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«Three essays on corporate boards R. Øystein Strøm A dissertation submitted to BI Norwegian School of Management for the degree of Dr.Oecon SERIES ...»

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The paper’s results come from a panel data set of non-financial firms spanning the fourteen years from 1989 to 2002, containing financial information, data on ownership, and board composition data. Employee representation was mandated by law in 1972 in Norway, and regulations have remained almost unchanged since (Aarbakke et al., 1999). The data on employee directors seems to be superior to those pulled from German and Canadian institutional frameworks. While the employee director in a German board may be elected from the national labour union, and the Canadian evidence is from firms where employees have considerable shareholdings, in Norway the employee director must be employed in the company. Furthermore, because the mandatory employee director rules only apply to certain firms, some firms have employee directors, others have none. Thus, the study avoids the Dow (2003, p. 87) objection that empirical investigations on the effects of employee directors suffer from a lack of control group. Thus, unlike previous studies, the Norwegian institutional framework allows comparison between similar firms with and without employee directors. This setting allows for sharper estimates of the co-determination effects.

The paper has relevance for the emerging regulation literature on boards (Hermalin, 2005). Because the sample includes both co-determined (by regulation) and the shareholder determined kind, I can study the effects of governance regulation by comparing the two sub-samples.

Compared to the related Bøhren and Strøm (2007), I introduce a number of new features. I construct a board structure index that captures

CHAPTER 3. CO-DETERMINATION

many standard board characteristics in the same manner as Bertrand and Mullainathan (2001), I add financial leverage and average wage as new explanatory variables, perform a system estimation rather than a singleequation estimation, and I make separate regressions for various sub-samples, for instance employee-director firms only. These steps should yield better estimations of the employee director impact than the partial regressions in Bøhren and Strøm (2007), and should also, subject the codetermination hypothesis to more severe robustness tests. Furthermore, I confirm their results when using individual board characteristics instead of the board index.

In order to fully utilize the information in the panel data, I use the fixed effects model (Woolridge, 2002), employing a three-stage least squares (3SLS) methodology in system estimations. With the fixed effects method, I am able to remove firm heterogeneity as did Palia (2001). Therefore, few (if any) control variables are needed.

Using Tobin’s Q as the measure of firm performance, the results conrm the employee directors’ negative relationship to firm performance in earlier studies, but also show a positive indirect effect to the board index and leverage. This reflects endogeneity, but the economic significance of the indirect effects turn out to be much smaller than the direct. The reverse causation hypothesis also finds confirmation, since lagged firm performance is significant both regarding the board index and leverage.

But again, the indirect effects of the lagged firm performance are low compared to the direct. I find clear differences in the various board characteristics’ impact upon firm performance in sub-samples of co-determined and shareholder determined firms. This means that regulations have costs, both in relation to firm performance, and in the remaking of boards. The results stand up to a number of robustness tests, including alternative performance measures (stock return and accounting return on assets), and also to dividends replacing leverage.

The paper proceeds as follows. In the next section, a brief review of the literature is given. Then, in section 3.3 testable implications are spelled out. Section 3.4 contains data sources and institutional background, while the following section, 3.5, discusses estimation methodology. Then section

3.6 shows results, in 3.7 robustness checks are undertaken, and the final section, 3.8, concludes.

3.2. LITERATURE REVIEW 65

3.2 Literature review

Few empirical studies of co-determination have been undertaken. Evidence in FitzRoy and Kraft (1993); Schmid and Seger (1998) and Gorton and Schmid (2000) shows that co–determination has a negative economic effect upon firms in Germany, where employees have the right to equal representation in the Aufsichtsrat with shareholders. Recently, Fauver and Fuerst (2006) find a positive relationship to performance in a 2003 sample of German companies in information intensive industries. In the regressions with all industries, however, the relationship is not significant. The German data often contain two kinds of employee directors, some elected from among the employees in the company, while others may be national union representatives. In contrast, the Norwegian system is such that only persons employed in the company may be elected. Thus only a company and not a national, union representative may sit on a Norwegian board.

Presumably, company employed persons are more authentic stakeholders than their national union representatives.

Using Canadian data, Falaye et al. (2006) find that firms giving employees a greater voice in corporate governance spend less on new capital, take fewer risks, grow more slowly, create fewer new jobs, deviate more from value maximisation, show greater cash flow problems, exhibit lower labour and total factor productivity. This paper is set in a different institutional environment. The Canadian employee directors are elected in their capacity as owners of company shares. The influence of these directors on firm performance thus picks up two effects, one as a supplier of labour services, the other as owner. None of these studies use panel data or simultaneous data estimations.





Using Norwegian data, Bøhren and Strøm (2007) show that the employee director variable has a negative impact upon Tobin’s Q. They also find evidence of interdependencies among board characteristics. However, they do not explore the indirect effects of co-determination, neither do they carry their analyses into sub-samples of co-determined and shareholder determined firms. In this paper, the analysis is extended to include effects upon average wage, leverage is a new governance variable, the board index defined; I employ simultaneous equations modelling, and perform regressions in sharply defined sub-samples. The robustness tests are also more extensive, as I use return on assets and stock return as new dependent variables, and also vary the definition of the board index.

CHAPTER 3. CO-DETERMINATION

3.3 Theory and hypotheses 3.3.1 Stakeholder or interest group?

Board decisions include the formulation and control of strategy, larger investments and disinvestments, and the determination of the company’s organization. Employee directors’ influence upon these decisions may have long-time impact upon firm performance. Therefore, an analysis over a long period of time is needed to detect the effects. The impact upon firm performance could be positive, non-significant, or negative.

