Abatement, Care, and Compliance by Firms in Financial Distress

Abstract

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.