INTRODUCTION TO NEGOTIABLE INSTRUMENTS

 

UNIT STRUCTURE

1. Learning Objectives
2. Introduction
3. Meaning of Negotiable Instruments
4. Meaning and Features of a Promissory Note
5. Meaning and Features of a Bill of Exchange
6. Meaning and Features of a Cheque
7. Types of Cheques
1. Open Cheques
2. Crossed Cheques
8. Meaning and Kinds of Endorsement
9. Let Us Sum Up
10. Further Readings
11. Answers To Check Your Progress
12. Possible Questions

LEARNING OBJECTIVES

 
After going through this unit, you will be able to:
explain the meaning and types of negotiable instruments
discuss the meaning and features of promissory note, bill of exchange and cheque
differentiate among promissory note, bill of exchange and cheque
discuss the different types of cheques
discuss the meaning of crossing a cheque and the various types of crossing
discuss the meaning of endorsement and the types of endorsement

INTRODUCTION


Individuals, businessmen and firms use various instruments to facilitate transfer of money and settlement of transactions. Perhaps you have heard the word ‘cheque’ and if you have an account in a bank, probably you know the uses of a cheque. A cheque is used to transfer money from one person to another. There are some other documents which are used in business transactions to facilitate the transfer of money. These documents are called negotiable instruments. In this unit, we will discuss the meaning and different types of negotiable instruments. We will also discuss the parties involved in these negotiable instruments.


MEANING OF NEGOTIABLE INSTRUMENTS


You know that a business firm can purchase and sale goods in cash or on credit. In case of cash transactions, they are immediately settled by paying cash (cash purchases) or by receiving cash (cash sales) and generally the parties have no further obligations in respect of payments. But it is not so in case of credit transactions. The purchaser who purchases goods on credit have to make payment at some later date though not immediately. The seller, in that case, writes an order (a written document) to the purchaser that he has to make payment after a specified period of time. That order has to be signed by the purchaser indicating that he has accepted the order and will make payment on the specified date. The seller retains the order with him till the specified date when the purchaser makes the payment.

But the seller instead of waiting to collect the amount on the specified date can transfer the document to some other person to meet his own business obligation. The seller can transfer the document by writing the name of the person on the back of the document and thereby instructing the purchaser to pay the amount to that person on due date. The seller must sign on the back of the document to transfer the document. At the end of the specified period, the person can collect the amount from the purchaser.

From the above discussion, it can be said that there are certain documents which facilitates the payments in business and thereby reduce the physical handling of cash. These documents are called negotiable instruments.

Hence, negotiable instruments may be defined as written documents which can be transferred from one person to another to make payments until the final payment is made. In India, the Negotiable Instruments Act, 1881 contains the rules relating to negotiable instruments. According to Section, 13 of this Act, a negotiable instrument means “a promissory note, bill of exchange or cheque, payable either to order or to bearer whether the words “order” or “bearer” appear on the instrument or not.”

According to this definition, there are only three types of negotiable instruments i.e. promissory note, bill of exchange and cheque. But some other documents like, dividend warrants, railway receipts, hundies etc. are also considered as negotiable instruments if they satisfy the conditions of a valid negotiable instrument.
Now, let us know something more about these negotiable instruments.


MEANING AND FEATURES OF A PROMISSORY NOTE


A promissory note is a negotiable instrument which contains an unconditional promise to pay a certain sum of money to a certain person or to the bearer of the instrument. Let us take an example. Suppose Shri Ram has taken a loan of Rs. 10, 000 from Shri Amal. Now, Shri Ram can write a promissory note stating “I promise to pay Shri Amal or order a sum of Rs. 10, 000, value received.” Shri Ram must put his signature and it must be properly stamped to make it a valid promissory note.

Section 4, of the Negotiable Instrument Act, 1881 define a promissory note as “an instrument in writing (not being a bank note or a currency note) containing an unconditional undertaking, signed by the maker, to pay a certain sum of money only to or to the order of, certain person, or to the bearer of the instrument.”

Thus, a promissory note contains an unconditional promise to pay a certain sum of money only to a certain person or to his order, on a specified future date. This instrument must bear the signature of the person who promises to make payment.

