Agency Costs and Misrepresentation in Leveraged Firms

40 The Journal of Corporation Law 99 (2014)

44 Pages Posted: 25 Jan 2017

See all articles by Sharon Hannes

Sharon Hannes

Tel Aviv University - Buchmann Faculty of Law

Avraham D. Tabbach

Tel Aviv University

Date Written: September 1, 2014

Abstract

The financial crisis that began in the United States in 2007 and spread into a deep worldwide recession focused attention on agency costs in leveraged firms. Particular attention was given to the incentives of shareholders in such firms to overinvest (known as the "risk-shifting" problem) or underinvest (known as the "debt-overhang" problem). Besides these problems, the earlier financial crisis of 2002 brought to light shareholders' incentives to misrepresent the financial condition of the firm. Interestingly, to date the interactions between these adverse incentives have not been analyzed in either the legal or finance literatures. The aim of this Article is to fill that gap. Its main conclusion is that misrepresentation of the firm's financial results alleviates the classic agency costs between shareholders and debt-holders, leading to less overinvestment (less risk-taking) and less underinvestment due to the debt-overhang problem. In a nutshell, the explanation is that shareholders in leveraged firms can be viewed as holding a call option on the firm 's assets, and misrepresentation pushes the option into the money, leading to better alignment between the interests of shareholders and the interests of all stakeholders of the firm. Our theoretical results shed new light on the causes of the financial crisis of 2007 and the ensuing slow recovery. The Article also offers policy recommendations.

Keywords: Agency Costs, Leveraged Firms, Financial Crisis, Corporate Governance

Suggested Citation

Hannes, Sharon and Tabbach, Avraham D., Agency Costs and Misrepresentation in Leveraged Firms (September 1, 2014). 40 The Journal of Corporation Law 99 (2014), Available at SSRN: https://ssrn.com/abstract=2904360

Sharon Hannes (Contact Author)

Tel Aviv University - Buchmann Faculty of Law ( email )

Ramat Aviv
Tel Aviv, 69978
Israel

Avraham D. Tabbach

Tel Aviv University ( email )

Ramat Aviv
Tel Aviv, 69978
Israel

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