Contractual Inequality

Manisha Padi* March, 2022

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.

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 terms²⁵ 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 performance that disparately impacts protected classes, opening the door to antidiscrimination lawsuits.³³ Finally, disclosures to private actors such as information aggregators, private regulators, and insurance companies could help private markets hold actors accountable for worsening social inequality.³⁴ Recognizing and addressing contractual inequality is essential for lawmakers to sustainably serve the needs of all types of contracting parties.

The Article proceeds as follows. Part I introduces contractual inequality and its potential harms, focusing on negative distributional effects and inefficiency. Part II describes how contract law worsens inequality, including traditional embedded options in contracts such as the exercise of reserved discretion, waiver, enforcement, modification, renegotiation, and breach. Part III introduces residential mortgage contracts as an empirical setting to demonstrate the magnitude of inequality in contract outcomes. Part IV lays out the limitations of using existing tools to oversee contractual inequality. Part V suggests disclosure reforms tailored to minimizing the negative impacts of contract law on social inequality and maximizing the efficiency of contract markets.

I. Inequality in Contract Performance

Boilerplate contracts are essential to households’ income, education, and long-term financial well-being.³⁵ Contract terms, however, are written in legal language that ordinary individuals cannot understand.³⁶ Vanishingly few consumer contracts include negotiated terms; instead, businesses offer exactly identical contracts to multiple consumers.³⁷ Even sophisticated parties who hire big law firms often find that their contract terms are identical to those used in other transactions.³⁸ A large fraction of the contract language is taken from other sources, including previous contracts written for similar transactions, forms drafted by law firms, and recommended language suggested by professional associations.³⁹ Written contracts therefore reflect historical custom and the psychology of the drafters more than the relevant details of a particular transaction.⁴⁰

Standardized “contracts of adhesion” signed by parties with unequal sophistication, such as a consumer and a firm, have concerned scholars for decades.⁴¹ Because the consumer has relatively little power to negotiate and understand the contract terms, standard form contracts may contain terms that are one sided in favor of the firm. If a dispute arises, the more powerful firm is likely to prevail, ultimately decreasing the value of the contract to the less powerful consumer. To combat these harms, scholars have argued for more informed assent, careful drafting procedures, and judicial and regulatory measures to improve the quality of standard form contracts.⁴² Regarding consumer financial contracts in particular, these concerns have spurred the creation of the Consumer Financial Protection Bureau (CFPB) to ensure that consumers assent to high-quality financial contracts.⁴³

This Article focuses on a different issue with this market—the performance of standard form contracts. Transactions subject to the same terms evolve differently during performance as circumstances change, new information becomes available, and parties make decisions.⁴⁴ At the completion of the contract term, decisions made about performance mutate the written contract’s “paper deal” into very different “real deals” for different transactions.⁴⁵ Contractual inequality occurs when two similar transactions with similarly situated parties end with different outcomes due to decisions made during performance.

Consider the example of two families trying to build their wealth. Each has a savings account at a local bank, where their paychecks are directly deposited and their bills are automatically paid each month. The system breaks down when their paychecks are delayed during the COVID-19 pandemic. Both families are charged an overdraft fee of $225 when their bills are paid without sufficient funds in the account.⁴⁶ At this point, their experiences diverge. The first family waits until the paycheck is deposited and calls the bank about the overdraft fee. The bank representative explains that they themselves opted into the overdraft protection program and that the standard fee is $225.⁴⁷ Ultimately, they pay the overdraft fee along with the other bills after their paycheck is processed. The second family calls the bank and complains about the charge. By asking to speak with a manager and threatening to post negative reviews of the bank on social media, they manage to get the overdraft fee waived.⁴⁸ This pattern repeats itself over the course of the pandemic, leaving the first family thousands of dollars poorer than the second.

This example highlights two key features of contractual inequality. First, the two transactions were largely similar until the overdraft fee was levied, with identical formal terms in each contract. Therefore, the literature on assent and consumer understanding of contract terms does not shed light on how and why the two families’ experiences diverged. Second, the divergence may occur for any reason and need not be driven by animus or intent to harm the consumer. The second family may simply have had a more aggressive negotiating strategy, have been advised by a lawyer, or have promised the bank more business if they waived the fee. On the other hand, the bank representative may have been swayed by gender or racial bias.⁴⁹ Each of these explanations raises different concerns. Regardless, contractual inequality causes two types of harms.

First, in common with other settings, unequal treatment may be inherently undesirable. For instance, contractual inequality can worsen existing disparities across social groups, resulting in regressive redistribution or impermissible disparate impact. Second, unequal treatment generates economic inefficiency. Individuals who are considering entering into a standardized contract are aware that once the contract is signed, the company is free to stringently enforce the contract with them, while other customers are treated cooperatively and leniently. Consumers therefore may rationally distrust companies offering standard form contracts, ultimately choosing not to participate in key contracts because the law does not protect them against the risk of loss during performance. This phenomenon arises due to a commitment problem inherent to contract law, which does not allow parties to contract out of waiver, the exercise of discretion, modification, renegotiation, and breach. Consequently, inequality is particularly harmful in the contracts context. Each of these harms is discussed in turn below.

A. Regressive Redistribution

Social inequality has grown significantly in the last few decades.⁵⁰ High-income households have seen their income grow at four times the rate of low-income households in the last twenty years.⁵¹ The large disparity in standards of living and opportunities for social mobility between rich and poor households was highlighted by the 2009 recession and gave rise to the Occupy Wall Street movement.⁵² Since then, a significant movement among politicians, activists, and voters has given a national stage to policy debates directly addressing inequality.⁵³ The global pandemic of 2020 highlighted how little progress has been made in remedying inequality, with low-paid essential workers risking their lives to supply the needs of much more affluent at-home workers.⁵⁴ Policy remedies have been difficult to find, in part due to the complex sources of the problem, including long-standing historical factors surrounding race and communities, systemic failures in public education, and misaligned economic incentives.⁵⁵ Most policies targeting inequality have focused on direct redistribution of wealth from rich to poor, usually through taxes and social welfare programs.⁵⁶

Legal scholars have focused on the role of law in the creation and exacerbation of harmful social inequality.⁵⁷ Economic, gender, and racial inequality have been aggravated by differential use of legal tools against social groups. The criminal justice system, administrative agencies, and other public actors have been heavily studied by scholars⁵⁸ and regulated by lawmakers⁵⁹ as a source of social inequality. Public law scholars have a deep interest in the differential understanding of how legal institutions interact differently with the rich and the poor.⁶⁰ Research on access to justice has highlighted that providing the opportunity to litigate may benefit the most powerful to the detriment of the weak.⁶¹ Even differences in contract formation between genders and racial groups have been studied and litigated as having an impermissible disparate impact on protected classes.⁶²

Contractual inequality refers to a less-studied disparate impact—differences in value created by contract performance across social groups.⁶³ Among consumers subject to the same contract terms, for example, some may consistently be treated well while others are treated poorly.⁶⁴ Disparities in contract performance are particularly important to deter and remedy due to contracts’ essential role in facilitating the exchange of labor for income, the accumulation of savings, and the purchase of consumer goods, education, investments, and other assets.

Disparities in performance may be particularly harmful if they are regressive. For instance, suppose the bank customer whose overdraft fee was not waived is Black and poor. The unequal treatment meted out by the bank adds to the list of obstacles facing poor and Black individuals trying to build wealth.⁶⁵ Since the Black family is part of a protected class, the bank’s conduct could even violate federal antidiscrimination law.⁶⁶ Though bank overdraft fees have been widely studied and regulated, regulators do not quantitatively assess how many fees are waived for Black customers relative to others.⁶⁷

It is essential to note that disparate treatment may be economically rational. For instance, the bank could rationally believe that the second family’s threat to tweet about the company’s behavior would lose them more money than the lost overdraft fee. Or the bank may have noticed that aggressive overdraft-fee negotiators bring more business to the bank, making it profitable to keep those customers happy. The bank may not even be aware of the individual’s gender, race, or wealth. The distributive harm remains in this case, however, since there is a disparate impact on underprivileged populations.

