The Economics of ESOPs--Posner's Comment

I share Becker's concerns with the favorable tax treatment of employee stock ownership plans. Such treatment would be justifiable only if such plans conferred benefits on society that could not be generated more cheaply by other means. Proponents of the law that authorized ESOPs and conferred favorable tax treatment on them argued that ESOPs would unlock a new source of capital—namely workers, who contribute capital to the corporations that employ them when they take part of their compensation in the form of participation in an ESOP. But there is no shortage of capital, so no justification for subsidizing investment in corporate stock. If anything, ESOPs can be criticized from an overall social-welfare standpoint as an antitakeover device that we do not need: workers are unlikely to vote for a takeover, as it might jeopardize their jobs. As Becker points out, abolishing the favorable tax treatment of ESOPs would permit a market test of this form of corporate governance. (In confining my discussion to cases of governance, I focus on situations in which, as in United Air Lines before its bankruptcy, or the proposed reorganization of the Tribune Company, the ESOP owns all or a controlling amount of the common stock of the corporation.) I believe that it would usually flunk the market test. Granted, the ESOP has an advantage over the conventional worker-owned firm: the value of a firm's capital stock is the discounted present value of its expected future earnings, so that a worker who owns ESOP shares has, at least in his role as part owner, the same horizon as the corporation itself, rather than the truncated horizon of the worker in a conventional worker-controlled firm (a cooperative), who cannot benefit from anything the corporation does after he retires and who consequently has no financial stake in maximizing the corporation's present value. But this advantage of the ESOP over the conventional worker-controlled form will usually be modest. A worker will trade off any long-term benefits to the corporation from a corporate action that would increase the value of his shares against whatever short-term benefits, in the form of a higher salary or greater fringe benefits or a lighter workload, an alternative course of action would confer on him; and usually the tradeoff will favor increased compensation for work over increased stock value. It is true that to be entitled to the tax benefits of the ESOP form, the workers' shares must be placed in trust, and the trustee must vote them to maximize share value; he cannot trade a lower share value for higher employee compensation of the worker owners. (And so he cannot oppose a takeover that would maximize share value, even if it would do so by laying off many of the workers.) If the favorable tax treatment of ESOPs were abolished, there would be no requirement of placing ESOP shares in trust. But that would still be an attractive choice for the ESOP in order to reduce the misalignment of incentives in conventional worker-controlled firms. But overcoming the problem of incentive incompatibility would not create an affirmative reason for a worker to own shares in the corporation that he happens to work for rather than in some other corporation, a mutual fund, etc. Becker rightly rejects the notion that having an ownership interest closely aligns a worker's incentives with those of the corporation. Unless the corporation is very small, which obviously is not the case with United Air Lines or the Tribune Company, the efforts of an individual worker will not have a significant effect on the market price of the corporation's shares and hence on the worker's wealth. Of course, some workers may not realize this (they may exaggerate the contribution that their working harder would make to the firm's bottom line); or they may, by virtue of being "owners," become altruistic toward "their" company; but such workers would be likely to buy shares in the company voluntarily (or take part of their compensation in the form of shares), without all the workers having to do so. The ESOP has one genuine advantage over the conventional corporate form, an advantage that played a role in the decision to convert the ownership of United Air Lines to an ESOP. It can smooth labor relations by increasing the cost to workers of striking or otherwise pressuring the corporation to incur greater labor costs. Even though, as I have suggested, workers' work-compensation gains will usually exceed the losses in share value that will result from the corporation's greater labor costs, their demands will be moderated by the cost to them in lower share value. This depends however on the shares being held in trust, so that the workers' interest as workers is not reflected in how the shares are voted; otherwise workers may use control of management to increase rather than moderate their demands for employee compensation. But as I have said, the trust format could be retained even if it were no longer required. Against the possible (tax-independent) advantages of the ESOP form stands the powerful disadvantage of underdiversification. The shares in their employer's ESOP are likely to be the principal financial asset of the workers. If they are risk averse, they will be bearing uncompensated risk by holding an underdiversified portfolio. The consequences were dramatically demonstrated by the United Air Lines bankruptcy. The trustee was sued for not having sold United stock before the collapse, but because the purpose of an ESOP is to hold stock in one company, namely the employer of the participants in the ESOP, an ESOP trustee does not have the usual trustee's duty of diversification; what exactly his duty is to protect the participants against excessive risk is unclear. A further complication is presented by employee turnover. An employee who quits and goes to work for some other employer cannot remain a participant in his former employer's ESOP. His shares must be redeemed—but at what price? If the ESOP owns all the common stock in the employer, the fixing of a redemption value will be awkward. If it is too low, this will reduce the value of the shares to other employees who anticipate quitting at some future time; if too high, it will reduce the value of the shares by diminishing the corporation's assets, out of which the price to redeem departing employees' shares is paid. Still another complication is reconciling the competing interests of different classes of ESOP shareholder, such as active and retired employees. To summarize, were it not for the favorable tax treatment of ESOPs, one would not expect the device to be common except in small corporations (and perhaps not even there, since the partnership and the closely held corporation provide attractive alternative governance forms) and in some firms that have particularly troubled labor relations.

