Memorandum
RE: Corporate governance in Japan: The upside of lifetime employment
One of the striking differences between Japanese and American corporate governance is that in the former, the welfare of employees is of concern to managers. A major reason for this is that a substantial number of employees have a job for life.[1] I argue that lifetime employment is better at developing human capital, controlling agency costs, and even increasing long-term shareholder value. As with any choice in corporate governance there are downsides, yet maintaining lifetime employment is on the whole preferential.
I. Inherent Cultural differences are not the key reason for lifetime employment
A) Culture is an inadequate explanation.
It is often thought that the reason employees have a less important role in American corporate governance is due to culture. Some believe Americans have a cultural preference for at-will employment. The view is that both employees and the employers are aware and appreciate the fact they can end the relationship at any point in time. One problem with this view is that most empirical studies have confirmed that employees believe they can quit at any time, but that they cannot be fired. This suggests at-will employment is not well understood among American employees.[2] They understand that they have mobility and access to a robust external labor market, but don’t understand that the employer can fire them for any reason, at any time. American legal scholars, Gilson and Roe, believe Americans prefer at-will employment because they have a cultural preference for it, whereas the Japanese have no cultural preference.[3] The fact that employees don't understand that their employment is at-will means that it is not a cultural preference but rather a legal reality. To prove there is no Japanese cultural preference for lifetime employment they examine Japanese labor history.
B) Historical differences
Prior to WWI Japan had a flexible labor market, which meant that when there was a shortage of labor, employees sought to extract the highest price for their labor by changing jobs, and when there was an excess supply of labor firms dismissed employees. Lifetime employment was only introduced as an emergency measure specifically designed to head off extreme labor unrest.[4] At the time, employees were striking, taking over the management of factories, and voting for socialist parties. This is an accurate description of Japanese labor history. As of today Japan has a cultural preference for lifetime employment but this wasn't always the case, but more importantly there is a legal obligation. What is missing from the Gilson and Roe research is a symmetrical explanation of at-will employment. The fact that America has always had a flexible labor market doesn't mean it is an inherent part of American culture. In the US, at-will employment is so entrenched, and exceptions so rare, that it is taken for granted among employers that an employee could be fired for any reason with few exceptions. US law does prohibit dismissal based on race, gender, age, sexuality, and disability, but at-will employment remains the default legal rule. It is Japanese employment law that grounds the different approach to life time employment.
III. Employment Law
A. Japan. Japanese employment law strongly protects labor against dismissals, and this gives the corporation strong incentives to include them in corporate governance. Even the New Deal inspired Japanese constitution expressly protects labor. Article 25 of the Japanese Constitution provides that “all people shall have the right to maintain the minimum standards of wholesome and cultured living”.[5] According to Sugeno lower courts have interpreted this to mean that they can subject any national legislative or administrative act to judicial examination to determine whether or not it consistent with maintaining these standards[6]. For example, if the government suddenly decided to pass legislation allowing employers the unfettered right to dismiss employees courts might very well strike it down as unconstitutional. There are low levels of litigation given the strong involvement of the government in regulating labor contracts, when cases do go before courts there is generally a pro-labor bias.[7] As Sugeno notes, “article 27 which states that, “all people shall have the right and obligation to work”…has been established as a basic principle in the legal regulation of the labor market.[8] Lastly, article 28 establishes the right to bargain and act collectively. With these powerful constitutional provisions it is not hard to see that employees would naturally have an important role in corporate governance. Nevertheless, the powerful role that employees have in the management of corporations was not legislated. As Takashi Araki notes, “the Japanese stakeholder model significantly relies on customary practices and thus shows a striking contrast with the institutionalized German stakeholder model.”[9] Case law in Japan developed the abuse of right doctrine to protect against unjust dismissals, and that means that dismissals are invalidated unless the misconduct is serious.[10] Most important of all, there is protection against economic dismissal, something entirely inconceivable in the US. As Araki explains:
First, there must be business-based need to resort to reduction of personnel. Second, the employer must take every possible measure to avoid adjustment dismissals, such as: reduction in overtime; reduction in regular hiring or mid-term recruitment; implementation of transfers (haiten) or “farming out” (shukko) with respect to redundant workers; non-renewal of fixed-term contracts or contracts of part-timers; and, solicitation of voluntary retirement. In other words, dismissals must be the last resort to cope with the economic difficulties. Third, the selection of those workers to be dismissed must be made on an objective and reasonable basis. Lastly, the management is required to explain the necessity of the dismissal, its timing, scale and method to the labor union or worker group if no union exists, and consult with them concerning the dismissals in good faith.[11]
