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New watchdogs for fraud? Different courts have reached various conclusions when it comes to the duty of escrow officers to report signs of mortgage fraud to lenders. It pays to know what the law says in different jurisdictions.

Homeownership is the great American dream. But as with all dreams, there is a segment of the population prepared to exploit the dream of homeownership. Exploitation in the form of mortgage fraud impacts every community and demographic group in America. [??] As the crisis facing the subprime mortgage market continues to capture the attention of not only the press, but also the president and the Federal Reserve, answers are being sought about the how and why behind the decline in the subprime market. A contributor to the crisis is mortgage fraud. [??] According to the Federal Bureau of Investigation (FBI), the incidence of mortgage fraud continues to rise exponentially. In 1999, there were a mere 3,088 cases of mortgage-related fraud reported; in 2005, the number grew to 21,994. This trend continues to increase as local and federal law-enforcement agencies pursue mortgage fraud in communities across the country. [??] Law-enforcement agencies throughout America have begun to formulate special task forces to investigate and prosecute acts of mortgage fraud. For example, within the past two years the Harris County, Texas, district attorney formulated a special prosecutorial division to investigate two fraud rings that resulted in approximately $60 million in bad loans. In Detroit, 20 individuals were indicted for fraudulent acts resulting in $10 million in losses. Most recently, a Texas man was convicted of mortgage fraud involving properties in four counties that resulted in more than $10 million in losses.

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All too aware of the national problems presented, the FBI has also created specialized task forces to curtail such activity. Currently, the FBI monitors instances of mortgage fraud by compiling data filed by federally insured financial entities, the Department of Housing and Urban Development (HUD) and the Office of Inspector General (OIG). The FBI also responds to complaints received from the mortgage industry.

As part of its efforts to curtail mortgage fraud, the FBI has established specific personnel contacts to major groups in the mortgage industry, including the Mortgage Bankers Association (MBA), the Mortgage Insurance Companies of America (MICA), Fannie Mae and Freddie Mac.

The FBI first began investigating mortgage fraud in 1999. Since then, it has created 15 task forces throughout the country responsible solely for investigating instances of the crime. The latest figures provided by the FBI are impressive. As of the end of 2006, 818 cases of mortgage fraud were investigated by the FBI. Of these investigations, 263 resulted in indictments and 204 in convictions. In terms of monetary success, as of the end of 2006, the FBI investigations resulted in the recoveries of $388.9 million in restitution, $1.4 million of fraudulently obtained lending and $231 million in fines.

As the subprime lending market continues to struggle, lenders are looking to recover some of the enormous losses resulting from fraud. The parties to fraud transactions who reap the largest rewards are generally judgment-proof, in that they do not tend to keep the money fraudulently pulled from the transactions in a savings account.

One "deep-pocket" party lenders look to for recovery of their losses is the title company escrow officers responsible for closing the questionable transactions. Although many title companies operate on a national level and close transactions throughout the country, the extent of their responsibility for spotting and reporting potential fraud varies from jurisdiction to jurisdiction.

Role of the escrow agent

An escrow agent's function is typically defined by statute. Most commonly, however, an escrow agent's duties include collecting all the proper documents to consummate a real estate transaction and making a determination, among other things, that all property taxes have been paid, all monies properly disbursed and all necessary paperwork (i.e., deeds) properly executed and filed. In this role, the escrow officer is often the only party who has access to all of the documents related to the transaction at one time in one place prior to the closing of the sale.

In a perfect world, the escrow agent would remain completely objective and neutral throughout the closing process. Escrow agents owe a three-sided duty of loyalty (a fiduciary duty). That duty extends to the lender, seller and buyer. Courts are in agreement as to what this fiduciary duty comprises.

The U.S. Sixth Circuit Court of Appeals--which has federal appellate jurisdiction over cases in Kentucky, Ohio, Michigan and Tennessee--held in the case of West Knoxville Associates Limited Partnership v. Ticor Title Insurance Company, this duty of loyalty translates into the duty of an escrow agent to communicate knowledge of material facts that he or she learned throughout the course of the agent's relationship to the parties.

