Medina AugmentingValueOwnership 2003

Augmenting the Value of Ownership by Protecting It Only Partially: The "Market-
Overt" Rule Revisited

Author(s): Barak Medina
Source: Journal of Law, Economics, & Organization , Oct., 2003, Vol. 19, No. 2 (Oct.,
2003), pp. 343-372
Published by: Oxford University Press
Stable URL: https://www.jstor.org/stable/3555108
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JLEO, V19 N2 343
Augmenting the Value of Ownership by Protecting It Only

Partially: The "Market-Overt" Rule Revisited
Barak Medina
College of Management Academic Studies and the Hebrew University of

Jerusalem
This article analyzes alternative rules for settling conflicts between right
owner and a bona fide purchaser. The optimal rule, so it is argued, is the
one which maximizes the expected value of the ownership right, given the
risk of right violation. In order to maximize this value, one must seek to
both mitigate the risk of right violation and augment a potential buyer's
willingness to pay for the right. The analysis specifies the relevant para-
meters that define which rule is optimal in given circumstances, and proves
that there are cases in which the value of the ownership right is maximized
if the owner's right is only partially protected against innocent third parties.
Two prevailing notions are challenged: first, that the "market-overt" rule
necessarily induces buyers to invest fewer resources in prepurchase pre-
cautions, and second, that a buyer's willingness to pay is unaffected by the
choice of the legal rule.
1. Introduction
Should a bona fide purchaser, who bought an asset from an unauthorized

seller, be entitled to an ownership right in the asset?1 This issue has
attracted considerable attention in recent years, mainly with respect to
stolen works of art (Hayworth, 1993; Landes and Posner, 1996; Maples,
2001; Reyhan, 2001). The different ways of treating this issue across jur-
isdictions (Levmore, 1987; Mattei, 1998; Reyhan, 2001) gives rise to com-
plex issues relating to the conflict of laws (Reyhan, 2001) and poses a
puzzle as to the efficient rule.
I am grateful to Omri Ben-Shahar, Ofer Grosskopf, Louis Kaplow, Amir N. Licht, Joram
Meyshar, Uriel Procaccia, Omri Yadlin, participants in the law and economics workshop at
Tel Aviv University and the ALEA annual meeting (May 2002), and to two anonymous
referees for their thoughtful comments on earlier versions of this article, and to Susan
Kennedy for superb editorial work.
1. Related-but not identical-conflicts arise in numerous contexts, such as competing
claims of secured parties, a purchase of entrusted goods, etc. See, for example, Durfee (1959)
(discussing the pattern of conflicts of priorities) and Mautner (1991).
The Journal of Law, Economics, & Organization, Vol. 19, No. 2,

? Oxford University Press 2003; all rights reserved. DOI: 10.1093/jleo/ewg014

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344 The Journal of Law, Economics, & Organization, V19 N2
The quest for the efficient rule in this respect spans thousands of years
(Waite, 1925; Murray, 1960), but remains unresolved. Generally speaking,
two distinct schools can be characterized: The traditional school, dating
back to ancient law, underscores the expected adverse effect of exposing
potential buyers to the risk of purchasing the right from an unauthorized
seller. This school focuses on reducing the transaction costs which create
obstacles to the circulation of goods (Murray, 1960; Hawkland, 1962;
Brown, 1975; Jillison, 1979; Davies, 1987; Nyquist, 1995; Mattei, 1998).
The analysis tends to disregard the effect of the legal rule on the magnitude
of the risk of right violation. This effect is underscored by the second
school, which is based on a tort law-like analysis and assesses which
party is the "efficient risk bearer" (or the "least cost avoider") (Weinberg,
1980; Levmore, 1987; Mautner, 1991; Schwartz and Scott, 1991:491). This
approach is based on the conjecture that the rule which settles conflicts
between owners and buyers has no effect on a buyer's willingness to pay,
since any advantage to the buyer is a disadvantage to the owner, whereas
the buyer is also a would-be owner.
This article puts forward three main arguments: The first contests the
conjecture that the legal rule does not have an effect on trade. A careful
analysis shows that the legal rule does affect a buyer's willingness to pay,
and therefore might "clog" (or "unclog") channels of trade. As a result,
this effect must be considered in determining the optimal rule. The second
argument focuses on the effect of the legal rule on the buyer's incentives to
mitigate the relevant risk. It is shown that the analysis of the optimal rule in
this light is actually more complicated than it seems at first glance, since the
buyer can be induced to take optimal precautions not only by being made
to bear the risk, but through a "market-overt" rule as well, which resem-
bles directing behavior through a negligence rule in tort law.
The main argument is the third. Given the first two arguments, the
proper measure of the optimal rule must incorporate the rule's two
effects-on trade and on the magnitude of the risk of right violation.
This goal is achieved by defining the optimal rule as the one which max-
imizes the value of the ownership right. This value is a weighted average of
the right's "reservation" value and its "liquidation" value. The first ele-
ment is (negatively) correlated with the magnitude of the risk of losing the
right, while the second resembles a potential buyer's willingness to pay for
it. The analysis does not support any single rule as the universally optimal
one, in accordance with the diversity of the relevant rules across jurisdic-
tions and, within a given one, across subject matter. However, it specifies
the relevant parameters that define which rule is optimal in given circum-
stances and shows that there are cases in which the value of the ownership
right is maximized if the owner's right is only partially protected against
innocent third parties.
The article is organized as follows: Section 2 outlines the framework of
analysis. Section 3 discusses the limitations of the prevailing measure of
assessing the alternative rules and sets forth the measure of maximizing the

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The "Market-Overt" Rule Revisited 345
value of ownership. The basic model is described in Section 4 and the

results of the analysis are detailed in Section 5. Section 6 deals with
the effect of title insurance and title guarantee on the results. Section 7
concludes.
2. The Framework of the Analysis

Assume a potential buyer is unable to distinguish between authorized and
unauthorized sellers, at least not at a reasonable cost, and thus faces the
risk of purchasing an asset from an unauthorized seller. This prospect is
relevant given two assumptions: First, there is a significant chance that the
"original" owner will be able to both locate her asset in the hands of the
buyer and establish her right over it (e.g., in an action for "replevin").
Clearly, if one assumes that the probability of recovery is marginal (as do
Shavell [1996], Schwartz and Scott [1991:509], and Weinberg [1980]), the
effect of the legal rule on a buyer's willingness to pay is insignificant, since
the rule is applied only if the owner locates her asset.2 However, it is then
inconsistent to assume that the choice of the legal rule affects a buyer's
incentive to take risk-prevention measures. If the probability of recovery is
negligible, ex ante, efficiency-based analysis is futile, and corrective justice
considerations or ex post-based efficiency considerations should prevail.3
The following analysis is based on the assumption that this probability is
not insignificant (an assumption which seems particularly plausible in the
context of stolen works of art4).
A second assumption is that the parties expect that if an unauthorized
transaction takes place, it is practically avoidable for the buyer to recover
restitution-based on a claim of breach of implied warranty of title-from
the seller. In addition, it is assumed that the seller cannot give the buyer an
absolutely reliable "title guarantee." This set of assumptions, as well as the
effects of the possibility of purchasing title insurance from a third party
and of the parties ability to affect the "effectiveness" of the title guarantee
are discussed in Section 6.
Given these assumptions, the analysis focuses on a comparison of two
alternative rules: "Absolute protection" (AP), in which the law favors the
owner in case of a conflict with an innocent buyer; and "market overt"
(MO), where the buyer is favored, given that he fulfills various conditions,
which are specified below.5 In practice, intermediary rules can be applied
2. Generally, possession of a chattel gives the possessor a superior right to the chattel over
everyone but the owner (see, e.g., Helmholz [1986]).
3. For such an analysis in the current context, see Mautner (1991) and Schwartz and Scott
(1991:510-12) (under corrective justice the "market-overt" rule should govern, since the
owner cannot show that the buyer wrongfully harmed her).
4. See Landes and Posner (1996:179) ("Disputes over title are more likely if a work is
valuable, mobile, relatively easy to hide but still traceable-conditions frequently satisfied in
the case of works of art").
5. Note that legally, the "market-overt" rule refers to specific circumstances-the pur-
chase of a stolen good by a bona fide buyer from a merchant who deals in goods of that kind

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(such as AP with a defense of contributory negligence) (see subsection 5.1.1

below), but the current analysis focuses primarily on a comparison
between the two benchmark rules.
3. Choosing a Measure for Assessing the Alternative Rules

