The Deal Behind the Deal: Participation Agreements, Hypothecations & Related Structures

Kevin S. Kim, Esq.:

So let's get started with today's webinar. Today we are talking about what we have called the deal behind the deal. This is commonly used strategies in lending for both investors and institutional counterparties to fund loans, to get some liquidity and to do all kinds of fun stuff, get leverage. And so we get a lot of questions about this, that's why we're talking about this today. The goal today is to get through three core structures that we see a lot, and that has to do with participation agreements, hypothecations, and other types of structures. I am Kevin Kim. I'm a partner here at Fortra Law. I lead the firm's corporate and securities practice. I'm also the host of Lender Lounge with Kevin Kim, our firm's podcast. With me today is our resident expert in participation agreements and all kind of funky transactions and commercial deals and someone you all probably have worked with before.

So Kyle is here with us today to join us. Kyle, please introduce yourself to our audience.

Kyle Niewoehner, Esq.:

Yeah, I am senior counsel in our banking and finance department. And as Kevin mentioned, I'm generally in the weeds on these types of transactions, drafting the documents, negotiating the documents. And so I'm going to be kind of kicking off here talking about the documentation side, and then Kevin is going to take over and talk about those compliance considerations, securities, all of that stuff, which is also going to come up when you delve into this. So we're going to first just talk through these transactions, what they look like, what the basic structure is and the basic advantages and disadvantages to help you guys evaluate what type of approach we'd want to use in a specific situation. And then Kevin will be going through here at the end, like I said, and talking through compliance. So just to look at the basic structure here, the three main transactions that we're dealing with, there's the fractional sale side, which is the basic option that, I don't know if I would say most common, but it's kind of the most basic.

It's a loan sale. And so obviously you're all familiar with selling whole loans or you can sell fractional loans. We're going to talk about that because that is a sort of related type of transaction. And then we will talk about selling the participation interest and then thirdly talk about hypothecations before I turn it back over to Kevin here.

First off, fractional interest. So we're just going to start here as a baseline because this is a really good way to compare and contrast and set the stage for the other types of more complex transactions. If you're just selling a fractional interest in your loan, you're recording an assignment of a deed of trust, a partial assignment and a launch, you may have an associated loan sale agreement. We would generally recommend that you have a loan sale agreement in place. And the buyer is a lender, they're a co-lender. So I mean, this is a co-lending structure, very basic and pretty straightforward. If a borrower goes into default, the buyer is a lender. They're secured the same way that the originator is, whoever, if it's multiple co-lenders, whoever, they're all secured creditors. And you would then probably have an administration agreement or a service agreement. There's something in place that governs the relationship between the co-lenders.

So there's a couple of documents that you need to have in place when you're doing fractional interest sales. Like I said, we would recommend that you have a sale agreement in place. I know it may be common industry for people to just assign interest back and forth, but you do really want to make sure you document any types of reps and warranties that are being given or not given, as well as the relationship between the lenders. If there's a foreclosure, who is doing what, who has what decision-making power. You want to make sure that you document that anytime you're entering into a co-lending relationship, whether it's at origination or whether you are selling an interest after origination.

But people generally understand the interest of the parties pretty well in these fractional interest ones. It's just co-lenders. And so the advantages are the big advantages, of course, that you can free up part of your capital. You don't have to fully fund the loan as the originator. And the buyer doesn't have to originate and gets to be part of the loan, be a co-lender on the loan. And for people who want to be in loan, basically in lending to own loans without wanting to go through the origination process, it's really great for them. The disadvantage or at least potential disadvantages, depending on what you want, as the seller, you're giving up some control of the loan. I mean, the co-lender, the buyer is going to have some type of input generally, although you can limit that in the administration agreement, but there may even be legal requirements of what type of consent that you need from a co-lender and restrictions on what you can do there.

And then of course the sale is publicly recorded. As I mentioned, it's an assignment of deed of trust. So you're recording this in the public records, which is also an additional administrative burden there of you need to go through the process of getting these documents signed, getting that notarized, recording it, and then it's going to be public record. And that's a higher administrative burden than, for instance, the participations as we'll discuss. But people generally understand pretty well how to do these and what exactly is involved.

So moving then into the participation agreement, it's a good comparison because the participation route does provide you with. Kevin, can you move the slide forward? I think it's not going through on my end. The participation route is substantially different than the fractional sale. And we see this quite often where the seller, the originator wants to maintain full control of the loan and also may not want to go through the whole sale process and record something in the public records. And that could be for a variety of reasons, for ease of administration, or you simply want to be the only conduit that your borrower has on the lending side. You don't want them to even necessarily see that there are multiple lenders involved in this loan, and you want them to just be always coming straight through you. So when you're selling a participation interest, you're not selling a loan, you're not selling a fractual interest in the loan.

You're selling a right to receive interest from the loan and potentially fee sharing, et cetera, pursuant to the terms of a participation agreement. And in the participation agreement, you will delineate exactly what interests you are sharing. So you could be sharing a full interest rate return on a portion of the loan, or you could even on the part you're participating, you can keep a spread. You can share fees as much or as little as you want. Sometimes we see that the sellers don't share fees at all. Sometimes they share all the fees pro rata, and that's all up to you and what you negotiate with your participant. And so in this case, the buyer, the participant, their return is as specified in the participation agreement, which is pretty much obvious you're going to get interest and potentially other fees, other types of compensation as well.

But it's only as set forth in the participation agreement. The participant doesn't have any rights directly under the loan documents against the underlying borrower. And if the loan goes into the default here, the buyer is relying on the seller, the originator's collection efforts. They're not going to be involved in that foreclosure process generally. And you can negotiate more control, but the standard in a participation agreement is that the seller, the originator maintains control of the loan and generally has most of the say, if not all of the say, with regards to administering the loan, foreclosure, default mitigation, and even a lot of modifications of the loan. And so the big advantage here is that if you're the originator, the participation agreement route allows you to main full control of the underlying loan. And as I mentioned, you're still the borrower's sole reference point in terms of being on the lender side.

