Optimal Disclosure Rule and Efficient Liquidation

Abstract

We study optimal disclosure rules that alleviate inefficiencies caused by managerial private benefits. An entrepreneur raises capital from investors by designing a security and an associated covenant. The covenant allocates the control right of the project to the entrepreneur or investors in the intermediate period according to a public signal. The party obtaining control rights can decide whether to liquidate the project or continue to generate a random cash flow. The entrepreneur enjoys private benefits from continuation which may give rise to inefficient decisions. The regulator designs the disclosure rule of the public signal in order to alleviate the potential inefficiencies. The optimal disclosure rule features binary signals and is characterized by a threshold. The first-best is always achieved under small private benefits. For large private benefits, first-best is unachievable and the threshold decreases in private benefits. This result has an implication in accounting that more severe agency conflicts call for less conservative disclosure rules. In addition, our results also suggest that more conservative disclosure rules are associated with, but not the cause of, more efficient investment decisions. This implication is consistent with the empirical facts (e.g. Lara et al. 2015) but the underlying mechanism differs from those argued in the literature. Finally, our results are robust to various forms of security designs and the contract used in equilibrium is renegotiation-proof.