This article discusses the disclosure of affiliated business arrangements.
A profit to be taken, not a referral fee
In times of slowing real estate activity, prudent residential brokers listing a property or representing a buyer can generate additional income by diversifying their brokerage business, becoming full service brokers by 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 he makes to these controlled businesses.
However, the single family residential (SFR) broker’s ability to profit from referrals is regulated by the federal Real Estate Settlement Procedures Act (RESPA) Section 8.
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 loan on a one-to-four unit residential property. These augmented costs too frequently take the form of illegal referral fees; some don’t since they are subject to competition.
Referral fees are paid by service providers, which include brokers, for referring business to them so they can perform a service in connection with a real estate purchase agreement or escrow to close a sale. 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, escrow companies and brokers.
The broker receiving a broker fee for negotiating the sale or purchase of a one-to-four residential unit which involves the origination of a loan may not receive a referral fee in addition to the brokerage fee on the sale as it would then be illegal. However, he can still profit from referring a buyer or seller to a service provider if he is an owner or co-owner of the service provider he recommended, creating an affiliated business arrangement.
For the broker to meet the conditions to profit from an affiliated business arrangement, he must:
- have an ownership interest greater than one percent in the business he’s recommending to the buyer or seller; and
- hand a written disclosure of the affiliation to the person he refers to the controlled business.
The referral to an owned or co-owned service provider for profit is an affiliated business arrangement and 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.
Thus, when the broker of a listed property refers the owner to a pest control business in which he holds an ownership interest, an affiliated business arrangement is created. If fully disclosed, the broker may benefit by sharing in any end-of-year profit the business realizes on the referral. Conversely, the broker who does not possess an ownership interest in the referred business is not involved in an affiliated business arrangement. Thus, the broker may not receive a referral fee and will receive no financial benefit from the referral.
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 in a civil suit receive up to three times the amount of the improper referral fee received by the broker, plus attorney fees. [12 USC §2607(a), 2607(c)(4)(a), 2607(d)]
The savvy broker may receive a financial benefit by referring a seller or buyer to a provider of services needed to close the sale of a one-to-four unit residential property if the broker has an ownership interest in the provider, such as an escrow, finance, or title company. Though prohibited from receiving a referral fee as compensation (unless the referral is the only service the broker performs), the broker may circuitously benefit from the referral through participating in the increased annual profits of the provider due to the seller’s or buyer’s patronage. Thus, the broker’s share of the provider’s profit is comparable to that of a stockholder in a corporation.
However, the broker referring a seller or buyer to a service provider he owns or co-owns must disclose his ownership of the provider to the seller or buyer on or before referring them to the provider. [24 CFR §3500.15(b)(1)]
The disclosure includes the nature of the business relationship between the broker and the business providing the settlement services, as well as an estimate of the cost or range of costs to be charged. [24 CFR §3500.15(b)(1)]
Analyzing the affiliated business arrangement disclosure statement
A residential broker listing a property or representing a buyer uses an Affiliated Business Arrangement Disclosure Statement [first tuesday Form 519] when referring the owner or buyer to a business he owns or co-owns.
The following instructions are for the preparation and use of the Affiliated Business Arrangement Disclosure Statement – Residential Broker; Regulation X (RESPA); (24 CFR §3500.51) [first tuesday Form 519]. Form 519 fulfills the RESPA disclosure requirements, enabling the broker to provide real estate services and share in the profits gained by the referral.
Each instruction corresponds to the provision in the form bearing the same number.
Enter the date and name of the city where the disclosure is being prepared. This date is used when referring to this disclosure.
- Notice: Establishes the parties to the disclosure.
Enter the name of the owner or buyer who is being referred to the service provider owned or co-owned by the residential broker.
Enter the name of the broker making the referral.
Enter the property’s legal description, common address, or the assessor’s parcel number (APN).
- Business relationship: Enter the name of the broker making the referral. This discloses the existence of the business relationship between the referring broker and the business the owner or buyer is being referred to.
2.1-2.3. Description of relationship: Enter the name of the service provider, percentage of ownership interest held by the referring broker, and a description of the relationship between the broker and the service provider.
3. Financial benefit: Enter the name of the broker making the referral. The broker may receive a financial or other benefit due to the relationships between the broker and provider.
4. Estimate of charges: States the estimated charge or range of charges for the settlement services is listed below to be performed by a nonrequired provider.
