What Is A Promissory Note

While the idea of promissory note has likely been around since the advent of currency (if not before), the promissory note itself dates from about the 10th century. The promissory note has changed little in a millennium. It is still a very simple contract-or at least, it can be. The theory remains the same, which is that one party promises to repay a debt to another party for prior value received. Today's promissory notes contain several basic elements, including the parties-the one who owes the debt is called the maker, the lending party is the payee-the sum to be repaid, the terms of repayment, the interest rate (if applicable), and the maturity date.

Today's more sophisticated promissory notes contain much more. Some have a governing law provision. Many have an acceleration clause whereby the repayment terms speed up (such that the entire sum may become due) in the event of a specific occurrence, usually when the maker misses a payment.

Promissory notes can be both secured and unsecured. Secured notes are backed by some type of collateral put forth by the maker, such as real estate or a car. In the event that the maker defaults, the payee in a secured note has the peace of mind that attachment to the collateral is always possible. By contrast, unsecured notes offer no collateral. Such notes will usually be found in the more informal cases of individuals loaning one another money. An unsecured note will always be trumped by secured liens; if a maker defaults, the payee of an unsecured note will have to wait-often fruitlessly-for other, secured creditors to be paid before seeking payment on the unsecured note. Thus, the payee of an unsecured note is best advised not to loan more money than he or she is willing to lose.

Another problem that the payee may encounter has to do with usury laws, which vary from state to state. These laws apply differently to banks that lend than they do to individuals who lend. Usury laws put a cap on the rate that the payee is allowed to charge interest. Interests rates that violate state usury laws can carry not only civil but also criminal penalties.

More recently, however, it has been the maker, not the payee, who has had to take care with promissory notes. Companies have used promissory notes as a tried and true method of raising capital. But whereas the individual-to-individual note is often a very simple written agreement, the company-to-individual note is usually very complex. It is for this reason that corporate promissory notes are primarily sold not to the general public but rather to sophisticated buyers who are capable of performing their own due diligence. Such notes are usually classified as securities, and anyone trying to sell them on behalf of a company must be registered with the Securities and Exchange Commission or a state equivalent.

Recent scams have come to light whereby con artists induce previously legitimate independent insurance agents to sell promissory notes to members of the public. These agents, who have no license to sell these securities, persuade their clients to "invest" in seemingly legitimate insurance companies, offering high returns and the reassurance of "guaranteed" promissory notes. Because the clients have often dealt with the agents before in legitimate dealings, the clients are more easily persuaded by the agents, who themselves are in on the con and receive a cut from the original fraudsters. Countless unsophisticated, usually elder investors have been bilked out of millions of dollars this way.

In short, while promissory notes are very useful, valuable, and well-traveled debt instruments, both the maker and the payee are well advised to do their homework when dealing with them.