BILL ANALYSIS Ó
SENATE JUDICIARY COMMITTEE
Senator Hannah-Beth Jackson, Chair
2015 - 2016 Regular Session
SB 647 (Morrell)
Version: April 7, 2015
Hearing Date: April 28, 2015
Fiscal: Yes
Urgency: No
TH
SUBJECT
Real Estate Investments: Securities: Qualification Exemption
DESCRIPTION
The Real Estate Law requires any transaction that involves the
sale of a note secured directly by an interest in a parcel of
real property to comply with specified requirements, including
limiting the principal amount of the note based on a percentage
of the current market value of the property. Existing law also
requires specified real estate brokers to make reasonable
efforts to ensure that the sale of an interest in a note secured
by real property is suitable and appropriate for the purchaser.
This bill would add a new loan to value limit for real estate
based lending involving land producing income from crops,
timber, or minerals. This bill would also remove the
requirement that brokers annually obtain a completed investor
questionnaire from each person to whom the broker offers or
sells a note secured directly by an interest in a parcel of real
property, and would remove a reporting requirement for certain
types of real estate loans.
BACKGROUND
California law authorizes the non-institutional lending of money
secured by real estate from private individuals and small
pension plans to other private individuals or businesses in a
financing arrangement colloquially known as "hard money"
lending. This method of financing involves raising money from
investors, typically by a real estate broker, and lending it out
SB 647 (Morrell)
Page 2 of ?
to a borrower using the borrower's real property as collateral.
Borrowers resorting to the hard money market typically cannot
secure loans through institutional lenders, often due to poor
credit histories or the level of risk associated with the
purpose of the loan.
This type of lending and investing arrangement is generally
exempt from securities laws that otherwise require certain
regulatory filings and impose specific qualification
restrictions designed to protect investors. SB 978 (Vargas, Ch.
669, Stats. 2012) enacted a series of consumer protection
measures designed to protect investors by focusing greater
regulatory scrutiny on, and providing greater transparency
regarding, participants in the hard money market. That bill,
among other things, imposed loan to value limits that capped the
aggregate principal amount of the note or interest that could be
sold to investors based on the market value of the
collateralized real property, required a copy of the appraisal
or the broker's evaluation of the collateralized property to be
given to the investor, and imposed suitability restrictions on
investors based on income or net worth. That bill also imposed
certain fiduciary responsibilities on brokers to ensure that an
investment is suitable and appropriate for each purchaser, and
provided that collection and evaluation of an annual investor
questionnaire produced by the Real Estate Commissioner would
satisfy that requirement.
This bill would make technical and clarifying changes to the
laws governing hard money lending, including adding a new loan
to value category for income producing land, and removing the
annual investor questionnaire requirement for years in which
investors make no additional investments.
CHANGES TO EXISTING LAW
Existing law requires any transaction that involves the sale of
or offer to sell a note secured directly by an interest in one
or more parcels of real property or the sale of an undivided
interest in a note secured directly by one or more parcels of
real property to not exceed certain loan to value ratios, as
specified. (Bus. & Prof. Code Sec. 10232.3(a).)
Existing law specifies that the aggregate principal amount of
the note or interest sold, together with the unpaid principal
amount of any encumbrances upon the real property senior
SB 647 (Morrell)
Page 3 of ?
thereto, shall not exceed the following percentages of the
current market value of each parcel of the real property:
Single-family residence, owner
occupied........................ 80%
Single-family residence, not owner occupied
........................75%
Commercial and income-producing properties
........................65%
Single-family residentially zoned lot or parcel which has
installed offsite improvements........................ 65%
Land that has been zoned for commercial or residential
development................... 50%
Other real property ........................ 35% (Bus. & Prof.
Code Sec. 10232.3(a).)
Existing law specifies that a copy of the appraisal or the
broker's evaluation, for each parcel of real property directly
securing the note or interest, shall be delivered to the
purchaser. (Bus. & Prof. Code Sec. 10232.3(a).)
Existing law states that a note or interest directly secured by
one or more parcels of real property shall not be sold unless
the investment in the transaction does not exceed 10 percent of
the investor's net worth or that the investment in the
transaction does not exceed 10 percent of the investor's
adjusted gross income for federal income tax purposes, as
specified. Existing law requires the investor to sign a
statement confirming his or her income or net worth
qualifications, which shall be retained by the broker for four
years. (Bus. & Prof. Code Sec. 10232.3(b).)