One possibility may be that the firm performance and employee link is positive. Blair and Stout (1999) view stakeholders as members in a team production. Since stakeholders invest in firm-specific investments, it is in their interest to co-operate. The firm-specific human capital investments make the employees residual claimants to much the same extent as shareholders (Zingales, 2000 and Becht et al., 2003). The upshot is that employees should be represented on the board, and that this co-determination will lead to improved firm performance. The conclusion rests on the argument that the stakeholders’, including the shareholders’, interests are aligned.

How could this be manifested in the board? Employee directors could have a dual informational role in bringing inside information to the board Blair (1995, p. 16), but also in relating board information to the employees (Freeman and Lazear, 1995). Since employees are in the middle of the day-to-day running of the company, they may bring valuable operational knowledge to the board. The information may expand on or contrast with information from the CEO. Thus, the information set available to the outside directors is enlarged. This comes close to viewing the employee director in the same role as the insider in the Raheja (2005) theory, although in this model the insider is willing to furnish the outside directors with information only if this furthers his own career interests. Secondly, the role as messengers of board information to the employees at large could be of particular value in the case of personnel reductions or plant closures, when the board may want to instil an understanding for the need for drastic measures among employees. The dual informational role of employee directors should lead to better firm performance (Fauver and Fuerst, 2006).

Another possibility is that co-determination has no significance for firm performance. This may come about through co-optation (Pfeffer, 1981, p. 166-173). In the board employee directors are exposed to fiduciary duties and conformity pressures to accept the shareholder value logic.

3.3. THEORY AND HYPOTHESES 67 Also, by making the employee director co-responsible for decisions with adverse outcomes for employees, the decisions carry higher legitimacy among employees. If co-optation is the case, interests are again aligned, but this time because employee directors have taken on the views of shareholders. The effect upon firm performance should be non-significant.

The third possibility is that the co-determination impact upon firm performance is negative. It may be hard to accept the premise that stakeholder interests are aligned. If this were so, co-determination would be an efficient economic organisational mode, and firms would adopt this mode voluntarily (Jensen and Meckling, 1979 and Hansmann, 1996). But while shareholders seek to maximize residual income, employees want to maximize pay and the protection of firm-specific human capital5, that is, a part of the residual income. The inconsistency of these two objectives makes the board decision process longer and more difficult (Mueller, 2003). The firm’s objectives may become unfocussed, and the CEO may develop capabilities as a compromise maker rather than a shaper of the firm under a clear objective (Tirole, 2001, 2002). The implied consensual decision model in codetermination means that the firm pursues stability and predictability instead of bold new moves (Siebert, 2005). If employee directors are successful, they should influence the average wage positively. The unfocussed decision structure should result in weaker firm performance. I call this the interest conflict model for reference, and hypotheses stemming from the model are set forth in the next section.

When objectives diverge, shareholders and employees may game against each other so as to further their own interests. Employees may furnish information strategically to further their own interests (Pistor, 1999 and Hopt, 1998), and they may use moral arguments in parallel. Information strategising could take the form of economising on the supply of internal information to the board. For instance, employee directors may not inform of low productivity units in the organisation. Another form could be information leakage from the board6. Employee directors will hardly inform their fellow workers only on matters that owners and management find in their interests to inform about. Stakeholder theorists seem to assume only the beneficial information dissemination through employee 5 In a recent booklet, the long-time employee director Svein Stugu (2006) says that the main objective is to prevent plant closures. Mergers, takeovers, and outsourcing must also be prevented.

6 Stugu (2006, p. 63) says that opposition to plant closures was organized in cooperation with representatives of the local community, but that this could only be done effectively if labour representatives had access to internal information.

CHAPTER 3. CO-DETERMINATION

directors. Furthermore, moral arguments against for instance plant closures or high management pay may be put forward, too. The shareholder elected directors may have trouble withstanding such arguments, since they may experience large personal costs and small personal gains from making decisions that affect employees adversely (Baker et al., 1988). Taking the issue to the public attention could make the decision even harder for the shareholder elected directors. Thus, even though the employees are in a minority position in the board, they may influence board decisions to their advantage. Their access to board information seems to be vital in this respect.

But the presence of employee directors may have indirect effects upon the use of other governance mechanisms as well. Shareholders may adjust governance mechanisms in order to neutralize the co-determination impact. This is analogous to the situation Buchanan and Tullock (1962) point out, that when an exogenous regulation is imposed upon a (political) committee, it will try to compensate for the regulatory effect by placing a heavier weight on the unregulated. These previously unexplored indirect effects make a simultaneous equations approach necessary. In the remainder of this section governance mechanisms and hypotheses about interactions are explained.

3.3.2 Simultaneity and endogeneity In a simultaneous equations system some variables are endogenous, others exogenous. In the present setup, the exogenous variables are the fraction of employee directors, the lagged firm performance, the firm size, and firm risk. Since employee directors are imposed from outside the firm, they must constitute an exogenous variable. These variables determine firm performance and average wage, but also the intervening governance variables, the board characteristics and leverage. Thus, the intervening governance variables and the average wage are at least partly determined by the employee directors and lagged firm performance. The simultaneous setup gives the researcher the opportunity to recognise the governance variables’ endogeneity, but at the same time also to measure the magnitude of the effect relative to their direct effects upon firm performance.



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