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A RESPA green light?

HUD's RESPA rules have been on again, off again for years. Just when it looked like the industry had some new guidance, parts of the rule package were put on hold. When the rule takes full effect next year, the business will get more certainty than it's had in a while. Even so, some matters remain murky.

From the outset, the anti-kickback provisions in Section 8 of the Real Estate Settlement Procedures Act (RESPA) and the HUD regulations implementing them have been extremely controversial. The current RESPA regulations, issued in 1992, immediately triggered litigation against HUD. A number of voices called for changes to the regulations.

Now, the department has amended several of the more contentious provisions in its regulations and has issued statements of policy addressing other important areas. On June 7, 1996, HUD removed the blanket exemption from Section 8 for borrower payments for computerized loan origination services (CLOs) and significantly changed the exemption covering payments to employees for referring business to affiliate companies, and changed the disclosures required for affiliated arrangements. HUD also issued policy statements discussing sham joint ventures, rentals of office and desk space, and lock-outs of settlement service providers.

Each of these changes was scheduled to take effect October 7, 1996. Congress, however, recently delayed the effective date of the changes to the employee exemption until July 31, 1997. Upon passage of this delay, HUD itself delayed the remaining June regulatory changes - those eliminating the CLO exemption and implementing a revised disclosure - for an indefinite period. The policy statements on sham joint ventures, office leases are effective now.

Whether these pronouncements, when effective, will simplify compliance is open to question; in several instances, HUD has replaced bright-line rules with amorphous standards or balancing tests. One thing, however, is clear. With resources freed up and its positions made clearer, the department has indicated that it will increase its enforcement activities.

RESPA anti-kickback rules

Congress enacted RESPA in 1974 to attack certain practices that were thought to increase the cost of settlement services to consumers. Section 8 of the RESPA statute prohibits giving or receiving a thing of value in return for referrals of settlement service business. In short, kickbacks are prohibited.

In 1992, HUD issued comprehensive revisions to its RESPA regulations. Those regulations contained several controversial provisions. First, under an employee exception, HUD permitted payments to employees for referrals to affiliated service providers. This provision was seen as giving a real competitive advantage to controlled business arrangements (CBAs) involving affiliations between builders or real estate brokers and other settlement service providers such as mortgage and title companies. Second, HUD established a blanket exemption for borrower payments for CLO services. Under the exemption, if appropriate disclosures were given, such payments would not violate the anti-kickback rules. These and other provisions were revised in HUD's latest action.

The June changes

* Employer-employee exemption. When it was adopted in 1992, the employer-employee exemption generated enormous controversy in the settlement service industry. While supporters claimed the exemption encouraged the development of CBAs, opponents argued that it conflicted with RESPA, exceeded the department's rulemaking authority and created uncertainty as to whether RESPA actually prohibited the payment of referral fees. Two industry groups, the Mortgage Bankers Association of America and the Coalition to Retain Independent Services in Settlements, filed independent lawsuits seeking to prevent the exemption's implementation, and interested parties on both sides of the issue repeatedly criticized HUD for causing confusion in the industry.

HUD has now opted to withdraw the 1992 regulation's employee exemption, concluding that the exemption unjustifiably allowed employees of settlement service providers to use consumer trust to gain referral fees. In lieu of the 1992 regulation's broad employee exemption, the new regulations permit payments to employees in three instances. Payments may be made (1) to employees that generate business for their employer, (2) to managerial employees based on the performance of an affiliate, so long as the payments are not based on the number of referrals to the affiliate, and (3) to employees that do not perform settlement services in any transaction.

RESPA has always permitted payments by an employer to a bona fide employee for referrals to the employer. Accordingly, the first provision is nothing new. However, the second provision - the special exemption for managerial employees - is unprecedented.

The new managerial employee exemption permits payments by an employer to its employee based on the performance of an employer's affiliate, if the payment is not based specifically on the number of referrals the affiliate receives from the employer. A managerial employee is defined as one that does not routinely deal directly with consumers. The term does not include independent contractors. In other words, while an employee's status as a licensed real estate broker or agent will not preclude him or her from being deemed a managerial employee, the exemption is not available to active real estate brokers.

Allowing bonuses based on criteria such as an affiliate's capture rate reflects HUD's acknowledgment that CBAs need to be able to provide management employees with performance-based incentives. The distinction between capture rate and referral-based bonuses, however, will not be easy to apply. One practical difference between the two approaches is that while employers could pay referral-based bonuses on a monthly basis, bonuses based on capture rate will need to be calculated over a longer period.

Finally, the revised regulations also permit employees that do not perform settlement services to receive payments for referring business to affiliates. For the nonsettlement service employee exemption to apply, several conditions must be satisfied. First, the exemption is restricted to payments to bona fide employees; an individual may not be hired on a part-time basis to make referrals because of his or her access to consumers as a settlement service provider. For example, an employment arrangement in which a title company pays a one-hour salary to a real estate agent who provides a referral, and issues a W-2 for services rendered to justify compensating the referral is and will continue to be in violation of RESPA.

