Development activity on the multifamily affordable housing front continues to be strong this year -- Public Housing Authorities are redeveloping their stock with HOPE VI and tax credit investment funds; Low Income Housing Tax Credit demand is overwhelming; owners, lenders, and loan servicers are beginning to experiment with HUD's Mortgage Restructuring process; and non-profits are finding themselves courted by owners of HUD-insured and subsidized properties, developers, and managers, all of whom desire to sell to, service, or partner with these charitable organizations in order to gain access to the perceived and real advantages such entities possess in the affordable housing arena.
Congress' appropriations activities continue forward, while tax credit and public housing legislation appears to be moving at a slower pace. Although these legislative initiatives are watched by those in the affordable housing industry, more anxious eyes continue to await the uncertain results of HUD's efforts to draft guidelines for the Mortgage Restructuring program and the Department of Treasury's response to the industry's request for a ruling on the taxability of subordinate loans created during the Mortgage Restructuring process.
Although progress and outcomes on legislative and regulatory efforts in many areas of interest to the affordable housing industry remain uncertain, in order to keep Pepper Hamilton clients informed on the current status of significant issues of industry concern, we have provided below a summary of some matters we believe to be of greatest interest.
NON-PROFIT ACTIVITY AND JOINT VENTURES
As the tax credit market continues to tighten and HUD enforcement mechanisms loom over private owners, non-profits are finding that they are often solicited by owners who wish to sell their properties or by developers looking for joint venture partners. Private developers are finding that LIHTC applications containing a non-profit component score additional points in most jurisdictions. Additionally, owners and, sometimes, general partners who wish to leave the HUD-regulated arena out of concern for what many consider to be HUD's over-enthusiastic enforcement techniques are soliciting non-profits in order to obtain a greater purchase price for their projects. Non-profit access to tax-exempt financing, more favorable FHA-insurance terms, and other tax incentives, as well as a longer term view of return on investment, sometimes allow non-profits to pay higher purchase prices for affordable housing properties than for-profit entities.
Interestingly, we are finding that some sellers of affordable housing also believe that non-profits must be able to pay a higher price due to lower operations costs and automatic property tax abatement available to their properties. These lower expenses allow for larger loans to non-profit purchasers while maintaining debt service coverage ratios satisfactory to lenders. Larger loans then allow for greater cash payments to sellers.
Sellers who expect that a non-profit owned property will have a more favorable operating statement or that tax abatement will automatically be available to the project are generally disappointed. Many of our non-profit clients have excellent operational records for their affordable housing portfolios, but their costs of operation do not generally run lower than those of for-profit owners with well managed projects and market-rate service providers. Additionally, property tax abatement is often not available, and the statutes for a given property's jurisdiction must be examined prior to underwriters making the assumption that it is.
Owners should also note that although some sellers may receive a higher purchase price from non-profit purchasers, the purchase is often financed through the issuance of unrated bonds which may require a more lengthy underwriting and negotiation period for loan documents, as investors play a more direct role in the process. FHA insurance programs, often attractive for non-profit purchasers, can add additional time to the closing schedule.
Nevertheless, there are advantages to selling affordable housing to non-profits, one of which may be the shrinking pool of for-profit owners willing to be included in the group of potential indictees under HUD's new enforcement policies. The market for HUD-regulated projects may be shifting out of for-profit hands, as owners and developers move away from FHA-insured properties.
Rulings for Non-Profit Joint Ventures
In addition to ownership within the HUD-regulated housing realm, non-profits are also major players in the tax credit market. Developers are discovering that LIHTC applications are more warmly received when a charitable organization is part of the ownership structure. The area of tax-exempt law and regulation of operation and financing for non-profit/for-profit partners has evolved over the last year as the Treasury Department attempts to keep pace with ambiguities created by the application of currently available guidance to some of these enterprises.
Two Private Letter Rulings released in 1997 provided some guidance as to what the IRS considers to be acceptable structures for partnerships involving non-profit general partners and for-profit investors in the context of tax credit properties. In March 1998, the Service also published additional guidance on 501(c)(3) joint ventures in the context of health care. This ruling is relevant to the field of affordable housing.
