Optimal Contracting of a busy Board with Reputation Concern under the Threat of Collusion

In a three-tier hierarchy agency model I study optimal contracts to induce the board of directors to efficiently monitor the CEO. I find that next to type of compensation (fixed or bonus), monitoring cost and potential reputation damage of the board determine the monitoring decision. Optimal firm value can be realised under both fixed and bonus pay, if the cost of monitoring is low enough relative to the board’s potential reputation damage of false reporting. The possibility of setting a bonus for the board increases the sustainable level of monitoring cost. This provides support for the optimal contracting view that bonuses may be optimal under certain firm-specific circumstances. However, the required level of CEO contribution to firm value to receive a bonus must be higher for the CEO than for the board to make the board’s bonus effective. Furthermore, the sustainable level of the bonus for the board is limited by the expected severity of reputation damage. As long as the monitoring cost is low enough relative to the expected reputation damage, optimal contracts are also sustainable under the threat of collusion. However, if the expected severity of reputation damage is low, CEO incentives need to be decreased to deter collusion between the board and the CEO. This necessarily leads to lower than optimal firm value.