Edwin J. Ricketts

Licensees, Beware of Secret Profit

Licensees beware! There are among us unscrupulous and ignorant real estate licensees who may profit off a client or customer, but without the client's or customer's knowledge, let alone their permission. Although the practice of profiting off a client without the client's permission is illegal in most states if not every state, it remains a very pervasive practice. It is undoubtedly practices like this that contribute to real estate licensees' terrible rating in Gallup's annual Honesty and Ethics Poll.

Few subjects generate as much emotion in real estate circles as the issue of undisclosed profit. Especially where a kickback is received in return for a referral to another service provider, to many real estate licensees this is (how shall I put it?) a very touchy topic. Add a little passion and - voila! - you've got yourself a red-hot issue. This article is based on the hopeful premise, however, that most real estate licensees wish to obey the law and to practice real estate in an honorable and ethical manner.

The law and the NAR Code of Ethics both have a lot to say about the requirement of disclosure to and permission from a client or customer before a licensee may receive a rebate or kickback for the referral of services to the principal. But even without the law or Code of Ethics, doesn't a common sense of decency and fairness dictate advance disclosure and permission before profiting off a client? Isn't that sense of decency and fairness part and parcel of how we real estate professionals promote ourselves? Then, why should clients and customers expect anything less of real estate licensees than fully lawful and ethical behavior?

The Standard of Care

The Law

The laws of most states prohibit licensees from receiving real estate related compensation without the knowledge and consent of the parties off whom this compensation is generated. In Arizona (my state), for instance, a real estate rule adopted by the Department of Real Estate reads:

"A licensee shall not accept any compensation, rebates or
profit for transactions made on behalf of a client without
the written consent of the client."

This rule includes any rebates, kickbacks, fees, commissions - compensation of any sort - that licensees may receive as the result of a referral to another service provider, for instance, a swimming pool contractor, home builder, home warranty company, transaction coordinator, etc. In short, profiting from a client's transactions without the client's prior knowledge and consent is flat illegal.

Most if not all states also require disclosure to all parties to a transaction - clients and customers alike - of any material facts, that is, information that may affect the principal's decision to go through with a deal as represented. This is implicit in the requirement of fair and honest dealings. In Arizona this law (Commissioner's rule) reads:

"A licensee participating in a real estate transaction shall
disclose in writing to all other parties any information
which the licensee possesses that materially and adversely
affects the consideration to be paid by any party to the transaction."

Therefore, even if the party is a customer, the law probably still requires at least advance disclosure of information that might influence a principal's decision. For instance, if you were the buyer, might it make a difference to you that the listing agent was going to receive a kickback from the service provider to whom he referred you?

Article 6, NAR Code of Ethics

Depending on the state, up to half or more of the real estate licensee population are REALTORS®. As REALTORS®, we swear allegiance to the National Association of REALTORS®, Code of Ethics. The Code of Ethics is very specific on the subject of secret profit:

"REALTORS® shall not accept any commission, rebate,
or profit on expenditures made for their client, without
the client's knowledge and consent.

"When recommending real estate products or services
(e.g., homeowner's insurance, warranty programs,
mortgage financing, title insurance, etc.), REALTORS®
shall disclose to the client or customer to whom the
recommendation is made any financial benefits or fees,
other than real estate referral fees, the REALTOR® or
REALTOR®'S firm may receive as a direct result of
such recommendation."

So, even if some "wiggle room" might be allowed under the laws of a state, the NAR Code of Ethics permits none. It clearly applies to both clients and customers.

Examples of Infidelity in Profiteering

The Swimming Pool Contractor

It is common practice for a buyer's agent to refer a client to a pool contractor, or even contact the pool contractor without the knowledge of the client, in return for a several hundred dollar kickback. Receiving such a kickback is a violation of the law and of the Code of Ethics. Prior written consent from the buyer must be obtained before receiving this "thank-you" from the pool contractor.

Home Warranty Company

Many licensees still opt to receive a modest (typically up to $50) kickback from the home warranty company in return for a client referral. Here again, advance written permission is required for the agent to profit off the client. Also, because the home warranty is a settlement service under the Real Estate Settlement Procedures Act (RESPA), the client's permission is not enough. Receipt of the fee also requires the agent provide genuine market-based service in return for the fee. However, whether or not services for the fee are actually performed, the law and the Code of Ethics require the advance consent of the client.

Transaction Coordination Fee

A number of brokerages assess clients a fee to oversee the processing of the transaction, providing an additional check on the escrow agent, lender, inspectors, etc. This is, potentially, a valuable service. These fees range between $100 and $400, depending on the brokerage. The transaction coordination fee is generally disclosed up-front and is signed off on by the client. However, if, as was one brokerage's practice of which I am aware, the fee does not all go entirely to pay the transaction coordination function, further disclosure is required. In this case, most of the coordination fee was actually distributed to the agent, as an incentive to get the client to agree to the fee, and to the brokerage. The clients had no knowledge of the "extra" commission being kicked back to the agents and the brokerage. The clients were not informed this fee was really a profit center for the agents and broker. Partial disclosure is as bad as - or worse - than no disclosure at all. Again, the law and the Code of Ethics require advance written permission.

Home Builders

Now let's discuss a big-ticket item - the home builder kickback. When a licensee refers a client to a custom home builder, a "referral fee" often results. If the buyer-client has not consented up-front to this kickback, it is an unlawful payment. In some cases, the agent will refer a client to three home builders, suggesting the client interview them and select one. However, what is seldom disclosed to the client is that the agent will receive a significant kickback.