Private Letter Ruling 9736039
In Private Letter Ruling ("PLR") 9736039, the IRS held that the tax-exempt status of the non-profit general partner in a LIHTC venture would remain intact where the partnership's organization provided sufficient control by the non-profit. In this case, the non-profit held a .15% interest as general partner, while a for-profit developer held a .85% general partner share. Under the partnership's original arrangement, the non-profit's duties as general partner were largely advisory, with the majority of substantive decision making to be made jointly by the general partners. This left the for-profit developer effectively in control of partnership operations. Additionally, the non-profit had pledged its partnership interest as security against default under the partnership agreement, including failure by the for-profit general partner to fulfill its obligation to return funds to the investor upon occurrence of credit recapture or shortfall in credit allocations.
The Service raised concerns that the non-profit's lack of control made it difficult to maintain the non-profit's charitable function, and that the non-profit's pledge for the benefit of the general partner placed the non-profit's assets at risk for the benefit of the for-profit developer. In response, the partnership's structure was changed to eliminate the pledge and to provide the non-profit with authority to cause the partnership to comply with the set-aside requirements, the regulatory and extended-use agreement, and all material provisions of the project documents.
Private Letter Ruling 9731038
In another Private Letter Ruling, PLR 9731038, the Service laid down some guidelines for acceptable non-profit guarantees regarding environmental indemnification, credit adjustments, and failure to meet project completion deadlines. In a largely fact-specific ruling, the general partner satisfied IRS concerns over the environmental indemnification by demonstrating that there was little likelihood of environmental problems with the project and by amending the guarantee to exclude losses resulting from recapture of credits unless the loss resulted from the gross negligence or willful misconduct of the general partner.
In further deference to Service concerns, the credit adjuster factors were amended to provide that (i) payments made in this regard would be characterized as capital contributions of the general partner rather than as liquidated damages for breach of warranty and (ii) credit adjuster payments would represent only the limited partner's overpayment of its capital contribution and not the amount of the anticipated credit amount. The completion guaranty was acceptable to the IRS because the risks were demonstrated to be minimal and the risks undertaken were under the control of the general partner.
These issues of control, guarantees, and indemnification by non-profit partners will continue to be fleshed out as LIHTC non-profit/for-profit partnerships come under more scrutiny by the Service. In both rulings, the Service appears to have used a reasonableness approach with regard to guarantees of the non-profit by evaluating the likelihood of certain events occurring under the given circumstances. The issue of control over the partnership will likely need to be further addressed, as investors working with smaller and sometimes inexperienced non-profits may find themselves uncomfortable with the risk of the non-profit's unrestricted and untested management. The issue will continue to be reviewed and negotiated among the members of these ventures.
Revenue Ruling 98-15
On March 4, 1998, the Service released Revenue Ruling 98-15, which is acclaimed as providing long-awaited guidance concerning health care joint venture operations. The Revenue Ruling addresses the acceptability of joint ventures between non-profit hospitals and for-profit health care organizations. Although not referred to in the Revenue Ruling, affordable housing joint ventures can also draw on 98-15 for guidance. Additionally, although the Private Letter Rulings noted above give some direction, in a strict legal sense they do not provide authoritative precedence to organizations other than those to whom they were addressed. As a Revenue Ruling, 98-15 may be cited as direction by the Service applicable to all non-profit joint venture organizations.
The Revenue Ruling presents two fact patterns concerning LLC joint ventures between tax-exempt hospitals and for-profit health care organizations. In both cases, the hospital contributes its hospital and other assets to an LLC, which then operates the hospital.
The Ruling largely concerns the organizational documents and management of the LLCs, and examines and contrasts their differing control allocations. In Situation 1, the organizational documents of the LLC provide that three out of five LLC board members will be appointed by the tax-exempt hospital. The governing documents also provide that both the for-profit and non-profit members of the LLC must approve budgets, distributions, acquisition and disposition of health care facilities, contracts in excess of a certain dollar amount, and other major decisions; the LLC's hospitals must be operated in furtherance of charitable purposes; and the board must act so that this charitable purpose takes precedence over any duty to operate the LLC for the financial benefit of its owners. Additionally, the LLC entered into a five-year management contract with an organization which is unrelated to either the non-profit or for-profit LLC members. The management agreement is renewable after five years only with the consent of both members.
