Pillai Institute of Management Studies and

Research (PIMSR),
New Panvel

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Master of Management Studies (MMS)
Semester - IV
Subject (Finance - Elective) :
Commercial Banking

Lesson-6 : Legal Aspects of Banking

Lecture date : 30.1.2018

by
Prof. K.G.S. MANI

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Lecture date : 30.1.2018
Lesson - 6 : Legal Aspects of Banking
(a) Negotiable Instruments Act (NI Act) :
(1) Definition of Negotiable Instrument :
According to section-13 of Negotiable Instrument Act 1881, a
Negotiable Instrument includes Promissory Note, Bill of
Exchange and Cheque, payable either to the bearer or order.
The special features of this instrument is its negotiability.

(2) Features of Negotiable Instrument :

(i) Property : The person owning the negotiable instruments is
said to be the owner of the property/instrument. He does not
only get possession of the negotiable instrument but can
transfer the instrument (cheque) by mere delivery in case of
bearer instrument (cheque) or by endorsement and delivery in
case of an order instrument (cheque).

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(ii) Title: The transferee of a negotiable instrument when satisfy
certain conditions is known as ‘holder in due course’. For a
person who takes a negotiable instrument (cheque) in good
faith, without negligence and for value becomes true owner
even it he takes it from a thief or finder. This is the most
important characteristic of the negotiable instrument.
(iii) Prompt payment: A negotiable instrument allows the holder
to expect quick payment because its transferable document
which contains the promise to pay a certain sum of money to
its holder upon demand on specified time.
(iv) Writing and Signature: Negotiable instrument must be in
written and signed by the parties according to the rules relating
to note, bills and cheque.

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(3) Types of Negotiable Instruments :
(i) Promissory Note : A Promissory Note is an instrument in
writing containing an unconditional undertaking , signed by the
maker, to pay a certain sum of money person or to the bearer
of the instrument (Section-4 of NI Act). A Promissory Note is
drawn and signed by the debtor who promises to pay the
creditor a certain sum of money. The following are the essential
elements of a Promissory Note.
(a) Writing : The first essential is that all negotiable instruments
must be in writing. An oral engagement to pay a certain sum of
money or promise to pay money cannot constitute a valid
promissory note.
(b) Promise to pay : Secondly, it must contain an express
undertaking or promise to pay, it is not important to use
clearly the word promise but a clean intention must show to
pay the amount. A mere acknowledgement of debt is not a

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 Promissory Note. An express promise to pay the money
contribute a good Promissory Note.
(c) Unconditional : Thirdly the promise to pay the money
should be absolute and unconditional. A conditional instrument
is invalid.

(ii) Bills of Exchange :

(a) Definition: According to the Section-5 of NI Act, “a Bill of
Exchange is an instrument in writing, containing an
unconditional order, signed by the Maker, directing a certain
person to pay a certain sum of money only to, or to the order
of a certain person, or to the bearer of the instrument”.
Therefore, Bill of Exchange is a written acknowledgement of
debt which contains an order from the creditor to the debt, to
pay a certain sum of money specified in it. The person who
makes the Bill is called ‘Drawer’ and the person who is entitled
to receive payment is called ‘Payee’. The person thereby
directed to pay (bank) is called ‘drawee’.
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(b) Essential Elements of Bill of Exchange (B/E) :
(i) Writing : The Bill of Exchange (B/E) must be in writing and may
be in any language and it may be in any form.
(ii) Order to pay : The Bill of Exchange must contain an order to
pay. Bill of Exchange cannot be issued to ‘Bearer” (since the
Primissory Note issued to the bearer is ‘currency note’ issued
by the Government). Hence, if the language of the Promissory
Note does not show any ‘order’ to pay the B/E, it will not be a
B/E as per definition.
(iii) Unconditional : The order to pay must be unconditional. If the
order given in the instrument specify any condition then, it will
not be treated as Bill of Exchange. Under the Act, conditional
bill of exchange is always invalid.

