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Commercial Credit Instruments

1. Open Book-account.

The most elementary type of credit instrument may be said to be the open book-account. A
sells goods to B and debits him with the value of these goods, or in the current phrase
"charges" them to him. A necessarily carries some kind of account books which, in the event
of necessity, can be produced and which contain entries to show the amount of goods he has
transferred to B. Such books are records, having, of course, only the validity which they
acquire from the fact that they are entries made in good faith at the time of the transaction to
which they refer. Ordinarily they present no evidence of having been acknowledged by B.
Nevertheless, they are in a sense a credit instrument - that is to say, they are a means of
recording or measuring credit, or of furnishing evidence that it has been extended. The idea
becomes more fully developed when we conceive of both A and B as keeping records, each
perhaps purchasing from the other, and their records, therefore, agreeing substantially with
regard to the amount of goods given and received. If at the end of a fiscal period they
exchange receipted statements, these are evidently elementary credit instruments, and
present on their face evidence that the transaction indicated by the charges to account has
been completed through the transfer of an equal amount of goods, or through some other
form of credit. Such receipted statements are a derivative of the books of record of the
concern, and may be regarded in an even fuller sense than the former as being credit

2. Promissory Note.

Another step in the direction of the credit instrument is taken when the recipient or buyer of
the goods gives to the seller an acknowledgment that they have been received. This might
conceivably be nothing more than a receipt for the goods - a signed statement that he had
received a given number of bushels of wheat or yards of cloth of a certain kind. Examples of
this sort are seen in the warehouse receipt which plays so important and growing a part in
business to-day. A cotton warehouse receipt, for example, is merely the acknowledgment of
the warehouse operator that he has received from his customer a given amount of cotton of a
specified grade and is holding it for him. A still further step is taken when the receipt specifies
the value of the goods - B, for example, certifying to the receipt of a given number of bushels
of wheat at $1 per bushel. Since in this instance B has acknowledged receiving goods of a
specified value, it is inferred that he has obligated himself to settle for or liquidate the
obligation in an equal amount. A final step may be taken when B does not specify the kind or
character of the goods received, but merely acknowledges himself to be indebted in a
specified amount for "value received." In this case a full-fledged "credit instrument" has been
worked out. It is what is ordinarily termed a note, and constitutes a legal obligation on the part
of B to pay A a given number of dollars - that is to say, to return to B value which is
represented by a given sum in dollars, although A may, if he choose, exact an actual
settlement in money.

3. Bill of Exchange.
Exactly the same result might be reached by a somewhat different route, giving rise to a
rather different type of credit instrument. If A, when he sent the goods to B, had drawn upon
the latter by issuing an order to him to pay a specified sum either to A himself or to some one
else at a given date, this order would have been called a "draft" or bill of exchange .

Bills of exchange may be classified according to the party on whom drawn or the time when
payable. If drawn on a person, firm, or corporation, they are called trade bills, and if on a
banking institution, they are described as bankers' bills. They are termed sight drafts if
payment can be demanded on presentation, or at a fixed time after sight, and time bills if they
mature on a specified future date. The term "acceptance" may have several meanings and
therefore requires explanation. In the first place it may refer to the act of the drawee in writing
across the face of the instrument a formal acknowledgment of the order addressed to him by
the drawer and an agreement to pay the obligation at its maturity. The term acceptance is
also applied to a time bill of exchange which has thus been duly accepted. This use of the
expression "acceptance" is found in commercial practice, but is not recognized in law.

Promissory Note

Bank Check
Bank Acceptance

In a more restricted sense, acceptance is the expression inscribed on the bill by the acceptor.
It may be written simply as follows:

Accepted July 1, 1921. William Smith.

This form is described as unqualified acceptance, for the drawee agrees to make payment at
the time, to the parties, at the place and in the amount specified on the face of the bill. The
acceptance written by the drawee is said to be "qualified" when it differs in any way from the
order addressed by the drawer. The above acceptance may be qualified in any one or more
of the following ways:

(1) Time. The bill reads "payable thirty days after sight," but the acceptor extends the time to
sixty days after sight.

(2) Parties. The draft is drawn on Jones and Smith, but Smith alone accepts.

(3) Place. A draft is payable at the acceptor's business office, but the place of payment is
restricted by an acceptance, reading, "Payable at the X Bank only."

(4) Amount. The bill is drawn for $1,000, but the drawee acknowledges only $800 and not the
full amount.

