Self-Enforcing Stochastic Monitoring and the Separation of Debt and Equity Claims

We study the incentive issues associated with self-enforcing stochastic monitoring in a model of investment and production. The efficient contract features a debt-like payment with a threshold in terms of the reported output in which all of the reported output is taken up to the threshold if monitoring doesn’t occur and all of the output is taken if monitoring does occur. An output report above the threshold leads to zero probability of monitoring and just the threshold amount being paid out. The efficiency gap between the self-enforcing contract and the commitment constraint is minimized when the monitors holds no part of the residual claim on the firm, which we associate with equity. Misreporting by the manager is an important component of the efficient contract.