Co-Author: Amanda S.P. Howe
More on Affiliated Business Arrangements
Some service businesses try to operate as simply as they can and out-source all services but their core competencies. Other businesses seek to provide one-stop shopping for customers. One stop shopping can enhance the quality of the services to the customer and help the business amortize its marketing resources over more revenue sources. Yet real estate companies that set up sister mortgage, title and other companies providing “settlement services” (as that term is defined by RESPA) do so in a highly regulated environment.
Question: I have a business friend who wants to offer REALTORS® ownership interests in her mortgage company. These REALTORS® will probably refer business to the mortgage company after receiving an ownership interest. Is this permitted by RESPA, as long as all other requirements for the ABA exception are met?
Response: Yes. She may offer ownership interests in her mortgage company to REALTORS® and qualify as an Affiliated Business Arrangement (“ABA”) under RESPA as long as each REALTOR® makes a capital contribution, his/her ownership interest is in proportion to the capital contribution made, any dividends the company issues are in proportion to ownership interests, and adjustments in ownership interests are not made based on the number of referrals made to the mortgage company.
Under RESPA, a person is allowed to receive a thing of value from an ABA as long as it is a return on that person’s ownership interest in the business. However, the ownership interest cannot be tied in any way to the number of referrals a person makes. Section 3500.15(b)(3)(ii) provides that a return on an ownership interest does not include payments that vary by the amount of actual, estimated or anticipated referrals or payments based on ownership shares that have been adjusted on the basis of previous referrals.
When determining whether a payment is a permissible return on ownership interest or a payment for referrals of settlement service business, HUD considers the following questions:
- “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?
- 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 be provided by the referring owner or participant to a particular cell or division within the entity?
- 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?
- Are the ownership interests in the new entity free from tie-ins to referrals of business? Or have there been any adjustments to the ownership interests in the new entity based on the amount of business referred?”
This list suggests a few pieces of advice for affiliated business arrangements.
First, any individuals who have an ownership interest in the ABA company should pay money into the company (i.e., make a capital contribution) in order to receive that interest. Loans made to the company do not count as capital contributions.
Second, the percentage of ownership of the company should be determined based on capital contributions. A larger capital contribution will result in a larger ownership interest. For example, two new owners each contribute $5,000 to the company. They should each receive the same ownership interest in the company but less than someone who paid $10,000.
Third, ownership interests should not be adjusted based on referrals. If the ownership interests are adjusted at any time, the basis for such adjustment should be a change in the amount of capital contributed. For instance, if the company needs additional funds and one member refuses to contribute additional capital, that member’s ownership interest may be decreased in proportion to contributing members. However, ownership interests cannot be adjusted based on how much business the owners refer to the company.
Fourth, when dividends or distributions occur, they should be based solely on ownership interest percentages, not on referrals. This means that each owner gets a share of the dividend based only on the percentage of the company that person owns. An individual owning 45% of the company gets 45% of the total dividend amount.
Ownership of the affiliated company must be completely separate from any referrals the owners might make.
For questions, please contact Jon Goodman.
A version of this article appeared in the Colorado REALTOR® News, the monthly publication of the Colorado Association of REALTORS®.