Free Up Capital, Fund New Deals

Dennis Baranowski:

So at first would on behalf of Kyle and myself, I'd like to welcome you to the latest installment of Geraci Webinars the new normal educational series. Our webinar today is called Free Up Capital and Fund New Deals. So just as a quick intro for those of you who have not worked with myself or Kyle or met us at a conference or through some other medium I'll just kind of tell you a quick little bit about each of us. I'm Dennis Baranowski and I'm a partner at Geraci and I work primarily with the banking and finance department here. I represent clients with respect to complex loan transactions, loan sales, participations, high classifications, and pretty much any other contract matter that doesn't really fall into your standard loan transaction as well as I council clients concerning structuring of financing compliance with state licensing disclosures as well. And then also we have Kyle and Kyle's an associate in our banking and finance department, and Kyle handles most of our larger balance and commercial loan transactions as well as loan sales hypothecation, he assists, represents the servicers, and then he also helps with other complex commercial transactions. And Kyle also advises on consumer and commercial compliance issues on behalf of our clients as well.

So let's go ahead and jump into this. So our agenda here today just kind of giving you an idea of where we're at. We're going to give you more of a 10,000 foot view rather than in an introduction to a lot of these concepts rather than giving you a deep dive we take any one of these and we would be able to present a quite lengthy webinar on each individual topic, but we felt that it was important based on the communications that we've been having with our clients that we present and offer the information on all three of 'em in this webinar here today. So like I had said, mentioned, we'll be introducing you to fractionalization, participation, and hypothecation. We'll also discuss how to evaluate which approach is best for you as well as for your investors or third party that will either participate in the loan or lend to you through hypothecation.

We'll also discuss some compliance considerations and then at the very end we'll have a question and answer section. We're going to try and finish with hopefully about roughly 10 to 15 minutes remaining. Based on the topic and the material we might be a little short on the time at the end. So your microphones are going to be muted. So if you have any questions during the webinar you can type them in to the q and a section and then we'll do our best to address them at the end. And then if your questions aren't answered by either one of us we'll do our best to get email response out to you to each of your questions.

And then finally, I just wanted to let you know like our other webinars we will be sending out a follow-up email with a copy of all the slides you see today as well as a recording. So in case you wanted to watch it or clarify something or just happen to come in late you will be able to view the recording along with some other materials and an article as well. So you'll be getting that later on today. So kind of going into this and the reasoning why we decided to discuss this topic today was really since the pandemic, we've really found that a lot of our clients and just non-conventional lenders in general have kind of faced two major hurdles to their business. The first challenge just being the decrease in actual number of originations.

And then the second challenge is reduction in available funds to make loans especially with respect to lenders that whose business model relies more on lines of credit from banks and other institutional lenders as well as selling loan portfolios to institutional buyers or to buyers that would package and pull those loans and either sell them to the institutional lenders kind of acting as the middle man as well as our lenders that are relying on freeing capital using the collateralized loan obligations. It's been a real challenge in finding that capital because the lines of credit from banks, a lot of banks our clients experienced issues with the banks, either suspending advances since then, some of they've been able to open back up but also there's kind of a tightening of the purse strings and tighten of credit where it's a little bit more difficult to get any type of line of credit from an actual bank.

And then with respect to the sale of loan portfolios and just loan sales in general what our clients were facing initially were just the market really wasn't out there for buyers. And right now the bigger issue is not so much not having buyers available. There's a disparity between the seller as the lender and the buyer right now there's a pretty large gap between expectation because the buyers want to buy the loans at a pretty big discount, whereas sellers, their expectation is to sell the loans at par and faced with those challenges fortunately origination seemed like they're trending well gradually in the positive direction. But of course as we come to a situation where we have more new originations that just kind of compounds the need for capital in order to make and fund these loans that are now being originated. So in order to do this, a lot of our clients are turning back to methods that they were using seven, eight years ago and really by leveraging their existing loan portfolio as well as loans that they're making in the future in order to create available funds. And the three more most common methods that they're utilizing are just selling fractional interests in the loan, selling participation interests, as well as hypothecation. And so those we will cover each one of those today. And I'm going to turn it over to Kyle right now to give you an overview of each of these areas.

Kyle Niewoehner:

Thanks, Dennis. So the first option that we're going to be discussing is sale of fractional interests in loans that you've already originated. And this is the most sort of simple of the different options we're going to discuss. This is just selling a piece of a loan that you already own. And for those of you who broker have brokered multi beneficiary loans, this is really the exact same concept except instead of having your multiple beneficiaries on the original loan documents. You essentially do the multi beneficiary component post-closing and so you know have a sale agreement for the interest in a loan, and then that's going to be evidenced by a recorded assignment of the deed of trust or mortgage if you're in a mortgage state. And then it'll launch to the note directing for the payments on the fractional interest to go to this new investor. And the buyers here are going to realize a return on the investment just the same as any other owner of a loan.

