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"We buy houses": market heroes or criminals?


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.

A. 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 refinance their loans using their own credit, or the credit of friends or loved ones; they can make a lump-sum payment; they can lease the property out; or, they can sell their homes quickly. (26) Unfortunately, many homeowners lose a lot of time in the refinance loan application process, only to be disappointed when rejected in the eleventh hour.' Finally, many homeowners lose time because they are in denial about what is happening to them." (28)

The trapped equity paradox exists due to a void of supply in the distressed end of the traditional lending market. Although there is high demand among these homeowners for loans, even at high rates, such rescue financing is extremely difficult to find. (29) Because they have defaulted on other commercially available original and backup loans, and are already facing the foreclosure process, these homeowners are seen as high-risk borrowers and, therefore, cannot obtain new financing through traditional or sub-prime channels. Sometimes, lenders simply do not want to lend more money on homes which they feel are likely to end up in the banks' inventories, especially if the equity of the home will be consumed by the expenses of foreclosure. (30) Many banks have an overarching rule to not lend to homeowners already facing foreclosure, regardless of the potentially mitigating variables. (31)

Banks also may avoid this segment of the borrowing population because these borrowers' risk-profiles require a large amount of individualized monitoring, which the big banks are not equipped to do. (32) They prefer sectors that reward size, volume, expediency, and market power which can be commoditized easily. (33) Rescue transactions, even where there is trapped equity, require small, nimble, and adept lenders who are on the ground and capable of managing individual transactions. (34) Therefore, banks have abandoned this piece of the borrowing market, creating a void. (35)

The market failure persists because banks have another profit-maximizing, redistributive motivation not to provide new financing. Banks have no incentive to refinance these homeowners because, where there are great stores of equity, the banks are able to recoup their full costs of foreclosure from the equity in the home without suffering cash losses. Therefore, the value of that equity is redistributed from the homeowners to the bank itself. (36)

B. RSLB as a Market Solution

The market has developed its own responses to the trapped equity market failure--the RSLB transaction. '7 There is a group of small, informal investors willing to provide solutions of last resort to these otherwise abandoned homeowners. Small investors are in an ideal position, from a risk tolerance and operational-efficiency standpoint, to serve this particular market. In fact, small investors have responded and designed a solution to fill this lending void. One market solution is the RSLB transaction--a transaction which mobilizes dormant equity. (39)

The RSLB is a non-bank financial transaction, and it is popular among credit consumers who either do not have access to or do not trust the established banking community. (40) At this time, through the RSLB transaction, the market solution to the supply and demand misalignment in the trapped equity paradox exists outside of conventional mortgage finance. (41) Non-bank investors come into this arena to reconfigure the marketplace. These investors realign the relationships between owners and lenders and extend or avoid the foreclosure process by liberating trapped equity. (42)

Commonly, the average RSLB investor (43) operates outside of the traditional banking structure, although she may have several ties to and relationships with larger banks in order to help her provide rescue solutions for troubled homeowners. (44) The RSLB investors describe specialized property niches, such as waterfront properties, inner city fixer-uppers, suburban homes with pools, or homes with store fronts. They also approach their investment strategies and activities like most financial investors, depending on their individual levels of sophistication and financial positioning. These investors share some similarities with traditional mortgage lenders but are also distinct in many ways. For example, while they face similar general and specific risks as their larger counterparts, RSLB investors can take a broader range of factors into consideration when they are making their assessments and decisions --such as familiarity and comfort with a particular neighborhood or other possible sources of income in the home, such as financial support from children, parents, and significant others of the property owner--because they are creating a lease as opposed to a long-term mortgage. (45)

As an RSLB homeowner approaches foreclosure and cannot obtain any more financing to save his property from foreclosure due to income and/or credit restrictions, he finds himself in the precarious trapped equity paradox. (46) Once a homeowner is far enough in arrears, his lender must publish the homeowner's name as well as the lender's intent to sell the property in a foreclosure sale in the near future in newspapers or other public fora. (47) The information is then picked up by various listing companies, which aggregate the information for their subscribers. (48) This publication initiates the foreclosure sale process, which would culminate in the disposition of the property. (49) As he loses his home in the foreclosure sale process, the homeowner also loses a large chunk, (50) or all, of the equity trapped in the property--unless something stops the process, such as an RSLB. Once the names of homeowners who potentially need this transaction are published, investors can easily make contact with them, which serves as this market's efficient, least-expensive search and matching function. (51)

After the publication, several investors are likely to contact a homeowner and offer an RSLB opportunity. (52) Usually, these investors then visit the property in order to make a personal assessment of the homeowner and to assess the property, including an attempt to identify any problems with the property or the homeowner that cannot be identified on paper. (53) This is one reason small investors are better able to execute these transactions than their larger counterparts. It also allows the homeowners a chance to meet the investors to make interpersonal decisions and increase their comfort levels with the investors by asking questions.

