A written instrument or document such as a check, draft, promissory note, or a certificate of deposit, that manifests the pledge or duty of one individual to pay money to another.
Commercial paper is ordinarily used in business transactions, since it is a reliable and expedient means of dealing with large sums of money and minimizes the risks inherent in using cash, such as the increased possibility of theft.
One of the most significant aspects of commercial paper is that it is negotiable, which means that it can be freely transferred from one party to another, either through endorsement or delivery. The terms commercial paper and negotiable instrument can be used interchangeably.
Since commercial paper constitutes personal property, it is transferable by sale or gift and can be loaned, lost, stolen, and taxed. Commercial paper is a specific type of property primarily governed by article 3 of the uniform commercial code (UCC), which is in effect in all 50 states, the District of Columbia, and the Virgin Islands. Although Louisiana has not enacted all the articles of the UCC, it has adopted article 3.
Types of Commercial Paper
The UCC identifies four basic kinds of commercial paper: promissory notes, drafts, checks, and certificates of deposit. The most fundamental type of commercial paper is a promissory note, a written pledge to pay money. A promissory note is a two-party paper. The maker is the individual who promises to pay while the payee or holder is the person to whom payment is promised. The payee can be either a specifically named individual or merely the bearer of the
instrument who has it in his or her physical possession when he or she seeks to be paid according to its terms. A note payable to "bearer" can be paid to the person who presents it for remuneration. Such an instrument is said to be bearer paper.
A promissory note that is payable on demand can be redeemed by the payee at any time, whereas a time note has a date for payment on its face that establishes the date when the holder will have an enforceable right to receive payment under it. There is no obligation to pay a time note until the date designated on its face.
The ordinary purpose of a promissory note is to borrow money. Promissory notes should not be confused with credit or loan agreements, which are separate instruments that are usually signed at the same time as promissory notes, but which merely describe the terms of the transactions.
A promissory note serves as documentary evidence of a debt. It can be endorsed and sold at a discount to other parties, and each subsequent endorser becomes secondarily liable for the amount specified on the face of the instrument. A number of consumer credit dealings are funded through the use of promissory notes.
Certain types of promissory notes are sold at a discount, such as U.S. savings bonds and corporation bonds. Such an instrument is sold for an amount below its face value and can subsequently be redeemed on the due date or date of maturity for the entire face amount. The interest obtained by the holder of the instrument is the difference between the purchase price and the redemption price. In certain instances, bonds that are not redeemed immediately upon maturity accumulate interest following the due date and are ultimately worth more than their face value when redeemed at a later time. If such bonds are cashed in before maturity, the holder receives less than the face value.
A draft, also known as a bill of exchange, is a three-party paper ordering the payment of money. The drawer is the individual issuing the order to pay, while the drawee is the party to whom the order to pay is given. As in the case of a promissory note, the payee is either a specified individual or the bearer of the draft who is to receive payment according to its terms. The draft is made payable on demand or on a certain date. A common example of a draft is a cashier's check.
A draft is often used in business to obtain payment for items that must be shipped over long distances. Drafts are often the preferred method of payment for purchasers who want to examine goods prior to payment or who do not have the necessary funds available at the time of sale. The vendor might have reservations concerning the buyer's credit and desire payment as soon as possible. The procedure ordinarily followed in such instances is that upon shipment of the goods, the seller receives a bill of lading from the carrier. The bill of lading also serves as a certificate of title to the goods, which is ordinarily in the seller's name.
Upon shipment, the seller draws a draft against the buyer-drawee, who is required to pay the draft. The seller's bank is named as the payee. The seller endorses the bill of lading to the payee and attaches the bill to the draft. The seller can either negotiate these instruments to the payee at a discount or use them as security for a loan. Subsequently, the papers are endorsed by the seller's bank and delivered to a correspondent bank in the community where the buyer is located. The correspondent bank seeks payment of the draft from the buyer and when payment is made, the bank transfers ownership of the goods from seller to buyer by endorsing the bill of lading to the buyer. The buyer can then obtain the goods from the carrier upon presentation of the bill of lading, which demonstrates his or her title to the shipped goods.