4.1 Nonrequired affiliated providers: States the owner or buyer is not required to use the listed providers as a condition for the settlement of his loan.
4.2 Other providers: States there are other settlement service providers available which offer comparable services and informs the owner or buyer of his right to shop around.
5.-5.3 Nonrequired providers: Enter the name of the service provider, the settlement service performed for the owner or buyer, and the charges or range of charges estimated to be charged.
6. Acknowledgment: Enter the name of the residential broker making the referral. The owner or buyer has read this disclosure and understands the broker making this referral may receive a financial or other benefit as the result of this referral.
Owner or buyer signature: Check the box to indicate whether the recipient of this disclosure is the owner or buyer for the property. Enter the date each owner or buyer signs the disclosure and the name of each owner or buyer. Obtain each owner’s or buyer’s signature on the disclosure.
Other disclosures for direct or indirect compensation exist and can be used in conjunction with the affiliated business arrangement. The Compensation Disclosure in a Real Estate Transaction (Calif. Bus and P C §10176(g)) form discloses the amount, its form and source of compensation and benefits the broker anticipates receiving for any service or from any party or provider as a result of their client’s entry into a purchase agreement or other real estate transaction in which the broker is receiving a fee as an agent. [See first tuesday Form 119]
Similarly, the Affiliated Business Arrangement Disclosure Statement – Loan Broker form can be used by a mortgage loan broker arranging financing for one-to-four residential units when referring a borrower to providers of settlement services whose earnings are shared by the loan broker. [See first tuesday Form 205]
A finder’s fee paid by the broker is not regulated by RESPA or its affiliated business arrangement sections. [See first tuesday Form 115]
A finder is an unlicensed individual entitled to a referral fee if he solicits, locates, places, introduces or delivers up names of prospective clients to a broker or principal. The referral is the one and only service he provides and thus is not controlled by RESPA. [Tyrone v. Kelley (1973) 9 C3d 1]
Sham businesses: use of a dummy
The affiliated business owned or co-owned by a residential broker may not be a sham created by the broker to obtain a fee. An affiliated business arrangement is a sham if the company does not provide core settlement services to the buyer. To be considered a bona fide business, the affiliated business arrangement must be a stand alone operation capable of competing with rival businesses offering the same service. The Department of Housing and Urban Development (HUD) applies numerous factors for distinguishing a sham entity from a bona fide provider of title or settlement services, including:
- is the business undercapitalized to perform the duties it claims to provide? Does the business have sufficient net worth and initial capital standard in the industry?
- is the business staffed with its own employees to perform the duties it claims to provide? Are the employees furnished by the broker making the referrals?
- does the business independently manage its own professional affairs? Is broker that aided in the creation of the business running it?
- does the business have an independent office separate from the broker’s? If the business is located at the same physical address, does it pay market value rent for the facilities furnished?
- does the business receive a fee for performing services essential to the functioning of a real estate settlement service? Does the business experience the risks and rewards standard to the industry?
- does the business perform the settlement services it claims to perform itself or does it contract out a portion of the work?
- if essential functions are contracted out, does the business contract services from an independent third party or are services contracted from the broker that helped create the business?
- if essential functions are contracted out, does the contracted party receive compensation reasonably related to the goods or services provided?
- is the business actively competing with competitors in the market place? Does the business receive or attempt to obtain business from settlement service providers other than the one which created the entity?
- is the business referring business exclusively to the broker that created it, other settlement services, or a combination of both? [HUD Statement of Policy 1996-2, Sham Controlled Business Arrangements, 61 FR 29264]
Thus, for a business to be a legitimate operation as an affiliated business arrangement, it must be adequately capitalized, have its own employees and office for which it pays fair market rent, manage its own business affairs and provide business comparable to its competitors. It must also be capable to taking risks similar to its competitors, compete for business in the marketplace, not subcontract out services it should perform itself, and not perform business exclusively for the referring broker.
Unless these conditions are met, the business referred to would be a mere scarecrow entity and the broker is prohibited from receiving compensation based on profit-sharing.
No additional service, no additional fee
A return of ownership interests though a controlled business arrangement is not the only method an SFR broker can use to receive additional compensation in excess of his brokerage fee on the transaction. The broker may receive a second fee if he renders substantial loan origination services otherwise performed by the lender. However, this too is strictly regulated by RESPA.