Moreover, economic efficiency cannot always justify contractual inequality because even sophisticated parties sometimes make inefficient choices, resulting in arbitrary performance inequalities.⁶⁸ A large legal literature has demonstrated that legal actors making discretionary choices are influenced by behavioral factors. For example, a famous study found that judges were more lenient in cases heard early in the day, with leniency dropping significantly until judges had a lunch break.⁶⁹ Increasing discretion awarded to prosecutors in charging decisions and judges in criminal sentencing led to larger disparities in sentences between Black and white defendants.⁷⁰ Individuals are not the only decisionmakers subject to these inefficient impacts. The literature on discretion in administrative lawmaking finds evidence that agencies make decisions that are biased in favor of interest groups and lobbies.⁷¹

The legal system is indirectly responsible for distributional harms of contractual inequality because the threat of court enforcement limits parties’ ability to walk away from their contractual obligations. Contracts scholars have argued that contract law can act as a powerful force for progressive redistribution at formation, including the use of unconscionability and other principles to protect vulnerable contracting parties.⁷² However, these doctrines do not typically extend to contract performance, leading to worsening inequality.

B. Inefficiency of Incomplete Contracts

A more subtle, but potentially more destructive, harm can arise from inequality in contract performance. Parties who anticipate unequal treatment and fear that they may be in the group that incurs losses due to their counterparty’s decision will expect diminished value from the contract. As a result, they may face inefficiently high prices. Moreover, the fear of being treated uncooperatively during performance may make already disadvantaged groups choose to opt out of the market. This chilling effect arises from the fact that contracts are incomplete, meaning that firms have many options to modify the performance of contracts, with the decisions made during performance potentially leading to widespread economic loss.⁷³

Returning to the example of banking, consider how new bank customers may behave in light of overdraft fee policies. More than 5% of American households have no bank account, limiting their access to a variety of financial benefits such as low-cost checking, direct deposits, and access to fairly priced loans.⁷⁴ Unbanked individuals may hear of stories like the one above and decide that the risk of incurring overdraft fees is high enough that they will only open a bank account when offered a bonus, despite the hidden costs associated with these “perks.”⁷⁵ Even worse, disadvantaged populations such as Black or immigrant families may realize that they are less likely to receive waivers and choose not to open a bank account at all, relying on expensive check-cashing services.⁷⁶ Economically efficient transactions that could have occurred in the absence of performance inequality are undermined by the possibility that firms will treat groups unequally.

Note that contract incompleteness causes harm in two ways. First, it can lead to inefficient pricing and quality in markets for consumer contracts.⁷⁷ Exceptional customer service and other hallmarks of high-quality contract performance cannot be guaranteed. Therefore, rational customers will refuse to pay full price for these amenities, and companies will be less likely to provide perks during contract performance. If firms could credibly commit to cooperating with their customers during breakdown of the relationship, the transaction would be more valuable. Second, the expectation of uncooperative behavior from firms can lead the market for consumer contracts to dwindle in trade volume and even die out in certain markets.⁷⁸ Some contracts may include too much risk for consumers to participate. The harm here arises from a value-creating trade that did not occur—if the consumer could be assured of good treatment, they would participate in the market, improving both their own and their counterparty’s bottom line. Contractual inequality could result in disadvantaged populations leaving markets for consumer contracts to the detriment of the entire economy.

Can incompleteness be eliminated by changing contract design? The gap between formal contracts as drafted and the economic value generated by the relationship arises from discretion in the hands of contracting parties. Written contracts do not specify the actions parties should take in every contingency, instead leaving the contract terms incomplete, waiting to be filled in by the parties or the courts. Economists have shown that it may be optimal to structure contracts in this way because gaps in a contract’s specification of rights or obligations can increase the value generated by a contractual relationship by allowing parties to tailor the contract to unexpected situations that arise during the contract term.⁷⁹ Moreover, parties to a contract can take advantage of incompleteness to make dynamic adjustments to the contract during the course of performance.⁸⁰ Legal scholarship typically looks to courts to fill these gaps.⁸¹ However, most incompleteness is resolved by unilateral or joint action by the parties before courts get involved in contract disputes.⁸² How parties fill these gaps determines the inequality the contract will generate.

Insurance contracts, for instance, are fraught with incompleteness.⁸³ The contract may specify the general outlines of coverage, but no contract can specify every detail of a particular claim. In theory, insurers could offer a contract that specified the precise documentation required of every claimant before being paid. The company may still choose to waive those conditions and pay the claim without full documentation.⁸⁴ Therefore, it is both too costly and likely unappealing to specify the insurer’s course of action in every conceivable scenario. Instead, some discretion is afforded to the parties in the language of the contract. The insurer can decide how exactly to administer claims, when to pay out, and how much coverage to award in each situation to fill the gaps in the contract language.⁸⁵

Despite technological advances prompting attempts to make fully complete contracts a reality,⁸⁶ solving commitment problems once and for all is not realistic. Mandatory embedded options, such as the option to waive specific provisions, are based on fundamental principles of contract law that underpin centuries of jurisprudence.⁸⁷ Moreover, some flexibility in enforcing contracts is often desirable, despite the risks it introduces. Parties in some cases prefer to see how circumstances external to the contract evolve before committing to a course of action.⁸⁸ To understand whether incomplete contracts create significant welfare loss, lawmakers and scholars must assess the extent to which parties use their discretion to modify contract outcomes and the reasons behind it.

Information about contract performance is hard to find, however, because courts are generally unwilling or unable to scrutinize these actions.⁸⁹ A large literature has studied the effect of discretionary action in generating disparate outcomes in other contexts, including administrative law and criminal justice.⁹⁰ Affording discretion to contracting parties is different from those contexts because individuals can opt out of contracts but not out of the criminal justice system or the administrative state. But although unequal treatment within a contract may not raise concerns about coercion, it still raises concerns about economic efficiency. Despite this, inequality is classified as “relational,” meaning that parties’ discretionary choices are outside the purview of courts and regulators.⁹¹

The common law of contracts also prevents parties from agreeing to limit contract incompleteness. Mandatory embedded contract options, such as breach and modification, cause inefficiencies because no party can commit fully to not breaching or not renegotiating a contract.⁹² Waiver and the exercise of discretion are difficult to contract around as well, although some doctrines exist to discipline their usage.⁹³ These legal levers are discussed in turn below.

II. How Contract Law Creates Unequal Outcomes

The common law of contract has long enabled contractual inequality.⁹⁴ Consider a typical debtor-creditor relationship in which the debtor is facing financial pressure. What choices does a debtor have when faced with the possibility that future payments will be difficult to make? The debtor could decide to prepay in anticipation of financial distress or offer partial payment after distress occurs in an exercise of discretion. The debtor could also breach and make no payment at all. Second, what choices does a creditor have if faced with the possibility that the debtor may be unable to make payments? The creditor could preemptively offer the debtor a modification of the debt obligations to make it easier for the debtor to make payments. The creditor could also waive the debtor’s obligation to pay on time, providing a forbearance period to accommodate the debtor’s needs while preserving their rights to collect on the original agreement.

More broadly, the exercise of reserved discretion, waiver of obligations, and the decision to breach, modify, enforce, or renegotiate a contract can each be utilized to generate unequal outcomes from standard form contracts. Empirical studies in economics, finance, and accounting have shown that contractual inequality is widespread in the context of health-insurance contracts, commercial debt, and household borrowing.⁹⁵ This Part uses examples from this literature to demonstrate the principles of contract law generating performance inequality and their widespread impacts.

