Do Lenders Really Need Promissory Notes?

INTRODUCTION

           Lenders have been relying on promissory notes to evidence their loans for well over a thousand years,[1] long before the advent of credit agreements. Even after the development in the late 20th century of lengthy credit agreements, some lenders continued to require that promissory notes be executed and delivered by their borrowers to evidence loans made under such agreements. Today, many lenders in United States commercial loan markets now forego promissory notes as part of closing documentation and instead rely on their credit agreements as the sole evidence of the loans to their borrowers. This change raises the question whether the manner in which commercial loans are now documented have rendered promissory notes superfluous or if lenders are foregoing potential benefits for the sake of more streamlined documentation. As discussed below, changes in law and in loan documentation and administration practices have limited significantly the traditional benefits afforded by promissory notes and may present certain detriments over using a credit agreement without an accompanying note. 

 HISTORICAL BENEFITS AND TODAY'S REALITIES

Promissory notes historically provided benefits to lenders due to the inclusion of essential terms – loan amount, interest rate, payment and repayment terms, and maturity date – in a relatively compact instrument. Oft-cited advantages to the use of notes include “negotiability” and its treatment under Article 3 of the Uniform Commercial Code (the “UCC”), and certain evidentiary and enforceability mechanisms afforded under state law. As discussed below, many of these same benefits can be achieved by lenders by virtue of their credit agreements in the absence of a promissory note. 

      A.      Negotiability. Many proponents of promissory notes point to the “negotiability” of notes as a reason for requiring them as part of the closing documentation. If a promissory note qualifies as a negotiable instrument under Article 3 of the UCC[2] and if the note is transferred to an assignee who qualifies as a holder in due course under Article 3,[3] then that holder takes the note free and clear of most claims and defenses that the maker of the note could assert against the note’s original holder.[4] It is generally believed that by making the note payable “to order of” the lender will create a negotiable instrument.

Notwithstanding this belief, most promissory notes used in current commercial loan transactions may not qualify as a negotiable instrument under Article 3 despite being made payable by the maker “to order of” the lender. As credit agreements have grown in length, the promissory notes accompanying those notes have become more summary in nature. Many of today’s promissory notes fail to state all relevant terms in the note itself. Instead, they make reference to the underlying credit agreement and incorporate by reference important terms of the related credit agreement, such as the interest rate, prepayment, repayment, default and acceleration provisions. The incorporation of such terms precludes the note from being a negotiable instrument and the benefits that otherwise would be afforded a transferee that is a holder in due course will not apply.[5] Instead, the assignee of a non-negotiable instrument takes the instrument subject to all defenses and claims that otherwise existed against the original holder. This results in the same treatment that would apply to a lender that assigns to a third party its loan documents and the obligations of its borrower under a credit agreement.

       B.       Extended Statute of Limitations. The statute of limitations for actions based on an obligation to pay varies from state to state. In most states, it is six years or less, and the applicable period may depend on whether the obligation is evidenced by a written contract or a promissory note. The laws of certain states also provide that a promissory note that qualifies as a “sealed instrument” is subject to a longer statute of limitations period than other notes, sometimes as long as twenty years.[6] Although this appears to provide a significant benefit to a lender, this may not be the case.

      As a practical matter, a lender in a typical commercial loan transaction rarely encounters a statute of limitations defense from a borrower or guarantor in a suit on a defaulted loan. The lender’s enforcement action likely will be commenced long before the applicable statute of limitations has run. Second, any practical benefit achieved through a sealed instrument possibly could be achieved without a note. In certain jurisdictions a credit agreement can qualify as a sealed instrument if it contains a recital in the body of its text that it is such an instrument and all of the parties’ signatures bear the appropriate seals.[7] In many states, the insertion of the word “seal” beneath or adjacent to the signature of the borrower will suffice as the signatory’s “seal.”[8]  As a result, in such jurisdictions a lender no longer needs a promissory note to achieve the benefit of the extended statute of limitations for sealed instruments.

      C.      Presumption of Consideration.  Actions to enforce an obligation to pay require that the lender demonstrate that the borrower received consideration from the lender in return for the borrower’s obligation to repay the debt.  In many jurisdictions there exists a presumption of consideration where the loan is evidenced by a promissory note that recites it is given “for value received” or if the note qualifies as a sealed instrument.[9] As above, this benefit is limited in practice and can be duplicated with the use of a credit agreement. First, the presumption is not conclusive. It merely shifts the burden to the borrower or guarantor to prove a failure of consideration.[10] Second, a lender can achieve the same legal presumption where its credit agreement includes the phrase “for value received” or the requisite sealed instrument provisions.

