Virginia Real Estate Settlement Services

Source of Business

Is the new entity actively competing in the market place 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? Is the joint venture seeking referrals from sources other than the owners? No specific percentage of outside business is required under the HUD Statement of Policy on sham affiliated business arrangements. However, several HUD settlements with sham affiliated businesses require the offending joint venture to generate 30% of its business from sources other than the owners of the affiliated business. As a practical matter, the parent businesses understand their needs better than businesses competing with their joint venture. A title agency owned by a mortgage lender understands exactly what a lender needs and expects from a title agency, and can more effectively market to and serve other lenders than its competition. Marketing the joint venture’s services to companies similar to the owners can turn the joint venture into a goose that lays golden eggs.

On balance, a joint venture must be a living, breathing business that operates in competition with similar businesses. Managed appropriately, a joint venture should be more successful that its competition. A joint venture that lives on life support provided by its owners, and which cannot survive in the “real world,” is suspect.

Services Provided by the Joint Venture

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?

(a) Does the new entity perform all of the substantial services itself? Or does it contract out part of the work? If so, how much of the work is contracted out? Will the joint venture provide all of the services that a similar business provides? If the joint venture is a title agency, will the joint venture close loans? If the joint venture is a real estate broker, will it broker commercial and residential properties?

(b) If the new entity contracts out 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? Will the joint venture use third party vendors for settlement services, or is the joint venture locked into exclusive contracts (e.g. for flood certification and tax services) with vendors serving one of the owners?

(c) If the new entity contracts out 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 service business to the party performing the service?

Will the joint venture receive market rates for services it renders to an owner?
If a transaction does not close, will the joint venture receive a fee for services rendered? For example, if a joint venture appraisal company is only paid a fee when the loan closes, and receives no fee when the loan does not close, is the waived fee a thing of value for the referral of future business?
How are title insurance premiums, closing agent fees, and mortgage broker fees split between a joint venture and a parent organization? Title agencies must provide all “core title services” to earn the insurance premium. Core title services include, at a minimum, the evaluation of the title search to determine insurability of the title, the issuance of the title commitment, clearance of underwriting objections, and actual issuance of the title policy on behalf of the underwriter. Similarly, mortgage brokers must take an application for a loan and provide at least five of fourteen brokerage services to earn a fee. If some of the functions designated as “core title services” are performed by one of the members (e.g., evaluation of the title search) how will the premium for the title insurance policy be split between the agency and the member for performing core title services? If a joint venture mortgage brokerage takes an application, and allows the owners to provide all processing functions, what basis does the borrower or the lender have to pay the joint venture broker a fee? Finally, if the parent organization handles the “escrow” portion of the transaction, how can the closing agent fee be split with the joint venture?
If you split the services and income generated from each transaction between the joint venture and a parent organization, how is the joint venture expected to earn a profit and pay dividends to its members?
(d) 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? If the joint venture is a title agency, will the joint venture contract exclusively with an underwriter member to issue title policies, and will the agency agreement with the underwriter/member be the same agency agreement offered to independent title agencies (e.g. is the insurance premium split between the affiliated agency and the underwriter the same split offered to an independent start up title agency)? If the joint venture is a mortgage broker business, will the joint venture broker loans to many lenders, or only broker loans to a lender that is an owner? Will the owner/lender offer the same yield spread premium to the joint venture that it offers to other mortgage brokers? If the joint venture is a real estate brokerage, will it have a franchise relationship with the same franchisor as one of the owners, or will it consider a franchise from another national real estate broker chain?

Facilities, Equipment, Vendors, and Management

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?

(a) Does the joint venture have separate equipment (e.g. phones and computers) for providing services to borrowers and lenders? Remember that any business violates Section 8(a) of RESPA if it provides a benefit directly or indirectly related to the referral of business, even if that benefit goes to a joint venture.

(b) Will the joint venture obtain search information, office equipment, software, insurance, or other similar services from one or both members, or from independent vendors? For example, will a joint venture title agency obtain some title search information and obtain some notary services from vendors other than one of the members? Will the joint venture have its own insurance policy, or is it under the umbrella policy of one of the owners?

(c) Are operational costs for facilities and services provided to the joint venture by a parent company allocated based on market rates for goods and services, or is the joint venture charged a percentage of income for these services?

Employees
Is the new entity staffed with its own employees to perform the services it provides? Or does the new entity have “loaned” employees of one of the parent providers? Will employees be “leased” from one of the owner’s businesses, or is the joint venture using the services of an independent professional employer organization as is customary for controlling benefit costs and taxes?
Does the new entity manage its own business affairs? Or is an entity that helped create the new entity running the new entity for the parent provider making the referrals? Will the entity be managed by an independent manager or by its members? The more the owners run the show, the more it will appear that the owners are doing all the work and few services are provided by the joint venture.
A joint venture must provide services to earn fees that can be distributed to the owners as profits. Remember that a legitimate affiliated business arrangement must be an operating business that provides substantive services. If insufficient funds are provided at startup, the owners are more likely to provide these services, and the joint venture will be a sham. If a joint venture has no employees, who is performing services, and how can the joint venture legitimately earn fees?

