For businesses to operate efficiently, money needs to be able to change hands easily, like cash. However, businesses also need to be sure that they will have a legal claim to be repaid the money if things don’t go smoothly, something that contracts typically provide. Bills of exchange, cheques, and promissory notes belong to a special category of contracts known as negotiable instruments (a fancy way to say “transferable documents”), which operate under some special rules to allow businesses to fulfill those needs. In sum, they allow you to “detach” your obligation to pay under a contract and have it be bought, sold, or traded freely.
Legal Requirements for Negotiable Instruments
In Canada, the rules for how bills of exchange, cheques, and promissory notes work are set out in the Bills of Exchange Act (the “Act”). It was written with the presumption that a person should be able to take the instrument at face value, and as a result it imposes five very specific requirements on negotiable instruments. They must:
- Be written and signed: In most cases, it’s just prudent business to get your contracts on paper rather than a necessity, but with negotiable instruments it’s required by law.
- Identify the parties: It should always be possible to clearly identify who is required to pay. However, it might not be required to identify who is entitled to payment.
- State a certain sum of money: It should be possible to immediately identify a certain sum of money just by looking at the document. Usually this is done by explicitly stating the amount to be paid but can also be a formula to calculate a certain sum, with clear interest rates and payment dates.
- State a specific time of payment: Whoever is looking at a negotiable instrument should be able to figure out exactly when it can be converted to cash. Again, the easiest way to do this is by explicitly stating the date, but something like “two business days before Easter Monday, 2018” would also work. If the payments are going to be made in instalments, the schedule should be set out.
- Contain an unconditional obligation: Negotiable instruments must contain an unconditional obligation to pay the certain sum of money. All of the uncertainties are dealt with in the underlying contract (eg. a sales agreement) between the original transacting parties.
To be clear, a document that’s missing one or more of these elements could still be an enforceable contract, but it won’t qualify as a negotiable instrument under the Act.
To appreciate how negotiable instruments differ from other contracts, we’ll build upon the following example.
Sam enters a purchase agreement to buy 100 barbeque grills at $400 apiece (at a total of $40,000) from Janet for his hardware store. Although he has promised to pay under the contract, Janet wants a cheque, which is technically a new contract. The cheque is payable to cash (the party entitled to payment is not named), and is therefore a promise to pay the $40,000 to whoever presents it at Sam’s bank (“Bank”).
Janet could go to cash the cheque herself. In case the bank refuses to honour it, she can sue him on the purchase agreement or on the cheque. It’s easier to sue on the cheque because it’s easier to prove the existence of the obligations in a negotiable instrument. However, suppose Janet owes money to her supplier, Lee. Instead of cashing Sam’s cheque herself and then transferring the money to Lee, she just hands the cheque to Lee, who cashes it for himself. Now, if Bank refuses to honour the cheque, Lee will have recourse against Janet and Sam.
In this manner, there was only one monetary transaction – from Sam’s Bank account to Lee. With fewer transactions, and the simple transfer of a paper, everyone’s debts are settled and cash only had to move once to get where it needed to go.
Regular Contracts vs. Negotiable Instruments: Consideration
For a contract to be enforceable (in common law jurisdictions), parties must exchange consideration which is just “something of value.” Returning to our earlier example, Sam promised to pay a certain sum of money and Janet promised to deliver barbeque grills. Here, both parties exchanged consideration.
However, you cannot use something you already did or already owe a party as consideration for a subsequent contract with that party. Janet already gave Sam her promise to deliver the grills. She cannot use that as consideration on a contract they sign later to get Sam to promote her products in his store. Sam is making a new promise to provide a promotional opportunity. Janet must make a new promise to match this.
Negotiable instruments ignore the rule on double-dipping with your consideration. Sam paid for the grills by cheque, effectively signing two contracts – the purchase agreement and the cheque. Janet’s promise to deliver the grills operates as consideration on both.
Regular Contracts vs. Negotiable Instruments: Privity
A contract is only enforceable by parties with privity, meaning that if you did not participate in the creation of the agreement or have no obligation or benefits under it, you cannot sue over it. If Sam failed to pay Janet, nobody other than Janet can sue for breach of contract. However, anyone who holds a cheque can sue on it. Since Sam paid by cheque, and Janet negotiated it to Lee, if Bank doesn’t honour Sam’s cheque, Lee can now sue Sam. Again, this is a consequence of the unconditional obligation and helps facilitate transactions.
Regular Contracts vs. Negotiable Instruments: Assignment
You can also assign rights under a contract, unless the contract states otherwise. However, the assignee (the person to whom the rights have been assigned) cannot be better off than the assignor (the person who assigned their rights).
Suppose that Janet had decided to assign her rights under the contract to Lee instead. Lee now has all the rights under the contract that Janet would have, no more and no less. Janet was entitled to receive $40,000 for the delivery of 100 grills to Sam. However, she breached the contract and only delivered 80 grills (worth $32,000) by the specified date. Now Lee can only recoup $32,000 from Sam because of Janet’s breach because he has acquired the contract subject to the equities.
Since Janet actually gave Lee the cheque for $40,000, Lee is now entitled to recoup the full $40,000 despite Janet’s breach because he can rely on the cheque at face value. If you’re thinking “hey, that’s unfair to Sam,” that’s because it is! Unfortunately, Sam has become the sacrificial lamb at the altar of economic efficiency.
Negotiable instruments are extremely complicated and this article barely scratches the surface. There are plenty of default rules stated here with numerous exceptions and plenty of topics we glossed over and simplified for the sake of brevity. But out of all this, there are a few broad takeaways…
- Every negotiable instrument should always be written and signed, specify a certain sum of money to be paid, specify who is to pay the money, specify when the money is payable, and contain an unconditional obligation to pay the specified sum.
- Negotiable instruments operate free of the equities – they are intended to create commercial efficiency which can sometimes leave you without recourse against a party that wants to cash a cheque.
- Consider the financial risk you are exposing yourself to before signing a negotiable instrument.
Author: Sahil Kanaya
– – – This article is provided for informational purposes only and does not create a lawyer-client relationship with the reader. It is not legal advice and should not be regarded as such. Any reliance on the information is solely at the reader’s own risk. Clausehound.com is a legal tool geared towards entrepreneurs, early-stage businesses and small businesses alike to help draft legal documents to make businesses more productive. Clausehound offers a $10 per month DIY Legal Library which hosts tens of thousands of legal clauses, contracts, articles, lawyer commentaries and instructional videos. Find Clausehound.com where you see this logo.
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This article is provided for informational purposes only and does not create a lawyer-client relationship with the reader. It is not legal advice and should not be regarded as such. Any reliance on the information is solely at the reader’s own risk. Clausehound.com is a legal tool geared towards entrepreneurs, early-stage businesses and small businesses alike to help draft legal documents to make businesses more productive. Clausehound offers a $10 per month DIY Legal Library which hosts tens of thousands of legal clauses, contracts, articles, lawyer commentaries and instructional videos. Find Clausehound.com where you see this logo.