A check is a specific kind of draft, which is drawn on a bank and payable on demand to a particular individual or to the bearer, in which case it can be written payable to "cash."
An individual who opens a checking account is engaged in a contractual relationship with a bank. The individual agrees to deposit money therein, while the bank agrees that it is indebted to the depositor for the amount in the account, in addition to promising to honor checks written for payment against the account when there are sufficient funds on hand to do so.
A certificate of deposit, frequently referred to as a CD, is a written recognition by a bank of the acquisition of a sum of money from a depositor for a designated period of time at a specified interest rate, coupled with a promise of repayment. The bank is both the maker and the drawee, and the individual making the deposit is the payee.
Ordinarily, certificates of deposit come in specific denominations that vary according to the length of the term that the bank will hold the funds and are available only for large sums of money. They are used mainly by corporations and individuals as savings devices since they generally bear higher interest rates than ordinary savings accounts. They must, however, be left on deposit for the designated time period. Ordinarily, a CD can be cashed in prior to the date of maturity, but some interest will be forfeited. Depending upon the provisions of the CD, however, a bank may have the legal right to refuse to close an account before the expiration of the designated date of maturity.
There are basic requirements for the negotiability of commercial paper. The instrument must be in writing and signed by either its maker or its drawer. In addition, it must be either an unconditional promise, as in the case of a promissory note, or an order to pay a specific amount of money, such as a draft. It must be payable either on demand or at a fixed time to order or to bearer.
The requirement that the instrument must be in writing can be met in various ways. The paper can be printed, typed, engraved, or written in longhand, either in ink, pencil, or both. Ordinarily, specimens of commercial paper can be obtained from banks or stationery stores.
Similarly, there are a number of ways to comply with the signature requirement. The signature may legally be either handwritten, typed, printed, or stamped by a machine. Individuals who are unable to write their names can sign with a simple mark, such as an X. Also permissible are initials, a symbol, a business or trade name, or an assumed name.
The pledge or order for payment must be unconditional to insure certainty that the instrument will be paid, since it is used in place of money and as a means of obtaining credit.
When the paper includes an unconditional promise or order, supplementary facts can be mentioned that will not defeat its negotiability. For example, the paper can indicate the transaction was secured by a mortgage. It might mention a specific account or fund out of which payment is expected, although not required. Ordinarily, such a collateral statement is made for purposes of accounting and does not create a conditional promise or order to pay. Payment can, however, be limited to the total assets of a partnership, unincorporated association, or trust.
A promise to pay is conditional when it indicates that it is either subject to or governed by another agreement. When payment is conditional, negotiability is terminated and the instrument is not commercial paper. The holder of the paper cannot rely upon the face of the document to establish and fix his or her right to payment.
A paper does not qualify for treatment as a negotiable instrument if payment of it is to be made exclusively from a particular fund, unless such instrument is issued by a government or division thereof.
In dealing with a promissory note, practically any terms that state a definite promise will suffice to make the instrument legally enforceable. The phrase "I promise to pay" clearly demonstrates an unconditional pledge of payment; whereas an IOU is not deemed definite enough to warrant payment and, therefore, is not a negotiable instrument. There must be an order to pay in a check or a draft. A mere request, as in "I wish you would pay," is insufficient. Language used for courtesy, such as "please pay," does not, however, defeat the order. Suitable language to instruct payment would be "pay to the order of X."
The holder of the negotiable instrument must be able to ascertain the precise value of the paper by looking at its face. In certain instances, it might be necessary to compute interest, as in the case of a promissory note that bears a certain annual rate. A provision for interest does not impair the determination of the actual sum. In addition, certainty regarding the amount is not altered by the fact that the interest rate can differ before or after default or before or after a particular date.
The amount payable remains a fixed sum even in the event that it is paid in installments, or reduced by agreement of payment prior to a set time or increased following the date of payment. In addition, the certainty of the sum is not affected by a provision for collection of expenses and lawyer's fees.
