Labor and Finance

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Labor and Finance

• Marco Pagano
• Università di Napoli Federico II, CSEF, EIEF and
  CEPR
• Conference on Labor, Law, Politics and Finance
  organized by the Korea Money and Finance
  Association
• Seoul, 20 June 2008

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Plan of the lecture

• Effects of financial markets on labor
• Boosting economic activity ? employment and wage
  growth
• Reallocation of resources ? employment and wage
  risk
• Private arrangements to limit employment and wage
  risk / enhance workers loyalty
• Formal contracts
• Implicit contracts
• Dark side of implicit contracts in widely held
  firms
• Role of regulation and the economic environment
• Shareholder protection
• Employment protection and trade union laws
• Takeover regulation
• Technological innovation, international financial
  integration

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I. Effects of finance on labor

• Financial development ? growth of output and
  productivity, firm entry. Prima facie beneficial
  for employment and wages. Supported by a vast
  literature that uses
• cross-country data (e.g., Demirguc-Kunt and
  Levine, 2001),
• industry-level data (e.g., Rajan and Zingales,
  1998),
• firm-level data (e.g., Galindo, Schiantarelli and
  Weiss).
• Reallocation of resources from ailing
  industries/firms to promising ones ? finance seen
  as inflicting employment losses and wage cuts
• Hostile takeovers in the U.S. during the 1980s
• Private equity leveraged buyouts (LBOs) in the
  last decade

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Employment effects of hostile takeovers
Michael Douglas as Gordon Gekko in Wall Street

• In 1981 Frank Lorenzo took over Continental
  Airlines, and in 1983 forced it into bankruptcy
  after fruitless negotiations with unions,
  breaching contracts and imposing new terms.
• In 1986, he acquired Eastern Airlines, divested
  non-strategic assets and, after a fight with
  unions, liquidated its assets in 1991.
• In 1986, Charles Icahn took over TWA and in 1988
  broke the union by hiring non-union workers the
  takeover premium was about ½ the PV of the wage
  losses to members of the TWA unions (Shleifer and
  Summers, 1988).

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Public perception of private equity LBOs

• In April 2005, the Chairman of the German Social
  Democratic Party, Franz Müntefering, likened
  private equity firms to swarms of locusts that
  fall on companies, stripping them bare before
  moving on, claiming that some financial
  investors don't waste any thoughts on the people
  whose jobs they destroy.
• In March 2007 John Evans, secretary of the Trade
  Union Advisory Committee referred to private
  equity as a cancer eating away at the
  job-creation system

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But evidence is less damning

• Rosett (1990) union wage changes in the 6 years
  after the takeover can account for 1 to 2 percent
  of such premium, and for 5 percent over 18 years.
  For hostile takeovers, he estimates that unions
  actually gain 3 over 6 years and 10 over 18
  years, of what target shareholders gain.
• Davis et al. (2008) private equity intervenes in
  ailing firms and shrink their less efficient
  operations. But it also tends to expand them in
  new directions in the first 2 years after the
  LBO greenfield job creation is 15 for target
  firms and 9 for control firms, and acquisition
  and divesture activity is also significantly
  greater. Conclusion private equity acts as
  catalyst for creative destruction.

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The case of Grohe

• Grohe is a bathroom equipment company that Franz
  Müntefering took as main example for his locust
  metaphor it was taken over by private equity
  group TPG, and was expected to fire more than
  half of its German-based workforce.
• However, David Haines, the CEO chosen by TPG,
  renewed Grohes product lines, by investing
  substantially in RD, restored its profitability
  and growth, and eventually cutting only 743 of
  the initially envisaged 3,000 jobs.
• Ironically, the current German finance ministry
  cites Grohe as an example of how private equity
  can successfully restructure companies and put
  them on a path to growth.

