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Bills of exchange and cheques

A bill of exchange is a primordial means of extending credit, whose antecedents one would do well to understand, as quite a lot of contemporary business of extending credit depends on them. This stuff is not immediately intuitive, but when you get in to it, it has a logic of its own, and is rather fun. We recommend it.

Bills of exchange are governed by the elderly, but still in force, Bills of Exchange Act 1882, and are defined in section 2 as:

“an unconditional order in writing, addressed by one person to another, signed by the person giving it, requiring the person to whom it is addressed to pay on demand or at a fixed or determinable future time a sum certain in money to or to the order of a specified person, or to bearer”

Unpicking this there are three parties involved here: the “drawer”, who directs the “drawee” — typically a bank or moneybags of some kind with whom it has some kind of banking or credit facility, to pay a specified sum to the “payee”. The drawer will issue the bill to the payee in exchange for goods and services — hence a bill of exchange. The payee accepts it as good value for the goods and services, recognising it as an independent claim against the drawee for the payment of that sum of money according to the terms and conditions on the face of the bill.

When drawing a bill of exchange one must designate clearly who is drawer and drawee. Where the drawee is a bank, and the bill is payable upon demand, older readers may recognise the arrangement as a cheque.

The payee to whom the bill is issued need not be named. If she is, she may transfer the instrument by “indorsing” it (this may mean just signing it and delivering it to a third party). If she is not named, the bill will be payable on presentation by the bearer, whoever that happens to be. That is to say, title to the bill passes by mere delivery.

This “triangular” arrangement makes for uncertainty at the point of delivery, especially as the drawee is not represented. How does the payee know the drawee will honour the bill? This will depend on a preexisting arrangement to that effect between drawee and drawer, to which payee is not party or even witness.

So there are some complicated arrangements springing into life here:

• A transaction between drawer and payee whereby drawer issues a bill to drawee in (conditional) discharge of the consideration required for the payee’s goods or services.
• A payment obligation from drawee to payer which, if the drawee dishonours, triggers reinstatement of the drawer’s primary obligation to pay payee under the original transaction;
• A reimbursement obligation (or debit entitlement) from drawer to drawee whereby drawee may deduct the amount drawn from drawer’s account with drawee upon drawer2 settling drawer’s original payment obligation to payee. And this is before we even get to negotiation.

Derivatives fans may see this as redolent of a give-up.

Promissory notes and IOUs

A promissory note is just a special case of a bill of exchange where the drawer and the drawee are the same person, and the drawer thus draws the bill on itself — saying, effectively, “I direct myself to pay you this sum, only later”. It is an IOU, effectively. The implication that it will be paid not now, but later — if it could be honoured right now it would have no point: you would just pay cash — it has the general quality of a credit arrangement. Where the credit arrangement is in return for not goods and services but cash, a promissory note is a form of loan.

At a high level, debt securities closely resemble promissory notes. They are a form of securitised loan.

Negotiability

All this is further confused if the holder of a bill of exchange is entitled to negotiate it — to sell it, effectively, in the secondary market to a random third party.

If it is a bearer bill, one can negotiate it by simple delivery. If the bill is made out to specified payee, the payee can “indorse” it, by signing it.

You might think there is some scope for fraud here, and you might be right. There are many provisions on the Bills of Exchange act about that.

History: Lord Mansfield and all that

Historian Jane Samson wrote an excellent article in the Dalhousie Law Journal in 1988, from which some of this history is taken. In Heylyn v Adamson [{{{3}}}] {{{4}}} {{{5}}} Lord Mansfield drew a distinction betweem “inland bills of exchange” where the drawee is to pay, and “notes of hand” (now called promissory notes) where the drawer is to pay (that is, drawer and drawee are the same person.

Addressed promissory notes — those not made out to bearer — are bilateral arrangements, until they are negotiated to a third party, at which point they look exactly like bills of exchange — the act of “negotiating” and “drawing” being economically equivalent.