Promissory notes are often issued in the course of business
arrangements and financial transactions to record indebtedness and
financial obligations. People who use these instruments, however,
should be aware of the specialized nature of promissory notes.
A promissory note is an unconditional promise to pay made by one
person to another, which must be signed by the person giving the
promise. The indebtedness contemplated in the promissory note may
be repaid either on demand or at a fixed time in the future,
depending on the specific wording of the note. Promissory notes are
governed by federal legislation, specifically, the Bills of
Exchange Act, RSC 1985, c. B-4.
The Bills of Exchange Act provides that promissory
notes, along with bills of exchange and cheques, are negotiable
instruments. "Negotiable" means that the title to the
promissory note can be transferred by the original creditor who
holds the note to a third party, without the consent or knowledge
of the debtor who gave the note. This concept may be more familiar
in the context of a cheque, which is another negotiable instrument.
A cheque may be made payable to Person A, who endorses it for
transfer to Person B. Person B then becomes the person entitled to
receive the amount of the cheque. The endorsement of the cheque is
A promissory note can be used in a business transaction as a
means of evidencing indebtedness, for example, as part payment on
an asset or share purchase or to evidence a corporate loan from a
shareholder. The relationship between the original creditor and the
debtor is often governed by a broader personal or contractual
relationship. However, if the promissory note is negotiated to a
third party, that "new" creditor may acquire the
promissory note free from contractual rights or other obligations
that existed between the original parties.
This results in at least two risks:
As noted, a buyer may give a
promissory note to a seller for part of the purchase price in a
sale transaction. Suppose the buyer, for example, has a claim
against the seller due to a misrepresentation or breach of contract
by the seller under the sale agreement. If the seller demands
payment of the promissory note, the buyer may be able to "set
off" its legal claim under the sale agreement against amounts
owing to the seller under the note. However, if the seller
transfers the note to a third party, that third party is typically
entitled (with some narrow exceptions) to payment from the buyer
free from any rights the buyer has against the seller, and may
enforce payment. The result is that the buyer has no right of
set-off and must pay the amount of the promissory note to the third
party. The buyer must separately pursue the seller for any loss due
to the misrepresentation or breach of contract.
In most cases, a promissory note is
construed to be separate and apart from the contract or other
rights or relationship that exists between the original parties. A
third party who holds a "demand" promissory note may
therefore be able to demand payment at any time (subject to the
specific terms of the promissory note), even where the agreement
between the original parties limited or otherwise directed
"if" or "when" the demand for payment would be
The risks can be managed by using the following tips:
Be cautious of "demand"
promissory notes, where payment could be demanded at any time.
Draft the promissory note in such a
way that makes it non-negotiable. Then, the promissory note will
only operate to evidence indebtedness and an obligation to repay
the original creditor.
Seek legal advice to ensure that the
promissory note is appropriate to the transaction and properly
addresses unforeseen legal risks.
Promissory notes can be a useful means of documenting financial
obligations, but care must be taken to avoid unintended
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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The British Columbia Court of Appeal has recently considered whether the doctrine of unconscionability can be invoked to set aside a contractual clause providing for the payment by one party to the other...
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