In a WSJ op-ed a few days ago, Senator Elizabeth Warren wrote that:
The Accountable Capitalism Act [that she recently introduced in Congress] ... would give workers a stronger voice in corporate decision-making at large companies. Employees would elect at least 40% of directors.
In effect, she would mandate a version of codetermination. Early in my career I wrote a series of articles explaining why employee involvement in corporate governance is a fundamentally bad idea:
Employee Involvement in Workplace Governance Post-Collective Bargaining (October 13, 1999). Available at SSRN: https://ssrn.com/abstract=183869
Corporate Decisionmaking and the Moral Rights of Employees: Participatory Management and Natural Law (September 28, 1998). Available at SSRN: https://ssrn.com/abstract=132528
Privately Ordered Participatory Management: An Organizational Failures Analysis (September 1997). Available at SSRN: https://ssrn.com/abstract=38600
Participatory Management within a Theory of the Firm (January 1996). Available at SSRN: https://ssrn.com/abstract=10023
In my (sadly out of print) book Corporation Law and Economics, my analysis of corporate voting rights begins by showing that public corporation decisionmaking must be conducted on a representative rather than participatory basis. It further demonstrates that only one constituency should be allowed to elect the board of directors. It then turns to the question of why shareholders are the chosen constituency, rather than employees. In this blog post, I focus on the latter issue, since that it the key issue raised by Warren's bill.
The standard law and economics explanation for vesting voting rights in shareholders is that shareholders are the only corporate constituent with a residual, unfixed, ex post claim on corporate assets and earnings.[1]In contrast, the employees’ claim is prior and largely fixed ex ante through agreed‑upon compensation schedules. This distinction has two implications of present import. First, as noted above, employee interests are too parochial to justify board representation. In contrast, shareholders have the strongest economic incentive to care about the size of the residual claim, which means that they have the greatest incentive to elect directors committed to maximizing firm profitability.[2]Second, the nature of the employees’ claim on the firm creates incentives to shirk. Vesting control rights in the employees would increase their incentive to shirk. In turn, the prospect of employee shirking lowers the value of the shareholders’ residual claim.
At this point, it is useful to once again invoke the hypothetical bargain methodology. If the corporation’s various constituencies could bargain over voting rights, to which constituency would they assign those rights? In light of their status as residual claimants and the adverse effects of employee representation, shareholders doubtless would bargain for control rights, so as to ensure a corporate decisionmaking system emphasizing monitoring mechanisms designed to prevent shirking by employees, and employees would be willing to concede such rights to shareholders.
Granted, collective action problems preclude the shareholders from exercising meaningful day-to-day or even year-to-year control over managerial decisions. Unlike the employees’ claim, however, the shareholders’ claim on the corporation is freely transferable. As such, if management fails to maximize the shareholders’ residual claim, an outsider can profit by purchasing a majority of the shares and voting out the incumbent board of directors. Accordingly, vesting the right to vote solely in the hands of the firm’s shareholders is what makes possible the market for corporate control and thus helps to minimize shirking. As the residual claimants, shareholders thus would bargain for sole voting control, in order to ensure that the value of their claim is maximized. In turn, because all corporate constituents have an ex ante interest in minimizing shirking by managers and other agents, the firm’s employees have an incentive to agree to such rules.[3]The employees’ lack of control rights thus can be seen as a way in which they bond their promise not to shirk. Their lack of control rights not only precludes them from double-dipping, but also facilitates disciplining employees who shirk. Accordingly, it is not surprising that the default rules of the standard form contract provided by all corporate statutes vest voting rights solely in the hands of common shareholders.
To be sure, the vote allows shareholders to allocate some risk to prior claimants. If a firm is in financial straits, directors and managers faithful to shareholder interests could protect the value of the shareholders’ residual claim by, for example, financial and/or workforce restructurings that eliminate prior claimants. All of which raises the question of why employees do not get the vote to protect themselves against this risk. The answer is two-fold. First, as we have seen, multiple constituencies are inefficient. Second, as addressed below, employees have significant protections that do not rely on voting.
