Virginia Real Estate Settlement Services

Secret storm: Congress battles White House over reform of rulemaking process
In January, the president quietly issued a new executive order that set out new rules for how federal agencies like HUD could proceed with regulatory reforms and issue guidance. Now, many months later, political debate about the true implications of the new executive order is just starting to heat up. Read on to learn why Congress is concerned about OMB’s growing control over the rulemaking process, what they are doing about it now and what the power play on Capitol Hill could mean for RESPA reform.

In the early dawn of 2007, President George W. Bush quietly issued a new executive order that set out new rules for how federal agencies like HUD could proceed with regulatory reforms and issue informal guidance.

Executive Order (E.O.) 13422 made new amendments to E.O. 12866 on Regulatory Planning and Review. As RESPA reform watchers might recall, it was under the aegis of E.O. 12866 that the OMB held nearly 20 meetings with industry members in 2004 to discuss the issues that were then on the table.

In January, government watchdog groups and policy officials said that the newest executive order made the biggest changes to the regulatory process yet. For details on that, see: “New Bush policy changes rulebook for RESPA reform, guidance.”

Now, many months later, political debate about the true implications of the new executive order is just starting to heat up.

GAO to investigate rulemaking process

E.O. 13422 officially took effect on July 24, just one week after Rep. Henry Waxman, chairman of the House Committee on Oversight and Government Reform, sent a letter to the Government Accountability Office (GAO) asking that it take a fresh look at the federal regulatory process, which Waxman observed has “grown increasingly complicated as congressional and presidential directives have expanded procedural and analytical requirements for rulemakings.”

Waxman asked the GAO to “examine how these requirements are affecting the agencies’ ability to issue timely and effective rules,” emphasizing that “it would be problematic if the numerous layers of analysis and review were playing a role in delaying and weakening agency rules.”

Waxman also asked that the GAO look at how agency interactions with the OMB’s Office of Information and Regulatory Affairs (OIRA) may contribute to delays.

In a 2003 report, GAO found OIRA was taking a more active role in agency rulemakings, acting more as a “gatekeeper” than a “counselor.” GAO noted that OIRA is increasingly conducting informal reviews of draft rules before the rules are formally submitted and said these reviews can have a “substantial effect on the agencies’ regulatory analysis and the substance of the rules.”

Waxman expressed concern about the transparency of OIRA’s informal review process, noting that “OMB could hold up a rule for months in an informal review but appear to approve the rule quickly during the formal review process.”

Waxman asked GAO to examine, among other things, which analytical and procedural requirements an agency must comply with in order to issue a major rule; how long it takes agencies to issue rules and how it compares to the length of time it takes independent agencies such as the SEC; what the cumulative impact of the required analyses and review on the length of time it takes for an agency to finalize a new rule is; how recent changes have affected the rulemaking process; and how agency interactions with OIRA help or hurt the rulemaking process.

Naturally, the results of such a review could be quite relevant to the real estate industry, which has been dragged through the federal rulemaking morass for years on the caboose of HUD’s RESPA reform train.

The regulatory superpower

Earlier this year, the House Science and Technology Subcommittee on Investigations and Oversight held two hearings on E.O. 13422, questioning whether it was “good governance or regulatory usurpation.”

In a charter released following those hearings, the subcommittee noted that, for the first time, the order requires agencies to identify in writing the “specific market failure or problem” that warrants a proposed regulation or guidance; that a Presidential appointee in each agency be designated as regulatory policy officer (RPO) and that the RPO approve each regulatory undertaking by the agency.

The subcommittee also examined the role of OIRA, noting that it “has quietly grown into the most powerful regulatory agency in Washington.”

According to the subcommittee, “The cumulative effect of OIRA’s behavior since 2001 has been to intimidate agencies into running away from pursuing their statutory responsibilities rather than get caught up in the political struggles associated with moving regulation forward. Supporters of this approach are happy to see some office moving to slow agency actions and argue that the net result of OIRA’s actions is a more defensible regulation at the end of the day.”

