Post by Yonathan Arbel, postdoctoral fellow in private law, Harvard Law School (job market candidate)
One of the central questions in the New Private Law is how ‘down-to-earth’ should legal analysis be? Regardless of one’s substantive view on this debate, there is one area in which we have been insufficiently realistic: private law enforcement. There is a real gap in our understanding of how legal norms are executed by sheriffs, bailiffs, and private ordering. Understanding the limits of doctrine and law could be informative for both economic and justice-based views of the law, as well as to views that look at the law from the internal point of view.
My scholarship focuses on questions concerning the enforcement of private legal norms. In Shielding of Assets and Lending Contracts (Forthcoming, Int’l Rev. L. Econ.) I consider the problem of asset shielding. Most judgments, if not voluntarily implemented, depend on enforcement through the seizure of the judgment-debtor’s assets. The problem is that ownership is too malleable and enforcement is too constrained, so there are many ways in which people can hide, shield, or protect their assets (transfer of money to an exotic offshore trust, bankruptcy planning, sham transfer to one’s relatives, hiding money under the mattress, etc.). Some of these techniques are more complicated than others, and some people will have moral reservations about deploying certain kinds of shielding techniques, or self-interested concerns about the effects of shielding on their credit scores, but overall, there is a real temptation here – especially since criminal enforcement against those who shield is quite rare. Given this temptation, it is puzzling why people do not shield assets more often. More generally, because avoiding judgments through asset shielding undermines many private legal obligations, it is important to have an account of when people would choose to meet their obligations and, if they decide to shield, the magnitude of assets that would be shielded.
In the paper I develop such an account which, interestingly for the private law theorist, draws on an old, almost invisible, and prevalent yet understudied principle of property law—the recourse principle. This is the principle that holds that debts are fungible; that money is not earmarked; that each asset in the debtor’s portfolio is substitute for another (with some exceptions, of course). It is the default rule for most credit transactions. To provide a basic understanding and appreciation of this principle, consider the following example. Suppose that a borrower has a loan for $10,000 secured by some collateral asset. The loan, we will suppose first, is a non-recourse loan, meaning that the lender is limited to collecting only from the collateral. Now suppose that by the time that the loan is due, the borrower has $15,000 in assets and the collateral is valued at $10,000. In this case, it will generally be in the borrower’s incentive to shield the $10,000 owed. Even if it will cost, say, $8,000 to move the collateral to an offshore account, this will still be “cheaper” than paying the $10,000. (Shielding will save $2,000.) However, if we introduce the recourse principle, as is the case in most loans, the analysis changes completely. Now, spending $8,000 on shielding the $10,000 will be necessarily irrational, for the simple reason that the creditor will be able to avail herself of the remaining $15,000 that are left exposed. To avoid even one dollar of the debt, the borrower will have to shield at least $15,001 dollars. Shielding this amount is more expensive than just shielding $10,000, and if the cost of shielding a minimum of $15,001 exceeds $10,000 then it will no longer be economically rational to shield assets. (note that this conclusion holds even though it was assumed that there is perfect shielding technology, so that once shielded, these assets cannot be recovered.) In sum, the recourse principle limits the incentive to shield because it essentially raises the value and magnitude of assets that one would need to shield to obtain the benefits of shielding.
Attention to the recourse principle has various implications for commercial and contract law. The primary implication, which is perhaps counter-intuitive, is that the wealthier a person is, the less likely she is to shield assets—holding debt equal. The reason, illustrated by the example above, is that for the same debt, a richer borrower would have to shield more assets than a poorer borrower. Shielding larger amounts ordinarily will be more expensive, thus reducing the incentive to shield. The other side of this conclusion is that poor debtors have a much greater incentive to shield ex-post. This will lead lenders to be less willing to lend in the first place, thus potentially leading to so-called ‘poverty traps’. Normally, when people feel that they can do better ex-ante by limiting their future opportunities, they seek a commitment mechanism: some way to ensure the other side that they will not ‘defect’ if a better opportunity presents itself. Indeed, most of contract law can be thought of as an elaborate commitment mechanism. Unfortunately, in the context of asset shielding, contracts falter as a commitment mechanism. The reason is that damages for breach are for the most part pecuniary. If a borrower breaches an obligation not to shield assets, this simply means that she owes an additional uncollectable debt. The problems with weak contractual mechanisms may suggest a role for public investment in the enforcement of private obligations as means of fighting poverty traps—a topic I seek to explore in future work.