It is very difficult to fire a permanent employee. On the other hand, fixed term employees can be let go when the term of the contract, usually one year, ends. However, just a few renewals can place these contract employees into the permanent employee category[12]. Japan also has joint management-labor consultations. In addition to a collective labor contract, each employer must establish its own distinct set of work rules in consultation with employees. These work rules are legally relevant and cannot be changed without mutual agreement. However, management is more or less free to introduce any changes it sees fit. But, in practice companies are very receptive to the opinions of employees. In addition, the Japanese labor relation’s board does periodic checks to make sure that the company is filing such reports. Prior to any changes to the work rules employees must be consulted. The consultation is somewhat of a formality but its very existence encourages employers to consult employees. As Araki observes, the existence of strong protections made management much more open to consultations with employees so as to avoid the formation of unions[13]. Araki also believes that Japanese employers are making minor concession to avoid labor militancy. Remarkably Japanese unions and work councils are comprised not only of lower level employees but also management. Because of internal promotion all managers have been at one time or another lower level employees. The uniqueness of the Japanese stakeholder model is that it depends largely on customary practice.[14]
B. USA. US courts have acted to stop both states and the federal government from regulating labor, and this lack of regulation gives corporations no incentive to include employees in corporate governance. It would appear at first glance that the US has had mild judicial intervention. Employees and employers are free to decide employment contracts. Araki argues that on the contrary, there has been heavy judicial intervention to keep employees from having any say whatsoever in corporate governance. As Araki notes, “American law, as interpreted by the National Labor Relations Board and Federal courts, prohibits most such employee involvement as illegal intervention into “labor organization” on the part of employers and as a hindrance to establishing bona fide, independent labor unions.”[15] Courts will curtail any state or federal regulation of employment based on the Fifth and Fourteen amendments to the constitution, and this has enshrined freedom of contract. Both the employer and the employee have the right to freely determine their employment relationship without government interference.[16] All attempts by organized labor to introduce national legislation have been struck down by US courts[17]. In contrast to Japan, there is no constitutional clause dealing with labor, and the courts are pro-employer. It is not much of an exaggeration to say that the at-will employment relationship is sacrosanct, and courts will almost never allow an employer to grant lifetime employment regardless of how many times the employee is given written or verbal confirmation.[18] The only real situation where courts will enforce promises of lifetime employer is where the employee was once an employer and sold the business because here courts feel they are enforcing normal contractual rights. To conclude this section it is fair to say the labor law of Japan establishes a firm basis for employee participation in corporate governance whereas US labor law actively prevents any such involvement. Another key difference between the two nations is the treatment of senior management. In the US senior management are treated differently from regular employees since they receive extremely high salaries, and usually a share of equity in the business. Senior management become significant shareholders in the company. By contrast, Japanese executive remuneration is much lower, and they belong to the same unions as regular employees. Perhaps looking at how these employees are treated will help settle whether the stakeholder model’s protections against dismissal are better than the shareholder model’s privileging of flexible labor markets.
III. Development of Human Capital
A. How strong is the link between lifetime employment and investment in human capital? Gilson and Roe argue that lifetime employment is not the reason Japanese corporations invest in human capital, but rather the lack of an external labor market is. Showing that the Japanese system of lifetime employment does not exist for the purpose of developing employee skills is not sufficient, they must also show that it is unreasonable to believe that it will aid in the development of those skills. They rely on the following thought experiment. Suppose you are the employee and you are living in a system where you have lifetime employment, but lack an external labor market. All firms hire internally, and therefore an employee cannot leave. Of course this is not entirely true since many Japanese corporations exist as part of a network of companies, so employees can usually join firms associated with their firm. They concede that an employee doesn’t need to invest in self-development. However, since there is no external labor market the employer has no incentive to pay the employee well. This is merely the logical corollary of employees being unable to take advantage of the rise and fall in demand for labor, or the scarcity of certain skills. But, it is well worth the sacrifice since an employee with limited foresight and funds cannot easily predict which skills will be of use in the future. Not that long ago employees in the US were told to invest in computer skills, many of those that did so were hugely disappointed when numerous companies opted to out source the work to India. For Gilson and Roe, the lack of an external labor market is the real reason for employer investment in human capital. Given that lifetime employment and an inflexible external labor market seem in Japan at least to be coextensive, it is difficult to see what is to be gained by attributing all causality to the latter. In favor of the value of a robust external labor market and employee self-investment they cite Silicone Valley[19].
