Since we’re working on definitions, let’s be sure we understand what an “arm’s length transaction” is.
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Business Definition for: arm’s length transaction
Dictionary of Accounting Terms
arm’s length transaction
one entered into by unrelated parties, each acting in their own best interest. It is assumed that in this type of transaction the prices used are the fair market values of the property or services being transferred in the transaction.
Dictionary of Finance and Investment Terms
arm’s length transaction
transaction that is conducted as though the parties were unrelated, thus avoiding any semblance of conflict of interest. For example, under current law parents may rent real estate to their children and still claim business deductions such as depreciation as long as the parents charge their children what they would charge if someone who is not a relative were to rent the same property.
Dictionary of Banking Terms
arm’s length transaction
transaction carried out by unrelated or unaffiliated parties, as by a willing buyer and a willing seller, each acting in his own self-interest. Pricing based on such transactions is the basis of fair market valuations.
Dictionary of Real Estate Terms
arm’s length transaction
a transaction among parties, each of whom acts in his or her own best interest.
Examples: Transactions between the following parties would, in most cases, NOT be considered arm’s length:
a husband and wife
a father and son
a corporation and one of its subsidiaries
What Does Arm’s Length Transaction Mean?
A transaction in which the buyers and sellers of a product act independently and have no relationship to each other. The concept of an arm’s length transaction is to ensure that both parties in the deal are acting in their own self interest and are not subject to any pressure or duress from the other party. Investopedia explains Arm’s Length Transaction
The concept of an arm’s length transaction commonly comes into play in the real estate market. When determining the fair market value of a piece of property, the price for the property must be obtained through a potential buyer and seller operating through an arm’s length transaction, otherwise, the agreed-upon price will likely differ from the actual fair market value of the property.
For example, if two strangers are involved in the sale and purchase of a house, it is likely that the final agreed-upon price will be close to market value (assuming that both parties have equal bargaining power and equal information about the situation). This is because the seller would want a price that is as high as possible and the buyer would want a price that is as low as possible.
This contrasts with a situation in which the two parties are not strangers. For example, it is unlikely that the same transaction involving a father and his son would yield the same result, because the father may choose to give his son a discount.
One of the problems with short sales is that it’s not the seller who is taking the loss; therefore, the seller has no incentive to get the “highest and best” price for the property — there is no incentive for him/her to act in his/her own best interest, except when they get to benefit at the expense of the lender. There is a tremendous conflict of interest here. If the seller or the agent is in any way related to the buyer (by blood, marriage, acquaintance, etc.), then the best way to ensure that the transaction is “arm’s length” would be to market the property on the open market (in real estate, that means a public listing service, almost always referring to the local MLS) for a minimum duration, and then take the higest and best offer to the lender. Anything less than this is fraud, as it causes losses for the banks/govt/taxpayers/mortgage insurers, for the benefit of the buyer/seller/agent. Because so many of these loans are being backed by the govt/taxpayers, either directly or indirectly, it is imperative that the lenders receive the highest/best offers possible to minimize losses.
The rules traditionally followed by realtors/buyers/sellers in regular short sale transactions (before the govt backing of the mortgage market) do not supercede the right of the govt/taxpayers to recover all the money they are entitled to from these short sales.
Once again, I couldn’t care less if the banks were taking the hit, directly (as long as the FDIC isn’t required to bail them out), nor would I care if an equity seller wanted to sell for below market to a related party — taking the losses themselves, rather than foisting them on the shoulders of the lenders/taxpayers. But once the government/taxpayers stepped in to take the losses, their right to recover whatever possible from the sales takes precedence over the rights of buyers/sellers/agents/investors to profit in any way.
