RESPA: still a waiting game.
HAVE YOU BEEN SITTING ON THE FENCE WAITING for HUD to resolve the decade-long debate over controlled business arrangements and computer loan originations? If so, make yourself comfortable. While recently proposed RESPA rules mark a dramatic shift in federal policy, the battle for market share using such approaches is far from over.
On July 21, 1994, HUD published its long-awaited proposal to revise Regulation X, which implements the Real Estate Settlement Procedures Act (RESPA). The proposed revisions flow from a previous request for public comment on four specific issues:
* payments to employees for referrals;
* payment for computer loan origination (CLO) services;
* ground rules for preempting state laws;
* disclosure of controlled business arrangement (CBA) relationships.
HUD received more than 1,500 comments when it invited feedback on these four issues--a telling measure of the current industry interest in this subject.
According to the proposed rule, HUD adhered to the following guidelines in reviewing the four areas under scrutiny:
* protection of consumers rather than mediation among industry interests;
* regulation of multibillion-dollar industries to end uncertainty;
* encouragement of technological and business initiatives that provide consumer benefits.
The department concluded that adherence to these principles mandated the following: substantially curtailing the employer-employee exception in the existing rule; limiting borrower payments to CLO services; retaining the present case-by-case federal determination on preemption of state laws; and modifying the controlled business arrangement disclosure statement.
While the preamble to the proposed rule shows HUD's basic understanding of the issues surrounding this debate, unfortunately this proposed rule avoids any final decisions. Instead, in the same circle game we have come to expect, the rules raise the same questions posed nearly a year ago and are likely to generate yet another round of comments. The proposed rule, for example, permits "managerial employees" in controlled businesses to receive bonuses for generating business among affiliates, but then creates a payment standard contrary to normal business practices. Additionally, the proposed rule does not explain in what way a CLO system differs from a mortgage broker and whether separate rules should apply to these two modes of originating when a computer serves as the facilitating origination tool.
Given the current intense industry interest in these types of integrated business arrangements any delay in resolving these issues is disappointing. Yet that appears to be the reality of the situation, as final regulations are not expected until next year.
The proposed regulations that appeared in July, however, do represent a major reversal of federal policy. The Clinton administration clearly intends to reshape the 1992 RESPA final rule that was put into effect during the waning hours of the Bush administration. The new administration's highest stated priority in reshaping RESPA rules is protecting the consumer, which it believes can best be accomplished by limiting CBAs and CLOs. The proposed reversal of aspects of the existing regulation represents a victory of sorts for the Mortgage Bankers Association of America (MBA), the National Association of Mortgage Brokers, the American Land Title Association and all those who sought to restrict the growth of CBAs and CLOs. But the path to a final rule--if the past is any guide--is likely to be a long and twisting route.
Let's look at a little RESPA history to see how we got where we are in terms of policy; what the most recent proposed rules state; what they mean; and what effect they are likely to have on individual mortgage lenders in the future.
Controlled business arrangements--Congress enacted the Real Estate Settlement Procedures Act in 1974 to protect homebuyers by requiring advance disclosure of settlement charges and by eliminating kickbacks and referral fees that cause higher settlement costs. RESPA applies to "federally related mortgage loans," which means virtually any loan secured by a lien on residential property including both conventional and government (FHA and VA) loans.
The anti-kickback provisions of Section 8 of the act generally prohibit a person or entity from giving or accepting a fee or thing of value for the mere referral of business related to a settlement service. For example, in some circumstances the payment of dividends by a controlled business mortgage company to its parent realty firm could be considered a violation of Section 8.
In 1983, Congress amended RESPA to say that mere operation of a CBA did not in and of itself violate RESPA, provided certain requirements were met. Under the 1983 amendment, a Realtor could refer a customer to its wholly owned mortgage company as long as:
* the relationship between the Realtor and lender was disclosed, along with the estimated charges of the lender;
* the consumer was not required to use the affiliated lender;
* the only thing of value the Realtor received from the lender was a return on ownership interest. If this "safe harbor test" were met, then the CBA was legal under RESPA as amended.
During the mid- to late 1980s, many national real estate brokerage firms formed controlled business arrangements. It became more common for Realtors to own mortgage companies, title companies, relocation firms, escrow companies and property insurance agencies. A series of informal advisory opinions from HUD, however, tended to keep the volume of business that Realtors referred to their affiliated mortgage companies and their other settlement-service companies in check--thereby restricting the widespread growth of CBAs.
Nonetheless, a widely held view in both the mortgage and title industries was that CBAs were a threat to the long-range survival of many firms that were unaffiliated with large real estate franchises. After all, there was a good chance that if there was a financial interest involved when a Realtor referred business to a commonly owned mortgage company, then it was less likely that business would be referred to the lender down the street.