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(iii) Cheque :
(a) Definition: A cheque is a Bill of Exchange drawn on a
specified banker and not expressed to be payable otherwise on
demand. ‘A cheque is a Bill of Exchange’. It is unconditional
order (i) drawn on a specified bank by a ‘drawer’ directing the
bank, (ii) to pay on demand, a certain amount of money to the
‘order’ of a specific person or to the ‘bearer’ of the instrument.
Cheque includes the ‘electronic form of cheque’. Electro image
of paper cheque means a cheque which contains mirror signed
in a secured system, which ensures the minimum, safety
standard with the use of digital signature.
(b) Essentials of the cheque :
(i) It is an instrument in writing;
(ii) It contains an unconditional order to pay;
(iii) It is drawn and signed by the ‘Drawer’
(iv) It is dawn upon a specified bank;

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(v) To pay a certain sum of money payable ‘on demand’;
(vi) Amount payable to certain person;
(vii) Cheque should be drawn by the ‘Drawer’ as prescribed by
Negotiable Instruments Act.

(c ) Characteristics of cheque :
(i) In writing : A cheque is a bill of exchange which must be in
writing done by printed character or a pen or pencil.
(ii) Unconditional order : The order to pay the money must
contain an unconditional order. It means , if bankers has order
to pay a certain amount of money to the ‘payee’ (beneficiary
of the cheque), if he fulfills certain conditions, then it cannot be
considered as a cheque.
(iii) Drawn by the Drawer : A cheque is to be drawn only by the
drawer or account holders (customers of the bank). Those
customers are entitled to draw a cheque who has either
savings bank account or current account with the bank.
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(iv) To pay a certain amount of money : The order of the ‘Drawer’
of a cheque must be, to pay certain amount of money. If the
cheque contains an order to pay something other than money,
or something more than the amount mentioned therein, it will
not be considered as a cheque. The request that the amount
should be started both in words and figures and both should
the same.
(v) Payable on demand : Section-19 of NI Act says, the the
instrument should specify the word ‘on demand’ and only then
it is payable. Otherwise the amount of the cheque would not
be paid.
(vi) Payable to a certain person : Amount written in the cheque will
be paid to a specific person or payee of a cheque is to be
certain. The term person includes individual person, corporate
bodies, local authorities, societies, Trust, Educational
Institutions, etc. The cheque may be drawn payable to the
Registrar, Principal, Director, Secretary of the respective
entities.
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(vii) Signed by the ‘maker or drawer’ : The cheque must be signed
by the ‘drawer’ (account holder in the bank), only then the
mandate of the drawer is complete for payment of cheque by
the bank. If the peson is illiterate his thump impression will
be taken on the cheque by the bank in loose leaf cheque (and
cheque bookwill not be issued to illiterate persons).
(viii)Parties to a cheque : There are three parties involved in
cheque namely, Drawer, Drawee, and Payeee. A person who
has an account in the bank and draws a cheque for payment is
known as ‘Drawer’, on whom the cheque is drawn (bank) is
known as ‘Drawee’ and to whom the cheque is payable is
called ‘Payee’.

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(4) Difference between Cheque and Bill of Exchange :
(i) Drawee : In cheque only a bank can be a drawee but in bill of
exchange (B/E), any ne can be a drawee including a bank.
(ii) Payment : A cheque is always payable on demand without any
days of grace but a B/E is normally entitled to three days of
grace after the expiry of its maturity period.
(iii) Stamp : Cheque does not require any stamp but B/E must be
properly stamped (only then it is valid).
(iv) Crossing : Cheque may be crossed ‘generally’ or ‘specially’ but
B/E can never be crossed.
(v) Countermanding of Payment : Payment of cheque may be
countermanded (stopped) by the drawer of the cheque, but
payment of bill cannot be stopped by any one.
(vi) Payable to bear on demand : A cheque drawn payable to
bearer on demand shall be valid but the B/E cannot be drawn
payable to ‘bearer” (It will become a ‘currency note’ and hence
not permitted).
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(vii) Acceptance : No acceptance is required in cheque but B/E
must be presented for acceptance by drawee. The drawee is
liable to pay, only after his acceptance.
(viii)Statutory Protection : Under the NI Act, statutory protection
for payment of cheque by the bank, is given to the bank, but
no such protection is provided to the drawee or acceptor of the
B/E.
(ix) Noting and Protesting : A cheque cannot be ‘noted and
protested’ for dishonour by the drawer of the cheque, but the
B/E can be noted and protested with ‘Notary Public’ for
dishonour, under the NI Act.
(x) Sets : Cheques are not issued in sets but foreign bills are
generally drawn in a set of three.

