Articles – Page 11 – Law Offices of Randolf Krbechek

Judgment in Unlawful Detainer Validates Foreclosure Sale

The overlap between real property law and trust law reaches back centuries, as early trust law was concerned with the conveyancing of real property. Similarly, Prof. Maitland in his famous (and tremendously readable) “The Forms of Action at Common Law” (1909) teaches that eviction law, known as “unlawful detainer,” also reaches back hundreds of years.

Here is an important rule, arising from the wave of foreclosures which we are now witnessing – a judgment in a simple unlawful detainer lawsuit has the effect of validating, and thereby eliminating any objections to, a prior foreclosure by a lender.

To start, an unlawful detainer action is concerned with the narrow question of the right to “possession” of real property. The law holds that almost all other issues cannot be raised in the summary proceeding known as unlawful detainer.

Yet, a federal case from last fall reminds us that the property owner has the right to contest the validity of a foreclosure sale in defense to an action for unlawful detainer. In Nyugen v. LaSalle Bank, C.D. Cal. Case No. 09-0881 (Order entered October 13, 2009), the court held as follows:

“Defendant LaSalle brought suit against Plaintiffs in Orange County Superior Court for unlawful detainer following the foreclosure sale. There, Nguyen (Plaintiff herein) urged that LaSalle’s foreclosure was improper and alleged multiple affirmative defenses. The state court entered judgment in favor of LaSalle, finding that LaSalle’s evidence established all elements of its claim”

“Plaintiffs urge that by alleging fraud, undue influence, and breach of covenant of good faith and fair dealing, that res judicata does not bar their claims. However, as discussed below, Plaintiffs’ allegations not only fail herein, but were also rejected in the unlawful detainer proceeding.”

Held the court, “Although most issues unrelated to possession can be raised in a subsequent action between the parties, the issue of the irregularity of the foreclosure or execution sale is barred by a judgment in an unlawful detainer action.”

That is a powerful statement of law. And correct, also. The federal court cited to Freeze v. Salot (1954) 122 Cal.App.2d 561, which held as follows:

“The municipal court had jurisdiction of the action between Aguilar and plaintiff. We must conclude from the allegations with respect to the averment of the complaint in the municipal court action that it was a proceeding in unlawful detainer.”

OK, so we know the court is reviewing the judgment in an unlawful detainer action. Note that the judgment was entered by default, which means that the defendant did not appear in the action, and did not contest the claim of unlawful detainer.

The court continued. “The facts [pled in the new lawsuit alleged] that plaintiff was not in default under the deed of trust, that the note had been fully paid on November 6, 1948, and that she had no notice that the property was to be sold, were available to her as a defense in that proceeding. The question is whether the judgment of the municipal court [in the eviction lawsuit] is res judicata in this action.”

Reviewing the decision in Seidell v. Anglo-California Trust Co., 55 Cal.App.2d 913, the court ruled in favor of the lender. Stated the court, Seidell “was a suit to set aside a trustee’s deed to realty for alleged fraud and irregularities in the foreclosure proceeding. The question on appeal was whether a judgment which was rendered in a former proceeding in unlawful detainer was res judicata. The purchaser at the trustee’s sale had conveyed the property prior to the proceeding in unlawful detainer.

“The judgment in the unlawful detainer suit bars the appellants from now contending the trustees’ deed to the real property was void on account of the alleged irregularities of procedure in the foreclosure of the deed of trust.”

“In this case the challenged unlawful detainer judgment determined issues tendered by these appellants in their answer which constituted legal defenses of alleged specific violations of the statute in failing to give the notice of sale required by section 2924 of the Civil Code, lack of consideration for the note secured by the trust deed, and other asserted defects going to the validity of the trust deed and note secured thereby, and to the proceedings on the sale of that property under the provisions of the deed.”

“All of those issues of law, as distinguished from equity, affecting the legality of the note, deed of trust and the sale were properly determined against the defendants in that unlawful detention suit.”

To drive the nail home, the court held that “Plaintiff’s failure to appear in the municipal court action was a confession that all the material facts alleged in the complaint in that action were true. A judgment by default is a complete adjudication of all the right of the parties embraced in the prayer of the complaint and stands on the same footing as a judgment after answer and trial with respect to issues tendered by the complaint.”

