Trust Deed Investments: California SB 978 Suitability Reqs

Trust Deed Investments: California SB 978 Suitability Reqs

Lender · Los Angeles, CA · Member since 2012 · 147 posts · 76 votes

I saw earlier posts about the new law, SB 978, investor suitability requirements for trust deed investments.

California now requires that when selling or brokering all of, or an interest in trust deed investments, hard money lenders and other providers have to:

1) obtain information about the investor, some of which was not necessarily required under previous law, including, but not limited to

* net worth
* other investments
* education or investment experience / level of sophistication
* career history
* age
* income
* tolerance for risk

There is a new form from the California Department of Real Estate that can be used to gather some of the information.

The form, although it asks questions some of my investors are not exactly thrilled to answer, is not all that bad.

2) The big part is that we now have to "consider the investor's circumstance and whether or not the investment is suitable for them."

That's where it gets a little more complex. Obviously, the 84 year old with only 100,000 in investable assets should not put 75,000 into a hard money construction loan - but many of the investment choices are not as clear cut.

3) 3rd new requirement: Previously, when we found an investor (1 investor) for a whole loan, there were a lot fewer requirements than when we placed multiple investors into a fractionalized loan, where each investor buys less than a 100% interest in the loan.

Now, investors in whole loans will benefit from a number of the restrictions and protections that previously applied only to investors in fractionalized loans, AND the same requirements (1 and 2 above) apply to whole loan investments.

I'm attending a conference soon, where extensive coverage of the topic will be provided.

I'm working with some attorneys and other trust deed investment providers to come up with procedures to fulfill the requirements, especially the more challenging # 2 above.

I think investments in California trust deeds will now be somewhat safer as a result of this. We (providers of trust deed investments) have a lot to implement here and those of us that do it right will likely face less competition. Some won't, or won't know how to comply......and sooner or later they'll be gone.

Joffrey Long

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  • Investor · Central Valley, CA · Member since 2012 · 6k+ posts · 3k+ votes
    13y

    Joffrey Long Does the law apply to brokering the origination of the loan or just the selling and/or brokering the already created note? I read the bill when when someone first posted it here and remember thinking it applied only to re-sale of notes.

  • Lender · Los Angeles, CA · Member since 2012 · 147 posts · 76 votes
    13y

    K. Marie,

    Thanks for the great question. It applies to loans sold to private investors, whether or not the investor is funding a new loan by placing money into an escrow, or if there's an already-closed loan that the investor is buying all or part of.

    What started this were various investor losses, and particularly, a HUGE loss up in Nevada County, Ca., in which a lot of small and large investors got burned. The Sacramento Bee ran a huge article about bad trust deed deals and investor losses, and how some people (and to some extent, it was true) put way more than they should have into investments that were more risky than they needed to invest in.

    Then the legislature and the regulators worked together on it, the law passed, and here we are!

  • Investor · Central Valley, CA · Member since 2012 · 6k+ posts · 3k+ votes
    13y

    Joffrey: thanks for your reply. I'm familiar with the "trust deed investments" that the bill is attempting to address. My marketing reaches a number of owners and investor groups that own NP paper and/or have taken back properties. I've talked to people who placed $50K or $100K (or more) of their savings or retirement account, mostly during the bubble. Many don't even know what a promissory note is, what property it was securing or their percentage of ownership. Many claim that just did whatever the broker/investor said to do and sign whatever they said to sign.

    I'm not all that familiar with trust deed offerings, so my question is about trying to understand which loans are covered by the bill and which are not. If a private lender wants to lend me $100K, it's a loan and I do not have to scrutinize the lender's financials. What makes a trust deed offering fall under the regs in the new bill?

  • Lender · Los Angeles, CA · Member since 2012 · 147 posts · 76 votes
    13y

    K. Marie,

    You always keep me thinking, which I appreciate!

    Great question(s) again. I'm going to your 2nd paragraph, question 1:

    Which loans are covered by the bill and which ones are not?

