SC Lawyer, Nov. 2004, #5. HUD-1 Misery.

• Author: By John Freeman

South Carolina Lawyer

2004.

SC Lawyer, Nov. 2004, #5.

HUD-1 Misery

South Carolina LawyerNovember 2004HUD-1 MiseryBy John FreemanThe biggest risk facing the good lawyer is the bad client. Even work as seemingly routine and mundane as residential real estate closings becomes tricky when clients are less than honest. Two Greenville law partners, Ray Lathan and Ronald Barbare, ended up with some bad clients and paid a fearsome price: federal criminal prosecution, license suspension, and the temporary dismemberment of their law partnership, not to mention the need to fork out large sums to settle civil claims. See Matter of Lathan, ___ S.C. ___, 600 S.E.2d 902 (2004); Matter of Barbare, 2004 WL 1661038 (S.C. 2004).

Lawyers Lathan and Barbare were law partners in a law firm handling 1,400 to 1,600 real estate closings per year, around six every business day. Lawyers willing to handle so many loan closings run foreseeable risks, among them paperwork glitches that leave mortgages unsatisfied, slipshod title work that leaves the lender without the bargained-for lien protection, and improper use of lay staff to do lawyer work, leading to unauthorized practice issues. None of these standard types of closing problems bit the two Greenville lawyers. What got them were crooked clients.

As chronicled in the Court's decisions, both lawyers ended up being played for patsies by greedy property sellers and a lender's crooked employee. Interfacing principally with the lawyers' paralegal, the bad guys worked relentlessly as a criminal ring to cheat lenders out of cash. Crime paid well for the law firm's crooked clients, at least temporarily. One, a real estate property seller, "admitted he had derived between $5,000,000 and $10,000,000 in benefits from his scheme." Matter of Lathan, 600 S.E.2d at 905. Another property seller who used the lawyers' legal services "admitted deriving $3,075,000 from the real estate transactions related to his plea." Id. at 907. Another defendant, a dishonest employee for a lender, "admitted deriving between $1,500,000 and $2,500,000 from his scheme." Id.

Lawyers Lathan and Barbare missed out on the lush financial returns enjoyed by beneficiaries of the loan closings they processed. Said the Court: "ODC's investigation reveals respondent did not receive any special financial benefit from the closings investigated by ODC. All fees received are shown on the Firm's class report [trust account ledger]; the fees appear to be reasonable and customary for work of this type in Greenville." Id. Further, there was no allegation either lawyer "deliberately sought to assist [others] in criminal undertakings or had knowledge of their criminal intent." Id. at 907-08. Not only did the lawyers not make excessive fees, for their efforts they, ended up paying hundreds of thousands of dollars to settle claims brought by bilked buyers and lenders. What led to the lawyers' criminal, civil and disciplinary woes was crooked real estate deals memorialized with bad paperwork, and, particularly, inaccurate HUD-1s.

Sometimes dangerous things come in small packages. The coral snake, for example, has a fearsome bite. So it is with HUD-1 Settlement Statements. Real estate lawyers fill out a humble, little (two-page) Form HUD-1 for virtually every residential real estate closing. HUD-1s are important because they travel from the closing room into the stream of commerce where, foreseeably, others, such as lenders, will rely on them. Real estate specialists know a HUD-1 is probably the most important document in the closing package.

Because they are ubiquitous and seemingly simple and straight-forward, it perhaps been easy for closing lawyers to overlook the crucial role HUD-1s play in the modern real estate financing market. After the Lathan and Barbare cases, any South Carolina lawyer who views HUD-1 completion as a minor matter is begging for trouble. The HUD-1 hits nerve centers in every direction. It is relied on by borrowers, lenders, sellers, and participants in the secondary financing marketplace.

Today mortgages are bundled together and sold in the secondary market. It is critically important to those who invest in that market that they be able to tell what it is that they are buying. HUD-1s are supposed to tell anyone looking at them the true facts about the underlying real estate loan transaction, with a key item being the money put into the transaction that came out of the borrower's pocket.

Naturally, lenders and purchases of mortgage paper like seeing that the borrower has made a substantial out-of-pocket contribution to the purchase. They know that the more money the borrower has in the property, the lower the risk of default. They see the borrower's money as an equity cushion. A lawyer who passes on a HUD-1 showing an illusory or inflated equity cushion has generated a fraudulent document. A federal statute, 18 U.S.C. ' 1010, criminalizes publication of false HUD-1s. The HUD-1 Settlement Statement's delivered to lenders by Lathan and Barbare showed such inflated cushions. The HUD-1s were false, and materially so.

Lathan and Barbare's woes stemmed from recording closings using two sets of books. One set, the HUD-1s, showed substantial investments in property by the buyers. Line 303 of the HUD-1, reflecting the sum of money provided from borrowers' pockets, was repeatedly pumped up and false. In each instance cited by the Court, the line 303 disclosure was bogus because the borrower's contribution to the deal was either nonexistent or fraudulently inflated. This was a huge error. It translated into criminal prosecutions.

