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A commercial draft is a demand for payment, typically made by a bank on behalf of one of its customers. It is substantially different from a check, which is another way for a bank to facilitate a payment made to one of its customers. Checks are negotiable instruments, which means that the check itself is offered in payment of a debt as a substitute for cash. A commercial draft, conversely, is merely a letter requesting a third party to acknowledge a debt and to come to the bank to make payment, or arrange for his bank to make payment.
Certain business transaction are conducted on open payment terms. This type of payment arrangement typically exists between businesses with an established relationship and impeccable history of honorable business transactions. The supplier allows the buyer to order merchandise when needed without paying for it upfront. Instead, whenever the supplier needs to close out his accounts receivables, or outstanding invoices, he tells his bank to issue a commercial draft to the buyer's bank to make payment out of the buyer's account.
The commercial draft is a demand for payment, typically to cover an extension of credit. Instead of the supplier using employees to generate a payment request, mail it and hope that the buyer will send a check, the supplier uses his bank to communicate with the buyer's bank. The buyer agrees in advance to honor commercial drafts when presented. He still has the option to refuse the demand for payment but if he does this, both banks will likely downgrade his credit standing.
Once a commercial draft is accepted by a third party or his bank, it becomes a promissory note, or a promise to pay. Acceptance of the draft acknowledges the validity of the debt and that the party intends to pay it. If the commercial draft is subsequently dishonored when presented for payment, it may be possible for the supplier to sue the buyer on the terms of the draft.
Businesses other than manufacturers may also use a commercial draft in international transactions. Corporations or agencies with employees stationed in other countries sometimes allow these employees to issue drafts to pay for goods and services. The commercial draft is almost always honored, but it gives the corporation control of the final payment. Unlike an instant payment made by cash, wire or check, the company still has to approve a draft once it is presented for payment.
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