Negotiable instruments are written documents that represent a promise or order to pay a specific sum of money, and which can be transferred from one person to another. They are designed to function as a substitute for cash, making transactions more convenient and efficient. Essentially, they are a way to move money around without moving physical cash.
Key Characteristics:
Written Document:
A negotiable instrument must be in writing. This provides a tangible record of the agreement and its terms.
Unconditional Order or Promise:
The instrument must contain an unconditional order or promise to pay a certain sum of money. This means that the payment cannot be subject to any conditions or contingencies.
Sum Certain in Money:
The amount of money to be paid must be clearly stated and definite. This ensures that there is no ambiguity about the value of the instrument.
Payable to Order or Bearer:
The instrument must be payable to a specific person (order instrument) or to whoever possesses it (bearer instrument). This allows for easy transferability.
Payable on Demand or at a Definite Time:
The instrument must be payable either on demand (when requested) or at a specific future date. This provides clarity about when the payment is due.
Types of Negotiable Instruments:
Bills of Exchange:
A bill of exchange is a written order by one person (the drawer) to another person (the drawee) to pay a certain sum of money to a third person (the payee). Checks are a common type of bill of exchange.
Imagine a scenario where a business owner (drawer) owes money to a supplier (payee). Instead of paying cash, the business owner writes a bill of exchange ordering their bank (drawee) to pay the supplier. This simplifies the transaction and provides a record of the payment.
Promissory Notes:
A promissory note is a written promise by one person (the maker) to pay a certain sum of money to another person (the payee). It is essentially an "I owe you" document.
If a person borrows money from a friend, they might give their friend a promissory note promising to repay the loan with interest by a specific date. This creates a legally binding obligation.
Checks:
A check is a specific type of bill of exchange drawn on a bank, payable on demand. It is a widely used method for making payments.
When you write a check, you are instructing your bank to pay the specified amount to the person or entity named on the check. This provides a convenient and secure way to transfer funds.
Certificates of Deposit (CDs):
A CD is a time deposit, a product offered by banks and credit unions. When a customer deposits money into a CD, they agree to leave the funds untouched for a specified period. In return, the bank agrees to pay a specified amount of interest.
CDs are a way for a person to invest their money for a set period, and gain interest on that money.
Transfer of Negotiable Instruments:
Endorsement:
An endorsement is a signature on the back of a negotiable instrument, which transfers ownership to another person.
If you receive a check and want to give it to someone else, you can endorse it by signing your name on the back.
Delivery:
For bearer instruments, delivery alone is sufficient to transfer ownership.
If a negotiable instrument is payable to the bearer, then whoever physically holds the instrument, owns it.
Essentials of a Check
A check is a specific type of negotiable instrument, namely a bill of exchange, drawn on a bank, payable on demand. It is a written order by a drawer (the person writing the check) to their bank (the drawee) to pay a certain sum of money to a payee (the person or entity to whom the check is made payable).
Written Order:
A check must be in writing. This provides a tangible record of the transaction. Oral instructions to a bank to pay money are not considered checks. The writing ensures that there's clear evidence of the drawer's intent and the amount to be paid. This written aspect is very important, because it allows for a clear record of the transaction and allows for evidence to be presented in court if needed.
Unconditional Order:
The order to pay must be unconditional. This means that the bank must be instructed to pay the specified amount without any conditions or contingencies. If a check states, "Pay to John Doe if he delivers the goods," it is not a valid check. The order to pay must be clear and straightforward. This requirement is in place to provide certainty to the payee, and the bank, that the check will be honoured.
Drawer's Signature:
The check must be signed by the drawer. This authenticates the check and indicates the drawer's authorization for the bank to pay the specified amount. Without the drawer's signature, the check is invalid. The signature is the legal mark of the drawer, that signifies that they agree to the terms of the check.
Drawee (Bank):
The check must be drawn on a specific bank (the drawee). This means that the bank where the drawer has an account must be clearly identified. The bank is the entity that will pay the money. The bank is the middleman, that holds the drawer’s money, and releases it upon the drawer’s order.
Payee:
The check must specify the payee, the person or entity to whom the money is to be paid. This can be a specific name or "bearer." If "bearer" is written, anyone who possesses the check can cash it. The Payee is the person who will be receiving the money from the bank.