Parties to a promissory note:
The main parties involved in a promissory note are-
i. Maker or Drawer: The person, who draws or makes the instrument, is called the maker of the promissory note. The maker promises to pay the amount specified in the promissory note. He must sign the note.
ii. Payee: The person to whom the amount will be paid is called the payee.

The payee may transfer the instrument before the due date to meet his business obligations. In that case, the parties will be-
· Endorser: The person, (the payee) who transfers the document to some other person to meet his financial obligation, is called the endorser.
· Endorsee: The person in whose favour the instrument is transferred is called the endorsee.
Now, let us discuss the features of a promissory note-
· A written document: To be a valid promissory note, it must be in writing. A verbal promise to pay is not a promissory note.
· Unconditional promise to pay: The promissory note must contain an unconditional promise to pay. A conditional promise to pay is not a promissory note. For example, if it is written as “I promise to pay Rs. 5, 000 to Hari, if he comes to my home”, is not a promissory note.
· The parties must be certain: The maker and the payee of a promissory note must be certain.
· The amount payable must be certain: The amount of money which is payable as promised by the maker of the promissory note, must be certain. Money means the legal tender money. If any other things other than money are promised by the maker, it is not a promissory note.

· It must be signed by the maker: The maker of the promissory note must put his signature on the instrument. The note may be signed by the agent of the maker but the agent must clearly state as to on whose behalf he is signing the note. The promissory note must be properly dated and stamped as per Indian Stamp Act.

· Time of payment: A promissory note may be payable on demand or after a fixed period of time. The promissory note which is payable on demand is called demand promissory note and those payable after a fixed period of time is called time promissory note.

The specimen of a promissory note is given below :



CHECK YOUR PROGRESS


A) State whether the following statements are true or false-
i. Negotiable instruments can be transferred from one person to another.
ii. Promissory note is not a negotiable instrument.
iii. Promissory note contains a conditional promise to pay.
iv. A promissory note need not be signed by its maker.
v. A promissory note contains a verbal promise to pay.




MEANING AND FEATURES OF A BILL OF EXCHANGE


Let us discuss another negotiable instrument i.e. bill of exchange. Section 5 of Negotiable Instruments Act, 1881 defines a bill of exchange as “an instrument in writing containing an unconditional order, signed by the maker, directing a certain person to pay a certain sum of money only to, or to the order of a certain person or to the bearer of the instrument.”

A bill of exchange contains an unconditional order as opposed to unconditional promise in a promissory note. The bill must be signed by the maker, usually a creditor, who directs the debtor, to make the payment at a specified future date.

Let us take another example. Suppose, Amar has purchased goods from Hari for Rs. 5, 000 on credit. Amar is the debtor and he have to pay Rs. 5,000 to Hari (creditor). Now, Hari can write a bill of exchange on Amar stating that Amar will pay him a sum of Rs. 5, 000 at a fixed future date. The bill must be accepted by Amar recognizing the fact that he will pay the money at the specified time. Suppose, Hari is indebted to Rakesh for Rs. 5, 000. Now, Hari can transfer the document to Rakesh, who will collect the amount from Amar on due date.
In a bill of exchange, the main parties involved are-

· Drawer: The person, who draws or writes the bill, is called the drawer.
· Drawee or Acceptor: The person, on whom the bill is drawn, is called the drawee.
· Payee: The person, to whom the bill will be paid, is called the payee. The drawer may himself be the payee.

Now, let us go through the features of a bill of exchange-
· The bill of exchange must be in writing.
· The bill of exchange must contain an unconditional order to pay.
· The drawer, drawee and the payee of a bill of exchange must be certain.
· The amount of money which is payable through the bill must be certain. Money means the legal tender money.
· The drawer must sign the bill. It must be properly dated and stamped as per the Indian Stamp Act.
· The drawee must accept the bill by putting his signature on the bill.
· A bill may be payable on demand or after the expiry of a fixed period of time.

