The Democratic Firm



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Chapter 5: Employee Stock Ownership Plans




ESOPs: An American Phenomenon


After a century of unionism in America, only about 15 per cent of the nonagricultural workforce is unionized and that percentage is declining. In only a decade and a half, ESOPs have spread to cover about 10 per cent of the workforce and that percentage is climbing. Clearly something signifi­cant is happening.

Employee ownership has so far not become a parti­san issue in America or the United Kingdom. Publications favorable to ESOPs in the UK have been recently promoted by the conservative Adam Smith Institute [Taylor, 1988] and by the Fabian Research Unit [McDonald, 1989]. In America, ESOPs draw support from across the relatively narrow political spectrum. While there is strong conservative sup­port for ESOPs, the right wing in America has not been a strong sup­porter of worker empowerment. That suggests most ESOPs have not been a form of worker empowerment. What then does drive the current ESOP movement in the minds of conservatives and moderates?

One motive cited by conservatives and moderates is the maldistribution of wealth and income. For instance, over half of the personally-held corporate stock is held by the top one per cent of households [with similar statistics hold­ing in the UK, see McDonald 1989, p. 10]. Conventional capitalism is characterized as a “closed-loop financing system”—in other words, the rich get richer and the poor get poorer. New wealth accrues primarily to equity ownership, so until workers get in on equity ownership, they will remain permanently outside the loop. Thus the idea is “Capitalism—Heal Thyself.” ESOPs are the prescription.

The developer of the leveraged ESOP idea, Louis O. Kelso, ESOPs as demo­cratic capitalism [see Kelso and Kelso, 1986]. There is much pressure to use the word “democratic” in America. The adjective “democratic” is sometimes used to mean anything that can be spread amongst the common people without discrimination—like the common cold. The wealth redistri­butive purpose of ESOPs is to give the common people a “piece of the action” and thus to make capitalism more “democratic” in that sense.

But other motives seem to have hitched a ride on the redis­tributive bandwagon. By investing workers with owner­ship, workers may be weaned away from unions. In fact many of the ESOPs designed as the opposite of workplace demo­cracy would leave workers without any form of collective decision-making and action.

Many ESOPs are set up in small to medium-sized family-owned firms which are seldom a hot-bed of unionism. The founder, or his family, want to cash out at least over a period of years. The traditional route has been to sell to a large firm—which left the loyal employees with an uncertain fate. The alternative of getting tax breaks by selling to the workers through an ESOP is thus motivated by a tax-sweetened paternalism. ESOP consultants sometimes use the pitch, “Here is how you can sell your company and still keep control of it.”

When hostile takeovers are a possibility (as in the USA in the 80’s), large firms turn to ESOPs for rather different reasons. With an ESOP, a sizable block of shares is in friendly hands so a hostile takeover is that much more difficult.

The takeovers seem driven less by real efficiency gains than by the short-term profits obtained by redrafting in the company’s favor all the implicit contracts with the employees, the (non‑junk) bondholders, and the local communities. The long-terms effects are anti-investment; they work against company investment in employee training or in new product development, against the investment of non-junk long-term capital, and against state and local government investment in infrastructure development for (now outside-controlled) companies.

Some unions have embraced ESOPs, but only after a shotgun marriage. The long-term decline of the unionized steel industry has forced workers to take their fate more and more into their own hands. The success of Weirton Steel, a 100 per cent ESOP buyout from National Steel, has been one of the brightest spots in employee ownership during the 1980’s.

Unions have found common cause with management on using ESOPs as an anti-takeover device. If the company is going to become heavily leveraged to prevent a takeover (e.g. to buy back shares), then the employees might as well be earning shares for themselves as they tighten their belts to pay off the company debt. Recently the unions led the ESOP buyout of United Airlines, one of the largest airlines in the world.

Employee ownership offers American liberals an almost unique opportunity to be pro-worker without being anti-business. We are witnessing the drawing to a close of the era of America’s economic prominence based on the vitality of its market economy and its endowment of unexploited natural resources in the New World. In the finely-tuned competitive environment of today’s inter­national marketplace, American industry can ill-afford the inherent “X-inefficiency” of the firm organized on the basis of the us-vs.-them mentality of the employer–employee relationship [see Leibenstein 1987]. A new cooperative and participative model of the enterprise is needed where the workers are seen as long-term “members” rather than as “employees.” Many forward-looking American liberals and progressives see worker ownership as the natural legal framework for that new model of the enterprise.

