Real Estate Compliance Consultant and former California Department of Real Estate (DRE) Investigator, Summer Goralik, outlines the inherent risks real estate professionals face when handling trust funds, and how to counter them. Learn more by visiting her blog: Expert DRE Compliance.
Compliance is a worthy challenge for many real estate brokers. Some brokers conquer it, while others struggle their way through it, and surprisingly, there are many that have yet to properly prioritize it. However, let’s put “baseline” real estate compliance aside for a minute. By baseline compliance, I mean, the laws and regulations that all real estate brokers and firms, regardless of their business models and activities, are subject to when they operate real estate businesses and supervise agents. The focus of this article is about a more rigorous and demanding type of compliance, and that is, the myriad requirements mandated under the California Real Estate law that only come into play when a real estate licensee receives or handles trust funds.
The engagement in trust fund handling requires a tireless commitment and strict adherence to the law, including precise accounting and meticulous record keeping. If real estate brokers are not 100% correct and compliant in their bookkeeping, then there is an actual chance that they may be disciplined by the California Department of Real Estate (DRE), or even worse, lose their real estate license. For this reason, it is my opinion that unless a real estate broker is extremely knowledgeable about trust fund handling requirements, and fully committed to satisfying them, they are officially operating in the danger zone of compliance, or as the title of this article reads, playing with fire.
Rather than cover a litany of trust fund handling requirements enforced by the DRE, which are lengthy, technical, and can just as easily be read in detail by referring to the Department’s website, this article will shine light on some straightforward and compelling facts that I believe tell a powerful story about trust fund handling and risk management. By the end of this piece, my hope is for brokers and salespeople, who handle trust funds in the course of licensed real estate activity, to better understand the critical importance of trust fund handling compliance and the inherent risks involved.
What are Trust Funds?
Before diving into the facts, let’s start at the beginning and understand the term, “trust funds,” and how it is used in the real estate industry. According to the DRE’s “Trust Funds” publication located on their website, trust funds are defined as “money or other things of value that are received by a broker or salesperson on behalf of a principal or any other person, which are held for the benefit of others in the performance of any acts for which a real estate license is required.”
Essentially, trust funds are monies belonging to principals, clients and/or the public, which are held and managed by a real estate broker, as trustee. The minute a licensee even “touches” trust funds, they trigger a world of regulatory requirements that have undoubtedly proven to be difficult for some brokerages to comply with. Such challenges can be gleaned by merely reviewing the Department’s annual reporting covering their government audits and findings which will be discussed below.
One way to quickly digest the huge undertaking required of real estate brokers who engage in trust fund handling is to simply examine the Department’s audit history and statistics which are released to the public on an annual basis. According to the DRE’s latest Fall 2022 Real Estate Bulletin, the Department closed 440 audits in fiscal year (FY) 2021-2022, of which 166 were investigative audits and 274 were proactive. Notably, the DRE found trust fund shortages totaling $9.5 million, which the Real Estate Commissioner called “troubling.” It should be mentioned that out of the 440 audits closed, 330 of the audits covered property management brokers and 124 of them had shortages totaling $9,019,436. Interestingly enough, the DRE closed more audits in FY 2020-2021 (480) and discovered less trust fund shortages totaling $3.6 million.
According to the Department’s annual reporting, property management brokers are usually the subject of most DRE audit examinations and the evidence suggests that this pattern is not a coincidence. Property management is an area of real estate activity where numerous trust fund handling issues and shortages tend to occur. That said, mortgage loan brokers and broker-controlled escrows are certainly no stranger to DRE audits, and where a good share of trust fund handling violations are discovered. As such, if any real estate broker engages in these types of licensed activities (e.g., property management, broker-controlled escrows, mortgage loans), they would be wise to pay attention to these numbers and issues, and better yet, review the Department’s monthly enforcement actions which I will talk about below.
DRE Enforcement Actions and Common Violations
As a real estate compliance consultant and former DRE Investigator, I have witnessed plenty of licensees mishandle trust funds, both intentionally as well as inadvertently, and be subject to significant enforcement actions and financial penalties, including the suspension, restriction or revocation of their real estate licenses. But, you do not have to witness it to believe it — just review the DRE’s website and their monthly enforcement actions. One common denominator amongst the more serious disciplinary actions is often related to trust fund mishandling. Of course, that is not to say that other violations of law like misrepresentation, fraud or dishonest dealing, which are tied to transactional accusations, are not a problem, but only that trust fund non-compliance will surely lead to formal administrative discipline.
