Understanding Credit Instruments: Drafts and Promissory Notes

Types of Credit Instruments

Drafts and Promissory Notes

1. Notes: A promise to pay, known as a promissory note.
2. Drafts: An order to pay, including bills of exchange and checks.

Detailed Analysis of Drafts

1. Drafts
   1. Definition: An unconditional order in writing addressed by one person to another, signed by the person giving it (the drawer), and requiring the person to whom it is addressed (the drawee) to pay on demand or at a fixed or determinable future time a certain sum of money to, or to the order of, a specified person (the payee) or to the bearer.
   2. Bills of Exchange: A bill of exchange is used to finance the sale of goods. Rather than paying the draft when it is presented, the drawee accepts the draft by signing it and adding the word “accepted,” thereby becoming the acceptor and contractually bound to pay the draft on the due date. If the bill is transferred by endorsement, the person to whom the bill is transferred is called the endorsee. Any person in possession of a bill, whether a payee, endorsee, or bearer, is termed a “holder,” and if they are a bona fide purchaser, a “holder in due course.”
   3. Legal Obligations: The basic rule applying to drafts is that any signature appearing on a draft obligates the signer to pay the amount drawn. It is a characteristic feature of a draft that it is not limited to the three-cornered relationship among drawer, drawee, and the named or unnamed creditor. The creditor may transfer it to a fourth party, and the latter may transfer it to a fifth, and so on, in a long chain.
   4. Transfer Methods: The means of accomplishing a transfer from one creditor to another is by endorsement or delivery. If an instrument is payable “to order,” the signature (endorsement) of the transferor is required. The draft is then delivered to the new creditor.
   5. Bearer Instruments: If the instrument is payable “to bearer,” delivery alone suffices. Endorsement transfers the rights of the endorser to the new holder and also creates a liability for the endorser for payment of the amount of the draft if the drawee does not meet payment when the draft becomes due.
   6. Dishonor: A failure to pay a draft must be formally ascertained through a formal “certificate of dishonor.” Upon due notice of dishonor, the holder of the draft may claim payment from any endorser whose signature appears on the instrument, and they in turn may claim from prior endorsers, from the drawee, and from the drawer.