A. Promissory Notes

Schillace v. Channell Shopping Partnership
Promissory Note

B. Determining the Amount of Compensation

1. Fixed and Variable Interest Rates
2. Interest-Rate Swaps

Figure 19.1 - Interest-Rate Swap

3. The Enforceability of Interest-Rate Agreements

Problem Set 19

Figure 19.1
Interest-Rate Swap
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Problem Set 19

19.1. Jude Fawley (a friend of yours who is a stone-mason) calls you to help finalize the settlement of a dispute that he has with one of his customers. He recently completed a custom headstone for a customer that had promised to pay $8,000 for the headstone. When the customer received the headstone, though, the customer insisted that the headstone should have been made from green serpentine marble rather than white marble. Feigning dissatisfaction, the customer refuses to pay. Jude privately believes the customer simply doesn’t have the money. In any event, the customer has offered to settle the dispute by signing a promissory note for $6,000, payable with 10% interest in twelve equal monthly installments. Jude wants to know whether the customer’s agreement to sign a note for the $6,000 will wipe out any of the customer’s defenses to payment. How would you advise him? In evaluating Jude’s question, consider §13 of the Promissory Note.

19.2. Jodi Kay comes to you with a question about a variable-rate promissory note held by CountryBank. The note calls for interest at the rate of “the Prime Rate plus two percent per annum.” The Prime Rate is defined as it is in §2(e) of the Promissory Note. She read in the newspaper yesterday that the Federal Reserve raised its interest rates yesterday and she knows that the interest that CountryBank pays on its funds will rise over the next few days. She is concerned because she knows that Texas Commerce Bank has been merged into Chase Bank and thus no longer announces a prime rate. She wants to know whether the interest payments due under the variable-rate note will remain constant now that Texas Commerce Bank no longer announces its own prime rate. What do you tell her? If the amounts of the payments will not remain constant, how can she figure out how much the payments will be?

19.3. Bill Robertson (your friend that operates and develops grocery stores) comes in to discuss a problem he has in obtaining financing for a new shopping center that he is in the process of constructing. When Bill finishes the shopping center, the income will come from long-term leases with rents that should provide a fixed return to Bill above the expenses of operating the shopping center. Bill tells you that he has no interest in trying to make a profit on the financing. He just wants to make sure that once he obtains a loan, future fluctuations in the interest markets do not put him in a position where payments on the loan exceed the amount he is receiving from the leases that he already has in place.

After Bill leaves, you ask your associate Tom McCaffrey to try his hand at producing a draft of a promissory note for the transaction. Tom - always careful - comes back a few minutes later and points out that Bill never said specifically whether the note should have a fixed interest rate or a variable interest rate. Tom wants to know which type of note he should use. What do you tell him?

19.4. As it turns out, the lender from whom Bill obtains his loan (TownBank) uses a five-year interest-rate swap to facilitate the transaction. The notional amount of the swap is $2 million. TownBank agrees to pay a fixed rate of 9% against a return from the swap dealer (Cheeryble Bros.) of LIBOR plus three percent. {LIBOR is 6% at the time of the swap.} Bill’s loan for $2 million is at a fixed rate of 10% per annum, with interest-only payments for a term of five years. Answer the following questions about the transaction:

(a) If interest rates do not change during the first year, what net payment will be due under the swap?

(b) If LIBOR increases to 7% during the second year, what net payment will be due under the swap during that year?

(c) If LIBOR falls to 5% during the third year, what net payment will be due under the swap during that year?

(d) For each year, what will the net rate of return be for TownBank, taking account of its outstanding loan to Bill, the interest that Bill pays to TownBank, and the payment made on the swap.

19.5. Your last task of the week is to write a policy memorandum for a bar committee advising the Board of Governors of the Federal Reserve. The memorandum relates to unsolicited loan checks (ULCs). ULCs are a device through which lenders make low-cost preapproved consumer loans. Lenders use publicly available credit information to identify consumers to whom they would be willing to make loans and then mail checks in the amount of the loan directly to the consumers. The consumer need not come to the bank office to fill out an application. The consumer need only cash the check. The amount of the check is less than the face amount of the loan because it reflects a deduction for the costs of the loan that the bank wishes the consumer to pay. If the consumer does not wish to accept the loan, the consumer need only discard the check.

Congress is considering a bill that would ban ULCs. Representatives opposed to the bill have asked the Federal Reserve for its perspective. Do you think the bill is a good idea? In evaluating that question, consider the policies reflected in TILA §132 and EFTA §911.

Assignment Update

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