The specimen of a bill of exchange is given below :



Differences between promissory note and bill of exchange
We know that both the promissory note and the bill of exchange are negotiable instruments. We have discussed the features of both these instruments. Now, let us discuss the differences between these two-



CHECK YOUR PROGRESS


A) Fill in the blanks:
i. The person who draws the bill is called the ………..
ii. The person on whom the bill is drawn is called the ……….
iii. A bill contains an unconditional ………. to pay.
iv. The ……… must accept the bill.
B) State two differences between a promissory note and a bill of exchange.



LET US KNOW
A promissory note and a bill of exchange can be made payable on demand or after the expiry of a fixed period of time.

MEANING AND FEATURES OF A CHEQUE


You have already come across that the Negotiable Instruments Act, 1881 recognizes three instruments as negotiable instruments. They are promissory note, bill of exchange and cheque. By now you have learnt the two negotiable instruments- promissory note and bill of exchange. In this section, we will deal with the third negotiable instrument i.e. cheque. Perhaps you have seen a cheque. A cheque is made available by a bank to the accountholders to facilitate the transfer of money from one person to another.

The cheque has been defined by Section 6 of Negotiable Instrument Act as “a bill of exchange drawn on a specified banker and not expressed to be payable otherwise than on demand.”

The cheque is an unconditional order given to a banker by its customer to pay a certain amount of money to a person or the bearer of the cheque or a person authorized by the person on whose name the cheque is issued. Only an accountholder can issue a cheque to its bank. The cheque is handed over to the payee and the payee collects the money in person or through his bank.

The main parties to a cheque are-
· Drawer: The person who draws the cheque is called the drawer of the cheque. The drawer is the accountholder of the bank.
· Drawee: The bank on whom the cheque is drawn is called the drawee. In case of cheques, the drawee is always a bank.

· Payee: The person on whom the cheque is payable is called the payee.

Features of a cheque:
A cheque is a bill of exchange. But it has some special features. They are-
· A cheque must be in writing.
· The cheque must be dated.
· It contains an unconditional order to pay.
· The drawer must sign the cheque. The signature of the drawer must match with the specimen signature given by the drawer (accountholder) to the bank at the time of opening the account.
· The cheque is always payable on demand. It means the banker must pay the cheque as and when presented for payment, if all other legal conditions are fulfilled like, availability of funds in the account of the accountholder, the amount of the cheque written in words must tally with the amount written in words etc.
· A cheque is always drawn on a specified banker.
· The parties to the cheque must be certain.
· The amount of money to be payable must be certain.

The specimen of a cheque is given below :



Let us go through the differences between cheque and bill of exchange-



CHECK YOUR PROGRESS


A) State whether the following statements are true or false-
i. The drawer must sign the cheque.
ii. A cheque is drawn on the creditor.
iii. A cheque is payable on demand.
iv. A cheque is not a negotiable instrument.
v. There are only two parties in a cheque.



TYPES OF CHEQUES


In the above specimen of the cheque, the word ‘Bearer’ has been written. It has a special significance so far as a cheque is concerned. If the word ‘Bearer’ is written on the cheque, it means the cheque can be paid to the person whose name is written on the cheque or to any person who presents the cheque to the banker for payment.
Based on this characteristic, cheques can be classified into two main groups. They are-
1. Open cheques; and
2. Crossed cheques

Open Cheques

In case of open cheques, the amount of such cheques can be collected by the payee over the counter of the bank. These cheques are of two types-

1. Bearer cheque: The cheque which is payable to the bearer or the possessor, is called the bearer cheque. Such cheque can be transferred by mere delivery without any endorsement. For example, “Pay Ram or bearer” is a bearer cheque, where Ram or any other person who possess the cheque, can collect the amount of the cheque.

2. Order cheque: The cheque which is payable only to a certain person (whose name appears on the cheque) or to his order, is called the order cheque. The word ‘Order’ is written instead of the word ‘Bearer’ on the cheque. The drawer can strick off the word ‘bearer’ and can write the word ‘order’ to make it an order cheque. An order cheque can not be transferred without endorsement and the paying banker takes reasonable care before making the payment of such cheque. For example, “Pay Ram or order” is an order cheque, where payment will be made only to Ram or to the person to whom Ram has endorsed the cheque.