Sum Certain in Money:
The check must state a definite amount of money to be paid. This amount must be clearly written both in numerical and written form. This prevents any ambiguity or alteration of the amount. The numerical amount and the written amount should match, to prevent fraud.
Date:
Although not strictly required in all jurisdictions, it is highly recommended that a check contains a date. The date helps to track the transaction and can be used to determine the validity of the check. Some banks may refuse to cash a very old check. The date is a helpful record keeping tool.
Payable on Demand:
A check is inherently payable on demand. This means that the bank must pay the specified amount when the check is presented for payment. This is a core feature of a check, that distinguishes it from other negotiable instruments.
Issuing of Cheques: A Step-by-Step Guide
1. Filling Out the Check:
This is the first and most crucial step. The drawer must fill out all the necessary information accurately and legibly.
Date: Write the current date. This helps track the transaction and can affect the check's validity.
Payee: Write the name of the person or entity to whom the check is being paid.
Amount (Numerical): Write the amount of the payment in numerals in the designated box.
Amount (Written): Write the amount of the payment in words on the line provided. This serves as a double-check against the numerical amount.
Memo/For: Write a brief description of the purpose of the payment (optional).
Accuracy is key. Any errors or discrepancies can lead to the check being rejected or returned.
2. Signing the Check:
The drawer must sign the check in the designated area. This signature authenticates the check and authorizes the bank to pay the specified amount.
The signature should match the signature on file with the bank.
3. Ensuring Sufficient Funds:
Before issuing a check, the drawer must ensure that there are sufficient funds in their account to cover the payment. Issuing a check with insufficient funds can result in the check being returned unpaid, which can lead to fees and penalties.
This is very important, because issuing a check without sufficient funds can cause legal issues.
4. Delivery of the Check:
Once the check is completed and signed, it must be delivered to the payee. This can be done in person, by mail, or through electronic means (if applicable).
The method of delivery should be secure and reliable.
5. Record Keeping:
The drawer should keep a record of the issued check, including the date, payee, amount, and purpose of the payment. This helps with tracking expenses and reconciling bank statements.
This can be done by filling out the check book stub, or by using accounting software.
6. Security Measures:
To prevent fraud, the drawer should take certain security measures:
Use a pen with indelible ink.
Fill out the check completely and avoid leaving blank spaces.
Store check books in a secure location.
Monitor bank statements regularly for unauthorized transactions.
If a check is voided, be sure to write VOID across the check, and keep the voided check.
7. Post-Dated Cheques:
A post-dated cheque is a check that is dated for a future date. While they can be issued, their legal status and enforceability can vary depending on the jurisdiction. Some banks may honour them before the date, while others may not.
Post-dated checks are not recommended, due to the varying legal ramifications.
8. Stale Cheques:
A stale cheque is a check that is presented for payment after a certain period has elapsed (usually six months). Banks may refuse to honour stale cheques.
Be sure to cash checks in a timely manner.
Negotiation of Cheques
The "negotiation" of cheques refers to the process by which a cheque is transferred from one person to another. This is a key aspect of negotiable instruments, allowing them to circulate as a form of payment. Here is a breakdown:
Essentially, negotiating a cheque means transferring the rights to that cheque to someone else. This allows that person to then cash or deposit the cheque. The way this transfer happens depends on the type of cheque.
Types of Cheques and Negotiation:
Bearer Cheques:
These cheques are payable to whoever possesses them. Negotiation of a bearer cheque is accomplished simply by delivery. This means that if you have a bearer cheque, you can give it to someone else, and they become the new holder.
Because of this ease of transfer, bearer cheques carry a higher risk of loss or theft.
Order Cheques:
These cheques are payable to a specific person or entity. Negotiation of an order cheque requires endorsement and delivery.
Endorsement: This involves the payee signing the back of the cheque. The endorsement transfers the rights to the cheque to another party.
Delivery: After endorsing the cheque, the payee must then deliver it to the new holder.
Key Aspects of Negotiation:
Transfer of Rights: Negotiation transfers the legal rights to the cheque, allowing the new holder to claim the funds.
Holder in Due Course: In certain circumstances, a person who receives a negotiated cheque in good faith and for value may become a "holder in due course." This status provides certain legal protections.
