Economic Planning Board Wednesday, June 24, 2015 Canada
Hazards of Lending Money
We have all heard sad accounts of events that would not have occurred if lenders and borrowers had made reasonable efforts to understand ramifications of oral contract, verbal and written IOUs. Some written IOUs may not be enforceable by law and promissory notes do not automatically have the backing of security on which enforcement action can be taken. Any legally enforceable obligation must meet the requirements for a proper contract in order for it to be enforceable. This means that at the minimum the parties to the contract, the terms of the contract, verification of representations and the consequences for default be clearly specified.
All transactions which lenders and borrowers enter into are simply their private transactions. A lender should ask for security to protect their interest and the borrower needs to be able to grant the necessary security to back up their commitment. Securities can take many forms; tangible as well intangible. Prospects of recovery are largely dependent on the nature and quality of the documentation and the marketability of securities a borrower pledges. Promissory notes should be properly and legally secured through additional documentation, if necessary and registration thereof.
Recently a person had lent money without a promissory note or any security. Repayment terms were not properly agreed to and had not been put in writing. Therefore, not only was the timing of the repayment uncertain, but the interest rate was also not specified. The lender had not even asked for the net worth statement of the borrower to know what assets the borrower truly held. As no details were secured of the assets that the borrower held, no further searches were made to establish the ownership of the borrower’s assets. So, while the borrower represented to the lender that he owned a house with large equity, the seller did not know that the house was in his spouse’s name, and perhaps also beneficially owned by the spouse. This illustrates the importance of having clear terms with respect to the arrangement and proper due diligence and verification of important representations.
The importance of knowing and verifying the identities and creditworthiness of the parties to the contract is critically important. Even with a good set of documentation one may not completely eliminate the risk of losing money when dealing with dishonest persons. Checking the credit record of the borrower, getting a reference from a previous lender and doing all other available searches is paramount to successful lending.
A written loan agreement is strongly recommended which would clearly specify all the terms and conditions and leave no doubts or any misunderstanding. The lender should obtain a proper promissory note so that in the event of a default by the borrower, the lender is protected. A lender should ensure that the promissory note is fully enforceable in a court of law without a right of protest. Proper legal advice should be obtained to ensure that the loan documents meet the necessary requirements for validity and enforceability. It is important to secure the promissory note with tangible marketable security with a value either equal to or higher than the amount lent and to register the underlying registrable interest in the security with the proper registry to establish the priority over others. A lender can search the appropriate property registry to determine whether there are any prior charges and whether there is sufficient equity to protect their interest. All searches should be done to properly establish that the lender is able to enforce on the security.
The critical message is this; if you are going to trust someone and provide them with a loan or a guarantee, it is essential that you seek proper legal and accounting advice to conduct verification and due diligence. This means at the minimum preparing a written agreement with the all the terms and obligations of the parties; verifying the identity and credit-worthiness of the parties; confirming and securing the representations and obligations of the parties with appropriate security instruments such as promissory notes, and specifying exit conditions and consequences for default.
By seeking appropriate legal and accounting advice, these matters can be discussed and addressed before the loan is given. A lender must take the responsibility to make sure that all due diligence was undertaken prior to lending. It is the lender’s money and they need to be prudent and vigilant about protecting their own interests and funds. Once funds leave their hands it is too late if and when the borrower neglects to fulfill their obligations.
DISCLAIMER: This is not a legal advice but an article of general interest and is only provided for general information only. It is not intended to be complete in all respects. Readers are cautioned that they must seek proper advice and direction from their professional advisors.
