BILL ANALYSIS Ó
SENATE BANKING & FINANCIAL INSTITUTIONS COMMITTEE
Senator Juan Vargas, Chair
SB 978 (Vargas and Price) Hearing Date: April 11, 2012
As Amended: March 15, 2012
Fiscal: Yes
Urgency: No
SUMMARY Would enact several changes to the Real Estate Law and
Corporations Code, by increasing real estate investor
protections, and requiring the Department of Corporations (DOC)
to focus greater regulatory scrutiny on, and provide greater
transparency regarding, the activities of those who solicit
investors in connection with real estate investments.
DESCRIPTION
CORPORATIONS CODE CHANGES
1. Would require persons who engage in certain types of
transactions that are exempt from securities qualification
requirements to file a notice of transactions with DOC, on a
form acceptable to the Commissioner of Corporations
(commissioner), as specified. Failure to file the required
notice, or failure to file the notice within the time
specified by the Commissioner, would subject the issuer to a
monetary penalty, equal to the fee that would have been
imposed on that issuer, if the transaction had been
qualified. The two types of transactions that would be
covered by these new filing requirements include:
a. Corporations Code Section 25102(e), which exempts
from qualification requirements any offer or sale of any
evidence of indebtedness, whether secured or unsecured,
and any guarantee thereof, in a transaction not involving
any public offering; and
b. Corporations Code Section 25102(f), which exempts
from qualification requirements any offer or sale of any
security in a transaction that meets all of the following
criteria: (i) sales of the security are not made to more
than 35 persons; (ii) all purchasers either have a
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978 (Vargas and Price), Page 2
preexisting personal or business relationship with the
offeror or any of its partners, officers, directors, or
controlling persons, or, by reason of their business or
financial experience or the business or financial
experience of their professional advisers, could
reasonably be assumed to have the capacity to protect
their own interests in connection with the transaction,
as specified; (iii) each purchaser represents that he or
she is purchasing for his or her own account, and not
with a view to or for sale in connection with any
distribution of the security; and (iv) the offer and sale
of the security is not accomplished by the publication of
any advertisement.
2. Would require any issuer that claims a securities
qualification exemption for the offer or sale of securities
involving real property, or involving any indebtedness
secured in whole or in party by real property, to provide
additional information regarding the nature of their
proposed offering to DOC on a form prescribed by the
commissioner. The form to be used by these issuers would
have to be developed by DOC, and would have to include any
information the commissioner believes to be reasonably
related to the protection of the public, as specified.
3. Would require any issuer that claims a securities
qualification exemption, and that is principally engaged in
the business of purchasing, selling, financing, or brokering
real estate, to make reasonable efforts to ensure all of the
following, on the basis of information he or she obtains
from the purchaser:
a. All persons to whom securities are sold can be
reasonably assumed to have the capacity to understand the
fundamental aspects of the investment, by reason of their
educational, business, or financial experience.
b. All persons to whom securities are sold can bear the
economic risk of the investment.
c. The investment in the security is suitable and
appropriate for each purchaser, given the purchaser's
investment objective, portfolio structure, and financial
situation.
4. Would require the commissioner to annually prepare a
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978 (Vargas and Price), Page 3
report, as specified, for publication on the Department's
Internet Web site, summarizing data collected from persons
to which it issues securities permits pursuant to
Corporations Code Section 25113.
5. Would authorize the commissioner to examine those persons
to which it issues permits pursuant to Corporations Code
Section 25113, review compliance with the conditions of the
permits and other applicable state law, and disqualify an
offering permitted pursuant to Section 25113, if he or she
finds that the issuer materially violated the provisions of
their permit.
