Summarizing DRE Regulations For Brokers and Private Lenders

When it comes to mortgage loans, California has extensive restrictions and limitations for brokers arranging these loans. The California Department of Real Estate (“DRE”) oversees licensing for brokers, as well as additional rules and regulations brokers must follow to remain in compliance with real estate law. Here, we discuss some of the most important laws and regulations that every DRE broker should know, as discussed in the Mortgage Loan Broker Compliance Evaluation Manual (“RE7”).

Business Considerations

First and foremost, every broker and each DBA they use, who arranges loans in California must hold a DRE broker license for each location they perform brokering activity at. Brokers who also originate consumer loans on residential one-four family properties must also hold a mortgage loan originator endorsement issued by the Nationwide Mortgage Licensing System (“NMLS”). Others that work with DRE brokers may also need a real estate license, such as broker-associates, salespersons, and independent contractors. Non-licensed employees may assist a broker, so long as they do not participate in  negotiations, and the broker exercises direction, control, and supervision over them. Brokers who also make loans have further licensing considerations. The type and number of loans they make determine whether they are subject to additional equirements under the provisions of Regulation 2844 and if the broker is subject to additional reporting obligations. 1

Brokers have other general business considerations under the DRE’s requirements. DRE brokers are required to retain copies of all documents related
to their transactions, trust accounts, and other documents for at least three years, except self-dealing statements, investor qualification statements for hard money loans, and information used to determine investor suitability for private lenders which must be retained for at least four years. Brokers  advertisements must not be false, misleading or deceptive, and must include their DRE license number. Advertisements may require other information, such as the loan APR, loan amount, and loan term, depending on the loan product advertised. Brokers who perform residential mortgage loan activity must submit an annual Business Activity Report, and originators must also submit quarterly Mortgage Call Reports through the NMLS system.

Naturally, the DRE also addresses a broker’s responsibility when collecting fees and funds. Under the DRE requirements, brokers should not collect any fee that has not been paid, incurred, or reasonably earned by the broker, and any earned fees are subject to strict disclosure requirements.

Allowable advanced fees and other funds collected from the borrower before the loan closing, such as appraisal and credit report fees, are required to be  maintained in a trust account, except when they are paid as reimbursement to the broker. Brokers who maintain a trust account for such fees should review the procedures the DRE describes in the RE7 to ensure their accounts are managed properly and to avoid any penalties. Advance fees may only be collected after an advance fee agreement has been approved by the DRE. Quarterly reporting must be provided to the client. Notably, real estate licensees cannot claim advance fees for residential loan modifications or loan forbearance activities. Additionally, fees and costs cannot exceed the fee customarily charged for similar services in the community where the services were rendered. Adding on to costs and fees is prohibited under the requirements and brokers must be careful to properly input costs when disclosing third party fees, sch as title and escrow fees.

For each loan, DRE brokers are obligated to provide disclosures to the borrower in the language the broker primarily negotiates in and within three days of receipt of the completed, written loan application. Required disclosures include, but are not limited to: (i) Mortgage Loan Disclosure Statement (Form RE 885 (interest-only loan on one to four SFR properties); or Form RE 882 (all other loans)); (ii) Privacy Policy; (iii) ECOA Appraisal Disclosure; (iv) Patriot Act Disclosure; (v) Multi-Disclosure (ECOA, Insurance); (vi) Fair Lending Notice (Form RE 867A); (vii) Borrower Authorization Form; and (viii) Hazard Insurance Disclosure. (This list is not comprehensive.)

These disclosures must also provide the broker’s licensing information, the amount of compensation payable to the broker, the DRE’s licensing information telephone number, and any broker-controlled funds involved in the loan. If the costs, expenses, or loan terms in these documents materially change after the initial disclosures were issued, brokers must disclose these changes to the borrower in a timely manner. Further, brokers arranging a loan and  representing the borrower in the underlying transaction must disclose this in writing to all parties involved within 24 hours, including their role in the transaction, as well as the form, amount, and source of compensation they will receive.

Private Money Transactions – Article Five

Article Five of the California Real Estate Regulations governs loans brokered to, notes sold to, or loans serviced for private individuals, non-institutional lenders, or note purchasers. Article Five will not apply to the negotiation or sale of notes created for financing the sale or exchange of real property where the broker was an agent, the broker was not a party to the transaction, and the required disclosures were given to each party is not a topic governed by Article Five.

Despite strict regulations on pooling funds, self-dealing is an acceptable practice so long as certain rules are followed. Selfdealing involves a broker who is soliciting funds for a transaction that will benefit the broker. Prior to making a solicitation involving self-dealing, a broker must present the investor with a Lender/Purchaser Disclosure Statement (LPDS) in a format that has been approved by the DRE.

The investor must be presented with the LPDS at least 24 hours before the broker receives any funds. The DRE provides a form, RE 851A, for this purpose.

