Lax Scrutiny Fosters Fraud in Trust Deeds

If anyone were watching, the First Pension Corp. disaster might have been headed off as long ago as Aug. 12, 1987.

On that day the firm’s owners filed notices with a California agency claiming that each of 23 virtually identical real estate investment pools was exempt from regulation as a public securities offering because it was not to be offered to more than 35 sophisticated investors.

To any attentive regulator such a flurry of exemption claims would have suggested that the promoters were trying to evade the normally strict rules of disclosure for public securities offerings.

But no one was watching.

The exemption notices were stamped by a department clerk and filed. No one from the state watchdog agency got a look at the books of promoter William E. Cooper or his partners. No one--not even the president of the First Pension affiliate selling the pools--ever knew what trust deeds, or mortgages, underlay the investment pools or even whether they existed.

Now, nearly seven years later, these pools are among hundreds offered by affiliates of First Pension into which nearly $100 million of investors’ funds may have vanished.

That the filings passed unnoticed--as did dozens of other potentially fraudulent offerings from companies affiliated with First Pension--illustrates a gaping hole in the regulatory safety net that has contributed to hundreds of millions of dollars in investor losses in California real estate investments in the last 15 years.

About 11,000 investors may have lost more than $450 million to mismanagement and fraud at three firms alone: San Diego’s Pioneer Mortgage, Property Mortgage Co. of Sherman Oaks, and First Pension.

Based in Irvine, First Pension sold many of its retirement-fund clients questionable mortgage investments packaged by its sister companies, Vestcorp and First Diversified Financial Services. Investors typically were referred to First Pension by their accountant or stockbroker.

The surge of losses has refocused attention on the riskiness of these investments as well as the difficulty of policing the field.

Many attorneys and government officials familiar with the trust-deed business say it is notoriously prone to fraud and firmly resistant to regulation. Regulators say they have neither the money nor manpower to supervise the investments thoroughly.

State agencies require no special expertise from those who set themselves up as mortgage brokers. Although a real estate license is required to handle certain transactions, licensees need get no special training in mortgage lending. Moreover, promoters of trust deeds can “rent” real estate licenses by simply hiring licensed brokers to front for their firms.

Regulatory jurisdiction is shared by two state agencies that do not habitually share information with each other: The Department of Real Estate oversees transactions between individual borrowers and individual lenders. But if the trust deed is “fractionalized,” or broken into pieces for sale to more than one investor, it comes under the jurisdiction of the Department of Corporations.

No one can expect the average investor to negotiate the resulting maze of jurisdictions. At least one First Pension customer was misled when he asked the Department of Corporations whether the firm’s owners had clean histories.

In August, 1991, the agency told one Ventura County investor that the firm, its affiliates and its principals had “no disciplinary records.”

In fact the Department of Real Estate had revoked the license of Cooper, one of First Pension’s three principals, in 1984 for misappropriating more than $577,000 of his clients’ money.

The department denied his application for reinstatement twice on grounds that he still owed more than $100,000 to more than seven clients who claimed he had given them worthless promissory notes to settle legitimate debts. (Cooper finally did get a new license.)

Other investors faced a regulatory runaround.

When Helen G. Schroeder of Torrance wrote the Department of Corporations last July to complain that First Pension fraudulently kept $6,500 of a $9,500 distribution due her, she got a form letter noting that the department gets 16,000 investor complaints a year and “has no jurisdiction over a company’s failure to provide a full accounting of funds.”

To the extent that the trust deed business does come under regulation, those performing the oversight are overworked and underpaid.

“The (regulators) I’ve worked with are all conscientious,” said Dennis Schmucker, a lawyer who has acted as court-appointed receiver for Pioneer Mortgage, American Home Mortgage and several other fraud-tainted operators in the business. “But there’s too much for them to do.”

Adds Scott Metzger, a San Diego attorney who represented 900 investors in a lawsuit against Pioneer Mortgage: “As a practical matter there’s not enough money in California for them to send auditors to check out all the firms they regulate.”

The Department of Real Estate, for example, employs 30 auditors to cover the entire state. “We’re just busy putting out fires,” said Deputy Commissioner John Liberator.

