On the appropriateness of performance based compensation for supervisory board members

An agency theoretic approach

Abstract

Central European countries such as Germany, Austria or the Netherlands require public firms to set up two separated 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 comprehensive performance based compensation to include members of the SB has been heavily discussed. As a result, e.g. the German Corporate Governance Code suggests to base compensation of SB-members on short term as well as long term performance measures.
In this paper we use a two stage principal-agent model to investigate incentive effects arising from such contracting. The first principal-agent relationship is established between the SB and the MB. The SB offers an incentive contract to the MB that motivates productive effort and requires a possibly biased report to be produced by the MB. The second principal-agent relationship involves the owners and the SB. The owners offer an incentive contract to the SB in order to motivate appropriate contracting with the MB and to induce a monitoring effort to be provided by the SB to restrict the MB's incentive to bias the report.
Allowing for two types of performance measures to be available for contracting, the report provided by the board and the market price of the firm, we obtain the following results regarding appropriate contracting with the SB: If the market price is used as a single performance measure, proper incentives are provided in some settings, but not in others. Adding the MB's report as a second performance measure always worsens the results. If the MB's report is used as the sole performance measure, no incentive alignment between the owners and the SB can be achieved at all and a purely fixed compensation is strictly preferred.