A. Exercise of Discretion

A party exercises its discretion when a range of options would satisfy the requirements of a formal contract and the party can unilaterally choose among these options. One form of exercising discretion arises when a party has explicitly reserved the right to make a discretionary choice within the formal contract terms, such as the choice of production amount in an output contract or the choice to exert efforts in an exclusive dealing contract, or more generally the type of choice governed by a mandatory common law duty of good faith.⁹⁶ Discretion also exists in the utilization of well-defined formal obligations, such as the choice to enforce a right, as will be discussed below.

A well-studied example of the exercise of discretion arises in the context of health-insurance contracts. Consumers of health care purchase insurance plans to smooth their potential expenditures over the contract term. A plan typically specifies the amount of coverage, comprising a deductible that is paid out of pocket and partial or complete coverage of expenditures above the deductible amount. Economists have documented that consumers obtain health care in a way that minimizes their out-of-pocket expenditures.⁹⁷ For instance, it is cheaper to visit the doctor for a checkup at the end of the year, when the deductible has already been spent and insurance covers additional care, than waiting until the following January to get a checkup that will require out-of-pocket-payment. It would be entirely within the bounds of the formal contract to strategically reschedule doctor’s visits to the end of the year. If sophisticated consumers decide to get more specialist care in years when their spending is already high, the insurance company bears the cost and no contract term can be used to deny the claim. This generates inequality among insurance companies. Companies whose sophisticated consumers strategically reschedule their health care consumption will have to pay out more, while companies with unsophisticated consumers will pay out less.⁹⁸

Note that the inequality in this example arises directly from the incompleteness of the insurance contract. Insurance companies could require their customers to provide documentation that doctor’s visits were scheduled in a timely fashion or could ration discretionary medical care to limit strategic consumption. Instead, insurance companies have taken another tactic for limiting the cost of inequality—they set premiums to compensate for the possibility of strategic health care consumption.⁹⁹ Parties bargain for and assent to agreements that leave discretion in their hands, explicitly allowing for unequal outcomes to arise.

B. Breach of Contract

Parties to a contract can always choose to breach their obligations to their counterparty. The option to breach is embedded in every contract and comes with the implicit cost of damages or other restitution from the harmed party.¹⁰⁰ Breach-of-contract claims require no showing of fault and therefore impose strict liability on a breaching party.¹⁰¹ This can be thought of as putting a “price” on breach. When two sets of parties are engaged in similar contracts, the strategic choice by one party to breach while its analogue continues to perform generates contractual inequality.

The strategic choice to breach has been studied by economists and lawmakers in the context of mortgage default. The decision to stop making payments on a mortgage constitutes breach—the terms of all mortgage contracts require mortgagees to make timely payments.¹⁰² Occasionally, default is unavoidable, with the mortgagee facing a liquidity crisis that makes payment impossible. On the other hand, some may decide to breach despite being able to perform if necessary. This is referred to as strategic default.¹⁰³ Mortgagees would rationally prefer to default if the value of their home drops so low that they no longer have any equity interest in the home, that is, if the mortgage is underwater. In this case, further payments toward a principal amount that is too high would be wasted. Moreover, failing to pay would force the creditor or servicer to choose whether to foreclose on the property. If the loan is underwater, foreclosure may not make the creditor whole. By strategically defaulting, a mortgagee may benefit by remaining in the house without payment until the home’s value increases. On the other hand, strategic defaults are considered both morally dubious and potentially harmful to the value of neighboring properties and communities.¹⁰⁴

The choice to breach, therefore, generates inequality across creditors, investors, and servicers. Some are lucky to have a portfolio of high-performing loans without many defaults at all. Others are faced with many defaults, resulting in poor performance and low returns. Despite this, the reasoning behind the choice to default is not considered by courts or regulators.¹⁰⁵ Damages are equivalent whether or not the breach was strategic, even though creditors with more strategic defaulters face larger losses.¹⁰⁶ Since the option to breach a contract cannot be modified by agreement, this lever is embedded in every single contract and can always result in unequal outcomes.¹⁰⁷

C. Waiver and Enforcement

When a contract imposes obligations on one party, the counterparty is empowered to waive those obligations. Waiver is a unilateral decision not to enforce a legal right, usually a right explicitly authorized by the written contract.¹⁰⁸ The exact nature of waiver is highly litigated and debated, since an offer to waive an obligation may be retracted at any time as long as compliance with the obligation is still possible.¹⁰⁹ The party entitled to waive the other’s performance is also empowered to insist on performance. Therefore, the choice to enforce is the opposite of the choice to waive.¹¹⁰ There is no legal obligation for contracting parties to enforce their legal rights by filing a lawsuit, but they may choose to do so unilaterally.¹¹¹ Waiver and enforcement can create inequality across counterparties—the same party can offer a waiver to counterparty A while enforcing the original terms of the agreement against counterparty B.

A large literature in finance and accounting has studied how waiver, relative to enforcement, generates unequal outcomes in the context of commercial debt.¹¹² Lenders include financial covenants in their debt agreements, meaning that if a borrower’s financial condition is worse than expected, lenders may terminate the relationship even if the borrower is still making payments.¹¹³ These covenants are often waived, but only for those borrowers who are likely to have continued future value.¹¹⁴ Covenant violations that are not waived have significant consequences, including inability to obtain follow-on financing and limitations on future investments.¹¹⁵ Despite this, covenant violations can provide an opportunity for creditors to step in, assert control rights, and ultimately increase the debtor’s value.

Waiver in this context generates inequality between debtors whose violations are waived and those whose violations are not. These disparities occur among sophisticated parties, who can change the price of debt to account for the possibility of covenant violations, following the pattern of insurance companies and mortgage lenders mentioned above.¹¹⁶ On the other hand, less informed parties are often at the receiving end of differential waiver policies.¹¹⁷ Recent experimental evidence shows that customers wishing to make retail returns despite violating the technical requirements of the store’s written return policy are provided with different waivers by store clerks.¹¹⁸ In a variety of contexts, then, waivers give rise to unequal outcomes across parties that are otherwise similar.

D. Modification and Renegotiation

Contract modifications arise whenever the rights or obligations laid down in the express contract are changed to accommodate new and different circumstances facing the parties. Valid modifications, which are usually written, preserve the fundamentals of the contract in a way that is mutually agreed upon by the parties while changing some terms. Since both parties must assent to a modification, it has a fundamentally different character than the one-sided tools available to contracting parties. On the other hand, the ability of one party to “hold up” its counterparty and strategically demand a modification, as well as the proliferation of unilateral modification clauses, has turned this bilateral tool into an increasingly unilateral one.¹¹⁹ The hold-up problem has led to limitations being placed on modifications, primarily in the form of bilateral agreements due to changed circumstances or unilateral changes by prior agreement including notice and opportunity to review the changes.

Despite these limitations, modifications continue to be a regular part of many contractual relationships, with unilateral modification clauses becoming increasingly common.¹²⁰ Yet scholars and lawmakers have noted that modification does not happen in cases when it would be socially optimal, such as during the financial crisis of 2008 when homeowners were foreclosed on instead of being offered modifications.¹²¹ The federal government created the Home Affordable Modification Program in response, which subsidized lenders who offered streamlined modifications to their borrowers.¹²² The effect of this program was much smaller than anticipated, and research has shown that this lack of modification caused inefficiently high levels of foreclosure during and after the crisis.¹²³

Unlike modification, which doesn’t replace the original contract, renegotiation creates an entirely new contract between two parties who contracted previously. As it is never unilateral, renegotiation is a more mutual tool. However, the choice not to renegotiate, just like the choice not to modify, is unilateral. Recent studies have shown that private credit agreements are regularly modified and renegotiated.¹²⁴ Violations of debt covenants, for example, often trigger renegotiations.¹²⁵ Recent research has shown that loan covenant violations and subsequent renegotiations of debt contracts were an important factor in the macroeconomic collapse during the 2008 financial crisis.¹²⁶ Selective failures to modify and renegotiate in a cooperative manner can generate inequality between debtors with a path to performance and those who face inevitable financial loss. Just as in the case of breach and waiver, there is no way for parties to opt out of modification and renegotiation. Every contract includes the embedded option not to modify or renegotiate, potentially generating unequal outcomes across similarly situated parties.

