Buying partial notes

[Robert Fry]

Reading through this site has opened my eyes to problems I never thought of. I usually stick to local rental properties. While trying to find a new investment for some cash I needed to put to work, a friend recommended I buy notes and gave me the name of someone who brokered notes. It sounded simple and so far everything has gone as planned for 6 months.

Then I saw @Dion DePaoli comments about partials and thought I better investigate.

He mentioned buying partials is dangerous for investors and can violate securities laws. Can anyone elaborate?

I bought 72 payments on a seller carried 30 year note. I am hoping I did not do anything wrong.

[Dion DePaoli]

Robert it is probably good you started a new thread on the matter so the debate can air out. I will go ahead and make my case that partial note investments are non-exempt securities. I am not sure this debate has occurred here on the boards.

First let's understand what the definition of a security actually is:

The term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.

So right there at the beginning of the definition we see "any note". In addition we also see "evidence of indebtedness" and "investment contract". So it seems pretty clear that all promissory notes are in fact securities. That means mortgage notes too.

So then we can apply the exemptions from registration as security. It is important to again point out - all notes are in fact securities - so no argument that says they are not is valid. "Some" notes are exempt from security registration which those families are as follows:

• Delivered in consumer financing
• Secured by a home mortgage
• Secured by a lien on a small business
• Evidencing a ‘character’ loan to a bank customer
• Secured by an assignment of accounts receivable
• Formalizing an open-account debt incurred in the ordinary course of business.

So we see that when a note is secured by a home mortgage it realizes an exemption from the securities definition. So one of the first tests we can apply to the sale of a partial is does the partial investor enjoy the same secured interest as that of the whole loan investor. This is where we need to acknowledge the variety of structural differences that are often put forward. If the partial buyer does not enjoy or can not rely on the security instrument then by definition we have a "different" note asset all together.

So if the partial sale comes with the Seller of the partial retaining full rights and interests in the note and mortgage/deed of trust then for sure we have a security. What tends to happen here is the Seller of the partial retains the rights and interests of the Mortgage then takes the bundle of payments and extends those payments to the partial buyer. This sale may come with guarantees of yield or return. If so, it instantly becomes a security, as any guarantee of performance is a security by definition.

Ok, so what happens if the partial buyer receives rights and interests granted to the Mortgagee and there is no guarantee involved?

For that we will introduce the Howey Test, which is a test on an investment contract to determine if it is a security. For the record, the Howey Test came about regarding a real property transaction. The property was a citrus grove and a contract was created and sold where a third-party retained the full rights to operate on the property collecting the harvest and selling said harvest to make the note payment which then would be distributed to investors. That contract was found to be a security and was not exempt from registration. The test criteria is as follows:

1. Expectation of profits
2. Common Enterprise
3. Depends solely on the efforts of others

I think number 1 is pretty easy to see and understand it will apply to most investments in the market period.

For number 2, common enterprise, we get a little abstract. A common enterprise has a couple of different concepts which go with it and those concepts are recognized differently depending on the court which entertains the matter. If we try and paraphrase some of the concepts that go into this analysis we can look to an idea of whether the Buyer of the partial rises and falls in profit in line with that of the Seller of the partial and if the Buyer of the partial holds the secured interests granted by the mortgage or deed of trust or if in fact the Buyer holds an interest secured by the security, meaning not holding the actual security instrument but rather has a [fractional] interest in the security instrument. Secured indirectly by the security instrument.

Sorting that out is certainly grueling. What happens in the event of default? What rights can the Buyer of the note actually invoke to cure any breach or default and from whom does the remedy emerge (Borrower or Seller of partial).

The more a Seller of the partial steps into a loan to administrate thereby reducing the rights of the Buyer of the partial to enforce the actual security instrument the more we travel toward a security.

Those idea are more easily understood when applying Howey Test part 3 which is "Depends solely on the efforts of others". If the Buyer of the partial has to rely on the Seller of the partial - seems pretty darn clear that we have a reliance and thus a security is likely present.

I will also add to this part of the analysis, often times partials are sold by the Seller as a "passive investment". That description has become more and more widely used by promoters to attract investors. Here is the thing, by definition a "passive investment" is a security.

Further one of the ideas that follows the testing of Howey Test #2 is how many investors are involved. This is sort of where marketing a partial can be source of turning the partial into a security. How investments are advertised or marketed has a direct affect on the perception of whether the investment is a security or not. The general idea there is the more public you make the offer the more the security definition should apply as the definition is present to protect the public.

One of the ideas that stems from the ideas around notes being exempt or not is:

"If the seller’s purpose is to raise money for the general use of a business enterprise or to finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely to be a ‘security."

To me, this in general seems to embody most note partial sales. A partial Seller usually is trying to raise money to repeat the investment structure again. The Buyer of the partial and the marketing of the partial is based on the profit the Buyer will realize from the note. This is on top of likely being defined as a dealer which requires license.

Further, whole loans are generally considered non-homogeneous. That is, no two whole mortgage notes are the same even though the terms of the note itself (rate, term, etc) may be similar. This is because the collateral to the note is not homogeneous. No two pieces of real property are substantially alike. This idea would seem to imply that the more homogeneous the investment becomes the more likely it should be treated as a security. This is because the more homogeneous an investment is the more widely marketable the investment is to the public. Most partials I see set out to specifically do just that. Create a widely acceptable investment to the public.

Two mortgages on two different properties are different. However, once we reduce the concept of the investment to merely that of the stream of cash flow, the investment starts to lose its uniqueness. All that is being sold is the cash flow or the possibility of the cash flow. The more the Seller relieves the Buyer of the risk of default and/or delinquency the more we move toward security.

In the case of the other thread where I made the comment the promoter was actually offering guarantee payments at X%. The investments were marketed as completely passive investments. The structure of the investment relied solely on the actions of third parties - the promoting Seller and the Mortgage Servicer. In a nutshell those combinations of things and a couple other smaller details allow the acts to be considered securities. Further, the deployment of defining the actions of selling securities was invoked specifically to "protect the public".

In that it is important to note, that one of the reasons we have the securities rule is to protect the public. Defining notes as securities along with other types of questionable vehicles/investments is solely to protect the public and create mandatory disclosures when those investments are being marketed to the public. The definitions are to some degree, meant to be flexible.

In that idea is where I think folks misunderstand that it was never meant to be a list of black and white ideas. Rather, a concept that can be applied to protect the public in various settings on various types of potential investments. Additionally, the presumption seems to be that a partial note sale is equivalent to a whole note sale and that is materially note true. That said, we always have to look at all the details to understand if the investment 'may' or 'may not' be exempt from registration as a security.

It is because of this much broader set of ideas that I do not advocate for investors to play with partial note sales. The ones I see pop up are almost always violating one of the concepts above with how they are solicited, how they are structured and how they are restrictive forcing reliance on third parties.

It is because of all of that I find myself saying that newbie note investors should really leave the ideas of partials alone. In my opinion, more often than not you are doing it wrong. The act is much more complicated than most even begin to think about let along understand.

To rebuttal the idea that "it is probably OK because others are doing it" - well we have a guy right here doing it and apparently doing it wrong. So, that defense doesn't seem to be strong enough to rely on.  

I suppose at the very least, those who have not paused to think about all the other rules that might apply now have some insight that - other concepts apply to the actions that are often seen being carried out in the market place and that doesn't mean they are proper.