Existing law states that any broker subject to the above
provisions shall make reasonable efforts to ensure all of the
following with respect to the offer or sale of notes or interest
in notes to be secured by a lien on real property or a business
opportunity:
all persons to whom notes or interests 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;
all persons to whom notes or interests are sold can bear the
economic risk of the investment; and
the investment in the notes or interests is suitable and
appropriate for the purchaser, given the purchaser's
investment objectives, portfolio structure, and financial
SB 647 (Morrell)
Page 4 of ?
situation. (Bus. & Prof. Code Sec. 10232.45(a).)
Existing law provides that a broker shall make the above
suitability determination on the basis of information he or she
obtains from the purchaser, including the investor's age,
investment objectives, investment experience, income, net worth,
financial situation, and other investments, as specified. (Bus.
& Prof. Code Sec. 10232.45(b).)
Existing law states that a broker shall be deemed to have
complied with the above provision if the broker:
obtains from each person to whom notes and deeds of trust or
interests therein are offered or sold a completed investor
questionnaire in a form approved by the commissioner;
uses the responses in that questionnaire as an aid in
determining the investors suitability; and
on an annual basis, obtains from each person to whom notes and
deeds of trust or interests therein are offered or sold, or on
whose behalf they are serviced, an updated investor
questionnaire, which reflects any material changes that may
have occurred with respect to any of the responses to
questions in the questionnaire. (Bus. & Prof. Code Sec.
10232.45(d).)
This bill would create a new loan to value cap of 60 percent for
real estate-backed investments directly secured by land that
produces income from crops, timber, or minerals, as specified.
This bill would remove the requirement to obtain an investor
questionnaire on an annual basis from the list of provisions
deemed to comply with a broker's duty to determine investor
suitability. This bill would instead provide that a broker must
obtain at least two business days and not more than one year
prior to completing each sale, a completed investor
questionnaire in a form approved by the commissioner. This bill
would additionally provide that after obtaining an initial
questionnaire, any subsequent questionnaire from the same person
need only reflect any updates from the immediately preceding
questionnaire obtained by the broker.
This bill would make other technical and clarifying changes.
COMMENT
1.Stated need for the bill
SB 647 (Morrell)
Page 5 of ?
The author writes:
SB 647 makes largely technical changes to sections in the
Business and Professions Code and Corporations Code relating
to real estate securities investments. These changes were
crafted after discussions with the Bureau of Real Estate.
Specifically, the bill makes the following changes:
Clarifies that the loan to value limits for investments
in land producing income from crops, timber or minerals,
under Business and Professions Code Section 10232.3, is 60
[percent]. Current law is unclear on the loan-to-value
standard for these types of investments.
Clarifies that a broker has no obligation to obtain
annual questionnaires from current investors in years when
no investments are made by the investors, as long as
updated questionnaires are obtained from investors within
specified times before new investments are made.
Eliminates a reporting obligation to the Department of
Business Oversight under Corporations Code Section 25102.2,
for garden-variety "whole note" investments which were not
the focus of the reporting obligation which was added to
the code in 2012.
1.Ensuring Investors are Protected
The Real Estate Law protects those who invest in loans directly
secured by real property in two primary ways. First, the law
imposes mandatory loan to value caps on the principal amount of
the note or interest securable against real property. These
caps help to ensure that in the event of a default and sale of
the subject property the investors can recover much of the value
of the note, especially if they need to sell the collateralized
property quickly. Second, the law imposes a duty on real estate
brokers to determine a potential investor's suitability before
they can invest in notes secured directly by real property. One
option to meet this requirement is to have a prospective
investor complete a questionnaire approved by the Real Estate
Commissioner, and evaluate their responses to determine
suitability.
This bill would make changes to both of these protective
mechanisms. The first change addresses an ambiguity in existing
law concerning properties that produce income from natural
SB 647 (Morrell)
Page 6 of ?
resources. Currently, the Real Estate Law imposes a loan to
value cap for commercial and income-producing properties of 65
percent, and a loan to value cap for other real property of 35
percent. According to the sponsor, California Mortgage
Association, land that produces income from timber, crops, or
minerals could potentially fall within either category. This
bill resolves that ambiguity by creating a new loan to value
category for this class of real property.
