Private money transactions are governed by Article Five of the California Department of Real Estate (DRE) Regulations. Article Five covers scenarios like pooling of funds, threshold reporting, and advertising to investors as these issues relate to private money transactions. Article Five is an incredibly detailed regulation, but there are a few things that brokers must know if they are to engage in private money transactions.
We’ll look in-depth at Article Five and how to comply with DRE regulations, below.
Pooling Funds and Permissible Self-Dealing Under Article Five
First, brokers should be aware of regulations surrounding the pooling of funds and self-dealing. Article Five strictly states that the funds deposited by an investor into escrow must be used for a specific transaction. Article Five also permits self-dealing on the broker’s behalf in certain situations. The DRE considers self-dealing to be a solicited transaction where funds will benefit the broker. Self-dealing is permitted when a broker presents the investor with a DRE-approved Lender/Purchaser Disclosure Statement (LPDS) 24 hours before the investor sends any funds to the broker.
Threshold Brokers: Reporting Requirements and Key Forms
Brokers negotiating ten or more loans secured aggregating over $1 million must submit a Threshold Notification (RE 853) to the DRE within 30 days of meeting the criteria. Brokers who service loans may also need to comply with this threshold reporting requirement, or risk penalties of up to $10,000. Threshold brokers must also submit annual reports (the RE 854 and RE 881) and quarterly reports (the RE 855 and RE 856 are the most common). If you are unsure whether you are a threshold broker, or if you are curious about exemptions to the threshold reporting requirements, seek the advice of an attorney who is familiar with DRE regulations.
Brokers take on a huge responsibility when taking on new investors to make sure the investors are financially sound. To aid brokers in determining whether an investor has the appropriate financial background, the DRE has provided an Investor Questionnaire (RE 870) that should be provided to all investors that a broker has solicited. The RE 870 is not a replacement for the LPDS, which should still be delivered to the investor as early as the broker can send it to the investor.
The Importance of Loan-to-Value in Private Money Transactions
If you have ever wondered why you must calculate the Loan to Value (LTV) for every loan, look no further than Article Five. Brokers must be wary of LTV because the penalties can be severe, so if your loan is creeping up on 80% LTV for single-family, owner-occupied properties, or all the way down to 35% for vacant land, you may consider asking the borrower if there is other collateral that can secure the loan. LTV gets more complicated for construction loans, where the completed value of a project may be used to calculate LTV (known as After Repaired Value or “ARV”).
Brokers who are not familiar with using ARV for construction loans should be cautious and consult an attorney first, because there are several limits on ARV, such as a $2.5 million maximum loan amount. More information regarding DRE construction loan requirements can be found here.
Acting as a Loan Servicer: What Brokers Need to Know
Although it is one of the lesser-known roles brokers take on, Brokers may act as loan servicers under Article Five. The compliance manual provides helpful guidance to brokers who may find themselves—acting as loan servicers— in the position to advance funds to protect the loan. Additionally, brokers acting as loan servicers may find themselves recording security instruments or other recording other real property documents. Here, brokers must be careful not to record these documents in the broker’s name but record the documents in the name of the investor. Recording the documents in the broker’s name may be considered table funding, and brokers should all be aware that California does not permit table funding.
Advertising Restrictions and Compliance with DRE Rules
Advertising activities are regulated by Article Five. Article Five does not permit brokers to offer inducements or gifts to investors as an inducement to invest. Despite the restriction on inducements to investors, an inducement that is not offset by other fees may be offered to the broker in certain circumstances. If you are unsure if your advertising activities are compliant with Article Five, or if you are unsure about how your brokering activities, in general, have complied with Article Five, it is highly recommended that you consult the DRE compliance manual and an attorney with DRE compliance experience.
Multiple Investors? Multiple Considerations
Often referred to as “multi-beneficiary” loans, a fractionalized loan is a loan where there are multiple beneficiaries named on the loan documents. Article Six of the California Real Estate Regulations governs fractionalized loans. The most significant rule Article Six implements is the requirement of the Multi-Lender Transaction Notice (RE 860). While there are three instances where a broker must file an RE 860, the most notable is when a broker makes their first fractionalized loan.
It is important to remember that fractionalized loans must still comply with Article Five, so an LPDS and investor questionnaire must still be provided for each investor. Brokers making fractionalized loans should consult the DRE compliance manual and speak to an attorney with a background in DRE compliance.
Investor Vetting and Identical Interests in Fractionalized Loans
Outside of the RE 860, the rules for a fractionalized loan are very similar to a loan with a single beneficiary with some exceptions. In advertising, brokers cannot mention Article Six or infer that an investment is guaranteed. Investor vetting is similar to a standard loan, but each investor must be vetted, and each investor must receive an identical interest in the terms of the Note. “Identical interests” does not mean the investors have to invest the same amount, but, as a general example, the investors must receive the same interest rate and the same collateral for their investment. Article Six, along with Business and Professions Code Section 10238, restricts the maximum amount of investors to ten.
Brokers should be aware that exceeding ten investors on a loan is a securities issue, and the loan may need a securities exemption such as a 25102(f). An attorney with California securities experience should be consulted if a loan has more than ten investors.
Fractionalized loans come with subtle nuances that are easy to miss and come with severe consequences if they are missed. The DRE compliance manual can help navigate these nuances, but attorneys who work with DRE regulations everyday can help connect the dots and see issues that may not be apparent to the untrained eye. It is also important to remember that there are securities issues that come along with fractionalized loans, so the compliance manual does not cover all the issues.
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