RESPA's latest chapter.

HUD's new proposed rule on RESPA raises some technical concerns. It offers a safe harbor that appears unsafe and seeks to create a bright-line test in a matter that is anything but clear. The proposal leaves many questions about where the issue of broker disclosure goes from here.

On September 17, 1997, the new secretary of Housing and Urban Development (HUD), Andrew Cuomo, did a fairly unusual thing: He held a press conference at HUD's Washington, D.C., headquarters just to announce a proposed rule. This is not normal procedure for an agency preparing to issue a proposed rule. Proposed rules are an occurrence so commonplace in Washington that the Federal Register is filled with pages of them each day. The secretary, however, seemed to want plenty of press coverage for his new "Honest Lending Contract," which he set forth as the solution to both consumers' and industry's problems.

To be more precise, Secretary Cuomo announced he was sending to Congress to review for 15 days prior to publication in the Federal Register a proposal that would remove the ambiguity from the rules governing payments to mortgage brokers; eliminate consumer confusion about the role of the mortgage broker; and save consumers "millions of dollars." None of these assertions is likely to prove true, however, especially if the proposal never becomes law, as seems likely.

On the other hand, the proposed rule probably would disrupt the wholesale lending process by effectively compelling the establishment of a fiduciary duty on the part of the mortgage broker and requiring disclosure of the broker's maximum income on each transaction at a preapplication stage. And instead of eliminating ambiguity for the industry, the rule would create more, in that it would try to create a test for whether the compensation paid to the mortgage broker is "reasonable."

This article examines the primary provisions of the proposal and considers their legal and regulatory implications. It also discusses the remarks contained in the proposal concerning the interaction between the proposal and the secondary market exemption from the Real Estate Settlement Procedures Act (RESPA). Finally, this article looks at the probable impact on the wholesale lending market should the proposal become law, and considers the fair likelihood that it will not.

The proposal's content

HUD's preamble to the proposed rule contains a discussion that somewhat helpfully addresses the issue of the per se legality of broker compensation. The latest wave of class actions has alleged that back-funded payments by wholesale lenders to mortgage brokers, whether termed "servicing release premiums," "yield spread premiums," or anything else, are per se illegal under Section 8 of RESPA. Naturally, a per se standard, if applicable, makes class actions easy to bring and to certify because there is little need for factual inquiry.

In the proposal, HUD refers to past pronouncements by the department that obviously contemplate the existence of yield-spread premiums. Specifically, the existing Regulation X under RESPA contains a Q&A appendix that explicitly refers to yield-spread premiums and servicing-release premiums. In addition, the recently revised HUD information booklet on settlement costs includes discussions regarding mortgage brokers and how they are paid. Still other instances exist where HUD made reference to back-funded broker compensation, such as the entire discussion of "zero cost" loans in the now infamous "Keating Letter" of 1992.

Some have argued that because HUD has counseled the industry on how to disclose back-funded payments, these pronouncements constitute tacit approval of such payments. This reasoning is a bit optimistic, as it does not account for the possibility that such payments are legal sometimes and illegal other times. In that case, the Q&A and the settlement-cost information booklet are merely HUD's guidance to the industry for those cases that are legal, without immunizing those cases that are illegal. This is, in fact, the correct analysis.

The preamble states there was no intention in those prior pronouncements to create any presumption of per se legality. Rather, the only valid test for legality of compensation paid to mortgage brokers is reasonableness of the amount in relation to the value of goods and services actually provided. It makes no sense under the existing statutory framework to assert that back-funded payments are either per se legal or per se illegal, and HUD's discussion in the preamble of the current proposal confirms that.

In the most recent group of class actions, the only cause of action asserted is that the wholesaler-to-broker payments are illegal. This was a strategic maneuver by the plaintiffs' lawyers, who had found classes too difficult to certify when the complaints included assorted other, fact-intensive causes of action, such as fraud, inducement to fraud, breach of fiduciary duty, breach of contract and other similar, state-law-based arguments.

