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The law of negotiable instruments (also called commercial paper in the US) is an area of commercial and business law which sets out the general rules that relate to certain documents of payment. A negotiable instrument is a document which promises the payment of a fixed amount of money and may be transferred from person to person. Negotiable instruments have two functions—a payment function and a credit function.
This area of law started developing in the fourteenth century because merchants needed a less risky and more convenient alternative to carrying large amounts of gold or money, as well as ways of obtaining credit. This law was eventually codified, and since 1882, in England, transactions in negotiable instruments are governed by the Bills of Exchange Act. In the US, this area is regulated by the Uniform Commercial Code, Article 3, which has been adopted in all states. The rules are very similar in other common-law jurisdictions such as Canada, India and Pakistan.

What is negotiability?

In this context, the word negotiable means transferable; it does not mean open to discussion or modification, as it does in a litigation context. Negotiability allows the transfer of ownership from one party (the transferor) to another (the transferee) by delivery or endorsement. Endorsement is the action of signing an instrument to make it payable to another person or cashable by any person. That means merely signing your name on the back of the document, or adding an instruction such as “pay to the order of Emily Burns”.

What kinds of instruments are negotiable?

There are several types of common negotiable instruments including promissory notes, certificates of deposit, cheques (US checks) and bills of exchange.

A promissory note is a document, signed by the person making the document, containing an unconditional promise to pay a fixed sum of money to a named person, to the order of a named person, or to the bearer (the person who is in physical possession) of the document. Loans are typically formalized in promissory notes, and since they often provide for payments over time, they function to provide credit to the borrower who is the maker of the note.

A debenture (UK) or bond or secured debenture (US) has a similar function to a promissory note; it is a written acknowledgment of debt, secured on the assets of a company. In fact debentures are the most common form of long-term loan used by UK companies.

A certificate of deposit (CD) is a document from a bank which indicates that a specific sum of money has been deposited and promises to repay that sum with interest to the order of the depositor, or to some other person’s order. A CD, which is also called a time deposit, bears a maturity date (the date when it must be repaid) and a specified interest rate, which is usually higher than on ordinary savings accounts.

A bill of exchange is a three-party written order signed by the first party (the drawer), requiring the second party (the drawee) to make a specified payment to a third party (the payee) on demand or at a fixed future date. A cheque is a type of bill of exchange where the drawee is always a bank and is payable on demand. Unlike promissory notes and certificates of deposit bills of exchange and cheques do not pay interest.

A letter of credit is a document provided by a bank or other financial institution as a guarantee that a specific sum of money will be paid once stated conditions have been met. Letters of credit are often used in the import and export business to ensure that payment will be received. Because of factors such as distance, different laws in each country and difficulty in knowing each party personally, the use of letters of credit has become a very important aspect of international trade.

Key legal concepts in negotiable instruments law—nemo dat and holder in due course

The nemo dat rule is an important general principle of law that states that only holders of good title (legal owners) can transfer ownership. However, this rule does not apply to negotiable instruments. This is to facilitate the free transferability of negotiable instruments, which aids commerce in general. Because negotiable instruments can be payable to the order or to the bearer of the instrument, they can be held by someone who is not connected with the underlying transaction and does not know of any potential defect in that transaction. If such a holder holds the instrument in good faith and is not aware of any problems with the instrument, the holder is a bona-fide purchaser for value or holder in due course (HDC). This means that the HDC takes good title to the instrument and can claim payment even if the person from whom he or she received it did not hold title. The HDC acquires greater rights under a negotiable instrument than an ordinary transferee of a contractual right.

Negotiable instruments law in practice

Lawyers who practice negotiable instruments law usually work for banks , commercial law firms, or governmental authorities.

Many lawyers at certain commercial law firms work in the field of capital markets. Capital markets is a term used to describe the pool of investors (including pension funds, hedge funds, financial institutions and retail clients) who have funds to invest in financial products. Such products would, generally, include corporate bonds, financial bonds and structured securities.

Capital markets lawyers will typically advise investment banks when they issue bonds to raise money. A corporate bond has similar characteristics to a loan in that money is borrowed by a company to be repaid at a date in the future with interest paid thereon. The key difference is that because the company is accessing the capital markets (and thereby a pool of investors), each taking a smaller proportion of risk than lenders in a loan agreement, the company may be able to borrow at more favourable rates. The investor receives interest throughout the life of the bond (in a similar way to a loan agreement) and receives back their principal at maturity (the end of the term of the bond). If there is an event of default (eg the company that issued the bonds becomes insolvent), the investor becomes a creditor in the company’s insolvency. In such an insolvency situation, lawyers may advise a trustee interposed in order to act on behalf of the bondholders.
Commercial lawyers in private law firms also deal with negotiable instruments because they are often used as means of payment in mergers and acquisitions, and other transactions. Lawyers who represent debtors and creditors in bankruptcy cases litigate regarding the validity of the instruments, the rights of the creditors to get paid and the lack of the debtors’ ability to pay. They also try to work out new payment plans on promissory notes, to enable debtors to pay.

Banks are often parties to negotiable instruments, for example, as lenders in promissory notes, as borrowers in CDs, and as guarantors in letters of credit. Therefore, bank lawyers are involved in drafting the forms and seeing that all of the legal prerequisites are met. They can also be involved in bringing collection proceedings and other litigation where other parties to the instruments have defaulted on their obligations, usually by failing to make timely payment under the instruments.

Lawyers who work for governmental tax authorities often monitor negotiable instruments to make sure that they are not used for evading taxes. Consumer protection authorities scrutinize instruments, particularly promissory notes, to see whether the terms and conditions of the loan are unreasonable to the consumer-borrower. For instance, they regulate the amount of interest that may be charged.

Helpful links

• Samples of promissory notes and debentures at : http://contracts.onecle.com/type/
• samples of certificates of deposit at: www.fltreasury.org/certificate_deposit_program/forms.html and https://www.fhlbdm.com/Docs/…/Certificate%20of%20Deposit.doc
• the American legislation governing negotiable instruments, Article 3 of the Uniform Commercial Code is found at : http://www.law.cornell.edu/ucc/3/
• an introduction to the law of negotiable instruments http://www.lexisnexis.com/lawschool/study/understanding/pdf/NegInsCh1.pdf
• a discussion of the law on cheques: http://www.lawhandbook.sa.gov.au/ch08s05s05.php