Oregon's Court of Appeals held in Gebrayel v. Transamerica Title Insurance Company that the duty requires the escrow agent to remain objective to the parties in a land-sale transaction and to not favor one party over the other.

Finally, the Texas Supreme Court held in City of Fort Worth v. Pippen that an escrow agent has the duty to exercise a high degree of care to conserve money entrusted to him or her and to pay only those individuals entitled to receive that money.

Fiduciary duty in cases of fraud

Although the majority of courts are in agreement as to what the duty is, there is a lack of agreement as to whether the fiduciary duty includes disclosure of information indicating that the transaction is irregular or fraudulent. The fiduciary duty must be balanced against the duty to remain an impartial third party to the transaction. The question then becomes: Is disclosure of facts indicating potential fraud permitted, required or prohibited?

One could easily make the argument that disclosure of potential fraud to the lender in and of itself would be a breach of the duties owed (the escrow officer took the side of the lender). Conversely, would it be a breach of fiduciary duty not to disclose indicators or fraud while there is an opportunity to mitigate a lender's losses?

Unfortunately, the case law on this question is developing and not well-settled. The answers range from quite favorable to lending entities, to downright illogical.

The first position taken by some courts (Florida in Watkins v. NCNB National Bank of Florida, Kansas in Lewis v. Shawnee State Bank, Alabama in Gurley v. Bank of Huntsville and a Massachusetts Federal District Court in Schmid v. National Bank of Greece) is that the engagement contract (often found in the lender's closing instructions) among the title company, lender, seller and buyer completely defines the duties that a title insurer owes. Upon a cursory glance, this seems logical. After all, the lending and real estate markets thrive upon reliance on carefully drafted contracts.

The problem with this view is that the previously mentioned fiduciary duties were created by law. That means the fiduciary duty is imposed upon every title insurer serving as an escrow agent, irrespective of whether or not the engagement contract specifically mentions the duty.

Lenders and their attorneys have argued--in opposition to the Florida, Kansas, Alabama and Massachusetts view--that, because the duties apply as a matter of law, any contract between the parties should not be able to carve out exceptions. In other words, if fiduciary duties can be whittled away by contract, then a breach of these duties would amount to nothing more than a breach-of-contract claim?

In jurisdictions that view the scope of the fiduciary duty in this limited manner, the only way to require escrow officers to inform lenders of potential fraud is to include specific instructions within the escrow agreement or closing instructions. One area of concern under this view is that closing instructions that may be sufficiently broad in Texas may not be sufficient in a state such as Florida or Alabama.

In some states, however, the escrow officer is required to notify the parties to the real estate transaction of his or her knowledge of actual fraud or of clear evidence indicative of fraud, regardless of the terms of the escrow agreement. Those states adopting the actual or clear-knowledge standard include California in Summit Financial Holdings, Limited v. Continental Lawyers Title Company and South Dakota in American State Bank v. Adkins.

Although this test is a slightly more expansive view of the scope of the fiduciary duty than limiting the duty to the terms of the escrow agreement, it still allows room for an escrow officer to withhold information that may indicate fraud in the transaction. More often than not, while the escrow agent does not have knowledge of actual fraud, he or she is in possession of information that indicates fraud. Such information would include mismatched signatures, forged documents, requests to disburse funds in a way that differs from the instructions on the HUD-1 or requests to allow the transaction to be closed outside the presence of the escrow officer.

While these instances may not prove that the transaction is fraudulent, they would certainly raise red flags for the lender.

What is reasonable evidence of fraud?

The other problem with this view is defining reasonable or clear evidence of fraud. After all, fraud is in the eye of the beholder (or judge and jury, as the case may be).

The Arizona Supreme Court in Burkons v. Ticor Title Insurance Company and the Nevada Supreme Court in Mark Properties Inc. v. National Title Company both held that a title insurer is not required to investigate for indications of fraud. However, once an escrow agent comes across reasonable evidence indicating mortgage fraud, it must be disclosed.

