A Twenty something DOES ONLINE LENDING.

A federal law prohibiting payments for straight referrals of mortgage-related business has relevance to the online mortgage market. But little guidance has been provided as to how the Real Estate Settlement Procedures Act (RESPA) applies to a world of hyperlinks and co-branded sites. Here's some unofficial guidance.

THERE IS YET ANOTHER 25-YEAR-OLD TO WORRY ABOUT IN THE E-COMMERCE WORLD. This one's not a tousled-hair entrepreneur who just completed his IPO for cut-ratemtgs.com. This one is the Real Estate Settlement Procedures Act (RESPA), a far-reaching federal law born in December 1974 that applies to almost all residential loan transactions, whether undertaken by pen, typewriter, computer or over the Internet.

RESPA requires disclosures in covered transactions, provides criminal and civil penalties for those who fail to follow the rules and, with substantial frequency, referees who wins and loses in the mortgage business. In a world where an idea strikes at midnight, the business plan is done by noon and the Web site is up by 6 p.m., it can be dangerous to your business health not to be mindful of RESPA.

It must be emphasized that while one of the authors had substantial regulatory drafting responsibility for RESPA for the Department of Housing and Urban Development (HUD) between 1984 and 1999, the author left HUD in April of 1999 and any views expressed here may not represent current HUD policy. The authors further recommend that readers consult with their own counsel before developing or implementing any business plan relying on guidance in this article.

RESPA referral fee prohibition

The statute is deceptively simple. RESPA Section 8 and Regulation X prohibit a person from paying or receiving a "thing of value" pursuant to an "agreement or understanding" that business incident to a "settlement service" involving a "federally related mortgage loan" shall be referred. Such business includes any origination--defined as the taking of loan applications, loan processing and the underwriting and funding of such loans. With limited exceptions, Regulation X provides that "any referral of a settlement service is not a compensable service." On the other hand, RESPA Section 8 never prohibits a payment by a lender to its duly appointed agent or contractor for services actually performed in the origination, processing or funding of a loan. Nor does it bar a payment to any person of a "bona fide" salary or compensation or other payment for "goods or facilities actually furnished or for services actually performed."

The dilemma in the e-commerce world (and frequently the paper-commerce world) is that the prohibitions run contrary to the business-generating instincts of the "marketing people." The typical marketing person might well ask, "If I can get enough eyeballs to my site that will eventually translate into customers for a lender, why shouldn't I be well rewarded for my success?" Similar questions have been raised since the dawn of RESPA.

California case law (Tyrone v. Kelley, Grant v. Marinell and Preach v. Rainbow) involving commercial real estate transactions allows finder's fees to be paid; many believed they should be permissible in residential real estate transactions as well. HUD said no. Later, HUD also disallowed payments by a lender to real estate brokers, even though a state regulatory board allowed them.

Economists occasionally suggest that a paid referral is cheaper and more efficient than requiring a business to sift through a sea of uninterested persons to find the few that care for its product. Nonetheless, this view has not prevailed in the residential real estate regulation context. It may be because the precept that "a man's home is his castle" has been transmuted into the official policy of the federal government and perhaps the state governments as well. Examples of this are the special tax treatment accorded home purchase costs, the ongoing subsidy in the federal tax code for interest paid during the life of the loan, the elimination of capital gains on residential property for all but the most expensive homes and the nurturing of a well-established and well-funded secondary market to provide liquidity for home loans.

Seen in this light, it is not surprising that a potential homebuyer and homeowner would be accorded special consumer protections by Congress in the form of RESPA. And despite wishful thinking that the cyberworld is so clear, simple and representative of the working of a perfect marketplace that fraud and deceit will disappear, this has not yet proven true, and the laws of the paper world, including RES PA, are likely to remain.

