This paper shows that contracting costs are sometimes minimized by contracts that induce managers to make "false" reports to investors.

Social Science Research Network

This paper shows that contracting costs are sometimes minimized by contracts that induce managers to make "false" reports to investors. Previous models presume that investors can be costlessly compelled to verify a manager's reports. In contrast, I assume that investors monitor only when they expect to benefit from doing so. This monitoring discretion overturns the Revelation Principle, and management misrepresentation can produce Pareto improvements. Discretionary monitoring also generates an equilibrium role for multiple-security financial structures, and efficiency improves when the investors are placed in conflict over monitoring strategy--one investor's decision to monitor hurts the other investor.

This paper shows that contracting costs are sometimes minimized by contracts that induce managers to make "false" reports to investors.

Liars Never Prosper? How Management Misrepresentation Reduces Monitoring Costs