Real Estate Fraud Claims and Criminal Prosecution

• Citation: Vol. 32 No. 4
• Publication year: 2014
• Author: By W. Dean Cloud

Real Estate Fraud Claims and Criminal Prosecution

By W. Dean Cloud

©2014 All Rights Reserved.

I. INTRODUCTION

The following information is presented to help lawyers better understand the various types of real estate fraud that are currently being perpetrated in California and the criminal causes of action that can be brought by prosecutors against the perpetrators.

In 2006-2007, the mortgage lending business was plagued with loose underwriting standards and soaring home values. This contributed heavily to increased levels of fraud and shaped the types of fraud being perpetrated. Over the past couple of years, foreclosures, coupled with tighter lending practices, no longer provide the framework for the types of fraud that were prevalent during the 2006-2007 housing bubble.

Despite stricter lending practices, there are still ample opportunities for fraud. According to the Financial Crimes Enforcement Network ("FinCEN"), California led the nation in 2011 and 2012 for mortgage lending fraud subjects per capita.¹Within California, Orange, Riverside, Los Angeles, and Santa Clara Counties were the top counties for mortgage loan fraud in the country per the October 2012 FinCEN Report.²

II. TYPES OF FRAUD

In its 2010 Mortgage Fraud Report Year in Review, the FBI defined mortgage fraud as "a material misstatement, misrepresentation, or omission relied on by an underwriter or lender to fund, purchase, or insure a loan."³ The FBI has divided mortgage fraud into two categories: fraud for property and fraud for profit. This article will focus on fraud for profit schemes involving the use of identity theft and the recording of fraudulent documents. Fraud for property will not be covered in this article.⁴

Fraud for profit involves elaborate schemes perpetrated to gain illicit proceeds from either the refinancing or sale of a property. Fraud for profit schemes invariably involve one of two techniques: (1) the conversion of existing equity or (2) the creation of false equity that is then converted. Fraud for profit schemes also usually involve forgery, gross misrepresentations of appraisals and loan documentation, and peripheral participants who are frequently paid for their individual roles, but may not be part of the larger scheme.

Mortgage fraud perpetrators can include licensed/registered and non-licensed/non-registered mortgage brokers, lenders, appraisers, underwriters, accountants, real estate agents, and attorneys. There have been numerous instances in which various organized criminal groups have also become involved in mortgage fraud activity. Using their experience in the banking and mortgage-related industries, mortgage fraud perpetrators exploit vulnerabilities in the mortgage and banking sectors and at the county recorder's office. These fraudsters often have high-level access to financial documents, mortgage origination software, notary seals, and professional license information.

To better track fraud-for-profit schemes, it is important to understand how a basic residential mortgage transaction works.

A. A Brief Primer on Basic Mortgage Transactions 1. Loan Documents

Basic mortgage transactions are generally the same whether the purpose of the loan is to purchase a property or to refinance an existing loan. A typical real property loan involves two parties: a borrower and a lender. The loan is documented by a promissory note. A security instrument accompanies the promissory note, giving the creditor a right to foreclose on the property if the obligation is not performed. In California, the security instrument most commonly used is a deed of trust. Under a deed of trust, the debtor is referred to as the trustor, and the lender is referred to as the beneficiary. The third party to a deed of trust is the trustee. The trustee's duties are two-fold: (a) to reconvey the deed of trust to the trustor upon satisfaction of the debt owed and to release the lien created by the deed of trust, and (b) to conduct a non-judicial foreclosure action on the property in the event of a default by the trustor. A foreclosure is initiated by the beneficiary and can ultimately result in the sale of the property pledged as security for the loan.

Another security instrument is a mortgage, with the borrower being the mortgagor and the lender being the mortgagee. In California, it is extremely rare to see a mortgage, and virtually all security instruments are deeds of trust.

2. The Loan Transaction

The three most common channels through which a residential borrower can obtain a loan secured by real property are: (a) the retail-loan transaction, (b) a broker, and (c) a hard-money lender.

