§ 15.01 Negotiable or Non-negotiable Notes
To be negotiable, a note must: (i) be in writing, (ii) be signed by the party who is to be obligated, (iii) contain an unconditional promise or order to pay a sum certain of money on demand or at a fixed or determinable future time, and (iv) be payable to the order of a specified person or to bearer.1 The note must be complete on its face. If certain items are omitted, it cannot be en- forced until it is completed in accordance with the authority given by the party signing and obligated under the note (maker).2 Parol evidence may be considered to explain any ambiguity or uncertainty in a written instrument.3 The terms “pay to the order of ” or “pay , or order” are terms of art or the magic words required to ensure the negotiability of an instrument. The promise to pay must be unconditional. If the note appears to have an unconditional promise to pay but the mortgage instrument, a separate instrument, has limitations or conditions to payment, a holder in due course (which will be discussed later) that acquires the note would not be bound by the limitations or conditions unless the holder has actual knowledge of such limitations or conditions.4 Any knowledge of a defect or condition attached to the note prevents a holder from becoming a holder in due course. There are some terms and conditions that may be contained in the note but that would not destroy its negotiability, such as failure to recite the consideration, a condition to furnish additional collateral, a confession of judgment and other similar provisions.5
The sum owing must be certain or specific. The note cannot state that different sums are payable depending upon the circumstances that develop.6 A note does not lose its negotiability if the amount stated is “(sum certain)” or “so much thereof as may be advanced hereunder,” as is seen often in construction loan financing notes.
The note must contain a definite maturity date or payment date. The note may be payable on demand or it may provide for payments at specified intervals.7
The note must indicate to whom the obligation is owed, that is, the payee of the indebtedness (the lender). The payee may be a specified person or the note may provide for payment to bearer.8
While a non-negotiable note is acceptable, a negotiable note is preferred if the note is to be transferred to a third party by the holder or payee. One cannot become a holder in due course of a non-negotiable note. Both types of notes may be assigned, but the assignee of a non-negotiable note takes the note subject to any defenses the maker might have against the payee. A negotiable note may be negotiated by endorsement to a third party who may become a holder in due course.
§ 15.02 Holder in Due Course
A “holder in due course” is one who acquires a negotiable instrument (a note) for value, in good faith, and without notice that the instrument is overdue or has been dishonored, or that any defense or claim exists on the part of any other party.9 The holder in due course is distinguished from a “holder,” which is a party who possesses a negotiable instrument drawn, issued or endorsed to the person or order, or to bearer or in blank.10 A holder merely has the status of an assignee of a contractual right to obtain payment and is subject to any defenses the maker has against the payee.
A holder in due course takes the negotiable instrument free of any personal defenses the maker may have against the payee. Personal defenses may include breach of contract, breach of warranty, fraud in the inducement, certain types of illegalities (such as gambling debt), certain forms of mental incapacity, discharge by payment, duress or undue influence, non-delivery, and unauthorized completion of an incomplete instrument.
The holder in due course takes the negotiable instrument subject to the real or universal defenses, such as forgery, fraud in the execution, material alteration, minority, discharge in bankruptcy, certain types of illegality and mental incapacity (person declared mentally incompetent), and extreme duress.11 If a statute declares something absolutely illegal, illegality is a real or universal defense. If the statute merely states an action is voidable, then illegality is a defense against a holder but not against a holder in due course.12
§ 15.03 Principal Provisions of Note
Taking into consideration the requirements that must be satisfied to a have a negotiable instrument that may be transferred by endorsement in lieu of assignment (although many transferees require that the note be transferred by both endorsement and assignment), a lender will fashion the note to a particular transaction.
§ 15.04 Principal Amount and Term
The principal amount of the note will be a sum certain, but the maker (borrower) may promise to pay the stated amount “or so much thereof as may be advanced hereunder.” This provision is common where the note, secured by a mortgage, evidences a line of credit, a credit card obligation, an acquisition and construction loan, or a loan for renovations or additional construction on the real property already owned. The disbursement will be made under the note as purchases are made, at certain intervals, pursuant to a loan agreement during the course of construction or when certain requirements, such as rental achievements, are met.
The period of a construction loan is usually short, for example, 18 months or three years, and is a standing loan that does not require payment toward the principal but does require payment toward the interest during the term. After the construction loan period, the disbursements end, and the note may be converted to a permanent loan that requires payments over an extended period, or could become immediately due and payable. In the latter case, the permanent lender substitutes a new note for the indebtedness.13 The construction loan note could be amended to provide for repayment over an extended period if those provisions were not incorporated in the note initially.