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(5) Crossing of the Cheque :
According to Negotiable Instruments Act 1881, a ‘crossing’ is a
direction to the payment bank that the cheque should be paid
only to a bank and if the name of the bank is mentioned in the
crossing, only to that bank. In other words the holder of a
crossed cheque is not entitled to encash the cheque across the
counter of the bank. This ensures the safety of payment by
means of cheques and the rightful holders only gets the
payment. There are two types of crossing namely (i) General
Crossing, and (ii) Special Crossing.
(i) General Crossing : According to Section-123 of NI Act, where
a cheque bears across its face an addition of the words ‘and
company’ or any abbreviation thereof, between two parallel
transverse line, or of two parallel transverse lines simly with or
without the words, ‘not negotiable’ that addition shall be
deemed a crossing and the cheque shall be deemed to be
crossed generally. Two parallel transverse lines, are essential

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 part of the ‘general crossing’. The words ‘and company, & Co,
account payee, account payee only, payee’s account, not
negotiable, without two parallel lines, do not constitute the
general crossing. Hence, the two parallel transverse lines are
essential in general crossing.
(ii) Effect of General Crossing : The effect of ‘general crossing’ is
that the cheque must be presented to the paying bank through
only another bank and not by the payee (person or beneficiary)
himself at the counter of the bank for payment.
(iii) Special Crossing : (Section-124 of NI Act) : Where the cheque
bears across the face an addition of the name of a bank with or
without the words ‘ not negotiable’ that addition shall be deemed
to be the crossing and the cheque shall be deemed to be crossed
specially to that bank. Examples :
----------------------------- ------------------------
State Bank of India Not Negotiable State Bank of India
Account Payee State Bank of India (without lines)
----------------------------- ---------------------------
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 In the case of special crossing, it is not necessary that there
should be two parallel transverse lines . The same of a bank is
sufficient to constitute a special crossing (as mentioned in the
examples above) .
(iv) Effects of Special Crossing : The effect of special crossing
is that the payment of the cheque will be made at the counter
in the bank. It can be collected only through the bank
mentioned in the crossing (State Bank of India). In other
words, the cheque will be paid by the paying bank only when
presented through the ‘bank mentioned in the crossing’ (State
Bank of India).
(v) Who may cross the cheque : (Section-125 of NI Act)
(a) By Drawer : The cheque may be crossed generally or specially
by the drawer (maker) of the cheque.
(b) Holder : The cheque is crossed generally or specially by the
‘holder’ in case of uncrossed cheque.

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(c ) The Bank : When a cheque is generally crossed, the bank to
whom it is crossed may again cross it specially to another bank
as agent (agent for payee) for collection.

(6) Endorsements of cheques :

(i) Definition : An ‘Endorsement’ is the signature of the drawer or
holder of a negotiable instrument (cheque) for the purpose of
negotiation. In terms of Section-15 of NI Act, when the maker
(drawer) or holder of a negotiable instrument (cheque) signs
the same otherwise than as maker (drawer), for the purpose of
negotiation on the back or face theeof, or on a slip of paper
annexed thereto, or signs the same for the same purpose a
stamped paper intended to be completed as a negotiable
instrument, he is said to endorse the same and is called the
endorser. Thus, an endorsement may be made either on the
face or back of the instrument or on a slip of paper annexed
thereto. Generally, the endorsement is made on the back of the
instrument (cheque).
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(ii) Significance of Endorsements :
When a cheque is endorsed and delivered, the endorsee (the
person to whom the cheque is endorsed) or transferee gets a
valid title toit. He, in turn, can negotiate the cheque to any
one, provided his endorser did not restrict further
endorsement. The transferor (endorser) by his act of endorsing
the cheque, warrants to his immediate transferee or to any
subsequent holder, that when the cheque left his hands he had
a good title to it, that it was a genuine one in every aspect, at
the time of his endorsement, and that any endorsements on it
previous to his own were genuine endorsements. Thus, if the
cheque is dishonoured, the holder can sue any or all of the
previous parties, and recover the amount of gthe cheque from
any or all the previous paraties.

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(7) Holder in Due Course of a Negotiable Instrument :
Section-9 of NI Act defines a ‘holder in due course’ as :
‘Holder in due course means any person who for consideration
became the possessor of a promissory note, bill of echange or
cheque, if payable to bearer, or the payee or endorsee theeof, if
payable to order, before the amount mentioned in it became
payable, and without having sufficient cause to believe that any
defect existed in the title of the person whom he derived his title’.
Thus a ‘holder in due course’ is a person who :
(i) Is in possession of the instrument as defined in NI Act;
(ii) Obtains possession of the instrument before maturity;
(iii) Obtains possession of the instrument for valuable consideration
(valuable consideration in the case of negotiable instrument is
always presumed until the contrary is proved);
(iv) Is a holder, without having sufficient cause to believe that any
defect existed in the title of the person from whom he received his
title.

