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Safety Monitoring, Capital Structure, and "Financial Responsibility"

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  • Feess, E.
  • Hege, U.

    (Tilburg University, Center for Economic Research)

Abstract

Firms will exert too little preventive care if damages are likely to exceed their equity. This is particularly important for environmental and product liability and motivates the current discussion about extending liability to creditors. We propose a model where the firm can be financed by equity, bank debt or publicly traded debt. There is a moral hazard problem about the choice of care that can be mitigated through stochastic monitoring of its safety standards. We show that the optimal allocation can always be implemented by a liability regime of "financial responsibility", that is mandatory liability coverage that can be fulfilled either by an insurer or by a lender. We find that the first best can only be achieved if the defendants are fully liable. This result is in contrast to related models which find liability below the level of harm optimal, and we show that the difference is due to the inclusion of safety monitoring. Financial responsibility is strictly superior to lender liability alone or strict liability without extended liability, but their relative ranking may vary.

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Bibliographic Info

Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 2000-33.

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Date of creation: 2000
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Handle: RePEc:dgr:kubcen:200033

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Web page: http://center.uvt.nl

Related research

Keywords: lender liability; compulsory insurance; choice betwwen private and public debt; limited liability effect;

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References

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  1. Kroszner, Randall S. & Strahan, Philip E., 2001. "Bankers on boards: *1: monitoring, conflicts of interest, and lender liability," Journal of Financial Economics, Elsevier, vol. 62(3), pages 415-452, December.
  2. Chemmanur, Thomas J & Fulghieri, Paolo, 1994. "Reputation, Renegotiation, and the Choice between Bank Loans and Publicly Traded Debt," Review of Financial Studies, Society for Financial Studies, vol. 7(3), pages 475-506.
  3. Boyer, M. & Laffont, J.J., 1995. "Environmental Risks and Bank Liability," Cahiers de recherche 9501, Centre interuniversitaire de recherche en économie quantitative, CIREQ.
  4. Boyd, James, 1996. "Banking on "Green Money:" Are Environmental Financial Responsibility Rules Fulfilling Their Promise?," Discussion Papers dp-96-26, Resources For the Future.
  5. Endres, A. & Ludeke, A., 1998. "Incomplete strict liability: effects on product differentiation and information provision 1," International Review of Law and Economics, Elsevier, vol. 18(4), pages 511-528, December.
  6. Gompers, Paul & Lerner, Josh, 1999. "An analysis of compensation in the U.S. venture capital partnership," Journal of Financial Economics, Elsevier, vol. 51(1), pages 3-44, January.
  7. Boyd, James & Ingberman, Daniel E, 1997. "The Search for Deep Pockets: Is "Extended Liability" Expensive Liability?," Journal of Law, Economics and Organization, Oxford University Press, vol. 13(1), pages 232-58, April.
  8. Kornhauser, Lewis A & Revesz, Richard L, 1990. "Apportioning Damages among Potentially Insolvent Actors," The Journal of Legal Studies, University of Chicago Press, vol. 19(2), pages 617-51, June.
  9. Ringleb, Al H & Wiggins, Steven N, 1990. "Liability and Large-Scale, Long-term Hazards," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 574-95, June.
  10. Rajan, Raghuram G, 1992. " Insiders and Outsiders: The Choice between Informed and Arm's-Length Debt," Journal of Finance, American Finance Association, vol. 47(4), pages 1367-400, September.
  11. Eberhard Feess & Ulrich Hege, 2000. "Environmental Harm and Financial Responsibility*," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan, vol. 25(2), pages 220-234, April.
  12. Lewis, Tracy R. & Sappington, David E. M., 1999. "Using decoupling and deep pockets to mitigate judgment-proof problems1," International Review of Law and Economics, Elsevier, vol. 19(2), pages 275-293, June.
  13. Feess, E. & Hege, U., 2000. "Environmental harm and financial responsibility," Open Access publications from Tilburg University urn:nbn:nl:ui:12-85388, Tilburg University.
  14. T. Randolph Beard, 1990. "Bankruptcy and Care Choice," RAND Journal of Economics, The RAND Corporation, vol. 21(4), pages 626-634, Winter.
  15. Balkenborg, D., 1997. "Bargaining power and the impact of lender liability for environmental damages," Discussion Paper Series In Economics And Econometrics 9709, Economics Division, School of Social Sciences, University of Southampton.
  16. Shavell, Steven, 1997. "The optimal level of corporate liability given the limited ability of corporations to penalize their employees," International Review of Law and Economics, Elsevier, vol. 17(2), pages 203-213, June.
  17. Dieter Balkenborg, 2001. "How Liable Should a Lender Be? The Case of Judgment-Proof Firms and Environmental Risk: Comment," American Economic Review, American Economic Association, vol. 91(3), pages 731-738, June.
  18. Bolton, Patrick & Scharfstein, David S, 1996. "Optimal Debt Structure and the Number of Creditors," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 1-25, February.
  19. Diamond, Douglas W, 1991. "Monitoring and Reputation: The Choice between Bank Loans and Directly Placed Debt," Journal of Political Economy, University of Chicago Press, vol. 99(4), pages 689-721, August.
  20. James Boyd & Daniel E Ingberman, 1996. "The “Polluter Pays Principle”: Should Liability be Extended When the Polluter Cannot Pay?," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan, vol. 21(2), pages 182-203, April.
  21. Demougin, Dominique & Fluet, Claude, 1999. "A further justification for the negligence rule," International Review of Law and Economics, Elsevier, vol. 19(1), pages 33-45, March.
  22. Gary S. Becker, 1968. "Crime and Punishment: An Economic Approach," Journal of Political Economy, University of Chicago Press, vol. 76, pages 169.
  23. Innes, Robert, 1999. "Optimal liability with stochastic harms, judgement-proof injurers, and asymmetric information1," International Review of Law and Economics, Elsevier, vol. 19(2), pages 181-203, June.
  24. Heyes, Anthony G, 1996. "Lender Penalty for Environmental Damage and the Equilibrium Cost of Capital," Economica, London School of Economics and Political Science, vol. 63(250), pages 311-23, May.
  25. Posey, Lisa Lipowski, 1993. "Limited liability and incentives when firms can inflict damages greater than net worth," International Review of Law and Economics, Elsevier, vol. 13(3), pages 325-330, September.
  26. Eberhard Feess, 1999. "Lender Liability for Environmental Harm: An Argument Against Negligence Based Rules," European Journal of Law and Economics, Springer, vol. 8(3), pages 231-250, November.
  27. Polborn, Mattias K., 1998. "Mandatory insurance and the judgment-proof problem," International Review of Law and Economics, Elsevier, vol. 18(2), pages 141-146, June.
  28. Jost, Peter-J., 1996. "Limited liability and the requirement to purchase insurance," International Review of Law and Economics, Elsevier, vol. 16(2), pages 259-276, June.
  29. Wiggins, Steven N & Ringleb, Al H, 1992. "Adverse Selection and Long-Term Hazards: The Choice between Contract and Mandatory Liability Rules," The Journal of Legal Studies, University of Chicago Press, vol. 21(1), pages 189-215, January.
  30. Randall S. Kroszner & Philip E. Strahan, 1998. "Bankers on boards: monitoring, financing, and lender liability," Proceedings, Federal Reserve Bank of San Francisco, issue Sep.
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Citations