So they now have a right to receive the interest, the income on the portion of the loan that they own. One thing to note on that though is oftentimes a seller is going to maintain the servicing or management rights on the loan and they may keep a yield spread, maybe a point or half or two points somewhere in that range as a servicing fee. And so in the case of selling a fractional interest, you may have less than the full interest on that part of the loan being realized by the buyer but that's going to be negotiated by the parties at the time of the sale. And another thing to keep in mind on selling fractional interests is the state law. So California allows the sale of fractional interests, but if you're going to go into other states and try to do this, you would want to check and see if there are any restrictions in that state, and we can definitely help you with that if that's something that you're looking to do. And for a fractional interest transaction, if the borrower goes into default again, it's just like a multi beneficiary loan where the buyer has the rights of a secure lender and they're going to be realizing the whatever return comes from the enforcement actions. Ultimately, if you get through a foreclosure sale the additional beneficiary the buyer is going to have direct right to whatever funds are recovered through the foreclosure sale or through whatever other enforcement actions are taken.

Dennis Baranowski:

And I'll kind of jump in here with some of the additional considerations with respect to self infractional interest. And one interesting thing to note is that Kyle had mentioned that oftentimes when selling a fractional interest what we'll call the originating lender, although it's really just the party that owns the loan at the time we'll will retain either servicing rights or some type of yield spread when they transfer it. So just by way of example, if the no rate is 8% the originating lender would retain, let's say a point or, and then the actual return on investment would be based on a 7% interest return for the investor.

The nice thing about that is that the originating lender can actually sell a hundred percent of the loan, so can't sell more than a hundred percent. Obviously at that point you're committing fraud but you can sell up to a hundred percent of the loan and still retain some type of residual income from that loan that was originated as well as any origination fees that you may have earned at the time the loan was closed. And so I think that's really a great opportunity for you as a lender or even as just from the standpoint of being a broker that maybe has a certain amount of funds that they can fund their own loans but when need to be able to free up those funds again quickly you can sell a hundred percent, you can sell the par at that point, you have nothing really left monetarily invested into that loan but at the same time, you're still going to receive an income stream with respect to that as well as for instance, I know a lot of you have repeat borrowers and then parties that you've established long-term relationships with. And it also would allow you to stay in the deal, so to speak, and oversee the servicing. And while your obligation is going to be to the investors you can also make sure that that things are handled fairly and that you don't burn any bridges in the process of any type of foreclosure or anything like that needing to happen.

The second thing that I wanted to just touch upon is most of the time you're going to find each of these lenders and each of the beneficiaries on this loan with the factual interest the priority's all going to be the same, meaning when the payment comes in each month, each lender gets paid prorata, their interest in the loan up to whatever their interest in that loan is. And the same thing is if there's any type of sale of the property foreclosure sale pay off, everybody gets prorata and shares equally with respect to any type of downside. So if there's a loss on the loan, each of the beneficiaries would share that loss equally, and that's in your standard transaction. The one thing is I'll discuss later on is these transactions, all three of the different vehicles that we're discussing today are very customizable, meaning the beneficiaries could enter into an agreement amongst themselves whereby one beneficiary would agree to maybe take a lower return on a loan in return for being you the first money out, meaning they have priority payment first.

Or maybe someone says, I'll take the risk, but I want all the upside if we foreclose. There's a lot of different ways that you can approach selling fractionalized interest and especially once you get into agreements amongst the beneficiaries. But in its simplest and pures form all the beneficiaries the fractionized interests will be treated equally in paid pro ratta. But I did want to point out that there are other options that to how you can proceed and possibly make it more appealing to your investors and fit their needs and tailor to their needs and their respective risk tolerances.

Kyle Niewoehner:

So the basic advantages and disadvantages of selling fractionalized interests are first of all, obviously the seller is going to free up part or all of the capital that they invested in that original loan, and then they can go in and use that to fund new deals. And on the buyer side, they get a loan investment without needing to originate and go through that whole process. They just skip all of that legwork and they just have an interest in a loan and they just have a much easier process. And obviously there are people who have that as their business model rather than wanting to go through the origination process. And the disadvantage is Ms. Solar is giving up some control of the loan. As Dennis mentioned, that recovery here is typically rata, and as you know, someone is going to own part of the loan, they're going to have some say in how things get administered and enforcement actions.

And of course the parties typically are going to document exactly what those arrangements are at the time of the sale. So you know, can negotiate how much control you're giving up, but as a new beneficiary, they're going to have some say. And then the other thing and one of the major differences you'll see between this and participation agreements for a fractional interest, this is public records. So the sale takes place and is evidenced by a recorded assignment of the deed of trust. And so from the barber's side, they can look at title and they're going to know, okay, there's a new lender that that's on my loan. And so the party that is buying is going to be disclosed. And for people who necessarily don't necessarily want to be disclosed as a beneficiary of record and kind of have that direct relationship with the borrower, that is a disadvantage.

Dennis Baranowski:

Can I just wanted to jump in real fast if it's okay, Kyle, just I'm an additional probe but also can be a as well is there's no requirement that these fractional interests be sold at par. So technically you could sell that fractional interest above or below par and maybe in times where you know, have a performing loan and it's appealing law transaction maybe the fractional lender investor would be interested in paying a little bit of extra money to obtain an interest in the loan. Conversely, obviously you're looking at our current environment and you some more savvy and conserv conservative buyers may want to come in for and try and get in for less than par at this point. Obviously these really don't work well for you unless you're selling those interests at par. But if you're able to retain servicing and get that yield it could be to your advantage depending on how far below par you go to maybe negotiate that. But again, you have a performing loan at this point. I don't necessarily think that it's as necessary to try and sell off loans below par but if you did often do it there are ways that you can still retain certain benefits for yourself if you were to do so.