3.1 The "Superior Risk Bearer" Measure and Its Limitations
The risk of an unauthorized transaction can be viewed as an accident. Each
of the innocent parties-the would-be buyer and the owner-can take
precautions to mitigate the risk of an unauthorized transaction. Thus
the assessment of the optimal legal rule can be based on an assessment
as to which party is "better suited" to bear the risk (or to insure herself).
Under this measure, the party who is the "least-cost avoider" should bear
the risk of an unauthorized transaction.
Under such an analysis, it was argued that the MO rule prevails in cases
of entrustment, where the owner is regarded as the superior risk bearer
(Weinberg, 1980; Mautner, 1991; Landes and Posner, 1996). In the case of
stolen goods, conflicting arguments were offered: On the one hand,
Mautner (1991:151) argues that the owner is better suited to prevent the risk,
since buyers cannot take any meaningful precautionary measure to detect
the theft. Therefore applying the AP rule in cases of stolen goods is ineffi-
cient. Schwartz and Scott (1991:509) reach the same result, claiming that
"while it is difficult to know who is the cheaper cost avoider" (unless one
assumes certain assumptions, which they characterize as "speculative"),
"owners seem to be the cheaper insurers." On the other hand, Levmore
(1987:47) argues that while the owner may be regarded as the better
insurer, since she is "less susceptible to a moral hazard problem," an
opposite result cannot be ruled out, since the owner may find it difficult,
due to moral hazard reasons, to insure any idiosyncratic value she places
on her property. Levmore concludes that the difficulty in gathering empiri-
cal evidence makes the identification of the optimal rule a matter of per-
sonal judgment, which explains the variety and lack of uniformity in the
treatment of the subject across jurisdictions.
To my view, the least-cost avoider approach can be challenged on three
main bases. First, the comparison in the literature of the two competing
rules is typically based on the premise that a party can be induced to take
risk-prevention measures only by assigning him the burden of bearing the
relevant risk. Since only one of the parties can be assigned the risk, a choice
of the least-cost avoider is required. This approach is based on the pre-
sumption that under the MO rule, the buyer is not required to take any
prepurchase precautions. Under such a rule, the buyer clearly has
no incentive to obtain information regarding the seller's rights (Jillison,
1979; Weinberg, 1980; Levmore, 1987; Schwartz and Scott, 1991:509-10).
(e.g., Murray, 1960). In the current context, this term is used in a broader sense to indicate a
rule under which, subject to various conditions, an innocent buyer is entitled to ownership
right, regardless of any deficiencies in the seller's title.

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However, in practice, under the MO rule the buyer must fulfill specifi
conditions in order to be entitled to the ownership right. As a result,
only does the MO rule not discourage buyers from acquiring informati
it can, in principle, induce them to invest even more resources in so do
than is anticipated under AP (see subsection 5.1.2 below). More generally
the choice between the rules cannot be regarded as a mere choice
whether to direct a buyer's behavior or to forgo this goal. It is actu
a choice between two means of directing the buyer's activities.
A second limitation of the least-cost avoider approach results from t
character of the relevant risk. In the paradigmatic case of unintention
accidents, the risk which the parties face is not affected by the legal r
However, the risk of an unauthorized transaction is a function of t
applied rule. A potential wrong-doer's incentives to violate an ownershi
right are set primarily by the expected gains of her activity, that is, by
buyer's expected willingness to pay for the good (since presumably
major motivation to violate rights is the prospect of selling the sto
goods).6 As a result, if the choice of the legal rule shapes a buyer's will
ingness to pay, it affects the magnitude of the risk of right violation. T
effect is overlooked by the least-cost avoider measure. Indeed, the least
cost avoider approach is based on the premise that the legal rule does n
affect a buyer's willingness to pay (Levmore, 1987:55; Landes and Posne
1989; Schwartz and Scott, 1991:491). Actually, even Weinberg (1980)
Landes and Posner (1996:196), who find the AP rule superior sinc
results in a lower willingness to pay by buyers, and hence in a low
risk of right violation, do not rule out such an approach, but prefe
assume that the rule affects a buyer's willingness to pay. The analysis be
demonstrates that the choice of the rule does affect a buyer's willingnes
pay. In particular, a buyer's exposure to the risk, under AP, is expected
drive him to discount his willingness to pay for the right.
The third, and most important shortcoming of the prevailing measure
that it views the effect of the rule on a buyer's willingness to pay exclusi
through the lens of a would-be violator's incentives (see Weinberg [198
and Landes and Posner [1996]). Actually, a rule which diminishes a buye
willingness to pay (and thus mitigates the risk of right violation) impo
social costs: It reduces the ownership right's "liquidation" value, an
may prevent "efficient transactions." These are costs which are di
garded under the prevailing measures.
3.2 The "Value of the Ownership Right" Measure

Given the limitations of the "least-cost avoider" measure, an alternativ
more comprehensive measure is needed. It should account for both
effect of each rule on the parties' incentives to take risk-prevention m
sures, and thus on the magnitude of the risk of right violation and on
6. Various studies show that most stolen goods are offered for sale, usually thro
"fences," to innocent buyers (see, e.g., Weinberg [1980:571-74]).

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buyer's willingness to pay for ownership rights. This aim can be achieved
by focusing on the expected value of the ownership right under each rule.
Under this measure, the optimal rule is the one that induces the highest
expected value of the ownership right.7 The value of the ownership right
(T) is represented by a weighted average of the owner's reservation value
(R) and the right's "liquidation" value, that is, the buyer's willingness to
pay (B).8 The weights may vary, based on the specific context, as will be
discussed below. Generally, denote the weight of the liquidation value of
the right as a, such that T - (1 - a)R + aB.
Two benchmark cases are explored: The case in which a = 0 represents
situations in which the ownership right's value is exclusively set according
to its "reservation" value. In this case, the only relevant basis of compar-
ison is the rule's effect on the magnitude of the risk of right violation. On
the other hand, in the case of a = 1, the ownership right's value is reflected
by its "liquidation" value. Here the optimal rule is the one that results in
the highest willingness to pay by buyers. The analyses of these two bench-
marks is followed by an assessment of the general case, in which 0 < a < 1,
where both goals-minimizing the risk of right violation and maximizing a
buyer's willingness to pay-are pertinent.
This measure can be viewed from either the owner's perspective or that
of the buyer (the would-be owner): They both have an interest in mitigat-
ing the risk of right violation and in augmenting the right's liquidation
value (Baird and Jackson, 1984; Miceli and Sirmans, 1995b; Barzel, 1997).
Both current and would-be owners are thus expected to choose the level of
protection of their right toward innocent third parties as the one which
maximizes the expected value of the ownership right. Setting the rule by
law is required simply because at issue is the settlement of potential conflict
between parties who are not in contractual privity. However, if the rule is
selected according to this measure, it coincides with fundamental purposes
of assigning property rights-promoting the owner's "freedom" or
encouraging efficient use of resources (Demsetz, 1967; De Alessi, 1980;
Barzel, 1997). It makes it possible to overcome the inefficiency which
results from the owner's inability to credibly (and costlessly) signal herself
as the holder of the right (or to assert an effective title guarantee).
Note that the measure which is applied here is incomplete: It excludes
both the costs associated with the attempts to violate ownership rights and
at least part of the costs of enforcing the protection of the owner's property
right. In addition, it does not account for the benefits which violators
derive from unlawfully possessing the good or "liquidating" it (this latter
7. A related measure is applied in other contexts. For instance, it was used in order to
assess the desirability of restrictions on property rights (such as, the rule against perpetuities)
(see, e.g., Epstein [1986], Ellickson [1986], and Barzel [1997]).
8. Practically, the owner may be able to benefit from only a portion of the buyer's will-
ingness to pay, based on the specific bargaining procedure and each party's relative bargain-
ing power. Nevertheless, for simplicity, I ignore the possible gap between the buyer's
willingness to pay and the right's "liquidation" value.

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omission is subject to an ongoing debate in the literature: it is supported

by, e.g., Stigler [1970], Lewin and Trumbull [1990], and McChesney [1993],
and criticized by Becker [1968] and Shavell [1991]). Notwithstanding these
exclusions, this measure seems, to my view, to be the proper one, at least if
one assumes that the law of settling conflicts between an owner of an asset
and its innocent buyer should be set such that it promotes the underlying
purpose of assigning entitlements.
4. The Model
The magnitude of the risk buyers face is defined according to the following
probabilities:
(i) The probability that the owner's right is violated (e.g., the asset is
stolen); denote this probability as v;
(ii) Given (i), the probability that the owner locates her asset, and can
establish her right over it (e.g., in an action for "replevin"); denote
this (contingent) probability as 1;
(iii) Given (i) and (ii), the probability that the owner recovers her asset
after it was sold to a good-faith purchaser; denote this (contingent)
probability as g.
It is assumed throughout that these probabilities are based on independent

distributions. As mentioned above, it is assumed that the parties expect
that if an unauthorized transaction takes place, it is practically avoidable
for the buyer to recover restitution from the seller (this assumption is
discussed in Section 6). The parties are assumed to be risk neutral
(since, for instance, the buyer can purchase "title insurance").9 In addition,
I assume that buyers do not face uncertainty regarding the fulfillment of
the requirements of the MO rule.
Denote the value of the right to the owner as Wo and to the buyer as Wb.
Assume that before entering into a transaction, the buyer chooses a level of
investment in acquiring information about the seller's title (as well as the
effectiveness of the title guarantee she offers). Denote the cost of taking
these precautions as x. I assume that the higher these costs are, the lower
the risk to which the buyer is exposed (with decreasing marginal returns),
given that he decided to purchase the good.' Denote the cost of care which
is the optimal one for the buyer under each rule as XAP, and XMO, respec-
tively (where xMo reflects the level of care required by the law).
9. Title insurance is discussed in Section 6.