HUD’s 1996-2 Statement of Policy regarding sham affiliated business arrangements gave us two lists of principles to live by. These principles are posed as questions, but the answers should be fairly obvious. These are not hard and fast rules. There is no bright line test of how many of these principles must be adhered to, or which of these principles are mandatory. HUD simply stated that it “will weigh them in light of the specific facts” without giving any further guidance on how much weight each principle deserves or which facts HUD considers. On balance, an affiliated business arrangement must comply with the better part of these principles.
These principles fall into five general topics (HUD’s principles are in italics, supplemented by my concerns):
Capital
Does the new entity have 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? Regarding capital contributed by the owners, HUD asked further:
(a) 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? Is the joint venture being funded with capital or with loans, are the loans from the owners, and is the ratio of capital to borrowings typical of a start-up business in the industry? Remember that the owners may earn a profit based on the percentage ownership interest. Ownership interests are created by capital contributions. A joint venture that has little capital may appear to be a sham if the loans made by the owners to the joint venture do not correspond to the percentage ownership. For example, a joint venture that is 90% owned by the referral source, but funded by large loan from the 10% referral source, might be viewed as a sham arrangement to increase distributions to the referral source if the loan was made at a favorable rate. Similarly, a joint venture that accepts a loan from a referral source at a high interest rate may improperly allow the referral source to strip income from the joint venture to reward referrals.
(b) 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?
(c) 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?
(d) Are the ownership interests in the new entity free from tie-ins to referrals of business? Or have there been any adjustments to the ownership interests in the new entity based on the amount of business referred? Are percentage interests, returns of capital, distributions of profits, and other benefits provided to each member reflective of or based upon the amount of business referred to the joint venture? Is there any opportunity to adjust the ownership interest of one member based upon the number of referrals made to the joint venture?

Early discussions with HUD officials and mortgage banking law experts revealed that providing an Affiliated Business Arrangement Disclosure at the time of a referral is a matter of preparation and practicality. The rule does not mandate that a mortgage company owner must keep a stack of Affiliated Business Arrangement Disclosures in his or her back pocket at a cocktail party on the chance that he or she will make a referral to an affiliated title agency. The Affiliated Business Arrangement Disclosure must be provided by persons who consider referrals to be part of their job or who regularly make referrals to an affiliated business. A chance referral by a silent owner who rarely makes referrals does not require that the disclosure must be provided at the time of the referral. Section 15 of HUD’s Regulation X states:
“Failure to comply with the disclosure requirements of this section may be overcome if the person making a referral can prove by a preponderance of the evidence that procedures reasonably adopted to result in compliance with these conditions have been maintained and that any failure to comply with these conditions was unintentional and the result of a bona fide error.”
When this disclosure is not provided at the time of a chance referral, the consumer should receive an Affiliated Business Arrangement Disclosure before selecting the affiliated business to provide settlement services. Some lenders and other settlement service providers include the Affiliated Business Arrangement Disclosure in the closing package as a prophylactic measure.
When you closely examine what the rule says, you will realize that the rule does not explain how the affiliated business arrangement should operate. That is why settlement service providers were leery of using this exception until HUD offered better definitions and direction regarding affiliated business arrangements. The exception was better defined in the 1992 rewrite of Regulation X, and in HUD Statement of Policy 1996-2 regarding sham controlled business arrangements (later changed to “affiliated business arrangements”). This Statement of Policy asks a series of questions that provide guiding principles for establishing affiliated business arrangements and for maintaining relationships between the owners of the joint venture.

Employees and owners who refer consumers to an affiliated business must provide an Affiliated Business Arrangement Disclosure to the consumer at the time of the referral. Do not try to improve on the form of this disclosure or eliminate the empty Section B. Use the full form promulgated by HUD in Appendix D of Regulation X. Make sure that the relationship of the referring person or entity is fully disclosed (including percentage ownership), and that each service provided by the affiliated business is separately disclosed in Section A. Section B is only used if the lender is affiliated with an appraiser, credit reporting agency and/or an attorney to represent the lender’s interests. The mandatory acknowledgement at the bottom of this Disclosure must be signed by the consumer at the time of the referral or, if this is not possible, the consumer must sign the acknowledgement no later than at closing. The signed Affiliated Business Arrangement Disclosure, like most RESPA disclosures, must be retained for five years by the person or business making the referral.
Special rules apply when a law firm is making a referral to an affiliated title agency. The Affiliated Business Arrangement Disclosure should be provided at the time that the client engages the attorneys or the law firm. In attorney closing states, where it is common for the attorney to have an affiliated title agency, the Affiliated Business Arrangement Disclosure should be attached to and signed with the law firm engagement letter.