Regarding E.O. 13422, the subcommittee observed, “OIRA is putting in place an economic criteria — market failure — for regulation and guidance that may have nothing to do with the values established in statute. This effort is coming with no consultation or input from Congress.”

The subcommittee also expressed concern about the appointment of RPOs for each agency, particularly in cases where agencies name their general counsel as RPO. “Will the general counsel make a claim of attorney-client privilege in response to FOIA requests (and even Congressional requests) related to any work on a proposed regulatory action?” the subcommittee wondered.

On HUD’s Couch

This could prove to be a concern for the real estate industry, as HUD has now named its general counsel, Robert Couch, as its RPO. Couch took the seat left warm by former general counsel Keith Gottfried, whose energetic suggestions for improved RESPA guidance won him many friends in the real estate industry during his brief tenure.

However, all indications thus far show that Couch has been open about meeting with industry leaders and addressing their concerns. Indeed, Couch invited the National Association of Realtors to submit a list of RESPA questions for him to pursue with HUD’s RESPA office in the interest of obtaining some clearer answers. In this way, Couch has shown signs of carrying on at least the spirit of the Gottfried guidance initiatives, if not the substance of the draft proposals.

This openness is especially important now that E.O. 13422 has hampered the agencies’ ability to provide official guidance documents in lieu of a full-blown rulemaking.

Under the amendment, each agency is to provide OIRA with advance notice of all proposed significant guidance documents. If OIRA chooses to hold up any guidance documents for review, there is no time limit on how long it could delay their release.

“The impact on agency conduct may be very, very significant and could potentially sweep up thousands of such proposals each year,” the House subcommittee said.

Wanted: Guidance — dead or alive

For an agency like HUD that was already fighting suggestions that it provide more guidance, adding new regulatory hoops to jump through seems like the kiss of death for progress on that front. (Notably, HUD mentioned a proposal titled “Access to Compliance Guidance” in its most recent semi-annual regulatory agenda, slating its release for April, but April has come and gone without a peep from HUD on the proposal.)

The House subcommittee concluded its remarks by noting that the reemergence of OIRA as a “gatekeeper” suggests that E.O. 13422 “will be used very aggressively to stall agency action,” which, they said, poses a concern for legislators.

“Should Congress passively accept an executive order that, just as an example, places presidential appointees in a position where they can arbitrarily block career agency officials from carrying out the purposes of the law Congress charged them with?” the subcommittee asked. “This new executive order invites Congress as a body, and the many, many committees that are affected, to undertake a vigorous and thorough review of the changes in [OIRA] since 2001.”

Lawmakers play their cards

Subcommittee Chairman Brad Miller (D-NC) is said to be “actively considering” offering legislative language that will enhance the transparency of the actions by RPOs. In the interim, Miller introduced an amendment to prohibit OMB from using funds appropriated in this year’s Financial Services Appropriations Act to implement E.O. 13422.

The House voted to approve the amendment on June 27, during a markup hearing on the appropriations bill. However, the Senate did not include a similar provision in its markup hearing on the appropriations bill in early July.

In the interest of easing regulatory burdens, the House has also approved legislation that would expand the ability of the Small Business Administration (SBA) to aid small businesses in complying with federal and state regulations.

The “SBA Entrepreneurial Development Programs Act of 2007” would give new responsibilities to existing regional Small Business Development Centers (SBDCs) to provide small businesses with regulatory compliance advice. SBDCs would provide free training and educational services and free “in-depth counseling” to small business owners and operators. The bill would also expand online sharing of regulatory compliance assistance information.

The objective of the bill is to reduce or eliminate the burden imposed on small businesses by those regulations SBA identifies. The bill would also raise the profile of those regulations and subject them to greater scrutiny by the White House and lawmakers. It is currently pending in the Senate.

The best/worst is yet to come

It is still just as unclear as it was January what the true impact of the new executive order will be. A Congressional Research Service report on E.O. 13422 stated, “The ultimate impact of these changes to the regulatory review process … will likely depend on how the changes are implemented by OIRA and the agencies.”