The sum must be payable in money, which is a medium of exchange adopted by governments; otherwise, the document is not considered commercial paper.
An instrument must be payable either on demand or at a set time in order to have negotiability. Papers that are payable on demand are payable upon presentation, such as checks.
When a note or a draft is payable on, or prior to, a fixed date or for a set period thereafter, it is considered to be negotiable at a definite time. When an instrument is payable on or before a certain date, payment is required no later than the date indicated, although it can be made prior to that date. Similarly, a paper made payable at an established time after sight is payable at a definite time. After sight means that upon presentation of the instrument to the maker by the holder, payment will occur after the expiration of the time designated on the note. The payee of a note due one week after sight must be paid by the maker within a week of the date it is presented for payment. It need not be paid immediately upon presentation, since the terms of the note do not make it a demand instrument.
If the time provided for payment of an instrument is definite except for the presence of an acceleration clause, the time of payment of the instrument is still considered definite. That is, a note can provide that the time for payment will be accelerated if a certain event takes place or at the option of one of the parties to the agreement without destroying its negotiability. Also acceptable are extensions of the payment period, which can be made at the choice of the holder, maker, or acceptor, or immediately when a particular act occurs.
An instrument retains its negotiable quality even if it is undated, antedated, or postdated. An undated instrument takes effect immediately upon delivery to the payee. An antedated paper is given a date that has passed, and a postdated instrument is given a future date. In the event that an instrument is either antedated or postdated, the determination of the date on which it becomes legally operative is contingent upon the date that appears on its face and upon whether it is payable on demand or on a certain date. A postdated check cannot be cashed prior to the date appearing on its face, in spite of the fact that a check is ordinarily payable on demand.
An instrument is not negotiable if it is payable upon an occurrence of indefinite timing, even when the event is certain to happen, such as death.
The requirement that an instrument be made payable either to order or to bearer is met when the paper is made available to the bearer, or to an individual specifically designated, or to the order of that person, as in "X, or his order." An estate, trust, corporation, partnership, or unincorporated association may be designated as a payee of a commercial paper.
An instrument can be made payable to two or more people, either together or in the alternative. If the paper is made out to two parties together, as in "to X and Y," then both payees must endorse it before payment will be made. An instrument made out in the alternative, however, as in "To X or Y," requires endorsement by only one payee in order to be paid.
Checks and drafts are ordinarily written on printed forms, made payable both to order and bearer. An empty space is left between the words "pay to the order of" and "or bearer." When the name of the payee is inserted by the drawer, the paper is regarded as an order instrument in spite of the fact that the phrase "or bearer" is not deleted. In such instances, the presumption is that the drawer merely neglected to eliminate this language. An instrument is bearer paper, however, when it is made payable to a specific payee and the words "or bearer" are either typed or handwritten on the document as additions to it.
Bearer paper is made payable either to the holder, a specific individual, the bearer, or to cash. It is common for such an instrument to read "pay to the order of bearer." This occurs in the case where a printed form is used and the term bearer is written in following "pay to the order of." The word bearer serves to make the instrument bearer paper in such an instance.
Bearer instruments are tantamount to cash because they are freely transferrable from one person to another without requiring an endorsement. They are thereby not as secure as order instruments since if they are stolen, their terms permit payment to be made to whoever possesses them at the time they are presented for payment. Many banks require customers to endorse bearer paper prior to payment as a safety measure. This provides both the drawer and the bank with the name of the individual who is given payment.
An endorsement is the process of signing the back of a paper, thereby imparting the rights that the signer had in the paper to another person. The number of times an instrument may be endorsed is unlimited. There is no requirement that the word "order" be embodied in the endorsement. Four principal kinds of endorsements exist: special, blank, restrictive, and qualified.
An endorsement that clearly indicates the individual to whom the instrument is payable is a special endorsement.
