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Optimal Property Rights in Financial Contracting

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  • 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.

Suggested Citation

  • Kenneth Ayotte & Patrick Bolton, 2007. "Optimal Property Rights in Financial Contracting," NBER Working Papers 13316, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:13316
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    References listed on IDEAS

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    Cited by:

    1. Giuseppe Dari-Mattiacci & Carmine Guerriero & Zhenxing Huang, 2016. "The Property-Contract Balance," Journal of Institutional and Theoretical Economics (JITE), Mohr Siebeck, Tübingen, vol. 172(1), pages 40-64, March.
    2. Arruã‘Ada, Benito, 2017. "Property as sequential exchange: the forgotten limits of private contract," Journal of Institutional Economics, Cambridge University Press, vol. 13(4), pages 753-783, December.
    3. Benito Arruñada & Giorgio Zanarone & Nuno Garoupa, 2019. "Property Rights in Sequential Exchange," Journal of Law, Economics, and Organization, Oxford University Press, vol. 35(1), pages 127-153.
    4. Donaldson, Jason Roderick & Gromb, Denis & Piacentino, Giorgia, 2020. "The paradox of pledgeability," Journal of Financial Economics, Elsevier, vol. 137(3), pages 591-605.
    5. Hoang, Daniel & Ruckes, Martin, 2017. "Corporate risk management, product market competition, and disclosure," Journal of Financial Intermediation, Elsevier, vol. 30(C), pages 107-121.
    6. Jason Donaldson & Denis Gromb & Giorgia Piacentino, 2019. "Conflicting Priorities: A Theory of Covenants and Collateral," 2019 Meeting Papers 157, Society for Economic Dynamics.

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    More about this item

    JEL classification:

    • K11 - Law and Economics - - Basic Areas of Law - - - Property Law
    • K12 - Law and Economics - - Basic Areas of Law - - - Contract Law

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