Negotiable Instrument - Effect on Underlying Contract
When a Negotiable Instrument is Separate from an Underlying Contract
Written by Jason Gordon
Updated at April 6th, 2023
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What effect does a negotiable instrument have on the underlying obligation?
Most negotiable instruments arise pursuant to an underlying agreement, contract, or obligation. A maker or drawer creates the instrument and issues it to the holder in satisfaction of her obligation under an underlying agreement. For ordinary instruments the underlying obligation is merged and suspended until the negotiable instrument is payed. That is, the issuee may withhold performance of her obligation under the contract (such as delivery of goods) until the instrument is paid.
An ordinary instrument is any instrument that does not qualify as a near-cash instrument. If the commercial paper is a near-cash instrument, the maker or drawers obligation is discharged at the time the instrument is accepted by the party to the underlying agreement. The idea is that these instruments are the equivalent of cash and thus satisfy the maker or drawers obligation. Near cash instruments include certified checks, cashiers checks, and tellers checks.
Note: If the holder of the ordinary instrument negotiates the instrument to a third party, the underlying contractual obligation is still not satisfied until the instrument is paid to the holder. If the instrument is not properly paid, the issuee may sue the maker or drawer on the note or the underlying obligation. A problem may also arise when the negotiable instrument only constitutes part of a partys payment obligation. In such a case, the underlying agreement is not fully discharged until the payment on the negotiable instrument satisfies the full obligation. In some situations, the parties will include a paid-in-full clause in the contract to indicate that payment of the instrument is in full satisfaction of the payors obligation.
Example: I agree to sell you a piece of equipment in exchange for a promissory note from you. I do not have the obligation to transfer ownership of the equipment to you until the promissory note is paid. If, on the other hand, I accept a cashiers check as payment for the equipment, your obligation on the underlying contract is satisfied (discharged). I would then be obligated to deliver the equipment.
Next Article: What is a Holder in Due Course Back to: COMMERCIAL PAPER
Discussion Question
What do you think about the use and role of negotiable instruments as consideration in a contract? Why do you think an underlying obligation is suspended until the note is paid? Given the increased risk to the issuee of an instrument, does this affect the value of the transaction?
Practice Question
Oscar agrees to sell equipment to Nyesha. Nyesha creates an on-time promissory note payable to Oscar or order. Is the contract fully executed (complete) when Nyesha transfers to the promissory note and Oscar transfers the equipment? Why? What are Oscars options if Nyesha fails to pay the note in accordance with its terms?
Related Topics
- Commercial Paper (Intro)
- What is Commercial Paper?
- Negotiable Instrument
- What are the common types of commercial paper?
- Promissory Note
- Cashier's Check
- Convenience Check
- Certified Check
- Substitute Check
- Bill of Exchange
- Bank Draft Definition
- Sight Draft Definition
- Bankers Acceptance
- Who is a Holder of a negotiable instrument?
- Commercial Paper Funding Program
- What is Negotiability and why is it important?
- What is required for commercial paper to be negotiable?
- Sum Certain (Contracts)
- Inflation Adjustment Clause
- When does commercial paper contain an Unconditional promise to pay?
- Backup Line of Credit
- What is Payable on Demand or Payable on Time?
- What is Order Paper and Bearer Paper?
- Bearer Form
- How is a payee identified on the negotiable instrument?
- What rules does the court apply in determining negotiability?
- How is commercial paper negotiated to a holder?
- What is Transfer of a negotiable instrument?
- What is Indorsement of a negotiable instrument?
- What are the various types of indorsement?
- Bank Endorsement
- Blank Endorsement
- Accommodation Endorsement
- How does a holder receive payment on a negotiable instrument?
- Who is potentially liable on (or obligated to pay) a negotiable instrument?
- When is an individual liable for a representative signing a negotiable instrument?
- What rules apply if a holder loses a negotiable instrument?
- When is payment of a negotiable instrument overdue?
- What effect does a negotiable instrument have on the underlying obligation?
- What is a holder in due course?
- What are the requirements for a holder to become a holder in due course?
- Receive an instrument for value?
- Receive an instrument in good faith?
- Receive an instrument without notice of a valid defense?
- How does discharge of the Underlying Obligation affect a holder in due course?
- What is the Shelter Rule?
- Can you limit a transferee from becoming a holder in due course?
- Personal Defenses?
- Real Defenses?
- What is a Claim in Recoupment?
- What are the rights of a holder in due course if the instrument involves a consumer transaction?
- What happens if a negotiable instrument is Forged?
- What happens if a negotiable instrument is Stolen?
- Guaranty or Guarantee
- Letter of Guarantee
- Personal Guarantee
-
What is the role of a Guarantor or Surety of a negotiable instrument?
-
Surety
- Cosign
- Accommodation Paper Definition
- Secondary Liability
- Avalize Definition
- What is an Accord & Satisfaction?
- What is primary and secondary liability on an instrument?
- What is Drawer or Maker Liability for a negotiable instrument?
- What is Transferor Warranty of a negotiable instrument?
- What is Indorser Warranty of a negotiable instrument?
- What is Presentment Warranty of a negotiable instrument?
- What is a warrantors liability for a dishonored note or draft?
- What is the time limitation for warranty of a negotiable instrument?
- When are the warranties of a negotiable instrument discharged?