III. Inequality in Residential Mortgage Foreclosure

To quantify the impact of contractual inequality, this Article considers one of the most important types of contracts in the United States—residential mortgages. Mortgages are the largest and most consequential contracts that a typical consumer will enter into during their lifetime. American households, taken together, have $11 trillion in outstanding mortgages.¹²⁷ Over 30% of income nationwide is eaten up by housing costs, a large fraction of which are mortgage payments.¹²⁸ The health and efficiency of mortgage markets have important consequences because they decide where and how households live. In turn, this contributes to the economic welfare of these households, the education of their children, the political climate of their local community, and the long-term development of towns and cities.¹²⁹

Moreover, mortgage markets underpin a large part of the national economy, as was highlighted during the 2008 financial crisis and the recession that followed. Government subsidies, both explicitly in the tax code and implicitly through reinsurance by government-sponsored entities (GSEs), have greatly expanded the mortgage market and have made high homeownership rates possible.¹³⁰ The large volume of mortgage debt contracts and the large quantity of data collected about them makes them an ideal case study for determining the extent to which contractual inequality arises in standard form contracts.

Given the importance of mortgages to the welfare of American households, lawmakers have given a great deal of thought to the structure and oversight of mortgage debt contracts.¹³¹ A typical mortgage is signed by a lender and a borrower; the lender promises funds to cover the purchase of a house, and the borrower promises to repay those funds over time. If the borrower stops making payments, the lender has the right to recover the property by utilizing the foreclosure process set out in the contract. The contract terms include some individually negotiated terms, such as the amount of loan, interest rate, and type of payment structure. In large part, however, the rights and obligations of the parties are derived from standard form terms that are common across most mortgages.¹³² Moreover, contract formation is subject to state and federal regulation that further regularizes terms.¹³³

At first glance, it seems as if mortgages can proceed in one of two ways—either the borrower makes payments on time and pays off the loan, or else the lender forecloses on the property. However, a wide variety of alternatives exist for both borrowers and lenders, leading to many different potential outcomes arising from the same contract. The first choice is made by the borrower, who may decide to prepay, pay exactly the required amount, make partial payment, or fail to pay altogether. In response, the lender has many options that are not restricted by the formal contract terms.¹³⁴ The lender can decide whether to credit partial payments as satisfying the borrower’s obligation, sparing the borrower from being classified as delinquent. The lender also has the option to charge or waive late fees.¹³⁵ Moreover, the lender can choose whether to intervene at the first sign of underpayment or to abstain until a serious delinquency develops. Lenders who intervene early can ask why the underpayment happened and offer modifications or repayment plans to help the borrower become current again.¹³⁶ The wait-and-see approach, on the other hand, is cheaper and allows the borrower to self-cure by repaying unpaid amounts.¹³⁷

If the borrower becomes seriously delinquent, typically meaning 90–120 days without making a payment, the lender gains the right to foreclose on the property.¹³⁸ This does not mean that the lender must foreclose on the property; the lender can once again choose to offer a repayment plan or modify the contract to help the borrower become current.¹³⁹ The borrower can also choose to sell the property and avoid payment as long as the unpaid principal is covered by the proceeds of the sale. Finally, the lender can choose not to foreclose, temporarily waiving the borrower’s obligation to pay in order to retain title. This option, also described as forbearance, was mandated during the COVID-19 pandemic to ease financial burdens on homeowners during the economic downturn.¹⁴⁰ In normal economic conditions, a large fraction of mortgage lenders forbear from foreclosing on delinquent homeowners despite having no legal obligation to do so.¹⁴¹

To further complicate the set of possible outcomes from a mortgage contract, lenders often sell the ownership and servicing rights attached to a mortgage.¹⁴² Investors purchase the ownership rights, either at the individual contract level or through shared pools of mortgages.¹⁴³ The servicing rights for these mortgages are assigned to specialized servicers, who are given the right to make decisions such as offering modifications, foreclosing, or waiving obligations.¹⁴⁴ These agreements, part of the process of securitization, both split up the rights and obligations under the contract and pool the risks of multiple mortgages together to minimize the risk of default that any one party bears.¹⁴⁵ By spreading the risk in this way, securitization changes servicers’ incentives to modify, waive, or foreclose in any particular contract.

A. Measuring Mortgage Inequality

To quantify inequality, a dataset is required that follows a pool of contracts with terms that are facially equivalent but actually result in different, measurable values to each party. Very few sources of such data exist. One intuitive source would be contract disputes, which would include information about a contract signed by its parties as well as the resulting actions taken. This data has a well-documented analytical issue, since litigated cases are very rare and create a biased sample of contracts.¹⁴⁶ Other databases that cover contract terms exist, but they do not follow parties until performance is complete or breach occurs, meaning that the value of the contract to each party is unknown.

This Article uses a large commercial database to fill this gap—loan-level mortgage servicer data. Assembled by Black Knight, this database gathers information from mortgage servicers on the monthly payment status of each loan over more than twenty years.¹⁴⁷ It also collects details of the mortgage contract itself, including the structure of the terms, as well as the loan’s status as delinquent, default, foreclosure, or modified on any given date.¹⁴⁸ Taken together, the data covers 160 million mortgage loans nationwide and includes over a hundred contract attributes.¹⁴⁹ Because residential mortgage contracts vary on relatively few terms, such as size, interest rate, and payment structure, it is relatively easy to capture the variation in contract terms in quantitative form. The large size of the dataset makes it possible to find a set of comparable loans that share the same features. Little variation in formal terms and large sample sizes distinguish residential mortgage data from other data sources used in empirical contracts scholarship and provide an ideal setting to test hypotheses about standard form contracts.¹⁵⁰

The sample for analysis is limited to mortgage performance prior to 2009 to capture the market before the financial crisis of 2008 permanently altered the regulatory landscape. The resulting sample covers 36.7 million loans originated between 2000 and 2008.¹⁵¹ Moreover, the analysis focuses on loans that households fell behind on by at least four months, referred to as the mortgage being “in default.” Once the loan is in default, the lender or servicer has the power to decide to foreclose or to pursue an alternative course of action.

Out of the full sample of loans, 6.8%, or just less than 2.5 million loans, fell into default before 2009. Focusing on this defaulted sample, the first question is how many loans directly move into foreclosure relative to those that are modified or avoid foreclosure altogether. The second question is whether lenders and servicers exacerbate existing social inequalities by providing more benefits and acting more cooperatively in high-income areas.

