Incorporation Rules

See Calabresi and Melamed (1972). For a thorough discussion and analysis, see Cooter and Ulen (2011:99–106), Posner (2010:68), and Kaplow and Shavell (1996).

Calabresi and Melamed’s work on alienable entitlements introduced the difference between “property rules” and “liability rules”. Property rules protect an entitlement by prohibiting its taking unless the owner’s consent is obtained. Liability rules protect an entitlement by mandating that any taking be conditioned upon compensation paid to the owner of the entitlement. The amount of the compensation is to be set by a third party, for example, a court or a regulating agency. For a description of the Calabresi and Melamed literature, see Bell and Parchomovsky (2002:1) (describing the evolution of the property rules – liability rules scholarship).

The concept of a residual owner (also known as the residual claimant or the residual risk bearer) is borrowed from the theory of the firm to emphasize the nature of the contractual relationship between the seller of the entitlement and the buyer, their conflicting interests, and their incentives with regard to utilizing the entitlement once control of it is granted to the buyer. A residual owner is the one whose interests would be best aligned to utilize the entitlement optimally (constrained only by his own limitations). For a discussion and a more formal definition, see Fama and Jensen (1983:328–329).

See, e.g. Schulz (discussing a case study, the problems it generates and possible solutions).

For the classic description of the problem, see Heller (1998).

Calabresi and Melamed identified of a third type of rules – inalienability rules. This latter type of rules is less relevant to the discussion here but is important in other contexts. See, e.g. Fennell (2009).

For a comprehensive overview of the literature, see Farnsworth (2007:188-197) and Smith (2004:1731–1748).

See, e.g. recent examples: Hylton (2011) (defensive conduct in tort law), Hylton (2012) (criminal law), Rule (2010) (solar access laws), and Lehavi (2006) (land use controls).

See Polinsky (1980:1078), Walgreen Co. v. Sara Creek Properties Co., 966 F.2d 273, 278 (7th Cir. 1992) (Judge Richard Posner describes the pervasiveness of the hold-out problem), Heller (1998), Lessig (2001:203, 260), Fennell (2004:983), and Bell and Parchomovsky (2010:1674).

See, e.g. Krier and Schwab (1995:465) and Rose (1997:2183).

See, e.g. Bell and Parchomovsky (2007:885–890) (discussing the context of eminent domain), Ayres and Talley (1995) (discussing the problem in a general bargaining context), and Keenan and Wilson (1993) (discussing the context of bargaining). Note that in standard accounts of asymmetric information contexts, the informational discrepancy that generates a problem concerns the owner’s reserve price for transferring his entitlement. The case at hand raises a preliminary question also with regard to the price of the entitlement itself to others besides the owner. See, however, Wonnell (1991:360–362) (discussing asymmetric information problems with regard to the value of assets).

Leading contributions include Morris (1993); Ayres and Talley (1995); Krier and Schwab (1995); Ayres and Balkin (1996); Epstein (1997); Levmore (1997); Rose (1997); Ayres (1998, 2005); Fennell (2005); and Avraham (2004).

One of Calabresi and Melamed’s innovative insights concerned the introduction of the four rules menu, which describes a protection protocol crossing the initial allocation of the entitlement (either to the pollutee or to the polluter) with the method of protection (either property rule or liability rule). This menu allowed Calabresi and Melamed to point to an insight – Rule 4 – according to which the initial entitlement is assigned to the polluter but is protected by a liability rule. Rule 4 means that the pollutee can decide to cease the pollution in exchange for compensation paid to the polluter, covering either the polluter’s costs of shutting down or relocating elsewhere. See Calabresi and Melamed (1972:1115-1117). Rule 4 was in fact already suggested in literature sometime earlier in Atwood (1969:315). Both Rules 2 and 4 demonstrate how an holder of an option can buy the entitlement from its holder in exchange for the exercise price.

While protecting entitlements with a call option (i.e. an option to buy an entitlement) has been widely accepted, the protection of entitlements with a put option (i.e. an option to sell an entitlement and in exchange be paid a fixed price) has been met with resistance. See Levmore (1997:2160–2168) (criticizing a rule which embodies a put option, allowing the polluter to stop polluting and collect the pollutee’s forgone damages, or alleged gain from cessation) and Epstein (1998) (criticizing the use of financial economics to analyze Calabresi and Melamed). In fact, adding put options into the menu of property and liability rules mandated the recognition of two additional rules to the four already recognized. These rules may certainly prove problematic to anyone who does not envision efficiency as a primary goal. Consider, for example, “Rule 5”, which allows a polluter to choose to either continue polluting or stop polluting and collect damages from the victim. See Krier and Schwab (1995:471–472); Ayres (2005:15). Moreover, the application of the mechanism leads to several distributional effects because it actually splits, sometimes awkwardly, various entitlements between the parties. See Rose (1997:2178–2179). “Rule 5”, for example, makes the victim subject not only to pollution but also to the possibility of having to “buy” from the polluter the latter’s entitlement to pollute. In other words, the victim is worse off when compared with a traditional victim of pollution. Such results have led critics to argue that protecting entitlements with puts is, at the very least, impractical. See Epstein (1997:2093–2094). Nevertheless, real-life examples demonstrating common law use of puts do exist. See Ayres (2005:29–36) (suggesting put options as a solution for nuisance disputes).

See Fennell (2005:1415–1416). In option terminology, the call option is “in the money”.

In option terminology, the call option is “out of the money”.

See Ayres and Talley (1995:1038–1039); Ayres and Balkin (1996).

See Ayres and Talley (1995:1029–1030).

