What mortgage brokers should know
Most mortgage company owners know that federal law allows mortgage lenders, Realtors and builders to share in title company revenues through ownership in entities called affiliated business arrangements (ABAs). That has been true since 1983, when Congress enacted an amendment to the original Real Estate Settlement Procedures Act (RESPA), called the Controlled Business Amendment. What many people don't know, however, is how much has changed since the early days. Today, it is much harder and more dangerous to start and maintain a profitable, claim-free and legally defensible ABA. Any mortgage broker owning a title company or contemplating starting one should examine carefully who is offering to help and how it is set up and managed. There are arrangements existing today that may not be managed well, operated in your financial interest or sufficiently RESPA-compliant to defend against increased the U.S. Department of Housing and Urban Development (HUD) investigations and the growing number of class action lawsuits.
Having created and managed approximately 40 ABAs since 1992, I have seen the damage a HUD investigation and class action lawsuit can do to a title company. Neither one is a pleasant experience. Fear and uncertainty infects employee morale, the paperwork and legal bills drain your resources, and you lose business from some clients. Beginning in 1992, ABAs started proliferating with offers of joint-venture arrangements that were either patently illegal or operated outside the spirit, if not the letter, of HUD's rules. At the time, industry professionals complained that HUD lacked enforcement, and class action lawsuits were rare. That changed about five years ago HUD increased its enforcement staff and the trial bar discovered lucrative opportunities in lawsuits attacking companies that they deemed to be operating sham ABAs. Just in the past five years alone, title companies have paid million of dollars to settle such lawsuits.
These legal developments have changed the game. It is no longer safe or responsible to participate in anything but 100 percent RESPA-compliant ABAs. Unfortunately, the cost to operate a 100 percent RESPA-compliant ABA is greater than operating one that is not compliant, especially with regard to smaller companies. This in turn has raised the barrier to entry for smaller lenders. The biggest challenge for most small- to medium-sized brokerages or lenders is to generate enough ongoing business to afford the expenses associated with knowledgeable management and competent staff that can perform the many diversified functions required to operate the business effectively and deliver high levels of service. Title companies are complex, heavily regulated and demand a strong attention to detail. Without strong management and trained personnel, losses from processing mistakes and title claims mount quickly.
Given the change in the regulatory environment, what are your options in today's market? What are the key criteria you should consider when choosing the safest and best business model for an ABA? Which model meets your objectives best? There are four primary types being offered today, and your appetite for risk and your size dictate which option you should choose. Here, first, are the four essential elements that today's ABA should contain:
The most important requirement is compliance. Your ABA must be a genuine title company, including employees paid on a W-2 and office space. Employees should perform title work, processing and closings. Avoid contracting work to other title companies to ensure a compliant business. Your business should meet and exceed the ABA law and all rules promulgated by HUD. Gone are the days when you could risk operating 25 ABAs from one address and pay 25 paychecks to a few shared employees.
Service is more important than the promise of large profits. Nothing ruins an ABA title company faster than poor service. Your time will be consumed responding to complaints from disgruntled loan associates. Before entering into an agreement, investigate in depth how your provider intends to set up and manage the company. Make sure you have employees that are dedicated to your company, including at least one or two settlement agents/marketing types. If you contract all the closings to another title company (possibly owned by a joint-venture partner), you won't get the same dedicated level of service. Plus, you will expose yourself to greater liability under RESPA.
The best ABAs no longer include sharing profits with a joint-venture title company partner. Better models exist, such as those where you or a group of producing partners own the company 100 percent with the title insurance agency agreement being established in your name, and the company is large enough to operate in full compliance with HUD's rules. I call this model, virtual partners. HUD has never liked joint ventures, and this model has other advantages, which are cited below.
Look for a model that does not require you to spend lots of time running the day-to-day operation, but has excellent management. There are only one or two companies around that provide professional management and don't ask for ownership. Whether you choose a management company or simply hire your own employee to manage, make sure you meet once a month and review the company's financial statements and operational health. That audit process should be thorough and include these essential terms: every title is reviewed by an expert, every HUD-1 is reviewed before closings, all disbursements are handled by specialists only, recordings tracked and confirmed, and reconciliations for both operating and escrow accounts completed within a few days of the end of each month. Also, make sure that you have all the proper licenses, bonding and insurances for the company and all employees.
Here are the four primary types of ABAs. The one you choose will depend on how much volume you can generate and your appetite for risk under RESPA.
1. The joint venture
The joint venture is probably the most common form of ABA. In this model, a title company approaches a mortgage lender or real estate company and offers to set up a new title company, which each party owns 50-50. The mortgage company is responsible for delivering business. The title partner manages the operation. While there can be variations to this model, generally the title company optimizes its resources by housing the new joint venture in its offices, charging the company a monthly lease for space and contracting closings to settlement agents that work for the title-company parent. This model is problematic if the ABA employees are part-time or shared. HUD requires bona fide employees who must perform a list of tasks, which HUD refers to as core title functions. HUD doesn't like it when these employees also work for one of the parent companies, or when employees are shared by many ABAs and receive multiple paychecks. While this model allows small companies to participate, it is dangerous and likely to be attacked by class action attorneys who believe they can convince juries that these types of ABA are sham arrangements, meant to funnel referral fees back to the mortgage company.
2. The title-only model
This model is common with companies that have a low volume of closings and do not want to assume high overhead expenses. It can be a joint venture or an entity wholly owned by the mortgage company. Either way, this model usually has one or two employees who perform just the core title functions and contract the processing, the closing, the post closing and some administrative functions to one or more outside title companies, which have brick-and-mortar office space. The owners save money and keep financial risk low by only paying for processing and closing services when a case closes. If the company is a joint venture, the partners share the profits in some negotiated proportion. If wholly owned, the mortgage broker/owner keeps all the profit. However, it is difficult to negotiate a reasonable outsourcing fee with a third-party title company if they are not also sharing in profits from title insurance.
3. The wholly owned title company
Only larger companies can operate these models successfully because they require a fairly large and steady volume of closings to pay for the variety and type of employees required to run all aspects of the company. In this model, everything is done under one roof or one company umbrella. This can be the safest and most profitable model, if you have 40 to 50 closings or more per month and people who know what they are doing. The main advantages of this model are the ability to hire a better quality of employee and the ability to meet all the rules promulgated by HUD.
4. Virtual partners
This model takes all the advantages of the wholly owned title company model and makes it available to smaller mortgage or real estate companies by putting them together in partnerships. Individually, the partners wouldn't have enough business to support a genuinely RESPA-compliant title company. By combining the partners into compatible groups, such as two real estate companies and two mortgage brokers, you end up with a very viable title operation that can return as much as $10,000 per month in net profit to each partner.
In summary, if you can direct 40 or more closings per month to an affiliated title company, the wholly owned version is your best option. Retain a professional title company management firm and you will optimize your chances for success. The best management firms should be able to provide experience, employees, oversight and emergency support that will prove invaluable. You may pay slightly more than hiring your own manager, but you will get an entire company of professionals supporting your effort and who are accountable to you. If you can only direct 10 or 20 closings per month to an affiliated title company, your best option in today's environment is the virtual partner concept. The joint venture model and the title only model may allow you to receive income, but they are both more risky from a legal standpoint. In addition to greater legal protection, the virtual partners concept creates opportunities for your loan officers to meet and work together with real estate agents who work for one or more of the other virtual partners.
John R. H. Cotter is president of Greenbelt, Md.-based Alliance Title Management LLC. He may be reached at (301) 802-6445 or e-mail [email protected].