Hard money loans, secured by second deeds of trust, and the sale of fractionalized interest in the secured notes, is a high risk/high reward gambit. In the recent case of Creative Ventures, LLC v. Jim Ward & Associates (2011) 195 Cal.App.4th 1430, one risk that investors in those notes never saw coming was liability for usury.
As assignees of fractional interest in notes made by a lender that lacked a broker's license, the unwitting investors "stood in the shoes" of the usurious lender. Despite themselves never having received interest in excess of 10%, the investors were forced to disgorge all of the interest they received. This disastrous outcome was the result of sloppy practices that are all too common in the private money lending business.
Facts of the Case
Two real estate development companies borrowed nearly three million dollars from Jim Ward & Associates ("JWA") to finance two real property development projects. The loans were evidenced by promissory notes, secured by deeds of trust on the two properties. The stated interest rates for the notes were 8% and 10%. Each note included a recital that the loan had been arranged by a real estate broker licensed under the laws of the State of California. The broker, JWA, was to receive a broker's fee, ranging from 4 to 6%, under each note.
JWA then solicited investors to fund the loans. It assigned the investors fractional interests in the notes, evidenced by separate loan servicing agreements between JWA and each investor. JWA retained physical possession of the notes, collected the loan payments and disbursed the principal and interest to investors, retaining the broker fees for itself.
On the surface, this seems like a perfectly ordinary series of transactions. So what went wrong? It turns out that while Jim Ward was himself a licensed real estate broker, JWA was not.
The Broker/Arranger Exception to the Usury Laws
The stated interest rates of 8% and 10% were not usurious. However, for purposes of the Usury Law, interest charges are computed by adding the stated interest rate to any commissions or fees the borrower must pay. If the interest plus commissions exceeds the maximum rate of 10%, the loan is usurious. (Cal. Const. Art. XV. §1.) Here, the stated interest, when combined with the broker fees, exceeded 10%.
This interest would have been entirely lawful had the loans been "made or arranged" by a licensed real estate broker and secured by liens on real property. (Civil Code § 1916.1.). This so called "broker/arranger exception" to the Usury Laws applies only if the broker actually makes the loan or acts as the intermediary in procuring the loan.
Exception Does Not Apply Where a Principal of the Lender is Licensed but the Lender is Not
When the borrowers learned that JWA was unlicensed, they sued to recover the interest paid on both notes. The trial court results as to JWA were predictable. The court made short shrift of JWA's argument that as a corporation, it could act only through its officers and since its president, Jim Ward, was a licensed real estate broker, these loans fell within the broker/arranger exception. The court pointed out that the DRE issues licenses to both individuals and corporations. When the license is issued to a corporation, it is through the license of a designated officer of the corporation. (Bus. & Prof. Code §10211) However, the license held by Jim Ward was issued to him, as an individual, not as a designated officer of JWA.
The court was equally unimpressed with the argument that Mr. Ward had made a good faith mistake. He had mistakenly applied to the DRE and received, at least temporarily, a license for "JWA, Inc." his former mortgage lending business. Since these loans were made by JWA, the license issued to JWA, Inc. was of no help.
In an interesting twist, the borrowers sued not only JWA, but also the 52 individual investors who had purchased fractionalized interest in the notes. Once again, the results were somewhat predictable.
The trial court found that the investors were holders in due course, having taken their fractional interests in the promissory notes for value, in good faith, and without notice of the additional loan fees that render the notes usurious. Since they were unaware of the fact that JWA was not a licensed broker, and they did not receive any part of the loan fees, they were held to be exempt from the usury liability.
An Assignee of a Note Can Not be a Holder in Due Course
The investors did not fare nearly so well on appeal. In concluding that they were not "holders in due course," the appellate court took great pains to distinguished between a "holder" of a note and an "assignee" of a note.
The California Commercial Code defines a holder in due course as the "person in possession of a negotiable instrument that is payable either to bearer or, to an identified person that is the person in possession." (Com. Code, §1201(b)(21)(A).) Since the notes were payable to JWA, and JWA retained physical possession of them under the servicing agreements, it was the actual holder. The investors could have become holders had JWA negotiated the notes by endorsing and transferring possession to them (Com. Code §3201).
Since no such physical transfer of the instruments occurred, the investors were mere assignees of fractional interests in the notes. An assignee's rights are derivative of whatever right the assignor has. The investors therefore took their interests subject to the borrower's claims against JWA. Since the interest terms were null and void as being usurious, the investors had no greater right to received interest payments than JWA. The fact that the investors had no knowledge of the usurious nature of the underlying loans, and the interest payments to them never exceed 10%, was irrelevant.
Ironically, an amendment to the Commercial Code designed to protect investors such as these may have contributed to their undoing. Under former Commercial Code §9304, a security interest in an instrument such as a promissory note or a deed of trust, could be perfected only by the secured party, or an agent acting on its behalf, taking physical possession of the instrument. Where multiple parties sought to perfect a security interest in the same instrument, a single agent could be designated to take possession of the instrument. The one catch was that the agent could not be the debtor itself. (In re Staff Mortgage & Investment Corp. 9thCir. (1977) 550 F.2d 1228, 1230). This was a cumbersome and somewhat inefficient process of perfecting a security interest.
Former Commercial Code §9304 was repealed effective July 1, 2001 and replaced with Section 9312. Under subdivision (a) of Section 9312, security interest in instruments may now be perfected by filing. No longer do secured parties need to take possession of an instrument, either directly or through independent agent services, to perfect their security interest. This is cold comfort for the Creative Ventures investors who would have been far better off had the notes been transferred to an agent acting on their behalf.
Take Away
These harsh consequences to the investors were the direct result of an easily avoidable mistake in the making the underlying loans. The Creative Ventures decision should serve as a clarion call to both private money lenders and investors to pay close attention to documentation of loans, especially where the interest charged is legal only by virtue of the broker/arranger exception to the Usury Laws.