This article discusses the documentation necessary for a syndicator to publicly solicit investors to fund the purchase or origination of a trust deed note and the securities risk involved when fractionalizing a trust deed investment.
Fractionalizing a trust deed note
Consider a buyer of real estate who retains a mortgage loan broker (MLB) to arrange a large loan secured by real estate. The buyer and the broker enter into a mortgage agreement contingent on the MLB locating trust deed investors with sufficient cash reserves to fund the mortgage.
To locate trust deed investors, the broker runs advertisements soliciting private investors with modest amounts of funds to form a trust deed investment group consisting of ten or fewer investors. The mortgage is too large for any one of the investors to handle alone or prudently carry the exposure to the risk of loss.
As investors respond to the advertisements and subscribe, their funds are placed in a neutral escrow trust account set up specifically for this mortgage until sufficient funds accumulate to fund the closing of the transaction. When fully funded, the borrower signs and delivers the note and trust deed to the mortgage escrow. Both documents reflect the fractional ownership of the note and trust deed by the numerous contributing investors named as beneficiaries, based on their proportional investments.
Collection and servicing agreement
The broker concurrently enters into a collection and servicing agreement, signed by each of the investors, to service the mortgage as their collection agent. The broker is authorized by the agreement to:
- advance payments to the investors from the broker’s own funds to cover any delinquent installments; and
- bid on the property for the broker’s own account in the event of a foreclosure under the investors’ trust deed. [See RPI Form 237]
Has the broker created an investment risk that is regulated by California securities law?
Yes! The broker’s singular activity of fractionalizing the investment in a note and trust deed among multiple private investors creates a risk of loss controlled by the securities law. [People v. Schock (1984) 152 CA3d 379]
An MLB syndicating trust deeds creates a security risk when:
- the trust deed is fractionalized among multiple investors rather than acquired by one trust deed investor for their own account; or
- they accept money from an investor or execute promissory notes before selecting the borrower or the real estate securing the trust deed, called a blind pool investment.
However, a broker may package multiple-lender trust deed investments and avoid securities violations, provided their conduct falls within one of two readily available exemptions from the securities law.
Editor’s note — In a blind pool investment, the investor puts up their money before a trust deed is located for purchase. In concept, the funds will then be readily available to the broker for funding the acquisition of a trust deed note when the broker later locates one they deem to be of suitable investment quality.
The securities risk is not in a trust deed which, as a security device, attaches the debt evidenced by a note to real estate, but in the performance of the broker’s promise to later select and deliver to the investor a suitable trust deed note. Thus, lacking specificity of the investment when the investor releases funds to the broker, a securities risk is created in the investment program offered to this investor.
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Securities exemptions for trust deed syndication
When fractionalizing a trust deed investment (and thus creating a securities risk), a syndicator has two options for complying with the securities law:
- the nonpublic offering exemption, called the 35-or-less interrelationship rule; or
- the public offering exemption, called the ten-or-less trust deed investment plan.
To use the nonpublic offering exemption, the syndicator needs to have a meaningful (deep-rooted), pre-existing business or personal relationship with the investors they privately solicit for the trust deed investment.
However, under the public offering exemption, trust deed investment groups need not be limited to persons with a pre-existing relationship with the mortgage loan broker. A mortgage loan broker may publicly solicit trust deed investors by filing a notice permit with the California Department of Real Estate (DRE) under this second claim of exemption option. [See RE 637: Exemption Request]
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The ten-or-less rules and reporting
The ten-or-less trust deed investment scheme (public offering exemption) allows a mortgage loan broker to publicly solicit investors to acquire a fractional interest in a trust deed note. To qualify for this ten-or-less exemption, the broker is required to comply with the following rules and guidelines:
1. A multi-lender transaction notice form, also called a notice permit or claim of exemption, is prepared and filed with the DRE within 30 days after:
1.1 the mortgage loan broker originates or sells the first trust deed note made or acquired by ten-or-less investors they solicited from the public [See Form 545 accompanying this chapter]; or
1.2 any change to the information in the original notice filed with the DRE, called an amendment. [Calif. Business & Professions Code §10238(a)]
Advertising trust deed and note requirement
2. Advertising for trust deed investors needs to:
2.1 include the name of the broker and their license identification number;
2.2 comply with §260.302 and §2848 of California Regulations, Title 10, regarding advertising criteria, wording and disclosures; and
2.3 include no reference to compliance with the DRE notice permit procedure since it infers merit or approval by the DRE. [Bus & P C §10238(c)]
3. The trust deed securing the note includes:
3.1 California real estate in which the broker, directly or indirectly, has no ownership interest or right to acquire an ownership interest [See Section 5 below];
3.2 no agreement for the future subordination of the trust deed; and
3.3 priority as a first trust deed when it is security for a construction loan, with funds disbursed as construction progresses; including 10% retention until expiration of the mechanic’s lien period, and covered by title insurance providing priority against mechanic’s liens. [Bus & P C §10238(d)]
