New from HUD: one rule, three policy changes

Real estate lenders who looked forward to a simple summer had better put away the suntan oil and pull out their compliance manuals instead. On June 7, 1996, the Department of Housing and Urban Development issued a final rule under the Real Estate Settlement Procedures Act and a series of related policy statements. The rule is effective in October, but the policy statements are already in effect.

The new pronouncements concern the ability of lenders and other residential real estate settlement service providers to: pay for business referrals; participate in controlled business arrangements (CBAs); offer services via computerized loan origination systems (CLOs); and "lock-out" certain service providers. These developments will result in major changes in how the residential real estate lending marketplace will be structured.

Payments to employees

Under the existing HUD Regulation X (implementing RESPA) employers may pay employees for any services, including referrals of business to the employer's affiliated businesses. Under the new rule, which will become effective Oct. 7, 1996, an employer will be able to pay its bona fide employees for referrals of business to an affiliate only under the following conditions:

1. In the case of a managerial employee, if the payment is not calculated as a multiple of the number or value of referrals.
2. In the case of a non-managerial employee, (a) if the employee does not perform settlement services in any transaction and (b) prior to the referral the employee provides the person being referred with a written disclosure of the affiliate relationship.

The new rule will not impact the ability of an employer to pay its own employees for generating business for the employer itself.

For purposes of this new test, a "managerial employee" includes an employee of a settlement service provider who does not routinely deal directly with consumers, but who hires, directs, or otherwise supervises employees or independent contractors or is in a position to formulate, determine, or influence the policies of the employer.

This new test will permit an employer to hire and compensate a financial services representative or an employee hired in a similar capacity to market the employer's affiliated providers (e.g., title insurance, appraiser, termite inspection, etc.). However, the representative can only serve as marketing support--he or she may not actually perform settlement services in any transaction.

These rules may be applied only to benefit bona fide employees and their employers. HUD is concerned that individuals are being hired on a part-time basis for the purpose of making referrals because of their access to consumers and other settlement services (e.g., a real estate agent hired on a "part-time" basis but who merely refers real estate customers to the mortgage lender or other settlement service provider). HUD views such arrangements as shams which violate RESPA Section 8. Such employees may not be compensated.

However, employees who are not commonly involved in settlement services may benefit from this exemption. For example, a bank teller may refer a bank customer to the bank's affiliated mortgage company or other settlement service provider and obtain a fee from the bank for such referral (provided that the teller is not involved in the provision of any actual settlement services in any transaction).

Controlled business arrangements

HUD has taken action on several fronts in regard to these arrangements.

New CBA Disclosure

The new rule redrafts the Regulation X controlled business arrangement disclosure to soften the language concerning the ability of a consumer to find similar services from others at possibly lower costs. That provision of the controlled business arrangement disclosure is now revised to read:

"You are not required to use ________________ as a condition for settlement of your loan ... THERE ARE FREQUENTLY OTHER SETTLEMENT SERVICE PROVIDERS AVAILABLE WITH SIMILAR SERVICES. YOU ARE FREE TO SHOP AROUND AND DETERMINE THAT YOU ARE RECEIVING THE BEST SERVICES AND THE BEST RATE FOR THESE SERVICES.

Sham joint ventures. In tandem with the new final rule, HUD issued a Statement of Policy condemning "sham joint ventures." Acknowledging that a combination of confusion over RESPA and Regulation X rules and intentional misrepresentation have led to CBAs which are joint ventures in name only, HUD announced that it will look at the following criteria to determine whether a given joint venture is a sham or a legitimate controlled business arrangement:

1. Whether the new entity has sufficient initial capital and net worth, typical in the industry, to conduct the settlement service business for which it was created? Or is it undercapitalized to do the work it purports to provide?
2. Is the new entity staffed with its own employees to perform the services it provides? Or does the new entity have "borrowed" employees of one of the parent providers?
3. Does the new entity manage its business affairs itself? Or is a third party that helped create the new entity running it for the parent provider making the referrals?
4. Does the new entity have an office for business which is separate from one of the parent providers? If the new entity is located at the same business address as one of the parent providers, does the new entity pay a general market value rent for the facilities actually furnished?
5. Is the new entity providing substantial services, i.e., the essential functions of the real estate settlement service, for which the entity receives a fee? Does it incur the risks and receive the rewards of any comparable enterprise operating in the market place?
6. Does the new entity perform all of the substantial services itself? Or does it outsource part of the work? If so, how much of the work is outsourced?
7. If the new entity outsources some of its essential functions, does it contract services from an independent third party? Or are the services contracted from a parent, affiliated provider, or an entity that helped create the controlled entity? If the new entity contracts out work to a parent, affiliated provider or an entity that helped create it, does the new entity provide any functions that are of value to the settlement process?
8. If the new entity outsources work to another party, is the party performing any contracted services receiving a payment for services or facilities provided that bears a reasonable relationship to the value of the services or goods received? Or is the contractor providing services or goods at a charge such that the new entity is receiving a "thing of value" for referring settlement services business to the party performing the service?
9. Is the new entity actively competing in the marketplace for business? Does the new entity receive or attempt to obtain business from settlement service providers other than one of the settlement service providers that created the new entity?
10. Is the new entity sending business exclusively to one of the settlement service providers that created it (such as the title application for a title policy to a title insurance underwriter or a loan package to a lender)? Or does the new entity send business to a number of entities, which may include one of the providers that created it?

