A liquidity-constrained entrepreneur needs to raise capital to finance a business activity that may cause injuries to third parties -- the tort victims. Taking the level of borrowing as fixed, the entrepreneur finances the activity with senior (secured) debt in order to shield assets from the tort victims in bankruptcy. Interestingly, senior debt serves the interests of society more broadly: it creates better incentives for the entrepreneur to take precautions than either junior debt or outside equity. Unfortunately, the entrepreneur will raise a socially excessive amount of senior debt. Giving tort victims priority over senior debtholders in bankruptcy prevents over-leveraging but leads to suboptimal incentives. Lender liability exacerbates the incentive problem even further. A Limited Seniority Rule, where the firm may issue senior debt up to an exogenous limit after which any further borrowing is treated as junior to the tort claim, dominates these alternatives. Shareholder liability, mandatory liability insurance and punitive damages are also discussed.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
14183.
Length: Date of creation: Jul 2008 Date of revision: Handle: RePEc:nbr:nberwo:14183
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Find related papers by JEL classification: D21 - Microeconomics - - Production and Organizations - - - Firm Behavior D62 - Microeconomics - - Welfare Economics - - - Externalities G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Capital and Ownership Structure G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation K13 - Law and Economics - - Basic Areas of Law - - - Tort Law and Product Liability K22 - Law and Economics - - Regulation and Business Law - - - Corporation and Securities Law
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