In Situation 2, three members of the governing board of the LLC are chosen by the hospital and three are chosen by the for-profit member. The organizational documents do not provide that any charitable purpose will be dominant in the LLC's decision making. Additionally, the management company with which the LLC contracts is wholly owned by the for-profit LLC member, and the initial five-year management contract is renewable at the management company's discretion, unless terminated by the LLC for cause.
Predictably, the Service determined that Situation 1 was acceptable and would not jeopardize the hospital's 501(c)(3) status, and that Situation 2 violates the charitable requirements of the hospital's tax-exemption. Situation 2 makes the hospital's charitable assets available for private financial benefit without insuring their use for charitable purposes.
The two situations offered by the Service are distinctly "good" and "bad." The gray area in between remains unaddressed. The Revenue Ruling is consistent with prior guidance from the Service, and frankly, offers legal practitioners little additional instruction on acceptable joint venture relationships. Pepper Hamilton believes that this Revenue Ruling restates the law as we understood it. Our clients involved in joint venture activities have generally required our counsel regarding considerably tougher decision making. When management terms, control, guarantees, distributions, and dissolution terms are mixed into unfamiliar and differing combinations, all relevant guidance and practice experience is called upon to determine organization structures which are acceptable under both legal and financial criteria.
The issues surrounding non-profit joint ventures continue to evolve as the affordable housing industry moves forward into this complex area.
LOW INCOME HOUSING TAX CREDITS
Our clients involved in tax credit development continue to find competition for tax credits to be the greatest impediment to their expanding development of affordable housing under the LIHTC program. As demand by tax credit investors increases, for-profit developers are discovering that many states go far beyond the mandatory 10% credit set aside for non-profits. With competition from Housing Authority public/private partnership redevelopment programs and non-profit housing developers, for-profit private developers are often required to partner with community or charitable organizations to compete in the tax credit allocation process. Investors are also finding that not only must they compete with other investors for rights to purchase tax credits from successful developers possessing LIHTC allocations, but they are being required to commit to making equity contributions at earlier stages in the development process. Developers now find that they may even be able to obtain loans and initial project funding from LIHTC investors prior to the developer obtaining a tax credit allocation.
Expansion of the Credit
The tightness of the LIHTC market has prompted significant efforts to expand the credit. The volume cap for low income housing tax credits has not been increased since the credit's introduction in 1986. The cap for each state is currently calculated by multiplying the state's population by $1.25. Currently there are three bills offered in Congress to raise the LIHTC cap to $1.75 and provide for additional annual increases indexed to inflation.
Senator Alfonse D'Amato (R-NY) introduced S. 1252 last year, and H.R. 2990 was introduced by Congressman Ensign (R-NV) and Congressman Rangel (D-NY). Also, Representative Nancy Johnson (R-CT) has introduced H.R. 3290 which, in addition to increasing the credit cap, would eliminate certain penalties for projects that combine HOME funds and tax credits and give preferences to projects designed to serve very-low income tenants.
Tax-Exempt Bonds
In addition to movement towards an LIHTC cap increase, there is strong support for an increase in the tax-exempt bond ceiling. Currently, each state is limited in its private activity tax-exempt bond issuing authority to the greater of $50 per capita or $150 million. Representatives Houghton (R-NY) and Kennelly (D-CT) have introduced H.R. 979 in the House, and Senators D'Amato and Breaux (D-LA) have introduced S. 1251 in the Senate. Both bills would raise the current limit, which has been in place for ten years, to the pre-1988 levels of $75 per capita or $250 million and would index the new cap to inflation. The House bill has over 228 co-sponsors, and the Senate bill has 36.
PUBLIC HOUSING DEVELOPMENTS
Public Housing Reform
Although both houses of Congress have passed their respective public housing reform legislation (the House bill, H.R. 2, passed the House in May 1997; the Senate bill, S. 462, passed the Senate on September 26, 1997), so far the compromises necessary to enact the public housing reform law have not been reached.
