Pfeifer & Reynolds LLP - Attorneys at Law

NET BRANCHING:  THE KEY TO SUCCESS OR THE PATH TO RUIN?

 

By Michael R. Pfeifer, Esq.[1]

 

 

            “Net Branching.”  It is appearing everywhere in the mortgage industry. But if asked to define the concept, industry participants are likely to give a bewildering array of different, and even conflicting, answers.  According to HUD Mortgagee Letter 00-15 (May 1, 2000), many so-called “net branch” arrangements violate the Mortgagee Approval Handbook, and subject participants to “the full range of HUD sanctions.”  But to many mortgage originators, “net branches” have been---and continue to be---the key to phenomenal financial success.  For talented loan officers flush with capital from the “refi-boom,” becoming a “net branch” may be a stepping  stone to eventual ownership of their own company.  And to existing mortgage bankers and brokers looking to expand---or even stay competitive---without significant outlays of additional capital, net branching is often seen as the perfect way to go.  Yet to some regulators and plaintiffs’ lawyers, “net branching” is nothing but a smokescreen for prohibited RESPA Section 8 “referral fees,” the payment or receipt of which can subject the participant to criminal penalties, including fines and even jail.

 

            In this confusing environment, many mortgage originators are asking:  What types of “net branch” arrangements are permissible, if any?  What kinds of legal and regulatory risks do net branches create? What are the operational pitfalls to avoid in maintaining a net branch network? How can net branch operators and managers protect themselves against third-party liability risks and other unexpected problems and losses?

 

Net Branch Or Illegal Kickback Scheme?

 

            Many people and companies are involved in the origination, processing, closing, sale, and servicing of mortgage loans.  Because each provider of services has the opportunity to refer the loan applicant to another participant in the process, companies have tried for years to structure relationships that allow them to profit from such referrals. The major obstacle has been the referral-fee restrictions of the Real Estate Settlement Procedures Act (“RESPA”) Sections 8(a) and (b), which provide:

“(a)  No person shall give and no person shall accept any fee, kickback, or thing of value pursuant to any agreement or understanding, oral or otherwise, that business incident to or a part of a real estate settlement service involving a federally related mortgage loan shall be referred to any person.

 

(b)  No person shall give and no person shall accept any portion, split, or percentage of any charge made or received for the rendering of a real estate settlement service in connection with a transaction involving a federally related mortgage loan other than for services actually performed.”

 

Under Regulation X, which implements RESPA, the term “real estate settlement service” is very broadly defined to include “any service provided in connection with a prospective or actual settlement,” including, but not limited to, taking the loan application, obtaining verifications and appraisals, loan processing, underwriting, title services, funding, document preparation, notarization, delivery, and recording, as well as the “rendering of services by a real estate agent or real estate broker,” and the “provision of any other services for which a settlement service provider requires a borrower or seller to pay.”

 

Net Branch Or Affiliated Business Arrangement?

 

            In 1983, Congress amended RESPA to create an exception to the restrictions of Section 8 that allowed the use of what were then called “controlled business arrangements” or “CBA’s.”  Through various regulatory and legislative revisions, such entities are now known as “affiliated business arrangements” or “ABA’s,” and are defined in RESPA Section 3(7) as an arrangement in which a person or an associate of a person in a position to refer settlement service business has an “affiliate relationship” with, or a direct or beneficial ownership interest of more than one percent in, a provider of settlement services and, in the context of a federally related mortgage loan, the person directly or indirectly refers business to that provider or affirmatively influences the selection of that provider.

 

            However, in order to take advantage of the “affiliated business arrangement” exception to Section 8, the person making the referral must also make a number of specific disclosures to the person receiving the referral, including:  (1) the existence and nature of the relationship between the referring party and the settlement service provider, (2) the estimated charges, and (3) the party’s freedom to select another service provider who may offer the services at a lower rate.  Standards and required elements for these disclosures are specified in Regulation X.

 

            Because the rules governing the “ABA” exception are becoming increasingly complicated and more difficult to satisfy, many companies have turned to “net branches” in the hope of creating profitable business relationships without running afoul of RESPA Section 8.  Theoretically, a “net branch” is an entity created under the licensing and investment relationship umbrella of an existing mortgage lender or broker (the “Sponsor”), with financial and management responsibility for the branch vested in the branch manager (“Manager”), who also participates in the profits generated by the branch operation, and assumes the risk of losses (e.g., lease defaults, telephone equipment, computers, etc.) if the branch does not work out.  If not established correctly, however, or monitored improperly, this type of arrangement may create more problems than it solves.