Crossed Cheques


In case of crossed cheques, the amount of such cheques can not be collected over the counter of the bank. The amount of such a cheque is paid through the bank account of the payee. Hence, they are safer as compared to the open cheques.

A cheque can be crossed by drawing two parallel transverse lines across the face of the cheque with or without the words “and company” or “not negotiable” or “account payee” between the parallel transverse lines. Crossing of a cheque means paying the money to the specified person only by transferring the money to his account and not directly (cash).

A cheque can be crossed by the-
1. Drawer; or
2. The holder; when the cheque is open; or
3. The collecting banker.

Let us discuss the types of crossing:
1. General crossing: Section 123 of the Negotiable Instruments Act, 1881 defines general crossing as “where a cheque bears across its face, an addition of the word “and company” or any abbreviation thereof between two parallel transverse lines simply, either with or without the words “not negotiable”, that addition shall be deemed a crossing and the cheque shall be deemed to be crossed generally.”

It means a cheque can be crossed generally by simply drawing two parallel transverse lines. The parallel lines are generally drawn on the left hand top corner of the cheque. The words “and company” or “not negotiable” may or may not be written in between the parallel lines.



2. Special crossing: Section 124 of the Negotiable Instruments Act, 1881 defines special crossing as “where a cheque bears across its face, an addition of the name of a banker with or without the words “not negotiable”, that addition shall be deemed a crossing and the cheque shall be deemed to be crossed specially and to be crossed to that banker.”
Thus, in case of special crossing, the name of a particular bank is written in between the parallel lines. The main implication of this type of crossing is that the amount of the cheque will be paid to the specified banker whose name is written in between the lines.



3. Account payee crossing: This type of crossing is done by adding the words ‘Account Payee’. This can be made both in general crossing and special crossing. The implication of this type of crossing is that the collecting banker has to collect the amount of the cheque only for the payee. If he wrongly credits the amount of the cheque to another account, he will be held responsible for the same.

4. Not negotiable crossing: When the words ‘not negotiable’ is added in generally or specially crossed cheques, it is called not negotiable crossing. A cheque bearing not negotiable crossing cannot be transferred. If a cheque bearing ‘Not negotiable crossing’ is transferred, care must be taken regarding the ownership of title of both the trasferer and transferee.

 

TYPES OF CHEQUES



In the above discussion, we have come across that a negotiable instrument (promissory note, bill of exchange, cheque) can be transferred from one person to another. At this point of time, it is important to discuss some important aspects relating to transferring of negotiable instruments. Let us start with the meaning and objective of transferring negotiable instruments.

At the first instance, a negotiable instrument is drawn by the maker or drawer. The payee of a promissory note or bill of exchange or a cheque, can transfer the instrument to settle his account with some other person instead of paying cash. Transferring a negotiable instrument implies that the person holding the instrument, transfer it with the objective of transferring the ownership of the instrument and subsequently the transferee becomes the owner of the instrument.

The negotiable instruments can be transferred through negotiation. Negotiation means transferring the ownership right in an instrument from one person to another so as to constitute that person the holder of the instrument.

A negotiable instrument which is payable to bearer can be negotiated by mere delivery. But a negotiable instrument which is payable to order can be negotiated by endorsement and delivery.

Now, what the term ‘endorsement’ mean? The term ‘endorsement’ means writing the name of the person on the back of the instrument to negotiate the instrument in favour of that person. Let us take an example. Mr. A wants to transfer a cheque to Mr. B. Now, Mr. A will write the name of Mr. B on the back of the cheque and put his signature to negotiate the cheque and then he delivered the cheque to Mr. B. This act is called endorsement. Mr. A is the endorser and Mr. B is the endorsee.

Kinds of endorsement
Let us discuss the different kinds of endorsements-
1. General endorsement: In general endorsement, the endorser put his signature on the back of the instrument without specifying the name of the endorsee. This type of endorsement makes an order instrument payable to the bearer. General endorsement is also known as blank endorsement.

2. Special endorsement: In this type of endorsement, the endorser adds a direction to pay the amount of the instrument to, or to the order of, a certain person. Therefore, the bearer is not entitled to get the amount of the instrument. Special endorsement is also known as full endorsement.

