Promissory notes might sound simple and can appear to be an attractive alternative to traditional investment products such as stocks and bonds. However, scams involving promissory notes have robbed investors of hundreds of millions of dollars.
While they can be legitimate investments, many promissory notes sold widely to individual investors are fraudulent. Fraudulent schemes include promissory notes purported to be secured by investments across a broad range of business ventures—from real estate to startups to self-offerings by brokerage firms—with the promise of guaranteed interest rates making these pitches particularly attractive. Take time to understand the investment you’re considering, and be aware of warning signs that might signal a scam.
What’s a Promissory Note?
A promissory note is a form of debt that companies and individuals sometimes use, like loans, to raise money. The issuer, through the notes, promises to return the buyer's funds (principal) and to make fixed interest payments to the buyer in exchange for borrowing the money. Promissory notes have set terms, or repayment periods, ranging from a few months to several years.
Even legitimate promissory notes involve risks: competition, bad management or severe market conditions can impact the issuer’s ability to carry out its promise to pay interest and principal to note buyers.
What's the Problem?
Fraud and investor deception related to promissory notes is significant. Fraudulent promissory note programs often promise very high or guaranteed returns to investors, state that the notes are backed by collateral to guarantee them, or make other appealing but ultimately unfounded claims. Frequently, promissory note schemes target seniors or other vulnerable investors and their retirement savings or existing lower-risk investments.
Additionally, although those selling them might not know or admit it, promissory notes are usually securities and must be registered with the SEC or the state in which they’re sold—or they must have a specific exemption from registration under the law. If the note isn’t registered, it can only be sold to certain individuals who meet specific net worth and income limitations, and it may be harder to find information on the issuer and the note.
Even when notes are registered, those selling them might not be. Individuals might be selling the notes without the required securities registrations or, when registered investment professionals are involved, without their firms’ knowledge or approval.
How to Protect Yourself
If you’re thinking about investing in a promissory note, carefully consider the following tips:
Ask questions. Ask many questions, including about the specifics of what’s going to happen with your money during the time period of the note and how your money will generate the represented return. It’s often impossible to generate a legitimate return in such a short time period. Ask how many other investors have been approached with this note and how many have agreed to invest; if possible, get the names of other investors. If you don't get good answers to all of your inquiries, walk away from the offer.
Be wary of pushy sales tactics. No reputable investment professional should push you to make an immediate decision about an investment. Other tactics include stating that the investment is open only to a limited number of investors or calling the investment “private” to create a sense of urgency and exclusivity. If someone pressures you to decide on a promissory note purchase, steer clear.
Check and double-check. Look on the SEC’s EDGAR Database to see if the notes are registered. Check with your state securities regulators to see whether the investment and the salesperson are in compliance with your state’s securities laws. Visit FINRA BrokerCheck to see if the investment professional is registered or has a disciplinary history. And check with the Better Business Bureau where the company issuing the notes is located to find any complaints against the company.
Know your seller. If you’re buying through an investment professional, ask if the note is being sold through their firm. If not, it’s being “sold away,” and you’ll miss important investor protections that flow from the investment professional and firm’s regulatory obligations. Be alert to red flags that your investment professional might be operating outside the oversight of the firm. These might include use of a personal email address, investment statements that don’t bear the firm’s letterhead or that appear to originate from a new entity, or printouts that look like they came from a home computer. Sometimes, even documents that appear to be legitimate brokerage firm statements are actually false. If you have any questions about a product’s legitimacy, call the firm—not the investment professional directly—to verify.
Don’t trust guaranteed returns. Know that a salesperson cannot guarantee a particular return. Even if the note has a fixed interest return, the investment might not pay that amount or even return your principal. Moreover, the seller might say the notes are insured but not mention that the insurer might not be legitimate or operates outside the U.S. Or they might claim that the notes are secured by collateral even though the collateral is insufficient to cover the notes’ full value. Ask for details and proof if the issuer makes these claims.
Consider the current market. Promissory notes sometimes offer double-digit returns, even when current yields on fixed-income investments are much lower. Be sure to consider prevailing market conditions. In high interest rate environments where savings accounts and CDs offer higher returns, a company or individual selling promissory notes might try to be more creative in their efforts to convince you to invest. Be wary of claims that an investment can provide above-market yields and remember that the higher the potential return, the greater the risk.
Understand commissions. Ask specifically how much compensation the salesperson is getting—and where that’s disclosed to you as an investor. Promissory notes often offer the salesperson significantly more than the average investment commission. Also verify whether the seller has an ownership interest or other incentive to sell the notes; even if the initial commission doesn’t appear high, the seller might have a conflict of interest that delivers them additional income. You should also ask how much of the investment will be used for marketing and promoter's costs, which might hurt the company's chances of paying you back.
If you’ve been approached about or think you’re already involved in a promissory note scam, act quickly, since statutes of limitation may apply to legal actions involving promissory notes and could limit your ability to recover. File a complaint with FINRA, the SEC, your state securities administrator and, if an insurance agent sold the notes to you, your state insurance commissioner.