    Actually, my understanding is that what is covered by the bill does not really fall to the loan, but to the investment. So if the investment, or investor becoming somehow obligated to invest, occurs on or after 1/1/13, then it would be covered, regardless of the specifics of the loan.

    Question # 2: If a private lender loans you 100,000, .....what must you do with respect to this?

    This is somewhat of a loaded question. According to the Calif. Dept. of Real Estate, you are not a real estate licensee, unless I looked it up incorrectly. This is good, as my understanding is that you would be more just a borrower and would not have all the obligations as a licensee or professional investment provider to look out for the other party.

    That said, your borrowing, as an experienced investor from possibly inexperienced or less experienced individuals may be "loaded" with other potential problems. I'd watch out for liability in dealing with all investors, particularly ones who are elderly, unsophisticated, (or may appear to be) otherwise under undue influence from someone or something else, etc. It may be worth it to get some consultation as to some minimal things you can do to protect yourself in these situations.

    If you just borrow from investor A once, that may have certain limitations as to liability. (not sure, though) Borrowing multiple times from the same investor OR borrowing from someone you have other business dealings / relationships with may cloud the issue and set you up for more problems.

    Obviously, your investors who make money will rarely, if ever, complain. But in real estate, some deals do go South, so always cover yourself.

    Overall, I can't see where SB 978 specifically involves your activity as long as you're not a real estate licensee or some other type of professional licensee that requires you to look out for the "clients," as these people appear just to be arms length lenders.

    Hope that helps. With respect to your first paragraph, yes, it's unfortunate that some people in our business may have just "written up investments" for people and not really informed them of what they were getting in to. On the other hand, it also requires the investor to listen to, read, and retain information that they're being provided.

    Thanks again for your questions.

    Joffrey

  • CA · Member since 2011 · 762 posts · 182 votes
    13y

    Joffrey: I just took a seminar on SB 978 a couple hours ago ... it's pretty sweeping! If I understand it correctly, whole loan investors are limited to investing 10% of their net worth, same as fractional investors, is that your understanding too? If so, I think that's a pretty big deal, that would mean a millionaire would only be allowed to invest up to $100k ... not a very big TD investment in CA.

  • Lender · Los Angeles, CA · Member since 2012 · 147 posts · 76 votes
    13y

    David,

    Thanks for raising another interesting point.

    I don't necessarily agree with the 10% limitation, although I'm not sure what is correct.

    I'm planning to ask a lot of questions, and get a lot of new information at the seminar I'm attending on this next week. Your question is one I'll definitely ask. The annual conference I'm going to usually has 160 or so signed up. This time it's over 240, largely due to the investor disclosure issue, I believe.

    There is a major challenge here in learning how far we need to go, as licensees, in considering other aspects of the investor's finances and how much we're supposed to take their whole situation (as in the question you raised) into account in advising whether they should or should not invest in one particular trust deed, or fractional interest in a California trust deed investment.

    Did you attend the "Doss" webinar, or another one? (If you don't mind sharing)

    Thanks again, David,

    Joffrey Long

  • CA · Member since 2011 · 762 posts · 182 votes
    13y

    Joffrey: Yes, the Doss seminar. I'm far from an expert, but the way I understand things, all the multi-lender (fractionalized) requirements now apply to single (whole) loans, including the 10% of net worth requirement. Pools seem to be exempt from a lot of 978, but, it seems pools already have the 10% of net worth requirement. I've only ever originated/sold whole loans, never multi-lender or pools.

  • Lender · Los Angeles, CA · Member since 2012 · 147 posts · 76 votes
    13y

    David,

    Yes, there's a lot to learn and figure out here. I don't know too much about pools/funds. But I agree that it seems to me they're more regulated in the investor area anyway.

    Joffrey Long

  • Investor · Central Valley, CA · Member since 2012 · 6k+ posts · 3k+ votes
    13y

    Joffrey Long and David C. Thank you for the additional info. I'm not a licensee and don't plan to become one. Whenever I think it may be to my benefit, I learn of something that I don't want to deal with or don't want to take the time to learn. I'm a very curious person and love love to learn new things, but licensee issues just make me anxious. I'm too used to being the principal in all my contracts and deals.