And on the buyer side, the participant doesn't need to administer the underlying loan at all. This is completely passive and they're not even going on the public record. There's no assignment. There's no notice to the public for a participation agreement. Nothing about this is going to be recorded in the public records. And so typically the underlying borrower doesn't even know that this is happening on the backend, and generally nobody else does either. And so if you do have a buyer that cares about maintaining some level of anonymity, this is perfect for them because they're going to be able to participate in the economic return while not showing any type of involvement in this, not having their business affairs being a public record. The big disadvantage is really just on the participant side. These are very seller-friendly, originator-friendly structures, and the buyer is unsecured, and their rights are based on the contract.

So again, comparing to the fractional interest where they are a secured lender, they're on title, here they're not on title, and they have a contractual relationship with the seller of the participation. And so there needs to be generally a pretty high trust level there where the participant trusts this seller and also generally has a high regard for their business acumen and how they're managing these loans. Because as I mentioned, the originator, the seller here is continuing to have pretty much full authority in managing the loans. And so as a participant, you're going to want to really investigate the seller pretty much as much as the underlying loan because you're trusting them to properly manage the loan and to make you whole ultimately even in the event of some type of default and liquidation foreclosure, those types of situations. So it's generally a more high trust type of structure, but it has a much lower administrative burden because all you're doing is signing a participation agreement.

You're not having to record anything. And as the loan proceeds, even if it does go into default, et cetera, you don't have to do anything more really with the participation. Obviously as the originator, you want to keep your participants informed about what's going on, but once you set up the structure, it just kind of stays in place and doesn't require additional administration. I did also want to note here, it's not on the slide, but something that we do have very commonly for the clients is setting up a master participation structure. So I do want to mention that briefly, whereas a just simple participation agreement would be a single loan of where you would agree with them, okay, we're selling this interest and this loan, here's the return, et cetera. We also commonly see our clients setting up master participation structures where similar to a master sale agreement or something like that, you have the main agreement in place and it covers multiple loans in the future.

And then you have a participation certificate that is originally attached as an exhibit to the participation agreement that covers details of a specific loan. So you fill in there all the specific details of a loan amount and the borrower and the property and how you want to split the return. And you can set up the master participation agreement so that the basic contract, the longer 20-page or whatever, however long it is, master agreement covers the basic agreement between the two parties, the legal structure, the reps and the warranties and all of that stuff. And then you don't have to redo that every time you participate in a new loan with that counterparty. You fill out and sign the participation certificate, which is going to have the specific loan information as well as the interest rate split and fee split arrangement, et cetera, for that loan.

And then we just have a reference in there to the master agreement. And so again, the big advantage of that type of structure is it's a minimal administrative burden. I would say it's probably the lowest administrative burden that you can really have for one of these structures where you have an ongoing investor relationship of somebody putting capital into your deals. So you have this agreement in place with them, and every time that there's a new deal that you want to participate, you just go to them, arrange between the two of you, okay, how much are you going to put in? How much of the interest rate are you going to get? Are we going to share fees? Et cetera. And then you just fill out the certificate for that loan with just the numbers, the basic loan information. You both sign that, and then they can transfer the money and you go forward with that.

And it's a very simple way to be able to bring in investor capital and to keep that going on a deal-by-deal basis without needing to go through a lot of the trouble of renegotiating a major document package. And so we've seen that be very popular. And so I wanted to just discuss that recently. So again, that's a great option if you have a high trust level between the originator and an investor, and you just want a structure where they can just put money in as easily as possible without needing to go and record a bunch of stuff, without needing to do a bunch of extra documentation. And so if you have an investor where there's a high trust level, they don't mind being unsecured, that's a really great option for them to just be able to continue investing in your deals and for you guys to be able to do it with a very quick and easy process.

And then next talk about the hypothecations, which are more maybe commonly known as note-on-note financing. And unlike the previous two options here, this actually adds a new loan. So this option is really adding a second loan on top of the underlying loan that you're making to a borrower that's going to be secured by real property. And so in this situation, you are pledging the underlying loan that you've already made. And then I'm coming at this generally from the point of the originator, but you take the underlying loan that you already made and actually take that as an asset and pledge it as collateral to your investor. So they're putting money in and they are getting collateral, but their collateral is not the property as it would be in the fractional interest where you're just co-lending. In that case, they're just directly secured by the real property.

Here, they're secured by a loan. So it's not real property, it's technically personal property, but then you do actually have an underlying component where there is real property. Because if the investor here needs to foreclose, if there's a default, they would become the lender of the underlying loan and then ultimately would be able to foreclose on that underlying property. They're just a step removed here. And so the security interest in the underlying loan here is typically perfected by recording a UCC and then recording a collateral assignment of the deed of trust. So there's a UCC1 filing that's also relevant here in order to secure your interest in the loan. But then we also always are going to recommend that you record a collateral assignment of the deed of trust in the underlying property records showing that there is a lien on the deed of trust because otherwise you run the risk.

And of course you never want to imagine that your counterparty is going to be dishonest or anything like that. But without the recording of the collateral assignment, you do run the risk that they could further even sell the loan or they could leverage the loan a second time. And if there's nothing on title, then you run the risk of not giving notice to third parties and get yourself into a mess. And so we always recommend the two-tier approach where you file a UCC one and also record a collateral assignment.

And in this case, the hypothecating lender is getting a return on the hypothecation note, not on the underlying note, but on the second note, the note on the note. And this could be completely passed through, but it doesn't have to be. The originator can take a spread. You could have an 11% rate on the original, the underlying loan, and then maybe you only pass through 9% to the investor, the hypothecating lender here, or you can do full pass through, pretty similar to a participation or obviously at a fractional interest, you can even do this through a spread agreement or whatever. So they're all pretty flexible, I would say, in terms of if you want to find a way to collect a spread as the originator. But in this case, the document that is going to lay that all out is another promissory note. So there's a second promissory note here involved that is going to be between the originator and now the hypothecating lender, the investor.

