An instrument that proves entitlement to money is sometimes described as a documentary intangible. Various types of documentary intangibles have evolved by custom and practice. Most are short simple documents. They carry the obligation to pay.
Possession of the instrument (in the case of a bearer instrument) or possession with an endorsement to the possessor (in other cases) is evidence of the possessor’s entitlement to the monies, the subject of the instrument. The entitlement lies with the holder of the instrument. He may produce it to the relevant party and demand payment.
An instrument may be negotiable or non-negotiable. This depends on the relevant custom and practice and in some cases, on applicable legal provisions. A negotiable instrument may be transferred by the delivery and where required, endorsement.
Promissory notes, banknotes, bearer bonds, share warrants, and certain certificates of deposit are negotiable instruments. So too are cheques, bank drafts, traveller’s cheques, postal orders, and certain monetary warrants.
The transfer of a negotiable instrument to a bona fide transferee without notice of defects for value, gives the transferee title, free from any actual defects in title. A non-negotiable instrument cannot give a successor better title than that held by the transferor.
Order to Pay
An instrument may contain an undertaking by its maker to pay a sum of money. More commonly, it contains an order to another to pay a sum of money, usually to a named payee. The order to a third party to pay does not itself create an obligation on the part of that party. He cannot be bound unless he has accepted the order. If the party who is ordered to pay, does not make payment, the person making the order is liable.
The order to pay may be immediate, in which case, it will be honoured or dishonoured immediately. If the order is for payment on a future date, the person to whom the order is made may accept the order. If that person then refuses to pay the instrument when due, he is liable to the payee. If he refuses to accept, he is not liable but the drawer is liable.
Bills of Exchange and International Trade
The bill of exchange developed in the context of trade finance. Bills of exchange have been recognised internationally, for many hundreds of years. The bill of exchange serves in international finance but also applies to inland or domestic use. The obligation on the bill of exchange is independent of any underlying transaction and contract for which it represents payment. Because of this independence, the instrument itself is marketable.
An importer wishing to pay an exporter in a foreign county may utilise his own bank, which in turn utilises a correspondent bank in the exporter’s country. The importer puts its bank in funds either from funds in his account or from the proceeds of a facility. The importer’s bank draws a bill of exchange on its foreign correspondent bank, ordering the latter to pay the sum stated to the exporter.
The importer pays the exporter by sending the bill to the exporter. The exporter presents the bill for payment to the local corresponding bank, which pays or credits his account. The respective banks may have numerous transactions in which case, they may settle them in aggregate, by payment of the net sum due. If the importer is given credit, the bill may provide for payment on a future date. The bill however itself may be sold prior to the due date at a discount.
Cheques and Promissory Notes
Cheques are said to have evolved from the practice of goldsmiths accepting instructions from depositors to pay sums to named third parties, from funds held on deposit. A cheque is a bill of exchange drawn on a bank payable on demand. It does not require acceptance. It is payable on sight (on presentation), on its due date.
A promissory note is not a bill of exchange because it is not an order to pay. The promisor makes the promise to pay. The promissory note usually contains the promise to pay a sum of money to the promisee or his order (the holder on the due date). Because the promisor agrees to pay the promisee (or his nominee or order), he is liable to the payee or the appropriate successor as holder of the note.
Many of the rules applicable to bills of exchange, apply to promissory notes. However, they are less complicated. The person who makes a promissory note undertakes that he will pay it in accordance with its tenor. He is precluded from denying to a holder in due course, the existence of the payee and his capacity to endorse it, at the relevant time. As with a bill of exchange, a person who endorses a promissory note has a secondary liability to subsequent holders, if the promisor fails to pay.
A bank draft is technically outside the definition of a bill of exchange. This is because the drawer and the drawee are the same entity. However, the holder may choose to treat it as if it is a cheque.
Certain securities (documents evidencing an investment) are constituted as negotiable instruments. Bearer debenture or bearer’s share in a public company is transferrable by delivery. Negotiable certificates of deposits, treasury and commercial bills, euro bonds, and equivalent capital market instruments. The rights applicable are defined in underlying trust prospectus documentation.
The above instruments would not qualify as bills of exchange. However, they are negotiable by financial custom in the financial custom.
An important characteristic of instruments is that they may be sold and discounted prior to maturity. Where a bank accepts an instrument, it lends the instrument an enhanced credit state.
A similar but related notion is that of an accommodation party. Where a person would enhance credit status relative to others, to the issuer or other endorsers either accept or endorses an instrument that person’s credit stands behind it. The accommodation party to a bill is persons who sign the bill as drawer, acceptor, or endorser without receiving value for the purpose of lending his name to some other person.
The accommodation party is liable to a holder for value even if the holder for value knows that he is an accommodation party only.
Where the bill is accepted by the accommodation party, it is an accommodation bill. The accommodating party is primarily liable. He effectively acts as a guarantor or surety. But with an accommodation bill, the primary liability lies with the accommodating party as acceptor.