In my opinion, if a broker is thinking about engaging in an activity which requires the handling of trust funds, then one prerequisite to that activity should include the review of the Department’s summary of monthly enforcement actions, statistics and related disciplinary documents. It’s a valuable and practical education that one can obtain (for free!) in order to instructively learn about the types of activities and non-compliance that can lead to formal discipline; how the Department interprets and enforces the law (which is not always intuitive) and hopefully highlights the crucial mistakes being made by licensees and how to proactively avoid them.
It’s worth noting that the Department has also published an advisory, “Ten Most Common Violations Found In DRE Audits,” which is located on their website. Remarkably, out of the 10 violations cited, the majority are related to trust fund mishandling and non-compliance. In reading through the Department’s enforcement actions and public advisories, I believe the message is clear. If you are a real estate broker who avoids or disallows activities involving trust fund handling, you are engaging in a much “safer” activity when it comes to risk management and compliance. Conversely, if your brokerage handles trust funds, then your real estate world is more complicated as you have more technical requirements to contend with and get right, and a higher burden of compliance and risk to bear.
True compliance story
Putting numbers and regulatory advisories aside for a moment, there is another way to convey the risky nature of trust fund handling and how even unintentional acts could lead to formal discipline. In my line of work, I have countless stories and cautionary tales to share which exemplify what can go wrong when a real estate broker mishandles trust funds. The following illustration is just one example of trust fund mishandling and the high cost of non-compliance.
A few years ago, a real estate broker who had an in-house escrow division consulted with me after the DRE filed an accusation against their firm. For those who may not be aware, a “broker-controlled escrow” is when a real estate broker acts as both a broker on behalf of one party and also as the escrow holder on the same transaction. In this case, the escrow officer, who was an employee of the broker, accidentally and unknowingly deposited $150,000, representing a buyer’s final down payment, into the broker’s general operating account instead of the trust account. This error was the result of the escrow officer using a remote deposit scanner and selecting the wrong bank account when completing the deposit transaction. Subsequently, the escrow officer proceeded to close the subject escrow transaction without the benefit of this deposit which resulted in a major trust account shortage totaling $150,000.
Furthermore, this error was discovered by the responsible broker six days later and immediately corrected. Specifically, the broker transferred the $150,000 from the firm’s general operating account back into the trust account, curing the shortage in the subject escrow and trust account. Nevertheless, the damage was already done. In fact, the brokerage was in violation of the Real Estate law on several counts. It is important to note that the ratio from one non-compliant act to a violation of the law is NOT one-to-one. The non-compliant act of accidentally making one deposit of trust funds into the broker’s general account actually caused six violations of the law which I will summarize below:
- First, the broker was in violation of trust fund mishandling due to the fact that the trust account was short as a result of the deposit error and the disbursements that were made from the trust account in the amount of $150,000;
- Second, the broker violated the DRE’s commingling rule because trust funds were deposited into the broker’s general account and commingled with the broker’s funds;
- Third, the broker failed to maintain an accurate, complete and compliant control record in violation of the law. For example, the broker’s control record indicated that there had been a deposit of $150,000 into the trust account (when it was actually deposited into the broker’s operating account), and hence the control record and the daily running balance were not correct on the date of the deposit;
- Fourth, the broker failed to maintain an accurate and compliant separate beneficiary record relative to the subject escrow. It should be noted that if a broker’s control record is not accurate, then it is likely that their separate beneficiary records (in connection with individual escrow files) are not accurate either, and that was no different in this situation;
- Fifth, the broker failed to deposit trust funds received into the broker’s trust account by the next working day in violation of the Real Estate law. In this scenario, the funds received totaling $150,000 were first deposited into the broker’s general account, and were not deposited into the trust account until six days later; and
- Finally, the Department alleged lack of broker supervision against the responsible broker. This comes as no surprise because a “failure to supervise” charge is closely tied to violations involving trust fund mishandling. One of the primary responsibilities bestowed upon responsible brokers is to ensure that the brokerage engages in compliant trust fund handling and maintains complete and accurate trust account records in line with the DRE’s laws and regulations.
