The Company I Lent Money To Defaulted on Its Notes. Investor Remedies

Start with the paper

Pull every document before deciding anything: the note itself, any subscription agreement or offering memorandum, any guaranty, any security agreement or deed of trust, the payment history, and the emails or decks used to sell the deal. Four questions decide the strategy. Is the note payable on a fixed date or on demand? Does it allow acceleration on default, and does it waive notice? Is there a personal or corporate guaranty? And was the note sold to you as an investment, to many people, with promises about returns?

Is the note a security?

Usually, yes. Under the Supreme Court's decision in Reves v. Ernst & Young (1990), every note is presumed to be a security unless it bears a strong family resemblance to a list of ordinary commercial instruments: consumer financing notes, home mortgage notes, short-term notes secured by a lien on a small business or its assets, notes evidencing a character loan to a bank customer, and the like. Courts apply four factors: the motivations of buyer and seller (raising money for a business and earning a return points to a security), the plan of distribution (offered to many investors), the reasonable expectations of the investing public, and whether another regulatory scheme or risk-reducing feature makes the securities laws unnecessary. The Texas Securities Act's definition of security in Government Code section 4001.068 expressly includes notes and other evidence of indebtedness.

A note sold to one bank in a negotiated loan is a loan. A note sold to 40 individuals through a salesman promising 12 percent is a security. The second kind opens a different set of defendants and remedies.

Lender remedies on the note

Demand and acceleration

A note payable on a date is due on that date; a demand note is due when you demand. Most investment notes let the holder accelerate the whole balance on a missed payment. Under Texas law, unless the note clearly and unequivocally waives them, the holder must give two notices before accelerating: notice of intent to accelerate, which gives the borrower a chance to cure, and then notice of acceleration. A defective acceleration can be undone and can cost the lender interest and fees, so the notices are drafted carefully and sent as the note specifies.

Suit on the note and the guaranty

A suit on a promissory note is one of the simpler commercial cases: the plaintiff proves the note, that it owns it, that the defendant signed it and that a balance is due. Summary judgment is common. The guarantor is sued in the same case; a Texas guaranty is read against the guarantor according to its terms, and most investment-deal guaranties waive the defenses the guarantor might otherwise raise. Attorney's fees are recoverable on a note and guaranty that provide for them and, for a claim on a written contract, under Texas Civil Practice and Remedies Code chapter 38.

Deadlines

For a negotiable note, Texas Business and Commerce Code section 3.118 gives six years from the due date or the accelerated due date, and for a demand note six years from the demand (ten years of no payment if no demand is ever made). A note that is not negotiable, for example one payable out of a specific fund or subject to other agreements, falls under the four-year period for debt in Civil Practice and Remedies Code section 16.004. Securities claims have their own, shorter clocks, covered in the guide on securities deadlines.

Collateral

A secured note lets the holder foreclose on the collateral under the security agreement and the UCC, or under the deed of trust for real property, often faster than a judgment. Check whether the security interest was ever perfected by a filing; investment notes described as "secured" frequently were not.

A usury check before you sue

Texas usury law applies to the investor as lender. Finance Code section 302.001 sets the maximum rate at 10 percent a year unless another provision authorizes more, and chapter 303 does authorize higher optional ceilings for many commercial loans. Section 302.002 sets the legal rate at six percent for a debt with no agreed rate. Chapter 305 imposes penalties on a creditor who contracts for or receives usurious interest, up to forfeiture of principal in the worst consumer cases, with a four-year period for the borrower's claim under section 305.006 and a cure procedure. A company sued on a high-rate note sometimes answers with a usury counterclaim, so the rate, fees and default interest are reviewed before the demand letter goes out.

Investor remedies when the note was a security

When the company is insolvent, the note itself is often worth little. The securities claims are what reach other pockets:

• Texas Securities Act, section 4008.052. If the note was sold by means of an untrue statement or misleading omission of a material fact, the buyer may rescind and recover the price paid with interest, less payments received, without proving the seller's intent. Section 4008.051 adds a claim if the notes were unregistered and no exemption applied, or were sold by an unregistered dealer or agent. The guide on unregistered securities and rescission covers that claim.
• Control persons and aiders, section 4008.055. Anyone who controlled the issuer is jointly and severally liable unless they prove they did not know and could not reasonably have known; anyone who materially aided the sale with intent to deceive or reckless disregard is liable too. That reaches founders, officers, salesmen and sometimes professionals.
• Federal Rule 10b-5 for knowing or reckless misstatements, in federal court.
• Common-law fraud and statutory fraud under Business and Commerce Code section 27.01 when the notes were part of a stock or real estate transaction.

A company that raised money from many investors on identical notes has often been running a program that cannot pay from operations, so the question whether it was a Ponzi scheme, and whether a receiver is coming, belongs in the first conversation.

Example

Suppose a Frisco investor lends $250,000 to a logistics start-up on a two-year note at 11 percent, with the founder's personal guaranty, after a deck states that the company has $3 million in signed customer contracts. Payments stop after eight months. The note allows acceleration and waives notice; counsel still sends a notice of intent to accelerate and then a notice of acceleration to remove any argument. The company has no assets. The guaranty is sued on, and the founder's house and brokerage account become relevant. Discovery of the deck's source shows the "signed contracts" were letters of intent. That adds a Texas Securities Act rescission claim against the founder personally as the seller's control person, and against the consultant who built the deck and earned a 5 percent finder's fee, if the consultant knew. Three paths to the same $250,000, each with a different defendant.

If the company files bankruptcy

The automatic stay under 11 U.S.C. § 362 stops any suit or collection against the company the moment the petition is filed. By its terms the stay protects the debtor and property of the estate; it does not protect a guarantor, a founder sued as a control person, or a broker who sold the notes, so those claims proceed. Inside the bankruptcy you file a proof of claim as an unsecured creditor, or as a secured creditor if the collateral was perfected. Note holders rank above shareholders, and a note holder's claim for the debt itself is a general unsecured claim, but a claim for rescission or damages for fraud in the sale of the note may be subordinated under 11 U.S.C. § 510(b), so the debt claim is usually the one worth filing. Priority and the other sources of recovery are covered in the guide on recovering from an insolvent company.

Collecting a judgment

A judgment on a note or guaranty is collected like any other: abstract of judgment, post-judgment discovery into assets, writs of execution and garnishment, turnover orders. Texas exempts the homestead and many retirement accounts, which is why the guarantor's non-exempt assets are investigated before suit. The guide on collecting a judgment in Texas walks through the tools.

When to involve a litigator

At the first missed payment, because the sequence matters: a demand or acceleration sent wrong can be undone, a usury problem is better found by your lawyer than the borrower's, and the securities clocks are shorter than the six years on the note. A litigator can also tell quickly whether other investors hold the same paper, which changes everything about how the case is run. Tina Wysk represents note holders and companies in securities and investment disputes in Dallas state and federal courts.