PROMISSORY NOTES

PROMISSORY NOTES

The Debt/Loan or Obligations

The promissory note is the evidence of the indebtedness between the borrower and the lender. It is also the
contract that represents the borrower’s promise to pay the lender in accordance with the agreed upon terms.
The promissory note may also evidence future obligations such as in home equity credit line loans or that may
occur pursuant to additional advances authorized in the accompanying security instrument (whether a deed of
trust or mortgage). The promissory note is the prime instrument and if there are conflicts in the provisions of
the note and deed of trust or mortgage, generally the terms of the promissory note are controlling. The deed of
trust or mortgage is the security instrument that makes the real property described therein the security
(collateral) for the debt/loan or obligations that the promissory note evidences.

Negotiable Instruments

A negotiable instrument is a written unconditional promise or order to pay a certain amount of money at a
definite time or on demand. The promissory note, a draft (whether issued by a bank and otherwise), and a check
drawn on a bank are examples of negotiable instruments. Each is subject to the promise to pay to the payee or
to the order of the holder. Bank checks are the most common type of negotiable instrument;drafts (also known
as bills of exchange and trade acceptances) are similar “three-party paper,” except these instruments generally
do not require a bank with Fed check clearing capacity.

Promissory notes constitute “two-party paper.” The maker promises to pay the payee a specified amount of
money on a date certain, upon demand, or in accordance with its terms. There are seven basic kinds of
promissory notes in general use with a deed of trust or mortgage:

1. A straight note calling for payment of interest only during the term of the note, with the principal sum
becoming due and payable on a certain date;

2. An installment note calling for periodic payments on the principal, plus separate periodic payments of
interest made as agreed;

3. An installment note demanding periodic payments of fixed amounts, including interest and principal
(amortized payments) until the loan is fully paid or to a date certain when the principal amount owing
is to be paid in full (a balloon payment);

4. An adjustable rate note with an interest rate that varies depending upon changes in an agreed upon
prescribed standard (a recognized index such as the 11th District Cost Of Funds, U. S. Treasury
Securities, the published Prime or Reference Rate, or the London Interbank Offered Rate);

5. A variable rate note with an interest rate that increases or decreases pursuant to movements in an
identified direction of a prescribed standard (index);

6. A renegotiable note with equal periodic payments of principal and interest being made for a specified
term, e.g., five years at which time the debt or loan is due or is subject to renegotiation/recasting at the
then prevailing interest rate based upon a preset margin in relationship to a recognized and authorized
standard (index); and,

7. A demand note that does not become due until the holder makes demand for its payment.

Negotiable instruments in the form of drafts or checks drawn on a bank are freely transferable in commerce.
They are typically accepted as virtual equivalents of cash, yet the hazards of handling large sums of cash are
avoided. However, to be regarded as a negotiable instrument, the document must conform strictly to the
statutory definition. Thus a negotiable instrument must be:

1. Signed by the maker or drawer;

2. Include an unconditional promise or order to pay a sum certain in U.S. dollars, and no other promise,
order, obligation or power is given the maker or drawer;

3. Payable on demand or at a definite time; and

4. Is payable to the holder or bearer.

Every one of the listed elements must be present if the instrument is to qualify as negotiable. If any one is
missing, the instrument may still be valuable and transferable (assignable) like an ordinary contract. As such,
the transferee or assignee receives no more benefits than held by the transferor. Personal and real defenses that
are available to the borrower/debtor against the payee (lender/assignor) are generally good against the
transferee/assignee, which affects the holder in due course status.

Negotiation

Negotiation is the transfer of an instrument in such form that the transferee becomes a subsequent holder. If the
instrument is payable to order, it is negotiated by delivery and acceptance with any necessary endorsement. If
payable to bearer, it is negotiated by delivery and acceptance.

