Financial Services Alert - Broadening Opportunities: Utilizing Referrals in Connection with Trust, Deposit and Loan Products

As competition in the financial services marketplace grows ever more intense, state and federal banks and thrifts (collectively, "Banking Institutions") have become more aggressive in seeking to promote their products and services. For a number of years, Banking Institutions have received referral fees by making their customers available to securities brokers and insurance agents (principally through kiosks or networking arrangements) and mutual fund complexes (in the form of servicing fees permitted by Rule 12b-1 under the Investment Company Act). However, there is a growing trend of Banking Institutions paying referral fees to affiliated and unaffiliated third parties as compensation for promoting Banking Institution products and services.

Referral fee arrangements can provide several benefits to Banking Institutions and their consolidated organizations. Obviously, these arrangements provide a mechanism to increase volume in key lines of business and associated revenue (for the Banking Institution and, indirectly, the consolidated organization) in today’s highly competitive marketplace. These referrals can be derived from unaffiliated parties, or, particularly with Banking Institutions that are part of a large financial services complex, affiliated entities. Indeed, if a Banking Institution is within a diversified financial services organization, referral fees can provide an important avenue to enable the Banking Institution to entice affiliates to deliver customers and thereby to access a broad, geographically diverse pre-existing customer base. Moreover, in some circumstances, referral fees also may provide an incentive to encourage potential competitors not to provide a product or service. For example, a Banking Institution offering to pay referral fees for trust products may encourage another Banking Institution to simply refer trust customers to the offering Banking Institution, for a fee, rather than incurring the expense and ongoing burden of offering trust products itself. This Article highlights some of the potential uses of referral fees, along with equity-based alternatives and the significant associated legal concerns with each.

I. Fee Based Incentives. Although Banking Institutions can pay referral fees or other compensation for virtually any product or service the Banking Institution provides, this Article will focus on three predominant sources of such fees: trust services, deposit products, and loan products.

Trust Services. An important example of a business a Banking Institution can promote through the use of referral fees is trust services. For example, Banking Institutions frequently enter into contractual relationships with affiliated or unaffiliated securities brokerage firms, financial planners, and investment advisers ("IAs"), pursuant to which these organizations advise their customers of the availability of the Banking Institution’s trust services. In return for referrals of qualified trust prospects, the third party normally receives referral fees equal to a certain percentage of trustee fees collected by the Banking Institution. A referring IA may obtain additional revenue by providing advice to the trustee. If the referring party is an affiliate of the Banking Institution, the referral arrangement thus enables the consolidated organization to retain the client funds through the use of the Banking Institution’s trust powers, rather than requiring the client wishing to establish a trust relationship to transfer its funds (and thus an ongoing contact-intensive relationship) to an unaffiliated Banking Institution.

The Office of the Comptroller of Currency ("OCC"), which regulates national banks, has permitted referral fee arrangements if they are reasonable under the circumstances and disclosed to the applicable customer. The Office of Thrift Supervision (the "OTS"), which regulates thrifts, has adopted a similar standard for referral fees paid by a thrift. Whether an arrangement is reasonable under the circumstances is a fact-based inquiry, but factors the agencies may consider include whether the referral fee program presents a significant financial risk to the institution and whether the program is necessary or useful in order for the Banking Institution to be able to compete effectively in competitive businesses, such as the provision of trust services. Referral fee arrangements may not create a joint venture between the Banking Institution and the referring party. Thus, once t he referral has been made, the referring party must not exercise continuing control over trust accounts. Paying referral fees for more than 10 years may imply that a joint venture exists, although the OCC has permitted longer term arrangements.

Referral fee arrangements also must be consistent with state statutes that define the scope of fiduciary powers an institution may exercise. Therefore, financial institutions must ensure that the state (or states) in which they are located permit the payment of trust referral fees. In addition, a Banking Institution should consider whether the party receiving the referral fee owes a fiduciary duty to the client whose business in being referred. This is particularly important if client assets are subject to the Employee Retirement Income Security Act, which prohibits payments in certain circumstances to any person who is deemed to be a plan fiduciary. If a state bank is receiving referrals from several states, it must also ensure that it is not engaging in impermissible activities at out-of-state locations and that, if required, it has registered under or obtained appropriate licenses under applicable state laws regulating out-of-state fiduciaries (federally chartered Banking Institutions have less concern in this area because of federal preemption principles). Finally, because making a referral to a party providing fiduciary services may, in certain circumstances, constitute the giving of investment advice, the recipient of referral fees should consider whether it is required to register under federal or state laws regulating investment advisers.

