One of the most questionable transactions in the seller-financed note industry is known as the “PARTIAL”. A typical partial is your purchase of a certain number of time payments from the whole future payment stream of a note. For example, a partial would be your purchase of the next 60 payments of a 120 payment note. This deceptively simple sounding transaction is loaded with hidden problems.
Note buyers considering the purchase of a partial should always have their attorney examine the transaction and ask a checklist of questions beforehand. The potential problems of the partial are so serious that expert legal advice is essential.
Sale or Loan?
The most serious problem with your partial is that it may be interpreted either as a sale or a loan, giving rise to disastrous disputes. The purchase of a partial may be considered a simple sale of a number of time payments. It may also be considered a loan to the “seller” in which the note is put up as security. Sales and loans fall under different laws, and disputes about which kind of transaction it really is can have extreme consequences.
Thus, the first question you should ask your attorney about any partial is this: Is this transaction a sale or a loan? One of the most important legal tests in answering this question is intent. You, of course, intend the transaction as a sale, but if your “seller's” intent is that it is a loan, the overall intent of the transaction becomes unclear.
You should be particularly alert if your “seller” approached you first by asking to borrow against the Note. Even though you clearly tell the “seller” that you do not make loans, the “seller” may listen to your offer to buy a number of time payments on the Note and continue to think of the transaction as a loan. If your seller asks questions such as, “Well, isn't buying a payment stream the same thing as a loan?” you might have conflicting intent. Another sign of clashing intent is the “seller” subsequently asking “How is my loan coming along?” A certain sign of divergent intent may come after the partial transaction is completed, when the “seller” contacts you at the end of the year asking, “Are you sending me a statement saying how much interest I paid on my loan?”
How can an intelligent “seller” listen to your clear explanations that the partial is a sale, yet still think of it as a loan? The answer lies in the unclear nature of the transaction itself. If the “seller” borrowed against the Note, it would have the same end result as selling a time payment stream. The “seller” would give up payments for a period of time and when those payments were complete the “seller” would get the rest of the Note payments. The trouble with partials arises out of that simple fact: The end result of a sale or a loan is the same. So it is not unreasonable for the “seller” to continue thinking of the partial as a loan, even though you think of it as a sale. With that conflicting intent you may not be able to tell what kind of transaction you really have.
Even if language is included in the documents saying: “This transaction is a sale, not a loan” that does not necessarily clarify the intent. It could be argued that such a clause was deliberately included to disguise a loan as a sale. If the transaction was clear to both parties, with no reason to doubt its nature, such a clause would not be necessary. Courts may look at substance over form, and if the intent is unclear, regardless of what your written agreement says, other evidence outside of your documents may be weighed heavily in the court's eyes. So the next question to ask your attorney is: “Is the clause saying ‘this transaction is a sale, not a loan' evidence of conflicting intent?”
You should be particularly cautious about clauses that say anything like: “If this agreement is ever construed to be a loan, the seller agrees to hold harmless, protect, defend, and indemnify the buyer from any damage, loss, liability and additional expense, and pay costs and attorney fees.” Even though such a clause may appear to protect you from any claims the seller may file in a lawsuit alleging that the transaction is a loan, a court may view your agreement along with all other evidence, and decide that you have been deceptive by knowingly inserting this clause to wrongfully protect yourself. A judge may rule that this clause cannot be enforced. Ask your attorney: “If this transaction is ruled to be a loan, would this clause be enforceable?”
You should be prepared to defend yourself against any “seller's” claim that your transaction is a loan. But, in the event that a court rules that it is a loan, you need to ask your lawyer these questions about the consequences:
If this transaction is a loan,
- Would it violate the usury laws of my State?
- Would it violate the Federal Truth-in-Lending Act?
- Would it violate the Uniform Consumer Credit Code?
- Do I need a license to make a loan against personal property (the Note)?
- Would I lose my money if the “seller” files bankruptcy?
- What kinds of penalties would I face?
Usury laws regulate the amount of interest that can be legally charged on loans. A loan against a note is a loan against personal property, not a loan against real estate. The laws governing personal property loans are different from the laws covering loans on real estate, and you must avoid this potential confusion. If the interest rate (the yield) you make on the partial is higher than that allowed for a personal property loan, you could be subject to harsh money penalties as a usurer, and habitual usury offenders may be subject to criminal prosecution. It is essential that your lawyer explain these laws to you very carefully, especially if you or the “seller” are in a “usury-sensitive” State.
