Overcompensation as a Partial Solution to Commitment and Renegotiation Problems: The Case of Ex Post Moral Hazard

In a Costly State Verification world, an agent who has private information regarding the state of the world must report what state occurred to a principal, who can verify the state at a cost. An agent then has what is called ex post moral hazard: he has an incentive to misreport the true state to extract rents from the principal. Assuming the principal cannot commit to an auditing strategy, the optimal contract is such that: (1) the agent's expected marginal utility when there is an accident (high‐ and low‐loss states) is equal to his marginal utility when there is no accident; (2) the lower loss is undercompensated, while the higher loss is overcompensated; and (3) the welfare of the agent is greater under commitment than under no‐commitment. Result 2 is contrary to the results obtained if the principal can commit to an auditing strategy (higher losses underpaid and lower losses overpaid). The reason is that by increasing the difference between the high and the low indemnity payments, the probability of fraud is reduced.     

The benefits of extended liability

We characterize the optimal regulation of a firm that undertakes an environmentally risky activity. This firm (the agent)is protected by limited liability and bound by contract to a stakeholder (the principal). The level of safety care exerted by the agent is nonobservable. This level of care depends both on the degree of incompleteness of the regulatory contract and on the allocation of bargaining power between the principal and the agent. Increasing the wealth of the principal that can be seized upon an accident has no value when private transactions are regulated but might otherwise strictly improve welfare. An incomplete regulation supplemented by an ex post extended liability regime can sometime achieve the second best.     

Contracting for information under imperfect commitment

We study optimal contracting under imperfect commitment in a model with an uninformed principal and an informed agent. The principal can commit to pay the agent for his advice but retains decision‐making authority. Under an optimal contract, the principal should (i) never induce the agent to fully reveal what he knows—even though this is feasible—and (ii) never pay the agent for imprecise information. We compare optimal contracts under imperfect commitment to those under full commitment as well as to delegation schemes. We find that gains from contracting are greatest when the divergence in the preferences of the principal and the agent is moderate.     

Carrot or Stick? Contract Frame and Use of Decision‐Influencing Information in a Principal‐Agent Setting

A fundamental management accounting issue is how to incorporate decision‐influencing information (e.g., an ex post state signal) into employment contracts. Our experiment examines the effects of contract framing on such information use in a principal‐agent setting. In each of 40 rounds, participants (as employer and worker) negotiate a contract that specifies pay depending on an ex post state signal. State‐signal pay is framed as either a bonus or a penalty over two groups. The results show that the bonus frame facilitates information use, because of worker loss aversion. Although both groups initially underweigh the state signal, the bonus group quickly converges toward the optimal weight, whereas the penalty group persistently underweighs the state signal.     

Variance analysis and linear contracts in agencies with distorted performance measures

This paper investigates the role of variance analysis procedures in aligning objectives under the condition of distorted performance measurement. A risk-neutral agency with linear contracts is analyzed, whereby the agent receives post-contract, pre-decision information on his productivity. If the performance measure is informative with respect to the agent’s marginal product concerning the principal’s objective, variance investigation can alleviate effort misallocation. These results carry over to a participative budgeting situation, but in this case the variance investigation procedures are less demanding.     

Investing in a relationship

A principal can make an investment anticipating a repeated relationship with an agent, but the agent may appropriate the returns through ex post bargaining. I study how this holdup problem and efficiency depend on the contracting environment. When investment returns are observable, informal contracts ex post can be more efficient than formal contracts, as they induce higher investment ex ante: the principal invests not only to generate direct returns, but also to improve relational incentives. Unobservability of returns increases the principal's ability to appropriate the returns but reduces her ability to improve incentives. The optimal information structure depends on bargaining power.     

Information control in the hold‐up problem

We study the use of information control to mitigate hold‐up risks. We identify a distinction between asymmetric information that creates an ex ante investment incentive and asymmetric information that causes ex post inefficiency, which then allows ex post inefficiency to be eliminated without compromising the ex ante investment incentive. We characterize the properties of the optimal information structure and the payoffs and welfare achievable with information control in the presence of hold‐up risks.     

Delegation to Encourage Communication of Problems

We study a principal's choice to centralize or delegate decisions to an agent when delegation can be used to encourage the agent to communicate potential problems. We find that the principal may choose centralization either to exercise better control over the agent's actions or to provide stronger incentives. Delegation emerges in equilibrium only if the costs of effort to acquire information for both the principal and the agent are sufficiently high. We find that increases in the principal's penalties for an incorrect decision may increase the principal's expected payoff, owing to optimal organizational responses. In addition, catastrophic risk, the risk of incorrectly accepting a defective audit (or product), may be greater under centralization than under delegation. Furthermore, catastrophic risk can be increased by well-intentioned legislative efforts to decrease such risk by, for example, increasing the agent's penalties for failing to take a corrective action, because the organizational structure may change.     

