A promissory note is a legal instrument (more particularly, a financial instrument), in which one party (the maker or issuer) promises in writing to pay a determinate sum of money to the other (the payee), either at a fixed or determinable future time or on demand of the payee, under specific terms. If the promissory note is unconditional and readily salable, it is called a negotiable instrument.
Referred to as a note payable in accounting (as distinguished from accounts payable), or commonly as just a "note", it is internationally defined by the Convention providing a uniform law for bills of exchange and promissory notes, although regional variations exist. Bank note is frequently referred to as a promissory note: a promissory note made by a bank and payable to bearer on demand. Mortgage notes are another prominent example.
Promissory notes are a common financial instrument in many jurisdictions, employed principally for short time financing of companies. Often, the seller or provider of a service is not paid upfront by the buyer (usually, another company), but within a period of time, the length of which has been agreed upon by both the seller and the buyer. The reasons for this may vary; historically, many companies used to balance their books and execute payments and debts at the end of each week or tax month; any product bought before that time would be paid only then. Depending on the jurisdiction, this deferred payment period can be regulated by law; in countries like France, Italy or Spain, it usually ranges between 30 to 90 days after the purchase.
When a company engages in many of such transactions, for instance by having provided services to many customers all of whom then deferred their payment, it is possible that the company may be owed enough money that its own liquidity position (i.e., the amount of cash it holds) is hampered, and finds itself unable to honour their own debts, despite the fact that by the books, the company remains solvent. In those cases, the company has the option of asking the bank for a short term loan, or using any other such short term financial arrangements to avoid insolvency. However, in jurisdictions where promissory notes are commonplace, the company (called the payee or lender) can ask one of its debtors (called the maker, borrower or payor) to accept a promissory note, whereby the maker signs a legally binding agreement to honour the amount established in the promissory note (usually, part or all its debt) within the agreed period of time. The lender can then take the promissory note to a financial institution (usually a bank, albeit this could also be a private person, or another company), that will exchange the promissory note for cash; usually, the promissory note is cashed in for the amount established in the promissory note, less a small discount. Once the promissory note reaches its maturity date, its current holder (the bank) can execute it over the emitter of the note (the debtor), who would have to pay the bank the amount promised in the note. If the maker fails to pay, however, the bank retains the right to go to the company that cashed the promissory note in, and demand payment. In the case of unsecured promissory notes, the lender accepts the promissory note based solely on the maker's ability to repay; if the maker fails to pay, the lender must honour the debt to the bank. In the case of a secured promissory note, the lender accepts the promissory note based on the maker's ability to repay, but the note is secured by a thing of value; if the maker fails to pay and the bank reclaims payment, the lender has the right to execute the security.
Thus, promissory notes can work as a form of private money. In the past, particularly during the 19th century, their widespread and unregulated use was a source of great risk for banks and private financiers, who would often face the insolvency of both debtors, or simply be scammed by both.
The terms of a note usually include the principal amount, the interest rate if any, the parties, the date, the terms of repayment (which could include interest) and the maturity date. Sometimes, provisions are included concerning the payee's rights in the event of a default, which may include foreclosure of the maker's assets. Demand promissory notes are notes that do not carry a specific maturity date, but are due on demand of the lender. Usually the lender will only give the borrower a few days' notice before the payment is due. For loans between individuals, writing and signing a promissory note are often instrumental for tax and record keeping. A promissory note alone is typically unsecured, but these may be used in combination with security agreements such as mortgage, in which case they are called mortgage notes.
Definition and usage of promissory notes are internationally established by the Convention providing a uniform law for bills of exchange and promissory notes, signed in Geneva in 1930. Article 75 of the treaty stated that a promissory note shall contain:
- the term "promissory note" inserted in the body of the instrument and expressed in the language employed in drawing up the instrument
- an unconditional promise to pay a determinate sum of money;
- a statement of the time of payment;
- a statement of the place where payment is to be made;
- the name of the person to whom or to whose order payment is to be made;
- a statement of the date and of the place where the promissory note is issued;
- the signature of the person who issues the instrument (maker).
United States law
In the United States, a promissory note that meets certain conditions is a negotiable instrument regulated by article 3 of the Uniform Commercial Code. Negotiable promissory notes called mortgage notes are used extensively in combination with mortgages in the financing of real estate transactions. One prominent example is the Fannie Mae model standard form contract Multistate Fixed-Rate Note 3200, which is publicly available. Promissory notes, or commercial papers, are also issued to provide capital to businesses. However, Promissory Notes act as a source of Finance to the company's creditors.
The various State law enactments of the Uniform Commercial Code define what is and what is not a promissory note, in section 3-104(d):
|“|| § 3-104. NEGOTIABLE INSTRUMENT.
