Spotlight - Risky business

Some brokers choose to partner with building developers in a bid to generate additional revenue.

On the face of it, a referral partnership with a developer is no different from any other. However, while this sort of partnership can be financially beneficial for the broker and valuable to their clients, it does involve a much higher level of risk.

For a referral relationship of this kind to work safely and effectively, a broker needs to be up-front with their clients and completely transparent in their operations.

Clients should be made aware of the relationship their broker has with the developer and especially what remuneration is involved.

All licensed brokers are required to keep a register of referral partners and referred clients, to have a written agreement with their referral partner and to make known any remuneration involved in that agreement.

“If the developer is giving the broker a commission, that is risky,” Gadens Lawyers senior partner Jon Denovan says.

“It must be fully and prominently disclosed to the borrower, as it could be seen to inflate the price of the property they are paying for.”

In addition, brokers should be careful not to provide any guidance or advice on the future valuation, capital gains or tax on an investment property.

A broker should modify their finance broking contract to make it clear they do not make any representation about the value of the property or its future prospects, according to Mr Denovan.

“The finance broking contract should also state the borrower must rely on their own enquiries,” he says.

By making the appropriate changes to their finance broking contracts, brokers can minimise the risk to them if a deal goes sour.

Even with all the precautionary measures, however, some industry figures feel partnering with developers is still fraught with danger.

Finance Made Easy director Tony Bice does not refer his clients to developers and steers clear of any involvement in partnerships that could jeopardise his business.

“An arrangement with a developer is always going to have a slightly tarnished image to it,” Mr Bice says.

“In the market we are in right now, with the valuations involved, there’s so much grief trying to structure a deal with a developer.”

As a qualified financial planner and licensed mortgage broker, Mr Bice is well versed in the legal implications and consequences for brokers of offering advice to clients.

“I’m a qualified financial planner, so if I want to give advice with regards to an investment strategy I’m qualified to do that,” he says.

“With a mortgage broker, if they’ve got an arrangement with a developer, they’re not in a position normally to give advice on investment strategies.”

If a broker starts advising their client on their financial investments, they are treading on the domain of the Financial Services Reform Act, which if breached can carry some heavy penalties.

MFAA CEO Phil Naylor says the choice to refer clients to developers is an ethical issue that can easily end in trouble.

“I’m not saying don’t go there, but it is a possible ethical conflict of interest,” he says.

Brokers need to ensure they have the client’s best interests at heart when referring them to a developer. They should therefore educate themselves on the policy, pricing and procedures of a potential referral partner before entering into a referral agreement.

It is not uncommon for developers to build extra charges into the price of their properties, usually to cover marketing and distribution costs.

These tactics highlight some important differences between the mortgage broking and building development industries of which brokers should be aware.

“The building industry is closely aligned with the mortgage broking industry but it has different characteristics,” according to IHG Surety and General account manager, Stephen Keith.

“Insurance is an important part of that relationship because there is reputational risk,” he says.

To prevent any damage to the brand as a result of litigation, professional indemnity insurance is essential for all brokers who have entered into a referral agreement.

Mortgage Choice has recently secured professional indemnity insurance to cover its third party referral service.

In response to the widespread activity of brokers partnering with building developers, Mortgage Choice is developing a policy that will enable its brokers to refer clients on to developers in a risk-free environment.

While the policy is yet to be finalised, Mortgage Choice CEO Michael Russell says securing professional indemnity insurance allows a broker to be covered both for the referral activity and the associated risk of a claim made by a customer.

“We’ve insured the actual third party referral service, but we’ve also insured the risks associated with a client, for example, taking action against the referring party and naming as a second respondent our franchisee,” he says.

Mortgage Choice has had a third party referral policy in place for some time with respect to customer referrals to groups such as accountants, financial planners and real estate agents.

But until now, no policy has outlined a code of conduct for referral relationships with developers. Mortgage Choice brokers are currently not permitted to refer their clients to property investment specialists or builders.

“It came to our attention that the activity was quite widespread in the industry,” Mr Russell says. “We needed to investigate it from the perspective of what the potential brand risk and litigation would be.”

While the risks associated with developer partnerships are still there, having an insurance policy in place is the first step towards managing that risk.

Mortgage Choice has been working on its policy for the past six to eight months, and while the insurance cover has now been secured, it still requires a level of due diligence.

“Our insurer has put some pretty tight requirements around what we need to do,” Mr Russell says.

But despite the risk mitigation, Mr Russell believes the new policy will be beneficial both to Mortgage Choice franchisees and their customers.

“If you’ve got genuine investor clients looking to invest in residential property and who are asking their mortgage brokers for assistance, then there is an upside in servicing them there,” he says.