Employee Governance and the Ownership of the Firm

Abstract

A major moral criticism of the prevailing system of corporate governance is that it places control of publicly held corporations in the hands of shareholders. By law, shareholders have an exclusive right to make certain corporate decisions, and this arrangement is generally justified by the shareholder’s role as the owner of the firm. However, many thoughtful observers hold that such a privileged position for shareholders is morally objectionable, in part because it neglects the important role played by employees. Some of these critics contend that employees should also have a voice in corporate decision making and perhaps be owners themselves. Current corporate law might be said to uphold a system of shareholder governance, in which the corporation is governed by shareholders. The main alternatives that have been advanced are employee participation in decision making and employee ownership of firms. Examples of such employee governance include works councils and employee representation on supervisory boards that are legally mandated in Germany, the more informal, nonlegal forms of collaborative decision making found in Japan, and worker cooperatives, the most prominent example of which is perhaps the Mondragon system in Spain. The popular support for employee governance stands in stark contrast to the absence of

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© 2004. Business Ethics Quarterly, Volume 14, Issue 1. ISSN 1052-150X. pp. 1–21
EMPLOYEE GOVERNANCE AND
THE OWNERSHIP OF THE FIRM
John R. Boatright
Abstract: Employee governance, which includes employee ownership
and employee participation in decision making, is regarded by many
as morally preferable to control of corporations by shareholders.
However, employee governance is rare in advanced market econo-
mies due to its relative inefficiency compared with shareholder
governance. Given this inefficiency, should employee governance be
given up as an impractical ideal? This article contends that the de-
bate over this question is hampered by an inadequate conception of
employee governance that fails to take into account the difference
between employees and shareholders. It offers a different, more ad-
equate conception of employee governance that recognizes a sense
in which employees currently have some ownership rights. The argu-
ment for this conception of employee governance is built on an
expanded understanding of the ownership of a firm. The article also
suggests new strategies for strengthening the role of employees in
corporate governance.
A major moral criticism of the prevailing system of corporate governance is
that it places control of publicly held corporations in the hands of share-
holders. By law, shareholders have an exclusive right to make certain corporate
decisions, and this arrangement is generally justified by the shareholder’s role
as the owner of the firm. However, many thoughtful observers hold that such a
privileged position for shareholders is morally objectionable, in part because it
neglects the important role played by employees. Some of these critics contend
that employees should also have a voice in corporate decision making and per-
haps be owners themselves.
Current corporate law might be said to uphold a system of shareholder gov-
ernance, in which the corporation is governed by shareholders. The main
alternatives that have been advanced are employee participation in decision
making and employee ownership of firms. Examples of such employee gover-
nance include works councils and employee representation on supervisory boards
that are legally mandated in Germany, the more informal, nonlegal forms of
collaborative decision making found in Japan, and worker cooperatives, the most
prominent example of which is perhaps the Mondragon system in Spain.

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The popular support for employee governance stands in stark contrast to the
absence of employee participation and employee ownership in developed free-
market economies. Virtually every discussion of the subject notes the rarity of
durable forms of worker control in modern business enterprises, except when it
is mandated by law, as in Germany, or when special market conditions prevail,
which is the case in Japan and Spain. The major reason for a lack of employee
governance appears to be the relative inefficiency of worker-managed and worker-
owned forms. As a consequence, we face a critical question: Should employee
governance be given up as an impractical moral ideal, or should we attempt to
secure it by following the examples of Germany, Japan or Spain?
The discussion of this question has been hampered by an inadequate con-
ception of employee governance. The usual understanding takes the ownership
rights of shareholders as a paradigm of governance and seeks to make em-
ployees more like shareholders, if not actually shareholders. Advocates of
employee governance assume, in other words, that employees have no share
in governance unless they participate in the kinds of decisions generally re-
served for shareholders. However, this conception of what governance means
for both shareholders and employees fails to take into account of the differ-
ences between these two corporate constituencies.
Shareholders are equity capital providers with a claim on a firm’s residual rev-
enues, and their governance rights are safeguards for this kind of investment. Labor,
which is provided by employees, is as important as capital as a factor of produc-
tion, and employees also need governance rights to protect their stake in a firm,
which is largely a claim for wages. The rights of both shareholders and employees
include decision-making power over certain aspects of a firm’s activities. Indeed,
these two matters—namely, protecting assets and allocating decision-making pow-
ers—are the major tasks of corporate governance. As a result, we should expect
that employees have a right to some measure of control over a corporation but
also that their specific rights are different from those of shareholders.
This article offers a new conception of employee governance, one that takes
account of the differences between shareholders and employees and is appro-
priate for the distinctive situation of employees. On this conception, employees
already possess certain decision-making powers that are not commonly recog-
nized as matters of corporate governance because they differ from the kind of
control rights exercised by shareholders. However, the ways in which employ-
ees have ownership of a firm serves to protect their particular claims on a firm’s
revenues, just as the rights of shareholders protect their claims. The current role
of employees in corporate governance is not wholly satisfactory, though. It is
still possible to claim that employees’ interests are inadequately protected and
that employees should have more power in comparison with shareholders.
This article yields two practical conclusions about the possibilities for
strengthening employee governance, one negative and the other positive. The
negative thesis is that the main traditional strategies for realizing employee gov-
ernance, such as participatory management, employee stock ownership, and