A recent twist on the question of when disclosure is required was developed by a Texas Appellate Court in Harris County, in the case of Home Loan Corporation v. Texas American Title Company. In Home Loan, the mortgage lender sued the title insurer for breaching its fiduciary duties. The day prior to closing the loan, and after the mortgage lender had approved the HUD statement, the seller requested the title insurer to disburse half of the seller's proceeds to the mortgage broker. The closing agent refused to disburse the funds as requested, and did not disclose the request to the lender. The seller then made a second request that the seller's proceeds be disbursed directly to the individual mortgage broker. The title insurer complied with this request, and as with the first request, did not disclose this to the lender. Additionally, the disbursement of the seller's proceeds to the individual mortgage broker was not disclosed on the HUD statement that had been approved by the lender prior to the lender disbursing the loan proceeds.

In the Home Loan case, the title insurer took the position that its fiduciary duty was limited to carrying out the terms of the real estate contract and escrow agreements, and to disclose any actual knowledge of a fraudulent scheme directed toward the lender. Because of these limited duties, the title insurer asserted that it was not required to disclose the seller's requests, as the insurer was to remain impartial without favoring either party. Further, the title insurer asserted it had no obligation to police the affairs of the other parties or report suspicious circumstances unless it had actual knowledge of fraudulent plans.

The Home Loan court rejected the title insurer's arguments. Regarding the title insurer's position that the fiduciary duties are limited to the terms of the escrow agreements, the court noted that no Texas decision had directly addressed any limitation on the scope of an escrow or other settlement agent's fiduciary duty of disclosure, and that no rationale supported limiting an escrow agent's fiduciary duties to the terms of the contract. The Home Loan court succinctly stated that to hold that the fiduciary duty of disclosure is limited to the terms of the escrow agreement, the special relationship of trust established at law when a fiduciary relationship is established would be disregarded. The result would be that a breach of the fiduciary duty would be no more than a cause of action for a breach of contract. Finally, the Home Loan court held that full disclosure is required for all material facts known by the title insurer that might affect the rights of the lender, buyer and seller. Under the present state of affairs in Texas, a title insurer's fiduciary duty of disclosure is interpreted broadly.

The District of Columbia in Aranoff v. Lenkin Company and the Montana Supreme Court in KitchenKrafters Inc. v. Eastside Bank of Montana also adopted a similar view.

The level of disclosure required under these decisions may be quite broad. Title insurers in Texas, Washington, D.C., and Montana are no longer able to avoid liability by asserting that their fiduciary duties prohibit favoring one party over another.

The Home Loan court was also clear in stating that Texas law does not limit the scope of an escrow agent's fiduciary duties only to instances of known fraud.

Although this is unlikely to create the duty of becoming a watchdog, it certainly indicates that escrow officers in these states may need to be more vigilant in watching for and reporting facts that indicate mortgage fraud to the parties to the transaction--specifically those including the lender.

Summing up

The stakes of these legal findings are significant, especially considering the current state of affairs in the subprime mortgage market. Mortgage fraud can expose lenders and other parties to questionable real estate transactions to millions of dollars in damages.

As with most real-property-related matters, the scope of the parties' duties to each other in the real estate transaction varies by jurisdiction. This is clearly the case when it comes to the scope of the fiduciary duty owed by the escrow officer to the parties to a transaction. Lenders should be aware of these differences when proceeding with real estate transactions and when looking to recover losses for fraudulent transactions.

Stephanie Tolson is of counsel and Nathan Anderson is an associate in the Houston office of McGlinchey Stafford PLLC. They can be reached at stolson@mcglinchey.com and nanderson@mcglinchey.com.
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Title Annotation:Legal
Comment:New watchdogs for fraud? Different courts have reached various conclusions when it comes to the duty of escrow officers to report signs of mortgage fraud to lenders.
Author:Tolson, Stephanie; Anderson, Nathan
Publication:Mortgage Banking
Geographic Code:1USA
Date:Nov 1, 2007
Words:2322
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