On the Appropriateness of Performance-Based Compensation for Supervisory Board Members - An Agency Theoretic Approach

Central European countries such as Austria, Germany and the Netherlands require public firms to set up two separate boards: a management board (MB) that manages the firm and a supervisory board (SB) that controls the management. As part of the recent debate on corporate governance, the expansion of performance-based compensation to include members of the SB has been heavily discussed. In this paper we use a two-stage principal-agent model to investigate incentive effects arising from such contracting. The SB is responsible for contracting with the MB and for monitoring it. We allow for two types of performance measures to be available, a possibly biased financial report provided by the MB and the market price of the firm. We obtain the following results: both performance measures are beneficial and equally suitable for contracting with the MB. In contrast, the MB's report is never part of the optimal SB contract. Using the market price as a performance measure for the SB in some settings turns out to be beneficial as compared to a purely fixed compensation but not in others.