Eberhard Feess

Auditor liability rules under imperfect information and costly litigation: the welfare-increasing effect of liability insurance

This paper examines auditor liability rules under imperfect information, costly litigation and risk-averse auditors. A negligence rule fails in such a setting, because in equilibrium auditors will deviate with positive probability from any given standard. It is shown that strict liability outperforms negligence with respect to risk allocation and the probability that a desired level of care is met by the auditor if competitive liability insurance markets exist. Furthermore, our model explains the existence of insurance contracts containing obligations a type of contract often observed in liability insurance markets.

Environmental harm and financial responsibility

Firms will exert too little care due to a limited liability effect if damages are likely to exceed their equity. This is particularly important for environmental and product liability and motivates the current discussion about mandatory insurance and extending liability to creditors. We model the choice of the care level as a moral hazard problem that can be solved through costly monitoring. Conventional strict liability and lender liability both lead to distortions in the capital structure and to inefficiently low care. By contrast, mandatory liability coverage (financial responsibility) that can be satisfied by either an insurance contract or a lender guarantee leads to the first best allocation if managers can self-insure, and to the second best if managers cannot self-insure but choose to be monitored.

Lender Liability for Environmental Harm: An Argument Against Negligence Based Rules

A firm strictly liable for any harm done will choose an inefficiently low care level if there is a possibility that it goes bankrupt. One possibility to improve care is extending liability to secured lenders, as applied under CERCLA and as currently being discussed in the EU. I compare strict liability, partial liability and vague negligence for lenders in a model with moral hazard and environmental auditing. While auditing is socially valuable only if it increases the firms care level, the creditor also calculates the reduction in the information rent. Thus, for each possible care level, monitoring is always too high. This effect is aggravated by a vague negligence rule, where the probability that a lender is found liable decreases in the level of auditing. It is demonstrated that partial liability is superior, because the incentive for excessive monitoring is diminished.

The role of insurance in the adjudication of multiparty accidents

This paper considers the case where adequate negligence standards cannot be defined because actions of defendants before an accident are imperfectly observable. Negligence-based liability rules, which are often considered as the only efficient liability rule in the presence of multiple tortfeasors, are not feasible in this environment. We propose an insurance-based liability rule as a remedy: Damages are apportioned according to the insurance policies of the defendants. The adjudication is made dependent on the requirement that the injurers have taken out insurance coverage setting the right incentives. The liability rule is easy to characterize, efficient, and avoids the use of punitive damages. Insurance-based liability could also be helpful to mitigate the problem of unobservable avoidance costs.