Working Paper: NBER ID: w14183
Authors: Yeonkoo Che; Kathryn E. Spier
Abstract: 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.
Keywords: No keywords provided
JEL Codes: D21; D62; G32; G38; K13; K22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| secured senior debt (G32) | increased precautionary measures (D18) |
| increased precautionary measures (D18) | reduced risk of non-repayment (G51) |
| reduced risk of non-repayment (G51) | lower interest rate (E43) |
| lower interest rate (E43) | increased precautionary measures (D18) |
| excessive borrowing (F65) | decreased care (I12) |
| decreased care (I12) | increased risk of harm (I12) |
| mandatory subordination of debt to tort claims (G33) | prevent overborrowing (G51) |
| prevent overborrowing (G51) | lower precaution levels (Y50) |
| limited seniority rule (M51) | balance capital needs with precaution (G31) |
| balance capital needs with precaution (G31) | enhance social welfare (I30) |