A brief Post About Banking Instruments

9/27/2015 07:43:00 AM

What is a negotiable instrument?

Negotiability of an instrument depends on 2 criteria -

Price Rigidity - The price of the instrument is not firmly established, and can be adjusted depending on the circumstances. If it cannot be adjusted or be changed, then it is non-negotiable.
Transferability - The instrument can be transferred from one party to another, provided all proper documentation are included and valid. But if the ownership cannot be transferred, then it is deemed to be a non-negotiable instrument.

For example, Certificate of Deposit (CD) is a negotiable instrument, whereas Indian Government Savings bonds are non-negotiable instruments.
Negotiable Instruments Act, 1881 (India)
It is a British colonial age act that is still in use. It defines 3 types of negotiable instruments that are widely used in Indian market - Promissory Notes, Bills of exchange, Cheques.

Before going into the topics, let some concepts be cleared first -

Unconditional Undertaking / Promise - You are promising or undertaking to pay without any condition
Unconditional Order - You are providing an order (to someone, or some institution, or bank) to pay without any condition

Two more concepts -

Pay to Bearer - Pay the amount to, whoever comes with (bears) the instrument and demands to be paid

Pay to Order - Pay to a certain person, not anybody.

Promissory Notes -

It is a negotiable instrument in writing with an unconditional undertaking/promise, signed by a maker, to pay a certain amount of money to the order, or bearer of the instrument.

What we get from the definition?

It should be in writing
It is an unconditional undertaking / promise to pay
It should be signed by the maker / issuer. Remember it involves only 2 parties - the maker and the payee.
Payable to both bearer and order of the instrument

Bills of Exchange -

It is a negotiable instrument in writing with an unconditional order, signed by a maker, ordering a certain person/institution, to pay a certain amount of money to the order, or bearer of the instrument.

What we get from the definition?

It should be in writing
It is an unconditional order to pay (not an undertaking) [refer previous post for the difference]

It should be signed by the maker / issuer. Remember it involves 3 parties -

the maker/drawer/issuer, the drawee (may be a bank, or institution, or other person, whom the drawer is directing for
payment to the payee) and the payee (whom the drawer is paying)
Payable to both bearer and order of the instrument

Cheques -

It is a special type of bill of exchange, which is drawn on a specified banker (i.e., drawee is always banker), and not expressed to be payable otherwise than on demand.

What we get from the definition?

It is a special type of Bill of Exchange, where drawee is fixed (i.e., the banker)
As it a Bill of exchange, it is therefore an unconditional order to pay

It should be signed by the maker / issuer (i.e., the account holder of a bank).

Remember it involves 3 parties -

the drawer (e.g. account holder),

the drawee (always banker), and

the payee (whom the drawer is paying)
It should be paid on demand (i.e., whenever the cheque is presented to the bank)
Payable to both bearer and order of the instrument

Example - The drawer is the individual who issues the cheque, instructing the bank (drawee) to pay the recipient (payee)

Note - In case of cheque, drawee is always a banker or bank, whereas in case of BOE, drawee could be bank or any person

Now try to clear the differences between these three -

	Promissory Note	Bill of Exchange	Cheque
Nature	Unconditional undertaking, or promise to pay	Unconditional order to pay	Unconditional order to pay
Parties	2 parties – maker, payee	3 parties – drawer, drawee, payee	3 parties – drawer, bank, payee
Liability	Liability of maker is primary	Liability of Drawer (maker) is secondary, drawee (e.g. bank) is primary	Liability of drawer (maker) is primary
Special cases	Maker and payee must be two different persons	Both drawer and payee may be the same person	Both drawer and payee may be the same person for Self-cheque
Acceptance	No need of acceptance of maker, while presenting for payment	Can be presented for payment only when it is accepted by drawee (acceptance is must, before drawee can be made liable upon it)	Does not require any acceptance
Conditions	A maker cannot put any conditions on it	Drawee can put conditions only if he accepts the bill	Can be drawn payable to bearer or on demand
Legality cases	If doesn't contain payee’s name, but state to be payable to bearer, is illegal.	When made payable to bearer, it is not considered as illegal (entitled to 3 days of grace unless it is payable on demand)	Payable immediately on demand without any days of grace

