The wealth effects of labor representation on the board:

1. The wealth effects of labor representation on the board: Evidence from German codetermination legislation Stefan Petry University of Cambridge Cambridge, 10 April 2009

2. Content • Introduction • Institutional background • 1976 regulatory event study • 1998-2008 standard event study • Conclusion

3. 1. Introduction Codetermination: its definition and relevance Codetermination Definition: „The participation of labor in the decision-making of the firm“ • Relevance: • 17 of 25 European states legally mandate some form of codetermination • 11 of 25 European states, China, and Egypt mandate labor board seats „If codetermination is beneficial to both shareholders and labor, why do we need laws which force firms to engage in it?“(Jensen/Meckling, 1979, p. 474)

4. 1. Introduction Germany provides an ideal setting to test the effects of codetermination on shareholder wealth Unique institutional features in Germany • Highest number of codetermination laws and labor participation rights in Europe • Germany has always been a prime example for stakeholder value orientation and codetermination in the corporate governance literature • Number of labor representatives is determined as a percentage of board size. Three types exist: 0, 1/3, and 1/2 • Recent corporate scandals and economic crisis revive the discussion on codetermination

5. 1. Introduction Empirical tests because of correlation btw. firm and board size challenging – ambiguous results, so far Regression type Methodology Findings Event study Performance comparison before and after passage of 1976 Codetermination Act in firms that changed from 1/3 to 1/2 labor reps board representation • No effect (Baums/Frick, 1999) • Increase in productivity and profitability (Benelli/Loderer/Lys, 1987) • Negative (FitzRoy/Kraft, 1993; Gorton/Schmidt, 2004) • Positive in medium range (Fauver/Fuerst, 2006) Cross-section Comparison of production functions or performance between parity- and non-parity-codetermined firms Comparison of restructuring activities in poorly performing firms in 41 countries based on investor protection and labor union power Panel Bargaining betw. mgmt. and labor avoids layoffs and yields lower perf. (Atanassov/Kim, JF forthcoming)

6. 2. Institutional background In 1976 supervisory board size and % labor representation determined by 3 laws in Germany1 Name of Codetermination Law Board size range % labor reps. 1) Montan-Codetermination Act (1951) 11, 15, 21 1/2 2) One-Third Participation Act (1952)2 3-21 1/3 3) Codetermination Act (1976) 12, 16, 20 1/2 1 Another law that was passed in 1965 is the Stock Corporation Act, which applies to all stock companies and mandates the board size range to be between 3 and 21. 2 Amended and renamed in 2004 (previous name was Works Constitution Act).

7. 3. Regulatory event study, 1976 Illustration of board structure changes at passage of 1976 Codetermination Act Passage of Codetermination Act, 1976 Board size range % labor reps. Number of empl. in Germany Law name Montan-Codetermination Act 11,15,21 1/2 >1,000 empl. 3 - 21 1/3 One-Third Participation Act <2,000 empl. 12,16,20 1/2 2,000-10,000 empl. Codetermination Act 16,20 1/2 10,000-20,000 empl. 20 1/2 >20,000 empl.

8. 3. Regulatory event study, 1976 Event date identification and correct model specification are key in regulatory event study Event dates Description 1) Tuesday, 22 January 1974 Coalition parties present main components of first draft of the Codetermination Act 2) Thursday, 18 March 1976 Passage of the Codetermination Act in the German Bundestag with 389 yes and 22 no votes Multivariate Regression Model based on SUR Abnormal return Market model adjusted for infrequent trading Event window [-1,1]

9. 3. Regulatory event study, 1976 Table III: Regulatory event study, 1973-1976 • Notes: • Robust standard errors shown in parentheses • Di: dummy variable equal one for the [-1,1] announcement window on event day i • γpi: measures the abnormal return on portfolio p generated by event i

10. 4. 1998-2008 standard event study Illustration of board structure changes during the codetermination life-cycle of firms in Germany Num. empl. <500 500-2,000 2,000-10,000 10,000-20,000 >20,000 1/2 20 1/2 16 % labor reps. 1/2 12 1/3 3 0 min. board size Founded after 10 Aug. 1994 Founded before 10 Aug. 1994

11. 4. 1998-2008 standard event study Table VIII: Abnormal announcement returns on changes in board size, the number, or percentage of labor representatives on the supervisory board, 1998-2008

12. 4. 1998-2008 standard event study Table IX: Abnormal announcement returns on changes in the number and percentage of labor representatives on the supervisory board, 1998-2008

