Extrication Fraud, what is it and how to avoid it

This paper is a vital read for those lenders who finance the purchase of lots in newly completed developments, and their valuers and solicitors.

15 September 2009

What is extrication fraud?

Extrication fraud is so named because it involves a fraudulent developer extricating himself from a failed development with a profit, instead of having his company liquidated and being made personally bankrupt. The following describes how it comes about:

  1. The developer begins with little capital and little development skill. As a result, he is unable to obtain and/or to recognise optimum development opportunities. This means the projects he chooses to work on have intrinsically poor profitability.
  1. The developer believes he can get away with a smaller profit margin because he harbours the following delusional beliefs:
    • There will be fair weather during the whole of the project;
    • He can cut corners on building materials so as to reduce the costs;
    • He can cut corners on compliance with the DA and so reduce costs;
    • He will be able to bribe or bamboozle the building certifiers;
    • He will have smooth sailing with the council;
    • The disreputable builder he plans to use will not cause problems;
    • There will be no issues with the excavation that cause it to run over budget;
    • That somehow property values will increase during the course of the development and the ultimate sale prices will pay off the construction funder and provide at least a modest level of profit.
  2. Another consideration that motivates the developer to proceed on modest margins is that the builder is often the developer’s cousin (or a close acquaintance) and, therefore, the developer considers that the builder’s profit margins form part of his justification for undertaking the project.
  1. Generally speaking, when construction funders assess the feasibility of a project, they expect the land to cost 1/3rd of the gross realization, the construction & finance costs 1/3rd, and the builders profit margin 1/3rd. This level of profit margin is required to buffer the solvency of the project against contingencies. These include a drop in the market, problems with council, and problems with the builder or the weather.
  1. Due to the fact his project is not sufficiently profitable to attract finance the developer must somehow dupe the construction funder into believing the project will be more profitable than it actually is.
  1. Construction funders will typically require 40% genuine pre-sales. These must be at prices which, less a pre-sales discount, equate to the gross realization assessed by the valuer. The valuer appointed by the lender will often rely on any pre-sales in forming a view as to the gross realization of the completed units. Where analogous comparables are lacking (as they often are with a multi-unit development), pre-sales are ordinarily a good indicator of value. The only exception is if they are fraudulently inflated.
  1. The developer, therefore, has two motives for fabricating inflated pre-sales: to dupe the lender and to dupe the valuer on whom the lender relies. The inflated pre-sale contracts usually involve either using stooge purchasers or non-existent purchasers. False pre-sales are typically made to relatives or acquaintances. As they are fabrications there will usually be no genuine deposit. Thus the deposit will usually be:
    • a deposit bond; or
    • claimed to be ‘released to the vendor’; or
    • claimed to be held by a solicitor or real estate agent when it is not.
  2. Having successfully obtained construction finance the developer then suffers a series of set backs, usually of his own making or easily foreseeable, such as:
    • The market goes down;
    • The weather is inclement;
    • The substandard building materials used are detected by the certifier or council and must be replaced;
    • The council detects breaches of the DA/BA and forces compliance. This usually involves jack-hammering up concrete and so is expensive;
    • Council and building certifiers prove incorruptible;
    • The builder stops paying sub-contractors, who then walk off site;
    • There are significant variation claims made by the builder blowing out construction costs. These are often unjustified and reflect unrelated financial problems of the disreputable builder;
