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1-2006 Numerus clausus: An economic perspective Wei ZHANG Singapore Management University, [email protected]

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Citation ZHANG, Wei. Numerus clausus: An economic perspective. (2006). Social Sciences in China. 4, 1-16. Research Collection School Of Law. Available at: https://ink.library.smu.edu.sg/sol_research/2607

This Journal Article is brought to you for free and open access by the School of Law at Institutional Knowledge at Singapore Management University. It has been accepted for inclusion in Research Collection School Of Law by an authorized administrator of Institutional Knowledge at Singapore Management University. For more information, please email [email protected]. University of California, Berkeley

From the SelectedWorks of Wei Zhang

2006

Numerus Clausus: An Economic Perspective Wei Zhang, University of California - Berkeley

Available at: http://works.bepress.com/wei_zhang/3/ Numerus Clausus: An Economic Perspective1

Zhang Wei*

伴随中国物权法与民法典的制定，海峡两岸对物权法定原则质疑日渐增多，这促使我们重新审 视物权法定的一些理论问题。本文运用经济分析方法，从信息成本外部化与挫折成本这两个方面探 讨物权法定以及物权自由的成本—效益问题。由此得出结论：物权法定的挫折成本主要源自法律对 物权、债权的不同救济方式，而物权自由的信息成本外部化则是局部性的。因此，在规范上，推翻 物权法定不是降低挫折成本的唯一途径，而信息成本外部化也不必然要求否定物权自由。

I. Introduction of property rights just as contract law does to the contractual arrangements between Numerus clausus refers to the principle private parties. Due to the vagueness of the that both the form and the substance of a “freedom of property rights” concept, we property right shall be prescribed by the law, assume that the parties are totally free to which essentially restricts the freedom to devise their property rights under a regime “customize” the legally enforceable property without the numerus clausus principle in Part interests.2 It has long been regarded as a ba- II of this paper, and try to set up some limi- sic principle in Civil Law countries, while tations on this freedom in Part III. the recent studies of U.S. scholars suggest In this paper, we will explore the costs that its essence exists in the Anglo-Ameri- and benefits of the numerus clausus principle can law as well.3 as well as a property regime without it, us- In the ongoing legislative process of the ing an “information cost externality versus Chinese Property Law and the Civil Code, frustration costs” framework.4 The paper is however, the numerus clausus principle is centered on positive analysis elaborating the increasingly called into question by Chinese possible consequences under each of the two writers from both sides of the Taiwan property regimes. We do not attempt to make Straits. Yet those who advocate an entire or a direct choice for the policy-makers though partial abolition of this principle fail to spell certain normative implications will be men- out the exact meaning of the “freedom of tioned in Part III. property rights” which they are arguing for. Absent numerus clausus, it is still possible to II. Information Cost Externality versus set certain restrictions on the customization Frustration Costs NUMERUS CLAUSUS 41

