LIARS NEVER PROSPER - HOW MANAGEMENT MISREPRESENTATION REDUCES MONITORING COSTS

When monitoring is not contractible-so investors monitor only when, at that time, they expect to benefit from doing so-efficient contracts s ometimes induce managers to make false reports to investors. Because o f monitoring discretion, management misrepresentation can produce Pare to improvements by reducing monitoring costs. When costs of renegotiat ion are small, optimal contracts necessarily induce misrepresentation. Discretionary monitoring also generates an equilibrium role for multi ple-security capital structures. When an optimal contract has two inve stors, securityholder conflict arises endogenously as a means of reduc ing monitoring costs. It is efficient to write the contract so that on e investor's decision to monitor hurts the other investor. (C) 1997 Ac ademic Press.