Down the Tubes : Financial Distress, Bankruptcy, and Industrial Water Pollution

How do firms' efforts to prevent harm to third parties change as they approach, enter, and then exit bankruptcy? To help answer this, I investigate a panel of roughly 350 US firms, all of which declare bankruptcy and are regulated under the Clean Water Act (CWA) for pollutants they release into public waterways. As these firms approach bankruptcy, the rate at which they release pollutants beyond their permitted limit increases by 50%. Once firms file for bankruptcy, their compliance dramatically improves, returning to a baseline from well before they filed for bankruptcy. I explore mechanisms that may explain this pattern and conclude that the most likely causes are a nexus of moral hazard problems and financing frictions affecting thinly capitalized firms. These findings lend support to a range of policy interventions, such as changes in the priority of bankruptcy claims, that can help to alleviate moral hazard problems for thinly capitalized firms. Furthermore, the dramatic compliance improvements that occur after firms file for bankruptcy point to a less-recognized role of corporate bankruptcy in helping to prevent public harms that can occur as a result of firms operating while in significant financial distress. This suggests an added public benefit to bankruptcy policies that encourage firms to file for bankruptcy early, and an added detriment to policies and practices that seek to delay firms' resolution of financial distress