The Federal Truth-in-Lending Act may require disclosures for loans, such as the dollar amount of finance charges and the annual percentage rate computed on the unpaid balance of the amount financed. You may not make these disclosures during the partial transaction because you consider it a sale, not a loan. If the partial is ruled to be a loan, you may be subject to federal penalties under the Truth-in-Lending Act.
Some States have adopted the Uniform Consumer Credit Code that imposes rate ceilings and other restrictions on consumer credit and usury. If the partial is ruled to be a consumer loan, you may be subject to State penalties.
If a court rules you have made a loan to a consumer, using the note as security, your State may require a license to make personal property consumer loans.
Bankruptcy of “Seller”
What if the “seller” files bankruptcy and the bankruptcy court rules that your partial is a loan? The bankruptcy trustee wants to collect as much money as possible. There may be a powerful incentive to claim you are an unsecured creditor and therefore you must share the loss at so many cents on the dollar. Secured creditors, on the other hand, may obtain the full amount of the debt owed. Possession of the Note is your best protection to “perfect your security interest”. Ask your lawyer: “What documents should be obtained in order to avoid being an unsecured creditor and losing my money?”
Keep in mind that documenting the transaction to protect yourself in case the bankruptcy court rules it is a loan may solve one problem only to create others. For example, the bankruptcy trustee might make usury claims against you if it's ruled to be a loan, even though you are considered a secured creditor.
There is another serious problem with partials. Ideally, you want the highest protection of your legal ownership of the Note which is the status called a “holder-in-due-course”. This status confers significant legal advantages, protecting you from many claims of the seller, payor, and others. However, in order to be a holder-in-due-course, all of the Note must be transferred. Anything less is a “partial assignment” of the Note which may deprive you of holder-in-due-course status. Even if all of the Note is endorsed to you, a judge may examine your agreement to buy a portion of the payment stream and find that it is only a partial assignment. Ask your attorney; “Does this transaction allow me to be a holder-in-due-course?”
Internal Revenue Service Reporting
Another problem with partials is the fact that three parties are involved: you, the seller, and the payor. How to report the interest on partials to the IRS is a matter of considerable confusion. You receive interest income on the payments you bought. The payor pays interest on the entire Note balance. The seller's position may be unclear when it comes to interest received or paid. If all three parties, you, the seller, and the payor, send interest information to the IRS, all three forms are likely to show different amounts. Your form will show only the interest you received on the partial. The seller's form may show either, both, or none. The payor's form will show interest paid on the entire note. The Internal Revenue Service may question this difference and trigger an audit.
Reporting the interest on a partial to the IRS is not the only source of confusion. How does the seller claim the sale of the partial to the IRS? The question of the seller's tax liability on that sale could be a determining factor in deciding whether or not the partial would be desirable for the seller. The seller may discover serious tax consequences in selling a partial. Have these tax consequences been evaluated? Does the sale still look attractive after considering the tax consequences? Are you responsible for advising the seller to contact a tax professional before entering into the partial? Some tax professionals might think the partial to be a loan and either declare it as loan income or not declare it at all. Would such a loan declaration, or the lack of any declaration, indicate that the seller intended the partial to be a loan? Ask your attorney; “How should a partial be reported to the IRS?”
The transfer of part of a note may constitute a “pooling of interests”. That is, your interest in the Note and the seller's interest in the Note are pooled together, and such pooling may be a characteristic of a securities transaction. In addition, the partial transaction may constitute the creation of an “investment contract” between you and the seller. This may place your partial transaction within the federal and state securities laws. You are expecting money and so is the seller. You may be basically forming some sort of partnership with seller, usually a complete stranger to you.
Partials are so murky by their very nature that it could be difficult to convince a court that your partial is not an investment contract. Since partials may be interpreted to constitute a pooling of interests and to be an investment contract, you should ask your attorney, “Is this partial a security? Do I need a securities license and what disclosures and registration are necessary?”
You should ask your lawyer to discuss with you several fundamental problems with partials:
Seller Problems: There are many difficulties you may encounter with your seller. You may have difficulty locating the seller after a period of time. You may need to confer with the seller about a change in the terms with the payor. You may need to let the seller know that the payor is late making the Note payments and decide what to do about it. The payor may pay off the balance, and you may need to send the seller a share of the cash. Sellers, like anyone else, tend to move to new addresses as time goes on. Sellers sometimes pass away, or become legally incompetent.