1. Information cost externality nality exists with respect to the originating (1) Merrill and Smith’s theory parties and the potential successors in inter- Merrill and Smith suggest that “(p)arties est because any change in the value of the who create new property rights will not take interests resulting from the creation of new into account the full magnitude of the mea- property rights will be reflected in the deal- surement costs they impose on strangers to ing prices among these parties. The infor- the title.”5 They point out three classes of mation cost externality, however, does af- individuals who may potentially be affected fect the other market participants. First, since by the creation of idiosyncratic property a legally permitted Monday-only property rights: 1) the originating parties, the partici- right is created in A’s watch, for fear of pants to the transaction creating such new potential claims from third parties, F may rights; 2) the potential successors in interest, have to investigate whether the same right those who will succeed the property inter- exists in E’s watch which he is going to buy, ests from the originating parties; 3) the other while E might also need to disclose to F market participants. And the third class can whether such right is in existence. These be further divided into two subclasses. In costs of investigation and disclosure exter- the first are the individuals dealing with the nalized to E and F come from the same type of assets as the one in which the customization of the nonstandard property originating parties create new property rights. right between A and B. Second, concerned The second subclass includes all other people about violating the new property right in A’s that do not transact with the above type of watch, Is and Js will be obliged to collect assets yet must avoid violating property rights information about it as well. Again, these in- in all these assets. Merrill and Smith offer formation costs are not to be borne by A or the following example to illustrate their idea. B.7 In this paper, the externality arising among A is the sole owner of a watch. He wants to the first subclass of other market participants, create a “time-share” in it, a fancy under the such as E and F, is referred to as “the first current property law, and transfer this right level information cost externality,” and the to B, which allows B to use the watch only externality affecting the second subclass, on Mondays. In this example, A and B are i.e. Is and Js, as “the second level informa- the originating parties. Those who might tion cost externality.” According to Merrill purchase A’s reserved rights in the watch and Smith, the numerus clausus principle, by as well as who succeed to the interest ac- compulsory standardization of property quired by B are the potential successors in rights, is one way to control the externalized interest, named respectively as Cs and Ds. information costs to third parties. Anyone selling and purchasing rights in other Let’s turn to the second level informa- watches, Es and Fs, are in the first subclass tion cost externality first. Do Is and Js nec- of the other market participants, while the essarily need to know about the new right in remaining market participants, identified as A’s watch at additional costs in order to avoid Is and Js, make up the second.6 violating such a right? The answer should Merrill and Smith argue that no exter- be negative. Although property right is in 42 SOCIAL SCIENCES IN CHINA Winter 2006 rem, general market participants are charged meaning is applied, then potential buyers do with no more than a duty of abstention.8 To not have to investigate the property rights in observe this duty, they do not need to know the subject matter of purchase, while sellers who has a property right or what the right is. merely need to disclose nonstandard rights Knowing that I do not have a right is when they do exist. In other words, in this sufficient. Therefore, the second level ex- case, information costs incident to the cre- ternality appears to be imaginary even under ation of new property rights are completely a property regime without numerus clausus,9 internalized by the originating parties. Using provided that the ownership cannot be de- Merrill and Smith’s illustration, we can find vised freely and that nobody is allowed to that, in essence, there are only A, B, C, D in customize a property right beyond his power the market but no E or F exists if all pur- as an owner. This point is convincingly il- chasers without actual notice are protected lustrated by the fact that we hardly, if ever, as bona fide purchasers. consult the registration to avoid violating Second, “bona fide purchaser” may also other people’s rights in real estates in spite be limited to the acquirers not only without of the existence of well organized land reg- actual notice but also with no constructive istration systems in both Common and Civil notice, i.e., those who do not know and Law countries. Only the current and poten- should not have known the fancies.10 Under tial holders of property rights (like A, B, and this interpretation, the occurrence of infor- C, D) will have the incentive to investigate mation cost externality will turn on the dif- the substances of these rights. ferent systems for information disclosure. As to the first level information cost The information cost externality does externality, it can be a real problem if there not arise in a decentralized disclosure sys- is no legal protection for bona fide tem where the originating parties disclose the purchasers. As we see under modern prop- customized property rights on a one-on-one erty regimes, however, bona fide purchas- basis. In such a system, the potential buyers ers will rarely be obligated to honor the idio- have but one way to obtain constructive syncratic rights. So next we are trying to notice, namely, the direct disclosure by the analyze the first level information cost ex- creator of the novel rights. Essentially, the ternality with the bona fide purchaser pro- distribution of information costs among the tection rules in place. transacting parties remains identical in the (2) Taking the Bona Fide Purchaser Pro- decentralized system, no matter how “bona tection Rules into Account fide purchaser” is defined. In Merrill and The term “bona fide purchaser” can be Smith’s example, this means that F will be possibly interpreted in two ways. First, it may protected as a bona fide purchaser insofar refer to purchasers who do not have actual as E does not disclose the “time-share” in notice of the encumbrances in assets. They his watch, and that E need not make any are not required to honor any unknown fancy disclosure unless his watch does bear such in the assets to be acquired, even if their ig- an interest, yet the existence of a “time-share” norance results from negligence. If this in A’s watch is totally irrelevant. NUMERUS CLAUSUS 43