13. 5. Conclusion Takeaways • Codetermination reduces shareholder wealth if the percentage of labor representatives on the board changes from 0 to 1/3, or if a large number of labor representatives, i.e. more than 4, join the board at once • Findings from 1976 regulatory event study and 1998-2008 standard event study not contradictory but complementary • Note 1: Findings of 1976 regulatory event study could be contaminated by change in board size • Note 2: The size of the CAR coefficients seems too big although exclusion of outliers mitigates the problem • Note 3: Mainly the [-2,2] event window yields the most significant CAR estimates; effect seems to be driven by the 2 days prior to the event

14. APPENDIX APPENDIX

15. APPENDIX Recent anecdotal evidence revives the discussion on the effects of codetermination Survey results Corporate bribery scandals Volkswagen AG Siemens AG Parity-codetermination seen as competitive disadvantage compared to 1/3-representation (Stettes, 2007) Bribery of board labor reps. by top mgmt.: allowed to use corporate funds to enjoy costly pleasure excursions and parties in return for backing mgmt. decisions (FT.com, 15 July 2005) • Payments of EUR14mio. to help establish artificial labor union (AUB) to counteract other powerful labor union (IG Metall) • AUB provides one of Siemens’ 10 labor reps. on the board • (FT.com, 18 February 2007)

16. APPENDIX Theory specifically targeted at codetermination is rare – mainly predict positive impact Arguments against Arguments in favor • Why are laws necessary to force firms into codetermination?(Jensen/Meckling, 1979) • Knowledge of managers makes them influential board members; labor reps could take up important role of insiders (Fama/Jensen, 1983) • Insiders are important in firms with highly complex investment projects (Raheja, 2005)

17. APPENDIX Table II: Real and expected board structures in Germany before and after 1976

18. APPENDIX Table VI: Summary statistics for firm characteristics and board structures, 1998-2008

19. APPENDIX Table VII: Distribution of supervisory board structures in Germany, 1998-2008

20. APPENDIX An additional codetermination law introduced in 1994 allows small firms to remain un-codetermined Name of Codetermination Law Board size range % labor reps. 1) Montan-Codetermination Act (1951) 11, 15, 21 1/2 2) One-Third Participation Act (1952) 3-21 1/3 3) Codetermination Act (1976) 12, 16, 20 1/2 4) Small Company and Deregulation Act (1994) 3-21 0 Applies to all companies with less than 500 employees, founded after 10 August, 1994

21. APPENDIX Table IX: Abnormal announcement returns on changes in the number and percentage of labor representatives on the supervisory board, 1998-2008 SMALL SAMPLE – EXCLUDING OUTLIERS

22. APPENDIX Table IX: Abnormal announcement returns on changes in the number and percentage of labor representatives on the supervisory board, 1998-2008 MEDIUM SAMPLE (including weekend announcements) – INCLUDING OUTLIERS

23. APPENDIX Table IX: Abnormal announcement returns on changes in the number and percentage of labor representatives on the supervisory board, 1998-2008 MEDIUM SAMPLE (including weekend announcements) – EXCLUDING OUTLIERS

24. APPENDIX Confounding information? Reasons in announcements for changing the board structure Cases in which # of labor reps increased (in small sample) • Previous announcement is declared as incorrect • Economic success Cases in which # of labor reps decreased (in small sample) • 5x sale of business unit • 2x Rationalizations/Layoffs • 2x Reorganization • Reorganization into a holding company • 2x Restructuring • Less than 2 employees • No employees

25. References Atanassov, J., Kim, E.H., Forthcoming. Labor and corporate governance: International evidence from restructuring decisions. Journal of Finance, 1-55.Baums/Frick,1999 Benelli, G., Loderer, C., Lys, T., 1987. Labor participation in corporate policy-making decisions: West Germany's experience with codetermination. Journal of Business 60, 553-575. Fama, E.F., Jensen, M.C., 1983. Separation of ownership and control. Journal of Law and Economics 26, 301-325. Fauver, L., Fuerst, M.E., 2006. Does good corporate governance include employee representation? Evidence from German corporate boards. Journal of Financial Economics 82, 673-710. Fitzroy, F.R., Kraft, K., 1993. Economic effects of codetermination. The Scandinavian Journal of Economics 95, 365-375. Gorton, G., Schmid, F.A., 2004. Capital, labor, and the firm: A study of German codetermination. Journal of the European Economic Association 2, 863-905. Jensen, M.C., Meckling, W.H., 1979. Rights and production functions: An application to labor-managed firms and codetermination. Journal of Business 52, 469-506. Renaud, S., 2007. Dynamic efficiency of supervisory board codetermination in Germany. Labour 21, 689-712. Stettes, O., 2007. Workers’ codetermination in the supervisory board – survey results. IW-Trends 34, 1-15.