And in this case, if the borrower defaults, you're going to specify in the hypothecation documents exactly how that will be handled. Because if the underlying borrower default, it may be that the originator is still probably handling that process. But depending on the terms that you negotiate with the hypothecating lender, there's going to be a point where there's a default on the hypothecation as well. And so however you set that up, if there's a default between the originator and the hypothecating lender, the investor, then ultimately the investor here can foreclose on the loan and they now become the lender of the underlying loan and are now after that would be having a direct borrower-lender relationship with the underlying borrower. So they have collateral in this scenario, and they're just kind of one step removed. As I mentioned at the beginning, your hypothecating lender can ultimately reach the underlying real property collateral, but it takes two steps to get there rather than just the single step of foreclosure, as you would see in the co-lending with a fractional interest.

Some additional considerations here, as I already talked about, generally you need to record a collateral assignment in the property records, and that can be a sticking point for the originator. You may not want that to happen. I've certainly seen that be a sticking point in negotiations on these where the originator doesn't realize that they needed to record a collateral assignment if they're going to do note on note. And like I said, from the investor standpoint, you really want that in place to protect your interest. And so this one, you'll have to make sure that everybody is aligned and is okay with the administrative part of it, as well as the fact that there's public notice and even the borrower here is quite possibly going to find out because there's going to be something of public record. And so it's very conceivable that the borrower will realize that you've leveraged this loan and whether or not that you care about that is going to be something for you to consider.

But the big advantage here is you've got the originator able to leverage the underlying loan without giving up immediate control because it's this two-step process. So you're not adding a co-lender, you have a creditor. And so you're generally still in complete control of the underlying loan. And at least as long as things go smoothly, you're going to continue to be the sole point of contact and the only administrator of that loan. And from the hypothecating lender side, they don't have to administer the underlying loan. They don't have to be directly involved in that, but they do have collateral. And so that's a big advantage for them versus a participation is they do have collateral here. And even though it's a bit of a cumbersome two-step process, if they really need to, they can't access collateral and can have an assurance that they can be made whole or as whole as possible through that.

And a big disadvantage, of course, for the originator is that if something does go wrong here, you can potentially get foreclosed out of your loan and lose that collateral without being made whole. And it's like any transaction where you've got a secured creditor is where you have got a potential for loss and a potential for that foreclosure action.

So just to summarize what the major considerations are here when you're looking at these approaches, the first part of it is really deciding how much control that you want to give up. As we've gone through these, you obviously have seen that there's a pretty big difference in some of the control where if you're co-lending, you're selling a fractional interest, you're generally going to give up some portion of the control, and they're going to be a co-lender that's on title. A participation agreement, generally, the seller keeps full control. And even in the event of a foreclosure liquidation, they're still in full control. And then on the hypothetication, the note on note route, a bit of a blend. You do, as the originator, keep full control at the beginning, but then depending on what happens and where things go, you may not be able to maintain control and could of course be foreclosed out by the hypothecating lender.

Risk tolerance, and obviously it depends which party you're talking about here in terms of risk tolerance, because for the originator, the participation is really the lowest risk route. Whereas if you are the investor that's coming in and bringing capital into these loans, the lowest risk is going to be the fractional interest route of just being a co-lender, having direct collateral being on the deed of trust. And the hypothecation in that sense is kind of in the middle. And then the needs of the investors, which is often the dominating one. As I mentioned with the participation, it's really great for everybody if there's a high trust level, but the investor has to get comfortable with that. And if they're not comfortable with that, then you're going to have to look at one of the other ones and figure out basically how close do they want to be to the underlying collateral?

How much do they trust you to administer the loan with them just out of the picture? And then also, do they want to be a public record with this investment? Because that sometimes can also be a pretty huge consideration for the investor. So those are the basic overview. Kevin, I'll turn it over to you here to discuss the really tricky stuff of trying to make sure that you're doing this and being compliant.

Kevin S. Kim, Esq.:

Before we get there, we do have some really good questions from our audience that really hone into what you're asking. So let's get into these. I want to make sure we get to these first. One good question here is how does title insurance work when it comes to hypothecation? And audience, we don't get to all these right now, we're going to get to them later if we can. So that's a good question here because title insurance, how does that play out here when you're doing note on note financing?

Kyle Niewoehner, Esq.:

Yes, it is a great question. There's actually two levels of it. So on the one hand, you have the original loan, which will of course have its own title policy. And then that will usually cover, and you want to make sure if you're coming in as an investor, you want to make sure that it covers successors and assigned, which most title policies do. And so typically on that original level, if you as the investor end up having to foreclose and take the place of the original lender, you would succeed to the rights under that title policy. However, there's also a UCC title policy that you can get. And as I mentioned, when you are documenting the hypothecation, you secure it by filing a UCC, and then you also want to record a collateral deed of trust. But for the UCC filing, you can get UCC title insurance from title companies.

And so we commonly see this in mez loans, but you could also look to do this with a hypothecation if you want to make sure that your interest on the originator is secure. And what that does is basically title ensures that you are in first lien position for that personal property collateral of the loan. So they're doing searches and the UCC records and stuff like that, but they would ensure that if you need to come in and take over the loan, you actually have some title insurance for the first stage in that process. And then once you foreclose and you've taken over the loan, you would succeed to the underlying title policy that's actually securing the real property. Okay.

Kevin S. Kim, Esq.:

Another good question here is more of a, I guess you can call it, I guess, drafting questions in any of these strategies, particularly loans withdraws and all that. I'll just read the question. Can you please describe how the cashflow works in this situation? Construction loan funds are reimbursed to the borrower over time or dispersed to the borrower over time. Therefore, when the initial loan sale or participation occurs, how does the originator pull down cash from the purchaser? Please describe. How do these instruments handle draws effectively?

Kyle Niewoehner, Esq.:

Yeah. You basically need to customize language in any of these agreements to handle that. In the fractional sale, that would be a situation where you definitely want to make sure that you have the sale agreement in place, unless the fractional lender is just going to fund their proportion of the draws upfront. But in that case, I mean generally speaking then as the investor, you'd probably want to have that documented of how the originator is going to use that if you're going to put the funds in trust for them. But usually in the co-lending situation, you are signing up for your proportional interest in the future draws. But yeah, you'd want to document that. In the participation agreement route, you are going to have to figure out who's funding what and then customize the agreement for that because I've seen situations, I mean, obviously sometimes it's just pro rata.