EMPLOYEE GOVERNANCE 3
employee representation on boards of directors, are not likely to be effective.
These measures, which seek to make employees more like shareholders, again,
fail to appreciate the differences between equity capital providers and employ-
ees, who provide labor. The positive outcome is that there are more promising
strategies that can be built on this new, more adequate conception of employee
governance. However, these strategies can be developed only by understanding
what interests employees have in a firm and how these interests can be protected
in ways that are acceptable to other constituencies.
The first section of this article observes that the main arguments in support
of employee governance generally assume that worker-managed and worker-
owned firms can be relatively efficient and thus can compete in a free-market
economy. However, the explanation of economists for the rarity of these forms
of employee governance, which is presented in the second section, reveals the
causes of their inefficiency. The analysis proceeds largely from a contractual
perspective that models the firm as a nexus of contracts among its various con-
stituencies and employs concepts from financial economics, including transaction
and agency costs, asymmetric information, and risk preferences. The conclu-
sion to be drawn from this analysis is that employee governance, as commonly
conceived, is largely incompatible with a free-market economy and is prevalent
only when there is a legal mandate or else public support.
However, the same analysis provides the basis for a different conception of
employee governance. The argument, which is presented in section three, “La-
bor and Capital as Determinants of Ownership,” applies the analysis for
shareholder ownership to the employee’s provision of labor. The crux of the
argument is the claim that every firm-specific asset provided to a firm is accom-
panied by a set of rights that constitutes a form of ownership. Thus, employees’
relation to a firm, like that of shareholders, includes decision-making powers
that serve to protect the assets that employees provide. Such employee gover-
nance is not incompatible with control by shareholders and coexists with it. The
final two sections of this article further elaborate the new conception of em-
ployee governance and discuss the practical implications.
The Arguments for Employee Governance
The term “employee governance” covers various proposals for increasing
the control of employees over matters that affect them.1 This control may be
exercised either directly through participation in decision making or indirectly
through representation in decision-making bodies, such as a seat on the board
of directors. Control could also be delegated, for example, by appointing man-
agers who are then accountable to the workers. Some advocates of employee
governance include in their definition the replacement of hierarchical structures
with cooperative arrangements so that the workplace is more egalitarian and
democratic or participative (Putterman, 1982).

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Employees who own a majority of a company’s stock have legal control of a
firm, but their ownership rights as shareholders do not thereby increase their
participation in corporate decision making unless they use their control as share-
holders to change the decision-making process, which is rarely the case. Although
the employees of many American corporations own significant minority stakes
through Employee Stock Ownership Plans (ESOPs) and pension plans, includ-
ing 401(k) accounts, they are generally entitled only to share in the profits of an
employer and to exercise the rights accorded to all shareholders. Their position
is little different from that of employees in firms with profit sharing. Participa-
tory decision making and employee ownership are thus logically distinct in that
one can obtain without the other. However, in practice, employees are unlikely
to have significant decision-making power without substantial stock holdings.
That workers should have control over matters that affect them is advanced
on two principal grounds. One argument is the need to justify authority, and the
other is the right of individuals to freedom and autonomy. The first kind of
argument is made by Robert Dahl (1985; see also Pateman, 1970), who holds
that the modern corporation is a political system in which power is exercised by
one group over another. Such power must be justified in a state, usually by re-
quiring a democracy, and similarly, Dahl says, a firm must “satisfy the criteria
of the democratic process” (Dahl, 1985: 134). Christopher McMahon (1994)
rejects Dahl’s contention that managers exercise political authority on the grounds
that they lead voluntary associations that do not depend on coercion. However,
he also concludes that the authority relations in an economic organization can
be legitimate only if managers are accountable in some way to employees. Thus,
both Dahl and McMahon agree that employees have a right, similar to that of
citizens, to participate in decisions that affect them.
The second line of argument holds that the treatment of employees in mod-
ern corporations fails to respect the dignity of individuals and denies a right to
freedom (Brenkert, 1992; McCall, 2001). The result for Marxists is the alien-
ation of labor, whereas others prefer to describe this condition as a denial of
autonomy (Schwartz, 1984). However the case is made, participatory decision
making is presented by its advocates as something morally desirable and per-
haps as a right to which we are entitled.
These arguments generally hold that a presumption exists in favor of em-
ployee governance and that the main task is to defend this presumption against
objections. Thus, Dahl and McMahon argue at length that employee-governed
enterprises would not violate a superior right to property. However, advocates
also condition this conclusion on the economic viability of employee gover-
nance. They assume, in other words, that worker-managed and worker-owned
firms can exist and prosper in a free-market economy without any significant
loss of efficiency or any need for radical political or legal change.
For example, McMahon (1994: 266–272) considers the possibility that demo-
cratic firms might not be able to attract sufficient investment because of a lack
of efficiency, but he dismisses this as “a question for economists” that he will

EMPLOYEE GOVERNANCE 5
not attempt to answer (McMahon, 1994: 271). He concludes weakly that a soci-
ety concerned with “increasing social prosperity” might not want to mandate
that all firms be democratic but that, for the sake of freedom, legal provision
should be made for some to be.2 He disregards the possibility that in a free-
market economy, workers might overwhelmingly prefer employment in
nondemocratic firms for the sake of higher wages, which the empirical evidence
suggests is the case.
McCall admits that his argument for a right to participate in decision making
has only “presumptive force,” because it “depend[s] on beliefs that strong em-
ployee participation will not have seriously harmful economic consequences”
(McCall, 2001: 210). Similarly, Brenkert says that the right of workers to par-
ticipate in decision making is prima facie inasmuch as it can be overridden by
more compelling reasons (Brenkert, 1992: 262). Although he does not consider
the possibility that employee participation may impose considerable costs due
to inefficiency, such a factor might well be an overriding reason. Dahl also ob-
serves that his proposal for corporate democracy requires a trade-off “between
two conflicting visions of what American society is and ought to be” (Dahl,
1985: 162), namely political equality versus wealth and prosperity. Thus, he
recognizes that his argument for corporate democracy may not be persuasive to
people who value wealth and prosperity over equality.
Part of the argument of this article is that employee governance is inefficient
and is, for this reason, unlikely to be chosen by workers or any other group in a
free-market economy. Some rights, such as those involving minimum wage, dis-
crimination, and worker health and safety, ought to be secured regardless of
cost. Other rights or goods ought to be mandated by law or otherwise realized
only if the cost is not too great. (Even recognized rights involve standards, the
minimum wage level, for example, that are set with some regard to the cost.)
Advocates of employee governance have offered compelling arguments that
participation in decision making and employee ownership are worthy moral ends
other things being equal, but they have generally admitted that any right to em-
ployee governance is limited by economic considerations.
The relevant question, therefore, is not whether employee governance is of
some value—it clearly is—but whether the value is so great that it ought to be
secured by law or other means, given that it is unlikely to arise from the choices
people make in a free market. In order to answer this question, we need to un-
derstand the reasons for the rarity of employee governance.
Reasons for the Rarity of Employee Governance
Economists have sought to explain not only the relative rarity of worker par-
ticipation and worker ownership but also the distribution of firms with these
characteristics (Ben-Ner, 1988a, 1988b; Dow, 1993; Dow and Putterman, 1999,
2000; Putterman, 1984). Worker cooperatives, in particular, are clustered in a
few countries—including Italy, France, and Spain—and in certain industries,