Things will change, however, in a cen- nitude of such decrease and may be con- tralized disclosure system. Real estate regis- cerned about, among other things, the reli- tration may be the most familiar paradigm of ability of network or the necessity of backup a system where information is gathered and in hard copies. It is the technical experts that disclosed collectively. Externality will become are more appropriate to make these a real issue if the information about a non- estimations. Above all, even though the mon- standard property right is so released. Again, etary costs for establishing and maintaining we take Merrill and Smith’s “time-share” in filing systems reduce to zero, opportunity a watch as an example. Consider that the costs are still unavoidable for those who “time-share” created by A is the first non- make or check filings and who keep the sys- standard property right in a watch and that it tem running. In this sense, technological must be disclosed by filing. This invention development is not bound to eliminate these brings about two kinds of information costs two kinds of externalities. that are not to be borne by A or B, the origi- These externalized costs are distinct in nating parties. One is the cost of establish- one aspect: after a new property right is cre- ing a filing system for watches, including ated in a particular type of assets thus giving the expenses for devising and maintaining this rise to the externalities, the marginal costs system. The other is the information costs will increase only insignificantly when a sec- incurred by potential buyers of all watches ond nonstandard right turns up, regardless in verifying the legal dimensions of the of whether the second right is in the same property. When F wants to buy E’s watch, category as the first one. Once a filing sys- he will have to check whether the novel right tem for watches is built up because of the exists in that watch by consulting its filing, “time-share” coined in A’s watch, then the because F will assume any filed fancy in E’s “system costs” as well as the “nonuser watch even without actual notice. The first costs” have already sunk. These costs will kind of externalized costs falls on the whole largely remain unchanged when another society, and according to Hansmann and “time-share” or a “place-share” is created in Kraakman, this can be regarded as “system E’s watch.13 As a result, the legal restric- costs”; the second kind, which is borne by tions set on the forms of property rights have those who do not use the nonstandard prop- a bipolar character for a given type of assets. erty right, parallels the “nonuser costs” in The law tends to either permit no exceptions their framework.11 Some writers argue that to the prescribed forms or provide for an with the development of computer and open-ended set of forms that can be cus- internet technologies, costs involved in the tomized freely.14 operation of filing systems tend to decrease Is it practical to internalize the above two consistently, and therefore, the legal dimen- costs by charging fees?15 This may not be sions of more assets can be disclosed col- an easy task. As stated above, even a single lectively through filing systems.12 Indeed, this nonstandard property right in a certain type prospect seems highly credible, yet lawyers of assets will suffice to initiate almost the may find difficulties in estimating the mag- entire “system costs” and “nonuser costs” 44 SOCIAL SCIENCES IN CHINA Winter 2006 if this right is to be disclosed in a centralized property law and believe that the generative system. Consequently, the externality can- power of the system of property rights will not be ruled out unless the fees charged to help lower the frustration costs. They com- the originator of such a right are equivalent pare the inventory of property rights pre- to the sum of these two kinds of costs. As a scribed by law to the lexicon of a language, practical matter, nevertheless, it appears un- and the rules for combining property rights feasible to charge that high amount for one to a language’s grammar. The parties can filing. In addition, difficulties may also arise tailor potentially infinite forms of property concerning the appropriate compensation to rights in line with their transaction goals by “nonusers” given that they are not entitled to combining the standard property rights un- collect fees directly from those who make der certain available rules.17 They further filings. Free access to the filings alone will argue that “a complex property rights built not be sufficient as the nonusers’ transpor- from a small number of standard building tation costs or even opportunity costs de- blocks is likely to be easier for third parties serve compensation. Yet overcompensation to process than functionally equivalent com- will probably lead to too many consultations plex property rights for which third parties on filings. In fact, filing fees are usually must figure out the nature of the building charged on a per-item basis or according to blocks.”18 the value of the subject matter to be filed, The soundness of this “generative prop- which is indifferent to actual costs involved erty right” theory is nevertheless subject to in filing itself. These practices may arguably doubt in American law.19 Even if some new be explained as a response to the many diffi- property rights, such as a “tenancy for the culties in internalizing costs. duration of the war,”20 can be generated, it 2. Frustration costs by no means warrants free customization of Frustration costs are usually considered any form of property rights. The feasibility to be the disutility originated from the fact of generating depends ultimately on the na- that mandatory rules sometimes prevent the ture of the building blocks. For instance, it parties from achieving a legitimate goal cost- seems hardly possible, using currently avail- effectively.16 For our purposes, frustration able estates, to imitate the right of entry and costs are costs attributable to the numerus create a future interest shifting the owner- clausus principle, and any goal unattainable ship of land to a third party only upon his even under a regime without this principle choice of accepting the land.21 should not be counted as a source of frus- The generative theory can be more prob- tration costs. In this sense, frustration costs lematic in Civil Law countries. This is due to may well be understood as the difference in the different ways of standardizing property transaction costs of a given deal under a rights in American and Civil Law. The former numerus clausus regime and one without it. emphasizes restricting the forms, and leaves (1) “Generative property right” theory space for customizing the substance of prop- Merrill and Smith apply Noam erty rights. The latter, on the other hand, lim- Chomsky’s Generative Grammar theory to its both the forms and the substance. In the NUMERUS CLAUSUS 45

