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Institutional Foundations of Impersonal Exchange
Theory and Policy of Contractual Registries
By BENITO ARRUÑADA
The University of Chicago Press
Copyright © 2012 The University of Chicago
All right reserved.
ISBN: 978-0-226-02832-3
Chapter One
The Role of Verifiable Contract Publicity in Impersonal Trade
People prosper when investors feel secure and are therefore willing to invest in productive activities. But they prosper even more if they can trade beyond their personal circles of known people, as producers invest and specialize more when they can sell their production in a larger market. Good institutions facilitate these two key factors for development, as they not only make investors feel secure in their investments but also enable everybody to trade impersonally, thus creating wealth. Most of this book focuses on a subset of these institutions: those for contract registration, which makes it possible to ground contract enforcement directly on assets, in such a way that transacting parties need no personal information about each other and can therefore trade impersonally.
Impersonal Exchange Requires Rights on Assets, Not Merely on Persons
Reaching specialization advantages requires transferring all sorts of rights to the most productive user. It therefore requires exhausting the opportunities for exchange. Unfortunately, profitable exchange opportunities may be lost because potential parties do not trust each other.
To avoid distrust, parties display plenty of ingenuity to bond their own future behavior with a variety of safeguards and to learn more about their prospective contractual partners. When parties know each other well, they suffer less information asymmetry about the value of each other's promises; thus, conflicts are less likely. They also know about the safeguarding mechanisms that will be activated if a conflict eventually arises, and which may be based on public or private "ordering"—that is, mainly with or without help from an independent judiciary. This knowledge facilitates economic exchange, but only of a personal nature, as parties need to know each other's characteristics, including their solvency and reputation. In brief, they need local knowledge.
This personal nature of exchange is a more or less continuous attribute, derived from the more or less personal nature of the safeguards used to enforce contractual performance. In turn, the nature of these safeguards affects the amount of personal information that parties need to gather before committing themselves to the exchange. Going from the most to the least personal (and omitting individual moral traits), the starting points are expectations of future trade and market-observable reputation, then systems for indirect liability (including the use of assurance intermediaries and community responsibility), and, lastly, impartial judicial enforcement of contractual agreements.
First, most trade between parties who know each other is fully personal as it relies on their mutual knowledge and expectations of their future trade. This generally affects private ordering solutions (Williamson 1985, 163–205). Likewise, much of the trade with strangers also requires gathering information to know what performance assurances—for instance, their track record and reputation—they offer. So it, too, is mainly personal.
Second, trade also remains personal when performance assurances are not produced by the parties themselves but by assurance intermediaries, such as financial institutions, credit bureaus, credit and title insurers, rating agencies, auditors, and so on. In such cases, trade remains personal to the extent that it is based on the reputation of the intermediaries and their knowledge of their clients. Similarly, trade is also personal under community responsibility systems, when all members of a group (e.g., all merchants of a particular city in late medieval times) are liable for the behavior and contractual obligations of each of the group's members. Such a system allows strangers to trade with group members, but they do so based on limited personal information, just enough for them to unambiguously know which individuals are members of which groups and which groups are dependable. Moreover, such a system also requires monitoring individuals' characteristics within each group. Both assurance intermediaries and community responsibility therefore make transactions more impersonal but still retain important personal attributes.
Lastly, trade is often considered to be impersonal when it relies on independent judges. But this reliance only reduces the amount of personal information required for transacting, as parties still need to ascertain at least how solvent their obliged counterparties are. Even with perfect judges, creditors must worry about how likely it is for their debtors to become judgment proof—that is, even after a court order states their debts, their creditors still cannot collect any money. Insolvency carries little stigma today but even in old times, when insolvent debtors ended up in prison, jailing them must have provided little joy to their creditors. As before, therefore, judicial enforcement still depends on personal attributes, and judicially supported trade still remains substantially personal in nature.
To the extent that personal attributes are present in all these cases, parties must spend resources on developing personal safeguards and producing knowledge about them. Also, to the extent that such safeguards remain weak, contractual enforcement is unreliable, prone to conflict and thus costly. Lastly, where there is a risk of contractual default, parties withdraw and waste trade opportunities. Therefore, relying on personal exchange precludes profitable exchanges between unknown parties and limits specialization opportun-ities and efficient reallocation of resources, reducing economic growth.
