Restrictions on Payment of Referral Fees
for Loan Originations
Due to the increased focus on executive compensation, credit crises, and capital issues by the news media, financial institutions have been forced to focus on these hot button topics. However, it is this same current climate of heightened regulatory scrutiny that requires financial institutions also to be aware of and in compliance with all applicable regulatory restrictions.
While more commonly associated with the days of plentiful credit from the earlier years of this decade, payment of referral fees for loans continues to be an area of caution for all banks, especially those struggling to compete in a new or challenging market. In addition, on May 7, 2009, the U.S. House of Representatives passed H.R. 1728, The Mortgage Reform and Anti-Predatory Lending Act of 2009. This Bill would enact comprehensive reforms to mortgage origination and servicing practices, including the payment of fees for loan originations. While the Senate has not acted upon the Bill, the fact that the House was able to pass this Bill illustrates that this practice continues to be a focal point for legislators and regulators.
The current restrictions governing the payment of referral or origination fees depend on whether the proposed loan is for commercial or residential purposes. The payment of fees for referral of residential loans is much more heavily regulated (and in most cases prohibited) than referral fees on commercial loans. There is no general prohibition on payment of referral fees for commercial loans, but there is a restriction regarding this practice if the payment of fees by a bank is to a related party such as a director or significant shareholder.
Discussion of Regulations - Referral Fees for Residential Loans
Payment of certain referral fees for residential loans is prohibited under Section 8 of the Real Estate Settlement Procedures Act ("RESPA") and the federal regulations issued thereunder. These regulations clarify that referral fees on residential loans are prohibited if paid to a person or entity that merely refers the loan to the actual lending institution without providing additional services. Congress sought to eliminate these types of payments for residential loans so that the costs to the American home buying public would not be unreasonably or unnecessarily inflated. As a result, payments related to any settlement services for federally related mortgage loans must be reasonable compensation for the goods, services, or facilities actually provided. A charge by a person for which no or nominal services are performed or for which duplicative fees are charged is an unearned fee and violates Section 8 of RESPA. Violations of Section 8 are subject to both civil and criminal penalties.
The regulations explaining Section 8 clarify what payments are allowed - "a payment by a lender to its duly appointed agent or contractor for services actually performed in the origination, processing, or funding of a loan." In determining whether a payment from a lender to a mortgage broker is permissible under Section 8, the first question is whether goods or facilities were actually furnished or services were actually performed for the compensation paid. The fact that goods or facilities have been actually furnished or that services have been actually performed by the mortgage broker does not by itself make the payment legal. The second question is whether the payments are reasonably related to the value of the goods or facilities that were actually furnished or services that were actually performed. The US Department of Housing and Urban Development ("HUD") has identified the following services normally performed in the origination of a loan:
- Taking information from the borrower and filling out the application;
- Analyzing the prospective borrower's income and debt and prequalifying the prospective borrower to determine the maximum mortgage that the prospective borrower can afford;
- Educating the prospective borrower in the home buying and financing process, advising the borrower about the different types of loan products available, and demonstrating how closing costs and monthly payments could vary under each product;
- Collecting financial information (tax returns, bank statements) and other related documents that are part of the application process;
- Initiating/ordering VOEs (verifications of employment) and VODs (verifications of deposit);
- Initiating/ordering requests for mortgage and other loan verifications;
- Initiating/ordering appraisals;
- Initiating/ordering inspections or engineering reports;
- Providing disclosures (truth in lending, good faith estimate, others) to the borrower;
- Assisting the borrower in understanding and clearing credit problems;
- Maintaining regular contact with the borrower, realtors, lender, between application and closing to apprise them of the status of the application and gather any additional information as needed;
- Determining whether the property was located in a flood zone or ordering such service; and
- Participating in the loan closing.
