Lender Liability and Cleanup Procudure: A Comparison

There are several judicial cases under the US environmental law, in which a lending bank is liable for cleaning up environmentally hazardous materials generated by its borrowing firm. Such a liability rule, so-called lender liability, is applied to a lending bank which has been actively involved in the management of the firm. We first show that the application of lender liability does not necessarily lead to the first-best allocation if the cleanup cost per material depends on an agent who conducts the cleanup. This particularly holds true if the cleanup cost to the entrepreneur is the smallest. We then show that lender liability can lead to the first-best allocation if the bank captures the firm's control right before the environmental agency intervenes.