Business Regulatory Framework Notes

Business Regulatory Framework

3.1 Introduction

• Business activity involves the exchange of goods and services for cash or credit.

• Cash transactions provide immediate cash inflow, while credit transactions generate future cash.

• Businesses use negotiable instruments like cheques, promissory notes, and bills of exchange as payment methods to avoid carrying large amounts of cash.

• These instruments streamline operations and reduce risks associated with handling cash.

• Negotiable instruments are freely transferable documents used as a substitute for money.

• The Negotiable Instruments Act 1881 governs these instruments, based on English Common Law.

• The act came into force on March 1, 1882, and extends to the whole of India.

3.2 Meaning and Definition of Negotiable Instruments

• "Instrument" refers to a written document creating a right for an individual.

• "Negotiable" means transferable from person to person in exchange for payment.

• A negotiable instrument confers ownership over money and can be transferred by delivery, similar to currency.

• Negotiable Instruments = Transferability + Piece of Paper.

• A negotiable instrument is a written, transferable document specifying payment to someone or the instrument's bearer at a specific date.

• The term "negotiable instrument" means a written document transferable by delivery.

• A negotiable instrument represents money or value and is transferable for payment, creating a legal obligation for the issuer to pay the holder.

3.3 Definition: Negotiable Instrument - Negotiable Instruments Act 1881

• Section 13(a) of the Negotiable Instruments Act 1881 defines a negotiable instrument as a promissory note, bill of exchange, or cheque payable to order or bearer.

• Justice Willis defines it as an instrument where ownership is acquired by someone who takes it in good faith and for value, regardless of title defects.

• A negotiable instrument is a written document creating a right for someone and is freely transferable.

• Besides promissory notes, bills of exchange and cheques, other instruments can be added if they meet two conditions:

  • Free transferability (by delivery or endorsement and delivery) by trade custom.

  • The acquirer obtains it in good faith and for value, free from defects, and can recover the money in their own name.

• The main difference between a negotiable instrument and other documents is that the new owner gets good ownership, even if the previous owner didn't have it.

• This provides more security and certainty for business transactions.

3.3 Negotiable Instruments Act, 1881

• The law governing negotiable instruments in India is the Negotiable Instruments Act of 1881.

• The act is based on English common law relating to promissory notes, bills of exchange, and cheques.

• The act came into force on March 1, 1882 and applies to the entire country of India.

• The act provides a legal framework for the use and transfer of negotiable instruments, including rules for their creation, endorsement, and payment.

• It also establishes penalties for offences related to negotiable instruments, such as dishonoring a cheque or issuing a cheque without sufficient funds.

• The Act also provides remedies for parties who are aggrieved by the dishonor or non-payment of a negotiable instrument.

• The Act plays a vital role in facilitating business transactions in India by providing a clear legal framework for negotiable instruments as a means of payment.

3.3 Brief History of Negotiable Instrument Act 1881

• The Negotiable Instruments Act of 1881 has a rich history.

• Initially drafted by the 3rd India Law Commission in 1866, it faced objections due to deviations from English Law.

• Redrafted in 1877 and sent to a Select Committee, but did not reach its final stage.

• In 1880, it was referred to a new Law Commission, redrafted again, sent to a Select Committee, and finally passed in 1881 as Act No. 26 of 1881.

• The 'Hundi' is an important historical credit instrument, used since the 12th century for trade and fund transfers, similar to modern travelers' cheques.

• This evolution led to the current Negotiable Instruments Act.

3.4 Characteristics or Features of Negotiable Instruments

• Negotiable instruments are documents that represent a promise to pay a certain amount of money to the bearer or to a specified person.

• They are used in commercial transactions as a means of payment and can be transferred from one person to another by endorsement or delivery.

1. Writing

• A negotiable instrument must be in writing to be valid.

• Ensures terms are clear and legally binding.

• Example: A promissory note written on a napkin is valid if it meets other requirements.

2. Signature

• The instrument must be signed by the maker (for promissory notes) or the drawer (for bills of exchange or cheques).

• The signature serves as proof of authenticity.

• Example: A cheque without the drawer's signature is not valid.

3. Definite and Unconditional Order or Promise to Pay

• Must contain a definite and unconditional order or promise to pay a certain sum of money.

• Must clearly state the amount, the payee, and the terms of payment.

• Example: A promissory note saying "I promise to pay B or order $5000$" is valid.

• If it says, "I promise to pay B or order $5000$ if I win the lottery," it's conditional and non-negotiable.