10. This assumption can be justified in various ways. For instance, if the buyer can choose
among several sellers, other things being equal, he is expected to select the seller for whom the
relevant risk is the lowest. In such a case, the level of care can reflect the number of sellers from
which the buyer chooses.

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Table 1. Notations of Relevant Factors
Notation Variable
T The expected value of the ownership right

R The owner's "reservation value"
B The buyer's willingness to pay (the right's "liquidation" value)
a The weight of the "liquidation" value in the right's total value
Wo The value of the right to the owner
Wb The value of the right to the buyer
XAP, XMO The buyer's investment in prepurchase inquiries, under each rule
v The probability of right violation
/ The (contingent) probability that the owner can locate the stolen ass
g The (contingent) probability that the owner can locate the asset
only after it was sold to a bona fide buyer (given that the owner
can locate the asset)
The notations of the relevant factors are summarized in Table 1. Based

on these definitions and assumptions, the buyer's willingness to pay an
the owner's reservation value under each rule are as follows:
4.1 Buyer's Willingness to Pay
BAP (1 _- v)[ - v(1 - 1)]Wb - XAP (1)

BMo = [1 - v(1 - 1) - vlg] Wb - XMO (2)
Under AP a buyer faces the risk of losing the entitlement to the owner (vl)
In addition, as a would-be owner, a buyer is exposed to the risk that h
right would be violated without being able to locate the asset (v(1 - 1)).11
Under the MO rule, a buyer is protected from the risk of losing th
entitlement to the owner. However, as a would-be owner he is now expose
both to the risk that his right is violated and he would not be able to locate
the asset (v(1 - 1)), and to the possibility that he would locate the asset on
after it was sold to a bona fide purchaser (vlg).
4.2 Reservation Value
RAP [I _- v(1 -1)] W (3)

RMO = [1 - v(1 - 1)- vlg] W. (4)
11. Alternatively, this discounting factor can represent the lo
expected in the period between the right violation and the time w
(see Landes and Posner [1996]). Note, however, that under AP, the ow
restitution from the buyer for the rental value of the asset in the
Under this rule the owner is also entitled to receive (from third parti
asset in the period after the theft and prior to the purchase.

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Under both rules the owner faces the risk of losing her right if it is violated
and she cannot locate it (v(1 - 1)). Under the MO rule, the owner faces an
additional risk, that of losing her title even if she does locate the stolen
good, in the case of locating the good only subsequent to a transaction with
a good-faith purchaser.
5. In Search of the Optimal Rule

As mentioned above, the analysis proceeds in three steps: The first two
focus on a single purpose, by analyzing each of the benchmark cases-
those in which a = 0 and a = 1. In the first case, the goal is to maximize the
reservation value, that is, to minimize the risk of right violation; while in
the second the goal is to maximize the "liquidation" value, and the purpose
is thus to maximize a buyer's willingness to pay. Based on these assess-
ments, in subsection 5.3, the general case in which 0 < a < 1, where both
goals are relevant, is analyzed.
5.1 Maximizing Reservation Value: Minimizing the Risk of Right Violation

Assume a = 0, that is, the sole purpose is to maximize the right's "reserva-
tion" value. Such an assumption may be plausible, for instance, for rights
that are "inalienable," which are part of their holder's "personality" (for
instance, for most people, their wedding ring, their pets, etc.). These rights
may have "market value," and are thus subject to the risk of right viola-
tion; however, the owner is uninterested in "liquidating" the right.
The comparison between the rules starts with an assessment of the
magnitude of the risk of right violation under each rule. It is based on
a comparison of the innocent parties' incentives to take prepurchase pre-
cautions and on estimating the motivation of would-be wrongdoers to
violate ownership rights under each rule. Based on this assessment, an
analysis of the value of the ownership right under each rule follows. The
result is a prediction of the superiority of AP in this case.
5.1.1 Inducing Owners to Take Optimal Precautions. Generally speak-

ing, the higher the risk to which the owner is exposed, the greater incentive
she has in investing in the prevention of right violation (Weinberg,
1980:583-86). The main concern refers to precautions aimed at mitigating
the risk of unauthorized transactions: such precautions are socially desir-
able since they mitigate the incentive of would-be wrongdoers to commit
right violations. Under the MO rule, the owner is induced to take such
precautions since she bears the risk of losing her right to a bona fide
purchaser. On the other hand, under AP, once a right violation has
been committed, the owner may prefer to avoid taking precautions
which are aimed at preventing unauthorized transactions. For instance,
in some contexts, advertising might drive the possessor of the good to
conceal it and thus to decrease the probability of recovery (Landes
and Posner, 1996:207; Guggenheim Foundation v. Lubell). Such ex post

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considerations might result in a socially undesirable inaction by the owner,

who externalizes the costs of her behavior (by exposing bona fide purcha-
sers to the risk of transacting with unauthorized sellers); and even if such
an avoidance to prevent unauthorized transactions happens to be socially
desirable ex post, it may be suboptimal ex ante, since it augments would-be
wrongdoers' incentives to commit right violation.
This advantage of the MO rule may be the rationale (or at least one of the
rationales12) of the UCC entrustment rule (according to UCC ? 2-403(2),
whereby a good faith purchaser, who purchased the good from a "mer-
chant who deals in goods of that kind," who received it as an entrustee of
the owner, for sale or repair, is entitled to ownership right, even if the
entrustee was unauthorized to sell it to the buyer). Such a rule (which
resembles the MO rule) induces the owner to take precautions to mitigate
the risk of unauthorized transactions by the entrustee (Weinberg, 1980;
Mautner, 1991).
Note, however, that the owner can be induced to take optimal precau-
tions not only through a "strict" liability-like rule, which forces her to bear
the consequences of a purchase by a bona fide buyer, that is, the MO rule,
but through negligence-like doctrines as well. It can be achieved by apply-
ing the AP rule subject to the doctrine of "estoppel." This doctrine imposes
on the owner the obligation to use all reasonable efforts to locate the stolen
good (Hayworth, 1993:349-59; O'Keeffe v. Snyder) or to notify the theft
(for instance, through applicable stolen goods registration; Bibas 1994).
The scope of this doctrine can be fairly restricted, however. AP sufficiently
induces the owner to take precautions which are not specifically tailored to
mitigate the risk of unauthorized transactions, but are aimed at mitigating
the risk of right violation in general (since the owner is left uncompensated
if she is unable to locate the good). Therefore the precautionary measures
which the owner took (or could have taken) to mitigate the risk of the right
violation itself (such as, the risk that the good will be taken out of her
possession) are typically disregarded under AP (Schwartz and Scott,
1991:495; Landes and Posner, 1996).13 However, the owner's activities
once she was aware of the right violation, which can mitigate the risk
of unauthorized transactions with innocent buyers, should be evaluated
through the doctrine of estoppel.14
To summarize, under the MO rule, the owner internalizes the costs of an
unauthorized transaction with an innocent buyer, and she is thus induced
to invest resources in mitigating the risk of such an event, as desired. Under
12. An alternative rationale for this rule is offered in subsection 5.2.

13. The doctrine of estoppel has not been codified in the UCC, and may thus be invalid in
the current context (Schwartz and Scott, 1991:494). In England, the application of the
principle of estoppel by negligence is severely restricted, since there is no duty of care on
an owner of property to see that it does not get stolen (Atiyah, 2001:377-80).
14. See, for example, Reyhan (2001) (owners should be required to be "reasonably diligent
in searching for the property," once aware of the theft); Schwartz and Scott (1991:494);
Hayworth (1993:349-59); O'Keeffe v. Snyder.