An equity line or line of credit loan normally requires both principal and interest payments monthly during the term, and the note is often a demand loan under which the holder may call the entire loan at any time.
§ 15.05 Payments
The payment terms of a note may vary. Some of the more common payment terms are:
- Interest Only—An interest-only note provides for payment of interest periodically—for example, monthly, bimonthly, quarterly, semiannually or annually—with payment of the entire principal amount and all accrued but unpaid interest at the maturity date.
- Standing Loan—A standing note does not require any payments until maturity, at which time both principal and accrued interest are payable.
- Self-Amortizing Loan—A self-amortizing loan note has equal payments each month so that when applied first to the accrued interest and the remaining amount to principal, the entire principal and interest are paid by maturity.
- Balloon Payment Loan—A balloon payment loan note provides for a certain amount to be paid periodically, normally in an amount sufficient to pay the accrued interest and a portion of principal, but it results in a large remaining principal balance at maturity. A balloon payment loan is used where the cash flow is limited and a higher principal payment might result in default in the note after funds are provided for taxes, insurance, and maintenance for the project. The owner is in a better position to refinance a lower amount at maturity, and the lender is more certain to receive the payments regularly during the term.
- Principal Payments Plus Accrued Interest Loan—A principal payments plus accrued interest note provides for a fixed amount paid on the principal on each payment date, together with the interest accrued for the period. In such notes, payments are reduced each month as the interest amount is reducing based on the principal payments made.
There may be variations or combinations of any of the above prepayment terms. For example, the note may provide for interest-only payments for the first year and self-amortizing payments beginning in the second year. In this example, the owner is given an opportunity to have lower payments the first year while trying to rent space in the project. It is expected that the owner’s cash flow will increase within the year and will be able to meet higher payments thereafter.
As noted in Chapter 16, there may be graduated payments, variable rates, reverse annuities, and other types of payment provisions. So long as the payments do not violate any civil or criminal usury laws and are not deemed unconscionable, the payments will be acceptable (unless regulations under which a particular loan is made require certain payments, such as under certain FHA-insured loans).
Depending on applicable state law, interest amounts may not be added to the principal. In some states, interest on interest is prohibited. In other states, such as Ohio, simple interest on interest is permitted,14 but interest on interest on interest—in other words, compound interest—is prohibited.15 In many financing and workout situations, lenders have agreed to add interest to principal each month when payments are not sufficient to cover the entire amount of interest. Lenders are hopeful that the courts will decide that the custom of the marketplace has changed and would rule to permit the compounding of interest, as is permitted in other states.
§ 15.06 Interest
Interest is the next consideration when drafting a note. In commercial transactions, there are two principal types of interest payments.
§ 15.07 Fixed Interest
A fixed interest note contains a stated fixed interest rate, for example, 8% per annum, or a stated variable interest rate tied into an index, for example, 2% over the prime rate announced from time to time by a specified bank. If the rate is tied into an index, the dates for determining the rate and for changing the rate must be set forth in the note. Some other indices used for determining the variable rate are:
a. Latest three-week moving average interest rate as published by the Federal Reserve Bank of New York;
b. 90 to 119-day dealer-placed commercial paper rate as published by the Federal Reserve Bank of New York;
c. Prime commercial interest rate (or any rate established in lieu of the prime commercial interest rate) in effect from time to time at a specified bank;
d. Base lending rate, which is announced by the payee bank from time to time;
e. CD base rate, which is the amount the payee bank is required to pay as interest on certificates of deposit to certified certificate of deposit dealers of recognized standing, as determined by payee, for the purchase at face value from the payee bank of certificates of deposit. The changes of rates could be for 30, 60, 90, or 180 calendar day certificates of deposit or for the time when the interest rates on the loan would change;
f. LIBOR rate is the rate at which deposits in immediately available funds in U.S. dollars are offered to the LIBOR Bank (Nassau, Baha- mas, branch office of payee), in an amount equal to or comparable to note principal at the time the rate for the coming period is determined, by prime banks in the London Interbank Eurodollar Market deter- mined by payee bank at 11:00 a.m. London time. In other words, the interest rate would be the rate charged to the lender by the London Interbank Eurodollar Market if the lender were to borrow money in an amount equal to the amount the lender loans to the borrower in the mortgage transaction. That, in effect, is the amount the lender would have to pay to get money from the London Interbank Eurodollar Market to be able to make the loan to the borrower in the mortgage trans- action. The lender typically would charge 1% or 2% over the LIBOR rate to the borrower. The mortgage rate would be adjusted periodically to reflect the change in the LIBOR rate; and
g. Domestic base rate is the assessment rate, that is, the rate for the domestic interest period actually incurred by payee to the Federal De- posit Insurance Corporation for insuring the deposits, divided by 1.00—the domestic base rate (the average rate for certificate of de- posit of recognized certificate of deposit dealers plus the assessment rate).