• The note can be transferred from one person to another by endorsement, and the holder can demand payment from the maker at any time.

4. Payment by Money

• Payment must be in legal tender money, not in kind or through work.

• Must specify a sum of money to be paid in cash or equivalent.

• Example: A promissory note ordering the delivery of $50$ kgs of wheat instead of money is not a negotiable instrument.

5. Certain Sum

• The sum payable must be certain or capable of being made certain, not indefinite.

• Must specify a definite amount or a method for determining the amount.

• Example: A promissory note saying "I promise to pay B a sum of $10,000$ along with interest" is valid because the sum can be made certain by calculating the interest.

• If a promissory note says "I promise to pay B whatever amount I owe him at some future date," it is not considered a negotiable instrument because the sum payable is indefinite and cannot be made certain.

6. Drawer's Identity

• For a bill of exchange or cheque, the drawer must be named or described with reasonable certainty.

• The instrument must clearly identify the person issuing it and responsible for payment.

• Example: A cheque drawn without the drawer's name is invalid.

7. Transferability

• A negotiable instrument must be transferable by delivery or by endorsement and delivery.

• The instrument must be legally recognized to be transferred from one person to another.

• Example: A cheque payable to bearer can be transferred by delivery alone.

• A cheque payable to order can only be transferred by endorsement and delivery.

8. Free from Defects

• Negotiable instruments are free from defects on transfer to a holder in due course.

• When acquired in good faith and for value, the person's title is not subject to transferor's title defects.

• Example: If A transfers a stolen promissory note to B who acquires it in good faith and for value, B acquires a good title to the note, even though A's title was defective because he obtained the note through theft.

3.5 Kinds of Negotiable Instruments

*Under section 13 of Negotiable Instruments Act there are three kinds of negotiable instruments:

• Promissory Note (Section 4)

• Bills of Exchange (Section 5)

• Cheques (Section 6)

3.6 Promissory Note

3.6.1 Meaning and Definition

• Promissory notes are commonly used in business transactions, such as loans, and can be used as evidence of debt in legal proceedings.

• They are often used as an alternative to bank loans or other forms of financing.

Meaning: Promissory Note

• A promissory note is a type of negotiable instrument that is used to record a promise to pay a certain amount of money to another party.

• It is a written and signed document that contains an unconditional promise by one party (the maker) to pay a specific sum of money to another party (the payee) at a future date or on demand.

Definitions: Promissory Note

1. As per Legal Dictionary, Promissory Note is defined as, "A written, signed, unconditional promise to pay a certain amount of money on demand at a specified time. A written promise to pay money that is often used as a means to borrow funds of take out a loan".

2. As per Section 4 of Negotiable Instruments Act, 1881, Promissory Note is defined as, "A Promissory note is an instrument in writing containing an unconditional undertaking signed by the maker to pay a certain sum of money only to, or to the order of a certain person, or to the bearer of the instrument".

Analysis of Definitions:

• A Promissory note is a legal instrument, in which one party promises in writing to pay a determinate sum of money to the other, either at a fixed or determinable future time or on demand of the payee, under specific terms.

• If the promissory note is unconditional and readily saleable, it is called a Negotiable Instrument.

Examples of Valid and Invalid Promissory Note Statements

Legally Valid Promissory Note Expressions

1. Date: May 1, 2023
   I, Arjun, promise to pay Rahul or order the sum of $20,000$ on September 1, 2023.
   (Signed) Arjun

2. Date: June 20, 2023
   I, Meena, promise to pay the sum of $30,000$ to the order of Sunita on demand.
   (Signed) Meena

3. Date: April 15, 2023
   I, Rajesh, promise to pay the sum of $40,000$ to Rohit on December 1, 2023.
   (Signed) Rajesh

Legally Invalid Promissory Note Expressions

1. :
   Date: May 1, 2023
   I, Arjun, promise to pay Rahul or order the sum of $20,000$ on September 1, 2023, if it rains tomorrow.
   (Signed) Arjun

2. :
   Date: June 20, 2023
   I, Meena, promise to pay the sum of $30,000$ on demand to whoever finds my lost dog.
   (Signed) Meena

3. :
   Date: April 15, 2023
   I, Rajesh, promise to pay the sum of $40,000$ plus the amount I win in the lottery to Rahul on December 1,2023.
   (Signed) Rajesh

Note

• Bank notes and currency notes are not promissory notes, and are expressly excluded from the category.

• The words 'or to the bearer' are not operative.
  *The reason for the same is that Section 31 of the Reserve Bank of India Act, 1934, specifically provides that a promissory note cannot be made payable to bearer. Thus, a valid promissory note is one which is payable to a specified person or his order.