And then we have provisions in the participation agreement about loan advances, how those are going to work. And we specify of how many days notice do you need to give for a draw? What happens if the participant doesn't fund their draw that they're supposed to fund, et cetera. So you have to document all that. There may be also situations where one party is funding all of the future draws The other party is only funding a certain part upfront, et cetera. But you have to document that. With the hypothecation, it's a little different because at least traditionally the hypothecation gets funded upfront, like the note on note financing. So you can customize all of this stuff to do whatever you want if you want the hypothecating lender to keep funding it gradually. But in that case, you may want to also limit their collateral. And just because of the collateral structure and a hypothecation, it gets more complicated to do a future draw schedule.

And it's a lot cleaner to just have the investor fund the full amount upfront and then potentially the originator is going to hold it and disperse as necessary. But you can really, if you want to, you can really customize the hypothecation structure as well to do future draws. But I would say honestly, the hypothecation is probably not ideal for a future draw funding thing just because the collateral that they're giving is generally the whole loan or push loan or whatever. But because you need to file the UCC and do the collateral assignment and the property records, if their collateral interest in the loan is changing sort of throughout the loan based on how much of the construction draws they're funding, that's just harder administratively. So anyways, you can customize any of them, but that's kind of the basics of what you'd be

Kevin S. Kim, Esq.:

Looking at. All right. We're getting a lot of questions in the chat here or in the Q&A section here about California specific regulations. I'm going to go over that for y'all in a second. But I do want you guys to know, we're talking about this nationally guys. We're not honing into the unique, I guess you'd call it, precuities of California and their weird laws. And we can, but that's probably a whole webinar in and of itself. So we'll try to get to a lot of these today. All right. So before we get into all this stuff, I do want to preface that all of these structures, whether it be co-lender, participant lender or hypothecation, are all derived from capital markets. They're all derived from our friends and capital markets. And you have to answer one key question in how you're interacting and how you're transacting is this transaction you're entering into a capital markets transaction where you have a quote unquote institutional grade transaction happening versus is this really an investment that you're offering to a high net worth investor or retail investor or so on and so forth?

They're very different. And we're going to get in the weeds on that on the security section, but they're very different. Because you have to think about them differently. The reps and warrant, the document stack is going to be different. I get this all the time. Well, why is this so much more complicated than when I do, what I would call a country club fractional deal? Well, first of all, you're doing it wrong over there. So there's that aspect to it. So our approach is to make this so that you're addressing all the risks that come with these transactions and we're really only hitting tip of the iceberg today. All right, so let's get into licensing considerations. All of these transactions raise licensing considerations. And in certain states where you don't need a license to do business purpose residential or commercial real estate, less of a concern, but there's still unique regulations on the books.

And so you want to think about that. So let's start in the worst state in the country, my home state California. So we have three different options here. And they create all kinds of weird things for lenders. If you're doing fractional and you're a CFL licensed lender, you can't do it. Pure and simple, you can't do it. Why? Because CFL is limited. It's very narrow in what it can do. CFL allows you to lend. It requires you off your balance sheet. Licensee must be lender a record. So a lot of interesting issues there. So co-lending doesn't really work there, which is why you don't see CFL lenders co-lending. That's why the participation agreements are oftentimes very useful. Participation agreements are a contract that points to the loan. And so there's no selling of a fractional interest, no brokering of a fractional interest to an unlicensed party, which is all not allowed under CFL.

So it's a very commonly used solution for CFL lenders, both with institutional counterparties, but also with high net worth investors or so on and so forth. There are a lot of other states that have weird regulations here and they're not all licensing states for residential. So let's talk about other weird things. Nevada. Nevada has very strict regulations when it comes to fractional, the co-lending model. And what they have told us, the regulations basically make it look like you can only really work with an individual in that context. As a mortgage company in Nevada, you're going to be limited in who you can transact with. Have I seen entities on the other side? Yes, but very rarely. They've said to us directly, the regulator has told us directly, we do not authorize that. Fractionalizing with entities, we think that that entity for residential should have a license to do that.

So there are those issues. And then there are weird issues at the state level that are not necessarily associated with mortgage licensing. So for example, in Colorado, Colorado has a very strict regulation on its books that addresses whole and fractional note sales or even brokerage. And it's particularly specifically addressed to the individual context or the high net worth investor context. And what they've said is, and this came out during the advent of the peer-to-peer lending business models back post-recession, post - GFC, was Colorado says, while you don't need a license to make these loans, you don't need a license to make these loans for one to four family business purpose. You do need a securities license to offer whole and fractional trusted investments in Colorado to Colorado residents. And when I spoke with the regulator on this, it's the securities regulator. When I spoke to the regulator on this, their perspective was, we're going to keep this regulation.

We understand that it's kind of weird, but we're going to keep it. We're not getting rid of it. A. B, it's basically up to us to decide based on who the counterparty is, whether or not you need this license. And it is not one of those things that goes unenforced. If you're in the state of Colorado, you know that if you look at the market there, most folks don't use co-lender fractional because of this regulatory issue. And this applies to all lenders selling whole and fractional into the state of Colorado, residents of Colorado. It's a securities license too, so it's very unique. And then there are other states that say, "Well, we don't like this because of brokerage rules." So a lot of times whole and fractional are used to fund loans as a brokerage arrangement. Someone will get a loan and they'll do it at closing with either a whole or fractional investors to fund the loan as lenders.

It doesn't work because the state says you need a license to broker mortgages. Not lend, broker mortgages. And so that it's easier to sell the loans post-close, but if you wanted to do it in a brokerage context, it wouldn't work. States like Pennsylvania, New Jersey, New York, Michigan, all of these states are exempt business purpose residential, which you've been explained to multiple times in our webinars. But their real estate license, the definition of a real estate broker in those states includes someone that arranges a real estate loan for compensation. And many states, many lenders have wondered, are they enforcing this? And recently New Jersey took a strong position that we are enforcing this. And I've heard also similar stories in New York and Michigan. So it's not something you want to mess around with. That's why participations are so useful. Participations are an indirect transaction.