      D.      Expedited Court Proceedings. New York law provides a lender suing on “an instrument for the payment of money” the benefit of expedited court procedures in an action maintained in New York State courts.[11] The expedited proceeding, called a Motion for Summary Judgment in Lieu of Complaint, allows a plaintiff to commence the action by immediately moving for summary judgment on the instrument. This eliminates the need for a separate summons and complaint, which must be served on the borrower, plus the delay inherent in the filing of an answer and other responsive pleadings and potential motions practice which may be asserted for meritorious reasons or to achieve procedural delay.

The benefits from New York’s expedited procedures traditionally have been applied in actions based on a promissory note. However, case law suggests that such actions can be maintained where the “instrument” is a solely a credit agreement[12] or a combination of a credit agreement and note, even if the note incorporates by references the various provisions of the credit agreement.[13] As a practical matter, the benefits under New York law are procedural only, and would not apply if an action is maintained in a United States district court or bankruptcy court.  Moreover, the motion for summary judgment can be successful only if there is no material dispute regarding the instrument, its terms, or compliance. If the motion is denied, the action would continue as a traditional court proceeding. Consequently, to the extent a lender desires the benefits of New York law in an action maintained in a New York state court, it can obtain the same benefit whether or not a note is used to evidence the borrower’s obligation.

       E.      Modified Good Faith Requirement.  It is generally accepted that a party to a contract has an implied duty to exercise its rights under that contract in good faith.  This duty is implied in contracts evidencing most commercial credit facilities, the one possible exception being a demand note. By definition, a demand note allows a lender to demand payment at any time and for any reason.  Many courts and commentators are of the view that such a duty does not apply given the unfettered rights of the lender.[14] Demand notes were commonly used in commercial revolving credit facilities prior to the 1980’s when discretionary revolving credit lines were the norm. However, demand notes have since fallen out of favor and today’s borrowers typically obtain committed credit facilities with a stated termination and maturity date. Under the current lending environment, a duty of good faith and fair dealing would be implied in all loan documentation, whether or not a promissory note, credit agreement or combination of the two is used.

POTENTIAL DETRIMENTS TO REQUIRING PROMISSORY NOTES

In addition to the marginal benefits that run in favor of a lender that has evidenced its borrower’s obligations by a promissory note, a number of factors suggest it may be better for lenders to forego a note and rely exclusively on their credit agreements.

      A.      Lost or Misplaced Notes. Promissory notes are unique collateral, and the existence of the original is critical. Despite modern laws permitting the use of electronic documentation and which permit facsimile or “PDF” signatures to serve as originals, the “original” promissory note is a hand-signed document delivered to and possessed by the lender. Like all original collateral, promissory notes can be lost or misplaced. If a lender becomes aware that the note has been lost after commencement of an enforcement action or a bankruptcy filing by its borrower, the lender may be delayed in enforcing its rights because it will need to prove that the note has been lost and there exists other evidentiary means to prove the debt. Consequently, a lender that requires a promissory note should take steps to ensure its record-keeping and retention policies and practices regarding the possession of original collateral are well formulated and consistently applied.

      B.      Changes in Debt Amount. Changes in the amount of the underlying credit facility may require that the promissory note be modified as well. Notes that recite the principal amount of the obligations will need to be amended or restated if the principal amount of a credit facility is modified due to, among other reasons, the borrower’s exercise of an optional accordion feature or change to the principal amount of the underlying debt pursuant to an amendment to the credit agreement.  Where a new note is executed, the borrower may request that the lender return to the borrower the existing note that has been superseded by the new note reflecting the increased principal amount. In cases where a note may have been lost or misplaced, this may create client administration issues due to the lender’s inability to return the note in the ordinary course and the lender may need to agree to indemnify the borrower for any damage it may suffer due to the lender’s loss of the original promissory note. 

Given the need for a new note, some lenders that still require promissory notes are now using promissory notes that do not recite the principal amount of the loan or loans evidenced by the note but rather have a promise to pay the outstanding principal amount of any and all loans made under a separate credit agreement. While this practice might avoid having to obtain new notes with each change in the principal amount, the reliance upon external documentation to define the borrower’s obligation further highlights whether a lender is afforded any benefit by the use of such a note.