The home builders sometimes have undisclosed agreements with the brokerage to be one of the brokerage's "preferred" referral builders. Some builders make mention in the construction contract that a fee may be paid to the brokerage, but because that disclosure is designed to be late in the decision making process and is not pointed out to the client, the disclosure is neither timely nor sufficient. Further, it is the licensee who has the obligation to make the disclosure and secure permission, not the home builder. The prevalence of this illegal, unethical practice shocks me.

Construction Services

Another area of concern occurs when a home builder refers a buyer to another service provider. For instance, the new home buyer is given a $10,000 flooring allowance to contract with another provider for carpet and tile. However, what is not disclosed to the buyer is that the flooring contractor is kicking back to the home builder 20% of the buyer's total expenditures.

In this case, however odious this practice appears, it may not be illegal unless the home builder is a "licensee" under the that state's department of real estate, and the practice may not be a violation of the Code of Ethics unless the home builder is a REALTOR®. In Arizona, if the home builder is also a subdivider selling under the authority of a public report, then the builder is a licensee, and subject to the two Commissioner's rules previously discussed. In some states the licensing agency for contractors may additionally prohibit the practice of secretly profiting from referrals.

Law vs. Code of Ethics

While Arizona law requires the written consent of clients, no such consent is required of customers, although other states' laws may include both clients and customers. However, the Code of Ethics applies to customers as well as clients. The client, your principal in the real estate transaction, is someone to whom you have an "agency" relationship, and fiduciary duties of, for instance, loyalty, confidentiality and advocacy. Typically, the duty owed to a customer is a duty of fair and honest dealing, meaning the licensee cannot lie to the customer and must inform the customer of all material facts related to the transaction. As discussed above, even if the principal is a customer and you are not a REALTR®, before profiting off the customer via a referral, the laws of most states still require advance disclosure to the customer.

How to Disclose and Informed Consent

There are two components in making any disclosure of material information, and certainly the intent to profit off a client is a material matter. The disclosure must be made in a timely manner and in a meaningful way. Timely manner implies the disclosure is made at a time before the principal commits significant resources, either time or money, in other words, before a decision is made. To reveal information in a meaningful way implies disclosure in such a way that the principal at least understands enough to make further inquiry into the matter.

In the case of a kickback for service referrals, an additional level of response is required of the client - informed consent. This implies a level of understanding that allows the client to compare options and to make a reasoned decision based on the disclosure. Informed consent is always obtained in writing.

Consequences of Violations

Department of Real Estate

A violation of the state's laws could result in disciplinary action against a licensee, including license suspension and fines.

Association of REALTORS®

Violation of the Code of Ethics could result, depending on the seriousness of the violation(s), in up to a $2,500 fine and expulsion from REALTOR® membership and multiple listing service participation for up to three years.

Lawsuits

An adverse civil judgment may result from a lawsuit involving violation of the law and, to the extent that a violation of the Code of Ethics may be considered in your state as falling below the standard of care, it too might result in an adverse judgment. Many states' courts have ruled that the Code of Ethics establishes a standard of care, meaning that even if a law is not violated, the breach of the Code of Ethics might be used to establish the basis for a lawsuit. Damages, resulting from the failure to obtain the client's or customer's permission, would typically have to be proved. But a licensee is not entitled to keep compensation he has illegally received.

Payment of Compensation

Any referral fee, rebate or compensation that arises out of a real estate transaction in which a licensee is involved is real estate compensation. Therefore, all such compensation must be paid through the brokerage. The salesperson may not receive, for instance, a kickback directly from the pool contractor. The payment must be made to the brokerage, which may then pay it to the licensee.

Do the right thing!

Ethical and moral high ground dictates that a true professional will always want a client or customer to know the licensee is profiting off the principal. However, when I ask a licensee why, for instance, he does not want the client to know about the custom home builder's commission back to him, a not untypical response is that, if told, the buyer may balk at the idea, believing (not unreasonably) that this additional commission adds to the cost of the home. Therefore, often licensees do not inform the client, placing self-interest above the consumer's interest. There is really only one reason why a licensee will not attempt to obtain prior written consent from a consumer before receiving a kickback: fear the consumer will say no, and the additional profit center will be eliminated.

A negligent referral may also result from these secret kickback schemes. Why? It's obvious the reason for the referrals has little if anything to do with the licensees' desire to ensure the consumer is taken care of by a skilled professional of good reputation. The impetus for the referral is the secret profit. And it often happens that service providers who pay these secret kickbacks are not exactly blue-ribbon service professionals.

Ed's Advice

As an ethical, honest real estate professional, you should always desire to "do the right thing." Yes, money is an awesome inducement. And, although there are plenty of good, honest licensees out there, there are also plenty of marginal licensees whose primary interest is self-dealing. And, even though the Code of Ethics stresses in its preamble the application of the Golden Rule in all REALTORS®' conduct, not all REALTORS® employ it. We see licensees profiting all around us from secret profit. Why should we be any different? Hopefully, because we are ethical, law-abiding professionals.

WHAT YOU SHOULD DO: If there is even the remote possibility of you earning a referral off a client or a customer, immediately disclose the possibility to the principal in writing. Obtain the principal's written acknowledgement/permission. You may be surprised how amenable a client or customer is to you earning an extra fee when you surprise them with such candid disclosure. Americans expect us to lie, cheat, steal and double-deal them. But they don't like it. Candid, up-front honesty may actually result in greater long term pay-offs. Irrespective of long or short term pay-off, honesty and fair play is never anything to be ashamed of.

Edwin J. Ricketts is a broker-counselor and educator. He was Deputy Commissioner of the Arizona Department of Real Estate from 1991 to 1997. He may be reached at EJRetal@fastq.com or 602-277-4332.