Japanese Civil Code, for example, there are numerus clausus regime, the parties will re- three types of usufruct rights in land: the sort to the contractual mechanism to achieve superficies, the emphyteusis and the this transaction.24 A comparison is made be- easement. The substance of the first two low between the transaction costs of creat- types is strictly defined, and the parties are ing the property right directly and those re- allowed to tailor the duration of rights only. sorting to contractual arrangements. The easement is the only type that is rela- First, we need to classify the transac- tively open to customization, which is more tion costs to be compared. Usually, transac- or less similar to equitable servitude in Ameri- tion costs are divided into three categories: can law.22 Its non-possessory character and search and information costs, bargaining and dependency on titles of the dominant land decision costs, and police and enforcement nevertheless confine the scope of its costs.25 The first category, the search and application. Using Merrill and Smith’s anal- information costs, is not closely relevant for ogy to language, we can say that the ease- our purposes, because it is always neces- ment is like an uncommon word with a poor sary for the parties to discover each other, potential for combination. In this sense, we to investigate the creditability of their may draw an analogy between the standard- partners, to disclose or search the physical ization of property rights in American law and legal characters of the watch, etc. The and an algebraic expression with plenty of legal devices they are utilizing do not affect variables while the standardization in Civil their costs of taking these actions. The Law is closer to an arithmetic expression amount of the costs depends instead on such composed basically of constants. Against non-legal factors as whether the relevant in- such a legal background, it is more imprac- formation is readily available in the particu- tical to generate new types of property rights lar market, and how well the parties know out of the standard building blocks provided each other. Therefore, we will dispense with by Civil Law. the search and information costs and focus (2) The analysis of frustration costs: on the bargaining and decision costs, and the comparing the transaction costs under the police and enforcement costs. two regimes Two aspects need to be considered when We formulate the following example to we talk about the bargaining and decision facilitate the analysis. A, the owner of a costs. One is the costs involved in the nego- watch, hopes to create a property right in tiations determining the material rights and the watch and grant it to B. This will entitle duties of the parties. The other is the cost B to use the watch on Mondays during his spent documenting these rights and duties in lifetime. Also, B may freely transfer this right certain forms. The former does not vary with while he is alive. But the right reverts to A or the legal devices used to do the transaction. his successors upon B’s death.23 Under a The parties aim to realize the same business property regime without the numerus clausus objective regardless of the legal mechanism principle, A can set up the new property right they are utilizing, so the costs invested in directly and convey it to B, while under a bargaining and decision rest on the parties’ 46 SOCIAL SCIENCES IN CHINA Winter 2006 experiences in negotiations, their bargaining Thus, the marginal cost of inserting these power, the reliability of their partners and clauses is relatively small. In addition, since other business factors. H ow ever, the nu- the effects of a property right do not shift merus clausus principle does make a differ- with the subject matter or merits of the right, ence with respect to the second part. Under it is entirely conceivable that one can design a property regime without this principle, A certain boilerplate clauses meeting the needs and B can simply define the new right in the of all contractual arrangements mimicking watch in their contract, and label it as a prop- the effect of a property right. In that case, erty right. Under a numerus clausus regime, the marginal cost becomes even smaller. though the parties still need to enumerate the Consequently, only minimal transaction costs merits of the right in their contract, they can- will accrue in most cases when the parties not directly characterize it as a property right, have to add the “clauses imitating the prop- but have to design additional clauses to imi- erty effects” under a numerus clausus regime. tate the legal effects of a property right. In Between A and B, the contract itself is other words, the parties cannot use the term sufficient to illustrate the rights and duties. of “property right” to identify the nature of However, disclosure is necessary if a third the new right: rather, they must elaborate on party needs to know the new right A con- the substance of this term in their contract. fers upon B. Under a non-numerus clausus To grant B a right in A’s watch bearing regime where the new right is designated as the legal effects of a property right, the con- a property right, the disclosure is made tract between A and B should stipulate that through entering notation or taking 1) A is prohibited from granting a third party possession, otherwise the bona fide purchas- any right incompatible with B’s right; 2) B ers will not be required to honor the new and the successors of his right can transfer property right. Similarly, under a numerus the right freely and the successors can claim clausus regime, the contract creating the new the right directly against A or his successors; right has to be disclosed to the assignees and 3) neither A nor any of his successors is al- delegatees of the contractual rights and lowed to transfer A’s rights in the watch to duties. In short, regardless of the nature of a third party without delegating A’s duties the right created between A and B, its sub- under this contract; and 4) B, as well as the stance should always be disclosed to suc- successors of his right, is entitled to require cessors of such right and the corresponding specific performance of duties provided in duties insofar as the right and the duties are 1), 2) and 3). These clauses are referred to transferable. Thus, the costs involved in dem- as “clauses imitating the property effects” in onstrating the new right to third parties will this paper.26 arise under both regimes. Of course, adding the “clauses imitat- In a decentralized disclosure system, ing the property effects” entails costs as well. such costs will be the same whether or not Nevertheless, bargaining and decision costs the property regime embodies the numerus have already sunk significantly beforehand clausus principle: A, B may use the same to fix the parties’ material rights and duties. method — e.g. binding the contract to the NUMERUS CLAUSUS 47 watch, or attaching a label to the watch indi- curred by B (and his successors), the holder cating “B is entitled to use the watch and of the right, in seeking legal remedies. please refer to B for details” — to disclose Presumably, there are two major types of the new right in either regime. However, in a violators to B’s right — the owner A (and centralized disclosure system, the costs for his successors) and third parties in general. disclosure can be different under these two With respect to each type, the remedial costs property regimes because the centralized further differ depending on whether the vio- system is applicable only to property rights, lator is in bankruptcy. So the police and en- but not to contractual rights imitating prop- forcement costs should be discussed in four erty effects.27 With respect to originating separate situations. parties like A and B, a centralized disclosure In the first situation where the owner A system might save their costs for disclosure. violates and is not in bankruptcy, B can al- A decentralized systems is probably less re- lege the claims out of property right and re- liable and more expensive to maintain. The quest A to restore his right under a regime label attached to the watch, for instance, may without the numerus clausus principle. To fall off or be falsified, so the parties need to make these claims, B only has to prove that check it frequently. By shifting to a central- A does violate his right. Under a numerus ized system, they can spend less time and clausus regime, however, B must allege a money on these checks. Nevertheless, this breach of contract and seek contractual states but one possibility. The scale of the remedies.30 As the parties have agreed on costs for disclosure tends to vary with the specific performance, normally the results substances of the rights to be disclosed. To are the same no matter whether the contrac- illustrate, imagine that there