Mortgage fraud – a risk to your professional indemnity

Andrew Horrocks and Simon Schooling look at possible mortgage-fraud claims scenarios, and how you can fight back.

As solicitors specialising in defending professional indemnity claims, we are seeing a rapid increase in claims against solicitors by lenders anxious to recoup their losses in this falling property market. Some lenders have now set up units to specifically target claims against professionals. In similar circumstances in the 1990s, thousands of such claims were brought against solicitors.

As happened in the last property boom, many loans are likely to have been obtained by fraud. In recognition of this problem, a Law Society Mortgage Fraud Practice Note was issued in March 2008 (the Practice Note), and it is vital that all property solicitors become familiar with its contents. It warns that criminals have been exploiting weaknesses in lending and conveyancing systems, noting that solicitors are involved in almost all UK property transactions. It also comments that while some frauds are opportunistic, others are by organised crime syndicates. In August 2008, Bradford & Bingley reportedly took an £18 million charge to cover losses from organised mortgage frauds uncovered during just the first half of the year.

As long ago as 1991, the Law Society’s Green Card Warning on Mortgage Fraud described warning signs, which have now been updated in the 2008 Practice Note. These include:

Where the seller is a private company connected to the buyer;
The seller has owned the property for less than six months;
The value of the property has increased out of line with other properties in the area;
The seller has provided incentives or discounts; and,
The deposit is being paid by someone other than the purchaser.

Common claim scenarios

Proper risk-management should require that all property lawyers be made aware of the kinds of scenarios which commonly lead to claims by lenders saying that they have been misled, or where solicitors should have told them what was going on.

The first, which we see quite frequently, is where a developer offers a large cash-back to the buyer, but this is not disclosed to the lender. A loan intended to be for no more than 85 per cent of the purchase price can be more than 100 per cent of the price paid once the cash-back is taken into account. Since the buyer may not be making much of a net contribution to the purchase, numerous purchases can be made, leaving the borrower highly likely to fall into arrears. In recognition of this, the Council of Mortgage Lenders (CML) introduced specific measures which came into force in September 2008, requiring developers to disclose cash-backs directly to lenders.

Secondly, particularly in relation to buy-to-let mortgages, at the height of the boom lenders relaxed their lending criteria to such an extent that few (if any) checks were carried out. Sometimes guided by brokers, buyers would give false information which lenders did not verify. In worsening economic conditions, these mortgages are likely to fall into arrears and come under lenders’ scrutiny, and they may say that the solicitors ought to have alerted them.

Thirdly, buyers and sellers – sometimes with false identities – collude to inflate the price of the property far above its true worth through one or more artificial transactions such as ‘sub sales’. Eventually, a lender repossesses a property whose real value is much lower than the purchase price, and whose condition may have deteriorated due to it being used for drugs or other criminal purposes.

A fourth more complicated fraud is when fraudsters impersonate the seller, and, often in league with purported purchasers, carry out a fraudulent sale without the real owner’s knowledge. Elaborate as this may sound, these frauds are not uncommon. There have been a number of criminal prosecutions. The largest fraud of this type known to us involved property which was worth several million pounds.

How claims are made

In all of the above situations, the lender may sue the professionals involved in the original loan transaction. The claim against solicitors is often for negligence, rather than an allegation of fraud. Equally, not all the events giving rise to such claims necessarily amount to fraud, much less fraud on the part of the solicitor. The lender’s claim is that, if properly advised, it would not have advanced funds at all, or not as much. Typically, it repossesses the property, and after selling it at a loss, claims for its unrecovered lending plus interest.

A particular danger is that a fee-earner working alone repeats errors (whether honestly or not) in successive transactions, making the total value of lenders’ claims against the firm enormous. This underscores the need for proper supervision, even of those working on straightforward high-volume conveyancing.

In many transactions, the solicitors acting for the borrower also act for the lender. Many lenders in turn expressly impose the duties set out in detail in the CML Handbook. These include a duty to follow the Law Society’s guidance on mortgage fraud and money laundering. There is a specific duty to alert the lender if the seller has owned the property for less than six months, or if the solicitor has any reason to suspect that the information the borrower has given the lender is not true or is no longer true. The lender must also be told if the balance of the purchase price is not being provided from the borrower’s own funds. Cash-backs above a certain level must also be reported to the lender, as must other incentives such as, for example, a rental guarantee offered with the property.

Solicitors also have duties to verify clients’ identities under the Money Laundering Regulations 2007. In a conveyancing context, it is particularly important that they are not lulled into a false sense of security by reassurances from other professionals such as mortgage brokers. Identity checks on corporate clients may also present problems, particularly where they are registered overseas.

The consequences for solicitors may go beyond receiving a claim from the lender. The extension of the definition of fraud in the Fraud Act 2006, and the anti-money laundering regime, mean that solicitors can be criminally liable even if they were unaware of the fraud or did not actively participate in it. Care must be taken, however, to avoid ‘tipping off’. One of the more graphic cautionary tales from the 1990s concerned a former senior partner who was obliged to resign as a circuit judge in the aftermath of a prosecution for mortgage fraud.

Fighting back

Prevention is, of course, better than cure, and the threat from organised crime remains high even today. It is vital that all solicitors are fully aware of the duties owed to lenders under the CML Handbook, and of the warning signs of fraud discussed above. More generally, a culture must be developed so that any peculiar features to a transaction can be recognised in law firms and appropriate reporting structures are in place internally.

If claims are asserted, there are a number of useful strategies open to firms and their insurers. There may be an argument that the lender itself should shoulder much of the blame, perhaps because it has been reckless in the level of the loan, it has not followed its own procedures, or it has ignored clear warning signs of fraud. In one case, we managed to find out that the broker had taken to telephoning the lender to explain why he thought that a fraud was taking place, but the lender proceeded to advance the loan anyway.

Documents from the lender should be obtained as soon as possible, so that its decision-making process can be thoroughly investigated. Many lenders, for example, circulate a list of warning signs of mortgage fraud to their staff. Circumstances vary from case to case, but through these arguments the amount awarded to lenders has been reduced by the courts by up to 90 per cent.

A slightly different approach is to consider whether the solicitor’s actions had any effect. If the lender’s complaint is that, due to the presence of cash-backs, it unwittingly made a loan at 100 per cent of the value of the property, believing it to have made a loan at 85 per cent, was it also at that time offering other loans at 100 per cent? If so, it might well have made the loan anyway. It can also be worthwhile arguing that the lender has failed to mitigate loss, if it has not pursued the borrower for payment or has delayed repossession and sale. Similarly, sometimes the borrower has employment or assets and in time can repay the lender. In these circumstances, the claim may be able to be substantially reduced or even defeated.

Another tactic is to examine the involvement of other professionals in the transaction, such as valuers or mortgage brokers. Often, any blame can be shared in this way, so reducing solicitors’ exposure.

Many firms are likely to be troubled over the next few years by lender claims particularly as more mortgage frauds come to light. Solicitors should take heed of recent guidance aimed at prevention of further frauds. If claims are nevertheless received, the right strategy can often reduce their impact.

Andrew Horrocks is a partner and Simon Schooling is an associate in the professional and financial disputes team at Barlow Lyde & Gilbert LLP. They can be contacted at ahorrocks@blg.co.uk and sschooling@blg.co.uk