COMMERCIAL PAPER, a term popularly applied to all kinds of short-term negotiable instruments which call for the pay ment of money and which may be used for borrowing. Strictly, it should be used only for such paper as arises from commercial, as distinguished from investment, speculative, personal, real es tate or public transactions. It includes such instruments as short term notes, drafts, bills of exchange, acceptances, etc.
In the more narrow financial sense, commercial paper signifies only those unsecured promissory notes issued by business borrow ers (industrial or mercantile corporations or partnerships) and sold through note brokers to banks, insurance companies and other large investors. Only loans of considerable size are represented by commercial paper, $25,000 being about the absolute minimum, as small issues would not pay the commercial paper house for the cost of the investigating and selling. Such notes usually range in denominations of from $5,000 to $ i o,000 each, but often, to accommodate the smaller banks, some are issued in denominations of $2,500. Commercial paper notes are signed by the borrower, made payable to himself or order and then endorsed in blank so that they can be transferred easily to whatever customer that note-broker may find. Guarantees or endorsements sometimes appear on such notes, but this is very rare, and makes the notes unpopular with both the commercial paper houses and the banks, for to them it indicates that the credit of the issuing firm was not sufficiently sound to carry the notes alone.
The commercial paper houses which sell the notes do not (al though there are exceptions) endorse or guarantee the paper they sell, but stake their futures as brokers upon the continued offering of sound material only. Before accepting an issue of notes the commercial paper house makes a most rigid and exhaustive exam ination to assure itself of their soundness, and in the event of the borrower's default, frequently assumes the loss itself in order to protect its reputation with its clients. These notes vary in time from one month to one year, the majority of them being for about a four months' period. Business houses which utilize the com mercial paper method of borrowing avoid as far as possible fre quent short term loans, as they have to pay -1% commission to the paper house for each successive issue. Both the length of the issue and the rate of interest paid, however, are necessarily largely governed by the financial condition and needs of the issuing com pany and by current demands of the banks and other prospective purchasers.
There are several reasons which may influence businesses to sell their paper on the open market rather than borrow directly from banks. Some of them are: (t) They may sell paper on the open market when the available funds of the local bank are insuf ficient to take care of the desired loan. (2) They may often be able to sell commercial paper at a lower interest rate than is ob tainable at the local banks. (3) They may reserve a regular line of credit at local banks to be used, if advisable, upon other occa sions. Care must be taken, however, not to pit the open market as a competitor against the bank for the firm's business, otherwise the bank's line of credit may be found to be withdrawn when wanted. (4) A larger line of credit is usually obtainable through the open market than through dealing exclusively with local banks. (5) A wide geographic distribution of a firm's paper, providing the firm makes all payments promptly and regularly, gives the firm a wide reputation as an issuer of "prime paper," and banks in every part of the country are willing to take it up. This makes future borrowing comparatively easy. (6) The open market may be used to obtain funds to settle up bank loans and thus maintain local bank credit. (7) In a loan obtained through the sale of commer cial paper no part of the proceeds is tied up, as is the case with bank loans, where a deposit of about 2o% of its line of credit is required.
There are also several reasons why banks are glad to purchase commercial paper. Among them are: (t) Banks may thus utilize funds that are not in immediate demand for local loans. (2) They may sometimes procure a higher interest rate on commercial paper than is current on local loans. (3) They may buy only such notes as have maturities fitting in exactly with the bank's expected needs for cash. (4) The bank is under no obligation, moral or otherwise, to renew such notes, and thus avoids embarrassment which sometimes arises over renewal demands on local loans. It is well assured that commercial paper will be paid at maturity without question or quibble. (5) The bank's money is in obliga tions scattered over a wide territory, which geographical diversifi cation gives assurance that only a small portion may be affected diversely by unfavourable local causes. (6) The bank obtains the advantage of the broker's careful investigation and experienced judgment in the selection of the paper. (7) The bank may redis count commercial paper through the Federal Reserve banks to provide liquid assets, in case of necessity. (J. H. B.) British Usage.—The term "commercial paper" is not used in English banking circles. The term implies the obtaining of credit by means of a promissory note issued to a "note-broker," or alter natively, direct to a bank, and the essence of such a document is that it is merely a promise to pay a certain sum at a certain date.
The usual way of obtaining credit in England is either by an advance from a banker, which may or may not be secured, and which may be for a definite sum and run for a definite period, or simply be a running overdraft ; or else by means of a bill of ex change (see BANK, Bills of Exchange). The bill is the nearest approach in England to an American note, but even so, there are several vital points of difference. The chief is that while a note is but a promise by a single individual, a bill is an order to pay given by one individual to a second. Thus, a note need only bind one person, while a bill must bind at least two. A bill, too, can be secured. Thus, if it is endorsed D/P, the goods against which it is drawn are only delivered to the purchaser after he has paid the bill.
In general, the bill is used extensively in international trade, where the case of the note would be impracticable. Take the case of a shipment of goods from Hamburg to New York. The seller may draw his bill upon a bank in London, which has arranged to accept on behalf of the New York buyer. The seller may then dis count it at his Hamburg bank who, in turn, endorse it and send it to London for acceptance and for sale in the London market. Thus the bill carries the "names" of the seller himself, of his Ham burg bank, and of the accepting London bank, and the holder has two banks and a private individual to fall back upon ; whereas if the buyer simply gave a note, all the holder of the note would have would be the name of an individual on the other side of the Atlantic. (N. E. C.)