Malpractice Laws and Incentives to Shield Assets: Evidence from Nursing Homes

• DOI: http://doi.org/10.1111/jels.12148
• Published date: 01 June 2017
• Date: 01 June 2017

Malpractice Laws and Incentives to Shield

Assets: Evidence from Nursing Homes

James A. Brickley,* Susan F. Lu, and Gerard J. Wedig

Empirical research on medical malpracticeliability has largely ignored incentives to restructure to

protect assets. This study provides evidence on asset shielding in the nursing home industry.

There was a rapid increase in lawsuits alleging patient neglect or abuse in states with plaintiff-

friendly tort environments beginning in the secondhalfofthe1990s.Wedocumenttwoapparent

asset-shielding trends in these states during the 1998--2004 period: (1) sales of homes by large

chains to smaller, more judgment-proof owners; and (2) a reduced propensity to “brand” chain-

owned units with names that linked them directly to the central corporation or sister units.

Twelve states enacted tort reforms during the 2003--2006 period that placed caps on

noneconomic damages. Using a difference-in-differences (DD) methodology, we find that the

trends in asset-shielding behavior abated or reversed in the states that enacted tort reforms. These

findings suggest that tort law affects ownership and other organizational choices in this industry.

I. Introduction

Empirical research on medical malpractice tort laws has focused on defensive medicine,

the supply of physician services, and the frequency of lawsuits and their outcomes.

1

*Address correspondence to James A. Brickley, Simon Business School, University of Rochester, Rochester, NY

14627; email: brickley@simon.rochester.edu. Brickley is Gleason Professor, Simon Business School, University of

Rochester Lu is Assistant Professor of Management, Krannert School of Management, Purdue University Wedig is

Associate Professor, Simon Business School, University of Rochester.

The authors thank Paulo Albuquerque, Bernie Black, John Bouman, Paul Ellickson, Richard Hirth, Michael

Mazzeo, Sanjog Misra, David Oliveiri, Sam Peltzman, Ivan Png, Michael Raith, Subramaniam Ramanarayanan,

Cliff Smith, Jerry Zimmerman, and Mark Zupan for helpful discussions and comments. They also thank the refer-

ees for useful suggestions and the seminar participants at the University of Rochester and Indiana University–Pur-

due University and conference participants at the 10th International Industrial Organization Conference (IIOC),

the 6th Biennial Conference of the American Society of Health Economists (ASHE), the 2013 Academy of Man-

agement Conference (AOM), and the 2015 American Economic Association Meeting, as well as David Grabowski

for sharing the state Medicaid rates data.

1

Papers on the effects of malpractice laws on the supply of physician services include Dranove and Gron (2005),

Dubay et al. (2001), Kessler et al. (2005), Klick and Stratmann (2007), and Mello et al. (2005). Avraham et al.

(2012) evaluate the effects of malpractice laws on employer-provided health insurance premiums. The literature on

so-called positive defensive medicine is more extensive and too lengthy to summarize here. The issue in this

research is whether tort liability provides incentives to physicians to “overtreat” patients (e.g., by performing unnec-

essary tests and procedures). For surveys of this research, see Kachalia and Mello (2011), Kessler (2011), and Van

Velthoven (2009). Papers examining the impacts of tort reforms on the frequency of malpractice lawsuits and their

outcomes include Avraham (2007), Holtz-Eakin (2004), Mello (2006),and Paik et al. (2012). Jelislow and Ohlander

(2010) provide evidence on the effectsof reforms on the state-level sanctioning of physicians.

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Journal of Empirical Legal Studies

Volume 14, Issue 2, 301–332, June 2017

Malpractice liability also creates incentives for deep-pocketed providers to protect their

assets from liability, for example, by selling them to more “judgment-proof” buyers and/

or by restructuring their legal form of organization. Although the incentive to shield

assets is well recognized in the legal literature, it has received scant attention in the

empirical research on malpractice.

2

Asset shielding is important to consider in evaluat-

ing malpractice liability because it reduces the deterrent effects of tort laws and makes it

less likely that victims will be compensated (Shavell 1986, 2004; Konetzka et al. 2013). It

also has potential effects on economic efficiency, for example, if it results in suboptimal

organizational choices. This study provides evidence on this issue by studying the behav-

ior of nursing home owners in contrasting periods of increasing and decreasing litiga-

tion risk.