Parties to a Promissory Note

• Maker: The person who makes the promissory note and promises to pay.

• Payee: The person to whom the payment is to be made.

3.6.2 Features or Characteristics of a Promissory Note

• A promissory note is a financial instrument that contains a written promise by one party (the note's issuer or maker) to pay another party (the note's payee) a definite sum of money, either on demand or at a specified future date.

• It serves as a legal tool for ensuring that promises of payment are upheld and is commonly used in many types of financial transactions.

1. Written and Signed Instrument: A promissory note must be a written document, not verbal, and signed by the maker.
   Example: If Seema borrows $50,000$ from Rohan, she writes, "I, Seema, owe Rohan $50,000$," and signs it.

2. Promise to Pay: The note must include an explicit promise to repay the money.
   Example: "I, Seema, promise to pay Rohan $50,000$".

3. Payable to a Specific Person: The promissory note is payable to a specific person or to the order of a specified person(payee).
   Example: "I, Seema, promise to pay Rohan $50,000$".

4. Unconditional Payment: The payment must be unconditional.
   Example: "I, Seema, promise to pay Rohan $50,000$ if it rains tomorrow" is not a valid promissory note

5. Fixed Amount: The note must state a precise amount of money that will be paid.
   Example: "I, Seema, promise to pay Rohan $50,000$".

6. Payment in Legal Currency: The amount must be payable in legal tender, not in kind of goods or services.
   Example: Seema can't promise to repay Rohan with a car or a piece of jewelry.

7. Payable on Demand or at a Determinable Future Time: A promissory note can be payable on demand or at a determinable future time.
   Example: "I, Seema, promise to pay Rohan $50,000$ on demand," or "I, Seema, promise to pay Rohan $50,000$ on January 1, 2024."

8. No Requirement of Stamping: As per the Indian Stamp Act, a promissory note does not require stamping.
   Example: Seema can write her note on any piece of paper; she doesn't need to use a specially stamped document.

9. Delivery of the Instrument: The maker must physically deliver the promissory note to the payee.
   Example: Seema would need to hand her written and signed promissory note to Rohan.

10. No Requirement for Acceptance: Unlike a bill of exchange, a promissory note does not require acceptance.
    Example: Once Seema hands over the promissory note to Rohan, it is assumed that Rohan accepts it.

3.6.3 Types of Promissory Note

There are no specific types of promissory notes mentioned in the Act. However, promissory notes can
be classified based on their features as follows:

1. Simple Promissory Note: Contains an unconditional promise to pay a specific sum on a specified date or on demand.
   Example: Ravi borrows $50,000$ from Sita and promises to repay with interest in $6$ months, issuing a simple promissory note with the terms.

2. Demand Promissory Note: Payable on demand by the payee without a specific maturity date.
   Example: Ravi owes Sita $25,000$ issues a demand promissory note, Sita can demand payment at any time.

3. Installment Promissory Note: Used when borrower agrees to make payments in installments over time.
   Example: Ravi borrows $1$ lakh from Sita, agrees to repay in monthly installments over $2$ years with interest, and issues an installment promissory note outlining the schedule.

4. Secured Promissory Note: Backed by collateral (property/assets) that lender can seize if borrower defaults.
   Example: Ravi borrows $5$ lakhs from Sita, pledges his house as collateral, and issues a secured promissory note stating Sita has a security interest until loan is repaid.

5. Unsecured Promissory Note: Not backed by collateral; relies on borrower's creditworthiness and ability to repay.
   Example: Ravi borrows $2$ lakhs from Sita, no assets to pledge, and issues an unsecured promissory note stating repayment with interest.

6. Commercial Paper: Short-term promissory note issued by corporations or financial institutions to raise short-term funds.
   Example: Company needs to raise $50$ crores for working capital, issues commercial paper with $90$-day maturity to investors willing to lend short-term.

3.7 Bill of Exchange

• Drafts have ancient use in commercial transactions since Babylon, Egypt, and Rome; earliest clear use in Genoa around 1156.

• Drafts are commonly used between geographically distant buyers and sellers.

• The seller draws a draft against the buyer for payment and sends it with shipping documents to his bank.

• The bank/agent presents draft for buyer's acceptance of payment obligation and buyer signs and adds a note of effect.

• This accepted draft is known as trade acceptance, representing a legal commitment to pay stipulated amount.

