Foundations of Impersonal Exchange: The Theory and Policy of Contractual Registries

Motivation for this book: Misguided property titling and business formalization policies

Discussions on economic development have lately focused on the role of institutions in protecting property rights and reducing transaction costs. In particular, the idea has taken root that development would benefit from facilitating access to legality. It is thought that, if those in possession of even small buildings and plots of land have good titles, they will enjoy better incentives to invest and can use these real assets as collateral for credit. Similarly, if business entrepreneurs are able to “formalize” (for our purposes, publicly register) their firms easily, they will benefit from operating them as legal entities. For instance, they will have access to the courts for enforcing contracts and settling disputes, and will also be able to obtain credit and invest more. Consequently, firms will grow faster and be more productive.

These simple ideas, inspired by the works of Ronald Coase, Douglass North and Oliver Williamson, and reminiscent of widespread arguments in the most advanced economies of the nineteenth century, have motivated thousands of reform and aid programs in developing countries, where the state of legal institutions is often considered inadequate. Some authors have even held that providing better institutions would by itself lead to greater development. Similar ideas have also influenced reform policy in developed countries, where some of the institutions for registering property and businesses have become outdated or captured by private interests. Simplifying administrative procedures was expected to have considerable impact on economic activity.

However, outcomes from these efforts in institutional building and reform have often been disappointing, failing to fulfill their promise of economic growth and even that of improving the institutional environment. Common mistakes have often been committed, such as seeing registries’ controls as mere entry barriers to legality, forgetting that they must be reliable to be socially useful. This has often led to reforms that emphasize quantity and speed, sacrificing quality and making registries speedy but useless. Of course, registries, like any other institution, can be used to capture rents and deter competition. This possibility must be considered and avoided but it only imposes one more policy and organizational constraint—it does not define registries’ function and should not therefore be treated as their only design factor.

In other cases, the error comes from mixing up cause and consequence when assuming that informality is causing poverty instead of the other way around. This has led, for instance, to the building of universal land titling systems that spend huge amounts to little effect, as they usually miss key objectives, such as the use of land as collateral for credit. In fact, given that formalization incurs fixed costs, informality may be appropriate for low-value assets and small, incipient firms. Registries are not silver bullets for development. Decision on the creation and coverage of registries must be guided by considerations of costs and benefits, which depend on the particular circumstances of each country.

The argument of this book: How public registries reduce the transaction costs of impersonal trade

I submit that these failures are rooted in a poor understanding of the role of registries and, consequently, of the demand for them and of their organizational requirements. I have written this book in the hope of correcting this shortcoming. First, I develop a theory of contractual registries that explains their rationale as an essential part of the institutions that make truly impersonal trade feasible, the trade in which contractual performance depends on assets instead of persons. Second, I use this theory as a basis for analyzing the main policy questions posed by the creation and organization of registries.

Opportunities for economic development are greater when trade is impersonal instead of limited to known people. To be fully impersonal, contractual performance must be independent of parties’ characteristics, including not only their reputation and wealth but even their legal authority to contract. Such fully impersonal trade therefore requires contractual enforcement to be based on assets, which poses a conflict between those holding and those acquiring property rights, between owners and buyers. (More precisely: between owners seen retrospectively as buyers, and owners seen prospectively as potential victims of future expropriation by, e.g., a fraudulent seller). In short, making contractual performance hinge on assets reduces transaction costs but may endanger the security of property. Overcoming this conflict is the role of contractual registries, a crucial role, because both secure property and low transaction costs are necessary conditions for economic development and would collide in the absence of registries.

This conflict can be better identified by considering legal remedies. Property rights are the foundation of economic incentives and prosperity. It therefore makes sense to enforce them strictly, so that in case of conflict goods are always returned to their legal owners unless they had granted their consent—treating them as rights in rem (from the Latin word res, thing). But such strict enforcement would increase transaction costs by worsening the information asymmetry suffered by acquirers of all sorts of rights, who would always have to gather the consent of the legal owners. Strictly enforcing property rights might therefore endanger trade. It would also endanger specialization, because specialization is often based on having agents acting as owners’ representatives, and acquirers would have reasons to doubt the legal authority of sellers. Economic development therefore requires this conflict between property enforcement and transaction costs to be overcome, so that both owners and acquirers are protected. Owners’ property rights need to be protected to encourage investment, and the transaction costs faced by acquirers need to be lowered to encourage them to trade and thus improve the allocation and specialization of resources.

Achieving both goals is straightforward when the consequences of private contracts are easy to verify: all it requires are clear adjudication rules between owners and acquirers. This is what usually happens in commercial trade of movable goods, for which Western law has been able to effectively overcome the conflict between property enforcement and transaction costs since the Middle Ages. Generally speaking, when one firm gives possession of movable goods to another, the legal system understands that it authorizes the receiving firm to sell the goods. Third parties acquiring from a firm are therefore secure and do not need to worry about the authority of the seller. Owners are protected because it is they who choose the seller. And they cannot renege from their decision because the transaction produces a verifiable consequence: the transfer of possession.

