Can Liars Ever Prosper

Anna Maria Menichini and Peter Simmons

Discussion Papers from Department of Economics, University of York

Abstract: The paper compares the optimal financial contracts of a firm which has private information over its expost revenues when the finance can be provided by either a single or two groups of investors. When they are the only investors we use a financial contract with non-contractible monitoring, in which the probabilities of cheating by the entrepreneur/firm and monitoring by investors are mutual best responses. The contract is written by the entrepreneur knowing that this equilibrium will subsequently occur. With a second group of investors who have no monitoring rights, we analyse a truth telling contract and a misrepresentation contract in which cheating and monitoring probabilities are chosen in a similar way to those of the single investor contract. The non monitoring investors learn the results of any monitoring for free. Our main results are that: the two investor group truth-telling contract achieves the second best despite the lack of commitment; this contract is only feasible under limited liability of investors if low state revenues are high enough. When low state revenues are too low for this then the two investor misrepresentation contract is optimal. This contract has a negative correlation between repayments to the two investor groups: the contract uses the non-monitoring group to smooth out the repayments of the entrepreneur optimally. This reduces his incentive to make false reports and mitigates the investor's incentive to monitor. A second result is that the two investor scenario is Pareto superior to the single investor model. We show that with unlimited liability on investor groups, the two investor misrepresentation contract is as good as the second best. Generally in this misrepresentation contract investors may have to make repayments to the firm rather than receive them. A further result is that the three party contract is always renegotiation-proof, as well as collusion-proof so long as the low state revenues are below the expected repayments of the monitor. Last we show that under limited liability the share of finance provided by the two is strictly positive and uniquely determined.

Keywords: financial contracts; multiple investors; no commitment. (search for similar items in EconPapers)
JEL-codes: D82 D83 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-ent
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

Downloads: (external link)
https://www.york.ac.uk/media/economics/documents/discussionpapers/2002/0210.pdf Main text (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:yor:yorken:02/10

Access Statistics for this paper

More papers in Discussion Papers from Department of Economics, University of York Department of Economics and Related Studies, University of York, York, YO10 5DD, United Kingdom. Contact information at EDIRC.
Bibliographic data for series maintained by Paul Hodgson ().