Promissory Note

A promissory note is a written, signed promise by one person to pay a specified sum of money to another, either on demand or at a definite time. The Uniform Commercial Code supplies the working parts: 3-103(a)(12) defines a "promise" as "a written undertaking to pay money signed by the person undertaking to pay", and adds that "an acknowledgment of an obligation by the obligor is not a promise unless the obligor also undertakes to pay the obligation." Under 3-104(e), an instrument "is a 'note' if it is a promise and is a 'draft' if it is an order", which is the difference between promising to pay yourself and directing someone else to pay.

The naming is worth one sentence, because the market word and the statutory word are not the same size. Lenders, borrowers and courts say promissory note. The UCC's defined term is simply note, and 3-104(b) narrows it further: "instrument" means a negotiable instrument, and 3-102(a) says Article 3 "applies to negotiable instruments". So an ordinary signed promise to repay that fails one of the negotiability tests is still a promissory note in the ordinary sense and still a binding contract; it is simply governed by general contract law rather than by Article 3.

The four tests, and the three things a note may add without failing them. UCC 3-104(a) defines a negotiable instrument as "an unconditional promise or order to pay a fixed amount of money, with or without interest or other charges described in the promise or order", if it "(1) is payable to bearer or to order at the time it is issued or first comes into possession of a holder; (2) is payable on demand or at a definite time; and (3) does not state any other undertaking or instruction by the person promising or ordering payment to do any act in addition to the payment of money". That third test would disqualify almost every real loan document if read strictly, so the same paragraph permits three additions: an undertaking or power "to give, maintain, or protect collateral to secure payment", an authorization to the holder "to confess judgment or realize on or dispose of collateral", and "a waiver of the benefit of any law intended for the advantage or protection of an obligor". That is precisely why a mortgage note can pledge a house and stay negotiable, while a note promising to pay money and deliver a car would not.

Non-negotiability can be an accident or a choice. A note tied to a contingency is conditional and fails the first test; a note payable "when the property sells" has no definite time and fails the second. Drafters also opt out on purpose: 3-104(d) provides that a promise "is not an instrument if, at the time it is issued or first comes into possession of a holder, it contains a conspicuous statement, however expressed, to the effect that the promise or order is not negotiable or is not an instrument governed by this Article." Nothing about that makes the note weaker between the original two parties. It changes what happens when the note moves.

What negotiability buys is a buyer who is hard to argue with. When a negotiable note is transferred to a holder in due course, UCC 3-305 splits the borrower's possible defenses in two. Paragraph (a)(1) lists the defenses that survive against anyone: infancy, "duress, lack of legal capacity, or illegality of the transaction which, under other law, nullifies the obligation of the obligor", "fraud that induced the obligor to sign the instrument with neither knowledge nor reasonable opportunity to learn of its character or its essential terms", and discharge in insolvency proceedings. Paragraph (a)(2) and (a)(3) cover ordinary contract defenses and claims arising out of the transaction itself, and (b) says a holder in due course is "not subject to" those. The commercial purpose is that a note can be sold at a price that does not depend on investigating the deal behind it. The consumer consequence is that a borrower's complaint about the seller can end up being no answer to the finance company holding the paper.

Consumer law takes most of that back, and it does so twice. The Federal Trade Commission's Holder Rule at 16 CFR 433.2 makes it an unfair or deceptive practice for a seller to take a consumer credit contract that omits a notice, set in at least ten-point bold face type, reading "ANY HOLDER OF THIS CONSUMER CREDIT CONTRACT IS SUBJECT TO ALL CLAIMS AND DEFENSES WHICH THE DEBTOR COULD ASSERT AGAINST THE SELLER OF GOODS OR SERVICES OBTAINED PURSUANT HERETO OR WITH THE PROCEEDS HEREOF", with recovery under the notice limited to amounts the debtor has paid. The rule is tied to a sale or lease of goods or services to consumers, and a parallel version at (b) covers purchase-money loans; it is not a rule about every consumer loan. The UCC then closes the gap left by a seller who simply leaves the notice out: under 3-305(e), where other law requires such a statement and the instrument does not carry it, "the instrument has the same effect as if the instrument included such a statement", and (f) subordinates the whole section to other law establishing a different rule for consumer transactions.