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such as construction, printing, and small craft manufacturing (Ben-Ner, 1988a).
In the United States, worker-owned firms are prevalent only in narrow market
niches, such as plywood manufacturing and waste hauling, and in some dis-
tressed industries, most notably steel.
However, if worker-owned firms are defined so as to include sole
proprietorships, partnerships, and close corporations, then they are very promi-
nent, especially in professional services and technology startups. Indeed,
partnership is the most common form of organization in law, accounting, and
investment, which are fields that involve highly specialized skills and knowl-
edge. Although numerous, such “worker-owned” enterprises constitute a small
percentage of firms measured by total assets. Moreover, they are rare among
heavily capitalized industrial enterprises, which employ the vast proportion of
workers. Discussions of the lack of employee governance have focused, there-
fore, on the kinds of corporations that dominate our economy. However, the
prevalence of partnerships in professional areas is due to the same factors that
account for the rarity of employee governance in the rest of the economy.
The economists’ explanation has also focused primarily on worker ownership
rather than worker management. However, ownership is a bundle of rights that
includes control, along with a right to certain revenues and a claim on physical
assets. Insofar as worker management involves the exercise of decision-making
powers over matters that would otherwise be left to shareholders, it includes a
central element of ownership. Therefore, the same factors that militate against
worker ownership operate with equal force against worker management.
The question confronting economists is often stated in the form: Why does
capital usually hire labor?3 If capital and labor were similar inputs, then, in a
competitive market, it should not matter which hires which (Samuelson, 1957).
The theoretical explanation of why capital usually hires labor identifies a large
number of related factors that work together to reduce the efficiency of em-
ployee-governed firms. These factors can be grouped under three main heads:
(1) problems of incentives and monitoring, (2) problems of obtaining adequate
financing, and (3) problems of collective choice.
Assuming that a firm brings together people with assets to realize the ben-
efits of joint production, it is important that workers, as well as other input
providers, have incentives to increase the value of the output. The alternative is
a situation in which some groups are able to increase their own return at the
expense of overall wealth creation. Workers can pose such a risk with respect to
the effort they expend and to their utilization of assets.
Alchian and Demsetz (1972) observe that in joint production it is difficult to
determine each worker’s contribution and to pay accordingly. However, if workers
are paid only on the basis of total output, then each one has an incentive to
shirk. The root of this problem is asymmetric information and monitoring costs:
each worker knows more about his or her effort than anyone else, and any man-
ager would have to expend resources in gaining this information. The solution,
according to Alchian and Demsetz, is ownership by an outside party who is

EMPLOYEE GOVERNANCE 7
motivated to monitor because of a right to the residual revenues and who can
use the information gained from monitoring to improve production.
The problem of shirking also arises in the maintenance of a firm’s physical
assets. If workers collectively owned plants and machinery, they would have an
incentive to overuse these assets and reduce their effort to maintain them. Again,
information asymmetry and monitoring costs are at the root of this problem, and
the solution is for the outside monitor who receives the residual to be the owner
to the physical assets of a firm as well. Such a person has an incentive to moni-
tor not only individual effort but also the utilization of assets.
There are some theoretical and empirical objections to this explanation.4
Workers generally have better information about each other’s effort than do
managers, and so they could, with sufficient incentives, engage in self-monitor-
ing. Such incentives might be provided by bonuses and profit sharing. These
objections show that employee ownership might be viable if monitoring prob-
lems were the only obstacle, which is not the case, though. The force of the
Alchian and Demsetz’s account, moreover, is to identify problems about incen-
tives and monitoring that any form of governance must address. In particular,
governance structures should create incentives for increasing the value of the
firm that overcome the obstacles of information asymmetry and monitoring costs.
More serious difficulties arise in connection with obtaining adequate financ-
ing. A common explanation for the lack of worker ownership is that workers
generally lack sufficient wealth to finance a cooperative enterprise. Redeployable
assets, such as machinery, can be financed with debt, but debt financing is lim-
ited by the problems of moral hazard and adverse selection. That is, lenders’
investment would be limited due to fears that workers would take undue risks or
would misrepresent their level of effort. The moral hazard faced by lenders is
increased by the fact that the human capital provided by workers cannot be used
to secure loans because workers can walk away from a failing enterprise and
leave the lender without sufficient assets to satisfy claims (Dow and Putterman,
1999; Hart and Moore, 1990). Capital for firm-specific assets and startup fi-
nancing could not easily be raised from lenders, then, without some assurance
of the workers’ commitment to the firm. Workers can signal this commitment by
making a significant capital investment themselves, but this solution highlights
the difficulty of obtaining external financing.
Although workers individually may lack significant wealth, they often have
enough wealth collectively through pension funds and ESOPs to take a sub-
stantial stake in an employing firm (Drucker, 1976). The rarity of worker
ownership, then, may be due less to a lack of wealth than to risk aversion.
Shareholders not only provide equity capital but also assume residual risk,
which provides insurance for employees’ wages. With less wealth, workers
are understandably more risk averse than outside shareholders and more in
need of diversification. Consequently, employees may be reluctant to assume
residual risk and to forgo this kind of insurance.