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(8) Payment of cheques by Paying Bank:
A Bank (Banker) undertakes to honour the customer’s cheques
upto the amount of credit balance in his account or upto the
limit of any agreed overdraft limit sanctioned to the customer.
This implied duty or responsibility of a paying bank, however,
is dependent on certain other important conditions as
mentioned below :
(i) The cheque must be in the proper form;
(ii) Drawer’s signature must correspond (tally) with the specimen
signature of the drawer in the bank’s records;
(iii) The cheque must not be either stale or post-dated;
(iv) The amount expressed in words and figures should agree;
(v) Material alterations must be confirmed by the drawer;
(vi) The cheque must be properly endorsed and should be in proper
order;
(vii) The ‘Crossings’ on the cheque must be in order;

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(9) Circumstances under which a Bank is justified in refusing
payment of a cheque drawn on the bank :
A banker’s (bank’s) obligation to honour the customer’s cheque is
terminated on the happening of any one of the following events :
(i) Letter / Notice from the customer to stop payment of the cheque
(countermanding payment);
(ii) Notice of customer’s death;
(iii) Notice of customer’s insanity;
(iv) Notice of customer’s bankruptcy;
(v) Knowledge of any defect in the title of the person presenting the
cheque;
(vi) Notice of attachment by Income Tax Authorities, of the available
credit balance in the customer’s account(s).
(vii) Notice of Garnishee Order received from the Court;
(viii)In the case of Trust Accounts, knowledge that the customer
contemplates breach of trust.

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(10) Payment in Due Course :
According to Section-10 of NI Act, ‘Payment in Due Course’ means
, payment in accordance with the apparent tenor of the
instrument, in good faith and without negligence to any person in
possession thereof, under circumstances which do not afford a
reasonable ground for believing that he is not entitled to receive
payment of the amount therein mentioned’.

Thus in order to constitute ‘payment in due course’ the paying

bank (banker) must ensure that the following conditions are
fulfilled.
(i) Payment must be in accordance with the apparent tenor of the
instrument. In other words, payment must be in accordance with
the intention of the parties as it appears on the face of the
cheque. When the paying bank disregards the crossing on the
cheque, and paying cash across the counter for crossed cheque,
the payment by the bank, cannot be considered as ‘payment in
due course’.

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(ii) Payment must be in good faith and without negligence : If the
bank pays forged signature of the drawer, the bank is liable
under the Negotiable Instruments Act for the loss of the
customer. There shall not be any negligence on the part of the
paying bank while making payment of the cheque of the
customer.
(iii) Payment must be made under circumstances which do not
afford reasonable ground for believing that the person
presenting the cheque is not entitled to receive payment of the
amount mentioned therein : The paying bank, before making
payment, should make sure that the person presenting the
cheque is entitled to receive the amount. For instance, where
the paying bank (banker) pays a cheque, the payment of which
has been stopped by the drawer, the payment of the cheque
cannot accepted in law. Hence the payment cannot be
considered as ‘Payment in Due Course’.
----------------------------------------------------------------------------------

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(2) Banking Regulation Act 1949 :
The Banking Companies Act 1949 was passed to consolidate
and amend the law relating to Banking Companies. With effect
from 1.3.1966, the name of the Act has been changed to
“Banking Regulation Act 1949”. The main provisions of the Act
are as follows :
(i) Definition of Banking and Banking Company : Section-5 (c)
defines ‘banking, means the accepting, for the purpose of
lending or investment, of deposits of money from the public,
repayable on demand or otherwise, and withdrawable by
cheque, draft, order or otherwise. The act defines banking
company as any company which transacts the business of
banking in India, i.e. accepting deposits and lending the same”.
(ii) Requirement of Aggregate value of paid-up capital and
Reserves : The Act prescribes aggregate value of paid-up
capital and reserves of Rs 5,00,000 for the banking companies.

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(iii) Cash Reserve : Every schedule bank is required to keep a
stipulated percent of the total of its time and demand liabilities
with the RBI as Cash Reserve (interest free) which keeps
varying as decided by RBI. Cash Reserve Ratio (CRR) can be
raised by RBI upto a maximum of 15% (currently at 4%) and
Statutory Liquidity Ratio (SLR) can be raised upto a maximum
of 40% (currently at 19.5%).
(iv) Reserve Fund : Section-17 : “Every banking company
incorporated in India shall create a reserve fund and shall, out
of the balance profit of each year, as disclosed in the profit and
loss account prepared under section-29 and before any
dividend is declared, transfer to the reserve fund a sum
equivalent to note less than 20% of such profit”. It means
every banking company incorporated in India is required to
create a reserve fund and transfer to such fund, before any
dividend is declared, 20% of its profit.