      C.      Real Estate Documentation. Many states’ laws require that a mortgage, deed of trust or deed to secured debt (a “mortgage”) recite the amount of indebtedness secured by the mortgage.[15] In those states, an increase in the principal amount of the indebtedness will also require that each mortgage be amended to reflect the new principal amount.[16] Potential issues can arise based upon the method used to evidence the increase in indebtedness. If the debt is referenced solely by a credit agreement, the increase normally would be documented by an amendment to the credit agreement. Thus, the credit agreement still evidences the debt and the mortgage amendment would need only to reference the increased aggregated amount of the debt.  In contrast, where a promissory note is used, it is fairly common to evidence the increased aggregate debt by an amended and restated promissory note, which is a new (albeit restated) instrument with a unique date. Issues can arise where there are errors, however slight, in the description of the note in the mortgage. At least one court has held that a mortgage that incorrectly identifies the date of the note by a single day can render a mortgage invalid and the lender’s claim unsecured.[17] In addition, even in cases where an invalidated mortgage may be enforceable under an equitable theory such as estoppel, demonstrating the merits of such a theory will require additional time and effort by the lender and can delay the exercise of remedies.[18] Nevertheless, most commercial real estate loans in the United States continue to be evidenced by promissory notes (other than revolving credit facilities for real estate investment trust borrowers)

      D.      Syndicated Facilities.  Most syndicated credit facilities provide each lender the option to request a promissory note, although many lenders do not do so for the reasons highlighted here. If the agent commences an enforcement action where fewer than all lenders have requested notes, the agent’s counsel will need to attach the credit agreement and the existing notes to the complaint. The lack of promissory notes evidencing the aggregate indebtedness and the agent’s ability to evidence only a portion of the debt by promissory notes could possibly confuse the judge or jury who may not be familiar with complex multi-lender commercial credit facilities. 

It is also common in syndicated transactions for a lender to assign all or part of its commitment to another lender. The assignment of indebtedness that is evidenced by a note may create logistical issues in cases where the borrower requests that the assigning lender return its note marked “cancelled” prior to issuing a new note to the new lender, or where the existing lender assigns a portion of its commitment to a new lender, and new notes must be issued to evidence the reduced commitment of the existing lender and the commitment of the new lender.

      E.      Potential Inconsistencies. The use of both a promissory note and credit agreement to evidence an obligation also creates a risk for inconsistencies between the two documents. These inconsistencies could include critical terms such as interest rate, maturity date, principal amount, and events of default, or boilerplate terms such as choice of law, venue, or waiver of jury trial. In instances where a lender requires a promissory note, any inconsistency that may exist could be used by a borrower against the lender in an enforcement action or bankruptcy proceeding. The borrower could assert that the inconsistent provision should be construed against the lender as the primary drafter of the note and credit agreement. A lender can minimize this risk by including in its credit agreement an acknowledgement by the parties that (a) the terms of the credit agreement should control if any inconsistency exists between it and any other loan document and (b) any ambiguity in terms should be interpreted as if the parties’ mutually drafted both the credit agreement and note. A more sound approach, however, may be to eliminate the risk of inconsistencies altogether by foregoing a promissory note and relying solely on the credit agreement.

REQUIRED USE OF PROMISSORY NOTES

           Notwithstanding the trend to forego the use of a promissory note, there are some transactions in which a lender may be required by its financiers or industry that a promissory note be executed by the borrower. For example, some specialty (non-bank) lenders are financed under bank warehouse lines that require their loans be evidenced by promissory notes.  The warehouse lender typically perfects its security interest in the loan by filing a financing statement naming the specialty lender as debtor. Out of an abundance of caution, the warehouse lender may also require that the notes contain a legend to show the warehouse lender’s security interest.[19] By obtaining a promissory note with a restricted legend, the warehouse lender protects against a double-pledge of the loan by its borrower to a good faith purchaser for value. As discussed above, if the note qualifies as a negotiable instrument, an assignee who is a “holder in due course” – a third party who purchases the note for value without notice of a prior lien -- takes the note free and clear of the warehouse lender’s security interest. The restrictive legend would prevent a purchaser from acquiring the note without notice of the warehouse lender’s interest.[20]  

In addition, some regulated lenders (such as insurance companies) may be required by law or internal lending policies and procedures to have their loans evidenced by notes or bonds in addition to indentures or credit agreements. The need for a note may be an anachronistic practice if, as noted above, there is no legal benefit provided by the note that does not already exist by virtue of the other loan documentation. Nonetheless, a lender subject to such requirements will need its borrower to comply.

The use of notes may also be a matter of local practice. In some cross-border credit transactions (particularly those involving Latin American borrowers), local law may require that loans to a borrower located in a foreign country be evidenced by a note in the local language that is governed by local law even where the foreign borrower is a party to a separate credit agreement governed by the laws of a United States jurisdiction. Moreover, some banks in domestic transactions may require promissory notes to evidence their commercial loans because it facilitates borrowing against or discounting those loans with its local Federal Reserve Bank or Federal Home Loan Bank.