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Risk aversion plays another role in explaining the lack of employee gover-
nance. Because of workers’ limited wealth and inability to diversify, the optimal
level of risk for a labor-managed firm is lower than for a comparable share-
holder-controlled firm. Workers’ preference for a lower level of risk is of little
consequence as long as all equity capital is generated internally, but it becomes
significant when a firm turns to external capital providers, who would demand a
premium, thus raising the cost of capital for the firm. Workers could offer to
raise the level of risk, but, as Herbert Gintis (1989) argues, the level of risk
cannot be guaranteed by a legally enforceable contract and is difficult and costly
to monitor. Gintis argues further that shareholders prefer a hierarchical firm
because providing incentives to a few top managers and monitoring their per-
formance is less costly than attempting to motivate and monitor all employees.
The third set of problems, those of collective choice, is concerned with the
difficulty and resultant cost of making decisions.5 Decision making itself incurs
costs in acquiring and processing information. For this reason, costs are reduced
when decision-making power is limited to a small group with the requisite skills.
Costs are further limited when there is a single objective (Jensen, 2002). Unlike
shareholders, who have the unitary goal of profit maximization, employees pur-
sue multiple ends, including job satisfaction, security, advancement, and, of course,
compensation. Thus, decisions made by employees are likely to involve some
balancing of these goods through a process that increases decision-making costs.
Moreover, individuals and groups vary considerably in the importance that
they attach to various interests, so that decisions made by employees may involve
protracted bargaining, which further increases the costs of decision making. Henry
Hansmann (1996) observes that collective decision making by employees not only
increases costs but encounters indeterminacy. That is, different outcomes are pos-
sible depending on the choice of procedures. Not only is it more costly, then, for
workers to make decisions than it is for shareholders, but also the decisions made
are less likely to pursue a consistent objective that satisfies everyone.
Worker-managed firms are subject to two specific problems. One, known as
the horizon problem, results when employees have different time horizons (Dow
and Putterman, 1999; Furubotn and Pejovich, 1974; Jensen and Meckling, 1979).6
For example, a choice between higher immediate wages and internal capital
accumulation for the sake of higher wages in the future are apt to be viewed
differently by younger employees and those closer to retirement. Although di-
versified shareholders also have different time horizons, they can usually adjust
their portfolio to match their preferences. The second problem is the commu-
nity property problem, which is due to the reluctance of employees who have
contributed to the accumulated capital of a firm to admit new workers, who
would benefit from the returns without having made a contribution (Dow and
Putterman, 1999; Jensen and Meckling, 1979). Although these problems admit
of solutions, such as individual capital accounts and markets for membership,
these mechanisms are costly and unwieldy and, consequently, have not been
widely adopted (Dow, 1986, 2001; Dow and Putterman, 1999, 2000; Fehr, 1993).

EMPLOYEE GOVERNANCE 9
These theoretical problems correlate with what we know empirically about
the distribution of worker-managed and worker-owned firms. Such enterprises
exist in any great number only when workers are highly skilled, have significant
personal wealth, and are relatively risk averse or are able to diversify (Ben-Ner,
1988a). Industries in which worker-controlled firms are numerous generally do
not require large capital investment, especially for nonredeployable or firm-spe-
cific assets (Dow and Putterman, 1999). They also tend to be in less competitive,
slow changing industries that demand less risk taking. In addition, firms with a
democratic decision-making structure tend to be small in order to overcome
collective choice problems.7
The conclusion to be drawn from this examination of the economic literature
on why capital usually hires labor, rather than vice-versa, is that worker-man-
aged and worker-owned firms involve considerable inefficiencies. This finding
does not diminish the moral desirability of employee governance except insofar
as it indicates the trade-off with efficiency that would be necessary to promote
it. This trade-off is especially significant if firms are to be financed with private
capital in competitive financial markets. Both theory and empirical evidence
indicate that private investors shun worker-managed and worker-owned firms or
demand a premium that significantly increases the cost of capital. This result
can be countered only by other sources of capital, such as public investment, by
legal mandate, such as German codetermination, or by economic conditions that
reduce the comparative inefficiency of employee governance.8
In economic terms, employee governance has the features of a public good—
that is, something desirable, like parks, roads, and police protection, that cannot
generally be secured by market exchange.9 If employee governance is suffi-
ciently desirable, then arguably the trade-off with efficiency ought to be made.
However, the benefit of financing large economic enterprises with the private
assets of individuals is of sufficient value that we should be wary of making this
trade-off. Countries that lack well-developed capital markets or that cannot at-
tract foreign capital are at a significant competitive disadvantage in a world of
global competition. Countries in Europe with legally-mandated employee gov-
ernance are under great pressure to weaken or eliminate these structures in order
to be more competitive.
Labor and Capital as Determinants of Ownership
The concept of ownership is central to an understanding of governance. Un-
derlying the assumption that employee governance consists primarily in employee
ownership or a significant role in corporate decision making is the view that
governance is the kind of control exercised by shareholders. The rights of share-
holders, in turn, are those that are considered to constitute ownership. Thus, it is
generally held that employees can have a governance role only if they are own-
ers of a firm or share some of the rights of ownership.

