Vendor Finance Frauds

What is Third Party Fraud?

This is a fraud committed against someone or some business by people other than their employees. They can be committed against individuals, businesses, companies, governments etc. 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 get away. The fraudster may not care if the fraud is eventually discovered as there is no continuing relationship with the victim and they have made their getaway.

What is vendor finance fraud?

It is a fraud committed by a purchaser of a property against the vendor by manipulating a vendor finance arrangement. These frauds usually relate to the sale of real property, but can be committed on the sale of any type of property.

Are these frauds hidden or not?

Frauds are either meant to remain undetected for ever, or will eventually be discovered after it is too late to do anything about them. A vendor financed fraud is not meant to remain hidden for ever. In fact, trying to hide the fraud for any extended period will reduce the 'profit' of the fraud.

Who is involved in the fraud?

There are three parties to this fraud, but two of them are innocent. They are:

1. The purchaser of the property, who is the fraudster. The fraudster purchaser is often a newly incorporated company and the directors and shareholders are men of straw or completely fictitious.
2. The vendor is the victim. The victim vendor is usually an individual that does not have much experience in buying and selling property. The fraudster is counting on a lack of legal sophistication in, and a lack of advice to, the vendor.
3. A finance company that is usually involved unknowing and suffers no loss.

What is vendor finance?

It is finance provided by the vendor of a asset to the purchaser of that asset. When a someone purchases an asset, they have to pay for it. If they do not have the resources themselves, they can borrow the money from someone. Vendor finance occurs when the purchaser borrows the purchase price from the vendor instead of a finance company or bank.

Typically the vendor would be repaid over time at a commercial rate of interest and would retain some form of security. The benefit to the vendor is that he obtains a sale and an automatic investment of the sale monies at a rate of interest and will usually obtain a charge over that asset to secure the loan.

Why do fraudsters target vendor finance?

Before making a loan, a third party financier will want to know what the asset is worth for security purposes and that the purchaser has the capability of paying back the loan. Most third party financiers will only lend to a percentage of the independently valued amount, and these valuations are usually done on a conservative basis.

Vendor finance may be able to be arranged without a finance approval process, with no valuation on the property, with no substantial checks done on the purchaser.

How is a vendor finance loan secured?

Commercial sense says that the vendor loan should be secured by a registered mortgage over the property. The aim of the fraud is to convince the vendor that the amount financed - the purchase price less any deposit - will be secured by a second mortgage. It is important that the vendor finance debt is not secured by a first mortgage.

What about a deposit?

Business sense says you should obtain as large a deposit as possible on credit sales. It lowers the risk in the period before settlement and lessens any loss if the transaction eventually goes bad. In vendor finance frauds, the deposit is usually small, only paid at settlement and financed by a third party financier (and secured by a first registered mortgage).

The fraudster will not use his own money for the deposit, as the fraud cannot be committed without this other financier and a first registered mortgage. Any deposit will be as small as possible to increase the amount that can be taken under the fraud. The benefits of the deposit being small is that the financier is more likely to provide the deposit, and the vendor will see that the reduction in his security is minimal. The fraudster does not want to pay the deposit when the contract is signed - they will want the deposit to be a cash component to be paid to the vendor at settlement.

How is the deposit secured?

The deposit borrowed from the finance company is secured against the property by a first registered mortgage.

How is this fraud done?

There are a number of steps in the process.

Step 1 - Find the property

The fraudster finds a target property. Sometimes the property is listed for sale, sometimes the fraudster just approaches an owner. The fraudster is looking for a property usually owned by elderly people looking to retire, or a deceased estate where a widow or children have acquired a property they want to sell. They will also target small businesses when the owners may not have regular solicitors or advisors.

The fraudster applies for a loan to be secured against the property. The amount of the loan will be for a percentage of the real value of the property and the amount to be drawn down for settlement will be for the minimal deposit. The terms of this loan are not given to the vendor.

