Sam owns a hardware store, and needs to buy 100 barbeque grills from Janet for a total of $40,000. He can’t afford the payment upfront although he can pay in eight instalments of $5,000 per month plus 10% annual interest. Janet needs to make the sale, but really needs the cash within the month to pay off one of her suppliers, Lee. At the outset, it seems like Sam and Janet’s interests are at odds and they might have a hard time forming a contract… were it not for the existence of the promissory note.

Simply put, a promissory note is created when one person gives a written promise (maker) to pay money to another person (payee) (Bills of Exchange Act, s. 176(1)) and is often used as a credit instrument. Promissory notes are more than just a simple IOU. They fall into a special category of contracts known as negotiable instruments (which just means “transferable documents”). There are several rules which apply to promissory notes in Canada, under the Bills of Exchange Act. These rules are very specific about what information has to be on the note, at a minimum, as well as how the note can be negotiated (transferred).

Suppose Sam creates a promissory note to give to Janet, and the note is payable in instalments as specified above. Even though the payment is not a lump sum, Janet can still accept this note, then sell it immediately to a third party. In this way, every party involved has benefited:

  • Sam can pay in instalments and get his grills from Janet
  • Janet has received an immediate cash influx and can pay off Lee
  • The third party profits from the payments or principal and interest on Sam’s note

This is the sort of economic efficiency that negotiable instruments, and promissory notes in particular, can create. Achieving a similar result using regular contracts would have been far more complex and cumbersome.

However, because of the way that negotiable instruments work, there are some inherent risks that need to be pointed out.

For one, a negotiable instrument is still a type of contract and non-performance is still a risk – although holders of notes will often have recourse and can sue on the note.

Another risk is that negotiable instruments do not operate subject to the equities. If Janet delivered damaged goods which required $10,000 in repairs, Sam can’t turn around to the third party and say he will only pay a maximum of $30,000 now even though the note was made in consideration for the delivery of the undamaged grills (some exceptions apply). The holder of the note is allowed to rely on it at face value. Sam can still sue Janet on the underlying contract for damages, but will have to continue paying on the note as well.

For the same reasons, it’s prudent for the maker to have the holder record a short receipt on the back of each note everytime an instalment is paid. Suppose Janet decided to keep the note for a month, so she received a payment of $5000 plus interest from Sam. In the second month she then negotiates it to a third party without recording a receipt on the back of the note. The third party, again, can take the note at face value. WIthout the receipt there’s nothing that indicates the first payment was made so Sam might actually have to pay twice.

Promissory notes also often have acceleration clauses which essentially say that if the maker is in default, the entire outstanding amount on the note becomes due immediately. The rationale behind this is quite simple. If Sam fails to make a payment in a manner that makes it fairly obvious that he will be incapable of making the remaining payments, the acceleration clause makes it possible for the third party to sue on the entire sum of the note. Without the acceleration clause, the holder would only be able to sue for the payments as they came due, so $5,000 this month, $5,000 the next month and so on.

TAKEAWAYS:

  • Promissory notes involve an unconditional written and signed promise by one person to pay another person, whether it is by demand or according to a determinate schedule
  • Promissory notes can be taken at face value, so it is exceptionally important for the maker to ensure that they are drafted accurately

Author: Sahil Kanaya

 

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