    • The developer diverts milestone payments paid by the lender to another project leaving the builder and/or subcontractors unpaid so they abandon the site;
    • The builder loses his building licence; or
    • The construction funder withholds payments due to concerns about all of the above.
  3. The developer then rectifies all the problems by:
    • drawing down on the lender’s contingency allocation; and/or
    • increasing the principal under the construction funder’s first mortgage; and/or
    • obtaining high interest mezzanine funding; and/or
    • defrauding private investors by telling them the project is profitable and inviting them to invest in it (they are usually easily dupable because the three-quarters completed development is an impressive prop for a con).
  4. However, once the occupation certificate is issued and the strata-plan registered, the project’s creditors (construction and mezzanine funders) then put pressure on the developer to refinance. The developer tries to refinance the units in a single line. The problem is prospective funders question why none of the pre-sales have settled. Valuers they retain suspect the truth and value the property at far less than the debt it is carrying.
  1. By now the construction funder has realized something is amiss with the pre-sales. This prompts an investigation and leads the construction funder to the conclusion that the pre-sales were fraudulent. The construction funder then threatens the developer with bankruptcy and criminal prosecution. At this point, the developer is introduced to someone with experience in extrication fraud and the scam begins. The first step is to enter into multiple fictitious contracts with either stooge or non-existent purchasers. It is not necessary to sell all of the units fictitiously. The reason is if four or five can be sold, ostensibly at the inflated prices, this will lay the ground for making genuine sales to victims who rely on (and whose financiers rely on) the fictitious sales in determining the value of the properties (there being a dearth of analogous comparables).
  1. Having created the fictitious contracts, the fraudster, who is usually the developer or someone acting in cahoots with the developer, then needs to find financiers willing to finance the fictitious purchases. The incoming financier is shown the contract with the inflated price as well as various documents that are required to process the application. The purchase price must be inflated to a level that enables the construction funder and mezzanine funder to be paid out. It must also be high enough to take into account that the incoming financier will only loan to a certain LVR (loan to value ratio). It must also be high enough to provide the fraudster with a profit. In order to fool the lender, an intimate knowledge of the lender’s underwriting requirements and habits is needed. For this reason, a broker is usually enlisted. The broker may or may not be innocent of the fraud. Where the same broker submits multiple deals the suspicion must be that the broker was involved. The reason is that whilst it is plausible that a loan was arranged without the broker meeting face-to-face with the borrower, or was duped by phoney identification, it is unlikely that a broker would fail to detect multiple false applicants.
  1. Once the fraudster has overcome the hurdle of meeting the lender’s underwriting requirements (pay slips, bank statements, etc) and of establishing a false identity, the next step is to convince the valuer of the incoming lender of the inflated price. The valuer will rely heavily on the contract (wrongly assuming it is genuine) and even more heavily on any settled sales that appear on RP Data. Valuers have even been known to rely on exchanged contracts that find their way into his hands. Each successive fraudulent sale is easier because the valuer of the incoming lender relies on the earlier sales as comparable sales evidence.
  1. The next hurdle for the fraudster is to convince the incoming lender that the difference between the loan and the inflated purchase price is genuinely being paid at settlement. At this point the solicitor acting for the lender should require evidence of this ‘hurt money’ being paid. Prudent lenders will also take pains to ensure genuine money is changing hands. If a requisition is made the following tactics are used by the fraudster:

    In relation to the deposit

    • The deposit has already been released to the vendor;
    • The deposit is held by the agent (and a false order on the agent is supplied);

    In relation to the difference

    • The difference is being provided as vendor finance;
    • The difference is being provided with a personal cheque;
    • The purchaser and vendor have other business dealings and the difference and/or deposit is being counted as a set-off in those business dealings;
    • The difference is provided with a solicitor’s trust account cheque (which is then returned to the solicitor for a full refund after settlement);
    • The difference is provided with a bank cheque (which is then returned to the bank for a full refund after settlement);

Avoiding extrication fraud

Extrication fraud is common and a prudent lender will take the following steps to avoid it. Failure to take these steps can be raised by valuers and solicitors as grounds for contributory negligence if they are sued by the lender.

  1. A prudent lender will restrict the number of units in a new development that it will fund.
  1. A prudent lender will treat with extreme caution multiple finance applications relating to the same development. The reason being, that ordinarily most purchasers will seek finance from one of the major banks. To have two applicants from the one building would be unusual, more than that should have alarm bells ringing very loudly.
  1. A prudent lender would treat with extreme scepticism multiple loan applications through the same broker on the same development. At the very least this implies that whoever has been selling the properties to the purchasers has also been arranging their finance. Often this is an indicator that sales are being made at inflated prices (whether genuine or dummy sales).
  1. A prudent lender, and more specifically its solicitor, will take the following steps to ensure that genuine ‘hurt money’ is being contributed:

    In relation to the deposit

    • Refuse to proceed if the deposit has been released to the vendor. At the very least, this indicates the purchaser is gullible and so probably paid too much. At it’s worst, it is an indicator of fraud (there was no deposit);
    • Before settlement, write to the real estate agent or solicitor and have them confirm they are holding the deposit in their trust account. Ask for a copy of the ledger in question so that the date can be compared with the contract date.
    • Refuse to proceed if a deposit bond was used. At the very least, this indicates that the purchaser does not have genuine savings. At worst, it is an indicator of fraud.

    In relation to the difference

    • Refuse to proceed if you are told that the difference is being provided as vendor finance;
    • Refuse to proceed if you are told that the difference is being provided with a personal cheque. No genuine vendor would accept a personal cheque;
    • Refuse to proceed if you are told that the purchaser and vendor have other business dealings and the difference and/or deposit is being counted as a set-off in those business dealings. At the very least this indicates that the transaction is not at arms length. Generally, however, it means you are dealing with fraud;
    • Investigate the provenance of the additional monies being tipped in. This is to ensure that the cheques handed over on settlement (even though they are a genuine bank cheque or solicitor’s trust account cheque) are not a ‘float’ for the scam and to be returned to whoever purchased them after settlement. The type of documentation you would ask for would be bank statements that show the money has been sitting somewhere for a long time.
  1. A prudent lender will take the following steps to uncover identity fraud during the application process:
    • Refuse to lend to someone who does not have a drivers licence and passport. A passport and drivers licence are very hard to fabricate and ensure that all but the most sophisticated frauds will be excluded.
    • Require a face-to-face meeting with the borrower or require that the borrower obtain independent legal advice from a solicitor who has known them for at least two years and can vouch for their identity independently of their identification.
    • If a solicitor is not used then require that some easily identifiable, verifiable and reputable person in the community vouches for the borrower’s identity. This might be a policeman, a civil servant, an accountant, or a teacher. This referee should be telephoned at work using details obtained from the white pages and then put on conference call with the borrower during the face-to-face meeting. This is the procedure adopted by the passport office in order to ensure fraudsters do not fraudulently obtain passports. It is a time honoured and well tested method. If suspicions are aroused, then an independent phone call should be made to the referee’s place of employment to speak to their supervisor and to verify the referee’s own bona fides.
  1. A prudent lender will recognize that financing the first purchaser of a property in a new development is an inherently risky proposition and make the following enquiries:
    • When was the strata-plan registered? This can be discovered by a simple historical title search.
    • When did the pre-sales settle? This requires historical title searches to be made of the other titles in the development, which the valuer has indicated have already settled. If it is a healthy development, there should have been a series of settlements amounting to approximately 40% of the development within six to ten weeks of the strata-plan being registered. If this is not the case, it is an indicator that the pre-sales were bogus.
    • Any caveats or second mortgages on the property will indicate that there have been funding issues and that the profitability of the development is suspect.
    • If the registered proprietor (developer) is a small company this calls for a higher level of due diligence. A substantial developer will have a website that lists all of their successful developments (with impressive photos of the same) which stretches back at least five years. A dodgy developer may still have a very impressive website, but not the history.
    • It should be noted that financing a purchase of a unit built by a two-bit developer is risky, even absent fraud. Often there will be problems that will come to light with the construction (such as a leaky roof or subsidence) only after several months have elapsed. The cost of rectification and pursuing home owners warranty insurance will find its way into the strata minutes scaring away potential purchasers and devaluing the units for resale.
    • The developer and the borrowers should be searched in Austlii and Google.
    • If the outgoing construction financier is a small and/or insolvent company, this calls for a higher level of due diligence. This is because such financiers are more likely to finance dubious developments.
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