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However, ownership of a firm is a complex concept that can be expanded to
include employees in their relation to a publicly held corporation. Ownership of
a firm is more extensive than the shareholders’ right of control, and many groups
can be said to exercise ownership or control of a firm. The key to developing a
different conception of employee governance, then, is an expanded understand-
ing of what it means to have an ownership role in a firm.
The ownership role of shareholders is due to the fact that they provide an
input, namely equity capital, in return for certain guarantees for their claim on a
firm’s revenues. However, employees also provide an input, namely labor, and
they do so with guarantees for their claim on a firm’s revenues. Although share-
holders and workers differ in their inputs, they are alike in that each group has a
bundle of rights that includes, first, a claim on a firm’s revenues. However, a
claim on residual revenues as opposed to fixed revenues is not an essential fea-
ture of ownership.10 Moreover, control, the second right held by shareholders, is
not a single, undifferentiated right. Many groups have different kinds and de-
grees of control over a firm. True, the control rights of shareholders are much
stronger than those of any other constituency, but there is no reason to say that
only the holders of these rights are owners of a firm.
Accordingly, ownership should be conceived not as a specific set of rights,
such as the rights to residual revenues and to ultimate control, but as a set of
rights that secures a claim on revenues of whatever kind. If this definition is
adopted, then other groups besides shareholders are owners of a firm. On this
proposed new definition of ownership, employees exercise a form of ownership
that is different from that of shareholders but is appropriate for their contribu-
tion to the productive process. A development of this claim requires, first, an
examination of the concept of ownership as it applies to a firm.
Ownership of a firm is conventionally defined as the rights of shareholders
to the ultimate control of a firm’s assets and to the residual revenues of a firm
(Hansmann, 1996: 11). These rights are conferred in return for providing equity
capital. However, shareholders provide more than capital. By settling for a claim
on residual revenues, they assume the role of risk bearer, and with control goes
the role of decision maker. Both of these roles—risk bearer and decision maker—
are services that are needed by a firm for production. That is, in addition to
securing financing, a firm must obtain the services of individuals who are will-
ing to assume the risk of an enterprise and to make decisions. Although these
roles are separable in the sense that they could be filled by different groups,
equity capital providers generally assume the other two roles, in part because
decision making rights enable shareholders to secure their claim on a firm’s
residual revenues.
This conventional view of ownership is complicated by the fact that each
component of ownership is divisible in the sense that they could be, and com-
monly are, shared among various groups (Putterman, 1993). Typically, a firm
has many sources of capital, each of which entails some form of ownership.
With respect to equity capital, different classes of stock and other investment

EMPLOYEE GOVERNANCE 11
vehicles, such as convertible bonds, lead to different forms of ownership. Debt,
like equity, involves some ownership claims. Thus, Oliver Williamson (1988)
has argued that equity and debt are best viewed not as alternative financial in-
struments but as different governance structures. More important, risk bearing
and decision making are not borne by shareholders alone but are widely distrib-
uted among a firm’s other constituencies.
Ownership is also variable inasmuch as the roles of capital provider, risk
bearer, and decision maker can be assumed in different proportion by various
groups. That is, ownership structures vary depending on whether these roles are
served by many or few and on the proportion of each source of financing.
Many different ownership arrangements are possible, but the particular ar-
rangement for any given firm will generally reflect the factors already noted:
(1) the needs of a firm for capital providing, risk bearing, and decision-making
services, and (2) the preferences of the capital providers, especially with re-
spect to risk, and the agency problems that these preferences create. In short,
ownership arrangements depend crucially on the features of capital providers as
well as the firm itself.
For example, corporations in the United States typically have a diffuse group
of risk-averse, highly diversified shareholders, who delegate virtually all decision
making to directors and executive officers. The well-known phenomenon of the
separation of ownership and control, noted by Berle and Means (1932), is thus
due to the fact that American corporations obtain capital largely from private indi-
viduals who seek diversification. The resulting ownership arrangements are
different from those found in Germany, which reflect highly concentrated owner-
ship by banks and other financial institutions that actively participate in decision
making. The differences show the importance of who provides capital to a firm.
Ownership of a firm is not like ownership of an asset (Schrader, 1996). Rather,
the firm is itself a collection of assets that are owned by those who provide them
for joint production, although the firm as a legal entity also owns assets. Thus,
investors own the capital they provide, and in return for providing this crucial
asset, as well as for assuming residual risk and providing decision-making ser-
vices, they receive a certain bundle of rights that includes a claim on residual
revenues and certain decision-making powers.
The sense in which shareholders own a firm can be generalized as a claim
on a firm’s revenues accompanied by a set of means for protecting this claim.
The claim on revenues is the return for providing some asset needed by the
firm. For shareholders, the means for protecting their claim consist of control
rights that include certain decision-making powers and the benefit of
management’s fiduciary duties.
On this definition of ownership, bondholders are owners inasmuch as they have
a claim on firm revenues for payment of interest and principal. They also have
whatever decision-making powers are provided in the bond covenants, and, in the
event of bankruptcy, they take control of the firm from shareholders. Indeed, bank-
ruptcy may be described as corporate governance under conditions of insolvency.

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12
Admittedly, the rights of shareholders are very extensive and overshadow those of
other groups. The key point, however, is that shareholder rights do not constitute
the whole of ownership. Ownership is shared by other corporate constituencies.
In particular, this definition of ownership can be applied to labor. The con-
ventional view of ownership tends to assume that labor is purchased like
equipment and raw materials in a market. However, labor shares some critical
features with capital. Most notably, it often has great asset specificity, espe-
cially when workers acquire skills and knowledge that make their services of
greater use to their current employer. Such asset specificity produces quasi-
rents, which can be appropriated by either workers or the employer, thus leading
to bargaining over wages.
Because employees’ wages constitute a fixed claim, unlike the residual claim
of shareholders that creates residual risk, it is commonly assumed that employ-
ees bear little risk. However, the insurance that risk bearing by shareholders
provides is not complete. Not only do employees face the possibility of job loss,
but future raises depend on the prosperity of the firm. Because of their limited
wealth and their inability to diversify their job-related income, workers are gen-
erally risk averse, and so considerations of risk influence their willingness to
provide labor to a firm and especially to undertake specialized training. In short,
risk preferences are factors for the providers of both capital and labor.
Labor is most like capital in providing decision-making services to a firm.
Although some shareholders, especially in close corporations, have superior knowl-
edge and skill, decision making on major matters is usually delegated to executive
officers and high-level managers, who are accountable to the shareholders. Large
business organizations could scarcely function, however, without decision mak-
ing on myriad matters at all levels. In general, who makes what decisions in a firm
is determined by two factors, namely information and incentives.
First, the allocation of decision making powers depends on who has the rel-
evant information—or alternatively on what it would cost for others to acquire
that information. Although shareholders usually prefer that information flow
upward so that decisions can be made by managers who are accountable to them,
a cost is incurred that can be avoided by leaving decisions to lower-level em-
ployees who already possess the information. Although hierarchy generally serves
to reduce information costs (Williamson, 1975), some savings can be realized
by adopting less hierarchical structures. This has led in recent years to so-called
“flattened” organizations in which decisions are pushed down to lower levels.
A second, more critical factor is employees’ incentives. Decision-making
powers will be allocated not only to those members of an organization with
superior information but also to those with incentives to increase the value of
the firm. The danger of pushing decision making down in an organization is that
employees will be unable to make decisions due to conflicts among their vari-
ous interests or that they will seek to benefit themselves at the expense of other
groups and the firm as a whole. These problems can be addressed, first, by se-

