Negotiable instruments are written orders or unconditional promises to pay a fixed sum of money on demand or at a certain time. Promissory notes, bills of exchange, checks, drafts, and certificates of deposit are all examples of negotiable instruments. Negotiable instruments may be transferred from one person to another, who is known as a holder in due course. Upon transfer, also called negotiation of the instrument, the holder in due course obtains full legal title to the instrument. Negotiable instruments may be transferred by delivery or by endorsement and delivery.
One type of negotiable instrument, called a promissory note, involves only two parties, the maker of the note and the payee, or the party to whom the note is payable. With a promissory note, the maker promises to pay a certain amount to the payee. Another type of negotiable instrument, called a bill of exchange, involves three parties. The party who drafts the bill of exchange is known as the drawer. The party who is called on to make payment is known as the drawee, and the party to whom payment is to be made is known as the payee. A check is an example of a bill of exchange, where the individual or business writing the check is the drawer, the bank is the drawee, and the person or business to whom the check is made out is the payee.
To be valid a negotiable instrument must meet four requirements. First, it must be in writing and signed by the maker or drawee. Second, it must contain an unconditional promise (promissory note) or order (bill of exchange) to pay a certain sum of money and no other promise except as authorized by the Uniform Commercial Code (UCC). Third, it must be payable on demand or at a definite time. Finally, it must be payable either to order or to bearer.
The laws governing negotiable instruments are spelled out in Article 3 of the UCC. Modeled after the Negotiable Instruments Law, Article 3 has been adopted as law by all 50 states and the District of Columbia. It spells out the basic requirements for valid negotiable instruments and covers such matters as the rights of the holder, types of endorsement, warranties given to subsequent holders, forgeries, dating, and alterations.
A negotiable instrument is said to be dishonored when, upon presentation, payment or acceptance has been refused. To qualify as a holder in due course, an individual or business must have taken the negotiable instrument before it was overdue and without notice that it had been previously dishonored, if such was the case. The negotiable instrument must also be complete and regular upon its face; that is, all of the necessary information must be present. The holder must also take the instrument in good faith and for value. At the time it was negotiated, the holder in due course must have had no notice of an infirmity in the instrument or a defect in the title of the person negotiating it.
If these conditions are met, then the holder in due course generally holds the instrument free from any defect of title of prior parties involved with the instrument. The holder in due course may enforce payment of the instrument for the full amount against all parties liable thereon, free from any defenses available to prior parties among themselves.
Negotiable instruments may be endorsed in various ways, and some negotiable instruments do not require any endorsement. If a negotiable instrument is a bearer instrument, then it may be negotiated by simply delivering it from one person to another with no endorsement required. Such negotiable instruments typically have a blank endorsement consisting of a person's name only. If the negotiable instrument is an order instrument, then the payee must first endorse it and deliver it before negotiation is complete. For example, if the instrument says, "Pay to the order of Jane Smith," then it is an order instrument and Jane Smith must endorse it and then deliver it to the payer or drawee.
Endorsements such as "Pay to the order of Jane Smith" are known as special endorsements and have the effect of making the instrument an order instrument rather than a bearer instrument. Restrictive endorsements ("Pay to Jane Smith only") and qualified endorsements ("Pay without recourse to the order of Jane Smith") also have the effect of requiring the payee to endorse the negotiable instrument. Qualified endorsements also affect the nature of implied warranties associated with endorsement.
Under the UCC, an unqualified endorser who receives payment or consideration for a negotiable instrument provides a series of implied warranties to the transferee and any subsequent holder in due course. An unqualified endorser warranties that he or she has good title to the instrument or represents a person with title, and that the transfer is otherwise rightful. The endorser also warranties that all signatures are genuine or authorized, that the instrument has not been materially altered, that no defense of any prior party is good against the endorser, and that the endorser has no knowledge of any insolvency proceeding involving the payer.
Other issues concerning negotiable instruments are also covered in Article 3 of the UCC. In the case of a forgery, the negotiable instrument becomes inoperative. Antedated or past-dated instruments are not invalid, provided the dating was not done for fraudulent or illegal purposes. Negotiable instruments that have been materially altered without the permission of all parties involved are void. But a holder in due course who is not party to the material alteration can enforce payment according to the instrument's original terms. Also covered in Article 3 are interpretations of contradictions that may appear from time to time in negotiable instruments.
[ David P. Bianco ]
Gallinger, George W., and Jerry B. Poe. Essentials of Finance: An Integrated Approach. Englewood Cliffs, NJ: Prentice Hall, 1995.