Kyle Niewoehner:

Yeah, thanks Dennis. Next option here participation interest. So the participation, a agreement structure is somewhat similar to selling fractional interest except it's a step removed. Rather than the buyer coming in and becoming a lender of record and buying a direct interest in the loan they make an agreement that's purely a contractual arrangement with the original lender and they're going to make an upfront payment to that original lender for the right to receive the future income stream, the interest from this loan. And so rather than having that direct relationship with the bar that you have, when you purchase a fractional interest, you only have a contractual relationship with the original lender. And so what that means is if there's anything that goes on with the loan with the borrower, it's going to be the original lender who's going to take care of that. They're going to be in communication with the borrower and they're going to deal with any type of servicing, administration, enforcement actions.

And from the borrower side, there's no change. They're not going to see anything happening with the participation because the only agreement is going to be between the original lender and then this new investor, the buyer of the participation interest. And so the buyer has a right to receive the interest as specified in the participation agreement. And here again, the original lender who's selling the participation interest can sell however much of the income stream that they want to that that's purely discretionary. And so you can just sell part of it, you can sell part of the interest to a bunch of different buyers or you can sell the whole thing. And again, as with the fractional interest, you could sell all the interest but keep part of the interest as a servicing fee and keep some income stream from loan that way but get as much money out as you can with the participation agreement.

If the would default, then the buyer who now owns a participation interest is relying on the original lender's collection efforts. So the buyer here has no rights against the underlying borrower or against the underlying collateral that is securing the loan. And it's going to be laid out in the participation agreement exactly how the recovery works. Often the buyer is in line to get their original investment out first in light of an enforcement action or foreclosure sale. But that's up for negotiation. And also it obviously is going to rely on what happens and how the seller does in collecting and enforcing the loan. So when you enter into a participation from the buyer side, you're really reliant on that original lender and their administration and then how well they're going to do enforcing the loan and making sure that you get your money back because there's no direct recourse to the collateral in the event something does happen and the participation buyer doesn't get their full investment back, their only recourse is going to be against that original lender. And oftentimes in the participation agreement, the original lender doesn't have any obligation to return the investment to make the buyer whole outside of what they get from their borrower.

Dennis Baranowski:

All right, so I just wanted to clarify a couple things. One is for those of you who who've worked in the credit union world the participations we're talking about here are a little bit different than what you see when credit unions participate in a loan together. This truly is the sale of a contractual ride to income stream and there's really no ownership interest in the underlying loan provided. But that being said, the one nice and interesting thing about participation interest and really any of these different methods of raising capital that we're discussing here today, it's highly customizable. And so if your investor says, no, I really do want some type of ownership interest, I need to change how the structure is, I need to be tied to the loan somehow. You don't have to necessarily record an assignment but I would like to still be deemed an owner, which has its own own challenges in doing that but you definitely would there, there's some real compliance both from a security standpoint as well as if potentially licensing things that you would need to make sure that you do if you were to actually sell more than just an income stream.

While there are compliance requirements for that, which we'll talk about in a little bit later it differs. So we'll just kind of look at the right now as and talk about really selling that income stream. So because the participant which is who I'll refer to as the party that's buying the interest, the participant is really walking in and not having any type of ownership interest as opposed to a ized loan sale or even a collateral interest which you'll see a hypothecation would provide to 'em there. There's a little bit more of a risk I would say to the participant than in the other options that we're going to discuss today. So what that usually means is there often is in order to entice investors to purchase participation interest, there often is some type of allocation of risk where maybe the participant is going to be their money's the first out.

So they can realize both getting paid any type of accruing interest or the monthly payment that they're due under the loan, as well as making sure that their initial investment is paid back with any type of principle pay down. So that's one way that you can make a participation interest a little bit more appealing to an investor. Another way that you can do it is actually to provide a return rate to the participant, maybe the higher than the actual return rate. The interest rate is a loan. And you ask, well, why would anybody want to do this? Well it would really be based again, on allocation of risk because maybe if you give them a higher return ready, everybody either sits in the same boat so to speak, and any type of interest payment or principal paydown resulting from the sale of property, refinance or foreclosure any of those payments would be also distributed maybe by giving a higher rate to return to the participant, maybe they're the last money out maybe.

So if the foreclosure sale is not sufficient to pay off both the remaining interest that's being held by the originating lender as well as the participation interest, the participation the participant is going to be the one that takes loss of that. So there it is. It's really interesting and a different variation that you can create and again, to really tailor to what your needs are as well as the needs of your investor. But again, it's just kind of within reason. And obviously it needs to remain legal and compliant with any statutes and regulations. But if you could dream it in a participation standpoint it's probably possible. Again, it may not be advisable or desirable really from the standpoint of what I found is in situations where we've assisted clients with drafting participation agreements and structuring the sale themselves, the more complex the distribution the more complex the relation between the participant and the originating lender the more variations, the harder it's going to be for you or a loan servicer to keep track of it administered the loan.