(d) A promise or order other than a check is not an instrument if, at the time it is issued or first comes into possession of a holder, it contains a conspicuous statement, however expressed, to the effect that the promise or order is not negotiable or is not an instrument governed by this Article.
Thus, a writing containing such a disclaimer removes such a writing from the definition of negotiable instrument, instead simply memorializing a contract.
|“|| § 83. BILLS OF EXCHANGE ACT 1882. Part IV.
Promissory note defined
(1)A promissory note is an unconditional promise in writing made by one person to another signed by the maker, engaging to pay, on demand or at a fixed or determinable future time, a sum certain in money, to, or to the order of, a specified person or to bearer.
(2)An instrument in the form of a note payable to maker’s order is not a note within the meaning of this section unless and until it is indorsed by the maker.
(3)A note is not invalid by reason only that it contains also a pledge of collateral security with authority to sell or dispose thereof.
(4)A note which is, or on the face of it purports to be, both made and payable within the British Islands is an inland note. Any other note is a foreign note.
Historically, promissory notes have acted as a form of privately issued currency. Flying cash or feiqian was a promissory note used during the Tang dynasty (618 – 907). Flying cash was regularly used by Chinese tea merchants, and could be exchanged for hard currency at provincial capitals. The Chinese concept of promissory notes was introduced by Marco Polo to Europe. According to tradition, in 1325 a promissory note was signed in Milan. There is evidence of promissory notes being issued in 1384 between Genova and Barcelona, although the letters themselves are lost. The same happens for the ones issued in Valencia in 1371 by Bernat de Codinachs for Manuel d'Entença, a merchant from Huesca (then part of the Crown of Aragon), amounting a total of 100 florins. In all these cases, the promissory notes were used as a rudimentary system of paper money, for the amounts issued could not be easily transported in metal coins between the cities involved. Ginaldo Giovanni Battista Strozzi issued an early form of promissory note in Medina del Campo (Spain), against the city of Besançon in 1553. However, there exists notice of promissory notes being in used in Mediterranean commerce well before that date.
Difference from IOU
Promissory notes differ from IOUs in that they contain a specific promise to pay along with the steps and timeline for repayment as well as consequences if repayment fails. IOUs only acknowledge that a debt exists. In common speech, other terms, such as "loan", "loan agreement", and "loan contract" may be used interchangeably with "promissory note" but these terms do not have the same legal meaning.
Difference from loan contract
A promissory note is very similar to a loan - each is a legally binding contract to unconditionally repay a specified amount within a defined time frame - but a promissory note is generally less detailed and rigid than a loan contract. For one thing, loan agreements often require repayment in instalments, while promissory notes typically do not. Furthermore, a loan agreement usually includes the terms for recourse in the case of default, such as establishing the right to foreclose, while a promissory note does not. Also, while a loan agreement requires signatures from both the borrower and the lender, a promissory note only requires the signature of the borrower.
Negotiable instruments are unconditional and impose few to no duties on the issuer or payee other than payment. In the United States, whether a promissory note is a negotiable instrument can have significant legal impacts, as only negotiable instruments are subject to Article 3 of the Uniform Commercial Code and the application of the holder in due course rule. The negotiability of mortgage notes has been debated, particularly due to the obligations and "baggage" associated with mortgages; however, in mortgages notes are often determined to be negotiable instruments.
In the United States, the Non-Negotiable Long Form Promissory Note is not required.
- Whaley DJ. (2012). Mortgage Foreclosures, Promissory Notes, and the Uniform Commercial Code. Western State University Law Review. LexisNexis entry
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- William N. Goetzmann; K. Geert Rouwenhorst (2005). The Origins of Value: The Financial Innovations that Created Modern Capital Markets. Oxford University Press. p. 68. ISBN 978-0-19-517571-4.
- Marco Polo (1818). The Travels of Marco Polo, a Venetian, in the Thirteenth Century: Being a Description, by that Early Traveller, of Remarkable Places and Things, in the Eastern Parts of the World. pp. 353–355. Retrieved 19 September 2012.
- As noted by Manuel Sanchis Guarner in La Ciutat de València. Ajuntament de València, València. Cinquena Edició 1989, plana 172. Quote in Catalan
Onorables senyors, nosaltres havem pres ací en Monsó, C florins de cambi de mossén Manuel d'Entença..., vos plàcia complir e donar aquí en València, per ell al honrat En Bernat de Codinachs, vista la present. Per la lletra que us enviam, vos fem saber aquells havíem ops. Plàtia-us, senyors, aquest cambi aja bon compliment.
- "La primera Letra de Cambio". Retrieved 27 May 2014.
- Beattie, Andrew. "Promissory Notes: Not Your Average IOU". Investopedia. Retrieved 27 May 2014.
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- Difference Between a Promissory Note & a Loan Agreement, Promissorynotetemplates.org
- "Non-Negotiable Long Form Promissory Note". Retrieved 27 May 2014.
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