Computerized loan originations--In 1986, the HUD general counsel issued an informal advisory opinion stating that payments made by a borrower to a Realtor or other front-end initiator of an application, under a CLO arrangement, did not violate RESPA. This, too, worried lenders and mortgage brokers. If a Realtor could be paid a fee for putting a borrower in touch with a certain lender (especially a CBA lender) through the use of a$computer in the Realtor's office, loan officers and mortgage brokers could become expendable.
The Mortgage Bankers Association and others lobbied HUD strenuously to require a system with multiple lenders and a capped CLO fee collected upfront before loan settlement that put a finite limit on the amount a Realtor, for example, might earn for assisting with the generation of business under a CLO arrangement. The thinking was that the fee should merely be a reflection of the value of the actual services rendered, and nothing more than that.
However, between 1983 and 1992, HUD failed to issue final RESPA regulations implementing either the CBA or CLO provisions. Without guidance from HUD, there was uncertainty in the marketplace, and a frontier attitude prevailed that anything goes. The attitude was fostered by HUD's inaction and the fact that existing rules neither defined a CLO system nor provided meaningful parameters.
The 1992 regulations
Those in favor of CBAs and CLOs didn't sit idly by for nine years. They, too, lobbied HUD, seeking rules designed to give them an advantage in the marketplace.
In November 1992, as the Bush administration was on the brink of closing up shop, HUD issued the first regulations outlining policies and procedures governing CBAs and CLOs. Simply put, the Realtors and others in favor of CBAs and CLOs got elected prom queen.
As for controlled business arrangements, two roadblocks in earlier HUD informal advisory opinions were removed. First, HUD concluded that an employer could pay an employee "for any referral activities" including referring customers to a controlled business. Beginning in 1992, the regulations permitted, for example, a mortgage company to pay its loan officer employee a referral fee for every loan he or she referred to the company's wholly owned title agency.
Second, the definition of "required use" was narrowed to no longer bar the offering of discounts or rebates to consumers for the purchase of multiple settlement services. Thus, a Realtor could say to a borrower, "If you buy a house from me, get a loan from my wholly owned mortgage company and buy title insurance from my wholly owned title company, I'll knock $300 off the price you would pay for those services if you ordered them from these companies separately."
These two changes in the RESPA rules gave distinct advantages to controlled business arrangements. As a result, sponsors of CBAs were free to provide incentives to both employees and customers to encourage the use of affiliated settlement-service providers.
Given such an environment, it should come as no surprise that controlled businesses flourished during the past 18 months. Large Realtors, mortgage companies and title companies that were able to support subsidiary mortgage broker and title agencies made such arrangements spread like wildfire. If volume didn't justify a wholly owned controlled business, smaller Realtors and mortgage companies formed joint ventures. Under such ventures, two or more Realtors would own equal shares of an affiliated mortgage broker operation or title agency.
The battle lines were drawn. Those supporting CBAs and CLOs claimed that controlled businesses and technologically advanced loan origination systems delivered convenient and efficient one-stop shopping to consumers at lower costs. Those opposed to the proliferation of CBAs and CLOs charged that borrowers were being steered to products that were not in the borrowers' best interests, and that such arrangements were anti-competitive and would eventually eliminate competition, causing borrowers' costs to rise.
No sooner had HUD Secretary Henry Cisneros arrived on the job than his phone began ringing off the hook with complaints about the November 1992 final rule. The secretary agreed to review the issues.
On July 6, 1993, HUD published a notice in the Federal Register asking for comment on whether it should reconsider CBAs, CLOs, state law preemption and disclosures. Of the more than 1,500 comments received, the overwhelming majority argued for changing the terms of the RESPA final rule.
On August 6, 1993, HUD held a public hearing on RESPA at which 36 witnesses testified. Again, the majority were opposed to the 1992 final rule.
A year later, on July 21, 1994, HUD issued a proposed rule addressing each of the four areas it set out to reexamine. It's important now for the industry to take some time to assess the proposed rule in light of what it might mean for mortgage lenders, mortgage brokers and other settlement-service providers.
The new proposed rule
Employer-employee exemption--RESPA exempts payments for actual services performed from its anti-kickback provisions. The 1992 revisions to the RESPA regulations broadly interpreted this statutory exemption to permit payments to employees for referrals to affiliated companies.
However, two years later, to minimize any monetary incentive for an employee to make referrals to affiliated or nonaffiliated entities, the department's proposed rule substantially restricts an employer's ability to compensate employees for business referrals to outside entities. The proposal would limit employer payment of referral fees to "managerial employees" and employees who do not deal directly with the public. Furthermore, neither the basis for payment of a referral fee to management nor payment of employee compensation can be tied to the amount of business referrals produced, such as some multiple of dollar volume or quantity of sales at an affiliated entity.