In terms of RESPA reform, HUD has already made it clear that the new proposed rule will be vetted through OMB and possibly Congress before it is released to the public, meaning that the new regulatory review guidelines and enhanced authority given to OIRA could delay the rule even more. On the other hand, as RESPA reform has long been a priority of the Bush Administration it doesn’t seem likely that it would attempt to impede the progress of its own initiatives.

But if Congress does embroil the White House in a power play over control of the regulatory process, who knows what havoc that could wreak on the advancement of pending proposals.

As for when the rule will be out, all current signs still point to an end of the year release.

On June 26, 2002 Housing and Urban Development Secretary Mel Martinez announced a proposal to reform the regulatory requirements under the Real Estate Settlement Procedures Act (RESPA) to simplify the home buying process by requiring greater disclosure, allow consumers more choice, limit excessive settlement fees and encourage innovation and competition in the marketplace. The proposed RESPA rule was founded on a set of consumer-driven principles mandating that homebuyers have the right:

To receive settlement cost information early in the process, allowing them to shop for the mortgage product and settlement services that best meet their needs;
To have the disclosed costs be as firm as possible, thereby avoiding surprises at settlement;
To benefit from new products, competition and technological innovations that could lower settlement costs;
To have access to better borrower education and simplified disclosure; and,
To know they are protected through vigorous RESPA enforcement and a level playing field for all industry providers.
To meet these principles, HUD planned to reform the home buying process by:

Changing the way lender payments to brokers are recorded and reported to consumers;
Significantly improving HUD’s Good Faith Estimate settlement cost disclosure; and,
Removing regulatory barriers to allow market forces and increased competition to promote greater choice for consumers by allowing guaranteed packages or “bundling” of settlement services and mortgage loans.
Mortgage Broker and Lender Fees
HUD’s proposal aimed to create a more “transparent” settlement process to facilitate consumers’ understanding of the true costs of their mortgage. The rule changed the way lender payments to mortgage brokers - yield spread premiums - were recorded and reported to consumers. Martinez wanted brokers to inform consumers about what they charge and how lender payments can help lower settlement costs. The RESPA reform rule mandated these payments be clearly disclosed so consumers could make the best financing choice.

More Choice Through Enhanced Disclosure
The proposal promoted greater choice for the homebuyer in shopping for lower-cost mortgages and settlement services. It aimed to improve HUD’s Good Faith Estimate (GFE) settlement cost disclosure to make it firmer so consumers could use it to shop for the best deals.

Removing Regulatory Barriers
In 1974, RESPA was passed into law to keep settlement costs down by targeting illegal unearned fees, splits of fees, referral fees and kickbacks. Over the years, however, RESPA rules have impeded the offering of guaranteed packages of settlement services and mortgages that could lower costs and enable consumers to more easily shop for mortgages. The proposal would have removed regulatory barriers to allow guaranteed mortgage loan packages for consumers to shop for their mortgages.

Read HUD’s Complete 2002 Proposed RESPA Rule

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Withdrawal of the rule
In March 2004, the new HUD Secretary Alphonso Jackson announced that the Department was withdrawing the reform rule due to the number of concerns from real estate industry and consumer groups. “There are many groups concerned that they have not had a chance to see the changes that have been made to the rule since it was proposed two years ago. They deserve to see those changes,” he said on March 22, 2004. Although no specific timetable was given, Jackson said the Department planned to review the comments and confer with Congress as well as various industry and consumer groups before then refining and reproposing another rule for comment.

Concerns from the Office of Management and Budget
In a letter to Secretary Jackson after the rule was withdrawn, John Graham, administrator, Office of Information and Regulatory Affairs for the Office of Management and Budget, identified several issues the OMB is concerned with regard to the RESPA rule: “HUD has improved the Good Faith Estimate (GFE) forms, but a recent study by the Federal Trade Commission (FTC) based on early drafts of the forms, concluded that the forms could produce unintended consequences. We understand that HUD undertook additional consumer testing as a result of the FTC findings. OMB urges HUD to ensure that the final forms enhance consumer comprehension without creating biases in consumer reaction to the disclosure of the yield spread premiums.”

