There are basically 3 types of negotiable instruments, such as a cheque, bill of exchange, and promissory note. These negotiable instruments are signed documents containing a promise to pay a specific amount of money to the assignee or bearer at a specified date or on being demanded. Such financial instruments are transferrable in nature and allow the person or entity to use them most appropriately.
What is bill of exchange and promissory note?
A bill of exchange and promissory note are written commitments between two or three parties to confirm a financial transaction that has been agreed on. These two financial instruments are used to confirm a struck deal. Promissory notes are used mostly in domestic trade, whereas bills of exchange are mostly used in international trade.
Generally, bills of exchange and promissory notes specifically, are governed by the Bills of Exchange Act 1882 (BEA 1882). Although the characteristics of promissory notes and bills of exchange are similar, they differ.
Let’s define promissory note and bill of exchange, individually, for more clarity, before comparing them.
Bill of exchange
A bill of exchange is a negotiable instrument that represents an unconditional order made by one party to pay another party, in accordance with the terms of that instrument. This negotiable instrument is usually used in the context of trade finance. In situations whereby, for one reason or the other, a party does not want to make immediate settlement of its account.
This financial instrument is a written agreement between two parties (the buyer and the seller) used widely in trade finance transactions and international trade. However, due to the risks involved with international transactions, the buyer or seller employs a bank to issue the bill of exchange. in regard to this, bills of exchange are sometimes referred to as bank drafts.
It is, therefore, a paper instrument used to transfer money from one party to another rather than transferring the actual money itself. The bill of exchange Act (BEA 1882) sets out in detail the requirements for the form of a bill of exchange. Hence, before any detailed consideration of a bill of exchange, consultation in accordance with this act, should be done.
The BEA 1882, s 3(1) provides that a bill of exchange is:
“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 the bearer”. An instrument which does not comply with these conditions, or which orders any act to be done in addition to the payment of money, is not a bill of exchange.BEA 1882, s 3(1)
It is simply, documentation that the purchasing party has accepted to pay the selling party a certain amount of money at a predetermined time for delivered goods. These bills of exchange can be transferred by endorsement, much like cheques. Also, in an event whereby the buyer fails to make good on his agreement with the seller, a bill of exchange can require the buyer to pay a third party (a bank). With such a situation, the bank of buyer will pay the seller’s bank, thus, completing the bill of exchange, then pursues its customer for repayment.
This bill of exchange is for payment in money and cannot include an agreement to carry out any other acts. It involves three parties, the drawer (the person who issues the instrument in order to receive a payment), the drawee (the person who needs to pay the amount to the drawer), and the payee (the person who receives the payment). However, the drawer and the payee are the same individuals, in most cases, unless it is transferred to a third party (payee) by the drawer.
A promissory note is a specific form of a bill of exchange because it is a financial instrument that is a written promise by one party to pay another party. The essential difference is that a promissory note is a promise by the maker to pay whereas an ‘ordinary’ bill of exchange is an order to a party to pay. Hence, it is a type of bill of exchange and is accordingly governed by detailed provisions of BEA 1882.
BEA 1882, s 3(1) provides that a promissory note is:
‘…an unconditional promise in writing made by one person to another signed by the maker, engaging 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 the bearer.’BEA 1882, s 3(1)
Promissory notes are, therefore, debt notes that provide financing for either a company or an individual from a source other than a traditional lender, most often one of the parties in a sales transaction. They are used widely in trade finance transactions where money is loaned to the maker of the promissory note. The promissory notes, in the United States, have historically been limited in usage to corporations or high-net-worth individuals. However, they have recently become more commonly used, primarily in real estate transactions.
These financial instruments are retained by the payee or seller and must be canceled and returned to the issuer or buyer once payment has been completed. A promissory note is more formal than an IOU, in terms of legal enforceability, but less so than a standard bank loan. These negotiable instruments can be transferred, either by endorsement and delivery (if it is payable to a specified person) or by delivery (if it is a bearer instrument).
There are 2 parties involved in the promissory note; the drawer/maker (the debtor who promises to pay the amount to the lender or creditor) and the drawee/payee (the creditor who is been promised by the borrower or debtor about the pending payment). The key factor used in the comparison between promissory note and bill of exchange is that a promissory note is a ‘promise’ to pay by the maker of the note while an ‘ordinary’ bill of exchange is an ‘order’ for one party to pay another party.
Features of a bill of exchange and promissory note
The following are the features of a bill of exchange:
- A Bill of exchange as a negotiable instrument is a legally binding document that contains an order to pay a certain sum of money to a person on demand by the bearer of the instrument or within a pre-determined time frame.