Representative Rick Lazio (R-NY) and Senator Connie Mack (R-FL), sponsors of their house's respective bills, have been negotiating on and off for almost three years on the final version of the legislation. Their differences concerning income targeting thresholds for public housing and local government versus PHA control of public housing funds appear to be the predominant issues of disagreement between the two leaders.
H.R. 2 requires that only 35% of public housing units be reserved for families and individuals earning less than 30% of area median income. Senator Mack's S. 462 would set aside 40% of units for such tenants. Secretary Cuomo has expressed displeasure with both income targeting schemes as providing too little housing for the nation's very-low income families.
The two bills also differ in their distribution of public housing funds. The Lazio bill would allow local governments direct access to public housing funds, while the Mack bill would keep funding in the PHA's hands.
Both bills would give more discretion to PHAs in the setting of rental payment standards for tenant-based assistance, each raising the allowable payment to 120% of either Fair Market Rent ("FMR") or "rental indicators." Both bills also permanently eliminate federal preferences, the 90-day notice requirement, and the "take one-take all" rule, and allow minimum tenant rental payments.
Different reports from different sources alternatively claim that compromise is near or that agreement is unlikely to be reached soon. It nevertheless appears that both sides are working to get some form of the legislation passed this year.
HOPE VI
The activity and success surrounding HOPE VI redevelopment have been noted by the Senate in its latest draft of appropriations for FY 1999. Although the administration had requested only a repeat of the $550 million in HOPE VI funding provided in both FY 1998 and FY 1997, the Senate Appropriation Committee passed its FY 1999 VA/HUD Appropriations bill on June 11, 1998 with $600 million available for the program.
Despite an Office of General Counsel audit report which found deficiencies in the review process for FY 1996 HOPE VI applications and the subsequent award process, the program is generally seen as the only means by which local housing authorities can obtain the capital necessary for large-scale redevelopment of dilapidated public housing stock, and will continue to be funded for another year.
The March 31, 1998 Federal Register contained HUD's first of three SuperNOFAs for this year, making available approximately $416 million of funding for HOPE VI revitalization, of which $26 million is set aside for demolition and replacement of elderly public housing. A separate demolition-only NOFA was published in the June 1, 1998 Federal Register, offering $60 million in HOPE VI funds for the demolition of obsolete and/or severely distressed public housing units without revitalization.
Applicants under the SuperNOFA will be ranked according to demonstrated capacity and ability criteria including:
(a) Organizational resources of the PHA necessary to implement the proposed activity in a timely manner, including the capacity and qualifications of subcontractors and consultants firmly committed to the project and experience in revitalization programs, including previous HOPE VI initiatives;
(b) Need for funding, demonstrated by documented problems such as level of physical deterioration, risk of continued deterioration without immediate intervention, and level of distress within the surrounding community;
(c) Cost effectiveness of the revitalization plan, cost effectiveness of plan design and implementation, market demand, long-run financial feasibility, and lessening of concentration of low-income residents;
(d) Effective leveraging of HOPE VI resources, including demonstration of firm commitments for additional funding and/or partnership investment;
(e) Coordination with other community groups and activities.
The above criteria are only a brief review of the HOPE VI NOFA guidelines. We find that our Public Housing Authority clients have generally employed consultants with specific experience in the HOPE VI program to organize and assist in development of their proposals for funding. In some cases, developer partners have been solicited prior to a NOFA release and have agreed to carry the up-front costs and effort involved in responding to the HOPE VI NOFA.
Pepper Hamilton is now working with housing authorities in New Jersey and Pennsylvania in their implementation of HOPE VI revitalization plans using current HOPE VI awards and in their efforts to obtain additional HOPE VI grants. Given the complexity of financing methods and HUD contracting and procurement rules involved in the development of public housing and the privatization of certain public housing services, our clients have generally discovered the need for significant preplanning, evaluation, and investigation prior to achieving success in the HOPE VI arena. Applications for funding under the current SuperNOFA HOPE VI offering are due June 29, 1998. Planning by interested Public Housing Authorities for the application and use of 1999 HOPE VI funding will likely begin soon. Applications for funding under the HOPE VI demolition-only NOFA must be submitted to HUD no later than September 3, 1998.