REAL ESTATE LAW CHANGES
6. Would add the following requirements to the portion of the
Real Estate Law (Article 5), which regulates real estate
brokers who make or broker loans funded by a single
investor:
a. The loans for which investors are sought could not
exceed specified loan-to-value (LTV) ratios specified in
the statute. These LTVs would vary from 35% to 80%,
depending on the type of property and its intended use
(i.e., developed single-family residence, developed
commercial, construction, undeveloped, etc.). The bill
would also impose additional, specified requirements
governing property valuations and loan disbursements,
when all or a portion of the loan is used for
construction or rehabilitation.
b. Interests in loans could not be sold, unless the
real estate broker soliciting the investor ensures that
the investor meets at least one of the following two
requirements: (i) the investment does not exceed 10% of
the investor's net worth, exclusive of home, furnishings,
and automobiles; or (ii) the investment does not exceed
10% of the investor's adjusted gross income for federal
income tax purposes for the last tax year or, in the
alternative, as estimated for the current year.
7. Would require every real estate broker that solicits
investors for privately-funded loans to make every
reasonable effort to ensure all of the following, on the
basis of information he or she obtains from the purchaser:
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978 (Vargas and Price), Page 4
a. All persons to whom securities are sold can be
reasonably assumed to have the capacity to understand the
fundamental aspects of the investment, by reason of their
educational, business, or financial experience.
b. All persons to whom securities are sold can bear the
economic risk of the investment.
c. The investment in the security is suitable and
appropriate for each purchaser, given the purchaser's
investment objective, portfolio structure, and financial
situation.
EXISTING LAW A detailed review of all of the relevant laws
governing the solicitation of investor funds for real estate
investments, and the making of so-called "hard money" loans, is
included in the background paper prepared for an informational
hearing jointly held by this Committee and the Senate Business,
Professions and Economic Development Committee in January, 2012.
The full text of that background paper can be found here:
http://sbnk.senate.ca.gov/sites/sbnk.senate.ca.gov/files/final%20
agenda.pdf
In the interest of brevity, this analysis will provide a summary
description of the statutory regime governing the activities of
hard money lenders and brokers. This summary explanation should
not be considered a comprehensive description of the laws which
regulate hard money activities, nor should it be given legal
interpretation. It is simply an attempt to condense an
extremely lengthy and complicated statutory scheme into a few
simple paragraphs, which provide a context into which the
findings and recommendations which appear later in this analysis
can be considered.
"Hard money" lending is the lending of money by private
individuals and small pension plans to other private individuals
and/or businesses. Hard money lending has two halves - a
"raising money from investors" half, and a "lending that money
out" half. Generally speaking, a license or permit is not
required to solicit investors to invest in real estate
securities. Investor solicitation may be conducted by licensed
real estate brokers (see discussion in the next paragraph), or
it may be conducted pursuant to state and federal securities
laws.
State securities laws generally authorize two types of activity:
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978 (Vargas and Price), Page 5
1) permitted or qualified activity, which requires the
submission of application documents to DOC, and the review and
approval of those documents, before money may be raised from
investors; and 2) exempt activity, which allows persons to raise
money from investors without a lengthy and costly securities
filing requirement, provided they adhere to the rules which
apply to the exemption under which they are operating. Many
of the findings and recommendations below are focused on this
exempt activity, with the goal of flushing into the open those
people who are hiding behind these exemptions to purposefully
avoid regulatory scrutiny and oversight.
The Real Estate Law also authorizes the solicitation of
investors in connection with hard money lending, and defines a
class of brokers called threshold brokers, who can generally be
thought of as those who make, broker, and/or service mortgage
loans that are funded by private individuals and small pension
plans, and who are authorized to solicit investors to fund these
loans. In deference to the nature of their activities,
threshold brokers are subject to several layers of regulatory
supervision and reporting to which other real estate brokers are
not. The special rules that apply to threshold brokers are
found in Articles 5 and 6 of the Real Estate Law. Real estate
brokers who make or broker single-investor loans (i.e., loans
where a single investor funds the entire loan) must follow
Article 5. Real estate brokers who make or broker
multi-investor loans (i.e., loans with between two and ten
investors funding the loan) must follow Articles 5 and 6. Both
types of brokers (single-investor and multi-investor) are also
subject to all of the other provisions of the Real Estate Law
that apply to non-threshold brokers.
