Are We Defrauding Our Lenders?

News & Views
Stephen Cea, Esq.

In December 2006, the New Jersey Supreme Court’s Advisory Committee on Professional Ethics issued an Opinion (#710) addressing the ethical problem faced by attorneys dealing with real estate transactions that include a “seller’s concession” on the purchase price.  In the Opinion, the Committee addressed a common scenario involving a contract for the sale of realty that stated a purchase price and included a mortgage contingency.  In the transaction, the buyer and seller request their attorneys amend the contract by increasing the purchase price and mortgage contingency by corresponding amounts. Additionally, the amendment would provide for a seller’s concession premised on that same amount.  A “seller’s concession” is a credit against the sale price given to the purchaser at the time of closing for various reasons.  In the Opinion, the credit sought by the buyer was for the closing costs. 

The Committee’s Opinion specifically mentions that the inquirer stated, “that those amendments to the contract were calculated to increase the size of the purchaser’s mortgage loan and was a fraudulent practice perpetrated upon the ultimate investor (i.e. the bank)”  In other words, it is a given fact that the amendment to the contract was a ruse to raise the loan amount simply to cover the purchaser’s expenses.

The Committee, in addressing that specific inquiry, opined that under those facts the attorneys involved violated the Professional Rules of Conduct.  The Committee reasoned, “by manipulating the sale price in the manner described by the inquirer, either the originating lender or the secondary investors may be deceived as to the true market price of the house.”  The credit to the buyer had no relation to any legitimate charges or cost usually paid by the purchaser at the time of closing.  The credit is a direct offset to the increase in purchase price.  Obviously, under those given facts, the only reason to increase purchase price is to increase the amount borrowed from the mortgage company.  The reason for the seller’s concession is so the seller does not make additional profit on the increased sales price. 

Today, the secondary market is a major category of finance in the residential mortgage lending industry.  Federal programs such as Fannie Mae, Freddy Mac and Ginnie Mac, enable mortgage companies to originate loans and earn financing fees and then convey those loans to those programs.  In return those programs issue mortgage backed bonds to investors who receive periodic payments of principal and interest.   It is that secondary market that is most affected by the practice of increasing the price so as to increase the amount of the mortgage.  The secondary market has no true way to determine the value of its secured interest. The Committee rightfully felt that an attorney involved in such a ruse has violated the Professional Rules of Conduct.

The Opinion has created a great stir among transaction attorneys within the State.  The notion from many attorneys was that any involvement in a transaction which included a seller’s concession was an immediate violation of the Rules of Professional Conduct.  While the Opinion is narrowly addressed to the facts presented, it is having a rippling effect in our industry. 

The heated discussion amongst practitioners prompted the Committee to make a clarification to the Opinion on December 22, 2006.  The Committee stated that the Opinion, “is based upon the particular facts submitted by the inquirer and recited in the Opinion.  It addresses fictional and deceptive increases in purchase prices unrelated to the actual circumstances or costs of closing, and contrary to the expectations of the lender or the ultimate holder of the mortgage.”  The clarification goes on to read that “a prohibited transaction is one that is not premised upon a legitimate charge against the seller on account of any actual costs assumed by and otherwise payable by the buyer.”  Lastly, the clarification states that the Opinion “does not implicate a contract of sale that explicitly states that the seller shall provide the buyer with a credit against legal and legitimate costs or expenses related to the sale, which would otherwise be absorbed by the buyer such as actual closing costs.”

What does this mean for attorneys who practice transactional work?  It means that having a contract that provides a seller’s concession is not unethical on its face.  However, the seller’s concession must be directly related to the purchaser’s legitimate and actual closing costs; unlike the facts set forth in the Opinion, where the seller’s concession was premised on an increase in sales price to raise the loan amount, but keep the seller’s profit as originally agreed.  If a seller’s concession is contemplated at the time of initial negotiations, and the seller takes the concession into account, then it is part of the consideration of the negotiated sales price.  At that point, the concession is an inducement for the buyer to enter into the contract and not merely a tool to allow the buyer to borrow more money.  The attorney handling the transaction should clearly delineate what items are to be included as part of buyer’s closing costs to be offset by the concession.  Additionally, while no attorney should be held accountable for any knowledge regarding the fair market value of the property being sold or purchased, the attorney should be diligent or at least mindful of any sales price that appears to be overly inflated. In doing so, the secondary market will be investing in mortgages that were the result of an actual arm’s length transaction.

Before agreeing to give or take a concession in a real estate transaction, consult with a competent attorney.  While the Opinion, and this article discusses an attorney’s liability, the last thing a party to a real estate transaction would want is to defend a lawsuit for fraud brought against them from a financial institution.

 The information you obtain in this article is not, nor is it intended to be, legal advice. You should consult an attorney for individual advice regarding your own situation.

Stephen F. Cea, Esq. is an experienced real estate attorney with the firm of Levy, Ehrlich & Petriello, P.C. headquartered in Newark, New Jersey. He can be reached at (973) 643-0040, ext. 114 or by e-mail at Steve@LEP-lawyers.com.