Buying partial notes

23 Replies

Reading through this site has opened my eyes to problems I never thought of. I usually stick to local rental properties. While trying to find a new investment for some cash I needed to put to work, a friend recommended I buy notes and gave me the name of someone who brokered notes. It sounded simple and so far everything has gone as planned for 6 months.

Then I saw @Dion DePaoli comments about partials and thought I better investigate.

He mentioned buying partials is dangerous for investors and can violate securities laws. Can anyone elaborate?

I bought 72 payments on a seller carried 30 year note. I am hoping I did not do anything wrong.

@Robert Fry mostly it depends on how your deal is structured.   I will let Dion explain all the things he thinks is wrong with this but I will say that I know a lot of people at Note School that sell partials.   Combined they sell hundreds of these a year.   They have run their deal structure through multiple lawyers and firmly believe they are in the clear.  

Robert it is probably good you started a new thread on the matter so the debate can air out. I will go ahead and make my case that partial note investments are non-exempt securities. I am not sure this debate has occurred here on the boards.

First let's understand what the definition of a security actually is:

The term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.


So right there at the beginning of the definition we see "any note". In addition we also see "evidence of indebtedness" and "investment contract". So it seems pretty clear that all promissory notes are in fact securities. That means mortgage notes too.

So then we can apply the exemptions from registration as security. It is important to again point out - all notes are in fact securities - so no argument that says they are not is valid. "Some" notes are exempt from security registration which those families are as follows:

  • Delivered in consumer financing
  • Secured by a home mortgage
  • Secured by a lien on a small business
  • Evidencing a ‘character’ loan to a bank customer
  • Secured by an assignment of accounts receivable
  • Formalizing an open-account debt incurred in the ordinary course of business.

So we see that when a note is secured by a home mortgage it realizes an exemption from the securities definition. So one of the first tests we can apply to the sale of a partial is does the partial investor enjoy the same secured interest as that of the whole loan investor. This is where we need to acknowledge the variety of structural differences that are often put forward. If the partial buyer does not enjoy or can not rely on the security instrument then by definition we have a "different" note asset all together.

So if the partial sale comes with the Seller of the partial retaining full rights and interests in the note and mortgage/deed of trust then for sure we have a security. What tends to happen here is the Seller of the partial retains the rights and interests of the Mortgage then takes the bundle of payments and extends those payments to the partial buyer. This sale may come with guarantees of yield or return. If so, it instantly becomes a security, as any guarantee of performance is a security by definition.

Ok, so what happens if the partial buyer receives rights and interests granted to the Mortgagee and there is no guarantee involved?

For that we will introduce the Howey Test, which is a test on an investment contract to determine if it is a security. For the record, the Howey Test came about regarding a real property transaction. The property was a citrus grove and a contract was created and sold where a third-party retained the full rights to operate on the property collecting the harvest and selling said harvest to make the note payment which then would be distributed to investors. That contract was found to be a security and was not exempt from registration. The test criteria is as follows:

1. Expectation of profits
2. Common Enterprise
3. Depends solely on the efforts of others

I think number 1 is pretty easy to see and understand it will apply to most investments in the market period.

For number 2, common enterprise, we get a little abstract. A common enterprise has a couple of different concepts which go with it and those concepts are recognized differently depending on the court which entertains the matter. If we try and paraphrase some of the concepts that go into this analysis we can look to an idea of whether the Buyer of the partial rises and falls in profit in line with that of the Seller of the partial and if the Buyer of the partial holds the secured interests granted by the mortgage or deed of trust or if in fact the Buyer holds an interest secured by the security, meaning not holding the actual security instrument but rather has a [fractional] interest in the security instrument. Secured indirectly by the security instrument.

Sorting that out is certainly grueling. What happens in the event of default? What rights can the Buyer of the note actually invoke to cure any breach or default and from whom does the remedy emerge (Borrower or Seller of partial).

The more a Seller of the partial steps into a loan to administrate thereby reducing the rights of the Buyer of the partial to enforce the actual security instrument the more we travel toward a security.