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AP, the owner may still have an adequate incentive to take precautions to
mitigate the risk of right violation in general, but may prefer, in some
contexts, to under invest in activities aimed at mitigating the risk of an
unauthorized transaction. This shortcoming can be dealt with by applying
a rule of contributory negligence or estoppel.
5.1.2 Inducing Buyers to Take Optimal Precautions. Buyers can play an

important role in mitigating the risk of right violation. As mentioned
above, the central motivation for violating ownership rights is presumably
the prospect of selling the stolen goods to innocent buyers. A buyer's
prepurchase investment in obtaining information about the seller's
right affects the "cost" of committing unauthorized transactions.15
Thus, other things being equal, a rule which induces buyers to take
more stringent prepurchase precautions is expected to result in a lower
magnitude of right violation.
Apparently a shortcoming of the MO rule is that it discourages buyers
from acquiring information about the seller's rights, whereas AP imposes
the risk on the buyer, and thus induces him to invest more resources in
acquiring information. This argument is based on a specific definition of
the MO rule, under which it is sufficient that the buyer acted, subjectively,
in "good faith," that is, without any knowledge-or suspicion-that the
seller is acting without the owner's permission (Weinberg, 1980:584)
Under such a rule, buyers have no incentive to obtain information.16
However, such a description of the legal rule is inaccurate. Actually the
MO rule typically sets both subjective and objective conditions which the
buyer must fulfill in order to be entitled to the ownership right. For
instance, under the UCC, in cases where the seller has a voidable title,
the buyer receives a good title only if he has purchased the asset in "good
faith" and "for value" (UCC ? 2-403(1)), where "good faith" is defined,
according to the revised Article 1 (I 1-201 (b)(20)), as both "honesty in fact
and the observance of reasonable commercial standards of fair dealing"
(see Moses, 2002);17 and under the entrustment doctrine, an entrustment
of "possession of goods to a merchant who deals in goods of that kind
gives him power to transfer all rights of the entruster to a buyer in ordinary
course of business" (UCC ? 2-403(2)), and the buyer qualifies as such only
15. A possible by-product of obtaining information by potential buyers is apprehension of

violators. However, this outcome is uncertain, unless would-be buyers can be motivated not
only to avoid purchasing the good-by exposing them to the risk of losing title over it-but
also to report their suspicions.
16. Similarly, where an official registration of rights exists, the buyer has no incentive to
acquire private information regarding the accuracy of the registration (Baird and Jackson,
1984:314).
17. The proposed revised Article 2 (? 2-103(j) of the August 2001 draft) provides identical
language as ? 1-201(b)(20). Existing versions of Article 2 apply the objective good faith
standard only to merchants, but it seems that even without the adoption of the proposed
revised Article 2, the definition of Article 1 would govern. See Moses (2002).

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if he shows that he acted "in good faith and without knowledge that the
sale to him is in violation of the ownership rights ... of a third party in the
goods," and that the transaction was made "in ordinary course, from a
person in the business of selling goods of that kind" (UCC ? 1-201(9)). As
Reyhan (2001:1043) reports, "under any of the right-defining rules... the
purchaser is required to exercise diligence... that may demand reasonable
inquiry regarding the chain of title."
Under these conditions, the MO rule does not discourage buyers from
acquiring information, but can, in principle, induce them to invest more
resources in so doing than is anticipated under AP. At its essence, the
argument is similar to the comparison between directing behavior through
"strict" liability and negligence in torts. Under "strict" liability (just as
under AP), the injurer (or the buyer) is expected to take optimal care only if
he fully internalizes the consequences of his activity. As will be shown
below, this condition is not met in the current context, and a sub optimal
"level of care" is expected. On the other hand, the negligence rule (and the
MO rule) induces optimal care through the threat of imposing liability (or
bearing the risk of an unauthorized transaction) if the injurer (or the
buyer) fails to take a "reasonable" or socially optimal level of care.
Under such a rule, even if the injurer (or the buyer) does not fully inter-
nalize the consequences of his activity, he still has an incentive, at least in
most cases, to act as socially desirable.'8
Under AP, the buyer is exposed to the risk of an unauthorized transac-
tion. Based on the definitions set forth in Section 4, the buyer is expected to
invest in prepurchase precautions xAP, which is the value of x which
maximizes BAP:
BAP - [1 - vl(x)][1 - v(1 - 1)] Wb - x, (5)

where vl refers to the probability that the specific seller is unauthorized,
and that the owner would locate the good. The magnitude of this factor is
function, so it is assumed, of the buyer's investment in risk-preventi
measures (with positive but decreasing marginal returns to his efforts). T
second element reflects the risk that the buyer faces as a would-be owner
This risk is independent of the buyer's investment in acquiring information
about the seller's rights.
Thus XAP is set such that:
v'(x) = -1/[Wbl(l - v(1 - 1))1 -- XAP.

This level of care, XAP, which is optimal from the buyer's perspective unde
AP, is not the socially optimal one. The socially optimal level of car
18. See, in the negligence context, Cooter and Ulen (1997:284-86) and Demougin an
Fluet (1999).

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(denoted as xs) is set such that the value of the right is maximized; that is, it
is the level of care x which maximizes
[1 - v(x)] Wb - x
v'(x)=- -1/Wb , xs.
We get that XAP < Xs. The intuition is analogous, in some aspects, to the
gap between a potential victim's optimal investment in precaution from
the victim's perspective and the socially optimal one.19 In the current
context, the buyer's investment in risk-prevention measures under AP
would be lower than the socially optimal one since the buyer is expected
to consider the effect of an increase in precautions only on the risk he faces
(i.e., the risk of detected right violation), whereas it is socially desirable to
mitigate the magnitude of right violation in general.20 In addition, risk-
prevention measures have a characterization of "public good" (specifi-
cally, it is a nonexclusive good), since the risk of right violation is deter-
mined by the average or common level of care, as perceived by would-be
violators. A specific buyer might "free ride" the average level of care, and
thus has a low incentive to contribute to the effort to shape would-be
violators' expectations through intense prepurchase inquiries. As a result,
the "privately" optimal investment in information gathering is expected to
be lower than the socially optimal one.21
Social welfare can be enhanced if buyers could cooperate to set an
agreed level of care to which all are committed. Such a result can be
achieved, at least in principle, through a negligence-like rule, which shields
buyers from the relevant risk if they act "reasonably." The MO rule can
induce an optimal level of care if the objective conditions which buyers
should meet in order to qualify under this rule are set according to
the socially optimal level of care.22 The requirements set forth according
19. See, for example, Clotfelter (1978), Shavell (1991), Ben-Shahar and Harel (1995). The
victim may take more care than socially optimal since he ignores the benefits that the perpe-
trator expects to derive from the violation, and the negative externalities of his activity, such
as the diversion effect of precautions; or he may take less care than socially optimal since he
ignores the positive externalities of his activity.
20. It is socially desirable to prevent right violation since violations are aimed at realloca-
tion rather than production of resources, and since their prospect may induce the owner to
invest wasteful resources in "protecting" her possession and discourage investing resources in
increasing its value (Besley, 1995; Alston, Libecap, and Schneider, 1996). For an alternative
view see Tullock (1967), Becker (1968), Shavell (1991), McChesney (1993).
21. There are, admittedly, some offsetting factors. For instance, an investment in acquir-
ing information benefits only the specific buyer. It may divert the risk to another buyer,
without actually eliminating it, given that the would-be buyer has no incentive to report the
results of his inquiry to the authorities or to the owner.
22. Taking into account objective elements may also serve evidential purposes: It may
separate what Weinberg (1980:576) terms as "non-innocent-shady purchaser" from real
"innocent purchaser."

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to the various MO rules are typically of "open-texture," such as "the

observance of reasonable commercial standards of fair dealing in the
trade" (UCC ? 1-201(b)(20); see, e.g., White and Summers, 1995:187).
These standards can be interpreted as referring to the socially optimal
level of care. The requirement that the transaction was made "in ordinary
course, from a person in the business of selling goods of that kind" (e.g.,
UCC ? 1-201(9)) may reflect, in addition to other rationales,23 a presump-
tion about "reasonable care." So does the requirement that the considera-
tion is a close resemblance of the market value of the good (Mautner,
1991): The price may serve as a "signaling device" for the probability of an
unauthorized transaction.24
Thus, in principle, the MO rule makes it possible to induce buyers to
invest more resources in risk-prevention measures than they would
under AP, and as a result, MO may induce a lower level of right
violation. However, both parts of this proposition must be
qualified. Consider, first, the level of care which buyers can be practically
induced to take through the MO rule. This level, denoted as XMO, may
not reflect xs, the socially optimal level of care, since it must meet the
following condition:
BM(x =- XMO) BAP(X XAP). (6)

If XMo is set such that a buyer's willingness to pay under the MO rule is
lower than its equivalent under AP, buyers are better off under AP. They
would opt out to AP (i.e., they would prefer to bear the risk rather than th
costs of fulfilling the requirements under the MO rule), and the goal
inducing them to take a higher level of care could not be achieved.
Recall that
BAP = (1 - vl)[ - v(l - 1)] Wb - XAP (1)
BMO = [1 - v(1 - 1) - vlg] Wb - xMO (2)

Thus Equation (6) yields that XMO must be set such that
XMO ? XAP + WbVI[(1 - g) - v(1 - 1)]. (6')
The term [(1 - g) - v(1 - 1)] may be either positive or negative, b

the values of the parameters. Therefore xMo may be either higher
23. For example, it may increase the chances that the original owner would
receive monetary relief from the seller, if the seller was unauthorized to sell the goo
reflect the owner's ex ante preferences, as shown in subsection 5.3.
24. See, for example, Wolinsky (1983). Mautner (1991:118-22) argues that this
serves to evaluate which of the innocent parties would suffer greater damage if the
entitled to the ownership right.