1. Foreclosure and Its Alternatives

When a homeowner falls into financial distress and has to stop making mortgage payments, they are confronted with a very different reality than the carefully documented process used to originate the mortgage. At the time of formation, a completely rational and forward-looking borrower knows that they have a less than 10% chance of missing multiple payments, so they give little attention to what will happen if they default.¹⁵² Once default occurs, however, the homeowner quickly becomes acquainted with the legal rights and choices available to the lender (or investor and servicer).¹⁵³ Most importantly, after default occurs, lenders can give borrowers a notice of foreclosure and then proceed to either take title to the property or sell the property at a foreclosure auction, retaining any gains from this sale as payment to cover the outstanding debt.¹⁵⁴ Some states authorize the lender to sue the borrower to recover additional money owed if the sale does not cover the debt in full.¹⁵⁵ On the other hand, if the sale covers more than the amount owed, the lender must pay back additional gains to the borrower.¹⁵⁶

The inefficiency of this process is that foreclosed properties lose value quickly.¹⁵⁷ Foreclosed properties are likely to sit vacant and unmaintained for months or years.¹⁵⁸ Outdoor spaces deteriorate, unused plumbing and wiring degrade, and abandoned items and other detritus make the property unsightly and difficult to sell.¹⁵⁹ Vacant properties also attract squatters and criminals, potentially impacting the neighborhood as a whole.¹⁶⁰ Moreover, sales of foreclosed properties happen at times that are not optimal for the local market and without a dedicated seller trying to obtain the highest possible price for the property.¹⁶¹ As a result, foreclosed properties sell at 30% or more below the price a seller would have paid in better circumstances.¹⁶² A foreclosed house in a neighborhood also lowers neighboring properties’ values by 1%.¹⁶³ Taken together, the pecuniary costs alone of foreclosure are very large, with additional losses due to family displacement, physical and mental health, and community investment.¹⁶⁴

Alternatives to foreclosure, therefore, have been discussed often and in a variety of contexts. An important alternative is loan modification, which was elevated to federal policy in 2009 with the Home Affordable Modification Program.¹⁶⁵ Loan modifications offer lower payments for longer periods, restructuring debt to make it more likely that a homeowner can make payments while living in a home and maintaining its value. Though this process seems like a win-win for borrowers and lenders, it is not commonly used.¹⁶⁶ As shown in Figure 1, loans that were in default prior to 2009 were offered loan modifications in substantial quantities, but the majority (60%) of loans that were four months behind were not modified despite the potential benefits. However, the failure to modify obligations does not imply that foreclosure will immediately result.

An important alternative that came to prominence during the COVID-19 pandemic¹⁶⁷ is forbearance—the choice not to exercise the right to foreclose. Lenders and servicers have no legal obligation to complete the foreclosure process. Loan forbearance is related to the contract law concept of waiver, with some courts interpreting long forbearance periods as a waiver of the lender’s right to foreclose.¹⁶⁸ Without changing the contract terms, lenders who waive the requirement of on-time payments for several months may ultimately allow borrowers to live in a home for years without making a payment. Figure 1 shows that regardless of whether a loan is modified, 42% of defaulted loans never end in foreclosure.¹⁶⁹ Foreclosure, therefore, is not the inevitable result of borrowers failing to make payments.

2. Social Inequality in Contract Outcomes

Do differences in contract performance contribute to social inequality? Servicer data can shed light on this by measuring forbearance rates across households with different characteristics. One hypothesis is that the discretionary choice to foreclose occurs more often in low-income neighborhoods, while forbearance is more common in high-income neighborhoods.¹⁷⁰ Similar disparities are likely to exist across race, gender, level of education, and other important characteristics.¹⁷¹

Mortgage data matched with census data on income can directly test this hypothesis. Standard linear regression models can test whether there is a statistical relationship between the two variables, controlling for all other factors included in the model.¹⁷² Avoiding foreclosure is the dependent variable, and can be thought of as equivalent to forbearance, or temporary nonenforcement of the right to foreclose. Reported in the first row of Table 1 is the relationship between a neighborhood’s mean income and the probability of forbearance. Since other characteristics of the borrower and the loan are separately included in the regression, the variable labeled “Mean Income > 100k” reflects the neighborhood, not the individual. The number reported can be interpreted as the difference in forbearance probability for the same individual when they move from a lower-income to a higher-income neighborhood. The coefficients of other regressors, such as credit score, separately describe the likelihood of forbearance varying with credit score or other characteristics. Table 1 shows these results.

Forbearance is strongly correlated with income. The first row of column 1 shows that high-income neighborhoods have a .033 higher probability of avoiding foreclosure. To put this number in context, remember that the average individual in a lower-income zip code has a 42% chance of avoiding foreclosure. The regression coefficient tells us that if the same individual moved to a high-income neighborhood, they would avoid foreclosure 45.3% of the time. High-income neighborhoods are measured as those with an average income above $100,000 per year, which corresponds to the richest 20% of zip codes. Another way to state the magnitude of this effect is that neighborhoods with high incomes are 8% more likely to receive forbearance than lower-income neighborhoods.¹⁷³

The following rows of column 1 show the effect of formal contract terms on the propensity of defaulted loans to avoid foreclosures. A surprisingly robust pattern emerges—most formal terms have little to no impact on the foreclosure decision. Starred regressors, including credit score and loan amount, have very small magnitudes consistent with a zero effect on foreclosure avoidance. Interest rate and loan-to-value ratio also have no effect. Mortgages with different structures do have a varying propensity to avoid foreclosure: first mortgages have a higher foreclosure risk than second mortgages, whereas adjustable-rate mortgages are more likely to end in foreclosure than fixed rate mortgages.¹⁷⁴

To isolate the effect of discretionary forbearance, the regression is run again with two additional controls. The first regressor controls for the rate of property appreciation between the mortgage’s origination and the homeowner’s default, measured as an average across the property’s zip code. This ensures that only homes with similar liquidation values are being compared. Second, the regression controls for the fraction of loans whose servicing rights are transferred, leading to principal-agent problems between servicers and lenders. Controlling for these characteristics can be thought of as comparing financially equivalent mortgages in rich and poor communities.

Column 2 presents the results of this comparison. Forbearance patterns still differ by wealth, with rich neighborhoods avoiding foreclosure 2.8% more often than poor neighborhoods. Moreover, the regression shows that highly appreciated homes are more likely to receive forbearance, in contrast with the expectation that lenders may receive more from the sale of appreciated homes. Finally, servicing transfers make forbearance more likely, suggesting that foreclosure avoidance is driven in part by the assignment and sale of mortgage servicing rights.

Figure 2 visually represents the relationship between discretionary choices and neighborhood income. Comparing the 90th percentile of income to the 10th shows that a homeowner being in a 10th percentile neighborhood has 4% less of a chance of avoiding foreclosure than if the same homeowner lived in a 90th percentile neighborhood. Compared to the average avoidance rate of just above 40%, this is an increase of almost 10%. Moreover, the very richest neighborhoods, marked as the 99th percentile here, avoid foreclosure nearly 50% of the time. As in the literature on economic inequality generally, the most well-off receive disproportionately large benefits from contractual inequality, despite being governed by the same contract terms.

The cost of foreclosure is typically estimated to be about $80,000 per home.¹⁷⁵ Given the 2.5 million borrowers in default in 2009, we can calculate the excess losses to low-income neighborhoods driven by differential forbearance rates. Low-income neighborhoods could have benefited by a total of $5.14 billion if they had received the same forbearance rates as high-income neighborhoods.¹⁷⁶ This difference means that low-income neighborhoods faced $572 million in excess losses per year compared to high-income neighborhoods.¹⁷⁷ Different choices made by lenders and servicers during contract performance generate serious inequities across the same types of individuals in different neighborhoods.

B. Implications of Mortgage Inequality

The large disparities in outcomes of mortgages in default significantly impact communities. The empirical analysis establishes two important facts. First, similarly situated households often face very different outcomes when they stop making payments on their mortgages. Nearly 40% of households in default manage to avoid foreclosure, though their mortgage servicer has every right to repossess the collateral. Second, discretion is exercised differentially in rich and poor neighborhoods. More than $500 million in foreclosure losses incurred by low-income neighborhoods are avoided by richer neighborhoods due to the discretionary choices of servicers during contract performance. Mortgage providers are using their discretion regressively, whether intentionally or unintentionally.