Tests of ex ante versus ex post theories of collateral using private and public information

Collateral is a widely used, but not well understood, debt contracting feature. Two broad strands of theoretical literature explain collateral as arising from the existence of either ex ante private information or ex post incentive problems between borrowers and lenders. However, the extant empirical literature has been unable to isolate each of these effects. This paper attempts to do so using a credit registry that is unique in that it allows the researcher to have access to some private information about borrower risk that is unobserved by the lender. The data also include public information about borrower risk, loan contract terms, and ex post performance for both secured and unsecured loans. The results suggest that the ex post theories of collateral are empirically dominant, although the ex ante theories are also valid for customers with short borrower–lender relations that are relatively unknown to the lender.     

Investor Reaction to Celebrity Analysts: The Case of Earnings Forecast Revisions

We examine the effects of analysts' celebrity on investor reaction to earnings forecast revisions. We measure celebrity as the quantity of media coverage analysts receive in sources included in the Dow Jones Interactive database, and find that media coverage is positively related to investor reaction to forecast revisions. The effect of celebrity on the reaction to forecast revisions remains significant after controlling for forecast performance variables examined in prior studies (ex post forecast accuracy, ex ante accuracy, award status, and other variables shown to be related to forecast accuracy). While these results are consistent with the familiarity of the analyst's name affecting the market reaction, we cannot rule out that our measure of celebrity is correlated with error in the performance measures we examine and/or correlated with other unexamined dimensions of forecast performance. A content analysis of a random subsample of the media coverage of our sample analysts suggests that our findings likely are not due to the increased availability of forecast revisions. Finally, an investigation of the excess returns around the quarterly earnings announcement date suggests that market participants react too strongly to forecast revisions issued by analysts with high levels of media coverage. Taken together, these findings suggest that an analyst's level of media coverage can affect the initial market reaction to his forecast revisions.     

Rewarding improvements: optimal dynamic contracts with subjective evaluation

We study a T‐period contracting problem where performance evaluations are subjective and private. We find that the principal should punish the agent for performing poorly in the future even when the evaluations were good in the past; at the same time, the agent should be given opportunities to make up for poor evaluations in the past with better performance in the future. Optimal incentives are thus asymmetric. Conditional on the same number of good evaluations, an agent whose performance improves over time should be better rewarded than one whose performance deteriorates.     

The option market’s anticipation of information content in earnings announcements

We exploit information in option prices in order to study whether the ex post responsiveness of stock prices to earnings information is reflected from an ex ante, firm- and quarter-specific perspective. Specifically, we develop a measure of anticipated information content (AIC) that isolates the forecasted magnitude of the stock market’s reaction to earnings information. We find that the AIC positively correlates with the ex post magnitude of the stock market sensitivity to unexpected earnings, increases with earnings persistence, firm growth prospects, the richness of firms’ information environments and the presence of (and changes in) sophisticated ownership, and decreases with discount rates. Our paper sheds light on the role that earnings information plays in shaping option-market behavior and offers researchers an option-market approach to studying the responsiveness of stock prices to earnings information.     

Reinsurance contract design with adverse selection

ABSTRACT

In light of the richness of their structures in connection with practical implementation, we follow the seminal works in economics to use the principal–agent (multidimensional screening) models to study a monopolistic reinsurance market with adverse selection; instead of adopting the classical expected utility paradigm, the novelty of our present work is to model the risk assessment of each insurer (agent) by his value-at-risk at his own chosen risk tolerance level consistent with Solvency II. Under information asymmetry, the reinsurer (principal) aims to maximize his average profit by designing an optimal policy provision (menu) of ‘shirt-fit’ reinsurance contracts for every insurer from one of the two groups with hidden characteristics. Our results show that a quota-share component, on the top of simple stop-loss, is very crucial for mitigating asymmetric information from the insurers to the reinsurer.     

Stairway to heaven or highway to hell: Liquidity,sweat equity,and the uncertain path to ownership

We study a setting in which a principal contracts with an agent to operate a firm over an infinite time horizon when the agent is liquidity constrained and privately observes the sequence of cost realizations. We formulate the principal’s problem as a dynamic program in which the state variable is the agent’s continuation utility, which is naturally interpreted as his equity in the firm. The optimal incentive scheme resembles what is commonly regarded as a sweat equity contract, with all rents back loaded. Payments begin when the agent effectively becomes the owner, and from this point on, all production is efficient. These features are shown to be similar to features common in real‐world work‐to‐own franchising agreements and venture capital contracts.     

