1. Marco Pagano University of Naples Federico II, CSEF, EIEF and CEPR FIRN Corporate Finance Workshop Sydney, 14 October 2013 Finance and labor: an overview 1

2. Expanding research field Today I will focus only on three areas related to corporate finance: 1.Does corporate ownership (family vs. non-family) affect firm-level insurance provision to workers? 2.Does capital structure (leverage) affect the relative bargaining power of capital and labor? 3.What is workers’ role in corporate governance, and how does it affect firm performance? But there are many other fast-developing areas: effect of finance on employment and job reallocation, effect of employment laws and trade unions on innovation and risk taking, etc. 2

3. Issue no. 1: corporate ownership and employment risk 3

4. Which firms are better at insuring employees? In principle, large firms with good access to financial markets should be better at it But if insurance is given via implicit long-term contracts, these firms also face greater commitment problems (“breach of trust”):  managerial turnover  hostile takeovers Family firms can better commit to such contracts with employees:  no danger of hostile takeovers  family “name” is on the line: reputation! Symmetric weakness: they often have no easy access to financial markets to unload risk The verdict is up to the evidence… 4

5. French and U.S. evidence In France, the pro seems to prevail on the con, at least for listed family firms in the late 1990s:  heir-managed firms pay lower average wages and earn larger profits, and their employment is less sensitive to industry sales shocks (Sraer and Thesmar, 2007)  family-promoted CEOs are associated with lower job turnover and less wage renegotiation (Bach and Serrano-Velarde, 2010)  family firms have fewer layoffs, sanctions and disputes ending in court (Müller and Philippon, 2007; Waxin, 2009) In U.S. listed companies, the evidence is more limited:  family management: downsizing is less likely, but more severe  family owners: large job cuts (> 6%) are less likely (Block, 2008). 5

6. Worldwide evidence Ellul, Pagano and Schivardi (2013) use data from 41 countries to investigate if employment and wages respond to sales shocks differently between o firms with different characteristics, e.g. family vs. non-family o in countries with different social arrangements, e.g. with high vs. low public provision of job security Also look at interaction between the two: is the insurance role of family firms less prominent where there is more job security? Distinguish between different types of shocks to sales:  industry- vs. firm-level  negative vs. positive  transitory vs. persistent 6

7. Firm-level international data Financial and accounting data from 41 countries for the period 1988- 2011 obtained from Worldscope and Osiris Use firms with employment data for at least 5 years: this screen reduces the number of firms to 6,298, i.e. 89,815 firm-year observations Wage data is only available for 2,485 firms Ownership data from Ellul, Pagano and Panunzi (2010) identifying a family as the firm’s ultimate blockholder Dependent variable in the employment insurance regressions: log change of total employment Two different dependent variables in the wage regressions :  log change of real wage to test for wage insurance  log of average wage to test whether insurance is priced by wages 7

8. Country-level data Country-level worker protection provided by social security system:  gross replacement rates: unemployment benefits as fraction of last wage, time-varying Country-level worker protection provided by the market:  labor market tightness: reciprocal of ratio of long-term to total unemployed Measure of financial development (stock market cap. to GDP) 8

9. Employment regression The specification of the employment growth regression is: η ijct = growth rate in the employment of firm i in year t ε ijct = measure of the shock: either the unexpected change in the sales of firm i or the change in the sales industry j (ex-firm i) in year t F it = family-firm dummy – Family if a family blockholder has at least 20% of cash flow rights S ct = replacement rate (measure of the effectiveness of the public employment insurance system) in country c and year t X ijct = vector of company-specific variables μ cj = country-industry effect μ t = year effect 9

