THE REAL ESTATE COVENANT AS COMMONS: INCOMPLETE CONTRACT REMEDIES OVER TIME JAY WEISER♦I. INTRODUCTION Real estate covenant regimes are a form of common pool resource in which property owners retain ultimate ownership but contractually surrender some rights to the use of their land into a commons. The pooled rights generate surplus (additional value from the exchange) for the owners.1 This article will explore the efficiency of legal rules protecting covenants, applying three perspectives: the property/contract interface, incomplete contracts and common pool resource literatures. Efficiency will be considered at two points: (1) when the initial investment decision is made (ex ante in law-and-economics terminology), and (2) at a later point (ex post) when a new use would be higher-valued and the covenant should be modified or terminated. Covenants are interests along the property/contract interface: promises with respect to the use of land. Doctrinally, these contractual interests may be characterized as real covenants, equitable servitudes, or occasionally even easements, but for purposes of this article, I will follow common parlance and refer to all promises relating to land use as “covenants.”2 ♦ Associate Professor of Law, Zicklin School of Business, Baruch College. B.A., Columbia College (NY); M.A., (History) Stanford University; J.D., Columbia Law School. Former primary mortgage counsel, The Prudential Insurance Company of America. Thanks to Kuo-Fei (Ray) Ou Yang, Aaron Menzi, and Dexter Dizon for research assistance, to the members of the DIRT and Condo Lawyers listservs for real-world insights, and to Randy Anderson, Elliot Axelrod, Vincent DiLorenzo, Robert Ellickson, Lee Fennell, Shi-Ling Hsu, Steven Lilien, Robin Paul Malloy, Steven Melnik, Sandra Mullings, Francesco Parisi, Eric Posner, and Henry Smith for their comments. This article also benefited from comments at the Canadian Law and Economics Association meeting in Toronto on September 28-29, 2002. 1 In an effort to make the article more accessible, I have tried to write in plain English, with references to law-and-economics terminology added for the benefit of specialists. 2 Academics prefer the term “servitudes,” J. E. Stake, Land-Use Doctrines, in NEW PALGRAVE DICTIONARY OF LAW AND ECONOMICS 437 (Peter Newman, ed., 1998) [hereinafter Stake, Land-Use Doctrines]; RESTATEMENT (THIRD) OF PROPERTY, SERVITUDES (1998). But practitioners usually talk about “covenants.” The Restatement uses “servitudes” to refer to covenants, easements, and other permanent restrictions on the use of land. While negative easements are, in effect, a covenant to permit the use of land for a specific purpose, easements are generally simple rights of passage rather than use restrictions, and will therefore not be considered in this article. At common law, the default rule is that 269270 Southern California Interdisciplinary Law Journal [Vol. 13:2 As discussed in Part III.A, the choice between property or contract status is determined by which will maximize investment while minimizing the sum of holdout and transaction costs on renegotiation. When investment incentives predominate, this favors property status protected by property rules. When the later risks of high transaction costs and holdouts predominate, this favors contract status, which allows easy breakage protected by liability rules. Because real estate is an investment-intensive asset class, covenants are generally given property status and governed by property rules protected by injunctions. The investment induced by the property status of generates an expectation of surplus for each unit owner; when these rights are defeated, the result may be demoralization leading to underinvestment.3The incomplete contracts literature, discussed in Part III.B, looks at the remedies the parties would design to maximize both efficient investment and efficient renegotiation or breach.4 Applying a nontechnical version of incomplete contracts theory, this article will determine whether the legal rules applied in practice are efficient. It will look at the choice of property rules: injunctions versus private-ordered remedies such as fines, forced sale, or self-help, and will apply recent work on erosion rules5 – rights that diminish if unenforced – to look at the impact of transaction costs on investment. The common pool resource literature, as discussed in Part III.C, examines governance as a solution when the holdout risk is too high to justify property rule protection of a shared investment, but the investment incentives are too important for liability rule treatment.6 Viewing common pool resources and covenant regimes as a form of collective property, this article will examine how community association governance structures and remedies regimes reduce transaction costs, and the effect this has on inducing efficient investment in the short term as well as efficient termination in the long term. The primary conclusions are, as discussed in Part IV, first, that the courts should give greater respect to the private ordering of remedies, such as fines, self-help, and expulsion for most covenant violations. These real covenants do not run with the land, but parties routinely contract around this, Stake, Land Use Doctrines, supra note 2, so this article will assume that all covenants run with the land. 3 Frank Michelman, Property, Utility, and Fairness: Comments on the Ethical Foundations of “Just Compensation” Law, 80 HARV. L. REV. 1165 (1968). See discussion infra text at note 81. 4 The recent incomplete contracts literature on the design of remedies for nuisance and covenants is Lucian Arye Bebchuk, Ex Ante Investments and Ex Post Externalities, unpublished manuscript (Dec. 2001), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=297091 [hereinafter Bebchuk, Ex Ante Ex Post]; Lucian Arye Bebchuk, Property Rights and Liability Rules: The Ex Ante View of the Cathedral, 100 MICH. L. REV. 601 (2001) [hereinafter Bebchuk, Ex Ante Cathedral]; Rohan Pitchford & Christopher M. Snyder, Coming to the Nuisance: An Economic Analysis from an Incomplete Contracts Perspective, SSRN Stanford/Yale Jr. Faculty Forum Paper No. 01-17 (February 16, 2001). 5 Omri Ben-Shahar, The Erosion of Rights by Past Breach, 1 AM. L. & ECON. REV. 190-238 (1999). 6 For a synthesis of the common pool resource literature, see ELINOR OSTROM, GOVERNING