(a) Retail Loans

In a retail loan transaction, the borrower applies directly to the financial institution. These transactions are the most direct. An application package is prepared by the financial institution consisting of the borrower's loan application, a credit report, a property appraisal, a preliminary title report, and credit-related documents. The lender's underwriting department then reviews these documents to make its credit decision. Upon loan approval, the financial institution releases the funds to a closing agent to be disbursed according to the loan agreement and escrow instructions. The closing agent can be either an escrow company or a separate division within the financial institution that handles the disbursement of funds. Once escrow closes, the financial institution either retains the loan on its books or sells the loan on the secondary market.

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(b) Broker-Originated Loans

A broker-originated loan is similar to a retail loan transaction, except that the borrower submits an application to a loan broker who then submits it to a financial institution. Acting on behalf of either the financial institution or the borrower, the broker matches the borrower's financial needs with an institution's mortgage lending practices. Brokers receive a commission expressed as a percentage of the total loan amount.

In a broker-originated loan, the broker performs many of the loan processing functions including taking loan applications, ordering credit reports and preliminary title reports, and verifying the borrower's income and employment. A financial institution's underwriter reviews the information submitted by the broker and makes a credit decision. A financial institution may also perform pre-funding quality assurance activities such as re-verification of income and employment.

(c) Hard-Money Loans

A hard-money loan is based upon the quick-sale value of real property pledged as security for the loan. Most hard-money loans are secured by a first deed of trust. Typically, private investors or companies fund hard-money loans. Because of the higher risk taken by the lender, interest rates and processing fees are higher than conventional commercial or residential property loans. Most hard-money loans have a maturity date lasting from a few months to a few years. This type of loan is similar to a bridge loan—a short-term loan meant to provide or extend financing until a more permanent loan can be arranged. In contrast to a bridge loan, hard-money loans often involve some type of distressed financial situation, such as where the borrower is in arrears on an existing secured loan.

The criteria for a hard-money loan vary widely by lender and loan purpose. Credit scores, income, and other conventional lending criteria rarely play a role. Most, if not all, hard-money lenders determine the loan amount based on the value of the real estate being collateralized. Typically, hard-money loans do not exceed sixty-five percent to seventy percent of the property value. The low loan-to-value ratio provides greater security for the lender in the event of a default by the borrower.

3. Title Insurance

Title insurance means insuring or indemnifying owners of real property or the holders of liens or encumbrances against loss or damage suffered by reason of: "(a) liens or encumbrances on, or defects in the title to, said property; (b) invalidity or unenforceability of any liens or encumbrances thereon; or (c) incorrectness of searches relating to the title to real or personal property."⁵

The policy of title insurance is in essence an indemnity contract and is not a representation that the contingency insured against will not occur.⁶ When a contingency does occur, e.g., a deed of trust is missed and not listed as an exception to policy coverage, the insured has a claim under the policy. Since a policy of title insurance is a contract of indemnity, the title insurer has a wide variety of options in responding to a claim.⁷ These range from paying policy limits to eliminating the defect in title and thus perfecting title as insured. When the claim is resolved, the title insurer often acquires subrogation rights and can initiate collection efforts to recover from the wrongdoer the funds that were paid to resolve the claim.

Virtually all real estate fraud scenarios involve either the sale or refinancing of real property. Almost every real estate sale involves issuing an owner's policy of title insurance to the buyer. Likewise, any refinancing or purchase money secured loan involves the issuance of a lender's policy of title insurance to the new lender. Since it is the new buyer or lender who is defrauded, almost all real estate fraud involving forged recorded documents results in a title claim. Therefore, it is most often the title insurer who suffers the lion's share of the financial loss when these types of real estate fraud occur.

B. California's Economic Conditions and Real Estate Fraud

Real estate fraud is affected by economic conditions; loan originations, unemployment, housing inventory, lower housing prices, default rates, and foreclosures all play a role in determining what types of fraud will be successful. For instance, in 2004 and 2005, home values appreciated in excess of twenty percent per year. This created a financial environment where property-flipping frauds were extremely...