What is a promissory note? | Insights & Analysis

A promissory note is a document between a lender and a borrower that is legally binding. In this guide, we look at the finer details as well as how they can be used.

What are promissory notes?
Examples of when to use a promissory note
Requirements of a promissory note
Promissory note characteristics
Details required in a promissory note
What happens if the borrower defaults on the promissory note?

What are promissory notes?

Promissory notes are documents where a person or company unconditionally promises to pay a sum of money under a specific set of terms as described in the note. It is more than a simple statement as it requires specific information in a formalised manner. Promissory notes contain details of the amount borrowed, the terms of repayment as well as the consequences if the borrower defaults on payment.

Promissory notes are defined in section 83 (1) of the Bills of Exchange Act 1882 as: “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.“

Promissory notes have developed over several centuries and their nature gave rise to the banknote. Before paper cash, transferring money was cumbersome due to the weight of coins and so promissory notes were issued as the precursor to official banknotes. In fact, if you look at a banknote today you will see that it still says “I promise to pay the bearer on demand the sum of…” along with the signature of the governor of the Bank of England which are the hallmarks of a promissory note. Previously all banks were able to issues promissory notes but owing to concerns that a shortage of gold could mean they might not be able to be redeemed, leading to the Bank Charter Act 1844 which restricted the issuing of promissory notes by banks to the Bank of England in England and Wales.

Examples of when to use a promissory note

As per the definition of a promissory note, they are used as a legal guarantee to repay lenders. They are now no longer used as widely as they once were but some examples and benefits of their uses include:

Business loans – businesses lending or borrowing money
Real estate loans – for example when assisting somebody with a deposit for a house that needs to be repaid
Student loans – lending money for university tuition
Personal lending between family and friends for any reason normally for larger sums
To add an extra element of trust when lending money
To allow repayment in instalments
Charging interest on the loan

Requirements of a promissory note

Sum certain/loan amount

Under section 83 (1) of the Bills of Exchange Act 1882, the amount due under a promissory act must be a “sum certain”. In other words, the amount to be repaid is a specific sum that must be clearly outlined. Additionally, it is possible to add interest to the initial sum if clearly specified as well as repayment in instalments at set intervals.

Negotiability

Promissory notes are negotiable instruments meaning they are for a set amount of money to be paid at a specific time and to be paid by a specific person/company. Additionally, this also means they can be freely transferred with the process of transferring the right to be paid called ‘negotiation’. Acquiring a promissory note does so without any of the defects that the previous may have had. In effect, this means they can be traded, often below the face value of the note by debt collectors seeking to make a profit.

Unconditionality

A key requirement of a promissory note is that it must be unconditional. This means payment must not rely on certain factors or conditions being met for repayment to be due. Should any payment be “subject to delivery” or a similar statement then it will not be a promissory note.

Execution and consideration

For a promissory note to be valid, it requires the signature of the promisor (i.e. the person creating the note). Without the signature it is unenforceable and no action can be pursued. The person who is due to be paid does not however have to sign the document.

It is assumed that contrary to usual contract rules that consideration has been provided. In layman’s terms, this means that the contract has a ‘value’ and both parties have agreed to this.

Promissory note characteristics

Transfer of title

With regards to a promissory note, a bearer note is a note that does not name the person/company that is owed repayment. Instead, repayment is due to whoever possesses the note at the time it is due.

Alternatively, if a promissory note does have a specified payee then to transfer (negotiate) the note, indorsement is required which is where the document is legally signed over to a third party. This can be done by signing the back of the promissory note which can be made payable to a specific individual or the bearer. Additionally, the indorsement must be for the entire note and any attempt to negotiate part of the note or to multiple individuals would be invalid.

Amendment

It is possible to amend a promissory note but to do so, this must be consented to by all parties. If a note is amended without the consent of all parties then it is not valid

Discharge and presentment

The simplest way to discharge a promissory note is to pay the full amount due on or after the maturity date as per the obligation described in the note. Should an alternative arrangement be pursued there will need to be an express agreement that this method is to discharge the note.

A promissory note can also be discharged if the promissory note is held by the maker at the time of maturity. In other words, if they have managed to come into possession by payment or some other deal. Additionally, it is also possible for the holder to either cancel or renounce their right to payment if done so in writing or by delivering up the promissory note back to the promisor.

Consideration nor deed is required to be released from a promissory note. This means that once payment has been made it is possible to unilaterally discharge the note.

It is not required for a promissory note to be presented for payment unless specifically required within the note. Failure to present the note also does not discharge the promisor’s liability to pay.

Limitation period

Section 5 of the Limitation Act 1980 applies to any claims related to promissory notes as it is a contractual claim meaning that after 6 years of the cause of action a claim cannot be brought. The right of action does not accrue until the note has been delivered unless affected by a condition within the note.

Security and Guarantees

It is possible to include a guarantee or other form of security within a promissory note. For example, a charge can be placed over assets that can be sold should the obligated payment not be made. It is possible to provide this security separate from the note but additional care will be required to ensure that it is correctly documented should the note be negotiated.

Details required in a promissory note

A promissory note requires the following details to be valid:

The names of the two parties
A contact address for the party borrowing money
The amount of money being borrowed
The duration of the loan and when repayment is due and if applicable details of a repayment plan
Whether interest will be charged and if so at what rate
What happens if the borrower defaults on the loan i.e. what the penalties for failing to repay are
Whether it is a secured or unsecured loan i.e. if there’s any collateral
Signature of the borrower and if required witnesses

What happens if the borrower defaults on the promissory note?

Should the borrower fail to make the payment that is due, then a demand letter should be sent to enforce the promissory note. At this point it is possible to seize assets used as security or alternatively begin legal action.

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