Second, the referring employee must not provide settlement services in any transaction. For the purposes of this requirement, however, the performance of a settlement service does not include marketing a settlement service or product of an affiliated entity. Marketing includes the collection and conveyance of information, the taking of an application or order and incidental communications with the consumer after an application or order, but does not include coordinating the delivery and provision of settlement services.

Third, the employee must provide the consumer with a written disclosure of the affiliate relationship before the referral is made. This requirement, which is not new, is intended to alert the consumer to the affiliate relationship and the potential business interest of the employee making the referral and thus enable the consumer to make an educated decision about whether to use the recommended provider.

Fourth, the referral must be to a settlement service provider that has an affiliate relationship with the employer or in which the employer has a direct or beneficial ownership interest of more than 1 percent. Finally, the exemption currently applies only to payments made by the employer, not by the party to whom settlement service is referred.

* Computer loan origination. RESPA's applicability to payments for CLO services has been another controversial issue during the past several years. In the mid-1980s, HUD issued a number of informal opinions generally concluding that RESPA permitted both borrower- and lender-paid CLO fees. In the 1992 regulation, however, HUD withdrew its informal opinions and established an exemption for borrower-paid CLO payments only. The 1992 regulation did not define the term "CLO," discuss the timing of the payment of CLO fees or address whether settlement service providers could pay CLOs for including their products on a CLO system.

The new regulations eliminate the existing CLO exemption and substitute a CLO policy statement. The CLO policy statement does not add any new restrictions on CLO business practices. Rather, it provides guidance on how RESPA's current provisions apply to CLOs. The CLO policy statement defines the term "CLO" as "a computer system that is used by or on behalf of a consumer to facilitate a consumer's choice among alternative products or settlement service providers in connection with a particular RESPA-covered real estate transaction." The policy statement lists seven services that a CLO may provide and indicates that, if a CLO provides services to consumers, the CLO operator may charge consumers for the services performed. According to the policy statement, Regulation X does not address the timing of settlement service payments. In other words, CLO fees may be collected from borrowers prior to or at closing.

The policy statement also says that CLO fees must be disclosed on the good faith estimate and the HUD-1 or HUD-1A settlement statement. Furthermore, any CLO charge that is paid outside of closing must be disclosed as such on the settlement statement. Finally, the policy statement indicates that settlement service providers whose products are offered on a CLO system may reimburse consumers for their CLO fees. One of the principal reasons that the CLO industry has not developed more quickly is that consumers generally have been unwilling to pay for CLO services. Accordingly, this change may stimulate the CLO industry's growth.

* Payments by service providers. The CLO policy statement provides that settlement service providers may pay CLOs for compensable goods, facilities or services, provided that the payment bears a reasonable relationship to the value of goods, facilities or services provided; and the value of a referral is not included in the value of the goods, facilities or services. RESPA prohibits charges for which no or nominal services are performed or for which duplicative fees are charged. Applying this concept to CLOs, the policy statement indicates that, if a CLO lists only one settlement service provider and presents only basic information about its 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." Under these circumstances, any payment by the settlement service provider could be construed as an impermissible referral fee. If, however, a CLO lists only one settlement service provider, but provides more than basic information about that provider's services, then arguably a fee from the provider could be justified. As HUD did not provide a definition of "basic information," it will be difficult to make such determinations under the revisions.

* Controlled business arrangement disclosure. Under the RESPA statute, a person making a referral to an affiliated entity in a CBA must give the consumer a written disclosure detailing the nature of the relationship between the two entities and setting forth an estimate of the charges imposed by the provider. The disclosure must be provided no later than the time of referral, follow the format of HUD's regulations and be made on a separate piece of paper. HUD's new regulations set forth a revised model form and require that at least one borrower's signature be obtained on the disclosure. Settlement service providers should review their forms to make sure they comply with the new model.

* Sham controlled business arrangements. HUD's 1992 regulation was viewed by some as giving a green light to virtually any type of CBA arrangement. As a result, joint ventures, involving real estate brokers and builders and established providers have proliferated. In addition, a number of wholly owned subsidiaries have been established. These new entities typically act as mortgage brokers or title agents.

Before HUD issued the 1992 regulations, it informally expressed concern with arrangements that met the technical requirements for a CBA but were designed, in the department's view, to circumvent Section 8's prohibition on referral fees. While the 1992 regulation withdrew earlier informal interpretations, the department's concern with sham arrangements has continued. The department received a number of complaints, including some from trade associations, alleging that many ventures lacked substance and performed few legitimate services.

