A consumer advocacy non-profit, the National Consumer Law Center, has submitted a really good opinion in support of HUD's 1996 policy statement on sham affiliated business arrangements in Carter v. Welles Bowen Realty, an important RESPA Section 8 case currently before a federal appeals court.

Quick background, for those who have not followed the Carter case: In 1996 HUD created  policy statement outlining a set of 10 criteria that was supposed to serve as guidelines for regulators in determining the legitimacy or sham-ness of affiliated business arrangements.  It issued this statement precisely because there was some confusion-- or perhaps wishful thinking-- on the part of some as to whether certain arrangements for the primary purpose of diverting settlement service profits to the referrers of settlement service business might be technically legal under the black letter law of RESPA.

Recently, a court ruled in Carter that HUD's 1996 policy statement was unconstitutionally vague, and it refused to apply it in the case.  That ruling has been appealed, and the government and several advocacy groups, including the NCLC, have issued briefs in support of overturning that ruling.

Full disclosure here: it's important to mention that the National Consumer Law Center has its own agenda:

The National Consumer Law Center is a nonprofit advocacy organization that seeks to build economic security and family wealth for low-income and other economically disadvantaged Americans.  We promote access to quality financial services and protect family assets from unfair and exploitive transactions that wipe out resources and undermine self-sufficiency.  For over 40 years NCLC has used its expertise to write the rules of a fair marketplace.

Reading that, I would not expect these folks to have a pro-business point of view. It gave me a little pause that right off the bat in their brief, they call the title insurance businesses "highly profitable"-- an assertion that is highly debatable especially at the present, with the major underwriters barely showing any profits at all or even in some cases running at losses in their title insurance operations.  They support that claim by bringing up the low claims payout ratios in the industry compared to other types of insurance, which we know is one of the most misunderstood and overused statistics by those who want to beat the title insurance industry over the head and don't care if they take a few low and unfair blows in the process.

Furthermore, it's important to take into account that NCLC's claims of fact against Welles Bowen Title regarding its nature as an affiliated business arrangement are merely allegations.  If they've gotten their facts wrong, the conclusion that Welles Bowen Title is a sham could be wrong also.

That being said, I believe that sham affiliated business arrangements currently exist, thrive, and cause harm.  Affiliated business arrangements, to the extent that they exist only to funnel unearned income back to referrers of title business, are hostile not only to consumers, but to ethical independent small title business owners who have no stomach for the conflicts of interest inherent in affiliated business arrangements.  These small independents are damaged by a lack of opportunity to compete for title referrals on the merits of their services in a marketplace when the real meat of business is tied up in pay-for-play affiliated business arrangements created only to enrich the referrers of business.  In many areas there are only some scraps left over for independents. 

Admittedly without benefit of checking every single assertion of fact in the brief, I believe that the National Consumer Law Center makes a credible and powerful argument that Welles Bowen Title is just such a sham, created only to enrich a producer of title business, Welles Bowen Realty, for title business referrals.

The NCLC claims that "[t]he sole reason for Welles Bowen Title's existence is to reward Welles Bowen Realty for referring customers of its real estate agency to Chicago Title, which does all of the substantive title insurance work." In other words, the NCLC sees Welles Bowen Title as a sham AfBA.  It believes that the HUD  10 criteria policy statement adds some teeth to RESPA and would like to see it applied in this case.

According to the NCLC, it should have been easy for Welles Bowen Title's founders to determine that the entity was not a legitimate affiliate business arrangement. And, assuming that they have their facts straight on Welles Bowen Title (they cited various depositions of Welles Bowen and Chicago Title employees in support of their facts), I'd have to agree with them wholeheartedly.  Nearly every item in HUD's supposedly "unconstitutionally vague" list of 10 criteria used by regulators to distinguish between legitimate affiliated business arrangements and sham AfBAs apply directly to the characteristics of Welles Bowen Title. 

Quite the opposite of being too vague to be useful, HUD's guidelines would have clarified things for Welles Bowen Title's creators... unless they were dumb.

Consider the facts as alleged by the NCLC, and how HUD's 10 criteria for evaluating the legitimacy of AfBAs:

"Welles Bowen Title is actually managed by an employee of Chicago Title-- its Toledo-area manager..."

Criteria 2 from HUD's supposedly unconstitutionally vague guidelines clearly applies to this:  "Is the new entity staffed with its own employees to perform the services it provides?  Or does the new entity have "loaned" employees of one of the parent providers?"

Unless you are dumb, you can infer from the HUD rules that if an AfBA has its own employees performing its services, that would weigh on the side of legitimacy, and having loaned employees from one of the parent companies would weigh on the side of a sham determination.

Clearly, if true, this characteristic of Welles Bowen Title weighs toward a sham determination, and its creators, unless they are dumb, could have known that.

Criteria 3 from HUD also applies-- "Does the new entity manage its own business affairs? Or is an entity that helped create the new entity running the entity for the parent provider making the referrals."

Clearly, if a Chicago Title manager also managed Welles Bowen title, that would weigh on the side of a sham determination under this criteria-- and unless they are dumb, Chicago Title and Welles Bowen Realty could have known that by reading the HUD criteria.

"Chicago Title does the title search and the substantive underwriting... Welles Bowen Title does the final clerical work on the title insurance.  Welles Bowen Title does not cure defects or handle the closing and escrow."

Criteria 5 and 6 from HUD clearly applies here-- "Is the new entity providing substantial services, i.e. the essential functions of the the real estate settlement service, for which the entity receives a fee?... 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?"