Deposit Products. Another example of Banking Institutions generating business through the use of referral fees is in acquiring brokered deposits, which are obtained, directly or indirectly, from or through the mediation or assistance of a "deposit broker" - generally defined to include any nonbank person or entity that facilitates the placement of deposits. Brokered deposits also include high interest rate deposit products. The repeal in December 2000 of former registration and recordkeeping requirements imposed on deposit brokers has made it somewhat easier for Banking Institutions to acquire brokered deposits.

There are certain limitations on the acceptance of brokered deposits. For example, Federal law limits the use of brokered deposits to "well-capitalized" (as defined by the Federal Deposit Insurance Corporation Improvement Act) insured depository institutions and, with a waiver from the Federal Deposit Insurance Corporation, "adequately capitalized" institutions. "Undercapitalized" institutions are not permitted to enter into any program involving brokered deposits.

More generally, from a safety and soundness perspective, brokered deposits must be managed properly. The OCC very recently issued Bulletin 2002-39 warning national banks to be aware of the credit quality and regulatory supervision distinctions among deposit brokers and the implications of these differences on credit risks in dealing with them. Indeed, Bulletin 2002-39 declares it an "unsafe and unsound practice for banks to wire funds to purchase deposits to an unregistered deposit broker, or to allow that deposit broker to act as custodian for insured CDs, unless the deposit broker’s financial strength and reputation warrants an unsecured credit facility in the cumulative amount of the investments a bank has purchased." The OCC has also highlighted in Bulletin 2002-39 that, as a custodian, an SEC-registered broker dealer may be more risky than a bank custodian, as with the failure of the former all customers share in losses on customer securities (and banks are not entitled to SIPC protection), whereas with an insured bank failure a customer incurs a loss only if there is a shortfall in its particular account. In addition, customers who are attracted to such products are highly rate sensitive and may rapidly transfer funds to new institutions or investments if more attractive rates become available.

Loan Products. Both Banking Institutions and nonbank lenders generate loan business through the use of mortgage brokers and other originators. Mortgage brokers provide mortgage origination or retail services that bring a borrower and a lender together to obtain a loan (often, without providing the funds for loans). Mortgage brokers provide various services in processing mortgage loans, such as assisting borrowers in completing applications, ordering required reports and documents, counseling the borrower and participating in the loan closing ("Broker Services").

Of particular note with respect to referral fees in the mortgage loan context, Section 8 of the Real Estate Settlement Procedures Act ("RESPA") prohibits the payment of kickbacks and referral fees in connection with residential mortgage loans. Any arrangement that involves payment of a "thing of value," even if it does not involve the payment of money (i.e., referral of customers in exchange for providing another type of service to the lender for free or at a discount) may violate RESPA. However, under current regulations adopted by the Department of Housing and Urban Development ("HUD"), it is permissible for a lender or other provider of real estate settlement services to pay fees for bona fide services. Therefore, a mortgage lender may pay a mortgage broker or originator fees for providing Broker Services. It is also important to note that HUD currently takes the position that if the fee exceeds the going market rate for the services provided, the excess may be considered an illegal kickback or referral fee. While reliance on brokers to originate loan products is an important marketing strategy for many lenders, Banking Institutions should also be aware that the Federal Trade Commission, HUD, and the Department of Justice have reached settlements with mortgage lenders in recent cases in which these agencies have sought to hold the lenders responsible for alleged violations of law by unaffiliated third party originators.

When an affiliate of a mortgage lender provides services relating to the origination of a mortgage loan, it is important to be mindful of RESPA’s restrictions on affiliated business arrangements. Although a Banking Institution or loan originator may obtain real estate settlement related services from an affiliate, the Banking Institution or originator should provide the customer with a special disclosure regarding the affiliated relationship between the entities. Affiliated business referrals have been granted a safe harbor under RESPA provided that: (i) the nature of the affiliated relationship and the cost of the referred business is disclosed to the customer; (ii) the consumer is not "required to use" the affiliated service provider, subject to certain limited exceptions; and (iii) the only thing of value that may be received by the referring party as part of the arrangement is payment for goods or services actually provided and not payment based on the number of executed referrals. The safe harbor also generally exempts payments of dividends to parent companies and other forms of return on ownership interest.

