Fresh Start or Fresh Water: The Impact of Environmental Lender Liability

Stakeholder Value

At the Gupta Governance Institute 15th Annual Corporate Governance Conference held on April 8, 2022, a researcher from the University of Pennsylvania showed that lenders play a role in promoting better environmental practices. When their environmental liability is reduced, their debtors increase on-site pollution, cut investment in abatement technology, and incur more environmental regulatory violations.

Key Insights

• The Lender Liability Act 1996 limited the circumstances under which lenders are liable for environmental clean-up costs of their debtors. Companies, whose facilities are located where lenders experienced a reduction in environmental liabilities, increased on-site pollution by 13.7% and were 17.54% more likely to incur at least one environmental violation compared to companies that were unaffected by the 1996 Act.
• The deterioration in environmental practices was not driven by changes in production. In fact, process-related abatement activities were reduced by 36.64% after 1996, suggesting that companies decreased their efforts to reduce pollution. Evidence points to the conclusion that the effects on pollution outcomes were linked to lenders’ diminished monitoring of the environmental practices of their debtors.
• There is a trade-off between protecting the environment and job creation. Companies that were less influenced by their lenders to adopt better environmental practices experienced an increase in employment of 2.08%, with no impact on wages. Since capital investment in pollution-reducing projects remained the same, the results support a substitution of labor at the expense of capital after 1996.

Summary of Complete Finding

As the importance of setting environmental goals grows in U.S. companies, insights from academic research point to the critical role of financial intermediaries in monitoring and encouraging environmental sustainability.

Lenders’ environmental responsibility means that lenders incur costs if their debtors implement non-sustainable environmental practices. In order to investigate how the exposure of lenders to their debtors’ environmental damages affects corporate environmental policies, the research assesses the effects of a federal law that overruled the liability standards previously made by the courts.

Before the Lender Liability Act of 1996, the 11th Circuit Court adjudicated in United States v. Fleet Factors Corp (11th Cir. 1990) that any lender holding a security interest in a facility with the capacity to influence the environmental practices of their debtors could be held responsible for environmental clean-up costs. After the Lender Liability Act of 1996, this “capacity-to-influence” test was suppressed; only lenders that influence their debtors on a day-to-day basis became exposed to the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) liability. This study compares firms located in the 11th Circuit, where lenders were more exposed to CERCLA liability before 1996, to other companies in the United States.

The empirical analysis uses an original database created by matching datasets from the Environmental Protection Agency and the US Census Bureau. The database includes detailed environmental information at a firm’s facility by year and chemical levels of variables such as total amounts of toxic releases, environmental violations, investment abatement, production and stack-air emissions. It also gives information on employment, payrolls, legal status, ownership structure between plants, and costs and quantity of inputs.

The first finding is that on-site pollution increased by 13.2% in facilities of companies located in the 11th Circuit as compared to the other Circuits after 1996 (this rises to 13.7% when production controls are added in the model specification). Second, companies increased the release of chemicals on-site by 17.54%. Third, after 1996, facilities of companies located in the 11th Circuit were 2.5 percentage points more likely to incur at least one environmental violation than companies in other states. This increase is equivalent to 21.2% of the average rate of violations in the sample. Overall, the findings suggest that reducing the responsibility of lenders for the environmental clean-up of their debtors under CERCLA negatively impacts the environmental practices of the debtors.

The study then tests and rejects the hypotheses that the increased pollution was driven by a surge in production. The latter could have been the result of the lower cost of capital and increased credit that lenders could offer due to their reduced environmental liability. Since production did not drive the additional pollution, less environmental effort by the companies was most likely the cause. The study corroborates this hypothesis by showing that companies in the 11th Circuit reduced investment in process-related abatement activities on average by 2.917 percentage points. This decrease is equivalent to a reduction of 36.64%.

To support the view that the effects on pollution outcomes were triggered by lenders’ monitoring efforts, the study demonstrates that these effects were stronger for companies with high initial leverage. This is consistent with the view that lenders have greater bargaining power to impose sustainable practices when companies cannot easily substitute to other forms of financing. Similarly, the effects on pollution were significantly higher for companies close to bankruptcy, consistent with the view that lenders focus their monitoring efforts on companies with a higher probability of repossession. Moreover, the reduction in pollution was driven by companies that were more likely to trigger a CERCLA clean-up action, consistent with the view that lenders focus their efforts on companies with higher environmental liability risks.

Finally, the study quantifies the impact of the 1996 Act on employment and wages. The results support the view that there is a trade-off between environmental compliance and employment, but there is no effect on wages. Environmental compliance encouraged by banks pre-1996 led to lower employment levels and higher capital investment in abatement projects. These quantities reversed after 1996 when environmental compliance was cut down.

In conclusion, this research finds that reducing lenders’ environmental liability weakens banks’ incentives to influence the practices of their debtors, thus triggering a deterioration in pollution outcomes. The study provides a deep insight on how stakeholder governance can impact the ability of firms to set and achieve sustainable goals.

“Fresh Start or Fresh Water: The Impact of Environmental Lender Liability” by Aymeric Bellon (University of Pennsylvania).
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