Agency Costs and Misrepresentation in Leveraged Firms.

The financial crisis that began in the United States in 2007 and spread into a deep worldwide recession focused attention on agency costs in leveraged firms. Particular attention was given to the incentives of shareholders in such firms to overinvest (known as the "risk-shifting" problem) or underinvest (known as the "debt-overhang" problem). Besides these problems, the earlier financial crisis of 2002 brought to light shareholders' incentives to misrepresent the financial condition of the firm. Interestingly, to date the interactions between these adverse incentives have not been analyzed in either the legal or finance literatures. The aim of this Article is to fill that gap. Its main conclusion is that misrepresentation of the firm's financial results alleviates the classic agency costs between shareholders and debt-holders, leading to less overinvestment (less risk-taking) and less underinvestment due to the debt-overhang problem. In a nutshell, the explanation is that shareholders in leveraged firms can be viewed as holding a call option on the firm's assets, and misrepresentation pushes the option into the money, leading to better alignment between the interests of shareholders and the interests of all stakeholders of the firm. Our theoretical results shed new light on the causes of the financial crisis of 2007 and the ensuing slow recovery. The Article also offers policy recommendations.