Optimal Incentive Structures for the Board of Directors: A Hierarchical Agency Framework

Abstract

We examine optimal equity-based incentives for the Board of Directors (BOD) in a hierarchical agency framework. The underlying agency problem is due to a shareholder-manager conflict on investment policy. There is an endogenous demand for directors to monitor the quality of the firm's investment opportunity set and ratify managerial investment decisions, since managers have private information on the economic prospects of the firm. But self-interested directors must be motivated to exercise personally costly due diligence in monitoring the management. We show that under certain conditions it is optimal for the shareholders to create a hierarchical double-agency situation in equilibrium, where both the managers and their purported monitors are subject to moral hazard, but equity incentive awards to the BOD are still incentive efficient. Our analysis highlights the role of firm-and industry-specific variables such as past economic performance, the size of investments and the span of the investment opportunity set, firm leverage, and profit volatility. Finally, we provide a parsimonious and tractable ordering of the strength or effectiveness of endogenously determined corporate governance mechanisms, and relate the effectiveness of internal corporate governance mechanisms to observable firm- and industry-specific variables.