- It is unconditional: Payment cannot be subject to any requirements or conditions whether it is set out in the instrument or referenced externally. It needs to be fulfilled irrespective of the condition prevailing on the date of payment.
- It is issued by a creditor to a debtor for payment of money owed by the debtors for the goods and services availed.
- A prominent feature of this instrument is that it needs to be accepted by the debtor in order to be valid.
- In business, it is used to settle an outstanding debt between the parties involved in the transaction.
- In the bill of exchange, 3 parties are involved, namely the drawer, drawee, and payee.
- This instrument is a written order drafted by the drawer to the drawee.
- It holds a legal stamp (stamped by the drawer) to ensure its validity. Hence, the signature of the drawer is mandatory.
- This document is duly accepted and signed by the drawee who owes the sum to the payee.
- The bill of exchange has the date of payment mentioned on it and must be appropriately dated.
- The order of payment and its amount should be defined on the bill of exchange.
- This document must be delivered to the relevant payee.
- The “sum certain” which is the amount due cannot be contingent or qualified in any way and must be able to be determined from the instrument itself. Nevertheless, if an interest must be paid in addition to the principal amount, that can still be the “sum certain” given that the interest rate is fixed in the instrument and is not floating.
The following are the features of a promissory note:
- A promissory note as a negotiable instrument is a written promise by an individual or entity to pay a certain amount of money to its holder either at a pre-specified date or on-demand by the holder.
- A prominent feature of a promissory note is that once it is drawn by the debtor, it need not be accepted by the creditor.
- In the promissory note, two parties are involved, namely the drawer/maker and the drawee/payee.
- This negotiable instrument is duly signed and stamped by its drawers, promising to pay a certain sum of money to the drawee at a specific date or on-demand.
- Unlike a bill of exchange, the parties to a promissory note remain the same throughout. They do not change throughout the execution.
- For settlement, it is the legal currency of the relevant country that is used to pay the drawee. Thus, on a promissory note, the amount to be paid is mentioned in the monetary denomination
- This written promise has to be agreed upon by both the promisor and promisee for payment of the agreed sum of money.
- It is a promise to pay a defined amount of money at a particular time or when demanded. Thus, the mentioned amount can neither be added nor subtracted.
- The promissory note has a fixed date of payment. Thus, it states a particular date of repayment on which the promise has to be fulfilled.
- It is an unconditional promise to pay a certain amount of money that must be absolute in all cases. Hence, a conditional guarantee is not accepted.
- The promissory note has all the required information including the name of the drawer and payee, date of maturity, terms of repayment, issue date, name of the drawee, name, and signature of the drawer, principal amount, and the rate of interest, etc.
Examples of bill of exchange and promissory note
In order to grasp a proper understanding of these two financial instruments, let’s differentiate between bill of exchange and promissory note with a practical case example.
Mr. Dave sold goods worth $2000 to Mr. James on credit for 5 months. Mr. Dave at the same time had purchased raw material worth $2000 from Mrs. Racheal on credit for 5 months. Henceforth, Mr. Dave drafts a bill of exchange ordering Mr. James to pay $2000 to Mrs. Racheal, after 5 months. This draft was then duly signed and accepted by Mr. James, making it a legal bill of exchange.
In this case,
Mr. Dave is the drawer
Mr. James is the drawee, and
Mrs. Racheal is the payee.
Mr. Williams wants to start an electronic business but doesn’t have enough capital. Hence, Mr. Peter, a well-established businessman agrees to finance Mr. Williams’s business proposal. Mr peter then gives a loan of $4000 to Mr. Williams at 15% interest to be paid in 50 equal monthly installments of $92 each.
Mr. Williams then wrote a promissory note where he promised Mr peter to pay the total debt on time.
In this case,
Mr. Williams is the maker/drawer, and
Mr. Peter is the drawee/payee
Difference between bill of exchange and promissory note
The major difference between a bill of exchange and a promissory note is that a promissory note is a ‘promise’ to pay by the maker of the note while an ‘ordinary’ bill of exchange is an ‘order’ for one party to pay another party. In order to distinguish between a bill of exchange and a promissory note, we can compare these two instruments using some factors.
