After the introduction of negotiable instruments in the previous article, we will now focus on two instruments that are extensively used in business transactions in numerous countries: the promissory note and the bill of exchange. This article is about the promissory note and will handle the following topics:
What is a promissory note?
Contents of a Promissory Note
Parties involved in a promissory note
Endorsement of a promissory note
Discounting of a promissory note
Factoring of a promissory note
What is a promissory note?
A promissory note is a negotiable instrument in which one party (the drawer, maker or issuer) promises in writing to unconditionally pay a determinate sum of money to the other (the drawee, payee or beneficiary), either at a fixed or determinable future time or on demand of the payee. A (promissory) note can be payable to bearer or payable to order:
- Payable to bearer means payable to the holder or presenter. When a promissory note is payable to bearer, it means whoever holds the note can receive the payment due on it.
- Payable to order (or payable to the order of) means the drawer is agreeing that he will repay the money to the payee or the person the payee designates to receive the payments. For instance, the payee can supply goods or services to the drawer and then direct the drawer of the note to make the payment to another person / company that the payee owes money to. A promissory note payable to order gives the payee flexibility in designating who will receive the funds.
Simply put, a promissory note is a “promise to pay” given by the maker. But the maker can fail to deliver on his promise and the payee may not get the money at the specified time. Many payees (Lenders particularly) therefore request the drawer to issue or sign a secured (promissory) note. A secured note includes a form of collateral. In the event the maker fails to pay the promised amount, the payee can legally seize and sell the collateral to recoup its losses. When an unsecured note goes unpaid, the payee can pursue legal action and file a judgment, but if the maker does not have the means to repay, the payee will end up taking a loss.
Contents of a Promissory Note
A promissory note complies with the Characteristics of Negotiable Instruments presented in the previous article. Issuer of a promissory note must stick to strict rules related to both form and substance of the document. In many countries, a promissory note document must contain some of the following elements (Read the commercial laws of your own country to find out which elements are mandatory):
- Maker of the Promissory Note: This is the individual or entity (company) that promises to pay the sum of money. Name and address are generally requested.
- Beneficiary / Payee of the Promissory Note: This is the person or entity to whom or in the order of whom the payment is to be made. Name is generally requested. However, a promissory note can be payable to the order of bearer. This means that anyone bearing the note can present it to the maker for payment.
- Creation date and place of the Promissory Note: The date and place where the Promissory Note is created.
- The unconditional promise to pay: In certain countries, the phrase “promissory note” must be visible on the document. In other countries, it is enough to use a language that clearly undertakes payment.
- Amount of the Promissory Note: The sum of money that the payee will receive must be clearly featured on the document. The amount of a promissory note is called the face value or the maturity value. A best practice in many countries is to write the amount twice on the Promissory Note.
- Maturity date / due date of the promissory note: this is the date on which the note is to be paid. If the exact due date is not explicitly indicated on the note, information should be available allowing to calculate the payment date. If a promissory note is payable after one month, then it means 30 days after it was issued. Note : A Promissory Note may not contain a date at all. That is the case for promissory notes payable on demand (mentions “At sight” or “On presentment” on the note), or after presentment for sight (mention “After sight” on the note).
- Signature of the maker of the promissory note: the signature (handwritten or electronic) is the binding force of the promissory note. It is the formal proof that the maker agrees to the content of the document and is promising to pay. In some cases, the signature of the payee might be on the document too. But that is generally not mandatory.
In certain cases when the promissory note is issued for a loan contract between a borrower and a lender for example, the document contains some or all of the following elements:
- Interest Rate of the Promissory Note: This is the amount of interest rate due on the amount of loan that the borrower pays.
- Dates when First Payment and Subsequent Payments are due: payments may be due every 5th of each month beginning in 3 months from the date of issue.
- Date the Promissory Note ends: This is the date after which the total amount due will have been paid. After this date, this promissory note is not valid anymore provided the borrower has paid the total amount due.
- Terms of the Prepayment Penalties of the Promissory Note: These terms are foreseen by the lender in case the borrower wants to make Prepayments and reduce the amount of interest to pay. The lender takes “penalties fees” to still perceive a (smaller) rate of return despite that.
Below is an example of what a simple promissory note looks like.
Additional elements can be added like signatures of the payee, witnesses or even a notary public. But the drawer and particularly the payee must ensure that all mandatory information are featured on the note.