Comments

[Corey]

As I said on the Becker side, most workers aren't holding portfolios at all, nor do they have extra cash to buy shares on their own. I will take an undiversified portfolio over no portfolio any day, thank you.

With the favorable tax treatment, a worker's salaray needn't be dropped as much as the ESOP shares are potentially worth. If the company breaks even or does well, there will always be a net gain from the employee's point of view. (I have participated in several ESOP plans as a computer engineer.) If the company collapses, the worker is jobless and stockless either way.

What you both seem to be saying is, "no we won't let you workers have stock, because then you will feel worse when we fire you and also take the stock back." Apart from being uncharacteristically paternalistic re: the investment strategies of workers, your approach uses a strawman "diversifying-worker" that doesn't exist. The crucial choice facing a worker is between company stock or no stock. On an individual basis, workers aren't holding enough shares to make diversificaton worth the fund management overhead anyway. Suits against the ESOP trustee in bankruptcy are no more wasteful than derivative suits against management after stock collapses in more traditional firms. Both are ways of leveraging for interests that might not otherwise have a seat at the negotiation table.

ESOPs should be embraced by capital as the new form of labor capture that they are. Company towns are no more, pension plans are no longer tied to companies, but you can still make engineers work 80 hour weeks with term-vesting stock options of suitable size.

[Jack]

Whew! Where to begin? As Becker and Posner reveal enough of their establishment bias to raise a soul from the dead?

For now, I'll just take the part about employees not voting for a corporate merger/takeover that would endanger their jobs. Blasphemy! Indeed, the role of opposing a merger that would endanger one's job "really" should be that of top management while the role of the employees shall be "only a pawn in their game."

Also, if the employee's are thought to be wise enough to spot a takeover that endangers their jobs, surely they'd be wise enough to favor a merger that was beneficial to their ESOP owned company and that would enhance their career opportunities.

Let's see, then there is that crimson herring of a larger company providing too little ownership benefits to be an incentive to work harder ---- and dare I mention? smarter? No! Those small benefits really must be combined in one large pile so the corporation can afford to compete for a competent CEO, the fee for which has risen from 80 times worker pay to over 500 times since the onset and continuation of "Reaganomics" in 1980.

Wait! Can I take one more? The claim that studies do not confirm ESOPS being managed any better than traditional ownership forms? Ah! Then also true is that they are not managed any worse either?

Had we a far higher percentage of ESOP owned companies over the last 25 years could we at least speculate that total compensation for the working bloke would not have fell at such a rapid rate relative to top management and large stockholders than has been the case?

[N.E.Hatfield]

ESOP's, a solution to the age old animosity between Labor and Capital? ESOP's seem to be a good idea, in principle. They seem to make every one feel all warm and fuzzy inside. But, are they a good, Becker has pointed out the potential problems of investment diversification and employee effeciency and the like. Posner on the other hand has pointed out potential problems with social benefits especially in their angle. There is perhaps a third problem, based on the manner in which ESOP's are organized and set up that can lead to abuse and leaving the employees holding the bag in a massive corporate stock sell out to them of a failing company.