And what I mean by more complex is again, really looking at going, okay, who's having differing risk allocation having a higher rate of return than the interest rate for certain participants in exchange for them assuming some type of additional risk. I've also seen it where the waterfall that would occur following a refinance take out of the underlying loan ends up being something completely different than the waterfall that would occur upon the foreclosure of the loan. So again, the more complicated you make it, the more difficult it's first of all, and difficult it's going to be and more negotiated the transaction's going to be been my experience. And then also from an administrative standpoint, if you're not familiar with participation and you don't have the underlying resources to manage the differing terms if you're going to sell participation interest in a loan, it it's going to be best to really try and keep it as simple as possible because you definitely don't want to put your self into a position of where you're taking improper actions or you're giving too high of a return to one participant or not enough money.

Those can end up being an invitation to a lawsuit. So the easier it is to understand the inner workings of the structure of the participation, I think that the easier it's going to be for especially for people that have never really delved into this world before to actually administer it. So maybe the takeaway on this is going to be if this your first one, I would start off pretty straightforward and basic as you go through this and you worked with 'em more and you understand what it takes internally to administer and the law, the interest then maybe you can start changing up your terms a little bit more and allocating the risks in different ways. But yeah, participation I find really fascinating because they're, the contractual rights is really contractual, right? That's created. So because it's a contractual right, you can contract around and to conform and to really meet just about any type of legal structure that you can imagine.

Kyle Niewoehner:

So some of the basic advantages and disadvantages of the participation approach first of all, the seller, the original lender is going to maintain full control of the underlying loan and they're going to be responsible for all the servicing, administration, enforcement all of that. So correspondingly, the buyers doesn't need to administer the loan at all, doesn't need to participate in an origination although the buyer is still going to want to come in and do their due diligence on the underlying loan and everything because ultimately that's where they're getting their return. And as see there on the disadvantages the buyer's interest is unsecured and based solely on the contract. And so they're kind of secured in a derivative way because the participation agreement typically is going to provide that they get whatever is recovered in the event of a default. In the event of a foreclosure sale or something like that, there's going to be a waterfall as Dennis mentioned where there's an order to who recovers from the money that's left.

But ultimately, if the buyer doesn't get their full investment back after whatever enforcement actions are taken they're unsecured and their rights are going to be basically on the contract. And often, and you're going to see in a participation agreement, the original lender, the seller doesn't have any obligations to make the buyer whole other than what comes out of that underlying loan. So for this participant who buys in they're basically just going to get whatever comes out of the enforcement action and through the waterfall in the participation agreement of what happens if there's a default and there's not a full recovery who gets what. And then so there's no recourse for them to the underlying collateral directly.

The third option last one that we're going to discuss today. So hypothecation are kind of the more complex of the three, and the hypothecation is really just a loan that is secured by another loan or loans. And so the structure here is a little bit more complicated because you have another loan to document, and this way the new investor that's coming in is in as a lender but rather than lending to a borrower that is going to provide a property as collateral, the new lender is lending to a lender that is already owns a loan or a portfolio portfolio of loans, and those loans are going to secure this. And so there are a number of different approaches taken for how the documentation works on these. So on the security side, you may have an actual recorded collateral assignment at closing. So the original lender who is now a hypothecation borrower, may provide an actual recorded assignment at closing of their deed of trust, or if there are a bunch of them that it could be a bunch of assignments and they may record a collateral assignment that just says in the event of a default on this other loan that I'm taking out, this new lender is going to have a right to the ownership to be the beneficiary on this other recorded document, the original deed of trust that the underlying borrower gave.

However, a lot of times the lenders may not want to record a collateral assignment or they may not be able to. So depending on the jurisdiction, there may be restrictions on whether you can even record a collateral assignment because obviously a collateral assignment is, it's not exactly like someone is recording an interest in real property. It's a potential interest in real property. And so some jurisdictions are not even going to allow you to do that. And so in that case, what you may see is the original lender will sign and notarize an assignment of a deed of trust, and then they are going to provide it to their hypothecation lender or sometimes the hypothecation lender and the original lender may agree that this signed and notarized assignment of the deed of trust is going to be held by a third party, often by an escrow company.

And so in that case, the escrow company would hold this assignment of deed trust that is ready to record, and typically also the rest of the loan documents in the underlying loan. And so then there'll be an agreement there where if there's a default under the hypothecation, then the escrow company is going to go ahead and record that assignment of the deed of trust that will transfer ownership of the underlying loan over to the hypothecation lender. And so the Hypothecation lender will be secured that way. And so there are all kinds of also variations and all the scenarios that I just mentioned. And then the hypothecation obviously is a more complex type of transaction and there are a lot of different things and a lot of different options to consider. But again, the basic principle here is that you have a loan secured by another loan.