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than XAP. Specifically, if Equation (6') yields that XMO < XAP, the MO rule
induces buyers to invest fewer resources in prepurchase precautions
than AP.
To summarize, if the exclusive goal were to maximize a buyer's
investment in precautions, the choice of the optimal rule is subject to
the specific values of the relevant parameters. If Equation (6') yields
that xMO < XAP, AP is superior; but otherwise, MO is the optimal rule.
Clearly it seems impractical to reliably estimate the values of the relevant
parameters and thus a rigid prediction of which rule is superior is
unattainable. However, it can be stated that the standard presumption
that the MO rule necessarily results in buyers taking a lower level of care is
not self-evident.
Clearly the goal is not merely to maximize a buyer's investment in
precautions, but to minimize the risk of right violations. In order to assess
the expected risk of right violation under each rule, and to qualify the
second part of the proposition set forth above, we must incorporate the
third factor which shapes this risk, wrongdoers' incentives.
5.1.3 Mitigating Wrongdoers' Motivation to Commit Right Violations. The

innocent parties' precautions can be regarded as the costs which would-be
wrongdoers face if they attempt to violate ownership rights. The addi-
tional, and probably the major, factor which shapes the risk of right
violation is the expectation of would-be wrongdoers regarding the benefits
of committing right violations. These expectations are set according to a
buyer's willingness to pay for the good, and therefore the greater the value
of the buyer's willingness to pay for the good, the higher the level of right
violation to be expected.25
A buyer's willingness to pay under the MO rule is set according to the
required level of care under this rule, xMO. We've seen already that the MO
rule cannot induce a lower level of a buyer's willingness to pay than AP,
since if BMO(x = XMO) < BAP(x = XAP), buyers would opt out to AP. If we
focus on the goal of minimizing a buyer's willingness to pay (based on the
assumption that this factor affects wrongdoers' incentives more substan-
tially than a buyer's prepurchase investment in information gathering26),
xMO must be set such that BMO(x XMO) = BAP(x- XAp), that is,
xMo = XAP + Wbvl[(1 - g) - v(1 - 1)]. (6")
25. See, for example, Posner (1998:91), "[Under MO rule] thieves would get higher prices
from their 'fences', because the fences could... get higher prices in the resale market; people
will pay more for an assured than a clouded title;" Weinberg (1980:577), Landes and Posner
(1996), Shavell (1996).
26. Mautner (1991:117) suggests that purchasers "are unable to take any meaningful
precautionary measures." See also, along the same lines, Jillison (1979:515-19), Weinberg
(1980:584-85), Landes and Posner (1996:191).

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In this case, the optimal rule (i.e., the rule which minimizes the risk of
right violation) is the one which induces a higher level of investment in
prepurchase information gathering by potential buyers, given that both
rules yield equal willingness to pay of buyers. Specifically, if Equation (6")
yields that XMO > XAp, the MO rule is superior.27
Therefore, in principle, the MO rule may induce a lower risk of
right violation. Notwithstanding that, it seems more plausible to predict
that the risk of right violation under the MO rule exceeds that under AP
(in accordance with Landes and Posner [1996], Shavell [1996], Davenport
and Ross [1993], and Weinberg [1980]). This prediction is based either
on the assessment that XMO is typically set such that BMO > BAP; or
even if it is set such that BMO= BAP, it is rarely the case that xMo >
XAP, that is, the MO requirements are typically set such that buyers are
induced to invest fewer resources in risk-prevention measures than they
would under AP.
To summarize, the risk of right violation is lower the lower the magni-
tude of a buyer's willingness to pay and the greater his prepurchase invest-
ment in information gathering. The MO rule cannot induce a lower
willingness to pay than AP. The MO rule may result in a lower risk
only if it induces buyers to take a great enough level of care (which
more than offsets the effect of the higher willingness to pay under this
rule). Given the typical requirements under the MO rule, it seems more
probable that the MO rule would result in a higher risk of right violation
than AP.
5.1.4 Maximizing Reservation Value. The preceding analysis focused

on the risk of right violation induced under each rule. However, as men-
tioned above, the underlying purpose of the law should not be merely to
minimize the risk of right violation, but to maximize the expected value
of the ownership right. Given the presumption that a = 0, the value of
the ownership right coincides with the right's "reservation" value,
such that
TAP = RAP [1 - AP(l - 1)] Wo (3)
TMO = RMO = [1 - vMO(1 - 1) - vMOlg]
27. Note that the analysis is based on the assumption that the effect of a b
ingness to pay on the risk of right violation is more significant than the effect of
in information gathering. If this assumption is relaxed, the MO rule may pr
standing that it results in a higher level of a buyer's willingness to pay, if it induc
enough level of care.

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where vAP and vM0 represent the magnitude of the risk of right violation
under each rule. As a result, TMo exceeds TAP (i.e., the MO rule is superior)
only if
vAP > MO{l + [lg/(1 -l)]}. (7)

It seems more plausible to predict that Equation (7
we saw in subsection 5.1.3, it is more probable tha
violation under the MO rule exceeds the same
vAP< vMO). In addition, even if applying the MO
risk of right violation (a possibility that cannot be
unlikely that this rule should prevail: Applying the M
reservation value since it exposes the owner to the ri
to a bona fide purchaser. Thus, even if a shift fr
rule mitigates the risk of right violation, the dec
be substantial in order to compensate for the "co
MO rule.
To summarize, when a = 0 it is more probable that AP induces a higher
expected value of the ownership right. This conclusion justifies the
approach under both common law and the UCC, whereby in cases
where the seller's title is void, the MO rule is applied only when the
owner entrusted the good to a "merchant who deals in goods of that
kind" (UCC ? 2-403(2)) and in other "commercial" contexts (Jillison,
1979; Kozolchyk, 1987). When "personal property" is involved, that is,
when a = 0 (or, more generally, when a is low), the owner is not expected
to entrust the good in such a "commercial" manner, and AP thus generally
applies. This result reaffirms the second part of the observation of the
draftsman of the UCC, Grant Gilmore (1954:1060), that the distinction
between "void title" and "voidable title" "made it possible to throw the
risk on the true owner in the typical commercial situation, while protecting
him in the non-commercial one."
5.2 Maximizing Liquidation Value

In order to evaluate the first part of Gilmore's observation, consider the
other benchmark, where a -1. In such a case, the sole purpose is to
maximize the "liquidation" value. Such an assumption may be (partly)
plausible for rights which cannot be used in order to derive "direct" utility,
but only for exchange, such as various means of payments, business inven-
tory, etc. (Nyquist, 1995). The owners do have an interest in the right's
"reservation value," since they expect to hold the right for some (typically
short) period. However, in these cases one may assume that a is relatively
high, and as a benchmark, assume it equals 1.
The optimal rule is the one which induces the highest magnitude of a
buyer's willingness to pay. Under AP, the prospect of an unauthorized
seller exposes a potential buyer to the risk of having to surrender the

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entitlement to its original owner, while restitution of the amount paid for it
might be practically avoidable. Buyers are thus expected to discount their
willingness to pay for the right. This risk can be eliminated by operating an
official registration of rights.28 However, in many cases the operation of
such a mechanism is practically avoidable (such as when the assets are not
easily recognizable) or inefficient (such as when the assets are relatively
cheap).29 In such cases, the MO rule can be applied in order to eliminate
that risk.
The discounting of a buyer's willingness to pay under AP may prevent
"efficient transaction" (which increases social welfare by transferring an
entitlement to a buyer who derives higher utility from it). The MO rule,
which shields buyers from the relevant risk, facilitates the removal of such
obstacles to efficient trade. The succeeding analysis reinforces this ancient
rationale of applying the MO rule. It should be noted, however, that this
advantage of the MO rule does not imply that this rule necessarily prevails.
Recall that the purpose of the rule in the current context is to maximize a
buyer's willingness to pay. As we'll see below, it may well be (subject to the
value of the relevant parameters) that AP induces a higher magnitude of a
buyer's willingness to pay.
5.2.1 Removing "Obstacles to Trade." The "traditional" rationale of

applying the MO rule in both ancient and modern legal systems is to
"unclog the channel of trade." As stated, for instance, by Murray
(1960), "the rule of market overt... was a common-sense solution to a
vexing problem which was bound to occur as soon as man entered into a
system of exchange of goods for money. ... [O]therwise all commerce...
must soon be at an end." Modern scholars have questioned this argument,
claiming that since any advantage to the buyer is a disadvantage to the
owner, and since the buyer is also a would-be owner, the rule which settles
conflicts between owners and buyers has no effect on a buyer's willingness
to pay.30 Thus, so it is argued, "metaphors of freely flowing commerce or
unclogged channels of trade do not illuminate this issue" (Schwartz and
Scott, 1991:491).
28. See, for example, Baird and Jackson (1984); Miceli and Sirmans (1995b), Epstein
(1998); Posner (1998:89-90) (the land title system reflects the modern separation of possession
from ownership, by placing all potential purchasers on notice of properly recorded ownership
claims).
29. A related question arises with respect to the legal status of unofficial registration of
rights, or private registration of stolen assets (such as stolen art items). See Bibas (1994);
Landes and Posner (1996).
30. See Levmore (1987:55), "[Under the 'market overt' rule] buyers are correspondingly
less eager to become owners or to purchase goods in general because the market-overt
doctrine makes it more expensive for them later to reclaim goods stolen from them and
then sold to other buyers;" Schwartz and Scott (1991:491).

