Enterprise Risk Management: Legal Liability for Injuries and Workers' Compensation - Prof., Study notes of Finance

Download Enterprise Risk Management: Legal Liability for Injuries and Workers' Compensation - Prof. and more Study notes Finance in PDF only on Docsity! FINC 3134 – Enterprise Risk Management Review for Exam 3 CHAPTER 12 – LEGAL LIABILITY FOR INJURIES SOME BACKGROUND ON THE LAW There are two main sources of legal liability: (1) common law (law that has evolved over time as a result of previous court decisions); and (2) statutory law (passed by legislative bodies & signed into law by the executive branch). Law can also be categorized as either: (1) criminal law (covers acts against the state); and (2) civil law (covers acts against individuals; includes both contract law & tort law). OVERVIEW OF TORT LIABILITY RULES & PROCEDURES Liability rules allocate accident risk to various members of society and thus affect incentives to engage in risky activities and to take precautions. There are three types of liability rules: 1. A “no liability” rule makes some institutions and/or professions (such as charitable organizations) immune from liability for certain types of actions. 2. A “negligence” rule holds people liable if they fail to exercise the required standard of care to prevent injury to another party. 3. A “strict (absolute) liability” rule holds parties (such as manufacturers of defective products or those who engage in ultrahazardous activities) liable even if they are not negligent. Tort liability law allows injured parties to recover damages for losses. There are two categories of damages: (1) compensatory damages, which compensate victims for monetary losses (e.g., medical expenses, lost wages) and nonmonetary losses (e.g., pain & suffering); and (2) punitive damages, which are designed to punish the defendant & deter future actions in cases in which the defendant recklessly or willfully disregards the risk of harm to the plaintiff. In cases where the actions of more than one party combine to cause a loss, the doctrine of joint & several liability means that if some parties are unable to pay, the full burden of paying damages will fall on the other parties. However, the plaintiff can only recover damages once. LIABILITY FROM NEGLIGENCE To recover damages under a negligence rule, a plaintiff generally must establish: 1. the existence of a legal duty by the defendant to prevent harm to the plaintiff; 2. a breach of this legal duty by failing to exercise the required standard of care; 3. that the breach was the proximate cause of the plaintiff’s harm; and 4. that an injury was suffered. In many non-business liability cases, the required standard of care usually is what a “reasonably prudent person” would have done under similar circumstances. In the case of professional liability, the standard often is what a reasonable, adequately trained professional with the same area of expertise would have done in the same circumstances. In many business liability cases, the court apply an economic standard under which a business is liable if it fails to take cost-justified precautions to prevent harm. A breach of duty is considered the proximate cause of an injury if it would not have occurred “but for” the defendant’s action (sine qua non, or “but for” rule). When there are intervening events between a defendant’s action and the ultimate injury, the courts often apply a foreseeability test (i.e., if a defendant should have reasonably foreseen that his/her action could create a significant risk of injury, then that action is deemed the proximate cause of the injury even if there are unusual intervening events). FINC 3134 – Enterprise Risk Management Review for Exam 3 Under a negligence rule, a defendant may be able to avoid or reduce liability by showing that the plaintiff assumed the risk (assumption of risk), or that the plaintiff’s negligence or actions contributed to the accident (contributory or comparative negligence). Under contributory negligence, the defendant is not liable for any of the plaintiff’s losses, while under comparative negligence the defendant can be found partially liable. THE ECONOMIC ROLE OF THE TORT LIABILITY SYSTEM From an economic perspective, the tort system has two fundamental objectives: (1) to provide incentives for parties to engage in the optimal level of loss control; and (2) to provide optimal compensation (insurance coverage) to accident victims. The optimal level of loss control occurs where the additional (marginal) benefits of loss control expenditures equal the additional (marginal) costs. (It is rarely optimal to try to achieve a “zero-risk” society). The optimal amount of compensation is equal to the amount of insurance coverage that a victim would have wanted to purchase prior to knowing whether he/she would be involved in an accident if he/she were fully informed about both the risk of an accident & the costs associated with coverage via the tort system. The tort system usually attempts to compensate victims fully for both their economic & noneconomic losses. However, risk-averse people typically do not want to purchase either full insurance coverage for economic losses (because of premium loadings, moral hazard, & adverse selection) or any coverage for noneconomic losses. This suggests that the tort system forces many people to pay for more insurance than they probably desire. One possible explanation is that less-than-full compensation would not produce sufficient incentives for loss control, & our tort system may place greater weight on optimal safety than on optimal compensation. LIMITED WEALTH & LIMITED LIABILITY The judgment-proof problem means that some people are able to avoid paying damages either because they do not have sufficient wealth or their wealth is protected by limited liability (bankruptcy) rules. So, these people may invest too little in safety and injured victims may not receive the optimal amount of compensation. Compulsory liability insurance (i.e., forcing judgment-proof people to buy liability insurance) in some cases can improve victim compensation and loss control incentives. PROPOSALS FOR TORT REFORM Two major types of tort reform proposals have been made to address problems in the tort liability system: 1. reforms that modify incentives to bring suits (e.g., limits on contingency fees and adoption of a “loser pays” rule under which the loser pays at