Vicarious Liability for Managerial Myopia

Abstract

This paper models a shareholder's choice of managerial compensation to demonstrate that vicarious liability (i.e., firm-level fines) can optimally deter managerial misreporting. Shareholders choose compensation in light of the manager's control over effort and disclosure, as well as the degree of agency cost (modeled as the manager's relatively shorter time horizon, or myopia). Where agency costs and/or fines are small, shareholders award equity compensation, leading to both high effort and misreporting. Where expected fines are set at a function of the misreporting externality, shareholders optimally choose whether or not to award equity and induce effort/misreporting. Reforms aimed at decreasing agency costs (such as those promoting long term compensation) may actually reduce social welfare where fines are not set at the externality level: shareholders will award equity when they, socially, should not. Conversely, reducing misreporting by increasing fines arbitrarily may reduce social welfare, as shareholders will fail to award equity when it is optimal to do so.

Keywords: Executive compensation, corporate governance, misreporting, fraud, securities law, moral hazard

JEL Classification: D21, D82, G30, K22, M52