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II. Employment risk and firm-level relationships

• Firms may buffer employment risk by developing
  long-term relationships. Efficiency gains from 2
  sources
• Risk-sharing firms can diversify shocks better
  than workers
• Loyalty-building enhance firm-specific human
  capital investment
• This can be done via employment contracts. But
  specifying all possible contingencies may be too
  complex/costly.
• Alternative implicit contracts (Baily, 1974).
  But these pose an enforcement problem. How to
  sanction contract breach?
• Front-end loading but not feasible if both
  parties may breach.
• Reputation but what if firm is taken over by a
  raider? (Shleifer and Summers, 1988)

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Implicit contracts in family firms

• Reputation can support implicit contracts in
  family firms
• familys name is on the line.
• If the familys stake is large enough, control is
  unassailable. By definition true if the firm is
  not publicly listed.
• Sraer and Thesmars (2007) study on French family
  firms
• not only the founder but also his heirs pay lower
  wages to employees
• heir-managed firms shelter employees from
  industry-level sales shocks
• heir-managed firms are not damaged by such
  arrangement their profitability exceeds that of
  comparable non-family firms.

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Implicit contracts in widely held companies

• With dispersed ownership, the firm is a coalition
  of shareholders and management, riddled by
  corporate governance problems.
• Pagano and Volpin (2005) if governance problems
  are acute, managers have an incentive to forge a
  generous implicit contract with the employees at
  the expense of shareholders
• With long-term contracts, employees become shark
  repellents the inability to renegotiate wages
  makes the firm unattractive to raiders.
• Well-paid employees will also act as white
  squires they will fight hostile takeovers by
  lobbying against the raider.
• If employees also own shares in the company
  (ESOPs), they will vote against the takeover.

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Evidence on ESOPs

• Chaplinsky and Niehaus (1994), Beatty (1995) and
  Rauh (2006) ESOPs reduce the likelihood of
  takeover attempts.
• Kim and Ouimet (2008)
• ESOPs increase firm value if they are small (less
  than 5 of outstanding shares), but leave firm
  value unaffected when the ESOP is larger, where
  the productivity gains induced by ESOPs are
  offset by increases in worker compensation,
  because employees can affect the firms policy.
• Large ESOPs prevail in states with laws that make
  them an effective anti-takeover deterrent, and
  there compensation increases following the
  adoption of ESOPs.

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III. Role of regulation

• Regulation also affects
• the establishment and survival of long-term
  employment relationships
• their tendency to induce collusion betweens
  managers and workers.
• Various aspects of regulations are relevant
• shareholder protection
• employment protection and union empowerment
• takeover regulation.

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Shareholder protection

• Poor legal shareholder protection allows managers
  to extract large private benefits of control at
  the expense of non-controlling shareholders.
• Hence, managers will be keener to enlist workers
  in defense of such benefits.
• This is consistent with evidence by Atanassov and
  Kim (2007) who study 9,923 firms in 41 countries
  in 1993-2004. They find that in weak investor
  protection countries
• poorly performing firms are less likely to
  replace top managers
• they are less likely undertake mass layoffs of
  employees.

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Employment protection

• Pagano and Volpin (2005) the stronger is legal
  protection against changes of employment
  contracts, the greater is the incumbent managers
  ability to use long-term wage contracts as a
  shark repellent against raiders.
• Atanassov and Kim (2007) top managers are less
  likely to be replaced as union power increases,
  in low investor protection countries
  consistently with the idea that these are the
  countries where private benefits should be
  largest and therefore managers should be more
  eager to entrench themselves.
• Also consistent with OECD evidence frequency of
  hostile takeovers is inversely related with high
  employment protection (see figure).

