Articles

What’s the problem with Promissory notes?

By Paris Tamang, Last updated: 2022-11-07 (originally published on 2022-10-03)

Promissory notes are a financial or a debt instrument with a written promise by one party to another that a certain amount of borrowed money will be paid in a set interval of time with some interest on it. It is often used by companies to raise money. Companies promise to pay back the principal which is the buyer’s funds along with interest payments in exchange for the borrowed money. These notes have set terms of payment.

Problems with legitimate promissory notes vs. illegitimate promissory notes

Promissory notes by nature come with inherent risks while investing. There is always the risk of the note itself is illegitimate. However, even legitimate promissory notes have their own issues and risks. While the high rate of return that promissory notes talk about can be quite tempting, it comes with its own set of risks, issues, and problems too.

Some problems that arise for even legitimate notes are cutthroat competition in the market, bad management of the company, severe market conditions, or drastic changes which make it impossible for the company to carry out the initial promise to pay back the principal as well as the interest to the buyers.

Illegitimate promissory notes are a problem by themselves. Two main types of problems with these notes are:

Deception: At times investors are promised unreasonably high amounts of returns on their investment. They are deceived about the true amount of return they will receive. The alleged returns are untrue and not back in terms of value by the collateral associated with the principal. This is a form of fraud and the most common target for this is the elderly.

Unregistered securities and sellers: Promissory notes which are just securities are not registered. Hence, they are not reviewed by regulators and can carry more investment risk. Additionally, promissory notes are transferable meaning that they can be sold through a licensed professional; someone with a securities sales license. But as they are just securities they are not reviewed by regulators and so investors should carry out their own investigation and confirm if a company can pay the debt amount. Also, sellers do not require their firm’s approval for a note’s sale either and so it comes with quite some risk.

How to avoid problems with promissory notes

As an investor, if you are planning on investing in promissory notes, you need to be aware of how to read into things with great scrutiny and be alert to a few things to avoid problems with promissory notes.

Promissory notes are usually sold to sophisticated buyers, and rarely to the public So if a promissory note is being sold to an individual investor, it is a sign of danger. This is because sellers look for investors who are capable of doing their own research to determine whether the notes are a good deal.

Avoid pushy deals. Promissory notes are quite complex, and no valid firm would push you to make an immediate decision. It is also quite inappropriate as well.

If you’ve decided on a specific promissory note, do check if it is registered. Check with your local securities regulator to see if your salesperson is compliant with the state security regulator.

Be wary of the salesperson you are dealing with. A big red flag is a salesperson who speaks of guaranteed high returns. Always remember with promises of great return comes great risks and responsibilities.  A salesperson cannot guarantee how much the return will be, if someone’s promising you this, just buckle up your horse’s mate. Also, do ask them what their commission amount is. An exorbitant commission from a salesperson that sounds unreasonable is probably just that. UNREASONABLE.

Another way to keep yourself safe from problems with promissory notes is to ask companies a lot of questions. Ask them about how they plan on generating interest for the note. Ask questions about the marketing and promotion costs as well as this will affect how the company pays you back.

Apart from the direct problems associated with promissory notes, you also need to be aware of the fact that promissory notes can be invalid. For a promissory note to be legally binding it needs to have certain things and avoid certain other elements which can invalidate it. Some common triggers that can invalidate and cause problems in a promissory note are: missing the payment schedule or interest rate, loss of the original copy of the document, and others. When a promissory note becomes invalid the lender cannot sue the borrower legally if they fail to make payments.

Conclusion

Hence promissory notes allow individuals to act as investors for a company, but it does come with its own set of risks and problems. As an investor one can avoid many of these problems by simply being more aware of promissory notes and asking the right questions. Never hesitate to inquire more about your investments to keep yourself safe from problems with promissory notes. 

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