In Taylor v. Roeder,16 the court held that the variable interest rate, “3 percent (3.00%) over Chase Manhattan’s prime, to be adjusted monthly,” made the note non-negotiable, citing the official comments to the Uniform Commercial Code (UCC) to the effect that, for the note to have a sum certain, the amount then payable must be determined from the note itself. Many states17 have followed the view expressed in Taylor v. Roeder, based on the common-law theory that to be negotiable, a document must be complete within itself and not require any reference to matters not within all fours of the instrument.
Other states have adopted the revisions to the UCC or similar provisions.18 The revisions to the UCC, recommended by the Commissioners on Uniform Laws provide, at UCC § 3-122(b), that “interest may be stated in an instrument as a fixed or variable amount of money or it may be expressed as a fixed or variable rate or rates . . .” for a negotiable instrument. Any state adopting the revisions does not have to concern itself about negotiability of the note simply because the note contained a variable interest rate.
§ 15.08 Contingent or Percentage Interest
Contingent or percentage interest is based on the business operations of the property that secures the loan, for example, 5% of the net adjusted income from the property. The term “net adjusted income” would be defined as the gross receipts that would be included and the permissible expenses, deductions or exclusions from the property. It is a cash flow computation, eliminating any paper expenses, such as depreciation, that would be used to determine net income. Other items often excluded are receipts from pay telephones and vending machines and the sale of lottery tickets, as the borrower does not keep the entire amount received. A careful drafting of the terms and the computation to be made will be beneficial to both the maker and the payee of the note. When there is to be contingent or percentage interest, the lender will require monthly or quarterly reports from the borrower and will require quarterly or annual payments of the amounts due. If quarterly payments are required, the borrower will require an adjustment when the annual amount is determined. Some years have high and low periods of gross income, and the borrower might have paid too much interest in some quarters when deter- mined annually. For example, a retail store may have high sales in November and December, April and May, and August and September, but very low sales in other months. As a result, some quarterly payments might be higher and give the payee more funds than it is entitled to on an annual basis. In such cases, the payee would agree to refund the difference or to permit the maker to offset the excess amount against future payments due.
The interest rate could be calculated on the basis of one of the following:
- 360-day year, 30-day month;
- 365-day year, computed on the basis of the number of days from the last interest period;
- 365-day year computed on the number of days in each month; or
- 360-day year but computed each month on the basis of the actual number of days in the month.
A concern for all lenders is usury. Usury occurs when a lender charges a borrower interest for the use of the money at a rate in excess of the maximum rate permitted by law. There are two forms of usury: civil and criminal. Usury typically is determined at the time the loan is closed. However, the court in Northwestern State Bank of Luverne v. Gangestod held that the loan was enforceable when it was not usurious at the time of enforcement even though it was usurious when made.19
The maximum amount for civil usury is set forth in the state statutes. However, there may be exceptions, such as, in Ohio, for loans in excess of $100,000, a nonconsumer loan payable on demand or in one installment, real estate loans for which the statute provides a special formula for computing the usurious rate, or loans to corporations.20
There is also criminal usury. In many states, the penal or criminal usury rate is 25%. Even though a higher rate may be permitted or a transaction might be exempt from the civil usury statute, the rate might be illegal under the criminal usury statute. The statute in each state must be studied carefully when preparing a note for which a particular state law applies.