By the end of the day, the homeowner may have several tentative RSLB proposals, which they would spend the next day or two considering privately before selecting one of the investors. (54) The homeowner controls the process and would use his own selection criteria in choosing to work with any particular investor. (55)

Once the homeowner has selected the investor he wishes to work with, they negotiate and agree on the terms, usually including an additional cash payment to the homeowner. (56) The three main terms in an RSLB transaction are the purchase price, the duration and rate of the lease, the buyback price and the date. (57) It is through the negotiable combinations of these three variables that the investor's premium is outlined and secured. The parties then sign the contracts and suspend their communications for the duration of the statutory waiting period, which corresponds with the homeowner's statutory right to cancel, also called a waiting period. (58) During the statutory waiting period, both parties must have the fully negotiated contract in hand and cannot take any action on the contract during that time, (59) which is intended to eliminate the influence of one party over the other, (60) although it does cut into the short timeframe leading up to the lender's foreclosure sale date. During this waiting period, the homeowner has the time and opportunity to carefully look over the contract and to have it reviewed by an advisor. After the waiting period, if both parties are committed to the contract, they will move forward with the transaction. (61)

Shortly after the waiting period, the investor will purchase the home from the homeowner in order to stop the foreclosure procedure; this often occurs within the lender's statutory timeframe of mere days. (62) At the closing, title transfers to the investor and the homeowner's underlying debts are paid off, including the defaulted mortgage and the other liens attached to the property. (63) To buy the homeowner's property, the investor will have used his own investment funds or will have borrowed funds, generally at "hard money loan" rates, (64) which are used for short-term, high-risk loans.

Once the investor has bought the home from the homeowner thus halting the foreclosure process, the leaseback period begins. (65) After the homeowner has settled into his lease, the investor then resells the property to a secondary investor in order to bring down the interest rate. A secondary investor is a person or entity with access to more traditional funding sources at widely available commercial or investment rates. (66) Despite the sale, the homeowner retains the right to buy the property back and must give written permission to the initial investor to transfer the property. (67) During the leaseback period, because the secondary investor is a silent investor, the initial investor often assumes a landlord and property management function, incurring the costs of property maintenance, repairs, taxes, and insurance. (68)

At the end of the leaseback period, the homeowner may exercise her call-option and repurchase the home, if she gets new financing. (69) This buy-back right may also be assignable depending on the negotiated terms and the jurisdiction. (70) The homeowner can also renegotiate her leaseback duration, possibly getting more time to contemplate her decision or to better organize her affairs. (71) It is also possible that the homeowner may finally decide to leave her home. Indeed, the homeowner can, at this point in time, decide under less-frenzied and less-stressful circumstances that she wishes to transition into a new phase, which does not include owning the home, and, therefore, she will let her repurchase option lapse. (72) If she lets the option lapse, she must either move out or negotiate a new leasehold without the repurchase option. (73)

C. Benefits of the RSLB for a Homeowner?

When a homeowner's circumstances suggest that his home is no longer able to provide the traditional benefits of owning property--storage of capital, reliable shelter, and income generation--owning the home in fee simple becomes less valuable to that homeowner. (74) In that case, a sale/leaseback can provide a superior bundle of benefits for the homeowner, such as liberating the stored value in his property by not owning it while continuing to use the property, the two most important factors to an owner facing foreclosure and wanting to remain in his homestead. (75)

Effectively, the RSLB transaction changes the homeowner's status from owner in fee simple to leaseholder. (76) The RSLB transaction, with its convenient search and matching function, saves the homeowner the cost of finding a fast-moving buyer. (77) This transaction allows the homeowner his only chance to convert his equity to usable cash that can be extracted for the homeowner's purposes, most importantly the foreclosure, but also any other current debts that he negotiates for. By paying off his bills, the homeowner is spared the ordeal of eviction, foreclosure and possibly bankruptcy. He also gets his name out of the newspapers and off of the negative public records. In fact, by having done the RSLB transaction, regardless of whether he ever repurchases his home, the homeowner has forever avoided that foreclosure on his credit report and will be able to spare whatever is left of his credit rating. (78)