HUD now has weighed in saying, in effect, that although such payments may be illegal in some cases, they are not illegal in all, merely by virtue of having been paid. It amounts to a restatement of the reasoning offered by the judges who have denied class certifications in the cases to date. This is very helpful because by clarifying that the appropriate test is a case-by-case analysis, it makes class certification under a RESPA cause of action as unwieldy as it has been under other common law causes of action. This tends to take away a great deal of the plaintiffs' lawyers' incentive to bring these cases in the first place.

So much for the good news. The rest of the proposal's provisions are troublesome from several perspectives. First, the proposal would create a "qualified" safe harbor. The qualification is based on the perennial stumbling block of RESPA: the reasonableness of compensation. Second, HUD expects the final rule emerging from this process to achieve the impossible in addressing the qualification: a bright-line rule for reasonableness. Third, the rule would create a negative presumption, i.e., a presumption that if one does not avail oneself of the safe harbor, a RESPA violation exists.

A qualified safe harbor

The rule creates a safe harbor from Section 8 scrutiny for mortgage brokers if they enter into a prescribed disclosure agreement with consumers before application and they abide by its terms. The safe harbor would be qualified, however, in that it creates only a presumption of legality, which can be rebutted by a demonstration that the compensation is unreasonable. Immediately, this is troubling because it runs contrary to the concept of a safe harbor. The idea of a safe harbor usually is to establish a set of criteria that if satisfied makes it unnecessary to worry further about compliance with the law in question. Instead, however, HUD would permit this safe harbor to be undone by a plaintiff or by HUD in challenging the payment under scrutiny.

The test for reasonableness - How to rebut a safe harbor

To serve as the basis for undoing the qualified safe harbor, HUD proposes to create a test for reasonableness, although the proposal does not set forth the test. Rather, the proposal only seeks comment from the public on how to fashion such a test. In the preamble, the following discussion appears:

There are several possibilities for such a test that could result from this rulemaking, including defining the outer boundaries of permissible or legal total compensation in terms of range or amounts of dollars that could vary based on the size of the loan or other factors; a test comparing the total compensation for a loan to the total compensation for similar loans by mortgage brokers and lenders; or such other test or tests that would provide a clear line between compensation presumed legal and compensation that would not enjoy such presumption.

The term "clear line" resembles the classic legal term, "bright line," for a test that clearly and unambiguously dictates the legal conclusion given a set of facts. In proposing a bright-line test, HUD is attempting to establish a standard by which anyone can know, merely by learning the facts of a case, whether the compensation is reasonable. HUD does not know how to structure such a test, yet apparently believes such a test is possible, and in the quoted language HUD discusses a couple of possible ways it could be structured.

The first possibility is obviously indirect language for establishing a cap on broker compensation. This suggests that HUD cannot think of a bright-line test that would not involve fixing such a cap. There is a good reason for this difficulty. The concepts of "reasonableness" and "bright line" are mutually exclusive; it is inherently contradictory to speak of a bright-line test for reasonableness. Indeed, this is why tort law is so fuzzy: Jurists traditionally resort to "reasonableness" tests for standards of duty in complex circumstances where simple bright-line tests simply will not do. Similarly, if reasonableness is to be the standard for legality of mortgage broker compensation, it hardly can be proved or disproved by virtue of a bright-line test.

The second possibility mentioned, comparing compensation to that of "similar" loans, is not much of a bright-line test given the subjectivity of what constitutes a similar loan. Also, although HUD's language makes no mention of it, any test based on comparing compensation to the market would require a definition of the relevant market, another vague factor that undermines the objective of drawing a bright line.

It bears noting that HUD ought to be aware of the lack of viable alternatives for a clear-cut test for reasonableness of mortgage broker compensation. As discussed, reasonableness is a complex standard typically used when too many different possible factual scenarios may arise to permit the establishment of a single, bright line, or per se rule.

Moreover, the same quest for a clear-cut test for reasonable compensation found no answer from among all of the assembled interest groups during the negotiated rulemaking process of 1995-96. Yet, HUD now appears to believe that what eluded all of the most interested parties assembled back then has suddenly become possible.

Alternatively, and more likely, HUD has decided to impose a cap as part of the safe harbor being proposed and wants to do it under the final rule, rather than include it in the initial proposal. This strategy might allow the department to avoid receiving too much negative feedback on such a politically sensitive approach.

