Incorporation Rules

Abstract

Following Calabresi and Melamed, legal theory has employed the property rule/liability rule distinction in order to hone our understanding of existing norms, as well as suggest new ones. This paper suggests an addition to the pantheon in the form of a protocol that we call an “Incorporation Rule”. It is a novel mechanism allowing private parties and courts to combine property rule and liability rule protection where both apply to the same entitlement. Incorporation Rules allow for separating the effects of intertwined property and liability rules, focusing on ex ante voluntary determination of levels of protection usually adjudicated ex post. Under the protocol, the entitlement is transferred to a special-purpose corporate vehicle, which then issues tailor-made securities to the owner of the entitlement and to the potential buyer or frivolous user. In this manner, the entitlement is split along the contours of three basic corporate instruments — heterogeneous capital structure, separation of ownership and control, and an independent legal personality. By relying on these known-and-tested corporate mechanisms, risk and transaction costs are minimized, enforcement is improved, and heterogeneous preferences of individuals can be accommodated. The Incorporation Rule protocol thus allows for flexibility in protecting entitlements while facilitating efficient exchange.

Keywords: Calabresi & Melamed, property rules, liability rules, bilateral monopoly, options

JEL Classification: K00, K110, K200, K220