Abstract

It is one of the well-known cornerstones of corporate governance that (minority) share-holders are subject to a risk of being expropriated by the controller of the firm, i.e. either entrenched management under a dispersed ownership structure or a controlling share-holder under concentrated ownership. On the other hand, economic theory has increasingly begun to recognize the role of employees and other "nonshareholder constituencies" during the past years. While potential shareholders may be reluctant to invest if they are adequately protected against private benefits of control, stakeholders may be deterred from investing if they are subject to the risk of ex post opportunism (e.g. holdup). Although both aspects may be important to corporate governance, their interaction has not yet been thoroughly investigated. In our model we study the incentives that influence the decision by the controller of the firm (either a controlling shareholder or manager) to divert resources from (other) shareholders and employees. We also analyze how these incentives vary, between firms, according to the specific corporate governance structure chosen by a certain firm and the degree of protection granted by the law. The effectiveness of diversion (i.e. the amount taken from the prior expectation of dividends or wages and additional implicit benefits) depends on the effectiveness of corporate law and employment law respectively against the taking of private benefits of control (to the detriment of shareholders) or the exploitation of (e.g.) holdup situations (to the detriment of workers). Naturally, the incentive of the controller to expropriate labor depends on his share in the firm, since shareholders (as a group) are the beneficiaries of holding up labor. Ex post, minority shareholders will therefore want the controller to exploit labor. Because of his increased financial incentive, a controlling shareholder will ceteris paribus have a larger financial incentive to hold up employees than a mere manager with a negligible share in the firm. By contrast, a strand in the corporate governance literature presupposes that large shareholders are better able to "bond" with labor than dispersed ones, while other authors emphasize that dispersed ownership helps managers to form long-term relationships with the firmýs stakeholders, and that large shareholders may be in a better position to exploit them. We elucidate the circumstances under which each of these two assumptions is correct. Furthermore, our model shows that employees will not only benefit from labor law, but also from corporate law protecting minority shareholder against expropriation, since it will reduce the financial incentive of a controlling shareholder to exploit employees. It also highlights how corporate law and labor law are interdependent in their effects on expropriation of both groups. Moreover, this interdependence has different effects depending on the corporate governance structure chosen by the company. The more careful analysis of our paper suggest that the crucial factor is not concentrated ownership as such (to the contrary), but other factors that can be identified as private cost of expropriation borne by the controller (be it a controlling shareholder or manager). For example, the literature on family firms suggest that controlling families may have a "taste" for a certain social position in the community and therefore be reluctant to take an overly tough stance vis-ý-vis employees. Similarly, a controlling manager may have a taste for empire building and therefore be reluctant to initiate redundancies and plant closures. Similar reasons for private costs of expropriation can be brought with regard to shareholders. The cost of expropriation therefore creates a commitment against expropriation that may encourage workers to make specific in-vestment and investors to buy shares. However, in some cases the private cost of expropriation that we identify as an important factor for the protection of shareholders and employees might be substantially reduced (or even negative). For example, the decreased probability of a hostile takeover in a corporate governance system with dispersed ownership and an effective market for corporate control could be seen as a negative private cost of expropriation that makes ex post opportunistic situations more likely. By varying the degree of ownership concentration and the amount and sign of the controllerýs private cost of expropriation, our model is able to explain the interaction of corporate and employment law in corporate governance systems and firm-level structures, such as Berle-Means firms (both with entrenched managers and an effective market of corporate control), publicly traded and privately held family firms, firms controlled by financial investors (including hedge funds), and professional partnerships such as law firms.