How Hud Determines Whether

HOW HUD DETERMINES WHETHER

A MORTGAGE OR TITLE COMPANY

IS A SHAM

2 HOW HUD DETERMINES WHETHER A MORTGAGE OR TITLE COMPANY IS A SHAM

HUD determines whether a mortgage or title company is a sham company formed to illegally funnel compensation to persons who refer it business by (1) considering ten factors that point to whether the company is a bona fide settlement service provider; and (2) examining whether the company owners receive payments only in the form of a return on ownership interest that is not tied to the actual, estimated or anticipated volume of referrals the owners make to the company.

A. General Background

Section 8(a) of RESPA prohibits giving or receiving fees or kickbacks for the referral of settlement service business involving a federally-related mortgage loan. See 12 U.S.C. §

2607(a). There is a statutory exemption for affiliated business arrangements that allows referrals to an affiliated settlement service provider under certain circumstances. An affiliated business arrangement is an arrangement in which a person (such as a real estate broker or agent) is in a position to refer settlement business to a settlement service provider that is owned, in whole or in part, by the referring party. 12 U.S.C. § 2607(c). Under this arrangement, the referring party receives no direct payment for the referral to the settlement service provider in which he has an ownership interest, but he can receive indirect compensation based on the financial growth of the affiliated provider. Gardner v. First American Title Insur. Co., 296 F. Supp.2d 1011, 1016-17

(D. Minn. 2003).

The affiliated business arrangement exemption allows referrals of business to an affiliated settlement service provider if three conditions are met: (1) the relationship is disclosed to the person referred, (2) the person referred is not required to use the affiliate, and (3) the

3 referring party receives payment only in the form of a return on ownership interest (or permissible payment for services rendered). 12 U.S.C. § 2607(c).

Sham business arrangements do not fall within the affiliated business arrangement exemption because the exemption is available only where referrals are made to a "provider of settlement services," and a shell or sham entity would not qualify. See HUD Statement of Policy

1996-2, Regarding Sham Controlled Business Arrangements, 61 Fed. Reg. 29258-64 (June 7,

1996) ("Congress did not intend for the [affiliated business exemption] to be used to promote referral fee payments through sham arrangements or shell entities."). Thus, to qualify for the affiliated business arrangement exemption, the affiliated provider receiving referrals must be a bona fide provider of settlement services.

B. Factors HUD Uses to Determine Whether a Company is a Bona Fide or Sham Provider of Settlement Services

In RESPA enforcement cases involving an affiliated business arrangement created by two existing settlement service providers,1 HUD will assess whether the entity receiving referrals of business (regardless of legal structure) is a bona fide provider of settlement services or a mere sham arrangement used as a subterfuge for passing referral fees back to the referring party. The sham arrangement may be a joint venture, limited partnership, limited liability company, wholly owned company or combinations thereof. Id. The common feature is that at least two parties are involved in their creation: a referrer of settlement business (such as a real estate broker or agent) and a recipient of referrals of business (such as a mortgage banker, mortgage broker, title agent or title company). Id. At least one or both parties will have an ownership, partnership or participant's interest in the arrangement. Id.

1 A real estate broker or agent is considered a settlement service provider under RESPA. See 12 U.S.C. § 2602(3).

4 In many of the sham arrangements, the substantial functions of the settlement service business that the new entity purports to provide are actually provided by a pre-existing entity that otherwise could have received referrals of business directly. The entity actually performing the service may reduce its profit margin and share its profits with the referring participant in the arrangement. Id. In some cases, companies ("creators") that could have received referrals of settlement business directly help the referring party create a wholly owned subsidiary at little or no cost to the referring party. The subsidiary in turn refers or contracts out most of the functions of its new business back to its creator or uses the creator to run the business. The two general types of arrangements are illustrated in Attachment One, although there are numerous variations on these two general types. Id.

To determine whether a mortgage or title company is a bona fide or sham provider of settlement services, HUD will balance the responses to the following questions (no one response is determinative):

(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 it have loaned employees of a parent provider?;

(3) Does the new entity manage its own business affairs; or is an entity that helped create it running the new entity for the parent provider making the referrals?;

(4) Does the new entity have a separate office 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? If so, how much of the work is contracted out?;

5 (7) If the new entity contracts out some of its essential functions, does it contract services from an independent third party (or does it contract services from the provider that helped create it; if the new entity contracts out work to the 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 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?