While this list is not exhaustive of all possible settlement services, and while technological advances since 1995 have changed how a broker's settlement services are performed, this list still represents a generally accurate description of the mortgage origination process. Under HUD guidelines, there generally will be sufficient origination work to justify compensation if the mortgage broker takes the application information and performs at least five additional items on the list above. However, in some cases it is necessary for the loan originator to perform more than 5 additional tasks, such as if the tasks performed focus heavily on what HUD might consider to be "steering" of borrowers to a lender or loan.
The question of whether the payments are reasonably related to the value of the goods or facilities that were actually furnished or services that were actually performed is not discussed in detail by the regulators. A fee that is normally paid by a similar-sized institution to a nonaffiliated mortgage broker performing comparable settlement services would be a good measurement of a reasonable fee.
In addition, if a fee is paid pursuant to an affiliated business arrangement in return for a referral, written disclosure must be provided to the consumer. This disclosure must specify the nature of the relationship (explaining the ownership and financial interest) between the person performing settlement services (or business incident thereto) and the person making the referral, and must describe the estimated charge generally made by the provider of settlement services. The consumer also generally cannot be required to use the services of the referred affiliate.
Referral Fees on Commercial Loans
The most likely restriction governing the payment of referral fees on commercial loans would be Sections 23A and 23B of the Federal Reserve Act. Congress passed this legislation to protect a bank from adverse consequences resulting from imprudent transactions with its affiliates of the bank, such as mortgage companies, securities firms, and insurance companies. In October 2002, the Federal Reserve Board adopted Regulation W, thus codifying in regulations years of the Federal Reserve's formal interpretations of Sections 23A and 23B.
Section 23A requires, among other obligations, that banks conduct transactions with their affiliates on terms that are consistent with "safe and sound banking practices." For example, pursuant to Section 23A, the FDIC has previously determined that the acceptance of origination fees by a director, absent full disclosure to and consent by the bank's board of directors, is an unsafe and unsound practice.
Section 23B of the Federal Reserve Act provides that most transactions between a bank and its affiliates must be on terms and under circumstances that are substantially the same or at least as favorable to the bank as those prevailing at the time for comparable transactions with or involving nonaffiliated companies. Section 23B specifically applies to a number of transactions not covered by Section 23A, including both the payment of money or the furnishing of services to an affiliate under contract, lease, or otherwise and any transactions in which an affiliate acts as an agent or a broker or receives a fee for its services.
In summary, if a bank intends to pay a referral fee to an affiliate for a commercial loan, such payment must be (i) on terms that are consistent with safe and sound banking practices and (ii) on terms and under circumstances that are substantially the same or at least as favorable to the bank as those that in good faith would be offered to or applied to nonaffiliated persons or entities.
The subject of referral fees continues to be a focus for legislators as well as for bank regulators and banks must remain vigilant concerning their regulatory compliance obligations regarding this practice.
For further information on this subject, please contact Benjamin A. Barnhill at (864) 250-2246.
 On May 12, 2009, the Bill was received in the Senate, read twice and referred to the Committee on Banking, Housing, and Urban Affairs. As of May 27, 2009, no further action had been taken regarding this Bill.
 "Referral" includes "any oral or written action directed to a person which has the effect of affirmatively influencing the selection by any person of a provider of a settlement service or part of a settlement service when such person will pay for such settlement service or business incident thereto or pay a charge attributable in whole or in part to such settlement service or business." It also includes "any instance in which a person paying for a settlement service or business incident thereto is required to use a particular provider of settlement service or business incident thereto." As a practical matter, HUD interprets "referral" very broadly, and will even find impermissible referral arrangements when a gift is provided to a potential referral source.
 "Affiliated business arrangement" means an arrangement in which (A) a person who is in a position to refer business incident to or a part of a real estate settlement service involving a federally related mortgage loan, or an associate of such person, has either an affiliate relationship with or a direct or beneficial ownership interest of more than one percent in provider of settlement services; and (B) either of such persons directly or indirectly refers such business to that provider or affirmatively influences the selection of that provider.
The articles published in this newsletter are intended only to provide general information on the subjects covered. The contents should not be construed as legal advice or a legal opinion. Readers should consult with legal counsel to obtain specific legal advice based on particular situations.