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.