Capital, Labor, and the Firm: A Study of German Codetermination

TLDR

In Germany, codetermination legally grants employees seats on supervisory boards, which oversee and approve management decisions, appoint executives, and set their salaries. The study empirically examines how employee participation in supervisory boards affects firm outcomes. Firms with equal employee and shareholder representation trade at a 31 % discount, exhibit management compensation misaligned with shareholder interests, longer payrolls, and trigger shareholder responses such as performance‑linked compensation and increased leverage. JEL codes: G32, G34.

Abstract

Under the German corporate governance system of codetermination, employees are legally allocated control rights over corporate assets through seats on the supervisory board—that is, the board of nonexecutive directors. The supervisory board oversees the management board—the board of executive directors—approves or rejects its decisions, and appoints its members and sets their salaries. We empirically investigate the implications of this sort of labor participation in corporate decision making. We find that companies with equal representation of employees and shareholders on the supervisory board trade at a 31% stock market discount as compared with companies where employee representatives fill only one-third of the supervisory board seats. We show that under equal representation, management board compensation provides incentives that are not conducive to furthering shareholders' interests, possibly because labor maximizes a different objective function than shareholders. We document that, under equal representation, companies have longer payrolls than their one-third representation peers have. Finally, we provide evidence that shareholders respond to the allocation of control rights to labor by linking supervisory board compensation to firm performance and by leveraging up the firm. (JEL: G32, G34)