3.7.1 Meaning and Definition

Meaning: Bill of Exchange

• A Bill of Exchange is a written order from one party (the drawer) to another party (the drawee) to pay a certain sum of money to a third party (the payee) on a specified date or on demand.

• It is a negotiable instrument that can be transferred from one person to another by endorsement and delivery.

• In simpler terms, it is a legal document that represents an unconditional promise by the drawee to pay the amount specified in the bill to the payee.

• The bill contains details such as the name of the parties involved, the amount payable, the date of payment, and any other relevant terms and conditions.

• The bill of exchange is also termed as Money draft.

• It can be used in foreign trade and can also be discounted with an acceptance house, bank etc.

Understanding Bill of Exchange with an Example:

• A company in India wants to import goods from a company in the United States.

• They agree on terms, including price and payment method.

• The US company may request payment via a Bill of Exchange.

• The US company (drawer) creates a Bill of Exchange and sends it to the Indian company (drawee).

• The Bill specifies that the Indian company must pay a certain amount to a third party (the payee), who could be either the US company or another party designated by them.

• The Indian company reviews and accepts the Bill by signing it, indicating agreement to pay by the due date.

• This document serves as proof of payment obligation when importing goods.

• The Indian company can transfer/endorse the document to another party for payment.

• This allows payment flexibility facilitating trade between parties without an established credit relationship.

Definition: Bill of Exchange

• As per Section 5 of the Negotiable instrument act 1881, 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 or the instrument.

Parties to Bills of Exchange

• Drawer: The person who gives the order to pay or who makes the bill.

• Drawee: The person who is directed to pay. When the drawee accepts the bill, he is called the acceptor.

• Payee: The person to whom the payment is to be made.

3.7.2 Features or Characteristics of Bill of Exchange

• A Bill of Exchange shares many characteristics with a Promissory Note, as both are important negotiable instruments under the law.

• However, there are certain features that are specific to a Bill of Exchange.

1. Written and Signed Instrument: A bill of exchange is always a written document, signed by the drawer.
   Example: if Amit creates a bill of exchange instructing Bina to pay Chetan, Amit would sign the bill.

2. Unconditional Order: The bill contains an unconditional order to pay.
   Example: If Amit's bill states, "Bina must pay Chetan 20,000," that's an unconditional order.

3. Specific Parties: A bill of exchange involves three parties - the drawer, the drawee, and the payee.
   Example: In Amit's bill, Amit is the drawer, Bina is the drawee, and Chetan is the payee.

4. Certain Sum of Money: The bill must state a specific amount to be paid.
   Example: The bill clearly instructs Bina to pay Chetan 20,000.

5. Payable in Legal Currency: The payment to be made under a bill of exchange should be in legal currency.
   Example: Bina would need to pay Chetan in Indian Rupees, not in goods or services.

6. Payable on Demand or at a Determinable Future Time: The bill must specify when the payment is due.
   Example: Amit's bill could instruct Bina to pay Chetan "on demand" or "on July 1, 2024."

7. Stamping Requirement: As per the Indian Stamp Act, a bill of exchange must be stamped.

8. Acceptance by the Drawee: Unlike a promissory note, a bill of exchange needs to be accepted by the drawee.
   Example: This means that Bina, the drawee, must agree to the terms of the bill and indicate her acceptance by signing it.

9. Transferable: A bill of exchange is transferable.
   Example: He could do this by endorsing the bill and delivering it to the new party.

10. Dishonour: If the drawee fails to make payment on the specified date, the bill is said to be dishonoured.
    Example: If Bina fails to pay Chetan, Amit may have to make the payment instead.

3.7.3 Types of Bills of Exchange

A bill of exchange may be classified into different types based on time period, purpose, place, and parties:

(I) On the basis of Time Period: On the basis of period, the bills are grouped into two types:

1. Demand Bill: Also known as Sight Bill, payable when presented/on demand without fixed date.

   • Payable on demand or when presented by payee.

   • May or may not have a maturity date.

2. Term Bill: Also known as Usance Bill, payable after a specified period, the term usance refers to the time period recognized by custom or usage for payment of bills. In other words, usance bills are called Time bills.

   • Payable at a specified future date, known as due date or maturity date.
     *Example: Sixty days from date pay Mr. XYZ or to order a sum of ₹ $1,00,000$ for value received.

(II) By Purpose/Object: On the basis of the purpose, the bills are also grouped into two types:

1. Trade Bill: Issued by a trader for payment on a future date and becomes accepted when signed by acceptor/debtor. It is drawn by a creditor on his debtor for consideration. Bills Receivables are termed as trade bill.