A powerful lesson, 50 years on. A homeowner must contest the validity of a foreclosure in a subsequent action for unlawful detainer whereby the lender seeks a judgment for possession of the real property. Failure to do so waives all defenses, both state and federal, relating to irregularities regarding the foreclosure.

Deed to Estate Planning Trust – Struggling for the Right Result

A recent decision involving a deed to an estate planning trust achieved the correct result, but with unnecessary effort.

The facts in Luna v. Brownell (June 15, 2010) 2010 DJDAR 8811 were simple.

“On August 13, 2006, Al executed a quitclaim deed transferring his interest in the Property as an individual to himself as trustee of the Trust.”

“On August 29, 2006, Al executed the declaration of trust for the Trust. The declaration of trust stated that Al was the trustee.”

“On September 8, 2006, the grant deeds transferring plaintiffs’ interest in the Property to Al as trustee of the Trust were recorded.”

“Al died on September 19, 2006.”

The hitch in the analysis arises because the court implicitly considered Al’s revocable estate planning trust to be different from Al. It is not: the trust is not different from a Will, at least during Al’s lifetime.

The court presented its discussion as follows. “A deed does not transfer title to the grantee until it has been legally delivered. Delivery is a question of intent. A valid delivery of a deed depends upon whether the grantor intended that it should be presently operative.”

The court starts pushing in the wrong direction from the beginning. This is should be treated as a wills question, not as a conveyancing question.

“In addition, acceptance by the grantee is necessary to make a delivery effective and the deed operative. Whether the deed was accepted by the grantee so as to complete a transfer of title to him is likewise a question of fact for the trial court.”

The court continued. “On August 8, 2006, after understanding that Al wanted his property in his own name for purposes of creating a trust, the plaintiffs did not dispute his ownership . . . The [real] question before this court therefore is whether the quitclaim deed executed by Al on August 13, 2006, transferring the Property from Al as an individual to Al as trustee of the Trust was void because the Trust did not exist on the date the deed was executed.”

Following decisions from other jurisdictions, the court held the conveyance was effective. For example, in John Davis & Co. v. Cedar Glen # Four, Inc. (Wash. 1969) 450 P.2d 166, the court considered the validity of a quitclaim deed transferring real property to a corporation. Held the court, “A deed to a corporation made prior to its organization, is valid between the parties. Title passes when the corporation is legally incorporated. This is particularly true as against one who does not hold superior title when the corporation goes into possession under the deed.”

Similarly, in Heartland v. McIntosh Racing Stable (W.Va. 2006) 632 S.E.2d 296 the court held that “A deed drawn and executed in anticipation of the creation of the grantee as a corporation, limited liability company, or other legal entity entitled to hold real property is not invalidated because the grantee entity had not been established as required by law at the time of such execution, if the entity is in fact created thereafter in compliance with the requirements of law and the executed deed is properly delivered to the entity, the grantee, after its creation.”

Both are solid analyses under corporate law. What the recent California court should have looked at in Al’s case was the following:

(1) Did Al want his property to be handled in a probate?

A. He did not. He wanted to provide for a non-probate transfer via an estate planning trust.

(2) Did Al intend for his trust to control the disposition of his real property?

A. Yes.

Unfortunately, current trust law invites confusion by (sometimes) treating a revocable estate planning trust as a separate entity. Having considered authorities from other states, the California court held as follows:

“A quitclaim deed transferring property to the trustee of a trust is not void as between the grantor and grantee merely because the trust had not been created at the time the deed was executed, if (1) the deed was executed in anticipation of the creation of the trust and (2) the trust is in fact created thereafter. Such a deed is valid between the grantor and grantee on the date the trust was formed.”

That’s a nice, concrete statement of law, and obviously the result intended by the decedent. But the conveyancing gloss detracts from a focus on the decedent’s intention.

Luna v. Brownell (June 15, 2010) 2010 DJDAR 8811

No Claim in California for Intentional Interference with an Inheritance Expectancy

A recent case affirms that California does not recognize a claim based on “intentional interference with an inheritance expectancy.” However, the court’s analysis leaves the door open to future litigation arising from different fact patterns.

