Most banks these days insist upon an arms-length transaction. That is a transaction in which the buyer and seller act independently and have no relationship to each other. They are not related, nor are they business associates. The concept of an arm’s length transaction is to ensure that the parties are acting in their own self-interest and are not subject to any pressure from the other party.
If a woman sells a house to her brother, she may sell the house at a discount. If the owner of a business sells his commercial property to an employee, he may sell at a discount or perhaps provide favorable financing.
If two strangers are involved in the sale of a house, it is more likely that the sale price and terms will be close to fair market value. The assumption is that both parties are well informed, well represented, and not under any major duress. The notion is that the seller seeks the highest possible price and the buyer seeks the lowest possible price, and they meet near fair market value.
In a short sale, the mortgage lender insists upon an arms-length transaction to prevent collusion or fraud. There are instances where someone facing foreclosure will ask a family member with a different last name to purchase the house. The lender would forgive the remaining debt, which could be tens of thousands of dollars. The family member who buys the house might then rent or sell it back to the previous owner. That person would have the benefit of continuing to live in the house, but for less money. Furthermore, the lender would bear the brunt of the loss. In addition, the lender assumes that the offer price from the family member might be far below fair market value, further deepening the lender’s loss and unjustly enriching the owner.
Most lenders today require that the buyer, seller, and real estate agents sign an affidavit in which they swear that it is an arms-length transaction. Some banks have short sale fraud departments, and they investigate suspicious transactions a few months after they are consummated. If a bank discovers evidence of a non-arms-length transaction when the parties all signed an affidavit to the contrary, the lender can press criminal charges and sue for civil damages. The buyer, seller, real estate agents, and even the title agent or attorney can be sued for committing a fraud. Lenders are losing tens of millions of dollars in fraudulent short sales, and they are serious about finding evidence of illicit activity.