What is Third Party Fraud?
This is a fraud committed by people outside an employee employer relationship. They can be committed against individuals, businesses, companies, the government or any other entity. Third party frauds are not as common as occupational frauds, but on average each fraud is for a larger amount.
Some third party frauds are not meant to remain hidden forever. Some only remain hidden long enough for the fraudster to make their get-away. The fraudster may not care if the fraud is eventually discovered as they do not have a continuing relationship with the victim and they cannot be found.
What is Vendor Finance Fraud?
This is a fraud done by a purchaser of an asset against the vendor (seller) of the asset, where the vendor provides finance to the purchaser for the acquisition of that asset. The aim of the fraud is to use the asset as security to obtain third party finance before the purchase price is paid to the seller.
Major Headings
Description of Vendor Finance Fraud
For Example
Lessons to be Learned
Prevention and Detection
Description of Vendor Finance Fraud
A vendor finance fraud in committed through a transaction that was entered into for the express purpose of committing the fraud. It is rarely just a side product of an otherwise legitimate transaction. The fraud is generally committed in transactions for the sale of real property, though the fraud can be committed with the sale of any asset.
Three parties need to be involved in any vendor finance fraud:
1. The vendor (the owner and seller) of the property. These are the victims of the fraud.
2. The purchaser of the property (generally a company set up for this purpose). This is the fraudster.
3. The third party financier (generally a financial institution and an innocent party). They provide the money.
Some Common Factors
There are 5 common factors behind these frauds, or more particularly, 5 common elements to the transaction put to the vendors:
(i) A high price is offered, usually significantly higher than the true market value of the asset. The amount of the fraud will be limited by the true market value of the asset, not the sale price. But, the high price is used to entice the vendor into the deal.(ii) Casual, unsophisticated or greedy vendors. Vendors that are suspicious, cautious or seek independent advice are not good targets. Vendors who believe they are about to make a big windfall and want to do so quickly make much better targets. They will not ask the right questions or push for answers fearing that they may scare off the purchaser and the high price. They may rush into the transaction to try to get the big money offered.
(iii) A rushed time period – urgency is the fraudster’s friend. The vendors will be put under pressure to make decisions quickly, which means that the vendors may not be able to get proper advice or properly consider the transaction. The entire deal may be pushed through within a few days, and sometimes over a weekend when it is inconvenient to seek advice.
(vi) A first mortgage securing a loan from the third party financier. This loan will be for a small amount paid to the vendors at settlement. The loan needs to be structured so that the fraudster can draw down on the loan without giving notice to what will be the second mortgage holder (the vendors). The critical task of the fraudster is to get this first mortgage registered at settlement without a detailed review of the terms by the vendors.
(v) A second mortgage securing the amount of the vendor finance loan. This loan will have to be structured so that the first mortgagee is not obliged to give notice to them of any further advance on their loan. The fraudsters also want this loan and mortgage to be signed without detailed examination.
How is vendor finance fraud committed?
The fraudster’s role is to convince the vendors:
(a) that they should sell the property. The property may already be on the market or the fraudster may just approach the owners, particularly if those vendors fit the target profile set by the fraudsters. The price offered will be high price to entice the sale. It will also usually contain other conditions that appear to benefit the vendors.(b) that selling will not inconvenience them. If the vendor runs a business from the premises, they will be able to continue to occupy the premises under a generous lease back arrangement. This does not worry the fraudster as they have no intention of occupying the premises and do not care about earning an income from it.
(c) that there should be no or very little deposit paid at the time of signing the contract. If a high price is offered and as title of the property will not pass until settlement, vendors may forgo a deposit. If a deposit is paid, it will usually be very small, as this will usually be the fraudster’s own money invested in the scheme. The short time period between the initial offer and settlement of the contract will be used as an excuse that a large deposit should not be paid.
(d) that the vendors should finance a majority of the purchase price themselves. A high interest rate will be offered and the loan will be secured by a second mortgage over the property. It will be easier to convince the vendors that this is acceptable if the vendors were not attempting to sell the property at the time of the approach. If the vendors have the property on the market, they may want the money for some other purpose and vendor finance may not appeal to them. If that is the case, the fraudster will walk away from the deal.
(e) that the vendors should allow a small mortgage to be registered on the property in priority to their mortgage to allow a small cash payment to be made the vendors at settlement. Without this mortgage, the fraud cannot be committed.
To commit the fraud, the fraudster must get a financier to lend them money against the property. These monies need to be secured by a first mortgage. An independent lender will generally not lend money on the property under a second mortgage as all of the equity in the property will be available to the vendor. Usually there is little problem getting finance approved to a limit of about 70% of the market value of the property, based on a valuation conducted by the financier, the proposed tenancy of the building and the first mortgage. A small amount of that limit will be drawn down and used to make the cash payment to the vendors at settlement.
The vendors will know that there is a loan for the monies to be paid at settlement and must agree to have the financier receive a first mortgage – believing the mortage only covers that small initial amount. They must not know that the mortgage does not just cover the small amount paid at settlement, but can be drawn down for a greater amount without their approval. Many people inexperienced in selling property will not consider this point.