A paper containing a blank endorsement is one that has the signature of the payee but no specific endorsee is designated. A check that is made payable to the order of X is endorsed in the blank when X signs it. Once endorsed, it becomes bearer paper and is negotiable by anyone who physically holds it. A blank endorsement is changed into a special endorsement if certain words are written above the endorsee's signature, such as "pay to the order of Y."
A qualified endorsement is one wherein liability is disclaimed by the endorser through inclusion of a phrase preceding his or her signature. Ordinarily, an unqualified endorser's liability may be either secondary, whereby the endorser is bound to pay if the individual expected to pay defaults and certain conditions are met or by warranty, by which the endorser incurs liability upon alteration of the instrument. To disclaim secondary liability, the endorser can include the words "without recourse," thereby relieving himself or herself of any responsibility to pay it.
Attorneys who are the recipients of checks drawn in settlement of the claims of their clients commonly sign their clients' checks with qualified endorsements. This type of check is ordinarily made payable to the lawyer and client jointly. It is generally endorsed by the lawyer without recourse and given to the client. The attorney then is not liable if the client does not receive the money promised by the terms of the check.
A restrictive endorsement is conditional and attempts to prevent subsequent transfer of the document. The language of the endorsement indicates that the instrument is intended for limited use, such as "for deposit only," or specifies that the paper is meant for the benefit of the endorser or another individual, as in "Pay X in trust for Y." The condition imposed by a restrictive endorsement must be satisfied before payment can be properly made.
However, an endorsement that tries to prohibit further transfer of an instrument will not succeed. If a check says "Pay X only," it is still completely negotiable upon its endorsement by X.
Liability of Parties
An individual who signs an instrument is either primarily or secondarily liable for payment. Primary liability is extended to the person who is expected to pay first, and the individual who is legally responsible to pay upon the failure of the first party to do so is secondarily liable.
The maker of a promissory note is primarily liable, since that person is the individual who has originally promised to pay. He or she must meet this obligation when payment becomes due unless he or she has a valid defense or has been discharged of the debt.
The drawer of a check or draft is secondarily liable, since that individual does not make an unconditional promise to pay the instrument. He or she expects the bank to pay and promises to pay the amount of the instrument only upon notification of dishonor, a refusal by the drawee to accept the paper when properly presented for payment. This might occur, for example, if the bank refuses to pay a check due to insufficient funds in the drawer's checking account or because he or she has notified the drawee to stop payment.
The drawee of a draft or check has primary liability to the holder, an individual who has lawfully acquired possession and is entitled to payment, upon acceptance of the instrument by the drawee. A draft is accepted for payment when the acceptance is indicated by the drawee
on the face of the document. Certification of an instrument, such as a check, is its acceptance by a bank guaranteeing that payment will be forthcoming. A drawee is liable to the drawer if the drawee refuses to pay a draft or check that is properly drawn and presented because such action constitutes a noncompliance of the drawee's contractual obligation to the drawer.
Any person who places his or her unqualified endorsement on a commercial paper incurs secondary liability for its payment. Such liability occurs when the individual who has the primary duty to pay defaults on his or her obligation.
A maker or drawer is not relieved from payment of an instrument endorsed with the payee's name when an imposter manages to have a paper issued to himself or herself by the maker or drawer; when an individual signing on the behalf of the maker or drawer plans that the payee shall have no interest in the paper, for example, the case of a check being made out to a fictitious payee; and when the agent or employee of the maker or drawer designates the name of a payee with the intent that the named party will actually have no interest in the instrument. In the last two instances, the failure of the employer to use reasonable care in choosing and supervising employees makes the employer personally responsible for all losses that arise from his or her negligence. Many employers guard against such risks by taking out fidelity insurance policies to cover losses that might occur through employee misconduct.
Individuals who are secondarily liable on a negotiable instrument are not obliged to pay unless it has been presented for payment and dishonored. The commercial paper must first be given to the person who is primarily liable for payment. In the event that the instrument clearly notes the date of payment, the instrument must be presented on the date indicated. If payment is unjustifiably refused by the individual who has primary liability, the secondary party must be given notice of the dishonor and the presentation of the instrument for payment must be made within a reasonable period of time. What constitutes a reasonable time is contingent upon what type of instrument is involved. If the paper is a check, the drawer has primary liability for thirty days following the date on the check or the day it was given or sent to the payee, with the later date prevailing. An endorser is secondarily liable for seven days following his or her endorsement. When presentation does not occur within these time periods, either the drawer or the endorser may escape liability.
