Shareholder Interests, Human Capital Investment and Corporate Governance

Abstract

Corporations simultaneously claim that human capital is increasingly important to their success - "People are our most important asset" - and that their executives are the loyal agents of shareholders - "Our primary goal is the maximization of shareholder value." This paper studies the relationship between these two claims in a context of incomplete contracting.

We show that the strict pursuit of shareholder interests may require ceding a role in corporate governance to employees in order to motivate their investing in firm-specific human capital. We consider three versions of such involvement: profit-sharing (applicable when profits are contractible), ex post bargaining effectuated by giving workers representation on the board, and comitting to respect the human capitalists' interests. Ceding a role to workers becomes more attractive as their investments increase in importance.

This result bears on the on-going debate about reforming European and Japanese governance systems in the direction of the American system, reducing employees' influence. In this context, we present a model on the optimal choice of governance systems based on ideas suggested by Bengt Holmstrom. The model allows firms to respond to changes in the environment by changing strategy, which benefits shareholders but hurts workers. The workers can accept the change, quit, or use open conflict (strikes) to try to limit the change in strategy. The firm can reduce the likelihood of conflict by granting workers a say in strategy selection. The model predicts that there will be two regimes: one with shareholders in complete control and with strikes from dissatisfied workers, and the other with workers having a sufficient role in governance to ensure labor peace. Comparative statics analyses of the model suggest that differing historical conditions in the US and Europe made the selection of different regimes appropriate. The increasing pace of globalization and technological change, however, does favor shareholder dominance. On the other hand, increasing the importance of human capital favors granting a role in governance to workers, which is then associated with larger investment in specific capital and with inertia in firms' strategic choices.

JEL Classification: D23, G34, J24, L14, L22