In addition to the RESPA rules, which were substantially revised in 1992, three important issuances from HUD have a bearing on online mortgage lending. They are: the Retsinas, or Independent Bankers Association of America letter (IBAA letter, February 14, 1995), which itemizes a number of common origination services and sets forth a minimum number of services that a person would have to perform to justify compensation in a mortgage lending transaction (IBAA Test); the Computer Loan Origination Policy Statement of 1996 (CLO Statement, 61 Fed. Reg. 29255, June 7, 1996), which sets forth broad policies showing how HUD views computer loan originations; and the HUD Policy Statement 1999-1 Regarding Mortgage Broker Fees (Broker Fee Statement, 64 Fed. Reg. 10080, March 1, 1999), which sets forth important principles regarding compensable goods and services and cross-references the IBAA letter as providing useful information regarding compensable services.

This article will now examine some common questions concerning the legality under RESPA Section 8 of certain practices connected with the marketing of mortgage loans online. Using the HUD pronouncements mentioned earlier as a guide, the article attempts to provide answers to these questions, or at least some thoughts on how HUD might be expected to address them.

Questions and answers regarding Internet lending

Question I: Suppose a lender enters into an agreement with a Web site operator whereby the Web site operator creates a hyperlink on its site so visitors can click through to the lender's Web site and be offered a special program of rates and terms. May the lender pay the Web site operator a fee based on the number of people who visit the Web site operator's site, or on the number of people who click through to the lender's Web site? How much of a fee can be paid by the lender to the Web site operator?

A: Payment based on the number of people who visit the Web site operator's site would appear analogous to payment for the placing of an advertisement in a newspaper or magazine, with the cost of the advertisement being based on the publication's circulation numbers. HUD has never questioned such payments, which, it seems, can rather convincingly be characterized as payment for a "good" (advertising space) or for "services" (the service of disseminating information to the public about the lender's products).

In addition, HUD in the past has approved payments for a list of potential customers. It seems that a payment to the Internet Web site operator based on the number of "click-throughs" can be perceived as payment for a stream of prospects, at least insofar as there is no obvious endorsement of the lender and/or its products by the Web site operator. However, these payments would undoubtedly have to be minimal--say, a maximum of several dollars per item--and payments for comparable prospect lists or advertising rates in the industry would likely be used for comparison. To be logically entitled to achieve greater payments, it would appear that the Web site operator would have to be in a position to undertake or contract to perform--and actually perform-settlement type services.

Question 2: If only minimal fees can be paid, how can the Web site operator legally earn greater fees? Must the Web site operator perform a variety of loan services as specified in the IBAA letter to receive more substantial compensation, including, say, a flat fee or a percentage fee per loan? Would such an arrangement meet the safe harbor provisions of 24 C.F.R. 3500.14(g) (1) (iii) and (iv)?

A: Under the IBAA Test, it appears arguable that payments to the Web site operator of a flat fee for, or a percentage of the amount of, each loan originated through the Web site operator s site could only be characterized under the IBAA Test as a permissible payment by the wholesale lender if the Web site operator is performing or arranging for performance of origination-type services. The test for compensability would be whether the services provided by the operator satisfied the threshold level of origination services set forth in the IBAA Letter (listed services).

Some relatively ministerial duties that the Web site operator can undertake include taking the borrower's loan application, initiating/ordering verifications of employment and deposits, initiating/ordering requests for mortgage and other loan verifications, initiating/ordering appraisals and ordering flood certifications. In addition, the Web site operator could also be seen as performing "counseling services" for the borrowers through the display on its Web site of detailed information concerning the loan rates and terms available from the wholesale lender. Other counseling-type services include the display and maintenance of a toll-free telephone number through which a consumer can obtain additional information and/or answers to questions concerning: the home-buying and financing process; how closing costs and monthly payments would vary under each product; helping the borrowers to understand and clear up credit problems and similar questions.

Because these activities arguably include the taking of a loan application and at least five additional listed services, one could conclude that the services provided by the Web site operator to the wholesale lender would meet the first part of the IBAA Test and would therefore be compensable.

