Bargaining power and the impact of lender liability for environmental damages

Should lenders be made liable for environmental damages caused by their customers? In a recent paper Pitchford studied the case where the customer is a wealth-constrained manager-owned firm. He argued convincingly that a joint liability of lender and firm may reduce the firm's incentive to prevent an environmental damage and may therefore be socially harmful. However, his argument hinges on the assumption that the lender has no bargaining power and makes 0-profits in a contract. In this paper we study all possible optimal contracts between the borrower and the lender. In particular we study the case where the lender has all the bargaining power. We use the weighted Nash-bargaining solution to handle both cases in a unified framework. The results for the case where the lender has a high bargaining power differ substantially from Pitchford's findings. Then a joint liability rule is socially preferable to single liability of the firm. In fact, often it is optimal to require a liability above the actual costs of a damage or to set it so high that it extracts all potential profits from the project