Those idea are more easily understood when applying Howey Test part 3 which is "Depends solely on the efforts of others". If the Buyer of the partial has to rely on the Seller of the partial - seems pretty darn clear that we have a reliance and thus a security is likely present.

I will also add to this part of the analysis, often times partials are sold by the Seller as a "passive investment". That description has become more and more widely used by promoters to attract investors. Here is the thing, by definition a "passive investment" is a security.

Further one of the ideas that follows the testing of Howey Test #2 is how many investors are involved. This is sort of where marketing a partial can be source of turning the partial into a security. How investments are advertised or marketed has a direct affect on the perception of whether the investment is a security or not. The general idea there is the more public you make the offer the more the security definition should apply as the definition is present to protect the public.

One of the ideas that stems from the ideas around notes being exempt or not is:

"If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a ‘security."

To me, this in general seems to embody most note partial sales. A partial Seller usually is trying to raise money to repeat the investment structure again. The Buyer of the partial and the marketing of the partial is based on the profit the Buyer will realize from the note. This is on top of likely being defined as a dealer which requires license.

Further, whole loans are generally considered non-homogeneous. That is, no two whole mortgage notes are the same even though the terms of the note itself (rate, term, etc) may be similar. This is because the collateral to the note is not homogeneous. No two pieces of real property are substantially alike. This idea would seem to imply that the more homogeneous the investment becomes the more likely it should be treated as a security. This is because the more homogeneous an investment is the more widely marketable the investment is to the public. Most partials I see set out to specifically do just that. Create a widely acceptable investment to the public.

Two mortgages on two different properties are different. However, once we reduce the concept of the investment to merely that of the stream of cash flow, the investment starts to lose its uniqueness. All that is being sold is the cash flow or the possibility of the cash flow. The more the Seller relieves the Buyer of the risk of default and/or delinquency the more we move toward security.

In the case of the other thread where I made the comment the promoter was actually offering guarantee payments at X%. The investments were marketed as completely passive investments. The structure of the investment relied solely on the actions of third parties - the promoting Seller and the Mortgage Servicer. In a nutshell those combinations of things and a couple other smaller details allow the acts to be considered securities. Further, the deployment of defining the actions of selling securities was invoked specifically to "protect the public".

In that it is important to note, that one of the reasons we have the securities rule is to protect the public. Defining notes as securities along with other types of questionable vehicles/investments is solely to protect the public and create mandatory disclosures when those investments are being marketed to the public. The definitions are to some degree, meant to be flexible.

In that idea is where I think folks misunderstand that it was never meant to be a list of black and white ideas. Rather, a concept that can be applied to protect the public in various settings on various types of potential investments. Additionally, the presumption seems to be that a partial note sale is equivalent to a whole note sale and that is materially note true. That said, we always have to look at all the details to understand if the investment 'may' or 'may not' be exempt from registration as a security.

It is because of this much broader set of ideas that I do not advocate for investors to play with partial note sales. The ones I see pop up are almost always violating one of the concepts above with how they are solicited, how they are structured and how they are restrictive forcing reliance on third parties.

It is because of all of that I find myself saying that newbie note investors should really leave the ideas of partials alone. In my opinion, more often than not you are doing it wrong. The act is much more complicated than most even begin to think about let along understand.

To rebuttal the idea that "it is probably OK because others are doing it" - well we have a guy right here doing it and apparently doing it wrong. So, that defense doesn't seem to be strong enough to rely on.  

I suppose at the very least, those who have not paused to think about all the other rules that might apply now have some insight that - other concepts apply to the actions that are often seen being carried out in the market place and that doesn't mean they are proper.

It's part of the securities rules I spoke to a securities attorney about before I started creating and selling notes in 2010.  It can't be a public offering, the note can't be fractionalized (only selling a portion of the return) and must be real estate based.  If the note is assigned, it should be assigned in it's entirety.

Fractional note contracts have been around for many years and many (including myself) use them successfully without issue.  Most of the major funding companies I am aware of, who make a business out of buying owner finance paper, use partials on a large percentage of their purchases.

