Safety Monitoring, Capital Structure, and "Financial Responsibility"

E. Feess, U. Hege

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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.
Original languageEnglish
Place of PublicationTilburg
PublisherFinance
Number of pages30
Volume2000-33
Publication statusPublished - 2000

Publication series

NameCentER Discussion Paper
Volume2000-33

Keywords

  • lender liability
  • compulsory insurance
  • choice betwwen private and public debt
  • limited liability effect

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