For more than 150 years, limited liability has been a defining characteristic of many business entities. This legal concept is often credited with spurring economic growth and the development of capital markets; some call it ‘one of man’s greatest inventions’ (The Economist, 2016). Economists and policymakers have long recognized, however, that limited liability engenders a moral hazard problem because the assets of a firm may be insufficient to pay creditors’ claims. This, in turn, may incentivize behavior that is privately profitable but socially costly. Indeed, Senator Elizabeth Warren cites limited liability protection as justification for extending the fiduciary obligations to other stakeholders: ‘American corporations exist only because the American people grant them charters. Those charters confer valuable privileges - such as limited legal liability for their owners - that enable businesses to turn a profit. What do Americans get in return? What are the obligations of corporate citizenship in the U.S.?’ (The Wall Street Journal, 2018).

In our paper, The Limits of Limited Liability: Evidence from Industrial Pollution, we study the tradeoffs of limited liability for environmental cleanup costs in the parent-subsidiary context. While reducing exposure to environmental liabilities may encourage investment and economic growth, it also weakens incentives to limit toxic emissions. Such emissions potentially impose significant costs on other stakeholders, including adverse health outcomes, decreased worker productivity, and lower home prices. Policymakers in many countries have adopted a ‘polluter pays’ approach to environmental regulation to encourage the internalization of such costs; Etsy (2008) states the principle has ‘taken on a quasi-constitutional aura in international environmental law.’ However, the effectiveness of this regulatory framework is, to an extent, undercut by limited liability. If liability truly is limited, a parent will not bear the costs of environmental remediation that exceed the value of its subsidiary’s assets.

Our empirical setting uses a Supreme Court case that clarified parent company liability under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA), also known as Superfund. CERCLA authorizes the Environmental Protection Agency (EPA) to impose ex post liability on parties responsible for toxic sites. In United States v. Bestfoods (524 U.S. 51, 1998), the Supreme Court narrowed the circumstances under which parents are responsible for subsidiaries’ environmental cleanup costs. Prior to Bestfoods, some circuit courts held parent firms liable for such costs under a relatively broad range of circumstances, namely if they had ‘actual control’ of or the ‘ability to control’ subsidiaries. In Bestfoods, the Supreme Court invalidated these tests. We use this decision as a natural experiment in a difference-in-differences framework. The treatment group for our analysis consists of plants located in areas that had weaker liability protection prior to Bestfoods; the control group consists of those located in areas where a relatively narrow standard for parent liability was already in place.

Our findings indicate that the Bestfoods decision was associated with significant changes in the environmental behavior of firms. Treated plants increase ground emissions by approximately 5-9% relative to the control group in the five years following the case. This increase is driven by both the intensive and extensive margins of pollution. We document similar magnitudes for chemicals known to cause harm to humans (including cancer and other chronic diseases) and for other chemicals. Increased liability protection also has a positive effect on firm value; CARs around oral arguments for Bestfoods are approximately 1% for parents with relatively high exposure to the decision.

We consider multiple channels that potentially explain this change in environmental behavior. Evidence suggests that the increase in emissions stems, at least in part, from reduced investment in abatement technologies. Specifically, Bestfoods is associated with approximately a 15-17% decline in abatement related to the production process (e.g., modifying equipment or improving chemical reaction conditions). We do not, however, find evidence that the increase in emissions is a result of an increase in production or reallocation across plants.

We perform a series of cross-sectional tests to explore heterogeneity in response to Bestfoods. First, we consider the role of subsidiary solvency. The likelihood of parent liability is, in part, a function of the likelihood that the cost of an environmental cleanup would bankrupt a subsidiary. Consistent with this idea, the increase in pollution and reduction in abatement concentrate in less solvent subsidiaries. The effects are also driven by facilities of parents with a higher proportion of tangible assets - those for which pollution abatement activities are likely more costly. Finally, we document a moral hazard motivation for the increase in pollution and decrease in abatement activities. Specifically, the effects of Bestfoods are concentrated in the plants of parents that are close to financial distress and likely prioritize short-term financing needs over the avoidance of long-term liabilities.

Overall, our findings highlight the moral hazard problem associated with limited liability. While our setting precludes a rigorous welfare analysis, the results suggest that strengthening limited liability for parents leads to an increase in costs borne by other stakeholders. Thus, efforts by policymakers to strengthen liability protections should carefully weigh the interests of the owners of corporations with those of other constituencies.


Pat Akey is Assistant Professor of Finance at the University of Toronto.

Ian Appel is Assistant Professor of Finance at the Carroll School of Management, Boston College.