You're not doing a direct placement, you're not brokering anything. Really what's happening here is it's a indirect contract that points to the underlying mortgage. And we borrow this from our friends in banking and credit unions and life insurance. They're the ones that pioneered this. And to Kyle's point, the master lender needs to be the one that's in control. And the participant lenders, they can have all the contractual rights that they can put in the documents, but they're really behind the scenes. They're not on title. So it's a contractual obligation in a lot of ways, but it's a very good solution to a lot of licensing restrictions, but also a lot of covenant restrictions that we find on restricting transfer of loans and so on and so forth. Considerations for licensing in the context of hypothecation are also something that you want to think about. At scale, we have faced accusations, not a heavy enforcement activity, but accusations nonetheless from state level, we call it licensing regimes, asking whether or not those investors need to be licensed because they're making, technically speaking, what's happening here is they're making a loan.

And this is no different than leverage. This is leverage. This is note-on-note financing. And so at scale, it is worth considering. As an investment product, it typically is not, but it is worth considering because we have been asked that. And so if you're in the business of providing note-on-note financing, you may want to consider compliance on the licensing side. Also, what's interesting is because this is not real estate finance, there might be unique commercial licensing regulations that apply to you. Let me give you an example. California, our regime does not differentiate the license that you would get. It applies whether or not you're making a real estate loan or a commercial loan on mortgages. So that would be a CFL license. The Department of Real Estate license is for real estate finance. So a lot of times random states may say, "Hey, don't you need a license to do that?" Now as an investment product, less so.

Less of a concern. But it does raise interesting questions. And there are many states in the country that do have some regulatory regime when it comes to commercial finance, similar to the states that regulate business purpose residential or commercial real estate finance. You can predict that those states likely have an interest in regulating commercial finance as well. Those are the considerations in licensing. You want to make sure you think about this kind of stuff. You're not going to just jump in and do it. But it is less complicated than the securities considerations. And this goes to a lot of the topics that have been discussed in the questions. First things first, I want to differentiate as to when this stuff kicks in. So we have two tests that we rely on primarily in the securities world. We have the Reeves test and we have the Howie test.

And these tests are not mutually exclusive no matter what online guru might tell you. And contrary to what your online gurus are telling you, these can be these structures, co-lending, fractional, participant interest, no, no financing. These all can become securities. Why? Well, the counter argument is, oh, they're loans. They're loans. How are they a security? Well, so is a bond. In its core essence, a bond, municipal bond, a treasury bond, whatever you want to call it, whatever bond you want to talk about, CMBS, these are all bonds. You're making a loan. The investor is making a loan to the issuer, to the government in a treasury bond situation. It's really what it is at its core. So if you really want to distill this down, really, any kind of transaction can become a security. And what I tell people is you really have to differentiate between institutional capital markets transaction versus high net worth investor transaction, retail investor transaction.

This is where the rubber meets the row when it comes to differentiating between what is a security and what is not. My general school of thought to guide you guys, if your counterparty is an investor, high net worth investor, you can rest assured that this is going to be defaulted to be a security. If your counterparty is a bank, if your counterparty is an asset manager like Atlas, Churchill, Turak, Fidelis, probably not. Definitely not actually because the transaction is going to look remarkably different. And so in the context of dealing with investors, high net worth investors, retail investors, even family offices, we have to consider securities regulations. And the securities regulations are nuanced because, well, in these transactions, you've got the confluence of multi-state issues. And so whether it's a participation interest or a fractional deal or a hypothecation, you have this core issue. State laws govern the offer and sale of securities if you are selling in that state and that state alone.

If you cross state lines and you're selling to one investor who resides in California, one investor who resides in Nevada, one investor who resides in Florida, well, now you've crossed state lines, you're offering the same security, therefore federal law applies. And we got to think through those kind of things. Some of the key issues to think about are along the same lines we've discussed on our fund webinars. You want to think about accredited investors as your primary resource. You want to think about not publicly marketing this stuff because there are restrictions on that. There are exemptions that allow for it, but there are exemptions that don't. Do you have to comply with anti-fraud rules if you're dealing with non-accredited investors? Very important consideration.

In the context of doing this at scale, doing a programmatic offering to a large number of investors, it is best practice also to consider preparing offering documents to make sure you disclose all the mechanics to the investors as well. It's common product. You see that out there a lot. Many companies have done that over the years. Many of our clients have done that over the years using these exact structures, participation interest, no, no, no financing, hypothetication, even fractional. Now, many of you have asked questions about the Department of Real Estate here in California. Us being in California, we do have a lot of audience members who are from California. California is unique. I will admit that. California is unique. If you are a Department of Real Estate broker, you are allowed to do this thing called fractional under your license. But remember, the Department of Real Estate grants you a securities exemption to do that.

If you read the code carefully, it is a securities exemption to the California corporate code. That's issue number one. Issue number two, it limits you specifically to the state of California. The loan must be in California and the investors must reside in California. Must, must, must and must. You cannot deviate from that. Now in that particular small exemption, you are permitted to do a lot of things. You are allowed to have non-accrediteds. You're allowed to market the thing, but that's unique to California. Do not think that this allows you to suddenly bring investors in from other states to utilize that exemption. It will not work. It's unavailable to you in that situation. It will not work for non-California loans. It will also not work in the context of tranches. You want to have different risk profiles in your fractional note offering. It will not work.

And so that's a very limited exemption at the state level. And we have researched the entire country to find something like this in other states. And it's very unique because it's the only one that exists. No other state has created an exemption exactly like this. Do they allow it? Yes. But do they have a security exemption around it? No. And I will tell you guys, my opinion, my advice is that all of these transactions, when the counterparty is a high net worth investor, they're relying on your expertise. They're not doing their own underwriting. They're relying on your, I guess you can call it service to make the money. You can rest assured that this is a security. And same thing with any of these other transactions. No, no, no. Participation. We really want to be cautious there. Other issues that come up with this stuff on the security side are not on the issue inside.