The affiliated business must be capitalized by contributions from each investor. A loan to the affiliated business is not a sufficient capital contribution. Most joint ventures are start up businesses. Buying into an existing business is expensive since the new owner would be required to pay market value for the ownership interest. Capitalization is usually not a significant hurdle for a start up business, unless minimum capital is required to obtain a license, or operating capital is necessary for a protracted start up period until income is generated.
An affiliated business relationship exists when a person or entity, or their associate or affiliate, owns more than 1% of a settlement service provider (or enters into a franchise arrangement), and is in a position to directly or indirectly refer business to the affiliated business, or to influence others to select that business to provide settlement services. An affiliated business relationship also exists when one person, or members of an immediate family, controls two businesses.
Examples of “control” include the right to (a) select a majority of the directors, (b) vote owner’s shares by proxy, or (3) elect family members as corporate officers of the two businesses. We might be tempted to say that you will know an affiliated business arrangement exists when you see one, but that is not true.
For example, one spouse working for a mortgage lender and the other spouse working for a title agency does not create an affiliation between the lender and title agency, unless the spouses control these businesses or they have an ownership interest. Similarly, a loan officer who works a second job on weekends as a real estate salesperson does not create an affiliated business relationship between the mortgage broker and real estate broker.
The owners, directors, officers, employees, and others associated with the affiliated businesses cannot require the use of the affiliated business. There is one exception. A lender can require the use of an affiliated appraiser, credit reporting agency and/or an attorney to represent the lender’s interests. This exception is rarely used, since the fees and premiums charged by any settlement service provider that is affiliated with the lender count toward federal and state high cost “point and fee” thresholds, even though these fees are not finance charges.

As Clear as Mud

Section 8(c) of RESPA provides a not so simple affiliated business arrangement exception to the prohibition against kickbacks found in Sections 8(a) and 8(b):

“Nothing in this section shall be construed as prohibiting…. affiliated business arrangements so long as (A) a disclosure is made of the existence of such an arrangement to the person being referred and, in connection with such referral, such person is provided a written estimate of the charge or range of charges generally made by the provider to which the person is referred (i) in the case of a face-to-face referral or a referral made in writing or by electronic media, at or before the time of the referral (and compliance with this requirement in such case may be evidenced by a notation in a written, electronic, or similar system of records maintained in the regular course of business); (ii) in the case of a referral made by telephone, within 3 business days after the referral by telephone,\1\ (and in such case an abbreviated verbal disclosure of the existence of the arrangement and the fact that a written disclosure will be provided within 3 business days shall be made to the person being referred during the telephone referral); or (iii) in the case of a referral by a lender (including a referral by a lender to an affiliated lender), at the time the estimates required under section 2604(c) of this title are provided (notwithstanding clause (i) or (ii)); and any required written receipt of such disclosure (without regard to the manner of the disclosure under clause (i), (ii), or (iii)) may be obtained at the closing or settlement (except that a person making a face-to-face referral who provides the written disclosure at or before the time of the referral shall attempt to obtain any required written receipt of such disclosure at such time and if the person being referred chooses not to acknowledge the receipt of the disclosure at that time, that fact shall be noted in the written, electronic, or similar system of records maintained in the regular course of business by the person making the referral), (B) such person is not required to use any particular provider of settlement services, and (C) the only thing of value that is received from the arrangement, other than the payments permitted under this subsection, is a return on the ownership interest or franchise relationship…”

Reading this provision several times in a row may make your head swim. However, the concept behind an affiliated business arrangement is simple. One or more persons or entities are entitled to receive a return on an investment in a business that they control. The principal prerequisite to establishing an affiliated business arrangement is to establish a business. The affiliated business (most people call them “joint ventures”) can be any type of legal business entity (partnership, limited partnership, limited liability company, corporation, etc.).

15. Affinity relationships under RESPA: Affiliated business arrangements
Affiliated business arrangements are discussed at the end of this series of columns for a reason. Affiliated business relationships should represent the culmination of an affinity relationship, and not the first step in an affinity relationship. Affiliated business arrangements are complex and challenging to set up properly. They are also, potentially, the most lucrative affinity relationship that a settlement service provider can establish.

One of the owners in an affiliated business relationship must have a steady stream of referrals, or be able to generate a steady stream of referrals, to make the affiliated business arrangement profitable. These next three columns will discuss the affiliated business exception to Section 8’s prohibition against kickbacks, the principles to live by when establishing an affiliated business arrangement, and practical tips for maintaining these relationships.