least part of the winning side’s legal costs); and 2. reforms that reduce damages paid to victims (e.g., caps on pain & suffering awards and punitive damages, altering the collateral source rule to allow juries to take into account compensation from sources other than the tort system, and limiting the application of joint & several liability). FINC 3134 – Enterprise Risk Management Review for Exam 3 CHAPTER 28 – CORPORATE LIABILITY TO CUSTOMERS, THIRD PARTIES & SHAREHOLDERS PRODUCTS LIABILITY Products liability law has evolved from contract law to negligence to strict liability for product defects. Prior to 1916, a manufacturer could not be held liable unless the victim & the manufacturer had a direct contractual relationship (a requirement know as the privity limitation). In 1916, the MacPherson v. Buick case established that consumers injured by defective products could recover damages under tort law if the manufacturer had been negligent. The case of Escola v. Coca-Cola Bottling Company in 1944 helped establish a strict liability standard for certain kinds of product-related injuries (i.e., manufacturers could be held liable even when they were not negligent if their products were “unreasonably dangerous” and “defective”). Since manufacturers are strictly liable for product defects, the important issue is whether a product is defective. There are three types of product defects: 1. Manufacturing Defects exist if a particular product deviates from what the manufacturer intended. In most jurisdictions, if a product differs from the normal production run & a consumer is harmed as a result of the defect, then the manufacturer is liable. 2. Design Defects exist if foreseeable risks of harm presented by the product could have been (1) reduced by the adoption of a reasonably safer design, or (2) discovered & corrected through more exhaustive product testing. In most jurisdictions, some form of cost-benefit analysis is used to determine whether a product is unreasonably dangerous (i.e., could the defect have been corrected at a reasonable cost?). 3. Warning Defects exist if a product has not been properly labeled or the risks associated with using the product have not been properly explained. In most jurisdictions, courts will hold manufacturers liable if the danger was foreseeable & the manufacturer failed to provide a warning that could have reduced the risks of harm. But, some jurisdictions hold the manufacturer liable even if the danger was not foreseeable, as long as a warning would have prevented the harm. Depending on the alleged defect & the jurisdiction, manufacturers can defend themselves by arguing that customers: (1) assumed the risk; or (2) engaged in the unforeseeable misuse of the product, in which case the defendant’s liability may be reduced in a manner similar to a comparative negligence standard. In addition to tort liability, firms also are subject to liability under contract law as a result of warranties that are made when products & services are sold to consumers. An express warranty is an explicit statement that a product or service will perform according to some standard. An implied warranty is an implicit performance guarantee that the product is reasonably fit for its intended use. Insurance coverage for products liability is provided by a firm’s Commercial General Liability (CGL) policy. A CGL policy provides liability coverage for bodily injury & property damage as well as a duty to defend the firm (and pay defense costs) in the case of a lawsuit. Coverage is available on both an occurrence and a claims- made basis. Claims-made coverage usually is only purchased for hazards that involve a large risk of unexpected increases in claim costs for the insurer (which includes some product liability exposures). Making manufacturers strictly liable for all consumer losses can improve safety incentives when consumers are uninformed about product risk, because strict liability gives manufacturers proper incentives to make safe products and to reduce the likelihood that consumers will purchase too many risky products (by ensuring that they are informed about product risk). However, it is also argued the strict liability system: (1) is unnecessary when consumers are well-informed; (2) may lead to excessive safety & higher prices; (3) may discourage innovation & encourage use of older, less safe products; & (4) is regressive in nature (i.e., lower-income consumers pay the same price for products but receive less insurance coverage). FINC 3134 – Enterprise Risk Management Review for Exam 3 A number of product liability reform measures have been adopted or proposed, including measures that would: (1) reduce the potential liability of producers (curtailing joint & several liability, capping pain & suffering awards & punitive damages, & altering the collateral source rule); (2) reduce the incentive of plaintiff attorneys to file marginal cases by adopting a “loser pays” rule & reducing contingency fees; and (3) adopt a “statute of repose”, which requires that suits be brought within a certain number of years (e.g., 20 years) after the product has been purchased. ENVIRONMENTAL LIABILITY Liability for environmental damage under common law expanded greatly during the last half of the 20th century. For many years, environmental hazards were handled under “nuisance law”, with strict liability reserved for situations where the environmental damage was caused by sudden events that occurred because someone brought something unnatural in the area & when losses were easily linked to a particular event. However, scientific advances led the courts to interpret gradual leaks of potentially toxic substances into the environment as being equivalent to sudden events that directly led to illness or death. An important source of statutory liability is the Superfund law enacted in 1980. Its purpose is to provide funds needed to clean up waste dumps & accidental spills of toxic substances. Most courts interpret the Superfund law as imposing retroactive, strict, and joint & several liability on owners, former owners, & anyone who has dumped waste at a site, including transporters of that waste. While the Superfund law has increased incentives for safety, it has been criticized for: (1) spending excessive resources to clean sites that have little chance of posing harm to residents; (2) setting safety standards too high by cleaning sites for