    At this time, all my private lenders, both secured and unsecured, are either savvy business people or are licensed, or both. I think I'll keep it that way and leave it to you gentleman to attend the seminars and to keep up with the latest regs.

  • Investor · Central Valley, CA · Member since 2012 · 6k+ posts · 3k+ votes
    13y
    Originally posted by David C.:
    Joffrey: Yes, the Doss seminar. I'm far from an expert, but the way I understand things, all the multi-lender (fractionalized) requirements now apply to single (whole) loans, including the 10% of net worth requirement. Pools seem to be exempt from a lot of 978, but, it seems pools already have the 10% of net worth requirement. I've only ever originated/sold whole loans, never multi-lender or pools.

    David: So, did you come away from the seminar with the understanding that you can't loan/place more than 10% of an investor's net worth, even in a whole loan situation? That is a big deal. Lots of interested private lenders don't have net worths over a few M, but are interested in lending more than $100K. That seems bizarre and arbitrary.

  • Lender · Los Angeles, CA · Member since 2012 · 147 posts · 76 votes
    13y

    K. Marie,

    I'm not sure I should be the only one stuck attending seminars, but I won't debate you on that.

    I do agree that you're wise to make a considered choice about getting or not getting a license. I'm sure a lot of people have suggested you get one without understanding or thinking through what that means.

    A lot of people (many with licenses) don't realize that the license, above everything else can change your role in dealings with others from being required to comply with contracts and laws to actually looking out for the interests of the other parties, and (scary) actually putting their interests ahead of your own.

    That said, a licensee can engage in certain transactions as a principal and have the other parties agree that they are not acting as an agent of the other parties, etc., etc., but there can be confusion and problems with that. Anyone wanting to do battle with you, knowing you're a licensee will first make all the claims against your duties as a licensee, and then let you fight it out and prove that the particular transaction you engaged in was not within, or was agreed not to be within the scope of your license.

    So I applaud your choice, based on what you stated your goals are.

    Joffrey

  • Lender · Los Angeles, CA · Member since 2012 · 147 posts · 76 votes
    13y

    K. Marie,

    Regarding your question about the 10% requirement: Although we're not sure how that applies to we that are licensees, I don't believe it applies to you as just a non-licensed borrower in a purely non-advisory non client-professional relationship with the borrower -no more than the private lender has to look out for you, and whether the loan is appropriate to your financial circumstance.

    With respect to the 10%, if that requirement exists, it's big for licensees if they're covered by it and if David's understanding of it correct. ( I don't know. )

    Joffrey

  • CA · Member since 2011 · 762 posts · 182 votes
    13y

    Another way of looking at this whole thing is that all this stuff doesn't matter if broker is willing to buy back a bad loan, investor is made whole and there is nothing to get in a snit about.

  • Lender · Los Angeles, CA · Member since 2012 · 147 posts · 76 votes
    13y

    David,

    Great thought, but here I respectfully, but definitely disagree.

    First, a broker can never "guarantee" or in any way lead an investor to believe that they have a practice of, or agree to buy a loan back, which is just another way of saying "guarantee."

    (Unless they have a permit/approval from regulatory authorities which is near impossible to get)

    We are so regulated on this, we can't even say, in our ads that trust deed investments are "safe" or "secure" or other words that may lead investors to believe that normal investment risk doesn't exist.

    That said, a broker could comply with all the new laws, and then if a loan went bad, could AT THAT TIME offer to buy it back from an investor. I've done that a few times, but I always have to tell them that it's a one-time offer and that it does not mean I'll ever be willing or able to buy it in the future. That would of course put me back in the guarantee business.

    Thanks for the question - hope this all makes sense. I think it's a good thing that brokers are not allowed to "guarantee."

    Joffrey

  • CA · Member since 2011 · 762 posts · 182 votes
    13y

    Joffrey: I didn't know a "guarantee" was so regulated, but, I assumed it was, i was suggesting, as you suggested, that nothing be said or written but that the loan would be bought back without any pre-arrangement. I have been in that situation and offered to buy back a loan from one of my investors but didn't have to in the end. Good point.