The RSLB transaction also gives the homeowner a reprieve from the costs of ownership, including insurance, property tax, maintenance, and certain utilities. (79) These costs are shifted to the investor. (80) In fact, the transaction frees the homeowner of any incentive to make improvements, repairs, or to take special care of the property. (81) This is heightened as a homeowner becomes more certain that he will not exercise his option to repurchase. (82) Indeed, a homeowner will often hold off on his efforts to improve the property until he knows whether he will be willing and able to buy the property back. (83)

An RSLB transaction very effectively allows a homeowner to hedge herself against real estate price risk and to limit her downside, if she anticipates that the market is going to contract. (84) In such a case, a property owner's goal would be to not own the property when it tumbles in value, but to extract any value out of it and then sell it to someone else before it tumbles. The RSLB transaction gives her the ability to shift that risk by selling the property to the two investors, while having her bills and debts paid off by the mobilized equity. (85) This makes the RSLB transaction superior to refinancing her mortgage to avoid the foreclosure because, in the latter case, the homeowner would still bear the risks of a declining market or home value. (86)

While the RSLB transaction provides some very apparent financial benefits for rational homeowners facing foreclosure with trapped equity, it also serves some of the emotional and mental needs of homeowners as well. It allows the homeowner to stay in her home, which keeps her kids in their schools, and allows the homeowner to remain a part of her community. She is also spared the shame and humiliation within her community of a foreclosure, eviction, and possibly bankruptcy. By avoiding the foreclosure, the RSLB preserves what remains of the homeowner's credit and gives the homeowner a much-needed emotional reprieve. (87)

The homeowner also benefits from the sale of the property to the secondary investor. The role of the sale to the secondary investor is integral to the success of an RSLB transaction yet is very much misunderstood. It is often held out as dispositive of fraud, implying that it is a shell game or an attempt to confuse the title and the homeowner's rights. (88) The secondary investor is an investor who sees real estate as a portfolio opportunity and is able to provide cash and credit to the deal in exchange for capital gains (escalation of property value during the leaseback), income (rent as dividends), and tax advantages and deductions, specifically the ones that the homeowner was unable to maximize as the owner of the home. (89)

Another benefit to the homeowner is that the secondary investor is able to get low, market-rate financing, or may have his own pools of capital. Because the homeowner's credit rating makes this type of money unavailable to her, the secondary investor is able to bring the cost of the deal down significantly, including the homeowner's rental price, which drives this transaction. If the homeowner is not able to afford market rent or to cover the investors' costs, the investors may subsidize the homeowner's monthly payments by using some of the newly mobilized equity. (90)

The secondary investor also will have an investment horizon that allows him to delay his gains long enough to facilitate the leaseback period, which must be longer than the statutory redemption period in the jurisdiction. (91) The secondary investor's capacity allows the primary investor to reallocate the funds he had committed to the transaction. The secondary investor frees the primary investor's capital from the prohibitively expensive hard money rates, which allows him to pursue other deals, to perform maintenance on the property as needed, or to pay taxes and insurance.

With the buyback option, a homeowner retains her ability to regain the American Dream of homeownership. (92) Although certain jurisdictions allow a homeowner to retain a statutory right of redemption, (93) the sale/leaseback and repurchase option often can be the superior option for the homeowner, who plans to regain her property. The negotiated RSLB transaction allows the homeowner greater certainty about the timing of her homeownership and possible relocation in the future. The foreclosure process is messy and strips the homeowner of any control she might have over when she must relocate, when the house will actually be sold at foreclosure, to whom, or at what price. (94)

The repurchase price is another highly-scrutinized aspect of these transactions. (95) RSLB transactions are generally initiated when home prices are rising. (96) Therefore, the future purchase price will be set higher than the current market price. (97) This transaction depends on both parties believing the property value is rising. (98) However, there may be an exception to this expectation for the homeowner who knows that, even if the market declines, she is still no worse off by doing the RSLB than had she lost the home to foreclosure. She just will not exercise his repurchase option and will walk away. If she were able to extract one dollar over what she would have received through the foreclosure, she is better off having done the transaction. There is no reason for the investors to do this deal if they anticipate a decline in the market, as they would be forced to carry a home that is losing value during the leaseback period. (99) In fact, the failure of an investor to recognize the early signs of a market downturn can be his most costly mistake. (100)

If the home is worth $100 today, and the 4-year repurchase price is $110, then the homeowner expects the value of the home to increase to more than $110 over the next four years. If the market rises as expected, the homeowner may repurchase her home and has captured any equity over the $110 repurchase price. The primary and secondary investors are able to liquidate the investment, having captured their share of the equity up to the $110 repurchase price.