is a real cov- tual or the property remedy is sought. Also, enant prohibiting pets in a condominium. in the jurisdictions where res ipsa loquitur Perhaps it is much cheaper to disclose this (e.g. Japan) or strict liability (e.g. China) is covenant by posting it in the lobby than fil- applied to the breach of contract, B’s bur- ing it with the real estate registry if the den of proof will not be any heavier. In homeowners have already employed general, B’s costs for seeking legal remedies doormen, as they can take care of the post do not change to any meaningful extent un- at almost no additional cost. Generally der either property regime, as long as he speaking, therefore, with a decentralized dis- brings suits before the statue of limitations closure system, the costs for disclosure are runs out. substantially identical under a numerus In the second situation where A, the clausus regime and one without it,28 while violator, is in bankruptcy, because of the with a centralized system, these costs can priority of property rights, B’s claims out of be greater under a numerus clausus regime property right remain intact in a non-numerus for some rights, yet for others, a regime clausus regime. On the contrary, B’s con- without numerus clausus costs more.29 tractual right enjoys no priority in the bank- Finally, we turn to the police and en- ruptcy proceeding. His right of using the forcement costs and focus on the costs in- watch on Mondays may thus be totally sub- 48 SOCIAL SCIENCES IN CHINA Winter 2006 verted and he may recover no more than the higher policing and enforcement costs. In damages equivalent to a fraction of the value particular, when the violator is in bankruptcy, of this right.31 Such a result cannot be possi- the parties’ business goals can fail completely bly avoided through ex ante contractual with the restriction laid by the numerus arrangements. Therefore, in the second clausus principle. The policing and enforce- situation, the numerus clausus regime may ment costs are the major components of frus- lead to serious frustration costs. tration costs resulting from the numerus The third situation involves the violation clausus principle. This is attributable to the by a third party who is not in bankruptcy. extreme difficulty in establishing, through Without the numerus clausus principle, B is contractual arrangements, the priority com- entitled to a property right and may seek le- ing with a standard property right.34 gal remedies based on claims out of prop- erty right. Under a numerus clausus regime, III. Normative Implications on the other hand, B is granted a contractual right that cannot be claimed against a third 1. Two revelations and one puzzle party. Consequently, he must turn to the rules (1) Two approaches to alleviate the frus- of unjust enrichment or interference of con- tration costs tracts for recovery.32 Yet in either the unjust The most powerful argument against the enrichment suit or the interference suit, B numerus clausus principle relies on its ac- will have to prove more elements, compared companying frustration costs. The theoreti- with asserting the claims out of property cal analysis done above reveals, nonetheless, right, to make a prima facie case. In terms that the frustration costs in a numerus clausus of the remedies, injunctions may be awarded regime comes mainly from the different en- in unjust enrichment suits, but B might forcement rules available to property rights merely recover damages in tort cases. Hence, and contractual rights. Given this diagnosis, the third situation will give rise to high frus- we can easily find two prescriptions: either tration costs as well. to keep the current dichotomy in enforce- Finally, when B’s right is violated by a ment rules and abolish the numerus clausus third party in bankruptcy, he will become an principle, or to keep this principle but elimi- unsecured creditor and wait for distribution nate the disparities in enforcement rules. In if he did not acquire a property right in the terms of lowering the frustration costs, these first place due to existence of the numerus two approaches are supposed to play com- clausus principle. By contrast, he is able to parable roles. So to make a choice between make the claims out of property right under the two may require studies on their differ- a non-numerus clausus regime. Similar to the ences in other aspects, such as the potential second situation discussed above, numerus costs associated with the reform of rules, clausus will also lead to great frustration costs which is beyond the scope of this paper. No in this scenario.33 matter which approach is to be taken, It is evident from the above analysis that however, we can predict for sure that the the numerus clausus regime brings about holder of the nonstandard right will always NUMERUS CLAUSUS 49 prevail over the unsecured creditors of the new items are added to the list of property grantor or violators of this right. In other rights. Hence, if a centralized system helps words, for these creditors, these two ap- reduce the costs for disclosing the individu- proaches lead to the same end. ally tailored rights in these assets, such rights (2) Rights that need to be earmarked as may as well be designated as property rights, property rights though they are probably not so sensitive to The analysis in Part II indicates that the bankruptcy as is the security interest. priority of property rights cannot be easily (3) Why strictly restrict property rights established by contractual arrangements, and in real estate the policing and enforcement costs are es- If a centralized disclosure system al- pecially high when the grantor or violator of ready exists for a certain type of assets, no the novel right is in bankruptcy. Therefore, further information cost externality will ac- among the rights in property, those particu- crue by adding new forms of property rights. larly sensitive to bankruptcy are most in need This lends support to free customization of of being earmarked as property rights to en- property rights in that type of assets. Yet the sure their priority. A typical example is the property rights in real estates are strictly re- security interest, the essential function of stricted in both Common Law and Civil Law which is to create priority over other credi- countries, although the registration systems tors in a bankruptcy proceeding. There has for real properties have been functioning, at been a fair amount of literature advocating least in some of these countries, for centuries. more freedom to customize security Certain historical backgrounds may account interests. The enormous transaction costs for this conservatism,36 but do these restric- involved in imitating the priority effect of tions still serve the needs of modern society? security interests through contracts is the key They are at least unwarranted under our ana- rationale behind our support of these lytical framework. It is worth mentioning, arguments. however, that the development of equitable Whether to earmark a right as property servitude in the Anglo-American legal sys- right is one thing; whether to disclose the tem does signal some compromise of nu- information of such a right through a cen- merus clausus with respect to real property.37 tralized system is quite another. When mak- This being said, it might still be too early to ing decision on the second issue, we need to decide whether such compromise is but an compare the “users’ savings” from disclos- isolated coincidence or represents an ongo- ing through a centralize system with the sum ing retreat of the numerus clausus principle. of the “system costs” and the “nonuser costs.” 