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Safety monitoring, capital structure, and "financial responsibility"

  • Feess, Eberhard
  • Hege, Ulrich

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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Article provided by Elsevier in its journal International Review of Law and Economics.

Volume (Year): 23 (2003)
Issue (Month): 3 (September)
Pages: 323-339

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Handle: RePEc:eee:irlaec:v:23:y:2003:i:3:p:323-339
Contact details of provider: Web page: http://www.elsevier.com/locate/irle

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  1. Boyd, James, 1996. "Banking on "Green Money:" Are Environmental Financial Responsibility Rules Fulfilling Their Promise?," Discussion Papers dp-96-26, Resources For the Future.
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  21. 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.
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  24. repec:ner:tilbur:urn:nbn:nl:ui:12-85388 is not listed on IDEAS
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