This article discusses the concepts behind forming a limited liability company (LLC) to gather funds for the purchase of trust deeds.
The need for an exempt security
Forming a limited liability company (LLC) to purchase trust deeds will require some modification of the basic investment circular and the operating agreement. An offering circular for a trust deed investment requires a full disclosure of the note and trust deed to be purchased – its payment schedule, interest rate, due date and so on. | A 1984 court ruling suggests the mere multiple ownership of a trust deed note is sufficient activity to create a securities risk. |
Also, the trust deed investment circular requires the same real estate disclosures as an investment circular for income-producing property, since the real estate is the security for the paper the group will acquire.
Finally, the circular must disclose the special risks of trust deed investments on the borrower’s default, such as being forced to pay off any senior lenders or acquire ownership of the real estate on a foreclosure sale.
A trust deed investment program also requires redrafting the operating agreement for the LLC. For example, the purpose provision of the operating agreement states the LLC is being formed to acquire a note secured by real estate, rather than to acquire income-producing property.
Also, “spendable income” is defined differently for a trust deed investment than for an investment in rental property. In the case of a trust deed investment, the only spendable income generated is the interest on the note.
Overall, an LLC formed to invest in trust deeds does not differ greatly from one formed to acquire real estate. However, the syndicator should be aware group investments in trust deeds fall in an evolving application of securities law.
Most LLCs investing in the ownership of existing real estate will only undertake ownership and management activities which do not establish a corporate securities risk. Like managing rental properties, any real estate broker can manage an existing trust deed portfolio.
However, the securities status of an investment group formed to purchase trust deeds is less certain. An investment group formed to purchase an existing trust deed should not be a securities risk. The trust deed note purchased is a fixed asset of known value and secured by real estate of greater value.
However, a 1984 court ruling, so far unclarified and uncontradicted, suggests the mere multiple ownership of a trust deed note is sufficient activity to create a securities risk. [People v. Schock (1984) 152 CA3d 379]
After Schock and until 1998, a regulatory exemption from the securities laws was available to remove the confusion created by Schock about the securities status of a trust deed investment involving 10 or fewer investors. Since 1998, no middle ground has existed between pre-Shock non-securities and the regular securities permits and exemptions.
Blind pool risks
In a blind pool investment, the investor puts up money before a trust deed is located for purchase. | A trust deed broker, on receiving funds he will later place into trust deeds, executes interest-bearing promissory notes to individual trust deed investors who respond to his solicitation in an advertisement. The notes evidence his receipt of their funds. |
As agreed with the investors, the broker uses the funds to purchase trust deed notes he selects and acquires. 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 claims the broker’s trust deed investment program violates securities law, since the individual promissory notes were not registered or qualified as corporate securities. The investor demands the return of his funds, plus 10% interest from the date he delivered the funds to the broker.
The broker claims no corporate securities risk exists since the notes became fully secured by the collateral assignment of the trust deeds.
Has the broker created corporate securities risks by placing the transactions under the control of securities law, calling for the broker to personally return the invested funds?
Yes! The investor placed his capital at a risk of loss when he handed funds to the broker, relying on the broker’s skill in the subsequent selection and investment in reliable trust deed notes. The success of the investment was inextricably bound to the broker’s managerial prowess in later selecting a suitable investment. [Underhill v. Royal (1985) 769 F2d 1426]
A loan broker syndicating trust deeds creates a corporate security if:
- the broker accepts money from an investor, or executes promissory notes, before locating the trust deed investments, called a blind pool investment; or
- the trust deed is fractionalized among multiple investors.
The mere acquisition by a single investor of a trust deed note through a trust deed broker is not conduct which creates a security under the California risk capital/fixed asset test. On advancing his funds through escrow, the investor receives the full value of his investment by an absolute assignment of a note secured by a trust deed on real estate of sufficient, current value.
Conversely, a trust deed investment program contains a securities risk when the investor:
- does not concurrently receive a trust deed in return for the his cash; and
- 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 theory, the funds will then be readily available to the broker for funding the acquisition of a trust deed note he later locates and deems to be a suitable investment.
Thus, the investor initially invests his capital, not in a trust deed, but in the broker’s expertise in analyzing trust deed investments. The broker is given carte blanche to use the investor’s funds as he sees fit. The investment risk is not in a trust deed, but in the syndicator’s promise to select and deliver to the investor a suitable trust deed note in the future. Thus, a corporate securities risk is created.
Future investments
To eliminate the possibility of a future investment securities risk, a trust deed investor, on funding, must concurrently receive the trust deed and note which:
- was the ultimate inducement for him to invest; and
- on assignment, will constitute the full value of his investment – only collection and servicing of the note and trust deed remains.
Consider the broker who maintains a pool of trust deed notes collectively owned by several investors to diversify their risk of loss. Again, a securities risk exists since the investors are not relying on the performance of specific trust deed notes, but on the broker’s skill in successfully managing the continuing quality of acquisitions for the trust deed pool.