While the response to any one item may not be determinative, responses to these questions overall will help HUD determine whether an entity meets the conditions of the CBA exception to Section 8 or whether it is, in essence, a sham joint venture. HUD will also look at the investment of the principals of the new venture to determine if a true investment has occurred. For example:

1. Has each owner or participant in the new entity made an investment of its own capital, as compared to a "loan" from an entity that receives the benefits of referrals?
2. Have the owners or participants of the new entity received an ownership or participant's interest based on a fair-value contribution? Or is it based on the expected referrals to be provided by the referring owner or participant to a particular cell or division within the entity?
3. Are the dividends, partnership distributions, or other payments made in proportion to the ownership interest (proportional to the investment in the entity as a whole)? Or does the payment vary to reflect the amount of business referred to the new entity or a unit of the new entity?
4. Are the ownership interests in the new entity free from tie-ins to referrals of business? Or have there been adjustments to the ownership interests in the new entity based on the amount of business referred?

If an entity fails to meet the conditions for a valid CBA, any payments given or accepted in and the participants to the arrangement will be subject to scrutiny under RESPA Section 8, violation of which may trigger financial penalties as well as imprisonment. Section 8 violations may also result in litigation initiated by individual and civil class-action plaintiffs.

Unlike the revised CBA disclosure form, HUD's position on sham joint ventures is now in effect. It is imperative that all controlled business arrangements be reviewed immediately and carefully to ensure their compliance with these Section 8 criteria.

Computerized loan origination systems

Under the final rule, the computerized loan origination exemption will be deleted from Regulation X. The CLO disclosure will also be eliminated. (These effective October 7, 1996.)

However, in a second Statement of Policy, HUD confirmed that consumers may continue to be charged for CLO services after Oct. 7, 1996. These charges must continue to be identified on Good Faith Estimates and HUD-1 (or 1-A) Settlement Statements. CLO payments may be made at loan closing or earlier.

HUD's Statement of Policy also provides that organizations wishing to be listed on a CLO system may pay for that listing opportunity. However, a CLO operator may not steer consumers to particular companies from among the CLO's list of lenders in return for those otherwise similarly situated companies paying the CLO operator higher or different fees. Also, similarly situated organizations listed on the CLO system must be presented in a neutral manner. Failure to do so will raise the suspicion that those receiving superior display are receiving that benefit in return for an improper referral fee.

HUD cautions lenders that if a controlled business arrangement exists within a CLO, the controlled business arrangement requirements of Regulation X will still apply.

Rental arrangements and lender lock-out

In yet a third Statement of Policy, HUD clarifies the application of RESPA Section 8 to settlement service providers wishing to rent space from other settlement service providers (e.g., a mortgage company wishing to rent space from a real estate office).

Unchanged is HUD's requirement that the rental rate be at fair market. The value of referrals from one organization to the other may not be considered in calculating the rent.

HUD construes fair-market value to be the rental rate that a non-settlement service provider would pay for the same amount of space and services in the same or comparable building. HUD views rental arrangements in which the rent is based on a market rate among settlement service providers, as opposed to a general market value for that space, as prohibited under RESPA. Therefore, the fact that a real estate agent might pay an amount in excess of otherwise fair-market square footage for space in a real estate office is irrelevant in determining the rent for a mortgage company renting space in that realty office. That space must be rented to a mortgage company or other settlement service provider at the general fair market rate of a given location.

HUD also states that RESPA does not address lender lock-outs or retaliation. Therefore, lenders seeking redress against real estate brokers and other parties which systematically impede free market access to customers and/or retaliate against employees for sending business to unaffiliated service providers must look to law other than RESPA to bring their claims (e.g., state consumer protection, real estate licensing, anti-trust, or other laws).