And so if there is a default, and typically a default is going to happen where the underlying borrower default and then that flows up through the hypothecation because the original lender is making payments on the hypothecation based on payments that they're receiving from their underlying borrowers. And so basically in a default it all just kind of flows up the chain. If the borrower is not making payments and then the original lender can't make payments to the hypothecation lender, then the hypothecation lender can take over that original loan receive the assignment of the deed of trust, and then go ahead and foreclose on that underlying deed of trust and have recourse to that real property to recoup their original investment. And the return here is a little bit different because the hypothecating lender is not receiving a return based on the original note, they're going to be receiving interest based on the hypothecation note.

There's actually a new note here and that's going to decide what the return is. But like we saw with the other two options where there's really a lot of flexibility on what the interest rate is and what the return is the parties negotiate what the interest is on the hypothecation note typically in hypothecation, I think almost always you're going to see an interest rate that is lower or maybe the same as what is in the underlying loan or portfolio of loans because typically that original lender is making payments on the hypothecation directly off of what they're getting from their borrower or borrowers. So that's typically going to be how the interest on the hypothecation or at least the starting point for that negotiation. And as I've kind of already gone through, if you have a default on the hypothecation, then the Hypothecating lender takes possession of the underlying loan or loans the collateral, and then they go ahead and can conduct an enforcement action on those loans because they, they're now the lender of record.

Dennis Baranowski:

All right, so classifications probably are the most common transactions that come across my desk out of the three that we're discussing here today. And as can probably be expected, and as Kyle mentioned there's quite a wide variation in what each transaction looks like. The one kind of common thing is typically we're going to be, in this instance, our client is actually the borrower because obviously we're sifting them with, we assist our clients with raising capital and we're freeing up capital so they can go out and redeploy it. So we're representing the borrower quite often in these instances. Occasionally it, it's a little bit different, but for the most part we're usually representing the borrower, which obviously is a completely different focus in what we're dealing with here.

So in dealing with it, we have one off high cation is great because it can be a single loan where you're just taking out a loan and that loan is going to be secured and tied directly to one other loan or it can be used as really a capital large capital raising tool where it ends up getting tied into an entire pool of loans. And in those instances, typically there there's going to be well rope in our securities group and in order to ensure that there's a compliance with applicable securities laws and regulations because really what you're doing now is instead of just being, oh, well I'm going to free up capital I'm going to borrow against this one loan here, you're now looking at really a plan and a method for you really to capitalize and raise funds for your company or maybe it's for your fund.

And so as a result of that you know need to make sure and that you speak with somebody and work with somebody that's familiar with securities because oftentimes, and this is a lot of the times where I end up working on high cations nowadays, is really in conjunction with our corporate insecurities team because it's become a pretty common method for a lot of our clients to leverage the loan pools. And so I'll usually, I'll work hand in hand with Tay typically and getting those things done but again, there's a lot of variation as far as how those are treated. Even once we get into it like Kyle had mentioned they can be borrower payment dependent meaning if the borrower doesn't pay, then the hypothecating lender doesn't get paid. There could be a limitation of recourse on those loans basically saying, look, it's fine borrowing the money from you, it's secured by the loan or loans but if there's a default payment on this, you get the collateral and we're going to call it a day. I'm not going to be liable for anything above and beyond that. So it again, if it's something where it's very customizable and can be tailored to the individual needs of both our clients as well as who their investors are,

Kyle Niewoehner:

So some of the pros and cons here the original lender can leverage the full amount of the underlying loan or loans. One of the ways that this can be really powerful is if you do secure it with your loan portfolio. And so it can be a way to kind of leverage your full loan portfolio or a good chunk of it at one time with one transaction. And then of course the hypothecating lender doesn't need to administer the underlying loan, it doesn't need to go through the process of originating the underlying loan, although in this case they obviously still do have a new loan to administer, but dealing with a lender is obviously substantially different than dealing with the original borrower where that's going to be a individual person or typically a smaller entity. And so there's some advantages there in the ease of administration. And then the potential risk here is the original lender can lose all the loan or the loan portfolio that they put up as collateral potentially without being made whole. If there's a default and your hypothecating lender for closes on your loan then you know may not be made whole. You don't have recourse to that underlying collateral anymore. So obviously as with any loan, the borrower puts up collateral and potentially if it's a default, you can lose your underlying collateral. So that's obviously a risk and hypothecation in that way are more risky for this original lender than the other two options we've discussed.

Dennis Baranowski:

All right, so why don't we take a look at how do you answer the question of which approaches is going to be best for you? And in order to get to that question, I think it's worth a quick recap and kind of general statement, and please forgive me, it's not going to cover everything as far as the real differences between the three so you know, have sale of fractionalized interest and in that instance you're dealing with an actual ownership interest in the loan that's being transferred From the seller standpoint, your liability is to the purchaser as far as any type of return on investment, unless there's some type of fraud or something like that involved is going to be passed on. So you're really not going to have any further obligation as far as the return on investments concerned. Granted, if you were to, let's say you retained servicing when you did transfer that interest, there's servicing obligations that are involved, but it's not with respect to the sale itself and I would differentiate between those two because your responsibility is not making sure that the full return on investments coming back to the buyer, it's really then in a collection and making sure that you're using best practices or that you've hired using best practices to service the loan.

