Detecting and Avoiding Short Sale Fraud

Detecting and Avoiding Short Sale Fraud

Short sales are usually legitimate transactions that serve the interests of multiple honest parties, including lenders, borrowers and buyers.  But enter dishonest parties—sometimes with a cast of accomplices—and you have perfect recipe for fraud.  This fraud is common enough to generate its own name: flopping.

A legitimate short sell serves the interests of all parties.  The owner of a property worth less than the unpaid principal balance of the mortgage is able to walk away from the burden of a mortgage they cannot afford.  The lender avoids a lengthy and expensive foreclosure and keeps the property out of their REO portfolio.  And, the buyer gets a good deal on a property.  All of this, however, assumes that the sale is an arms-length transaction at a price that reflects the market value.

A dishonest seller working with a sham buyer, however, can sandbag the price, effectively stealing from the lender who ends up with less than the market value of the property.  The most common version of the scheme works like this: the seller and buyer—working together—artificially lower the price.  The buyer then turns around and resells the property at market value, collecting the difference between market value and the artificially low amount paid to the lender during the short sale.

Floppers employ various methods to discourage legitimate buyers or convince those buyers to make artificially low offers.  They damage surfaces, remove fixtures and appliances, create unsavory odors or paint realistic—but fake—water damage on the ceilings. They invent problems with the plumbing, heating, air conditioning or electrical systems.  Fraudsters even produce fake repair estimates or enlist dirty contractors as accomplices to create artificially high repair estimates or estimates for issues that don’t actually exist.  It can be hard to detect these bogus damage claims from afar.

Alternatively, a flopper may simply withhold higher legitimate offers from bona fide buyers from the lender.

Either approach—or both together—eliminates market-price offers, allowing the seller’s accomplice to step in with a winning—albeit artificially low—offer.  Once the lender approves the short sale at the artificially low price, the fraudster markets the property at its true market value. Without the short sale lender’s knowledge, the flopper finds a bona fide purchaser at a higher price, thus buying low, selling high, and keeping the difference—all at the expense of the lender.

There are red flags that may indicate a higher likelihood that a short sale is fraudulent, including double escrows; an LLC or fictitious entity as the buyer; a buyer purchasing under a power of attorney; or a purchase agreement that gives buyer the option to resell property in a short timeframe.  Similarly, a seller who acquired a property through a short sale and is immediately selling the property for a substantial profit may indicate the possibility that fraud was involved in a short sale.  Of course, there are numerous legitimate reasons for any of these red flags to appear in a given transaction, so they should only be treated as cause to investigate, and certainly not as proof of malfeasance.

While the seller is often involved in the fraud, the fraud can be perpetrated without the knowledge or involvement of the seller through the collusion of realtors, appraisers and others, making both the seller and lender victims.  A real estate agent, for example, can set an unrealistically high price for a distressed property to prevent interest and offers.  Sometimes, an appraiser even provides an inaccurate valuation report to support the real estate agent’s listing price.  Then, just as the house looks set to go into foreclosure, the price is lowered.  A lone buyer—working in collusion with the real estate agent—then miraculously appears.  Notably, while this situation is unfolding, the struggling owner’s credit score suffers from months of missed mortgage payments.  The “miraculous” buyer then resells the home immediately at a profit and splits the ill-gotten gains with the real estate agent and appraiser.

Alternatively, the real estate agent can simply turn down or dissuade higher offers on the home without informing the seller or lender, allowing their illegitimate buyer to step in.  Even if the fraudulent buyer does not share the ill-gotten gains with the real estate agent, the real estate agent has violated his fiduciary duty to the homeowner by failing to disclose the receipt of better offers and accepting the bonus payment for directing the deal.

A final variation on the flopping scheme involves a straw buyer.  The “buyer” acquires a property, never makes any mortgage payments and then requests a short sale.  An accomplice then steps in and secures a short sale purchase at a bargain price, likely using some or all of the tactics discussed.

Freddie Mac considers all of these schemes flavors of “short payoff fraud.”  They define short payoff fraud as “any misrepresentation or deliberate omission of fact that would induce the lender, investor or insurer to agree to the terms of a short payoff that it would not approve had all facts been known.”

To minimize the risk of unwittingly being a part of a flopping scam, always check the reputation of each of the parties, including the agent.  If a client or customer of yours is selling his home under duress, ensure that all parties are aware that you know about flopping and establish your dim view on the practice. Make it clear you want the homeowner to receive the best possible price for his home.  If you suspect any type of deception, tell the lender immediately and potentially get a second opinion on the appraised value.

Experts recommend the following protective measures to detect and mitigate the severity of short payoff fraud:

  • Review all short payoff documentation carefully, including the sale contract. This helps determine if there is an option clause to resell the property at a higher price without notifying the lender.
  • Draft a short payoff arm’s-length affidavit/disclosure notice for all parties involved in the short payoff to help avoid any hidden contracts, or side agreements. The parties involved should be, but are not limited to: the buyer, seller, listing agent, selling agent, short payoff negotiator(s)/facilitator(s), and closing agent.
  • Solicit information from your client or borrower.  Is he aware of any other parties involved with the short payoff other than real estate professionals?
  • Is there a short payoff negotiator/facilitator involved?
  • Is the borrower aware of any other purchase contracts on the property?
  • Require an executed and signed IRS Form 4506-T, Request for Transcript of Tax Return, from each borrower and process the form to determine if the borrower’s qualifying income is accurate.
  • Order an interior Broker Price Opinion (BPO) and review all other BPOs that have been ordered on the property to establish a high/low value variance. The BPOs should include a past and present Multiple Listing Service (MLS) listing history, as this will determine if the property was relisted in MLS while the short payoff is being processed.
  • Review the Freddie Mac Exclusionary List to see if the parties to the short payoff are on the list.
  • Immediately notify the lender if you are aware of a second purchase contract for a higher price.

Fraudsters can get away with flopping because banks are swamped with short sale requests and cannot carefully examine each transaction or otherwise view each property in-person.  The real victims of flopping are innocent (i.e. non-colluding) homeowners, who could have used the money that went into the floppers’ pockets to save their credit record, the lender who eats most of the loss, and taxpayers who might end up meeting part of the lenders’ short sale loss through a federal process that enables lenders to claim a refund.