Promissory Note

Understanding The Promissory Note

A promissory note is a financial instrument that contains a written promise by one party (the issuer or maker) to pay a definite sum of money to another party (the payee) either at a fixed or determinable future time or on demand. It serves the primary purpose of documenting a loan between parties and providing evidence and terms of repayment.

In a business context, promissory notes are often used when a business borrows money, especially for short-term financing needs. They can also be used in business sales, where the seller finances the purchase by allowing the buyer to make payments over time. In addition, promissory notes are also common in real estate transactions, such as mortgages or property sales.

Regarding loans between family and friends, the Internal Revenue Service (IRS) does have rules around applicable federal rates (AFR). Regardless of the length of the loan, short-term (3 years or less), mid-term (over 3 years but no more than 9 years), or long-term (over 9 years), the IRS usually requires interest to be charged at least at the AFR. If the interest charged is less than the AFR, the IRS might deem the loan a gift rather than a bona fide debt, which may have tax implications.

Common issues that can arise with promissory notes include default or late payment, disputes over terms, or ambiguity in the language of the note, which can cause confusion about obligations. In addition, there can be issues related to enforceability if the note is not properly structured or if it does not comply with applicable laws. Moreover, if a promissory note is sold or transferred to a third party, there may be questions about the transferability of the note and the rights of the new holder.

Different Types Of Promissory Notes

In the business arena, a variety of promissory notes are used based on the unique needs and circumstances of each situation. These diverse forms serve different purposes and have distinct characteristics.

Secured promissory notes are backed by collateral, which can be claimed by the lender if the borrower defaults on the loan. This type of note is often used when large sums of money are involved or if the borrower’s creditworthiness is questionable.

Contrastingly, an unsecured promissory note does not involve any collateral. The lender’s only recourse in the event of a default is to take legal action against the borrower. These notes are typically used when the borrower has a high credit rating or in situations involving smaller loan amounts.

A mortgage promissory note is a specific type of secured note, where the collateral is real estate. This type of note is used in conjunction with a mortgage agreement, and it represents the borrower’s promise to repay the mortgage loan.

A demand promissory note allows the lender to demand repayment of the loan at any time. These notes are often used in more flexible lending arrangements or when the lender and borrower have a high degree of trust.

Installment promissory notes require the borrower to make regular payments (or installments) of principal and interest over a specified period until the loan is fully paid. They are common in many business loans and personal loans.

A convertible promissory note is typically used in startup financing. It’s a debt instrument that can be converted into equity (usually preferred shares) in the company at a later date, often at a discounted rate.

Lastly, a balloon promissory note requires the borrower to make small, usually interest-only payments over the term of the loan, with the entire principal amount due in a lump sum at the end. This type of note is often used in real estate or business financing, where the borrower expects to have a significant influx of cash at a future point to repay the loan.

It’s important to note that each type of promissory note has its own set of legal considerations and risks, and the appropriate type to use depends on the specific circumstances of the loan and the parties involved.

Typical Contract Provisions Included In A Promissory Note

A promissory note, being a binding legal contract, typically contains several critical provisions that detail the terms and obligations of the borrower and lender.

First and foremost, the principal amount, or the total amount of money loaned, is clearly stated. Alongside this, the interest rate, whether it’s fixed or variable, is outlined. The interest rate defines the cost of borrowing and is usually presented as an annual percentage.

Another critical provision is the repayment schedule. This section specifies how often and when payments are to be made, be it monthly, quarterly, annually, or upon demand. If the promissory note is an installment or balloon note, this section will detail the amount of each payment or the final lump sum due, respectively.

The note will also specify the events of default, such as failure to make timely payments, bankruptcy, or breach of any terms in the note. Consequences of default, including acceleration of the debt (where all amounts become immediately due), late fees, and legal remedies available to the lender, are also typically stated.

If it’s a secured note, a description of the collateral backing the loan will be included. In case of default, this collateral can be seized by the lender.

Terms related to the note’s enforceability, such as the governing law (which jurisdiction’s laws will interpret the note), waiver of jury trial, and an agreement to use arbitration or mediation in the event of a dispute, may also be included.

Finally, many promissory notes will include a provision indicating that the note can be transferred to another party (assignability), and will specify the rights of any such assignee.

These are just a few of the common provisions included in a promissory note, though each note can be customized to the specific lending situation and may contain additional terms.

Promissory Notes, Security Agreements & UCC Filings

The Uniform Commercial Code (UCC) is a comprehensive set of laws governing commercial transactions in the United States. When a promissory note is backed by a security agreement, it is often appropriate, and indeed crucial, to file a UCC financing statement to perfect the lender’s security interest in the collateral.

A security agreement is a contract that provides a lender with a security interest in a specified asset or property that is pledged as collateral. In the event the borrower defaults on their obligations under the promissory note, the lender has the right to seize the collateral. However, to ensure this right is enforceable against third parties and to assert priority over subsequent lenders or creditors, the lender must “perfect” the security interest.

Perfection is typically achieved by filing a UCC-1 financing statement with the appropriate state agency, often the Secretary of State’s office in the state where the debtor is located. The financing statement must include the debtor’s name and address, the secured party’s name and address, and a description of the collateral.

Filing a UCC-1 statement gives public notice of the lender’s security interest and establishes priority over other creditors who may have or later acquire an interest in the same collateral. It is especially important when the collateral is a type of asset that may be subject to multiple liens, such as business equipment, inventory, or accounts receivable.

Common Issues In Enforcing Promissory Notes

Enforcing a promissory note can bring forth several issues for the lender, particularly when the borrower defaults on their obligations. One common issue is determining the exact point of default. Depending on the specific language of the promissory note, default could be triggered by various events, not just non-payment. These may include bankruptcy, violation of specific covenants in the note, or the debtor’s death. Interpretation of these provisions can sometimes lead to disagreements.

Another issue concerns the process of seizing and selling collateral in the case of a secured note. Laws governing the disposal of collateral, such as providing proper notice to the debtor and conducting a commercially reasonable sale, can be complex and failure to adhere to them can lead to legal liability for the lender. In the event the collateral depreciates in value or is insufficient to cover the debt, the lender may face difficulties recovering the full amount owed.

Disputes can also arise if the borrower contests the validity of the note, claims the signature was forged, alleges the terms were misrepresented, or asserts a defense of fraud or duress. These assertions can complicate enforcement and may require court intervention to resolve.

Finally, if the promissory note has been sold or assigned to a third party, there may be issues related to the transfer of the note and the rights of the new holder, particularly if the transfer or assignment was not properly documented or notice was not given to the borrower.

Contact Our Chicago Business Attorneys

We understand the complexities and potential challenges surrounding the use of promissory notes in business transactions. Whether you are a lender needing to secure your investment, a borrower ensuring your rights are protected, or an individual dealing with an issue of default, our team of experienced business attorneys can provide the guidance you need. We invite you to contact us today to discuss how we can assist with your promissory note matters. Our goal is to provide you with a comprehensive understanding and strategic approach to ensure your interests are safeguarded and your business objectives are met.