2. Numerus clausus and the current Only if the former outweighs the latter should Civil Law property right system a centralized disclosure system be applied.35 (1) Ownership In terms of the assets that already have The concept of ownership refers to the a centralized system for disclosure, such as most complete property right in an asset that real estates, the information cost externality can be enjoyed by a private person in a Civil will not be aggravated significantly even if Law property system. It also serves as the 50 SOCIAL SCIENCES IN CHINA Winter 2006 basis for creation of the other two catego- byproduct of such free customization of ries of property rights — the usufruct rights ownership. Now that A is allowed to declare and the security interests. We have assumed a 3-mile overlooking right, who knows that so far that the substance of the ownership is he has not declared a 30-mile or even 300- not subject to personalized designs. Now let mile right? Consequently, any party planning us explore the reasons for prohibiting such to build up a mansion or fly an aircraft within designs. To customize an ownership is, in a reasonable radius from A’s land will have essence, to either narrow or expand the le- to make out the exact merits of A’s right to gally prescribed scope of the power of the avoid violation. owner. On one hand, to narrow the scope is Secondly, allowing the free custom- effectively equivalent to giving up certain le- ization of ownership will directly compro- gal entitlements, which is usually no big is- mise the distribution standard set by law. For sue insofar as the abandonment is made at example, the current rules governing the ad- the owner’s free will. On the other hand, jacency relation require the landowner, A, however, the expansion of powers deserves not to block the natural flow of ground wa- close observation. ter coming from a neighboring piece of land, First, we shall explore the problem of which means that the law allocates the right efficiency. If the legally defined scope of of passage of water to the neighboring private ownership can be altered unilaterally, landowner, B.40 If A is free to change this then owners will have the potential power to allocation of rights and forbid the water flow encroach upon each other’s domain of from B’s land, B will have to either refrain ownership. To illustrate, suppose A declares from draining water through A’s land or pay that the ownership of his land embodies a A for removal of such prohibition. This way, right of overlooking within 3 miles. Similarly, the distributional standard established by the B, the owner of the adjacent land, announces law will be overthrown. In short, if we be- that his ownership includes a right of drop- lieve that the legal rules prescribing the scope ping farm chemicals from airplanes over his of ownership represent the legislature’s land. The law must then decide which of sense of equality, any alteration of this these two individualized ownerships should scope at odds with such a sense should be prevail when B’s airplane interrupts A’s disallowed. view.38 “First in time, first in right” might be (2) Usufruct rights a clear-cut criterion for solving such a If we allow free customization of usu- conflict. In other words, whoever declares fruct rights but do not establish a centralized and discloses his right first will win the game. disclosure system for these rights, we will However, this solution is by nature a varia- be able to eliminate the frustration costs while tion of the first possession rule which is be- getting around the information cost exter- lieved to be inefficient as it inspires uneco- nality problem. Conversely, if we strictly nomic investments.39 In addition, as sug- implement the numerus clausus principle, for gested by Merrill and Smith, the second level those usufruct rights that are not expensive information cost externality will occur as a to enforce or sensitive to bankruptcy, there NUMERUS CLAUSUS 51 will not be enormous frustration costs either. erty rights because of their dependency on If we choose to abolish the numerus clausus priority in bankruptcy proceedings. But this principle with respect to the usufruct rights, by no means requires abolishing the numerus however, we need to strike a balance among clausus principle for security interests. The the “user benefits,” the “nonuser costs” and gist lies in diversity of collaterals rather than the “system costs,” when further deciding free customization of the substance of se- whether to set up centralized systems for curity interests. This task can be well ac- disclosure of individually tailored rights. complished even under a numerus clausus Let’s take the heavily discussed “right regime by gradually lengthening the list of of occupancy” as an example.41 The func- statutory security interests. Among those tions of the “right of occupancy” are achiev- who argue for freedom of property rights or able through many other legal mechanisms security interests, very few, if any, have such as trusts or third party beneficiary clarified the essence of the “freedom” they contracts. So our goal is to identify the most are advocating.42 cost-effective one among them. The cost of Notwithstanding our vote for diversify- enforcing the “right of occupancy” does not ing collaterals, we also believe that the sub- change whether it is characterized as a prop- stances and effects of security interest ought erty right or not, because it is a possessory to be strictly regulated by law. The fact that right in real property and the right-holder is the priority status of security interests greatly always able to assert the claims out of pos- influences the interests of third parties war- session for legal remedies. Thus, judging rants the adoption of mandatory legal provi- from the police and enforcement costs, it is sions to control the externalities this is likely unnecessary to label the “right of occupancy” to cause.43 There are other open questions as a property right. With this being said, it not covered by this paper, including whether nevertheless deserves a spot in the list of to allow the parties to choose the method of property rights, if we wish to strengthen foreclosure — judicial sale, gaining title or protection to the occupant when the home- appointment of receiver — when the debtor owner is bankrupt. Furthermore, since the is in default, and whether to allow the par- registration system already exists for disclos- ties to tailor the status of junior creditors ing property rights in real estates, not only when the collateral is auctioned off. These will no information cost externality arise with questions must be revisited if one wishes to the introduction of this new property right, argue for a non-numerus clausus regime for but the right-holder will save disclosure costs security interests. by registering his right as well. Therefore, it is desirable to recognize the “right of occu- IV. Conclusion pancy” as a new property right as far as ef- ficiency is concerned. Merrill and Smith suggest that the func- (3) Security interests tion of the numerus clausus principle is to As mentioned above, security interests lower the externalized information costs re- in particular need to be established as prop- sulting from free customization of new 52 SOCIAL SCIENCES IN CHINA Winter 2006 forms of property rights. These costs are might be reduced by a so-called “generative” thought to be imposed basically on two cat- approach. We reasoned, however, that when egories of nonusers of the idiosyncratic forms of property rights are strictly defined property rights: those who intend to acquire by the law, parties desiring new rights will the same type of asset as the one in which be forced to achieve the same through con- new forms of property rights are created, tractual arrangements, in which case the and those who have no intention of dealing police and enforcement costs will signifi- with this type of asset yet have to refrain cantly increase should there be a breach or from violating such fancies. Such a theory other violation of such rights by third parties. does not seem to have taken into account It is this increased cost that frustrates the protections the law would afford to bona fide parties’ intention to transact and the prob- purchasers. In this paper, we argue instead lem is especially severe if the breaching or that the issue of information cost externality violating party is in bankruptcy. regarding the first type of nonusers turns on Our study on information cost external- whether the disclosure system for property ity leads to a puzzle: why are property rights rights is centralized or decentralized. In a in real estate strictly restricted even when decentralized disclosure system, information the registration system is fully established in costs associated with idiosyncratic property both Civil and Common Law countries. As rights are essentially internalized by their for frustration costs, we come up with two users. By contrast, information cost exter- normative implications. The first is that there nality does occur in a centralized disclosure are at least two ways to overcome frustra- system. In addition, such costs as are in- tion costs, either by abolishing the numerus volved in managing a centralized disclosure clausus principle or by unifying enforcement system are yet another component of exter- rules for contractual and property rights. The nality attributable to customization of prop- second is that among the rights in property, erty rights. As for the second category of those particularly expected to enjoy a pre- nonusers, we concur with Hansmann and ferred status in enforcement, with security Kraakman that it is unnecessary to incur any interests as a typical example, are most in cost to investigate the merits of idiosyncratic need of being earmarked as property rights property rights. to ensure their priority. On the frustration cost side, Merrill and Smith stopped with the compromise that it * Zhang wei, LL.D. Student, Graduate School was a negative effect of numerus clausus that of Law, Waseda University.

