A promissory note is a promise by the borrower to repay the lender on a specific date or dates, usually with interest. In my experience there have been more worthless notes than good ones. Strange as it may seem, the worst of a promissory note have come from friends, and the closer the friend the worse the note. When a person is in need of funds he naturally turns to the people who can least refuse him—and these are often his friends. It is most difficult to say you are a friend in one breath and refuse to lend $1,000 in the next. It is well in such a case to remember that the person wanting the loan had no hesitation about asking you for your hard earned money. For many years I have had a stock reply ready to friends who ask for loans: "That's funny; I was just going to ask you for a loan."

Such an attitude may seem hard and cold, but it was developed after I had lost over $35,000 lent to various friends over the years.

Early in my business career I got the right answer, but I guess I forgot it. Shortly after I was out of college and working in New York, a friend of mine who also lived in the YMCA asked me to lend him some money because he had no funds with which to buy meals. Since I then had the princely salary of $31.15 a week I felt I should let this friend in need have some money. I did—$10— but as far as I went it was not a loan. It was a gift. I never expected to get it back and I never did. Years later the same friend asked me for a loan of $1,500 to buy a business. I inquired whether he would give me a second mortgage on his property. He became indignant and told me I was no friend to ask for col­lateral, that his word should be good enough. Perhaps his word became more valuable over a period of 20 years!

There are some loans which you must make to friends in need or to relatives. These should in no way be considered business propositions, however. They are charity and should be judged on the basis of charitable contributions but with the added feature of there being a small chance, perhaps one in ten, that you will get back your funds. In this chapter we are not talking about this type loan. It is not a business proposition. I will, however, in a later chapter, describe in some detail how a friend managed to get away with no less than $28,000 of my money.

There are three essential elements to a promissory note besides the legality of the note in the state in which it is used, and these are (1) the integrity of the borrower, (2) the soundness of his assets and (3) a sound use to which the money is to be put. These elements must be present or else the loan is a poor one. Later the advisability of collateral will be discussed, and this is really a fourth element in judging the soundness of a loan.

But first let us see where you can place your money on the basis of a promissory note. Almost every Sunday in the New York Times and in every other paper in a major city there are advertisements listed under "Money Wanted" in the busi­ness or classified section, and the Wall Street Journal often carries items about notes for sale. A business associate of mine in Florida makes a point of advertis­ing from time to time that funds are available for investment. Out of the many answers he sometimes finds a very good investment.

In almost any trade, dealers need working capital. This is particularly true where there is a buying season and where sizable amounts of capital have to be put into inventory at that time. The art industry is an example. In addition to the buying season and the large dollar amounts of inventory, there is a slack or no-selling season in the summer. This is also the buying season, so that when the dealers have to put out large amounts for inventory they have diminished amounts coming in. Very many dealers go to Europe every summer to buy and this expense adds to the need for seasonal funds.

At the present time the larger art dealers have tremendous trouble in getting good paintings for their stock, and for the most part they do not need funds. The medium size and smaller dealers do, however, and I have from time to time invested in their notes. Over the years I have placed considerable sums in loans to the art industry and I have collected every cent. In one case the ultimate buyer did not pay and had to be sued, but even here there was a profit in the transaction.

New York City may not be the soundest place in the country to make loans. There are many unscrupulous dealers and wholesalers, as well as manufacturers of all types located here, but there are also good dealers, and my experience runs to the field of art.

There is always a trade from the smaller dealers to the larger ones. When the smaller dealer acquires an outstanding art object, and he does this quite often, he may ship it to the larger dealer who may not pay right away but a month or two later, particularly if the shipment is made in the slack season. The larger dealer may give a note to the smaller dealer. I have purchased such notes at a discount. Those that I have bought have been without collateral and have yielded a rate of well over 20% per year. None has ever defaulted. The only note that posed a problem was one given by a large purchaser, and the difficulties make interesting reading. They will be taken up later.
To go back to the first criterion of a loan, a Dun and Bradstreet or Stone's Mercantile Agency report should be secured on the dealer, or whoever the borrower is, and perhaps a Retail Credit Report. These reports should be sup­plemented by inquiries at the borrower's bank, provided he has borrowed at the bank, and it must be determined why he is not now borrowing the money from the bank. The reason may be a technical one, such as the fact that the bank does not lend over a given percentage of the net worth of the dealer, or it may be that he has in the past been a bad credit. A check with other dealers may add to your evaluation of the risk. If any other dealer has had bad experiences he is likely to let you know, being careful not to say so much about the prospective borrower as to lay himself open to suit. In the case in which I ran into trouble on my loan I was warned in advance by another dealer or by a supplier who told me to be careful. This advice and these warnings should be enough to scare you off. If there is even a question about the man's integrity, drop the whole matter.

