Promissory Notes: Investigate before Investing

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Many investors seek out safe, fixed-rate investments—especially ones that boost interest.

If you're looking for sound investments that pay better than average, always remember the correlation between risk and reward. Every investment involves some risk, and the greatest-yielding investments usually carry higher risk levels.

One common interest-paying investment is the promissory note. Companies often use these notes to raise capital, and most are marketed to corporate investors.

Corporations are typically able to research the note issuers and determine if they can pay the promised interest and principal. For sophisticated or corporate investors, promissory notes can be useful. They provide a reasonable reward for those who accept the risk. However, promissory notes marketed to the general public often turn out to be scams. And even legitimate notes carry some risk that the issuers can't meet obligations.

Unfortunately, bogus promissory notes exist. Sellers of fake notes promise to deliver above-market, fixed interest rates, while safeguarding investor principal. Fraudulent promissory notes claim to give investors the two things they desire most—higher returns and safety. But they're ultimately worthless.

Remember, if something sounds too good to be true, it probably is.

Fraud Costs Some Investors Their Life Savings

Promissory note fraud can have crippling consequences. Here are two examples of how note investors lost their money:

Business Risk

A company selling premium coffee at drive-thru kiosks sought investments. At least 100 investors nationwide invested more than $4 million in promissory notes, with a promised rate of 13 percent over nine months. Savvy, slick marketing materials hyped the company and its products.

But the promissory notes were illegitimate. They were sold by unregistered and unlicensed individuals. The company eventually collapsed, defaulting on its notes. Investors lost all of their principal, including $200,000 in life savings from an Oregon resident.

Fraud

A Georgia start-up sought investments to pay for new ambulances. Commissions-driven salespersons promised “risk-free” investments. Investors gave them more than $2.5 million, with the expectation that after the ambulances were purchased, they would be leased to pay back the money the company borrowed. The ambulances would also be used as collateral for each promissory note. But the company never purchased the ambulances. And it pledged fictitious ambulances as collateral.

As in the coffee scandal, the notes were sold by unregistered salespersons. And investors were out over $2.5 million when the scam was revealed.

How Promissory Notes Work

Legitimate promissory notes are a form of debt, similar to a loan. Companies issue these notes to finance any aspect of their business, from launching new products to repaying other debt. In return for the loan, companies agree to pay investors a fixed return over a period of time.

Even Legitimate Promissory Notes Are Not Risk-free

These notes are only as sound as the companies or projects they're financing. Smart public companies can still stumble because of competition, bad management decisions, or unfavorable market conditions. If a company's financial health suddenly weakens, it may not be able to pay interest and principal to investors.

Do the Notes Need to be Registered?

In most cases. Promissory notes are registered as securities with the SEC, and states where they're sold. But some promissory notes may be exempt. This often occurs with short-term notes of less than nine months.

Exempt notes aren't subject to securities regulatory review, so they've been major sources of investor complaints and fraudulent activity.

Why should notes be registered?

The registration process includes due diligence research. This means that financial professionals have looked into the company, the notes, and any extenuating circumstances. Due diligence doesn't guarantee return on your investment, but you'll have accurate information to make an informed investment decision.

Who Can Sell Promissory Notes?

Securities brokers, insurance agents, financial planners, and investment advisers typically sell promissory notes. Since promissory notes are usually securities, they must be sold by properly licensed or registered salespeople.

How a Scam Works

Promissory notes are common fraud targets because of growing investor interest for above-market interest rates with little risk. Bogus note sellers promise high, fixed-rate returns (up to 15 or 20 percent), hoping to lure buyers who don't ask too many questions.

In 2000, securities regulators brought 370 actions against firms that defrauded more than 4,500 investors out of $170 million with fake promissory notes. In many of these cases, investors didn't get their money back—because the fraudsters have already spent it.

In one case, fake promissory note promoters claimed that funds were earmarked for Caribbean resort development. But the investors' dollars were instead used for personal travel and to pay high commissions.

Signs of Promissory Note Fraud

If you're offered a promissory note investment, these signs indicate that it may be fraudulent:

"Insured" or "Guaranteed" Returns

To create a false sense of safety, the sellers may offer to “insure” the payment of interest and principal. Such “insurance” would come through nonexistent insurers, or unregulated offshore insurers.

The Promise of Above-market Returns

Any promotion of higher-than-market returns should raise questions.

"Risk-free" Notes

Any seller who promises a "risk-free" investment is lying to you.

If you invest with a promissory note, there is a chance that the issuing company will not be able to make principal and interest payments. Risk and reward are intrinsically related, and there is no such thing as a low-risk, high-reward investment.

"Prime quality" Labels on a Start-up's Note

Prime quality investments originate from companies with established histories of operations and earnings. So if the company issuing the "prime" notes is a start-up or new company, steer clear.

Short-term Notes

Notes with a nine-month term may be exempt from securities registration.

Notes from a Stranger

Don't accept promissory note offers from people you don't know. An investment professional familiar with your financial situation can determine if an investment is appropriate for you.

Your investment checklist

✓ Research the opportunity

• Check the note's registration or exemption status with your state securities regulator or the SEC's EDGAR database.
• Use the North American Securities Administrators Association to find your state regulator.
• If you suspect fraud, alert your state regulator and the SEC.

✓ Avoid short-term promissory notes

• These short-term notes, sometimes exempt from securities registration, are frequent sources of fraudulent activity.
• You might not be entitled to some of the redress that the securities laws or regulators provide.

✓ Buy only from licensed or registered securities brokers

• Insurance agents, financial planners, and investment advisers can't sell securities— including promissory notes—without a license or registration.
• Verify your broker's registration or license status by contacting your state securities regulator or using FINRA's Broker Check program.
  The Broker Check program provides a background report on the broker, detailing any existing legal or regulatory problems.

✓ Ask yourself: Does this investment make sense for me?

• Before making any investment, review your financial goals and objectives. Always consider the risk-reward ratio—higher yield generally means higher risk. Shop around for investments with similar returns and less risk.