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In order to assess these conflicting views, recall the expected value of a

buyer's willingness to pay and the owner's reservation value under each
rule. Under the MO rule,
BMo = [1 - v(1 - 1) - vlg] Wb - Mo (2)
RMO = [1 - v(1 - 1) - vlg] Wo. (4)

Under the MO rule the owner and the buyer face an identical risk and
thus expected to discount their reservation value and willingness to pa
respectively, by the same proportion. As a result, regardless of
magnitude of the risk, trade is expected whenever Wb > Wo, as
desired.31 Indeed, the required investment in prepurchase inform
gathering under the MO rule, XMo, might obstruct the goal of ensuri
efficient trade. As a result, if the exclusive goal is to remove obstacle
trade, xMo should be set at zero, that is, the subjectively innocent buy
should be entitled with the ownership right, regardless of his prepur
activities (as, for instance, in the case of negotiable instruments). If t
required prepurchase investment is set such that xMo > 0 (since the go
minimizing the risk of right violation is also considered, as discussed
subsection 5.3), efficient trade is avoided under the MO rule if
xMo > [1 - v(1 - 1) - vlg](Wb - Wo). (8)

Given that Wb > Wo (otherwise, trade is inefficient), Equation (8) may
hold. However, the probability that efficient trade is avoided is highe
under AP. The relevant values under this rule are
BAP = (1 - )[1 - (1 - /) Wb - XAP (1)

RAP = [1 - v(1 - 1)] Wo (3)
Here there is a portion of the risk, vl, to which only the buy
(the risk is of losing the right not to a future violator or
purchaser, but to the "original" owner). Thus efficient tra
under AP if
xAP > [ - v(1 - 1/)][(1 - vl) Wb - Wo]. (9)

The second element of the right-hand side of Equation (9) is sm
its equivalent in Equation (8). As a result, the probability that E
31. A related argument may justify the rule of "adverse possession," which red
associated with land transfer, either through clearing the title of the seller, if sh
the land for the statutory period, or by ensuring the purchaser clear title after
land for this period (which ranges from 5 to 30 years) (see Netter, Hersch, and M
Micely and Sirmans [1995a]).

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holds (efficient trade is avoided under AP) is higher than the probability
that Equation (8) holds (trade is clogged under the MO rule).32 In addi-
tion, recall that under the MO rule, XMO can be adjusted to as low a level
necessary to ensure efficient trade, whereas the level of XAP is given.
Note that in some contexts an owner is able to "signal" herself as a
legitimate right holder, and thus to "separate" herself from illegitimate
sellers. In these cases, in equilibrium, buyers who purchase the right from
an owner do not face the risk of losing the title. However, the "signaling"
mechanism is typically costly. Applying the MO rule makes the saving of
these costs possible and may thus be beneficial in such cases as well.33
5.2.2 Maximizing a Buyer's Willingness to Pay. The essential lesson of

the preceding analysis is that the choice of the legal rule does affect a
buyer's willingness to pay and hence the right's "liquidation" value. As a
result, this effect must be considered in assessing the optimal rule. As
mentioned above, the advantage of the MO rule in enhancing trade
does not imply that this rule is the socially optimal one. Given the assump-
tion that a= 1, the optimal rule is the one which induces the higher
liquidation value, that is, the greater willingness of a buyer to pay for
the right.
Refer, first, to the optimal requirement of investment in information
gathering by a buyer under the MO rule (xMo). Recall that
BMO = [1 - v(1 - 1) - vlg] Wb - XMO. (2)

An increase in the "stringency" of the requirements under the MO rule
(xMO) results in two opposite effects: On the one hand, it decreases B, since
the higher the prepurchase costs which buyers must incur, the lower their
willingness to pay for the right (assuming these costs are not "sunk"). On
the other hand, an increase in xMo increases B since it also mitigates the
risk of right violation, v (for two reasons: it increases the "costs" of right
violation, since sellers are subject to more intense inquiries by would-be
buyers; and it decreases the "reward" for right violation, due to the
decrease in B, as a "secondary effect"); and since it may also decrease
g, the (contingent) probability that the owner locates her asset after it was
sold to a good-faith purchaser (since the greater the required investment
xMO is, the less probable it is that future buyers comply with this require-
ment). Therefore, as a general matter, the optimal value of xMo is a
function of these parameters. Only if one assumes that the former effect
32. The first element of the right-hand side of Equation (8) is smaller than its equivalent in
Equation (9), but the effect of this difference is less significant than that of the gap in the
second element.
33. For a related argument, see Aghion and Hermalin (1990) (restricting the freedom of
contracting parties to set high liquidation damages may enhance efficiency by saving the costs
of signaling). This point is discussed in Section 6.

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is the dominant one, such that an increase in XMO is expected to result in a

decrease of B, do we get that for a = 1, the optimal "stringency" of the
requirements under the MO rule is xMo = 0, that is, buyers should not be
required to invest in information gathering at all.
Next, compare a buyer's willingness to pay under each rule, in order to
assess which rule is superior. Based on Equations (1) and (2), we find that
the MO rule is superior (i.e., BMO > BAP) if
[1 - vMO(1 - 1) - vMOlgl Wb - XMO >(1 - VAP/)[I - vAP(1 - 1)] Wb - XAP.
Rearranging this inequality yields that the MO rule is superior if
xAP - XMO + WbAP[ AP(1 - 1) > Wb[( - l)(vMO - AP) + VMOlg.

(10)
The intuition of Equation (10) is as follows: The left-hand side represents

the buyer's "benefits" from a shift from AP to MO. These benefits consist
of two elements: The first is the (possible) saving of the cost of investing in
prepurchase precautions. Other things being equal (a simplifying assump-
tion, since the risk of right violation under the MO rule may actually
depend on xMo), the lower XMO is, the more probable it is that the
MO rule results in a higher "liquidation" value, and the greater XAP is,
the more "attractive" the MO rule is. The additional "benefit" buyers
derive when the MO rule is applied is protection from the risk of losing
the good to its original owner. It is the risk that buyers face under AP,
which is the (joint) probability that the seller is unauthorized and that the
owner would locate the asset in the hands of the buyer (vAP/), multiplied by
the expected value of the right to the buyer under AP (as a would-be owner, a
buyer faces the risk that his right would be violated, without being able to
locate it). Therefore the greater this risk, the more probable it is that the
MO rule is superior.34
The right-hand side represents the "costs" a buyer incurs, as would-be
owner, due to a shift to the MO rule. These costs include the (possible)
increase in the risk of right violation as a result of a shift from AP to MO
(see subsection 5.1), and the risk that the buyer (as a would-be owner) is
able to locate the stolen good only after it was purchased by a good-faith
buyer (vMOlg). Therefore the lower the risk of right violation under the MO
rule, the lower the difference between this risk under the alternative rules
and the lower g (the probability that an asset is located only after it was
purchased by a good-faith purchaser) are, the more probable it is that the
MO rule is superior.
34. This risk increases the larger 1 (the (contingent) probability that the owner can locate
the stolen asset) is; and the greater Wb (the value of the right to the buyer) is. v (the risk of right
violation) may have either positive or negative effect, subject to the values of the parameters.

