Some time ago, my client was presented the opportunity to purchase a high interest rate loan from a private investment firm and take its place as lender. This describes a transaction involving private money (non-bank) lending, an alternative to traditional bank loans. From the view of the acquirer of the loan, this is an opportunity to receive an income stream at a high rate of return. Other benefits are that the initial lender has performed due diligence on the borrower, priced credit risk, and drafted the documents. But for an investor thinking about participating in this sort of transaction in which they step into the shoes of a prior lender, there are several legal and risk-related issues worth considering.
Assignability
First, it is important to determine what the loan documents have to say about sale and transfer. It is common for a loan or note to provide that the lender may freely sell, assign, and transfer the loan without the borrower’s consent, but this is not always the case. Even where there is an explicit allowance for transfer, I have seen uncooperative borrowers nonetheless argue that sale and assignment was improper and litigate to prevent the new owner from enforcing it. It would be smart to have the borrower sign off that they consent to the sale. Notice of the sale should also be given, if for no other reason so that the borrower knows where to send payments going forward.
Timeliness
Another important consideration is timeliness, so that the loan can be enforced and the debt collected in the event of default. In California, the statute of limitations is four years for breach of written contract, measured from the date breach occurs. For a promissory note that is a negotiable instrument, the statute is six years after the due date, or for a note due on demand it is six years after demand. There are circumstances where the statute of limitations can be extended. For example, where the borrower restarts making payments on the loan, this can constitute a reacknowledgement of the debt. (Code Civ. Proc., § 360.) Also, the loan might provide for waiver of the statute of limitations. (Code Civ. Proc., § 360.5.) In addition, the statute can be extended where the borrower makes repeated promises to repay: the idea is that a borrower should not be able to “lure” a lender to hold off bringing suit with promises to repay, only to wait for the statute to run and argue “gotcha.” All of the above are fact-intensive and can be the subject of litigation.
Rate of Return
The interest rate, which may be an appealing factor in the loan purchase, must also be examined. In California, a lender cannot charge interest that is usurious – generally the greater of 10% or 5% above the Federal Reserve Bank of San Francisco discount rate. Interest in excess of usury can be subject to defenses and recovery. There are exclusions to usury for state and federal banks, licensed finance lenders, payday lenders, and others. An acquirer must examine the loan documents to determine whether the loan is subject to an exemption to usury and whether it will continue to be exempt following transfer. The risk is not only that the loan fails to provide the anticipated rate of return, but forfeiture of treble the amount of usurious interest paid or forfeiture of all interest paid (i.e. return of principal only).
Credit Risk
In addition to assignability, rate of return, and timeliness, the lender must perform a credit analysis to assess the risk of nonpayment. This will include more than the creditworthiness of the borrower. For instance, in one case, the relationship between the initial lender and borrower had deteriorated significantly prior to my client acquiring the loan. The borrower painted the new lender with the same brush – to the extent that it chose to litigate, spending on attorney’s fees in excess of what it would have cost to simply bring the loan current.
All of the above were at issue in my client’s purchase of the loan from the investment firm (at the top of this article), in which the Court awarded my client repayment in full, with interest and an award of attorney’s fees at the summary judgment stage.
Laine Mervis is a litigator specializing in business and investment frauds. He can be reached at laine@eanetpc.com.