In corporate governance, the focus is increasingly shifting toward non-financial stakeholders, particularly employees, as important contributors to a firm’s competitive advantage and long-term success. Historically, investment in labor has been a big topic in corporate finance, especially within agency theory. According to that theory, conflicts between shareholders and managers often lead to suboptimal investment decisions, resulting in either overinvestment (such as over-hiring or under-firing) or underinvestment (such as over-firing or under-hiring) in labor.

While prior studies have extensively explored independent boards, blockholder ownership, and other governance mechanisms that influence capital investment decisions, labor investment efficiency remains underexplored. Yet, the effect of stakeholder orientation – making the welfare of non-shareholder constituencies a priority – on labor investment has attracted increasing attention in recent years. Stakeholder orientation could theoretically mitigate agency conflicts by promoting long-term investments, but it could also foster alliances between managers and employees, leading to inefficiencies.

In a new paper, we address whether stakeholder orientation improves or detracts from labor investment efficiency, and in doing so, contribute to the debate over the economic consequences of stakeholder-oriented governance. We leverage the staggered adoption of constituency statutes across U.S. states as a quasi-natural experiment. These statutes promote stakeholder orientation by encouraging corporate boards to consider the interests of non-shareholder constituencies, such as employees, in their decisions. Using a difference-in-differences (DiD) methodology, we analyze the effects of this regulatory shock on labor investment efficiency, defined as the deviation of a firm’s net hiring from the level justified by its economic fundamentals. Our study draws on a comprehensive dataset of 64,459 firm-year observations covering the period from 1983 to 2018.

The state statutes effectively shifted the focus of corporate governance by promoting the interests of non-shareholder stakeholders, including employees, customers, and communities, in strategic decisions. This shift created a unique natural experiment, allowing us to compare the labor investment behaviors of firms subject to the statutes (treatment group) with those of firms not subject to them (control group).

By exploiting this staggered adoption as an exogenous shock to stakeholder orientation, we can isolate the effects of enhanced employee orientation on labor investment decisions, while controlling for other confounding factors that may influence both labor investment efficiency and stakeholder orientation. This approach helps mitigate concerns about reverse causality and omitted variable bias, ensuring that the observed changes in labor investment efficiency are indeed attributable to the adoption of constituency statutes.

We find that the adoption of constituency statutes leads to a deterioration in labor investment efficiency, primarily driven by underinvestment in labor. Firms subject to the statutes tend to hire fewer employees than would be justified by their economic fundamentals. The effect is most pronounced in firms with weaker governance – those with lower levels of institutional and blockholder ownership, more free cash flow, and weaker board monitoring. In these firms, managers appear to prioritize personal benefits, such as job security for themselves and their employees, at the expense of labor resources.

Our results are consistent with the “manager-employee alliance” hypothesis, which suggests that managers, especially in firms with weak governance, form alliances with employees to secure their support and retain personal benefits, even when this behavior is not in the best interests of shareholders. For example, managers may avoid layoffs or overpay employees to maintain harmony and job security, even when these actions lead to inefficiencies.

Interestingly, while stakeholder orientation generally leads to underinvestment in labor, we also observe that it reduces over-firing in firms where this behavior was previously prevalent. This suggests that stakeholder orientation can, in some cases, promote a more balanced approach to labor investment by curbing excessive downsizing. However, the overall effect of stakeholder orientation on labor investment efficiency remains negative, particularly in firms with weak shareholder oversight.

We further observe that the impact of stakeholder orientation on labor investment efficiency is moderated by several factors. Firms with a strong, pre-existing focus on other stakeholders, such as customers and local communities, are less likely to experience a decline in labor investment efficiency following the adoption of constituency statutes. Conversely, the negative effect is more pronounced in firms facing higher takeover risk, where managers have a stronger incentive to align with employees to secure their positions.

Our study makes several important contributions to the literature on corporate governance, labor economics, and stakeholder theory. First, we provide new empirical evidence on the effects of stakeholder orientation on labor investment efficiency, an area that has been largely overlooked in previous research. While prior studies have focused on the positive effects of stakeholder orientation on innovation, firm value, and capital investment efficiency, our findings highlight a potential downside: the creation of inefficiencies in labor investment.

Second, we extend the literature on agency theory by showing that stakeholder orientation can exacerbate agency problems in firms with weak governance. Specifically, we demonstrate that the adoption of constituency statutes, which heightens stakeholder orientation, can lead to the formation of manager-employee alliances that reduce labor investment efficiency. This finding challenges the view that stakeholder orientation always leads to improved corporate decision-making and suggests that its effects are more complicated.

Third, our study contributes to the policy debate on the role of stakeholder orientation in corporate governance. While stakeholder-friendly policies such as constituency statutes may promote long-term value in some contexts, they can also create labor investment inefficiencies by encouraging managerial entrenchment. Policymakers and corporate boards must consider the trade-offs in promoting stakeholder orientation, particularly in firms with weak shareholder monitoring and high takeover risk.

Finally, we add to the growing body of research on labor economics by documenting the significant impact of stakeholder orientation on firms’ hiring and retention decisions. Given that labor costs account for a large share of global economic value added, understanding the factors that influence labor investment efficiency is critical for both firms and policymakers. Our study provides valuable insights into the complex relationship between stakeholder orientation and labor investment efficiency, offering a more comprehensive understanding of the economic consequences of stakeholder-friendly policies.

Overall, the documented labor investment inefficiencies in our study resulting from constituency statutes appear to undermine the wisdom of giving shareholder interests priority (Jensen and Meckling, 1976).

This post comes to us from professors Rajib Chowdhury at Penn State University – Harrisburg, John A. Doukas at Old Dominion University’s Strome College of Business, and Jong Chool Park at the University of South Florida. It is based on their recent paper, “Employee Governance or Tacit Collusion? The Effect of Stakeholder Orientation on Labor Investment Efficiency,” available here.