Sellers sometimes sell or borrow against their share without telling you. You may find out, to your surprise, there are others who came into the picture after your partial agreement was made with the seller.
The worst problem is that many sellers, not being sophisticated in financial matters, do not understand the partial transaction. They have a certain dollar figure in their minds and expect to get their share of the money after the passage of time. The seller of a partial is the most likely person to sue you if the money expected is not received. You may be accused of having practiced unfair, deceptive, or unconscionable trade practices. You, perhaps being more sophisticated than the seller, may have to fight the seller in court defending claims that you had unfair bargaining status and the agreement was written too much in your favor.
Payor Defaults: If the payor quits paying, you and the seller have a serious problem. You need to have a clear understanding with the seller as to what happens if the payor defaults. When should you or the seller be notified of the default by the payor? Who has the right to negotiate with the payor to correct the problem before legal action is taken? Does the seller have to make the payments to you if the payor does not? Who has the right to foreclose and who pays for it? What if you want to foreclose against the payor but the seller does not? Who decides what type of legal action to take against the payor? When does the seller lose all rights? Do you and the seller both own the property after foreclosure? Who pays for and manages the property after foreclosure? There are endless questions, with few clear answers. Again, these questions are murky because of the nature of the partial transaction itself.
Accounting Mistakes: Three-cornered transactions are inherently prone to accounting mistakes. The payor on the Note, or the payor's agent, is at risk of receiving erroneous accounting information from you or your servicing agent if the payor wishes to sell the property and asks for payoff or assumption amounts. Because you or your servicing agent may only look at the transaction from a partial viewpoint, only the amount due you on the partial may be submitted, not what's owing on the entire Note including the seller's share.
Or, you or your servicing agent may report to the payor the correct amount owing on the entire Note and receive the money, but inadvertently neglect to forward the seller's share of the money.
Early or Late Payoffs: How to you divide the money between yourself and the seller if the payor pays off the Note sooner or later than originally agreed? The payoff amount of the note is completely dependent upon the time at which the payor pays it off, which is usually beyond the control of you and the seller. Even though the principal amount does not change with time, the interest amount is based on time alone. If the Note pays off sooner than required, the total amount of the Note payoff will be less than expected. If the Note pays off later than expected, the total amount will be more. Each situation has its unique problems.
If the payor pays off earlier than required, the total amount of the payoff will be less than expected. In some instances, the payoff amount will be so much less than expected that the seller will not receive any money at all because you get all the payments. In most cases of early payoff, the seller will receive some amount less than expected. The resulting upset can lead to a lawsuit against you by the seller.
If the payor pays off the Note later than required, the total payoff on the entire Note will be greater than expected. However, you will earn a lower interest yield rate because it took more time to collect the same amount of payments over a longer period of time than originally agreed upon. An example would be if you wanted 60 monthly payments, but it took 70 months to collect. In practical terms, that means your partial receives no interest for that last 10 months. You could want compensation for the lost 10 months, but have difficulty getting the seller to agree.
You need to have answers for all types of situations. For example, if you make too much money by getting a windfall because of an early payoff, might you be accused of extracting an unconscionable amount of money from the “seller”? What if the payor wants to change the terms of the Note? Who gets the late charges? Who should collect the payments? Who should pay the servicing charges? Who gets extra payments made by the payor and how is it figured into your transaction? Does the “seller” understand the transaction? Who should be named in the fire/hazard insurance policy? What exceptions will the title insurance company require on the title insurance policy? Will the title insurance company insure the transaction knowing the true nature of your partial? Should the public record show you and the seller both holding the security for the Note? What if the payor requests a partial release of the security or a subordination of the security. The possibilities are endless.
It is virtually impossible to foresee or anticipate every complication into a partial agreement. The longer the agreement grows, the less the “seller” is likely to understand it. If there is a legal challenge, a complicated agreement may make you look suspicious in the eyes of the court. The political and social attitudes of judges in your State may have an impact on how the law is interpreted. Because the partial is an inherently complicated and conflict ridden transaction, you must seek the counsel and assistance of your attorney to ensure all aspects of your legal position are scrutinized.