So from that standpoint, your liability as a seller is lessened out again outside unless you go outside the scope of the actual sale agreement itself for the most part and the assignment and the launch as opposed to participation where participation is really just a transfer contractual to receive income. So from your standpoint on that, yeah, that's not too bad of a deal as well because obviously you're going to be able to control the loan. Really any type of a recourse that the participant's going to have against you is really going to be defined in that agreement. So oftentimes it may be where you assign an actual interest upon a default, you assign an actual interest in the loan. There's a lot of different ways that you can approach this, but at the end of the day, most of the time recourse against you is going to be limited to the associated loan or loans.

And then finally, obviously like Kyle mentioned, is a loan secured by a loan. And so a lot of investors that aren't necessarily huge fans of necessarily being the lender that that's out there and identified on the deed of trust or really needing to be active in the management and servicing of the loan do the idea of coming in as a hypothecating lender because they're a little bit more in the background and they also feel secured because they do have the underlying loan or loan securing their interest. So really, which approach is best for you? You could almost argue, and we could probably even discuss it in going through this, figuring out a way to tailor each of these transactions to come close to meet the needs of your client or your investor I should say. So it really ends up coming into a balance of needs and risk tolerances. So it's the first question you'd want to ask yourself is how much control do you want to give up?

How much do you want to need to deal with another owner of the loan? Also, do you want be in debt? Do you want to secure another loan? Do you want have that extra additional debt on your books? Do you want to secure a loan with another loan? What do you want to give up there? What is your risk tolerance? What is the risk tolerance of your investors? Do they want more security? Do they feel more secure actually being an owner of the loan and having a full-blown assignment of that fractional interest? Are they okay with being in the background and relying on their contractual rights that are established through the participation agreement? It really boiled down to what do you need and what do your investors need? What's going to be most effective for you knowing the people in the pool of investors that you would be taking this to, what's going to be most effective for you to raise capital?

Then we can go through and once you answer that question, then we can discuss ways to try and give and take through these different transactions because A, we've hopefully noticed a recurring theme, they're highly customizable. Then we kind of figure out, okay, where do we want to go? So the real question is going to be probably even the threshold is what do you want to give up and B, what is the investor requiring to receive in return? Once you answer those two questions, you can point get pointed in the right direction as far as what options going to be in the best and then we can then discuss and negotiate and tailor the terms within the respective agreements.

So the final thing is, and I'm actually going to, there are some questions that are kind of coming in here and I do want to try and get to them because they're actually relevant to some of what we're covering here as well. So just kind of relevant compliance considerations. The first thing to note is that these are securities, so you're going to need to make sure that they're either registered or there's an applicable exemption to registration, and that's going to depend on state law as well as potentially if you have investors that are coming in multiple states, then obviously you're also looking at needing a federal exemption on this as well.

But the bottom line is that there's securities and so you need to understand and proceed and treat them as such. So if you don't have and know what the applicable exemption is in your state or the state, the applicable state where you're selling this interest you need to make sure you get with somebody that does because there's a good chance that you perceive through this transaction and you don't comply with applicable securities law. I'm not going to lie to you. I know enough about this to be dangerous and understand and spot the issues. We have an amazing securities team I had mentioned Tay with whom I work with quite a bit on these types of transactions and so he wrote a great article in conjunction with the materials that'll be sent out on this later this week. And so I do advise everybody to kind of take a look at that as well because he addresses a lot of the securities issues.

And then the final thing is licensing and some states there's going to be a license required possibly by the originating lender in order to transfer it to third parties possibly just to broker the transaction between the originating lender and a third party investor that they're purchasing the that. And that's kind of both the securities as well as if you're complying with the licensing side. For instance here in California if you're complying with the licensing requirements and in making the necessary disclosures, then securities compliance will also likely fall into line. For instance, if you were to have the fractional interest sale brokered by broker that's licensed by and regulated by the Department of Real Estate, D R E broker involved in that sale transaction will also help bring you into the securities exemptions as well as ensure that the transaction is compliant in of itself. Because let's say for instance, if you're a CFL and you originate the loan and then you want to try and sell off interest you're not able to do that directly.

And so the way those things get accomplished or through the involvement of a broker as well as if you just don't have any license at all if you're going to sell it and it is advisable to have a broker that's involved in that instance as well, you're going to find it in states that require brokers to broker the underlying loan transaction, oftentimes those are going to be the states that will require broker involvement on the secondary sale of the interest of the loan. For the most part, we found that states that don't have any type of, especially with respect to commercial or business purpose loans states that don't have any type of requirement licensing with respect to licensing on the origination of the original law typically will not require anybody to be licensed in the sale. But again, I step back, just because there's not a license required does not mean that security laws and regulations are complied with.