 

Regulatory Compliance/Relationship Issues

 

            A net branch can take several forms, but the three most common are: (1) an employer/employee relationship in which the Manager’s compensation is based on the net profits of the office; (2) an “outsourcing” relationship in which the Sponsor contracts with a servicing entity for the staffing and management of a branch office; and (3) a franchisor/franchisee relationship in which the Sponsor licenses logos, trademarks, marketing techniques, and pre-packaged materials.  Each structure has its own unique set of risks and pitfalls.

 

Employer/Employee Net Branch

 

            Regulation X was amended in 1996 to specify that payment of commissions to an “employee” for the origination of mortgage loans is not an illegal referral fee in violation of RESPA Section 8.  However, to the extent the branch Manager is only an employee of the Sponsor, the objective of shifting responsibility to the Manager for branch expenses such as leases, telephone equipment, marketing expense may be defeated entirely or, at best, more difficult to track.  As an employee, the branch Manager is also an agent of the Sponsor, which means that the Sponsor is probably responsible to third parties for all activities at the branch within the scope of the Manager’s duties. In practical effect, this structure differs little from a standard branch (except that calculation of compensation is much more complicated), and can undermine the incentive of entrepreneurial branch Managers since all assets remain under ownership of the Sponsor.

 

Outsourced Services Net Branch

 

            If the net branch is structured as an outsourced provider of services, it could fall within the exemption to Section 8 for “payment by a lender to a duly appointed agent or contractor or services actually performed in the origination, processing, or funding of a loan.” However, care must be taken to make sure that actual services are performed and that any compensation paid is “reasonable” for the services rendered. Moreover, unlike the employer/employee situation, any compensation paid to a separate entity will probably have to be disclosed to the borrower under both RESPA and the Truth-In-Lending Act/Regulation Z.  And the existence of an agency relationship between Manager and Sponsor undermines any goal of shifting liability exposure to the branch.  Furthermore, if any of the principals of the branch or Sponsor has an ownership interest in the other, the relationship might be characterized as an “affiliated business arrangement,” necessitating additional ABA disclosures.  And finally, licensing requirements might also impact the structure, depending on the type of license held by the Sponsor and the services actually performed by the net branch.

 

Franchisee Net Branch

 

            Adopting this structure necessitates compliance with Federal and California state franchise laws.  These create rights in the franchisee---or even a “de facto” franchisee--- that may or may not be consistent with the Sponsor’s goals and licensing obligations in areas such as the permissible form of the agreement, standards of operation, and termination.  As a separate company, the franchisee may also have to be separately licensed. And again, because the franchisee is a separate entity, any compensation paid would probably have to be disclosed to the borrower under both RESPA and the Truth-In Lending Act/Regulation Z.

 

Operational and Third Party Liability Issues

 

            Participants in net branching activities should also be careful to address in their contract the various operational issues applicable to such arrangements, including:

 

·        Who will hire, train, supervise, and terminate branch staff?

 

·        Who will create vendor relationships with credit reporting agencies, appraisers, property inspectors, escrow and title companies, etc.?

 

·        Under what name will the branch operate?

 

·        Who can enter into marketing contracts or purchase lead services?

 

·        Who has authority to issue lending commitments, lock rates, close loans?

 

In most instances, regardless of who has “internal” authority to make the above decisions and others, the Sponsor cannot avoid liability to third parties by establishing a net branch. So arrangements also need to be made contractually (and with insurance where available) for allocating the risk of such liability between the Manager and Sponsor. Similar arrangements should also be made to cover liability for regulatory violations and investor repurchase demands, not to mention Federal and California state laws dealing with hiring and firing, discrimination, sexual harassment, etc., etc.  In this regard, the Sponsor, in particular, should remember that even an “airtight” indemnity contract provides no real protection if the Manager has no significant assets.

 

Conclusion

 

            Net branching can offer an innovative and potentially rewarding vehicle for expanding an existing mortgage origination business, without significant additional capital. It can also offer the opportunity for talented loan officers with low net worth to “own a piece of the action.” But legal, regulatory, and investor constraints create a host of potential pitfalls that can lead to financial disaster for both the sponsoring company and the branch---as well as their respective principals--if the arrangement is not structured properly, or managed and supervised with sufficient care.  One thing is certain: no one should enter into a net branch arrangement casually.