Strategic Judgment Proofing

38 Pages Posted: 14 Jul 2008

See all articles by Yeon-Koo Che

Yeon-Koo Che

Columbia University

Kathryn E. Spier

Harvard University - Law School - Faculty; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: February 18, 2008


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 debt holders 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.

Keywords: the judgment-proof problem, strategic judgment proofing, capital structure, subordination, lender liability, limited seniority, shareholder liability

JEL Classification: D21, D62, G32, G38, K13, K22

Suggested Citation

Che, Yeon-Koo and Spier, Kathryn E., Strategic Judgment Proofing (February 18, 2008). Harvard Law and Economics Discussion Paper No. 618, Available at SSRN: or

Yeon-Koo Che

Columbia University ( email )

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Kathryn E. Spier (Contact Author)

Harvard University - Law School - Faculty ( email )

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United States
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National Bureau of Economic Research (NBER)

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