Vicarious Liability for Managerial Myopia

Abstract

This paper shows that fines on the firm (vicarious liability) can optimally deter misreporting by the firm's manager. In a principal-agent model, shareholders choose whether to award equity compensation to a myopic (short-termist) manager. Equity induces both effort and misreporting. 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, large decreases in agency costs lead to more equity grants, more misreporting, and are consistent with higher shareholder welfare. Social effects are, however, ambiguous given misreporting externalities. Counterintuitively, decreases in agency costs may decrease social welfare if vicarious fines are set too low: shareholders will award equity and induce misreporting even when not justified by the accompanying economic production. The proper level of vicarious fine results in a second-best optimal where shareholders award equity if, and only if, the social gains exceed the cost.