3. Restrictive endorsement: This type of endorsement restricts the right of the endorsee as regards further negotiation of the instrument. For example, Mr. A negotiate a bill as “Pay Mr. B only”, is a restrictive endorsement.

4. Conditional endorsement: If any condition is added while endorsing the instrument, it is called conditional endorsement or qualified endorsement. This type of endorsement restricts the liability of the endorser. Conditional endorsement are of the following types-

a) Sans recourse endorsement: When the words “sans recourse” are added as a part of endorsement, it becomes conditional endorsement. The implication of this endorsement is that the endorser is not liable to the endorsee or any subsequent holder, for the dishonour of the instrument.

b) Facultative endorsement: In this type of endorsement, the endorser is liable in the event of dishonour of the instrument, though the notice of dishonour is not served on the endorser as a result of facultative endorsement.

c) Sans frias endorsement: Through sans frias endorsement, the endorser makes it clear that the endorsee or any subsequent holder need not incur any expense on his account in respect of the negotiated instrument.

d) Liability of endorser depends upon a contingency: In this type of endorsement, the liability of the endorser depends upon the happening of an event. If the event does not take place, the liability of the endorser does not arise. For example, if Mr. A makes an endorsement as “Pay Mr. B on his arrival”

CHECK YOUR PROGRESS


A) Identify the parties in the following case-
i. Mr. X, the customer of ABC Bank draws a cheque in favour of Mr. Y, who in turn, endorses the cheque to Mr. Z.
B) State whether the following statements are true or false-
i. A cheque can be negotiated by drawing two parallel lines on the cheque.
ii. An order cheque can be paid to bearer.
iii. In general endorsement, the endorser is not required to put his signature.
iv. In restrictive endorsement the right of the endorser is restricted.
v. The amount of a specially crossed cheque must be paid to the specified banker.


 
 

LET US SUM UP


In this unit we have discussed the following-
  • Negotiable instruments facilitate the transfer of money from one person to another.
  • In India, the rules relating to negotiable instruments are contained in the Negotiable Instruments Act, 1881.
  • According to Negotiable Instruments Act, 1881, promissory note, bill of exchange and cheque are the negotiable instruments.
  • A promissory note contains an unconditional promise to pay a certain sum of money to a certain person. It must be signed by the maker.
  • A bill of exchange contains an unconditional order to pay a certain sum of money. A bill must be accepted by the drawee.
  • A cheque is always drawn on a specified banker and it is payable on demand.
  • Open cheques are of two types- bearer cheques and order cheques.
  • A cheque can be crossed by drawing two parallel transverse lines on the face of the cheque.
  • Different types of crossing are – general crossing, special crossing, not negotiable crossing and account payee crossing.
  • Endorsement means writing the name of the person on the back of the instrument to transfer the ownership right in favour of that person.
  • The person who endorses a negotiable instrument is called the endorser and the person to whom the instrument is endorsed is called the endorsee.


FURTHER READINGS


  • Practice and Law of Banking by B. S. Khubchandani
  • Banking Law and Practice by S.N. Maheshwari

ANSWERS TO CHECK YOUR PROGRESS


Answer To check Your Progress 1
A)
i. True
ii. False
iii. False
iv. False
v. False

Answer To check Your Progress 2
A)
i. drawer
ii. drawee
iii. order
iv. drawee

B)
i. There are mainly two parties in a promissory note.
There are mainly three parties in a bill of exchange.
ii. Promissory note contains an unconditional promise to pay.
Bill of exchange contains an unconditional order to pay.

Answer To check Your Progress 3
A)
i. True.
ii. False
iii. True.
iv. False.
v. False.

Answer To check Your Progress 4
A)
i. Mr. X- Drawer
ABC Bank- Drawee
Mr. Y- Payee and Endorser
Mr. Z – Endorsee
B)
i. False.
ii. False
iii. False.
iv. False.
v. True.



POSSIBLE QUESTIONS


1. Define bill of exchange. Mention the parties to a bill of exchange.
2. Define cheque.
3. Differentiate between promissory note and bill of exchange.
4. What do you mean by crossing of a cheque?
5. write short notes-
i. General crossing.
ii. Special endorsement.


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