California Legislature Moves to Impose Due Diligence Standards on Brokers

California Capitol Building

By N. Mitchell Feinstein, Esq.

An analysis of new legislation that will require brokers to qualify their investors before taking their money.

Read on to learn more about what changes to expect and how you can access new tools to protect yourself and your business now. Please be sure to take advantage of the free offer located at the bottom of this message.

For at least ten years I have been preaching to the mortgage brokerage industry that every day the members were acting less like real estate brokers and more like securities dealers.  My diatribe goes back to my being a member of the committee—appointed by then-Governor Jerry Brown (in his first iteration)—that wrote the original multi-lender rule.  The Department of Corporations (“DOC”) made clear that the sale or brokerage of a note secured by a deed of trust was and is the sale of a security.

In California, all securities have to be registered with the Department of Corporations (so called public offerings) or sold pursuant to one of several exemptions, including but not limited to the so-called private placement exemption found in Corporations Code Section 25101(f).

Of course the multi-lender rule (which was subsequently codified in Business and Professions Code Section 10237 et. seq. provided an exemption from the necessity of registering or qualifying the sale of the security, the note secured by deed of trust, if the sale was limited to ten or less investors and all of the other requirements of disclosure and reporting were followed.

In the last 10 years, many real estate brokers have decided to use the securities qualification or exemption to allow the sale of notes to more than ten investors and to carry out so called “business plans” that were beyond those allowed under the multi-lender rule.  Some of these securities allowed the division of the note into unlimited shares, allowing the sale to as many as 250 investors in a single loan, allowed construction and entitlement loans that exceeded the $2,500.000 limit, and in other ways sought to provide for business plans that were beyond what was authorized by the statutory exemption.

I am sure that the purveyors of these designed-business-plan programs were well intentioned, but the recent times have found that a number of the companies using such exemptions have not performed as intended, resulting in losses to investors.   These issues have come to the attention of the Department of Corporations and the Department of Real Estate based on complaints from investors, news stories, and other venues.

The result is that the DOC is proposing legislation that they believe will deter the sort of conduct that caused the problem.  In analyzing the problem, the Department found three key areas to address:

1.     That brokers need to understand that because they are selling a security, they have the same duty as a stock broker: the “know your customer rule.”   This rule is a foundation of the regulation of the securities industry.  Too often brokers have been told that all they need to do is make sure that a lender checks the box on the Lender/Purchaser Disclosure statement averring that the loan being purchased does not exceed 10% of the investors net worth or in the case of a public or private offering, simply sign the subscription agreement attesting to meeting whatever income or net worth requirements are set forth in the offering.

The DOC asserts, and I believe correctly, that this far understates the duty of one selling an investment.   The seller has duties, which include verifying that the proposed investment is suitable for the risk profile of the investor, and that the financial condition of the prospective investor is appropriate for the risk to be undertaken.

A brief example:  A widow whose entire net worth, other than the equity in her house is $1,000,000 from a life insurance policy.    Assume she purchases 10 interests in 10 notes each of $100,000.  The widow can correctly check the box that each investment does not exceed 10% of her net worth, but such an allocation of risk is completely inappropriate.   If the real estate market goes down, as it did, the widow’s entire net worth could be in jeopardy.
Another simple example: An investor purchases an interest in a large second trust deed, behind a large first trust deed on a commercial property.  The investor lives off the income of trust deed investments and has only limited liquid assets.  Without any investigation of the ability of the investor to meet cash calls to protect his investment, such as advances to prior encumbrances or taxes, the seller has placed this investor and perhaps all others in the transaction at risk, for the failure to assess the ability to meet calls for advances.

See Senate Bill 978 as amended March 15, 2012.  The bill adds the following requirements to a broker selling or brokering any interest in a note secured by deed of trust:

a.     Assure that the purchaser can bear the economic risk of the investment
b.     That the investment is suitable, given the purchaser’s investment objectives, portfolio, and financial situation
c.     The broker must obtain information about the investor that includes at least the age, investment objective, investment experience, income, net worth, financial situation and must maintain a record of this information for four years.

The DOC envisions the use of a questionnaire to gather the information that is described.  Such a form has been in use by the general securities industry for many years.

See important note at the end of this article regarding tools to use today to meet your duties and protect yourself from lender lawsuits.

2.     That whatever rules and limitations that applies to a loan sold to two or more investors should also apply to a loan sold to a single investor.  Under their view, the sale of single note to a single investor is no less a security than one sold to multiple investors, and therefore, there is no logic to support having one set of rules for multiple investor loans and a different, more lenient set, for loans sold to a single investor.

3.     In order to regulate the use of the private placement exemption, which the DOC feels has been abused, a new requirement is made that those intending to use an exemption for the sale of interests in notes must file the notice within 15 days of the first sale.  Under the old law there was no penalty for filing of a late notice, even after the sale of all interests was complete.  The failure to timely file is to pay the same fee that would have been due if an offering for a public sale were made, a not insubstantial amount.

The primary purpose for this change is to allow the DOC to collect the names of those filing and to track the volume of these offerings.  No doubt these offerings will be subject to greater scrutiny and audit than in the past.


My answer is: no.

When I was a principal in my own mortgage company, under my direction we instituted procedures to gather the information that the DOC is now seeking to require by statute.   While I am confident this bill will pass, it is my opinion that this statue is merely a statement of EXISTING law and not something new.  I believe that every broker has the duty to “know his customer” and to obtain enough information to assess whether or not the investment he is offering is appropriate for the investor.

Perhaps more importantly, the use of this procedure will also help limit liability, especially from those investors who would choose to sue a broker for a bad loan rather than accepting the responsibility for their own decision to invest, and the greed that drives it.   More than one of the brokers I know who have been sued, who used the methods I recommend, report that these procedures have fended off many of the most avaricious and persistent investors and their lawyers.

If you would like to receive a FREE copy of my general advice document, “How to Protect Yourself and Your Investor” — including a FREE draft form of an Investor Questionnaire that meets the requirements envisioned by this statute, please e-mail me at

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