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Note that an increase in the value of 1( the probability that the owner can
recover her stolen asset) makes the MO rule more "beneficial" to the buyer,
since he then faces, as a buyer, a high risk of losing the title to the owner.
(This benefit is only partially offset by an increase in the "cost" of applying
the MO rule to the buyer, as a would-be owner. This offsetting is partial
since as a would-be owner he still has a chance, even under the MO rule, to
regain the title, since he may locate the asset before a future good-faith
purchaser buys it.)
To summarize, in cases in which Equation (10) holds, the MO rule
results in a greater willingness to pay by potential buyers. Therefore, in
these cases an owner who focuses on maximizing the "liquidation" value of
her entitlement is expected to prefer only partial protection of her right
against third parties by favoring a bona fide buyer who purchased her asset
from an unauthorized seller. However, unlike in the opposite benchmark
case, where it was possible to offer a relatively rigid prediction that the
preferable rule is AP, in the case of a 1 (and obviously when a < 1), such
a general assessment is avoidable. That said, the conclusion that the MO
rule might possibly be superior cannot be ruled out and may (at least
partially) explain the universal application of the MO rule in typical
cases of high values of a (high interest in the right's "liquidation"
value). For instance, the MO rule is applied where financial instruments
are concerned (e.g., UCC Article 3). It may also explain (again, only
partially) the entrustment doctrine, according to which, when the owner
entrusts the good to a "merchant who deals in goods of that kind," she
gives him the power to transfer her title to "a buyer in the ordinary course
of business" (UCC ? 2-403(2) ). This doctrine, which is a version of the MO
rule, may resemble the preferences of the owner, since the entrustment of
the good to a "merchant who deals in goods of that kind" typically reflects
her interest in the "liquidation" value of the right; that is, she attaches a
high value of a to the ownership right.35 In this spirit, Kozolchyk
(1987:1500) argues that "as the industrial and financial revolutions set
in, litigation was increasingly commercial. Courts were thus inclined to
validate the good-faith purchase of goods acquired in "voidable transac-
tions." As mentioned above, the same intuition led Gilmore (1954:1060) to
distinguish between "void" and "voidable title," in order to "[make] it
possible to throw the risk on the true owner in the typical commercial
situation" (see UCC ? 2-403(1), which empowers a seller with voidable title
"to transfer a good title to a good faith purchaser for value"). Typically a
seller's title is voidable (but not void) whenever he gained it by transacting
with the owner (and then breached his contractual obligations36), that is, in
35. Atiyah (2001:383) reports that the typical case to which such a rule applies concerns a
motor vehicle entrusted to a car dealer for sale or to obtain offers.
36. See, for example, White and Summers (1995:188): "In general voidable title passes
to ... buyers who commit fraud, or are otherwise guilty of naughty acts (bounced checks), but
who conform to the appearance of a voluntary transaction."

89.138.144.121 on Sun, 23 Jul 2023 13:26:23 +00:00
cases where the owner was interested in "liquidating" the value of her
ownership right. It is in those cases that it is more probable that the MO
rule should prevail.
5.3 The General Case: Maximizing the Expected Value of Ownership

Based on the two extreme cases, we can analyze the general case, where
0 < a < 1. Start with the optimal level of risk-prevention requirements (or
their "stringency"), under the MO rule. Recall that the expected value of
ownership is a weighted average of its "reservation" and "liquidation"
values, such that T (1 -a)R + aB. Thus, under the MO rule, the
expected value of the right is
TMo = (1 - a)[1 - vMo(1 - 1) - vMOlg] Wo
+ a-{[1 - vMo(1 - 1) - vMlg] Wb - XMO}. (11)
Setting the optimal level of xMo is complicated. An increase in xMo

has two opposite effects: while it (probably) decreases B (and might
obstruct efficient trade, as we saw in subsection 5.2.1), it also increases
R (since it mitigates both the risks of v and that of g, as discussed in
subsection 5.1). Thus, generally speaking, the greater the value of a
(the importance of the right's "liquidation" value), the lower the optimal
level of care.37 In particular, the higher the value of a, the lower investment
xMO may require in prepurchase information gathering. This proposition
may support the different treatment under the UCC between different
types of assets (Kozolchyk, 1987; Nyquist, 1995). For instance, where
negotiable instruments are concerned, that is, when a is high, Article 3
protects the "holder in due course" of the instrument, that is, a holder "in
good faith". In the case of chattels, where a is presumably lower,
more stringent requirements are imposed, such as the requirement that
the transaction was made "in ordinary course, from a person in the
business of selling goods of that kind" (? 2-403(2) and ? 1-201(9)). This
effect of the value of a on the optimal "stringency" of the requirements
under the MO rule supports the assertion that "the patina placed on
the definition of [good faith] when applied to negotiable instruments
does not transfer readily to chattels" (Graves Motors, Inc. v. Docar
Sales, Inc.).
As for the comparison between the two rules: Based on the preced-
ing analysis, the expected value of the ownership right under each rule
37. For a related argument see Netter, Hersch, and Manson (1986), who argue that the
"stringency" of adverse possession requirements is set in order to balance the trade-off
between the benefits of reduced uncertainty and the costs of allowing title to pass through
possession (mainly, costs of monitoring by owners).

89.138.144.121 on Sun, 23 Jul 2023 13:26:23 +00:00
is as follows:
TMO = (1 - a)[1 - vMo(1 - 1) - vMOlg] Wo

+ a {[1 - vMo(1 - 1) - vMOlg] Wb - xMO}. (11)
TAP = (1 - c)[l - vAP(l - 1)]Wo

+ a{(1 - vAP/)[1 - vAP(1 - 1)] Wb - XAP}. (12)
Applying the measure of maximizing the expected value of the owner-

ship right, the MO rule is superior if TMO > TAP, that is (after
rearranging), if
SWb{l(VAP - vMOg) - (1 - )[VMO - vAP(1 - vAPl)]} + O0(XAP - XMO)

> (1 - a) Wo[(1 - 1)(vMO _ AP) + MOlg]. (13)
The right-hand side of Equation (13) is positive (based on the presumption
that vMO> yAP). As we saw in subsection 5.2, it reflects the "costs" of a
shift from AP to MO. For Equation (13) to hold (and thus for the MO rule
to prevail), the value of its left-hand side (the "benefits" of applying the
MO rule) must be positive and greater than the element on the other side.
Such an outcome cannot be ruled out.
Note that the lower a is, that is, the less weight the owner assigns to
the right's "liquidation" value, the less probable it is that the MO rule is
preferable. Note also that the MO rule may prevail (since it augments
a buyer's willingness to pay), notwithstanding the fact that it also
induces, as a by-product, a greater level of right violation. Finally, if
Wb < Wo (for instance, since the owner derives some idiosyncratic
benefits from the asset) trade is avoidable. It is thus a case in
which a= 0, analyzed above, in which AP is preferable. It is only
where Wb> Wo that Equation (13) may hold, and the MO rule may
prevail.
6. Title Guarantee and Title Insurance

The preceding analysis is based on the assumption that in case of
an unauthorized transaction, the parties expect that it is practically avoid-
able for the buyer to recover restitution-based on a claim of breach of
implied warranty of title--from the (unauthorized) seller. Obviously the
plausibility of this assumption is not self-evident, and thus deserves
some attention.
Consider, first, the effect of a given level of risk that the buyer would not
be able to recover restitution from the unauthorized seller. Refer, as a

89.138.144.121 on Sun, 23 Jul 2023 13:26:23 +00:00
benchmark, to the case in which the seller is able to give an effective

guarantee of her own title to the buyer. In this case, the buyer's willingness
to pay is maximized under AP: This alternative assumption does not affect
the value of BMO, but it increases BAP:
BAP = [1 - v(1 - 1) Wb (1')
BMO = [1 - v(1 - 1) - vlg] Wb - XMO, (2)

(if the buyer expects to be able to recover restitution from the seller in
case of a right violation, he does not face, under either AP or MO, the risk
of losing the entitlement to the owner (vl), but only the risk of losing
his right as a would-be owner to a future right violator. In addition, in
this case, under AP the buyer is expected to avoid any prepurchase
investment).
As a result, BAP > BMO. In such a case, the sole benefit of applying
the MO rule is the incentive it gives buyers to invest in prepurchase
precautions (and thus to mitigate the risk of right violation). Excluding
this factor, if the seller is able to give an effective guarantee of her own
title to the buyer, AP clearly prevails. The greater the risk which buyers
face of being unable to recover restitution from an unauthorized seller,
the more probable it is, other things being equal, that the MO rule
prevails.38
Next, consider the parties' incentives-and means-to mitigate the risk
that the buyer would be unable to recover restitution from the unauthor-
ized seller. Clearly the value of the ownership right is negatively correlated
with the magnitude of this risk (since a decrease increases BAP, and dis-
regarding its effect on a buyer's incentives to take precautions, it also
increases TAP). Given this risk, the parties may be able to purchase title
insurance from a reliable third party (such as insurers, endorsers of nego-
tiable instruments, auction houses, etc.). Purchasing title insurance makes
it possible to protect the buyer from the risk of an unauthorized transac-
tion.39 However, generally speaking, the insurer faces the same risk as the
buyer. Purchasing title insurance makes it possible to transfer the risk but
not to mitigate it, such that it does not increase a buyer's willingness to pay.
In particular, if the buyer faces, under AP, a risk vl of losing the value
of the right (which is [1 - v(1 - 1)] Wb), the insurance premium (or the
38 An additional relevant factor is a possible difference between the subjective value of the
right to its possessor and its market value. See Miceli (1998) (the possessor's subjective value
of the asset grows over the time of possession) and Schwartz and Scott (1991:509-10) (as far as
depreciable goods are concerned, the costs of "yielded goods" to purchasers is higher than the
worth of those same items as "returned goods" to the owners). When this gap is substantial,
even fully effective title guarantee may not shield the buyer from the risk that the transaction is
unauthorized.
39. For a general discussion on title insurance see Arrunada (2002).