The penalties for usury vary from state to state. In some states, the entire debt is discharged.21 In other states, any excess interest paid over the permitted maximum rate is applied to reduce the principal debt.22
The Internal Revenue Service (IRS) has adopted an imputed interest rate. Under the Deficits Reduction Act of 1984, the imputed rate changes every 6 months based upon the applicable federal rate as set forth in the Revenue Rulings, the first one being Rev. Rul. 84-163. The imputed interest rate is the rate the IRS states is the minimum income that may be reported in a loan transaction for tax purposes. For example, assume A makes a loan to B of
$100,000 at 5% per annum interest. If the imputed interest rate for that period is 9% per annum, A would be required to report interest income of $9,000 instead of $5,000 for the loan year. The theory behind the imputed interest rate is that no one in an arm’s-length transaction would lend money for less than the market rate. If it is less, the IRS believes it is a cover-up for the true return on the loan to the lender and, thereafter, requires the lender to pay taxes on the imputed rate of return, which the IRS believes is the proper income. There are some exceptions to the imputed interest rate rule, but because these exceptions change, the IRS regulations and rulings should be examined when considering a loan at a below-market interest rate.
§ 15.09 Prepayment
A maker is required to pay the loan in accordance with its provisions. If the loan has no provision for prepayment, then prepayment of the loan is prohibited in some states. For this reason, a prepayment right usually is one of the provisions contained in the note. The parties must decide whether the note may be paid prior to maturity or before the scheduled dates. To prepay stops the investment and the return or income to the lender. To continue the loan might subject the borrower to higher interest payments than the borrower might be able to negotiate elsewhere. Unless the maker is given the right in the note, a payee cannot be required to accept the prepayment before the debt is due.23 Many times a payee will prohibit any prepayment for the first few years in order to recover the costs of making the loan. In later years, the lender will permit prepayment provided a certain percentage of the original principal amount, or a certain percentage of the unpaid balance, is paid as a prepayment premium to compensate lender for the loss of income until the amount of principal is reinvested. Another formula for a prepayment premium is based on the cost of funds to the lender, that is, how much money the lender will lose between prepayment and maturity if the lender must reinvest the funds at a lower interest rate for the period.
§ 15.10 Defaults
The note should provide for a default interest rate, usually 2% higher than the stated fixed interest rate, if the maker is in default of any payment. The note should provide whether the default rate applies only for the period of default or until maturity, even though the maker pays the arrears and is current on its payments.
Grace period and default provisions should be contained in the note. The grace period gives the maker additional time to make payments before a default occurs. The default provision sets forth what is considered a default, such as not paying the amounts as required, not complying with the terms of the mortgage securing the note, borrower’s filing for bankruptcy, failure to protect the security, and the like. The default clause will give the holder of the note the right to declare the entire loan due and payable and to impose the default interest rate.
In many commercial real estate transactions, there is a “without recourse” or an “exculpation” provision. In effect, this paragraph provides that the holder will not look to the maker personally in the event of default, but will look only to the property encumbered as security for the loan. In the beginning, this process was simple and straightforward. The provision would provide that under no circumstances would the holder look to the maker for any deficiency. The holder would only be able to recover the amount owed from the property pledged or encumbered as security. After many borrowers walked away from properties during time of recessions, leaving taxes unpaid, the property in a state of disrepair, and the property uninsured in many instances, the lenders began to have exceptions to the release of personal liability. In most instances, the maker is personally liable if the borrower does not maintain the property or pay the taxes, does not comply with environmental and building laws and regulations, files for bankruptcy, makes misrepresentations in the mortgage application or the mortgage documents, makes an assignment for the benefit of creditors, sells the property or subordinates the financing without the permission of the lender, and other similar situations. Personal liability may only be to the extent of curing the violation or default, or it may be for the total indebtedness, thus eliminating any exculpation because of the violations.
§ 15.11 Due on Sale
Lenders began inserting a “due on sale” provision in their notes in response to borrowers selling properties subject to a mortgage when the note had a low interest rate and market interest rates had risen substantially. Due-on-sale provisions state that in the event of the sale of the property securing the loan without permission of the lender, the entire indebtedness becomes immediately due and payable at the option of the lender.
§ 15.12 Prohibition Against Subordinate Financing
A second mortgagee can permit the borrower to “milk” the property of all income while simultaneously failing to pay taxes or to make required repairs. As a result, first mortgagees often place prohibitions in notes against any subordinate financing without the first mortgagee’s approval. Thus, if such financing is undertaken without approval, there is a default, and the entire loan becomes due and payable immediately at the option of the first mortgagee. In such cases, the second mortgagee will not be willing to make a subordinate loan unless the approval of the first mortgagee is obtained, as the second mortgagee may lose its security upon foreclosure of the first mortgage. The first mortgagee has an opportunity to decide whether the second mortgagee is reputable and is not likely to milk the property. Also, such a provision gives the first mortgagee an opportunity to examine the borrower’s cash flow to be certain the borrower has sufficient funds to meet all expenses and emergencies.
