Promissory Note Scams: Too Good to Be True

By: AARP Outreach & Service | Source: AARP.org | April 19, 2006

When Joan sold her condo, she had money to invest. She went to a broker with a reputable company.  He referred her to another broker who she didn’t know. The second broker persuaded her to make a short-term investment in a growing company. It was guaranteed, he said, that she would get her money back with 20% interest in just three months. He claimed the investment was backed by the Small Business Administration. It was a “sure thing,” he said, “another MicroSoft.” Joan signed the papers and handed over $50,000. But within a couple of months, the company went bankrupt and the broker – who wasn’t really an employee of the investment company – disappeared. Joan’s money disappeared as well.

An offer like the one Joan fell for is a form of promissory note. 

Thousands of people each year get caught in similar costly investment scams. But if you know what to look out for, you can avoid them.

What is a Promissory Note?

With a promissory note, the investor is in effect making a loan to a company. The company promises to return the investor's money and make fixed interest payments over a certain period of time. 

Promissory notes are a form of security. With some exceptions, they are supposed to be registered with the state securities regulator or the Securities and Exchange Commission (SEC). The person selling the security must have a securities sales license. The persons selling a promissory note might deny that what they’re selling is a security, but don’t take their word for it. It is.

Promissory notes can be legitimate investments, but genuine ones are almost never available to the general public. Simply the fact that an offer like this was made available to her should have made Joan suspicious.

How Promissory Note Scams Work

In Joan’s case, the investment fraud was being pulled by someone posing as a broker. But often in this type of scam, the con artists stay behind the scene.  They persuade honest, independent life insurance agents to sell promissory notes by promising them large commissions. The agents often rely on the information they’ve been given. They may not know that the information is false or misleading. The life insurance agent may not even know that their insurance license doesn’t allow them to sell promissory notes. The promised high sales commissions can cloud their ability to determine if the investment is right for you and your need for a secure investment.

Don’t let the lure of a so-called “guaranteed” high rate of return keep you from doing your homework before you invest.

Red Flags

Several red flags should alert you that a promissory note may be a scam:

1. Claims that investing in a promissory note is “risk free.”
2. Promises of quick, guaranteed double-digit returns. Compare the promissory note’s rate of return with market rates for similar fixed-rate investments, Treasury bonds, or certificates of deposit. If the seller promises an above-market rate on a short-term note, be careful.
3. Labels of “prime quality” on a start-up company’s promissory notes.
4. Notes that are for a period of nine months or less.
5. Notes that are offered to the general public.

Do Your Research

People offering honest investments welcome questions. They give you time to do some research.

• Check the product.  Most promissory notes must be registered with state securities regulators or the SEC.
• Check the person. Sellers of most promissory notes must be licensed by state securities regulators. You can find contact information for your state securities regulator by going to the North American Securities Administrators Association web site and click on "Contact Your Regulator."
• Don’t be pressured to act quickly.  Be ready to say, “I’m not making a decision today.”
• Read everything you can. Get on your computer or go to the library to look up articles about the product being offered and the person offering it.
• Read the Securities and Exchange Commission's warning about the risks of investing in promissory notes.
• Read the Financial Industry Regulatory Authority's warning that promissory notes can be less than promised.
• AARP's Money Matters Tip Sheet on Choosing Suitable Investments has more information and action steps.