Neil H. Buchanan

Should Federal Agencies or Courts Protect Consumers in Financial Markets?

By NEIL H. BUCHANAN


Thursday, November 5, 2009

As Congress and the Obama administration struggle with a variety of proposed changes to the laws governing U.S. financial markets, it appears likely that existing regulatory agencies will ultimately be given more responsibility to guarantee the safety and soundness of the markets.

In addition, new agencies are likely to come into existence. For example, in my most recent FindLaw column, I discussed the proposed new Consumer Financial Protection Agency, which would be empowered to prevent the more rapacious practices that banks, credit card issuers, and other financial players have perfected over the last decade or so.

Is this expansion of existing regulatory powers a good idea? And even if it is, is there a better way to achieve the same goal? In particular, is it possible that it is the courts that should temper the extreme behavior of financial companies, rather than having employees of executive branch agencies enforce financial laws?

The answers to these questions paint a picture of the pluralist nature of our legal system, suggesting that the best system will rely on both methods of enforcement -- but that it is better to rely more heavily on agencies than courts.

To highlight the issues at stake, I will discuss below a recent example of a court's surprising decision to "regulate" the mortgage market by strictly enforcing the law. This approach, while laudable and quite valuable in the immediate context, is ultimately unlikely to make consumers' lives better.

In the end, courts have an important role as a backstop in regulating economic activity, but direct agency regulation is still the first-best option if we truly want to end the financial system's abuse of its non-elite customers.

The Courts and Regulation: Not an Either/Or Proposition

In my most recent column, in the course of endorsing the proposal to create the Consumer Financial Protection Agency, I noted that the notion of financial markets' being "more regulated" or "less regulated" is extremely misleading. Because the government operates the legal system – administering the public courts that interpret laws, and directing the police and other authorities that enforce them -- and because the financial companies rely on the courts to force people to pay when a loan is in default -- there is always a regulatory system in play.

With the government thus always in the background as the enforcer of financial contracts, a family that owes money under a contract always has the option of going to court to prove that they should not be forced to pay. If, on the other hand, an agency exists to police the behavior of financial companies, then the family can instead appeal directly to that agency. Better still, the agency can engage in pre-emptive regulation, preventing companies from abusing their customers in the first place.

There is, therefore, really only one issue when we consider how to design legal protections for consumers of financial products: When a family's house is at risk of foreclosure, or when credit debt threatens to push them into bankruptcy, will they be able to turn to an agency whose explicit role is to protect them, or will their only recourse be to fight for their future through the courts?

A Homeowner's Victory in Court

A recent article in The New York Times describes a case in which a federal judge completely discharged a homeowner's mortgage debt as part of a bankruptcy proceeding. The judge determined that the company that was suing for payment of the mortgage could not prove that it actually had the legal right to receive payments under the mortgage. In other words, the company was trying to collect on an I.O.U. that it could not prove it owned.

How could this happen? The company's representatives essentially said that this is now "standard operating procedure," that the mortgage market in recent years has involved so much repackaging and reselling of mortgages (often with mortgages grouped and used as the basis for securities) that no one has really kept track of all the paperwork. The incredulous judge simply said that this was unacceptable. Because the judge was not sure who was really owed the money under the mortgage, he explained, he could not reasonably order the homeowner to make payments to anyone.

This story has received a lot of satisfied reaction in the press and among commentators, for obvious reasons. Finally, it seems that a dreaded "technicality" has snared one of the companies that routinely rely on fine print and technicalities to extract money from their customers. What delicious irony!

Going forward, however, this victory seems both difficult to replicate in the short run and impossible to maintain in the long run. Not all judges will be so demanding of financial companies, and many are likely to accept the "standard operating procedure" excuse and essentially to say that, as long as there is not a dispute among two potential owners of the mortgage, there is no problem. Even if some judges are sympathetic to homeowners, moreover, the companies will learn their lesson quickly and will make sure that such blunders do not happen again. The next time they want to foreclose, they will surely have their papers in order.

The underlying problem here is that all but the most savvy and well-represented consumers of financial products are grossly mismatched against the mortgage giants and credit card issuers. If a credit agreement includes a mandatory arbitration clause, or a complicated method of computing interest, or a hidden trigger to increase the interest rate, few customers will notice these provisions or feel that they have any choice but to accept them. And the occasional victory in court, under rather unusual circumstances, should not blind us to that ongoing reality.

Courts and Contract Protections: Too Weak, and Too Infrequently Applied

Of course, parties in a contract dispute have much more to rely on than simply hoping that the other side has lost their legal documents. So-called "equitable doctrines" developed in the common law continue to exist, and they allow courts to set aside seemingly valid contracts under various circumstances.