Once again it is clear-- if the AfBA does the bulk of the title work, it would weigh on the side of legitimacy.  If the bulk of the work is farmed out, it would weigh on the side of a sham. And once again, by farming out core title functions, Welles Bowen Title has a characteristic of a sham-- and Chicago Title and Welles Bowen Realty could have known that by reading the HUD criteria, unless they are dumb.

Furthermore, criteria 7 from HUD directly applies here:  "If the new entity contracts out some of its essential functions, does it contract services from an independent third party? Or are the services contracted from a parent, affiliated provider or and entity that helped create the controlled entity?"

Crystal clear again-- if the AfBA farms out work, if it farms it to the title company that created the AfBA, that would weigh on the side of a sham determination. 

Also, HUD criteria 10 applies: "Is the new entity sending business exclusively to one of the settlement service providers that created it?...  Or does the new entity send business to a number of entities which may include one of the providers that created it?"

Welles Bowen Title used its creator Chicago Title exclusively as its underwriter.  This weighs in favor of a sham determination.  If it had used other underwriters as well, that would have weighed on the side of legitimacy. 

Once again, more alleged Welles Bowen Title characteristics are the characteristics of a sham, and even if its creators couldn't figure that out from pure common sense, they could have known that from the HUD policy statement on shams, unless they are dumb.

"Chicago Title supplies the office space and all of Welles Bowen's nominal employees are carried on the payroll of Chicago Title's corporate parent.  Welles Bowen does not even have a properly qualified title agent on staff, instead using its marketing representative in an impermissible dual role."

HUD criteria 4 applies-- "Does the new entity have an office for business which is separate from one of the parent providers?"  Having separate office space weighs on the side of legitimacy; setting up shop in the office of one of the parent companies weighs on the side of a sham determination.  You have to be dumb not to realize this after reading HUD's criteria, and once again, another of Welles Bowen Title's alleged characteristics looks like the characteristics of a sham.

Criteria 2 again applies.  Welles Bowen Title was allegedly not staffed by its own employees.  It is again clear from HUD criteria 2 that this weighs on the side of a sham determination.  Far from being too vague, HUD's criteria make this clear to all but the very dumb among us.

"Welles Bowen Title was significantly under-capitalized at its formation, allowing [the owners of Welles Bowen Realty] to reap huge profits from a tiny investment."

Just how huge were Welles Bowen Realty's profits on the venture in comparison to its tiny investment?  According to the NCLC, "in 2005 alone, Welles Bowen reaped a tenfold (i.e. 1000%) return on its investment on its capital investment." 

Such a high return is "too disproportionate to be indicative of anything other than a sham," according to the NCLC, since "there is no rational purpose for such a deal unless Chicago Title is paying for referrals."

Think about it for a second.  Why on earth, if they were getting an 1000% annual return on their investment, didn't Welles Bowen Realty put up more money, so that the AfBA could be bigger, go after even more business, and return larger profits?  Implicitly, we know the answer.  Welles Bowen Title was not designed to go after as much business as possible.  Rather, it was created to lock up the title business produced by transactions handled by Welles Bowen Realty-- a limited amount of business.  Unlike a legit business competing in an open marketplace, where reinvesting profits into a highly profitable business would likely be expected to increase returns, additional investment in Welles Bowen title wouldn't have produced additional returns.

There is other evidence to support the view that Welles Bowen existed to do the title business for Welles Bowen Realty transactions, and pretty much only those transactions.  According to depositions cited by the NCLC, "almost all of Welles Bowen Title's business comes from transactions in which Welles Bowen Realty agents are known to be involved (e.g. 98.5% of all title orders from the beginning of August to the end of October 2005)."

HUD criteria 1 directly applies here-- "Does the entity have initial capital and net worth, typical in the industry, to conduct the settlement service for which it was created?  Or is it under-capitalized to do the work it purports to provide?"

It is obviously not typical for a $30k capital investment in a new title business to support a title business that can handle a volume of work capable of producing a $300k annual profit, as is allegedly the case for Welles Bowen Title.  The initial investment seems to be on the low side of "typical," to say the very least.  That would weigh on the side of a sham determination, and anyone can know that from reading the HUD guidelines, unless they are dumb.

Other alleged characteristics of Welles Bowen Title indicate that this was a sham:

• "The nominal ownership split between Chicago Title and [the owners of Welles Bowen Realty] does not include the full value of Chicago Title's large in-kind contributions to the business."
• "Chicago Title gives Welles Bowen Title the same share of the title insurance premium for doing no substantive work as it would ordinarily pay to a title agent who provided the usual services."
• "Welles Bowen Realty gave Welles Bowen Title preferential access (compared to other title insurance companies) to its office and its agents, facilitating referrals."

Actually, Chicago Title and Welles Bowen Realty could have known that these characteristics of Welles Bowen Title were the characteristics of a sham without reading HUD's policy statement on sham AfBAs.  But if they did read the policy statement, it could have only served to remove any doubt from their minds... unless they were dumb.

The characteristics of Welles Bowen Title as alleged by the NCLC are clearly the characteristics of a sham AfBA, when viewed in the light of HUD's 1996 policy statement.  By nearly every single measure that HUD said it would take into consideration, Welles Bowen Title fails to measure up to the standard that a legitimate title business normally would. 

Weighed as a whole, any objective person can determine that the characteristics of Welles Bowen Title would have weighed more on the sham side of things for nearly every one of the criteria that HUD indicated as relevant to making a sham determination.  This should have made it clear to any person of reasonable intelligence that HUD would be likely to consider Welles Bowen Title to be a sham.