Labor Representation in Governance as an Insurance Mechanism

E. Han Kim is Everett E. Berg Professor of Business Administration at University of Michigan Ross School of Business; Ernst Maug is Professor of Corporate Finance at University of Mannheim Business School; and Christoph Schneider is Assistant Professor of Finance at Tilburg University. This post is based on their recent article, forthcoming in the Review of Finance.

Is labor representation on the board of directors bad? Not necessarily. It can improve risk sharing between employers and employees without hurting shareholders, according to our study on the German experience. Germany requires 50% employee representation on the supervisory board when firms have more than 2,000 employees working in Germany.

We study establishment-level data on employment and wages. (An establishment is any facility having a separate physical address, such as a factory, service station, restaurant, or office building.) Our sample covers the top 100 listed German firms during the period 1990-2008. We compare establishments belonging to firms required to have parity codetermination of 50% employee representation (parity firms, in short) with those belonging to firms not required to have 50% representation (non-parity firms). Employees working for parity firms are paid, on average, 3.3% less than employees of non-parity firms. These lower wages, we argue, represent an insurance premium, because when other firms in the same industry lay off more than 5% of the work force, parity firms do not lay off workers in any significant way. That is, parity firms protect their employees when others in the same industry go through a major restructuring of their work force. As such, we interpret the lower wages as insurance premiums workers pay in return for their employment guarantees.

Workers’ employment risk preferences might influence where they work. Those who are more worried about employment risk may choose to work for parity firms at a lower wage, while those who are more risk tolerant may choose to work for non-parity firms at a higher wage. Availability of such risk-return tradeoff opportunities leads to more efficient risk sharing between employers and employees.

Why do firms need labor representation on the board to enter into an employment insurance contract? Can’t they just promise not to lay off employees in the future? Such contracts have no teeth and hence may not work. A viable contract requires an enforcement mechanism to ensure the insurer will keep its promise even when it is in its best interest to renege it (e.g., laying off workers during industry downturns.) Without an effective enforcement mechanism, employees would not accept lower wages for promises with no teeth. The 50% employee representation on the board, in our opinion, provides an effective tool for workers to ensure employers will honor the contract when they need the protection.

Skeptics argue that allowing labor representation on the board will have a harmful effect on firm performance. This is a real possibility, because when workers have much influence on governance, they may capture the management. Management captured by workers tends to misallocate resources, leading to lower earnings and share prices. We search for evidence of such harmful effects by examining how parity co-determination impacts operating earnings and shareholder value. We find only neutral effects; parity firms perform no worse or better than non-parity firms.

Surprisingly, unskilled blue-collar workers of parity firms are unprotected from layoffs during adverse industry shocks—only white-collar and skilled blue-collar workers are fully protected. We attribute this lack of protection to the absence of unskilled blue-collar worker representation on supervisory boards. We could not identify a single unskilled blue-collar worker among labor representatives for any company in the sample, which underscores the importance of worker participation in governance for an effective implementation of implicit employment insurance contracts.

Thus, the bottom line: labor representation on the board improves employee welfare by providing them an option to purchase employment insurance via lower wages, and the board representation does not hurt shareholders. Germany is not the only country with labor representation on the board. Most countries grant workers some degree of representation, at least in the form of work councils at the firm or establishment level. By 2015, only two countries among the OECD countries—the United States and Singapore—did not grant workers any representation.

Finally, a caveat is in order. The German experience is likely to have been influenced by the country’s societal, legal, and educational institutions and, thus, may not be universally applicable. More research is needed on the experiences of other countries which allow worker participation in governance before we can safely conclude that worker representation on the board is welfare improving.

The complete article is available for download here.

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One Comment

  1. Stephen Crimmins
    Posted Monday, May 28, 2018 at 12:33 pm | Permalink

    Sad to learn that the US joins Singapore as the only OECD countries not giving workers board representation. Why are we an outlier on this? If it succeeds in a developed and prosperous economy like Germany, why not give it a try for American workers?

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