The proposed rule defines a managerial employee as one "who does not routinely deal directly with the public, and who either hires, directs, assigns, promotes and rewards other employees, or is in a position to formulate, determine, or influence the policies of their employer." HUD also clarified the definition of employee to exclude independent contractors, a class that includes most real estate agents and many others engaged in providing settlement services.
In short, if the proposed rule becomes final, controlled businesses will no longer be able to pay sales staff who deal directly with the public for referrals to affiliated entities. HUD would allow managerial employees to receive bonuses and other compensation for making referrals, but by prohibiting production-based referrals, HUD effectively may have precluded payment of referral fees even to managerial employees.
Sponsors of controlled business arrangements most likely will view HUD's curtailment of the employer-employee exception as an intrusion by the government into employers' internal compensation practices. If modifications are not made in the final rule, we shouldn't be surprised if pro-CBA interests consider filing a lawsuit to enjoin this portion of the rule.
CLO arrangements--The November 1992 final rule exempted from the anti-kickback provisions payments by borrowers to CLO operators. In doing so, the department sought to encourage the use of new technology to provide meaningful information and services to consumers. But the 1992 exemption raised a number of questions because it failed to:
* define the term "computer loan origination;"
* propose a minimum number of lender participants;
* set a cap on CLO fees;
* designate whether the CLO fee must be paid at the time of service or at settlement;
* address the issue of payments by lenders to CLO operators.
HUD certainly should be applauded for attempting to answer some of these unanswered questions in its proposed rule. For the first time, for example, HUD defines a CLO system as a computer system that:
* provides borrowers with information regarding the rates and terms of the loans;
* collects, assembles and transmits information concerning the borrower, the property and other relevant information for evaluation by a lender;
* responds to borrowers with detailed information on loan terms and payment schedules for various loan products based on the data transmitted.
Thus, it appears the CLO system must have an on-line interactive capability.
HUD proposes to amend the 1992 final rule by only granting a per se exemption for payments by borrowers to"qualified" CLOs. Payments by borrowers for CLO services other than from "qualified" CLOs would not be prohibited, but would be subject to scrutiny under Section 8 as to whether or not the CLO fee is bona fide compensation for goods provided and services actually performed.
Qualified CLO systems would have to meet the following requirements:
* Provide openings for 20 or more lenders offering various loan products. If the qualified system has fewer than 20 lenders, the system has to remain open to accept additional lenders until at least 20 lenders participate;
* Use selection factors that are "fair and impartial." These factors include the quality of services and capabilities the lender provides to consumers, type of loan products offered and the extent to which the lenders' participation will increase the variety of products offered by the system to consumers;
* Be lender neutral. No lender can be favored or disfavored.
* Provide a CLO disclosure form to the borrower before the CLO services are performed. The form, Appendix E of the proposed rule, would have to be signed and acknowledged by the borrower-and an enlarged completed copy of the form must be prominently displayed within five feet of the CLO terminal;
* Charge all borrowers the same CLO access fee for the same service or component of services. The fee must be paid by the borrower "outside of and before the closing of any loan that may be obtained through use of this system;"
* Charge all lenders the same access fee, which must be reasonably related to the costs of maintenance and operation of the system.
HUD stated that its new RESPA proposals are intended to encourage new mortgage lending technology. Yet, in my opinion, some of its proposed requirements for "qualified" CLOs could produce the opposite effect. Requiring 20 lenders on a computer screen, each with half a dozen or more loan products, could confuse the prospective borrowers with too many details to sort through. This of course, depends on how user-friendly the system is for the average consumer. If the sheer volume of information provided overwhelms the potential borrower, then the 20-lender requirement might be counter-productive and make these systems less useful to the very audience HUD intends to help.
Furthermore, one might well ask how requiring borrowers to pay a CLO access fee before closing protects consumers? It is my view that the requirement actually may violate a number of state mortgage brokering laws. Most states that regulate mortgage brokers prohibit collecting fees from borrowers prior to settlement. Moreover, presumably the CLO operator would be in compliance with this requirement by collecting the CLO fee shortly before dosing.
The difference between brokers and CLOs
While payments by borrowers to nonqualified CLO systems are permitted if the payments comply with RESPA's Section 8, most nonqualified CLO operators may choose to label themselves mortgage brokers (rather than CLO operators) and avoid the CLO disclosure and fee requirements altogether.
This last point raises the issue of what distinctions there are, if any, between CLO systems that offer the loan products and terms of several lenders, and mortgage brokers who serve a similar, if not identical, function. A CLO, in its simplest form, can be viewed as an electronic mortgage broker. A CLO system uses a computer to select a loan product, while a mortgage broker may go through lender rate sheets manually. In fact, many state laws would classify CLOs as mortgage brokers and require they be licensed as such. Nevertheless, the proposed rule does nothing to address what can be paid to a mortgage broker. Must mortgage brokers have 20 or more investors? Must they charge each borrower the same "access fee?" Must mortgage brokers be investor neutral? This issue is relevant because CLO operators not finding the qualified CLO requirements to their liking might be tempted to say they are operating as mortgage brokers and not CLOs--and thus sidestep what they view as onerous requirements. With no definition of mortgage broker in the rule, such an escape hatch remains wide open.
