Pfeifer & Reynolds LLP - Attorneys at Law

MORTGAGE FRAUD: ARE YOU PART OF THE SOLUTION?

 

Do mortgage brokers commit fraud? If you ask some lenders, it is not uncommon for them to answer you with another question having something to do with the behavior of bears in the woods. If you ask most mortgage brokers, however, the answer is likely to be that they themselves have never committed mortgage fraud personally, but that they once heard of someone who did, long ago. The truth is that mortgage fraud continues to be a huge problem in the industry---involving, by some estimates, hundreds of millions of dollars annually. And someone is committing it.

 

Fraud hurts not only the lender and investor, but responsible brokers and correspondents whose financial survival often depends on avoiding onerous repurchase requirements or costly indemnifications. The problem is compounded because many brokers are now choosing to acquire mini-warehouse lines in order to fund and sell their own loans. As loan “sellers,” they are often required by investors to make “representations and warranties” that are far more comprehensive than anything previously required of them as brokers. Thus, it may now be more important than ever to ask: What can brokers and other mortgage originators do to prevent fraud from ever occurring in their loans?

 

Know It When You See It

Most brokers believe that they can recognize fraud in a mortgage file. But few understand the specific legal requirements for establishing fraud liability in a civil lawsuit, or the numerous ways in which liability can be incurred for misrepresentations that fall far short of actual fraud. Therefore, they sometimes overlook serious legal problems while, at other times, assume the worst when in fact they likely have no liability at all.

 

In California, in order to establish civil liability for misrepresentations in a loan file, the plaintiff must prove all of the elements of a “cause of action” for “deceit.” California Civil Code §1710 recognizes four (4) kinds of “deceit,” each having its own proof requirements, but each authorizing the imposition of legal liability:

 

(1) The suggestion, as a fact, of that which is not true, by one who does not believe it to be true [intentional misrepresentation of fact];

(2) The assertion, as a fact, of that which is not true, by one who has no reasonable ground for believing it to be true [negligent misrepresentation of fact];

(3) The suppression of a fact, by one who is bound to disclose it, or who gives information of other facts which are likely to mislead for want of communication of that fact [concealment or suppression of fact]; or

(4) A promise, made without any intention of performing it [promissory fraud].

A cause of action for “deceit” or fraud requires the plaintiff to prove each of the following elements:

(a) Misrepresentation (false representation, concealment, or nondisclosure);

(b) Knowledge of falsity (or “scienter”);

(c) Intent to defraud (i.e., to induce reliance on the representations);

(d) Justifiable reliance on the representations by the plaintiff; and

(e) Resulting damage.

 

A misrepresentation need not be written or oral; it can be implied by conduct. False representations made recklessly and without regard for their truth in order to induce action by the plaintiff are the equivalent of misrepresentations knowingly and intentionally made.

 

Understand Your Representations and Warranties

To prevent their own liability for fraud, mortgage originators need to understand and carefully control (to the extent possible) their own “representations.” Every broker or correspondent agreement contains certain “representations and warranties.” These are typically less onerous in brokerage agreements than in seller or correspondent agreements. But, almost always, they contain specific “representations” about the integrity of information in the loan application, and in the documentation supporting it. These “reps and warranties,” if false, can give rise to contractual liability, but they can also be used to establish the first element in a cause of action for fraud.

 

It is also important to remember that, even without specific contractual representations, the mere act of submitting a loan file can itself constitute a representation by the submitting party of the information contained in the file. If any essential information in that file is false, and the file is submitted “recklessly” and without regard for the truth or falsity of the information, the broker may be liable for fraud---even without specific knowledge that any particular item of information in the file is false!

 

Institutionalize Anti-Fraud Attitudes and Policies

Mortgage originators have very little control over the kinds of documentation required by lenders or investors in an application file. They have significant control, however, over the accuracy, completeness, and internal consistency of that documentation. It is an obvious, but frequently overlooked fact, that the degree to which integrity is institutionalized in the information gathering process, and in completion of application documents, largely determines the likelihood that a file will be free of fraud. When formal policies and procedures reflecting this institutional integrity are actually written down and followed, fraud is minimized.

Moreover, internal records showing compliance with these policies and procedures can often negate the “guilty knowledge” or “scienter” requirement of a fraud claim, and demonstrate the broker’s conscientiousness in seeking to avoid fraud. [2] This is particularly true if “zero tolerance” anti-fraud attitudes are adopted by the company’s senior executives and communicated to the entire organization through adequate training programs.

It is also essential to build into this structure---to the extent possible---a program for compliance with the numerous laws and regulations pertaining to the loan origination process.[3] Many broker and seller contracts contain representations and warranties to the effect that the mortgage originator “has complied with all state and federal laws and regulations applicable to the origination process.” And while assuring such compliance is difficult, expensive, and often beyond the reach of many brokers because of the volume and complexity of applicable laws, a well documented, good-faith effort can go a long way toward eliminating any claims that the broker acted in “reckless disregard for the truth.”

 

Conclusion

Preventing mortgage fraud is not easy. The industry’s apparent preoccupation with loan “production” often seems directly at odds with the procedural checks and balances---and financial commitments---needed to maximize data integrity in the origination process. Yet, as rising interest rates threaten to “lay bare” a generation of mortgage loans probably made without adequate attention to fraud prevention, mortgage brokers who hope to survive may benefit greatly by understanding better the elements of fraud, and taking steps now to institutionalize policies against it. Lenders and investors will expect---and tolerate---nothing less.

 

[1] Michael R. Pfeifer is a litigation attorney and licensed real estate broker. He is the managing partner of Pfeifer & Reynolds, LLP, which is based in Orange County, California. His practice concentration is on lender liability defense, mortgage fraud and repurchase disputes, and State and Federal regulatory compliance. This Article is for general information and discussion purposes only and should not be construed as, or relied on, as legal advice. For more information, or to consult with the author about possible legal representation, please contact: Michael R. Pfeifer at (714) 703-9300.

[2] An excellent resource for such anti-fraud policies and procedures is a book entitled “Combating Fraud and Unethical Practices in Real Estate Transactions, Second Edition: A Practice and Training Guide,” which is edited by the author, was published in 2002 by the Mortgage Bankers Association of America, and is available from the MBA online bookstore at www.mbaa.com.

[3] E.g., Truth-In-Lending, RESPA, ECOA, FCRA, Fair Lending, etc. and a host of state statutes and regulations, including some of the more recent, but lesser known requirements pertaining to “predatory lending” and identity theft. (See for example, Civil Code §1785.20(a) that requires any person who uses a consumer credit report in connection with approval of credit, and who discovers that the consumer’s first and last name, address, or social security number, on the credit application does not match, within a reasonable degree of certainty, the consumer’s first and last name, address or addresses, or social security number listed on the consumer credit report, to take reasonable steps to verify the accuracy of the consumer’s first and last name, address, or social security number in order to confirm that the extension of credit is not the result of identity theft.