To avoid the trust deed pooling securities risk, the broker must only accept an investor’s funds which, when released from trust or escrow, will acquire the entire beneficial interest of a specific, existing trust deed investment.
Thus, full value is received when the risk of loss commences – on receipt of the trust deed note.
Fractional interests
On account of Schock, notes fractionalized among multiple investors fall into a judicially confused area of the securities law.
For example, 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 amounts to invest for the purpose of forming an investment group. The loan is too large for any one of the small investors to handle alone, or to carry the entire risk of loss.
As investors respond to the advertisements, their funds are placed together in a loan escrow trust account until sufficient funds accumulate to fund the loan. The borrower signs and delivers his note and trust deed to the loan escrow. Both documents reflect the fractional ownership of the numerous investors in the note and trust deed based on their proportional investments.
The broker concurrently enters into a contract collection agreement with the group of investors to service the note and trust deed as their collection agent. The broker is also authorized to:
- advance payments to the investors from the his 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 which 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. [Schock, supra]
The Schock decision suggests any origination of a trust deed or assignment of a trust deed note involving multiple lenders (beneficiaries) creates a corporate securities risk – without any other loan activities or conditions placing individuals at a risk of loss due to activities performed to perfect the investment after closing.
Negative presumption of a security
At first glance, and supporting the Schock decision, corporate securities law appears to include fractionalized notes within the definition of a securities risk. Trust deed investments are entirely excluded from control under securities law unless:
| To say an investment program is not an exempt security does not mean the transaction automatically is a security. |
However, on second glance, nowhere do the securities laws state fractionalized notes are securities. The Schock court found the fractionalized notes to be securities, not by any statutory definition, but by the its deduction that the exception of fractionalized trust deed notes from the automatic exemption granted to trust deed notes means fractionalized notes are securities since they are fractionalized.
An exception to the trust deed exemption from securities law is not sufficient to elevate an investment program that presents no securities risk to the status of a security. A court must first resort to an economic analysis of the investment program and establish whether an existing activity is a securities risk, unless the investment is characterized as acquiring stock in a business. Again, fractional interests in trust deed notes are not part of the extensive statutory list of activities constituting securities. [Corp C §25019]
To say an investment program is not an exempt security does not mean the transaction automatically is a security, only that it might be, if the transaction includes an activity that is a securities risk.
An activity that is to be performed for the investor, after the funds have been released and the return of the funds becomes dependent on the investment, must be a unique, non-economic risk of loss to bring the transaction under the control of securities law. Only when the investment is a security can it be considered an exemption in order to avoid obtaining a permit before accepting funds. Trust deed notes themselves are not corporate securities unless they are coupled with a securities-type risk-of-loss activity, such as construction, subdivision or farming.
Similarly, fractional interests in trust deed notes are not securities in the first place – they only become securities if the investment qualifies for control under the federal substance-over-form securities test or the California risk capital test. [Leyva v. Superior Court (1985) 164 CA3d 462]
However, the Schock court abruptly concluded, without analysis, that the broker’s conduct in fractionalizing a trust deed investment created a security under the federal substance-over-form test. Unfortunately, the court fails to specify what activity of the broker in arranging, servicing, or assuring a return of capital investment for multiple investors qualifies as that which creates a securities risk.
The broker in Schock, besides delivering a qualified borrower and a secured interest in real estate of sufficient value, acted as a contract collection agent, collecting installments due on the note and disbursing the proceeds pro rata to the investors.
Contract collection is merely an administrative activity a licensed broker is authorized to perform and routinely undertakes. Note collection is not conduct which triggers a corporate securities analysis. “Full value” exists on release of the collected funds from a trust account and precludes the creation of a securities risk.
However, fractionalizing the interests in a note does heighten the risk of loss. At some point, the coordination of the sheer number of investors may become the activity that creates a security.
For example, if fractional interests in a trust deed are held by only three or four investors, the risk of loss due to lack of cooperation is not much greater than if the trust deed were held by a single individual.
Conversely, a trust deed ownership shared among 200 investors might well be a security. The risk of loss, independent of the underlying economic value of the security for the investment, increases with the number of investors, until each individual’s participation is so small it alone becomes meaningless to attempt to manage.
Thus, multiple lender investments fall in a borderline area of securities law. The line separating transactions controlled as securities from uncontrolled investments should be easily located through precise guidelines – which is what Schock fails to do.
Thus, Schock states no useful rule of law to be followed by brokers who wish to syndicate trust deeds and avoid subjecting themselves to securities law.
Leyva suggests a fractionalized interest in a note is not automatically a security.
The questions to address in establishing exactly when a multiple lender transaction becomes a controlled security include:
- how many investors are involved;
- how much control the investors have; and
- what are the foreclosure and resale procedures.
Remember, the multiple ownership of the real estate underlying a trust deed investment is not a security.
Pending further judicial or legislative clarification, brokers who package trust deed investments for multiple investors must be aware no clear securities guidelines are available. However, a 35-or-less, interrelation exemption exists for group investments in trust deed notes. [Corp C §25102(f)]
