A recent memorandum from the legal department of the California Association of Realtors® (CAR) warns CAR members as follows: "Undisclosed payments in short sale transactions, especially those paid outside of escrow, may violate the law, including RESPA, laws against loan fraud, and licensing laws."
The cautionary memo goes on to describe as a "common scenario" a situation "when a short sale seller’s senior lender authorizes a payment of $3,000 for example, to extinguish a junior lien, but the junior lender demands that the buyer pays an additional $9,000 outside of escrow." Other "outside of escrow" payments that a buyer might make could be for a loan negotiator’s fee, past dues owed the homeowners association, or to clear some lien on the property.
Now suppose that a buyer were willing to pay for items such as these. Why would he be willing to do so? Most likely because he or she figures the agreed-upon purchase price is a very good deal, and the price will still be good even if it is necessary to add some money to cover such other costs.
But why outside of escrow (or "closing" or "settlement")? Because, the lender won’t allow it. To put it simply, if there’s more money on the table, the seller’s senior lender wants it; he doesn’t want it to go to these other sources. The lender gives approval for a short sale based on certain net proceeds and certain closing costs. For example – hard as it is to imagine – a lender might condition his approval on a reduction in the contractual real estate commissions, with the difference going to the lender’s payoff.
Before the closing, the lender must approve a tentative HUD-1 (closing statement) that shows where the money is going. He will already have approved a certain amount of closing costs. If the lender, as in the example, had only authorized $3,000 for the junior lien, he will not approve a tentative closing that now has the buyer putting more money in, money which will go to the junior lien but not the senior. If the buyer puts in more money (essentially, pays more) the senior lender wants it.
What is the solution to such a standoff? It is the practice to which the CAR memo is addressed. That is, the practice of payoffs being made outside of the escrow (closing) process. So the senior lender does not know about it.
Many, many people feel that such a practice is justified. "It is the lenders who have caused the problem in the first place. Besides, they are stupid, arrogant, and greedy." All of this, and more, may be true. Nonetheless, as the CAR memo points out, "concealing this additional payment from a federally-insured senior lender may constitute loan fraud, which is a crime punishable by 30 years imprisonment plus a $1 million fine (18 U.S.C. section 1014)"
And that’s not all. The practice may also be a RESPA violation. Appendix A to the Real Estate Settlement and Procedures Act (24 C.F.R. Part 3500) says that "The settlement agent shall complete the HUD1 to itemize all charges … whether to be paid at settlement or outside of settlement … ." Charges paid outside of settlement "shall be included on the HUD1 but marked P.O.C. for Paid Outside of Closing… ."
There may, indeed, be compelling arguments for trying to help buyers and distressed sellers by having payments made outside of a short sale escrow (settlement). But agents need to remember that this may be considered fraud, and most, if not all, Errors & Omissions policies don’t cover fraud. It’s something to think about.
Published: April 27, 2010
Bob Hunt is a director of the National Association of Realtors and is author of the recently published book, "Real Estate the Ethical Way." A graduate of Princeton with a master's degree from UCLA in philosophy, Hunt has served as a U.S. Marine, Realtor association president in South Orange County, and director of the California Association of Realtors, and is an award-winning Realtor. Contact Bob at scbhunt@aol.com.