Protecting third parties without damaging owners is harder when contracts remain private. This is what happens in transactions such as mortgages or those involving companies, which lack verifiable consequences. History suggests that achieving both goals in these cases requires effective, independent, public registration of property rights or private contracts. Only such reliable registers can ensure that owners of resources have publicized their property rights (so that acquirers can find out about them before contracting), or have consented voluntarily to a weakening of their property rights with respect to innocent acquirers (so that owners cannot opportunistically renege from such consent). When purchasers of land and mortgage lenders rely for their contracts on the information filed with the registry, developed legal systems protect their acquisitions even against unregistered legal owners. A similar function is performed by company registries with respect to personal and corporate creditors so that, for instance, if a corporation has remained unregistered this should not damage third parties. In both cases, these protections in fact eliminate the information disadvantage suffered by third parties, and so reduce transaction costs, making trade easier. Furthermore, well-functioning registries achieve these feats without damaging the property rights of landowners or company shareholders.

The role of contractual registries can be more easily clarified by considering that most economic transactions are interrelated sequentially. In the most simple sequence, with only two transactions, one or several “principals”—such as owners, employers, shareholders, creditors and the like—voluntarily contract first with one or several economic “agents”—possessors, employees, company directors and managers—in an “originative” transaction. Second, the agent then contracts “subsequent” transactions with third parties.

These sequential exchanges offer the benefits of specialization in the tasks of principals and agents—between landowners and farmers, employers and employees, shareholders and managers, and so on. But they also give rise to substantial transaction costs, because, when third parties contract with the agent, they suffer information asymmetry regarding not only the material quality of the goods or services being transacted but also the legal effects of the previous originative contract. In particular, third parties are often unaware if they are dealing with a principal or an agent, or if the agent has sufficient title or legal power to commit the principal. This constitutes a grave impediment, especially for the impersonal transactions that are necessary to fully exploit the advantages of specialization.

Moreover, principals also face a serious commitment problem when trying to avoid this asymmetry because their incentives change after the third party has entered the subsequent contract. Before contracting, principals have an interest in third parties being convinced that agents have proper authority but, if the business turns out badly, principals will be inclined to deny such authority. This is why the typical dispute triggered by sequential transactions is one in which the principal tries to elude obligations assumed by the agent in the principal’s name, whether the agent had legal authority or not.

Judges can adjudicate in such disputes in favor of the principal or the third party. I will refer to favoring the third party as enforcing “contract rules”, as opposed to the seemingly more natural “property rules” that favor the principal. The effects of these rules are clear.

Take the simple case in which an agent exceeds his legal powers when selling a good to an innocent third party (that is, a good-faith party who is uninformed about the matter in question.) If judges apply the “property rule” that no one can transfer what he does not have, they return the sold good to the “original owner” and the innocent third party wins a mere claim against the agent. Owners will feel secure with respect to this contingency, because this outcome maximizes property enforcement, but it worsens the information asymmetry suffered by all potential third parties with respect to legal title.

Conversely, judges can apply an indemnity or “contract rule” so that the sold good stays with the third party and the principal only wins a claim against the agent. This will minimize information asymmetry for potential third parties but will also weaken property enforcement, making owners feel insecure. Enforcing contract rules thus obviates the information asymmetry usually suffered by third parties and encourages them to trade. In so doing, contract rules transform the object of complex transactions into legal commodities that can be traded easily, thus extending the type of impersonal transaction that characterizes modern markets. However, contract rules weaken the principals’ property rights, endangering investment and specialization in the tasks of principals and agents.

The choice of rule therefore involves a tricky conflict between property enforcement and transaction costs. This conflict puzzles some economists because the economic literature on property rights has been interested in problems such as violence, externalities and the tragedy of the commons, which can be successfully analyzed using a simplified view of property enforcement. In particular, these problems are independent of the legal remedies that are made available to the rightholder in case of a dispute or, in particular, the type of protection—real or personal—the law gives to different entitlements.

These remedies are of two types: either the rightholder gets a real right, a right in rem, or a personal right, a right in personam—in legal terms these are called, respectively, property and contract rights. The enforceability and, therefore, the value of these two types of right are often markedly different because, while rights in personam are only valid against specific persons, inter partes, rights in rem are valid against all individuals, erga omnes. The latter, therefore, provide the strongest possible enforcement: without the consent of the rightholder, the rights in rem remain unaffected. However, as already mentioned, this makes transactions more risky for acquirers, endangering impersonal exchange. Without the supporting institutions which are the object of this book, enforcing rights in rem is incompatible with the multiplication of rights and frequent transactions needed for specializing and allocating resources. The function of registries is precisely to make rights in rem viable without increasing transaction costs.