The Department of Corporations also lacks the resources for systematic review of the exemption claims filed by investment pools, although something of the sort might have picked up Cooper’s blizzard of claims in 1987.

Under law, essentially similar offerings from a single promoter have to be treated as if they are all one. Thus, instead of 23 offerings to 35 customers each, Cooper was really making a single pitch to more than 800 customers.

If regulators had noticed that, they would have held the promoters to stringent terms, including audits, public disclosure of their financial backing and an accounting of exactly which properties and what kind of mortgage investments they were selling. The state commissioner of corporations would have to give his approval before the investment could be offered for sale.

“These are just routine filings and we get 40,000 of them a year,” said G. W. McDonald, the agency’s regional enforcement chief. “There’s no red flag system to pick up the violations.”

First Pension was long a beneficiary of such cracks in the regulatory edifice, and not only at the state level.

Although as a pension administrator it was subject to auditing by the U.S. Department of Labor, regional officials at that agency say they did not get around to examining its books even once in its 14 years of existence.

Trust deeds entered the universe of popular California investments in November, 1979, when voters approved Proposition 2, lifting the usury ceiling of 10% on mortgage brokers.

Barely a year later the business had generated its first major fraud investigation when the Securities and Exchange Commission charged San Bernardino-based Western Sierra Group with defrauding investors of as much as $100 million by telling them they were buying second mortgages when in fact they were buying thirds, fourths or fifths.

“There’s a lot about this business that attracts problems,” said Sheldon M. Jaffe, who was receiver for Southern California Realty, a trust deed firm that went under with millions in investor funds in the 1980s.

Start with the borrowers.

Typically homeowners turn to trust deed lenders because “traditional lenders won’t touch them,” Schmucker said. The reason may be a poor credit history, a lost job, or concerns that the home equity being posted as collateral is not enough to support the mortgages already on it.

In any event, Schmucker said, “there’s not enough high-quality product to go around in a business where your best loan is already a questionable loan.”

In the pattern followed by most of the failed trust deed brokerages, as defaults mount on their best loans--and as new money continues to flow in from unwitting investors--the promoters go trolling among ever more suspect borrowers.

Defaults proliferate and “then the Ponzi scheme starts,” Schmucker said. To mask the defaults on the earlier loans they use money coming in from new investors.

“They begin to make loans they know they shouldn’t, to buy time,” he said. “Pretty soon they’re making phony loans and pretty soon they’re in jail. I’ve handled four or five of these and they all fit the bill.”

These problems naturally intensified with the crash in California property values of the last few years.

“In the real estate industry, a lot who were running an honest business just got killed,” said Steven Gourley, a Los Angeles lawyer who was chief deputy commissioner of the Department of Corporations during the last great surge of trust deed scams, in the early 1980s. “If you were playing fast and loose from the beginning, this economy cut you in half.”

It is precisely the decline in real estate that has uncovered many of the latest problems, the way old shipwrecks are exposed by a receding tide. “As long as property values went up, no one ever counted the money to see if it was still there,” Gourley says.

Meanwhile, as a putative investment in real estate offering high returns--some promoters have contended that they could pay their customers 20% a year or more--trust deeds have attracted inattentive or incautious investors.

“The widow Jones, left a half-million dollars by her husband, at 5% gets $25,000 a year. She’s a prime target for someone who says he can give her 10%,” Jaffe said. “The broker is minimizing the risk of the investment and she’s convincing herself to believe him.”

Many investors are especially unaware that they may need to put up more capital to protect their investment if the borrower defaults.

If a homeowner stops making payments on his first mortgage, for example, a foreclosure by the bank or other institution holding the first will typically wipe out all of the other mortgage holders--unless they keep up the payments on the first long enough to foreclose themselves, a period of at least four months. Most small investors in trust deed pools do not have the wherewithal to do that.

But as most investment experts say, the best defense against such surprises is for investors to be more careful going in.

“If the average investor would ask the promoter for the same information he gives when he fills out a MasterCard application, most of these guys would just go away,” Jaffe said. “I’ve seen people invest in these with less information than I’d use to buy a stereo.”