Short Sales — An Overview and Warning to Real Estate Licensees Re: Fraud, and Legal and Ethical Minefields

 Short Sales — An Overview and Warning to Real Estate Licensees Re: Fraud, and Legal and Ethical Minefields1

In April of 2010, the federal government will offer financial incentives to push short sales through a program called Home Affordable Foreclosure Alternatives. The program is designed to spur home sales, and it specifically imposes new requirements on lien holders, including requiring certain debt forgiveness, an abbreviated time frame to respond to short sale offers, and provides government payments to homeowners (for moving and/or relocation expenses), servicers, and lien holders.

A. What is a Short Sale?

Because not all real estate professionals are aware of the mechanics of short sale transactions, the following overview is offered as a quick primer.

A short sale is a pre-foreclosure residential real estate transaction where the owner of the mortgage loan, the lender or lien holder (hereinafter sometimes “Lender”), agrees to (i) allow the home owner to sell his or her property for less than — or “short” of — the outstanding amount owed on the mortgage loan, and to (ii) release the property from the mortgage.

Homeowners who are “underwater” or “upside down” with respect to their mortgage loans, seek to sell their homes “short” to avoid the threat of foreclosure action and to lessen the credit damage that would accompany a foreclosure. Because of the “shortage”, the transaction may involve “debt forgiveness” by the Lender. But this is often preferable to the Lender compared to a foreclosure – which has costs and risks for the Lender in terms of lost payments, eviction, property maintenance, insurance, taxes, fees, and the like — or a loan modification, with the associated lack of certainty. Also, a short sale gets the non-performing mortgage loan asset off of the Lender’s financial books.

 B. Is a Real Estate License Required to Represent the Parties to a Short Sale

The simple answer is YES, with some extremely narrow and limited exceptions and exemptions.

A real estate broker license (or a real estate salesperson license where that person is working under the supervision of his or her broker) is required under section 10131 (d) of the California Business and Professions Code (B&P Code) where a person, in a representative capacity on behalf of another, “negotiates loans…or performs services for borrowers or lenders …in connection with loans secured directly or collaterally by liens on real property…” for or in expectation of compensation, “regardless of the form or time of payment”.

In addition, under section 10131 (a) of the B&P Code, a real estate broker license (or salesperson license with appropriate supervision by the broker of record) is required of any person who, as a representative of another, “Sells or offers to sell, buys or offers to buy, solicits prospective sellers or purchasers of, solicits or obtains listings of, or negotiates the purchase, sale or exchange of real property…”

The exceptions and exemptions from the licensure requirement are few and narrowly drawn. For example, a California licensed lawyer is exempt when that person renders services in the course and scope of his or her practice as an attorney. Additionally, if a person is acting solely on behalf of himself or herself, or itself in the case of an entity, there is no need for a real estate license since the person or entity is not acting on behalf of another or others.

Because there is or may be mortgage loan “debt forgiveness” in a short sale, some people and entities argue that they can, and attempt to, consummate short sales on behalf of others without a real estate license by asserting that they are “debt negotiators”, “debt resolution experts”, “loss mitigation practitioners”, “foreclosure rescue negotiators”, “short sale processors”, “short sale facilitators”, “short sale coordinators”, “short sale expeditors”, or some other type of unlicensed short sale or debt specialist.

Yet it is because the loan debt is “secured directly or collaterally by liens on real property” that brings into play the legal mandate for a real estate broker license under California law.

If a real estate licensee wants to take a short sale listing and not conduct the short sale negotiations with the homeowner’s lender, then the licensee must seek to ensure that an unlicensed third party is not performing the negotiations on behalf of the seller.

Criminal Penalties for Those Who Participate in Unlicensed ActivitiesII. Fraud, and Questionable Conduct and Activities.

Those who engage in short sale transactions, including the related “negotiations”, and who are unlicensed (and do not have the benefit of an exception/exemption), are in violation of California law. The penalties include fines and/or imprisonment under section 10139 of the B&P Code.

In addition to seeing unlicensed activities in the market with respect to short sales, the California Department of Real Estate (hereinafter “DRE”) has also been alerted to fraudulent short sale transactions. Before discussing an example of short sale fraud that is becoming prevalent, it must be noted that the types and varieties of fraud (some quite elaborate) are many and are limited only by the imaginations of those who commit fraud. Thus, this segment and the succeeding discussion on scenario/scheme variations and legal and ethical minefields, is intended to raise concerns and issues for real estate licensees in California. But it is not intended to be comprehensive in scope.

A. Short Sale Fraud — Flipping by Unlicensed Entities Using Straw Buyers.

In some cases, unlicensed “short sale facilitators” hone in on homes that are on the verge of foreclosure and persuade the lenders to accept “lowball” purchase offers, often times by using “straw buyers”, questionable or self-interested broker price opinions or appraisals, and by failing to disclose that a sale at a higher price has previously been put on the table or negotiated.