To achieve this feat of overcoming the conflict between in rem property enforcement and transaction costs, expanding the set of viable contractual opportunities without damaging property rights, the law applies property or contract rules depending on conditions which provide proper safeguards. In essence, for judges to apply property rules, which favor owners, owners must have publicized their claims or rights, which should protect acquirers. That is, principals can opt for a property rule to make their rights safer but, thanks to publicity, third parties suffer little information asymmetry. Conversely, for judges to apply contract rules, which favor acquirers, owners must have granted their consent, which should protect them. That is, when principals choose a contract rule, third parties’ rights are safe while principals’ rights are weaker. But this weakening of property is limited since principals choose the agent whom they entrust with possession or appoint as their representative, this being the moment when they implicitly “choose” a contract rule.

Smooth operation of this conditional application of rules poses varying degrees of difficulty for different transactions. The difficulty is minor when the originative transaction inevitably produces verifiable facts, such as the physical possession of movable goods or the ordinary activity of an employee. For these cases, judges can base their decisions on this public information, which is produced informally. What judges or legislatures have to do is to clearly define efficient contract rules to be applied. The difficulty is greater when the originative transaction produces less verifiable facts, making informal solutions harder to apply. Such informal solutions may even be impossible if the contract remains hidden and its consequences are not verifiable. Consider, for example, the difficulties for clearly establishing by purely private contract the existence of a corporation, distinguishing the corporation’s assets from the personal assets of its shareholders.

In such contexts of harder verifiability, defining contract rules is not enough because applying them requires information on originative contracts, which, in principle, are not always verifiable. To make them verifiable, it is necessary to enter and preserve at least some information on them in a public registry, which is costly to start up and operate, and must enjoy independence and public access.

First, the costly nature of registries means that their existence is not always efficient. Therefore, as often happens with institutions, they are supportive of markets and may even be a necessary condition, at least of the most impersonal type of transaction. But they are not a sufficient condition. Reformers have to be attentive to signals indicating if demand really exists for new institutional development. Public intervention without such demand is wasteful and may even have negative consequences: if these attempted institutions fail, reforming them in the future will often be more difficult than starting from zero.

Second, to prevent interested manipulation, the registration process must be independent of all the parties involved, including parties to the originative contract. This requirement of independence makes registration wholly different from the documentary formalization performed by lawyers and conveyancers, which is mainly designed to safeguard the relation between parties to the same contract but lacks the public element required to have full in rem effects in the context of a sequence of contracts.

Third, at least the key features of the originative contract need to be made available to the public or at least to potential third parties, so that they know beforehand which rules are applicable to any subsequent contracts. In essence, registration thus becomes the means to make the voluntary choice of market-enabling contract rules verifiable by courts and therefore to commit principals to their choices.

These three attributes of efficiency, independence and effective access summarize the organizational requirements of public registries. They are not automatic or easy to achieve—they must be consciously pursued. Furthermore, registries suffer from two structural weaknesses. First, because or their public nature, they are subject to all the limitations of public organizations. Second, because, by drastically reducing transaction costs, they also reduce the demand for providers of palliative services such as lawyers, notaries and conveyancers, these professionals have an interest in impeding the development of effective, independent public registries.

Organization of the book

The book follows a logical theory-policy order, developing a theory of registries in the first three chapters and applying it to policy-oriented issues in the last four substantive chapters. Thus, the first chapter describes the analytical framework presenting a general theory of public contract formalization, which is then developed in the second and third chapters to explain, respectively, how the different types of property and company registries perform their functions.

The remaining chapters mostly apply this framework to the key strategic, policy, regulatory and organizational questions posed by property titling and business formalization institutions. Thus, Chapter 4 ponders essential strategic issues, such as the conflict between legal orders and the logical sequence to be followed in formalization reform. Chapter 5 considers the main design choices for registries, including how to consider the demand for formalization institutions, how to introduce them and how to choose between different types of property and business registry. Chapter 6 analyzes the nature of conveyancing services and their interactions with registries, and outlines a proposal for regulating conveyancing and other complementary services. Lastly, Chapter 7 deals with five organizational issues with a more managerial content: the use of information and the design of information systems for sensible decision making in this area; the synergies and risks of integrating contractual and administrative formalization; the challenges posed by technical changes in information technology; the need to apply strong incentives in the organization of public registries, seeing them as an organizational hybrid between private enterprise and public administration; and the importance of considering the self-interests of all participants and managing these by means of counterbalancing incentives.

A brief closing section recapitulates the main arguments and conclusions.