RESPA Reform: Round Two
On June 27, 2005, HUD announced their plan to hold six roundtables to discuss with the industry what provisions a new RESPA reform rule should contain. Those roundtables were held across the country in July and August, and HUD ended up holding a seventh roundtable just to ensure that everyone’s voices were heard. Since then, HUD has been very vocal about their plans to issue a new RESPA reform rule, but have not yet given an indication as to when that might happen.

The Bush Administration has quietly issued a new executive order that could have serious implications for RESPA reform. The already-controversial order sets out new rules for how federal agencies like HUD can proceed with regulatory reforms and issue informal guidance. But how will the new regulatory playbook affect the RESPA rulemaking process and what will it mean for HUD’s fledgling guidance proposal? Read on.

On Jan. 18, 2007, President George W. Bush issued Executive Order (E.O.) 13422, making new amendments to E.O. 12866 on Regulatory Planning and Review. On the same day, the Office of Management and Budget (OMB) released a memorandum to the heads of executive departments and agencies announcing the issuance of the OMB’s “Final Bulletin for Agency Good Guidance Practices.”

E.O. 12866 was first issued by the Clinton Administration in 1993, and was further amended in February 2002. As RESPA reform watchers might recall, it was under the aegis of E.O. 12866 that the OMB held nearly 20 meetings with industry members in 2004 to discuss the reform issues that were then on the table.

Government watchdog groups and policy officials are saying that this most recent amendment makes the biggest changes to the regulatory process yet.

Outline of the changes

E.O. 13422 requires federal agencies to identify the specific market failure the proposed regulation is intended to address before issuing it, as well as obtain the approval of the agency’s Regulatory Policy Office. It also requires agencies to assess the combined aggregate costs and benefits of all the regulations they plan to issue in a year. More specifically, the amendments:

Shift the criterion for promulgating regulations to the identification of “the specific market failure that warrants new agency action.”
Require guidance documents to go through the same OMB review process as proposed regulations before agencies can issue them.
Requrire “significant” guidance documents (those that are estimated to have at least a $100 million effect on the economy, among other criteria) to go through the same OMB review process as “significant” regulations.
Make the agencies’ Regulatory Policy Officer a presidential appointee and give that person the approval authority for any commencement or inclusion of any rulemaking in the Regulatory Plan unless specifically authorized by the agency head.
Require each agency to estimate the “combined aggregate costs and benefits of all its regulations planned for that calendar year to assist with the identification of priorities,” which will be overseen by the Regulatory Policy Officer.
Reasons why

In explaining the reasoning behind the changes to agency guidance practices, Rob Portman, director of the OMB, said, “The OMB has been particularly concerned that agency guidance practices should be more transparent, consistent and accountable. …Guidance documents, used properly, can channel the discretion of agency employees, increase efficiency, and enhance fairness by providing the public clear notice of the line between permissible and impermissible conduct while ensuring equal treatment of similarly situated parties.

“Experience has shown, however, that guidance documents also may be poorly designed or improperly implemented,” Portman continued. “At the same time, guidance documents may not receive the benefit of careful consideration accorded under the procedures for regulatory development and review.”

Portman said that poorly designed or misused guidance documents can “impose significant costs or limit the freedom of the public,” and that it is in this interest of preventing these consequences that the OMB is issuing the new restrictions.

Business interests vs. consumer interests

The impact that these amendments will have on the mortgage industry is still undetermined, but initial analysis indicates that it could be a double-edged sword. Public interest and business groups appear to have already drawn a line in the sand, taking opposing views of whether the amendments will help or hurt the nation.

According to Rick Melberth, director of Regulatory Policy at OMB Watch, a government watchdog group, “The revised Executive Order that results from these amendments is a further threat to public protections from an administration committed to elevating special interests over public interests. It substitutes executive authority for legislative authority.”

OMB Watch added, “This new standard decidedly favors the regulated community and places yet another hurdle for agencies to issue regulations in pursuit of protecting the public.”

Public Citizen, a consumer group, also criticized the order, saying that requiring the agencies to get White House approval of important public guidance will create a “bureaucratic bottleneck” that will slow down agencies’ ability to give the public information it needs.

