✅ Compliance Checklist for Private Lending Transactions in California Dan J. Harkey

✅ Compliance Checklist for Private Lending Transactions in California

1. Legal Framework

It is crucial to confirm that the transaction is subject to California Real Estate Law and Securities Law, as these laws form the foundation of our compliance.
Determine whether the Offering qualifies for an exemption or requires a permit/registration under state and federal Securities Laws.

2. Investment Structure

Identify whether the investment is:

Direct participation (promissory notes and deeds of trust).
Indirect/quasi-direct participation (ownership interests in LLCs, LPs, LLPs).

Ensure entity ownership interests are appropriately documented and issued through permitted offerings.

3. Documentation

Name private investors/lenders as payees/lenders on promissory notes and beneficiaries on deeds of trust.
For fractionalized interests:

Confirm compliance with the 10-investor limit under California Law.

Endorse promissory notes (typically without recourse) and record assignments of deeds of trust promptly.

4. Escrow & Title

Use a licensed escrow holder for closing, who plays a crucial role in ensuring the transaction is conducted securely and in compliance with the Law. Their involvement is a regulatory requirement and a best practice in private lending transactions.
Obtain title insurance with proper endorsements to confirm lien priority.
Verify escrow instructions reflect Borrower and investor interests.

5. Investor Protection

Assets must be held by a qualified independent trustee, not solely controlled by a broker.
Avoid issuing participation certificates or agreements that rely solely on broker-controlled assets.

6. Broker Responsibilities

As brokers, we must always act as agents and fiduciaries for private investors/lenders. This role carries significant responsibilities, including full and fair disclosure of material facts, suitability determination, and avoidance of conflicts.
Conduct due diligence on:

Property condition and title.
Borrower creditworthiness.
Compliance with Real Estate and Securities Laws.

Supervise all professionals involved (escrow, title, appraisers, underwriters).

7. Securities Compliance

Prepare and deliver Private Placement Memorandum (PPM) for exempt offerings.
Ensure offerings are structured as direct or quasi-direct participation securities.
If outside these structures, obtain a permit or registration before issuing securities.

8. Closing Requirements

Record instruments of encumbrance or assignments at closing.
Confirm title insurance coverage and lien priority.
Retain all compliance documentation for audit and regulatory review.

9. Post-Closing

Maintain accurate investor records.
Provide periodic reporting as required by the offering documents and applicable Law.

California Private Lending Compliance Guide

Direct, Indirect & Quasi‑Direct Participation in Promissory Notes & Deeds of Trust

· Scope & Definitions

· Regulatory Architecture (What laws apply and when)

· Structuring the Investment (Direct vs. Indirect/Quasi‑Direct)

· Broker Authority & Fiduciary Duties

· Securities Compliance (Exemptions, permits/registrations, PPMs)

· Fractionalized InterestsRule‑beneficiary rule & operational controls)

· Due Diligence Standards (Borrower, collateral, title, insurance)

· Escrow, Title, and Closing Mechanics

· Documentation & Endorsements/Assignments

· Investor Protection Controls (Custodianship, segregation, servicing)

· Advertising, Investor Suitability & Subscription Process

· Post‑Closing Servicing, Reporting & Recordkeeping

· Governance: RACI, Internal Controls & Audit Artifacts

· Common Violations & Practical Risk Mitigations

· Templates & Checklists (ready-to-use outlines)

1) Scope & Definitions

Direct participation securities: Investors/lenders are named payees on promissory notes and beneficiaries on deeds of trust (whole or authorized fractional interests).
Indirect or quasi-direct participation securities: Investors provide equity to LPs/LLCs/LLPs formed to fund loans or acquire notes/DTs; the entity is named payee/beneficiary; returns distributed pro rata by ownership interests.
Security: Interests sold for the expectation of profit—whether in the form of direct debt, fractional interests, or entity ownership—are typically securities under state and federal Law when offered/sold by brokers or issuers.