The lawsuit in Munn v. Briggs, 2010 DJDAR 8680 (4th Dist. June 11, 2010) was based on the following claim. “James alleged Carlyn and Michael intentionally interfered with his inheritance expectancy. Before the codicil, James had an expectancy to share equally with his sister Carlyn in the balance of the survivor’s trust, each having a one-half interest.” As a result of the codicil, James took less than he expected from his parent’s estate.

James sued his sister claiming that we was deprived of his inheritance due to Carlyn’s tortious conduct. “The probate court sustained the demurrer without leave to amend. In so doing, the court ruled no California case has ever expressly held that the cause of action of intentional interference with an inheritance expectancy is recognized in California.”

On appeal, the court held that “Under American law, testators have a right to completely disinherit nearly anyone, and there is no right to inherit. Of course, tortious conduct relating to wills, such as the use of undue influence, threats, or coercion to procure a particular disposition, or destruction of a will, has long been understood as a legal wrong, but only against the testator whose right of free testation is infringed upon, not the beneficiary.”

“A purported injury to an intended recipient is not cognizable (because there is no right to inherit); instead, the probate system through the will contest proceeding aims to offer all interested parties a forum in which to litigate the testator’s true intentions.”

The court recognized that “Section 774B of the Restatement (2d) Torts provides: ‘One who by fraud, duress or other tortious means intentionally prevents another from receiving from a third person an inheritance or gift that he would otherwise have received is subject to liability to the other for loss of the inheritance or gift’.”

Let’s pause there. The predicate act must be “fraud, duress or other tortious means.” Such wrongful conduct is independently actionable. We do not need to create a new tort to cover acts that are already unlawful.

The Restatement further notes liability under section 774B is “limited to cases in which the actor has interfered with the inheritance or gift by means that are independently tortious in character,” including when a third person has been induced to make or not make a “bequest or gift by fraud, duress, defamation or tortious abuse of fiduciary duty,” or when a will or document making a gift has been “forged, altered or suppressed.”

Now we are sliding into the same morass as “tortious interference with a contract,” which also requires such “independent wrongful conduct.” Tortious inference with a contract is a murky, unclear area of the law, and should not be expanded.

Even more, we can ask, Why isn’t slander an adequate remedy? If a person was deprived of a gift because someone lied about them, then slander would be the appropriate remedy.

The court of appeal added that “our independent research also confirms that when a party has an adequate remedy in probate, the party generally will be precluded from recovering in tort for interference with an expectancy.”

For example, “if the claimed wrongdoing relates to the execution or revocation of a will, and the claimant has standing in the probate proceeding, the court should not entertain an independent action even if the jurisdiction recognizes the tort of interference with an inheritance.”

The court of appeal noted that inheritance laws are “purely a creature of statute” (see In re Darling (1916) 173 Cal. 221, 223), and cited a New Mexico case with approval. The court in New Mexico stated:

“We feel compelled to protect the jurisdictional space carved out by our legislature when it enacted the Probate Code and created remedies, such as a will contest, designed exclusively for probate. We note that a will contest in probate requires a greater burden of persuasion than an independent action in tort. A presumption of due execution normally attaches to a testamentary instrument administered in probate, but not necessarily in tort.”

“If we were to permit, much less encourage, dual litigation tracks for disgruntled heirs, we would risk destabilizing the law of probate and creating uncertainty and inconsistency in its place. We would risk undermining the legislative intent inherent in creating the Probate Code as the preferable, if not exclusive, remedy for disputes over testamentary documents.” Wilson v. Fritschy (N.M. App. 2002) 55 P.3d 997.

For now, California does not recognize the tort of “interference with an expectancy.” To this author, there is no need for such a tort. However, we would need to consider the proper factual situation, which would involve a lifetime transfer accompanied by “independent wrongful acts,” which would merit further scrutiny.

Munn v. Briggs, 2010 DJDAR 8680 (4th Dist. June 11, 2010)

Florida Court of Appeal Permits Assets to be Hidden in Trust

A recent decision from the Florida court of appeals exalts form over substance to a achieve an unjust decision. Here is the case in a nutshell. Mom set up an irrevocable trust for benefit of one of sons. The trust contained a spendthrift provision, meaning that creditors could not reach trust assets before distribution to the beneficiary.