“By requiring White House approval of important guidance, the White House will insert its political agenda and pro-business bias into every level of agency policy, so that our federal government will handcuff itself instead of the companies that violate the law and put the public in danger,” said Robert Shull, Public Citizen’s deputy director for regulatory policy.

Rep. Henry A. Waxman, Chair of the House Committee on Oversight and Government Reform, told the New York Times that the order was “great news for special interests,” in that it allows the White House to dictate decisions even if the government’s own experts disagree.

Taking the business side, the U.S. Chamber of Commerce applauded the order, saying it will help tame an “out-of-control regulatory system that costs the American public $1 trillion annually.”

“President Bush’s amendment is a paragon of common sense and good governance,” said William Kovacs, the Chamber’s vice president of Environment, Energy and Regulatory Affairs. “It’s the first truly significant attempt by an administration to hold federal bureaucrats to account and insist they act with discretion when imposing new and expensive burdens on businesses and consumers.

“Regulations play an important role in ensuring the safety of our citizens and guarding against corporate abuses, which is why it’s so important that we have a well-functioning, rational rulemaking process,” said Kovacs. “That’s not what we have today, and this amendment will go a long way toward fixing it.”

Impact on RESPA reform

So what does this mean for RESPA reform?

On the one hand, if the White House takes greater control of the rulemaking process at HUD, it could increase the chances of them pushing through a reform proposal, as many government officials have stated that it is a priority for the Bush Administration to enact meaningful RESPA reform before the president leaves office.

But Marc Savitt, vice president of the National Association of Mortgage Brokers, doesn’t think the amendments will change anything where RESPA reform is concerned.

Savitt is familiar with the requirements of E.O. 12866, having testified about it in 2004 during the first round of RESPA reform.

Savitt said, “I don’t see where the process in this case is going to be any different. First of all, it’s always been known one of the president’s priorities was for meaningful RESPA reform. The previous secretary of HUD, Mel Martinez, was working toward that goal. When Secretary Jackson took over, he saw that there were some technical difficulties with it and things that needed to be changed, but still saw that it was a priority of the president. Of course, there have been a lot of things that have come up that have diverted their attention, such as Hurricane Katrina and Rita and so forth. I think they’re still working on it and I think we’ll probably see something, but I don’t think [the amendments] will really change anything where RESPA reform is concerned. I still think that HUD is committed to some type of reform, maybe not what they originally had in mind, but some type of reform before the president leaves office.”

Savitt added, “HUD has put a lot of time and energy in RESPA reform and of course, whatever they do still has to go to OMB. Secretary Jackson also said that prior to releasing any proposal for RESPA reform, he would consult with Congress first, and to the best of my knowledge he hasn’t done that. I really don’t think that as far as RESPA reform is concerned we’re going to see much of a change — whatever they were going to do they’re still going to do.”

The guidance killer?

But even if the amendments don’t materially affect the RESPA reform process, they could mean certain death for the guidance initiatives former HUD General Counsel Keith Gottfried proposed, that appeared on HUD’s most recent regulatory agenda as being slated for an April 2007 release.

Already, concerns had surfaced about HUD’s level of commitment to the idea and how the department could logistically handle the sheer volume of requests for guidance that would undoubtedly flow in. As the new executive order appears to impose even greater restrictions on agencies issuing guidance documents, it could provide HUD with enough reason to shelve the proposal entirely.

Indeed, as OMB Watch said, “By requiring agency guidance documents to come under OIRA review, and to treat ‘significant’ guidance in the same way as ‘significant’ regulations, the E.O. amendments will lead to further delay in providing information to the public about compliance with regulations, as well as with general guidance on agency policies.”

RESPA reinvented

But with all of the hassling and confusion over RESPA reform and guidance policies, some say that a more dramatic overhaul of the RESPA rule is in order. What if the government decided to not just reinterpret or further amend the old rule, but to rewrite the entire thing, instead? RESPAnews has learned that there may already be some movement in that direction. Is it possible that the industry could see RESPA reinvented instead of just reformed?

