Remedying Illegal Actions of Judgment Proof Injurers Via Contracts, Fines and Sanctions

This paper studies the impact of the judgment proof problem on the design of incentives to prevent illegal behavior when the principal delegates a risky production activity to the agent in the presence of moral hazard and adverse selection. The agent can reduce costs by engaging in an illegal action that generates liability. When insolvency is endogenously determined, the principal neither provides incentives to the agent to induce a fully legal action nor designs a contract that makes either party insolvent. The social optimum can be achieved by a fine or non‐monetary sanction. If the fine cannot correct inefficiency, non‐monetary sanction achieves the social optimum by the fully legal action. Copyright © 2013 John Wiley & Sons, Ltd.