A large judgment was entered against the beneficiary son. After mom’s death, the second son served as named trustee, with complete discretion as to when to make distributions to the debtor brother. In fact, the trustee son allowed all trust decisions to be made by the debtor brother.

The creditor argued that the debtor’s interest should be available to satisfy the judgment, because the debtor brother effectively exercised control over the trust property. Notwithstanding these facts, the court held that the creditor was not able to reach the debtor brother’s interest because of the spendthrift provision.

This is a terrible decision on policy grounds, as the court expressly permitted the two brothers to manipulate a legal entity to commit fraud on the creditor. Here are the facts in more detail.

“In April 2004, Elizabeth Miller established the James F. Miller Irrevocable Trust (the James Trust) for the benefit of her son, James. She named her other son, Jerry, sole trustee. The James Trust is a discretionary trust under which Jerry has absolute discretion to make distributions for James and James’s qualified spouse.”

“The James Trust contains a spendthrift provision and gives Jerry, as trustee, the complete discretion to terminate the trust by distributing the entire principal to the beneficiary for any reason.”

After forming the trust, Elizabeth transferred property to the trust. The principal asset of the trust was “a residence located in Islamorada, Florida” with a value greater than $1 million.

In 2007, Kresser obtained a judgment against James for $1,019,095. Elizabeth died on September 10, 2007. “When Kresser was unable to collect on his judgment from James he brought proceedings supplementary against them and impleaded Jerry, as trustee of the James Trust. Kresser asserted that he was entitled to execute on the James Trust’s assets . . . because James exercised dominion and control over all of the trust assets and over Jerry, as trustee.”

The trial court found in favor of the creditor. The trial court “set forth a detailed account of James’s significant control over the James Trust and over Jerry, as trustee. The trial court found that Jerry had almost completely turned over management of the trust’s day-to-day operations to James. James controlled all important decisions concerning the trust assets, including investment decisions. ”

“Jerry never independently investigated these decisions to determine whether they were in the best interest of the trust, and some of the decisions have turned out to be unwise. The trial court concluded that Jerry simply rubber-stamped James’s decisions and ‘served as the legal veneer to disguise James’s exclusive dominion and control of the Trust assets.’”

It’s remarkable that a court of appeal would have interest in reviewing this decision. Even more remarkable, the trial court was reversed on appeal. In ruling against the creditor, the court of appeal held that “the James Trust does not give James any express control over distributions of the assets. Jerry, as trustee, has sole discretion to distribute income or principal to James, or to terminate the trust.”

Said the court of appeal, “while we agree that the facts in this case are perhaps the most egregious example of a trustee abdicating his responsibilities to manage and distribute trust property, the law requires that the focus must be on the terms of the trust and not the actions of the trustee or beneficiary. In this case, the trust terms granted Jerry, not James, the sole and exclusive authority to make distributions to James. The trust did not give James any authority whatsoever to manage or distribute trust property.”

That’s the court of appeal saying form matters more than substance, and adding that, “We’ll ignore what’s really going on if you right it down properly.”

Stated the court, “In this case, James may ask Jerry for as many distributions as he because Jerry has sole discretion to make distributions, he may also choose to deny James’s requests at any time, and James would have no recourse against him unless he were abusing his discretion as trustee.”

“Until Jerry makes a distribution to James, Kresser and other creditors may not satisfy James’s debts through trust assets. Accordingly, the trial court erred in invalidating the James Trust’s spendthrift provision and allowing Kresser to reach trust assets before they have been distributed to James.”

To rub salt in the wound, the court of appeal stated that “to conclude otherwise would ignore the realities of the relationship between a beneficiary and trustee of a discretionary trust – the beneficiary always pining for distributions which he feels are rightfully his, and the trustee striving to allow only those distributions that coincide with the settlor’s express intent, as set forth in the trust documents . . . In the case before us, it is not the role of the courts to evaluate how well the trustee is performing his duties. We are instead limited, by statute, to evaluating the express language of the trust to determine the extent of the beneficiary’s control and the extent to which a creditor may reach trust assets.”