The basic organization is as follows;

1. loaner bank
2. the company
3. selling share holders
4. the ESOP trust
5. the employees

Basically, 1,2,3 place into and take out of 4. No. 5 gets its stock from 4 (and the process dead ends at this point). If the company is strong and viable, all is well and good. If not, and the company is shaky or weak in the midst of collapse, No. 5 gets stuck with essentially worthless paper and 1,2,3 walk away with the cash. My advice, beware and make sure that the company is strong and viable before agreeing to go ESOP.

[Jack]

Hat......... Good advice. Selling pigs in pokes is a long tradition! And I'm hoping that United's out going CEO will manage to make ends meet with his gleanings. On top of all else having his dues paid for life at a tony country club while ticket agents with 15 years in were sent packing with but two weeks severance is a truly ugly picture.

But, both myself and Warren Buffet think the whole market is primed for "bagholders". I think he has $60 billion in cash instruments as he's not been able to find any worthy investments. I have a somewhat smaller amount that's not seeing much either.

More seriously, corporate employees are seeing the fruits of their labors being squirreled away by top management and perhaps the stockholders (ala Walmart?) as well. Posner & Co seems not to hold the prospective ESOP employees in very high esteem, but surely in a company of any size the employees would do their DD.

Oh...... here's another example of biz in America:

Major steel company declares bankruptcy. The employees pension plan reserves of a billion bucks disappear and the Pension Guarantee program does a partial patch, but basically considering lost med care and pension the pensioners are nearly zeroed out.

An "investor" buys the assets now stripped of liability along with the assets of two small steel cos............. and sells the package one year later for a billion bucks in gain. So, we've a new billionaire and a bunch of broke guys who spent their lives in front of steel furnaces. Hmmmmmmmm, perhaps the employees should always have a right of first refusal?

Ha! and lastly, the 2,000 mile long Alaska Gasline which would lower US energy prices substantially and make our steel cos more competitive is being held up in part due to a shortage of 50" pipe made only in Japan and they are busy supplying the rest of the world's needs. Ha! The last miles of that pipe will be but a stone's throw from the great Masabi Iron range.

Keep the faith though as we're the world's leader, Jack

[n.e.hat]

Jack, I know about the pipe problems in this country. Do you know that the rolling and forming mills that the Japanese use were once U.S. corporate property? Sold off to make a fast buck. The same problem also exists in the manufacture of Hyper-compressor equipment used to power the pipelines and other industrial operations. There used to be six manufacturers of this equipment in the world. Three in the US, one in Germany, one in Japan and one in Switzerland. Today, there are only three and guess where? The whys are answered by the fact that their governments were'nt about to lose this basic core industry. It's playing hell with Engineering and Construction in this country and the companies involved with it. Multibillion dollar contracts have been lost because the countries concerned won't allow US companies to buy. Thereby, forcing customers to go to them for the engineering, design, procurement, and construction. And all because of sho

[Justin]

In your post you state that the favorable tax treatment of ESOPs "would be justifiable only if such plans conferred benefits on society that could not be generated more cheaply by other means." What are your thoughts on ESOPs being a tool to keep/direct wealth domestically? That is, to keep American workers benefiting, rather than foreign investors? Also, to protect American companies from foreign takeovers? While this may not have been an original motivator for the favorable tax treatment of ESOPs, does it warrant any inquiry given the present fears among many in the U.S. with regard to globalization and foreign competition?

[ben]

Jack

Sorry to break in on the congratulations being thrown around by you and your friends. Love it, by the way, how you mention crimson herrings in the same paragraph as you use CEO pay to rebut the idea that employee ownership in large firms does not improve incentives. Brilliant.

