What makes a promissory note valid?

When an individual or corporation lends someone a sum of money, a promissory note can be used, effectively like an IOU, to document the terms of the loan. Promissory notes are used for anything from informal loans between friends to much larger business loans.

Even among friends, when significant sums of money are involved, it is wise to have a formal agreement. Circumstances sometimes change, meaning the repayment of the loan may not happen in the way the lender (or borrower) expects.

In these moments having a valid promissory note is essential if the lender wishes to take legal action to reclaim their money. However, in order to enforce it, you will need to be certain that your promissory note is valid.

What is a promissory note?

A promissory note is a legally binding document between a lender and borrower agreeing the terms of repayment of a loan. Although the complexity will vary depending on the type of loan, typically a promissory note is a fairly straightforward document which is less extensive than a Loan Agreement. For loans that are less secure, perhaps to an unknown party, a Loan Agreement provides more comprehensive terms, so may be preferable for added security.

A promissory note will usually include:

  • The names of the lender and borrower
  • The borrower’s address
  • The amount to be borrowed
  • The date that the note is issued
  • The term of the loan period
  • Whether the amount due is payable on demand
  • Details around any interest and interest rates
  • Details about any collateral

How the loan is repaid can vary. The borrower may pay in regular instalments throughout the loan period, or pay it all as a lump sum at the end. It is common for the borrower to pay interest on the amount they borrow, although not always. The interest rate is agreed upon between the lender and borrower, and would generally be higher if there is no collateral provided.

Does it need to be in writing?

Since a promissory note is an agreement between two parties, it does not necessarily have to be in writing. A verbal agreement is still seen as binding. However, it will be extremely difficult to enforce the terms of the agreement in court unless they are in written form. Therefore, as a lender, if there is any uncertainty around the repayment of the loan, it is advisable to draw up a promissory note in writing.

Who needs to sign?

The signature of the borrower is obligatory in order to make the written promissory note valid. Whether or not the lender also signs will depend on the level of trust involved and the type of loan. However, without the borrower’s signature the document would be unenforceable.

Why might a promissory note be considered invalid?

For a promissory note to be enforceable, the terms and conditions should generally be fair and balanced between the two parties. If the terms are seen to weigh heavily in favour of one party, or if there is evidence that the borrower signed any of the terms under duress, there is a greater likelihood that they will not be enforced by the court.

Is it governed by the Consumer Credit Act?

If your promissory note is over £30.00 and is considered a commercial agreement – for example from a lender who regularly gives out loans as part of their daily business – the note will normally be governed by the Consumer Credit Act. Under this Act, your promissory note will need to comply with certain regulations in order to be valid, such as providing an annual percentage rate (APR) for interest. 

How do you enforce a promissory note?

Promissory notes can be either secured or unsecured, and this will decide how the note can be enforced in the event of non-repayment.

If the borrower is required to provide collateral for the loan, this can be seized and sold by the lender to claim back all or part of the debt. If the collateral does not cover the full amount of the note, or if the promissory note is unsecured, it is more complex for the lender to reclaim the outstanding amount. Initially they can try to negotiate directly with the borrower, or instruct a debt collection agency. Ultimately though, they may need to take the borrower to court to enforce the terms of their agreement.

What is a Debenture and when it is used?

Debentures have become increasingly popular in recent years and are typically used as a means of securing debt. Investing in or lending to a business is never without risk, but debentures provide an element of protection for the investor/lender.

They can also be a useful tool to borrowers who would otherwise struggle to attract debt finance on reasonable commercial terms.

What is a Debenture?

A debenture is a legal agreement between an investor and a borrower, in which a loan is secured against some or all of the company’s assets. It is a form of charge, similar to a mortgage. The lender can expect to have a priority claim on the business’ assets in case of insolvency or defaults on payments of interest or capital.

In addition, a debenture awards the lender the rights of a mortgagee, giving them an element of control over the company’s assets. They must be consulted on the sale of assets outside of normal business transactions, and can require the borrower to obtain their consent before doing certain things that might change the risk profile of the investment.

If the company were to run into financial difficulty, the lender can ultimately assert their powers to appoint their own administrators to take over the business and realise the assets.

When is a debenture used?

A debenture is generally used in circumstances that may be deemed a higher risk for the lender. When investing in a business, the lender must rely on the creditworthiness and likely success of the business in order to get a return on their investment. A debenture provides a layer of protection for the investor. If things were to go wrong, the holder of a debenture takes a prior claim over company assets to any unsecured creditors, increasing the likelihood that the lender will be able to reclaim their debt if the worst were to happen.

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