A negotiable instrument is (a) a guarantee, promise, or obligation (b) made by a specified party (c) to pay an exact amount (d) either on demand, or at a set time. Such instruments are typically memorialized in, and evidenced by, a document or contract which details a promisor’s obligation to pay money without condition either on demand or at a future date. The expression of the obligation often includes, but does not have to, a description of how the obligation arose and the party to whom the obligation is owed. The instrument, and the right to collect payment on the instrument, can be transferred by whomever has rightful, legal title to the instrument. Therefore, while the promisor always retains the obligation to pay, person to whom the obligation is owed may change depending on who holds the instrument.
Rightful Possession. Rightful possession of the document containing the promise of payment entitles the holder to receive payment according to the terms stated therein. “Rightful possession” refers to a “holder in due course”, which means that the possessor of the instrument must obtain possession of the instrument by lawful means from the promisor or from the previous rightful possessor. Obtaining a negotiable instrument through theft or fraud, for example, does not give one the right to collect payment on the instrument. Conversely, obtaining the instrument by purchasing it or receiving it as a gift from the previous holder are examples of how one may obtain rightful possession of the instrument, and lawful title to receive the benefits of the obligation.
Negotiability. The word “negotiable” refers to the instrument’s ability to be transferred (or “negotiated”) for an agreed upon value between parties. The negotiability of the instrument arises from its unconditional nature. Since the value of the instrument does not depend on anything other than the value stated in the instrument, this allows for easy valuation, which makes the instrument easy to transfer. To appraise the value of a negotiable instrument, one must assess the ability of the promisor to make payment and the likelihood that they will deliver on their promise. However, if the instrument were conditioned upon the occurrence of other events, the value of the instrument would have to account for the likelihood that those events will occur. Thus, the unconditional nature of the obligation to pay specified in a negotiable instrument allows for easy valuation and transferability.
Transferring the Instrument. The instrument may be transferred (or “negotiated”) to a third party when the holder of the instrument endorses and hands it over to the purchasing (or “discounting”) party. The final holder of the instrument will ultimately get paid by the party obligated to pay on the instrument. Transfers can happen at less than the face value of the instrument and this is known as discounting, which may happen if there is doubt about the payer’s ability to pay.
Examples of Negotiable Instruments. Common examples of negotiable instruments include promissory notes, bills of exchange (also known as drafts) and checks. The most commonly encountered instruments in export / import transactions are bills of exchange and promissory notes. While bills of exchange or drafts are the most frequently encountered negotiable instruments used in international trade transactions, promissory notes are also commonly used.
While different categories of negotiable instruments vary in their form, their core features are essentially the same throughout. A promissory note contains a written promise by one party to pay another party a definite sum of money either on demand or at a specified future date. A promissory note typically contains all the terms pertaining to the indebtedness by the issuer or maker to the note’s payee, such as the amount, interest rate, maturity date, date and place of issuance, and issuer’s signature. By contrast, a check simply states an amount that can be drawn, typically from a bank institution. When a check is endorsed to someone, that person becomes a holder in due course and obtains legal title to collect or draw the amount stated in the check. All of the above examples are independent payment undertakings that can be transferred from one person to another.
Governing Law. In the most countries, negotiable instruments are ruled by legal norms specific to the country. In the United States, most states have adopted the Uniform Commercial Code, which defines negotiable instruments and other payment schemes and methods commonly used in the course of routine business and commercial transactions. (see https://www.law.cornell.edu/ucc/3/3-104 for a definition of “negotiable instruments” according to the UCC).
Other Resources. A number of websites define discuss negotiable instruments. Below is a list of a few we found helpful:
Investopedia: http://www.investopedia.com/terms/n/nonnegotiable.asp (describing “non-negotiable instruments”)
General Information about the Uniform Commercial Code: http://www.nolo.com/legal-encyclopedia/uniform-commercial-code-ucc
Uniform Commercial Code Full Text: https://www.law.cornell.edu/ucc