RESPA established a no-service, no-fee restriction on real estate brokers and agents who are already acting on behalf of a buyer or seller in an SFR real estate transaction financed by a RESPA loan. A lender is prohibited from paying brokers and their agents a fee of any type when the broker is already receiving a fee on the sale for brokerage services they have rendered on behalf of a buyer or seller, unless the broker performs significant services on behalf of the lender. A second fee cannot be paid to the broker by anyone if it is received by the agent for acting only as a referral agent.
For example, the broker and his agent are entitled to a second fee in a sales transaction if they handle the loan escrow or process a loan application and loan documents, services which are significantly more involved than the act of a mere referral.
A lender or broker are in compliance with the no-service, no-fee rule if the earnings the broker is to receive for the second service were due the broker as:
- payment for goods; or
- payment for services rendered, other than the referral. [12 United States Code §2607(c)]
Before a broker and his agent who is to receive a brokerage fee on a sales transaction can accept another fee for an additional second significant service, such as a fee paid by a lender to the broker (or agent), the broker or the agent must perform numerous loan origination activities normally performed by the lender. Further, if sufficient loan origination activities are performed by the broker or his agent, then the second fee for loan related services must be justified as a dollar amount others would be paid to competitively perform the same services for the lender.
The minimum loan origination services which must be performed by the broker or his agent before any fee can be justified begins with the broker’s or his agent’s preparation of the loan application. In addition to preparing the loan application, the broker or his agents must also perform any five of the following loan origination services:
- prequalify the buyer/borrower to determine the maximum loan amount he can afford by analyzing the buyer’s/borrower’s income and debt [See first tuesday Form 230];
- advise the buyer/borrower on the home-buying and purchase-assist loan process, about the different types of loans available and the variations in costs, rates and payments on the various loans;
- gather financial information from the buyer/borrower such as tax returns, profit and loss statements, bank statements, and balance sheets needed to complete the application process [See first tuesday Forms 207 and 207-1];
- order out verifications of employment and cash deposits [See first tuesday Forms 208, 208-1 and 209];
- order out requests for loan verification on other debts owed by the borrower [See first tuesday Forms 210 and 210-1];
- order out the appraisal to determine the property’s fair market value (FMV) [See first tuesday Form 228];
- order out property inspection and engineering reports [See first tuesday Form 130];
- review with the buyer/borrower the process for clearing credit problems which might arise;
- apprise the buyer/borrower, broker and lender of the status of the application and what further information or documentation each needs to close by conducting regular contacts after taking the loan application and continuing contract until the close of the transaction [See first tuesday Forms 203-2 and 520];
- order out legal documents (statements) which are required for escrow to close, or a policy of title insurance to be issued;
- order out a flood hazard report on whether the property is located in a flood zone [See first tuesday Form 131]; and
- assist as an active participant in the closing of the loan. [HUD Policy Statement 1991-1, Section C]
However, should the broker or his agent complete an application, and the five loan origination activities performed are related only to counseling (as contrasted to loan documentation efforts), then the broker or his agent must:
- present and advise the buyer/borrower on the availability of loans from at least three different lenders (to avoid steering the buyer/borrower to a single lender):
- be paid a fee for his counseling services regardless of which lender is ultimately selected by the buyer; and
- inform the buyer/borrower that the fee paid for the broker’s loan origination services is a competitive rate based on the value of the services rendered, and not contingent or based on the loan amount or type of loan originated with the referred lender.
Duplicate charges for services
Real estate sales transactions are increasingly subject to duplicate charges imposed on both buyers and sellers by brokers, lenders, escrow agencies and title companies during periods of rising property values. Duplicate charges for integral services, called kickbacks or hidden costs based on who ultimately receives them, are redundant and constantly experienced by the buying and selling public.
Public policy and sound economics suggest that duplicate charges are improper and make the real estate market more inefficient. They usually result from the systematic elimination of more competent and less costly competition. Kickbacks to listing and selling brokers (and builders), which are a violation of RESPA, are openly undertaken by some mortgage banks and title insurance companies in an illegal effort to garner a larger share of the available business.
Kickbacks are a corrupting business policy. Legitimate operators find it difficult to compete with fraud without also stooping to the same fraudulent actions to meet the corrupt competition. Kickbacks, in the form of referral fees or other indirect financial benefits used to steer or capture business, interfere with the availability of lower rates and fewer charges. The buyer is referred to the lender (or title company) providing the kickback and away from the legitimate non-participating competition who will not take part in the consumer fraud.
