This article discusses the documentation necessary for a syndicator to publicly solicit multiple investors to make or purchase a trust deed loan. Referenced first tuesday forms can be downloaded by clicking on the blue links.

Fractionalizing a trust deed

A loan broker is retained by a borrower to solicit and arrange a large loan to be secured by real estate. The borrower and the broker enter into a loan agreement contingent on the broker locating trust deed investors with sufficient funds.

To fund the loan, the broker runs newspaper advertisements soliciting private investors with modest funds to form a trust deed investment group consisting of ten or less investors. The loan is too large for any one of the investors to handle alone or to prudently carry the entire risk of loss.

As investors respond to the advertisements and subscribe, their funds are placed in a loan escrow trust account set up specifically for this loan until sufficient funds accumulate to fund the loan. When fully funded, the borrower signs and delivers his note and trust deed to the loan escrow. Both documents reflect the fractional ownership of the note and trust deed by the numerous investors as beneficiaries, based on their proportional investments.

The broker concurrently enters into a collection and servicing agreement, signed by each of the investors, to service the note and trust deed as their collection agent. The broker is authorized by the agreement to:

  • advance payments to the investors from his own funds to cover any delinquent installments; and
  • bid in the property for his own account in the event of a foreclosure under the investors’ trust deed.

Has the broker created an investment risk that is regulated by California corporate securities law?

Yes! The broker’s singular activity of fractionalizing the investment in a note and trust deed among multiple private investors creates a corporate security. [People v. Schock (1984) 152 CA3d 379]

A loan broker syndicating trust deeds creates a corporate security if:

  • he accepts money from an investor or executes promissory notes before locating the trust deed investment, called a blind pool investment; or
  • the trust deed is fractionalized among multiple investors rather than acquired by one trust deed investor for his own account.

However, a broker can package multiple lender trust deed investments and avoid securities violations, provided his conduct falls within one of two readily available exemptions from the securities law.

Securities exemptions

When fractionalizing a trust deed investment and thus creating a securities risk, a syndicator has two options for complying with the securities law.

The first is the non-public offering exemption, called the 35-or-less interrelationship rule. To use this exemption, the syndicator must have a meaningful, pre-existing business or personal relationship with investors he privately solicits for the trust deed investment.

However, trust deed investment groups need not be limited to persons with a pre-existing relationship with the loan broker. A loan broker may publicly solicit trust deed investors by filing a notice permit with the Department of Real Estate (DRE) under the second claim of exemption option, called the ten-or-less trust deed investment plan.

The ten-or-less rules and reporting

The ten-or-less trust deed investment scheme allowing a loan broker to publicly solicit investors to acquire a fractional interest in a trust deed note is structured on compliance 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 loan broker originates or sells the first trust deed note made or acquired by ten-or-less investors he solicited from the public [See first tuesday Form 236];
  • 1.2 any change to the information in the original notice, called an amendment [Calif. Business & Professions Code §10238(a)]; or
  • 1.3 the broker becomes the servicing agent for fractionalized trust deed notes with payments exceeding $125,000 during any three-month period or payments during any three-month period are distributed to more than 120 investors. [Bus & P C §10238(b); see first tuesday Form 237]

2. Advertising for trust deed investors must:

  • 2.1 include the name of the broker and his license identification;
  • 2.2 comply with sections 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 §5 below];
  • 3.2 no agreement for future subordination of the trust deed; and
  • 3.3 priority as a first trust deed if 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 must not be a promotional note secured by a junior trust deed, or a trust deed subject to a future subordination agreement, executed on:

  • a. lots in a subdivision;
  • b. unimproved property; or
  • c. newly constructed, unsold property. [Bus & P C §10238(d)]

5. The fractional interests may be sold by a real estate broker acting as either a principal or an agent to finance:

  • 5.1 his acquisition of real estate at a foreclosure sale under a trust deed he is servicing or one that he originally sold to investors; or
  • 5.2 the broker’s resale of real estate he acquired at a foreclosure sale under a trust deed he was servicing or originally sold to investors. [Bus & P C §10238(e)]

6. The fractional interests are sold to ten or less investors. [Bus & P C §10238(f)]

  • 6.1 The number of persons publicly solicited to purchase an interest is unlimited. [Bus & P C §10238(f)(2)]
  • 6.2 Husband and wife, or any retirement funds or entity wholly owned by an individual and spouse that may acquire a fractional interest are treated as one investor. [Bus & P C §10238(f)(3), §10238(f)(4)]
  • 6.3 Any organization, such as a partnership, 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), §10238(f)(6)]
  • 6.4 Each investor must sign a statement indicating he meets minimum income or net worth standards. [See first tuesday Form 373]In it he must state his total investment in the trust deed note from all sources (directly or through his spouse, retirement fund or controlled entity) represents:

  • ten percent or less of his net worth (excluding cars, home and furnishings); or
  • ten percent or less of his current or prior year’s adjusted gross income (AGI) for his Internal Revenue Service (IRS) 1040 tax return. [Bus & P C §10238(f)(1)]

7. Each investor is given all the rights of a lender and each interest sold to 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)]

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 must not exceed the greater of:

  • 8.1 80% for owner-occupied, single-family residences;
  • 8.2 75% for non-owner-occupied, single-family residences;
  • 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); see first tuesday Form 234]

Editor’s note — If unique circumstances exist, the broker may exceed the statutory LTV ratios if he can justify in writing his reasons for exceeding the limits. However, the LTV ratio must 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 cannot exceed 65%.