Individuals who are secondarily liable must receive notice of the dishonor of a commercial paper in order to be held liable for its payment. Such notice must be given by a bank prior to midnight on the date following the dishonor. Notice can be oral or in writing, as long as the language identifies the paper and indicates that it has been dishonored. If more than one person is eligible to obtain payment, only one of them need notify those parties who are secondarily liable.
A holder is an individual who is in possession of an instrument that is either payable to him or her as the payee, endorsed to him or her, or payable to the bearer. Those who obtain instruments after the payee are holders if such instrument is either payable to the bearer or endorsed properly to their order. The party in possession is not considered to be the holder in a case in which a necessary endorsement has been forged.
According to law, a holder may either be an ordinary holder or a holder in due course, who has preemptive rights to payment. An ordinary holder becomes a holder in due course upon taking an instrument subject to the reasonable belief that it will be paid and that there are no legal reasons why payment will not occur.
In more technical terms, to be a holder in due course, the party must take the paper for value, in good faith, and absent the notice that it is overdue, has been dishonored, or is subject to an adverse claim. Such notice of problems affecting the validity of the instrument exists if the party either is specifically informed about something or otherwise has reason to believe in the existence of a problem.
A holder takes a paper for value when the holder has imparted something of value, such as property or services, in exchange for the value of the paper, as evidenced by its terms. In such a case, the individual becomes the holder for value.
If a paper is used in satisfaction of or as security for the repayment of a debt, even though the debt might not be due when the paper is taken, the instrument is taken for value. In addition, value is given when one commercial paper is traded for another.
A person who receives a check or other type of negotiable instrument as a gift is an ordinary holder as opposed to a holder in due course, since no consideration that is bargained-for value has been exchanged by the parties. A holder in due course has greater legal rights concerning protection for enforcement of the provisions for payment of a negotiable instrument than does an ordinary holder.
For an individual to be a holder in due course, the negotiable instrument must be taken in good faith that it represents a valuable legal right. There must be honesty in the transaction, but the determination of whether or not good faith is present is totally subjective.
Frequently, a due date is clearly specified on the face of the document. A holder is presumed to have knowledge of the terms appearing on the paper. If an individual is presented with a note on May 15 that is payable on May 1, he or she is regarded as having knowledge that it is overdue. A person is legally considered to have knowledge that a demand instrument is overdue if he or she accepts it after being informed that a demand for payment has previously been made and refused or if a reasonable period of time has elapsed since its issuance. Ordinarily, 30 days after the date on which a check was issued is a reasonable time period within which its presentation to a bank for payment should occur. An individual who accepts a check that is more than 30 days old is assumed to be doing so with the knowledge that it is overdue.
An instrument that has been dishonored ordinarily has that fact indicated on its face. For example, a check might be stamped "insufficient funds," "account closed," or "payment stopped." An individual who accepts such a document possessing knowledge of its dishonor cannot be a holder in due course. A person cannot be a holder in due course if he or she takes an instrument subject to his or her knowledge that a claim exists against it, such as when it has been stolen or transferred as a result of fraud.
A holder of a negotiable instrument who has been refused payment when payment was due has a cause of action against the party or parties liable for payment. Ordinarily, when an individual is sued on a negotiable paper, he or she will try to defend his or her right to refuse payment. Certain defenses, known as real defenses, are valid against ordinary holders as well as holders in due course, whereas personal defenses are only valid against ordinary holders.
Normally, any defense that can be asserted in an action concerning a contract may also be used in an action brought to enforce payment of a negotiable instrument. The legal incapacity of the maker, drawer, or endorser, a signature effected by duress, illegality, or fraud, and alteration of the instrument qualify as real defenses.