An exception to the requirement of delivery of the instrument is set forth in Section 10233.2 of the Business
and Professions Code. A real estate broker (MLB) acting as a servicing agent of the note holder or holders may
perfect delivery by retaining possession of the promissory note and the deed of trust or mortgage, including
collateral instruments and documents securing the debt/loan or obligations evidenced by the promissory note
(provided the deed of trust or mortgage or an assignment or assignments of either and of related collateral
documents identifying the lender/beneficiary/mortgagee/assignee is/are recorded in the office of the recorder of

the county in which the security property is located). The promissory note is to be made payable to the
lender/holder or to the assignee(s) or endorsee(s) of the lender/holder.

An endorsement must be written by or on behalf of the holder and on the instrument or on a paper so firmly
affixed thereto so as to become a part thereof. An endorsement on a paper so affixed shall be valid and effective
even though there is sufficient space on the instrument to write the endorsement. When so affixed, the paper is
known as an allonge. An endorsement is effective for negotiation when it conveys the entire instrument or any
unpaid residue. If it purports to do less, it generally operates (with certain exceptions) as a partial assignment.

There are various types of endorsements, including:

1. Blank: the holder simply signs his or her name on the back of the note (Caution: Such an endorsement
should not be made without the advice of legal counsel);

2. Special: the holder executes “pay to the order of (a named transferee)”;

3. Restrictive: the holder restricts future negotiation by inscribing, “pay to the order of
_____________________________State Bank, for deposit only to ______account”; or,

4. Qualified: the holder inscribes the promissory note with the words “without recourse” to the
endorsement, which means if the maker refuses to pay, the endorser will not be liable for the amounts
owed.

Regarding item 4 above, a qualified endorsement does not eliminate the endorser’s contingent liability
concerning certain representations and warrantees included within an agreement between the parties or implied
by law. That is, by negotiating a promissory note by delivery or by endorsing the instrument, the transferor, as a
matter of law, still represents and warrants that: (a) the instrument is genuine and what it purports to be; (b) the
transferor/assignor or endorser has good title to the instrument, that no previous endorsement(s) has or have
occurred by the identified transferor, or that no previous assignment(s) of the same interest by the transferor has
occurred; (c) all prior parties had capacity to contract; and (d) the transferor neither has notice nor knowledge
of any fact or defect that would impair the validity of the instrument or render it valueless.

It is common for the transferor/assignor or endorser of a promissory note to enter into a global agreement with
intended assignees or endorsees regarding the future transfer of promissory notes. These agreements typically
include representations and warrantees made by the transferor upon whom the transferee relies to perform the
representations and warrantees that are distinguishable from an assignment or endorsement without recourse.
Accordingly, the duties and obligations of the transferor pursuant to these agreements would remain operative
irrespective of whether the promissory notes are assigned or endorsed with or without recourse. With
representations and warrantees, it is preferable that the transfer or assignment be made with recourse integrating
the agreement between the transferor and the transferee.

When negotiation is by delivery only, the above warrantees extend only in favor of the immediate transferee.
Negotiability of a promissory note is neither affected by inclusion of a clause adding court costs and reasonable
attorney’s fees in the event litigation becomes necessary to collect nor by inclusion of an acceleration clause
which provides that default in one of a series of payments makes the entire principal amount and any interest
accrued thereon immediately due and payable. These and similar provisions actually make promissory notes
more acceptable to lenders and investors.

Holder in Due Course Defined

A holder in due course is one who has taken a negotiable instrument: (a) for value; (b) in good faith; and (c)
without notice or knowledge that it is overdue or has been dishonored or of any defense against or claim to it on
the part of any person. A holder in due course may be a person who has taken the instrument through a prior
holder in due course, or, for that matter, through a person who was not a holder in due course.

Notice may be obtained in many ways, including defects on the face of the instrument, in the loan documents,
through actual knowledge of dishonor or of a defense, or through the operation of law. Recording of an

instrument does not give notice of a defense or claim in recoupment, or of other claims to the instrument to
prevent the holder from being in due course (Commercial Code Section 3302).

