer.'
Additionally most commonwealth jurisdictions have separate Cheques Acts providing for additional protections for bankers collecting unindorsed or irregularly indorsed cheques, providing that cheques that are crossed and marked 'not negotiable' or similar are not transferrable, and providing for electronic presentation of cheques in inter-bank cheque clearing systems.

The 1911 Encyclopædia Britannica Eleventh Edition has a comprehensive article on the Bill of Exchange, detailing its history and operation, as understood at the time of its publication.

In the United States

In the United Statesmarker, Article 3 and Article 4 of the Uniform Commercial Code govern the issuance and transfer of negotiable instruments. For a writing to be a negotiable instrument under Article 3, the following requirements must be met: 1) The promise or order to pay must be unconditional; 2) The payment must be a specific sum of money, although interest may be added to the sum; 3) The payment must be made on demand or at a definite time; 4) The instrument must not require the person promising payment to perform any act other than paying the money specified; 5) The instrument must be payable to bearer or to order.

The latter requirement is referred to as the "words of negotiability": a writing which does not contain the words "to the order of" or indicate that it is payable to the person in possession, is not a negotiable instrument and is not governed by Article 3, even if it has all of the other features of negotiability. The only exception is that if an instrument meets the definition of a cheque (a bill of exchange payable on demand and drawn on a bank) and is not payable to order (i.e. if it just reads "pay John Doe") then it is treated as a negotiable instrument.

Persons other than the original obligor and obligee can become parties to a negotiable instrument. The most common manner in which this is done is by placing one's signature on the instrument: if the person who signs does so with the intention of obtaining payment of the instrument or acquiring or transferring rights to the instrument, the signature is called an indorsement. An indorsement which transfers the instrument to a specified person is a special indorsement. An indorsement by the payee or holder which does not contain any additional notation (thus making the instrument payable to bearer) is a indorsement in blank. An indorsement which requires that the funds be applied in a certain manner (i.e. "for deposit only", "for collection") is a restrictive indorsement.

If a note or draft is negotiated to a person who acquires the instrument i) in good faith ii) for value iii) without notice of any defense to payment, the transferee is a holder in due course and can enforce the instrument without being subject to defenses which the maker of the instrument would be able to assert against the original payee, except for certain real defenses which are rarely applicable. These real defenses include forgery of the instrument, fraud as to the nature of the instrument being signed, alteration of the instrument, incapacity of the signer to contract, infancy of the signer, duress, discharge in bankruptcy, and the running of a statute of limitations on the instrument.

The rule is what makes the free transfer of negotiable instruments feasible in the modern industrial economy: a person or company who purchases such an instrument in the ordinary course of business can reasonably expect that it will be paid when presented to the maker, without involving itself in a dispute between the maker and the person to whom the instrument was first issued.

The foregoing is the theory and the law. In reality the issuer of an instrument who feels he has been defrauded or otherwise rawly dealt with by the payee may nonetheless refuse to pay the holder in due course, requiring the latter to resort to litigation to recover on the instrument.

Usage

While bearer instruments are rarely created as such, a holder of commercial paper with the holder designated as payee can change the instrument to a bearer instrument by an endorsement. The proper holder simply signs the back of the instrument and the instrument becomes bearer paper, although in recent years, third party checks are not being honored by most banks unless the original payee has signed a notarized document stating such.

Alternately, an individual or company may write a check payable to "Cash" or "Bearer" and create a bearer instrument. Great care should be taken with the security of the instrument, as it is legally almost as good as cash.

Exceptions

Under the Code, the following are not negotiable instruments, although the law governing obligations with respect to such items may be similar to or derived from the law applicable to negotiable instruments:

  • Letters of credit, which are governed by Article 5 of the Code
  • Bills of lading and other documents of title, which are governed by Article 7 of the Code
  • Securities, such as stocks and bonds, which are governed by Article 8 of the Code
  • Deeds and other documents conveying interests in real estate, although a mortgage may secure a promissory note which is governed by Article 3
  • IOU


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