4. The Check.

The credit instruments which we have spoken of thus far have been, as already seen,
evidence of obligations growing out of the transfer of goods between individuals and giving
rise to obligations stated either in terms of goods or in terms of money. There is no reason,
however, why the transaction should not be an operation in money throughout. For example,
if A advances to B a title to money or money itself, he may simply charge B with the amount
on his books, or if B "deposits" money with A, the latter may simply credit the former with the
amount. When a bank does this it enters the amount thus deposited in a deposit book or bank
book which is presumably a duplicate of B's account as carried on the books of A (in this case
the bank), and which thus acts as a kind of receipt or voucher, or, as we have learned to call
it, a credit instrument. Suppose now that B, desiring to withdraw some of these funds from the
custody of A, directs A to pay them out in cash either to himself or some one else, or to
transfer them on his books to the credit of some one else, a written instrument will be needed
for this purpose, which is nothing more than an order to A to pay or transfer the credit
obtained by B. This is called a draft or check. When the transaction in question occurs
between an individual (B) and the bank (A) the term "check" is universally employed, and the
check is in the fullest sense of the term a credit instrument.

II. Legal Aspects

In commercial usage the term bill, or bill of exchange, is practically synonymous with the draft
or accepted draft. Where the words notes, drafts, and bills of exchange are used, the term
"notes" covers direct obligations between persons of the kind already referred to; the term
"drafts" usually means orders drawn upon a bank or by one bank upon another, while the
term "bills," or bills of exchange, is used to include drafts, whether accepted or unaccepted,
growing out of transactions in goods.

Lawyers usually apply to the economic class of credit instruments the term "negotiable
paper." Negotiable paper is not exactly identical with credit instruments, the concept of the
lawyer being rather different from that of the economist or of the individual business man.
Works on legal relationships and commercial paper usually state that there are to be included
under the term "negotiable instruments," or "negotiable paper," checks, drafts, and bills, the
last named being either accepted or unaccepted. Negotiability is defined by lawyers as the
power to transfer title absolutely and without the necessity of notice incurring liability on the
part of the recipient. For example, if A gives B a check, B may indorse the check and transfer
it to C ,who may then cash it without paying any attention to the question whether B had come
by the instrument lawfully or whether he was indebted to others who may have been
conceived to have a prior claim or not.

The parties to negotiable paper are said to be the maker or drawer, the drawee, and the
various 3indorsers. Thus if A borrows $500 from B and gives B a note for $500, A is the
maker of the note which evidences the transaction. If, however, B draws on A for $500, B is
the maker or drawer of the draft and A is the drawee. If B then accepts the draft he is the
acceptor. A party who comes into possession of an instrument before its maturity through
legitimate means, and with the belief in its legality, is known as the "bona-fide holder" or
"holder in due course."

1. Conditions of Negotiability

Since credit instruments are the means of making payments, they must possess certain
characteristics which enable them to pass freely from hand to hand. In the United States,
these features are summarized in the Negotiable Instruments Law as requiring that a credit

"1. Must be in writing and signed by the maker or drawer;

2. Must contain an unconditional promise or order to pay a certain sum in money;

3. Must be payable on demand or at a fixed or determinable future time;

4. Must be payable to the order of a specified person or to bearer: and,

5. Where the instrument is addressed to a drawee, he must be named or otherwise indicated

therein with reasonable certainty."

Thus the essential conditions of negotiability relate to the general nature, parties, and
payment of the instrument.

Although a credit instrument is in the nature of a contract, it must always be in written form.
An oral obligation to pay money would not be a tangible evidence of the debt and so could not
be transferred from one party to another.

Further, the instrument must be specific in its reference to all parties. The maker must affix his
name to the instrument, otherwise he cannot be held liable for an obligation which he has not
signed. The signature must be a true one, since the holder of a forged instrument has no
claim against a party whose name has been thus misused. Although the instrument must
indicate a payee, this does not necessarily mean that the name of the individual payee shall
be specified. An instrument reading, "Pay ten dollars to John Smith," is nonnegotiable in form,
while, on the other hand, "Pay to bearer" is negotiable, since any holder for value may claim
payment. The instrument may be addressed to a definite payee or his order as, "Pay to the
order of John Smith." Forms which are payable to bearer or to order are negotiable, for they
indicate an intention on the part of the maker or drawer to become generally liable not only to
the person named, but to unknown persons into whose hands it may pass, while in the case
of an instrument not payable to order or bearer the maker or drawer contemplates liability only
to the payee specified.

