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Strategic Judgment Proofing

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Author Info
Che, Yeon-Koo
Spier, Kathryn

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Abstract

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, reducing his incentives for care and generating wasteful spending. 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 University Library of Munich, Germany in its series MPRA Paper with number 6100.

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Date of creation: 12 Jun 2006
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Handle: RePEc:pra:mprapa:6100

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K0 - Law and Economics - - General
G3 - Financial Economics - - Corporate Finance and Governance

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  1. Pitchford, Rohan, 1995. "How Liable Should a Lender Be? The Case of Judgment-Proof Firms and Environmental Risk," American Economic Review, American Economic Association, vol. 85(5), pages 1171-86, December. [Downloadable!] (restricted)
  2. 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.
  3. Boyer, Marcel & Laffont, Jean-Jacques, 1997. "Environmental risks and bank liability," European Economic Review, Elsevier, vol. 41(8), pages 1427-1459, August. [Downloadable!] (restricted)
    Other versions:
  4. Bruce Hay & Kathryn E. Spier, 2005. "Manufacturer Liability for Harms Caused by Consumers to Others," American Economic Review, American Economic Association, vol. 95(5), pages 1700-1711, December. [Downloadable!]
  5. Steven Shavell, 2004. "Minimum Asset Requirements and Compulsory Liability Insurance As Solutions to the Judgment-Proof Problem," NBER Working Papers 10341, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  6. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October. [Downloadable!] (restricted)
  7. 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. [Downloadable!] (restricted)
  8. Tracy R. Lewis & David E. M. Sappington, 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 724-730, June. [Downloadable!] (restricted)
  9. Spier, Kathryn E. & Sykes, Alan O., 1998. "Capital structure, priority rules, and the settlement of civil claims," International Review of Law and Economics, Elsevier, vol. 18(2), pages 187-200, June. [Downloadable!] (restricted)
  10. T. Randolph Beard, 1990. "Bankruptcy and Care Choice," RAND Journal of Economics, The RAND Corporation, vol. 21(4), pages 626-634, Winter. [Downloadable!] (restricted)
  11. Shavell, S., 1986. "The judgment proof problem," International Review of Law and Economics, Elsevier, vol. 6(1), pages 45-58, June. [Downloadable!] (restricted)
  12. Innes, Robert D., 1990. "Limited liability and incentive contracting with ex-ante action choices," Journal of Economic Theory, Elsevier, vol. 52(1), pages 45-67, October. [Downloadable!] (restricted)
  13. Lucian Arye Bebchuk & Jesse Fried, 1998. "The Uneasy Case for the Priority of Secured Claims in Bankruptcy: Further Thoughts and a Reply to Critics," NBER Working Papers 6472, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  14. Mattiacci, Giuseppe Dari & Parisi, Francesco, 2003. "The cost of delegated control: vicarious liability, secondary liability and mandatory insurance," International Review of Law and Economics, Elsevier, vol. 23(4), pages 453-475, December. [Downloadable!] (restricted)
  15. Hart, Oliver & Moore, John, 1995. "Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management," American Economic Review, American Economic Association, vol. 85(3), pages 567-85, June. [Downloadable!] (restricted)
    Other versions:
  16. Boyd, James & Ingberman, Daniel E, 1994. "Noncompensatory Damages and Potential Insolvency," Journal of Legal Studies, University of Chicago Press, vol. 23(2), pages 895-910, June.
  17. Kathryn E. Spier & Michael D. Whinston, 1995. "On the Efficiency of Privately Stipulated Damages for Breach of Contract: Entry Barriers, Reliance, and Renegotiation," RAND Journal of Economics, The RAND Corporation, vol. 26(2), pages 180-202, Summer. [Downloadable!] (restricted)
  18. Boyd, James & Ingberman, Daniel E., 1999. "Do punitive damages promote deterrence?1," International Review of Law and Economics, Elsevier, vol. 19(1), pages 47-68, March. [Downloadable!] (restricted)
  19. 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. [Downloadable!] (restricted)
  20. Perotti, Enrico C & Spier, Kathryn E, 1993. "Capital Structure as a Bargaining Tool: The Role of Leverage in Contract Renegotiation," American Economic Review, American Economic Association, vol. 83(5), pages 1131-41, December. [Downloadable!] (restricted)
    Other versions:
  21. Ulph, Alistair & Valentini, Laura, 2004. "Environmental liability and the capital structure of firms," Resource and Energy Economics, Elsevier, vol. 26(4), pages 393-410, December. [Downloadable!] (restricted)
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