Tailored Claims and Governance: The Fit between Employees and Shareholders

Posted: 22 Jul 1997

See all articles by Edward B. Rock

Edward B. Rock

New York University School of Law; European Corporate Governance Institute

Michael L. Wachter

University of Pennsylvania Law School - Institute for Law and Economics

Date Written: June 1997

Abstract

We generalize the internal labor markets (ILM) analysis of the employment relationship to provide a comprehensive model of the relationships among employees, capital providers (particularly shareholders), and the firm. We start by showing that all are variable claimants and all participate in governance, but that the characteristic differences in the payment streams and governance rights of employees and shareholders can be explained by differences in the four principal industrial organization (IO) factors -- investments in match, asymmetry of information, risk aversion and transaction costs. In arriving at these results, we analyze the ways in which employees are typically variable but not residual claimants and why making employees residual claimants over the relevant set of assets, while providing strong incentives for maximizing the value of those assets, is typically not incentive compatible. Our principal conclusions are the following. First, the ownership rights of shareholders have direct parallels in the employment relationship, with the difference between the two parallel tracks reflecting the parties' ability to gain from investments in match, their willingness to trade off higher return for greater risk and their incentive-compatible solutions to the problems of asymmetric information and transaction costs. Second, in terms of the four critical IO factors, the shareholder/managers of the closely held corporation share many features with employees in the classic internal labor market, and that the characteristic arrangements that emerge strongly resemble the solutions of the ILM. Finally, we show that both relationships are fundamentally different from the relationship between the publicly held firm and its suppliers of equity capital, and that the arrangements between shareholders and the publicly held firm are the limit case in which investments in match approach zero.

JEL Classification: J54, G34

Suggested Citation

Rock, Edward B. and Wachter, Michael L., Tailored Claims and Governance: The Fit between Employees and Shareholders (June 1997). Available at SSRN: https://ssrn.com/abstract=10532

Edward B. Rock (Contact Author)

New York University School of Law ( email )

40 Washington Square South
New York, NY 10012-1099
United States

European Corporate Governance Institute ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Michael L. Wachter (Contact Author)

University of Pennsylvania Law School - Institute for Law and Economics ( email )

3501 Sansom Street
Philadelphia, PA 19104
United States
215-898-7852 (Phone)
215-573-2025 (Fax)

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