Strategic judgment proofing

A liquidity-constrained entrepreneur raises capital to finance a business activity that may harm bystanders. The entrepreneur raises senior (secured) debt to shield assets from the tort victims in bankruptcy. For a fixed level of borrowing, senior debt creates better incentives for precaution taking than either junior debt or outside equity. The entrepreneur's level of borrowing is, however, socially excessive. Giving tort victims priority over senior debtholders in bankruptcy prevents overleveraging but leads to suboptimal incentives. Lender liability exacerbates the incentive problem even further. A limited seniority rule dominates these alternatives. Shareholder liability, mandatory liability insurance, and punitive damages are also discussed. Copyright (c) 2008, RAND.