Dion makes a point that a fractional note sale can be considered a non-exempt security if the buyer's interest is not secured by real estate.  Darren makes a point about complete assignment.  I won't dispute these assertions one way or the other, but I will say that the contract used to implement the strategy is the key element here.  Generally speaking, contracts for buying and selling subset of the remaining payments due under a note and security instrument do not remove the collateral security.  Also, every front-end partial contract I have reviewed calls for the note to be assigned in its entirety to the buyer, who agrees to assign it back to the seller again once the payments due under the contract have been paid.  It is important to understand that the underlying note and security instrument does not change at all with a fractional purchase contract.

There are provisions in the contract for dealing with scenarios like early payoff, default, foreclosure, etc.  The terms of the contact related to these scenarios are important and tend to vary contract to contract. They can be biased to the benefit of the buyer or the seller, and because of this it is important to review and understand how things will play out should one of these scenarios arise. 

Dion's point about partials not being suitable for newbie investors is a good one.  They add a layer of complication on top of something which can be complicated enough as it is.  On the other hand, buying and selling of partials is an important and valid strategy which can make many deals possible which would not be possible otherwise.  I would recommend legal review of the contact if you are unsure.

Originally posted by @Mike Hartzog :
Mike, you said it so well.  We deal in partials as well and have been for a couple of years now.  The contract is key, which is why, as you say, have it reviewed by legal, or use contracts which have been created by those who have been legally and successfully dealing in partials for many years.  Notes can be a challenge for newbies.  They should get educated before diving blindly into this arena because it can be done wrong.  But I will also say, it is a very interesting area of investing which we enjoy very much.  Kudos to your explanation. 

Getting back to Robert's original question of "I bought 72 payments on a seller carried 30 year note. I am hoping I did not do anything wrong.", I would say that you probably did not do anything wrong since you are the investor, not the issuer/promoter of the security. 

Usually where a security is concerned and as so thoroughly explained by Dion, any securities violations would rest on the shoulders of the issuer of that security. As long as he/she followed proper procedures compliant with WA and federal securities rules, then both of you are most likely in the clear. This is a broad generalization since we don't have much detail on the transaction, character of the issuer and how you both have the contract set up, but as the investor you are less likely to have securities liability than the issuer unless there was some level of complicity between the parties. 

If you are getting the timely loan payments and the contract you signed with the issuer provides for the parameters that Mike cited, and the issuer has provided some level of responsibility for the performance of the note payments in the contract you executed, then it sounds like you will be ok.  Feel free to connect with me if you want to discuss further offline, I'm happy to help.

Bob

Bob is right. You as the buyer did nothing wrong - all these securities regulations are there to protect YOU.

A securities attorney made it really easy to understand without all the legalese: is the investor putting money without managing the investment? If so then it's a security, no matter which gimmick you want to use to get around it.

If you think about a loophole... Don't bother, someone else has tried it before.

Whether it's creating a llc together, a joint venture agreement, or another tactic doesn't matter. If the investor doesn't manage the investment it's a security.

Now here's the real deal... There is a difference between theory and reality. In theory you were sold an unregistered, non exempt security. In reality, the feds aren't going to kick down your friend's door unless you and many other people complain.

They are after Madoffs and other scamsters on American Greed. The guy selling a partial is the least of their concern. I'm not suggesting you should break the law, but you should weight the spirit of the law vs its application. The same way most people drive 75-80 mph on a 70 mph highway.

Well, one securities attorney who did a presentation to our REIA group a few years ago called it the "good deal exemption" which is where if it is a good deal and everyone is happy, no harm/no foul.

This is what most RE investors practice either with full knowledge of the issues or out of just ignorance of the law. 

As Dion pointed out, the seller can not "guarantee" a bail out of your funds if the loan defaults, but he can structure the contract in a way that he has first right to purchase the note back from you in a case of default.   If you trust your seller, this would relieve the hassle of having to go through a foreclosure process. 