The other benefit to the homeowner of the buyback option is that the homeowner can sell it for cash. (101) If the option is assignable in the homeowner's jurisdiction, it becomes a thing of value for the homeowner. (102) If the property value goes up as expected, yet the homeowner still cannot repurchase the property, she can sell the option to another buyer for any price up to the difference between the repurchase price and the market price. (103) For example, in the simple example above, if the property rises to $120, and the homeowner owns the right to repurchase it at $110, she could sell the option for up to $9.99, and make herself and the buyer of the option better off.

The next aspect of these transactions that critics fail to understand is why they are so expensive for homeowners and exactly where the equity and sale proceeds go. (104) As demonstrated by simple example, most of it goes to paying off the foreclosure. (105) Some of it goes to a cash extraction by the homeowner. (106) Some of it goes towards paying off the other encumbrances on the title at the time of closing. (107) Some of it is retained for maintenance and other emergency payments. (108) Some of it is used to subsidize the homeowner's below-market rental payments. (109) Some of it is profit for the investors. (110)

The profit to the investors is widely-criticized. (111) However, it is important to note that an analysis of such profit cannot be detached from an analysis of the riskiness of the transaction. Where risk is greatest, reward is greatest. (112) The greatest indicator of the risk taken by RSLB investors is the fact that larger lenders will not lend to this group of homeowners at all. (113) The risk is that the investors face a likelihood of getting stuck with the property if the homeowners cannot buy back the property. That the lenders avoid this risk is the basis of the trapped equity paradox that gives rise to this transaction. (114) 115 Additionally, the benefits of the transaction for the investors must be higher than alternative uses of their funds. If the returns were not better on the RSLB transaction, the investors would choose other investment vehicles instead. If this transaction were priced at market value, the investors would be indifferent, at best, between this transaction and all other market-priced opportunities, which would be of no help to distressed homeowners. In fact, the investors might even disfavor the RSLB transaction because it would come with extra compliance requirements due to legislation regulating the sale of homes in foreclosure. (115) In order for the important secondary investor to become involved, he must make a profit, meaning he must be able to buy the property at a below market price. In order for him to make a profit in the second sale, the first sale must be priced even below that. This means that the original purchase from the homeowner must be priced low enough that it can be sold again, and still be below market. (116) In effect, this creates a three-way split of the homeowner's equity: one split for the homeowner, one for the primary investor, and one for the secondary investor. However, even if those splits are known in advance, the investors' shares are still uncertain due to unknown carrying costs; whereas, the homeowner's split is known upfront and not subject to depletion. The homeowner's split should be increased by the value of the intangible benefits, such as foreclosure avoidance, credit maintenance, subsidized rent, tax benefits, insurance, and other carrying costs, which are detailed above. (117) Therefore, the criticism of investor profits may be overstated because it fails to consider the benefits also achieved by homeowners in lieu of some of their equity.

Part II: Criminal Regulation

This Article has so far summarized the anatomy of the generic RSLB transaction, which represents the market's organic solution to its own problems. These transactions have been criminalized recently as the law works to eviscerate them as a solution. (118) Instead of seeing RSLB investors as the market heroes they could be, and working to facilitate their filling of this market void, the legislative and judiciary reactions demonize RSLB investors and subject them to criminal charges--including criminal mail and wire fraud, identity theft, and now burglary--and often extensive jail sentences. (119)

Traditionally, real estate cases have been tried in civil courts. (120) Increasingly, however, foreclosure rescue investors are being criminalized and sentenced to severe criminal sentences. (121) Because these transactions are contract-based, they raise the question of when to regulate contractual behaviors with the criminal law. Given the current culture of rampant white-collar allegations, (122) the inquiry is especially timely. This Article turns a lens on the question of where and why we draw the line between ordinary contracting behaviors, which are best handled by the civil courts, and criminal behaviors, which require the intervention of the criminal courts. This Article concludes that the line is moving dangerously close to over-criminalization and that the civil courts and contract theory are being underutilized in favor of less-efficient, more expensive criminal dispositions.