EMPLOYEE GOVERNANCE 13
lecting the decisions to be made by employees and, second, by creating incen-
tives for employees to make decisions that increase firm value.
From the point of view of the firm, then, labor and capital are both inputs
that because of their asset specificity can be secured only with credible commit-
ments that the providers’ claims on a firm’s revenues will be satisfied. For
shareholders this means that they will receive all residual revenues and that the
firm will be operated to maximize the residual. For employees this means that
wages will be paid, that they will receive some portion of the quasi-rents cre-
ated by their acquisition of firm-specific knowledge and skills, and that they
will share in the prosperity of the firm.
Furthermore, both shareholders and employees bear some of the risk of the
enterprise, although shareholders bear the preponderance and provide insurance
for employees. In addition, both shareholders and employees provide decision-
making services, which are allocated according to the information and incentives
that each possesses. The guiding principle is: Who in a firm is in the best posi-
tion to make decisions that increase the value of the firm at the lowest cost?
From the point of view of each input provider there are two concerns. One is
to satisfy individual risk preferences, and the other is to secure the claims on a
firm’s revenues. Because shareholders have a claim on residual revenues, their
claim is at risk unless they have control, which is to say decision-making power
over the utilization of a firm’s total assets. Although employees have no claim
on residual revenues, they have a fixed claim on revenues for the payment of
wages. Moreover, a firm’s total revenues are variable in the sense that they can
increase or decrease depending in part on employees’ efforts. Employees are
often motivated with an implicit understanding that wages will rise with rev-
enues. Sometimes this agreement is explicit in the form of productivity bonuses.
Thus, employees have some claim on a firm’s variable revenues that is similar
to the shareholders’ claim on residual revenues.
Employees benefit, then, by having decision-making power over decisions that
bear most directly on their claim on revenues. Some decisions of greatest concern
to employees may be reserved for shareholders, such as the question of whether to
relocate production that could result in job loss. However, many decisions of im-
portance to workers are ones that they are in a position to affect. This is true, most
notably, for decisions about the terms and conditions of work. Decisions about
such matters are also ones where employees have superior information, which, if
utilized, reduces information costs. However, the allocation of decision-making
rights must also reflect the agency costs of employee decision making.
In summary, ownership of a firm is not confined to shareholders alone. Every
asset that is contributed to production is accompanied by some ownership ar-
rangement. Each arrangement serves to secure the claim on a firm’s revenues
that constitutes the return for providing an asset. It also allocates the risk-bear-
ing and decision-making functions that must be fulfilled by some individuals in
a firm. The form that ownership takes will be determined, first, by the risk

BUSINESS ETHICS QUARTERLY
14
preferences of the input provider and, second, by the various transaction and
agency costs of the allocation.
Specifically, the provision of labor creates a form of ownership that defines
the relation of employees to a firm. This form of ownership is different from
that of shareholders and coexists with it. Thus, employee ownership and share-
holder ownership are not mutually exclusive alternatives.11 Employee-owned
firms are commonly understood as those in which employees assume the role of
shareholder, but in all firms, the rights of ownership, including decision-making
powers, are distributed among many groups. The matters over which employees
and shareholders have decision-making powers reflect each group’s need to se-
cure its claims and its ability to contribute to the value of the firm.
A Conception of Employee Governance
That employees have a form of ownership and hence a governance role has
been obscured by the assumption that ownership and governance concern the
kinds of decisions over which shareholders ordinarily have control. Employee
governance consists largely of control over the workplace and, in particular, the
terms and conditions of employment. These matters are generally treated in law
as labor relations rather than corporate governance (Charny, 1999: 93). How-
ever, the economic analysis of the relations of shareholders and employees to
the firm reveals many structural similarities.
Most notably, both relationships are formed by market transactions. Corpo-
rate governance can be characterized as the terms that firms offer investors in
order to obtain capital on favorable terms. The relevant transactions take place
in a competitive financial market. Although firms obtain employees in a com-
petitive external labor market, all subsequent transactions take place in an internal
market (Rock and Wachter, 1999). In this internal market, firms must induce
workers to exert maximum effort and to acquire specialized knowledge and skills.
Employees with firm-specific assets are more valuable to a firm than workers in
the external market, but they are also locked into a firm because they usually
cannot obtain the same wages elsewhere. The internal labor market thus has the
features of a bilateral monopoly with an accompanying lack of competition (Rock
and Wachter, 1999).
The problem facing firms, then, is how to structure the relationship with both
shareholders and employees in their respective markets so as enhance the value
of the firm. In solving this problem, a firm must provide sufficient inducement
to each group, allowing for the factors of asymmetric information, risk aver-
sion, and transaction and agency costs. Although different governance structures
emerge from transacting with employees and shareholders in an internal labor
market and a capital market respectively, the same factors are operative.
The resulting governance structures differ to some extent in their legal status.
Corporate governance is largely embodied in statutes and explicit contracts, which
have legally enforceable provisions. Although labor law and union contracts have