10. 10 Employment insurance: industry shocks (1)(2)(3)(4) Δ Industry Sales 0.1083** (2.58) 0.0906** (2.27) 0.0722** (2.10) 0.0863** (2.39) Family Firms 0.0253 (1.27) 0.0174 (1.21) 0.0101 (1.07)- Δ Industry Sales  Family Firms -0.0991*** (-2.81) -0.0898** (-2.49) -0.0659** (-2.20) -0.0750** (-2.40) Δ Industry Sales  Unemployment Security 0.0314 (1.46) 0.0415 (1.44) 0.0259 (1.24) Δ Industry Sales  Family Firms  Unemployment Security 0.1928** (2.10) 0.1399* (1.80) 0.1604* (1.88) Δ Industry Sales  Family Firms  Labor Market Tightness 0.0049 (1.28) Control VariablesYes Fixed EffectsCountry- Industry Firm Year DummiesYes R2R2 0.450.490.500.56

11. Insurance provided by family firms and social security 11 Vertical axis: country-level estimate of employment insurance provided by family firms

12. Wage growth regression The specification of the wage growth regression is: w ijct = growth rate of the average real wage of firm i in year t ε ijct = measure of the shock (either to the sales of firm i or of its industry j in year t) F it = family-firm dummy variable (equal to 1 for family firms, and 0 otherwise) S ct = replacement rate (measure of the effectiveness of the public employment insurance system) in country c and year t X ijct = vector of company-specific variables μ cj = country-industry effect μ t = year effect 12

13. Wage insurance: industry shocks 13 (1)(2)(3)(4) Δ Industry Sales 0.0426*** (3.12) 0.0391*** (2.82) 0.0340** (2.53) 0.0427** (2.65) Family Firms -0.0104* (-1.90) -0.0095* (-1.70) -0.0051 (-1.52) - Δ Industry Sales  Family Firms 0.0182** (2.61) 0.0109* (1.92) 0.0233** (2.35) Δ Industry Sales  Unemployment Security -0.0186* (-1.70) -0.0212 (1.57) Δ Industry Sales  Family Firms  Unemployment Security 0.0580* (1.74) 0.0662 (1.50) Firm Control VariablesYes Fixed EffectsCountry- Industry Firm Year DummiesYes R2R2 0.100.12

14. Is employment insurance priced? 14 (1)(2)(3)(4) Family Firms -0.0921** (-2.45) -0.0541** (-2.28) -0.0380** (-2.04) - Unemployment Security  Family Firms 0.0047** (2.18) 0.0049** (2.05) 0.0041* (1.89) 0.0058** (2.28) Financial Development  Family Firms 0.0030 (0.92) Unemployment Security 0.0091 (1.01) 0.0087 (0.93) 0.0072 (0.85) 0.0170 (1.34) Firm Control VariablesNoYes Fixed EffectsCountry- Industry Firm Year DummiesYes R2R2 0.080.090.110.14

15. Is employment insurance priced? (2) Firms that provide less employment insurance pay higher real wages 15 Horizontal axis: firm-level estimate of sales shocks “pass-through” (inversely related to employment insurance) Vertical axis: firm-level wage net of industry, country and time effects

16. Issue no. 2: capital structure and wage bargaining 16

17. Theoretical literature By taking more debt, a company reduces “surplus on the bargaining table”: Baldwin (1983), Bronars and Deere (1991), Matsa (2010) Perotti and Spier (1993) add incentive problem on shareholders’ side: debt not only reduces surplus, but also creates debt overhang  shareholders have less incentive to invest  wage concessions when profits are small Dasgupta and Sengupta (1993) add incentive problem also on workers’ side: bankruptcy risk reduces workers’ effort (or investment in firm-specific human capital)  too much debt not optimal 17

18. Evidence on debt and wages Hanka (1998): U.S. firms with more debt pay lower wages and fund their pension plans less generously, controlling for performance Benmelech, Bergman and Enriquez (2009): airlines in distress obtain wage concessions from workers with underfunded pension plans; effect is weaker for workers with greater pension insurance Myers and Saretto (2010): in wage negotiations, unions are more likely to strike and “win” if firm debt has decreased in previous years; when firms win, they do not increase debt further 18

