A negotiable instrument is a specialized type of contract which obligates a party to pay a certain sum of money on specified terms. The two primary classes of negotiable instruments are as follows:
- The promissory note, which is a written promise by the maker to pay money to the payee ; and
- The draft, which is a written order by the drawer to the drawee to pay money to the payee . The most common type of draft is the cheque. A draft was also formerly known as a "bill of exchange" but the latter term has become obsolete.
In the United States, Article 3 of the Uniform Commercial Code governs the issuance, transfer and enforcement of negotiable instruments.
For a writing to be a negotiable instrument under Article 3, the following requirements must be met:
- The promise or order to pay must be unconditional;
- The payment must be in a specific sum of money, although interest may be added to the sum;
- The payment must be made on demand or at a definite time;
- 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 check (an order 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 blank indorsement . 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 transferred 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 by the original payee may nonetheless refuse to pay the holder in due course, requiring the latter to resort to litigation to recover on the instrument.
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
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