Why are lenders and servicers treating borrowers in rich neighborhoods better than those in poor neighborhoods? One economically rational reason for this inequality would be that borrowers in rich neighborhoods are better credit risks. That is, these borrowers are more likely to pay off their loans, so naturally the mortgage provider is willing to be more accommodating. This explanation is unlikely to hold in this setting, however, due to the rich quality of data used in the analysis. Measures of borrower creditworthiness, including credit score and debt-to-income ratio, are included in the regression at the individual level. Conditional on these important indicators of ability to repay, average neighborhood income is not likely to be informative. Moreover, the regression controls for the appreciation of house prices in that zip code. Therefore, it is more likely that servicers are making the decision to extend forbearance based on qualities correlated with wealth but not directly determining creditworthiness. Examples of such characteristics include time and skill in negotiating, timeliness of responding to mail notifications, and other “soft skills” that correlate with social class.¹⁷⁸

Two features of these results should trouble lawmakers. First, regressive redistribution through contract performance is inherently troubling. Poor neighborhoods are already less able to bear losses from foreclosures, let alone disproportionately large losses relative to their richer counterparts. Moreover, poorer neighborhoods have many other characteristics that raise legal concerns—where mean incomes are lower than $100,000 a year, a larger fraction of the population is Black than in zip codes with higher mean incomes.¹⁷⁹ Disparate treatment of neighborhoods with different racial characteristics raise the possibility of actionable disparate impacts under federal laws such as the Fair Housing Act, the Equal Credit Opportunities Act, and the Constitution’s Equal Protection Clause.¹⁸⁰ These results may be an argument in favor of more aggressive redistribution away from wealthy neighborhoods toward poor neighborhoods, primarily through the tax code but also through public benefits and consumer law.¹⁸¹

The second cause for concern arising from these results is the possibility of economic inefficiency due to firms’ use of discretion. Lenders and servicers can unilaterally decide to delay or avoid enforcing their foreclosure right against borrowers in default. Borrowers are aware that lenders and servicers have power during contract performance, and they cannot be sure that discretion will be exercised in their favor. Therefore, borrowers will only enter into contracts with low enough up-front costs to account for potential losses from stringent contract enforcement.¹⁸² Borrowers without full understanding of financial products may therefore be enticed by good “deals” like interest-only and balloon loans, which decrease payments up front but cause financial catastrophe if anything goes wrong.¹⁸³ The result is welfare loss—contracts that would have been valuable to both parties will not be signed because there is no mechanism to guarantee a higher payout to borrowers. The total loss to low-income neighborhoods is likely greater than $572 million because the calculation does not account for welfare loss from incomplete contracts.¹⁸⁴ Moreover, this number does not account for decreases in access to credit for low-income borrowers.¹⁸⁵

Similar issues plague all the unilateral, discretionary choices both borrowers and lenders make through the course of the mortgage. Borrowers can privately choose to default or make insufficient payments.¹⁸⁶ Lenders and servicers can choose to modify contractual obligations rather than enforce their right to foreclosure.¹⁸⁷ Each of these mechanisms can cause both borrowers and lenders to either opt out of the mortgage market due to rational expectations about their counterparty’s behavior or to enter the market based on incorrect, overoptimistic expectations.¹⁸⁸ Parties have little scope to contract their way out of these issues due to the standardized nature of contract drafting and the deep commitment problems that always leave some discretionary choices available to the parties.¹⁸⁹ Taken together, it is likely that this analysis shows just one of many examples of contractual inequality in the setting of residential mortgages alone.

Similar phenomena are likely occurring in a variety of contracts, including rental and employment contracts. In each case, different norms and regulations may influence contract performance. For instance, mortgage servicers face different incentives in mortgage markets due to the existence of secondary markets, which pool mortgages and modify the economic relationship between lender and borrower. Landlords and employers may have better incentives. Nevertheless, every contract is incomplete in some way, and the embedded options that generate contractual inequality remain the same.¹⁹⁰ Landlords have incentives to differentially waive on-time rent payments depending on their private needs or preferences, while employers can utilize their discretion to fire or demote employees that they feel are not a good fit for their company. As long as these tools remain in the hands of one party, often the more sophisticated one, contract performance has the potential to generate and exacerbate social inequality.

IV. The Limitations of Existing Oversight

Undesirable inequality in contract performance, like the regressive redistribution documented in Part III, is largely driven by the choices of private actors. This Part explores the mechanisms available in law and in markets to limit contractual inequality.

A. The Legal Invisibility of Inequality

Existing tools in contract law that could minimize the negative impacts of inequality have not been utilized to that end. The common law doctrine naturally suited to overseeing contract performance is the duty of good faith.¹⁹¹ The duty of good faith is widely considered a mandatory requirement underlying all contractual obligations.¹⁹² However, the legal requirements on a party acting in good faith do not match the typical layperson’s understanding of the term “good faith.”¹⁹³ Instead, courts ask if the parties contemplated the action taken at the time of formation and if they would have bargained for the action taken had they contemplated the particular circumstances, even if the action appears uncooperative or stringent to the counterparty.¹⁹⁴ The duty of good faith requires fairness and honesty in exercising one’s discretion as reserved explicitly by the contract, but most jurisdictions do not require fairness in the exercise of contract rights such as waiver, modification, or breach.¹⁹⁵ Moreover, in evaluating whether an action taken during contract performance violated the duty of good faith, most jurisdictions do not consider alternative actions that were available to the party.¹⁹⁶ That is, an action that was reasonably fair and honest will satisfy the duty even if alternative actions would have increased the contract’s value.¹⁹⁷ This diverges from the traditional law-and-economics view of contract law, which posits that the purpose of contract law is to give incentives for value maximization.¹⁹⁸ Courts do not interpret the duty of good faith as requiring cooperative actions that raise the joint value of the contract for both parties.

Alternatively, courts could consider evidence of inequalities in performance during disputes over the contract’s interpretation. However, the Restatement and the common law have been hostile to the presentation of extrinsic evidence about performance in cases when there has been no defect in assent. The Second Restatement’s language on standardized agreements succinctly states that contract language is “interpreted wherever reasonable as treating alike all those similarly situated, without regard to their knowledge or understanding of the standard terms.”¹⁹⁹ If courts were faced with quantitative evidence that the same contract term generates highly disparate outcomes, it would no longer be reasonable to treat all parties to standardized contract terms as similar.²⁰⁰ But courts have been unwilling to admit evidence that unsophisticated parties are harmed by contract performance while sophisticated parties have benefited, allowing contractual inequality to flourish.

Finally, regulators have not stepped into the vacuum left by the courts in overseeing contractual inequality.²⁰¹ Consider the role of the CFPB as created by Dodd-Frank in 2010. Its mandate largely focused on rulemaking, with some provision for oversight for enforcement purposes.²⁰² The CFPB’s first public steps included limiting the type of consumer contracts that were considered enforceable, their terms, and how their formation should be structured.²⁰³ The CFPB acted unilaterally in promulgating its Qualified Mortgage standards, which caused a significant decrease in risky lending.²⁰⁴ The results of this regulatory action could be measured publicly using data from the Home Mortgage Disclosure Act.²⁰⁵ The main steps the CFPB took regarding contract performance, on the other hand, had to do with debt servicing. For instance, after the financial crisis of 2008, servicers were not responsive to customers and failed to credit payments properly, which ultimately led to thousands of preventable foreclosures.²⁰⁶ The CFPB did regulate servicer behavior by promulgating Regulations X and Z,²⁰⁷ and it entered into the national mortgage servicing settlement with a coalition of state attorneys general.²⁰⁸ The effects of these regulations cannot be assessed using public data. Instead, the CFPB is limited to overseeing debt servicing through their supervision and examination functions only when the political will exists.²⁰⁹ Ultimately, the CFPB’s power is tilted toward the oversight of contract formation and away from scrutiny of contract performance.

