The benefits of extended liability.

We characterize the optimal regulation of a firm that undertakes an environmentally risky activity. This firm (the agent) is protected by limited liability and bound by contract to a stakeholder (the principal). The level of safety care exerted by the agent is nonobservable. This level of care depends both on the degree of incompleteness of the regulatory contract and on the allocation of bargaining power between the principal and the agent. Increasing the wealth of the principal that can be seized upon an accident has no value when private transactions are regulated but might otherwise strictly improve welfare. An incomplete regulation supplemented by an ex post extended liability regime can sometime achieve the second best.

1. Introduction

[] Extending liability toward deep-pockets stakeholders of firms engaged in environmentally risky activities has been a major building block of recent legislation affecting environmental accidents. For instance, under the U.S. 1980 Comprehensive Environmental Response, Compensation, Liability Act (CERCLA), (1) any owner or operator of an environmentally risky venture (2) may be found liable for the losses generated by the firm's activity if the latter is itself judgment-proof, i.e., if its assets cannot cover the cleanup costs of contaminated sites. (3) Despite the international tendency toward strict liability for environmental harm, a general agreement on the rationale for relying on liability rules is still missing. (See Faure and Skogh (2003).) Extending liability to stakeholders has often been viewed as a successful legal response to finance the remediation of hazardous sites or to indemnify victims (a compensation role). Common sense suggests that it might also foster incentives for prevention by inducing private actors to internalize the environmental concerns of the rest of society (an incentive role). This legal doctrine has nevertheless encountered fierce opposition both among practitioners and scholars. Opponents argue that the benefits of extending liability also come with some costs. On top of the administrative costs of litigation, extended liability might change transactions between risky ventures and their contracting partners. Market structures could be modified accordingly.

This article gives some theoretical foundations for using a regime of extended liability and, more broadly, analyzes how private transactions between principals and their agents are modified accordingly. The key justification for doing so is the incompleteness of the regulation. Indeed, the contracts linking the firm to various stakeholders might affect the level of care chosen by the firm and thus have an impact on the environment. These contracts should thus be regulated in one way or another. We show in this article that even when no such regulation is possible, the threat of extended liability might induce private actors to internalize environmental concerns and design private transactions accordingly.

Designing a complete regulation may be of tantamount difficulty when the set of partners who contract with the firm performing some hazardous activities and who can therefore influence the management of environmental risk is not clearly defined at the design stage. (4) Even if the relevant stakeholders can be found out ex ante, environmental regulators generally do not have the statutory or the auditing rights, or even the expertise, to control the contracts that bind those stakeholders to the firm's management. (5) The regulation of environmental risk in such a context is thus necessarily highly incomplete and leaves these contracts largely uncontrolled. As a result, these contracts may influence caretaking in ways that are detrimental to social welfare. Because of this incompleteness, relying ex post on liability might improve welfare by putting the various stakeholders of the firm under the threat of being sanctioned for having wrongly distorted the firm's caretaking if a bad environmental performance occurs.

We determine circumstances under which an incomplete regulation can be improved by ex post liability rules.

We start with a bare-bones model of a vertical relationship between an agent who is subject to environmental risk regulation and liability, and his principal. We first characterize the optimal complete regulation in a moral hazard framework where the agent's level of safety care is nonverifiable but the transaction between the principal and this agent can be controlled. Moral hazard and limited liability (6) force the regulator to leave a socially costly rent to the agent to induce care. Reducing this rent requires a downward distortion of the level of care below the first best.

When the transaction is itself nonverifiable, the regulatory contract is incomplete. This incompleteness may increase significantly the social costs of inducing safety care. To the rent left to the agent to induce care, one must now also add the rent left to his principal so that he designs a private transaction that does not undermine caretaking. Increasing the amount of wealth collectable from the principal under a liability regime helps nevertheless, reducing these extra agency costs. Extended liability may be a rough substitute for a more complete regulation.

To understand more precisely how this substitution works, note that the regulator faces two different moral hazard problems. First, he must induce the cashless agent to exert the proper level of prevention. Second, the regulator must also ensure that the private transaction linking the principal and the agent does not interfere with the regulatory incentives for safety care. If this transaction were regulated, these two problems could be addressed separately. First, the regulator could force the principal to make a payment for the agent's services independent of his environmental performance. Private transactions would thus not affect caretaking. Second, the regulator could design a convenient set of regulatory rewards and punishments to induce the agent to exert care. Extending the principal's liability would then be useless, since, de facto, the principal would not interfere with the agent's management of environmental risk.

When private transactions cannot be regulated and a regime of extended liability is used, the principal is concerned with the agent's environmental performance, since he may be prosecuted to pay fines following an accident. Part of the benefits from private contracting may be dissipated through these fines. Private contracting is modified accordingly. This is where the distribution of bargaining power in private contracting matters. The higher the principal's bargaining power, the less he will be prone to leave the rent that a cash-constrained agent must receive to exert care. Private contracts are thus designed with an eye on reducing this rent. This calls for reducing the level of care performed by the agent. The unregulated design of private contracting thwarts regulatory incentives.

Anticipating this countervailing effect, an incomplete regulation must induce the principal to design a private contract that gives to the agent the correct incentives for safety care. This can be done by increasing sufficiently fines through a liability regime. However, the principal's wealth may not suffice to cover large fines. We characterize a lower bound on the principal's wealth above which the incompleteness of the regulation does not hurt if extended liability is also used. Below this bound, one reaches a third-best outcome characterized by significant care distortions. The principal can still be induced to choose the right private transaction from a social viewpoint, but he must also receive a rent to do so. The rents left to both the principal and the agent compound, and the social cost of inducing care increases. As a result, the downward distortion in care is exacerbated.

When the agent has most of the bargaining power, he can reap most of the surplus from the transaction with his principal. When this surplus is independent of the agent's environmental performance, contracting has no impact on caretaking. Increasing the principal's wealth at stake is then useless. More generally, there is a positive relationship between the wealth needed from a principal to induce care and his bargaining power.