Optimal Deterrence of Illegal Behavior Under Imperfect Corporate Governance

Abstract

We study the optimal design of liability schemes (at the corporate or individual level) when the objective is to deter socially harmful corporate behavior without discouraging productivity enhancements. We assume that firms face agency problems between shareholders and managers (moral hazard) and that unlimited sanctions on individuals are not available. We show that pure corporate liability rules can induce the first-best outcome only if firms can condition compensation on detection and the enforcement system is good enough. In other circumstances, unless individual sanctions can be very high, optimal mechanisms typically impose both corporate and individual liability.