Lloyd Charton recalls a fateful knock on the door. At his Dana Point home stood a cheerful man with an impressive knowledge of Charton's personal life. It was a neighbor, Dan J. Harkey.
Harkey congratulated him on his retirement and asked about a recent vacation. He told him about his company, Point Center Financial Inc., which raised money from private investors and lent it to real estate developers.
It was Charton's introduction to the little-known and risky world of "hard-money" lending, a lightly regulated segment of the real estate business marked by short-term loans with high interest rates and fees.
In the years that followed, Charton invested more than $1.2 million with his neighbor, earning handsome returns, for a time.
Then, as the real estate market soured in 2007, borrowers started to default on their loans. Today, Harkey acknowledges that at least 60% of the loans are in default. He faces a lawsuit from more than 50 private investors -- including Charton -- whose nest eggs helped fund the bad loans.
Harkey, 62, who is married to Assemblywoman Diane Harkey (R-Dana Point), disputes the claims of the investors and blames his Aliso Viejo company's downturn on the soured real estate market.
Whether or not the investors prevail in court, real estate experts say the dispute illustrates the perils inherent in hard-money lending, which is often a final option for borrowers who can't qualify for bank loans.
The term "hard-money" lending can be traced to the Great Depression when private individuals started lending money because of the banking crisis, said Leonard Rosen, whose La Jolla-based company, Pitbull Mortgage School, teaches mortgage brokers about hard-money loans.
"No one really knows the reason they used 'hard money' as a term. It could be that it was hard to get, hard to find or because it was hard cash," Rosen said. "I'm not an advocate for hard-money lending. But it's something that has its place as long as it's done responsibly. There are some people who should not be in the lending business at all."
Hard-money lenders rely almost exclusively on the value of property used as collateral, expecting to profit when loans are repaid or to foreclose when they're not. In a good economy, investors can make significant gains. Harkey said he paid investors 9% annually, sometimes more.
With those hefty payouts comes risk. If the real estate market crashes, hard-money lenders can end up with foreclosed properties suddenly worth far less than the money they lent. And investors, once confident that their loans to developers were backed up by property, can find that their holdings are now of little value.
The estimated billions of dollars in hard-money loans fall outside the purview of regulators like the Federal Reserve and the Office of Thrift Supervision, putting significant responsibility on lenders to act in the best interests of investors.
"Those who invest their money with hard-money lenders are taking on significant risk. That's why they would expect a significant return relative to other investments," said Stuart Gabriel, a UCLA finance professor and director of the university's Ziman Center for Real Estate. "If they need to take the property back, there's legal risk and marketing risk. There can be very significant losses."
At the peak of the real estate boom, Harkey said, he managed $500 million from 3,000 private investors. The company, he said, made millions of dollars by charging fees to borrowers and by keeping a portion of the interest payments.
His company's website lists several examples of hard-money success stories: apartment buildings, a medical center, an automobile dealership, all launched with Point Center loans that were fully repaid.
Harkey often described himself as a self-made man who reached unlikely success after a childhood of poverty in Belleville, Ark., where his home was on a dirt road and lacked indoor plumbing.
His adult life, thanks to success with Point Center Financial, included all the trappings of comfort and luxury: a multimillion-dollar home in a gated Orange County beach community (Magic Johnson has a place next door), a Learjet for business trips and a fleet of luxury cars including a Bentley, a Porsche and a Jaguar. Harkey's wife was elected last year to the California State Assembly, giving the family political muscle to accompany its financial might.
"I hate the phrase 'rags to riches,' but that's kind of what it was," Harkey said in an interview.
Harkey's path to the hard-money lending industry started when he was teaching school in south Orange County. The mothers of some students invited him to work part time selling real estate and brokering loans. He went to real estate school, passed a test for his license and within a couple of years was making more money from his part-time job than he was teaching.
He gave up teaching and began selling real estate and brokering loans out of a room he used as an office at a Dana Point motel on Coast Highway. In 1986, he decided to focus exclusively on real estate lending, convinced that it had the most promising future.
