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PROMISSORY NOTES: THE BASICS
Introduction:
When
one borrows money and pledges to pay it back, one creates a binding
obligation, usually with a document in which the terms of payment are
spelled out in detail. Such a document is commonly termed a Promissory Note and is the topic
of this article.
Note Compared to Contracts
The
reader is advised to read the web article on Binding Contracts
and Legal Actions Predicated on Breach of Contract on this
website. A promise to pay in writing is merely a contract imposing the
obligation to pay someone and most of the requirements for a binding
contract listed in detail in the above article apply equally to the
Promissory Note. From this point of view, a Promissory Note is merely one
type of contract.
Oral Promissory Notes
Just
as with some other types of contracts, there is a requirement for certain
Notes that they be in writing and that requirement is located in the
California Civil Code, 1624(a) which provides that certain contracts,
“…are invalid unless the same, or some note or memorandum
thereof, is in writing and subscribed by the party to be charged or by
his agent.” Among such contracts are agreements which, by their
terms, cannot be performed within a year from the making of the agreement
(unless the agreement is only to be performed by one party); or involves
sales of goods in excess of five hundred dollars. The rules and the cases
get quite complex but suffice to state that Notes can only be expected to
be easily enforceable if in writing signed by the person obligated and,
as one wag put it, “An oral promise is as good as the paper it is
written on.”
Before
giving up on an oral Note, be sure to consult legal counsel, but if one
is in the process of creating a Note, BE SURE TO HAVE IT PUT IN WRITING
AND SIGNED BY THE DEBTOR.
Other Legal Requirements
The
usual standard requirements of consideration,
mutuality, lack of ambiguity, meeting of the minds and competency to execute the Note are
all required as for any other contract. While our web site has forms to
use for such Notes (on the Retainer Forms
page), the usual terms are:
1. Identification of Parties
2. Amount owed and interest to
be charged.
3. Date of payments.
4. Right to assign (transfer
the obligation to another.)
5. Place the Note is entered
into and to be enforced.
6. Signature Line.
Usury is illegal in California and that is defined as
charging too much interest for the particular type of loan. Oddly enough,
certain financial institutions are exempt from the usury laws (which is
why credit cards are so expensive) and real estate brokers can engage in
loans involving real estate and also be exempt but most citizens are
subject to those laws and the penalty for violating usury laws is loss of
ALL interest to be charged. Normally, one only loses the interest to be
charged, not the principal.
Ten
percent is the normal limit on legal interest in California, subject to numerous
exceptions as noted above. Should you wish to charge more than ten
percent (or if you are being charged more than ten percent) you should
seek legal counsel. It can be
charged as a crime to intentionally engage in usurious interest
transactions.
Security for Promissory Notes
When
one enforces a legal action on a Note, one gets a judgment that allows
one to attach assets of the debtor who refused to pay. This usually
requires court action that can last two or three years or arbitration (if
one was wise in creating the Note) which still requires three to six
months or more. A much surer and faster way to assure collection against
those who breach their duty to pay is to have an asset pledged in
security of the Note. Typical assets pledged are real property (Deeds of Trust or Mortgages) or
personal property (UCC-1 Financing
documents).
Both
of these types of security allow a creditor to seize the secured assets
much more quickly than a court or arbitration proceeding and can avoid to
some extent the danger of bankruptcy making the debt uncollectible. (Note
that bankruptcy can still delay enforcement of foreclosure of the
security however, and if one receives a notice of bankruptcy one should
not proceed absent obtaining appropriate advice.)
Again,
on the
Retainer Forms page one
will find appropriate forms for these secured transactions, but be sure
to obtain professional advice in enforcement of same.
Death and Bankruptcy
The
death of a debtor does not eliminate the obligations of a Note. The
estate of the debtor becomes liable on the Note and the holder of the
Note should make claim on the executor of the estate with a creditor’s claim.
Bankruptcy
is a far more dangerous event. It can discharge an unsecured Note and,
using Chapter Eleven or Chapter Thirteen plans, can reduce the amount of
the Note and delay payments. See the web article on Bankruptcy, the
Constitutional Right to Start Over on the Articles Page of
this web site. One discovers that a debtor has filed bankruptcy when one
receives a notice from the Bankruptcy Court and it is thereafter illegal
to engage in further efforts to collect outside of the jurisdiction of
the Bankruptcy Court. One should then seek legal counsel.
Conclusion
Promissory
Notes can be misleading in their simplicity. While they are often tens of
pages long (the typical Bank or Car loan subject to numerous legal
requirements) they can also be scrawls on the back of an envelope.
A
client once remarked, as he idly fingered a torn piece of stationery with
a Note upon it that this dog eared piece of paper was worth over a million
dollars. He was right. It is a
never ending source of wonder to this writer that people, to avoid a few
hundred dollars in attorney’s fees, or the trouble of getting
professional advice, will write documents, sometimes unenforceable,
involving millions of dollars. With real property often requiring Notes
for the purchase or sale of the property, one sees Real Estate Brokers
often scribbling documents affecting two or three million dollars on
stationery store form Notes published thirty years ago and without any of
the numerous business protections which have since become common in
Notes, such as arbitration and legal attorneys fees clauses.
But
if drafted correctly that one or two page document can make the
difference between a bad debt and recovery of significant sums. And if
you are the debtor, you might find that errors in the drafting radically
alter the odds of you having to pay.
And
for those who think a Note is not needed because a friend is the person
borrowing the money-remember the 16th Century Arab proverb:
He that has satisfied his thirst turns his back on the
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