Real Estate Fraud: How to Prevent It and Detect It.

Almost everyone has heard the old saying, "The pen is mightier than the sword." For real estate lenders and, for that matter, sellers and buyers of real property, the saying "It is easier to steal a million dollars with a pen than with a sword" reflects a day-to-day reality of doing business, and a danger against which they must take precautions.

This article surveys the distinction, in terms of the potential for fraud, between commercial and residential transactions; a variety of common real estate fraud schemes; approaches one may take to prevent/detect fraud at the outset; and ways in which to maximize recovery of loan funds or property if fraud has occurred in your transaction.

Commercial Vs. Residential Real Estate Fraud

Fraud in commercial real estate transactions is uncommon. A commercial transaction is typically conducted with the active assistance of counsel for the seller, buyer, lender, title insurer and, at times, others. Each attorney is charged with protecting his or her client's interests zealously. In a residential transaction attorneys rarely participate, except in those states which utilize attorneys as closing agents. Even in those transactions, however, the attorney as closing agent does not generally owe the seller, buyer or lender the same degree of zealous loyalty as counsel engaged by the parties.

Residential transactions give the criminally inclined person an ideal environment in which to operate. The following aspects of many residential transactions help to create and nourish that environment, and also distinguish residential from commercial transactions:

* A substantial amount of residential lending is brokered, with most employees of mortgage brokers operating on commission income structures.

* Often the lender or mortgage broker never meets the borrower.

* Loan documents are often delivered to the borrower at his or her home by a "loan signer," whose sole job it is to obtain and notarize the borrower's signature.

Unlike commercial transactions, where the parties and their counsel may be working on no more than a handful of deals at any onetime, residential lenders count on loan volume to generate fees, commissions and income. Thus, it is not uncommon for loan processors to be handling more than thirty loan applications at once.

In a slow real estate economy, the residential lender/broker may have fewer applications to process, but without the loan volume to generate income, loans that would ordinarily be considered sub-par may be pushed through the system. Of course, when the real estate market is booming, as it has been in most parts of the country, loan processors have less time to conduct the due diligence required to assure quality loans. In both circumstances, individuals with a fraudulent intent will be waiting.

Common Fraud Schemes

What follows is a description of various types of schemes utilized to defraud lenders, buyers and sellers:

Incomplete Public Property Records

In some counties, particularly in California, criminals have seized upon the fact that the recording of property records has become backlogged, as has the computerization of those records used by title insurers.

In one case, a homeowner sought to refinance her home and utilize some of the equity she had accumulated to perform home improvements. What the homeowner did not disclose was that she had simultaneously applied for the same loan to approximately six different lenders, mostly through loan brokers.

The homeowner explained the numerous inquiries on her credit report by saying that she had been "loan shopping." Each lender approved the loan and, as the homeowner had anticipated, each deed of trust was recorded within two to three days of the others. Each loan was disbursed and the homeowner's fraud brought her hundreds of thousands of dollars.

The fraud was able to be perpetrated because the county did not "index," i.e., make public, the recorded deeds of trust until several days after they had actually been recorded. Exacerbating the situation was the fact that the title insurers for each of the lenders utilized a computerized "title plant," not the Hall Of Records, for determining the state of title prior to funding the loans. Whereas the Hall Of Records was two to three days backlogged, the title plant was two to three weeks behind.

As a result, when the lenders' title insurers investigated title just prior to recording and funding, the records available to them failed to disclose the existence of other deeds of trust.

Forged Vesting Deeds

One of the most common, and troubling, real estate fraud schemes involves the transfer of title to property, through a forged deed, to the person who will perpetrate the fraud.

For example, Homer Homeowner owns his home with only a few thousand dollars remaining to be paid on the mortgage. Unbeknownst to Homer, Freddie the Forger signs Homers name on a deed conveying the house to Freddie.

Freddie then applies for a home equity loan, utilizing Homers house as security. The lender feels secure to make the loan because of the large equity cushion, fails to conduct much due diligence, and disburses the loan to Freddie, who then disappears into the shadows from whence he came.

Stolen Identity/Stolen Credit

This type of fraud has become much publicized in recent months. One version of this scheme experienced in southern California a few years ago involved 80 separate properties and drew the attention of the FBI.

In the scheme, an individual acquired the credit and personal history of a creditworthy borrower, impersonated that individual and obtained loans to purchase properties. Thereafter, the impostor either leased the properties or sold them using an All Inclusive Trust Deed (AITD), skimming the rents or absconding with the down payment in the case of an AITD sale.