Statement of Policy, 61 Fed. Reg. at 29262.

C. Factors HUD Uses to Determine Whether the Referring Party Receives Payment Only in the Form of a Return on Ownership Interest

To qualify for the affiliated business arrangement exemption the referring party may receive payments only in the form of a return on ownership interest. See Statement of Policy,

Fed. Reg. at 29262. A return on ownership interest does not include (1) payments that vary by the amount of actual, estimated or anticipated referrals; or (2) payments based on ownership shares adjusted on the basis of previous referrals. 24 C.F.R. § 3500.15(b); Id.

When assessing whether a payment is a return on ownership interest or a payment for referrals of settlement business, HUD will consider the responses to the following questions:

(1) 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?;

(2) 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

6 be provided by the referring owner or participant to a particular cell or division within the entity?;

(3) 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?; and

(4) Are the ownership interests in the new entity free from tie-ins to referrals of business; or have there been adjustments to the ownership interests in the new entity based on the amount of business referred?

Statement of Policy, 61 Fed. Reg. at 29262.

D. HUD Examples and Analysis Regarding Whether a Company is a Bona Fide or Sham Provider of Settlement Services

In its Statement of Policy, HUD provides five examples of affiliated business arrangements and analyzes them to determine whether they are bona fide service providers or sham arrangements. 61 Fed. Reg. at 29263-64.

Example One. A title insurance company solicits a real estate broker to form a title agency ("new entity") each contributing $1,000 initial capital. The new entity will be an exclusive agent for the title insurance company. The title insurance company enters a service agreement with the new entity under which the title insurance company will provide title search, examination and title commitment work at a charge lower than its cost. The title insurance company manages the new entity and provides it with office space and leases it an employee who conducts closings and prepares policies (the same work she did for the title insurance company). The broker is the new entity's sole source of business referrals. HUD Analysis: This arrangement involves a sham settlement service provider. The new entity is undercapitalized to do the work of a full-service title agency. Also, the title insurance company provides much of the title insurance work, office space and management oversight for the new entity to operate.

Although the new entity has an employee, she is leased from and continues to be supervised by

7 the title insurance company. The new entity receives all referrals from the broker participant and does not compete for business in the market place. The new entity provides a few of the essential functions of a title agent but it contracts many of these back to its creator. Also, the title insurance company provides the search, examination and title commitment work at less than its cost so it may be seen as providing a "thing of value" to the referring title agent, which is passed on to the broker in a return on ownership.

Example Two. A title insurance company ("creator") solicits a real estate broker to form a title agency ("new entity"). The creator sets up the new entity but it is wholly owned by the broker. The creator manages the new entity and provides its former employees who continue to do their former work. The new entity contracts back certain core title agency services from its creator (examination and determination of insurability of title and preparation of the title insurance commitment). The creator charges the new entity less than its own costs for these services. The new entity's employees conduct closings and issue only the title insurance company's insurance policies. HUD Analysis: This arrangement involves a sham provider. The legal structure of the new entity is irrelevant; it does little real work and contracts back a substantial part of the core work to the title insurance company that set it up. The employees do the same work, the title insurance company manages the new entity which is not competing for business in the marketplace. All referrals come from the broker owner. The title insurance company does the bulk of the title work.

Example Three. A lender and real estate broker form a mortgage broker ("new entity").

The new entity has sufficient initial capital standard in the industry to perform mortgage broker services. The lender and broker's interests are based on fair value contribution. The broker's participation is free from tie-ins to referrals. The new entity has its own staff, manages its own

8 business, shares space with the broker but pays fair market rent, performs functions of a mortgage broker, contracts out processing work to third parties, including its creator lender, submits loan applications to numerous lenders not just its creator. The broker is the sole source of the new entity's business. HUD Analysis: This arrangement involves a bona fide settlement service provider. The new entity has sufficient capital, has its own staff, manages its own business, and pays fair market rent for the shared space. It provides substantial mortgage brokerage services. While the broker is the sole source of referrals, the new entity only sends a small percent of its loan business to the lender participant. The broker is thus actively referring loan business to lenders other than its lender participant.

