Although appearing relatively simple in concept, a promissory note and the accompanying loan documents can be very complex in construction. Additionally, the attorney must insure that its terms and conditions of the note and other loan documents comply with all federal and state laws.
Most attorneys are trained to draft promissory notes and loan documents that are enforceable in a court of law. But, that is only providing one-third of the necessary valuation features that the client actually needs. The additional valuation features required are that the note be collectable and marketable.
Most attorneys have little actual experience in structuring notes and loan documents for collectability and marketability—and, generally, attorney’s do not considered doing so to be their responsibility. But, the client implicitly does hold the attorney responsible.
Most clients are essentially uninformed and inexperienced with promissory notes and loan documents—they assume that the attorney is “taking care of them”—100%. They assume that the attorney will provide them with all of the necessary document features that they will need in the future.
Consequently, when the note and loan documents are being drafted, there is a serious disconnect between what the attorney believes to be his responsibility—enforceability only—and what the client believes the attorney is providing him—enforce ability, collect-ability and marketability.
Normally, neither the attorney nor the client has a clear understand of these three distinct attributes. Therefore, neither party clearly states to the other exactly what they expect to result from the drafting of the note and the loan documents. But, in the future, if or when the client needs to collect on the note from a non-paying borrower, or needs to pledge the note to his bank as collateral for a loan, or needs to sell all of part of the note to raise cash, then the missing attributes—the deficiencies–become vividly clear to both parties. That is when the trap is sprung.
Tips to Avoid the Trap
Value Compared to Price
We are all trained to assume that “value” and “price” are normally the same or are equal. And, in most (but not all) cases that is true. Examples: a hundred dollar bill has a value of one hundred dollars of purchasing power; a hundred dollar doctor’s invoice probably provided a hundred dollars of value to the ill patient; a $45.00 price tag on a pair of Levi’s probably represents $45.00 of value to the purchaser.
But, there are many exceptions—Examples: a thousand dollar corporate bond may not trade at one thousand dollars after its initial offering; the price of a share of common stock today may be significantly different tomorrow; the purchase price of a diamond ring today may be far different tomorrow. All of these differences between price and the market value are real and they are routinely accepted as being “normal’”.
Now, let’s explore why there is this discrepancy between price and value in the realm of promissory notes. Part of the explanation, as we previously learned, is that the Fair Market Value of a promissory note is dependent on three key elements—enforceability, collectability and marketability. We can now understand that if one or more of these elements are deficient, then the value of the note will be negatively impacted—its market value will be different than its price—a $100,000.00 note may be worth much less than $100,000.00 because it has deficiencies. Generally, promissory note valuation engagements require the appraiser to determine the Fair Market Value of the note. The “price” (face amount or unpaid balance) may be $100,000.00, but its Fair Market Value may be substantially less.
Fair Market Value Definitions
To add a major complication to this market valuation challenge, we must determine in every case exactly what definition of Fair Market Value we are going to base our conclusions on. The specific Fair Market Value definition selected will have an impact on the ultimate market value of note. Examples of some of the most common valuation definitions that are most communally used are:
Fair Value (Financial Reporting under U.S. GAAP)
One of the most vexing problems that the appraisal expert must deal with is that there is no recognized market place where private promissory notes are bought and sold.
There are stock markets, bond markets, wheat markets, cocoa markets, and many other types of markets, but there is no private promissory note market. These notes change hands informally, based on one-on-one negotiations, between the parties. In order to even obtain a tentative offer or quote from a potential buyer, the seller must first locate the correct person or entity that understands the specifics of the note being offered, and who has the capital to fund the purchase, and who has an interest in purchasing that specific loan package, and who is willing to make a bona fide purchase offer.
Typically, note buyers tend to be specialists, because the individual notes are each specially tailored to a specific business transaction—each note is unique. As an example there are farm and ranch note buyers, single family home note buyers, business sale note buyers, commercial and industrial note buyers, and mobile home note buyers. Some note buyers only deal with individual notes, some only with packages of notes, some only with small denomination notes, and some with only large denomination notes. Some only deal in one state, some only in one region, and some deal nationally.
Another major challenge that the valuation expert must deal with is the analysis and evaluation of each and every promissory notes collateral security. What are the quality and the quantity of the collateral security? Has the collateral security been intelligently valued by a competent third party appraiser? In most instances the valuation of the collateral security supports the value of the promissory note. If it is deficient, then the value of the note probably will be deficient.
The type and the quality of the loan documentation are critical to the market value of the note. There are numerous and specific documents and information that are required for each particular type of promissory note. By way of example, each of the following type of note will require some specific loan documents to establish its market value: Note secured by farm or ranch land; Note secured by water rights; Note secured by furniture, fixtures and equipment; Note secured by another note; Note secured by a lease; Note secured by future earnings; Note secured by a mobile home.
In each of the above examples the attorney drafting the loan documents is dealing with a potential “trap” if his work is not done properly.
Being a Promissory Note Expert as a Consultant to the Attorney, is as Much an Art as a Science
Remember, each note has its own unique terminology, collateralization, and history. Each note is custom drafted to the particular situation. The valuation of a promissory note is influenced by many, many facts, documents, and assumptions. Further, it should be clear that the “value” of any note is tied to the valuation definition being used.
The investors—individuals or business entities—that comprise the market for these individual notes consist of small, fragmented, and specialized groups of specialized investors. The various techniques one can use in determining the value of a note are like mechanic’s tools. The one you use depends on the situation and your goal. Just as no tool is appropriate for every mechanical job, neither is any valuation technique appropriate for every situation. Each technique has advantages and disadvantages and most are only useful in a narrow range of circumstances.
It is not enough to do your best; you must know what to do, and then do your best.– W. Edwards Deming
Written by This Real Estate Broker Expert Witness No 83