We consider optimal incentive contracts when managers can, in addition to shirking or diverting funds, increase short term profits by putting the firm at risk of a low probability "disaster." To avoid such risk-taking, investors must cede additional rents to the manager. In a dynamic context, however, because managerial rents must be reduced following poor performance to prevent shirking, poorly performing managers will take on disaster risk even under an optimal contract. This risk taking can be mitigated if disaster states can be identified ex-post by paying the manager a large bonus if the firm survives. But even in this case, if performance is sufficiently weak the manager will forfeit eligibility for a bonus, and again take on disaster risk. When effort costs are convex, reductions in effort incentives is used to limit risk-taking, with a jump to high powered incentives in the gambling region. Our model can explain why suboptimal risk-taking can emerge even when investors are fully rational and managers are compensated optimally.