Anyone who wants a loan must supply a balance sheet and profit and loss statement for your examination. This statement should be prepared by a reputa­ble accountant, and if the accounting firm is not known, inquiries about its repu­tation should be made in the same way that inquiries about the borrower are made. This is the great value to a statement prepared by a reputable accounting firm such as Arthur Anderson, Leidesdorf or Ernst and Ernst.

Balance sheet and profit and loss statement analysis will be explained in a later chapter, but at this point it is sufficient to say that the statements should show (1) enough cash to make the business sound, (2) a ratio of assets which the dealer will realize within six months or a year at most to equal twice the debts he has which are payable within the same period, and (3) a good net worth (that is what is left when you subtract all his debts from all of his assets). In counting assets disregard completely goodwill. It means little. You can take the item "land and property" with a grain of salt and look into it carefully, noting whether the figure is what he actually paid for it or whether it is an appraised value, the latter being subject to much speculation.

The company should be "in the black." It should not be running at a loss. Leave loss companies to professional investors and do not ask for trouble.

We come now to the final criterion of whether to make a loan: the purpose to which the funds are to be put.

One of the leading finance companies in the country states that it will make no loan that is not for a relatively short term business purpose and which does not provide for and make possible repayment. If the prospective borrower says, "I am short of money. I need to pay my bills," there is no adequate reason for granting the loan. If he says, "This is my buying season. I want to stock up so that I can have my inventory for the year," this is a good business reason. He needs something to sell, and the sale of it provides the money with which he will repay the loan.

One of the major reasons for seeking finance is the desire to get money out of receivables. Many dealers will sell on the "buy now pay later" plan. The buyer agrees to pay in two or six months or a year and gives a note to that effect. If the buyer is a good credit, and you have to check this fact in the standard way in which you evaluate the dealer, the business purpose is a good one. Some finance companies exist on financing the dealer's receivables. This is called factoring, but the factoring finance company takes over the receivables and holds them until the dealer pays off the loan, and sometimes has the customer pay directly to the finance company.

Unless the dealer or other borrower is highly reputable, is financially very sound and has a thoroughly legitimate use for the funds and can offer a totally valid reason for not borrowing from the banks, collateral must be taken to secure the loan. This collateral may be the item or items the borrower wants to finance.

From time to time I have lent funds to a finance company, and have taken the promissory note or notes of the persons financed by the finance company, in this case the conditional sales contracts of the mobile home purchasers. I thus have the promissory note of the finance company, and I have the conditional sales con­tract of the person who bought the mobile home, including the title to the mobile home. In the event the finance company does not pay, I can come back on the purchaser, and in the event he does not pay I can take his mobile home since I have the title to it. This type loan pays me 10% to 12% and is extremely sound.

We have spoken in brief about collateral, which is really additional security for a loan; but the collateral we have talked about is that which was created out of the loan which I made. Collateral does not, however, have to be directly re­lated to the purpose of the loan. It can be anything of value. In the art business paintings are sometimes given as collateral. It is not recommended that these be considered collateral. Their true value can be judged only by experts, and one of the best ways to swindle is to borrow money against a "priceless Old Master" and then default on the loan, letting the lender find out how "priceless" the "Old Master" really is.

Stocks, bonds and mortgages are good as collateral, but must be valued in accordance with principles laid down in the chapters dealing with these things. Very often the borrower needs the money badly and will post as security, assets worth a good deal more than the amount of money he wants to borrow because he feels certain he can repay and does not fear losing the collateral.