When soliciting to investors, brokers must make certain the investors have capacity, can bear the financial risk, and that the investment suits the investor’s risk tolerance. Investor suitability and limits, net worth, age, investment objectives, investment experience, financial situation, and the investor’s other investments must be investigated by the broker. To comply with these requirements a broker should request that the investor complete an Investor Questionnaire (RE 870) and use the information from the RE 870 to aid in investor suitability determinations.

Loan to Value (LTV) is a major measuring stick for many regulated loans, but LTV restrictions are specifically addressed in Article Five. As a reminder, the LTV is the aggregate amount of all encumbrances on a property as a percentage of the property’s current market value. LTV maximums range from 80% for single-family, owner-occupied properties down to 35% for such properties as non-income producing, vacant land. Certain mortgages may exceed these limits; for example, a loan where mortgage insurance is purchased.

LTV limitations also apply to construction loans; however, the as-completed value of the project may be used for construction loans with a holdback over $100,000 if the following safeguards are followed:

1. A third-party fund control is used
2. The loan is fully funded prior to recording
3. A comprehensive, detailed draw schedule is used
4. The draws are based on an independent qualified person’s verification
5. An appraisal is conducted in accordance with USPAP
6. The documents include detailed actions to be taken if the project is not completed
7. The entire amount of the loan does not exceed $2,500,000

Article Five also addresses loan servicing and the broker’s obligations when servicing loans for third parties. The DRE requires written authorization of the borrower, lender, or note owner for a broker to service a promissory note. The written authorization must provide proper accountings of who holds the original note or contract and deed of trust, and the authorization must provide the lender or note owner with written notification of major developments occurring with the loan.

Brokers will often find themselves in the position of recording trust deeds and assignments as a loan servicer; it is important to remember that recordable documents cannot be recorded in the name of the broker but should be recorded in the name of the beneficiary (investor). Recording a trust deed in the name of a broker, when there is a separate beneficiary, is considered table funding and is prohibited in California. Similarly, assignments must be recorded in the name of the note purchaser. A broker-loan servicer is responsible for delivering copies of recorded documents in a reasonable manner.

Finally, it is important to remember that the DRE restricts a broker’s advertising activities. Advertising gifts to an investor as an inducement to invest in a note secured by real property is prohibited by Article Five. However, brokers may offer inducements to prospective borrowers, so long as all conditions are disclosed, and the inducement cannot be offset by an increase in other fees.

Fractionalized Loans and Article Six

Loans where there are multiple beneficiaries are considered “Fractionalized Loans” by the DRE. These loans are regulated by Article Six of the California Real Estate Regulations. Fractionalized Loans require additional disclosures from a broker and there is some variation to the standard broker requirements. The main notice that must be submitted to the DRE is the Multi-Lender Transaction Notice (RE860). The RE 860 must be submitted within 30 days of (1) the brokers’ first fractionalized loan; (2) any material change to the information in the notice, or (3) becoming a servicing agent for notes with payments exceeding $125,000 due within a three-month period, or there are more than 120 persons entitled to payment.

Each investor in a Fractionalized loan must be vetted for suitability according to the process outlined above, and the standard LTV ratios from Article Five are also applicable to Fractionalized Loans. Despite the similarities to a standard, single investor loan, there are a couple of crucial aspects that can often go overlooked: (1) a Fractionalized Loan in California cannot exceed 10 investors; and (2) the investors must be presented with identical interests. The second requirement may be mistaken for identical ownership interests, but the DRE requires that the investors have identical interests in the underlying terms of the Note. For example, all investors must receive the same interest rate, and their percentage of ownership must be secured by the same collateral.

DRE requirements for trust accounts and controlling funds for fractionalized loans are very similar to a standard single-investor transaction, but a point to stress is that loan funds cannot be collected and pooled for separate transactions. Loan funds should be received for each transaction as they occur, as stated in the discussion of fees above. Brokers servicing notes where there are $125,000 of payments due in a three-month period or there are over 120 persons entitled to payments must have a Trust Account Report for Multi-Lender Transaction (RE 852) prepared and submitted by a CPA to the DRE.

Loans Regulated by Article Seven – Small Loans

Real property loans are regulated by Article Seven of the California Real Estate Regulations. Specifically, Article Seven applies to bona fide senior liens under $30,000 and bona fide junior liens under $20,000. However, loan amount is not the only determining factor when examining whether Article Seven applies to a loan. Article 7 covers loans secured by a single dwelling in a condominium or cooperative or any parcel containing four or fewer residential units.

As you have seen up to this point, California DRE regulations are complicated and can be difficult to navigate. It is vital for any DRE broker to take time to understand the regulations they are subject to, and to fully understand the loans they are arranging. DRE brokers who fail to comply with this web of regulations in place face repercussions and disciplinary actions by the DRE. Fortunately, in addition to the summary herein, the DRE provides a Mortgage Loan Broker Compliance Checklist within the RE7 that is beneficial for brokers to follow.

Endnotes

1 10 Cal. Code Regs. tit. 10 § 2844.