Scale effects in dynamic contracting

We study a continuous-time contracting problem in which project scale plays a role. The agent may speculate to enhance the drift of a cash-flow process; doing so exposes the principal to large, infrequent losses. The optimal contract includes scale as an instrument: downsizing along the equilibrium path is necessary to preserve incentive compatibility. We characterize the optimal contract, and specifically the downsizing process, and prove there is an optimal liquidation scale that is reached in finite time. We also analyze some finer properties of the state variables of the contract and the resulting value function of the principal. The optimal contract is implemented using standard financial securities plus debt covenants; holding equity is essential to curb risk taking. Conflicts emerge between classes of security holders and explain phenomena like priority of claims at liquidation.