Regulating ordinary bargaining behaviors with the criminal law usurps the ability of contract theory and the civil courts to resolve their own problems. (123) It also imposes on contracting parties unpredictable and unquantifiable outcomes, thus chilling the willingness of one party to enter into potentially socially-beneficial contracts and increasing the cost of such contracts for the other party. (124)

This Article seeks to understand one type of contracting behavior--the buying and selling of distressed homes--which may serve as a proxy for certain other types of contracting behaviors, but not for all. Alleged white-collar activities come in two forms: contract-based activities, (125) whether oral or written; and non-contract-based activities, such as embezzlement, check fraud, insider trading, etc., which can arise without formal contract relationships. (126) Further, contract-based activities fall into two categories: those where the contract is performed as written--the focus of this Article--and those where the contract is not performed as written, such as Ponzi schemes. (127)

In those instances where the contract is not performed as written, where the allegation of wrongdoing more closely resembles a breach, there may be a stronger case for criminal regulation based on criminal performance of the contract. (128) However, in other instances, like RSLB transactions, the contract is performed as written and the prosecutor alleges instead some type of criminal formation of the contract, (129) either in procedure or in substance. In these cases, claims can be brought under traditional contract theories of misrepresentation, fraudulent inducement, unconscionability, misunderstanding, promissory fraud, and other theories that attack the formation. (130) In such cases, even where these claims have been fully supported or where there has been a finding of a bad act, there are several traditional contract remedies available to the civil courts, namely specific performance, injunctive relief, modification of terms, contract avoidance or rescission, severability, equitable mortgages, (131) and cash remedies. (132)

The criminal regulation response of the judiciary and legislature to alleged real estate fraud and other white-collar cases amounts to no more than a frenzied mis-response, which creates more problems than it cures. The resulting deluge of prosecutions and statutes is an attempt to triage, which has resulted in casting too-wide a net, which ensnares too many false positives, scapegoating small investors because they are the lowest-hanging fruit, and over-compensating some homeowners, while leaving other homeowners undercompensated. (133) For these reasons, this Article argues that a strengthened contract law, not criminal law, is best equipped to handle these types of cases.

This Article defines criminalization as the process by which acts are placed on a linear spectrum that starts with totally benign and welfare-maximizing conduct on the left, journeys through neutral conduct and questionable conduct, and ends with totally malevolent and destructive conduct on the right. Every point on that spectrum carries with it a commensurate level of punishment for the act. At some point, as acts move from left to right on that line, they shift from just being undesirable, through a gray area, then cross the line into being clearly undesirable and requiring a state reaction. Criminalization is the act of assigning conduct to that gray area or further to the right of the gray area. In this analogy, criminalization represents an escalation of the penalties to which an actor is subject for an act. Overcriminalization, therefore, is the mA-assignment of acts along that spectrum by placing them farther to the right than the conduct actually warrants. Similarly, over-criminalization can be viewed as an over-escalation of punishment. The spectrum of criminalization is analogous to one that would exist for civil conduct, with the corresponding civil monetary penalties related to the degree of undesirability. While the civil and criminal spectra should and could exist as two separate spectra, criminal regulation of contracts collapses them into one, or creates a bridge at some point between the two spectra. Why?

Where does a civilized, yet capitalistic, society draw the proverbial line in the sand between ordinary business conduct and criminal conduct? (134) Where there is gray area, prudence and efficiency dictate that civil courts ought to resolve these issues. (135) Nonetheless, the criminal law is expanding to envelop ordinary business conduct, (136) such as RSLB transactions, thereby collapsing the two spectra. In the case of RSLB rescue transactions, the sentiment that gives rise to criminal regulation starts with the popular opinion that homeowners are duped out of their equity and homesteads through affirmative fraudulent misrepresentations or omissions by investors. (137) While there may be fraud in some cases, as there is in any industry, it is incorrect to call RSLB transactions fraudulent transactions broadly.

To a large extent, the question of where we draw this line becomes a matter of interpretation. What factors do we use? Do we allow prosecutors and the criminal courts to take what they want and leave the rest for the civil courts? (138) Should the criminal court have this power to decide which conduct falls outside of reasonable business practices? Or, should we rely on business specialists and experts to make those determinations in civil fora?

