Financial Assurance versus Liability as Solutions to the Judgment-Proof Problem

Abstract

A firm is said to be judgment-proof if it can cause an accident and then skirt its environmental liabilities by pleading bankruptcy. Judgment-proofness is a public-policy problem because it saddles society with uncompensated liability and stifles the firm’s incentive to undertake due care. We employ a simple lending model that incorporates moral hazard to compare three instruments designed to remedy the judgment-proof problem; namely, environmental bonds, mandatory liability insurance and liability. Incentives are unambiguously stronger under liability than they are under either bonds or mandatory insurance. Credit is more rationed and the span of potentially damaging projects is lower under bonds and mandatory insurance than they are under liability. The relative impact of these instruments on social welfare ambiguously depends on entrepreneurial wealth.