Chapter Outline 17.1Risk Shifting through Limited Liability Limited Liability as Insurance against Loss The Case of Parents and Subsidiaries Who Pays for the Implicit Insurance? The Moral Hazard Problem Why Have Limited Liability? Individual Shareholders Limited Liability for Parent Corporations Exceptions to Limited Liability 17.2Liability for Actions of Employees and Other Parties Vicarious Liability Doctrine Liability of Businesses for Actions of Independent Contractors

Chapter Outline 17.3Hold Harmless and Indemnity Agreements Effect on the Cost of Risk The Role of Insurance Summary of Incentive Effects 17.4Claims Management and Administration General Claims Strategy Incentives to Settle Reputation Effects Effects of Multiple Suits Nuisance Suits and Fraud Releases and Advance Payments Lump Sum versus Structured Settlements Monitoring Performance of Insurers and Outside Contractors Claim Cost Allocation 17.5Summary

Limited Liability of Corporations Definition of LL: – Shareholders _______ be held liable for claims against the corporation that exceed the corporation’s assets – I.e., shareholders’ liability is limited to their __________ interest

LL as Insurance – Compared to a system with unlimited liability, LL provides shareholders with _________against losses that exceed corporate assets – Example: Firm has assets = $10 million Firm has no liabilities ==> equity value = $___ million What if someone wins a tort judgement against the corporation for $12 million?

LL as Insurance – Graphically, Total tort liability claims Loss to Shareholders $10 m

LL as Insurance Main Points: – LL allows risk shifting analogous to insurance – Potential ______________ bear the risk of losses in excess of the corporation’s assets

Subsidiaries and LL – A parent corporation can organize so that it owns all the stock of other corporations (its subsidiaries) – Example: – This limits the liability of the ________ PARENT Subsidiary BSubsidiary A

Illustration of How LL Reduces Risk for Parent – Assumptions: Each subsidiary has $____ million in assets Each subsidiary has a ______ probability of a $50 million tort claim but both subsidiaries will not have claim Parent Loss Distribution (values in $millions) Limited Liability for ParentUnlimited Liability for Parent Probability: 0.98 (no claim)$0$ ($50 m claim against A) ($50 m claim against B)2550 Expected Value Standard Deviation3.5_____ Expected Value of Unpaid Claims______ 0

Who Pays for the Implicit Insurance Provided by LL? – Is the risk reduction from LL free? – Not when the party who bears the risk is in a contractual relationship with the corporation is informed because they will demand ______ _________ before contracting

LL and Moral Hazard Since LL shifts some of risk to other parties, LL might induce corporations to take on too much risk – Problem is likely to be negligible for corporations with ____________assets

Why Have LL? Simple answer: – Positive effects of LL dominate the moral hazard (the negative effect) effect in most circumstances – Positive effects of LL for individual shareholders: Facilitates separation of _____________ and risk bearing functions Makes the risk associated with investment in firm not depend on the_________of other investors

Why Have LL? – Positive effects of LL for parent corporations: Encourages formation of various enterprises under one parent –To the extent that parents sometimes pay claims in ________ of a subsidiary’s assets LL can lower risk to other claimants –Synergies associated with combining entities are gained

Piercing the Corporate Veil – Situations when courts do not uphold LL (pierce the corporate veil) – In a parent-individual shareholder situation: Corporation is ________ held Firm engages in obviously risky activities w/o ________ or significant assets

Piercing the Corporate Veil – In a parent-subsidiary situation: Parent has effective ________ of subsidiary Sub engages in obviously risky activities with little capital – In both situations: –Benefits of separation of management and risk bearing are not present –_______ ________ problem is potentially severe