Statutes such as the Federal Arbitration Act similarly impact contract formation more than performance. As courts have protected arbitration more stringently under the Act, contract disputes are increasingly resolved by arbitrators.²¹⁰ Parties subject to a mandatory arbitration agreement have less guidance about the types of actions that would fall foul of an arbitrator, since most arbitration is private and does not rely on other arbitral awards as precedents. Therefore, once parties sign an agreement with a valid, binding arbitration clause, they are relatively free from judicial scrutiny during performance. Taken together, contract law and regulation intervene less often in the performance of contracts than in their formation, allowing private preferences and incentives to determine the choices made within the gaps of formal contract terms.²¹¹

B. Limitations of Market Competition

Scholars in consumer and commercial contracts have noted that even in the absence of legal oversight, private market forces will limit the harms of unequal treatment.²¹² One example the literature considers is hotel checkout policies.²¹³ Hotels may require on-time checkouts for badly behaved, opportunistic guests but not for well-behaved customers who genuinely need extra time.²¹⁴ This generates inequality across guests, but it comes with an important benefit: hotels have the option to enforce a strict checkout policy and minimize costs to themselves. Moreover, the hotel will not use this power in most cases because it would harm the hotel’s reputation to kick out guests who might review the business on internet forums or recommend that their friends stay elsewhere. In this way, inequality is not eliminated but instead efficiently disciplined by the private market.²¹⁵

This story is incomplete, however.²¹⁶ Most contracts do not occur in the type of competitive market that can encourage cooperative behavior.²¹⁷ First, competition fails in the face of transaction costs that deprive individuals of meaningful alternatives outside the contract. For instance, search and switching costs may make it difficult to shop across contracting parties in high-stakes markets, including the mortgage market. Disaggregated contract rights may make it costly or impossible to match reputation to a particular firm. Second, even when a competitive market with few transaction costs exists, it is unlikely to protect social groups that are already suffering ill effects from social inequality. Low-income parties from minority communities with little bargaining power cannot exert the same competitive pressures as more powerful parties. Therefore, contract terms that may serve powerful social groups may not help vulnerable groups and may even harm them.²¹⁸ Contractual inequality increases when there is an imbalance in bargaining power across parties to different contracts, each with the same terms.²¹⁹

1. Transaction Costs

Every contract is formed in the context of some market. Parties wishing to enter into a contractual relationship can choose across potential counterparties based on the price and characteristics of the transaction. For instance, borrowers can choose among mortgage providers and lenders can select borrowers that satisfy their pre-approval requirements.²²⁰ If market participants base their decisions on their counterparties’ reputations, counterparties will want to treat market participants well to stay competitive.²²¹

Transaction costs, however, can dissociate choices from reputations. First, consider search or switching costs. When looking for a mortgage lender, for example, a borrower may know the name of their bank and a couple other highly advertised lenders from TV.²²² To discover the names and prices of more obscure local lenders, the borrower may have to spend time and money to search through the phone book or Google, or to ask her friends. Switching costs make it difficult to move from one contract to another, either by causing psychological distress or consuming resources.²²³ These costs may include the damages paid to the original counterparty, as well as the types of mental and logistical costs that prevent consumers from shopping for mortgages to get the highest returns on their investments.²²⁴ In all of these cases, one party would feel that the other party is their best hope at obtaining a service or minimizing their costs. Consequently, the party cannot utilize market mechanisms to hold the counterparty accountable for exploitative behavior. Consider a credit agreement including a unilateral modification clause. If the credit card company modifies the agreement to include a mandatory arbitration clause, the customer may wish to threaten to switch to another card company if her rights are not restored.²²⁵ But if the customer has to endure a drop in her credit score to switch to another company, she may well choose not to switch, leaving the credit card company free to make any changes it wishes.

Second, consider the coordination costs created by a highly diffuse ownership structure to a contract. An important example of this arose during the financial crisis of 2008, after mortgages had been securitized and sold on a secondary market.²²⁶ Investors, whose returns depended on good performance, were not in control of the debt collection process. Instead, it was outsourced to servicers through contractual agreements that gave them very different incentives than those of the investors.²²⁷ Outcomes for mortgagees varied depending on whether decisionmaking rights were assigned to a separate servicer during the securitization process or retained by the original contracting party.²²⁸ Borrowers often did not know who their servicer was, nor were they able to choose which servicer would process their payments once their mortgage was securitized.²²⁹ The result was a very high foreclosure rate that undermined the financial health of the entire nation.²³⁰ By making it prohibitively costly to connect a counterparty with their earned reputation, coordination costs prevent firms from competing on reputation, leaving their performance of contracts entirely free from market oversight.

2. Heterogeneity and Unequal Bargaining Power

The problem of unequal bargaining power has been a longstanding concern in contract law. It is the underpinning of the doctrine of unconscionability,²³¹ and scholars concerned with one-sided contract terms, like those in standard form consumer contracts, have debated this issue. Typically, this literature discusses inequalities between counterparties to the same contract, such as a standard form consumer contract that benefits a large firm with significant bargaining power more than the small individual consumer without bargaining power.²³² Another important dimension of this issue arises from unequal bargaining power across similarly situated parties to different, comparable contracts.

Parties to the same exact contract terms may differ widely in their circumstances. For example, terms that allow a secured lender to repossess a borrower’s property upon nonpayment are often identical across loans of the same type.²³³ Whether the property is promptly repossessed, however, depends on the bargaining power of the individual borrower at the time of nonpayment. Some borrowers may be well informed and even litigious.²³⁴ They can harm the lender’s reputation and drive business away from them; in other words, they may be able to threaten the lender into leniency.²³⁵ Borrowers with small social networks or less information may have no alternative to relying on the lender’s mercy.

Firms can take advantage of these differences to maximize their reputation while still harming less powerful consumers. In the example above, borrowers who complain the most will be treated cooperatively and given leniency in repossession, while those with the least power and influence will be treated poorly. Reputation provides no recourse for unequal treatment if consumers have unequal influence over a firm’s reputation. Indeed, letting market incentives discipline firm behavior gives incentives for firms to treat their customers more unequally during contract performance.²³⁶

V. Strengthening Disclosure to Discipline Inequality

Lawmakers have the power to limit inequality in contract performance in a variety of ways. However, they must act carefully to avoid perverse consequences that ultimately hurt underprivileged populations. A cautionary tale arose in criminal law when attempts were made to discipline racial disparities in sentencing. Mandatory sentencing laws were promulgated in the 1980s and 1990s in part to limit disparate impacts of judicial discretion on communities of color.²³⁷ Despite this intention, limiting judges’ discretion did not eliminate disparities—prosecutors continued to treat disadvantaged defendants differently.²³⁸

A similarly naive solution in the context of residential mortgage servicing would be to limit discretion in lender and servicer behavior in a sweeping, standardized way. In March 2020, the federal government passed the CARES Act, which provides relief to debtors having trouble making payments on their mortgages and student loans. Mortgage borrowers may request forbearance to delay making payments on their home, and student loan borrowers may delay payments until at least January 2022.²³⁹ Renters may not be evicted for nonpayment while the pandemic continues.²⁴⁰ The debt forbearance offered during the pandemic is a rare and extreme example of lawmakers intervening in contract performance. All borrowers who meet regulatory guidelines may request the same discretionary benefits that were previously provided disproportionately to those in rich neighborhoods, limiting performance inequality.

A short-term ban on the use of legal tools that generate inequality does not address the long-term harms of unequal outcomes. In the case of the CARES Act, mortgage inequality will likely begin to grow immediately after the forbearance period passes. The results may be as negative as those of mandatory minimum sentences—poor communities that have trouble avoiding foreclosure will be more likely to see widespread foreclosures after the pandemic protections end, while rich communities will be more likely to receive extended forbearance. Ultimately, the legacy of pandemic mortgage policy may be a worsened wealth gap between already disparate neighborhoods, hammered into place by poor households’ distrust of mortgage lenders that could lead to exit from homeownership altogether.