B. Can investment in human capital take place without lifetime employment? Gilson and Roe give the example of Silicon Valley to demonstrate that lifetime employment is not needed to develop human capital. Here you have the ideal evidence justifying flexible labor markets. But, this example is unsuitable for several reasons. First, it totally ignores the fact that California is one of only a handful states to ban non-competition agreements. In most of the US highly valuable employees cannot simply quit their job and join another company because they enforce non-competition agreements. The enforceability these agreements is determined by strict criteria.[20] Non-competition agreements must be reasonable in time, space, and subject matter. These factors are interdependent. A non-competition agreement that covered all of America but was restricted to Nuclear fusion might be valid, because the job is very specific. In any individual case it is difficult for the employee to determine if it possible to join a competitor without violating the agreement. Often even senior management employees are forced to sign non-competes.[21] The very existence of a non-competition agreement has a chilling effect and induces employees to remain at their company when they might have quit.[22] Another reason to doubt the generalization of Silicone Valley is that high tech workers have a highly specialized skill set that the vast majority of Americans lack. To say that these employees can self-invest in training and profit thereby does not mean that most employees can. Finally, it overlooks the massive amount of government funding that flows from the Pentagon and other sources to these industries. In other industries jobs are much more difficult to obtain and the external market is subject to more extreme variation. It would be remiss when considering the role employees play in corporate governance to not look at the laws each country has in place. If you do, you see that Japan has firmly entrenched labor rights, and thus labor involvement in corporate management flows naturally. By contrast, US statutes are almost completely silent, and when courts do speak they are firmly excluding labor from corporate governance.
V. The agency problem is not solved with flexible employment.
A) Despite senior management in the US receiving high salaries the agency problem is worse because there is no lifetime employment. The tales of management malfeasance extend from the Enron scandal to the collapse of Lehman Brothers. The stakeholder model does a better job of solving the agency problem. Ronald Dore argues that the punishing inefficient managers through dismissal, or by a decrease in the value of the corporations stock is external and impersonal. The Japanese approach is based upon internal controls whereby the manager is made to feel moral guilt for failing to succeed. More importantly because the top managers have worked for the firm their entire lives they are closely identified with the firm and see the firms interests as coextensive with their own. [23]The Japanese manger learns to love his employer because he has lifetime employment. There is no reason to fear being replaced by external managers either. Shareholders have much less need to watch over management. Mangers have much less need to watch over employees. Employees have much less hatred for managers. Even more fascinating is the evidence that the stakeholder model is more suited to post industrial capitalism.
B) The stakeholder model and with it lifetime employment is better for post-industrial capitalism. The Japanese economist Katushito Iwai makes some important observations about the nature of the corporation.[24] On the one hand a corporation has shareholders, and on the other it is a legal person. If one only focuses on the shareholders than the corporate form is merely a fiction maintained as a tax shelter and conduit to funnel dividends and capital gains to shareholders. In a closely held or private corporation this appears to be accurate and the shareholder is a puppeteer pulling all the strings. However, the corporation also has a legal personality and can enter into contracts and own property. In large public corporations no shareholder is directing policy. Managers are free to guide the corporation in whatever direction they so choose. Aside from first amendment speech protections, American law treats the corporate form largely as a fiction, the corporation exists to serve shareholders. On the other hand, the Japanese system is more committed to the corporation as a legal person. Both models have advantages. The Japanese one is better at addressing the hold-up problem where employees and managers feel comfortable investing in firm specific knowledge knowing that the company promises them lifetime employment. At the same time the shareholder model is better at preventing moral hazard, but only if it is closely held. In a closely held corporation vigilant shareholders would fire managers who under-perform.
There are problems removing both senior management, and lower level employees. In America it is routine to talk about bringing in an external manager to take over a failing corporation. But, there are serious problems with bringing in external management. It is widely known in management circles, that in the vast majority of cases, bringing in external managers is extremely harmful to the corporation[25]. Intuitively this makes sense since the new manager is likely to know far less about the company. Furthermore, in most public corporations shareholders cannot actively monitor managers so it is difficult to justify that strategic change. There are also problems with dismissing lower level employees. It is increasingly doubtful that layoffs benefit shareholders. There is evidence that firing employees is bad for the corporation under general accounting principles, and for the share price of the corporation, both in the short and long term.
There are problems removing both senior management, and lower level employees. In America it is routine to talk about bringing in an external manager to take over a failing corporation. But, there are serious problems with bringing in external management. It is widely known in management circles, that in the vast majority of cases, bringing in external managers is extremely harmful to the corporation[25]. Intuitively this makes sense since the new manager is likely to know far less about the company. Furthermore, in most public corporations shareholders cannot actively monitor managers so it is difficult to justify that strategic change. There are also problems with dismissing lower level employees. It is increasingly doubtful that layoffs benefit shareholders. There is evidence that firing employees is bad for the corporation under general accounting principles, and for the share price of the corporation, both in the short and long term.