§ 15.13 Confession of Judgment
Some states permit the note to contain a provision for the confession of judgment in advance. In Ohio, there may be a provision that is a warrant of attorney to confess judgment24 in the event of default under the note for a commercial mortgage transaction. Since January 1, 1974, the warrant of attorney to confess judgment is invalid in Ohio in a consumer loan or consumer transaction. A “consumer loan” is a loan to a natural person in which the debt incurred is primarily for a personal, family, educational or household purpose. A “consumer transaction” means a sale, lease, assignment, or other transfer of an item of goods to an individual for purposes that are primarily personal, family, educational or household. One requirement in Ohio is that there must be a warning in the note that appears directly above or below the space provided for the maker’s signature, in type size and distinctive marking that appears more clearly and conspicuously than anything else in the document:
Warning: By signing this paper you give up your right to notice and court trial. If you do not pay on time, a court judgment may be taken against you without your prior knowledge and the powers of the court can be used to collect from you regardless of any claims you may have against the creditor, whether for returned goods, faulty goods, failure on his part to comply with the agreement, or any other cause.
A note containing a warrant of attorney to confess judgment is called a “Cognovit Note.”
§ 15.14 Security
The note must refer to the fact that the indebtedness is secured by a mortgage on certain real property located in a particular area. This ties the note into the mortgage and usually provides that default under either document will be default under the other document also.
§ 15.15 Miscellaneous
The note may provide for the applicable law, notices, and charges for late payments.
1. Dwight A. Pomeroy, Business Law 251 (2d ed. 1939); U.C.C. § 3-104.
2. U.C.C. § 3.115.
3. Hosford v. Auto. Control Sys., Inc., 14 Ohio App. 3d 118 (1984).
4. U.C.C. § 3-302.
5. U.C.C. § 3-112; the variable interest rate will not destroy negotiability.
6. U.C.C. § 3-106.
7. U.C.C. §§ 3-108, 3-109.
8. U.C.C. §§ 3-110, 3-111.
9. U.C.C. § 3-302.
10. U.C.C. § 1-201 (20).
11. U.C.C. § 3-305.
13. Norwest Bank Neb., Nat’l Ass’n v. Kizzier, 446 N.W.2d 204 (Neb. Sup. Ct. 1989); Riegel v. Belt, 119 Ohio St. 369 (1928); 1927 Ohio AG No. 396, pg. 687.
14. Cramer v. Lepper, 26 Ohio St. 59 (1875), permitted simple interest on interest at 6% per annum.
15. Anketel v. Converse, 17 Ohio St. 11 (1866).
16. 360 S.E.2d 191 (1987).
17. Northern Trust Co. v. E. T. Clancy Export Corp., 612 F. Supp. 712 (N.D. Ill. 1985); A. Alport & Sons, Inc. v. Hotel Evans, Inc., 65 Misc. 2d 374, 317 N.Y.S.2d 937 (Sup. Ct. 1970); Shepherd Mall State Bank v. Johnson, 603 P.2d 1115 (Okla. 1979).
18. Tennessee, Virginia, and Louisiana amended their statutes to provide in effect that variable rates of interest, based upon generally recognized commercial or financial indices, would not destroy negotiability. In Ohio, § 1302.12 (U.S.C. § 3.112) provides that “Interest may be stated in an instrument as a fixed or variable amount of money, or it may be expressed as a fixed or variable rate or rates.” The variable rate will not destroy the negotiability of the Note.
19. 289 N.W.2d 449 (Sup. Ct. of Minn. 1979).
20. Ohio Rev. Code § 1343.01; Ohio Rev. Code § 1701.68.
21. Williams v. Fitzhugh, 37 N.Y. 444 (1868); Buckingham v. Corning, 91 N.Y. 525 (1883); Scott v. Austin, 36 Minn. 460, 32 N.W. 89 (1887); Draper v. Emerson, 22 Wis. 142 (1867).
22. Ohio Rev. Code § 1343.04.
23. Pyross v. Fraser, 82 S.C. 498, 64 S.E. 407 (1909); Brown v. Cole, 14 Sim. 427; 60 Eng. Rep. 424 (1845); Patterson v. Tirillo, 581 A.2d 74 (Sup. Ct. of N.H. 1990).
24. Ohio Rev. Code § 2323.13.