Example Four. A real estate brokerage bought a 50% ownership interest in an existing full service title agency. The broker pays fair value contribution for its shares. The title agency provides core title services including conducting title searches, evaluating the title search, clearing underwriting objections, preparing title commitments, conducting the closing and issuing the title policy. The broker is not the sole source of the title agency's business and receives a return on ownership in proportion to its 50% ownership interest and unrelated to number of referrals. HUD Analysis: This arrangement involves a bona fide settlement service provider.

Example Five. A mortgage banker sets up a limited liability mortgage brokerage company ("new entity") and sells shares in divisions of the new entity to real estate agents. For

$500 each, the agents may buy separate "divisions" in the new entity to which they refer consumers for loans. Later, ownership may vary by the amount of referrals the agents made the previous year. Under this structure, ownership distributions are based on the business each agent refers to his division and not on an agent's capital contribution to the new entity as a whole. The

9 new entity provides all substantial services of a mortgage broker, does not contract out processing to its mortgage banker creator and sends mortgage packages to its creator lender as well as other lenders. HUD Analysis: The new entity is a bona fide provider of mortgage brokerage services, but this arrangement fails the third condition of the affiliated business arrangement exemption, that the referring party may receive payments only in the form of a return on ownership interest.2 Here, the capitalization, ownership and payment structure with ownership in separate "divisions" is a method in which ownership returns or shares vary based on referrals made, not on the amount contributed to the capitalization of the new entity. In cases where the percent of ownership interest or amount of payment varies by the amount of business the real estate agent refers, such payments are not bona fide returns on ownership interest but instead are an indirect way to pay a kickback based on the amount of business referred.

E. HUD Settlement of Cases Involving Alleged Sham Title Companies

In July 2003, HUD announced a settlement agreement involving alleged RESPA § 8 violations arising from sham business arrangements. See HUD Press Release, No. 03-082 (July

28, 2003). HUD determined that TitleVentures.com, a title insurance agency located in

Tennessee, established dozens of sham title insurance companies for the purpose of paying kickbacks to real estate and mortgage brokers in five states for the referral of title business. Id.

According to HUD, Jerry Holmes, the principal owner of TitleVentures.com joined with these brokers to establish sham title companies. Id.

HUD noted that the "bogus title companies" had few or no employees, no office space, and did little or no title work, while collecting 80 percent of title insurance premiums paid by borrowers. Id. Under the settlement agreement, Holmes will shut down 36 affiliated title

2 HUD states that since the arrangement does not fall within the exemption, the payments would need to be scrutinized further to see if they violate § 8 of RESPA. Id.

10 companies created with real estate and mortgage brokers. Further, Holmes agreed that all title agencies through which he conducts future business will have sufficient capital, be independent, be staffed by qualified employees, will perform core title work and will obtain at least 40% of gross revenues from independent sources. Id.

In March 2004, HUD entered into a settlement agreement involving an alleged sham business arrangement between Land Settlement Services, Inc. (“Land Inc.”) and Land Settlement

Services, LLC (“Land LLC”). See HUD website at hud.gov/office/hsg/res/landsettlement.pdf.

Land Inc. had total managerial authority over the operations of Land LLC. Both companies shared office space and business equipment, Land LLC was formed with insufficient capital, had no employees, no office space of its own, no telephone number or e-mail address, and no official lease or sublet agreement with Land Inc. Land LLC did not perform core title services but outsourced all of its work exclusively to Land Inc. Land Inc. performed all settlements for Land

LLC and issued the title policies and recorded the documents for Land LLC’s underwriter. HUD determined that this arrangement constituted a sham business arrangement in violation of the anti-kickback provisions of RESPA. In settlement, the companies agreed (among other things) to terminate Land LLC’s operations and pay $15,000 to the Government.

F. Conclusion

Real estate brokers or agents can form a mortgage or title company, refer business to it and as owners reap the company’s profits under RESPA’s affiliated business arrangement exemption.

But the arrangement would qualify for the exemption only if (1) the mortgage or title company is a real company – e.g., doing real work, with its own office, employees and sources of business

(see list of HUD’s ten factors); and (2) the broker or agent owners receive payments only in the

11 form of a return on ownership interest that is not tied to the actual, estimated or anticipated volume of referrals the owners make to the mortgage or title company.3

3 The two additional conditions of the affiliated business arrangement exemption mentioned earlier would need to be satisfied as well: (1) the relationship must be disclosed to the person referred and (2) the person referred cannot be required to use the mortgage or title company.