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Negotiable Instrument – Effect on Underlying Contract

Cite this article as: Jason Mance Gordon, "Negotiable Instrument – Effect on Underlying Contract," in The Business Professor, updated January 20, 2015, last accessed March 30, 2020, https://thebusinessprofessor.com/knowledge-base/negotiable-instrument-effect-on-underlying-contract/.
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Effect of Payment of Negotiable Instrument on the Underlying Obligation
How does the payment of a negotiable instrument affect the underlying transaction that gave rise to creation of the commercial paper.

Next Article: What is a Holder in Due Course


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 drawer’s 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 drawer’s obligation. Near cash instruments include certified checks, cashier’s checks, and teller’s 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 party’s 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 payor’s 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 cashier’s check as payment for the equipment, your obligation on the underlying contract is satisfied (discharged). I would then be obligated to deliver the equipment.

•    Discussion: 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 Oscar’s options if Nyesha fails to pay the note in accordance with its terms?

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