Missing from the HUD-1s was the notation POC ("paid outside closing") across from line 303, to flag for anyone reading the HUD-1 that the buyer's alleged payment had not passed through the closing lawyer's hands. Absent the POC notation, anyone looking at the lenders' HUD-1s would have been misled into believing that, at closing, all the funds had passed through the lawyer's trust account. Worse, the lawyers' internal financial reports on the transactions not only presented facts different from those shown on the HUD-1s delivered to lenders, in two cases the internal reports, but not the lenders' HUD-1s, reflected cash paid outside the closing supposedly by the borrowers, but coming in the form of checks drawn on the seller's account. This set of facts obviously cast doubt on the legitimacy of the selling price for the piece of property against which the lender was making the loan.

The lawyers' two sets of books thus each showed a materially different picture about the subject transactions' substance. The more rosy, more upbeat picture was presented in the HUD-1s released into the stream of commerce post-closing. This deception led to the temporary destruction of Lathan and Barbare's thriving real estate practice.

The Supreme Court did not mince words. It was dismayed by the respondent lawyers' conduct and, worse, by evidence before it suggesting the respondent lawyers' behavior was not unusual for lawyers handling residential real estate closings in South Carolina. In the mini-CLE lecture it delivered to all South Carolina real estate lawyers the Court scolded:

According to the parties in this matter, a large number of attorneys are not passing closing funds through their trust accounts and, at the same time, not identifying the funds as paid outside of closing on closing documents. Not only does this practice fail to accurately record the actual transaction for the buyer and seller, but it is misleading to lenders. In an attempt to eliminate this and other deceptive practices, we emphasize that costs and credits in connection with a real estate transaction must be shown on the [HUD-1] settlement statement and that the settlement statement must reflect all amounts paid, by whom paid, and to whom paid. Any charges or amounts paid outside of the closing must be reflected as such on the settlement statement (i.e., "POC"). For all funds exchanged during the closing, the attorney must have a record of the method of payment by the parties to the transaction, as well as an accounting of all receipts and disbursements by the attorney. The attorney's records must accurately reflect the transaction as evidenced by the settlement statement unless there is written documentation signed by all parties to the transaction (including any lender) indicating that funds were disbursed otherwise. Failure to comply with these standards may subject attorneys to disciplinary action.

Matter of Lathan, 600 S.E.2d at 909.

In the foregoing paragraph, which appears verbatim in both the Lathan and Barbare opinions, the court uses the word "must" five times. Any time our Supreme Court uses the word "must" five times in one paragraph in a lawyer discipline case, there is some teaching going on. There was here.

Payments by the borrower outside of closing, whether covered by line 303, or line 201 (which covers "deposit or earnest money" payments) must either be received and disbursed by the settlement agent (i.e., the lawyer handling the closing) or marked POC on the HUD-1.

If an internal addendum is used to reflect special facts modifying a transaction, then copies of the modifying addendum needs to be delivered to the lender.

If property is being "flipped," that is, bought and immediately resold with the proceeds of the second transaction being used to fund the first transaction, then the true facts concerning the second transaction needs to be disclosed so that the lender in the second transaction can see that the proceeds of the loan are being used to fund the first transaction. One way of making this disclosure is by using the blank lines from 204 to 209 and from 513 to 519 to make the economic reality of the transaction obvious to the lender (and possibly, the purchaser) who gets the HUD-1 on the second transaction.

The HUD-1 needs to reflect the material dealings between the borrower and the lender. Funds listed on the HUD-1 which do not pass through the lawyer's hands must be marked POC. However, a variance between amounts shown on lines 303 and 603 and the cash amounts disbursed from the lawyer's trust account is indicative of deception.

An important consequence of the two disciplinary orders is the implicit instruction to the Bar that accurate reporting in real estate transactions requires lawyers to ascertain the financial reality of the transaction, and to accurately and consistently report it externally (via the HUD-1) and internally (in the law firm's own records of the transaction).

The court expressed particular concern over the need for lawyers to keep their eyes open to the ever-present risk their services are being perverted or used abusively. In particular, Lathan and Barbare each were faulted for ignoring "'red flags' which should have alerted him that the [clients] were seeking to mislead lenders."

Implicit in the court's ruling is a call for lawyers always to take into account that their actions in a matter (such as preparing a HUD-1 or a title opinion) may have on third parties with whom the client is dealing. Explicit in the opinion was the court's expression of genuine concern that, in its words, "a large number of attorneys" may be handling real estate closings in a way similar to that leading to the downfall of attorneys Lathan and Barbare. Any lawyer with a substantial real estate practice needs to study, learn, and apply the lessons to be drawn from those two closing lawyers' wrenching experiences.

Copyright (c) 2004 by the South Carolina Bar. All rights reserved. No part of this publication may be reproduced without written permission.