Contracts in the Shadow of the Law: Optimal Litigation Strategies within Organizations

A principal can bring litigation against an agent for overstating the realized production costs. The lawsuit functions much like an audit; the principal's ability to bring suit against the agent can reduce the information rent and increase production efficiency by penalizing the agent misreporting costs. The principal benefits from higher trial awards depending on the ability of the principal to commit to a litigation strategy comprised of a frequency of and expenditure in litigation. While higher awards increase the agent's expected punishment for shirking, they also encourage excessive litigation expenditures by both parties ex post. When the principal can pre-commit to a probability of bringing suit, for large stakes in trial, the principal reduces the probability to maintain a constant expected punishment. Alternatively, if the principal were able to commit ex ante to a probability and intensity of litigation, even when stakes are large, the principal would litigate with certainty but reduce litigation intensity below what is ex post rational.