Money raised from investors is typically lent out either
pursuant to the rules contained in the Real Estate Law or (less
commonly) pursuant to the California Finance Lenders Law.
COMMENTS
1. Purpose: SB 978 would implement a series of
recommendations stemming from a joint informational hearing
held by the Senate Banking and Financial Institutions
Committee and Senate Business, Professions and Economic
Development Committees on Hard Money Lending in January
2012. These changes would increase real estate investor
protections, and require DOC to focus greater regulatory
scrutiny on, and provide greater transparency regarding, the
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978 (Vargas and Price), Page 6
activities of those who solicit investors in connection with
real estate investments.
2. Background: In June 2011, investigative reporters Charles
Piller and Robert Lewis of the Sacramento Bee co-authored a
two-part series on "hard money" lending fraud in Nevada
County. That investigation stirred interest among the
Senate Banking and Financial Institutions Committee and
Senate Business, Professions, and Economic Development
Committees. On January 18, 2012, those committees held a
joint oversight hearing to investigate the following
questions:
o What is hard money lending?
o How is it regulated, and by whom?
o Is the existing regulatory structure protective
of consumers who obtain hard money loans? Is it
protective of persons who invest money used to fund hard
money loans?
o Does the existing regulatory structure allow
members of the regulated industry to engage in regulatory
arbitrage (i.e., to structure their business activities
in ways that allow them to pick and choose their
regulator and the laws under which they are regulated, to
ensure the least possible oversight)?
o Are changes to the laws under which hard money
lenders and brokers raise and lend money necessary or
desirable?
The background paper developed for Committee members
answered many of these questions, and contained eight sets
of findings and recommendations to help plug existing
loopholes and increase consumer protection. SB 978 includes
language to implement six of these recommendations. Some of
the recommendations that are not included in SB 978 can be
accomplished without amending California law. Other
recommendations were deleted from the bill based on
negotiations with interested parties.
1. Discussion: The six findings and recommendations that
form the basis for SB 978 are summarized below.
a. Finding: DOC fails to require those who rely on
subdivision (e) of Corporations Code Section 25102 to
file a form with DOC, claiming the exemption. This is in
contrast to subdivision (n) of Section 25102, which does
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978 (Vargas and Price), Page 7
require filings. Without a filing requirement, DOC has
no idea how many persons are operating under 25102(e),
nor does it have any knowledge of their identities, nor
the purposes for which they are seeking to raise funds.
Recommendation: Amend Section 25102(e) to add a filing
requirement, and impose a financial penalty on those who
fail to timely file.
b. Finding: Corporations Code Section 25102(f)
authorizes DOC to require those who operate pursuant to
this exemption to file a form with DOC, claiming the
exemption, but does not require DOC to require that
filing.
Recommendation: Amend Section 25102(f) to change "may" to
"shall," thus requiring a filing. Impose a financial
penalty on those who fail to timely file.
c. Finding: DOC does not track the extent to which
securities exemptions are filed by persons seeking to
raise money from investors for use toward real estate
investments, nor does it track compliance with the terms
of exemption filings. Yet, approximately one third of
all securities law actions brought by DOC involve
securities issuers who sought to raise money for real
estate investments.
Recommendations:
Require those who file claims of exemption with DOC for
purposes of issuing real estate securities to file
separate paperwork with DOC, containing more information
about the nature of their offerings. At a minimum, this
will help provide DOC with more information about the
segment of the issuer population that appears to pose the
greatest risk to the investment public. It could also
help the Department of Real Estate (DRE) and DOC focus
regulatory scrutiny on these issuers, to ensure that they
are complying with the provisions of the Real Estate Law
and/or California Finance Lenders Law, when they lend out
money they raise from investors.