To recap, one mishap involving trust funds caused several violations of law. In my opinion, this is a persuasive example of what can go wrong when handling trust funds, even when you are trying to do everything right. In this instance, there was no intentional motive on the part of the broker to violate the law, commingle or convert trust funds. Contrarily, the deposit into the broker’s operating account was a mere accident. Nonetheless, this error resulted in a formal accusation being filed against the real estate broker and eventually, administrative discipline.
With regards to discipline, the broker was fortunate in this case to receive a “public reproval,” the lowest level of formal discipline that may be rendered by the DRE against a real estate licensee. By “fortunate,” I am referring to the fact that the discipline did not include any suspension, restriction or revocation of their real estate license, which based upon my experience, is not always the norm. Additionally, the broker was required to pay the Department over $10,000 in audit and enforcement costs, and incurred costly legal fees in order to receive such a settlement.
Ultimately, the broker has formal disciplinary action on its real estate license record now, which can be reviewed by anyone on the DRE’s website. Therefore, the broker’s reputation has also been damaged and some may argue that this punishment far exceeds any fees paid or financial penalties rendered.
Admittedly, I know many brokers who have accidentally deposited trust funds into their general operating accounts versus their trust accounts. Sometimes this deposit error is discovered by the broker right away and prior to causing any shortages in their trust account. This timely discovery is usually by design and the result of appropriate policy and procedures in place, and an effective system of broker supervision, where daily controls exist in order to catch such trust account issues. On the other hand, a deposit error such as this one may go unnoticed for several days or much longer, causing trust account shortages, other violations of law, and an unforgiving paper trail evidencing lack of supervision and oversight by the responsible broker.
Sadly, it is not uncommon for some brokers to mistakenly engage in non-compliant trust account activities. While some of these brokers have managed to escape regulatory scrutiny, their fate can quickly change with just one DRE audit examination. Moreover, the primary point to take away here is that one unintentional accounting issue can potentially cause extensive regulatory repercussions.
When a real estate broker decides to take on trust fund handling, they must fully commit to a new world of compliance which requires a “premeditated” or proactive game plan. This plan, which should be comprehensive and meaningful, should incorporate the following, without limitation:
- A review and understanding of the laws and regulations enforced by the DRE. If you do not understand the requirements or have questions, it is wise to seek outside help or assistance which may include a licensed real estate attorney, compliance consultant, or even contacting the DRE for clarification;
- Creation of, adherence to, and enforcement of sound policy and procedures which will enable the broker to fully satisfy and continually stay compliant with the DRE’s statutory expectations and rules;
- Establishment of a well-rounded and structured system of supervision which requires daily and monthly trust fund controls and maintenance, methods of review, spot-checking, brokerage reporting requirements, and risk management; and
- Supervision and oversight by the responsible broker which may also include reliance on some delegation of authority and supervisorial responsibility to other affiliated and trusted licensees.
The above outline of highlighted tasks serves as a high-level description of what needs to be done, and truthfully, it only gets harder and more complex as you iron out the critical details needed to make real compliance possible. Notwithstanding, the important thing to keep in mind is that without this type of wholehearted and robust course of action, complete with constructive controls, a broker will not have the necessary tools to actually carry out, achieve and monitor compliance, and their license, business and reputation will be at risk.
For those brokers already knee-deep in trust fund handling, they are not precluded from this exercise and overall discussion. Real estate brokers can always stop and re-evaluate their trust fund handling compliance and broker supervision, and ideally, before they are audited by the DRE. The self-evaluation and identification of non-compliance, as well as the correction of existing policy, procedures, systems and rules, in good faith by any broker, always has value and is strongly recommended no matter how compliant or non-compliant they may be.
The goal of this piece is not to scare or deter real estate licensees from engaging in trust fund handling, but to motivate them. If real estate licensees are going to handle trust funds, it would be wise to first adopt a multi-pronged approach to regulatory compliance. Without the execution of fundamental tasks as briefly touched on above, a broker is walking a tightrope that could cost them their real estate license if they lose their balance. As I like to preach, please do your homework, read and take steps to understand the law and requirements, ask questions, create solutions to potential problems (before they occur), hire outside help if you have to, and get the job done right the first time. Put another way, and more crudely perhaps, invest in trust fund compliance now or trust fund mishandling could be your reality and all the consequences that come along with it.
Author’s note: Any opinions, or recommendations contained in this article are based on my experience working for, and knowledge of the laws and regulations enforced by, the California Department of Real Estate, and must not be considered legal advice. Please consult with a licensed real estate attorney for legal support or clarification.
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