Hidden Usury Traps

With banks and other lenders awash in loans that are under-performing, non-performing, and underwater, we all are receiving offers of "opportunities" to buy notes for substantially less than the face amount. No interest is payable on a loan that violates the California usury law. Any interest that has been paid is required to be paid back to the borrower. The borrower also can seek to recover three times the amount of any interest paid within one year prior to filing the lawsuit. Here are three hidden traps I have come across recently that converted what appeared to be fair and reasonable loans into usury.

Not A Holder-In-Due-Course

Most promissory notes are made by the borrower "or order." Those two words are intended to make the promissory note a "negotiable instrument." That means that someone who purchases the instrument without actual knowledge of any defenses to enforcement of the instrument, buys the instrument free and clear of any such defenses, including usury. In the recent case of Creative Ventures, LLC v. Jim Ward & Associates, the Court of Appeal held that the purchasers of the usurious notes at issue were not entitled to the holders-in-due-course defense, because the originator of the notes retained possession and custody of the notes. Many companies in the business of selling and re-selling notes, also offer the service of servicing the note, as in collecting the payments and forwarding them to whomever is entitled to them, or their proportionate shares. As part of such servicing, they also retain custody of the notes themselves, for safekeeping. The failure of the note purchasers to take custody and possession of the actual original notes will deprive them of the holder-in-due-course defense and subject them to whatever claims and defenses the borrowers may have against their original lenders.

Not a Broker

There are three parts to this one. A loan made or arranged by a licensed real estate broker and secured by real property is exempt. "Made" means the broker is the lender, not the borrower, and "arranged" means he receives a commission and actively participates in the negotiation and drafting of the loan terms. The Department of Real Estate's website will let you look up whether someone is licensed in California as either a sales agent or broker. The website can be several months behind. If the license appears to have expired or is about to expire, then you will need to follow up with the broker and the Department in order to make sure.

I have seen several cases where a person lost his or her license years ago and has continued arranging loans for decades without a license. Just because they sound, look, and act like a broker or agent is not good enough. A simple call to DRE's 800 number or click on DRE's website would have revealed that one never was licensed and that another had his license revoked for bad conduct.

In the recent case (which provoked this letter) of Creative Ventures, LLC v. Jim Ward & Associates, Jim Ward was a licensed broker, but all of the negotiating, lending, and commissions were run through his corporation. Mr. Ward had not bothered to file the papers to place his real estate license in the corporation. DRE took this seriously enough that it took all the steps and went through all the procedures to cancel Mr. Ward's license over it. Since the loans were arranged by the corporation and it was not licensed, even though he was, the loans were held to be usurious. Be picky about who is negotiating and arranging the loan and who is licensed. The courts, DRE, and litigation attorneys for borrowers are taking the difference seriously.

Another work around that can work, but only if it is done correctly, is that an unlicensed person can be paid a "finder's fee" for introducing a borrower and a lender to each other, as long as the "finder" does not negotiate, draft, or do anything else beyond introducing the parties. Such a finder might then turn over the negotiation, drafting, and closing to a licensed broker. If there turn out to be problems with the loan, especially the loan documentation, the broker might deny having anything to do with the negotiating and drafting in order to avoid malpractice liability, especially if it is true that the "finder" actually negotiated or drafted the defective documents. Some brokers think that the finder can then negotiate or draft the loan documents as an independent contractor or agent of the broker. One can imagine what a dim view the DRE takes of such arrangements. A judge or jury seems likely to have the same reaction.

In one case I handled, the broker died before the transaction was completed and the finder took advantage of the situation to steal the broker's commission from the widow by directing that it be paid to an account he set up with the same name as the deceased broker's company. There was no one, especially the cheated widow, to testify that the finder was acting as an employee or agent of the deceased broker. That loan was likely to be found usurious.

So check out the licenses, check them carefully, and be skeptical of transactions that rely on finders to get around the requirement that the loan be arranged by a licensed broker. Or let me, my partner Joanne Rosendin, or one of the other experienced real estate trial attorneys at our law firm review the transaction and make sure that it does not suffer from any of these weaknesses.