The shrinking middle class and the widening gap between the rich and the poor threaten social and financial stability. The noted economist Hernando De Soto has explained how the lack of credit increases wealth inequality. Largely due to poverty, 70 percent of the world’s population lacks registered title to their land, even in developed countries. The poor therefore cannot use their homes as collateral to borrow and create wealth. The impact is devastating not only to individuals but also to commerce, because mortgage lending is the primary source of capital used to start small businesses.
My new article, available here, analyzes whether—and if so, how—the law should recognize de facto rights to enable the poor to obtain credit. To date, all efforts to bridge this “credit gap” have failed because they focus on transforming property law, which is tightly bound to tradition and protecting vested ownership. My article takes a radically new but intuitively logical approach by focusing on using commercial law rather than property law.
Modern principles of commercial law increasingly recognize important policy goals and commercial realities as a basis to override traditional limitations imposed by property law. For example, commercial law recognizes the reality that the risk of losing goods in shipment should be allocated to the party who controls the goods and can be expected to insure his interest in them, whether or not that party owns the goods at the time of their loss. To facilitate the transferability of goods and negotiable instruments, commercial law gives good faith purchasers greater rights in the transferred goods and instruments than the seller itself had.
The article argues that commercial law should similarly override property-law limitations to enable the poor to pledge de facto rights in their property, as collateral to obtain credit. The ability to pledge those rights would unlock the entrepreneurial potential of billions of people and would facilitate the important commercial reality of allowing de facto right-holders gainfully to use property that de jure owners are not using (and do not intend to use).
Furthermore, de facto rights are real rights, though not formally recognized. Property law nonetheless implicitly recognizes de facto rights through its view of property as a “bundle of entitlements.” Rights in property may include the right to use, the right to exclude use, and the right to transfer, and different persons can have different rights in the same property. The poor often have the right to use the property where they live and, arguably, also to exclude use of that property by others. The poor also have the de facto right to transfer their use-and-exclusion rights, at least to family members such as children.
In order to turn these de facto rights into collateralized credit, the poor would need to be able to transfer security interests in that property to lenders, as collateral for loans. Given their de facto right to transfer their use-and-exclusion rights to related parties, enabling them to transfer security interests in those rights to obtain credit should be a trivial additional step—certainly justified by its benefits. However, lenders almost certainly would require another step that is far from trivial: transferring a security interest in the underlying de jure rights in the property. This reflects the practical reality that they are unlikely to extend credit unless, in a foreclosure, they can obtain the full rights—both de facto and de jure—in the property pledged as collateral.
This poses a puzzle: A borrower that has only de facto rights in that property cannot normally pledge greater rights. This reflects the long-standing property law principle of “nemo dat”—the concept that one cannot transfer more rights than one owns. How could holders of de facto rights also transfer the de jure rights?
Commercial law already addresses this conundrum. To facilitate the sale of goods, commercial law gives buyers of goods, in the ordinary course of business, full unencumbered rights to those goods. Similarly, to facilitate the transferability of negotiable instruments, commercial law gives holders in due course full unencumbered rights to these transferred instruments. If commercial law did not override property law in these ways, the transaction costs of selling goods and negotiating instruments would be prohibitive. One could not buy a computer from a store, for example, without performing due diligence to ensure the seller’s ownership and the absence of third-party encumbrances.
These “bona fide purchaser” exceptions from nemo dat epitomize commercial law’s recognition of important policy goals and commercial realities as a basis to override property law’s limitations. Should access to collateralized credit justify another exception to nemo dat, enabling the poor to pledge not only their de facto rights but also the underlying de jure rights? In answering this question, one should realize that although nemo dat is a “common sense” rule, leading property-law scholars agree that other rules are conceivable and that practical exceptions to nemo dat are common.
Taking into account common sense and practicality, my article argues that the critical benefits provided by access to collateralized credit should justify another exception to nemo dat to enable the poor to transfer as collateral the underlying de jure rights as well as their de facto rights—if doing so is not unfair to holders of those underlying rights. Would recognition of that transfer be unfair to holders of those underlying rights?
Commercial law constantly grapples with conflicting rights and the need for fairness. It often preserves fairness by enabling parties to protect their rights by providing clear notice of those rights to subsequent transferees. Providing clear notice to preserve original rights also has precedent in the somewhat parallel tension between the de jure rights of landowners and the de facto rights of squatters in adverse possession cases.
Applying this same type of approach to collateralized credit—recognizing the original de jure rights of persons who provide clear notice to preserve those rights—should similarly respect fairness while helping to promote the effective utilization of property. One might question, though, whether allowing de jure right-holders to give notice could effectively prevent the poor from obtaining credit: Wouldn’t reasonable de jure right-holders always give notice, thereby preventing foreclosure on their property (and thus effectively preventing it from being used as collateral)? In answer, relatively few de jure right-holders likely know of their rights; it is unclear who, other than the government, owns much of the property in which the poor hold de facto rights.
My article also addresses a host of practical questions, including how to identify de facto rights. It shows, for example, how technical advances, including satellite imagery and drones, could facilitate that identification. It also examines whether banks and other lenders would actually extend credit to poor borrowers based primarily on collateral, emphatically distinguishing this type of asset-based financing from the imprudent subprime lending that led to the financial crisis. Additionally, it examines whether the poor would be willing to borrow, given that people tend to be risk averse.
The article also explains why overriding property law to enable the poor to obtain credit should be economically efficient. Allowing the poor to borrow to start small businesses could alleviate their poverty as well as create new jobs and broadly foster economic development. The World Bank, for example, sees small businesses as important drivers of local growth and job creation in low-income countries. It also supports small businesses as a top priority in its global agenda. Furthermore, overriding property law to enable the poor to obtain credit would create an important new source of “sustainable finance”—no longer dependent on charitable sources of funding, which are extremely limited, or on mandatory regulation of finance to impose social responsibility but designed to attract arm’s length commercial funding sources.
Finally, the article sets forth the text of a Model Law that could be considered as a basis for legislatively enacting the article’s proposal.
This post comes to us from Steven L. Schwarcz, the Stanley A. Star Professor of Law & Business at Duke University School of Law and Senior Fellow at the Centre for International Governance Innovation. It is based on his recent article, “Empowering the Poor: Turning De Facto Rights into Collateralized Credit,” available here.