There are many well-developed theories of criminalization; (139) however, none fully explains why RSLB transactions are being criminalized. (140) This

Article introduces another explanation: criminalizing perceived unconscionability, (141) which suddenly is possible after a perfect storm of social, political, and economic forces materialized in the real estate and securities markets and led to the criminalization and over-criminalization of RSLB contracts. Specifically, a groundswell of public sentiment fueled, in part, by the otherwise innocuous American ideal of homeownership, driven by media sensationalism against anything that smacks of white-collar activity in the wake of large, unremedied corporate and banking fraud, coupled with a downturn in the real estate and securities markets. Prosecutions of alleged RSLB and similar crimes usually peak just after a mortgage correction, based on earlier conduct that occurred during the preceding market boom (142) and a mob mentality set on punishing somebody for the losses in these markets in an era of weak contract remedies, is the best explanation that can be developed for criminalizing small RSLB investors. This perfect storm leads to scapegoating the low-hanging fruit and the casting of an overly-wide net, which produces too many false positives.

A. Fraud and Misrepresentation

Once prosecutors and opponents make the decision to criminalize, they have a basket of charges to use to prosecute investors. The traditional contract doctrines of misrepresentation and fraudulent inducement, (143) which can be difficult to prove, and the doctrine of mistake (144) give way to criminal fraud doctrines, including promissory fraud (145) and theft by false pretenses, (146) which is one criminal theft charge that can be used to prosecute real property transactions. (147) In some cases, prosecutors will include forgery and identity theft charges as well. (148) They can also prosecute under an equity sales act, if their jurisdiction has one. (149) Additionally, there are often various statutes allowing for enhancements of the charges and sentences for equity or theft transactions involving a certain dollar amount, (150) or for crimes involving the elderly. (151)

In tough economic times, contracting parties are especially susceptible to allegations of fraud and misrepresentation by their contracting counterparts. (152) Because real estate fraud allegations spike just after market corrections, (153) in RSLB cases and other cases alleging fraud, there should be two important potential gatekeepers to avoid over-prosecution and overconviction of investors under fraud statutes. The first gatekeeper exists at the indictment or preliminary hearing stage. (154) To provide the best protections for defendants at the indictment stage, criminal fraud cases should look to recent civil cases, such as Iqbal and Twombly, to import those heightened pleading standards to criminal contracts cases. (155)

The second gatekeeper should sit at the testimonial stage, but perhaps does not. Promissory fraud (156) requires evidence that the investor affirmatively promised something different than what was actually written in the contract, and which the investor never intended to happen, such as, "He told me I would still own my home!" or, the omission, "He never told me I was selling him my home!" Homeowners may say, for example, that they were led to believe that the investors were helping them make restructured payments. (157) This is perhaps the most common form of complaint in an RSLB transaction. (158) A homeowner may offer testimony about conversations that he had with the investor in which the investor allegedly made false statements to the homeowner about the investor's intent, which contradict the written contract.

Under normal civil contract circumstances, such conversations would be inadmissible under the Parol Evidence Rule, (159) in part, because it creates an opportunity for a frustrated party to use the courts to try to amend or to get out of undesirable contracts. (160) However, under the fraud exception to the Parol Evidence Rule, (161) such statements are admissible to prove fraud and to rebut the validity of the signed contract; yet, the same opportunities for deception are still there. (162) However, the Parol Evidence Rule only applies to contract law and does not have a reliable counterpart in criminal law. RSLB cases highlight one problem with criminalizing contracts and bring into question how to handle issues during criminal prosecutions, which would normally arise under the civil Parol Evidence Rule. Although the evidentiary standard in criminal cases is the higher "beyond a reasonable doubt" standard, (163) do the higher stakes in criminal court not warrant something analogous to, but even tougher than, the civil Parol Evidence Rule? Where criminal fraud is found simply by combining homeowner testimony of misrepresentations with unfavorable contract terms, which erroneously appear dispositive of malintent, a dangerous inferential leap has occurred. (164)

Foreclosure rescue cases are often initiated by a legal services-type organization, not by individual plaintiffs. (165) Often those legal services attorneys seek out the homeowners after thorough public records searches, telling the homeowners that they may have been defrauded. (166) Consequently, even if unwittingly, legal services attorneys may present both the opportunity and the incentive for homeowners to falsely allege fraud, by suggesting or promising that the homeowners could get their homes back, if the judge decides that they actually did not understand the transactions or believes that the investor misrepresented his intentions. Given the American worship of homeownership, the incentive is too great, and the stakes are too high, to allow false inferences in criminal courts.
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Title Annotation:Introduction through II. Criminal Regulation A. Fraud and Misrepresentation, p. 649-680
Author:Harvey, Cori
Publication:Missouri Law Review
Date:Jun 22, 2014
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