There have thus been many reasons for the ESOP phenomenon and for the widespread political support. To further analyze the ESOP contribution, we must turn to a closer description of ESOPs.


Worker Capitalist Corporations


A worker-capitalist corporation is a company where the conventional ownership bundle remains as a bundle of property rights, that is, as capital (not partially restruc­tured as personal rights) and those property rights are owned by the employees of the corporation. Instead of directly working for themselves, the workers own the capital that employs them.

In a worker-capitalist firm, the employee might own the shares directly or only own them indirectly through a trust such as an Employee Stock Ownership Plan or ESOP. Before considering these two forms, it should be noted how worker-capitalist firms violate the democratic rule of one vote per person and do not allocate the net income in accordance with labor.

Votes are conventionally attached to shares, and different employees will usually own widely differing numbers of shares (different longevity, pay rates, and so forth). The votes will be as unequal as the share distribution. The voting rights are part of the property rights attached to the shares so it is the shares that vote, not the people. The shareholders don’t vote them­selves; they vote their shares.

In any capitalist firm, worker-owned or absentee-owned, the net income ultimately accrues to the share­holders either in the form of share dividends or capital gains (increased share value). Both dividends and capital gains are per share so they are proportional to the share­holding of the employees, not their labor during the fiscal year.

Before the development of ESOPs, there were sporadic examples of worker buyouts that established worker capitalist firms where the workers directly owned all or a majority of the shares. When the shares are directly owned by some or all of the employees, the employee ownership tends to be a very temporary characteristic of the company—at least in a full-blown market society. If the company succeeds, the share value rises so the workers and their shares are soon parted. The Vermont Asbestos Group and the Mohawk Valley Community Corporation were examples of pre-ESOP worker buyouts in the 1970s. Within three to five years, managers or outsiders had purchased majority control in both companies.

Employee-owned corporations are more stable if the shares are indirectly owned through a trust as in the employee stock ownership plans (ESOPs). In an ESOP, each employee has an account which keeps track of the employee’s capital. The shares represented in the accounts are held in the trust so the employees cannot sell them. The employees only receive the shares upon leaving the company or retirement, and even then the company usually buys back the shares to maintain the employee-owned nature of the company.

In a conventional ESOP, the voting and profit rights are distributed to workers—not according to their labor—but according to their capital. The voting is on one per share basis, and workers and managers can own widely differing numbers of shares depending on their pay scale and longevity with the company. The profits accrue to the employee-shareholders either as dividends or as capital gains (realized increase in share price) and both are proportional to the number of shares held, not the labor performed by the worker.

Origin of ESOPs


The original architect of the ESOP was a corporate and invest­ment banking lawyer, Louis Kelso, who has co-authored books entitled The Capitalist Manifesto, How to Turn Eighty Million Workers Into Capitalists on Borrowed Money, and Two-Factor Theory. The conservative but populist aspects of the Kelso plan appealed to Senator Russell Long (son of spread-the-wealth Southern populist, Huey Long), who pushed the original ESOP legislation through Congress and continued to spearhead the ESOP legislation (e.g. the Tax Reform Act of 1984) until his retirement from the Senate.

An ESOP is a special type of benefit plan authorized by the Employee Retirement Income Security Act (ERISA) of 1974. As in any employee benefit plan, the employer contri­butions to an ESOP trust are deductible from taxable corporate income. But, unlike an ordinary pension trust, an ESOP invests most or all of its assets in the employer’s stock. This makes an ESOP into a new vehicle for worker owner­ship but it is not a substitute for a diversified pension plan.

ESOPs have received strong tax preferences so for that reason, if for no other, their growth has been signifi­cant. From the beginning in 1974, 10,000 ESOPs sprung up in the United States covering about 10 per cent of the workforce (in compari­son, about 15 per cent of the workforce is unionized). There are perhaps 1000 ESOPs holding a majority of the shares in the company. However, only 50–100 of the ESOPs have the demo­cratic and cooperative at­tributes such as one-person/one-vote as opposed to one-share/one-vote. The overwhelming majority of ESOPs are designed by managers to be controlled by manage­ment and the lenders (at least for the duration of the ESOP loan).

