Working Paper: NBER ID: w13316
Authors: Kenneth Ayotte; Patrick Bolton
Abstract: In this paper we propose a theory of optimal property rights in a financial contracting setting. Following recent contributions in the property law literature, we emphasize the distinction between contractual rights, that are only enforceable against the parties themselves, and property rights, that are also enforeceable against third parties outside the contract. Our analysis starts with the following question: which contractual agreements should the law allow parties to enforce as property rights? Our proposed answer to this question is shaped by the overall objective of minimizing due diligence (reading) costs and investment distortions that follow from the inability of third-party lenders to costlessly observe pre-existing rights in a borrower's property. Borrowers cannot reduce these costs without the law's help, due to an inability to commit to protecting third-parties from redistribution. We find that the law should take a more restrictive approach to enforcing rights against third-parties when these rights are i) more costly for third-parties to discover, ii) more likely to redistribute value from third-parties, and iii) less likely to increase efficiency. We find that these qualitative principles are often reflected in observed legal rules, including the enforceability of negative covenants; fraudulent conveyance; corporate veil-piercing; and limits on assignability.
Keywords: No keywords provided
JEL Codes: K11; K12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Law should restrict the enforcement of property rights against third parties when these rights are costly to discover (K11) | Redistribution of value from uninformed third parties (H23) |
| Stricter enforcement of property rights (P14) | Reduction of uncertainty and investment distortions (D89) |
| Stronger property rights (P14) | Alleviation of credit constraints (E51) |
| Stronger property rights (P14) | Reduction of moral hazard (G52) |
| Anticipation of redistributive contracts by lenders (G21) | Incurrence of due diligence costs (G32) |
| High due diligence costs (G19) | Credit rationing (G21) |
| Optimal legal design should balance enforcement of property rights with costs imposed on third parties (P14) | Prevention of inefficient redistributions that could harm uninformed lenders (G21) |