There're two separate questions. So even though you may not need a license in order to do this or a license party's not required to be involved make sure that you're aware of how you need to comply with applicable securities law. And in doing so I think you'll be able to both enjoy a successful transaction and also kind of sleep with the peace of mind knowing that you're this transaction's not subject to attack down the road. Obviously if something were to go bad when people start losing their investments, obviously that's when you start seeing complaints from investors. And so one way to make sure that you bar that and protect yourself would be is to ensure that you're complying with applicable securities laws. So moving forward into

Moving into the next thing before we get to the q and a here I just want to remind everybody that the next webinar in our webinar series is going to be on October 27th, 22nd, I apologize, October 22nd and it was titled AB 3088. What Private lenders Need to Know and Release is to take a look at, for those of you who lend here in California, it it's going to be in-depth, look at California's Homeowner Bill of Rights and the changes that have occurred through AB 3088 and how they apply now to your business purpose loans here in California. So I encourage you all to attend, especially if you lend here in California. I think it's going to be a very informative session. So we invite you all to come in. So we have some questions here. Let's see in the q and a.

So let's see here. So I'm going to take the first question here and can you list a number of platforms or portals which we can fractionize sell our loan portfolio? Is there a maximum number of investors per each loan or deed? Yeah, so I'm aware of one portal that can assist you and I'm happy Michael or Mikel to forward that information to you but it, we've had a couple of parties that have tried to set up this portal and just over time it hasn't necessarily fit within their business model and they've pivoted in other directions. But I'm happy to get that information over to you so you can try and figure out who you can sell this to. Your second question, is there maximum number of investors per each loan or deed of trust?

So if you're looking at it with respect to when you and the initial number, so if you're talking about obviously here in California, if you're looking at a D R E broker brokers loan do, if you're relying upon the business and professions code as your securities exception then yeah, there is a limitation to the December investors that you can have. However if you claim an exemption through 25,102 F, I believe it is the correct subsection of the corporations code, then if you do it go and note it that way, then there is not a limitation. There is no maximum number of investors that you can sell that interest in the loan too. So I will get that email out to you with some information on unavailable platforms or pulled or portals that where you can potentially sell your fractional interest in your loan portfolio.

Kyle Niewoehner:

Another question we have here from David, would having multiple parties on the deed of trust accomplish the same thing from a security collateral standpoint for the lenders as selling a fractional interest? And the answer is yes. So the selling a fractional interest is essentially creating a multi beneficiary loan after the original closing. And so from a security and collateral standpoint the investor who purchases a fractional interest after closing has the same rights as a secure lender as if they had been a beneficiary on the original deed of trust in the original loan documents. So from the collateral standpoint of what their security is selling, the fractional interest is the exact same as originating a multi beneficiary transaction.

Dennis Baranowski:

And then we've run over a little bit, but I'm going to try and address a couple other questions in here just to make sure. And then to the extent that we can't get to them we'll follow up. But the first question in the chat is from Jeff, is which states allow a multi beneficiary fractionalized loan to occur and is there a place to look it up? That typically is a question that I work with our securities team on and Jeff, and I'm happy to I know that they had performed the research on this to create a list of states that do allow it as well as what their individual requirements might be. We've just internally hear from the standpoint of how we divide the expertise within our firm, we, we've kind of looked at that question as more along the lines of what our securities team does. And so I'm happy to get you in touch with somebody on that team or to go ahead and forward you whatever information I can pull up on that. Want me, I can take the next one here as well. So is selling fractional interest the same with selling a B piece? It can be

Selling fractional interest is just kind of a bigger

Pie and a bigger, more general description of the transactions itself. One variation on selling fractional interest is adding that B piece into the loan transaction. And just as a reminder, that B piece could either come in at the time of origination or post-closing. Since we're talking about selling fractional interests of closed loans, we will kind of look at it as just being, okay, well you're going to set it up and have a piece when you're selling interest. Yeah, that's essentially a similar concept. Again, like I said, the fractional interest itself is the general term while a BP is just a variation on what's available.

Kyle Niewoehner:

Next question here do you still record participation interests? For example, if I sold 50,000 participation in a 100,000 loan should I record an assignment for that 50% interest or is there no requirement to record if there are no participation interests as opposed to selling the full amount of the loan? So with the participation agreement approach, there's not going to be any recording. So in that example, you sell 50% of your loan you're really just selling the right to the return on that loan. And so there's no requirement to record anything with a participation agreement because it's purely a contractual arrangement between the original lender and then this participant, this buyer. And so that's one of the key distinctions between a participation agreement and an actual sale of the loan is that there's no recording, there's nothing of record. The borrower probably has no idea that this has even happened because it's just purely a contractual contractual arrangement between that original lender and then this new investor that comes in as a participant.

Dennis Baranowski:

Let's see. So the next question from Herb do you have any referrals for escrow companies that will hold the assignment of the Deta trust? And the original note typically we found is if you end up using a sub-servicer oftentimes that is who holds the assignment, the beta trust and the original note for the benefit of the lender. But that being said, as far as an escrow company, I think we just, it's kind of a general term that was utilized, and I assume this means when it's being held for collateral purposes you know, can utilize a custodian or like I said a service or even some type of third party that the key on all this is really that it's a disinterested, unbiased third party because that's really how you end up perfecting everything as well as ensuring that it's fairly administered. Meaning if there's a default and you're holding the assignment at de to trust and until there's a default you want to make sure that whoever that third party is going to act under a strict set of instructions of, for instance, upon presentation and proof that the payment has been defaulted for X number of months that you shall record it.

