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Lessons from the Labor Markets

In general, most CEOs accept the basic proposition that free competition in both capital and labor markets is the surest road to social prosperity and business success. Speaking in the most general terms, U.S. capital markets (with the notable exception of SarbanesOxley) are freer now than they were 50 years ago. Labor markets are not. Without question, labor markets were severely compromised by two major 1960s legislative reforms, seemingly unrelated at the time. The first is the expansion of the class action, both in federal and state courts. The second is the ever-greater regulation of the employment relationship, particularly through the modern antidiscrimination law, which has carved a huge hole in the principle of freedom of contract.

Let’s start with the substance and then turn to the procedure. The great engine of U.S. economic productivity rests on the ability of employers and workers to set mutually agreeable terms on wages and conditions, largely without state intervention. Freedom of contract in labor markets creates a win-win situation. The employer values the worker’s services more than the salary it pays; the worker values the salary and the opportunity more than the demands of the job.

The parties are the sole judges of their own interests, and they are protected against exploitation by being able to quit or fire without explanation-on what is commonly termed a “contract at will.” The contract at will has many vocal critics today. Their central complaint is that this arrangement is the outgrowth of un-equal bargaining power that leaves the worker with little or no job security. That bargaining power conception is largely incoherent, however, because it cannot explain how supply and demand come into equilibrium, or why wages rise when supply is tight.

Unfortunately, catchy phrases often lead to unwise proposals, in this instance a legal rule that allows firms to fire workers only “for cause,” a term which sounds a lot clearer on paper than it turns out to be in practice. Unfortunately, this proposal would create a de facto civil service that would make it impossible to reconfigure work forces to meet the challenges of a fast moving marketplace. Nor does this proposal help workers as a class. In my view, their best protection against employer abuse lies in their ability to switch jobs.

Ideally, all protections for both the firm and the worker should depend on a fair reading of the labor contract in its social setting, not on external state commands that impose nonwaivable obligations on the parties. That older, largely judge-made system is easy to understand and cheap to operate, and it avoids the greatest peril that managers have to face: being second-guessed in court years after any disputed personnel decision is made.

In general, that view has not prevailed in the U.S. Yet, ironically, our labor markets are less regulated than those, say, of Europe—where employees in France work a maximum 35-hour workweek—that have led to civil-service-like rigidities in private firms, coupled with management versus labor strife, both leading to the endemic levels of high unemployment. 

Employment Discrimination Laws

Nonetheless, outdoing the Europeans hardly amounts to a clean bill of health. Let’s look at the key development of the 1960s: The antidiscrimination laws based on race and sex joined shortly thereafter by prohibitions based on age and disability. On their face, the protection these laws extend to “any individual” seems to limit the ability of firms to adopt voluntary affirmative action. Indeed, most CEOs have consistently supported carving an exception for these programs into the civil rights laws, and for good reason: They amount to a partial repeal of the 1964 Act that increases a firm’s control over its own hiring.

Yet other developments under the 1964 Civil Rights Act and its progeny should, and do, send shivers down the spine of any responsible CEO. I am not concerned here particularly with “animus-based” discrimination, which constitutes only a tiny fraction of the current civil rights docket. No, the rubber hits the road when any firm practice is said to exert a disparate impact that appears to disfavor members of a protected group such as racial minorities, women, people over 40 and disabled persons. The working judicial assumption is that bias, not worker preferences or worker performance, accounts for the skewed impact. The firm has to show virtually a perfect correlation between the practice and some conception of workplace merit. In practice, this burden is very hard to discharge.

In my view, that presumption of discrimination in disparate impact cases is the wrong way to look at labor markets. Often it is invoked even against firms that have overt affirmative action programs, when there is no hidden agenda of discrimination to smoke out. Nor does gratuitous discrimination make sense. It is costly to hire and train new workers. Smart businesses always prefer carrots, like pay raises and promotion, to sticks, like stagnation, demotion or dismissal. It is dangerous business to assert in litigation, for example, that men and women want different things out of their employment relationships. The initial suspicion of firm motives means that any individual lawsuit alleging employment discrimination involves a major commitment of time and effort to review, and then to explain to a jury, every aspect of performance, payment and promotion. These suits send shudders through the executive suite because of the corrosive effect on corporate morale. 

Class Action Synergy

Matters only get worse because of the unfortunate synergy between class action employment discrimination cases. The major 1966 class action reform had relatively modest ambitions, to allow class actions whenever common issues dominated litigation. The paradigmatic case was, for example, the denial of dividend payments to a given class of shareholders, all of whom are similarly situated vis-à-vis the firm. But resourceful lawyers and compliant judges kept expanding the types of cases amenable to class action relief.

Consider a recent class action lawsuit that Lorene F. Schaefer filed against General Electric. Schaefer claims her recent demotion after favorable reviews showed that she had collided with GE’s “absolute glass ceiling.” Her complaint details why her demotion, after 13 years of success and promotion, reflected so ill on GE. Her suit joins key members of the GE management team, including CEO Jeffrey R. Immelt. After Schaefer details her own case, she adds the kicker that her grievances are not individual but structural, which makes her the appropriate class representative for all GE’s female “executive band,” or upper echelon, employees and all its female lawyers regardless of rank. All this takes place without uttering a word about the dissatisfaction of any other female employee.

GE’s highly complex internal structure, with seven different divisions, necessarily relies on decentralized control, which cries out against class actions. The common issues are few and far between on complex personnel matters. But knowledgeable plaintiffs’ lawyers think they have a fair shot of certifying all or part of this mass as one huge class action. 

What Next?

The battle is fought on two fronts. The internal management strategy, which can be unilaterally implemented, requires all large firms to rigorously document every personnel decision to rebut any inference of discrimination. Similarly, firms should be wary of giving extravagant praise to any individual employee lest it undermine the company’s position in any subsequent litigation. Sound crazy? Well, it is-for any rational firm that relies on informality for and praise for motivation of its top people. Just as Sarbanes-Oxley has created a “compliance culture” for investment decisions, so the modern employee class action creates a similar culture for personnel matters.

On the external side, there is no real prospect of easing employment discrimination laws. CEOs might organize a campaign to curb class actions in employment disputes, or even knock out class actions for highlevel employees altogether. The securities class action reforms in 1995 and the Class Action Fairness Act of 2005 suggest the law here is fluid, and some motion possible. After all, mega-suits like Schaefer almost make CEOs pine for the European system, which does not presently allow employee class actions.

And remember, any relaxation of class actions will help across the board. More forgiving labor laws will encourage CEOs to take risks, which is far more valuable to women and minorities as a group than the class actions which benefit, at best, a tiny fraction of that population at the expense of a far larger labor market.

Richard A. Epstein, the James Parker Hall Distinguished Service Professor of Law and the Peter and Kirsten Bedford Senior Fellow at The Hoover Institution, is the author of Forbidden Grounds: The Case Against Employment Discrimination Laws.


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