What are Promissory Notes?
Promissory notes are contracts in which one party “promises” the other party a specific amount of money to be returned to them at a predetermined time. Legitimate promissory notes are investments that provide a loan to a company as opposed to actually purchasing equity in it. However, many promissory notes sold to investors are actually fraudulent. Under the guise of being legitimate, some unscrupulous brokers use promissory notes as a tool to convert investor funds.
Unsuitable Promissory Notes
Promissory notes are mostly offered by private companies looking to expand in some fashion. While many promissory notes offered by these types of companies are legitimate, this does not mean they are suitable for investors. These notes are actually incredibly risky investments.
While the investor does have a predetermined amount of funds that is to be returned to them, it is still entirely dependent upon the company’s success. If the company goes under and defaults on the money it owes, then the investor is in the same position as if they had purchased equity in a risky private investment in the first place. These companies can in no way guarantee success and are some of the riskiest investments out there.
When presenting promissory notes to investors, some brokers fail to disclose the associated risks involved. These notes are often implied to be safe investments due to the fact that they are loans as opposed to purchasing equity. Brokers who present them in this fashion are not looking out for their customers’ best interests.
What proves to be most enticing to investors is the fact that promissory notes usually have excessively high interest rates that fall between 5 and 15 percent and are often paid out in scheduled distributions. These interest rates, compounded with the misconception that these promissory notes are safe, are the reason why brokers are able to convince unsophisticated investors to purchase them.
Fraudulent Promissory Notes
In addition to legitimate promissory notes hurting investors, many promissory notes are actually just fronts for fund conversion. There have been instances where individual brokers and even some companies sold promissory notes to investors without any intention of paying them back.
For instance, an individual broker might set up a fictitious company or use an existing company in order to sell an elderly investor promissory notes backed by that company. However, the broker then just transfers the solicited funds to their own private account for their own personal use. The broker will then usually pay interest dividends from the converted principal or by selling fraudulent notes to other investors. They will then provide these investors with fictitious financial documents about where these distributions actually came from. The broker does not have to worry about the investor becoming suspicious if the security fluctuates in value since the investor is promised back a predetermined amount. These fraudulent promissory notes can be very useful tools for perpetrating Ponzi schemes.
This unscrupulous act also works on a grand scale with an entire company perpetrating it. For example, the Woodbridge group of companies spent years soliciting over a billion dollars from over 8,400 investors—most of whom were elderly. The selling brokers claimed that these promissory notes were backed by mortgages; however, these Woodbridge funds were not providing any mortgages and were thus generating no income. In order to make monthly interest payments to these note holders, the companies had to solicit funds from new rounds of investors. It was a giant Ponzi scheme that eventually filed for chapter 11 bankruptcy and defaulted on all the promissory notes.