Endorsement Types:
There are various types of endorsements, such as:
Blank endorsement: Only the payee's signature.
Special endorsement: Specifies the person to whom the cheque is being transferred.
Restrictive endorsement: Limits the use of the cheque (e.g., "for deposit only").
Legal Considerations:
The rules governing cheque negotiation are typically found in negotiable instruments laws, which vary by jurisdiction.
Forged endorsements can create significant legal problems.
Principles of Negotiable Instruments
1. Negotiability:
This is the core principle. It means that negotiable instruments can be freely transferred from one person to another. This transfer can occur through endorsement and delivery (for order instruments) or simply by delivery (for bearer instruments).
This principle allows these instruments to function as substitutes for money, facilitating commerce by enabling easy transfer of value.
2. Certainty:
Negotiable instruments must be certain in their terms. This means that:
The amount payable must be clearly stated.
The parties involved (drawer, drawee, payee) must be identifiable.
The time of payment must be definite or determinable.
The order or promise to pay must be unconditional.
Certainty reduces ambiguity and ensures that all parties understand their obligations and rights.
3. Transferability:
As mentioned earlier, negotiable instruments are designed to be easily transferable. This principle is crucial for their function as substitutes for money.
The ability to transfer these instruments allows them to circulate freely in the marketplace, facilitating transactions.
4. Holder in Due Course:
This principle protects a person who acquires a negotiable instrument in good faith, for value, and without notice of any defects or defences.
A holder in due course gains enhanced rights and protections, making it more difficult for the original parties to the instrument to raise defences against payment.
This principle encourages people to accept negotiable instruments, knowing that they can rely on them for payment.
5. Presentment:
This refers to the act of presenting a negotiable instrument to the drawee (e.g., a bank) for payment.
Presentment is necessary to demand payment and to establish liability in case of dishonour.
6. Notice of Dishonour:
If a negotiable instrument is dishonoured (e.g., a check bounces), the holder must provide timely notice of dishonour to the parties liable on the instrument.
This notice is essential to hold these parties responsible for payment.
7. Consideration:
Like any contract, a negotiable instrument generally requires consideration. This means that there must be an exchange of value between the parties.
Consideration ensures that the instrument is not a mere gratuity but represents a genuine obligation.
8. Formality:
Negotiable instruments must adhere to certain formal requirements, such as being in writing and containing specific language.
These formalities provide a standardized format that enhances certainty and facilitates recognition of the instrument.
Promissory Notes vs. Bills of Exchange
Both promissory notes and bills of exchange are written instruments that represent a promise or order to pay money, but they differ in their structure and the parties involved.
Promissory Notes
Definition:
A promissory note is a written promise by one party (the maker) to pay a certain sum of money to another party (the payee). It is essentially an "I owe you" document.
Key Characteristics:
It is a two-party instrument.
It contains a promise to pay.
The maker is primarily liable for payment.
Parties Involved:
Maker: The person who makes the promise to pay.
Payee: The person to whom the promise is made.
Example:
If you borrow money from a friend, you might give them a promissory note promising to repay the loan with interest by a specific date.
Bills of Exchange
Definition:
A bill of exchange is a written order by one party (the drawer) to another party (the drawee) to pay a certain sum of money to a third party (the payee).
Key Characteristics:
It is a three-party instrument.
It contains an order to pay.
The drawee becomes liable upon acceptance.
Parties Involved:
Drawer: The person who issues the order to pay.
Drawee: The person who is ordered to pay.
Payee: The person to whom the payment is to be made.
Example:
A check is a type of bill of exchange. You (the drawer) order your bank (the drawee) to pay a certain amount to the person or company you are paying (the payee).
Key Differences Summarized:
Promise vs. Order:
A promissory note contains a promise to pay, while a bill of exchange contains an order to pay.
Number of Parties:
A promissory note involves two parties (maker and payee), while a bill of exchange involves three parties (drawer, drawee, and payee).
Liability:
In a promissory note, the maker is primarily liable. In a bill of exchange, the drawee becomes liable upon acceptance.
Use Cases:
Promissory notes are commonly used for loans and other debt obligations.
Bills of exchange are used for various commercial transactions, including checks and trade finance.