Issue Date: RESPA News Monthly July 2007, Posted On: 7/26/2007
Mortgage

The new “Fair Mortgage Practices Act” being championed by House Financial Services Committee Ranking Member Spencer Bachus and cosponsors Reps. Paul Gillmor and Deborah Pryce contains, among many other things, a recommendation for a simplified mortgage disclosure form.

Introduced on July 12, the bill is the culmination of a 16-month effort to achieve a bipartisan solution to concerns about unfair practices within the subprime lending industry.

Notably, the bill is asking that $20 million be appropriated for FY 2008-2012 to the U.S. Attorney General “for the purpose of enhancing the efforts of the Department of Justice and the Federal Bureau of Investigation to prevent, investigate and prosecute mortgage fraud.”

The bill also contains a provision to amend Chapter 2 of the Truth in Lending Act (TILA) by inserting a new section on the “disclosure requirements required for all consumer credit plans secured by the consumer’s principal dwelling.”

First, a “Simplified Disclosure of Basic Mortgage Facts” would be required, the contents of which would include a statement of mortgage facts, that would be a single page, written disclosure regarding the mortgage with the heading, “Your Basic Mortgage Facts.” This disclosure would set forth:

the amount of the principal obligation under the mortgage;
the loan-to-value ratio for the mortgage;
the final maturity date for the mortgage;
the amount and due date for any balloon payment under the mortgage;
the amount of any prepayment fee to be charged if the mortgage is paid in full before the final maturity date for the mortgage;
the initial interest rate under the mortgage expressed as an annual percentage rate, and the amount of the monthly payment due under such rate;
the duration during which such initial interest rate will be charged;
the fully indexed rate of interest under the mortgage expressed as an annual percentage rate and the amount of the monthly payment due under such rate;
the maximum possible rate of interest under the mortgage expressed as an annual percentage rate and the amount of the monthly payment due under such rate;
the monthly household income of the mortgagor upon which the mortgage is based;
the amount of initial monthly payment due under the mortgage, and the amount of such initial monthly payment plus monthly amounts due for taxes and insurance on the property subject to the mortgage, both expressed as a percentage of the monthly household income of the mortgagor;
the amount of the fully indexed monthly payment due under the mortgage, and the amount of such fully indexed monthly payment plus monthly amounts due for taxes and insurance on the property subject to the mortgage, both expressed as a percentage of the monthly household income of the mortgagor;
the amount of any points to be paid by the mortgagor under the mortgage and the aggregate amount of any other closing costs in connection with the mortgage;
the amount of any late payment fees and a brief description of the consequences of making any payment late or defaulting on the mortgage, including foreclosure;
a name, telephone number, and electronic mail address that may be used by the mortgagor to obtain information regarding the mortgage;
an authorized signature of the originator of the mortgage;
a blank space for the signature of the borrower; and
immediately above such blank space, a conspicuous statement in bold typeface, in all capital letters, in a font at least equal in size to the largest font otherwise used in the disclosure, as follows: “DO NOT SIGN THIS IF YOU DON’T UNDERSTAND IT!”
The document would also include a two-page written disclosure that set forth basic easy-to-understand definitions or explanations, for purposes of residential mortgages, for all of the following terms: appraised value, types of loans, initial interest rate, fully indexed rate of interest, maximum possible rate of interest, monthly household income, monthly mortgage payment including taxes and insurance, fully indexed housing expense ratio, prepayment fee, balloon payment, payment option loan, points, closing costs, and default and foreclosure.

The provisions of this section relating to the disclosure of basic mortgage facts would supersede the provisions of the law of any state relating to the disclosure of such facts.

Aside from the provisions detailed above, the bill also includes the following new or enhanced consumer protections:

Creates a national registration and licensing standard for mortgage originators to enhance accountability and professionalism within the industry;
Encourages financial institutions to evaluate a borrower’s ability to repay a mortgage loan before extending credit;
Increases support for housing counseling;
Restricts prepayment penalties on Hybrid ARMs including 2/28s and 3/27s.
Requires that subprime mortgages have escrow accounts for taxes and insurance at the time the loan is consummated;
Strengthens enforcement against mortgage fraud schemes; and
Improves the integrity of appraisals.

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.