Step 2 - Make the offer

An offer is made to purchase the property for an amount above its market value, and sometimes significantly so. The fraudster does not care what price is offered, as he never intends pay it. The high price is used to entice the vendor to sell, and do so before the offer is withdrawn. It is common for the offer to have a short time to accept to force the vendor to act before thinking about the transaction or getting advice.

Step 3 - Negotiate the deposit and when it is paid

The deposit is negotiated with the vendor. The best way for the fraudster to structure the deal is to have no deposit paid at the signing of the contract, but to make some money (borrowed from the other financier) payable on settlement. The benefit to the fraudster is that they do not need to raise the deposit money from another source, or use their own money before the first registered mortgage to the third party financier is placed on the property. The structure of this loan is important.

Step 4 - Negotiate the loan and repayment arrangements with the vendor

The loan arrangement for the vendor finance is negotiated with the vendor. The interest payable on the outstanding amount is usually above commercial rates to make the deal look good - as the interest will not be paid for very long, the fraudster will not care what interest rate is used.

To show good faith, the first few months interest may be paid in advance. This is not good faith, it buys the fraudster some time after settlement to perpetrate the fraud and get away. The vendor believes that he is getting a great price for the property, and a high interest rate on the investment and is secured.

Step 5 - Settlement of the sale contract

Settlement occurs and the vendor is paid the deposit, a small lump sum financed by the third party financier. The financier gets a first mortgage to secure that small sum. The third party financier must get a first mortgage, and the vendor must not know or understand the full terms of the first mortgage. The vendor gets a second mortgage to cover the vendor finance.

Step 6 - The Sting

The fraudster then draws down the balance of the loan covered by the first mortgage and disappears. The financier with the first mortgage will recover their money from the property as they have usually lent to a percentage of a commercial valuation. The vendor will only be able to recover the surplus after the first mortgagee has been paid. The vendor will lose about the amount of money drawn down after settlement.

What are the important factors?

The first mortgage is represented to the vendors as being to secure the small deposit. However, the loan and mortgage documentation must allow the fraudster to draw down on that loan. Without this, the fraud cannot be done.

The payment of the some interest in advance buys enough time to have this occur. The amount drawn on the first mortgage (the amount of the fraud) is usually significantly less than the sale price, about 70% of the true value of the property.

FOR EXAMPLE

A building has a true market value of $1,000,000. The fraudster approaches the owner and offers to buy it for $1.5 million. The deal is structured so that $100,000 cash is paid at settlement and the balance of $1.4 million is vendor financed at high interest rates. The lump sum of $100,000 is financed from a third party bank, that gets a first mortgage. The vendor gets a second mortgage. The deal is done.

After settlement, the fraudster draws down the remaining $600,000 on the loan from the third party financier - 70% of the $1 million true value less the $100,000 already drawn. The fraudster disappears and no more is paid to the vendor or the bank. The first mortgage takes control of the building under their security and sells it. Assuming that the market value is achieved at the mortgage sale, the first mortgage will get their $700,000 back and the vendor will get $300,000 less all costs.

Add the $300,000 to the $100,000 small lump sum received, and the vendor gets $400,000 and losses of $600,000 on the true value of the property.

LESSONS TO BE LEARNED

A vendor should insist on a first registered mortgage. That usually means that the purchasers will have the deposit monies themselves. Regardless of where the deposit monies come from, if you have a first registered mortgage, you will get the monies from a mortgagee sale before anyone else. This may not bring you the entire purchase price, especially if the purchase price was over-inflated, but you will get the maximum amount possible.

If the deposit has to be borrowed and the lender of the deposit insists on a first registered mortgage, you should ensure that the first mortgage is limited to the amount of the deposit. That is, make sure it does not allow further drawings to be made.

The best advice that we can give is seek legal advice before you sign the contract and have all of the relevant documentation examined. Most people should not buy or sell real property without legal advice. The second best advice that we can give is "if it seems too good to be true, it probably is!".

Disclaimer
The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.

Acknowledgment
The material in this Fact Sheet was sourced from various publications including those listed in the Reading List on the Fraud Awareness page on this website.

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Last Updated: 4.4.2008