That is not correct. It is the court’s duty to “evaluate how well the trustee is performing his duties” when the trustee has effectively turned over control of the assets to the judgment debtor. The Florida court of appeal failed badly in reversing the trial court.

Miller v. Kresser, — So.3d —, 2010 WL1779899 (Fla. 4th DCA May 5, 2010)

Lenders Behaving Badly

Professor Brent T. White from The University of Arizona Law School has followed up his report issued last fall regarding troubled loans. Prof. White personally communicated with more than 350 individuals regarding their mortgage problems.

His new report raises a number of troubling issues, but none more so than the dissembling tactics of lenders.

Writes Prof. White, “The reason that many strategic defaulters struggle so long before deciding to default is that fear and anxiety are not typically enough in isolation to cause them to stop making payments. Rather such anxiety more frequently serves as a call to action, driving homeowners to try to do something about their situation – such as contacting their lender to try to work out a loan modification or a short sale.

“In fact, not a single strategic defaulter in the 356 accounts reviewed for this article reported having stopped paying their mortgages without first contacting their lender . . . Many underwater homeowners who seek help from their lenders, however, are turned away at the door. As one homeowner explains, ‘I called my lender and ask if I could discuss a loan modification and they said absolutely not.’ Lenders give numerous reasons for this, most commonly that homeowners are current on their mortgages.”

If you are current on your loan, regardless of the financial struggles to maintain the loan, you will never get your loan modified. “The fact being a ‘responsible’ borrower is the surest way not to get a loan modification can be a rude awakening for many homeowners.”

Prof White continues. “This is because most lenders don’t modify mortgages or agree to short sales for homeowners who might continue making their payments absent such accommodation. The best predictor that a homeowner will continue making payments is a good credit score and a past history of making their payments. Homeowners with such characteristics thus have little chance of getting help unless they first miss some payments, and they are frequently told this by the loan servicing personnel who take their calls.”

Worse yet, “The loan modification process turns out, however, to be immensely frustrating[.] Homeowners are frequently unable to reach anyone to discuss their applications’ status[.] Their paperwork is ‘lost’ repeatedly[.] They are treated rudely and lied to[.] Worse, after months of frustration, most homeowners learn that their lender is not willing to work with them after all.”

Prof. White is not exaggerating. I have yet to meet a borrower with anything positive to say about the loan modification process. As a society, we are not serious about helping borrowers with troubled home loans.

Brent T. White, Take this House and Shove it: The Emotional Drivers of Strategic Default (May 2010)

The Mortgage Crisis Continues

This is an updated report on the status the foreclosure crisis in Fresno County as of June 2010, based on anecdotal evidence. In a word, it’s brutal for troubled borrowers.

Foreclosures Are Continuing: There does not seem to be any slowdown in foreclosures. Lenders buy in for the amount of the unpaid debt, then sell at a slight markup. The buyer then markets the property for a greater profit.

Example: A house might sell at foreclosure to the lender for $120,000. The lender resells the property for $150,000. The buyer in turn markets and sell the house for $200,000. All of this takes place within six months. The original owner takes nothing on the mark up.

Cash is King: Lenders have little risk on foreclosure sales because houses re-sell quickly on all-cash offers. Evictions follow rapidly after the foreclosure sale, and are sometimes started on the day of the sale.

Securitization Creates Murky Ownership: Because of the securitization of mortgages, it is extremely difficult to determine who is calling the shots for the lender. It seems that mortgages have been sold off piecemeal, and the third-party mortgage holders are conducting the foreclosures. The owner is greatly distanced from the lender, and it is almost impossible to identify the entity that is in control of the mortgage and the foreclosure process.

The Home Affordable Modification Program is a Failure: This writer has yet to see one mortgage that was modified as a result of the federal Home Affordable Modification Program. The external evidence on the HAMP program is damning.

Professor Jean Braucher from The University of Arizona Law School explains that “HAMP provided for modification of first-lien mortgage loans originated on or before January 1, 2009, where the loan was secured by a one- to four-unit property, one unit of which was the borrower‘s principal residence.”