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Employment protection and takeover activity in
the OECD
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Takeover regulation

• The law itself can offer protection to managers
  by enhancing their ability to fend off hostile
  takeovers for instance, by allowing them to
  include poison pills, staggered boards, and other
  anti-takeover provision in their companys
  statute.
• This is consistent with evidence that ESOPs tend
  to substitute for other anti-takeover schemes by
  Chaplinsky and Niehaus (1994).
• Rauh (2006) finds that after Delaware validated
  the use of poison pills together with staggered
  boards in the mid-1990s, companies incorporated
  in Delaware saw a fall in employee ownership
  between 0.3 and 1 percentage points of the
  companys value.

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Political economy of regulation

• Regulations that promote manager-worker alliances
  such as poor shareholder protection, strict
  employment protection and pro-union regulation
  can persist only if a political majority supports
  them.
• Naturally, this majority will tend to include the
  same people who benefit from these regulations.
• Hellwig (2000) Incumbent managers who try to
  buttress their positions will regularly find
  allies in the political system against outside
  shareholders.
• This leads us to Perottis theme the political
  economy of regulation!

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Technological change

• When technological innovation improves firms
  growth opportunities
• the efficient re-allocation of capital becomes
  more important than in a more stable environment,
  
• the need to raise fresh external capital makes
  the inefficiencies caused by manager-worker
  collusion more damaging.
• Then regulation and social norms may change so as
  to favor outside shareholders and break down
  stable employment relationships.
• When instead technology is mature and stable, the
  incentive and risk-sharing benefits of long-term
  relationships may be more important than their
  costs.

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Globalization

• When obstacles on international capital flows are
  removed, firms can invest in countries where
  labor costs and employment protection are lower,
  directly or by acquiring local companies.
• To take advantage of low labor costs or good
  investment opportunities, they tend to breach
  local pre-existing implicit contracts, shedding
  excess labor and/or slashing wages.
• Multinationals can also be tougher negotiators
  with unions being internationally mobile and
  less subject to local political and media
  pressure, they are more likely to leave the
  bargaining table and shut down local operations
  than the typical domestic company.

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Globalization (2)

• Foreign ownership of firms tends to lower the
  union wage premium.
• Using matched employer-employee data for Denmark,
  Braun (2008) reports that, while
  domestically-owned unionized firms pay 2 to 4
  higher wages than non-unionized ones, foreign
  firms pay no such wage premium.
• This, together with their greater tendency to
  rely on large employment cuts to improve
  profitability, helps to explain the frequent
  resistance of trade unions to foreign ownership.

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Globalization (3)

• Example from Korea
• In May 2001 GM bid for Daewoo Motor, on the
  condition that it layoff 5,000 employees. This
  led to mass nationwide strikes and labor unrest
  until April 2002, when an agreement was reached.

• Now acquisitions of European companies by Asian
  ones
• Jaguar and Land Rovers U.K. car plants by Tata
• French Arcelor steelmaking group by Mittal.
• In both cases, local unions opposed these
  acquisitions, and workers unrest has mounted.

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Labors global response

• The U.S.-based United Steelworkers (USW) and
  Britains UNITE are about to announce a merger,
  aimed at helping workers whose jobs or terms of
  employment are threatened by economic
  globalization.
• The new union would have about 3 million members
  in the U.K., Ireland, U.S., Canada and the
  Caribbean. Plans to extend it to Latin America,
  Eastern Europe and Asia.

• Ironically, global capital may succeed where
  socialism failed, pushing labor to realize Marx
  and Engels appeal Workers of the world,
  unite!
• But a global union merger would have to overcome
  the conflicts of interests between workers in
  developed and developing countries.

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IV. Concluding remarks

• A fascinating new research area, where new
  insights can be obtained by joining knowledge of
  labor and finance.
• Much work remains to be done, especially on the
  effects that technological innovation and
  globalization have both on corporate finance and
  labor relations.
• Recent empirical work shows the fruitfulness of
  bringing firm-level and plant-level data to bear
  on these issues, but so far is limited mainly to
  U.S. and U.K.
• Very important also for policy this is a very
  controversial and politically loaded area, where
  policy is at risk of being ransom of slogans and
  catchwords.