Are Promissory Notes Legally Binding in Canada and How Do They Work in Canadian Law?
Introduction: Promissory Notes in Canada
Helping a family member or close friend out with an altruistic loan is not uncommon. It may be a brother or a high school friend who may need to borrow a few thousand dollars for a car, rent payment, or other necessities. In these situations, we likely won’t reach out to a lawyer to draft a loan agreement with complicated procedures on what occurs on default or upon a late payment.
A promissory note is a legal document to evidence when a lender loans a sum of money to a borrower. The document contains a promise to repay the loan amount under specific terms and conditions and is a simpler alternative to a loan agreement. In Canada, Part IV of the Bills of Exchange Act generally governs promissory notes.
In this article, we review how promissory notes work in Canada and Ontario and answer whether promissory notes are legally binding in Canada. This piece further details when you should have a promissory note over a traditional loan agreement and what terms and clauses to consider for a promissory note.
When Should You Use a Promissory Note?
Generally, a promissory note comes in handy for smaller loans with someone you’re close with. The borrower and lender likely trust each other and believe that the borrower will pay back the amount without the Canadian law having to step in.
Although some may not use any documentation when lending money to those they trust, a promissory note can ensure that both the borrower and the lender are on the same page about the terms of the loan. Promissory notes are generally legally binding and can thus be enforced in court, in a case of default or disagreement. Further, a promissory note in Canada creates a verified paper trail of who the money is being lent to or borrowed from. This can prevent organizations such as the Canada Revenue Agency from suspecting the parties of tax fraud or money laundering.
In contrast, a loan agreement usually involves a substantial amount of money. It’s significantly more detailed than a promissory note, and lawyers are typically involved with both the drafting and review process. Therefore, it’s more expensive to execute a loan agreement than a promissory note in Canada and generally in any jurisdiction. A loan agreement contemplates details such as payment plans, what happens upon default, and more. However, both a promissory note and loan agreement are both just as legally binding as the other.
A lender and borrower may choose a loan agreement over a promissory note where there is a lot of money involved (such as a big loan for a house). If a borrower is looking to private lenders for a loan, regardless of the amount, there will likely be a loan agreement since the borrower is likely not close friends or family members with the private lender.
Additionally, if there’s money from a shareholder loaned to a corporation, the two parties will likely use a shareholder loan agreement instead of a promissory note or loan agreement. A shareholder loan agreement will better account for the relationship between the shareholder and the corporation than a promissory note or loan agreement will.
What Terms Should You Include in Your Promissory Note?
Promissory notes in Canada are straightforward relative to most legal contracts. Commonly, individuals use online resources to write their own. At the most basic level, a promissory note should include:
● The sum of money being advanced/borrowed;
● The identity of the lender and borrower;
● When the borrower has to repay the money;
● How the borrower will repay the money;
● Whether the borrower will need to pay interest, and if so, how much;
● Whether there’s collateral to secure the loan against; and,
● The borrower’s recognition of the promissory note, evidenced by their signature.
Concerning when the borrower repays the money, there are commonly two ways that a promissory note arranges this. The first is for the promissory note to carry a “maturity date” of which the borrower must repay the debt on. The second is a demand promissory note, where there’s no specific maturity date, and the borrower must repay the debt on a few days’ notice by the lender.
How a borrower repays the debt can also differ between promissory notes. The debtor can ultimately repay the principal amount (the amount initially borrowed) in instalments or all at once. Another option is for the borrower to pay only the interest before the maturity date or pay part of the principal along with interest. There are ultimately dozens of ways to arrange how a borrower repays the amounts owed.
Lastly, collateral is an important option to consider in a promissory note. If the lender does not take the collateral and the borrower defaults on the loan, the only option is to go to court. Collateral will let the lender seize the pledged assets if the borrower fails to repay the amount. If the collateral is worth less than the borrowed amount, the lender can still sue for the difference.
Promissory notes are not limited to these terms, however. It’s up to the lender and borrower on how they want to construct their agreement.
Promissory Notes in Ontario
An important caveat regarding promissory notes in Ontario is how the Limitations Act, 2002 affects a note’s enforceability in court. Because of the Limitations Act, a borrower has no obligation to repay a loan under a promissory note in Ontario after a certain amount of time has passed. A lender has two years to collect repayment or commence legal proceedings for repayment after the maturity date of the loan or after the date where the lender demanded repayment. After the two years, the agreement is statute-barred and unenforceable.
For those who wondered whether a promissory note is legally binding in Canada — it is! A promissory note in Canada and in Ontario is a powerful tool that simplifies the borrowing process, without leaving out the details. If you’re lending or borrowing money to or from a close friend or family member, a promissory note may be the best option because there’s already trust between you and the borrower/lender. This document ensures that the borrower and lender understand what the loan details are — often, without the fuss of lawyers.
Jeff is a lawyer in Toronto who works for a technology startup. Jeff is a frequent lecturer on employment law and is the author of an employment law textbook and various trade journal articles. Jeff is interested in Canadian business, technology and law, and this blog is his platform to share his views and tips in those areas.