The second change involves eliminating the requirement for real
estate brokers to obtain annual investment questionnaires from
individuals who are not actively purchasing notes or interest
directly secured by real property. The Real Estate Law offers
brokers a statutory method for gathering information needed to
comply with their fiduciary duty to determine an investor's
suitability before selling an interest in a real estate secured
loan. Part of that statutory method includes gathering annual
investment questionnaires from both prospective and current
investors, whether or not members in the latter category are
actively seeking to invest further in asset-based loan products.
Consequently, existing law would have brokers collect annual
questionnaires from existing investors with whom the broker
maintains only a loan servicing relationship.
This bill would also remove the requirement for real estate
brokers to obtain annual investment questionnaires and replace
it with an obligation to obtain a new or updated questionnaire
at least two business days but not more than a year before
selling an investment. This modification of the Real Estate Law
would not appear to impact the fiduciary duties a real estate
broker owes to his or her client, which are as follows:
The general principles of agency combine with the statutory
duties created by the Real Estate Law [to impose] on a real
estate agent the same obligation of undivided service and
loyalty that it imposes on a trustee in favor of his
beneficiary. This relationship not only imposes upon him the
duty of acting in the highest good faith toward his principal
but precludes the agent from obtaining any advantage over the
principal in any transaction had by virtue of his agency. A
real estate licensee is charged with the duty of fullest
disclosure of all material facts concerning the transaction
that might affect the principal's decision. (George Ball
Pacific, Inc. v. Coldwell Banker & Co. (Cal.App.1st Dist.
1981) 117 Cal.App.3d 248, 256 (citations and internal
SB 647 (Morrell)
Page 7 of ?
quotations omitted).)
By requiring real estate brokers to obtain new or updated
investment questionnaires prior to each transaction, the changes
enacted by this bill would continue to ensure that brokers
obtain information needed to determine an investor's financial
suitability, allowing them to effectively discharge their
fiduciary duties.
2.Elimination of Reporting Requirement
This bill would also remove a reporting requirement in the
Corporations Code related to the sale of unfractionalized or
"whole" notes directly secured by real property. Under existing
law, it is unlawful for any person to offer or sell any security
in an issuer transaction unless such sale has been qualified or
unless such security or transaction is exempted or not subject
to qualification. (Corp. Code Sec. 25110.) Qualification of a
security generally involves submitting regulatory filings to an
appropriate regulatory agency, such as the U.S. Securities and
Exchange Commission. Existing law provides an exception for
promissory notes secured by a lien on real property, so long as
it is neither one of a series of notes of equal priority secured
by interests in the same real property nor a note in which
beneficial interests are sold to more than one person or entity.
(Corp. Code Sec. 25100(p).) Despite this exception, the Real
Estate Law requires brokers who sell these single investor loans
to provide additional information regarding these offerings to
the Real Estate Commissioner, including the names of the
issuer's officers and directors, copies of the offering
disclosure documents provided to prospective purchasers, a list
of all state and federal licenses required to further the
purposes of the investment, and the names of all licensed
persons that will undertake those activities. (Corp. Code Sec.
25102.2.)
According to the sponsor, California Mortgage Association, this
reporting obligation ought to be eliminated because
"garden-variety 'whole note' investments . . . were not the
focus of the reporting obligation which was added to the code in
2012." This bill would delete that reporting requirement.
Support : None Known
SB 647 (Morrell)
Page 8 of ?
Opposition : None Known
HISTORY
Source : California Mortgage Association
Related Pending Legislation : None Known
Prior Legislation :
SB 978 (Vargas, Ch. 669, Stats. 2012) See Background.
SB 53 (Calderon, Ch. 717, Stats. 2011), among other things,
included a requirement that hard money lenders inform investors
about which provision or provisions of the Real Estate Law or
the Corporate Securities Law govern their transactions, as
specified.
Prior Vote : Senate Banking and Financial Institutions Committee
(Ayes 7, Noes 0)
**************