The same instrument keeps reappearing under different names. A home loan produces a note plus a mortgage or deed of trust. Federal student loans use a master promissory note, one document covering loans made over several years. A loan between relatives is documented by a note, which is also what separates a loan from a gift when the Internal Revenue Service looks at it. A seller-financed sale produces a note payable to the seller, secured by the property sold. An estate-planning installment sale to a grantor trust produces a note payable to the seller of the assets. A shareholder advance treated as a loan needs one for the same reason. In each case the surrounding rules differ completely and the instrument is recognizably the same object: a signed promise, for a stated sum, payable at a stated time.

One caution about the source of all this. The Uniform Commercial Code is a model act drafted by the Uniform Law Commission and the American Law Institute, not a federal statute. The section numbers and text quoted here are the uniform text; what governs any particular note is the version of Article 3 the relevant state has enacted, and state enactments differ in wording and in which later amendments they adopted. Two notes with identical terms can therefore produce different results in different states, and the state's own code is the text to read before relying on any of it.

A note does three jobs in sequence. It records the promise, naming the amount, the rate, the payment schedule and the maturity date, and it is signed by the person who will pay. It establishes who may enforce it, through the words making it payable to a named person's order or to bearer. And it can then be transferred, at which point the question of which defenses survive becomes a practical one rather than an academic one.

Take an example of that last step. Devin signs a $9,000 note payable in monthly installments to a home-improvement contractor. The work is done badly and Devin has a $2,000 claim against the contractor arising from the same transaction. The contractor sells the note to a finance company.

If the finance company is not a holder in due course, UCC 3-305(a)(3) lets Devin assert the claim in recoupment "only to reduce the amount owing on the instrument", so the balance to be collected is $9,000 minus $2,000, or $7,000. If the finance company is a holder in due course, 3-305(b) says the claim cannot be asserted against it at all, and the full $9,000 remains payable whatever Devin's grievance with the contractor.

Now apply the consumer rule. Because this was a consumer credit contract for services, 16 CFR 433.2 required the contract to carry the Holder Rule notice, and UCC 3-305(e) gives the note the same effect as if it did even where the seller omitted it. The holder-in-due-course shelter therefore does not close the door: the $2,000 claim can be raised against the finance company, and the notice's own wording caps what Devin can recover under it at the amounts he has already paid. The arithmetic is unchanged; what changed is who has to answer for the contractor's work.

Pros

• A note converts an understanding into an enforceable obligation with a stated amount, rate and maturity, which is the difference between a loan and a gift when anyone later asks.
• Negotiability lets a lender sell the loan, which is what makes long-term consumer credit available at the volumes it is.
• The permitted additions in UCC 3-104(a)(3) mean a note can be secured by collateral without losing negotiability, so the same document works for a house, a vehicle or a business asset.
• A drafter who does not want the instrument to travel can say so: a conspicuous non-negotiability legend under 3-104(d) keeps the deal between the original parties.

Cons

• Against a holder in due course, most of what the borrower would say about the underlying transaction is not a defense, and the borrower usually discovers this only after the note has been sold.
• The consumer protections are conditional. The FTC Holder Rule is tied to sales of goods and services and to purchase-money loans, so it does not reach every consumer note.
• The governing law is a state enactment of a model act, so the same words can be read differently across state lines.
• Signing a note creates personal liability for the whole amount. Pledging collateral does not cap the obligation at the collateral's value unless the note or state law makes the debt non-recourse.
• Informal notes between family members are frequently vague about maturity, interest and default, which is exactly where the document is supposed to do its work.