As far as being "active" or "passive" in this investment, the loan servicing company is the only one doing any work.  They are collecting the payments (and hopefully the insurance and tax escrows).  They will notify you of the monthly payment or the lack of monthly payment.  The home owner is responsible for all aspects of the actual property.  Hopefully you are being "active" in the investment by seeing the valuation of the property and payment history before you make the investment.  

One thing to be aware of is the originator of the note.  If an investor is originating more than 5 notes per year, then a RMLO needs to oversee the process.  Otherwise, there could be Dodd-Frank implications which could effect the actual note.

I believe partial notes are a good way for investors to place smaller chunks of money with a decent return.  It also keeps their investment to asset value in a more comfortable range.  Many times you can find a placement where your investment in the partial will be at 50-75% of the overall value of the real estate being used in the deed of trust/mortgage. 

I am new to BP, so maybe someone can help me with my profile.   I am listed as a wholesaler, but I have experience in flips, long term holds, performing and non-performing notes. 

I would like my profile to say more than just wholesaler.  Anyone have any suggestions?

@Robert Fry  From my experience you have very little to worry about, with your purchase of 72 payments of a NOTE.  My disclaimer... I am not an attorney (but I am guessing no one on here is an attorney with the SEC with direct litigation experience on this exact issue...), I am a former Series-7 Stock Broker- General Securities Dealer, and I am a current CA Real Estate Broker for 22+ years.  

The SEC has at times gone after people who are unlicensed and offer securities for sale.  This is almost always when there is securities fraud involved, and a victim has lost money.  In some cases, there was no fraud and no loss of any money by investors.  Either way, you would be the "victim" not the one the SEC would go after.  You are not the one who offered a "security" for sale, without being properly licensed, and without proper compliance with securities laws.  

I did as much research as I could on Google in a 15-minute period to see what actually happens if you are guilty of offering securities without a license, and you did not commit fraud.  I found 2 cases where someone / or a company, was unlicensed and offered investment advice and offered securities for sale.  Neither one of them went to jail.  In one case, a guy without a license was able to raise $500 Million (I would hire this guy!), from investors.  The SEC came after him, he was ordered to pay $375,000 in fines, or less than 1/2 of 1% of the money he raised. 

My point here is not to make light of the law, or the risk of penalty for breaking the law.  My point is to answer the question from @Robert Fry... , who is concerned about doing something wrong.  

Here in CA, RE Brokers arrange loans and notes every day, and they are licensed to do it.  I have no idea if they also have some kind of SEC exemption because they hold a RE Broker's license, but I am guessing CA would not allow you to do it, if it were deemed illegal by the SEC.  Again, if a RE Broker or owner of a NOTE solicited you to purchase 72 payments, or offered 72 payments for sale, the burden of proper licensing, and proper compliance and disclosure would be on them and not you.  Have a great day :-)  (If I am wrong, and you get sued and go to jail for the rest of your life, by reading this last sentence, you release me of all liability!)  

In all investment offerings, you can never be SURE that your offering is not a securities offering.  An attorney will offer only his opinion, not any kind of guarantee.  Further, the only way to insure that your offering of a security is an exempt private offering, is to comply with the safe harbor exemption of Rule 504, or if an intrastate offering a similar setup at the state level.

As a practical matter, the issue for the small, occasional deal maker would only arise if an investor lost money, sued the deal maker, and claims the sale of an unregistered security with out the private offering exemption.  

Personally, I HATE the fact that we live under a regulatory environment in which a guy with a good investment or business idea can't shop it to some people and obtain risk capital without worrying about arcane issues of compliance and disclosure written into law 80 years ago when the world was a different place.  However, on the plus side new legislation makes it quite practical for even relatively small sums of money to be raised in compliance.  However, the deal maker will have to front about $10,000 + for legal fees to use the safe harbor 504 already mentioned.

@Mike Hartzog  said above that "every front-end partial contract I have reviewed calls for the note to be assigned in its entirety to the buyer, who agrees to assign it back to the seller again once the payments due under the contract have been paid." This implies that the buyer of the partial would have the right to foreclose on the borrower in the event of a default. In that case, wouldn't the exemption for notes secured by a home mortgage apply because the buyer of the partial stepped into the shoes of the seller? It does not seem the same as the case of a promoter offering a guaranteed passive investment and maintaining title to the note the whole time.