In order to qualify for a HAMP modification, “the debtor‘s gross monthly mortgage payment had to exceed 31 percent of gross income [and] the borrower had to document a financial hardship and be delinquent on the loan.”

That would cover a lot of troubled mortgages. Explains Prof. Braucher, “The goal of HAMP is to create a partnership between the government and private institutions in order to reduce borrowers‘ gross monthly payments to an affordable level. The level has been set at 31 percent of the borrowers‘ gross monthly income.”

However, the rules have never been explained. “The HAMP [ ] formula was not made public, in part out of concern that doing so would have allowed borrowers to game the calculation, but making it difficult for borrowers and their mortgage counselors to know whether to apply for a modification and to assess denial of an offer.”

Further, the lender bears the costs. “HAMP made investors responsible in full for the cost of bringing the debtor‘s gross monthly mortgage payment down to 38 percent of gross monthly income. HAMP also provided for the government to then share equally with investors the further cost of bringing the mortgage payment down to 31 percent of income.”

So, in order for HAMP to work, the lender has to admit it made a bad lending decision, and has to agree to eat part of the loss. Sadly, given the availability of cash in the housing market, it’s easier for the lender to precipitate a foreclosure sale, then sell the property for the full amount of the loan and all delinquency charges, meaning that the lender is made whole, and the owner absorbs the entire loss.

Notes Prof Braucher, “through September 1, 2009, the Congressional Oversight Panel reported that HAMP, with a goal of avoiding three to four million foreclosures in three years, had achieved only 362,348 three-month trial modifications. Even more disappointing, the Congressional Oversight Panel reported that the program had achieved only 1,711 permanent modifications through September 1, 2009.”

Thus, the federal loan modification program has been a profound failure. This writer’s experiences with troubled borrowers have been similar.

Jean Braucher, Humpty Dumpty and the Foreclosure Crisis: Lessons from the Lackluster First Year of the Home Affordable Modification Program (May 2010).

Private Trust Company – A Curious Hybrid

Attorneys Jim Weller and Alan Ytterberg published a recent article discussing an odd hybrid entity – the “private trust company.” As the authors explain, “Similar to a regulated trust company, an unregulated trust company is an entity formed under state law for the limited purpose of providing trust services to a single family.”

A private trust company is first an entity established under state law. “Most states that authorize private trust companies allow them to be formed as a corporation or a limited liability company.” However, “there is no information available to ascertain the number of unregulated trust companies that have been formed in the U.S.”

By way of history, “U.S. Trust Company (est. 1853), Northern Trust (est. 1889), and Bessemer Trust (est. 1907) were originally formed as private trust companies, but today they are known and respected as public trust companies that provide a wide range of fiduciary and trust services.”

A private trust company is a state-chartered institution that is formed to manage assets for wealthy families into the future. Thus, “it is a state chartered entity that is formed for the express purpose of providing trust and fiduciary services to a single family” and is tied to one or more irrevocable trusts established by the family.

State the authors, “there are a variety of states which promote private trust companies. Most of these states have favorable tax laws, and they have modernized their trust laws. In that regard, Wyoming, Nevada, South Dakota, and Texas are some of the more popular states where wealthy families are chartering private trust companies.”

States have different requirements for physical presence in the jurisdiction, but the requirements are not difficult to satisfy. For example, “Licensed family trust companies in Nevada must have at least one officer who is a Nevada resident, a physical office in Nevada, and “a bank account with a state chartered or national bank having a principal or branch offices in Nevada.”

The authors further explain that, “State banking commissioners have less incentive to subject a private trust company to the same regulatory oversight that a public trust company has because there is no public interest to protect. This distinction is formally recognized in states which permit private trust companies to seek exemption from certain regulatory provisions that apply to trust companies transacting business with the public.”

So, the state sanctions the formation of an entity, accords it the privileges of conducting business and of limited liability, but provides for little if any public or regulatory oversight. “A private trust company must meet minimum capital requirements in order to exercise the fiduciary powers granted to it by the chartering state. These capital requirements vary from state to state. South Dakota has the lowest capital requirement at $200,000.”