Notes

1. The author would like to thank Prof. Su for their help with the authoring of this paper. Yongqin, Prof. Duan Kuang and Dr. Cai Xiang All errors are the author’s. NUMERUS CLAUSUS 53

2. Duan Kuang, “The Numerus Clausus Principle Principle: From the Perspective of the Devel- in Germany, France and Japan” in Liang opment of Property Law and Economics” in Huixing, eds, Civil and Commercial Law The Economic Rationality in the Freedom of Review, vol. 7, Law Press, 1997, pp. 255, 256. Private Law, China Renmin University Press, 3. Thomas W. Merrill & Henry E. Smith, “Opti- 2004,pp. 84 and 113. mal Standardization in the Law of Property: 13. This does not mean, however, that there will The Numerus Clausus Principle,” Yale Law be no increase in these costs at all with the Journal, 2000, vol. 110, pp. 3-4. appearance of more novel property rights, but 4. My study is vastly influenced by the pioneer- merely suggests that the increase is insignifi- ing works of Merrill & Smith (see note 3) and cant marginally. See Hansmann & Kraakman, Hansmann & Kraakman (Henry Hansmann & supra note 4, p. 401. Reinier Kraakman, “Property, Contract, and 14. ibid., pp. 399-400 (expressed in a different way Verification: The Numerus Clausus Problem to this paper, yet conveying substantially the and the Divisibility of Rights,” Journal of Le- same meaning). gal Studies, 2002, vol. 31, p. 373). Based on 15. Prof. Su states that the costs for investigating this path-breaking literature, this paper pro- filings can be internalized by charging fees, see poses to shed new light on the numerus clausus Su Yongqin, “Social Costs of the Statutory problem mainly by analyzing the information Property Rights: A Comparison Between and cost externality when legal protections to bona Some Suggestions on the Legislative Policies of fide purchasers are taken into account, and by the Two Sides across the Taiwan Strait,” ascertaining the origins of frustration costs un- Zhongguo Shehui kexue, 2006, no. 6, pp. 79 der a numerus clausus regime. and 90. 5. Merrill & Smith, supra note 3, pp. 26-27. 16. Merrill & Smith, supra note 3, p. 35. Merrill and Smith admit that for the purposes 17. Ibid., pp. 35-36. of their article, the term “measurement costs” 18. Ibid., p. 37. can be used interchangeably with “information 19. See Hansmann & Kraakman, supra note 4, p. costs” (Merrill & Smith, supra note 3, p. 26, 382, footnote 23. footnote 107). Therefore, we use “information 20. Merrill & Smith, supra note 3, p. 35. costs” instead in this paper. 21. This is distinguished from the standard execu- 6. Ibid., pp. 27-28. tory interest in that the ownership does not 7. Ibid., pp. 29-32. shift automatically on the occurrence of 8. See Thomas W. Merrill & Henry E. Smith, contingencies. “The Property / Contract Interface,” Colum- 22. Merrill & Smith, supra note 3, pp. 16-17. bia Law Review, 2001, vol. 101, pp. 773 and 23. We slightly change Merrill & Smith’s example 788-789. to make the new right more fancy even in Civil 9. Hansmann & Kraakman, supra note 4, p. 411. Law countries. 10. Dr. Zhang Peng has mentioned notation as a 24. Contract is by no means the only legal mecha- mechanism to overcome the information cost nism available to the parties. They can turn to, externality. See Peng Zhang, “The Numerus among others, the trust as well. In this paper, Clausus Principle in American Law,” Faxue, we discuss the contractual mechanism alone 2003, no. 10, pp. 108 and 111-112. This is simply because it is universally available in al- supposed to be an approach similar to bona most every modern legal system. fide purchaser protection in its second meaning. 25. Carl J. Dahlman, “The Problem of Externality,” 11. Hansmann & Kraakman, supra note 4, p. 396. Journal of Law and Economics, 1979, vol. 22, 12. Su Yongqin, “Rethinking the Numerus Clausus pp. 148; see also Robert Cooter & Thomas 54 SOCIAL SCIENCES IN CHINA Winter 2006