It is possible in the case of negotiable instruments that the transferee may receive more benefits than held by the
transferor. If the holder of the instrument transfers it to a third party who is a bona fide purchaser for value, that
third party enjoys a favored position provided the third party takes the note as a holder in due course (without
notice of defect or dishonor and absent a continual business relationship with the transferor). This holder in due
course status facilitates trade and commerce because persons are more willing to accept such instruments
without careful investigation or thorough due diligence of the maker’s credit worthiness and financial standing
and of the circumstances surrounding creation of the debt/loan or obligations evidenced by the promissory
note/negotiable instrument.

Holder in due course status is limited if the loan transaction is subject to the federal Truth-In-Lending Act
(TILA). Transferees of such loans are liable to the maker if:

■ Violation of the Truth-in-Lending Act is apparent on the face of the disclosure statement or in the loan
documents (e.g., Regulation Z final disclosures show the amount of the broker’s (MLB’s) commission
to be $2,000.00 and the HUD-1 lists the commission as $5,000.00); or,

■ The assignment was voluntary as opposed to involuntary (e.g. court-ordered sale and assignment of
the promissory note/negotiable instrument, unless the order expressly states that the assignee is free of
any claims including TILA that may be brought by the borrower/debtor).

In addition, loans which are subject to 12 CFR Section 226.32 of Regulation Z (TILA) include a broader
assignee liability standard, i.e., assignees of high cost and high fee loans do not benefit from standing as a good
faith purchaser or as a holder in due course.

Holder in due course status may also be limited when private investors/lenders acquire promissory notes
through MLBs who are required to function as their agents and fiduciaries. This is a result of the legal theories
of imputation of liability and of respondeat superior, i.e., the master must respond for the actions or conduct of
the servant performing within the course and scope of the employment, including any applicable notice or
knowledge possessed by the servant. This issue would depend upon the facts, including whether any conduct of
the MLB as the agent and fiduciary was adverse to the interests of the private investors/lenders, or was deemed
to be criminal. Accordingly, legal counsel should be consulted before a conclusion is drawn by practitioners
about holder in due course status, particularly when involving private investors/lenders.

FTC “Holder in Due Course Rule”

State law governing the rights of a holder in due course has been limited by the so-called “holder in due course
rule” of the Federal Trade Commission (16 Code of Federal Regulations, Part 433, Preservation of Consumer’s
Claims and Defenses, 1977). Under this rule, any holder of a consumer credit contract is subject to all claims
and defenses that the consumer could assert against the seller of goods or services obtained under or with the
proceeds from the consumer credit contract.

This rule has limited application in the field of promissory notes secured by deeds of trust or mortgages on real
property. It appears to be applicable in the context of a home improvement contract secured by a deed of trust
or mortgage on the home of the borrower. A typical example would be a siding contract. The normal
promissory note secured by deed of trust or mortgage used to finance the purchase or construction of
improvements on residential or other real property is not subject to the FTC holder in due course rule.

Conflict in Terms of Note and Deed of Trust or Mortgage

Where there is a conflict in the provisions of the promissory note and deed of trust or mortgage, the provisions
of the note will generally control. A deed of trust or mortgage gives no additional validity to an unenforceable
promissory note. However, the assignment or endorsement of the promissory note carries with it the security as
described in the deed of trust or mortgage.

The promissory note and deed of trust or mortgage are to be construed together, and if a deed of trust or
mortgage contains an acceleration clause, exercising it may cause the promissory note to become due, even
though the note contains no such clause. Since July 1, 1972, every California deed of trust or mortgage
describing security property containing 1 to 4 dwelling units that includes a provision accelerating the due date

of the debt/loan or obligation upon the sale, conveyance, alienation, lease, succession, assignment or any other
transfer of the security property (subject to the deed of trust or mortgage) will not be valid, unless the clause is
uniformly set forth in both the promissory note and the deed of trust or mortgage.