So it's been my experience with a lot of our clients often will use the loan servicer, the servicer, servicing the underlying loan. Let's work best offhand that I'll try and think of specific escrow companies, but to be honest with you, usually when this comes through, we really have come up with other solutions then than locating a specific third party escrow that all they're doing is holding the documents. So I know in larger transactions they're custodians that can hold it and where it ends up being much more important to the parties involved just based on the size of the investment that we're dealing with. But in general, it usually is not the case. It ends up just being held by, like I said, either the servicer or servicer.

Kyle Niewoehner:

So this next one doesn't require a security registration on behalf of the borrower. So Hypothecation is a new security, and I think Dennis has kind of touched on this earlier, but you are going to need to deal with securities compliance. So on the original loan, that's a security you're going to need to deal with it, either registration or what we see almost exclusively as people operating off of exemptions. And then the hypothecation is another security. It's a security in its own. And so you will also need to deal with that securities compliance issue there typically, again, by finding an exemption but I'm not sure exactly what is meant by on behalf of the borrower essentially for the hypothecation, then it's a hypothecating lender that is going to need to worry about making sure that they deal with the securities compliance issue. I dunno if you have anything else to add there, Dennis?

Dennis Baranowski:

Yeah, and I think I understand. So Jeff, I think when Jeff is referring to borrower, I think he's referring to the originating, what I'm calling the originating lender and not the underlying borrower. So yeah, absolutely. I think I covered this, albeit probably not as in depth as you'll be able to get from a member of our corporate insecurities team but yeah, you do. There would have to be registration that occurs unless there's an applicable exception. So next question is from Herb, is there a securities issue of two lenders have a percentage ownership interest on a hypothecation loan?

Potentially, yeah, because obviously it depends on if the security interest that's being pledged, the collateral that's being pledged overlaps, meaning you're a claimed a hundred percent interest going to the other parties. Or even really if you're looking at just multiple lenders in general, there's going to need to be some type of disclosure to the different lenders. Obviously if there's somebody else that's going to be tied into this collateral the investor needs to know you can't just leave them completely in the dark. And so that's obviously the first little bit there. And then if there's overlapping security that's that's just a huge problem to begin with because at that point you're now over collateralizing yourself or I should been under collateralizing the loan really. And if those investors aren't aware of the fact that they're under collateralized, I think you're going to run into some serious securities and notification issues, not to mention just fraud and other basic tort and contract causes of action because that type of practice is going to end up hurting somebody and someone's going to lose money.

That's why oftentimes when we are, one thing is obviously in the documents, making sure if they're going to hypothecate two additional lenders, then it's clear that there could potentially be some type of dilution of the interest. And that often happens. And that's why when we get into any type of bigger offering, especially with the hypothe we work so closely with our securities team because oftentimes it ends up being a debt offering that really needs to be accomplished. And then through that debt offering all the disclosures as far as dilution of collateral and other things like that, the fact that there will be other lenders that are secured by the same security what the waterfall's going to look like, what's priority looks like, all that good stuff you're really getting into a much more complex transaction and you would want to make sure that you do register that. And more than likely, it would really be a debt offering.

Kyle Niewoehner:

So Michelle asked what is the difference between Hypothecation and a credit line, and then I'm assuming here that she's asking about a credit line extended to a lender to make loans where you're taking money off of the line and then making loans and then it's secured by those loans that you're making. And so in that case, there's definitely some overlap. One of the big differences is when it happens, so a credit line is, in that case, is more of a forward-looking thing where the borrower on the credit line that's going out and originally loans has access to this credit line and they can take it and then go and make loans and put those on the line, whereas the Hypothecation is going to be taking place after these loans are already originated and is going to take preexisting loans and then borrower against those. But it is kind of a similar concept in that you're using loans to secure this other financing and then using that typically to make loans and then you know, could structure a hypothecation as a credit line potentially. There's a lot of customization you could do, but in kind of the basic scenario we're talking about, your hypothecation is just taking out a fixed amount of money.

Dennis Baranowski:

So just to add a little bit on that. So answer to that question is potentially yes, in certain circumstances it can be a credit line but if it's, it's going to oftentimes differ from, let's say, for instance, like a warehouse or a line of credit or rehab line of credit where really the goal is getting the loans off of the line and moving them into either just selling 'em or packaging in them and putting 'em into some type of MBS or clo. So that's why they differ from your typical lines of credit that are offered by a bank to a lender is really just the sole purpose. A hypothecation. The credit line really is meant to last for the duration of a specific duration. It's not going to be a short term you would get with a rehab or a warehouse line but at the end of the day, yeah, it can be a line of credit. It could also be a single advanced loan as well. So it really just depends on how it's structured and what the parties want.

So I'm going to wrap this up here. We've gotten about 20 minutes over. We have a few questions that are remaining. I promise you either Kyle or myself will respond to those questions and we will email those answers to you. Again, we really appreciate you all for coming out here and attending and sticking through our presentation today. Hopefully that you've all have learned something and I encourage you again to attend our next webinar on AB 3088. I think it's really important that if you're a lender here and you make business purpose loans here in California, that you understand what changes have taken place as a result of that bill passing. So thank you all again. It is been a real honor to be able to speak with all of you and hopefully we'll see you around soon.