Instead of directly limiting discretion in performance, this Article proposes a disclosure-based approach that will allow for intervention tailored to particular contexts. Lawmakers must require contracting parties to disclose data on contract performance and outcomes, specifically including the legal levers discussed above: discretionary actions, modification, waiver, enforcement, and renegotiation.²⁴¹ The data should be released to regulators, and it should be available to the public, private enforcement authorities, and information aggregators. Interested parties should be able to get a complete picture of how contracts are being performed and the effects of performance on social inequality. More importantly, disclosure can help informed actors distinguish between disparities that fall afoul of antidiscrimination law, those that are not illegal but could cause reputational harms, and those that are irrelevant or even beneficial to social welfare.

How exactly would the process work? It would start with data on contract terms, including the form contracts that GSEs drafted for mortgages,²⁴² deposit account agreements that banks disseminate publicly,²⁴³ material contracts filed with the Securities and Exchange Commission (SEC),²⁴⁴ and contract characteristics collected in public databases like those mandated by the Home Mortgage Disclosure Act (HMDA).²⁴⁵

These terms are of great interest, but they are likely to be selectively enforced and otherwise modified once performance begins. Therefore, existing disclosure requirements should be extended to include consumer outcomes as well as original contract terms. In the context of mortgage servicing, this would mean requiring lenders and servicers to disclose the income, race, gender, and other demographic information of those borrowers able to continue making payments and those facing foreclosure. Moreover, it would include offers for loan modifications, imposition and waiver of late fees, foreclosure filings, and other records lenders and servicers keep of their interactions with customers. Combined with data already compiled under HMDA about the characteristics of the mortgage application and the loan, this would give regulators a comprehensive picture of the mortgagor-mortgagee relationship.

Data collection can be mandated without a significant extension of regulatory power. Many regulators are already authorized to compile data on contract performance. The CFPB, federal banking regulators, and the SEC, as well as state insurance regulators and other state and local authorities, can promulgate rules and bring enforcement actions when contracts have not satisfied regulatory requirements.²⁴⁶ These agencies engage in significant data collection. Returning to the mortgage example, the CFPB took over the collection and dissemination of HMDA data in 2011.²⁴⁷ Current guidelines require mortgage originators to release home mortgage application and origination information, but loan delinquency, default, and foreclosure data are not released to the public.²⁴⁸ This oversight means that regulators have more limited access to data on contract performance and that the public cannot hold regulators and contracting parties accountable for generating disparate impacts.

Implementing this more expansive disclosure regime has several key benefits. First, regulatory bodies like the CFPB would have incentives to replicate and extend the analysis performed in this Article to study inequality by race, age, disability, and other characteristics, covering a wider range of important contracts. The CFPB could not only quantify the losses to disadvantaged communities but could also pass that information to the Treasury Department or the Office of Management and Budget to consider when evaluating tax changes and other redistributive social policy. Moreover, the CFPB has the authority to audit servicers to understand why they treat borrowers unequally.²⁴⁹

Second, regulatory data on contract performance could streamline in-court disputes that require comparative data. Primarily, disclosing data on contract performance could expand the ability for regulators and private parties to detect impermissible discrimination and disparate impacts that could be actionable under antidiscrimination provisions.²⁵⁰ For instance, if disparities similar to those shown in this Article existed across racial groups, there may be basis for a discrimination lawsuit. Creative lawyering could generate other bases for suits alleging disparate treatment by contract parties. For instance, test cases could be filed claiming that highly disparate treatment of consumers by firms violates state and federal unfair and deceptive acts and practices statutes. If these are successful, they could remedy any inefficiency in contract performance by requiring firms to treat their customers equally or find a compelling justification not to.²⁵¹

Third, and perhaps most importantly, disclosure of contract outcomes by government officials can augment existing private market forces that discipline inequality and inefficiency in contracts. Disclosing data about contractual inequality to private regulatory organizations or well-positioned third parties can strengthen parties’ private incentives to act efficiently. Search engines and aggregators like Yelp already generate reputational incentives for cooperative behavior.²⁵² Regulators concerned about inequality can encourage aggregators to inform potential customers about unequal firms’ performance quality and unequal treatment of disadvantaged populations. Consumers can then “vote with their dollars” for the companies who match their values. Alternatively, insurance companies²⁵³ or private regulatory bodies²⁵⁴ could each intervene to limit inequality. This approach also sidesteps common criticisms of disclosure policy, as it is aimed at sophisticated parties.²⁵⁵

Contractual inequality is just one of many sources of inequality in modern society, but lawmakers have a duty to understand it because it is enabled by the coercive power of the courts. Moreover, although its impact may be dwarfed by other forms of inequality, the significant losses created by unequal contract performance may be remedied with fewer political repercussions. Disclosures of contract-performance data create transparency and accountability and can encourage disadvantaged consumers to enter into banking, mortgage, insurance, and other key contracts, knowing that their experience will be monitored and observed by regulators and the public. Observing and remedying contractual inequality can provide benefits well beyond redistribution.

Conclusion

Contracts empower parties to create high-value relationships and facilitate key transactions. However, not every party is treated equally during contract performance. The same contract terms that can enable the American Dream or generate profits for one individual can be used to cause loss and harm to others, depending on how the terms are enforced.

This Article develops a theory of contractual inequality that shows how legally protected discretion in contract performance causes inequality in contract outcomes. The rights and obligations specified in formal contracts can be adjusted throughout performance, using tools like waiver, modification, and the exercise of discretion, as well as the option to breach or renegotiate the contract. As a result, parties can use their discretion to engage in regressive redistribution or ultimately cause economic inefficiency by being unable to commit to treating their counterparties cooperatively.

Using empirical data from a large sample of residential mortgages, this Article provides novel quantitative evidence that contract performance generates inequality on a large scale through the selective use of foreclosure on financially distressed homeowners. More than a third of mortgages in default avoid foreclosure, thereby avoiding some of the ill health, community displacement, and lost wealth that foreclosure brings. Homeowners in rich neighborhoods are nearly 10% more likely to avoid foreclosure than homeowners in poor neighborhoods despite facing exactly the same formal contract terms. Given the high cost of foreclosure, this means the richest neighborhoods are gaining $513 million more than poorer neighborhoods each year from the unchecked decisions of lenders and servicers.

Despite the potentially catastrophic effect on underprivileged parties, contract law has chosen not to discipline inequality, with years of jurisprudence defanging doctrines that could have played a role in minimizing the negative effects of inequality. Instead, private markets have been delegated the important role of overseeing contractual inequality. This Article argues that economic incentives are insufficient to deter the growth of harmful contractual inequality. Law has an important role to play in uncovering and remedying both the distributive and efficiency harms of inequality.

The Article proposes a disclosure regime to shed light on inequality and address it in a sustained way. Regulators can obtain data about inequality in contract performance. By disclosing this data to courts and private actors, they can incentivize parties to treat their counterparties equally and cooperatively. By scrutinizing inequalities in the performance of contractual obligations, lawmakers can foster trust and cooperation and help create both a more equal and more efficient society.

* Assistant Professor of Law, University of California, Berkeley, School of Law. Email: mpadi@berkeley.edu. This work was supported in part by the National Science Foundation, under the Social, Behavioral and Economic Sciences Award Number 1715010. Many thanks to the members of the Berkeley Junior Working Group, the UC Irvine School of Law Workshop, participants in the Consumer Law Scholars’ Conference, and the Stanford Law and Economics Seminar as well as to Kenneth Ayotte, Adam Badawi, Bobby Bartlett, Samuel Becher, Omri Ben-Shahar, Erwin Chemerinsky, Jonah Gelbach, Mark Gergen, David Hoffman, Sonia Katyal, Prasad Krishnamurthy, Adam Levitin, Daniel Markovits, Patricia McCoy, Frank Partnoy, Daniel Schwarcz, Rory Van Loo, Lauren Willis, and Tess Wilkinson-Ryan for helpful comments. Special thanks to Liam Azartash, Emma Hagemann, MJ Han, and Carter Jansen for excellent research assistance.