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What Are Promissory Notes and How to Avoid Promissory Note Fraud

Promissory notes are instruments of debts to companies and investment instruments to investors. To raise capital, a company may borrow money from an investor. To formalize the loan, the company gives the investor a promissory note.

A promissory note is a contract between the company (the debtor) and the investor (the creditor). It is basically the promise of the company to pay the investor a specific amount of money at a specific time in the future.

Promissory Note Provisions

A promissory note is detailed. It indicates the names of the parties involved in the loan transaction (the name of the company and the name of the investor), laying down clearly the relationship between them (who owes whom).

A promissory note also states the details of the loan. It indicates the amount of the principal (the loan's face value), the applicable annual rate of interest and - if the interest is fixed - the full value of the amount owed (principal plus interest).

Finally, a promissory note indicates, in no uncertain terms, the terms of loan repayment. First, it states the loan maturation date - when the loan is expected to have been repaid in full. This can be a specific date or it can be left as an "upon demand" provision, in which case the investor decides when he will call the loan in full. Next, it also lays down the repayment schedule and the amount of payment required for each specific payment interval.

Promissory Notes versus IOUs

Promissory notes, although similar to IOUs in the sense that they are both instruments of debt, are not the same as IOUs.

IOUs are an informal agreement between a debtor and a creditor. It simply states the names of the creditor and the amount owed. It is issued by the debtor to acknowledge that it owes the creditor money - thus its name, which actually reads "I owe you." Furthermore, IOUs are non-negotiable instruments. They cannot be transferred and cannot be used as currency.

Promissory notes, on the other hand, are detailed loan contracts. It is as good as money, and can be used as such. It can also be transferred from one party to another. Upon a formal transfer from the original investor to another, the new owner of the promissory note becomes the new creditor and it is this new owner that the promissory note issuer must make payments.

Promissory Note Fraud

Investors are advised to be cautious when buying promissory notes. Promissory notes are legitimate investment instruments, as above explained. However, there has been a recent rash of promissory note fraud targeting individual investors, so it pays to be careful when making a promissory note investment.

The following is the typical modus operandi of promissory note fraud:

  • First, the fraudsters or the scam perpetrators make promissory notes. These promissory notes promise great returns - often from 15 to 20 percent annually. Investments are also often insured and returns are guaranteed.
  • The fraudsters then convince life insurance agents to sell the notes. They draw in these insurance agents with the promise of high commission rates - often from 20 to 30 percent.
  • Insurance agents then sell the promissory notes to clients. They use materials and information fed to them by fraudsters. The fact that they are insurance agents lends credibility to the claim that returns are guaranteed and the investment is insured.
  • Initially, the fraudsters may pay the insurance agents their commission in full to encourage more sales. At first, they may also pay investors the expected interest payments. These may be done to encourage more investors to prolong the scheme and gain even more investors. To pay investors interest, they simply use gains made from new investors.
  • Not long after the start of the scheme, however, the fraudsters pack up, abscond with their insurance agents' commissions and investors' money and go somewhere else or put up another bogus company to sell more fake promissory notes.

Avoiding Promissory Note Fraud

Remember the following things to avoid promissory note fraud:

  • Promissory note fraud is usually geared towards senior citizens. If you belong to this category and you are offered a promissory note fraud, be on the alert.
  • Unsolicited promissory note offers are typically fraudulent. If someone offers you promissory notes out of the blue, and you are an unseasoned or inexperienced investor, beware. Remember, companies that issue legitimate promissory notes usually do not offer such notes to the general public. They usually approach their contacts or private, sophisticated investors.
  • Be skeptical of promissory notes offered by life insurance agents. Remember the typical modus operandi? If an insurance agent tries to sell you a promissory note, check whether he or she has the license to sell securities. If he or she doesn't have a securities license, don't buy any negotiable instrument (including promissory notes) from him.
  • Check out the promissory note's registration status with the SEC. If it's not registered there, check with your state securities regulator. If it's still not registered, find out if the promissory note is exempt from registration requirements. If the note is registered as a viable investment instrument, read all of the corporate reports filed by the company issuer. If the note is exempt from registration requirements, do your own research and find out as much as you can about the company issuer.
  • Confirm the investment terms. Compare the promised rates of returns to current market rates for comparable instruments. If it's too high, then it's probably a scam.
  • Beware of promises that returns are guaranteed and investments are insured. These are red flags that a promissory note investment opportunity is fraudulent.
  • Find out as much as you can about promissory notes, typical rate of returns and typical repayment terms. Ask the promissory note seller relevant questions and do not back off until you're given a satisfactory answer. Of course, don't forget to confirm the truth behind the answers you're given.
  • If you're determined to buy a promissory note, it would be best if you consult a reputable financial professional about it before you finally take the plunge.

Been Scammed?

If you are a victim of promissory note fraud, visit the SEC website or your state securities regulator to file a complaint. If an insurance agent sold you the promissory note, you should also file a complaint with your state insurance commissioner.

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