4. The note cannot be a promotional note secured by a junior trust deed, or a trust deed subject to a future subordination agreement, executed on:
4.1 lots in a subdivision;
4.2 unimproved property; or
4.3 newly constructed, unsold property. [Bus & P C §10238(d)]
Fractional interests sold by a broker
5. The fractional interests may be sold by a real estate broker, acting as either a principal or an agent, to finance:
5.1 their acquisition of real estate at a foreclosure sale under a trust deed they are servicing or one that they originally sold to investors; or
5.2 the broker’s resale of real estate they acquired at a foreclosure sale under a trust deed they were servicing or originally sold to investors. [Bus & P C §10238(e)]
Ten investors or less
6. The fractional interests are sold to ten or fewer investors. [Bus & P C §10238(f)]
6.1 An unlimited number of persons may be publicly solicited to purchase an interest. [Bus & P C §10238(f)(2)]
6.2 A married couple, or any retirement funds or entity wholly owned by an individual and/or their spouse, that acquire a fractional interest are treated as one investor. [Bus & P C §10238(f)(3), (4)]
6.3 Any organization, such as a partnership, limited liability company (LLC) or corporation that was not specifically formed for the purpose of investing in the fractional interest is treated as one investor. [Bus & P C §10238(f)(5),(6)]
6.4 Each investor is to sign a statement indicating they meet minimum income or net worth standards. [See RPI Form 373]
In the statement, the investor needs to state that their total investment in the trust deed note from all sources (directly or through their spouse, retirement fund or controlled entity) represents:
- 10% or less of their net worth (excluding cars, home and furnishings); or
- 10% or less of their current or prior year’s adjusted gross income (AGI) for their Internal Revenue Service (IRS) 1040 tax return. [Bus & P C §10238(f)(1)]
Each investor is given all the rights of a mortgage holder and each interest sold to the investors is on the same terms.
7.1 The investor’s interest in the trust deed as a named beneficiary will be recorded before a release of the funds from escrow. [Bus & P C §10238(g)]
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Loan-to-value (LTV) thresholds
8. Based on the combined principal amounts of the fractionalized note and any prior encumbrances (bonds and trust deeds), as well as the current market value of the real estate as stated in a written opinion of value by an appraiser or the broker, the loan-to-value (LTV) ratio may not exceed the greater of:
8.1 80% for owner-occupied, single family residences (SFRs);
8.2 75% for non-owner-occupied SFRs;
8.3 65% for commercial and income-producing property;
8.4 65% for single family, residential-zoned lots or parcels;
8.5 50% for undeveloped property zoned for commercial or residential use;
8.6 35% for other real estate; or
8.7 the percent of value set by any private mortgage insurance (PMI) coverage issued for the fractionalized note. [Bus & P C §10238(h)(1)]
Editor’s note — When unique circumstances exist, the broker may exceed the statutory LTV ratios when they are able to justify in writing their reasons for exceeding the limits. However, the LTV ratio may never exceed 80% of improved real property or 50% of unimproved property, except for single family, residentially-zoned lots or parcels, for which the LTV ratio may not exceed 65%.
The broker needs to keep the statement containing the justification for exceeding the LTV limits in their files. Also, they need to provide the investors with a copy of the LTV statement with the lender disclosure statement.14 [See RPI Form 235-1]
Beneficiary statement and disclosures
9. The beneficiaries’ operating agreement stipulates:
9.1 a default on the note or trust deed is a default on all the investors’ interests in the note; and
9.2 a vote of investors holding more than 50% of the ownership interests in the note controls the action taken on a default in the trust deed and the selection of the broker, servicing agent or other persons who will act on behalf of the investors. [Bus & P C §10238(i)]
10. The broker needs to disclose to the investors the identity of the specific trust deed note they are under contract to arrange or buy, thus eliminating the formation of blind pool trust deed investments under the ten-or-less notice of exemption. [Bus & P C §10238(j)]
10.1 On the sale of fractional interests, the investors’ funds need to be deposited in a neutral escrow and disbursed on the recording of the investors’ individual interests as named beneficiaries in the trust deed and note. [Bus & P C §10145(b)]
10.2 The broker needs to maintain records of the mortgage transaction, clearly identifying the manner of the receipt and disbursement of the investors’ funds. [Bus & P C §10238(j)(3)]
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Servicing agreement
11. A servicing agreement for managing the trust deed investment is entered into by the investors, in which the broker (or other licensed person) agrees to receive payments on the note, disburse the payments received to the investors and begin foreclosure proceedings on a default in the trust deed. [See RPI Form 237]
The mortgage collection agreement contains provisions for:
11.1 the deposit of payments into the broker’s trust account on their receipt;
11.2 notice that payments deposited will not be commingled with any other funds, and will not be used for any purpose other than the servicing of the mortgage;
11.3 the disbursement to the investors of their pro rata share of the payments within 25 days of receipt;
11.4 notice to the investors when the source of payments is other than the borrower;
11.5 no guarantee or advance of funds for payments by the broker, unless the advance is due to the borrower’s check being dishonored;
11.6 filing a request for notice of default (NOD) on prior encumbrances; and
11.7 sending investors a copy of any notice of trustee’s sale (NOTS), filed on their behalf, or a request for reconveyance. [Bus & P C §10238(k); See RPI Form 237]
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Disclosure of material facts