Specific knowledge and performance measurement

I examine optimal incentives and performance measurement in a model where an agent has specific knowledge (in the sense of Jensen and Meckling) about the consequences of his actions for the principal. Contracts can be based both on “input” measures related to the agent's actions and an “output” measure related to the principal's payoff. Whereas input‐based pay minimizes income risk, only output‐based pay encourages the agent to use his knowledge efficiently. In general, it is optimal to use both kinds of performance measures. The results help to explain some empirical puzzles and lead to several new predictions.     

Domain knowledge,ability, and the principal's authority relations

I consider how different managerial traits affect the authority relation between a principal and his agent. An increase in the principal's domain knowledge—which enhances his capability to verify the agent's recommendations—leads to an increase in the proportion of the agent's recommendations that are approved, an increase in the agent's initiative, and is unambiguously beneficial to the principal and to the agent. In contrast, an increase in the principal's general ability to explore additional alternatives on his own leads to the principal making a larger proportion of the decisions. This discourages the agent's initiative and can adversely affect the principal.     

Buyer Brokerage: Incentive and Efficiency Implications

This article examines the incentive and efficiency implications of buyer brokerage. We show that it is possible to perfectly align the interests of the seller with those of his agent and the interests of the buyer with those of his agent. Furthermore, effort levels can be efficient. This result is a departure from earlier conclusions in the literature that the agent's effort level can neither be perfectly aligned with the principal's interests nor be efficient. The departure is primarily due to the feature of our model that it recognizes the costs as well as the benefits of an agent's effort to her principal, and vice versa. Finally, we discuss the implications of buyer brokerage for the future of MLS services.     

Capital Markets Regulation: How Can Accounting Research Contribute?

In examining the possible contribution that accounting research can play in ensuring effective and efficient regulation of securities markets, two principal opportunities stand out. First, the role of research in informing debate about proposed regulatory intervention (ex ante contribution to regulatory debate). Second, the ability of research to inform analysis as to the effectiveness of previously implemented regulatory changes (ex post contribution to regulatory debate). In the ex ante case, there is a natural tension between the way in which regulatory initiatives often arise quickly and the inevitable passage of time required to fully appreciate the degree to which underlying problems have been correctly characterised and can be framed in a manner suitable for addressing via rigorous analytical and empirical research. It is also impossible to empirically assess the effect of regulatory intervention that has not yet occurred. Finally, if data are simply not available, then research is limited to analytical analysis and prediction. In the ex post case, there is often a natural reluctance to subject regulatory intervention to mandatory analysis, and even when a statutory requirement exists for such analysis and review, the time horizon is often far too short for meaningful analysis. In both the ex ante and ex post cases, what is unavoidable is that regulation can only be legitimately informed by research that is sufficiently rigorous so as to have robust conclusions. Assessing research on these dimensions means that transparency is required so as to allow researchers to engage in meaningful debate about the validity of the conclusions. This inevitably means that research needs to be a partnership between regulatory agencies and academia, and that when research is used to justify regulatory interventions it must be publicly available and subject to robust debate.     

Competitive risk sharing contracts with one-sided commitment

This paper analyzes dynamic equilibrium risk sharing contracts between profit-maximizing intermediaries and a large pool of ex ante identical agents that face idiosyncratic income uncertainty that makes them heterogeneous ex post. In any given period, after having observed her income, the agent can walk away from the contract, while the intermediary cannot, i.e. there is one-sided commitment. We consider the extreme scenario that the agents face no costs to walking away, and can sign up with any competing intermediary without any reputational losses. We demonstrate that not only autarky, but also partial and full insurance can obtain, depending on the relative patience of agents and financial intermediaries. Insurance can be provided because in an equilibrium contract an up-front payment effectively locks in the agent with an intermediary. We then show that our contract economy is equivalent to a consumption-savings economy with one-period Arrow securities and a short-sale constraint, similar to Bulow and Rogoff [1989. Sovereign debt: is to forgive to forget? American Economic Review 79, 43-50]. From this equivalence and our characterization of dynamic contracts it immediately follows that without cost of switching financial intermediaries debt contracts are not sustainable, even though a risk allocation superior to autarky can be achieved.     

The dynamics of portfolio management contracts

We consider the multiperiod relationship between a client anda portfolio manager and the resulting problem of motivatinga manager of unknown ability to acquire valuable information.We explore the contractual form and the optimal retention policyof the client and find that the optimal initial set of contractsfeatures a smaller performance based fee component paid to themanager than in a first-best contract, and the contract choiceelicits only partial information about the manager. As a result,ex post performance measurement is critical to future recontracting.In general, managers are retained only if the returns on theirportfolio exceed the benchmark by an appropriate amount.