any potential future use rather than limiting use & relocating existing residents; (3) providing compensation under the tort system for hazards already covered by private insurers (e.g., medical expense, disability income, & life insurance); (4) imposing huge legal costs; and (5) deterring development of former industrial sites. Prior to 1970, most CGL policies covered liability for environmental damage as long as it was neither expected nor intended by the insured. As liability expanded, insurers first attempted to restrict coverage in CGL policies to only “sudden & accidental” pollution; subsequently, they introduced an “absolute pollution exclusion” that excludes coverage for most pollution other than environmental damage due to sale & use of the insured’s product. Some policies today contain a “total pollution exclusion” that eliminates coverage for all pollution liability. Pollution coverage is now available through customized environmental impairment liability (EIL) policies, which usually are sold on a claims-made basis. DIRECTORS’ & OFFICERS’ LIABILITY Directors & officers of corporations have a legal duty to act in the interest of the shareholders. Specifically, they have a duty of care (i.e., a duty to make informed decisions) and a duty of loyalty (i.e., a duty to act in the interests of shareholders when corporate decisions involve a potentially material conflict of interest between shareholders & directors/officers). When a “duty of care” violation is alleged, the courts employ the business judgment rule, under which directors & officers are not held liable for informed decisions even if they turn out to produce poor results. In suits alleging violation of the “duty of loyalty”, not only must directors & officers be informed, but they also must take whatever steps are necessary to ensure that decisions are in the shareholders’ best interests. Directors & officers also can be sued by shareholders for violations of securities laws that require firms to disclose material information in a timely manner. Suits brought by shareholders on behalf of the corporation are known as derivative suits, while suits brought by shareholders on their own behalf are called direct action suits. Direct actions against directors & officers can be either individual actions (brought by an individual who alleges harm) or class actions (brought on behalf of a group of plaintiffs that are alleged to have been harmed. Depending on the state and corporate charter, directors & officers are indemnified by their corporations for legal defense costs and/or settlements & awards. Directors & officers (D&O) liability insurance often is purchased to cover: (1) some non-indemnified losses to directors & officers (i.e., defense costs and judgments paid by the director & officer for which they have not been reimbursed by the corporation); and (2) corporate costs of indemnification (i.e., amounts paid by the corporation to indemnify directors & officers for their losses). FINC 3134 – Enterprise Risk Management Review for Exam 3 CHAPTER 29 – ISSUES IN LIABILITY RISK & ITS MANAGEMENT RISK SHIFTING THROUGH LIMITED LIABILITY The doctrine of limited liability means that the liability of corporate shareholders is limited to the value of their equity investment (i.e., those with claims against the corporation generally cannot reach the personal assets of individual shareholders or the other business assets of corporate shareholders). The protection provided by limited liability is similar to insurance protection against large tort liability claims for both individual shareholders and a parent corporation with multiple subsidiaries. But, like insurance, it can lead to moral hazard (i.e., induce corporations to take on too much risk) and excessive risk of injury because corporations might not have to pay for all of the harm they might cause from risky activities. The rationale for limited liability is that the positive effects of limiting a corporation’s liability more than offset the negative (moral hazard) effect in most circumstances. The positive effects of limited liability for individual shareholders are that: (1) it facilitates the separation of the management & risk-bearing functions; and (2) it makes the risk associated with investment in a firm not depend on the wealth of other investors. Courts sometimes have refused to uphold limited liability and forced shareholders to pay claims in excess of corporate assets or equity (an outcome known as “piercing the corporate veil”). This typically occurs when a corporation engages in obviously risky activities without insurance or significant assets or capital and it is either: (1) a closely held corporation that is controlled or managed by its shareholders; or (2) a subsidiary controlled by its parent company. In both cases, the moral hazard problem is potentially severe and the social benefits of separating the management and risk-bearing functions are not present. LIABILITY FOR ACTIONS OF EMPLOYEES & OTHER PARTIES Under the doctrine of vicarious liability, principals generally are liable for the torts of their agents (which includes liability of employers for torts of employees in the course of their employment). This gives the principal incentives to choose agents carefully and to train & monitor agents. Firms that use independent contractors often can be held liable for torts of the contractor in order to mitigate the judgment- proof problem and encourage safety. There are three main situations where a firm can be held liable for the actions of independent contractors: (1) when there is ambiguity or disagreement over whether a party is an employee or an independent contractor; (2) when the state has determined that the duty to keep the public safe cannot be delegated to another party (the independent contractor); and (3) when a business is liable for negligence in failing to take reasonable precautions to select a safe contractor. HOLD HARMLESS & INDEMNITY AGREEMENTS A hold harmless (indemnity) agreement is a contract between two parties in which one party agrees to hold the other party harmless (indemnify the other party) for losses that arise out of some activity. Hold harmless and indemnity agreements backed by liability insurance help reduce the cost of risk by allocating the ultimate responsibility for harm to the party best able to reduce injury costs and by reducing costly disputes between the parties.