Promissory Notes

Notes sold to investors are often securities, which means securities laws and regulators apply to them. Regulators have repeatedly listed promissory notes among the top threats to investors. Losing money on a promissory note is not, by itself, a claim. The key questions are whether the note fit the investor and whether the professional who sold or recommended it fulfilled their duties.

This May Not Be Your Fault

Many promissory notes are legitimate. State securities regulators have noted that when notes turn out to be a scam, many of the victims are older. Trusting someone who seemed to be looking out for you is not a mistake on your part.

The professional who sold you a note had duties to you. Anyone selling securities must be registered or licensed, and a broker at a FINRA-member firm (FINRA is the Financial Industry Regulatory Authority, which oversees brokerage firms) must have a reasonable basis for a recommendation under Regulation Best Interest. A broker who sells a note outside the firm’s knowledge may also be breaking FINRA Rule 3280, which requires advance written notice to the firm, and the firm must then supervise the sale. When those duties are not met, responsibility may belong with the seller and, in some cases, the firm.

How Promissory Notes Work

With a promissory note, you lend money to a company. In return, the company agrees to pay you interest and to repay your principal, the amount you invested, on a set date. Everything depends on the company’s ability to pay. The Securities and Exchange Commission (SEC) says promissory notes are typically securities, which means they must be registered with the SEC or a state securities regulator, or qualify for an exemption. Not every note is a security. The U.S. Supreme Court has said a note is presumed to be a security unless it closely resembles certain exceptions, such as a note issued in consumer financing or one secured by a mortgage on a home.

The North American Securities Administrators Association (NASAA), which represents state securities regulators, has repeatedly listed promissory notes among the top threats to investors. Regulators point to the same warning signs:

• Unusually high promised returns. The SEC says the rate promised is typically very high while the risk promised is very low.
• Claims that a note is “risk free” or “insured.” NASAA says every note carries the risk that the company cannot pay.
• Unlicensed sellers. The SEC says insurance agents cannot sell promissory notes without a securities license.
• Short-term notes. NASAA notes that notes lasting nine months or less may be exempt from registration, and that exempt notes have been a major source of complaints.
• Payments funded by new investors. The SEC describes a pattern in which money from new note sales pays interest on older notes, and investors rarely get their principal back.

Example: a retiree is approached by a trusted insurance agent about a short-term note that pays well above bank rates, is described as risk free, and is not registered anywhere. The interest arrives for a while, then stops.

Common Examples of Promissory Note Claims

• Notes sold by someone without a securities license, including insurance agents and other professionals outside their usual role — see Fraud and Misappropriation
• A registered broker sold notes on the side, without the brokerage firm’s knowledge or approval — see Selling Away
• Notes described as risk free, insured, or assured, without an honest explanation of what could cause a loss — see Misrepresentation and Omission
• Interest paid to earlier investors with money from newer ones — see Ponzi Schemes
• A firm that failed to supervise a broker or advisor who was selling notes to clients — see Failure to Supervise
• Notes recommended to retirees who needed steady income and access to their savings, including offerings sold as private placements — see Unsuitable Recommendations
• Older investors encouraged to cash in insurance policies or other savings to buy notes — see Elder Financial Abuse
• A large share of savings placed in notes from a single company — see Overconcentration

How Can You Protect Yourself From Promissory Note Losses?

A legitimate seller will welcome questions. A few steps that help:

• Ask who is selling, and check their license. Look up the seller with your state securities regulator or on FINRA BrokerCheck before sending any money.
• Ask whether the note is registered or exempt. The SEC says you can check its EDGAR database or call your state securities regulator.
• Compare the rate to safer choices. The SEC suggests comparing the promised rate with Treasury bonds or bank certificates of deposit that are insured by the FDIC (the Federal Deposit Insurance Corporation). A much higher rate means much higher risk.
• Be careful with promises of no risk. No note is free of risk, and no promise or outside insurance replaces the company’s ability to pay.
• Slow down on unsolicited pitches. The SEC warns that a call or visit from someone trying to sell you a note is a reason for extra caution. Talk it over with someone you trust first.

Signs Your Promissory Note May Have Been Unsuitable or Misrepresented

• The promised return was far above what banks or Treasury bonds were paying
• You were told the note was risk free, insured, or carried assured returns
• The seller was not licensed to sell securities, or was a professional selling outside their usual role
• No one told you whether the note was registered or exempt, or gave you written information about the company
• You paid a person or business directly instead of through your brokerage account, and the note does not show on your account statements
• You were encouraged to cash in an insurance policy, annuity, or retirement account to buy it
• A large part of your savings is tied up in notes from one company
• Payments stopped, or you were told repayment would be delayed