The case for imperfect enforcement of property rights.

• Author: Bell, Abraham

INTRODUCTION I. AN IMAGINARY WORLD OF PERFECT ENFORCEMENT II. THE DISTORTIVE EFFECT OF STATE ENFORCEMENT A. Prepay Pumps B. Copyright Formalities C. Policing Land Boundaries D. Trade Secrets E. Deductibles III. IMPLICATIONS FOR PROPERTY THEORY CONCLUSION INTRODUCTION

There is nothing so uncontestable as the incentive of an owner to safeguard her belongings. Yet property law contains various rules and doctrines that force owners to adopt measures to protect their assets. For instance, a number of regulations and administrative procedures require owners of gas stations to use "prepay pumps" to eliminate the threat of customers pumping gas and then fleeing before paying. (1) Pre1976 copyright law provides another example: historically, authors of copyrightable works lost ownership rights if they published the works without affixing proper notice to all copies of the work, and thereby notifying potential users of the copyright claim. (2) The law of trade secrets supplies a third example: the Economic Espionage Act explicitly requires "reasonable measures to keep ... information secret" as a condition of enjoying legal protection for the information as a trade secret. (3)

These and similar state-imposed demands on property owners seem puzzling and counterintuitive. After all, property owners have their own incentives to voluntarily adopt measures to secure their entitlements in their belongings. So why do lawmakers deem it necessary to enact rules to induce behavior that would happen in any event?

In this Article, we argue that one solution to the puzzle lies in an important and underappreciated countereffect emanating from state enforcement of property rights. The accepted lore among property theorists is that state enforcement of private property rights is both desirable and efficient due to economies of scale and scope that can be realized via this centralized enforcement. (4) Going against the conventional wisdom, we argue in this Article that state enforcement also has a downside: it may give rise to a moral hazard problem that distorts owners' investment incentives, causing them to take suboptimal precautions to protect their property and externalize those costs onto the state instead. After all, it is easy to think of some cases where owners can protect their property rights more cost-effectively than can the state, and of other cases where a combination of private and state provision of enforcement is optimal. For instance, in many cases, mandatory registration requirements provide a far cheaper and more effective means of protecting many kinds of property rights than any action the state may take alone.

The idea of moral hazard is not generally thought to be central to property law. Rather, the moral hazard problem is most widely recognized in the insurance context. For our purposes, moral hazard is best defined as the extraneous risk taken on by parties as a result of insurance insulating that party from loss from the risk. (5) When a person buys full insurance for her losses, she no longer has an incentive to invest in private precautions to prevent the relevant harm from materializing. (6) For example, an automobile owner who has full insurance against theft may not bother to install a car alarm because it would be cheaper to collect on the insurance policy than it would be to install the alarm. To combat moral hazard, the insurance industry must protect itself by denying coverage to policy owners who do not adopt such precautionary measures, (7) denying payment to policyholders who fail to undertake required precautions, (8) or requiring the insured to maintain some financial exposure to risk. (9)

Although best known in insurance settings, problems of moral hazard may arise in other contexts as well. For property scholars, the most familiar context is takings compensation. Under the Takings Clause of the Fifth Amendment, (10) the government must pay just compensation to private property owners from whom it has taken property. (11) The just compensation mandate has sparked a lively scholarly debate about the optimal compensation measure. (12) It is easy to justify--on an intuitive level--that a government must make condemnees whole by paying them for the loss they have suffered as a result of the government taking. Yet economists Lawrence Blume, Dan Rubenfield, and Perry Shapiro take issue with this intuition. (13) They point out that payment of full compensation to aggrieved property owners can distort the owners' primary behavior by creating moral hazard problems, thereby inducing them to overinvest in assets. (14) In other words, asset owners who know that they will receive full compensation from the government are prone to making suboptimal decisions concerning the location of their properties and how much to invest in them. For instance, where buildings are likely to be taken and destroyed to make way for a public project, it would be best for society if owners were to refrain from overinvesting in the buildings' development; however, takings compensation may induce the owners to invest anyway, secure in the knowledge that the developments will be paid for in the event of a taking. Blume, Rubinfeld, and Shapiro's insight has been accepted and expanded upon by many takings scholars (15)

The takings context is not unique. As we show in this Article, a similar problem pervades the entire law of property. State enforcement of property rights resembles a form of insurance policy for property owners in several important respects. Like insurance, state-sponsored enforcement of private property rights can distort investment decisions and lead owners to invest excessively in assets or to under-invest in preventing harm. Thus, as with insurance, the state should combat this moral hazard in certain instances by requiting owner-sponsored protections or by making owners bear part of the losses.

Imagine a legal regime under which the government undertakes to make whole every aggrieved property owner for harm she suffers from violations of her property rights. It is easy to see that under this regime, property owners would have little incentive to protect their belongings. Since compensation would be completely independent from the level of precautions taken by the owner, rational owners would find it in their best interest to invest as little as possible in precautions. A gas station owner who knows that police will stop gasoline thieves attempting to pump gas without paying will feel no need to take her own measures to prevent theft, even if police enforcement is more expensive than the measures that she herself could take.

To be sure, state enforcement in the real world falls short of providing full insurance to property owners. First, state enforcement is largely deterrence-based, as opposed to compensation-based. The state does not guarantee that it will pay property owners the value of their property if it is compromised, converted, or destroyed by others. For example, if Mice converts Beatrice's laptop, uses it, then burns it, Beatrice will not be able to collect compensation from the state even if Mice is apprehended. Of course, Beatrice may be able to recover the value of the laptop from Mice by bringing a conversion action against her. If Mice is judgment proof, however, Beatrice will not be made whole. Thus, where the state fails to achieve absolute deterrence, owners cannot view state enforcement as the perfect equivalent of insurance.

A second difference between insurance and state enforcement in the real world concerns the rate of wrongdoer apprehension. Unlike insurance arrangements that guarantee compensation to policy holders, the state enforcement system can only operate if the wrongdoer is first apprehended, and the rate of such apprehension is far from perfect. (16) Thus, even where full compensation is theoretically available to the owner--for instance, where the thief is not judgment proof and a civil action is available--the owner may not receive full compensation because the thief cannot be identified.

Contrary to conventional wisdom, we argue that this lack of perfect enforcement could actually be a good thing. (17) As we will show, in a world with perfect enforcement, property owners will refrain from taking any measures to protect their property, even if those measures are as effective as state protection and could be implemented at a lower cost.

We do not mean to claim that the current level of protection is optimal. Rather, we posit that the optimal level of enforcement--whatever it may be--falls short of perfect enforcement. Perfect enforcement is liable to distort owners' investment incentives and create a moral hazard problem. By contrast, imperfections of state enforcement of property rights may sometimes mitigate this problem by giving owners an incentive to invest in private protection measures. Hence, perfect state enforcement of private property rights is not universally desirable, as it may lead owners to overinvest in their assets or underinvest in protecting their assets.

Relatedly, our analysis suggests that policymakers should be especially concerned about the moral hazard problem in the following two scenarios. The first scenario occurs when existing state enforcement of property rights is nearly perfect, such that the probability of apprehending offenders is almost absolute. The second scenario occurs when the law provides property owners with supercompensatory remedies that give aggrieved owners compensation above and beyond their loss. In these cases, it makes sense for lawmakers to adopt the same measures that private insurers use to combat moral hazard problems. Such strategies include reducing the expected recovery amounts (a measure akin to the use of deductibles in the insurance context), forcing property owners to take certain affirmative steps to protect their property (a measure akin to insurance companies' denial of coverage to policyholders...