Despite the RESPA prohibition on kickbacks, it is common industry practice for brokers to receive indirect compensation from lenders or wholesalers. Such indirect fees may be referred to as "back funded payments," "servicing release premiums," or "yield spread premiums." These indirect fees paid to mortgage brokers, which may be based upon the interest rate of each loan entered into by the broker with the borrower, have been the subject of significant controversy.

To provide greater clarity and comfort in this area in the future, HUD has proposed a rule (the "HUD Proposal") that would change the way mortgage broker compensation is reported to borrowers on the Good Faith Estimate (the "GFE") provided as part of a residential mortgage loan transaction. The HUD Proposal would require that all payments by a lender to a mortgage broker (except for the transfer of settlement cash to fund the loan amount) be reported on the GFE as a payment from the lender to the borrower, and it would permit borrowers to use these payments to fund compensation payable to the mortgage broker, which must be fully disclosed on the GFE. Thus, the HUD Proposal would clarify that these payments are permissible by essentially requiring all broker compensation to be paid (ultimately) by the borrower.

In addition to clarifying the status of payments to brokers under RESPA, the HUD Proposal also addresses the provision of packages of mortgage related services to borrowers. Historically, mortgage lenders have been reluctant to negotiate volume based discounts with settlement service providers to obtain lower costs for borrowers because these arrangements could involve payment of a "thing of value" to the lender that would constitute an illegal referral fee. The HUD Proposal would provide a safe harbor from the RESPA prohibition on kickbacks for entities offering a Guaranteed Mortgage Package ("GMP") in which a borrower would be offered (i) a guaranteed package price for virtually all settlement services required to close a loan, and (ii) an interest rate guarantee (which may be locked immediately or allowed to float based upon a verifiable index). The ability to provide a GMP will allow lenders to negotiate volume based rates with settlement service providers that may result in savings to borrowers. The terms of the GMP would be reflected in a GMP Agreement that must remain open for 30 days, thereby giving consumers the opportunity to comparison shop. Under the HUD Proposal, the GMP safe harbor would not apply to high cost loans subject to the Home Ownership Equity Protection Act.

II. Equity Based Incentives. If it is anticipated that one or a limited number of parties will be the source of significant referrals, another possible approach is to provide equity stakes rather than referral fees. More specifically, a Banking Institution could establish an operating subsidiary (i.e., the Banking Institution owns more than 50% of the voting stock of the subsidiary and otherwise controls it) to provide the service to be promoted, and offer an equity stake in the subsidiary to the referring party (indeed, the size of the equity stake could even be tied to the volume of referrals). This option may be particularly attractive with a national bank or federal thrift, as subsidiaries of these entities are deemed to have the same preemption over state law licensing and other restrictions (including limitations on providing trust services on an interstate basis) as the parent bank or thrift. Thus, for example, if a financial services organization had a large subsidiary and a national bank to provide trust powers, the subsidiary could be incented to refer trust business by providing the subsidiary an equity stake in an operating subsidiary of the national bank that had been established to engage in trust activities. Of course, fiduciary and other issues must be examined in connection with any such arrangement. Another approach is to offer interests in the Banking Institution itself. However, this may raise significant additional issues under the Change in Bank Control Act, the Bank Holding Company Act or the Home Owners’ Loan Act, all of which are avoided by using the subsidiary investment approach.

Conclusion. In sum, financial institutions have begun to pay referral fees to third parties in order to generate business to a much greater extent in recent years than has historically been the case. As this Article suggests, while referral fees are a useful tool for incenting business referrals, there are a variety of legal and regulatory requirements and limitations associated with referral fee programs. Because this article does not describe all of the potential requirements associated with referral fee arrangements, in addition to the requirements described in this Article, Banking Institutions that desire to implement one or more referral fee arrangements should also consider other requirements, including privacy laws, quality control, special limitations on referral fees with respect to the sale of insurance products and business issues such as how to terminate a referral arrangement in an orderly fashion if necessary.