@Don Konipol

I just went through 4 rounds of my partials agreement with two attorneys and the logistics on these are very complex as you have written. The biggest takeaways I got from them are

1. You cannot advertise them like you can when selling a full note - especially if you are keeping control of the note.

2. Similar to a JV deal if the note becomes non performing then you want the partials buyer to be an active participant in the resolution.

There are a lot more complexities involved. One thing you may want to consider is to have the individual provide you with a loan backed by the asset vs. selling a partial.

What baffles me about this recently is I see companies popping up offering fractional ownership of properties - I am always curious how that does not violate SEC regulations

@Chris Seveney ,

A private placement, or private offering of a security is an exemption from SEC registration, if indeed the offering is a private offering and not a public offering.

Problem is that the definitions are unclear, and hence the SEC can rule either way.  Then the offerer is left with the option of accepting the SEC fine and punishment, or fighting it in Federal court.  Further, in a civil lawsuit claiming monetary damages by disgruntled investors, the offeror will have to defend his actions against a variety of charges based on non compliance with state and Federal statutes.

So, years ago, the SEC established a safe harbor for private placements.  This is the famous Regulation 504, 505, and 506 (b) and (c).

If an issuer complies with the provisions of Reg D, two good things occur.  (1) the issuer is automatically granted private placement status, with no further possibility of the offering being declared non compliant and (2) in regard to any civil lawsuits, the offerer can use compliance with Reg D as a difinitive defense.  In other words, absent fraud, a disgruntled investor would not be able to use non compliance of securities laws, inappropriate investment for investor, misleading investment pitch, etc. as a legal issue.  As a practical matter no attorney will pursue the case on a contingency basis under these circumstances, so the usual tatics of some investors of suing others for bad investments are eliminated.

So, a private placement does not have to occur utilizing RegD to be compliant with SEC regulations, but the advantages of Reg D are such that for all but the smaller offerings it may be worth the time and cost.  

In regard to active participation, should you come to me with an investment proposal, and we both will be active in decision making, that is not a security offering, it’s a joint venture or partnership.  Should you come to me with a investment proposal in which I will be a passive investor, that is a security offering.  If we have an existing relationship, the offering is a private placement and exempt from securities registration based on the general exemption for private placements.  Should the same occur, we both live in the same state, and the property is located in that same state, and we do not have an existing relationship, you can either claim an exemption from registration based on an intrastate offering ( andcomply with the securities laws of that state), or wait 90 days after contacting me to accept my money so that we now have a pre existing relationship.

Realistically, SEC ever looking at one of my deals and declaring it non compliant is virtually nil.  The reason I utilize Reg D 506c is twofold.  First, it virtually eliminates lawsuits should any of our investment participation’s lose money.  Second, having a PPM, Operatinf Agreement, Subscription Agreement, and filing with the SEC under Reg D provides a level of comfort and confidence in our offerings to investors.

@David Fligor a partial sale involves a receivables contract and usually there is language which defines what happens should the borrower default. Usually the seller of the partial has rights to repurchase the note and pay off the partial buyer so that the seller can foreclose and recoup his or her investment and equity in the property.

Since the note is assigned to the partial buyer for the term agreed, that assignment is a transfer of the asset -- so there is no "investment" made by the partial buyer that would be subject to regulatory exposure by the seller.

@Don Konipol @Chris Seveney   One thing I have learned the hard way is attorneys are not always correct or their interpretations of the laws are not the same as regulators..  These securities issues are quite complex and to prove your point against a regulator will cost far more then just doing as Don advises up front .

Chris as to real property.. the difference is a NOTE is a SECURITY  and then there are exemptions.

Real property is real Property.. so you can have tenant in common interest.. and all sorts of different vesting's.. IE life estates we see these are somewhat state specific..  joint tenants on west coast.. tenant in their entirety in some states.

etc etc. 

