On extended liability in a model of adverse selection

Abstract

We consider a model where a judgment-proof firm needs finance to realize a project. This project might cause an environmental hazard with a probability that is the private knowledge of the firm. Thus there is asymmetric information with respect to the environmental riskiness of the project. We consider the implications of a simple joint and strict liability rule on the lender and the firm where, in case of a damage, the lender is responsible for that part of the liability which the judgment-proof firm cannot pay. We use a weighted version of the neutral bargaining solution (Myerson 1983 / 1984) to determine the financial contract between the lender and the firm. In the given model we show that either full or a punitive liability is optimal.judgement proofness, extended liability, neutral bargaining solution.