Labor Representation in Governance as an Insurance Mechanism

E. Han Kim is Professor of Finance at the University of Michigan.

Worker participation in corporate governance varies across countries. While employees are rarely represented on corporate boards in most countries, Botero et al. (2004) state “workers, or unions, or both have a right to appoint members to the Board of Directors” in Austria, China, Czech Republic, Denmark, Egypt, Germany, Norway, Slovenia, and Sweden. Such board representation gives labor a means to influence corporate policies, which may affect productivity, risk sharing, and how the economic pie is shared between providers of capital and labor.

In the paper, Labor Representation in Governance as an Insurance Mechanism, which was recently made publicly available on SSRN, my co-authors (Ernst Maug and Christoph Schneider) and I focus on risk-sharing between workers and the firm. Our point of departure is implicit contract theory, which holds that the risk-neutral principals of the firm provide job protection to risk-averse employees against adverse shocks. Employees, in turn, accept lower wages. Commitment to such implicit insurance contracts may require a means for employees to monitor and enforce the implementation, an aspect often taken for granted in the theoretical literature. We hypothesize labor representation on corporate boards provides an ex-post enforcement mechanism to ensure contracts will be honored when employees need protection.

To test this hypothesis, we examine the German system, which requires 50% employee representation on supervisory boards—hereafter referred to as parity-codetermination—when firms have more than 2,000 employees working in Germany. We choose the German case because it offers a laboratory in which companies that are similar on many dimensions nonetheless have different degrees of labor representation. In addition, the Institute of Employment Research (IAB) in Germany provides detailed, high quality panel data on employment and wages for all establishments located in Germany over our sample period 1990 to 2008. The establishment data allow us to construct adverse industry shocks using other, non-sample firms in the same industry with establishments located in Germany. We consider an industry is subject to a shock when establishments belonging to the non-sample firms in the same industry as a whole decrease their work force by at least 5% with no increase in employment in the following year.

Using a difference-in-differences approach, we find white-collar and skilled blue-collar workers of parity-codetermined firms are protected against layoffs during adverse industry shocks, while those working for non-parity firms are not. Surprisingly, unskilled blue-collar workers of the same parity firms also are unprotected from layoffs during industry shocks. We attribute this to the composition of labor representatives on the supervisory boards, which favors skilled blue-collar and white-collar workers.

We also find skilled blue-collar and white-collar workers are fully protected from wage cuts. However, this wage protection does not depend on whether firms are parity-codetermined or not. We attribute this downward rigidity in wages to the effectiveness of industry-wide collective bargaining agreements, which cover parity as well as non-parity firms.

Job protection does not necessarily imply the implementation of implicit insurance contracts. It could be due to greater worker influence arising from their representation on boards. If it is worker influence, rather than insurance, which prevents layoffs during industry shocks, there is no reason to expect employees to receive lower wages. We find that workers with vocational and higher educational qualifications, two categories that cover most skilled blue-collar and white-collar workers, accept significantly lower wages at parity-codetermined firms. Their average wage concession is about 3.5% during non-shock periods. Wage concessions are greater in areas with higher unemployment, consistent with the conjecture that workers value insurance more if the consequences of becoming unemployed are more severe.

To the extent that firms with parity-codetermination provide job protection against adverse shocks, their operating leverage should be higher. The higher operating leverage makes firms more vulnerable to industry shocks. We find parity-codetermined firms’ profitability and valuation suffer more, and their stock price beta increases more during shock periods than firms without parity-codetermination. Parity-codetermined firms also engage in more major asset sales during shock periods, perhaps to avoid cuts in their payroll. These asset sales are followed by improved profitability.

The baseline results on employment and wages are robust to a battery of robustness tests. We are particularly concerned with parity co-determination being a discrete function of the number of employees. We address this issue in three different ways: (1) by explicitly controlling for the size effect with an interaction of the shock indicator with the number of firm employees; (2) by estimating placebo regressions, in which the parity co-determination indicator is replaced by the median number of employees for each of the parity and non-parity sample; and (3) by conducting a regression discontinuity analyses around the 2,000 employee threshold for parity codetermination. All three tests support the robustness of our findings.

Is mandated parity-codetermination efficient? It may increase efficiency by improving risk-sharing. However, Jensen and Meckling (1979) argue the opposite: Mandatory codetermination is inefficient because workers’ decision rights may guide the firm towards value-decreasing policies. To help shed light on this issue, we estimate the relation between parity codetermination and firm profitability and valuation, as measured through the cycle over the non-shock and shock periods. As in previous studies (see Renaud (2007) for a survey), our evidence is also inconclusive. We do not find a significant relation between parity codetermination and firm profitability or valuation, as measured by ROA (EBITDA/Total Assets) and Tobin’s Q. On average, parity firms perform no better or worse than non-parity firms.

The hypothesis that firms insure workers against shocks goes back, at least, to the implicit contracting models of Baily (1974) and Azariadis (1975). More recently, Guiso, Pistaferri, and Schivardi (2005) examine a matched employee-firm panel of Italian firms and show that firms have a significant role in protecting workers against wage shocks. We add to these contributions by examining how workers are protected against employment shocks. In addition, we explicitly address the commitment problem inherent in the insurance hypothesis by comparing firms with 50% worker representation on the board with those that do not have such representation. In so far as German firms are concerned, insurance is not automatic. The insurance effects are most prevalent when workers have a 50% representation on the board. Even with such representation, not all workers are covered by the insurance; only workers who have their own peers represented on the board seem to benefit from the insurance.

A similar insurance mechanism may be at work for family firms. Sraer and Thesmar (2007) show that family firms in France insure workers against employment shocks and argue that it is easier for family firms to commit to implicit contracts because their managers have a longer time horizon. Ellul, Pagano, and Schivardi (2013) find evidence of employment insurance for a cross-section of countries in contemporaneous work. In contrast to our findings, they find that workers pay a price for employment insurance in the form of higher fluctuations in wages. We do not find such fluctuations in wages, probably because most wages in Germany are protected by unionized wage agreements.

Our study is also related to the literature on employment protection, which focuses on the protection of workers through instruments such as severance pay and notice periods and how they impact employment and unemployment. The literature mostly follows the lead of Lazear (1990) and is summarized in Addison and Teixeira (2003). A later strand of that literature examines cross-country differences in legal institutions protecting employment and worker rights (e.g., Botero et al., 2004). Our contribution is the examination of an important employment protection mechanism overlooked by these firm-level or country-level studies—the implementation of implicit insurance contracts through worker participation in governance. A large literature also investigates the implications of German codetermination on firm profitability and valuation. Renaud (2007) surveys 13 studies investigating the impact of codetermination on company performance using different methodological approaches, sample constructions, and performance variables The overall evidence seems inconclusive. Our analysis adds to this discussion by analyzing establishment-level data with a specific economic rationale for codetermination.

The full paper is available for download here.

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