19. Evidence on debt and workers’ insurance Hypothesis: when workers are protected by larger unemployment benefits, firm choose higher leverage Agrawal and Matsa (2010) find precisely this using U.S. data from 1950 to 2008: increases in U.S. state unemployment insurance (UI) benefit entitlements are associated with increases in firm leverage. Doubling UI  4.1 percentage points increase in debt/assets ratio Impact stronger for firms where workers face greater unemployment risk (layoff separation rates), that are more likely to fire workers in adversity (low operating cash flow, no dividend) and have greater labor intensity 19

20. Evidence on debt and unions Matsa (2010): in the U.S., collective bargaining coverage and pro-union changes in state labor laws increase firm leverage (except in industries with low union presence). The same is found for Sweden by Cronqvist et al. (2009) Bronars and Deere (1991): workers less likely to join a union if debt leaves less surplus on the bargaining table. In the U.S. leverage is higher in firms facing greater threat of unionization (but possible endogeneity bias) Simintzi, Vig and Volpin (2009): in firm-level data from 21 countries, greater employment protection (EPL  union power  ) leads to lower debt in countries with weak creditor rights (with likely renegotiation in bankruptcy) 20

21. International evidence on debt and EPL 21 Source: estimates of Simintzi, Vig and Volpin (2009), Table VII, Column 3

22. Assessing existing evidence U.S. evidence: in line with strategic view of corporate debt: leverage reduces wages, and is more intensively used when unions are stronger International evidence: strategic use of leverage (more debt where unions are stronger)  in countries with pro-liquidation bankruptcy law  not in those with pro-renegotiation bankruptcy law 22

23. Workers’ protection in bankruptcy Existing research neglects that there is much cross-country (and some time-series) variation in worker protection in bankruptcy:  workers’ seniority in bankruptcy law  government guarantees, in two varieties:  guarantee funds for wages, severance pay and pensions  unemployment insurance benefit Andrew Ellul and I have collected data on these items via  questionnaires to Lex Mundi law firms (for OECD countries)  information drawn from the web (for non-OECD countries) We investigate how leverage correlates with workers’ protection: same spirit as Agrawal and Matsa (2010) for U.S. 23

24. Measuring worker seniority in bankruptcy Worker seniority in liquidation differs across countries. Andrew Ellul and I looked at the rank of workers’ claims relative to the following claim classes:  secured debt (e.g. real estate mortgage loans)  expenses of the bankruptcy procedure  post-petition credit extended to debtor  unpaid taxes  unsecured debt Define workers’ seniority from 0 to 4, so that 0 = they are treated as unsecured creditors, 4 = they are the most senior 24

25. Salary priority around the world 25

26. Public guarantees around the world Unpaid wages, retirement allowance and pensions are paid upfront by a government fund that acquires the same seniority as the workers, in  all EU countries since the 1980s, based on Council Directive 80/987/EEC (limits vary: e.g. 3 months’ pay in Germany, 5 in Hungary)  Australia since 2001, with annual income cap of A$108,300 in 2010  Canada since July 2008, Hong Kong (both with caps)  Japan: up 80% of unpaid wages and severance pay In the U.S., pensions (only) are guaranteed by the PBGC, up to $51,750 per year/employee in 2008 No guarantee fund in: Argentina, Brazil, Malaysia, Mexico, New Zealand, South Africa 26

27. Unemployment benefits around the world 27 Average unemployment benefit replacement rates for 2 earnings levels, 3 family situations and 3 unemployment durations, sorted by 2007 level. Source: OECD.

28. Merge these indicators with company data We started exploring how firm-level leverage correlates with these measures of workers’ protection in bankruptcy Our initial data set of company-level financial and accounting information: 11,290 firms from 38 countries, 1990-2008, drawn from Worldscope and Osiris We only use firms for which we can find accounting data for at least 5 years: this reduces the number of firms to 7,588  94,056 firm-year observations Standard errors clustered at the country-industry level 28

29. Leverage and workers’ protection in bankruptcy 29 Dep. Variable: Book Leverage(1)(2)(3)(4)(5) Salary Priority0.0138*** (2.98) ---- Salary Priority x Firm Employees (Scaled by Assets) -0.0592** (2.09) --0.0418* (1.89) Unemployment Insurance--0.0218* (1.74) -- Unemployment Insurance x Firm Employees (Scaled by Assets) ---0.0914 (1.60) 0.0816 (1.49) Control VariablesYes Firm Fixed EffectsNoYesNoYes Industry and Time Fixed EffectsYes No. of observations94,056

