CONTRACTUAL INEQUALITY.

• Author: Padi, Manisha

Most individuals strive to satisfy every obligation laid out in standard form contracts such as mortgages, insurance plans, or credit agreements. Sophisticated parties, however, adapt and modify their obligations during contract performance by negotiating for lenient treatment and taking advantage of unclear terms. The common law explicitly authorizes variance from standardized contract terms during performance. When the same standard terms create value for sophisticated individuals and destroy value for others, the result is contractual inequality. Contractual inequality has grown without scrutiny by courts or scholars, enabling regressive redistribution of resources and creating economic inefficiency by sowing distrust in markets for consumer contracts.

To document the magnitude of contractual inequality, this Article provides novel empirical evidence from a case study of residential mortgage contracts. Data from a large nationwide sample show that many mortgage servicers choose not to utilize their power to foreclose on a borrower in default, with more than one-third of nonpaying borrowers avoiding foreclosure. Servicers disproportionately foreclose on borrowers in poor neighborhoods, regressively redistributing over $500 million in wealth to high-income communities each year. Moreover, servicers' unfettered freedom to choose who undergoes foreclosure may have reduced the value of mortgages to consumers, increasing market inefficiency.

Courts and regulators need not turn a blind eye to contractual inequality, allowing private market forces to determine the exercise of contract rights. This Article argues that lawmakers should gather information about inequalities in contract performance and disseminate such data to private and public enforcement authorities. By bringing these inequalities to light, lawmakers can take a first step toward more efficient contract markets and a more equal society.

TABLE OF CONTENTS INTRODUCTION I. INEQUALITY IN CONTRACT PERFORMANCE A. Regressive Redistribution B. Inefficiency Through Moral Hazard II. HOW CONTRACT LAW CREATES UNEQUAL OUTCOMES A. Exercise of Discretion B. Breach of Contract C. Waiver and Enforcement D. Modification and Renegotiation III. INEQUALITY IN RESIDENTIAL MORTGAGE FORECLOSURE A. Measuring Mortgage Inequality 1. Foreclosure and Its Alternatives 2. Social Inequality in Contract Outcomes B. Implications of Mortgage Inequality IV. THE LIMITATIONS OF EXISTING OVERSIGHT A. The Legal Invisibility of Inequality B. Limitations of Market Competition 1. Transaction Costs 2. Heterogeneity and Unequal Bargaining Power V. STRENGTHENING DISCLOSURE TO DISCIPLINE INEQUALITY CONCLUSION INTRODUCTION

Standard form contracts impose equality in contract terms across transactions. (1) All mortgage instruments, for instance, borrow their terms from the same federally drafted forms. (2) However, standardization in contract terms does not mean that all transactions are equal. Despite assenting to the same terms, different parties may find that contract terms are utilized differently during performance. (3) The result is that one mortgage borrower may find multiple obligations waived, receiving an easy path to payoff, while a similarly situated borrower may be threatened with legal action at every turn.

This Article develops a theory of inequality in contract performance, rather than inequality in terms offered, across social groups. (4) Differences in performance across identical contracts, termed contractual inequality, have two implications. (5) First, they may unfairly privilege sophisticated parties and worsen existing social inequalities. (6) Second, individuals who are considering entering a new contractual relationship may be deterred by the possibility that they will be mistreated later during performance, resulting in fewer transactions and inefficient prices. (7) Households rely heavily on standardized consumer contracts to secure housing, pay for expenses, and insure against losses, but contractual inequality exposes the most disadvantaged populations to the highest risk of serious loss. (8)

This Article connects fundamental principles of contract law to the growth in economic inequality. (9) The common law of contracts has traditionally authorized contracting parties to treat social groups differently. (10) As long as parties satisfy the formal terms of a contract, remaining discretion in contract performance may be used to harm disadvantaged groups and benefit privileged groups. (11) When the written contract leaves some discretion to the parties, no contract law cause of action exists to challenge unequal treatment during performance. (12) Moreover, every consumer contract has some incompleteness, or areas in which contract performance can vary while satisfying formal legal requirements. (13) For instance, parties are free to exercise their reserved discretion, breach their contracts, waive or enforce their counterparties' obligations, and modify or renegotiate their agreements without oversight from courts and regulators. (14) Courts and regulators have granted private parties the right to make these discretionary choices but have turned a blind eye to the use of this power, (15) allowing contractual inequality to grow unchecked.

