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Legal scholars Katharina Pistor and Chenggang Xu say that law is necessarily incomplete.

What Is Incomplete Law?

Lawmakers cannot foresee all situations in which the law may be applied or needed. Changes in social conditions, innovations in markets and developments in new technologies may create circumstances not contemplated when the law was created. A very specific law may very quickly become obsolete. So, legislatures often formulate general law that can be applied to all conditions and individuals covered under the law. While a general law prevents arbitrariness with respect to the application of the law, it makes it impossible to create a complete law. New circumstances always arise.

Two Ways the Law Is Incomplete

Pistor and Xu identify two ways in which law may be incomplete:

Type I. Law may incomplete because it mandates a broad set of outcomes without specifying actions (or specifying only a few actions) covered by the law. For instance, the government may mandate that all school children should attain a particular degree of academic competence, but not indicate how this is supposed to happen.

Type II. Law may be incomplete because it prohibits certain actions, but does not capture all possible actions that may fall under the law. For instance, law may prohibit managers from defrauding investors, but exactly which accounting practices “count” as illegal may be unclear.

Because law is incomplete and cannot cover every situation or action, legislatures often use others to decide how the general principles of the law are applied in concrete circumstances. This is called “residual lawmaking and enforcement.”

Who Is Responsible for Residual Lawmaking and Enforcement?

There are two main ways that countries deal with the incompleteness of law.

• Reactive approach. Residual lawmaking and enforcement occurs through courts. This does not work well in every situation since it requires that a problem or dispute has already occurred, and it can be costly and time consuming.
• Proactive approach. Residual lawmaking and enforcement can also occur via regulators. When regulators have the right to adapt rules flexibly, disputes and law breaking can be avoided, generally at a lower cost.

A country may attempt to minimize residual lawmaking through legislation. That is, the legislature may try to create legislation to cover every circumstance. However, this approach is very ineffective since legislative bodies are cumbersome and generally reactive (for instance, they respond more slowly to changing market conditions and innovations).

Approaches to Dealing with Incomplete Law

Different social factors that may affect whether governments rely on courts or regulators for residual lawmaking and enforcement. England, the U.S. and Germany provide good examples of how government divide up responsibilities for applying and enforcing the law.

Social Factors Shape the Way Countries Deal with Incomplete Law

Even though different countries may confront similar problems (for example, incomplete law for handling damages within a securities market), the way that they seek to remedy the incompleteness of law depends on a number of different factors. Some of the social factors that affect the allocation of residual lawmaking and enforcement include:

• The legal family of the country (for instance, common law versus civil law),
• Existing institutions for handling residual lawmaking and enforcement,
• The experience of other countries in handling similar challenges,
• Political and economic context (for example, the timing of financial crisis),
• The period of industrialization.

In short, the peculiar history and context of a country’s legal system affects the manner in which the country divides up the work of applying and enforcing the law.

Market Effects

The ways that countries deal with incomplete law also has important effects on markets. The "flow" of the effects from the incompleteness of law to the effect on markets is illustrated in Figure 1.

Figure 1. Relationship between Incomplete Law and Markets

England, the U.S. and Germany provide a good example of different ways of dealing with incomplete law in securities markets. Each country’s approach to allocating residual lawmaking and enforcement between courts and regulators had important effects on the country’s markets.

Placing the "path" of each country into the framework in Figure 1 provides a way to compare the way the three countries responded to the challenges of incomplete law governing securities markets.

Table 1. Institutions, Residual Lawmaking and Market Effects in Three Countries.

Country	Social Factors	Method of Dividing Up Residual Lawmaking and Enforcement Powers	Market Effects
England	Strong common law court system.	Common law was "stretched" by courts to fit the situation. Slow pace of move to regulation was spearheaded by stock exchanges. Limitations of stock exchanges lead to state regulation.	Business were threatened until state regulation took over from the courts. State regulation covered both exchanges and securities outside exchanges.
U.S.	Early existence of self-regulating stock exchange (New York Stock Exchange).	Early, fast self-regulation, less reliance on courts. Federal regulation (SEC) follows later (after market crash of 1929).	Regulated securities market. Strong business environment.
Germany	Civil law, unclear how principles applied. Relatively late industrialization.	Legislative restrictions on corporate access to stock markets. Stock exchanges under supervision of state. Little allocation of residual lawmaking and enforcement.	Restricted securities exchange market, largely unregulated outside securities exchange.

So, even though all three countries were responding to the incompleteness of law with respect to the securities market, social conditions affected the way that residual lawmaking and enforcement powers were allocated which, in turn, had important effects on the securities markets.