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Cited by:
  1. Coestier, B. & Gozlan, Estelle & Marette, Stephan, 2002. "Prevention, Limited Liability and Market Structure," 2002 International Congress, August 28-31, 2002, Zaragoza, Spain 8531, European Association of Agricultural Economists.
  2. Marcel Boyer & Donatella Porrini, 2007. "Sharing Liability Between Banks and Firms: The Case of Industrial Safety Risk," CIRANO Working Papers 2007s-04, CIRANO.
  3. Eberhard Feess & Gerd Muehlheusser & Ansgar Wohlschlegel, 2009. "Environmental liability under uncertain causation," European Journal of Law and Economics, Springer, vol. 28(2), pages 133-148, October.
  4. Hutchinson, Emma & van 't Veld, Klaas, 2005. "Extended liability for environmental accidents: what you see is what you get," Journal of Environmental Economics and Management, Elsevier, vol. 49(1), pages 157-173, January.
  5. Helm, Carsten, 2008. "How liable should an exporter be?: The case of trade in hazardous goods," International Review of Law and Economics, Elsevier, vol. 28(4), pages 263-271, December.
  6. Juan José Ganuza & Fernando Gómez, 2003. "Optimal negligence rule under limited liability," Economics Working Papers 759, Department of Economics and Business, Universitat Pompeu Fabra, revised May 2004.
  7. Bidénam Kambia-Chopin, 2010. "Environmental risks, the judgment-proof problem and financial responsibility," European Journal of Law and Economics, Springer, vol. 30(2), pages 77-87, October.
  8. Henry van Egteren & R. Smith & Dean McAfee, 2004. "Harmonization of Environmental Regulations When Firms are Judgment Proof," European Journal of Law and Economics, Springer, vol. 17(2), pages 139-164, March.

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