Monitoring for latent liabilities: When is it necessary and who should do it?

Published date15 August 2002
Date15 August 2002
AuthorTimothy Swanson,Robin Mason
Timothy Swanson and Robin Mason
The problem of intentional environmental harms is discussed as the com-
bined consequence of limited liability laws and specific capital
structures. When the conditions are "right", then the option of planned liq-
uidation is optimal for certain types of firms. These firms are typified by
capital structures that make it easy for them to engage in "hit and run"
strategies on their industries, i.e. they operate with the intention of early
exit. When this is the case it can be demonstrated that mandatory
insurance forms of institutions are inadequate to the regulation of this par-
ticular problem. It is necessary to engage some manner of continuous mon-
itoring institution, capable of observing and identifying when the capital
structure of the firm begins to resemble those that would choose to engage
in strategic liquidation. The paper concludes by stating that it might be pos-
sible to introduce private sector (bonding) institutions that perform this
function, but it is more likely that a combination of public and private sector
institutions will be able to best undertake the combined monitoring/insur-
ance role that this requires. In short, the paper recommends that the public
An Introduction to the Law and Economics of Environmental Policy: Issues in Institutional
Design, Volume 20, pages 387-411.
Copyright © 2002 by Elsevier Science Ltd.
All rights of reproduction in any form reserved.
ISBN: 0-7623-0888-5
sector should have the obligation to monitor~audit all limited liability
institutions for the existence of the pre-conditions for "looting" behaviour,
and then to charge these firms for limited liability in order to cover the
costs of the monitoring. In this way the costs of incorporation would
be raised sufficiently to render the worst forms of looting unlikely from
the outset.
One of the major causes of large-scale environmental damages is the system
of incentives for strategic liquidation inherent within a limited liability system.
In effect the intersection between the regulatory role of a civil liability
system and the exculpatory function of a limited liability regime makes
available a loophole to appropriately structured firms. These are firms that are
designed to operate on a "hit and run" basis and able to escape liabilities
that take time to accumulate within the environment. In this case strategic
liquidation is the option that is chosen from the outset as the most profitable
approach to the joint use of the firm's assets, and the environment's resources.
This theory of strategic bankruptcy was developed initially in the context of
the American savings and loan (S&L) crisis. The analysis there was undertaken
by Akerlof and Romer (1993) and they stylised the use of strategic bankruptcy
for the appropriation of S&L rents as "looting". In an earlier paper (Mason &
Swanson, 1996) we extended and generalised their analysis to the environmental
context, and identified the structure of firms that would make the "looting
strategy" viable. In this paper our objective is to set forth our conclusions
regarding the appropriate means for regulating for looting. Who can monitor
for this problem and when is it necessary?
Looting is a phenomenon with which most people are now familiar. It has
taken two very noticeable forms recently. In the U.S., the thrifts crisis has been
estimated to have generated societal losses in the amount of US$140 billion.
According to Akerlof and Romer, the S&L crisis resulted from the deliberate
relaxation of the regulatory regime for the savings and loan industry. The
regulators reduced reserves requirements and relaxed monitoring, and this then
produced the loophole through which the looting strategy was able to operate.
Another example of the same phenomenon of looting occurred on a much
more widespread basis in the form of the toxic waste disposal site problem.
This is now a worldwide problem occasioned by the almost complete absence
of any regulatory system regarding the disposal of toxic wastes prior to the
1980s. In this regulatory context, an obvious loophole existed whereby firms
were established for the single purpose of providing landfill sites for the disposal

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