Settlement occurs with title passing to the fraudster, the initial monies and a second mortgage passing to the vendors and a first mortgage passing to the finance company.
The balance of the loan from the financier will be the amount of the fraud. This is drawn down after settlement and without the knowledge of the vendors who have a second mortgage – this is the key to the fraud. The fraudster disappears after the money has been received. The first mortgagee will usually take possession of the property when their loan payments are not made.
This fraud is explained easiest by example.
For Example
The owners of an unencumbered commercial property wished to sell their property. The property was valued by an independent third party at $1,200,000 based on the usual factors. The value of the property was not advertised and no price was placed on the property by the owners.
The fraudsters appeared on the scene. They knew what the property was worth by talking to commercial agents in the area and doing some basic research. They also researched the owners and found that they may fit their target profile. The fraudsters approached the owners and made an offer to purchase the property for $1,600,000, a full $400,000 over the market value. The owners were looking at getting 33% more than they thought and became anxious to do the deal.
The deal was offered in the following way:
1. $200,000 cash would be paid to the vendors at settlement;
2. a lease for a 5 year period would be given to the vendors at a low rate and the vendors would have the right to terminate the lease with 2 months notice. This appealed to them as they would be able to move into a leased premises when required.
3. $1.4 million would be borrowed from the vendors at a rate that was 2% above the commercial lending rates. The rate was higher than other lending rates, and significantly higher than the vendors would receive if they placed the money in the bank at normal deposit rates.
4. the vendor would get a second registered mortgage over the property to secure that loan of $1.4 million.
5. the bank would get a first registered mortgage for the $200,000.
The vendors favorably considered that offer on the basis that:
(a) the price was good,
(b) the interest rate was good,
(c) the tenancy arrangement was good, and
(d) the security over the property would secure the $1.4 million owed to them.
They would also be paid $200,000 up front. Even if the property was sold by the bank at the lower valuation price of $1.2 million, they should still get the other $1 million after the bank received its $200,000 back. The deal looked great, but the fraudsters said that they were looking at another property, so they needed to move fast.
Their problems with the deal were numerous.
(a) The property was not worth the amount offered, but the vendors did not become suspicious. They did not consider that there was some other hidden benefit.
(b) The interest rate would only be any good if interest was actually paid.
(c) The vendors were not involved with or examine the details of the first mortgage to the bank.
The fraudsters approached a bank and requested a loan against the property. The bank reviewed the property and decided to loan up to 70% of the valuation of $1.2 million, or $840,000. A facility was approved for $840,000 to activate after settlement, but with $200,000 to become available for settlement.
The property was transferred to the fraudster’s shell company at settlement. The bank paid $200,000 to the vendors. The bank and the new owners executed a first mortgage. The vendors received a second mortgage, the $200,000 and a lease agreement. Everyone seemed happy.
Shortly thereafter and without any notice, the fraudsters drew down the balance of $640,000 on the loan from the bank. The fraudsters and the money disappeared leaving the shell company registered with false information. They ceased paying the bank (never having made a payment of interest to the vendors).
The property was sold at auction by the bank’s receiver for $1.1 million by mortgagee sale. The bank took its $840,000 and $90,000 in costs and commissions, leaving $170,000 for the vendors. Added to the $200,000 that they initially received and their return on their $1.2 million building was $370,000 – a loss of $830,000.
Lessons to be Learned
1. Two factors combine to allow the fraud to occur.
A. Greed. Vendors are offered a price that is too good to let go and they do not examine the deal or the purchaser for fear that they may lose the deal.
B. The first registered mortgage in favor of the bank. If the first mortgage is limited only to the amount paid at settlement or there is a requirement that the second mortgagees approve any request for a further draw down, the fraud cannot occur.
2. Greed does not cause the fraud, but reduces the diligence that should be used in examining the deal. It is a motivating factor.
3. The first mortgage allows the fraud to occur. Vendors should insist on reviewing the mortgage to verify the terms. It should be limited at the amount paid at settlement, require notice to be given and approval received from the second mortgagee before any further money is lent, or any further money lent should have a security priority after the second mortgage.
Prevention and Detection
Insist on checking the first mortgage and have the first mortgagee confirm and agree to formal priority of the second mortgage over additional borrowings. This can be done in a number of ways. The best advice that can be given is “seek legal advice before signing contracts!”
Be particularly careful where:
(i) the offer is far above what a reasonable and prudent purchaser is likely to offer. Don’t get carried away with the dollar signs.(ii) any form of urgency is suggested, including that the purchaser is looking at other properties. Expiring time limits and a sense of urgency are tools used by fraudsters to force a quick decision. It makes people think emotionally and make a gut decision, not a rational or commercial decision.
(iii) there is a need for another mortgage to be registered in front of your mortgage, regardless of how small the amount secured is said to be. This mortgage should always be reviewed.
(iv) the purchaser will not come to a meeting with your accountant, solicitor or other advisor, or not allow sufficient time for the purchaser to do so. Secrecy is important to fraudsters.