MORTGAGE RESTRUCTURING (MAHRAA)
Overview
In October 1997, as part of the FY 1998 VA/HUD Appropriations Act (P.L. 105-65), the Multifamily Assisted Housing Reform and Affordability Act of 1997 ("MAHRAA") was enacted. MAHRAA represents the permanent version of HUD's Portfolio Reengineering program, intended to address the ever increasing costs of renewal for Section 8 project-based rental subsidy. The annual cost of renewal of Section 8 contracts expiring over the next decade was projected by Congress to increase from $1.2 billion in 1997 to almost $7.4 billion by 2006. This is generally seen as untenable by Congress and HUD, and for this reason, a Mortgage Restructuring program was required. Under MAHRAA and its predecessor programs, subsidized properties with high subsidized rent levels will have their subsidy reduced or eliminated over time, and mortgages on FHA-insured subsidized properties will generally be restructured to accommodate this reduction in rental income. (A complete summary of MAHRAA was contained in our February 1998 Housing Update and may be obtained from any Pepper Hamilton attorney.)
Mortgage Restructuring (and its predecessor, Portfolio Reengineering) drew few participants. The program generally requires a reduction of subsidy rent levels for those projects eligible to participate and a corresponding reduction in project debt. This decrease in project debt is to be most often accomplished by the bifurcation of the project's mortgage into a first mortgage, serviceable from project income, and a below-market interest rate second mortgage, serviceable from excess cash flow. In most cases, it appears that the second mortgage will not be serviced, and will instead accrue interest until the first mortgage is paid off. It is foreseen that the subordinate mortgage will carry an interest rate at well below the Applicable Federal Rate ("AFR") (HUD has indicated a 0% or 1% rate). If a portion of the original mortgage debt is spun off into such a low-interest, and in many cases non-performing, second mortgage, under current guidance, it appears that at least a portion of the restructured second note will not meet the IRS requirements for indebtedness, but instead, be considered as forgiven debt for federal tax purposes. This would require recognition of taxable income by owners of restructured properties.
Rather than be subject to tax for recognition of income upon restructuring of their projects, owners have so far predominantly preferred to either end their participation in the Section 8 program and convert their projects to market rate properties or to accept renewal of their HAP contracts at subsidy levels below the Mortgage Restructuring threshold (120% of FMR under Portfolio Reengineering and "Comparable Rents" under MAHRAA). We have seen clients do both. We have also seen a few clients enter the restructuring program, but as yet, in large part due to the tax issue, they have not yet agreed with HUD on the proper restructuring plan for their projects.
Without some recognition by the IRS that second mortgages created under a MAHRAA restructuring will not cause recognition of taxable income, the Mortgage Restructuring program is acceptable to very few properties, and we expect that participation will continue to be low.
Revenue Ruling Request Concerning Debt Forgiveness
Congress has been unable to legislate the recognition of second mortgages created under MAHRAA as debt without an income component. The IRS has been unwilling to confirm that these second mortgages will not be treated as creating taxable income for project owners. In an effort to clarify the Service's position, and hopefully to make the Mortgage Restructuring program a success, on April 6, 1998 the accounting firm of Reznick, Fedder and Silverman filed with the IRS a request for a Revenue Ruling on the tax treatment of below-market interest rate second mortgages created under MAHRAA.
The request, supported by the affordable housing industry, proposes that these bifurcated loans not be treated as creating income for federal tax purposes. This position is largely based on the inapplicability of Section 7872 of the Internal Revenue Code (the "Code") to the MAHRAA process. Section 7872 provides that below-market interest rate loans are generally taxed as income to the loan recipient to the extent that the loan amount exceeds the present value of payments to be received by the lender. The present value of payments is to be calculated using the AFR, compounded semiannually, as the interest rate. Where all payments on a loan that carries no interest are discounted back using a higher interest rate, the calculated original principle amount will be less than the actual principle amount of the loan. This excess principle amount is considered income immediately received by the borrower under Section 7872.
The Revenue Ruling request maintains that second mortgages created under MAHRAA fall within an exception to Section 7872 provided under IRS Regulations. The applicable Regulations hold that loans that are subsidized by the federal, state, or local government and that are made available under a program of general application to the public are exempt from Section 7872, so long as they are not "tax avoidance loans."
