The Horror of a Hard-Money Audit

By Pam Strickland

This article was originally published in the May 2019 Points of Interest. It has been updated to provide information on the resolution of the audit.

I am actually sitting with the DRE auditor as I type this column (she can’t see my screen) and I’m going to try to give you a play-by-play of the violations she is finding and the citations she is citing. Hold on, it isn’t going to be pretty, unfortunately.

First and foremost, she has now spent three (3!) days trying to reconcile the trust account that was already reconciled by the broker’s CPA. To make matters worse, there was bank fraud from outside hackers and a change of banks (the original bank was acquired by another bank) during the audit period. Every adjustment that was made by the CPA to account for these two events has been questioned by the auditor to make sure they adhered to DRE requirements (and, unfortunately, some of the ways the CPA made the adjustments met generally accepted accounting requirements but not the DRE’s strict requirements for trust accounting). Even though the CPA showed the trust account as IN BALANCE, the auditor is insisting that the account is $5,000 short. This still hasn’t been resolved, but we are working fervently to show her that it isn’t short. The confusion and perceived shortage were caused by the unfortunate timing of the changed banks and hackers, which makes it hard to show the DRE the absolute linear paper trail that they demand.

Next she started working on specific loans (chosen at random) and asked the broker to choose a construction loan for her to review (which is unusual, since the auditor usually picks the loans to review, but since this is a “routine” audit as opposed to an investigative/complaint driven audit, she let the broker choose the construction loan and she chose the rest from the list of paid off loans from the last year). After discussing with the broker in his office with the door closed and the auditor not in attendance the fact that a DRE broker cannot originate a construction loan with a principal amount of over $2,500,000 (until and unless the pending legislation is approved to raise that limit), we began to review his construction loans closed during the audit period. Fortunately, this broker was well aware of the $2,500,000 limit and none of his construction loans violated that provision of the law (as you can imagine, there are brokers I have encountered who are unaware of the limitation).

Once we provided a copy of the construction loan, the first thing she noticed was that there was no fund control company holding the construction funds, but that the broker had opened a single use trust account for the holdback. It was a multi-lender loan, and the rule is that there is no threshold for holdback in the broker’s trust account (single use or otherwise) for any amount of holdback (even though on a single-bene loan the broker can hold back up to $100,000). The fund control company handled the inspections and approved the draws, but the broker controlled the funds. This is a big hurdle that we are still trying to get over.

She noted that there were rollovers from the investors into this loan, even though there was nothing in writing from the investors to allow the broker to hold the funds from a paid off loan to roll into this loan AND the fact that no rollovers are allowed on multi-lender loans. The only time an investor’s money can be held past the 25 days by regulation is in the case of a single investor who wants to roll over their payoff into another loan that is identified in writing (loan amount and property address).

The new bank that the trust accounts are now held in has Analysis Accounts, which means that bank fees are offset by the deposits in the account (either eliminating or reducing the charges to the broker). This is allowed, as long as there is a disclosure in writing signed by each investor or included in the loan servicing agreement disclosing the fact that the broker receives this benefit from the bank. She asked for proof of this disclosure, which we provided.

She asked for copies of the signature cards for the full audit period (18 months) for all bank accounts from both banks. Luckily, their bank provided these, as most banks DO NOT agree to provide copies of signature cards. This creates a problem, as the DRE then has to subpoena the bank and wait for the copies. (Note: If you have trust accounts, try to get your bank to provide a copy of the signature cards NOW. Don’t wait for an audit and then try to convince them to give them to you in a timely manner.)

The good news here is that the accounting software they are using gives the right reports, the reconciliations are done on a monthly basis (with some changes in how they are done going forward now that the CPA has sat with the auditor for three days and has seen where he was making errors), the signer on the trust accounts is only the broker, they are giving the MLDS and LPDS on all loans and having them personally signed by the borrowers/investors and broker (no electronic signatures), their dba’s are filed correctly, and their agents are properly licensed and have compliant contracts with the broker.

We have to finish the exhausting in-office field work with the auditor reviewing files and payoffs (hopefully today is the last day), she writes her report and submits it to her supervisor, and the supervisor decides whether to send it to legal or cite and fine. Now is the waiting period (months, perhaps) to see how the DRE decides to proceed. They will either file an accusation or issue a cite and fine (I’m thinking the latter).

Audit Outcome:

It took the DRE five months after the completion of the audit to contact the broker with the consequences of the findings. In this case the broker and corporation both received Cite and Fine Citations ($1,250.00 to the corporation and $1,250.00 to the broker). These do not go on the public record, unlike an accusation or desist and refrain.

Broken down, the fines were as follows:

Corporation: Violation of B&P 10238(h)(4) Respondent used prospective property value after completion of construction project for “current market value” in LPDS. Respondent did not use a neutral third-party escrow for the transaction, as required. Fine: $1,000

Corporation: Violation of Comm. Reg 2832.1 Respondent allowed $600 trust fund shortage. Fine: $250

Broker: Violation of B&P 10159.2(a) Respondent failed to adequately supervise the activities of the corporation resulting in trust fund handling and lending violations. Fine: $1,250