Form-of-the-Week:

Disclosure of a Conflict of Interest and Affiliated Business Arrangement — Forms 527 and 519/205

Professional relationships compromised

When a broker or their agent, acting on behalf of a client, has a competing professional or personal bias which might hinder their ability to fulfill the fiduciary duties they have undertaken by acting on behalf of the client, a conflict of interest arises.

In a professional relationship, a broker’s financial objective of soliciting and receiving compensation for services rendered as disclosed is not a conflict of interest. It is an exchange of known quantities — brokerage services and the receipt of an agreed fee or fees, regardless of the source of the fee(s) generated due to the client’s transaction.

Whether the broker or their agents represent a buyer or seller, the client is entitled to know the exact amount of all compensation the broker expects to or will receive arising out of any aspect of the employment relationship.

Thus, fees and benefits derived from other sources and arising out of the client’s transaction are to be disclosed to the client. These include expectation of fees or benefits in situations like:

  • professional courtesies such as referrals made by the broker or their agents;
  • familial favors due to direct or indirect involvement of a relative of the broker or any of their agents in the client’s transaction; and
  • preferential treatment having monetary value and given by others to the broker or agent. [See RPI Form 119]

In contrast to brokerage fees, a conflict of interest addresses a broker’s or agent’s personal relationships with others that are potentially at odds with the agency duty of care and protection owed the client. Thus, a conflict of interest creates a fundamental agency dilemma — it is not a matter of compensation or business referral income.

Editor’s note — The referral of a client to a financially controlled business owned or co-owned by the broker or others in their office is a financial benefit from a transaction disclosed by use of an affiliated business arrangement (ABA) disclosure. The affiliated business arrangement is discussed in greater detail later in the article. [See RPI Form 519 and 205]

Unless disclosed and the client has given their consent, an undisclosed conflict of interest is a breach of the broker’s fiduciary duty of good faith, fair dealing and trust owed to the client when the broker continues to act on the client’s behalf after the conflict of interest became known to the broker or their agent.

Related video:

Analyzing a Conflict of Interest

Conflicts abound in everyday brokerage situations

When a conflict of interest arises and becomes evident to a broker or agent, be it conspicuous or potential, they are to disclose it as soon as possible (ASAP) after the conflict arises.

Typically, the conflict arises when:

  • providing property information to a prospective buyer;
  • taking a listing from a seller;
  • commencing negotiations to enter into a transaction; or
  • assisting in the client’s performance for closing.

Disclosures of personal or client conflicts serve the public policy of creating transparency in the transaction, sufficient for the client to take the conflict of the broker’s bias into consideration in negotiations. The disclosure requires client consent. However, consent does not neutralize the inherent bias disclosed. What is eliminated by disclosure and consent is the element of deceit which, when left undisclosed, breaches a broker’s or agent’s fiduciary duty.

Potential overlaps of a broker or their agent’s allegiance or prejudice with other persons which the broker needs to disclose to the client include:

  • the broker or their agent holds a direct or indirect ownership interest in the real estate involved in the transaction;
  • the broker or their agent are directly or indirectly a buyer of the property in the transaction, including a partial ownership interest in a limited liability company (LLC) or other entity which owns or is buying, leasing, or lending on the property [Whitehead Gordon (1969) 2 CA3d 659];
  • an individual related to the broker or one of their agents by blood or marriage holds a direct or indirect ownership interest in the property or is the buyer [Sierra Pacific Industries Carter (1980) 104 CA3d 579];
  • an individual with whom the broker or a family member has a special pre-existing relationship, such as prior employment, significant past or present business dealings, or deep-rooted social ties, holds a direct or indirect ownership, leasehold, or security interest in the property or is the buyer;
  • the broker’s or their agent’s concurrent representation of the opposing participant, referred to as a dual agencysituation [See RPI Form 117]; or
  • the unwillingness of the broker or their agent to work with the opposing participant, or their brokers or agents in a transaction.

Simply, a conflict of interest arises and is disclosed to the client when a broker or their agents have a pre-existing relationship with another person that might hinder the licensee’s ability to fully represent the needs of their client, due to:

  • kinship;
  • employment;
  • partnership;
  • common club membership;
  • religious affiliation;
  • civic ties; or
  • any other socio-economic context.
To disclose or not to disclose?

Legislatively, comprehensive rules do not exist setting forth instances where a conflict of interest arises and needs to be disclosed. Thus, the courts are left to ferret out the relationships which need to be disclosed as conflicts that might, when known to the client, alter the client’s behavior with the broker or in negotiating or performing to close a transaction.

Thus, brokers and agents are left to draw their own conclusions when situations regarding a property or a transaction with or involving third-parties arise. In practice, brokers, and especially agents, all too often err on the side of nondisclosure, putting their fee and license at risk. [Calif. Business and Professions Code §10177(o)]

Generally, when a broker or agent even questions whether it is appropriate to disclose a potential conflict of interest to a client, the conflict ought to be disclosed as a matter of prudent practice.  By timely disclosing a potential conflict of interest and obtaining consent, the honestly-held working relationship with the client is reinforced.