  • CA · Member since 2011 · 762 posts · 182 votes
    13y

    K. Marie: Yes, no more than 10% of net worth, for whole loans or otherwise. They have to sign the exact statement at the end of CA B&P 10232.3.

  • Lender · Los Angeles, CA · Member since 2009 · 1k+ posts · 2k+ votes
    13y

    I just got off the phone with my attorney. Perhaps it was just me being dense, but to clarify, each note cannot exceed 10% of the investor’s net worth, but in aggregate they can. That is, using the example above, if an investor had $1 million in net worth, the broker could do ten $100k notes with him and no one note could exceed $100k.

    From my read of the bill, and I didn’t discuss this with my attorney, there is also a limit based upon 10% of adjusted federal gross income? This could be even more restrictive.

    I don’t imagine there will be less money available to lend, but more deals will be fractionalized (and the world will become that much more complicated).

    Jeff

  • Lender · Los Angeles, CA · Member since 2012 · 147 posts · 76 votes
    13y

    Jeff,

    Yes, I am still learning all this, so I am not sure, but it sounds like you've checked things out very well.

    World becoming more complicated - YES!

    That's why, our California Mortgage Association seminar Thursday and Friday in Universal City, which usually attracts about 150 to 160, is almost sold out today at 258 !

    I think the main draw is that we have a panel of attorneys and people who worked with the DRE on the legislation and regs as presenters.

    There are many who will just rely on their attorney's interpretation of this, and if their attorney is right, they're in great shape! The challenge for many, and this is the critical part, is our new obligation to "consider the investor's circumstances and background in determining if the investment is suitable." Yeah, got it. Right.

    Thanks, as always, for sharing your knowledge.

    Joffrey

    P.S. The seminar can be found at www.cmabrokers.org

  • Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    13y

    Interesting, I just read the thread, not the regs yet. I have been against fractionalized interests to or with anyone who didn'yt know each other and agree how thier interests would be collected to the penny, I would never advocate a broker doing business simply assigning a note in part without considerable understandings and most that I have seen were ill prepared imo. Not saying it can't be done, but I'd stick to sophisticated investors.

    The issue of guaranteeing a note is pretty easy, it's in a re-purchase agreement in the event of default, seperate agreement or in the note purchase agreement. All of my notes were done with re-purchase agreements.

    Another way is through the loan servicing agreement, it allows for the assignment of the note and deed of trust in the event of default and the servicer carries out foreclosure or acquires the collateral, sells the collateral and pays the par amount outstanding.

    Before reading the Act, my question would be, what stops new members from joining an LLC and the LLC buying the note in the company name, then breaking out profits to the capital accounts to all the members as applicable? I don't see partners as being individual outside investors.....unless there are restrictions for a company buying a note. :)

  • CA · Member since 2011 · 762 posts · 182 votes
    13y

    Picking up on what Joffery said about it being the brokers obligation to determine investors suitability: broker is now required to look at, among other things, the diversification of investors investment portfolio. Meaning, to me, that if broker is considering selling a TD investment and the investor has several other TD's at 10% of his net worth each, it may not be prudent for that broker to sell to that particular investor.

    SB 978 requires broker to dig, deep, into investors finances ... income, net worth, investment experience, diversification of investments, liquidity and education. Broker must totally undress a potential investor's entire financial picuture, using DRE approved investor questionnaire. There is no simple formula, it's subjective, and you can bet that if the deal goes sideways, broker's (subjective) judgement will be the subject of serious scrutiny.

    There is a lot to this act. To try and analyze it here is very much a bottom up approach, it needs to be looked at top down to really see the whole picture.

    The bottom line is that if the deal goes sideways investor can (and will) easily claim (in court) broker's suitability analysis was faulty.

    At the end of the day, all the lawyers are going to have their opinions but they will tell you nothing for sure.

