Bank Loan Frauds in the Real Estate Development Industry

www.freshfields.com

Recent reports in the PRC media have exposed an “underground pattern” of bank loan frauds in the mainland's real estate development industry. The extent of the problem has recently come into focus with the investigation and trial of several significant bank loan fraud cases.

The Shenhow Apartment Case

Declared as one of China's “top 10 cases of 2006″, the Shenhow Apartment Case (Shenhow) serves as a textbook example of the recent spate of bank loan fraud cases. Held in Beijing, the Shenhow trial featured a real estate developer accused of fabricating the existence of 250 apartment buyers in order to obtain individual bank mortgage loans worth a cumulative Rmb750 million (US$96.5 million). In total, 10 defendants were charged in the case, including the head of the real estate development company and several of his employees (charged with contractual fraud), three bank employees (charged with criminal negligence), and two lawyers, who were charged with issuing certifications (i.e., the legal opinions attesting to the authenticity of the fictitious buyer applications) containing materially false statements.

Despite the scale of the fraud and the number and variety of defendants involved in the case, few industry insiders were surprised by the circumstances, and it seems possible that such fraud would never have been uncovered had the real estate developer succeeded in finding enough real buyers to replace the fictitious buyers whose names had been used to secure the original loans. Below is a hypothetical scenario of how such a case might play out.

A real estate developer unable to secure the financing to complete a development project might use a variety of means (including deceit, borrowing or “hire”) to obtain personal identification (ID) cards from a large number of persons acting as fictitious apartment buyers.

The developer could then create corresponding sets of fake application documents (such as proof of income) for bank loans, obtain legal opinions from cooperative lawyers that attest to the authenticity of the fake applications and bribe bank officials to approve the individual mortgage loan applications for the fake buyers.

Once such loans are approved, the real estate developer could use the funds to complete the project and sell the units to real buyers. Each time a real buyer is found, the developer could direct a fictitious buyer to terminate his relevant fake contract, after which the developer could proceed to enter into a real contract with a real buyer.

For outstanding fake contracts, the developer could continue to make monthly mortgage payments to the bank on behalf of his fictitious buyers.

At the same time, the developer might advertise that most of the units in the development have already been sold to create a false sense of demand and convince potential buyers that the property is worthy of their investment. If enough real buyers are found in time, the perpetrator might enjoy significant financial rewards without suffering any repercussions.

Other Interesting Cases

Several other notable trials have also been heard recently in Beijing. In one case involving the Tong Tai Real Estate Development Company (Tong Tai), the court held that 60 people who had “lent” their personal ID cards to Tong Tai for use in fake mortgage loan applications (as part of a Rmb100 million bank loan fraud scheme) were individually responsible for paying back the actual loans. In the Zhong Sheng Xing Real Estate Development Company case, 38 fictitious buyers – all current or former employees of the developer – claimed not to know that the developer had used their ID cards in fake loan applications.

News of real estate bank loan fraud has emerged in other parts of China as well. In Shanghai, for example, an individual was recently reported to have secured bank loans worth Rmb650 million through the use of borrowed ID cards of fictitious buyers, after which he used those funds to purchase more than 100 luxury apart-
ments in the city.

The Implications

The Chinese government is aware of these transgressions and is taking steps to address these issues. For example, the Sixth Amendment to the PRC Criminal Law that took effect on June 29 2006 included specific wording that made it a crime to obtain bank loans through fraudulent means, with a penalty of up to seven years imprisonment.

Perhaps more important, from the banks' point of view, is the PRC Law on the Supervision and Administration of the Banking Industry (promulgated in December 2003 and amended in October 2006), which grants the China Banking Regulatory Commission (CBRC) the power to impose sanctions on banks that violate the principle of “operation with due diligence”.

Such sanctions include, among other things, fines against the defaulting bank, ordering the defaulting bank to suspend certain businesses, taking disciplinary action against the responsible directors or employees, and barring the relevant individuals from working in the banking industry.

It has been reported that in June 2006, the Shanghai branch of the CBRC gave a Rmb500,000 fine to a local bank and temporarily suspended the bank's personal mortgage loan business, after discovering that loan fraud had been perpetrated against the bank.

Clearly, these administrative measures all point to the need for banks to carry out appropriate levels of due diligence when handling mortgage loan applications, particularly with prospective real estate buyers.