The authors add that, “a private trust company must apply for and obtain a charter from the state where it is to be located. Once the charter is granted, the private trust company is subject to the laws and regulations of that state. The lone exception is an unregulated trust company which can be formed in Massachusetts, Nevada, Pennsylvania, Virginia, and Wyoming.”

That’s private justice for the very wealthy in America, which is a distressing topic.

We’ve Been Taken for A Ride

It may be time for average persons to stop investing in the stock market. I’ve been a big believer in the market over the years, and am familiar with the statistics showing how stock market investments have grown over the years.

But the evidence is mounting – and may now be overwhelming – that shows that the big players have rigged the markets.

First, flash trading a.k.a. computerized trading controls the stock market these days. The stock exchanges TAKE MONEY to allow traders to hitch their computers closer to the computers used by the stock exchange.

The weird gyrations in the market are driven by computerized traders that make a little going up and a little coming down, as long as the trades keep happening. For example, Goldman Sachs makes most its income from trading. Trading your stocks. For its own benefit.

“Goldman made $3.5 billion in profits in just three months. While it doesn’t break down profits in detail, it does give a broad sense of where its revenues come from. Just $1 billion or 8 percent, came from traditional investment banking. The biggest slice, 72 percent, came from trading. Morningstar analyst Michael Wong says that trading category covers a wide range of activity.”

“What we do see is a trend which has been developing over the past few decades. Goldman Sachs and the other investment banks are making more money making trades than they do doing the things investment banks traditionally do.”

The part that makes this all crazy is the hidden derivatives market. As Matt Taibbi recently reported (Rolling Stone – May 26, 2010), “This insane outgrowth of jungle capitalism has spun completely out of control since 2000, when Congress deregulated the derivatives market. That market is now roughly 100 times bigger than the federal budget and 20 times larger than both the stock market and the GDP.”

Try to get your arms around that point. The derivatives market is 20 times larger than both the stock market and the GDP.

Gary Gensler, chairman of the Commodity Futures Trading Commission, described the problem as follows at a June 2010 exchanges conference in New York: “The buyer and seller never meet in a centralized market. Right now, when Wall Street banks enter into derivatives transactions with their customers, they know how much their last customer paid for the same deal, but that information is not made publicly available. They benefit from internalizing this information.”

Taibbi also reports that “Five of America’s biggest banks (Goldman, JP Morgan, Bank of America, Morgan Stanley and Citigroup) raked in some $30 billion in over-the-counter derivatives last year. By some estimates, more than half of JP Morgan’s trading revenue between 2006 and 2008 came from such derivatives.”

That is simply insane unregulated capitalism. Your 401k account goes into the tank, the stock market experiences unprecedented gyrations, and the big players make money hand over fist, at your expense.

“Imagine a world where there’s no New York Stock Exchange, no NASDAQ or Nikkei: no open exchanges at all, and all stocks traded in the dark. Nobody has a clue how much a share of IBM costs or how many of them are being traded . . . That world exists. It’s called the over-the-counter derivatives market. Five of the country’s biggest banks [ ] account for more than 90 percent of the market, where swaps of all shapes and sizes are traded more or less completely in the dark.”

Congress drafted legislation to bring derivatives out into the open, which the Senate gutted this spring. Notes Taibbi, “The Senate [functions] as a kind of ongoing negotiation between public sentiment and large financial interests.”

Folks, we are getting clobbered here. The Wall Street giants don’t want us to make money the old fashioned way in stocks, by buying good companies at a fair price. They want trades, lots and lots of trades. And they want derivatives, where they can gamble all day and make lots and lots of money.

Traditional investing look like a bad play until there is fundamental change in the markets. Derivatives must come out into the open. America just suffered a “lost decade” in which the market declined over a 10-year period, just like happened previously in Japan. Your 401k money is a pawn, and we are all losing while the big players just get richer and richer.

Could Breach of Contract Be Immoral?

Prof. Seana Shiffrin of UCLA Law School tackles the issue of “contract law’s strong traditional bar on punitive damages for intentional, gratuitous breach of contract.”

She jumps right into the fray: “Morality, I claimed, correctly regards some breaches of promise as morally wrong and as warranting not only compensation but the administration of morality’s punitive remedies, including blame, criticism, recrimination, and avoidance.”