  • CA · Member since 2011 · 762 posts · 182 votes
    13y
    Originally posted by Bill Gulley:

    Before reading the Act, my question would be, what stops new members from joining an LLC and the LLC buying the note in the company name, then breaking out profits to the capital accounts to all the members as applicable? I don't see partners as being individual outside investors.....unless there are restrictions for a company buying a note. :)

    This is what I was thinking. The only thing I can think of is the usury limit. If a broker isn't involved the max interest rate is 10%, which isn't bad if the LTV is low. I kind of like this idea. It's reasonably secure with a reasonable return. Then a broker could possible get involved with a higher interest second to fill the gap between the LLC first and balance requested by borrower.

  • Lender · Los Angeles, CA · Member since 2009 · 1k+ posts · 2k+ votes
    13y
    Originally posted by Joffrey Long:
    … but it sounds like you've checked things out very well.

    Ha!! Hardly, Joffrey. If you start taking legal advice from me, the only thing I promise is to send a cake with a hacksaw baked into it to your jail cell.

    As someone who is delighted to have been out of the stock market for many years, some of these regulations seem eerily similar to the “Known Your Customer” and related “Suitability” rules that stock brokers must comply with. I wonder about the parallels and how well those have been working in that industry, as well as if there are any lessons learned that could be applicable.

    Those regulations are also relatively new, but old enough that you’d think there would be enough legal claims at this point to learn from. Sorry, I can’t make the seminar, but you might add the question to your list.

    Jeff

  • Lender · Los Angeles, CA · Member since 2009 · 1k+ posts · 2k+ votes
    13y

    I'm curious how retirement plans will be treated. My "expert" legal read, indicates 401k plans that don't require member contributions could be exempt. I have a feeling that IRA's, which are individually funded, must comply since you could directly establish the net worth of the owner. I don't know if that's an appropriate criteria but it seem to meet the tone of the bill. Unfortunately, there's no specific mention of Solo 401k's that I could see, which I suppose could fall into either category.

    OK. Enough playing Perry Mason.

    Jeff

  • CA · Member since 2011 · 762 posts · 182 votes
    13y
    Originally posted by Jeff S:

    As someone who is delighted to have been out of the stock market for many years, some of these regulations seem eerily similar to the “Known Your Customer” and related “Suitability” rules that stock brokers must comply with.

    Jeff: Those are exactly the terms being used to describe a broker''s responsibilities under the new rules ... "know your client", "investor suitability", same fiduciary duties as a "broker-dealer".

  • Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes
    13y

    From a regulatory point of view, "investor suitability" and "know your client" are simply catch you traps. A mortgage broker who does not hold a Series 7 license won't have chance to properly access an investment portfolio and even with that, you'll be wrong.

    You look at my portfolio and say it's good, I buy into you deal and in 3 months it goes south and you and I are at odds, we go to court. My portfolio has changed, the portfolio value is down, and my note losses become significant in light of my total investments. Had the mb identified the potential loss and assessed risks the mortgage loss would not have been as significant. As mentioned, it's subjective but beyond that a mb is not usually qualified to perform risk analysis and diversification issues. If you think you can, don't fool yourself.

    Further, I doubt a mb can accurately assess the risk associated with thier loan unless it was made to secondary market standards, unless you simply say it is a high investment risk.

    In reality, this is an impossibility to perform unless you obtain expert advice. And, when you do attempt to seek professional advice,unless that reviewer is working with you, you can expect them to give what might be a competing investment advice.

    Your best chance and defense will be with an astute qualified investor and keeping them at or below that 10% threshold.

    This consumeristic move simply says don't mess over the investor or we will find ways to nail you. With hine sight it's not hard to show poor judgment or incompetence and putting someone in an inappropriate investment will be expensive to defend.

    I used the LLC concept I mentioned as the members were not "investors" but business partners. Mo. has had a 10% usury law for real estate before I ever started in the business, you can certainly make money at that. Not applicable for commercial.

    Problems will only arise (unless mb's will be audited) when a deal blows up. I'd suggest you be prepared to take out any investor on short notice, no harm no foul. You can do that with a repurchase agreement and servicing agreement. Such arrangements can be at 100% of par or less and your ability to perform will need to be reasonably effective. This will certainly act as your most valuable risk management tool. :)

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