Vicarious liability, managerial compensation and the manager-shareholder relationship

Chapters 4 and 5 discussed the judgement proof problem - if an individual or a firm does not have sufficient assets to pay for accidental harm, then both strict liability and the negligence rule will, with some exceptions, fail to induce efficient behaviour by the injurer. The judgement proof problem may occur in a wide variety of situations, including in corporate law. For example, a manager who is employed by shareholder and runs the day-to-day operations of the firm may take actions on the firm's behalf that cause harm to a victim, but for which the manager, if he were held personally liable for the harm, would not have sufficient assets to compensate the victim.

If the harm exceeds the manager's wealth, then the analysis of Chapter 4 suggests that this will lead, in general, to the manager having poor incentives to take care. But can this inefficient arrangement be improved upon? Vicarious liability is one way of addressing the judgement proof problem. Vicarious liability occurs when liability for damages is imposed on one party for losses caused by another party. This situation arises in many applications, including between shareholders and managers; construction companies and subcontractors; and between firms and employees. This section analyses a simple model of vicarious liability and applies it to the shareholder/manager relationship. We assume that there are three parties:

  • • An employee of a company (for example, a manager) who can take care of x to reduce the probability of an accident.
  • • A principal, who owns the assets of the company and employs the manager and pays him a wage of W. The wage can be structured in such a way as to depend on the level of care (if care is observable). Alternatively, if the manager's level of care is not observable, the wage can be structured in such a way as to depend on whether an accident occurs or not.

We consider a principal-agent contracting framework in which there are two possible outcomes: an accident either occurs, or does not. We assume that the manager (the agent) takes an action (care) that can be directly observed by the shareholders (the principal). We assume that both parties are risk neutral.

The shareholders are the owners of the firm's assets, and these exceed the harm to the victim. On the other hand, The manager does not have a sufficiently high level of assets to cover the victim's damages. The shareholders contract with the manager for the performance of some service. Let:

Wn = wage if harm does not occur Wh = wage if harm occurs W = the manager's reservation utility

Throughout the analysis we will assume that:

where a is the level of the manager's assets.

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