The request for Revenue Ruling proposes that (1) the second mortgage is provided by funding available exclusively from the federal government, (2) the sheer number of properties subject to MAHRAA makes Mortgage Restructuring a program of general application to the public, and therefore the second mortgages created by restructuring are loans created under a program of general application to the public, and (3) the subordinate mortgage structure is mandated by statute and was not created by borrowers in order to avoid taxes.
The treatment of restructured debt under MAHRAA as non-taxable indebtedness is supported by the housing industry and generally recognized as necessary to the success of the Mortgage Restructuring program. Although no official comments regarding the Revenue Ruling request have been offered by the Service, the IRS has indicated that some guidance on the tax treatment of restructured loans is forthcoming before the end of this year.
Program Guidelines and OMHAR Leadership
In addition to the unanswered question of tax treatment, the industry also awaits the release of HUD's implementation regulations for Mortgage Restructuring. The current program generally operates under guidance provided by the former Portfolio Reengineering program, updated to account for the few FY 1998 changes made under the MAHRAA legislation. FY 1999 is the year in which the permanent program is to be implemented. This will require the implementation of programmatic regulations as well as the appointment of a director for the Office of Multifamily Housing Assistance Restructuring ("OMHAR"), which was created under MAHRAA to oversee Mortgage Restructuring operation.
It had been rumored that HUD would release Mortgage Restructuring guidelines for comment in June. It had then been expected that draft regulations would be released in August. There is now indication that HUD may offer a preliminary draft for Congressional review in July. In any case, prior to implementation, MAHRAA requires that HUD hold no fewer than three public hearings, and HUD is expected to hold these meetings no earlier than late August. At this time, no proposed drafts have been available. HUD must issue permanent regulations by the later of (1) October 27, 1998 or (2) three months after the appointment of the OMHAR director.
The OMHAR director of choice is reported to be Larry Simons, a former FHA Commissioner, but the Administration has yet to make any appointment recommendation to Congress. The statute requires that the OMHAR director be appointed by October 27, 1998, and if no appointment has then been made, the Mortgage Restructuring program is to be suspended.
ADDITIONAL ITEMS OF INTEREST
HUD Appropriations
On June 11, 1998, the Senate Appropriations Committee passed its version of the FY 1999 VA/HUD appropriations bill (S. 2168) by a 27 to 0 vote. The Senate bill provides for full funding of expiring Section 8 contracts and increases the amount of HOPE VI funding available in FY 1999 to $600 million, up $50 million from this year. Of additional note, the Senate has rejected the Administration's request that Section 202 (elderly housing) funding be cut from this year's $645 million to $159 million for FY 1999, and has increased its appropriation for Section 202 to $676 million for FY 1999. The complete Senate package provides $24.2 billion for HUD, a 12.4% increase from FY 1998 levels. The House Appropriations Committee is expected to consider its version of the bill on June 25.
Section 8 Rent Adjustment Procedures
On January 23, 1998, HUD issued Notice H 98-3, by which it announced the extension of current procedures for requesting Section 8 Annual Adjustment Factor ("AAF") rent increases. The Notice extends the procedures contained in Notice H 97-14 concerning (1) the application of comparability to rent adjustment for Section 8 new construction and substantial rehabilitation projects and (2) rent adjustment for non-turnover Section 8 units (for Section 8 new construction and substantial rehabilitation projects, loan management ("LMSA") projects, property disposition ("PD") projects, and renewal or extension projects). The procedures do not apply to rent adjustments for the Section 8 Moderate Rehabilitation Program or the Project-Based Certificate ("PBC") program.
The Notice also contains requirements for owners of projects receiving contract rent payments of greater than 100% of FMR. Owners of such projects will continue to be required to hire an independent appraiser to perform an analysis of rents at comparable properties prior to applying for an AAF increase, although the cost and relative uncertainty of success for this option generally discourages owners from undertaking the effort.