Parties involved in a promissory note
Two main parties are involved in a promissory note: the drawer or maker and the drawee or payee. But depending on how it used, other parties listed below might be involved too (and the list is not exhaustive as we will see). In this paragraph, we will see when they come in and which role they play.
- Drawer: the person who makes a promissory note. He is also called the promisor, the maker, the payor, the debtor.
- Drawee: the person in whose favor the promissory note is drawn and who is meant to receive the payment. He is also called the promisee, the payee, the creditor.
- Bearer: the person who holds a promissory note. He is also called the holder. The bearer and the payee is usually the same person, but they can be different.
- Endorser: the person who endorses a promissory note.
- Endorsee: the person in whose favor the promissory note is endorsed and who receives it after endorsement. He becomes the new bearer and payee after endorsement.
Now let us consider the different parties and when they step in from the time the promissory is written and issued. We begin with the drawer and the drawee.
Drawer: The drawer of a promissory note is the maker and the debtor. The drawer issues the promissory note and promises to pay a certain amount to the drawee (payee). He is also called the promisor. The drawer of a promissory note can theoretically consist of 2 or more parties. In that case, the promissory note can be made payable jointly (the debt is divided by the number of drawees) or alternatively (the drawees pay in turn one after another, if there several payments deadline).
Drawee: The drawee is the other main party involved in the promissory note. It is the payee or creditor who would receive the money from the maker/debtor. He is also called the promisee. The word drawee for a promissory note can be a bit confusing since money is not drawn from him. He is actually the one who receives it. Therefore it is better to say payee or creditor.
It is important to say here that a promissory note is not an order to pay and does not require acceptance like a bill of exchange. Rather it’s a promise made by the drawer to the payee through a written contract. The drawer primarily sees the promissory note as an instrument of credit or a deferred mean of payment, a promise to pay in 30, 60 or 90 days for example. If the payment is made immediately, then it is not interesting to use a promissory note.
After drawing the promissory note, the drawer does not keep it, but hands it over to the payee who becomes the first bearer or holder. The payee now has many options between the following:
- He may decide to wait until maturity and present the promissory note for payment.
- He may decide to negotiate the promissory note to another person.
- He may decide to receive a short term finance by performing a discounting of the promissory note.
- He may decide to receive a short term finance by performing a factoring of the promissory note.
Endorsement of a promissory note
For option 2, the payee must endorse the promissory note and delivers it to the next party. Endorsement consists of a mandatory signature and (optional) words qualifying that act. The payee, who is then using the note as a financial instrument, becomes the endorser and the party receiving the note is the endorsee, the new holder of the promissory note. He is also called the holder in due course. Below is a figure showing what happens (the right part).
Why would the first holder negotiate the note to another party? There are several reasons. He may have a debt with that party that he wants to resolve. He may agree with the next party to negotiate the note in exchange of a sum of money. The negotiation is generally carried out to fix a financial problem. Otherwise, it is of no interest.
The negotiation process can happen as many time as needed. There is no limit to the number of endorsements that may be made on a promissory note. A Bearer is not obliged to inform the initial drawer or any previous party that the note has been negotiated. At maturity, the holder in due course presents the promissory note to the maker for payment.
Discounting of a promissory note
If the payee chooses option 3, then he must perform the promissory note discounting. Discounting is the arrangement in which a bank grants a short term credit on the basis of a promissory note to his holder, for less than the value shown on it before it is due to be paid. The holder, after providing evidence that he is in possession of a promissory note, receives the promissory note amount less administrative charges, fees and interest. The holder uses the note in this context as a credit instrument.
To compute the total fees, the bank takes into account the following elements: the amount and maturity date (due date) of the promissory note and the interest to apply. The longer the maturity, the higher the interest rate. The interest rate is referred to as the bank discount, or simply the discount rate. It usually includes the nominal interest rate and other charges. The period of discount is the period from the date of discount to the maturity date. The difference between the promissory note amount and all the charges, fees and interest is called the proceeds. The bank expects to receive the face value (total amount of the promissory note) as reimbursement amount at maturity date, generally in 30, 60 or 90 days. This explains why discounting is a short-term credit.
In general this is how Bank Discount and proceeds are computed:
- Bank Discount = Maturity Value x Discount Rate x Period of Discount
- Proceeds = Maturity Value – Bank Discount
The bank discount is what the bank earns in the process.