EMPLOYEE GOVERNANCE 15
a legal status similar to that of corporate governance, many of the elements of
employee governance are the subject of implicit contracts or are merely en-
trenched practices. Because employees are more deeply involved than
shareholders in the day-to-day operations of a firm and have a much more com-
plex set of interactions with it, their governance role is not easily codified in law
and must rely more on informal mechanisms.12
The matters which are subject to employee governance are primarily the terms
and conditions of employment that bear on workers’ claims on a firm’s rev-
enues. Although employees rarely make actual decisions on such matters, the
managers who do must offer terms and conditions that employees are willing to
accept inasmuch both parties are engaged in market transactions. Similarly, share-
holders do not typically make decisions about corporate governance, many details
of which have already been established in corporate law and in the charter and
bylaws of a corporation. Many specific decisions that affect shareholders, such
as the dividend policy, are also made unilaterally by managers. Nevertheless,
we can understand all of these decisions as the result of bargaining in a market
that allows both parties to contribute to the outcome.
The roles played by both shareholders and employees in the operation of a
corporation are confined largely to specific features of their respective relations
that have been established over a long period of time and are not easily subject
to change. In truth, shareholders are rarely called upon to make decisions about
significant issues. Their control over a firm lies more in the governance struc-
tures that they have accepted, including the delegation of most powers to a board
of directors. Similarly, the control exercised by employees lies less in making
specific decisions and more in their contribution to establishing the general fea-
tures of the employment relation that prevails in most firms. And insofar as
there are marked differences between the employment relations in different coun-
tries, these can be attributed to the different choices that have been made during
a long history of development.
Employee governance is perhaps most evident in the patterns of compensa-
tion that prevail in business organizations (Rock and Wachter, 1999). Generally,
wages are based on job categories and seniority with little attempt to assess the
differences between individual workers’ performance. Increases are gradual,
except for promotions, which increase the level of responsibility. Wages are
usually maintained in periods of declining profits and increased only slightly
when profitability improves. In times of distress, some workers are laid off rather
than subjecting all to pay cuts. In addition, the penalty for inadequate perfor-
mance is usually termination rather than a reduction of wages.
The overall effect of these patterns is to stabilize employees’ compensation
by insulating it from changes in the fortunes of a firm and the vagaries of pro-
duction. If the contributions of workers could be precisely measured and pay
calculated accordingly, then compensation would be more closely correlated
with profitability, which would expose them to more residual risk. Thus, pay for
performance and profit sharing schemes make employees more like shareholders.

BUSINESS ETHICS QUARTERLY
16
Under prevailing compensation patterns, employees are more like bondholders
than shareholders in the security of their return, although they still bear more
risk than bondholders. However, they are unlike both in the respect that the only
investment at risk is their development of firm-specific knowledge and skills,
whereas capital providers can lose the whole of their investment. (Workers may
be exposed to greater risk, though, because they cannot diversify as easily as
investors.)
In addition to the role that employees play in determining the terms and condi-
tions of employment, they also make specific decisions about the utilization of a
firm’s assets. Although this control is more limited in scope than that of share-
holders, who have decision-making power over a firm’s total assets, workers have
a degree of active involvement that shareholders lack. That is, shareholders and
top management may make the major strategic decisions, but employees handle
most of the operational details where they have superior information. These deci-
sions do not generally bear directly on protecting the firm-specific assets of
employees but are more of the nature of discharging their duties to a firm. How-
ever, it is a benefit to employees that they have control over the decisions that they
are best equipped to make. Moreover, part of what employees and shareholders
offer a firm is decision-making services, for which they are compensated—with
wages for employees and with residual earning for shareholders. This compensa-
tion is best secured when decision-making power over any given matter is assigned
to the party that can best increase the value of the firm.
The Practical Implications
Those who advocate employee governance as a morally preferable alterna-
tive to shareholder governance generally assume that any trade-off with efficiency
is minor and easily accommodated. However, an explanation of the lack of
worker-managed and worker-owned firms in a free-market economy reveals the
significant problems that they encounter. The fact that workers could take con-
trol of many firms but almost always choose not to suggests that the benefits are
not worth the costs.13 In particular, employees are understandably reluctant for
their pay to vary with the fortunes of an enterprise.
Advocates also assume that these two forms of organization are in conflict.
Indeed, they are incompatible if employee governance is understood to confer
on workers the rights of ownership that are commonly accorded to sharehold-
ers. However, employee governance need not be in conflict with shareholder
governance, given a full understanding of ownership. On such a view, every
asset provided to a firm is accompanied by an ownership structure that entails
some set of rights. These rights include a claim on a firm’s revenues and control
of certain assets. The major factors that determine the specific form of owner-
ship are asset specificity, information asymmetries, risk preferences, and
transaction and agency costs.

EMPLOYEE GOVERNANCE 17
On this view of ownership, employees and shareholders are alike to the ex-
tent that they provide some asset to a firm and thus have some form of ownership.
However, the differences with respect to the determining factors are substantial.
As a result, firms in which workers have the rights that ordinarily belong to
shareholders are relatively rare, and the employee governance that firms exhibit
is markedly different from shareholder governance. Instead of conflicting, then,
the two forms of governance are complementary and mutually beneficial. In
particular, decision making is shared in such a way that the two groups make
decisions on matters where they have superior information and an incentive to
increase the value of the firm. Their respective forms of governance also fit the
need of each group to protect their firm-specific assets and to satisfy their risk
preferences.
This view of ownership has important practical implications. First, traditional
efforts to increase employee governance by promoting worker-managed and
worker-owned firms are unlikely to succeed in a free-market economy. These
kinds of enterprises will continue to exist in niches where they are economically
viable, but their numbers cannot be easily expanded without legal mandates or
public investment. Moreover, increasing employee stock ownership through
pension plans and ESOPs serve primarily to increase workers’ risk without con-
ferring significant power.
The impetus for these changes comes from a conception of ownership that is
modeled on shareholder rights. The underlying assumption is that employees
can play a role in governance only if they become more like shareholders. How-
ever, this view overlooks the differences between shareholders as capital
providers and employees, who provide labor, and fails to appreciate the inter-
ests of employees and the best means for protecting those interests.
Second, a far more effective strategy for enhancing the governance role of
employees in publicly held corporations is to build on the new conception of
ownership developed in this article. In addition to recognizing the extent to which
employees already exercise a form of ownership in a firm, steps can be taken to
strengthen the bargaining position of employees and enlarge the sphere of their
decision-making power.
One possibility is increasing the investment in human capital, which is the
asset that gives rise to employees’ ownership rights. Just as corporate governance
is the set of rights that firms offer investors in return for equity capital, employee
governance consists of the terms that workers require for providing skilled labor.
Consequently, the more essential capital and labor are for production, the greater
the ownership rights that the provider of each can command. Economists have
focused primarily on wages as a means for attracting labor, but doing so neglects
the bargaining that takes place in the internal labor market over matters of con-
cern to employees. Investors are concerned with good corporate governance
because of its bearing on their expected return. Similarly, employees consider
employee governance as a factor in the security of their wages.