In this case example, ABC Short Sale Services (hereinafter “ABC” — the name has been changed for the purposes of this example), an unlicensed “short sale facilitator”, contacts a distressed homeowner and tells him that ABC will facilitate the sale of underwater property with the best possible economic outcome to the homeowner. Payments to the homeowner may even be promised to entice interest.

ABC then contacts a licensed California real estate broker (hereinafter “Broker”) with little or no knowledge about short sale transactions, and offers to refer a short sale listing to the Broker. For the business, the Broker pays a referral fee to ABC. Once ABC has a Broker on board, ABC requires that the homeowner/seller sign a contract with ABC, in which the homeowner/seller agrees to permit ABC to serve as the homeowner/seller’s “short sale negotiator”. The contract has language like the following: “Seller agrees that he will no longer market the property and grants to ABC all necessary rights to market, negotiate, and enter into an agreement to sell the property to an unrelated third party”.

For its services, ABC charges the homeowner/seller a $395 upfront fee and then a second $195 fee for the negotiation services.

In this case, $480,000 is owed on the mortgage loan to the Lender, a federally insured financial institution, and the fair market value has fallen to $410,000. The property is listed by the Broker for $410,000, and the Broker takes no part in the “negotiations”. Because lenders and lien holders do not always require the listing brokers to present to them every single offer made for the short sale property, ABC only presents to the Lender the offer(s) it so chooses. Because ABC controls all of the information provided to the Lender, ABC also decides to withhold legitimate offers from the Lender and convinces the Lender that the home is overpriced at $410,000.

ABC presents its own $340,000 offer to the Lender, in the name of a fictitious buyer or “straw person” (hereinafter “SP 1”). Because ABC has controlled all of the information to the Lender during the listing period, and has withheld legitimate higher offers, the Lender is led to conclude that SP 1’s $340,000 offer is the highest and best, and the Lender accepts SP 1’s offer.

Following acceptance of SP 1’s $340,000 offer, and once escrow is open, ABC will focus on the primary objective of its scam by finding a second, legitimate buyer for more money as a “flip”. To accomplish this, ABC, through SP 1, will offer the soon to be newly purchased property for sale via the Multiple Listing Service. ABC will also contact the various buyers’ agents who presented offers higher than $340,000 during the short sale listing process, but whose offers were not presented to and withheld by ABC from the Lender.

ABC will inform all prospective buyers’ agents that “the short sale property is already in escrow”, but that it will be available for immediate sale after the close of escrow.

Buyer 1 is extremely interested in the property, and is willing to pay the fair market value of $410,000. Buyer 1 then agrees to participate in a double or simultaneous escrow and offers $410,000. ABC, through SP 1 (ABC’s confederate), concurrently enters into a $410,000 purchase contract for the property with Buyer 1, conditioned upon SP 1 obtaining title, and that the “second” sale to Buyer 1 go through ABC’s handpicked lender.

After the closing of the second sale, ABC makes over $70,000, including referral fees from the Broker and fees from the original distressed homeowner/seller.

Brief Analysis of Short Sale Flipping Fraud Example

In the case above, ABC has violated the California B&P Code by engaging in real estate licensed activities without a license. Also, they have collected advance fees in violation of California law. Then, they have made a large profit through false pretenses at the expense of a federally insured financial institution, by misrepresenting the value of the home to the Lender. This may constitute federal loan fraud, which is a serious felony offense which is punishable by imprisonment and fines.

The Federal Bureau of Investigation lists variations of short sale flipping as real estate fraud. 

B. Short Sale Fraud – Scenario/Scheme Variations and Warnings re: Legal and Ethical Minefields.

1. Multiple Lenders and Lien Holders, and Payments Outside of Escrow.

Where more than one Lender or lien holder is involved, the negotiations are complicated. Second and other subordinate lien holders often hold up the short sale transaction, and seek to extract the largest possible payment in consideration for releasing their lien.

Often times there are monies secretly paid outside of escrow, without the knowledge of the senior lien holder. This is a sure sign of fraud. Such undisclosed payments are likely illegal. The economic substance of and all payments in the short sale transaction should be disclosed on the HUD 1 statement. There should never be dual or multiple contracts, only one of which shows the true purchase price.

Added Twist re: Payments Outside of Escrow

– some short sale listing contracts have a provision in an addendum for payments outside of escrow for some amount of money (usually $1,000 up to 1 percent of the sales price) to a third party short sale negotiator, processor, or facilitator, for some unknown or unspecified service. The money is sometimes to be paid by the seller, and other times by the buyer. These may be payments to a confederate of the real estate broker, some affiliate of the broker, and/or an unlicensed short sale entity. It is not known from a review of the addendum whether these fees are paid for a real service, or whether they are “junk” fees paid to increase the monies payable to the real estate licensee. If they are paid for a legitimate purpose, they must be disclosed to all parties to the transaction, including the senior Lender. If they are “junk” fees, or fees paid to an unlicensed entity, they are problematic from a legal perspective.

All such payments may violate RESPA, the Real Estate Law, and other federal and/or State laws.