Note that the holder remains responsible for collecting the promissory note amount after this arrangement. That means in case the promissory note is dishonoured, the holder may get into big trouble, because he must pay back the credit to the bank anyway.
Factoring of a promissory note
The final option listed above is the factoring agreement. Factoring means an arrangement between a factor and his client where the factor buys a debt from its client. In Factoring, accounts receivable are highly discounted in order to allow the buyer, the factor, to make a profit when the debt is settled later. Discount rate are much higher in factoring than in normal discounting (explained above). Factoring transfers the ownership of accounts receivable to the factor that then chases up the debt.
In factoring the holder negotiates the promissory note to the factor. He is not responsible for collecting the promissory note amount anymore and therefore does not care that much if the promissory note is later dishonoured. The risk of non-payment (at maturity date) is completely transferred on the factor. That is why rates applied by factors are generally much higher than for those applied by discounting banks. And furthermore, the factor sometimes pays in two installments to limit the risk: one advance payment after endorsement and delivery of the promissory note and a final payment when the face value is collected.
Dishonour of a promissory note
A promissory note can only be violated by non-payment. There is no need of acceptance since the payor is himself the maker of the note. A promissory note is dishonoured by non-payment when the drawer or maker makes default in payment of the sum partly or totally.
When this happens, the holder must give a sign or notice of dishonour to all the earlier parties to make them accountable. A notice of dishonor is simply a notice given by the holder of the promissory note to previous endorser(s) to inform them that payment has been refused. The maker does not need a notice since he is the payor and is aware that the promissory note was dishonoured. Only after giving due notice of dishonour, the holder can sue the liable parties for the recovery of amount due on the instrument.
To provide a notice of dishonour, the holder takes the note to a notary public who presents it again for payment. In case the maker refuses again, the notary public records the refusal on the note. Thus ‘noting’ means recording the fact of dishonour on the dishonoured instrument or on a paper attached thereto for that purpose. It is recommended not to wait too long before doing noting. It should be done in the next 24 to 48 hours. Noting should specify the following on the instrument:
- Identification (Initials) of the notary
- A minute indicating that the instrument has been dishonoured and why; if the instrument has not been expressly dishonoured, the reason, why it is being treated as dishonoured
- The date of dishonour;
- The noting charges;
- The noting reference to the notary’s register.
In certain cases, noting may not be suitable to sue the previous endorser(s) and the maker. The holder can then request the Notary public to draw a certificate of protest or certificate of dishonor.
Despite all that, the holder may still not get its money back. The holder can then choose to turn the delinquent debt over to a debt-collection agency or a company that buys such debt and then tries to collect the debt. He then sells the note for a cheap price.
We analyzed the promissory note in this article and saw that many parties can be involved in the related processes. There are other players with a major role that we did not mention at all: the drawer’s bank and the drawee’s bank. We will have a closer look at their roles in the next article: the four corner model for promissory notes.
All promissory notes constitute three primary parties. These include the drawee, drawer and payee.What is a promissory note simple definition? ›
A promissory note is a written agreement between one party (you, the borrower) to pay back a loan given by another party (often a bank or other financial institution). Anyone lending money (like home sellers, credit unions, mortgage lenders and banks, for instance) can issue a promissory note.How many parties are involved in the initial stage of a promissory note? ›
There are only two parties to a Promissory Note, one is the maker or the payer and another one is the payee. It is not transferable and thus, the amount is not payable to the bearer. The liability of the maker is primary and absolute.Who is primarily responsible for promissory notes? ›
Who is primarily liable on a promissory note. It is the maker who is primarily liable on a promissory note. The issuer of a note or the maker is one of the parties who, by means of a written promise, pay another party (the note's payee) a definite sum of money, either on-demand or at a specified future date.Who is one who signs a promissory note? ›
Only the borrower signs a promissory note, whereas both the lender and the borrower sign a loan agreement. Once the document is signed, it means that the borrower agrees to pay back the loan.Who are the two key parties to a promissory note quizlet? ›
The two key parties to a note are the maker and the payee. 36. In a promissory note, the party to whom payment is to be made is called the maker.What are three types of promissory notes? ›
- Simple promissory note.
- Demand promissory note.
- Secured promissory note.
- Unsecured promissory note.