The most well-known equitable doctrines that can be used in a contract case include duress (the use of too much, or the wrong kinds of, pressure), undue influence (certain questionable behavior short of duress), incapacity (a situation where one party is impaired, and not able to freely or intelligently consent), misrepresentation (essentially, a lie or misdirection by one side), and unconscionability (the idea that there are some contracts so inherently objectionable that no one can validly agree to them). Under each of these doctrines, courts (sometimes in conjunction with legislatures) have developed a set of conditions under which an otherwise-valid contract can be set aside.

As an example, consider the doctrine of unconscionability. It has two prongs. The first is procedural unconscionability: The contract was formed under suspicious circumstances; for instance, the signing party was not given adequate time to read the contract. The second is substantive unsconscionability: The resulting contract was grossly unfair. For instance, a person has agreed to put up $10,000 worth of collateral against a loan to buy a $100 music player. If both prongs are fulfilled, then the contract will not be enforced.

On paper, this doctrine looks like a financial consumer's dream come true. There are extremely good arguments that many financial contracts (in particular, sub-prime mortgages) violate both procedural and substantive standards of contract law, making such contracts unenforceable. Sub-prime mortgages, for instance, can be seen as grossly unfair because financial institutions knew very well that their mortgage customers would be overwhelmingly likely to default, based both on their individual credit histories and on statistics about the payment rates of individuals with similar credit histories – yet did not share that information with the customers. (Why would such institutions rationally act this way? Because they passed on the risk of the loan to those who bought mortgage-backed securities.).

In practice, however, the promise offered by the equitable doctrines is illusory. Courts are extremely reluctant to endorse equitable defenses, permitting only the most extreme examples of abuse to fall under equitable scrutiny. As a realistic matter, therefore, people who want to fight their mortgage company or credit card issuer will not be saved by current doctrines of contract equity.

Should We Force the Courts to be More Open to Arguments Based on Equitable Doctrines Such As Unconscionability?

It is possible, of course, for legislatures to change the law, in essence ordering courts to be less parsimonious in applying doctrines of equity. We could, therefore, legislate a change in the legal doctrines available to financial consumers, opening up the courthouse doors to those who would claim that their financial contracts were abusive in any of a number of senses.

While this is possible, the resulting legal regime would also be extremely expensive. It is true that case-by-case litigation will have an effect on people who do not go to court, as precedents are set and business practices are reconfigured in light of the new rules of the game. Even so, the playing field would still be tilted strongly in favor of the financial companies.

Why? For one thing, the financial companies are "repeat players" in the game of litigation. They would be able to take their chances on winning some cases and losing some, as some cases would go their way by mere chance -- for example, because of witnesses dying, documents being lost, judges making hasty decisions, and so on.

Moreover, losing a contracts case legally cannot result in a company paying punitive damages. If you lose a contracts case, you merely pay what you would have paid anyway; and if you win, you are ahead. Thus, from the standpoint of repeat players, there is no reason not to abuse your customers (except to maintain goodwill, which many of the companies at issue here have already forfeited). In addition to the possibility of winning cases that should really be lost, the companies can reasonably assume that some people will never sue, others will settle for less than they are owed, and still others will simply give up.

In short, even a legal system with a more robust set of equitable doctrines would be inadequate to do justice in this context. Indeed, in a sense, such a system would be the best regulatory system that the financial industry could possibly imagine. It would have the veneer of fairness, but it would still result in companies having virtually free rein to continue their abusive practices.

Why Agency Regulation is More Effective than Regulation by Courts

The contrast between using courts to regulate economic behavior and protect consumers -- even under the more pro-consumer legal rules just described -- and using agencies is thus rather stark. An agency can be empowered by Congress to order changes in behavior, changing business practices broadly and generally in order to level the playing field on which financial institutions and their customers do business.

Interestingly, it is possible to imagine that businesses, too, should embrace agency regulation – rather than preferring the court system. After all, if the alternative is for businesses to face numerous lawsuits, then we might imagine that the same business groups that decry "out of control lawsuits" would also favor a system that makes lawsuits less likely – the system in which an agency, not the courts, is the prime regulator. But that hypothetical, of course, ignores the financial industry's real agenda, which is to fight to maintain both weak legal rules (allowing them to win in court) and weak-to-nonexistent agency regulation.

We need not allow this to continue. Indeed, Congress now seems prepared to make changes that will stop some of the worst abuses. As it does so, it should bear in mind that reforms of the rules governing lawsuits can be helpful, but also that real consumer protection is best provided through agencies aggressively enforcing new laws to protect us all.


Neil H. Buchanan, J.D. Ph. D. (economics), is a Visiting Scholar at Cornell Law School, an Associate Professor at The George Washington University Law School, and a former economics professor.

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