See Avraham (2004:270) (arguing that the law should employ a pair of options).

See Fennell (2005:1433–1440). Introduced by Professor Fennell as an alternative to the classic property rule – liability rule dichotomy, and building on insights from the literature on self-assessed valuation mechanisms, an ESSMO regulation makes the holder of an entitlement package his true subjective valuation of his entitlement in the form of an option, to be exercised, or not, by another. Thus, an ESSMO creates a liability rule, which enables a unilateral transfer of an entitlement (the other party can unilaterally decide whether to take the entitlement and pay the required compensation), while allowing an entitlement holder to set himself the option’s exercise price and thus package into the price his subjective valuation of the entitlement. The ESSMO mechanism overcomes the problem of the entitlement holder’s incentive to lie about his true subjective valuation by ensuring that both too-high and too-low valuations will carry negative consequences. To illustrate, consider a classic historical example – the law of general average contribution in Admiralty. Under this rule, shippers are required to place a value on the goods they ship aboard a vessel. In case of a storm at sea, the captain of the vessel might decide to toss some of the cargo to save the ship. Of course, in such a case, the owner of jettisoned cargo would be compensated. The valuation of each shipper serves as a basis to the captain’s decision whether to toss the cargo, and later, the compensation payment, if the shipper’s cargo was in fact tossed from the vessel. However, each shipper’s valuation also serves to decide on the percentage of his participation in compensating the shipper whose cargo was tossed. In short, “Value one’s good too low, and they become more likely to be tossed overboard, in which case one will get too little compensation. Value one’s goods too highly, and one will almost certainly avoid having them cast into the sea, but one will have to pay proportionately too much to compensate the owners of the goods that were jettisoned”. See Fennell (2005:1441). For a discussion of the self-assessment literature, see also Bell and Parchomovsky (2007:891–892).

Using the corporate form to generate options has been suggested as a solution to the takings problems, by which eminent domain powers are used to confiscate private property for public use, see Lehavi and Licht (2007). There, the issue tackled is that of under-compensation to original owners due to the liability rule exercised, or taking at (current) market price. Since takings by eminent domain powers often increase property value, they suggest incorporation of the contested asset in order to allow previous owners a fair share of asset appreciation. While they do not directly phrase their suggestion in the language of real options, the result is similar. Despite superficial similarities, their suggestion is a very narrowly-construed private case of the general mechanism we propose. To illustrate the difference, consider the taking in eminent domain scenario: according to the Incorporation Rule protocol, when applied to this case, the residents should not become the residual owners of the corporate vehicle (holders of common stock shares) but rather a preferred share holders. The common stock shares should be allocated to the state.

As will be explained shortly, the amount x can be dictated in some cases by the court (establishing a liability rule protection for the seller’s basic entitlement, e.g. in cases such as I), or in other cases can be agreed upon by the parties (establishing a property rule protection for the seller’s basic entitlement, e.g. in cases such as II).

Preferred shares can be explained as a hybrid of the two basic patterns of financing used by the firm, which are common stock (equity) and debt. See, e.g. Klein and Coffee (2004:302). The primary purpose of a preferred share is usually to give its holder the entitlement to a dividend of a specific amount, which precedes the entitlement of the common shareholder, while preserving the preferred shareholder’s claim as a residual rather than as a fixed one.

Animosity is most often present when bargaining occurs between parties to a pre-existing dispute, see, e.g. Farnsworth (1999:381–384). Endowment effects can serve to create an impasse in bargaining when parties focus not just on the underlying asset but also on the gains from trade. When parties seek “at least a fair share”, and assume the other is shading her offer, they react in kind – leading to the forgoing of a mutually beneficial deal. See, e.g. Babcock and Loewnestein (1997).

Further derivations are necessary to specify how the distribution of preferences involved with multiple buyers might influence some of the results obtained herein. We thus focus on the unitary buyer, and issues involving multiplicity are left for further research.

Bell and Parchomovsky (2002).

For example, the “Fair, Reasonable, and Non-discriminatory” terms common to standard-setting organizations. Courts dealing with add-on pricing and granting competitors access to essential facilities impose similar constraints, see, e.g. Eastman Kodak Co. v. Image Technical Services, Inc. (Kodak), 504 U.S. 451 (1992); Aspen Skiing Co. v. Aspen Highlands Skiing Corp., 472 U.S. 585 (1985).

See, e.g. Williamson (1983).

See Bell and Parchomovsky (2002:53).

See the discussion in Section 2, supra, following reference to Footnote 14.

Taking into account that above a threshold depending on specific functional forms f(y) = 0 (deeming the coupon overpriced) and below other thresholds f(y) = 1.

When wishing to focus on protection of sellers’ property interests, we might separate between sellers’ valuation of the non-economic harm suffered by high-intensity usage and their profit motive. Such a formulation would be: EΠS=x+y−yTRUE•fy−yTRUE where sellers maximize their expected profit only as to the premium above the minimal necessary compensation for suffering such harm. Qualitative results of both formulations are similar, thus we concentrate on the more general case.

See, e.g. Easterbrook and Fischel (1991:15).

See Brealey et al. (2006:15–16), at 541 (characterizing various securities issued by a corporation as a set of options with regard to the corporation’s assets); Bebchuk (1988) (characterizing each claim against a financially distressed firm as an option to receive the assets of the firm conditioned on payment of all higher-ranking claims and suggesting that corresponding options be issued to each claimholder in order to rearrange the capital structure of a financially distressed firm).

See, for example, the authorities cited in Footnote 14.

See Fennell (2005:1466).

Fennell (2005:1407).

Fennell (2005:1466).