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Strategic Judgment Proofing

Yeon-Koo Che

Columbia University

Kathryn E. Spier

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

July 2008

NBER Working Paper No. w14183

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 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.

Number of Pages in PDF File: 38

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Date posted: July 21, 2008  

Suggested Citation

Che , Yeon-Koo and Spier, Kathryn E., Strategic Judgment Proofing (July 2008). NBER Working Paper No. w14183. Available at SSRN: https://ssrn.com/abstract=1165511

Contact Information

Yeon-Koo Che
Columbia University ( email )
420 W. 118th Street, 1016IAB
New York, NY 10027
United States
212-854-8276 (Phone)
HOME PAGE: http://www.columbia.edu/~yc2271
Kathryn E. Spier (Contact Author)
Harvard University - Law School - Faculty ( email )
1575 Massachusetts
Hauser 302
Cambridge, MA 02138
United States
(617) 496-0019 (Phone)

National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
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