The negative presumption

Perhaps even more disturbing about the qualified safe harbor is the fact that if it is not attained, or if it is rebutted, the result is a presumption that the broker and wholesale lender have violated Section 8 of RESPA. This would appear to be the case even if the compensation is reasonable, because failure to attain the safe harbor can result merely from not using what Secretary Cuomo dubbed the "Honest Lending Contract."

Thus, the safe harbor HUD proposes becomes, for all practical purposes, a de facto requirement. HUD should know that it cannot put out a safe harbor with such a negative presumption attached to it without effectively compelling the whole market - through wholesale investors' insistence - to use it. No wholesaler would purchase a loan originated without the contract.

Interestingly, HUD considered and rejected creating a similar presumption of violation for failure to satisfy the controlled business arrangement (CBA) safe harbor elements during the rulemaking that resulted in the 1992 final rule. In that case, HUD received extensive public comment against such a negative presumption and, noting that "presumption" is a legal term relating to the burden of proof in a criminal proceeding, deleted it from the final rule. It appears now that HUD has changed its mind about the undesirability of triggering those criminal-burden-of-proof ramifications.

Details of the "Honest Lending Contract"

The prescribed form has six basic parts:

* A section describing the relationship between broker and consumer.

* A section setting forth the broker's compensation.

* A section explaining how points and rate may be mutually compensating factors in the price.

* A statement that the terms recited are subject to qualification.

* A broker's certification and signature lines.

* A statement directed to consumers about knowing their rights.

The relationship section entails three check-boxes for the broker to choose, and they read as follows:

* "I represent you."

* "I represent you, but I may receive a fee from a lender."

* "I do not represent you."

Each of the three options is followed by some text elaborating on the caption. The first two options include the sentence, "I am your agent and I will get you the most favorable mortgage loan that meets your stated objectives." This arrangement raises the question of whether the agreement creates a fiduciary duty on the part of the broker toward the consumer. Although HUD insists that it does not because the broker always can choose to check the third box, it seems clear that in any kind of competitive market brokers would tend to check the first box, or at least the second box. Consequently, brokers are effectively compelled to undertake a fiduciary duty toward consumers under this rule. Further, any broker who does not get the borrower "the most favorable loan that meets your stated objectives" would fall out of the safe harbor, and both broker and wholesale lender, as discussed earlier, would be presumed violators.

The compensation section sets forth the maximum total compensation the broker can earn and sub-itemizes it according to the portion to be paid directly by the borrower and the portion to be paid indirectly through back-funded payments from the wholesale lender. It also states the note rate assumed for purposes of the foregoing numbers. (Incidentally, assuming this "Honest Lending Contract" constitutes an advertisement as defined under Regulation Z, the inclusion of a note rate triggers the Truth in Lending Act requirement that an APR be included as well.)

This disclosure, then, is the very requirement that the mortgage brokers fought hard against during the negotiated rulemaking and that the Mortgage Bankers Association of America (MBA) also opposed. It forces mortgage brokers to establish caps on their compensation on every transaction and to disclose what their profit margins are, unlike any other retail sales business.

The document also provides a discussion of how rate and points may be changed to buy each other up or down. It then states that the broker can display alternatives with higher rate and lower points, or vice versa, for the consumer to consider before entering into the agreement. Apparently, brokers must arm themselves with some sort of software package that can display various alternative rate-points combinations.

The document recites that the terms disclosed are subject to the borrower qualifying for the loan. The front of the form then ends with a certification by the broker that all of the information set forth complies with Section 8 of RESPA and signature lines for both broker and consumer(s). That is not all, however.

The reverse side of the document provides, under the heading, "Borrowers - know your rights!" a list of borrowers' rights. These range from RESPA-related rights, such as a right to receive a good faith estimate, to the right to a credit decision that is not made on a prohibited basis under the fair lending laws and the right to know the reason if the loan is denied. Does this mean that, unless a broker advises consumers about their fair lending rights on the back of a retainer contract, the broker and wholesaler are both presumed in violation of RESPA?