   • Drawn and accepted for trade on credit.

2. Accommodation Bill: Drawn/accepted to help each other, without sale/purchase of goods and without consideration.

   • It does not involve any trade of goods.

   • It is mainly drawn for raising funds among parties and for discounting in money market.

   • It is drawn without any consideration.

(III) By Place: On the basis of the place, the bills are also sub-divided into two categories:

1. Inland Bill: Drawn on Indian residents, may be endorsed in a foreign country, or may remain in circulation in foreign countries and bill drawn in a foreign country is considered an inland bill if it is drawn on resident of India.

   • It is drawn for trade in the same country.

   • Drawer and Drawee reside in the same country.

2. Foreign Bill: Drawn in one country and accepted/payable in another.

   • It is drawn in one country and payable in another country.

   • Drawer and Drawee reside in different countries.

   • Drawn in India but made payable outside India.

(IV) By Parties: On the basis of the parties, the bills are also divided further in two types:

1. Order Bill: Made out to/to the order of a particular person, transferable by endorsement/delivery of the bill. In practice, the bill is made out either to the shipper's order or to that of the consignee or to his order.

   • It is payable to a specific person whose name is appearing on the bill i.e. either the Drawer or Any Endorsee.
     *Example Sixty days from date pay Mrs. Malini or to order a sum of $2,50,000$ for value received.

2. Bearer Bill: States delivery will be made to whosoever holds the bill. Such bill may be created explicitly or it is an order bill that fails to nominate the consignee whether in its original form or through an endorsement in blank. A bearer bill can be negotiated by physical delivery.

   • It is payable to any person in possession of the Bill on the maturity date.
     *Example Sixty days from date pay Mrs. Malini or to bearer a sum of $2,50,000$ for value received.

3.7.4 Differences between Bill of Exchange and Promissory Note

3.8 Cheque

3.8.1 Meaning and Definition

• The cheque has its origins in the ancient banking system, where bankers would issue orders at the request of their customers to pay money to identified payees. This order was known as a bill of exchange.

• The use of bills of exchange helped facilitate trade by eliminating the need for merchants to carry large amounts of currency, such as gold, to purchase goods and services.

• Over time, bills of exchange evolved into cheques.

• A cheque is a written order from an account holder (the drawer) to their bank (the drawee) to pay a specified amount of money to a named recipient (the payee).

• Cheques are used as a means of payment in commercial transactions and are widely accepted by merchants and service providers.

• The use of cheques has several advantages over other forms of payment.

• They are convenient, secure, and provide a record of payment.

• They also allow for delayed payment, which can be useful in situations where funds may not be immediately available.

Meaning: Cheque

• A cheque is a written order from an account holder (the drawer) to their bank (the drawee) to pay a specified amount of money to a named recipient (the payee).

• Cheques are used as a means of payment in commercial transactions and are widely accepted by merchants and service providers.

Definitions: Cheque

• As per Section 6 of Negotiable Instrument act, 1881, "A cheque is a bill of exchange drawn on a specified banker, and not expressed to be payable otherwise than on demand".

In simple language, a cheque is a bill of exchange drawn on a bank payable on demand. Thus a cheque is a bill of exchange with two additional qualifications, namely:

• It is always drawn on a bank and

• It is always payable on demand.

• All cheques are bills of exchange, but all bills are not cheques.

• A cheque, being a species of a bill of exchange must satisfy all the requirements of a bill.

Understanding Cheque with an Example:

• Mr. Sharma owes ₹$5,000$ to Mr. Gupta.

• Mr. Sharma writes a cheque for ₹$5,000$ and gives it to Mr. Gupta as payment.

• The cheque includes details such as the payee's name (Mr. Gupta), the payable amount (₹$5,000$), and the payment date (January 1st, 2022).

• Mr. Gupta deposits the cheque into his bank account.

• The bank processes the cheque and transfers funds from Mr. Sharma's to Mr. Gupta's account.

Parties to a Cheque

• Drawer: The person who draws the cheque.

• Drawee: The drawer's banker on whom the cheque is drawn.

• Payee: The person who receives the money through cheque.

Specimen of a Cheque

In a specimen cheque, the following parts are included.

• The drawee, the financial institution where the cheque can be presented for payment.

• Payee

• Date of issue

• Amount of currency

• Drawer, the person or entity making the cheque.

• Signature of drawer

• Machine readable routing and account information.

The proforma of a cheque is as under:

3.8.2 Features or Characteristics of a Cheque

(a) Bill of Exchange: The expression