Dedicate the time to properly evaluate the borrower.

If you are a private lender, your primary goal is ensuring you get paid back. The best way to improve those odds is to scrupulously follow your due diligence checklist. Your checklist may include engaging an appraiser, performing a property inspection, running a background check, obtaining a credit report, and anything else necessary to mitigate risks. The goal is to ensure the value of the property will be sufficient to cover the loan if the borrower can’t (or won’t) pay you back. Usually things go as planned, but not always.

As Voltaire wrote, “Is there anyone so wise to learn from the experience of others?” With learning from the experience of others in mind, I offer a cautionary tale that I hope you never face. This is a true story, though names and certain details were omitted to protect the not-so-innocent.

Several years ago, we received an offer to purchase a $4 million (20% loan-to-value) first-position note from another private lender with whom we had done business in the past. The terms of the note were not complicated, and the borrower’s exit strategy was straightforward. He had a signed purchase and sale agreement with a third-party buyer.

The lender had done several loans with this borrower and reported that he had always performed as expected. We put the prospective note purchase through our due diligence procedure; everything appeared to be in order. However, based on the note seller’s experience with the borrower, we deviated from our protocol by using the stale credit check the note seller provided, and we didn’t run our own background check. Deviating from our standard process was a mistake, because we would have uncovered that the borrower had been involved in litigation that would have raised red flags.

We negotiated the note purchase and took over the assignment of the note. The experience to that point was as professionally fulfilling as purchasing some papers can be. The borrower performed as expected throughout the initial loan term. As the maturity date neared, however, it was clear the borrower needed additional time to complete the sale of the property. Since we could see that he was making progress, we offered him an extension.

In response to our extension offer, the borrower and his attorney presented us with a preliminary title report showing a large senior lien ahead of our loan, which the borrower failed to disclose when our purchase note was funded. This new title report was from a different company than the one on our policy. The newly discovered senior lien was cross collateralized with multiple properties, and the total loan amount was substantially more than the value of our collateral.

Our first action was to dust off our title policy to confirm it showed us in first priority position, which it did. We then presented the situation to our title company and asked them to run a search for this senior lien. Surprisingly, it still didn’t show in their search. At this point, we concluded we either had a fraud situation or a title claim on our hands. It turned out to be both.

The title company was largely uncooperative at the onset, despite the fact they essentially acknowledged their search had missed the senior lien on two separate occasions: when the policy was issued and again when we had evidence a senior lien existed. Rather than rely on the title company’s attorney to solve the problem, we engaged an attorney who specializes in title insurance to tender a claim.

In hindsight, engaging our own attorney to represent us early in the process turned out to be invaluable, due to the yearlong legal quagmire that was about to unfold. In response to our effort to assert our priority lien position, the borrower engaged in a series of evasive tactics.

Fraudulent Borrower Tactic #1: Sell the Property

The borrower advised us of his plan to sell the property to pay off this senior lien, which would have left nothing to pay off our loan. He asserted that, in light of the shortfall caused by the senior lien, he had no obligation to pay our loan back, despite the fact the borrower personally guaranteed our loan and had executed an owner’s affidavit certifying there were no deeds, mortgages, or other security interests affecting the property. Concerned the borrower would sell the property, pay off the senior loan, and leave us empty-handed, our attorney successfully petitioned the courts to block the sale of the property.

Fraudulent Borrower Tactic #2: Foreclose on Himself

Although the borrower initially claimed he was unaware of the senior lien, we later learned he was a partner in the senior lending entity and used several shell companies to obtain an assignment of the senior deed of trust. The borrower assigned the senior loan to a newly created entity that he controlled. This senior lending entity then began foreclosure of the property.

Essentially, the senior lender, who was also our borrower, sought to foreclose on his own property to avoid paying our deed of trust. To stop this action, our attorney again successfully petitioned the courts for a temporary restraining order to stop the foreclosure.

Fraudulent Borrower Tactic #3: Renegotiate Our Loan Through Mediation

Since the borrower’s attempts to sell the property and foreclose us out both failed, he threatened us with a protracted legal battle. We agreed to go into mediation, whereby the borrower offered to settle in exchange for a $150,000 reduction of our loan payoff. Although we weren’t enthusiastic about a protracted legal battle, we also weren’t willing to take a discount.

We presented the title company with an offer: We would settle if they paid the $150,000 the borrower was demanding, ensuring we would be made whole. Because the title company was aware they were on the hook for the full policy amount, they made the wise decision to mitigate their losses and pay the borrower’s demand.

Ultimately, we reached a three-way settlement agreement whereby the title company paid the unscrupulous borrower $150,000, the borrower released all claims, and we released our restraining order. The borrower sold the property and paid us back our full loan amount, including all late fees, default interest, and legal fees.

Lessons Learned

As you underwrite new loans, consider some of the lessons we learned and best practices.

1. Know your borrower // Since the note seller vouched for the borrower, we let our guard down and skipped the background check. Learn as much about your borrower as you can. If possible, contact several of the borrower’s past lenders for reference.
2. Redline the pro forma title policy to strike through any exceptions // Make sure it ties to the lenders’ escrow instructions, and have title sign the lender’s escrow instructions before closing.
3. Double-check the excluded exceptions before the closing // Lenders escrow instructions show which title exceptions need to be removed. Do not hesitate to ask your attorney for clarifications if something doesn’t look right.
4. Make sure you get the final and full title policy document // It usually comes in the mail about 30 days after loan closings. The preliminary title report is not the actual title policy. Sometimes the title company fails to mail the final policy, so you might need to follow up with them.
5. Review the final policy // Confirm it matches the preliminary pro forma title report, the exceptions listed in the lender’s escrow instructions, and the required endorsements. If you’re not comfortable doing this, ask your attorney to do the reviews.

If a title issue arises, engage your own counsel to review the policy; if necessary, tender a claim against the insurance company. Insurance companies will defend you to an extent, but they’re also loath to pay claims.

The inherent risk in providing a loan never shows up at the closing table. Issues typically don’t reveal themselves for months or years. Asset-based lenders are wise to dedicate the time it takes to properly evaluate the borrower in addition to the value of the asset. Most importantly, don’t deviate from your due diligence procedures.