The "Loan to Own" Scam

The idea behind this fraud is to make a loan to a financially stressed property owner who has significant equity in her property. The perpetrator finds a reason to foreclose within a few months after the loan is made and takes the property through foreclosure. Since the foreclosure is private, there is no court scrutiny. The police will consider this a “civil matter” because they do not know whether the victim really defaulted on the loan. Unless the victim has money to sue, the perpetrator gets away with the crime. Even if the victim has money, the perpetrator will transfer or encumber the property to make recover difficult or impossible.

Our office uncovered an application of the “loan to own” scheme in Washington State. In this case, the perpetrator was running a Ponzi scheme to obtain money to make “hard money” loans. The lending was advertised on a website targeting contractors. A contractor in Southern Washington was the victim. The numbers and facts in this illustration are simplified and slightly fictitious to make the scam easier to understand.

The contractor-victim owned land worth $200,000 subject to a $30,000 first deed of trust obligation to the seller of the property. He had a building permit for a new home on the property but could not find construction financing. The lender-perpetrator offered a $300,000 loan at 12% interest-only for two years including funds to service the monthly interest due on the loan. The contractor believed he could build the house and make a reasonable profit on these terms.

The loan closed with the perpetrator advancing $50,000 to pay off the deed of trust ($30,000), leaving $20,000 for the contractor-victim. After closing the lender-perpetrator owned a first deed of trust for $300,000 against the property. The contractor proceeded with the construction of the home, spent the $20,000, and incurred obligations to subcontractors. The lender-perpetrator refused to advance any more money claiming interest was unpaid. He denied there was any agreement to fund the interest due on the loan. The contractor had no more funds and was dealing with angry subcontractors.

The lender-perpetrator foreclosed two months after closing and took title to the property, free and clear of any liens. He then transferred the property to a related entity that he claimed was arms-length. The related entity divided the property among other related entities including the perpetrator’s pension plan. The victim did not have money to pursue the case and lost the property.

One of the victims of the Ponzi scheme brought action against the perpetrator for fraud and Criminal Profiteering. After almost two years of litigation, when the plaintiffs were about to obtain judgment, the perpetrator filed a Chapter 13 bankruptcy petition. He had placed almost $1 million in his pension plan and claimed the money exempt from claims of his victims and other creditors. The Ponzi victim moved to dismiss the petition, pointing out that the perpetrator had creditor claims exceeding the limit in Chapter 13. The perpetrator voluntarily dismissed his Chapter 13 case.

The plaintiff-Ponzi victim proceeded to obtain a $4 million Criminal Profiteering judgment which including provisions that deeded property owned by the perpetrator to the plaintiff. Unknown to the plaintiff, the perpetrator filed a Chapter 7 bankruptcy petition the day before the judgment was entered.

The Ponzi victim sued the perpetrator in bankruptcy court. This type of case is known as an “adversary proceeding” and follows the federal rules of civil procedure. An adversary proceeding is essentially a federal civil case filed in bankruptcy court.

The Ponzi victim asked the court to have the perpetrator’s petition denied for fraud. In the alternative, the Ponzi victim sought a nondischargeable judgment against the perpetrator. The bankruptcy code has three provisions which are primarily used to obtain nondischargeable judgments against perpetrators of fraud. The first is 11 USC § 529(a)(2) which covers fraud as defined by bankruptcy law. The second covers misappropriation of funds in the possession of a fiduciary (11 USC § 529(a)(4)). The third was enacted with the Sarbanes Oxley act and makes violation of securities laws nondischargeable (11 USC § 529(a)(19)).