Negotiable instrument

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 and banknotes (paper money).

Differences from a contract

A negotiable instrument is not a contract, as contract formation requires an offer, acceptance, and consideration, none of which are elements 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

The two primary classes of negotiable instruments are 'promissory notes' and 'bills of exchange.'

Promissory note

A promissory note is a written promise by the drawer to pay money to the payee. The most common type of promissory note is a bank note, which is defined as a promissory note made by a bank and payable to bearer on demand.

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. The most common type of bill of exchange is the cheque, which is 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 sometime in the future.

Prior to the advent of paper currency, bills of exchange were a more significant part of trade. They are a rather ancient form of instrument: they were used by medieval trade fairs, such as the Frankfurt Trade Fair.

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 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.

In the United States

In the United States, Article 3 and Article 4 of the Uniform Commercial Code govern the issuance and negotiation 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 in 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 be payable to bearer or to order.
5. The instrument does not state any other undertaking or instruction by the person promising or ordering payment to do any act in addition to the payment of money.

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.

The most remarkable feature of a negotiable instrument is that if it is negotiated to a person who acquires the instrument i) in good faith ii) for value iii) without notice of any defenses to payment, then 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.

The holder in due course 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 letter of the law: of course, 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.

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
• IOUs