All brokers and sales agents when acting in the capacity of a licensee are prohibited from accepting a referral fee for referring parties involved in the transaction they are negotiating. Referral fees from escrow companies, escrow officers, pest control
operators, security providers and title insurance companies are prohibited by state law. [Calif. Business & Professions Code §10177.4]
California legislation does not, but should, prohibit referral fees from lenders or anyone else who renders services as a third-party in a real estate related transaction in which a broker is collecting a fee for acting on behalf of a principal.
Real estate agents who are employed by a broker (which they must be to act as a licensee) face a similar prohibition in real estate transactions. Agents acting under their licensee are prohibited from accepting a fee or other benefit from any person other than
their employing broker, or from themselves paying a fee to any other broker or agent without first directing the payment through their employing broker. [Bus & P Code §10137]
The yield spread premium (YSP)
Consider an agent who introduces a potential homebuyer to a mortgage lender. The mortgage lender will pre-approve the buyer for a loan which will fund the buyer’s purchase of a single family residence (SFR) the broker is going to locate.
The agent’s broker enters into an oral agreement with the mortgage lender for payment of a fee in exchange for referring mortgage business to the lender. The cost incurred by the lender for payment of the referral fee to the broker will be reimbursed by fees paid by the homebuyer and the premium the mortgage lender receives on the table funding or resale of the loan. The note rate charged the buyer is set at a rate greater than the lender’s par rate for the loan at the time the loan is originated, creating the yield spread premium (YSP) the lender will receive to cover the referral fee.
After the buyer is pre-qualified by the mortgage lender, the agent locates a suitable SFR for the buyer. The buyer enters into a purchase agreement with the agent which provides for the agent’s broker to receive a fee for brokerage services rendered in connection with the sale of the home – one service, one fee. The closing of the sale is contingent on the buyer obtaining a loan to fund the purchase of the SFR.
The buyer’s loan application is submitted to the “tied” mortgage lender. The loan is processed, approved and funded entirely by the lender. On closing, the agent’s broker receives fees from both the seller, through the seller’s agent for producing the buyer, and the mortgage lender for the referral and preparation of the loan application.
After closing, the buyer discovers the mortgage lender’s kickback to the buyer’s broker (or directly to the agent). The buyer makes a demand on the broker for a return of the fee they received from the lender, as well as all other fees received by the buyer’s broker since, as agents of the buyer, they breached their fiduciary duty owed to the buyer to disclose all their earnings on the transaction.
Also, the buyer claims the fee the broker’s agent received from the mortgage lender was a kickback that was specifically prohibited by RESPA since:
- the agent’s broker was already paid for services he rendered in the sales transaction as the listing or selling broker; and
- the agent performed no significant loan processing services which would justify the second fee paid by the mortgage lender (or that the amount paid exceeded the value of the services rendered).
Further, the broker and his buyer’s agent failed to disclose to their buyer the agreement to receive a fee from the lender, which was a breach of their agency duty. [See first tuesday Form 119]
In this instance, the acceptance of the fee by the agent’s broker from the lender is also a violation of RESPA. The lender improperly paid the agent’s broker a fee for assisting in the origination of a loan on the sale of a SFR, since:
- the agent’s broker already received a fee for services he rendered negotiating the sale (the one fee for the one service performed);
- the service the buyer’s agent rendered for a fee from the lender on the loan transaction was limited to the service of referring the buyer to the mortgage lender; and
- the fee the lender paid the agent’s broker unnecessarily increased the buyer’s costs by the amount of the referral fee. [Culpepper v. Inland Mortgage Corporation (11th Cir.1998) 132 F3d 692]
However, if the agent’s broker performed compensable loan brokerage services for the lender, such as obtaining a credit report on the buyer, ordering an appraisal, collecting and analyzing the buyer’s financial information, or explaining the loan process to the buyer, the agent’s broker’s acceptance of a fee from the lender is not a RESPA violation. [Schuetz v. Banc One Mortgage Corp. (2002) 292 F.3d 1004]
Of course, the broker and his agent would have to disclose their additional earnings to their client, be they the seller or the buyer. The additional earnings can be disclosed in the Compensation Disclosure in a Real Estate Transaction. [first tuesday Form 119]
The compensation statement discloses the amount, form and source of benefits the broker anticipates receiving for any service or from any party or provider as a result of his client’s entry into a real estate transaction in which the broker is receiving a fee as an agent.