The table below compares a bill of exchange from a promissory note.
|Factors for comparison||Bill of exchange||Promissory note|
|Definition||This is a negotiable instrument issued to order a debtor to pay a creditor a certain sum of money on demand or within a specific date.||This is a negotiable instrument issued by a debtor with a written promise to pay the creditor a certain amount on demand or within a specific date.|
|Section||Bill of exchange is mentioned under Section 5 of the Negotiable Instruments Act, 1881||A promissory note is mentioned under Section 4 of the Negotiable Instruments Act, 1881|
|Issued By||It is drawn by the creditor||It is drawn by the debtor|
|Parties Involved||There are 3 parties involved i.e a drawer, the drawee, and a payee. Due to the risks that come with international transactions, the parties usually bring in a bank to issue the bill of exchange.||There are 2 parties involved i.e a drawer/maker and the drawee/payee|
|Acceptance||The drawee needs to accept the bill of exchange before payment.||There is no acceptance needed from the drawee.|
|Liability||The liability of the drawer is secondary and conditional.||The liability of the maker/drawer is primary and absolute.|
|Copies||There can be copies of the bill of exchange||The promissory note allows no copies|
|Is it Payable to the drawer/maker||In the bill of exchange, the same person can be the drawer and payee.||In the promissory note, the same person cannot be the drawer and payee.|
|Notice in case of dishonor|
In case of dishonor of bill of exchange either due to non-payment or non-acceptance, notice must be served to all the concerned parties involved in the transaction
|In case of dishonor of promissory note, a notice of dishonor to the drawer/maker is not necessary|
|Stamps||For a bill of exchange, stamping is necessary except for “bills payable on-demand”||With no exceptions, stamping is necessary for promissory notes|
|Collateral||In the case of a bill of exchange, no asset is held as a security||In the case of promissory notes, an asset can be held as collateral for the loan|
Similarities between promissory note and bill of exchange
- Bills of exchange and promissory notes are both financial instruments.
- They are both used for financial transactions.
- They are both written commitments between a buyer and seller, or any other parties that are agreeing to a financial transaction.
Difference between bill of exchange, promissory note, and cheque
Cheques, bills of exchange, and promissory notes are the 3 types of negotiable instruments. The table below, however, highlights the difference between promissory note, bill of exchange, and cheque.
|Bill of exchange||Promissory note||Cheque|
|Meaning||This is a negotiable written instrument that holds an unconditional order by the drawer/maker to pay a certain amount of money either to a specific person or its bearer.||This is a negotiable written instrument given with an unrestricted promise to pay a certain amount of money to a certain individual which is signed by the maker of it.||This is an instrument whereby a party orders the bank to transfer money to the bank account of another party in whose name the cheque was issued.|
|Legal||Bill of exchange is mentioned under Section 5 of the Negotiable Instruments Act, 1881||A promissory note is mentioned under Section 4 of the Negotiable Instruments Act, 1881||A cheque is mentioned under Section 6 of the Negotiable Instruments Act, 1881.|
|Notice of Dishonour||In case of dishonor of bill of exchange either due to non-payment or non-acceptance, notice must be served to all the concerned parties involved in the transaction||In case of dishonor of promissory note, a notice of dishonor to the drawer/maker is not necessary||A notice of dishonor is not compulsory for a cheque. A cheque bounce notice is to be given to the defaulter. However, if it is due to faults of overwriting, mismatched signature, etc., the payee can ask for the resubmission of the check to the drawer for clearance.|
But, if it is due to insufficient funds in the account then a cheque bounce notice is issued under Section 138 of the Negotiable Instruments Act within 30 days of an intimation sent by the bank. 15 days after the notice is given, the payee can initiate legal action under Section 138 of the Act and the offense of cheque bounce is a criminal offense under it.
|Copies||Bill of exchange can have copies||The promissory note allows no copies||The cheque allows no copies|
|Drawer of the instrument||It is drawn by the creditor||It is drawn by the debtor||It is drawn by the creditor|
|Partied involved||There are 3 parties involved i.e a drawer, the drawee, and a payee. The same person can be the drawer and payee||There are 2 parties involved i.e a drawer/maker and the drawee/payee||Three parties are involved which are the drawer, drawee and payee|
|Payability||It is payable on-demand or on the expiry of a certain period.||It is payable at a pre-specified date or on-demand by the holder||It is only payable on-demand|
|Grace period||This instrument has a three days grace period.||The third day after the day on which it is expressed to be payable.||Once a cheque is presented, it does not have a grace period.|
|Liability||The liability of the drawer is secondary and conditional. Thus, the parties that do not get a notice of dishonor are free from the liability of paying||The liability of the drawer is primary and absolute||Even though no notice of dishonor is given, the parties remain liable to pay|
|Validity period||There is no validity period to a bill||A promissory note is valid only for a period of 3 years from the date of its execution after which it becomes invalid.||A cheque is generally valid for 6 months. However, some cheques issued by the central government may be valid only for 3 months from the date of issue.|
|Acceptance||A bill of exchange must be accepted first before payment can be demanded on it||No acceptance is required from the drawee.||A cheque does not require acceptance and its object is for immediate payment|
|Stamp||A bill of exchange must be stamped||A promissory note has to be sufficiently stamped.||A cheque does not require any stamp except in certain cases|