2) Regulatory Architecture

Primary regimes that commonly apply

California Real Estate Law (licensure, conduct, fiduciary duties, fractionalization rules, trust funds, records).
Federal & California Securities Laws (registration or exemption; broker‑dealer implications; offering documents; anti‑fraud).
Escrow Law and Title Insurance practices (priority, endorsements, settlement procedures).
Consumer protection (if owner‑occupied/consumer credit—usually not the case in most private business‑purpose loans, but verify).
Local recording/transfer tax/permit items when relevant to collateral.

Practice tip: Treat every investor-facing transaction as a securities event unless your counsel has specifically concluded otherwise.

3) Structuring the Investment

A. Direct

The investor is named the payee (note) and the beneficiary (deed of trust).
Works for whole loans or permitted fractional interests (up to 10).
Transparent, traceable custodial chain; simpler investor‑level ownership records.

B. Indirect / Quasi‑Direct

Investors purchase ownership interests in an entity (LP/LLC/LLP).
The entity is named payee/beneficiary.
Distributions are pro rata via the operating/Partnership's agreement.
Requires offering compliance and custodial safeguards to avoid the broker’s sole control over assets.

Do not issue “participation certificates” that depend on assets under the sole control of the broker; use a qualified independent trustee/custodian.

4) Broker Authority & Fiduciary Duties

Brokers act as agents and fiduciaries of private investors/lenders. Duties include:

Full and fair disclosure of material facts.
Suitability determination and avoidance of conflicts.
Proper handling of trust funds; segregation and reconciliation.
Competent supervision of staff and third-party professionals.

Keep a defensible paper trail demonstrating these duties were satisfied.

5) Securities Compliance

A. Pathways

Exempt Offering (e.g., Reg D / state exemptions): Use a Private Placement Memorandum (PPM); restrict to qualified offerers; manage resale/transfer restrictions; file required notices.
Permit/Registration: If the structure doesn’t fit into direct/quasi-direct or an exemption, seek a license or registration before selling securities.

B. Core Anti-Fraud Tenets (always apply)

No material misstatements/omissions.
Balanced risk disclosures (market, Borrower, collateral, liquidity).
Substantiated performance claims; no “blind pool” hype.
Control of funds: Implement an independent custodian; prohibit broker unilateral access.

C. PPM Must-Haves (see Templates)

Issuer/Manager/broker backgrounds & conflicts.
Strategy, underwriting, and limits (LTV, geography, asset class).
Fees (origination, servicing, asset management), waterfalls, and priority of payments.
Risk factors (foreclosure, valuation, illiquidity, regulatory).
Custody/trust arrangements and investor rights.
Financials (where applicable) and audit/review plans.
Subscription procedures and eligibility standards.

6) Fractionalized Interests (Rule-Beneficiary Rule)

Up to ten private investors/lenders may fund a single note/DT secured by real property as fractional interests when arranged by a broker.
Operational guardrails:

Each investor is named as payee/beneficiary at or before closing (or promptly via recorded assignment if the loan was pre-funded).
Maintain an identical security position and rights proportionate to the investment.
Use consistent documentation across all fractional holders.
Servicing and voting mechanics are spelled out; actions (modifications, extensions, enforcement) must follow agreed thresholds/consents.

Non-compliance (e.g., failing to timely endorse or assign timely, or obscuring the investor’s secured position) risks license discipline, civil liability, and criminal exposure.

7) Due Diligence Standards

A. Borrower/Guarantor

Purpose of loan (business vs. consumer), entity docs/resolutions.
Financial capacity: tax returns/financials; debt schedule; liquidity.
Credit review, background checks, litigation/judgment/UST search.

B. Collateral

Appraisal or credible valuation; verify the highest and best use.
Zoning, permits, and environmental red flags (Phase I triggers if needed).
Physical condition (inspection reports; capex budget; rent roll/leases if income property).
LTV/ARV thresholds consistent with PPM or offering criteria.

C. Title & Liens

Preliminary title report; easements/restrictions; senior liens; taxes.
Required endorsements and closing conditions (see §8).

D. Insurance

Property insurance with lender’s loss payable and sufficient limits.
Flood (if applicable); builder’s risk for construction.
Verify insurer strength, renewal dates, and cancellation notices.

Document findings in a due diligence memo signed off by underwriting and compliance.

