Insolvency and Incentives for Efficient Care

Abstract

Limited liability has long been recognized to incentivize owners of firms near bankruptcy to take suboptimal care to prevent harm to third parties. I use violations of the Clean Water Act to study these incentives. I show that as firms approach bankruptcy (as measured by their credit ratings) they indeed become more likely to violate laws designed to protect third parties. A move from the best to worst credit rating is associated with a seven-fold increase in violation frequency. These results are robust to time and company fixed effects, an instrumental variables strategy, and controls for company liquidity, leverage and profitability. I also propose a policy solution that can improve incentives for firms near bankruptcy. This proposal calls for agencies such as the EPA to increase monitoring of firms closer to insolvency. This can be implemented without legislative changes, and without disrupting foundations of corporate law such as limited liability.

Keywords: Limited Liability; Involuntary Creditor; Bankruptcy; Efficient Care; Tort