A promissory note must include the date of the loan, the dollar amount, the names of both parties, the rate of interest, any collateral involved, and the timeline for repayment. When this document is signed by the borrower, it becomes a legally binding contract.What are the essential elements of promissory note? ›
A Promissory Note must always be written by hand. It must include all the mandatory elements such as the legal names of the payee and maker's name, amount being loaned / to be repaid, full terms of the agreement and the full amount of liability, beside other elements.Does a promissory note need to be signed by both parties? ›
A mortgage includes a schedule of payments as part of its promissory note to clearly define what is owed when and how much is principal and how much is interest. Signatures are required to make the document legal. Both parties need to sign since both parties are entering into an agreement.
As per section 32 of negotiable instrument act, in the absence of a contract to the contrary, the maker of a promissory note and the acceptor before the maturity of a bill of exchange are under the liability to pay the amount thereof at maturity.What is not correct about the promissory note? ›
A promissory note cannot be made payable to the bearer, no matter whether it is payable on demand or after a certain time.How many and who are the parties involved in a promissory note? ›
Typically, there are two parties to a promissory note: The promisor, also called the note's maker or issuer, promises to repay the amount borrowed. The promisee or payee is the person who gave the loan.Which party in a promissory note is making the promise to pay? ›
The party making the promise to pay is called the maker.Who is the person to whom the amount of the promissory note is made payable? ›
The person in whose favour the promissory note is drawn is called payee. He is also known as drawee or promisee. Usually, the drawee is also the payee. In the above case, the payee is the person to whom the amount due on promissory note is payable.Who is the bearer of a promissory note? ›
PAYABLE TO ORDER OR BEARER: The promissory note must be payable to order or to bearer by using language such as “Pay to the order of Jan Smith”—or “I promise to pay to the order of bearer”. A bearer is simply the person who presents the note to the person who made it for payment.Who are the original parties to a 1 promissory note 2 bill of exchange? ›
A bill of exchange is issued by the creditor and orders a debtor to pay a particular amount within a given period of time. The promissory note, on the other hand, is issued by the debtor and is a promise to pay a particular amount of money in a given period.What are promissory notes that are freely transferable from one party to another? ›
Promissory notes that are freely transferable from one party to another are called. negotiable instruments.What is the most common example of a promissory note? ›
A banknote is frequently referred to as a promissory note, as it is made by a bank and payable to bearer on demand. Mortgage notes are another prominent example. If the promissory note is unconditional and readily saleable, it is called a negotiable instrument.What is better than a promissory note? ›
It is more difficult to recover repayment through a promise alone than if there is collateral involved and described in the promissory note. Loan agreements tend to afford greater safety for both the lender and borrower.
Enforcing a secured promissory note is simply a matter of either repossessing the secured asset through your own efforts, or hiring a professional agency to accomplish the task on your behalf. These agencies will charge a set fee for their services, but they usually have a very high rate of success.Does a promissory note hold up in court? ›
Promissory notes are legally binding contracts that can hold up in court if the terms of borrowing and repayment are signed and follow applicable laws.What are the limitations of promissory note? ›
A statute of limitations promissory note refers to the amount of time a lender has to take legal action against a debtor who is not paying back the amount they owe or has breached the contract in some way.Does a promissory note need to be notarized? ›
Promissory notes don't have to be notarized in most cases. You can typically sign a legally binding promissory note that contains unconditional pledges to pay a certain sum of money. However, you can strengthen the legality of a valid promissory note by having it notarized.What kind of obligation is a promissory note? ›
Promissory notes may also be referred to as an IOU, a loan agreement, or just a note. It's a legal lending document that says the borrower promises to repay to the lender a certain amount of money in a certain time frame. This kind of document is legally enforceable and creates a legal obligation to repay the loan.How do you structure a promissory note? ›
- Name of the lender and borrower.
- Loan amount.
- Whether the loan is secured or unsecured. If it's secured with collateral: What is the collateral? ...
- Payment amount and frequency.
- Payment due date.
- Whether the loan has a cosigner, and if so, who.