HUD Enforcement
Of greater concern to owners than any single procedural change at HUD over the last few years is the change in tone of its enforcement policies. Under the prior enforcement paradigm, HUD field offices would take enforcement actions as a last resort, and often only when they had concluded that a particular owner or manager was not playing a useful role in the overall affordable housing picture. This view is now passi. Over the past two years, HUD has been instituting its Get Tough Initiative, and is moving towards its new vision of IRS-like enforcement: it does not matter to the IRS that almost all of the deductions you have claimed are valid, and it does not matter to the IRS that you are paying substantial amounts in taxes. If the IRS believes that you have made improper deductions, it will pursue action on that narrow basis.
However, there is a significant difference between HUD and the IRS, one that makes the HUD approach even less flexible. While the IRS is usually only concerned with one tax year at a time, HUD will not be restricting its enforcement actions to the violations of a single project. If HUD finds that an owner has violations at one project, it can, and has indicated that it will, act to prevent owners from participating in any new projects. Currently, under HUD's Get Tough Initiative, the number of landlord debarments has increased by 300% from the prior year, and the number of civil enforcement actions and settlements has increased from 24 to 46.
As part of its new program, HUD has developed new inspection protocols. (They are being tested now.) Every HUD-regulated project will be inspected using these new protocols. HUD has made a concerted effort to reduce its inspection to a series of objective tests (e.g., is the faucet leaking), such that anyone can perform the inspection. It is planned that inspectors will carry hand-held computers and, guided by the software, check off conditions found to exist, or not exist, in each inspected unit. At this point, it appears that the inspection is supposed to focus on the current condition of the project and not on the capital needs. Individual inspectors, however, may be more aggressive than the protocol allows in making future needs judgments. In addition to this physical inspection, each project, and especially those with significant identity of interest transactions, will be required to show that significant expenditures were the result of competitive bidding.
The results of the inspections will be downloaded into the HUD computers and transmitted to the newly created Assessment Center. At the same time, the data will be transmitted by e-mail to owners/managers who have installed the appropriate software on their computers. The Assessment Center will divide projects into three classes: (1) those which unequivocally "pass" the inspection; (2) those which unequivocally "fail" the inspection; and (3) those in between. Projects in the second group will be referred to the newly created Enforcement Center in Washington, D.C. Projects in the third group will be simultaneously referred to the HUD field office and the Enforcement Center. The Enforcement Center will refrain from taking any action until the elapse of a specified time in which the field office will further investigate, and will close the file if informed by the field office during that time that the deficiencies have been resolved. The field office will have some flexibility in working with owners to remedy deficiencies, but it is not clear how bold field offices will be in this regard.
The Enforcement Center was explicitly created as the cornerstone of the new enforcement mentality. It was thought at the higher levels of HUD that field office staff had been compromised by their wanting to help owners succeed -- that field offices had "gone native." Thus, instead of having the responsibility for taking enforcement action (and, more importantly, the discretion as to when to take action and what type of action to take) vested in "compromised" field staff, the Enforcement Center was created, and the current director of the Enforcement Center, an FBI agent on loan, and a number of Department of Justice attorneys on loan were brought in to direct operations. The current plan is to assemble 40 lawyers and suitable support staff to take enforcement actions nationwide. In addition, in order to prevent field office staff from interfering with Enforcement Center actions, whenever a project is referred to the Enforcement Center, it will assume from the field office all program responsibilities related to the property, such as approval of rent increases.
It is important to note that this enforcement is not a substitute for the investigations currently under the control of the HUD Inspector General. The IG will continue to handle criminal matters and serious civil violations. The Enforcement Center replaces only the enforcement efforts of the program staff -- efforts HUD has concluded were seriously deficient. What this means to any owner is clear: much greater care must be taken to ensure that the property meets physical standards. To the extent that this includes getting tenants to take better care of the property -- and the inspection protocols will not distinguish between tenant-caused deficiencies and those known to the owner -- a tenant housekeeping program is in order. In addition, complete records should be kept of all identity-of-interest transactions, and written competitive bids should be obtained and retained.
In recognition that owners may now be subject to an often heavy-handed and intimidating action by HUD's new enforcement arm, even in cases where violations are not significant to the operation of safe and well-maintained affordable housing, Pepper Hamilton has instituted a fast action response group comprised of members of our White Collar Criminal Defense Practice Group, our Government Contracts Group, and our Affordable Housing Group. This team is tasked with immediately responding to HUD actions and assisting owners with their planning and actions in this adversarial environment.