To expand the scope of transactions and fully exploit the benefits of comparative advantage, parties must be able to trade without any knowledge of personal characteristics. This requires making contractual performance independent of such characteristics, a feat that can only be achieved by granting acquirers rights directly against the acquired assets instead of against the sellers, that is, rights in rem (from the Latin res, thing) instead of in personam. However, providing this in rem protection to acquirers would endanger the rights of owners, who might be left holding mere claims against persons, rights in personam (e.g., against a fraudulent seller). Take the example of a simple asset sale when the seller is not the owner. The acquirer is better off if she is granted a right in rem against the asset itself, so that, for instance, possible defects as to the relationship between owner and seller do not affect her purchase. In contrast, were she given a right in personam, such defects might require her to return the asset to its owner, leaving her with a mere claim against the seller. Obviously, the opposite is true for owners.
In sum, legal systems face a hard choice, as rights on assets are needed for both the security of owners and impersonal exchange. But these two goals conflict because they entail protecting, respectively, current owners and acquirers, leaving the other party unprotected. And the choice is not made easier by the fact that today's owners are yesterday's acquirers: even though they share a common interest in abstract terms, their interests clash in any specific conflict. Protecting the interests of both owners and acquirers requires institutions and, in particular, contractual registries. For instance, if judges grant assets to those registered as owners in a public register, acquirers can avoid their information asymmetry by simply checking the register.
Before explaining in more detail the rationale behind contractual registries, I will examine in the next two sections what it means to define rights directly on assets instead of on persons, the comparative advantages of both enforcement strategies, and how they are handled by the two disciplines called on to support the analysis: the economics of property rights and property law.
The reason why I focus on the asset-versus-personal dichotomy is because it is key for contractual registries. But, of course, given that assets are not physically homogenous, eliminating personal elements does not exhaust the possibilities of commoditization that make trade easier. Establishing standard physical measures of assets greatly facilitates exchange—as, for example, when developing production standards useful in subcontracting manufacturing tasks (Arruñada and Vázquez 2006) or when demarcating land using a uniform grid (Libecap and Lueck 2011a and 2011b). In contrast, removing personal elements and defining rights on assets comes close to commoditizing the key legal, instead of physical, attributes.
What Do Rights on Assets Mean? The Difference between Rights on Assets and Rights on Persons
A right in rem is more valuable than a corresponding right in personam even when both allocate to the holder the same set of asset uses—that is, the same decision rights about what to do with the asset—because rights in rem are easier to enforce. It will be useful to examine several examples illustrating this enforcement advantage.
Imagine, first, a lease of real estate, which in many jurisdictions may be structured either in personam or in rem, as either a contract or a property right. Imagine also that both of these define and allocate the same uses for the asset, including its possession. However, if the lease is a property right, which is generally the default rule in the United States, the lessee keeps the right of occupation unless she consents to leave. It is then the land buyer who will have a claim for compensation against the seller if the sale was made free of leases. From the viewpoint of the lessee, the buyer simply replaces the seller without any change to the lease, which is said to "run with the land" from the seller to the buyer, surviving intact after the sale. Conversely, if the lease is a contract right, as in Roman law, the lessee loses the right of occupation when the leased land is sold during the life of the lease, following the principle of emptio tollit locatum or "sale breaks hire." Instead, the lessee gains a right to be compensated by the lessor.
The same happens when using property to guarantee the owners' debts. For example, a landowner may use her land as collateral for a loan by granting a mortgage to the lender. Alternatively, she may contract an unsecured personal loan. In both cases, the creditor has a right to be paid from the land, conditional on the borrower's default. However, the mortgage lender keeps the same claim on the land even after the debtor sells it or contracts a second mortgage on it. By contrast, when a landowner borrows personally, the land is also safeguarding the transaction but much more weakly, as the lender is granted only conditional in personam rights on the borrower's assets. Therefore, when the debtor defaults on such a personal loan, the lender is allowed to trigger the seizure and sale of debtors' property in order to be paid, but only if such property has not been legally transferred to an innocent third party before the debtor's default. The personal creditors' claims do not run with the land.
Finally, perhaps the most important example is ownership itself, which, even if held by the same person, is distinct from the right to use and enjoy the asset (usufruct in civil law) and from control of the asset (broadly equivalent to legal possession). Therefore, were someone purporting to be the owner to sell the land in a fraudulent sale, the true legal owner would recover it, and the buyer would thus get only a personal claim against the fraudulent seller. In fact, ownership is so much the ultimate in rem right that talk of the in personam owner seems awkward. However, it is in personam ownership that a claimant holds when a judge finds (or would find if asked to decide) that an alternative claimant is really the legal owner; thus, this alternative claimant is (or would be) given ownership of the land, the in rem right on it.