Ulen, Law & Economics, pp. 91-92 (4th ed., tralized and the decentralized systems can use International Edition, 2004). either of these methods. See Hansmann & 26. Here, 1) is aimed at imitating the exclusive Kraakman, supra note 4, pp. 394-395. effect of a property right, 2) and 3) imitate 30. But if B’s right is possessory and A physically the in-rem effect, and 4) is the remedial mecha- intrudes on his possession, B can assert the nism safeguarding these effects. The priority claims out of possession, which is essentially effect of a property right is hardly imitable the same as the claims out of property right. through contractual arrangements. See the 31. Indeed, B will become an unsecured creditor analysis below about the police and enforce- once A falls in bankruptcy, even if B’s right is ment costs. not actually violated by A. This also gives rise 27. Contractual rights imitating the property ef- to an increase in B’s enforcement costs. For fects are in personam by nature, which means convenience, we do not discuss this situation third parties should not be required to obtain separately. information from a centralized source even if 32. Similarly, if B’s right is possessory and the there is such a disclosure system. In essence, third party physically intrudes on his posses- no constructive notice can be expected on the sion physically, B can assert the claims out of part of assignees and delegates. possession, which is essentially the same as 28. A similar conclusion is reached in Hansmann & the claims out of property right. Kraakman’s study with respect to rights in 33. These four situations are based on the di- intangibles. See Hansmann & Kraakman, su- chotomy of enforcement rules for rights in rem pra note 4, p. 391. and in personam in the German Civil Law 29. These conclusions are drawn on the disclosure system. With the fluctuation of the extent of side. How about the costs on the searching side? disparities between property and contractual Some scholars argue that a centralized system remedies, the magnitude of frustration costs can immensely lower the searching costs (Su arising under a numerus clausus regime will Yongqin, “The Property Right System Under vary accordingly. a Mitigated Numerus Clausus Regime: Re-prob- 34. Hansmann & Kraakman showed us the diffi- ing the Feasibility of the Civil Code in Main- culties in establishing by contract the priority land China,” Cross Straits Law Review, 2005, of business creditors over shareholders’ per- no. 8, pp. 110-142). However, we do not think sonal creditors, which is largely applicable to this is always true. Regarding the processing of our situation. In short, there exist two major information, costs will not change insofar as obstacles: the enormous transaction costs en- the information to be processed is substantially tailed in reaching subordination agreements the same, regardless of the place of disclosure. with all other creditors, past or future, of the Regarding the discovery of information, costs creator of nonstandard property rights; and the may vary with the different ways of disclosure. problem of moral hazard facing the grantee of Information about a right can be disclosed in such nonstandard rights in that the creator has either of the two methods: disclosing the par- strong incentive not to obtain the necessary ticular terms of the right (direct method), or subordination agreements. See Hansmann & disclosing the mere presence of the right and Kraakman, “The Essential Role of Organiza- leaving the details with the holder (index tional Law,” Yale Law Journal, 2000, vol. 110, method). The index method incurs two costs pp. 407-409 and 410-411. — for discovering the presence of the right and 35. Hansmann & Kraakman, supra note 4, p. 397. the terms of the right — and therefore is more 36. For some of this historical background, see expensive than the direct method. Both the cen- Duan, supra note 2, p. 266. NUMERUS CLAUSUS 55

37. For the development of equitable servitudes, 41. For a summary of the points in this discussion, see generally William B. Stoebuck & Dale A. see Liang Huixing, “Why Do I Object to the Whitman, The Law of Property, 2000, the 3rd Provision of the “Right of Occupancy,” avail- ed., pp. 491-512. able at http://www.iolaw.org.cn/showarticle. 38. We are indebted to Prof. Yoshihisa Nomi for asp?id=1245. this illustration. See Yoshihisa Nomi, “Shintaku 42. e.g., Liang Shangshang, “Numerus Clausus: to Bukkenhoteshugi: Shintaku to Minpo no Between Freedom and Compulsion,” in Faxue Kosa (Trust and Numerus Clausus: The Inter- yanjiu, 2003, no. 3, pp. 43 and 54. section between Trust and the Civil Law),” in 43. For priority of security interests and the risk Nishihara Michio Sensei Koki Kinen: Gendai alteration problem, see Zhang Wei, “A Func- Minji Hogaku, No Riron (Essays in Honor of tional Analysis of the Constr uction the 70th Birthday of Professor Nishihara Contractor’s Priority Right,” Peking Univer- Michio: Theories in Modern Jurisprudence of sity Law Review, 2005, vol.7, no. 1, Beijing Civil Law, vol. 1), 2001, Shinzansha Press, University Press, pp. 253 and 275-278. available at http://www.j.u-tokyo.ac.jp/~nomi/ index.html. — Translated by the author from 39. Cooter & Ulen, supra note 25, p. 145. Zhongguo shehui kexue, 2006, no. 4 40. e.g., Statute 214 of Japanese Civil Code. Revised by Sally Borthwick