Related reading:

Brokerage Reminder: Disclosing a conflict of interest – the counterpoint mitigating a bias

The client’s tardy discovery of the conflict and their complaint to the California Bureau of Real Estate (CalBRE) for failure to make the disclosure and obtain consent before continuing to advise or act on behalf of the client are grounds for the suspension or revocation of the broker’s or agent’s license by the CalBRE. [Bus & P C §10177(o)]

Editor’s note — A broker or agent selling or buying property for their own account acts solely as the seller or buyer. Their licensee status is not a conflict due to its existence since they are not holding themselves out as a licensed broker or agent acting on behalf of another person in the transaction. They are acting for their own account as a principal and thus are unable to also legally act as their own agent. [Robinson v. Murphy (1979) 96 CA3d 763]

However, when a licensed broker or agent receives a fee on the sale or purchase of their own property, they are holding themselves out as a transaction agent and now take on a general duty which becomes owed to the other participant. Thus, they become subject to real estate agency requirements which do not arise when the individual acts solely as a principal. Worse, taxes are incurred at ordinary income rates on the amount labeled a fee.

Preparing the Conflict of Interest Disclosure

The Conflict of Interest Disclosure — Kinship, Position or Undue Influence form published by Realty Publications, Inc. (RPI) is used by an agent or broker when a conflicting situation arises between the agent or broker and another principal or third-party to the transaction, to disclose relationships or positions held by the broker, their agents or family members which may appear to be in conflict with the agency duties owed the client. [See RPI Form 527]

The section of the form labeled “FACTS” is used to indicate:

  • which type of agreement this disclosure is made in connection with, such as an employment (listing) agreement, purchase agreement or escrow instructions [See RPI Form 527 1];
  • whether the disclosure is made on the same date as the previously referenced agreement, or when different, the date disclosure is being make and city where it is being prepared [See RPI Form 527 .1.1];
  • the names of the participants involved in the underlying transaction and what positions they hold under the agreement [See RPI Form 527 §1.2 – 1.3]; and
  • the address of the real estate involved. [See RPI Form 527 1.4]

The name(s) of the client(s) represented by the broker or agent making the disclosure with regard to the referenced agreement is noted at the end of the “FACTS” section. [See RPI Form 527 §2]

The body of the Conflict of Interest Disclosure is used to disclose to the broker’s client the specific relationships or positions held by the broker, their agents, family members, or business associates which present circumstances that might appear to be in conflict with the agency duty owned to the client. [See RPI Form 527 §3]

Such items which have the potential to create a conflict of interest include:

  • an ownership interest in the real estate held by the broker, their agents, their kin, or business associates [See RPI Form 527 3.1];
  • a position held in a government agency by the broker, their agents, their kin, or business associates [See RPI Form 527 3.2];
  • a business position held by the broker, their agents, their kin, or business associates [See RPI Form 527 3.3];
  • a business investment of the broker, their agents, their kin, or business associates [See RPI Form 527 3.4];
  • the broker’s or their agent’s representation of others in or servicing the transaction [See RPI Form 527 3.5];
  • kinship or employee relationships between the broker, their agents, their kin, or business associates which many conflict with the client’s objectives. [See RPI Form 527 3.6]

In each provision, space is provided to clarify the nature of the activity potentially creating a conflict, including the identifying information of the people, places or entities involved.

Direct or indirect compensation received by a broker needs to be disclosed, but is not a conflict of interest. The Compensation Disclosure in a Real Estate Transaction form is used to disclose the amount, its form and the source of compensation, and the benefits the broker and their agents anticipate receiving for any other service they provide or from any other individual, company, or provider as a result of a participant’s entry into a real estate transaction in which the broker is acting as a broker. [Bus & P C §10176(g); see RPI Form 119]

Similarly, when a broker listing a property or representing a buyer refers the owner or buyer to a business or service provider the broker owns or co-owns, an Affiliated Business Arrangement Disclosure Statement is used to inform the participant of their ownership interest in that company. The disclosure enables the broker to indirectly benefit from the referral.  In so doing, the broker properly shares in any operating profits from their referrals to businesses the broker controls. When properly disclosed, income resulting from these referrals is not a conflict of interest. [See RPI Form 205 and 519]

A profit to be taken, not a referral fee

In times of slowing real estate activity, enterprising residential brokers who list property or represent buyers generate additional income by diversifying their brokerage business by becoming full service brokers and referring buyers and sellers to lenders and service providers they own or co-own. These business relationships, called affiliated business arrangements or controlled business arrangements, properly enable the broker to indirectly benefit by sharing in any profits from the referrals they make to these controlled businesses. Of course, the controlled businesses need to actually perform all or significant aspects of the service provided and not simply function as an artifice, just a shell created to justify a fee.

However, when a consumer mortgage origination is involved in a transaction, a broker’s ability to profit from referrals is regulated by Section 8 of the federal Real Estate Settlement Procedures Act (RESPA).