Various states adopted strongly pro-plaintiff resident rights laws during the 1980s

and 1990s with the stated intent of protecting nursing home residents. These laws were

not associated with an immediate increase in litigation, reportedly due to the wide-

spread belief that the expected proceeds from nursing home cases would not cover the

high costs of litigation. Pioneering lawsuits in the 1990s demonstrated that cases assert-

ing neglect or abuse of nursing home patients could be highly lucrative to plaintiffs and

their attorneys. States with plaintiff-friendly tort environments subsequently witnessed a

dramatic increase in the frequency of lawsuits, the size of settlements/judgments, and

the costs of liability insurance. Legal experts advised large nursing home chains to divest

homes in high-litigation states or to adopt legal structures that would better shield them

from liability. Previous studies provide examples of national chains that sold their homes

in Florida and Texas (the two states with the most pro-plaintiff legal environments at

that time) to smaller more judgment-proof owners or otherwise restructured in apparent

response to litigation concerns (e.g., Stevenson et al. 2006b).

This article provides more systematic evidence on the relation between changes in

the tort environment and judgment-proof behavior using a two-part empirical methodol-

ogy. In the first part of our analysis, we present descriptive and fixed effects regression

evidence that provides support for the hypothesis that large nursing home chains under-

took actions to shield assets in pro-plaintiff legal environments during the 1998 to 2004

period when the threat of litigation was dramatically increasing. First, large chains sold

many homes in high-litigation states to smaller, more judgment-proof owners, that is,

owners with fewer assets, little or no liability insurance coverage, and protective legal

structures. Second, chains in these states reduced the frequency with which they

“branded” their homes with names that linked them directly to either the central corpo-

ration or sister units (we discuss below how branding affects legal liability)—a potential

dimension of judgment-proof behavior not considered in previous studies.

While the findings from this first stage of our analysis are highly suggestive, we are

reluctant to infer a causal relation between the legal environment and judgment-proof

2

One exception is a recent working paper by Helland et al. (2016), which provides evidence that physicians

respond to liability exposure by investing more of their assets in personal homes when they are shielded from

claims due to the state’s bankruptcy law.

302 Brickley et al.

behavior from this evidence alone. A common approach to studying the effects of state

laws is to conduct a difference-in-differences (DD) analysis, which helps to remove the

biases that result from permanent differences between the treatment and nontreatment

states, as well as comparisons over time in the treatment group that could be the result

of trends. Unfortunately, ambiguous and multiple enactment dates, as well as the lack

of historic information on the ownership of nursing homes prior to the late 1990s, pre-

clude us from conducting a DD analysis around the enactment of resident rights laws.

3

To help resolve the issue of causality, the second part of our empirical analysis

focuses on a subsequent inflection point in the litigation environment that occurred in

various states. During the interval 2003–2006, 12 states enacted laws that placed mean-

ingful caps on noneconomic damages in malpractice cases. These tort reforms particu-

larly impacted the nursing home industry, where a large fraction of litigation awards is

based on noneconomic considerations (e.g., pain and suffering and punitive damages).

If increases in litigation risk caused the changes in ownership and branding in the earli-

er period, we would expect to find an abatement or reversal of these trends following

the enactment of reforms that reduced the risk in the legal environment. Data availabili-

ty and knowledge of the precise enactment dates allow us to conduct a more convincing

DD analysis of the effects of these reforms.

In the aftermath of these reforms, we find that the earlier-documented trends

abated or reversed in the states that enacted damage caps. In particular, we find that

nursing homes in these states experienced a positive shift in their underlying time

trends in both large chain affiliation and branding postenactment. In our basic distrib-

uted lag model, the estimated likelihood of large chain ownership increases by about 12

percentage points over the ensuing five-year period after the reform relative to past

trends. The estimated likelihood of being branded increases by about 6 percentage

points. The measured effects are statistically significant and robust to a series of checks

for endogeneity and other concerns. The collective evidence from our two-part method-

ology provides relatively strong support for the hypothesis that there is a causal link

between changes in tort liability and asset-shielding behavior in the nursing home

industry.

While our study focuses on the nursing home industry, it has potentially broader

implications for the topic of tort law and asset shielding. Ringleb and Wiggins (1990)

document that a substantial increase in tort liability motivated large manufacturers to

sell hazardous plants (producing carcinogens and other disease-causing byproducts) to

smaller firms, which were either “more likely to go out of business before latent claims

emerge or have insufficient assets to pay damages and declare bankruptcy when claims

are filed.” We consider the use of asset shielding by a set of service industry firms (i.e.,

nursing homes). In so doing, we extend the literature on asset shielding by considering

a different set of tradeoffs and firm behavior.

3

For example, the first patient rights law in Florida was passed in 1980 but additional laws that clarified and pro-

vided remedies for patients were passed in 1993 and 2001. Systematic information on the ownership of individual

nursing homes prior to 1999 is not publicly available.

303Malpractice Laws and Asset Shielding