Basically, we've been talking about issuance compliance. So Reg D, credit investor, those kind of things, as you the person that's arranging these transactions. The other part of this is for companies that have funds. If you are a fund, if you are what the SEC views as a pooled investment vehicle, and you have loans, and you do these from your fund to a high net worth investor, so you enter into a securities transaction from the fund. Then we also have to consider compliance with the Investment Company Act and the Investment Advisor Act. Meaning that the fund manager will have to file as a private fund advisor with the state regulator and eventually the SEC and will likely trigger audited financial requirements for the fund. This is typically avoided if you just are just a balance sheet fund. But once you trigger those things, it does. It's no different than if the fund were buying marketable securities because the regulator views it as the fund is now in the business of buying and selling securities.

And this is not a theoretical exercise. It has happened before. We have seen this come up before. We've seen it happen in California, we've seen it happen in Texas, seen it been an accusation being levied in Florida. So you do want to be cautious there as well. You do not want to trigger those things unnecessarily because the obligation is significantly higher now. It triggers always additional compliance.

So one question we always get in this arena is like, well, how do we ensure that we are not triggering all these securities things? The way I look at it once again is, okay, who's the counterparty? If it's a high net worth investor, I don't care if he's using an entity or not. Don't get cute with the rules here. If the counterparty is a high net worth investor and they're pretty much passive and they just prefer a debt investment, they just prefer a direct placement, they prefer that kind of arrangement, you should just automatically defer to the point that this is a security. Why? Because it's not worth the risk. Because these transactions are usually pretty small. They're not big transactions. And the cost to defend an inquiry from a state regulator or federal regulator is going to be probably five to 10X that. So why mess with it?

And it's so easy to comply. The most easy way to comply is to make sure that they're an accredited investor. It's super easy to comply with these days.

If the counterparty is more institutional, so if they're another going concern lender, so lender to lender transaction, and once again, don't get cute with me. Just because they invest in whole or fractional notes as an investor doesn't mean that they're a lender. They're actually in the business of lending. They've got a team, they've got a staff, they've got a track record, they originate their own loans. That's what I'm looking for. Or they're a bank or they're an aggregator or they're an asset manager. That is typically going to be more of an institutional counterparty. And the transaction is going to look much more robust because they're going to dictate a bunch of additional reps and warranties. There's a lot of independent lending criteria, a lot of independent lending. They're calling the shots on what they're going to fund and what they're not going to fund. They're not reliant on you.

It's really a capital markets transaction. And that you can rest assurity is not going to be considered a security.

So that's going to be one of those things where you have to really think through it. And my position is typically why risk it? Let's be very cautious here because we don't want to run afoul of state regulator actions. Even just an inquiry alone from them can get quite expensive. So that's really it on my side. We can do a whole day's session on this, but I want to be respectful of everyone's time here. Some business issues we want to make sure we talk about. So overall, right? Kyle, so one of the things here is there's a lot of unique covenants that pop up both with counterparties that are more investor oriented versus capital markets oriented. What are some key things to watch out for?

Kyle Niewoehner, Esq.:

Well, I think there's several levels to this. For clients that are kind of layering and using multiple of these arrangements at the same time, then you're going to have to be really careful that you don't get your wires crossed. I mean, if you are originating a loan and then you sell a fractional interest and then you participate another part of it, you're going to have to be really careful that, for instance, your sale to the fractional lender allows you to still participate your part of it or doesn't restrict that and vice versa. Depending on what you negotiate, even in a participation agreement, if the participant wants to make that a little bit more strict and they want to restrict your ability, you have to be careful. Our default on our participation is that you can do whatever you want with the retained interest.

And obviously if you've got other financing arrangements in the background, if you're putting these on a line or doing anything like that, you're going to have to be really careful about what the covenants are in one, if it restricts your ability to go and participate or do a fractional sale or whatever of another part of that loan. And I mean, generally speaking, if you're planning to use multiple structures on the same loan, you would definitely want to be consulting an attorney and making sure that you're carefully reviewing all the different sides of what you're doing. And of course the simplest approach is to just do one thing per loan, but people want to get creative. And so really with any of these arrangements, there's usually going to be a provision somewhere in there that talks about can the originator assign or sell or participate their retained interest?

Can the investor sell or assign or whatever their interest? If you do a hypothecation, can the hypothecating lender sell that note, the second note to someone else, et cetera. And so you just have to carefully review the arrangements that you're getting into to make sure that you're not doing one thing, and then you do another thing that conflicts with the original structure that you've already put in place.

Kevin S. Kim, Esq.:

And in the same vein, one of the things guys we run into a lot is this is more on the institutional side is if the client has other capital markets opportunities in which they would prefer to sell loans or do participation interests with, or even do note on note, and they have a line of credit with a bank or an asset manager, there are a lot of covenants there where you really have to be cautious. You could be in breach of covenant by simply doing this because they have very strict restrictions on not just the assets themselves being levered or sold, but also in the context of, I guess you can call it debt service covenants. And so overly levering your business could also get you in hot water. I've also noticed that a lot of counterparties get really anxious about, I guess you can call it lender risk.

Are they throwing covenants in that have to do with lender risk like portfolio risk or operator risk or key man risk or those kind of things?

Kyle Niewoehner, Esq.:

Yeah, I mean you definitely need to, I guess, especially like you said, if you've got a warehouse line or any other types of repurchase agreements or whatever in place that covers basically your operations or your whole portfolio, then you need to make sure that you're very well aware of that stuff. I don't usually see key man and stuff provisions like that coming in terms of the structures that we were talking about today. Although I mean you could put that in, but it is more so in warehouse lines and stuff like that. And then if that's the case, then you just need to be really careful of what your warehouse lines, what your mastery purchase agreements, et cetera, are allowing you to do. And then obviously proceed accordingly as you use some of these other specific structures.

Kevin S. Kim, Esq.:

Yeah. One other thing that I want to make sure you guys understand is these arrangements can get very, very creative very, very fast. So tranches meaning you have different kind of classes and you can do A/B structures and different risk profiles, different economic profiles. You can even do a mini securitization with this stuff and slice and dice the transaction with different economics. And so all that tie it together. The issue is disclosure there. So even if it's not a security transaction, it's a massive obligation to make sure that you are completely transparent because the last thing you want to do is get overly creative and then all of a sudden get caught with your pants down. Even in the simplest context of a note on note or participation over levering the underlying loan. And we've unfortunately seen some bad actors do this where you've got a million dollar loan.