The broker must keep the statement containing the justification for exceeding the LTV limits in his files. Also, he must provide the investors with a copy of the LTV statement with the lender disclosure statement. [Bus & P C §10238(h)(2); see Form 235-1 accompanying this article]

9. The beneficiaries’ operating agreement provides:

  • 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 must disclose to the investors the identity of the specific trust deed note he is 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 must 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 must maintain records of the loan transaction, clearly identifying the manner of the receipt and disbursement of the investors’ funds. [Bus & P C §10238(j)(3)]

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 first tuesday Form 237]

The trust deed loan collection agreement contains provisions for:

  • 11.1 the deposit of payments into the broker’s trust account on their receipt;
  • 11.2 the disbursement to the investors of their pro rata share of the payments within 25 days of receipt;
  • 11.3 notice to the investors if the source of payments is other than the borrower;
  • 11.4 no guarantee or advance of funds for payments by the broker, unless the advance is due to the borrower’s check being dishonored and the investor is notified within 10 days;
  • 11.5 filing a request for notice of default (NOD) on prior encumbrances; and
  • 11.6 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 first tuesday Form 237]

12. Material facts will be disclosed to the investors on a DRE designed form.

The Terms of the sale of undivided interests in the trust deed note include:

  • 12.1 if it is an origination of a trust deed loan, 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 Form 235-1];
  • a. if it is the acquisition of an existing note, its sale price, any premium or discount on the principal balance and unpaid interest, the effective rate of return, 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 first tuesday Form 235-2]; or
  • b. if 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); see first tuesday Form 235-4]
  • 12.2 All other relevant material facts affecting the sale of the trust deed note.

13. On request from an investor, the broker must notify the investor of the names and addresses of all other investors in the note. [Bus & P C §10238(m)]

14. The broker is prohibited from acquiring, directly or indirectly, an option to buy the interests of the investors in the note or to acquire 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 if it is negotiated at the time of his purchase. [Bus & P C §10238(n)]

15. If 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 must:

  • 15.1 have his 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 first tuesday Form 546];
  • 15.2 file an annual report on the status of the trust account with the DRE [Bus & P C §10238(o); see first tuesday Form 547];  and
  • 15.3 file an annual report of his trust deed sales, originations and servicing with the DRE. [Bus & P C §10238(p); see first tuesday Form 540]

No blind pools with Notice Permit

A trust deed broker receives funds from investors that he will later place in trust deed notes he will originate or select. To evidence his receipt of the funds, the broker executes interest-bearing promissory notes in favor of the investors.

As agreed with the investors, the broker later uses the funds handed him by the investors to purchase trust deed notes he selects. The broker collaterally assigns the notes and trust deeds to the investors to secure the promissory notes he previously executed.

An investor who loses money on the scheme demands the return of his funds, plus 10% interest from the date he 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 corporate securities.

The broker claims no corporate securities risk exists since the notes became fully secured by the collateral assignment of trust deeds.

Has the conduct of the broker created a corporate 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. 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 investor released his funds by handing them to the broker without treatment as trust funds. The investor had no choice in the selection of the trust deed note acquired before his funds were put at risk. [Underhill v. Royal (9th Cir. 1985) 769 F2d 1426]

The mere acquisition or origination of one trust deed note by one investor, arranged by a trust deed broker and fully identified to the investor before he releases his funds, is not conduct that creates a security under the California risk capital test. When the investor advances funds through an escrow to purchase or originate a specifically identified trust deed note, the investor receives the full value of his investment by an absolute assignment or execution of the note, secured by a trust deed on real estate of sufficient current value.

However, a trust deed investment program does contain a securities risk when:

  • funds are handed to the broker for release without specifying the trust deed note and 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 for the funds he previously placed with the broker.

In a blind pool investment, the investor puts up his money before a trust deed is located for purchase. In practice, the funds will then be readily available to the broker for funding the acquisition of a trust deed note when he later locates one he deems to be of suitable investment quality.

The investor initially does not invest his capital in a trust deed, but in the broker’s expertise to conduct due diligence investigations and to analyze and select a future trust deed investment. The broker is given carte blanche to use the investor’s funds as he sees fit. The securities risk is not in a trust deed, 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, a corporate securities risk is created in the investment program entered into by this investor.