As to whether the fee paid to the Web site operator would satisfy the second part of the IBAA Test (i.e., whether the fee can be seen as reasonably related to the services actually provided) would depend on whether comparable fees are paid under similar marketing arrangements. To show that the fee paid to the Web site operator was reasonable, market data would be needed to show that the fee is in fact competitive in the marketplace for similar services in the geographical regions in which it is offered.

In the Broker Fee Statement, HUD cautioned that the IBAA Letter is not dispositive in analyzing more costly mortgage broker transactions where more comprehensive services are provided. As noted, the particular program HUD reviewed in the IBAA Letter involved the performance of six listed services in return for a flat fee of about $200. To achieve a higher fee, the Web site operator should arguably perform more than six and, to be safe, as many of the listed services as possible.

Under the CLO Test, the Web site operator's Web site could be viewed as constituting a CLO as defined in the CLO Statement, i.e., a computer system used by a consumer to facilitate choice among alternative lenders and/or loan products offered in connection with a particular RESPA-covered real estate transaction. The Web site provides to consumers who visit it almost all the information and services HUD identified in the CLO Statement as being representative of the information and services provided through a CLO.

Although the Web site may apparently be characterized as a CLO if listed services are being performed via the site, it may be more appropriate to analyze the services under the Broker Fee Statement and the IBAA Test rather than under the CLO Statement. Because of how and where the borrower and lender are brought together and an application is taken, the Web site can be said to meet the definition of a "mortgage broker" in regulation. As previously indicated, the CLO Statement says that if a CLO elects to operate as a mortgage broker, the mortgage broker compensation rules apply.

On the other hand, if the Web site were to be used only for general marketing purposes rather than for brokerage or origination-type services similar to those set forth in the IBAA Letter, resorting to the CLO Statement to determine whether fees paid for such marketing services are compensable under RESPA would appear appropriate. The CLO Statement says simply that payments made to a CLO operator do not violate RESPA Section 8 so long as services are provided to the customer by virtue of the CLO and the payment is reasonable in relation to those services.

Under the CLO Statement, no specific form of payment is prescribed or prohibited and, in particular, payments based on closed loans are permitted so long as the payments are reasonable in the marketplace for the services provided. However, in 1996 at least, HUD frowned on the concept of a single-lender CLO. The department indicated in the CLO Statement that "if a CLO lists only one settlement service provider and only presents basic information to the consumer on the provider's products, then there would appear to be no or nominal compensable services provided by the CLO to either the settlement service provider or the consumer, only a referral."

Question 3: Does it matter if settlement services are automated?

A: There is no indication in RESPA, Regulation X or any official HUD interpretation of RESPA or Regulation X that mortgage processing or underwriting services performed by a person are to be treated differently if performed in an automated manner. To the contrary, what little HUD has said on the subject indicates that the performance of mortgage processing and underwriting services will be treated essentially the same under RESPA, whether performed manually or through automation.

For example, in the Broker Fee Statement, HUD acknowledges that the "advent of computer technology has, in some cases, changed how a broker's settlement services are performed" and indicates that "[f]or...services [other than the listed services] to be acknowledged as compensable under RESPA, they should be identifiable and meaningful services akin to those identified in the IBAA [L]etter including, for example, the operation of a...[CLO] or an automated underwriting system [AUS]."

In addition, HUD specifically addressed in the CLO Policy Statement the provision of settlement services through the use of a CLO (which by its very nature is automated). HUD indicated it would essentially employ the traditional RESPA Section 8 analysis to determine whether payment for such services is permissible under RESPA Section 8.

Not examined here is the more complicated question of whether a Web site operator could outsource some or all of its mortgage processing or underwriting services to an entity jointly owned by the Web site operator and a lender. However, there is no obvious reason why the same rules that apply to affiliated business arrangements generally would not also apply to online structured arrangements such as this.

Question 4: Is providing access to the Web site operator's Web site a facility or goods for which the Web site operator can be compensated in addition to the compensation for services that the Web site operator performs?