30. Issue no. 3: labor and corporate governance 30

31. Employees’ ownership and control rights 31 percent of U.S. workers invest in their company. Employee Stock Ownership Plans (ESOPs) have become common:  1,601 plans in 1974, 11,500 in 2000  5.3 million workers in 1980, 7.2 million in 1995 Co-determination is mandated by law in some countries:  Germany: 1/2 of seats on supervisory board in companies with more than 2,000 employees, 1/3 in listed companies with 500-2,000 employees  also in other EU countries workers have some control rights (see graph) 31

32. Mandatory control rights to workers 32

33. Impact on corporate governance Worker control rights may affect corporate governance, e.g. shift balance between shareholders and management If there is separation between ownership and control, e.g. with dispersed share-ownership, it is a 3-players game: 33 shareholders manager workers owner-manager agency conflict: manager steals or under-monitors workers (if he owns a small equity stake) industrial relations conflict over division of surplus agency conflict: workers shirk, underinvest in firm-specific human capital conflict if manager owns a large equity stake congruence if manager has small equity stake

34. Managers’ “easy life” and “natural alliance” with workers Pagano and Volpin (2005):  If managers have a small equity stake (conflict with shareholders), they wish to overpay workers to buy an “ easy life ” : less monitoring, better industrial relations  They will also want to deter takeover raiders who would replace them  So their interest is aligned to that of workers:  pay generous wages to buy an easy life  deter control changes that would breach implicit contract  “ natural alliance ” between workers and managers in firms with owner-manager conflict ( “ bad governance ” ) 34

35. Evidence on “easy life” and “natural alliance” Swedish managers go for the “ easy life ” (Cronqvist et al., 2009):  wages are inversely associated with the manager ’ s equity stake (after wage bargaining became decentralized) U.S. anti-takeover state laws in the 1980s were associated with wage increases (Bertrand and Mullainathan, 1999) ESOPs correlate with  wage increases (Kim and Ouimet, 2009)  less frequent takeovers (Chaplinsky and Niehaus, 1994; Beatty, 1995) Successful raiders cut wages:  transfer from workers to shareholders accounts for 10% of hostile takeover premium in 18 subsequent years (Rosett, 1990)  hostile takeovers lower union wage premium (Becker, 1995) 35

36. Incentive effects of workers’ ownership/control So workers’ ownership and control tends to increase their “share of the pie” But they may also change the “size of the pie” by affecting  workers’ effort and human capital investment  productivity  workers’ cooperation in labor relations  strike frequency  corporate strategic choices  company growth, profitability,... Most studies find that after ESOPs firms experience  productivity increases (e.g. Jones and Kato, 1995; Beatty, 1995)  positive stock price reactions (e.g., Chaplinsky and Niehaus, 1994) 36

37. Incentive effects (2) Kim and Ouimet (2009) show that sign depends on stake:  Tobin’s Q and profits increase for ESOPs < 5%  are unaffected for ESOPs > 5% Same for German codetermination (Fauver & Fuerst, 2006):  it raises Tobin’s Q (in manufacturing and transportation) and dividend payout, only if workers have at most 1/3 of seats Greater cooperation in labor relations:  ESOPs reduce strike incidence in labor disputes (Cramton, Mehran and Tracy, 2008)  in France, employee board representation reduces the incidence of strikes and individual labor disputes (Waxin, 2009) 37

38. Conclusion The interface between labor and corporate finance is capable of giving exciting insights, as it goes beyond the interplay between financial claimholders Lively research area – yet, still much we don’t know Part of the problem is practical: need to merge databases of worker-level or plant-level data with standard financial databases = lots of hard work! Part of the problem is that “silo-busting is exceptional in academia – one is expected to specialize: there is a lot of turf warfare” (Jared Diamond, author of Guns, Germs and Steel, on yesterday’s FT, p. 13) 38