4. What is “negotiability” and why is it important?
Negotiation is the transfer of negotiable paper from one holder to another. To be a substitute for money, commercial paper must be freely transferable in the marketplace. That is, the paper must be “negotiable”. Negotiability concerns the rights of the holder of commercial paper. Paper that is not negotiable may still be transferred; however, it is far less valuable than negotiable paper. This is because the holder has fewer rights in enforcing payment of the non-negotiable, commercial paper. The rights of a holder of each type of paper is as follows:
• Non-negotiable Commercial Paper – An individual in possession of a non-negotiable instrument stands in the shoes of the original issuee. That is, she has the exact same rights in the instrument as the original issuee held. This means that, if the original party loses his right to be paid (think of defenses to payment of a contract), so does the transferee of the commercial paper. As such, the value of non-negotiable instrument is far less valuable to a subsequent transferee who cannot be certain that she will receive payment without being subject to a payor defense.
⁃ Example: Sarah enters into a contract to sell equipment to Robert. Robert gives Sarah a non-negotiable promissory note to pay for the goods. So, Sarah is the holder of a promissory note that is non-negotiable. She transfers the note to Tim, who is now the holder. If Robert has a defense against his obligation to pay Sarah for the equipment (e.g., the equipment is faulty), he could assert that defense against his obligation to pay Tim if he presents the promissory note for payment. This possibility makes the note far less valuable to Tim.
• Negotiable Commercial Paper – The holder of negotiable paper may have greater rights than the original issuee. That is, when paper is negotiable and validly negotiated to a subsequent holder who qualifies as a “holder in due course”, the holder may acquire greater rights to enforce the instrument against the payor or maker. The holder in due course will have a greater right to payment because the maker or payor cannot assert certain defenses (personal defenses) to payment against the holder in due course.
⁃ Example: In the above scenario, suppose Robert provides Sarah with a negotiable promissory note. This means that it is transferable without conditions. If Tim later presents the note for payment, Robert’s defense against paying Sarah on the underlying contract does not apply to the promissory note. Robert will be liable if he fails to pay it. Robert may still sue Sarah, but this right is completely separate from his obligation on the promissory note.
• Discussion: Can you explain the concept of holder risk in terms of negotiable and non-negotiable paper? Is there any reason that the issuer of the commercial paper may prefer the paper to be negotiable or non-negotiable? Why? What about the original holder of the negotiable paper?
• Practice Question: Franklin receives a promissory note from Geo. The promissory note is transferable and Franklin immediately gives the note to Heath. Geo sues Franklin stating that he was defrauded into giving Geo the promissory note. How does this affect Heath’s ability to receive payment on the promissory note?