Employee directorship, corporate performance and reporting practices: a cross-country study.
This dissertation contributes to the corporate governance literature by providing a deeper understanding of the costs and benefits of board-level employee representation. The first chapter examines the association between ERB and corporate performance, focusing on whether ERB firms have to trade off between financial and social–environmental performance, and whether the ERB effects fundamentally differ between voluntary and mandatory ERB adopters. The second chapter studies the impact of ERB on aggressiveness in corporate financial and tax reporting, exploring how EDs seem to influence managers’ potential opportunistic behavior regarding financial reports.
From a theoretical perspective, the impact of ERB on firm social–environmental and financial performance is unclear. Agency theorists may argue that having EDs on the board improves effective monitoring over management since they are even more independent than standard outside directors. However, labor representation can also entail significant costs that may even outweigh the benefits, especially financially. The formal board vote gives employees a voice in the decision-making processes, which may open the door to proposals that spend shareholder money without a clear return, such as Corporate Social Responsibility (CSR). While social performance may very well improve, financial performance may suffer. Jensen and Meckling (1979) have consequently been critical of employee directorships on the grounds that co-determination acts as an inefficient constraint. In contrast, stakeholder theorists consider ERB as a quid pro quo story: if shareholders/management incorporate(s) labor’s needs and ambitions into their decision-making process, employees become more motivated, cooperative, and willing to provide private information, improve productivity and design, accept more flexibility, and so on. Regarding the potential cost-side, stakeholder logic predicts that projects with a clear financial burden will typically be avoided. For one, EDs always need the support of other directors to get CSR plans approved. EDs even have motive, means and opportunities to
become excellent monitors (and hence positively influence firm operating performance): they do know their jobs depend on the firm’s survival; they do not belong to, and are not co-opted by, an old-boys club of directors; and they have unique access to information about what is actually going on in the company. ERB is a potential win-win solution for both employees and shareholders, in that view.
Empirical evidence on the net effect of all these potential pros and cons is still lacking in the current governance literature. To reduce this gap in the literature, the first chapter of this dissertation examines the impact of board-level employee representation on various measures of social–environmental and financial performance, using a large international sample across 2012-2017 that covers both mandatory and voluntary ERB adoptions. Taking into account selection bias, we find that firms that freely opt into labor directorships exhibit better social and environmental performance which, interestingly, does not at all come at the expense of economic performance; actually, we see a gain in both short-term and long-term financial performance (ROA and Tobin’s Q). Mandatory employee representation, in contrast, not only brings no clear social and environmental performance benefits but even harms financial performance. Moreover, this chapter provides evidence that in voluntary-ERB firms, ERB works via coalitions: the fraction of employee-assigned seats itself seems to have no clear association with corporate performance; rather, the other key board members tend to be like-minded and to form coalitions with employee directors. Black-and-white thinking, where EDs
heroically wrestle with dollar-obsessed corporates, seems to be misguided, in short.
The findings of the first chapter provide more insight into the theoretical predictions of Jensen-Meckling agency theory as well as stakeholder theory. The stakeholder view holds when board-level employee representation is the result of free choices, while mandatory representation has the effects predicted by Jensen and Meckling. In addition, this chapter contributes to the voluntary versus regulated governance debate: board-level employee representation works best when entered into on a voluntary basis. Regulation that imposes labor representation on the board is less likely to achieve improved social and environmental performance and may backfire financially. It seems that mandatory corporate governance often imposes a nonoptimal board structure (Petry, 2018). For that reason, firms may look for ways to work around such regulations; failing that, they could adopt board practices that sideline EDs and make them ineffective. Additionally, when ERB is imposed, the cooperative spirit that is said to be the basis of all ERB benefits might very well be weaker, or missing, or even replaced by antagonism. These mechanisms may explain why mandatory ERB may not work nearly as well as voluntary ERB.
Besides looking at firm performance, the second objective of this dissertation is to examine how the presence of EDs on the board affects aggressiveness in corporate financial and tax reporting practices, the reflection of management’s willingness or unwillingness to adopt opportunistic behavior to extract rents. We develop three potential views about the effects EDs’ presence might have with respect to these aggressive reporting practices: (1) EDs act as monitoring&disciplining agents towards management, including unintentional disciplining when managers want to avoid the wage demands EDs would put on the table if earnings would be inflated; (2) the EDs’ own agenda is to reinforce employees’ morale; and (3) the EDs’ own
agenda is to maximize room for wage demands. The fourth and last scenario is the one where EDs have no effect on these issues, and thus provides the Null baseline.
Although corporate reporting practices have received substantial attention in the literature, most of prior studies on the impact of employees focus on non-ERB channels, especially labor unions (Bova, 2013; Bova, Dou & Hope, 2015; Chung, Lee, Lee & Sohn, 2016; Chyz, Leung, Li, & Rui, 2013; D’Souza, Jacob & Ramesh, 2000; Hilary, 2006; Liberty & Zimmerman, 1986; Wilde, 2017). Empirical evidence thus far is quite mixed, and often rather partial. The second chapter of this dissertation presents a comprehensive picture of ERB impact on corporate aggressiveness in reporting, considering both financial and tax aspects. Taking into account the endogenous relation between ERB adoption and corporate reporting practices, our finding
is that employee presence on the board is associated with uniformly less aggressive reporting. We observe that ERB firms go for less income-increasing accruals management, less delay in loss recognition, less income-increasing real-activities management, and less tax aggressiveness – all as expected under the monitoring&discipling view. Moreover, we find that the moderating effects are more pronounced when ERB is adopted voluntarily. These results once again indicate that legislation that mandates labor representation on board may fail to achieve its intended goal as it may either impose a nonoptimal board structure (Petry, 2018) or force firms to adopt board practices that sideline EDs and make them ineffective. There are also interesting interactions: the ERB’s attenuation effects on tax aggressiveness, for instance, are more prominent when independence matters more, while strong unions seem to make ERB less effective. ERB also have attenuation effects on the ex ante likelihood of fraudulent reporting practices. Again we find that how many seats EDs have in the board does not matter for their effectiveness, this time considering accruals management and real-activities management.
Given that prior research is piecemeal and confined to a number of isolated settings, specifically in Germany and Sweden (e.g. Overland & Samani, 2018; Eulerich & Fligge, 2019; and Gleason, Kieback, Thomsen & Watrin, 2019), the second chapter of this dissertation contributes to the literature by complementing these studies by looking at a large international sample, which adds external validity to the earlier studies in specific environments. We also broaden the diagnosis by investigating multiple dimensions of corporate reporting practices, including delayed loss recognition.
The findings of better performance from chapter one are not undermined by the manipulation of accounting data documented in chapter two. What we find is that upward management is reduced by ERB, so when we nevertheless see better profits in those voluntary ERB firms, the conclusion that performance seems to benefit is actually conservative.
Overall, the empirical results of this dissertation have broad implications for politicians, legislators, corporates and labor. Politicians and legislators should note that, when ERB is imposed by law rather than freely agreed upon, it does not seem to work well at all. Towards firms, our results suggest that it may be worthwhile to consider inviting an employee representative to the board of the firm, as it could be a win-win solution for both shareholders and other stakeholders in terms of corporate performance and reporting quality as well. To all stakeholders, EDs seem to work via coalitions, a finding that warns against black-and-white oversimplifications in one’s view of boards.