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Optimal Property Rights in Financial Contracting

Kenneth Ayotte

University of California, Berkeley - School of Law

Patrick Bolton

Columbia Business School - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

July 2007

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 likely to redistribute value from third-parties ii) less likely to increase efficiency, and iii) more costly for third-parties to discover. 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.

Number of Pages in PDF File: 38

Keywords: property rights, contracts, legal rules, covenants, bankruptcy

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Date posted: May 29, 2007  

Suggested Citation

Ayotte, Kenneth and Bolton, Patrick, Optimal Property Rights in Financial Contracting (July 2007). Available at SSRN: http://ssrn.com/abstract=989225 or http://dx.doi.org/10.2139/ssrn.989225

Contact Information

Kenneth Ayotte (Contact Author)
University of California, Berkeley - School of Law ( email )
215 Boalt Hall
Berkeley, CA 94720-7200
United States
Patrick Bolton
Columbia Business School - Department of Economics ( email )
420 West 118th Street
New York, NY 10027
United States
HOME PAGE: http://www0.gsb.columbia.edu/faculty/pbolton/

Centre for Economic Policy Research (CEPR)
77 Bastwick Street
London, EC1V 3PZ
United Kingdom
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
European Corporate Governance Institute (ECGI)
B-1050 Brussels
HOME PAGE: http://www.ecgi.org
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References:  39
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