This Article takes residential mortgage servicing as a case study for demonstrating the magnitude of contractual inequality. Consider two homeowners who have lost their jobs and cannot make payments on their long-term mortgages. (16) Both are embedded in their local communities and have children in local public schools. Each calls their mortgage provider and asks for their lender's cooperation in helping them keep their home. (17) Though both homeowners have the same credit score and their mortgages have similar interest rates and monthly payments, their two phone conversations proceed very differently. The first homeowner is given several options, including a "loss mitigation" program that can decrease her monthly payments or a short-term "forbearance" period during which she can temporarily stop payment. (18)

The second homeowner, on the other hand, is told that he must pay according to the terms of the mortgage, and he is advised that foreclosure proceedings may begin after four months of missed payments. (19) The first homeowner is ultimately allowed to stay in her home, while the second is forced to remove his children from school and relocate while saddled with a low credit score. (20)

Using a detailed commercial dataset on mortgage performance, this Article shows how common these disparities are and their devastating effect on consumers. Lenders and servicers making the foreclosure decision have significant discretion over which households face foreclosure rather than less costly alternatives like forbearance. The detailed data used in this Article show that 40% of borrowers who fell behind on their mortgage between 2000 and 2008 avoided foreclosure, largely due to the exercise of discretion by creditors. (21) Moreover, this Article is the first to show that a stark difference exists between creditors' treatment of borrowers in wealthy neighborhoods relative to those in poorer ones. (22) Loans in high-income neighborhoods are nearly 10% more likely to avoid foreclosure than identical loans in lower-income neighborhoods. The real impacts of foreclosure are widespread--uprooting families, destroying economic value, and negatively impacting communities. (23) Given the high cost of foreclosures, inequality in mortgage performance gives rise to $513 million in losses per year to poor neighborhoods that rich neighborhoods avoid. (24) Unequal treatment during foreclosure can also sow distrust of servicers that lowers the value of mortgages and creates economic waste.

The Article explains how existing legal regimes and economic incentives are powerless to scrutinize and discipline this type of inequality. Contracting parties have no legal obligation to behave cooperatively with their counterparties as long as they do not breach the contract's formal terms (25) or the common law duty of good faith. (26) Regulators have become more involved in scrutinizing contractual relationships over time, but their power has been tilted toward rulemaking and away from enforcement. The result is that parties' utilization of contract terms are primarily governed by extralegal forces such as market competition. (27) Contract law scholars have argued that economic incentives are sufficient to encourage parties to behave cooperatively, with no additional legal oversight needed. (28) This Article argues, however, that private economic incentives are insufficient in many cases to avoid harmful contractual inequality if transaction costs limit market efficiency. (29) Moreover, the private market cannot remedy existing social inequalities, which can occur when there is unequal bargaining power across contracts. For instance, when the same creditor lends to two debtors, one with high reputational influence and the other with little power to influence others, no private market force can prevent the creditor from treating the more powerful debtor better than the less powerful debtor. Private markets cannot discipline inequality without complementary legal mechanisms. (30)

This Article argues that lawmakers must intervene to bring contractual inequality to the attention of the public. Currently, contracting parties know nothing about how others in their position are treated during performance. Regulators can begin to understand and resolve this problem by requiring disclosure of data regarding contract performance to relevant regulatory authorities and to the public. (31) By disclosing the data to sophisticated parties, such as federal agencies, they can be used to facilitate redistribution and redress the distributive harms of contractual inequality. (32) Moreover, data disclosure could provide statistical evidence of inequality in contract...