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Article
Strategic judgment proofing
Rand Journal of Economics (2008)
  • Yeon-Koo Che, Columbia University
  • Kathryn E. Spier, Northwestern University
Abstract
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.
Keywords
  • the judgment proof problem,
  • strategic judgment proofing,
  • capital structure,
  • subordination,
  • lender liability,
  • limited seniority,
  • shareholder liability
Publication Date
2008
Publisher Statement
Discussion Paper 0506-14
Citation Information
Yeon-Koo Che and Kathryn E. Spier. "Strategic judgment proofing" Rand Journal of Economics Vol. 39 (2008)
Available at: http://works.bepress.com/yeonkoo/13/