"We buy houses": market heroes or criminals?

AuthorHarvey, Cori
PositionIntroduction through II. Criminal Regulation A. Fraud and Misrepresentation, p. 649-680

Introduction

The residential sale/leaseback/buyback ("RSLB") transaction is a socially beneficial foreclosure rescue transaction that is being regulated increasingly by the criminal courts to the detriment of the homeowners, investors, and society at large. Because the transaction is being regulated more aggressively with the criminal law, peculiar outcomes arise, which include investors being sentenced, in some cases, to draconian sentences--a trend that will eviscerate the transactions rather than improving them.

A standard RSLB transaction is a privately arranged alternative to foreclosure. The RSLB transaction allows a homeowner in foreclosure to sell his property to an investor, lease the property back from the investor, and retain the right to repurchase the property at a set price on a set date in the future (a call option). (1) Although it is not perfect, this arrangement provides numerous benefits for the homeowners, including several which would be lost in the traditional foreclosure process, (2) and, therefore, should be preserved and supported. Instead, the transaction finds itself besieged by consumer protectionists, academics, behavioral economists, the criminal courts, and the public alike.' For this reason, the transactions are often called "foreclosure rescue scam[s]" and "equity-skimming scheme[s]." (4)

In calling for a retreat from that position, this Article makes both descriptive and prescriptive claims. The first descriptive claim is that the transaction is a beneficial one and that it has valid, non-fraud raisons d'etre. The second descriptive claim is that the level of persecution of this transaction is escalating for several reasons. Those reasons emerge from a perfect storm of social, political, and economic factors, the desire to criminalize unconscionability, which largely has been obliterated as a civil contract doctrine, and the triumph of behavioral economics over rational choice economics in homeowner advocacy jurisprudence.

The first prescriptive claim is that criminal regulation creates more harm than it cures by eroding the institution of contracting and by exacerbating the very market failure that gives rise to the transaction. The second prescriptive claim is that, where there are problems with the transaction, there are several better alternatives to criminal regulation. Specifically, minor licensing and regulation and remedial civil dispositions create better outcomes than criminal dispositions.

Part I will explain the transaction briefly and introduce the generic homeowner and investor. (5) It will then examine a couple of key cases to demonstrate the escalation of RSLB charges from quasi-criminal loan sharking, including the popular 1L Contracts textbook case from 1988, Browner v. District of Columbia, (6) to a more recent case in which the first-ever white collar defendant, Timothy Barnett, an RSLB investor, was sentenced to 33.33 years-to-life for residential burglary under California's Three-Strikes Law. (7) Finally, Part I will spell out the benefits to homeowners in these transactions to highlight the importance of preserving these transactions as viable options for certain homeowners.

Part II will explore the means of and justifications for criminal regulation of this transaction. Part II will provide a brief overview of the statutes that are being used to prosecute these investors--traditionally fraud and its subspecies, and now residential burglary. This Part will include a brief discussion of the evidentiary problems inherent in criminal regulation of contract disputes and the problems with using burglary and other street-crime statutes to prosecute white-collar offenses. Rejecting both the justifications and the means described, Part II will suggest instead that a perfect storm of social, political, and economic exogeneities--coupled with both a goal to revive the dormant unconscionability doctrine in the criminal courts and a triumph of behavioralism over rational choice economics--actually explains the escalation of criminal regulation of these transactions. The result is an environment that criminalizes unconscionability and finds fraud and misrepresentation in too many contracts.

Part III will outline several problems with criminal regulation of ordinary economic behaviors, concluding that criminal regulation of foreclosure rescue transactions erodes the institution of contracting and exacerbates the market failure that typifies this already precarious market.

Part IV will suggest several alternatives to criminal regulation, including some that have been outlined by consumer protection advocates. Although it may over-sell the size and scope of the problem, consumer protection jurisprudence has proposed many good remedial measures and has made great strides in combatting such problems in non-criminal ways. Finally, Part IV will conclude that socially-beneficial conduct must enjoy clear legal boundaries or it will cease to exist, thereby harming the most vulnerable homeowners who need the options most.

Part V will detail the peculiar case of Timothy Barnett, which is introduced briefly in Part I. This case is important because it represents a conflation of white-collar and three-strikes jurisprudence, a blurring of the contract-crime divide, and, potentially, the scapegoating of a small accessible investor as the "fall guy" in a nation-wide foreclosure crisis in which large lenders are outside the reach of the criminal enforcement authorities. Mr. Barnett's case also may have tremendous precedential value in California and his prosecution may serve as a guideline for prosecutors in other jurisdictions.

Part I: The RSLB Market, Transaction, & Benefits (9)

To execute an RSLB transaction, in effect, a homeowner in foreclosure contracts with a small, non-bank investor to sell the home to the investor, and to rent the home back for a negotiated period of time, usually between two and five years, (10) called the "leaseback period," at a negotiated rent, while retaining the right to repurchase the property at a negotiated price on a negotiated date. (11) This solution averts the foreclosure by liberating the homeowner's trapped equity. (12) However, the transaction is not without risk for the investor and homeowner. While some of these transactions result in the homeowner eventually losing the home, the potential is there for the homeowner to salvage his home, which some homeowners indeed do. Even for those homeowners who do not end up salvaging their homes, they will end up no worse off, and possibly better off, for having had the chance to save their home.

  1. The Market Failure

    Foreclosure rescue transactions arise from a specific set of market failures. The RSLB rescue transaction arises because certain homeowners lack access to or the ability to qualify for traditional mortgage refinancing and do not trust mainstream banks. (14) Because these homeowners cannot access traditional sources of capital, which would allow them to access the equity stored in their homes, they seek opportunities in non-traditional marketplaces, often using services provided by small entrepreneurial firms who operate outside of the traditional banking system. (15) These smaller firms can often help homeowners access their stored equity in ways the larger banks cannot or are unwilling to do. (10) Home equity is the difference between the market value of a home and all encumbrances upon it. (17) Equity, once extracted as cash, can be used to meet any cash needs the homeowners might have. These homeowners face the "trapped equity paradox." (19)

    The trapped equity paradox refers to the simultaneous conditions of having equity in one's home, needing cash, and not being able to access the equity to convert it to cash. (20) The trapped equity paradox can cause high-equity homeowners to find themselves defaulting on their short-term debt payments and, in the case of RSLB homeowners, facing foreclosure because they cannot meet the monthly mortgage payments on the very home with the equity trapped inside of it. (21) It is while in the midst of the trapped equity paradox that a homeowner would pursue an RSLB transaction.

    Although accessible under normal market conditions using ordinary banking and credit functions, in the trapped equity paradox, a homeowner's equity cannot be released, or put to work, for lack of access to credit. (22) Homeowners who suffer the trapped equity paradox are primarily asset-rich and cash-poor. (23) The only asset they have is the equity in their homes. However, their equity is inaccessible because, when these homeowners cannot show both a means and a willingness to pay loans, either with current cash flow or other liquid assets, they cannot qualify for financing or refinancing to extract this equity. (24)

    When homeowners approach the final stages of non-payment before a foreclosure sale of their properties and eviction, they have a couple of options to bring their loans current to avoid foreclosure--all of them problematic. (25) Homeowners can try to...

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