Sham Controlled Business Arrangements
 
October 30, 2003
 
Jeffrey A. "Jeff" Arouh- New York

Section 8 of the Real Estate Settlement Procedures Act of 1974 (RESPA) prohibits any person from giving or accepting any fee, kickback or thing of value for the referral of settlement services business involving a federally related mortgage loan. A specific purpose of RESPA is to eliminate kickbacks and referral fees that tend unnecessarily to increase the costs of settlement services.

After RESPA was passed, numerous questions arose relating to the manner in which Section 8 would be interpreted and applied to referrals and other business arrangements between affiliated settlement service providers.  In order to deal with this issue, RESPA was amended to permit certain “controlled business arrangements” under certain conditions. A controlled business arrangement is defined as an arrangement in which “a person who is in a position to refer business incident to or part of a real estate settlement service involving a federally related mortgage loan, or an associate of such person, either has an affiliate relationship with or a direct or beneficial ownership interest of more than one percent in a provider of settlement services; ...and either of such persons directly or indirectly refers such business to that provider or affirmatively influences the selection of that provider.”  HUD issued its first regulation covering controlled business arrangements in 1992 stating that a controlled business arrangement was not a violation of Section 8, and that referrals of business to an affiliated settlement service provider are permitted so long as the following conditions are fulfilled: first, the consumer must receive a written disclosure of the nature of the relationship and an estimate of the charges; second, the consumer is not required to use the controlled entity;  and, finally, the only thing of value received from the arrangement, other than payments for services rendered, is a return on the ownership interest.

In each of the arrangements contemplated by the regulations, HUD generally assumed that there was a real business purpose for the relationship.  However, in an effort to avoid the intention of the statute while complying with the letter of the law, various providers of settlement services created joint ventures or used other similar mechanisms designed to enable them to share fees arising out of the providing of settlement services, a purpose generally proscribed by RESPA.

In order to deal with these joint ventures, HUD issued a policy statement on sham controlled business arrangements (Statement of Policy 1996-2, June 7, 1996).  HUD articulated a series of tests to determine whether a joint venture or similar arrangement is a bona fide provider of settlement services or is merely a sham created for the purpose of allowing its members to participate in referral or similar fees.  This policy statement has become the standard by which most joint venture arrangements are evaluated for purposes of determining RESPA compliance.

In its Policy Statement, HUD acknowledged that a joint venture is a special combination of two or more legal entities that agree to carry out a single business enterprise for profit and for which purpose they combine their property, money, effects, skill and knowledge.  The form of the business may be an actual joint venture or it may be a limited partnership, limited liability company, corporation or combination.  Irrespective of the form, the common feature of these arrangements is that at least two parties are involved in its creation, one of which is a referrer of settlement service business and the other of which is a recipient of business.  Normally, both of these parties will have some ownership, partnership or other economic interest in the arrangement.  For example, a real estate broker and a mortgage banker or lender may form an entity to which the broker refers potential borrowers so that the broker and the lender may share the fees earned by that entity.  Similarly, a broker and a title company may form an entity in which each of them has an ownership interest and in which they share the fees earned by that entity from the performance of title agency functions on behalf of the title company.  These arrangements are not prima facie prohibited.  However, they must be examined to determine if they truly reflect the providing of bona fide settlement services by a bona fide provider of settlement services.  In making this determination, HUD considers a number of factors to determine whether a violation may exist.  None of these factors are individually determinative, but must be considered together in reaching a conclusion:

(1) 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?

(2) 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?

(3) 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?

(4) Does the new entity have a business office that 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?

(5) 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?

(6) Does the new entity perform all of the substantial services itself; or does it contract out part of the work?  How much of the work is contracted-out?

(7) 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?

(8) 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?

(9) 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?

(10) 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?

The answers to these questions are considered together to determine whether the combined entity is a bona fide provider of settlement services.  Once the analysis has been completed, it is then appropriate and necessary to consider whether all of the other conditions required of a controlled business arrangement are satisfied, such as: written disclosure, estimate of fees, and determination that the only thing of value that comes from the relationship is the return on the ownership interest.

Only after this analysis has been completed is it possible to conclude that the joint venture or similar “controlled business arrangement” is RESPA compliant and not likely to be regarded as a sham, subject to enforcement action by HUD.  Obviously, these are highly technical considerations that require the attention of competent counsel as each will be decided on its own facts and circumstances.

For more information, e-mail Jeffrey A. Arouh at jeffrey.arouh@hklaw.com or call toll free, 1-888-688-8500.