That is a valid point. There are times when morality must be part of contract law. States Prof. Shiffrin, “The contract law invokes promise as the fundamental component of a contract but, puzzlingly, does not subject gratuitous breaches of contract (and hence breaches of promise) to the distinctive punitive measures endorsed and administered by law, save when those breaches are also torts.”

The argument continues. “If the law’s rationale for the bar on punitive damages is that the prospect of punitive damages might discourage efficient breach of contract – I label this the efficient-breach rationale – then the divergence between morality’s response to breach and the law’s response to breach is problematic in ways that morally decent citizens cannot accept.”

“The efficient-breach rationale forwards a justification for a legal doctrine that consists in the claim that barring punitive damages would encourage and facilitate certain breaching behavior.”

“But this behavior is condemned by morality. To the extent the law adopts and embodies this rationale, it thereby embraces and tries to encourage and facilitate immoral behavior. Although the law need not enforce morality as such, it is problematic when the law, either directly, or by way of the justifications underlying the law, embraces and encourages immoral action.”

Amen. It’s about time someone steps up like this. The law of contracts should not turn a blind eye to contract that is immoral.

Prof Shiffrin concludes that “Citizens, who in a democratic polity must be thought of as partial authors of the law, cannot, in all consistency, accept such laws and their justifications while simultaneously acting and reasoning as moral agents. The law ought not to be structured or justified in ways that place citizens in such an untenable position: it must accommodate the needs of moral agency even if it need not or should not enforce morality directly.”

(Seana Shiffrin, Could Breach of Contract Be Immoral?, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1551.)

Individual Freedom and Fault in Contract Law

Prof. Stefan Grundmann argues that strict liability is essential to contract law because it enforces an important societal norm – freedom of choice.

According to Prof. Grundmann, “The majority of civil law scholars endorse the idea that the fault principle is ethically well-founded, and some scholars clearly see it as ethically superior to strict liability. The core argument is the following: A system that grounds damages in fault gives the breaching party more freedom, since he does not have to answer for developments that he could not control.”

The professor bends the opposing argument. The application of fault to contract law rests on the premise that the society should condemn some acts, to a greater extent than merely enforcing the financial obligations that are established by private contract.

Prof. Grundmann continues. “In a Kantian tradition, it is seen as an act of freedom to choose between breach or conformity with a contract. Others, however, argue that a regime of strict liability may also foster some level of freedom by furthering the principle of pacta sunt servanda, that agreements must be kept – a principle of equal importance with freedom of will. Therefore, balancing of both principles seems necessary.”

Here the professor seeks to balance two moral standards. He asserts that “freedom and pacta sunt servanda are not of equal importance, at least not in the context discussed here. There is actually a clear hierarchy between them, and pacta sunt servanda is clearly more important because of the following reason.”

“Those who advocate the ethical superiority of the fault principle because it gives the breaching party the freedom to answer only for those acts and events for which he is responsible forget one rather simple fact: there is an earlier type of freedom that allows each party to decide what offers he makes and to which standards he wants to bind himself, i.e., the freedom of contract.”

Here we get to the heart of the argument – that protection of individual rights is more important than protection of societal norms. States Prof. Grundmann, “The most vital tenet of freedom in modern times [ ] is the right of each person to decide, to the greatest extent possible, which obligations to assume. This freedom – which comes first – is disregarded if the question of whether fault or strict liability should govern is decided, not on the basis of the parties’ expressed or implicit intentions, but rather on the basis of an ‘ethical credo’ about the superiority of fault or of strict liability.”

Again, the focus on individual rights ignores the question of whether fault – not as an excuse for breach of contract, but as justification for additional remedies – advances important societal values.

Concludes the author, “strict liability better fosters freedom of contract.” Thus, “If the freedom of the parties is taken seriously, the question is how to interpret their intentions, not to impose on them a regime judged by scholars, legislatures, or any other third party to foster their freedom and therefore be ethically superior. Replacing the choice made by the parties – even if justified as fostering freedom – is paternalistic.”

(Stefan Grundmann, The Fault Principle as the Chameleon of Contract Law: A Market Function Approach, in Michigan Law Review (June 2009), Vol. 107, No. 8, p. 1583.)