8) Escrow, Title & Closing Mechanics

Close through a licensed escrow holder; provide precise escrow instructions consistent with PPM/agreements.
Record instruments (deed of trust, assignments) at closing; confirm the legal names and vesting.
Title insurance:

Lender’s policy insuring first (or intended) priority.
Common endorsements (confirm with counsel/insurer based on asset):

Environmental Lien (e.g., ALTA 8.1)
Restrictions/Encroachments/Minerals (ALTA 9 series)
Access (ALTA 17 series), Tax Parcel, Condo/PUD (as applicable)

Clear conditions: subordinations, lien releases, mechanics’ lien coverage issues.

Funding conditions checklist: all signatures, resolutions, insurance binders, payoff demands, HUD/settlement statement, disbursement ledger, and post-closing tickler items (UCC filings if fixtures, estoppels, SNDA if needed).

9) Documentation & Chain of Title

If pre-funded/interim lender used: promptly endorse the note (typically without recourse) and assign the deed of trust to each rightful investor (or to the entity in indirect structures); record assignments.
For fractional loans: each investor appears as beneficiary of record (or via recorded assignment) in proportion to their interest.
Keep a Collateral File: original note, deed of trust, assignments, title policy with endorsements, escrow file, insurance, appraisal, and servicing instructions.

10) Investor Protection Controls

Independent trustee/custodian for investor funds and collateral documents.
Segregated trust accounts; three-way reconciliations; approval workflows for disbursements.
No broker has sole control over pooled assets; dual authorization for movements.
Written servicing standards (payment processing, reserves, escrow advances, tax/insurance monitoring, default handling).
Related‑party transactions: board/LPAC (limited partner advisory committee) approval; enhanced disclosure; fairness memo.

11) Advertising, Suitability & Subscription

Advertising: Align with offering exemption limits; avoid public solicitation unless permitted; no performance guarantees.
Suitability: Investor questionnaire covering net worth/income, experience, objectives, risk tolerance, and concentration limits.
Subscription Pack (examples below):

PPM / Risk disclosures acknowledgment
Operating Partnership's agreement
Subscription agreement & investor questionnaire
W‑9 (or W‑8), ID/KYC (as applicable)
Beneficial ownership certifications (if required)
Custodian/account forms

Confirm the cooling-off or rescission mechanics, if offered.

12) Post‑Closing Servicing, Reporting & Records

Payment processing: Timely collection, waterfall distributions, and detailed statements.
Covenant monitoring: Insurance renewals, tax payments, construction draws, DSCR triggers.
Defaults: Notice of default timelines, workout authorities, investor consent thresholds, and foreclosure counsel engagement.
Reporting:

Periodic investor statements (loan status, reserves, fees, events of default).
Annual tax reporting (K‑1s for entities; 1098/1099 where applicable).

Books & records: Maintain for statutory periods; audit trails; immutable logs of material decisions and votes.

13) Governance, Controls & Audit Artifacts

RACI (sample)

Responsible: Underwriting for DD; Servicing for payments/compliance; Escrow for closing.
Accountable: Broker of Record / CCO (Chief Compliance Officer).
Consulted: Counsel, Title Officer, Appraiser, Insurance Broker.
Informed: Investors (per offering docs), Custodian, Auditor.

Internal Controls

New deal Pre‑Close Compliance Checklist (sign‑off by legal/compliance).
Exception log (policy deviations with approvals).
Change management: Any post-close modifications require investor consent thresholds and documented rationale.
Annual independent review of custody and reconciliations.

Audit Artifacts (keep current)

Offering files (PPM, notices/filings, suitability evidence).
Loan files (DD memos, appraisals, insurance, title, closing statements).
Trust account reconciliations and disbursement approvals.
Investor communications archive; vote tallies.

14) Common Violations & How to Avoid Them

· Failure to name/assign correct payee/beneficiary → Use a pre-fund/assignment playbook with title/escrow milestones; calendar recording confirmations.

· Improper fractionalization (exceeding limits or unequal rights) → Track investor count; standardize documents; ensure pari passu rights.

