Abatement, Care, and Compliance by Firms in Financial Distress
46 Pages Posted: 23 Feb 2011
Date Written: February 19, 2011
We examine precautionary behavior, specifically compliance with environmental regulations, pollution abatement, and care spending, by firms facing two sources of insolvency risk. If poor profit or a realized environmental liability triggers insolvency, then the firm forgoes a profitable future. The behavioral implications of the survival motive vary across firms. Firms for whom the principal insolvency risk is liability-related liability choose supra-optimal precaution, even though these firms would have otherwise chosen suboptimal precaution. For other firms, whose primary insolvency risk is profit-related, the survival motive reinforces incentives for suboptimal precaution arising from the familiar judgment-proof effect. We characterize how insolvency risks affect not only these ex ante precautionary decisions, but also the incentive for a firm to conceal adverse events linked to these choices, such as an accident or a regulatory violation. An understanding of these incentives, and their potential implications for environmental quality, is particularly important during recessionary periods when firms struggle to survive the downturn.
Keywords: insolvency, compliance, abatement, judgment proof, liability, care, concealment
JEL Classification: Q53, D21, K32
Suggested Citation: Suggested Citation