They'll take out way more than a million dollars and they'll go well past the one-to-one ratio when everyone else involved was expecting that to cap out at one-to-one or nine-to-one, whatever it is, 0.9 to one or something like that. So those are issues that are very, very important from a business standpoint. You do not want to be considered dealing that fast and loose.

The amount borrowed, if you're going to be borrowing on a three to one leverage ratio, you better be disclosing all that. It's a business term whether you choose to do that or not. But if the counterparties who are lending to you do not know that's a possibility, yeah, you've got a major issue there. Particularly in these known-on-known arrangements where you see one loan being sliced and diced with 10, 20 investors. Even in fractional, it can get really messy. So you want to make sure that you're really thinking about fractional less so because you have just the loan amount being sold off. But in the note on note and participation world, this can get very messy, very fast, and it can well exceed the amount of available cap, the actual loan amount. And if you're not disclosing that, that's pretty much fraud. So we want to be very careful there.

Yeah.

Kyle Niewoehner, Esq.:

And I would just say too, yeah, basically all of these arrangements, there should be disclosures in the original documents about what the interest is being transferred and you can't double transfer that. Basically in any of these structures, you are basically then into the fraud realm. And also just to reiterate what something I already said, but what Kevin just said is one of the big risks for an investor in a participation. Because in that structure particularly, there's no public record. And if you have a bad actor who's originating, they can do duplicate participations without anybody catching on. And so that's why while that is a great structure for a lot of other reasons, there's a pretty high level of trust required to avoid that type of bad actor situation.

Kevin S. Kim, Esq.:

Which is why, like I said, in my section, when it's two banks doing it together, there's a lot of trust there. But if you look at those agreements in debt, there's a lot of reporting, right? A lot of reporting obligations. And so that may be something to think about as well for you and your counterparties, our audience. All right, so I do want to make sure we answer questions. We have some questions here we haven't addressed yet. All right. So first question let's get to here is a DRE question from LC. So DRE does not allow guaranteed payments for high failure and fractional loans. Yes. I wouldn't offer that. In general audience, it's a bad idea to guarantee any debt. Imp hypothecations structure, if the borrower defaults, does the DRE allow the original lender to continue to make payments to the hypothecating lender? My understanding here is that the DRE doesn't really govern those transactions because they're not really real estate loans.

It's not really contemplated by the DRE and it's not usually originated under that license, my understanding. I. So that's my - I just

Kyle Niewoehner, Esq.:

Pulled up the.

Kevin S. Kim, Esq.:

What was that?

Kyle Niewoehner, Esq.:

Oh yeah, I was just pulling up the Q&A here. I see the one that you talked. Okay, first of all, typically in a hypothecation structure, the most common thing that gets negotiated is that it's like a pass through structure where you're only passing through payments when the underlying borrower makes payments. But I mean, I would say this is not a fractional sale, which is why there are potential licensing considerations for a hypothecation. So you have to look at exactly how you're structuring the hypothecation, what license is being used on it. But generally speaking, a hypothecating lender is not getting a guarantee of payments. So if you are going to want to do that, then yeah, we'll have to make sure that it is going to be DRE compliant if you're not using a CFL or something on the note, the second note.

Kevin S. Kim, Esq.:

All right. Question from Rich. If you're an investor that purchases loans from an originating company and later wants to issue a participation agreement to a family member or friend, can that happen? The answer is yes. That would be more on the context of the security side. You were just offering an investment and in the form of a participation agreement. The agreement should probably be well tailored to the situation, but you are offering an investment to them and that's one way clients have obtained liquidity or offered an investment in their assets.

Kyle Niewoehner, Esq.:

Now, Kevin, in that situation, that would be a security. How much compliance would you need to do if you're selling a participation to a family member?

Kevin S. Kim, Esq.:

Same compliance. The SEC does not give two dams about friendly, friends, they don't care. So what they really care about is, all right, well, have you complied with the anti-fraud rules when you're an issuer? Are you offering this under what exemption? And same with the state regulators. So the key question really is, is the investor, are they an accredited investor or are they a non-accredited investor? The law dictates that if they're a non-accredited investor, you must deliver the equivalent of a prospectus. We call that a PPM in the private world. And even in the context of individual high net worth investors that are accredited, we still recommend it because it's a very good disclosure item. So it's very considered best practice. It would depend on the nature of the transaction too. So if you've got a one-off deal in one state, then we probably look at that state's regulations.

And remember, it's based on where the investor lives, not where the investment product is. So all that depends on the nature of the deal.

One really good question here. Again, it's a lot. So mortgages and promissory notes secured by US real estate and held by non-US residents, typically through an entity, generally qualify for the portfolio interest exemption. How do these types of instruments, when issued to other high net worth non-US investors, address or preserve eligibility for the portfolio interest exemption? Well, you're actually a mistake in here. So the portfolio interest exemption is a broader exemption under the tax code. What it says is the foreign national, non-US person lends into the United States and that loan qualifies under the portfolio interest exemption. And there's no, I guess you call it interrelation between the lender and the borrower. And the lender is not a bank, insurance company, financial institution in a foreign country. Then the portfolio interest exemption applies, meaning that the interest income earned is not subject to US withholding tax.

Now, where this becomes an interesting issue is technically speaking, all three of these programs will qualify, can qualify under PIE, portfolio interest exemption. However, it's nuanced. You have to make sure that, first of all, on the ownership side, the lender and borrower relationship side, there's no co-ownership over 10%. They're not family relatives, all that kind of stuff. The lender's not a bank, lender's not an insurance company. You have to be an eligible lender. Non-US person as well under the tax code, not under immigration laws, under the tax code. So you are not a US taxpayer.

