From failing to adhere to state-specific compliance regulations, to market volatility, private lenders must stay aware and informed of the various risks that impact the industry. One of those risks is fraudulent borrower claims. These claims typically arise after a borrower fails to make the balloon payment once the loan matures. Fearing the loss of equity in the property, the borrower then sues the lender by claiming the loan was a consumer loan and not a business-purpose loan. If the court agrees with the fraudulent borrower claims, the lender can be accused of violating a myriad of consumer-based licensing, underwriting, and disclosure requirements.
Understanding the risks associated with borrower claims and taking steps to mitigate them can save lenders from lengthy litigation and financial loss. Below are three critical strategies to avoid fraudulent borrower claims and protect your business.
Require Clear Borrower Statements
One of the most effective ways to prevent fraudulent borrower claims is to have clear, well-documented loan agreements that clearly identify the loan as a business purpose loan. Requiring the borrower to identify under penalty of perjury the intended business purpose is crucial. For lenders in California, the California Financial Code Section 22502 provides additional guidance on how to navigate borrower claims:
“Commercial loan” means a loan of a principal amount of five thousand dollars ($5,000) or more, or any loan under an open-end credit program, whether secured by either real or personal property, or both, or unsecured, the proceeds of which are intended by the borrower for use primarily for other than personal, family, or household purposes.
This code section outlines that loan documents that are properly structured and unequivocally describe the intended business purpose can serve as evidence against borrower claims. For loans that involve atypical transactions, such as a business purpose loan secured by a primary residence, tailoring the loan documents to the specific transaction rather than utilizing a general template is essential.
In instances where the borrower claims they were unaware of the terms, having confirmation that the borrower had an advance opportunity to review the loan documents before meeting with a notary for signature can also help protect against fraudulent borrower claims.
Conduct Extra Due Diligence
While the borrower’s written representations can help bolster a defense, the inquiry typically doesn’t end there. This is particularly true when the borrower accuses the lender of some form of fraud or civil conspiracy. In other words, even though California Financial Code Section 22502 permits a lender to rely on the borrower’s representations, that still won’t protect a lender if the lender knows the loan is not for a business purpose.
The more evidence a lender has in writing, the better. Letters of intent or explanation beyond the loan documents, separate interviews, and confirming email communications can all help supplement the record regarding the lender’s understanding of the borrower’s intended purpose. Regulation Z, or the Truth In Lending Act, provides five factors that a lender should consider when determining whether a loan is for a business purpose:
- The borrower’s primary occupation and how it relates to the acquisition.
- The degree to which the borrower will personally manage the acquisition.
- The ratio of income from the acquisition to the borrower’s total income.
- The size of the transaction.
- The borrower’s own statement of purpose for the loan.
Keeping these five factors in mind can help a lender build a strong defense and avoid further challenges in court.
Customize Loan Documents to Fit the Transaction
Private lenders will often pass on working with an experienced law firm and instead choose to utilize loan documentation software to draft their loan documents and cut costs. However, many loan document templates do not factor in the unique aspects of each loan transaction and can result in major litigation issues for lenders down the line. A lender must consider the following when drafting a loan document to mitigate risk:
- Ensure there is a clear outline of business purpose terms in the loan agreement.
- Use intentional, direct, language to prevent room for borrower interpretation.
- Keep all loan-related documents consistent – including closing statements, underwriting records, and communications from the borrower.
By crafting loan documents to the specifics of each transaction, lenders can prevent ambiguity and make it more challenging for the borrower to claim they were misinformed.
Additional Methods to Mitigate Fraudulent Borrower Claims
Disgruntled borrowers can quickly turn on their lenders when things don’t go as planned. By taking a proactive approach, lenders can strengthen their legal standing and minimize hefty litigation fees. Given the complex nature of borrower claims, it is crucial to partner with an experienced legal team that understands your needs. Our Litigation & Bankruptcy team specializes in protecting lenders from costly borrower disputes. Contact us today to ensure your business is prepared to withstand any legal hurdles it may face.