A concomitant of the criterion of the loan as being required for a business purpose is the timing of repayment. If $10,000 is borrowed for 12 months, what happens at the end of 12 months? Is the $10,000 supposed to appear mirac­ulously at that time? Too many borrowers discount the future, and 12 months seems so far away that surely by that time their fortunes will change and they will be able to repay that sum easily. Serial repayments are far better than one repayment. A $10,000 loan might well be repaid in part each month. Then the amount of money the borrower has to get together every month is $833. This is far less than a lump sum requirement of $10,000. It is well to gear the repayment into the thing financed. If the loan is to finance the yearly inventory, the money must be collected as the sales are made during the year. Any other plan is un­businesslike and hazardous.

In a general way the rate of return reflects the degree of risk. A government guaranteed savings bank account is as nearly risk free as any investment can be. A first mortgage which is government-guaranteed is fairly risk free, and the difference in rate between it and the savings bank reflects the fact that in a mortgage the money cannot be obtained as quickly as it can when it is on deposit in the bank. A nonguaranteed first mortgage is to a considerable extent risk free provided the owner has enough equity in the property. From here we get into more risky investments, and an uncollateralized note can be a very risky proposi­tion. For that reason the interest rate should be high—at least 20%.

Very often a weak borrower will secure the endorsement of someone to help strengthen his note. An endorser, or even several endorsers, mean nothing if they haven't the ability and willingness to pay if the maker of the note can't. A few years ago I bought several a promissory note from a lawyer in New York City. The notes were made payable to him by the debtor and he endorsed them over to me. There was also a third signature on the notes, the signature of a person we will call Mr. Johnson.

The debtor failed to meet the due date. The procedure in holding endorsers liable calls for informing the endorsers of the default within 24 hours. Otherwise they are released from liability. Special delivery letters were sent to the lawyer and Mr. Johnson. Mr. Johnson managed to have the letter sent back "unclaimed" and it was found that he was perennially out of money and even owed back rent.

The lawyer replied that he received the notice and was sure "everything would work out satisfactorily." That was as near as he ever came to making good on the notes. The choice was then one of suing the lawyer, who had some financial responsibility, or the maker of the note, a man of some consequence in the South, and himself a lawyer. It was felt best to bring suit against the maker of the note. We will go into this story in more detail later.

In promissory note purchasing here are the rules to follow:

1. You are dealing in high rate money in non-bankable risks, and you must recognize this fact and take steps to protect yourself.



2. Don't go into an unsound deal no matter how high the rate of interest offered. Your rate of return may work out to 50% per annum on nothing! The best thing you can do is quash the feeling of greed that can develop quite easily when a high rate of return is offered you.



3. Check the credit of the borrower through the national credit agencies, through the local credit agency and through the banks with which the borrower has done busi­ness. Also make inquiries in his town and neighborhood about him.



4. Look at his profit and loss statement and balance sheet. These should be prepared by an accountant, and preferably by a certified public accountant.



5. Use a waiver of judgment note if such note is valid in your state, rather than a straight note. It will save you trouble and expense in court.



6. Secure the signature of the corporation and the man personally and his wife. He may transfer funds out of the corporation to evade you and even put his estate in his wife's name.



7. Have the validity of the note checked by a lawyer.



8. Finance for a valid business purpose only—not just because the borrower hap­pens to need the money.



9. Finance things that provide for repayment over a period of time, preferably in installments that the man can be expected to meet.



10. Take collateral that has a real value and verify that value. You must be able to get your money out of the collateral if the borrower defaults, and be sure the collateral is properly endorsed to you.



11. Obtain the signatures of endorsers if you can and if they check out as substantial, do not forget to notify them in event of default within 24 hours.



12. Take collateral that has a real value and verify that value. You must be able to get your money out of the collateral if the borrower defaults, and be sure the collateral is properly endorsed to you.
    
    
    
13. Obtain the signatures of endorsers if you can and if they check out as substantial, do not forget to notify them in event of default within 24 hours.



14. Do not charge over the legal maximum interest rate in the state or you may be caught on usury and lose some or all of the investment. Often there is a difference in the rate that may be charged to individuals as against corporations, the latter being higher.



15. Buy the note at a discount to yield at least 20% per year unless the collateral is absolutely prime, in which event you may take as low as 10%. A promissory note is not the safest investment in the world, but the yield is generally high, and if precau­tions are taken, you can make money on them.