A: Arguably, payments for providing access to a Web site can be characterized as payments for "goods" (analogous perhaps to payments for print advertisements) or for a "facility" (the "rental" of space on the Web site that customers can "visit" and where they can "meet" with the functional equivalent of a loan officer and obtain information about the lender's products and submit a loan application). Under this argument, such payments would be permissible so long as reasonably related to the value of the Web site access furnished.

Furthermore, HUD has indicated in the Broker Fee Statement that mortgage brokers may furnish compensable goods and facilities in addition to performing compensable services, and has provided examples.

[A]ppraisals, credit reports, and other documents required for a complete loan file may be regarded as goods, and a reasonable portion of the broker's retail or "store-front" operation may generally be regarded as facilities for which a lender may compensate a broker. 64 Fed. Reg. 10085.

Again, accepting the argument that providing access to the Web site constitutes "goods" or a "facility," it would appear that the Web site operator may be reasonably compensated for providing such access in addition to receiving compensation for origination services.

Question 5: If marketing a lender's products through a Web site constitutes "goods" or a "service" for which the Web site operator can be compensated, are some methods of determining compensation more defensible than others?

A: If the compensation to be paid to the Web site operator is to be determined by the number of closed loans that came to the lender through the Web site operator's site, it seems possible the compensation could be deemed an impermissible payment for a referral. The argument, borrowed from some recent judicial decisions analyzing the legality under RESPA Section 8 of the payment of yield spread premiums to brokers, would be if the wholesaler pays a fee to the Web site operator for marketing services based on closed loans, never pays a fee for marketing services for loans that do not close or for which no application is made, and there is no significant difference in the marketing services provided with respect to all visitors to the Web site operator's Web site, it is possible for a court or HUD to conclude the payment is not for the marketing services, but rather is a prohibited finder's fee.

However, HUD has never specifically disapproved payments to mortgage brokers based on closed loans and, in fact, has indicated in an informal letter that percentage compensation based on closed loans does not necessarily violate RESPA Section 8. Rather, HUD stated it would first look to see whether the payment is for services actually performed, and would consider whether, in an arms' length transaction, a purchaser would buy the services at or near the amount charged. HUD also stated that, "[t]he fact that others pay comparable prices for similar services may be relevant to this inquiry." Additionally, HUD has clearly indicated that CLOs may charge settlement service providers a fee for each closed transaction arising from the use of the CLO.

Less problematic, clearly, is paying the Web site operator a flat fee for marketing services, assuming it is paid regardless of whether a loan closes. The only apparent issue in such a scenario would be whether the flat fee was reasonable in relation to the marketing services provided.

Somewhat less clear than charging a flat fee would be a fee based on the number of hits on the lender's Web site that came through the hyperlink from the other Web site operator's site. Also less clear in terms of RESPA would be a fee based on the total number of hits on the Web site operator's site. The former would be more susceptible than the latter to the argument that due to the way the fee is determined, it should not be considered to be for services rendered.

Question 6: Co-branding arrangements between one entity with access to potential customers and another entity with a product to sell are quite common on the Internet. Do cobranding arrangements involving residential mortgage lenders present special problems or limitations with respect to RESPA Section 8?

A: Co-branding presents the same type of RESPA problems as do finder's fees. It would appear that the co-brander, typically not in the settlement service business, is being paid a fee in exchange for steering its associated customers to the preferred lender or other settlement service provider. While a fee on the order of a reasonable fee paid for a selected prospects list (as set forth in Question 1) may be allowable, additional compensation without additional services, such as the listed services, would appear suspect under Section 8.