The proposal's relationship with the secondary market exemption

All of this would apply only in situations where current provisions relating to mortgage broker compensation apply. Accordingly, none of it would apply to any arrangement where a broker obtains its own legitimate warehouse line of credit and uses it to fund originations in its own name and then sells the loans to an investor (thus, in effect, ceasing to be a broker as the industry commonly thinks of them). Such an arrangement would render any back-funded compensation, otherwise subject to these proposed requirements, incident to a secondary market transaction, which is beyond the scope of RESPA.

It is interesting to note, however, that HUD's proposal contains some discussion suggesting that having and using a warehouse line of credit does not preclude one from being a "mortgage broker." At one point, for instance, HUD states, "In some transactions, mortgage brokers originate loans that are closed in the mortgage brokers' names, fund the loans temporarily using their own funds or a warehouse line of credit, and sell the loans after closing. These mortgage brokers function similarly to mortgage bankers, but they do not service loans." This language suggests that entities that we are used to thinking of as mortgage bankers, but that do not service, are considered to be brokers by HUD. As of this publication, HUD does not say, therefore, that such persons are unentitled to the benefit of the secondary market exemption, but it might be an indication of HUD's future direction on the question.

Impact and likely future of the proposal

If this proposal is implemented as proposed, several likely results are worth noting. First, it would impose a de facto requirement on mortgage brokers to disclose their maximum profits, before even taking an application, on every transaction they hope to sell to a wholesale investor. Second, the same de facto requirement would create a fiduciary duty on the broker's part to find the "most favorable mortgage loan" that meets the borrower's "stated objectives," with the attendant risks under the agency and contract laws of the states. It hardly seems likely, then, that this proposal would reduce the complexity, ambiguity and litigation risk currently facing mortgage brokers and the wholesale lending business generally.

Finally, and perhaps most significantly, HUD will have accomplished by indirection what it cannot do directly: Although HUD acknowledges that it has no authority under RESPA to regulate brokers' compensation directly, that would be the effective result under this proposal, the consequence of the following factors all acting together:

* HUD has created a qualified safe harbor.

* If it is not attained, a presumption of violation arises.

* The only way to avoid the presumption of violation is to use the Honest Lending Contract and to keep all compensation within the established test for reasonableness.

* The reasonableness test, although currently undetermined, can only turn out to be a cap on broker compensation because no other test exists that meets HUD's clear-cut criterion. HUD may argue that the safe harbor is voluntary, but no wholesale investor will purchase transactions originated outside of it, given the negative presumption.

If HUD accomplishes all this, the playing field, for mortgage brokers and direct retail lenders, will have gone from unlevel to downright vertical. No one should expect mortgage brokers to take kindly to that outcome or to remain passive and not seek a leveling of the field in the other direction.

In other words, if the broker community cannot have a market where no one is forced to disclose profit margins or involuntarily assume fiduciary duties, they will seek a market where everyone must do so. They will seek such a market through regulatory and legislative means and through the more public forum of the mainstream media.

These developments may not happen, however, because the rule may never take effect. HUD has set for itself an impossible goal. The Department intends to take a controversial and complicated proposed rule, which contains such legal impossibilities as a bright-line test for reasonableness, and make it a final rule. Don't hold your breath.

Following publication in the October 16, 1997, Federal Register, the 60-day comment period must expire before HUD can even consider publishing a final rule. Given HUD's past performance at turning complex and controversial proposed rules into final rules, we can safely expect it to take substantially longer than that. In fact, given how controversial this proposal is certain to be, and given the way political controversy has tended to cause regulatory paralysis at HUD, it is fairly likely that the proposal will never be published as a final rule. Nevertheless, it behooves those who do not want to live with the results described here to file comment letters opposing the proposed rule. It will not be controversial unless strong opinions on all sides are registered with HUD.

Even if the rule never is published in final form, the best thing in it, from the industry's perspective, already will have inured to its benefit: Because the language describing the proper test for legality of broker compensation appears in the preamble, it will be formally and irrevocably on the public record now that the proposed rule has been published in the Federal Register. Thus, even if this proposal never becomes law, the language helping the industry with the latest class actions - however slightly it may help at this late hour - nevertheless would be effective. Although it falls in the "too little too late" category, it still is better than nothing.

Paul Mondor is senior director, regulatory affairs at the Mortgage Bankers Association in Washington, D.C.