Jon Alan Enochs

Financial Disclosure: Good Idea or Bad Idea?

February 2010

If you have ever assisted a client in a short sale or loan modification then you are aware that lenders frequently request that your clients make financial disclosure. This financial disclosure is usually a condition precedent to the lender modifying the client’s loan or it’s made a condition precedent to the lender releasing their lien on the property incident to a short sale. Have you ever thought about whether or not your client should be making financial disclosure?

What is financial disclosure?

Typically, financial disclosure involves our clients turning over personal financial information to their lender in anticipation of receiving a concession by the lender. This concession comes in the form of a loan modification or the lender releasing its lien on the client’s property to facilitate a short sale. The information includes: (i) bank statements; (ii) pay stubs; (iv) profit and loss statements; (v) tax returns and the like.

Why do lenders request financial disclosure?

Before I address this question I must point out the obvious. The debtor creditor relationship is one of the most adversarial relationships that exist in our society. On any given day, whether we are in a good economy or a bad economy, you can walk into your local courthouse and you will find a large number of lawsuits that have been filed by lenders against borrowers for nonpayment on their loans. With this in mind it is appropriate to pose the question: Why do lenders request financial disclosure?

If someone owed you money on a loan and they were not making payments to you then what paperwork would you find useful in helping you collect your money? Bank statements? Pay stubs? Tax returns? Profit and loss statements? Balance sheets? One reason lenders ask for financial disclosure is that they want to identify personal and real property belonging to the borrower that can be liquidated to pay down the debt. Another reason lenders ask for financial disclosure is to identify sources of income they can intercept in an effort to pay down their debt. Whenever a borrower fails to pay on a loan that borrower will be confronted by the lender and the relationship between that borrower and that lender will become very contentious.

Are borrowers obligated to make financial disclosure?

Generally a borrower has no legal obligation to make financial disclosure. Likewise, lenders have no legal obligation to make a concession to their borrowers (i.e., loan modification or lien release in a short sale). Loan modifications and short sales essentially involve a new bargaining process. Financial disclosure is part of this bargaining process. The lender has the right to place as a condition precedent to even negotiating with the borrower that the borrower make financial disclosure. Likewise, the borrower is within his/her right to refuse to comply with this condition precedent (financial disclosure). However, when a borrower refuses to make financial disclosure then the bargaining stops and the borrower is left having to make the payments on his original loan or face foreclosure.

Bank Fraud

Many of the borrowers that are now looking for a loan modification or to short sell their home are in stated income loans. Many loan brokers and borrowers alike treated these stated income loans as invitations to lie about the borrowers’ income and assets. This is bank fraud and it is not without consequence.

Under federal law, bank fraud in the United States is defined, and made illegal, primarily by the Bank Fraud Statute in Title 18 of the U.S. Code. 18 U.S.C. § 1344 (Bank Fraud Statute) states:

“Whoever knowingly executes, or attempts to execute, a scheme or artifice—

(1) to defraud a financial institution; or (2) to obtain any of the moneys, funds, credits, assets, securities, or other property owned by, or under the custody or control of, a financial institution, by means of false or fraudulent pretenses, representations, or promises; shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both.”

There are civil implications associated with bank fraud as well. Fraud is non-dischargeable in bankruptcy. So the question becomes: How does bank fraud relate to financial disclosure?

If a borrower makes financial disclosure to their lender and the financial information conflicts with the information the borrower provided the lender in his / her loan application then the borrower may have inadvertently exposed the fraud that he had committed at the time he / she obtained the loan.

Whether consciously or subconsciously borrowers believe they have bankruptcy as a fall back position if they really lose control over their financial obligations. But where there is bank fraud then the bankruptcy option may not exist. A lender can file a lawsuit inside of the bankruptcy court called an adversary proceeding.

In an adversary proceeding the lender asks the court that the lender’s debt be determined to have been the product of a fraud and that the borrower’s obligation to repay this debt become non-dischargeable in the bankruptcy. Stated differently, in an adversary proceeding the lender seeks to have the borrower’s obligation to pay on the loan survive the bankruptcy.

Normally it is difficult for a lender to prove that a borrower committed bank fraud. However, with the advent of short sales and loan modifications it has become easier for lenders to come up with persuasive evidence of the fraud. When a borrower makes financial disclosure they may inadvertently provide the lender with very credible evidence exposing the fraud. In that we are talking about real estate secured loans we are frequently talking about loans measured in hundreds of thousands of dollars and sometimes millions of dollars. In a down real estate market a borrower could be looking at liability emanating from his loan(s) easily measured in hundreds of thousands of dollars. Imagine an obligation of this magnitude being non-dischargeable in bankruptcy. It is a sobering thought.

What should a real estate agent / broker do?

A real estate agent or broker has a duty to disclose facts that would likely affect their client’s willingness to enter into or complete a transaction. With this in mind, a real estate agent or broker should disclose any suspicions they may have concerning possible bank fraud and suggest that the client talk to a lawyer.

This disclosure should be in writing and signed by the client acknowledging receipt of the disclosure. A real estate agent or broker does not need to ensure that the client actually consult with a lawyer. Merely encouraging the client to do so in writing should suffice so long as it is accompanied by the actual disclosure.

But if the borrower does not disclose then they will not receive a loan modification or the lender may not approve the short sale

The lender usually has the legal right to refuse to modify the loan or release their lien on the property in a short sale unless the borrower makes financial disclosure. For the borrower experiencing mortgage distress he or she is confronted with a difficult choice. Assume the risk associated with financial disclosure in hopes of saving the house (or facilitating a short sale) or play it safe and lose the house to foreclosure. I will be the first one to admit that these are not attractive choices. But, more times than not, these are the choices the borrower has to choose from.

The lender usually has the legal right to refuse to modify the loan or release their lien on the property in a short sale unless the borrower makes financial disclosure. For the borrower experiencing mortgage distress he or she is confronted with a difficult choice. Assume the risk associated with financial disclosure in hopes of saving the house (or facilitating a short sale) or play it safe and lose the house to foreclosure. I will be the first one to admit that these are not attractive choices. But, more times than not, these are the choices the borrower has to choose from.

I hope you found this article helpful and I wish you all the best of luck in your real estate endeavors.

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