As shown in these examples, property in rem rights enjoy decisive enforcement advantages, as they define more direct relations with regard to things. They are thus claimable against the thing itself and therefore oblige all persons, erga omnes. This universal obligation means that, in the examples, the new owner who has purchased the land—whoever she is—must respect the in rem lease and the mortgage: in particular, the lessee's possession and the mortgagee's right to foreclose if the debtor defaults. And when she buys from a nonowner, she gets only a claim against the seller, without touching the owner's right on the land. This is why property rights run with the land—they survive unaltered through all kinds of transactions and transformations dealing with other rights on the same land or on a neighboring parcel. Enforcement of a property right in rem is independent of who holds this and all other rights on the same land, including ownership, because "rights and duties in rem do not refer to persons ... in the sense that nothing to do with any particular individual's personality is involved in the normative guidance they offer" (Penner 1997, 26, emphases in the original).
A consequence of particular importance for specialization and thus for the functioning of the economy is that in rem owners do not suffer the possible moral hazard of their agents. For instance, when the owner cedes possession, she does not risk losing the asset if the agent poses as owner and sells it to a third party. In rem rights may certainly weaken enforcement in one dimension: all current owners ave been acquirers and they can lose the asset against potential claimants with a better legal title. But this risk is delimited, being a risk from the past, and also diminishes with the lapse of time, due to the operation of rules that automatically purge titles, such as adverse possession and the statute of limitations.
In contrast, mere contract rights define obligations between the contracting parties and thus are enforceable only against these specific persons, inter partes. Moreover, persons last less and move more than durable assets, and their reliability suffers from all kinds of additional risks. In terms of the examples, if the lease were contractual, the lessee would have to attain an indemnity from the lessor, who might well have disappeared or be insolvent. The same might easily happen with insolvent debtors and fraudulent sellers.
Consequently, contract, in personam, rights provide little security and their value depends on who the obliged persons are and how they will behave. Information on these specific persons is thus necessary to alleviate the information asymmetries potentially causing adverse selection and moral hazard. Furthermore, the performance of contract rights remains conditioned on all these personal elements even if it ends up being materialized in uses of the asset—for example, an in personam land lease materializes in the same use of the land as an in rem lease, but with lower enforceability. This personal mediation in accessing assets compares badly in terms of enforceability with in rem rights, whose asset uses are enforced independently of any personal condition. So rights in rem are intrinsically different and more valuable than the mere addition of a corresponding set of rights in personam defining the same uses (Merrill and Smith 2001b, 786–87).
Rights in rem enjoy this enforcement advantage because they can be damaged only with the consent of their rightholder. This ensures enforcement but is costly when multiple, potentially conflicting rights are held in the same asset. In particular, potential acquirers of rights suffer additional uncertainty because, if they are sold more than the seller holds, adverse in rem rights will survive their acquisition. Such potential adverse rights are all those that conflict with the intended transaction. In our previous examples, they are the rights held by the lessee and the mortgagee when the land is sold purportedly free of in rem leases and mortgages. In the case of a fraudulent sale, the adverse right is the ownership held by the legal owner. In all these cases, if rightholders have not consented to the transaction, their rights survive intact, and the acquirer gets a claim against the grantor for the unfulfilled difference (which is all she gets in a fraudulent sale).
From this perspective, parties and institutions have to manage a tricky interaction between enforcement and transaction costs, between in rem property rights and the transaction costs they cause. Rights in personam offer less enforcement but are easier to contract over, given that they only affect the transactors. In contrast, rights in rem offer stronger enforcement but are harder to contract over, given that they affect and therefore require the consent of everybody. Moreover, the difference is important because the value of a given use right enforced in rem is greater than the same use right enforced in personam. Individuals may even be judgment proof, which would make in personam rights unenforceable. Different legal systems provide parties with ways to contract in rem rights more or less easily, so that parties can benefit from their enhanced enforceability. Otherwise, they have to rely on mere personal rights. There are, therefore, two distinct tradeoffs at the social and individual levels. First, society must decide how much to spend on institutions that ease in rem contracting, such as, for instance, contractual registries to make mortgages public. Second, given these institutions, parties must then decide how much to spend on transaction costs (e.g., examining the register) so that they transfer in rem rights or, in continuous terms, rights with a greater in rem content and thus enhanced enforcement.
This interaction between in rem enforcement and transaction costs, which lies at the core of property law, fits poorly in the economic analysis of property rights, which, when considering property enforcement, tends to disregard what may well be its essential element: the legal remedies available to owners. For economists, enforcement is often a matter of precisely defining the scope and allocation of rights, two aspects that should generally reduce the costs of transacting—that is, greater precision should reduce transaction costs. My next step is to clarify this divide between economics and property law which, far from being merely semantic, reveals their widely different but complementary perspectives.
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Excerpted from Institutional Foundations of Impersonal Exchange by BENITO ARRUÑADA Copyright © 2012 by The University of Chicago. Excerpted by permission of The University of Chicago Press. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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