RESPA-Compliant Business Arrangements
RESPA (the Real Estate Settlement Procedures Act) is a consumer protection statute passed by Congress in 1974. It only relates to loans secured by mortgages placed on one- to-four family residential properties, and has two primary purposes: First, it helps consumers become better shoppers for settlement services; second, it is designed to eliminate kickbacks and referral fees that increase the cost of those services. RESPA is enforced by HUD (Housing and Urban Development), and is a comprehensive law. This article will discuss a small sliver of the act: how to create and operate an AfBA (affiliated business arrangement) without violating RESPA Section 8 provisions.
Section 8 of RESPA prohibits a person from giving or receiving anything of value for referrals of settlement service business involving a federally related mortgage loan. It also prohibits a person from giving or receiving any part of a charge for services that are not performed by that person (fee-splitting or receiving unearned fees). Violations of Section 8 create criminal and civil penalties. A person found in violation of Section 8 may be fined up to $10,000 and imprisoned up to one year. In a civil suit, a defendant can be found liable to the person charged for the illegal service in an amount equal to three times the amount paid for the service.
The Section 8 Exemption
AfBAs are allowed because an exemption to Section 8 permits these arrangements, but only if certain procedures are followed. First, the affiliated entity must be a “bona fide” provider of settlement services rather than a sham. In 1996, HUD produced a Statement of Policy which explains that “HUD balances a number of factors in determining whether a violation exists and whether an enforcement action under Section 8 is appropriate.” This statement produced 10 factors HUD uses to determine compliance. These 10 factors are informally known as the “HUD 10-point test,” or the “HUD litmus test” (see sidebar page 14). Interestingly, the AfBA need not comply with all 10 items to be valid. It must substantially comply to pass the test. The second procedure that must be followed is set forth in HUD’s Regulation X. This section creates three rules which – unlike the 10-point test – must be completely complied with (see sidebar page 15).
Forming an AfBA
If you are a settlement service provider (meaning almost any party to a residential mortgage loan who gets paid for a service involving that loan) you can consider creating an affiliated arrangement. You can join up with other settlement service providers and share the income generated by the entity you create. The most common members of affiliated entities are mortgage brokers and lenders, real estate brokers, title companies, credit reporting agencies, etc.
The business you create must be a real business. It must be a legal entity (e.g. an LLC), it must have office space owned by the AfBA or leased at fair-market rent, it must pay for its own phones and equipment, and it must have its own employee(s). There has been a lot of debate concerning how many employees an AfBA may have, whether or not the employee must be full-time and whether or not the employee may be a shared employee with one of the AfBA members. An AfBA can have as many employees as are necessary to run the business, including a single employee. Going even smaller, the AfBA may have only a single part-time employee. Can that part-time person also be employed by one of the members? An interpretation I recently heard from an ex-HUD lawyer is that a partner to the business can share an employee with the business, so long as the time that person spends with each entity is carefully logged and paid for accordingly by both entities.
As indicated above, there are both criminal and civil penalties for violations of RESPA. Note that both the person giving and the person receiving the thing of value that caused the violation are equally punishable by HUD. So, if you are thinking of creating one of these entities only on “paper,” be prepared for a HUD review and the potential for attendant criminal and civil penalties.
Should you create an AfBA? That’s a question that should be answered only after a careful review of a proposed business plan and a financial pro-forma. As with any business, you should enter into it only if you believe your partners are credible and will work hard to make the business succeed. If your analysis is that it looks like a good plan and you won’t mind sharing the business with others, and you will make money at it, then call an attorney and your accountant and start the process.
HUD requires that the members creating the AfBA establish their ownership interests at the outset, and then stick with those percentages throughout the AfBA’s existence. HUD does not allow members to vary their interests to reflect changing amounts of input into the business, so this issue must be very carefully considered up front. Generally, the owners of an AfBA will have ownership interests equal to their capital contributions, which are reflective of what business input each member expects to bring to the AfBA. For example, if the AfBA has two members, one may have a 60 percent ownership interest and the other a 40 percent interest. If $25,000 was the total initial capitalization, then the 60 percent owner will have paid in $15,000 while the 40 percent owner paid $10,000. Note that the general practice is for the total capital contributions to equal three months’ operating expenses. HUD frowns strongly on undercapitalized businesses, as they indicate an intention to create a “paper” entity, so capitalize properly. Owners may come and go from the entity, but the percentages should remain the same, and there should not be a revolving door of owners. In other words, don’t create an entity that intends to have many owners come and go, as HUD may consider it a sham. Also, note that if you have more than 36 owners, things get very complex as you will have to make SEC filings to operate. Once operating, any income received by the entity will be reduced by its expenses, and the profit – if any – remaining will be split between the members according to their ownership interest percentage.
Review very carefully the HUD 10-point litmus test and the three Regulation X requirements for a valid AfBA (see sidebars). These arrangements must be entered into carefully. HUD has recently made clear that it intends to enforce RESPA to the max, and is preparing a hotline on its site to allow folks to “rat out” entities they feel are violating RESPA. Also, be sure the business plan makes sense. While it is not impossible to terminate an AfBA, it can be frustrating dealing with a partner who isn’t carrying his or her weight and share of the business.
This is a brief discussion of AfBAs. For more information, I’d suggest you research RESPA on Google and you will find an enormous amount of material on this topic. Finally, use your common sense. Most people know when something is a sham. Keep it legal, and remember that HUD believes the purpose of this law is to protect the consumer, not to build wealth for settlement service providers.
Joe Attura is area manager/vice president at First American Title Insurance Co., where he oversees the company’s operations in Maine, New Hampshire and Vermont. He can be reached at (207) 774-6884 or by e-mail at email@example.com.