Suppose a firm behaves opportunistically towards it employees. What protections do the employees have? Some are protected by job mobility. The value of continued dealings with an employer to an employee whose work involves solely general human capital does not depend on the value of the firm because neither the employee nor the firm have an incentive to preserve such an employment relationships. If the employee’s general human capital suffices for him to do his job at Firm A, it presumably would suffice for him to do a similar job at Firm B. Such an employee resembles an independent contractor who can shift from firm to firm at low cost to either employee or employer.[4]Mobility thus may be a sufficient defense against opportunistic conduct with respect to such employees, because they can quit and be replaced without productive loss to either employee or employer. Put another way, because there are no appropriable quasi-rents in this category of employment relationships, rent seeking by management is not a concern.
Corporate employees who make firm-specific investments in human capital arguably need greater protection against employer opportunism, but such protections need not include board representation. Indeed, various specialized governance structures have arisen to protect such workers. Among these are severance pay, grievance procedures, promotion ladders, collective bargaining, and the like.[5]
In contrast, shareholders are poorly positioned to develop the kinds of specialized governance structures that protect employee interests. Unlike employees, whose relationship to the firm is subject to periodic renegotiation, shareholders have an indefinite relationship that is rarely renegotiated, if ever. The dispersed nature of stockownership also makes bilateral negotiation of specialized safeguards difficult. The board of directors thus is an essential governance mechanism for protecting shareholder interests.
If the foregoing analysis is correct, why do we nevertheless sometimes observe employee representation? An explanation consistent with our analysis lies close at hand. In the United States, employee representation on the board is typically found in firms that have undergone concessionary bargaining with unions. Concessionary bargaining, on average, results in increased share values of eight to ten percent.[6]The stock market apparently views union concessions as substantially improving the value of the residual claim, presumably by making firm failure less likely. While the firm’s employees also benefit from a reduction in the firm’s riskiness, they are likely to demand a quid pro quo for their contribution to shareholder wealth. One consideration given by shareholders (through management) may be greater access to information, sometimes through board representation. Put another way, board of director representation is a way of maximizing access to information and bonding its accuracy. The employee representatives will be able to verify that the original information about the firm’s precarious financial situation was accurate. Employee representatives on the board also are well-positioned to determine whether the firm’s prospects have improved sufficiently to justify an attempt to reverse prior concessions through a new round of bargaining.
[1]See, e.g., Frank H. Easterbrook and Daniel R. Fischel, The Economic Structure of Corporate Law 66-72 (1991). An alternative answer based on the model used herein returns to the divergence of interests within constituency groups. Although investors have somewhat different preferences on issues such as dividends and the like, they are generally united by a desire to maximize share value. Board consensus therefore will be more easily achieved if directors are beholden solely to shareholder interests, rather than to the more diverse set of interests represented by employees.
A related but perhaps more telling point is the problem of apportioning the vote. Financial capital is fungible, transferable, and quantifiable. Control rights based on financial capital are thus subject to low cost allocation and valuation. In contrast, the human capital of workers meets none of these criteria. While one-person/one-vote would be a low cost solution to the allocation problem, it appears highly inefficient given the unequal distribution of reasoning power and education. If the most competent people and/or those with the most at stake should have the most votes, some more costly allocation device will be necessary.
[2]The superiority of shareholder incentives is a relative matter. Shareholders may have better incentives than other constituencies, but the phenomenon of rational apathy nevertheless limits the extent to which shareholders can be expected to act on those incentives.
[3]According to the Coase Theorem, rights will be acquired by those who value them most highly, which creates an incentive to discover and implement transaction cost minimizing governance forms. See Ronald H. Coase, The Problem of Social Cost, 3 J. L. & Econ. 1 (1960). Although shareholders and employees obviously do not bargain, a basic premise of the law and economics account is that corporate law provides them with a set of default rules reflecting the bargain they would strike if they were able to do so.
[4]See generally Oliver Williamson, Corporate Governance, 93 Yale L.J. 1197 (1984). This is not to say that exit is cost-less for either employees or firms. All employees are partially locked into their firm. Indeed, it must be so, or monitoring could not prevent shirking because disciplinary efforts would have no teeth. The question is one of relative costs.
[5]As private sector unions have declined, the federal government has intervened to provide through general welfare legislation many of the same protections for which unions might have bargained. The Family & Medical Leave Act grants unpaid leave for medical and other family problems. OSHA mandates safe working conditions. Plant closing laws require notice of layoffs. Civil rights laws protect against discrimination of various sorts. Even such matters as offensive horseplay have come within the purview of federal sexual harassment law.
[6]Brian E. Becker, Concession Bargaining: The Impact on Shareholders’ Equity, 40 Indus. & Lab. Rel. Rev. 268 (1987).