By using real estate to secure loans, such investments are safer than securities, Harkey said. If a borrower defaults, he ends up owning real estate, which can recover value as it did after downturns in the 1980s and 1990s, he said.
When the real estate market took off earlier this decade, there were plenty of customers looking for money to seed development projects. The loans were lucrative for Point Center Financial, which charged borrowers six percentage points or more in fees, sometimes earning more than $1 million for a single loan, and annual interest rates that reached 12% or more.
Things went so well that in 2007, Harkey purchased a new Learjet 60, which retails for about $13 million, according to aircraft industry publications. His wife, Diane, personally contributed more than $1 million to campaigns for the state Senate in 2006 (she lost) and state Assembly in 2008 (she won), campaign finance records show.
Then the real estate market crashed. Harkey told investors that so many of the company's loans were in foreclosure that he was freezing most investments, Charton said. In recent months, he has charged investors fees to manage the foreclosed properties they now owned, according to e-mail statements from Harkey provided to The Times by investors.
Few took the news harder than Charton. If the appraisals were accurate, there should have been plenty of equity: Properties could be sold and investments returned, he said.
Charton and dozens of other disappointed investors now say that Harkey misled them about the risky nature of the loans by misstating borrowers' creditworthiness and the value of the properties that served as collateral.
In February, the group of more than 50 investors filed a lawsuit accusing Harkey of recklessly managing their investments and using inflated appraisals to make loans appear safer than they were. They alleged that Harkey pushed through questionable loans so that he could charge fees, profiting whether or not the loans were repaid.
"Most of our clients have not received any return of principal and have no chance to. And these were supposed to be safe investments," said the investors' attorney, David C. Grant.
Harkey, who has not filed a response to the lawsuit, has asked that the case be assigned to private arbitration.
Charton said investors intend to ask a Superior Court judge to authorize a vote that would allow them to replace Harkey as manager of the foreclosed properties. Harkey insisted that he is best suited to manage the real estate. He says Charton is upset because he has lost money.
The dispute between the two has spilled from the courtroom to the Internet, with dueling websites. Charton's site, pointcenterinvestigation.com, accuses Harkey of duping investors. Harkey fired back with lloydchartoninvestigation.com, which attacks Charton's personal behavior.
As an example of the alleged mismanagement, Charton points to a $19.2-million loan that Point Center Financial made in 2006 for a golf course and residential development at Palm Springs Country Club.
Point Center's investment brochures praised the borrower, Burnett Development Corp., as a creditworthy customer, failing to disclose that Burnett had defaulted on two earlier loans from Point Center, according to sales literature and public records.
Burnett ended up defaulting on the Palm Springs loan, forcing Point Center to foreclose on behalf of the investors. The city later sued the investors personally, saying the property had fallen into such disrepair that it had become a public nuisance.
Harkey maintains that the loans were good investments. He said he had no control over appraisals. If the market had not declined, he would have been able to sell the foreclosed properties and recover his investors' money, he said.
"I'd rather have my money in real estate than Citigroup," he said, referring to the banking giant's stock, which has lost about 93% of its value since peaking December 2006.
Harkey's boosters say he never looked to victimize anyone.
"You don't become dishonest all of a sudden and cheat your investors. It's not even rational to think someone would do that, frankly," said Richard Rollnick, an Arizona developer who is one of Harkey's closest friends.
"Your reputation follows you your entire life. And Dan has built his company on his excellent reputation, his honest reputation."
Arnold Goldman, 78, had to take out a reverse mortgage against his Encino home because of the roughly $600,000 he has invested in bad Point Center loans. Still, he's not prepared to blame it on Harkey. He said the real estate downturn is the problem and there's only one cure: time for the market to recover.
"I have faith in him until anyone proves otherwise," Goldman said. "I truly feel this will pull through when the economy changes. The collateral will have some value. I expect I'll get everything back."