· Broker sole control of assets → Independent custodian, dual control, board/LPAC oversight.

· Inadequate disclosures → Refresh PPM risk factors per deal type; disclose conflicts; avoid performance hype.

· Trust fund mishandling → Segregate accounts, daily posting, monthly three-way reconciliation, surprise reviews.

· Insurance or tax lapses → Automated ticklers; forced‑placed protocols; reserve policies.

· Loose servicing actions (extensions, forbearances) without consent → Follow thresholds; document investor votes and rationale.

15) Templates & Checklists

A. Pre-Close Compliance Checklist (Broker/CCO)

☐ Offering pathway confirmed (exemption vs. permit/registration)
☐ PPM/term sheet finalized; counsel sign‑off
☐ Suitability standards and subscription package approved
☐ Independent custodian agreement executed
☐ Escrow instructions match security structure (direct/fractional/entity)
☐ Title commitment & endorsements list approved; priority confirmed
☐ Insurance binders with the lender’s loss payable received
☐ Appraisal/valuation, DD memo, and credit approval complete
☐ Note/DT forms prepared; fractional schedules (if applicable)
☐ Pre-fund assignment plan (if interim payee used) finalized
☐ Servicing agreement & authorities set; consents thresholds set
☐ Trust account designated; disbursement controls tested

B. Investor Subscription Package (Contents)

☐ PPM + Risk Factors Acknowledgment
☐ Operating/Partnership's Agreement (if entity)
☐ Subscription Agreement & Investor Questionnaire (suitability)
☐ Conflict disclosures & related‑party notices
☐ ID/KYC and Tax Forms (W-9‑9/W‑W-8)
☐ Custodian forms; ACH/wire instructions
☐ Receipt of Escrow/Title Notice & Summary of Security Interest

C. Escrow/Title Closing Checklist

☐ Correct legal names/vesting; EIN of entity if applicable
☐ Execution of promissory note(s); deed(s) of trust
☐ Endorsements (as applicable): ALTA 8.1, 9 series, access, Condo/PUD, tax parcel
☐ Payoff demands, subordination agreements recorded
☐ Record note assignments/deed of trust assignments (if pre-funded)
☐ Issue final lender’s policy; circulate recording confirmations
☐ Settlement statement reconciled; trust funds disbursed per instructions

D. Post‑Closing Servicing Checklist

☐ Boarding data complete; first billing and waterfall configured
☐ Tax and insurance ticklers active; collateral file secured
☐ Investor welcome packets (positions, contacts, schedules)
☐ Reporting cadence set (monthly/quarterly); audit calendar created
☐ Default/Workout playbook linked to consent thresholds

E. Due Diligence Memo (Outline)

1. Deal summary (purpose, collateral, structure, LTV)

2. Borrower/guarantor analysis (financials, credit, background)

3. Collateral analysis (valuation, condition, environmental, leases)

4. Title/endorsements, liens, taxes, HOA/CC&Rs if applicable

5. Insurance review and requirements

6. Risks, mitigants, exceptions (with approvals)

7. Recommendation, terms, and covenants

Closing Paragraph

Compliance with California Real Estate Law and applicable state and federal Securities Laws is a legal imperative in private lending transactions. Each requirement outlined in this checklist reflects statutory obligations and regulatory standards designed to safeguard investor interests and maintain the integrity of the marketplace.

Real estate and mortgage brokers, as fiduciaries, must ensure that all transactions are structured, documented, and consummated in strict conformity with governing Law. Failure to comply with these mandates may result in administrative sanctions by the California Department of Real Estate (DRE), enforcement actions by the California Department of Financial Protection and Innovation (DFPI), and potential civil or criminal proceedings by the Securities and Exchange Commission (SEC) and other regulatory authorities. Accordingly, compliance should be treated as an ongoing legal duty, integral to every phase of the transaction —from capital formation to post-closing servicing.

This article is incomplete. There are thousands of laws and regulations at the federal and state levels to consider in each transaction. Covering a complete overview would take hundreds of pages. The first necessary component of a real estate lender is to meet with competent real estate and securities counsel to discuss their transactions and compliance questions.