«Three essays on corporate boards R. Øystein Strøm A dissertation submitted to BI Norwegian School of Management for the degree of Dr.Oecon SERIES ...»
In this paper I pose the question whether board representation of one group of non-owner, the employees, improves ﬁrm performance. I conclude it does not. The conclusion runs counter to claims from stakeholder theorists (Freeman and Reed, 1983; Blair, 1995) and some ﬁnancial economists (Zingales, 2000 and Becht et al., 2003) that co-determination improves ﬁrm performance. Instead the results support most former ﬁndings in the empirical literature FitzRoy and Kraft (1993); Schmid and Seger (1998); Gorton and Schmid (2000); Falaye et al. (2006) and Bøhren and Strøm (2007) that employee board representation reduces ﬁrm performance.
The Norwegian regulations on co-determination provide the institutional framework. Co-determination is required by law for ﬁrms with more than 200 employees, and is an option if an employee majority demands so in ﬁrms having between 30 and 200 employees. A number of industries are exempted, and in all industries employees exercise their option. Thus, testing can take place using sub-samples, for instance in co-determined and shareholder determined sub-samples. For the whole sample, nearly 60 per cent do not have employee directors. The percentage has been rising during our period from 1989 to 2002. For ﬁrms with more than 200 employees, two thirds have employee directors. The resultant data set is of a panel nature.
I estimate a system of simultaneous equations where employee directors, ﬁrm size (sales), ﬁrm systematic risk, and one period lagged Tobin’s
CHAPTER 3. CO-DETERMINATIONQ are the exogenous variables, and Tobin’s Q, average wage, board index, and the leverage are endogenous. The board index is constructed from important board characteristics, that is, directors’ holdings, the board’s network, board size and the female fraction. The free cash ﬂow hypothesis (Easterbrook, 1984 and Jensen, 1986) warrants the use of the leverage.
The setup allows the testing of direct and indirect employee director effects upon ﬁrm performance. The indirect effects constitute a test of endogeneity (Hermalin and Weisbach, 2003). The lagged ﬁrm performance gives a test of the reverse causation hypothesis (Hermalin and Weisbach,
1998) that past ﬁrm performance determines current governance. Furthermore, it allows testing of complementarity between the two governance variables board index and leverage (Agrawal and Knoeber, 1996).
Regressions are performed on the whole sample, the sub-samples of co-determined and shareholder determined ﬁrms, and then for the subsamples of ﬁrms with more than 200 employees. I use a ﬁxed effects model implemented in a three-stage least squares (3SLS) estimation.
In all regressions, the estimated coefﬁcients for employee directors is signiﬁcantly negative. Moreover, the economic importance becomes larger as regressions proceed from the overall sample to the sub-sample of codetermined ﬁrms, and then to co-determined ﬁrms with 200 employees or more. The result is at odds with Fauver and Fuerst (2006), who ﬁnd a positive relationship when a dummy employee director variable is interacted with information intensive industries. In sub-samples of information intensive and other industries I conﬁrm the negative employee director correlation to Tobin’s Q. Overall, the results support agency theory and reject stakeholder theory.
The indirect effects are also present. Employee directors are positively associated with average wage, the board index, and, in co-determined samples, with leverage. For the board index, this means that shareholders improve board composition so as to neutralize the negative employee director effect, as Buchanan and Tullock (1962) predict. However, this neutralising effect falls far short of the negative direct employee director effect. The lagged ﬁrm performance is signiﬁcantly positively related to the board index and negatively to leverage. This result runs counter to the Hermalin and Weisbach (1998) reverse causation theory that earlier ﬁrm performance determines board composition. Thus, the results show endogeneity effects, but the economic signiﬁcance falls far below the importance of the direct effect. The negative direct effect of employee directors is only partially compensated for by a better board. Endogeneity matters,
3.8. CONCLUSION 87but not very much.
Furthermore, leverage turns out to be negatively related to ﬁrm performance, contrary to the free cash ﬂow hypothesis (Easterbrook, 1984 and Jensen, 1986). The negative association to ﬁrm performance conﬁrms ﬁndings in empirical studies (Barclay et al., 1995; Rajan and Zingales, 1995;
and Brick et al., 2005).
Jensen and Meckling (1979) argue that co-determination can only survive if supported by law. The long-term data set employed here supports this view. Evidently, owners have good economic reasons for not choosing the co-determination form of organisation if they can. This also implies that there are costs to maintaining co-determination required by law.
First, I document the negative impact of employee representation upon ﬁrm performance. Second, shareholders try to work around the regulations by strengthening aspects of board characteristics that are left unregulated. Thus, co-determination, supported by law, has costs. Therefore, these results are relevant for the emerging literature on board regulation (Hermalin, 2005).
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