Once it has compiled a few years of these additional data,
DOC should be required to report to the Legislature,
summarizing the information, and recommending any
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978 (Vargas and Price), Page 8
statutory or regulatory changes it believes are necessary
or appropriate to better regulate the practice of raising
money for real estate investment. To the extent
resources are available, thought should also be given to
requiring DOC to examine a sample of those who have filed
permitting exemptions, to check on compliance with the
provisions of their filing documents. (SB 978 does not
contain language to implement the reporting
recommendation or require DOC to examine a sample of
those who have filed permitting exemptions. Such a
one-time report can be requested by the Legislature
without the need for a statutory change. The idea of
examining those who have filed for permitting exemptions
can be revisited, once the state's budget situation
improves).
d. Finding: Although DOC captures considerable
information about the activities of its permit holders
from permit applications, the department is not required
to summarize this information, nor report it to the
Legislature. This contrasts with DRE, which not only
collects considerable information from its threshold
broker (hard money lending) licensees on a quarterly and
annual basis, but also publishes an annual report,
summarizing the activities of those brokers.
Recommendation: Amend state law to require DOC to publish
an annual report, summarizing the activities of its
permit holders. Authorize DOC to perform periodic
examinations of those to whom it issues permits, and to
revoke the permits of any permitholder who is found by
DOC to have materially violated the provisions of their
permit.
e. Finding: Article 6 of the Real Estate Law imposes
loan-to-value caps on multi-lender hard money loans, and
imposes suitability requirements on those who invest in
multi-lender hard money loans. Both of these investor
protections are absent from Article 5 of the Real Estate
Law, which contains rules for single-lender hard money
loans.
Recommendation: Import the investor protections contained
in Article 6 into Article 5, to better protect investors
who invest in single-lender hard money loans.
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978 (Vargas and Price), Page 9
f. Finding: The greatest harm to investors who
invest in bogus or fraudulent investment schemes, or
whose investments fall victim to a depressed real estate
market, are experienced by those persons who deviate from
suitability standards imposed by DRE and DOC, and who
invest significant portions of their life savings in the
failed venture. Although no investor is supposed to be
allowed to place more than 10% of his or her net worth
into any single investment, most of those who experience
significant investment losses from real estate ventures
were not dissuaded from investing large sums by the
securities issuers who took their money.
Recommendation: The Real Estate Law and the Corporations
Code should be amended to require that anyone who
solicits prospective investors for the purpose of raising
funds for one or more real estate ventures to evaluate
the suitability of those real estate investments for
those investors.
2. Summary of Arguments in Support: None received.
3. Summary of Arguments in Opposition: None received
4. Amendments: This bill is double-referred to the Senate
Banking and Financial Institutions Committee and Senate
Business, Professions and Economic Development Committee.
The authors do not expect to propose any amendments to the
bill prior to or during the April 11th Senate Banking and
Financial Institutions Committee hearing. However, the
authors are in discussions with the California Mortgage
Association and Department of Corporations, and expect to
propose technical and clarifying amendments to the bill,
before it is heard by the Senate Business, Professions and
Economic Development Committee.
5. Prior and Related Legislation:
a. SB 53 (Calderon and Vargas), Chapter 717, Statutes
of 2011: Enacted several changes to California's Real
Estate Law, to give DRE more enforcement tools with which
to crack down against mortgage fraud and other real
estate violations, add safeguards to protect consumers
who seek out services from real estate licensees, and
make technical changes. Among its provisions, the bill
included a requirement that hard money lenders operating
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978 (Vargas and Price), Page 10
under Article 6 inform their investors about which
provision or provisions of the Real Estate Law or the
Corporate Securities Law govern their transactions.
Prior to enactment of SB 53, that information was
required to be documented in a licensee's files, but was
not required to be shared with investors.
LIST OF REGISTERED SUPPORT/OPPOSITION
Support
None received
Opposition
None received
Consultant: Eileen Newhall (916) 651-4102