Preemption policy--HUD avoided the preemption issue regarding controlled business arrangements by deciding that it was unnecessary to create specific written standards for the preemption of state law. The department did not change the preemption standard contained in the 1992 rule (which provides that as long as a state law affords greater protection to consumers and/or competition, federal law will not preempt state law).
Commentators, including the title industry, sought assurance from HUD that RESPA's controlled business provisions not preempt more stringent state legislation or regulation. For example, a number of states restrict the amount of business a wholly owned title company may receive from its Realtor parent. Is this restriction more or less consumer friendly than the federal law that sets no limitation on the amount of business one affiliate may refer to another? By sidestepping the state law preemption issue, HUD is perpetuating uncertainty.
Controlled business disclosure--The department has proposed some changes to the CBA disclosure form by requiring the borrower's signature, adding language that the referring party may receive financial benefit from the referral, and capitalizing and expanding the clause that alerts the borrower to the availability of these services elsewhere.
A copy of the proposed CBA disclosure form is found in an appendix to the proposed rule. The new language reads: "You may be able to get these services or better services at a lower rate by shopping with other settlement service providers, and this is something you should consider doing." In other words, the disclosure actually urges the consumer to consider shopping around. Because the rule doesn't mandate this exact language, sponsors of CBAs will likely paraphrase this clause.
Effect of the rule
Although this rule is proposed and subject to modification before becoming final, it provides valuable insight into HUD's thinking on CLOs and controlled business arrangements.
The first message to grasp from the proposed rule is that CBAs are here to stay. HUD said as much in the preamble to the proposed rule, noting that Congress already has ruled that CBAs are legal. "The role of the department is not to encourage or discourage controlled business arrangements, but to clarify what activities between interrelated companies are permissible or not permissible under RESPA." Under the circumstances, controlled business opponents may have taken the department as far as it is willing to go in restricting CBAs. CBA proponents will lobby against the prohibitions on limiting the employer-employee exemption, but short of a court order, don't expect HUD to reinstate the full exemption.
The proposal also reflects the department's view that CLOs represent a technological advancement in loan origination--and HUD won't turn its back on technology. CLO sponsors may well protest that the proposal's criteria for being considered a qualified CLO are too restrictive. HUD may relax some of the qualifications (e.g., lowering the number of lenders on the screen from 20 to a more manageable number). Still, HUD has spent a considerable amount of time developing this qualified CLO concept and is unlikely to abandon it in the final rule.
When the rule is finalized, HUD will have placed more limitations on CBAs and CLOs--but such restrictions will not stop the trend toward interrelated companies or computer loan originations. CBAs allow Realtors and others a measure of control over a transaction and create an additional income stream. Both incentives make CBAs a sure bet to be around for years to come.
The same is true for CLOs. Software companies have spent a fortune researching and developing new technologies for delivering more efficient and less costly loans. Expect the use of this technology to continue to grow, and much of it will find its way closer to the point of sale--in the real estate broker's office.
Finally, and importantly, this proposed rule evidences a more proactive HUD than we have seen in the past. RESPA is a consumer disclosure statute. That means settlement service providers are supposed to provide full and advanced disclosure of settlement charges, so there are no surprises and to permit the consumer to comparison shop. This rule seems to go beyond that.
In discussing the employer-employee exemption, HUD says that referrals from one settlement service provider to another should not be based on full disclosure alone, but "rather on the highest quality and best price of the services." Whether you favor that or not, such a requirement is contrary to the fact that RESPA is not a rate-setting statute, nor does it impose fiduciary duties on anyone. Rather, RESPA relies upon fully informed consumers to operate in their best interests. If lenders make referrals on some basis other than highest quality and best services, have they breached a duty? Breaching consumer duties is the stuff class actions are made of.
The debate over CBAs and CLOs has been raging for more than a decade. Every point that can be made for or against such arrangements has been made--several times over. HUD clearly understands the issues. It's time for the agency to bite the bullet and end the uncertainty and finalize a rule that gives the industry clear and direct guidance.
Phillip L. Schulman is a principal with the Washington, D.C., law firm of Brownstein Zeidman and Lore, where he specializes in regulatory compliance and enforcement matters affecting the mortgage banking industry.
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|Title Annotation:||Regulatory; Real Estate Settlement Procedures Act|
|Author:||Schulman, Phillip L.|
|Date:||Oct 1, 1994|
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