Stakeholder Incentives, Self Dealing and Optimal Compensation

We analyze how a firm's legal and social environment affect its optimal compensation policies. We study a model of self dealing where stakeholder cooperation could lead to improvements in firm performance. A manager has access to an uncontractible portion of the total resources of the firm, which he may either use for personal benefit or choose to share with employees and other stakeholders as an incentive to develop productive social ties. The investor's problem is structured as a constrained two-layered moral hazard, solved to determine the compensation scheme for the manager. Hence, the manager acts simultaneously as an agent to an investor and as a principal to employees and external stakeholders. We show that if the proportion of discretionary funds available to the manager is within a specific range, and the social conditions are supportive of increased stakeholder effort, the manager can be made to forgo his private benefit while improving the outcomes for himself, the investor and the stakeholders involved. The theory captures the ability of the manager to divert the company's funds in a way that creates value rather than destroy it. As a result, incentive mechanisms that ignore the social context could be suboptimal.