For Finance Industry, a Possible Alternative to the Deregulation-Bust-Bailout-Reregulation Cycle

No one wants a replay of the financial meltdown of the past couple years, but can new regulations really provide a long-term solution?  Periods of heightened regulatory oversight seem inevitably followed by periods of deregulation, while the prospect of government bailouts may create a moral hazard that promotes excessive risk-taking.  Thus, in an interesting new article on SSRN, Shelley Smith suggests an alternative response that does not involve government regulatory agencies.  Her proposal instead focuses on the courts and reform of the law of adhesion contracts — those take-it-or-leave-it agreements that consumers routinely sign without reading or understanding.

Shelley argues that contracts of adhesion played an important role in creating the subprime mortgage mess, as consumers took on ruinous financial obligations without fully understanding the terms of the deals.  She suggests that courts should create stronger incentives for the drafters of contracts of adhesion to make the key terms comprehensible to ordinary consumers.  Thus, she would relax the normal presumption that the terms of the written contract will be strictly enforced where there is reason to doubt whether a reasonable person would have read and understood those terms.  If the “reasonable person” test is not satisfied, and extrinsic evidence fails to establish that the consumer actually received notice of the disputed term, then the court would not enforce the term as written, but would instead treat the case as a “missing term” case.

The article, entitled “Reforming the Law of Adhesion Contracts: A Judicial Response to the Subprime Mortgage Crisis,” is forthcoming in the Lewis and Clark Law Review.  The abstract appears after the jump. 

This Article examines the role of contracts of adhesion, in the form of home mortgages, installment sale agreements and other standardized contracts that impose future financial commitments on consumers, in causing the subprime mortgage crisis and the Great Depression. By shifting the focus to these “financial adhesion contracts” the Article suggests that the harm from the absence of mutual assent in adhesion contracts extends beyond specific terms that are unduly burdensome for consumers generally to economic risks that vary from consumer to consumer. When millions of consumers are convinced to sign unsuitable financial adhesion contracts, their collective risk-taking can undermine the stability of the entire financial system. The most common cures for the nation’s economic ills – free markets, monetary policy, and regulation – are found insufficient to resolve this challenge based on a review of the largest of country’s financial disasters, the Great Depression, the Savings & Loan crisis of the 1980s, and the subprime mortgage crisis. The Article then discusses why current doctrine and the proscriptions offered by scholars do not resolve the threat posed by financial adhesion contracts, and proposes a new method for salvaging mutual assent in adhesion contracts for the benefit of consumers and the security of the economy.

This Post Has 4 Comments

  1. Anthony Murdock

    In my opinion, the problem is not the law, but rather access of the law. The proposed “new” standard already is the law for contracts of adhesion.

    For example, insurance contracts, which in most instances are contracts of adhesion, are already intepreted under the “reasonable person” standard. Further, Wisconsin law is full of examples where an insurer is unable to rely on exclusions where it did not provide notice of the exclusion to its insureds.

    Yet, a large number of foreclosures are against pro se home owners that fail to appear at court appearances. Thus, the objections to “missing terms” or contractual ambiguities are never made.

  2. Salvatore Marino

    The reason why we got into this whole mess was that banks gave money to those who simply could not afford to pay it back. Unless there is law that regulates who can get a loan within reason, the same problem will continue. Even with new laws to regulate this, the economy is cyclical, isn’t it? So it is bound to happen again, just a different flaw.

  3. Shelley Smith

    Thank you for your interesting comments. Anthony, I agree that obtaining counsel for homeowners facing foreclosure is critical. NYU School of Law’s Brennan Center for Justice recently issued a report entitled, Foreclosures: A Crisis in Legal Representation, which recommends that Congress redress the funding restrictions imposed on LSC-funded legal aid programs in 1996. Even with increased funding, however, legal aid counsel do not have grounds under existing law to challenge the onerous terms of sub-prime mortgages based on lack of assent. LAF of Metropolitan Chicago, which has developed a handbook on claims available to borrowers in foreclosure, does not include any defense similar to the one I have developed in my article. In asserting that my proposal is already the law for adhesion contracts, I believe you have made a category mistake. While insurance contracts are adhesion contracts, courts have not applied the insurance doctrine of “reasonable expectations,” to all adhesion contracts including home mortgages. I chose not to rely on the reasonable expectations doctrine because it has been widely criticized for its lack of uniformity and could be useless for the no documentation loans so common prior to the recent crash.
    Salvatore, I believe, consistent with your remarks, that if regulators had maintained and enforced unsound lending regulations, the foreclosure crisis would not have occurred. Banks are supposed to lend money based on the borrower’s ability to pay, not on the value of the collateral. But regulators’ enforcement efforts are as cyclical as the economy, which is why I favor a common law solution.

  4. Trevor Hickey

    I agree with Smith. Many people don’t realize the danger of a contract. I heard that in California a lender was offer a product called “pick your payment” where the borrowers could choose to pay all, some or none of their mortgage payments for up to 1 yr. After the first year had passed and a large amount of money had accrued (since many people chose to pay $0.00/mth) the clients then had to start making inflated payments to chizel down their balance, which by now far exceeded the value of the house and it went into foreclosure.
    The moral of the story is this “confusing contracts hurt all parties”. Since the houses went into foreclosure the lender lost their money and the clients lost their shirt. In the end – everyone lost.

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