In the above examples, the lender does not have the option to forego the use of a promissory note. Nonetheless, a lender can benefit by acknowledging the potential detriments when using a promissory note together with a credit agreement, and ensuring its documentation and administrative procedures (a) provide for adequate procedures for holding original collateral and (b) ensure that the collateral documentation references accurately the promissory note and any amendments or restatements in any subsequent amendments or modifications over the life of the credit facility. These steps will help reduce the likelihood that the above-mentioned potentialities become realities.

CONCLUSION

           Whether or not more lenders forego the use of promissory notes remains to be seen. Nonetheless, the fact remains that many of the traditional benefits for the use of promissory notes have been largely undermined by changes in law and loan documentation and administration practices. In a world of more complex lending structures, and the increased reliance on signatures transmitted by e-mail in lieu of “ink” signature pages, the limited benefits achieved through promissory notes may no longer warrant their continued use.

[1] Parable of the Unjust Steward, Luke 16:1-13 (promissory notes issued for goods owing to steward’s master).

[2] See UCC § 3-104(a) (2015).

[3] See UCC § 3-302(a) (2015).

[4] See UCC § 3-305 (2015).

[5] See UCC § 3-106(a)(ii) and (iii) (2015). See, e.g., Guniganti v. Kalvakuntla, 346 S.W. 2d 242, 248-250 (Tex. App. 2011).

[6] See, e.g., O.C.G.A. § 9-3-23 (2015) (20 year limitations period); Pa. Cons. Stat. § 5529(b)(i)(2015) (same); S.C. Code Ann. § 15-3-520(b)(2015) (same).

[7] See Telfair Fin. Co. v. Williams, 323 S.E.2d 689 (Ga. App. 1984); Murray v. Wells Fargo Home Mortgage, 953 A.2d 308 (D.C. 2008); Mayor & Council of Federalsburg v. Allied Contractors, Inc., 338 A.2d 275 (Md. 1975).

[8] See, e.g., Whittington v. Dragon Group, L.L.C., 991 A.2d 1 (Del. 2009); Burgess v. Square 3324 Hampshire Gardens Apts., Inc., 691 A.2d 1153 (D.C. 1997); Hixon v. Woodall, 272 S.E.2d 727 (Ga. 1980).

    [9] See Jolles v. Wittenberg, 253 S.E.2d 203 (Ga. Ct. App. 1979); Citizens Bank of Blakely v. Hall, 177 S.E. 496 (Ga. 1934); United States v Beecher, 444 F. Supp. 121 (E.D. Mo. 1978).

[10] See Sanders v. Stewart, 266 S.E.2d 801 (Ga. App. 1980); In re Armstrong, 292 B.R. 678, 690 (10th Cir. B.A.P. 2003).

[11] See New York Civil Practice Law and Rules Section 3213.

[12] Spectrum Origination, LLC v. Hess, 2014 WL 1511159 (N.Y. Sup. Ct. Apr. 16, 2014).

   [13] Griffon V, LLC v. 11 East 36th, LLC, 90 A.D. 3d 705, 2010 WL 2379060 (N.Y. App. Div. 2011); Three Point Capital, LLC v. Myden, 2011 WL 444184 (N.Y. Sup. Ct. Sept. 21, 2011).

   [14] See Official Comment to UCC § 1-309 (2015). See also Fulton Nat’l Bank v. Willis Denney Ford, Inc., 269 S.E.2d 916 (Ga. App. 1980). But see K.M.C. Co., Inc. v. Irving Trust Co., 757 F.2d 752 (6th Cir. 1985) (implying duty of good faith and fair dealing in transaction involving a demand note).

  [15] See, e.g., O.C.G.A. §§ 48-6-61 and 48-6-66 (2015); Ind. Code § 32-29-1-5 (2015).

   [16] See, e.g., O.C.G.A. §§ 48-6-65 (2015).

   [17] In re Head Grading Co., Inc., 353 B.R. 122 (Bankr. E.D.N.C. 2006). But see in re Willows II, LLC, 485 B.R. 528 (Bankr. E.D.N.C. 2013) (and cases cited therein) (criticizing Head Grading while holding against imposing a “rigid rule” for determining whether a mortgage properly identifies the “obligation secured”).

   [18] In re Easthaven Marina Group, LLC, 2009 WL 703383 (Bankr. E.D.N.C. March 13, 2009) (incorrect reference rendered the deed of trust invalid but was enforceable under a theory of estoppel). But see In re Owens, 2009 WL 939568 (Bankr. E.D. Ky. March 12, 2009) (mortgage lien was avoided in bankruptcy where mortgage did not state the date and maturity of the obligation secured).

  [19] Some warehouse lenders also require that the legended original notes be physically delivered to the warehouse lender or its agent.

  [20] See UCC § 9-330 (2015).