Maker or Drawer is the person who makes or draws the promissory note to pay a certain amount as specified in the promissory note. He is also called the promisor.What is the difference between a note payable and a promissory note? ›
Notes payable, also called promissory notes, are written agreements where a borrower agrees to pay back the borrowed amount of money with interest at a certain date in the future. Notes payable generally accrue interest and have varying repayment periods.What happens to a promissory note when the lender dies? ›
The death of the noteholder does not release the payor, except in the rare case where the note states that death will cancel the debt. Absent such a provision, the debt becomes an asset of the noteholder's estate, and it is then owed to the estate.What is the interest rate on a promissory note? ›
The default is 10% if no written contract is established, 12% is the general usury limit, and 10% is the limit on judgments. Unless stipulated in a written agreement, the legal rate is 12%. The rate of interest on money due on court judgments is 5%. The general usury limit is 9%.
a promissory note must be containing an unconditional promise to pay. it must contain a consideration in monetary terms only. the parties must be certain. a promissory note should be payable either on demand or at a certain date.Which of the following statements are true for a promissory note? ›
A promissory note is a legal, financial instrument in which one party promises another to pay a debt on a specific date. It's a formal agreement signed by the drawer promising to pay the money on a certain date or whenever it's requested.Can a promissory note be sold to a third party? ›
While a promissory note is not typically a “negotiable instrument” as defined in the UCC, it is intended to be and is codified as an instrument that can be easily transferred by the lender to a third party.Who are the parties to a promise? ›
There are at least two parties to a contract, a promisor, and a promisee. A promisee is a party to which a promise is made and a promisor is a party which performs the promise. Three sections of the Indian Contract Act, 1872 define who performs a contract – Section 40, 41, and 42.Who draws a promissory note debtor or creditor? ›
Two parties are involved in the promissory note. They are: Drawer/Maker: Drawer is the debtor who promises to pay the amount to lender or creditor. Payee: Payee is the creditor who is been promised by the borrower or debtor about the pending payment.Is a promissory note the same as a loan? ›
Promissory notes and loan agreements are both documents detailing the terms and conditions of a loan. Promissory notes are typically for smaller loans between people with a personal or business relationship, while loan agreements are typically more formal agreements for larger, conventional loans.Which of the following best describes a promissory note? ›
Which of the following best describes a promissory note? It is an agreement where a financial institution keeps a monetary deposit for a defined period of time.What is another name for promissory note? ›
In common speech, other terms, such as "loan", "loan agreement", and "loan contract" may be used interchangeably with "promissory note". The term "loan contract" is often used to describe a contract that is lengthy and detailed.
Although it is legally enforceable, a promissory note is less formal than a loan agreement and is suitable where smaller sums of money are involved. However, its terms - which can include a specific date of repayment, interest rate and repayment schedule - are more certain than those of an IOU.Who holds the promissory note while it's being repaid? ›
Who holds the promissory note while it's being repaid? The lender is the obligee who holds the note while it's being repaid. If the note is transferred, the new owner becomes the obligee and note holder.
A promissory note is a legally binding promise to repay a debt. These agreements could be used for personal loans, student loans, mortgages and more.Is a promissory note binding? ›
A promissory note is a written agreement to pay someone – essentially an IOU. But it's not something to be taken lightly. "It is a legally binding written document effectuating a promise to repay money," says Andrea Wheeler, a business attorney and owner of Wheeler Legal PLLC of Florida.What type of contract is a promissory note? ›
Promissory Notes Are Legal Contracts
Contracts indicate the type and amount of payment for services or goods rendered. In the case of a legal promissory note, the contract will be shaped around the amount of money or capital loaned and the terms of repayment of the promissory note.
Promissory notes don't have to be notarized in most cases. You can typically sign a legally binding promissory note that contains unconditional pledges to pay a certain sum of money. However, you can strengthen the legality of a valid promissory note by having it notarized.Does a promissory note need to be recorded? ›
Generally, it is not necessary for the note to be recorded officially. The borrower is required to sign the note, but the lender may choose not to sign it. A promissory note is a legally binding note that is often used between parties who know each other personally, and it is totally customizable.What happens if a promissory note is not paid? ›
The promissory note should set out any interest or late fees that apply. If the borrower does not pay in full, the lender has a right to file a lawsuit for the outstanding balance. In some cases, the lender may also have the option to send the debt to a debt collection agency.How long is a promissory note good for? ›
Depending on which state you live in, the statute of limitations with regard to promissory notes can vary from three to 15 years. Once the statute of limitations has ended, a creditor can no longer file a lawsuit related to the unpaid promissory note.