2. Sometimes the End or Retail Buyer is the Only One Putting Money into the Short Sale Transaction.

Here the end buyer’s money is used to close the transaction, without any or proper disclosure.

3. The Ownership of the Underwater Property is Transferred to Some Sort of Trust.

This may be done to keep the chain of title in tact and to hide the true owner of the property. In many cases, the homeowner seller is listed as the beneficiary of the trust.

a. Your fiduciary duties are to your principal(s), which cannot be signed away. The duties include honesty, loyalty, confidentiality, full disclosure of all material and relevant facts, skill, care, and diligence, and placing your client’s interests ahead of yours. For a more complete discussion of fiduciary duties that are imposed on California real estate licensees, please see DRE’s Real Estate Bulletin of Summer 2007.

If you are the listing agent, you have a number of fiduciary duties to the seller imposed on you. You certainly cannot delegate your real estate license and fiduciary duties to an unlicensed third party who shuts you off from communication with the short sale Lender.

Dual Agency Considerations

Consider also if you are an agent of the third party investor/short sale facilitator. You may have a dual agency situation which raises a whole host of issues. If you are a dual agent, you may have an irrevocable conflict that a dual agency disclosure cannot remedy.

By getting the best price for the first buyer/investor, you most assuredly cannot get the best sales price for the seller. If you have listed the home for the seller, your duty should run to that seller. How can it also run to the third party?

b. Your legal obligations under the California real estate law regarding disclosures, including agency relationships, and the prohibitions against fraud and secret profits.

c. Real estate licensees wishing to collect an advance fee in connection with performing short sales must first submit an advance fee contract to the DRE for review and then receive from the DRE the issuance of a no-objection letter relative to that contract. All advance fees collected thereafter under the terms of that contract must be placed in a trust account and handled as client trust funds under the California Real Estate Law and Regulations of the Real Estate Commissioner.

d. By entering into an agreement with a person who is engaged in mortgage fraud (even unwittingly or innocently), you can be held liable both civilly and criminally, and may be the subject of administrative discipline by the DRE.

e. RESPA’s anti-kickback and unearned fee provisions. The U.S. Department of Housing and Urban Development has many informative materials on RESPA and the prohibitions against giving or receiving any fee, kickback, or any thing of value for the referral of settlement service business.

f. By participating in a short sale fraud, with artificially deflated offers for the short sale property, you may be defrauding the new lender on the retail sale – in addition to the fraud committed against the short sale Lender. In a typical simultaneous sale transaction, a property is stated as having two different values to two separate lenders – the short sale Lender, and the new retail lender. While one of the values may represent a “distressed” property value, and the other a “non-distressed” property value, an issue regarding fraud is presented.

g. There is potential harm to the short sale home seller. In addition to not obtaining the highest price for the seller, which is or may be a violation of the law and or your fiduciary duty, the Lender may still require the seller (the original borrower) to pay off the remaining debt. In this case, there is no debt forgiveness. Even where the holder of the first lien allows for debt forgiveness, the holder of the second or subordinate liens might not forgive that debt. A deficiency judgment may then be pursued and obtained by the lien holder(s) for the deficiency. Moreover, the greater the debt forgiveness, the greater the potential tax liability. While the federal government has imposed a freeze on taxing the forgiven amount, State tax law may not do the same. Thus, if the short sale property is sold for the most amount of money that the market will bear, the potential tax consequence to the seller is diminished. Conversely, by accepting an artificially deflated offer, the seller’s potential tax liability is increased.

III. Conclusion.

Real estate and mortgage fraud is escalating and is never acceptable. It hurts everyone. Those who engage in short sale flipping fraud through the use of misrepresented valuations and/or manipulated prices make profits at the expense of lenders, which often times means at the expense of taxpayers. This takes money out of the system that is designed to assist homeowners and lenders. Furthermore, it manipulates the value of the real estate market, harms communities, innocent buyers, sellers, and lenders, and may ultimately scare off lenders from doing short sales, or from lending to purchasers of short sale properties.

While this publication addresses one particular type of short sale flipping transaction, and some varying related and other scenarios, California real estate licensees would be well-advised to be completely transparent and to fully disclose, and document the disclosure of, all material information, side-deals, and concurrent and related transactions to all parties to short sale transactions, including, without limitation, all involved third party participants and payments.

Licensees would also be wise to advise their clients to contact and consult with a qualified attorney or tax professional regarding the potential tax consequences of a short sale transaction.

Further, if you are considering engaging in short sale transactions, you should fully educate yourself about the mechanics of the process and the related legal and ethical issues, and work only with legitimate professionals.

 Finally, if you become aware of information about fraudulent short sale activity, please contact the DRE’s Enforcement section in Sacramento or at the office closest to you, or via the Internet at http://www.dre.ca.gov/cons_complaint.html.  In addition, you may want to contact the California Attorney General’s Office, the U.S. Department of Housing and Urban Development, and the Federal Bureau of Investigation.

_________________________________