Improper Disbursement of Loan Funds

In this situation, more commonly found in commercial than residential transactions, the owner of the property is a business entity (e.g., corporation, partnership, joint venture, limited liability company, etc.). A person affiliated with the owner, usually a control person, will then pursue a loan utilizing the business entity's property as security. Either at this point, or at loan disbursement, the control person will falsify company resolutions authorizing the borrowing and/or direct that loan proceeds be disbursed to an entity he or she controls other than the owner of the property.

For example, if the owner of the property is Blackacre Investments, Inc., how difficult might it be for the President and CEO of Blackacre Investments, Inc. to create a new entity, Blackacre Investments Co., Inc. and utilize that corporate entity to obtain a loan against real property owned by Blackacre Investments, Inc.?

Erroneous Property Description

In this unique scheme (amazingly on the rise), the person intending to commit the fraud will know how title insurers operate, and will have discovered real property encumbered by a security instrument which does not accurately describe the real property.

In one scenario, the property is encumbered by a first and second deed of trust. The loans have fallen into default and the holder of the second deed of trust has begun to foreclose. The first deed of trust incorrectly describes the real property (e.g., Tract 5096, Lot 97, instead of the correct description, Tract 5097, Lot 96).

The person intent on fraud will purchase the property at the foreclosure sale and immediately thereafter obtain preliminary reports from as many title agents as possible for the sole purpose of locating a title company which fails to detect the first trust deed on the property because of its incorrect legal description.

Having found the target title company, the person will market the property competitively and, as part of the escrow instructions, commit himself to provide the title insurance. When the lender makes its loan to the purchaser of the property, utilizing the title insurer pre-screened by the defrauder, the first trust deed will be missed, resulting in a huge windfall to the seller/defrauder.

It is only when the new owner fails to make payments on the unknown first deed of trust, causing foreclosure proceedings to commence, that the homeowner and the lender learn of the elaborate scheme to which they have fallen prey.

Prevention/Detection of Fraud

At the outset it must be understood that it is impossible to eliminate completely the risk of real estate fraud. Rather, by taking the following precautions, among others, the risk of fraud may be substantially reduced:

Know Your Borrower, Buyer and Seller

All too often, real estate transactions take place without the personal interaction of the parties or their counsel. There is no better way to protect a real estate transaction against fraud than to look the other parties or their counsel in the eye or, at a minimum, to speak directly with them.

In many transactions, sales agents, loan brokers and document signers conduct the actual business of the transaction. While these persons certainly owe a duty to their principals, their involvement can never replace the insight and instinct brought to the table by the parties themselves. To be sure, a sales agent's or loan brokers duty does not rise to the level of zealous loyalty that an attorney owes his or her client.

Therefore, if the parties themselves cannot participate in the transaction at some level, they should employ counsel to do so on their behalf.

Demand Precision in Due Diligence

Every party involved in a real estate transaction has, or should have, a thorough due diligence checklist. These checklists include, but are not limited to, income and deposit verifications, identity verifications, preliminary reports concerning the title to the property in question, and environmental investigations.

It is critical that whatever due diligence procedure is in place be followed precisely. That means looking for and questioning every inconsistency, to the point of being on the alert for fraud. In the first example of a fraud scheme above (Incomplete Public Property Records), questioning more closely the multiple credit inquiries could have revealed the scheme that was underway.

Avoid a False Sense of Urgency

No doubt many transactions are time sensitive; however, it is important to understand which transactions are subject to real or concocted time constraints. A person intent on fraud will typically attempt to create a frenzied or excited atmosphere for the transaction in an attempt to disrupt due diligence efforts, or dissuade a party from the type of critical analysis which is necessary to detect fraudulent schemes.

Avoid Last Minute Deal Changes

Part and parcel of the defrauder's bag of tricks is the effort to change terms of the transaction at the last minute. There should be no exception to the rule that due diligence is required concerning new terms, especially those arising at the last minute. To do otherwise is to increase substantially the risk of fraud.

In a commercial transaction, a last minute change in a business entity's structure, no matter how minor, could prove to be disastrous. For example, the risk of loan fund diversion to someone other than the owner of the real property security is made real by a borrower's last minute change in name, capacity or loan disbursement instructions (e.g., Blackacre Investments, Inc. v. Black-acre Investments Co., Inc.).

Peter K. Rundle is an attorney in Arter & Hadden's Irvine office and a member of the firm's Real Estate Practice Group. His practice focuses on representing lenders, as well as their title insurers, in a wide variety of litigation, including real estate fraud.