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.
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 well.