Vicarious Liability for Managerial Myopia

Abstract

This paper examines whether fines on the firm (i.e., vicarious liability) can optimally deter misreporting by the firm's manager. In an agency cost model, shareholders choose whether to award equity compensation to a myopic (i.e., short-termist) manager, where misreporting subjects the firm, and, derivatively, the shareholders, to fines. The wedge between managerial and shareholder time horizons provides a measure of agency cost; more-myopic managers tend to misreport more, increasing expected fines. In equilibrium, even though equity grants tend to encourage misreporting, equity grants (and to an extent misreporting) are consistent with higher shareholder welfare. Social effects are, however, ambiguous given misreporting externalities. Where such externalities exist, vicarious liability can result in a second-best optimal where shareholders award equity if, and only if, the social gains exceed the cost. Counterintuitively, reforms aimed at decreasing agency costs may decrease social welfare if vicarious fines are set too low: shareholders will award too much equity and produce a supra-optimal level of misreporting.