A negotiable instrument must also definitely determine the manner of payment. All credit
instruments contain either an order to pay, as in the case of check, or a promise, as in the
note. This order or promise to pay must be absolute and in no way conditional. For example,
a note in which the maker agrees to pay one hundred dollars "out of the next dividends of the
United Textile Corporation" would be nonnegotiable, for its payment is contingent on the
action of directors who may or may not declare dividends. Because a negotiable instrument
performs a function similar to that of money, the promise or order must be payable in money
and in an amount that is certain. An order to pay 100 shares of United States Steel would not
be considered a negotiable instrument. Although these securities are readily sold on the
market and easily converted into cash, still they possess a value which is continually
fluctuating, and so is not certain in amount. Payment must, therefore, be made in legal-tender
money, which means United States currency. If so specified in the instrument, payment may
be effected in another currency, such as the German mark, even though the value of this unit
in terms of the dollar varies from day to day.

There must be no uncertainty as to the time of payment. If payable at sight, the obligation
becomes due upon presentation, but if at future time, this date must be fully determinable. "
Sixty days after death," "on or before July 1, 1921," are both determinable periods of time,
and in fact "six months after my death" also is an ascertainable date, for it follows after an
event which is inevitably bound to happen. However, a promise to pay money "when A is
twenty-one years old" is nonnegotiable, for A may never attain this age.

2. Indorsement

The correct procedure of negotiating an instrument follows certain legal principles which have
been gradually developed by commercial usage. An instrument which is payable to bearer
may be negotiated by a holder in due course merely by transferring it to another party, and
this act is known as delivery. But if the document is payable to the order of a specified
individual, the holder must indicate the surrender of his title by writing his signature upon the
reverse side of the instrument. This act is known as indorsement. Therefore negotiation is
accomplished either by simple delivery or by delivery and indorsement. The payee who
performs the act of indorsement is called the "indorser," and the party to whom title is
transferred is known as the "indorsee."

Indorsement may serve another purpose in adding to the strength of an obligation. If A gives
B a promissory note , it may be further strengthened by having C add his indorsement. Thus
C gives his conditional promise to reimburse B in the event of refusal on the part of A.

The various forms of indorsement may be classified in respect to parties mentioned or

qualifications stipulated. As to parties, indorsements may be either "special" or "blank." A
special indorsement states the name of the indorsee, as, "Pay to the order of John Smith,"
who alone can further transfer the instrument. When the indorsee is not designated, the form
is called a blank indorsement. The instrument may then be negotiated by any holder upon
mere delivery, for no further indorsement is required. This form may well be used in
depositing a check with a bank. The depositor who signs a blank indorsement thus allows his
bank complete freedom in securing payment of the check, for the funds are payable to any

Classified on a different basis, indorsements are either unqualified or qualified and restrictive.
The illustrations given above are both unqualified, since they contain no statement which
limits the free negotiation of the instrument. A qualified indorsement transfers the title of an
instrument, but at the same time exempts the indorser from the usual liabilities which result
from this act. To accomplish this purpose, the indorser writes before his name the expression
"without recourse," and thus serves notice on any holder that he cannot enforce his usual
claims against the indorser if the original drawee refuses to meet his obligation. An instrument
may be qualified in another way by placing upon it a restrictive indorsement, such as the
following: "Pay to the X Bank for collection." The indorser thus names the bank as indorsee
for a specific purpose, which in this case is to secure payment of the instrument. The
consequence of this form of indorsement is to end the negotiability of the instrument, for the
indorsee is prohibited from further transferring it.
One of the earliest forms of a credit instrument is the check. Utilized by consumers as a legitimate
means of paying for goods and services received, the value of the check is underwritten by funds
that are placed in a bank account. Upon the presentation by the recipient of the credit instrument,
the bank deducts the specified amount as recorded on the check by the debtor. While the check is
no longer the main credit instrument employed in many financial transactions, it remains in use by
many businesses and individuals.

The credit card is another example of a common credit instrument. Using a credit card to pay for a
purchase creates a contract between the buyer and the seller. Essentially, the seller is extending
credit to the buyer with the assumption that the company issuing the card will cover the amount of
the purchase. In turn, the issuer of the credit card is anticipating that the cardholder will eventually
pay off the amount of the debt along with applicable interest and finance charges.

A third type of credit instrument is the promissory note. With this arrangement, debtors receive
funds from lenders with the understanding that the note will be repaid in full at a future point in
time. This type of debtor’s obligation may carry a specific date for repayment of be open-ended.
Promissory notes may be utilized in the lending of funds between individuals or between two
business entities.