Improving the Prevention of Environmental Risks with Convertible Bonds

In this paper, a manager borrows external funds in order to invest in production and also in prevention. The latter action must reduce the environmental risk driven by the activity of the firm. Prevention is observable neither by outside lenders nor by institutions such as environmental agencies for instance. In such a situation, we show that issuing convertible bonds - which permits the holder to exchange his bonds for a predetermined number of shares of the firm - from a limited liability firm could be a way to improve prevention compared to what can usually be done with standard debt. Such a relationship between the firm and the bank might be an alternative, or a complement, to the CERCLA legislation about extended liability which prevails in the United States and which is often discussed in Europe as a possible support of a more tightened European environmental legislation. We obtain an optimal convertible bond contract that induces more prevention and higher expected net revenues for the firm than standard debt. The expected social welfare is also improved. Finally, the economic implications of our findings are discussed.