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Vicarious Liability for Managerial Myopia

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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 effort and misreporting. The wedge between managerial and shareholders’ time horizons provides a measure of agency costs; more-myopic managers tend to misreport more, which increases expected fines. In equilibrium, large decreases in agency costs lead to more equity grants and more misreporting and are consistent with greater 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 fines results in a second-best optimum where shareholders award equity if, and only if, the social gains exceed the cost.

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