There have been several attempts to amend RESPA to allow co-branding arrangements. This has come covertly during last-minute discussions regarding the 1996 Budget Act as well as in two other bills (the Financial Regulatory Relief and Economic Efficiency Act of 1997 and the Financial Regulatory Relief and Economic Efficiency Act of 1999). However, no such proposal has ever been enacted. The U.S. Treasury and HUD and other opponents of this amendment have argued, so far successfully, that allowing payments to one group that performs no services, including groups yet unformed and for purposes unclear, would essentially eviscerate the anti-referral fee concept that is the essence of Section 8(a) of RESPA.

Thus, co-branding in circumstances where the nonsettlement services party performs no services, including Internet co-branding arrangements, will likely continue to be viewed by HUD as a violation of Section 8.

Conclusion

Some say that 25 years of RESPA is enough. They say the market has changed dramatically and so should the laws governing it. The view is that the Internet will so commoditize mortgage loans that referral fees and kickbacks will be squeezed out. Others are not so sure.

The residential mortgage market involved about $1.5 trillion of loans in 1998 and perhaps as much as $1.25 trillion estimated for 2000. Ordering a toy or a book that turns out to be the wrong one is one thing; entrusting your home to a cybersystem is another.

There is also a strongly held view that a referee or a sheriff is still, needed to bring order to the cyberfrontier. The residential mortgage market has long been made national by Fannie Mae and Freddie Mac. In such an environment, clear rules governing compensation arrangements for Internet mortgage loan transactions are needed. This is particularly true given that the technology that makes online mortgage lending possible also facilitates enforcement efforts against RESPA violators. Thus, any Web site is now only a mouse click away from a compliance audit from the PC on every desk of every federal regulator.

We believe HUD can and should, in conjunction with other federal efforts on encryption and digital signatures, commence efforts to establish rules for Internet online mortgage transactions. These rules obviously must continue to protect consumers, but should do so in a way that does not stifle innovation or lead to greater inefficiencies in the delivery of mortgage loan products to consumers.

Grant E. Mitchell is an attorney with the Washington, D.C., office of Reed Smith Shaw & McClay LLP. Prior to April 1999, he was the senior attorney for RESPA at HUD, with long-term responsibility for RESPA rulings and interpretations. Robert N. Jaworski is a partner in Reed Smith's Princeton, New Jersey, office and a former deputy commissioner of the New Jersey Department of Banking. Both are members of the Reed Smith Consumer Financial Services Group.

E-COMMERCE AND RESPA

COMMONLY USED TERMS IN ONLINE MORTGAGE LENDING

Single-lender site: a site that displays only the owner/lender's information and application materials for access to potential borrowers.

Multilender site: a site that provides information regarding more than one lender and allows potential borrowers to select a lender for further processing.

Content site: a Web site that contains information, commercial advertising and possibly, loan content information, which a potential borrower may select.

Click-through: an icon on a Web site that a potential borrower can click to be sent to another Web site.

Framing: a seamless process where the computer view goes from one Web site to a linked site without any obvious indication that the user has left the original site.

Link: a Web site connection via an icon that a Web site operator puts on its site, usually for some charge, so that a potential borrower can be sent to another Web site (see click-through).

Hyperlink: a link that, when clicked, automatically dials up the linked Web site.

Impression: a method of counting each time a Web site is visited.

Section 8 of RESPA: a criminal and civil federal statute administered by the Department of Housing and Urban Development (HUD. Section 8(a) prohibits compensated referrals of settlement service business and penalizes both the giver and the receiver; Section 8(b) prohibits kick backs, fee splitting and unearned fees.

Affiliated business arrangement: an exception to RESPA Section 8 that allows one company in the settlement services business to have profit-making interest in another company in the settlement services business so long as the provisions of a safe harbor are followed-use of the related provider (with limited exceptions), disclosure of ownership must be made, and the exchange of fees between the companies is limited. However, an employer may pay its own employees for referrals to an affiliated business company. An affiliated business (AfBA) disclosure informs the borrower of some of the important details of such an arrangements.

Settlement service: any service provided in connection with a prospective or actual residential mortgage settlement covered by RESPA (almost every residential real estate transaction where a lender takes a lien on the property).