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(v) Maintenance of Assets in India : At the close of business on
the last Friday of every quarter, every bank has to maintain its
assets equivalent to or not less than 75% of its demand and
time liabilities in India.
(vi) Prohibitions and Restrictions on Banking Companies : The Act
provides prohibitions and restrictions on banking companies,
and to safeguard the interest of depositors :
(1) Directly or indirectly, the banking company cannot get engaged
in trading activities or undertake trade risks.
(2) If prohibits a banking company from holding any immovable
property, except for its own use.
(3) Banking company cannot form any subsidiary company without
the permission of RBI.
(4) It cannot hold shares in any company, exceeding 30% of the
paid up share capital of that company or its own capital and
reserve whichever is less.

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(5) It cannot grant any loan or advance on the security of its own
shares, or behalf of or to any of its directors, any firm, in which
any of its directors is interested as partner, manager, employee
or guarantor, or any company in which any of its directors has
substantial interest of any kind.
(6) A banking company is prohibited from the payment of dividend
until all its capitalised expenses have been completely written
off.
(7) A director of a banking company, other than the Chairman or
the whole time Director cannot be continued for more than 8
years.
(vii) Powers of Reserve Bank of India : The Act provide wide
powers to the RBI to control and regulate the working of
banking companies :
(1) No banking company can operate in India, without getting a
licence from the RBI.

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(2) For opening a new branch or the change the location of an
existing branch in India, every banking company, Indian as well
as foreign bank has to take prior permission of RBI.
(3) Every banking company is required to submit the following
statements :
(a) Monthly return of liquid assets and liabilities.
(b) Quarterly return of assets and liabilities.
(c ) Return of unclaimed deposits.
(d) Half-yearly returns regarding the investment of banking
company.
(e) Classification of its advances in respect of Industry,
commerce and agriculture.
(4) RBI is empowered to inspect any banking company, its books
and accounts.

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(5) RBI can issue guidelines to the banks, from time to time,
particularly, in public interest or in the interest of banking policy
or in the interest of depositors.
(6) Powers regarding advances :
(a) Purpose of advance;
(b) Margin in secured loans;
(c ) Maximum advance to any Company, firm, individual or
association of persons.
(d) Rate of interest.
(7) Prior approval of RBI is needed for the appointment, re-
appointment or termination of Chairman, Managing Director or
While time Director or Chief Executive Officer of every banking
company.
(8) RBI is authorised to publish any information relating to banking
companies and can bring out reports and brochures relating to the
trend and progress of banking in India.

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(viii)Banking Companies Amendment Act 1994 :
The Banking Companies Act of 1970 and 1980 were amended
by Banking Companies (Acquisition and Transfer of
Undertakings) Amendment Act 1994. This amendment
provides for partial privatisation of the public sector banks,
after the merger of New Bank of India with Punjab National
Bank in 1993. The main features of amendments are as
follows :
(1) The authorised capital of every national bank has been set at
Rs 1,500 crores divided into 150 crores of fully paid up shares
of Rs 10 each.
(2) The Govt. of India may in consultation with RBI and by
notification in the official gazette, increase or reduce the
authorised capital subject to the condition, that the authorised
capital shall not exceed Rs 3,000 crores or less than Rs 1,50
crores.

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(3) The Central Govt. shall retain 51% of the shares in these banks,
and the private individuals and companies shall hold upto 495 of
the shares.
(4) The share holdings of Non-resident Indians shall not be more
than 20% of the 49% private shares.
(5) The shares which are not held by the Govt. of India shall be freely
transferable.
(6) No shareholders other than Govt. of India, shall be entitled to
exercise voting rights, in respect of any shares held by them, in
excess of 1% of the total voting rights of a all shareholders of the
bank.
(7) Each bank shall have 15 Directors on its Board, out of whom 9
directors shall be nominated by the Govt. of India and other six
shall be non-official nominees. There shall be one Director from
the workmen of the bank, and one from other employees.
(8) Every banks’ total capital shall be equal to atleast 8% of its risk-
weighted assets, by 31.3.1996. (presently more than 12%)

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THANK YOU

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