RESPA was enacted to prohibit brokers and lenders from unnecessarily augmenting a buyer’s costs when negotiating a transaction involving the origination of a federally-related mortgage on a one-to-four unit residential property — meaning a consumer-purpose mortgage, not a business-purpose mortgage regardless of the type of real estate which is security. These augmented costs for buyers and sellers frequently take the form of illegal referral fees.

Referral fees are paid by service providers, which include brokers, for referring business to them so they can perform and be paid for their service rendered in connection with a real estate purchase agreement or escrow to close a sales transaction.

These service providers, essential to the close of a sale, include:

  • title and finance companies;
  • credit reporting agencies;
  • home inspection and pest control companies;
  • hazard insurers; and
  • escrow companies.

Related reading:

Affiliated business arrangements

A broker who receives a fee for negotiating the sale or purchase of a one-to-four residential unit which involves the origination of a mortgage which funds the purchase by a buyer-occupant may not receive a referral fee, and in the same transaction, also receive a brokerage fee on the sale.

However, the broker can still profit from referring a buyer or seller to a service provider when the broker is an owner or co-owner of the service provider recommended, creating an affiliated business arrangement.

For the broker to meet the conditions to profit from an affiliated business arrangement in a sales transaction funded by a consumer mortgage, they need to:

  • have an ownership interest greater than 1% in the business they are recommending to the client; and
  • provide a written disclosure of the affiliation to the client referred to the controlled business. [See RPI Form 519 and 205]

The referral to an owned or co-owned service provider for profit is not subject to referral fee regulations of RESPA. As an owner of the service provider, the benefit the broker receives from the referral is not the payment of a referral fee. Rather, the broker receives an indirect benefit from the referral through any annual profits generated for the co-owners by the operations of the service provider to whom he referred the business.

An individual who accepts a referral fee or fails to disclose the existence of the affiliated relationship as prescribed by RESPA is subject to criminal penalties of $10,000, one year in jail, or both for each offense. Also, the person referred to the service provider may receive up to three times the amount of the improper referral fee received by the broker, plus attorney fees, in a civil suit. [12 United States Code §2607(a), 2607(c)(4)(a), 2607(d)]

Analyzing the Affiliated Business Arrangement Disclosure Statement

While prohibited from soliciting or receiving a referral fee as compensation (unless the referral is the only transactional activity performed or the broker performs significant tasks in the rendering of the separate service for the additional fee), the broker may circuitously benefit from their referral of a seller or buyer by participating in the increased annual profits of the referenced provider as an (co)owner of the provider who renders the referred service.

Here, the broker’s share of the provider’s profit is comparable to that of a stockholder in a corporation.

As a condition of the referral, the broker referring a seller or buyer to a service provider they own or co-own needs to disclose their ownership of the provider to the seller or buyer before or at the time they refer them to the provider. [24 Code of Federal Regulations §3500.15(b)(1)]

The Affiliated Business Arrangement Disclosure Statement – Residential Broker published by RPI is used by a broker and their agents when referring a seller or buyer to others who provide services in real estate sales, leasing or mortgage transactions and whose earnings are shared with the broker, to disclose the business relationship and the financial or other benefit the referral may provide the broker. [See RPI Form 519]

Similarly, the Affiliated Business Arrangement Disclosure Statement – Loan Broker form is used by a mortgage loan broker arranging financing when referring a borrower to providers of settlement services whose earnings are shared by the loan broker as a co-owner of the provider. [See RPI Form 205]

Editor’s note —Both versions of the form are identical with the exception of the type of brokerage service —residential or loan — identified in the subtitle. These two versions exist to place the form in both the “office administration” and “loan brokerage” series of RPI forms. [See RPI Form 519 and 205]

Both versions of the Affiliated Business Arrangement Disclosure Statement reference the nature of the business relationship between the broker and the business providing the settlement services, including:

The disclosure includes the statement that:

  • the broker may receive a financial or other benefit due to the relationships between the broker and provider [See RPI Form 519 §3 and 205 §3]; and
  • the client has the right to shop around and is not required to use the listed providers as a condition of the purchase or sale of the subject property, or for the settlement of their loan. [See RPI Form 519 §4.1 and 205 §4.1]

In addition to providing information concerning the broker’s affiliated business, both version of the disclosure form contain a list of three available competing settlement service providers which offer comparable services. [See RPI Form 519 §5.1—5.3 and 205 §5.1—5.3]

After the name and description of each competing service provider, space is given for the broker or agent to enter an estimate of the charges or range of charges offered by the non-required providers. This equips the buyer and seller with an understanding of the prevailing costs associated with the referenced services available in the open market. When they determine the costs charged by the affiliated business are not competitive, the buyer and seller have the opportunity to select any of the other providers to perform the settlement services without any deleterious effect to the underlying transaction.  [See RPI Form 519 §5.1—5.3 and 205 §5.1—5.3]

Similar to the Conflict of Interest Disclosure, the Affiliated Business Arrangement Disclosure creates transparency in the transaction, cementing the honest working relationship between the broker and client.

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