'We buy houses': a foreclosure rescue as the solution to the trapped homeowner equity problem.

• Author: Harvey, Cori

1. INTRODUCTION

   Foreclosure rescue transactions are viewed widely as scams designed, among other things, to dupe poor, minority, and elderly homeowners out of the equity in their homes. (1) The transactions are frequently called "foreclosure rescue scams," (2) "equity skimming schemes," (3) or other derogatory terms. However, foreclosure rescue transactions come in many forms and, as an alternative to foreclosure, often maintain valuable options for homeowners that the homeowners otherwise would lose in the traditional foreclosure process. (4) For this reason, many of these transactions, though imperfect, should be preserved and supported.

   This Article introduces one such foreclosure rescue transaction, the residential sale/leaseback/buyback ("RSLB") transaction, into the legal literature from the perspective of the rescue investors. (5) A basic RSLB transaction allows a homeowner facing foreclosure to sell his property to an investor and to lease the property back for a set period at a set rate, while retaining the right to buy the property back at a set price on a set date in the future (a call option). (6)

   This Article unveils the logic of these transactions and provides market context, which is often misunderstood and under-appreciated by academics, judges, and the public, who do not understand the value of the transactions to the homeowners who use them and to the communities in which the transactions are popular. (7) Instead, the transactions are met with bias and negative assumptions. (8) Critics often present the exceptions as if they are the rules and falsely stereotype the homeowners in these transactions as elderly, frail, and uneducated. (9) As a result, these transactions are increasingly regulated by criminal law, with convicted investors subject to severe criminal sentences. (10) The effect of this trend will be to eviscerate the RSLB transaction completely.

   Much of the limited scholarship on--and condemnation of--this transaction comes out of consumer protection jurisprudence, which has been slanted decidedly in favor of the homeowners, and has demonized the investors, who are generally small, entrepreneurial investors from the same communities as the homeowners. (11) Another failing of the existing scholarship is that it neither explains the economics of the transaction and the transaction's role in the residential real estate market--which is important in assessing the value of these transactions--nor the step-by-step process of creating and executing the underlying contracts. Instead, in its efforts to target the investors, consumer protectionism tends to overstate the size of the problem. While there is opportunity for fraud in any industry, including foreclosure rescue transactions, the transactions themselves are not wholesale fraudulent. Additionally, none of the consumer protection scholarship has addressed the issue that the foreclosure rescue investors are as vulnerable to unscrupulous, disgruntled homeowners as the homeowners are vulnerable to the investors. (12) It also takes a paternalistic view of the homeowners and strips them of any economic sophistication. (13) However, consumer protectionists make some very good suggestions about how to curtail harmful conduct when it does occur in this marketplace. (14)

   Currently, the RSLB transaction is being demonized and criminalized, with escalating numbers and severity of criminal charges and corresponding sentences. (15) This response is troubling because, although the transaction allows some opportunities for abuse, it is a good transaction for numerous reasons. The rubric for a "good" transaction would involve the creation of options and opportunities for the parties which did not exist before, and which would not exist without the transaction. In other words, a good transaction leaves both parties better off across the averages. This Article will demonstrate that the RSLB transaction satisfies this rubric. Currently, the RSLB transaction is the only available solution for a persistent market failure, it is the market's own endogenous solution, and it makes the parties generally better off. RSLB also has protections built into the transaction for the parties and creates clear expectations between the parties. Where the transaction falls short of the rubric, it could easily be tidied up, and therefore should be supported. However, the current trend of criminal regulation with unpredictable sentences will have the opposite effect and will likely eliminate the RSLB marketplace--to the detriment of the homeowners. (16)

   A second rubric can be introduced to evaluate the best way to regulate a marketplace. There are four institutions (17) available to regulate a marketplace and address its problems: a pure market-based regime, preemptive and market-facilitating regulation, the civil judiciary empowered with a full slate of contract doctrines and remedies, and the criminal court with its punitive sword. (18) One institution is "better" than another if it accomplishes desired outcomes or minimizes undesirable outcomes better than the alternative institutions. (19) A "good" legal outcome is one which promotes and supports efficient and wealth-maximizing outcomes with the least burden to society as a whole, (20) and which creates stability and a guide for subsequent parties. A good outcome also protects the parties from each other equally, concentrates costs between the parties, and creates incentives for the parties to resolve disputes within their contracts.

   For most of the problems in the RSLB marketplace, this Article argues that the best legal solution is to preempt the problems with market-facilitating regulation, thereby avoiding criminal or civil litigation altogether. Fortunately, due to the nature, size, and scope of this marketplace, many of the proposed regulations are minor and could be implemented at the level of the local jurisdiction or through local licensing requirements, instead of requiring sweeping regulatory reform. (21) To the extent that problems cannot be preempted, civil dispositions bring about the next best solutions. Civil dispositions are better than the current criminal dispositions because, based on the metrics stated above, criminal dispositions fail at every turn, whereas civil dispositions satisfy most of the metrics in the regulatory rubric.

   Part II will describe the unique market failure that the RSLB transaction emerged to combat, which is coined here as the "trapped equity paradox," and explain why that failure exists. Part 11 will demonstrate the legitimate need for economic solutions to fill this particular void within the marketplace as well as explain why small investors are uniquely positioned to fill this void.

   Part III will introduce and examine the market's own solution to the paradox, the RSLB transaction, and will present a previously unexamined view to demonstrate the logic and structure of the RSLB marketplace. This Part will also introduce the typical homeowner and investor, (22) and the role that RSLB transactions play in the market. Finally, Part III will show the actual, yet misunderstood, allocation of economic risks between the contracting parties, including an accounting of where the money goes. The prevailing wisdom in these cases is that the homeowners do not receive any meaningful benefit from these transactions. This Part will show that this argument is unfounded. Part III will also serve as the foundation for a series of articles on the RSLB transaction.

   Part IV will extrapolate the benefits of RSLB transactions to homeowners and also identify where the obstacles in these transactions might emerge, in order to start a meaningful conversation about how best to avoid the obstacles while preserving the transaction. It is not the goal of this Article to present complete solutions to these problems. (23) Rather, the goal simply is to take a good first step in that direction by making a thorough assessment of where the mines might be buried. As with any systemic problems, some will be easier to solve than others. Indeed, in the RSLB marketplace, there is a troubling market failure, a troubling market response to that failure, and a troubling regulation of that market response--all three of which need to be fixed. (24) However, this Article argues that most of these problems can be preempted quite easily to protect both homeowners and investors, and proposes that the marketplace for this transaction can be cleaned up without removing the transaction as a solution to very real problems. What follows is an illumination of why and how the market's own RSLB transactions are carried out. (25) The premise is that by understanding the transaction and the protections that are currently incorporated for homeowners and investors, academics will be better equipped to address problems arising from the transaction. It is easy to see how the protections could be strengthened if they are failing. It is also easy to see how additional protections could be built into the transactions to preempt problems and to support this marketplace in ways that would leave homeowners, investors, and society better off.

2. THE MARKET FAILURE

   In America, there are two classes of people: those who have accessible, value-generating capital and those who have either inaccessible "dead capital" (26) or no capital at all. "Dead capital," a term used to describe unproductive capital such as that in the Third World, refers to capital that could generate value, but fails to do so due to a lack of market and legal processes to release that value. (27) The Third World, however, does not have a monopoly on dead capital. In America, something very close to this dead capital exists where, due to a lack of access to outside funding and credit mechanisms, some homeowners cannot access their internal capital, which is the equity in their homes. Home equity is the difference between the market value of a home and all...