Verification Institutions in Financing Transactions

One of the most common problems in commercial transactions is the resolution of information asymmetries, situations in which one party to the transaction knows more about a relevant fact than the other party. The natural response of the disadvantaged party is to attempt to investigate the transaction for itself – to investigate the matter with due diligence – but often such an investigation will be expensive and, however diligently undertaken, leave the truth of the matter uncertain. A law-centered approach to the problem would call for the development of warranties and covenants that the party with superior information would give to the party with inferior information. Such an approach would rely on lawsuits to prevent and redress any breach of the applicable warranties and covenants. For numerous reasons, however, the formal legal system cannot provide a satisfactory solution to the problem. For one thing, formal legal rules cannot show the context sensitivity necessary to obtain the correct set of assurances from parties with superior information. Thus, formal legal rules by themselves often provide assurances that are either excessive or inadequate in the circumstances of a particular transaction. Similarly, the costs of transacting often make it impractical for the parties to develop those assurances on their own on a case-by-case basis. Finally, even if legislators or contracting parties could devise appropriate assurances, the cost and uncertainty of enforcing those assurances through legal processes is prohibitive. Accordingly, contracting parties often can provide more effective solutions to information problems through the use of privately instituted sanctions that operate either partially or wholly apart from the legal system. In that vein, this article works within the tradition of institutional economics associated with Douglass North. The article starts from the premise that the success and failure of parties in conducting value-increasing transactions cannot be explained solely by reference to the mechanics of supply and demand curves. A crucial part of any account of transactions must analyze the institutional background against which individual parties contract, because the success and failure of transacting parties often depends on the effectiveness of those institutions. I have published a series of articles in the last few years that present a substantial amount of empirical evidence drawn from interviews and case studies about the transacting practices that businesses follow in a variety of commercial contexts involving some form of credit or payment. Each of those articles has attempted to provide a localized theoretical explanation for the behavior that it describes, much of which consists of sophisticated mechanisms for resolving problems of information asymmetry. This article tries to build upon those prior articles by providing a unified theoretical framework for those mechanisms. Specifically, this article contends that all of those mechanisms (as well as the law-centered mechanisms described above) can be analyzed most clearly by reference to a single theme, the bond-like transaction described in Oliver Williamson\u27s seminal paper on the use of hostages in relational contracting