89.138.144.121 on Sun, 23 Jul 2023 13:26:23 +00:00
endorsement commission) is expected to be at least vl[l - v(l - 1)]Wb.

Thus a buyer's willingness to pay would be
BAP(with title insurance) =[1 - v(1 - 1)] Wb - vl[1 - v(1 - 1)] Wb

= (1 - vl)[1 - v(1 - 1)] Wb= BAP(without title insurance).
Voluntary purchase of title insurance is expected (and it may be

socially desirable to compel third parties, such as auction houses, to
issue such insurance) whenever its benefits (e.g., the transfer of the burden
to bear the risk from a risk-averse party to a risk-neutral one, and more
efficient monitoring activities) exceed its costs (e.g., administrative
costs and moral hazard inefficiencies). However, as a general matter,
the possibility of purchasing title insurance does not affect a buyer's
willingness to pay, and hence is irrelevant to the assessment of the alter-
native legal rules.
The parties can act in order to mitigate the risk that a restitution recov-
ery from an unauthorized seller would be practically avoidable. For
instance, the buyer can mitigate the risk by selecting a seller according
to its reputation and reliability; similarly the owner can act to credibly
convince the buyer to reduce the perceived risk, by investing in "signaling."
These activities are costly, and the optimal level of the risk varies,
according to the relevant factors. In general, if the assumption that the
seller cannot give the buyer a reliable guarantee is relaxed, such that
the "effectiveness" of the title guarantee (or the risk that a recovery
from an unauthorized seller would be practically avoidable) is set accord-
ing to the parties' activities, the value of the ownership right under AP
should be adjusted. It should reflect the optimal magnitude of the above-
mentioned risk, as well as the costs of the relevant activities. As discussed
above, the lower this optimal level of risk, the more probable it is that AP
prevails.
7. Conclusion
Generally speaking, in selecting the optimal protection of ownership rights
for innocent third parties, based on the goal of maximizing the value of
ownership, the following trade-off occurs: Partial protection, as under the
MO rule, may increase the "liquidation" value of ownership (or its "alien-
ability"), but would also augment the risk of right violation. Other things
being equal, the more important it is to increase the right's "liquidation"
value, the more attractive the MO rule is. In a shift from AP to MO, the
owner "pays" a premium, which is reflected in a discount of her reservation
value, and receives in return the opportunity to sell her right for a higher
value. Generally speaking, applying the MO rule is desirable only if this
"reward" exceeds the "cost."
A related trade-off applies regarding the "stringency" of the require-
ment of the MO rule between the desire to mitigate the risk of right

89.138.144.121 on Sun, 23 Jul 2023 13:26:23 +00:00
violation, by inducing potential buyers to carefully inquire into a seller's

rights, and the goal of augmenting a buyer's willingness to pay. Again, the
greater the weight the owner attaches to the right's "liquidation" value, the
lower the optimal level of stringency of the MO rule.
The analysis does not support any single rule as universally optimal,
in accordance with the diversity of the relevant rules across jurisdic-
tions and, within a given one, across subject matter.40 In light of the
complexity of identifying the optimal rule, it seems plausible to presume
that the relevant rules were set based on some intuitive perceptions
(Levmore, 1987).41 Nevertheless, the analysis makes it possible (at least
partially) to explain the existing law. It also serves to challenge some
intuitive arguments offered in the literature regarding the effect of apply-
ing the MO rule (in particular, it challenges both the notion that the MO
rule necessarily induces buyers to invest fewer resources in prepurchase
precautions, as well as the premise that a buyer's willingness to pay is
unaffected by the choice of the legal rule). The analysis specifies the rele-
vant parameters that define which rule is optimal in given circumstances
and demonstrates that there are cases in which the value of the ownership
right is maximized if the owner's right is only partially protected against
innocent third parties.
In addition, the article offers an alternative measure to that of the "least-
cost avoider" in order to assess which is the optimal rule. According to this
alternative measure, the optimal rule is that which maximizes the expected
value of the ownership right. This measure, as well as the framework of the
analysis used here, can be applied to several other contexts. For instance, it
may be used in order to assess the optimal rule-in a given context-
regarding the validity of ultra-vires transactions of agents and officers in
corporations; the law of contract formation; contract interpretation;
implied warranties (of product quality, clear title, etc.); and adverse pos-
session.
40. The argument of Weinberg (1980:586), that "the ... rule of stolen-goods' non-negotia-
bility is efficient [since] it has survived in the United States for over two hundred years" does
not explain the adoption of the opposite rule in other jurisdictions, including ancient ones.
See, for instance, Murray (1960:25) ("There are few legal concepts which have had a
more ancient origin than the notion that the bona fide purchaser of chattels... should be
protected").
41. It seems that Waite (1925:149) was correct in pointing out that "the original deci-
sions ... were probably intuitive expressions of a common attitude and belief. They must have
met and satisfied the needs of the time and place. Possibly, so define was the common attitude,
that any explanation of the decision would have seemed superfluous." See also, in this spirit,
Atiyah (1966). Others argue that the legal rules in this matter reflect the interests of influential
groups, such as banks. See, for example, Rosenthal (1971); Gilmore (1981), Sinclair (1990).
For a different assessment see Fuller (1978:371) ("Despite the zigzag pattern which the
decisions seem to present, the process illustrated is a 'rational' one... It derives from the
fact that the courts engaged in this development are drawing out the necessary, or at least the
reasonable, implications of a regime of private property and exchange").

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Medina AugmentingValueOwnership 2003

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Augmenting the Value of Ownership by Protecting It Only Partially: The "Market-

Overt" Rule Revisited

Stable URL: https://www.jstor.org/stable/3555108

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Augmenting the Value of Ownership by Protecting It Only

College of Management Academic Studies and the Hebrew University of

Should a bona fide purchaser, who bought an asset from an unauthorized

The Journal of Law, Economics, & Organization, Vol. 19, No. 2,

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value of ownership. The basic model is described in Section 4 and the

2. The Framework of the Analysis

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(such as AP with a defense of contributory negligence) (see subsection 5.1.1

3. Choosing a Measure for Assessing the Alternative Rules

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3.2 The "Value of the Ownership Right" Measure

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omission is subject to an ongoing debate in the literature: it is supported

It is assumed throughout that these probabilities are based on independent

9. Title insurance is discussed in Section 6.

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Table 1. Notations of Relevant Factors

T The expected value of the ownership right

The notations of the relevant factors are summarized in Table 1. Based

4.1 Buyer's Willingness to Pay

BAP (1 _- v)[ - v(1 - 1)]Wb - XAP (1)

4.2 Reservation Value

RAP [I _- v(1 -1)] W (3)

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5. In Search of the Optimal Rule

5.1 Maximizing Reservation Value: Minimizing the Risk of Right Violation

5.1.1 Inducing Owners to Take Optimal Precautions. Generally speak-

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considerations might result in a socially undesirable inaction by the owner,

12. An alternative rationale for this rule is offered in subsection 5.2.

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5.1.2 Inducing Buyers to Take Optimal Precautions. Buyers can play an

15. A possible by-product of obtaining information by potential buyers is apprehension of

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BAP - [1 - vl(x)][1 - v(1 - 1)] Wb - x, (5)

v'(x) = -1/[Wbl(l - v(1 - 1))1 -- XAP.

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v'(x)=- -1/Wb , xs.

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to the various MO rules are typically of "open-texture," such as "the

BM(x =- XMO) BAP(X XAP). (6)

BAP = (1 - vl)[ - v(l - 1)] Wb - XAP (1)

BMO = [1 - v(1 - 1) - vlg] Wb - xMO (2)

XMO ? XAP + WbVI[(1 - g) - v(1 - 1)]. (6')

The term [(1 - g) - v(1 - 1)] may be either positive or negative, b

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5.1.3 Mitigating Wrongdoers' Motivation to Commit Right Violations. The

xMo = XAP + Wbvl[(1 - g) - v(1 - 1)]. (6")

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5.1.4 Maximizing Reservation Value. The preceding analysis focused

TAP = RAP [1 - AP(l - 1)] Wo (3)

TMO = RMO = [1 - vMO(1 - 1) - vMOlg]

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vAP > MO{l + [lg/(1 -l)]}. (7)

5.2 Maximizing Liquidation Value

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