BUSINESS ETHICS QUARTERLY
18
Employee governance can also be enhanced by reducing the transaction and
agency costs and the information asymmetries that currently stand in the way.
This can be achieved, in part, by creating conditions that solve the problems of
collective choice and give workers the right incentives. David Charny (1999)
suggests that these conditions can be produced only by “culture,” which he de-
fines as the shared beliefs and social norms that influence members of a firm. A
supportive culture may also require background institutions and social welfare
entitlements that can be created only by political action. Consequently, the mar-
ket alone may not be sufficient to generate significant employee governance.
Whether employee governance is a moral ideal remains an open question. It
may be that workers are better served by a prosperous economy in which they
can easily change jobs and have other sources of support. However, to the ex-
tent that employee governance is morally desirable, we should abandon traditional
strategies to increase worker management and worker ownership and seek out
innovative means that are built on a concept of ownership that is appropriate for
the assets that workers provide. Instead of assuming that a firm can be owned
only by one owner and asking whether it should be employees or investors, we
should recognize the ownership rights that both have in a firm and seek forms of
governance that benefit both groups.
Notes
This article was prepared as the Rector Dhanis Chair Lecture, University of Antwerp (UFSIA),
Antwerp, Belgium, delivered April 29, 2002. My thanks to Jef van Gerwen, S.J., and to the
economics faculty of the University of Antwerp for the gracious invitation to serve as the
Dhanis chair and for their many helpful comments.
1 Although the term “employee governance” is not in common use, it is employed here to
cover a wide range of proposals for greater employee involvement in the workplace. This
usage agrees with that of Rock and Wachter (1999: 150–151), who use the term to describe
the range of decisions that employees “discuss with the firm.” In this usage, employee gov-
ernance is not incompatible with shareholder governance inasmuch as both groups participate
in decision making, although the range of decisions is different for each group.
2 Such a dual system of traditional capitalist and worker-controlled firms is explored in
Krause and McPherson (1986). Some would argue that the law provides adequate provision
for worker-controlled firms (Hansmann, 1996) and that their rarity is due to a refusal by
workers to take part. However, Krause and McPherson consider the current legal provision
to be inadequate.
3 The question is also stated in the economic literature as “Why do hierarchies exist?”
See Coase (1937); Alchian and Demsetz (1972); and Williamson (1980). This question is
similar to “Why does capital usually hire labor?” because capitalist bosses generally operate
by command whereas employee owners are assumed to be more cooperative.
4 For a fuller account of these objections, see Putterman (1984), pp. 173–175.
5 The cost of decision making is a major theme in Hansmann (1996).

EMPLOYEE GOVERNANCE 19
6 A horizon problem also results if, as Jensen and Meckling (1979) claim, worker-owned
firms have less incentive than shareholder-owned firms to make investments that will yield
profits only in the distant future. However, Hansmann (1996: 80) does not believe that this is
a significant impediment to employee ownership.
7 For a list of the conditions under which labor-managed and labor-owned firms may be
expected to perform well, see Dow (2001), pp. 214–215.
8 Countries in which worker-owned and worker-managed firms are prominent, such as
France, Italy, and Spain, are also characterized by inefficient capital markets, so that these
kinds of firms are at less of a competitive disadvantage relative to similar firms in countries
with more efficient capital markets.
9 Employee governance is a public good only if it has social benefits that affect other
groups besides employees. However, Pateman (1970), Dahl (1985), and Bowles and Gintis
(1986) all stress the importance of corporate democracy in developing a democratic society.
10 It is in virtue of having a claim only on residual revenues that shareholders seek con-
trol as the most effective means of protecting this claim, but one can imagine a system of
corporate governance in which the owners have nonresidual claims as well. Indeed, in bank-
ruptcy, bondholders and creditors, who do not have a claim on residual revenues, become the
owners of firm.
11 Rock and Wachter (1999: 124) speak of employee and shareholder governance as par-
allel and say that they “should not be thought of as opposites, but rather as deeply
complementary activities.”
12 Charny (1999: 117) argues that because employees have the power to withhold coop-
eration, they “may be largely indifferent to whether their commitments are enforced by legal
or nonlegal sanctions and may rely on nonlegal sanctions even when legal ones are in place.”
This suggests, he says, that “the decision to embody [employee] governance devices in le-
gally enforceable form is of secondary importance.” Rock and Wachter (1999: 127) note that
relationships in an internal labor market tend to be self-governing or norm-governed as op-
posed to being subject to legal arrangements.
13 As Drucker (1976) has observed, employee pension holdings would be sufficient, in
many cases, to take control of the employing company. However, Drucker’s prediction of
“pension-fund socialism” has not come to pass, in part due to the risk that employees would
be taking. Moreover, any time employees could operate a firm more efficiently than the
current managers, they should be able to find investors willing to back them in a takeover.
The fact that such employee buyouts seldom occur suggests that few groups of employees
could make a convincing case to investors, even if they were willing to assume the risk
(which most would not).
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