VI) Is firing employees is bad, good, or indeterminate for shareholders? If the share price is used as a guide there is evidence that firing employees is bad for shareholders. However, there is also evidence that firing employees is good for shareholders. Newsweek claims that layoffs are bad for company performance. The article notes:
Airlines faced not only the tragedy of 9/11 but the fact that economy was entering a recession. So almost immediately, all the U.S. airlines, save one, did what so many U.S. corporations are particularly skilled at doing: they began announcing tens of thousands of layoffs. Today the one airline that didn't cut staff, Southwest, still has never had an involuntary layoff in its almost 40-year history. It's now the largest domestic U.S. airline and has a market capitalization bigger than all its domestic competitors combined.[26]
This is not an isolated example, as Newsweek explains:
A study of 141 layoff announcements between 1979 and 1997 found negative stock returns to companies announcing layoffs, with larger and permanent layoffs leading to greater negative effects. An examination of 1,445 downsizing announcements between 1990 and 1998 also reported that downsizing had a negative effect on stock-market returns, and the negative effects were larger the greater the extent of the downsizing. Yet another study comparing 300 layoff announcements in the United States and 73 in Japan found that in both countries, there were negative abnormal shareholder returns following the announcement.[27]
It is possible that the reason that firms fire so many employees do so because they are in financial distress, and therefore labor market flexibility is not itself the cause of their decline in share price.[28] The firing of employees could be a signal to the market the company is in trouble. But there is other evidence that firing employees increases share price. Kevin J. Murphy notes that, “GD's stock jumped more than 30%, from $22.75 to over $30, in mid-March 1991 after three Wall Street investment banks issued “buy” recommendations, citing GD's new compensation plans and Anders' announced reductions in capital and research and development spending.”[29] General Dynamics also fired a large number of employees. From the following we can't say whether the movement of the companies stock after the dismissal of employees is because of the dismissal or some other factor. There are so many complex factors that enter into the judgments of shareholders when they are deciding whether to buy or sell. This fact alone suggests that labor flexibility is not inherently beneficial to shareholders.
Employees have a much larger role in Japanese corporate governance. An important reason employees in Japan have a bigger role is because many of them have lifetime employment. This paper argued that the Japanese system of lifetime employment is better at developing human capital, controlling agency costs, and may not decrease shareholder value. As with any system of corporate governance there are negatives to lifetime employment, however, these negatives are more than offset by the positives.
[2] Glynn, et al. Employment Law Private Ordering and Its Limitations, at 65 ¶ 3 (2007).
[3] Ronald J. Gilson, Mark J. Roe, Lifetime Employment: Labor Peace and the Evolution of Japanese Corporate Governance, 99 Colum. L. Rev. 508, at 17 (1999).
[4] Gilson, supra note 1, at 7.
[5] Kazuo Sugeno, Japanese Labor Law, University of Washington Press, at 14, (1992).
[6] Id, at 14.
[7] Id, at 14.
[8] Id. at 15.
[9] Takashi Araki, A COMPARATIVE ANALYSIS: CORPORATE GOVERNANCE AND LABOR AND EMPLOYMENT RELATIONS IN JAPAN, 22 Comp. Lab. L. & Pol'y J at 67, (2000).
[10] Id. at 6.
[11] Id. at 6.
[13] Araki supra, at 9.
[14] Id. at 8.
[15] Id. at 10.
[16] Cynthia L. Estlund, An American Perspective on Fundamental Labor Rights," in Social and Labour Rights in a Global Context (Robert Hepple, ed., Cambridge University Press), at 197, (2002).
[17] Id, 197.
[18] Hanson v. Central Show Printing Co., Inc., 130 N.W.2d 654 (Iowa 1964).
[19] Ronald J. Gilson, Mark J. Roe, Lifetime Employment: Labor Peace and the Evolution of Japanese Corporate Governance, 99 Colum. L. Rev. 508, at 16 (1999).
[20] An example of that test is in EarthWeb Inc. v. Schlack, 71 F. Supp. 2d (S.D.N.Y.) (1999).
[21] IBM v. Johnson 629 F. Supp. 2d 321 S.D.N.Y. (2009).
[22] Matt Marx, Deborah Strumsky, and Lee Fleming, Noncompetes and inventor Mobility: Specialists, Stars, and the Michigan Experiment, at 22 (2008).
[23] Ronald Dore, COMMENT: PAPERS ON EMPLOYEES AND CORPORATE GOVERNANCE, 2 Comp. Lab. L. & Pol'y J 159 (2000).
[24] Katushito Iwai, unpublished lecture, “What Will Become of the (Japanese) Corporation? – A Comparative Perspective,” 9th John Whitney Hall Lecture at Yale University, Nov. 2007
[25] The Economist, Schumpeter, The curse of the alien boss, Aug 5th 2010
[26] Newsweek, Lay Off the Layoffs, at 1 February 05, 2010. http://www.newsweek.com/2010/02/04/lay-off-the-layoffs.html
[27] Id, at 3.
[28] Tim, C. Opler et al. Financial Distress and Corporate Performance, The Journal of Finance, Vol XLIX , No 3. at 1 (1994)
[29] Ibid, at 14.