One of the most prevalent legal incapacity defenses asserted is infancy. The law affords protection to infants by permitting them to evade their contractual obligations, even when, in some instances, they have reaped the benefits. A holder is usually excluded from receiving payment on a note from a minor.
Another incapacity defense is legal insanity or incompetency. A party who has been legally declared insane or incompetent is not liable for any contractual obligations entered during that time so that if such a person signs or endorses a negotiable instrument, the transaction is nullified. Intoxication is not a valid defense to dishonor of a commercial paper.
Duress may be used as a defense in the event that the individual against whom a suit is brought can prove that he or she was subject to extreme pressure caused by another at the time of the execution of the paper. If the defendant signed the instrument subject to a threat of immediate physical violence or death, he or she is not legally bound to honor its terms since he or she had not freely entered into the transaction. Certain types of duress, such as a threat to report a wrongdoing to the police or to bring a civil lawsuit, are not valid against a holder in due course, although they can be used as valid personal defenses against an ordinary holder.
Certain jurisdictions deem a paper that has been negotiated to pay a usurious loan or gambling debt null and void. An individual can legally avoid payment to the holder in due course of such an instrument based on the illegal nature of the debt it was meant to pay.
Two basic types of fraud exist: fraud in the essence and fraud in the inducement. Fraud in the essence occurs when an individual is intentionally lied to about the nature of the instrument or its terms. It is a defense that is valid against both an ordinary holder and a holder in due course. Fraud in the inducement takes place when the party signing the paper is cognizant of its nature and terms but is misled into believing that the reasons for its creation have been satisfied when in actuality they have not. For example, an individual might be induced to issue a check for a certain amount to a mechanic who claims to have repaired a car. If the individual subsequently discovers that the car was not repaired, fraud may be used as a personal defense against the mechanic who has not performed his or her part of the contract to repair the car. Fraud in the inducement is only valid against an ordinary holder, not a holder in due course.
A material alteration is an addition or deletion of the language of an instrument, which changes the obligations of any party to it. A defendant may avoid liability for payment of a commercial paper if its terms have been materially altered. Examples of such alterations are a change in the date of payment or amount to be paid. When an individual's own negligence is a contributing factor to a material alteration, that negligence may not be asserted by him or her as a defense against someone who pays the instrument in good faith or against a holder in due course.
An alteration made by a holder that is both material and fraudulent can be used as a defense against enforcing the payment of the document by all those people whose agreements were changed. If these two conditions of materiality and fraud are not met, the instrument is ordinarily enforceable according to the way it was initially written, and none of those involved can use the alteration as a defense against payment.
When a holder in due course takes a paper following its fraudulent alteration by the previous holder, he or she is entitled to receive payment according to the original terms of the instrument prior to its alteration. None of the parties responsible for payment can use the alteration as a defense against a holder in due course, but it may be used against an ordinary holder.
Discharge from Liability
The most common way to be discharged from liability on a commercial paper is through payment. The intentional cancellation of an instrument by the holder by either marking the instrument paid or by destroying it discharges all liability.
The holder may also discharge an individual from liability for payment through renunciation. This can be accomplished when a document is signed and delivered by the holder or when a paper is relinquished to the party who is being discharged. A stop-payment order put on a check by its drawer has the effect of discharging the bank from liability for refusing to honor the check when presented for payment. It cannot, however, discharge the drawer from liability in cases where the drawer was contractually or otherwise obligated to pay the payee.
Bamford, Janet. 1992. The Consumer Reports Money Book. New York: Consumers Reports.
Blue, Ron. 1993. Master Your Money: A Step-by-Step Plan for Financial Freedom. Nashville, TN: Thomas Nelson.
Corley, Robert N., and William J. Robert. 1979. Principles of Business Law. Englewood Cliffs, NJ: Prentice-Hall.
Milling, Bryan E. 1993. How to Get a Loan or Line of Credit for Your Business: A Banker Shows You Exactly What You Need to Do to Get a Loan. Naperville, TN: Sourcebooks.