HUD now takes the position that sham joint ventures do not qualify for the CBA exemption and has articulated the standards it believes determine whether an entity is a sham. It is critical to evaluate any new or existing venture against these new standards. In determining whether a venture involving two existing providers is a legitimate arrangement, the department balances a number of considerations. These include whether the venture is realistically capitalized and has its own employees, manages its own affairs, has an office and pays market-based rent, provides substantial services, (that is, the essential functions of the type of entity at issue), incurs the risks and receives the rewards of a comparable enterprise in the marketplace, contracts out substantial services to a third party or a venturer competes for business from sources other than a venturer, and sends business exclusively to one venturer.

Assuming these factors, taken together, indicate that a bona fide venture is present, the entity may take advantage of the CBA exemption provided, of course, that it complies with the general controlled business arrangement requirements concerning disclosure, required use and returns on ownership interest.

* Office space rental, lender lock-outs and retaliation. Finally, the department also issued a policy statement discussing three issues that may arise in the CBA context, namely office space rental, lock-outs of competing lenders and retaliation against employees.

With respect to office rentals, controlled businesses and independent providers, CBAs are designed to provide one-stop shopping and therefore often establish a physical presence in the offices of an affiliated real estate broker or builder. In addition, an independent settlement service provider, such as a lender, also may wish to rent space from a broker or builder. Under Section 8, the rental payments under such arrangements could be viewed as disguised referral fees if they are not reasonably related to the value of the facilities provided by the lessor. The value of a referral (i.e., of any additional business obtained from the lessor) cannot be considered in determining whether there is a reasonable relationship between the rental payments and the facilities provided.

In assessing the value of a particular facility, the department indicated that a general market value standard should be applied. In other words, one must determine what a nonsettlement service provider would pay for similar space and services (which may include secretarial services, utilities, telephone service and access to office equipment) in a similar building. This standard attempts to remove the value of referrals from the determination of value. It also appears to rule out arrangements in which rent is based on what an alternative settlement service provider, such as a real estate agent, would pay for office space or a desk.

Once a CBA is established or space leased to one independent provider, competing providers sometimes complain that they are locked out by being denied access to customers of the entity establishing the CBA or leasing the space. In its policy statement, the department concluded that a lock-out, by itself, does not violate RESPA. At the same time, however, a lock-out will likely increase the scrutiny that will be applied to other aspects of the arrangement, such as the amount of rent that is paid or the disclosures that are provided. Furthermore, such activities could raise concerns under antitrust or state law provisions.

Finally, while RESPA prohibits certain incentives for referring business, it does not speak to disincentives for failing to refer business. In its policy statement, the department concluded that RESPA was not intended to reach retaliatory actions against employees for failing to refer business. Again, however, a retaliation policy may increase scrutiny of other activities and could raise concerns under antitrust or state law provisions.

What's in store

With Congress' delay in the effective date of the changes to the employee exemption, the nearly four-year debate on compensation for employees is not over. It appears likely, however, that the venue will shift from HUD to Congress, and we expect renewed attention to the issue when the 105th Congress convenes in January. Moreover, HUD will be turning its attention to other regulatory issues. Primary among them is the issue of payments to mortgage brokers for origination-related services. Since a negotiated rule-making that was conducted earlier this year did not reach consensus, HUD is likely to request comment on how mortgage broker compensation should be analyzed under the anti-kickback rules and what disclosures are required.

The June changes also highlighted another issue that might receive attention, namely co-branding and affinity marketing arrangements. Under such arrangements, a settlement service provider works with a group, such as a professional association, to become that group's provider of choice. In the preamble to the June changes, HUD suggested that it will study whether an exemption from the anti-kickback provisions may be appropriate for payments by settlement servicer providers to nonsettlement service providers - for example, payments by a lender (a settlement service provider) to an accountant (a nonsettlement service provider) who recommends that his or her client use that lender to refinance a mortgage. Payments by traditional settlement service providers such as lenders, Realtors and builders to trade associations, universities or labor unions might be permitted if such an exemption were adopted. If HUD were to finalize such an exemption, settlement service providers could explore whether such arrangements make business sense, although many settlement service providers might not welcome any change that might impose additional origination-related costs.

This latest round of regulations has not exactly leveled the playing field for settlement service providers, but it has drawn the dimensions. With a set of rules in hand, the RESPA police will step up enforcement efforts. Lenders would be wise to examine existing CLO and CBA arrangements to ensure continued compliance with RESPA rules.

Thomas J. Noto and Phillip L. Schulman are partners in the Washington, D.C., office of the law firm Kirkpatrick & Lockhart LLP. They specialize in federal and state regulatory compliance and enforcement matters involving the mortgage lending and financial services industries.
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Title Annotation:Regulatory Affairs; Real Estate Settlement Procedures Act of 1974
Author:Noto, Thomas J.; Schulman, Phillip L.
Publication:Mortgage Banking
Article Type:Cover Story
Date:Nov 1, 1996
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