Environmental Liabilities, Creditors, and Corporate Pollution: Evidence from the Apex Oil Ruling

Ross Levine is the Willis H. Booth Chair in Banking and Finance at the University of California, Berkeley, Haas School of Business. This post is based on a recent paper by Mr. Levine; Jianqiang Chen, Ph.D. student at the College of Technology Management, National Tsing Hua University; Pei-Fang Hsieh, Associate Professor at the College of Technology Management, National Tsing Hua University; and Po-Hsuan Hsu, Professor and Yushan Scholar at the College of Technology Management, National Tsing Hua University. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance by Lucian A. Bebchuk and Roberto Tallarita (discussed on the Forum here); Companies Should Maximize Shareholder Welfare Not Market Value by Oliver Hart and Luigi Zingales (discussed on the Forum here); Reconciling Fiduciary Duty and Social Conscience: The Law and Economics of ESG Investing by a Trustee by Max M. Schanzenbach and Robert H. Sitkoff (discussed on the Forum here); and Exit vs. Voice by Eleonora Broccardo, Oliver Hart, and Luigi Zingales (discussed on the Forum here).

The Environmental Protection Agency (EPA) shows that corporate pollution is the primary source of U.S. land and water pollution that increase cancer, reproductive, neurodevelopmental, and premature death rates. Extensive research examines how environmental regulations influence pollution and health. This work suggests that corporate decision-makers do not fully internalize the social costs of their choices concerning toxic releases, and U.S. environmental regulations do not fully counteract the incentives created by such externalities. However, this research leaves unaddressed the question of how redefining property rights over corporate environmental damages shapes corporate finance and pollution. In a recent paper, we evaluate the impact of the 2008 Apex Oil court decision that made some creditors more legally liable for their corporation’s environmental damages when those firms entered Chapter 11 bankruptcy.

A 2008 change in how courts treat environmental obligations in Chapter 11 bankruptcy offers a unique opportunity to assess how reassigning property rights over pollution shapes corporate behavior. Chapter 11 bankruptcy allows financially distressed firms to reduce (i.e., “discharge”) claims, such as debts. In a series of landmark cases (e.g., Ohio v. Kovacs (1985) and U.S. v. Whizco (1988)), the courts ruled that obligations to clean up polluted sites were financial “claims,” making them dischargeable in Chapter 11 like other debts. Consequently, environmental cleanup liabilities could be shifted from the corporation and its creditors to taxpayers in bankruptcy, leaving more corporate resources available to satisfy the claims of debtholders. Among firms close to bankruptcy, therefore, the dischargeability of environmental liabilities reduced the financial incentives of creditors to pressure their corporations to limit toxic releases.

In a surprising decision—the 2008 Apex Oil decision, the courts materially reduced the circumstances under which corporations could discharge environmental liabilities in Chapter 11. In Apex, the Department of Justice and EPA sought injunctive relief under the Resource Conservation and Recovery Act (RCRA) to require the corporate successor of Apex Oil to clean up a site that Apex Oil contaminated before filing for Chapter 11. On July 28, 2008, the U.S. District Court for the Southern District of Illinois ordered Apex Oil Company Inc. (the successor) to clean up the contamination, holding that the environmental obligations under RCRA were not obligations to pay; they were obligations to clean up the site. Consequently, the environmental obligations under RCRA were not “claims” as defined by Chapter 11 and hence not dischargeable.

Changes in the legal liability for RCRA-covered environmental damages among corporations in Chapter 11 suggest potentially significant effects of Apex on creditors and pollution. Apex only applied to environmental cleanup obligations covered by the RCRA. Furthermore, Apex was primarily relevant to firms close to bankruptcy because it reduced the dischargeability of environmental cleanup obligations in bankruptcy; it did not change environmental obligations outside of bankruptcy. Thus, for firms in Chapter 11 with RCRA-covered liabilities, Apex left fewer resources available for creditors: corporate resources first satisfy environmental obligations and are only then used to settle creditor claims, as documented by Ohlrogge. After Apex, therefore, the creditors of firms close to bankruptcy that release RCRA-pollutants had stronger incentives to pressure these firms to curtail RCRA-emissions because any resultant cleanup costs would no longer be dischargeable in bankruptcy.

We evaluate the impact of Apex on corporate creditors and pollution. We match data on U.S. public firms with information on the release of toxic chemicals by the facilities of those firms. We differentiate facilities that were heavy emitters of RCRA-pollutants before Apex from those that were not. Furthermore, we distinguish between corporations with comparatively high and low default probabilities. Since Apex only reduced the dischargeability of RCRA-related environmental liabilities in Chapter 11 bankruptcy, Apex should primarily influence the creditors of RCRA-polluting firms close to bankruptcy.

We discover that after Apex, (a) corporate releases of RCRA-pollutants fell among firms that were heavy emitters of RCRA-pollutants, and (b) the drop in RCRA-pollutants is larger among firms closer to bankruptcy. Furthermore, we conduct a placebo test by examining the release of non-RCRA-regulated chemicals. If the 2008 decision shapes corporate behavior by altering the dischargeability of environmental obligations in Chapter 11, it should only affect RCRA-pollutants. That is what we find. There is no change in non-RCRA-chemical releases after Apex. Moreover, we find no evidence that Apex reduced pollution by lowering production. Corporations reduce emissions without reducing production.

We also examine whether Apex induced creditors to pressure their corporations to reduce pollution. Examining the Apex-creditor nexus is crucial because the proposed mechanism through which Apex spurs firms to reduce pollution is by altering the financial incentives of creditors and inducing them to pressure firms to emit less.

The results are consistent with the Apex-creditor mechanism. First, we find that Apex reduced cumulative abnormal returns (CARs) on corporate bonds among heavy RCRA-polluters with high default probabilities but no change in the CARs of bonds among other firms. These results are consistent with the view that Apex reduced the dischargeability of RCRA-cleanup liabilities in Chapter 11, spurring bondholders to pressure firms to reduce RCRA-chemical releases. Second, we find similar results when analyzing interest rates. We discover a significant increase in interest rates after Apex among heavy-RCRA-polluters close to bankruptcy. The findings indicate that debtholders are aware of the enhanced risk and potential loss due to Apex. As a result, they raise the interest rates for lending to RCRA-polluting firms more exposed to bankruptcy risk. Third, we confirm these findings using interest rate spreads on newly issued bank loans. Consistent with the Apex-creditor channel, bank loan spreads for heavy RCRA-polluters closer to bankruptcy widened appreciably following Apex but not for other firms. This result suggests that banks readily responded to the increase in specific borrowers’ environmental liabilities due to the Apex Oil ruling by boosting interest rate spreads on their loans. Even in the presence of extensive regulatory restrictions on corporate pollution, reassigning legal liability over environmental damages has large, rapid effects on corporate creditors and pollution.

The complete paper is available for download here.

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