That requires no matter what. Second issue is, okay, well, what about the loan itself? Is the interest payment in compliance with the PIE exemption? The interest payment requirements under PIE is that it cannot be contingent interest. Contingent. So it can be based on an index, it can be a flat rate, but it cannot be contingent interest. And hypothecations is where this comes up. Sometimes in participation agreements as well. If it's conditional, depending upon payment of the underlying borrower, technically you have a risk there that it would not qualify. And then also one thing that's misunderstood by PIE is that you also have to be a registered form, meaning you either have to have a ledger recording all the payments and who the lenders and borrowers are, A, and actually written down somewhere, A, or B, the loan is non-transferable. It's very much an important feature to PIE.

And then the last component that's oftentimes overlooked is are you necessarily delivering the appropriate forms and getting an appropriate certificate? So the appropriate forms are the W8BEN form that's required to be delivered to make sure that this doesn't trigger all that stuff. And then separately, you also have to make sure that as the lender, you get a PIE certificate to make sure you are comfortable doing it as well. Very nuanced issue, but we deal with this a lot, particularly lately out of Latin America and the Middle East, but happy to walk through detailed issues on foreign national lending to the United States. Another question here, can you have multiple hypothecation agreements for different investors or is it preferable only one per underlying mortgage and note?

Kyle Niewoehner, Esq.:

So yes, theoretically, technically you can't have multiple hypothecation agreements with different investors on, like I assume we're talking about here, the one note. But it gets very complicated very quickly because of course in that scenario, each investor is secured not by the whole loan, but by a partial interest in the loan. And now you have to have this consideration of, okay, if this all goes bad and I've got a bunch of different original investors that all end up now as co-lenders on this loan, and how do they relate to each other in that situation? Suddenly they're thrown into a co-lending situation with a bunch of people that they may or may not even know. And so yes, you could do this, but it's going to be pretty complicated administratively and how you set up, because you're going to have to make sure that you set that up so that there's full disclosure to these people, they understand what you're doing, and then you're going to have to have something in place for them governing the relationship with each other.

As I mentioned, originally you're generally securing these with a UCC filing and then also a collateral assignment. And so best practices, you're going to need to do that for all of these different investors. And so while you can do this, just understand that there's going to be a lot going on there, and that's going to be pretty complicated and involved to document it and make sure you're covering all of your bases with these different lenders. And that's not even getting into some of the compliance considerations on the security side, et cetera.

Kevin S. Kim, Esq.:

Yeah. If you're doing this, I would probably make sure you're talking to a securities attorney. This has actually been done before. So in our industry, Peer Street, a company named Peer Street, they're no longer around. They made it famous, but there are other companies that do this. So many of them are still in a good operation right now, in good standing. They do this. They offer this as an investment product. This actually was, it's been around for ages. So Lending Club made it famous back in 2009. So it is a very commonly offered product, but it's a very nuanced and complex product, so you want to make sure you deal with it in the appropriate way. Last question here. In a participation agreement, do third-party servicers handle the payments or does the note holder company, I guess the master lender, do they handle the payments to the participant lenders?

Kyle Niewoehner, Esq.:

You can do it either way. This does create, depending on what you choose, you need to customize a participation agreement because it does make a difference in a number of provisions in the participation agreement. And you can also leave it open so that you can do it either way. But very commonly, at least right now, what I'm seeing is that usually the note holder continues to service the loan. Usually these are situations where the note holder is servicing, wants to continue to service and maintain full control and administration, and then they're participating it out. But you can go either way. If you want to have a third-party servicer, you can have a third-party servicer, but then you are going to end up needing to disclose the servicing arrangements to the participant if that's the scenario. If you're bringing in a third party, or maybe you already have a third-party servicer in place, but then at that point, the participant is going to need to get disclosure on what those servicing arrangements are.

And you're going to have to provide for that in the agreement of how that's all going to work between now you have essentially three parties that are involved in the flow of payments of a loan. But yeah, you can do it either way.

Kevin S. Kim, Esq.:

That actually raises an interesting compliance topic. We oftentimes get this question a lot. So if you're offering fractional, so you either are brokering the loan fractionally, or you're selling the loan fractionally, and you choose to continue servicing the loan, you are now in the business of third-party loan servicing. Understand that. And so for example, California requires a license to do third-party servicing and a CFL just won't do. It is a DRE regulated activity. We run into this problem a lot with CFL lenders who want to do some kind of transaction like that. A major limitation. Other states as well regulate third-party servicing in a very meaningful way. Up top of my Arizona is a big one. So you also want to be very cautious there. And that may lead you in the path of if you want to service the loan yourself, maybe doing an indirect route like a participation agreement, because servicing restrictions can be meaningful.

And getting those licenses are not the same as getting a lender's license because now you typically have a lot of additional obligations like compliance with collections laws, trust accounting, things like that, and may not be worth the squeeze there.

Kyle Niewoehner, Esq.:

Yeah, that's a great point. All

Kevin S. Kim, Esq.:

Right. Well, that's the close of today's webinar. As a reward to our guests, we want to make sure that you are aware that we are hosting a conference coming up, Fortra Conference coming up in August, August 25th through August 26th here in beautiful Newport Beach at the VEA Hotel in Fashion Island. For our webinar audience, here's a coupon code, $400 off your attendance tickets for the conference. And also to note, this year is the first year we're doing this, but I really want to promote it. We are kicking off the conference with a golf tournament. If you're a golfer, please make sure to sign up for that. It's going to be a great day out. Yours truly will be there. We'll be playing at Pelican Hill, a resort, a golf course on the South Course, and it will be a wonderful day out. Scramble, shotgun start at 9:00 AM on the 25th.

So if you're interested in the conference or if you're interested in the golf tournament, contact one of us. We'll make sure to get you guys set up. All right, that's all we have for today's webinar. If you guys have questions, you can reach us at these email addresses. You can also find us on our website, and you can also just call us, call the direct line. So happy to answer any further questions in this arena. I know it's very complicated. Besides that, Kyle, you have anything else to say in closing remarks? Nope.

Kyle Niewoehner, Esq.:

Nope. Appreciate everybody coming. And as you said, happy to discuss further. I know there's probably a lot of follow-up questions here.

Kevin S. Kim, Esq.:

All right guys, thank you for your time. Thank you for listening, and we'll see you on the next one.