Dishonor

If dishonored, no notice required

If dishonored, a notice of dishonor is required to be given by the holder (payee) to the maker of the bill (drawer)

Notice of dishonor is not necessary. Want of assets in the hands of banker is sufficient notice

Bearer Cheque & Ordered Cheque

There are two types of cheques -

Payable to bearer -

Whoever bears or holds the instrument. If you don't provide any crossing on the cheque, then it will be a bearer cheque. If you take it to the bank counter, you will be able to en-cash the cheque, without any issue.
Payable to order -

Only to a certain person/institution. If you provide a crossing on the cheque, it will be a ordered cheque. There will be several conditions for an ordered cheque as described below.

Crossing of Cheques are defined in Section 123 of Negotiable Instrument Act, 1881. There are four types of crossing (i.e., putting conditions on cheque):

1. Crossed Generally [Putting Two Parallel Transverse Lines on the cheque]

It provides the condition to the banker that the amount can be credited to any account but through a banking channel, so that the beneficiary may be traced.

2. Crossed Specially [Putting the name of the banker, e.g., SBI, ICICI, etc]

Here the bank makes payment only to the banker whose name is written in the crossing. It is more safe than the generally crossed cheques, because it restricts to the only banker you want to use.

3. Account Payee / Restrictive Crossing - [Putting the word 'Account payee']

The collecting bank is supposed to credit the amount only to the account of payee, nowhere else.

4. Non-negotiable Crossing - [Putting the word 'Not Negotiable']

Here, you are making the cheque (which is a negotiable instrument) non-negotiable. It means you cannot endorse the cheque to other person (restricting the transferability, refer to the previous posts)

For a better understanding of Not-negotiable crossing, here is an example scenario -

A buys a car from B, A gives a cheque crossed ‘not negotiable’. B gives it to C. C loses the cheque and it is found by D. D forges C’s endorsement and endorses it over to E. If the cheque is dishonored, E can sue D, but has no recourse to sue A, B or C, as it is marked ‘not negotiable’. Even though E accepted the cheque in good faith and ‘for value’ he cannot get a better title than the prior endorser D, who had none. Without the words ‘not negotiable’ E could have sued A, B, or D as prior endorsers (C can’t be sued as his endorsement was forged).

Demand Draft

It is a negotiable instrument similar to a bill of exchange, with some special features.

Demand Draft or DD is always issued by a bank (drawer) on behalf of its customers after taking the amount from him/her. The bank then directs another bank or its own branches (drawee) to pay a certain sum (the amount received from the customer) to the specified party (payee, whom the customer wants to pay).

You could think that why would you use a Demand Draft instead of a Cheque. There are few good reasons behind it -

Before issuing a DD, the bank will take the amount (advance payment) from the customer, i.e., the payment is guaranteed. But in case of Cheque, it could bounce, if the account of the customer doesn't have sufficient balance in it. So, to eliminate the risk, the payee could ask you to provide a DD instead of a Cheque.
For issuing a DD, you don't need a bank account, you can go to the bank counter, and issue it. But cheque is inherently related with a bank account.

Now, try to understand about the differences between a Demand Draft and a Cheque -

	Demand Draft (DD)	Cheque
Parties	Drawer – bank only (individual pays), Drawee – Same or other banks, Payee – any party	Drawer – individual/ac holder, Drawee – banker of individual, Payee – any party

Negotiability	DD can only be made payable to a specified party, also known as pay to order	Cheques can also be made payable to the bearer, along with pay to order
Payments	Orders of payment by a bank to another bank	Orders of payment from an account holder to the bank
Honor	Always honored, because already paid	Can be dishonored, depending on account balance
Guarantee	Issuer party is backed by a bank guarantee	Issuer party is liable to the cheque and not backed by a bank guarantee
Defined	Not precisely defined in NIA Act	NIA Act, 1881

To Be Continued