12. Material facts will be disclosed to the investors on a DRE designed form.
12.1 The terms of the sale of undivided interests in the trust deed note include:
- whether it is an origination of a mortgage, the name and address of the escrow holder, date for closing and an itemized list of the costs incurred by the borrower and the investors on the origination [Bus & P C §10238(l)(1)(B); See RPI Form 235-1];
- whether it is the acquisition of an existing mortgage, its sales price, any premium or discount on the principal balance and unpaid interest, the effective rate of return, the name and address of the escrow holder and the itemized costs incurred by the seller and the investors on the sale [Bus & P C §10238(l)(1)(A); See RPI Form 235-2]; or
- whether the note is secured by a blanket trust deed as a lien on more than one parcel of real estate, additional disclosures of the identification and value of each parcel, the dollar amount of equity in each property after an apportionment of the amount of the trust deed note to each parcel and the resulting LTV ratio for each parcel. [Bus & P C §10238(l)(1)(C)]
- All other relevant material facts affecting the sale of the trust deed note.
13. All other relevant material facts affecting the sale of the trust deed note.
14. On request from an investor, the broker needs to provide the investor the names and addresses of all other investors in the note. [Bus & P C §10238(m)]
15. The broker is prohibited from acquiring, directly or indirectly, an option to buy the interests of the investors in the note or the real estate as part of the initial transaction to acquire, originate or service a fractionalized note. However, the broker, after completing the syndication of the note or entering into a service agreement, may later enter into an agreement to purchase an interest in the note or the real estate when it is negotiated at the time the interest is acquired. [Bus & P C §10238(n)]
16. When the broker sells, originates or services fractionalized notes, and the amount of payments received from all sources in any three-month period exceeds $125,000, or the number of all investors participating during a three-month period exceeds 120, the broker is required to:
16.1 have their trust account inspected by a certified public accountant (CPA) and forward the CPA’s trust account inspection report to the DRE within 30 days after the period in review [Bus & P C §10238(k)(3); See RPI Form 546];
16.2 file an annual report on the status of the trust account with the DRE [Bus & P C §10238(o); See RPI Form 548]; and
16.3 file an annual report of their trust deed sales, originations and servicing with the DRE. [Bus & P C §10238(p); See RPI Form 547]
The 35-or-less interrelationship rule
The nonpublic offering exemption is the most useful exemption available to syndicators who put together an investment program which includes an activity containing a securities risk. The nonpublic offering exemption applies when:
- the investors do not number more than 35 (married couples counting as one);
- all investors have a meaningful, pre-existing business or personal relationship with the syndicator;
- the investors will not resell or distribute the interests they acquire;
- the solicitation of investors does not involve public advertising; and
- the syndicator files a notice of the transactions which fall under the exemption with the California Commission of Corporations. [Calif. Corporations Code §25102(f)]
Thus, when an investment program contains securities risks, the syndicator does not need to be further concerned with the securities law when their program falls under the 35-or-less interrelationship rule for the nonpublic offering of a security.
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No blind pools with notice permit
Consider a trust deed broker who receives funds from investors to purchase trust deed notes the broker will originate or select. To evidence their receipt of the funds, the broker executes interest-bearing promissory notes in favor of the investors.
After purchasing trust deed notes with the investors’ funds as agreed, the broker collaterally assigns the notes and trust deeds to the investors to secure the promissory notes the broker previously executed.
An investor loses money on the scheme and demands the return of their funds, plus statutory 10% interest from the date they delivered the funds to the broker. The investor claims the broker’s trust deed investment program violates securities law since the individual promissory notes issued to evidence the receipt of funds were not registered or qualified as a securities risk.
The broker claims no securities risk exists since the notes became fully secured by the collateral assignment of the trust deeds.
Has the conduct of the broker created a securities risk that placed the transactions under the control of the securities law, requiring the broker to obtain a permit or qualify for an exemption?
Yes! The broker placed the investor’s capital at risk of loss by an activity controlled by the securities law — a blind pool program. The funds were handed to the broker in reliance on the broker’s skill in the later selection and delivery of trust deed notes. The success of the investment was inextricably bound to the broker’s managerial expertise in selecting a suitable investment after the investors released their funds to the broker without treatment as trust funds. The investor had no choice in the selection of the trust deed note acquired before their funds were put at risk. [Underhill v. Royal (9th Cir. 1985) 769 F2d 1426]
A trust deed investment program does contain a securities risk when:
- funds are handed to the broker for release without first identifying the specific trust deed note and security interest to be acquired in real estate; and
- the investor relies on the skill and judgment of the broker to later locate and deliver a suitable trust deed investment in exchange for the funds the investor previously placed with the broker.
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