@Bob Malecki   Bob on another thread was asking about a fractionized interest in a Note in WA.. he did the prudent thing and asked the regulator for a ruling which he posted on BP... my reading of it .. was not legal in that state with out a security offering. and I know its not legal in OR I got in trouble for that .. in CA its the way we always do it and its legal .

So state specific.. I do believe the partial could be construed needing a securities offering but I don't do them so not really worried about that we only do whole notes.

@David Fligor   NO WAY you can guarantee a note with out a very robust securities offering.

@Jay Hinrichs thanks for answering about partial interest. 

so hypothetically (writing this tongue in cheek) you could sell a partial interest in a property then get someone on a land contract on the property and if done properly sell partials on the land contract as well.... not something I am by any means recommending or saying is legal but if done and a default try and figure that one out. 

Originally posted by @Chris Seveney :

@Jay Hinrichs thanks for answering about partial interest. 

so hypothetically (writing this tongue in cheek) you could sell a partial interest in a property then get someone on a land contract on the property and if done properly sell partials on the land contract as well.... not something I am by any means recommending or saying is legal but if done and a default try and figure that one out. 

not sure about the second half of your question but the first half for sure you can sell tenant in common interest in real estate.. now they are not very liquid..  we call them TICs these were used to circumvent the landlord tenant rules in SF for years.. 

But TIC happens a bunch when lets say you and I want to own a property together but don't want to own it in an LLC we just want to own it in our IRA's then rent it out.. Jay puts up 60k Chris puts up 40k we paid 100k Jay has a 60% tenant in common interest and Steve has 40%.

We do this a TON in foreclosure and tax sale rescues.. now I will say 75% of the time when we do this and rescue someone we are then having to go to court to have the judge force the sale of the asset.. I have one going now.  the people we rescue are fine and dandy when we rescue them.. but then when it comes time to sell.. Even though they are going to get their dough.. they balk. and then it cost me 10 to 20k to get the judge to rule and force the sale.  So for no equity deals I would not suggest it for those that don't know each other.

for family members and like mind folks not so bad..  

@Jay Hinrichs Be careful re real estate. Even if you structure your real estate as a TIC (or any other creative structure) it still may be a security. The rule is essentially any time you take other people's money and the returns are generated from your efforts, (in other words you are active and investors are passive) then you are dealing with a a security and must comply with both federal and state securities laws. So if you take money from 3 passive investors and give them TIC interest (as opposed to an LLC interest), that is a security. Actually even 1 would be a security, so with 1-5, you want to make sure they are ACTIVE participants. Ideally co-managers.

Hope this helps.

Mauricio

Originally posted by @Mauricio Rauld :

@Jay Hinrichs Be careful re real estate. Even if you structure your real estate as a TIC (or any other creative structure) it still may be a security. The rule is essentially any time you take other people's money and the returns are generated from your efforts, (in other words you are active and investors are passive) then you are dealing with a a security and must comply with both federal and state securities laws. So if you take money from 3 passive investors and give them TIC interest (as opposed to an LLC interest), that is a security. Actually even 1 would be a security, so with 1-5, you want to make sure they are ACTIVE participants. Ideally co-managers.

Hope this helps.

Mauricio

I get that ..the Howry test.. what I am talking about is family members close associate etc etc. not going out and doing a TIC to circumvent the securities laws. this is why the SF guys that were doing TICS got shut down.. :)

Originally posted by :

@Bob Malecki  Bob on another thread was asking about a fractionized interest in a Note in WA.. he did the prudent thing and asked the regulator for a ruling which he posted on BP... my reading of it .. was not legal in that state with out a security offering. and I know its not legal in OR I got in trouble for that .. in CA its the way we always do it and its legal .

So state specific.. I do believe the partial could be construed needing a securities offering but I don't do them so not really worried about that we only do whole notes.

@David Fligor   NO WAY you can guarantee a note with out a very robust securities offering.

 Just to be clear, in terms of the state, it's not "illegal" to execute a fractionalized deed of trust but it requires an exemption with the state. So from what I gather it is technically possible if the state consents to an exemption for it.