The main tax advantage to the company is the ability to deduct the value of shares issued to an ESOP from the tax­able corporate income. The Tax Reform Act of 1984 has increased the tax-favored status of ESOPs for companies, owners, and banks. The taxable income to a bank is the interest paid on a bank loan. On a loan to a leveraged ESOP, 50 per cent of the interest is now tax-free to the bank. Dividends paid out on stock held in an ESOP are deductible from corporate income (similar to an existing tax benefit of cooperatives) whereas dividends in conventional corpora­tions come out of after-tax corporate income. If an owner sells a business to an ESOP (or a worker-owned cooperative) and reinvests the proceeds in the securities of another business within a year, then the tax on the capital gains is deferred until the new securities are sold. These tax breaks have made the ESOP into a highly favored financial instrument.

Due to the strong tax preferences to the firms as well as to lenders, most large-sized worker-owned companies in the United States are organized as ESOPs. However, the trans­action costs involved in setting up and administering an ESOP are large, so the cooperative form is often used for smaller worker-owned enterprises. The ESOP structure al­lows for partial employee ownership—whereas a coopera­tive tends to be an all-or-nothing affair. Indeed, most ESOPs are hybrid companies which combine employee with absentee ownership. The average ESOP company has less than 20 per cent employee ownership [for a review of the ESOP literature and research, see Blasi, 1988].

Structure of ESOP Transactions


In the leveraged ESOP transaction, the corporate employer adopts an employee stock ownership plan (ESOP) which includes a trust as a separate legal entity formed to hold employer stock. The ESOP borrows money from a bank or other lender (step 1 in diagram below), and uses that money to purchase some or all of the employer stock at fair market value (steps 2 and 3). The loan proceeds thus pass through the trust to the employer, and the stock is held in the trust. Ordinarily, the company guarantees repayment of the loan by the ESOP and the stock in the trust is pledged to guarantee the loan.

Over time, the employer makes contributions of cash to the ESOP in amounts needed to repay the principal and interest of the bank loan (step 4) and the trust passes the payments through to the bank (step 5). Thus, the employer pays off the loan gradually by repayments to the lender through the ESOP—payments that are deductible from taxable income as deferred labor compensation. This deduc­tion of both interest and principal payments represents a significant tax advantage since the employer ordinarily can deduct only the interest payments. The implicit cost of the tax break to the original shareholders is the dilution of their shares represented by the employee shares in the ESOP.


A Standard Leveraged ESOP



An ESOP can also be used to partially or wholly buy out a company from a private or public owner. This is called the “leveraged buyout transaction.” Taking the previous owner as the government, the ESOP borrows money (step 1 in diagram below) and the loan payments are guaranteed by the firm with the purchased shares as collateral. The shares are then pur­chased from the outside owner, such as the government, with the loan proceeds (steps 2 and 3)—instead of buying newly issued shares from the company.

Leveraged Worker Buy-Out from Outside Seller


Again the firm makes ESOP contributions which are passed through to pay off the loan (steps 4 and 5). A variation on this plan is for the seller to supply all or some of the credit. By combining the functions of the bank and government in the above diagram, we have the “pure credit” leveraged buyout transaction.

Two Examples of ESOPs


One of the best-known world-wide companies that is employee-owned through an ESOP is the Avis car rental company. After going through five different corporate owners in eleven years, Avis was sold to an ESOP in 1987 for a little less than $2 billion dollars. Avis has added involvement to the bare bones of ownership with its employee participation group system. Before the buyout, Avis used the advertising slogan "We try harder"; after the buyout the slogan was "Owners try harder." After the buyout, profits increased from $16 million to $79 in the first year and to $93 million in the following year.

Today the biggest ESOP in America is also a well-known world-wide company, United Airlines. In 1993, two out of the three unions and the non-union employees agreed to a plan to reduce wages and benefits in the amount of about $5 billion dollars over the next five to six years. In exchange, an ESOP would received at least 55% of the shares with the remainder being still publicly traded. The workers' 55% of the shares were purchased with money from a package of loans to be paid off over the next six years. United, like Avis, uses employee ownership as a force in its advertising program. In American, the low morale of employees in conventional companies is sometimes expressed in the phrase "We just work here." United started its pride of ownership campaign with pictures of employee-owners saying "We don't just work here."


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