Then you close with this pearl:

Had we a far higher percentage of ESOP owned companies over the last 25 years could we at least speculate that total compensation for the working bloke would not have fell at such a rapid rate relative to top management and large stockholders than has been the case?

United was the world's biggest ESOP, and from any angle the employees were screwed. In fact, if this is accurate, the extent of the corruption that went on in that deal is extraordinary:

http://en.wikipedia.org/wiki/United_Airlines#Employee_Stock_Ownership_Plan

Here's a link which describes the way it locked employees onto a sinking ship, and created rifts within the company between those who were and were not in on the ESOP (i.e. those who felt they could or could not afford the pay cuts required):

http://www.sfgate.com/cgi-bin/article.cgi?file=/chronicle/archive/2002/12/08/BU148153.DTL

And finally head over here to a site dedicated to highlighting the quality of United's - and only United's - service:

http://www.untied.com/

I can't find any data on the United CEO's compensation during this period, but I believe it is in the millions and the same league as the corporate salaries you are so fixated on.

Of course, this is just one company, and United did enjoy some early benefits from the ESOP, but it ultimately created large problems and seriously harmed its employees. It is not clear employees in general gain from ESOP.

[n.e.hat]

Fear? Nothing to fear. Global Labor Arbitrage doesn't exist (at least in the minds of those who don't work for living) and besides ESOP's wouldn't help anyway.

[elisa (Italia)]

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[Jack]

Hat. Thanks for adding to my knowledge of the "curious" nature of steel and pipe in this largest economic power in history.

Ben....... Thanks for your critique, however I'm not too impressed by your having chosen a single sickly corporation to illustrate your point. Also Hat has already mentioned the problem (for any of us!) of buying a pig in a poke after the corporate raiders were done with it. Do you think United is any worse off today than are Delta and others?

I'd like to consider the word "company" for a moment as for much of our history it denoted a company of folks who set out to accomplish something and profit from the endeavor. For example in one of the more speculative businesses here in Alaska of commercial fishing crews are paid in shares or lays of the catch, just as in the days of the Apostles.

The reason? It puts all on a the team and works better than any other means. For example if the skipper paid wages competitive with union construction or so, in a skinny year the crew would get paid but the skipper would not, and after a couple of these, he'd lose his boat and no one would have a job.

Conversely in years when luck, skill and teamwork combine for a stellar season the crew would be underpaid and it would not be joyful at season end to go home with "wages" while the skipper went home with a windfall............ and gave much of it to Uncle Warmonger instead of to his hard working crew.

Today........ as NO ONE is watching over the antics of "our" nationless corpies (not even stockholders, as so much stock is held by funds whose managers have far more in common with CEO's than their own investors) and it would seem beneficial not only to the employee but to our communities and nation.

For example the flight of our steel cos and others; WERE the employees to have a voice in the matter the decision to "offshore" it would include the negative effect on one's career, and by definition, their communities and collectively....... what's left of our nation.

Now you may think the employees are so dumb they'd oppose necessary changes when the outlook for the corp's business is hopeless but I do not. Doubters will note countless compromises made to save airlines and auto companies (while they got their act together?) even when the employees did not own the company and, as mentioned, CEO's continued to "earn?" vast multiples both of employee pay and of CEO's pre-Reagan era. BTW! By today's standard Gordon Gecko (Greed is good!) is looking like one of the white hats.

Cheers! and are you wishing for the wage race to the bottom would proceed faster so as to lessen the pain? Kinda like pulling a band aid off all at once? Also do you think CEO and upper management compensation is too low and that working folk should tighten up another notch and pass the hat for them? Jack

[hypocriticist]

I know alot of corporate lawyer and professor types read this blog, so I'll throw this out:

Tangentially, but in the context of the implementation of the Clementi Commission reforms in the U.K. I had an idea while reading the ESOP comments: it might be useful to test the ESOP model in a law firm- the limited liability partnership context- rather than in a corporation. Essentially, it would make all associates incentivized like partners. Now, add to that another layer- the possibility of non-lawyer investors owning equity in law firms- and you've got a far better overall alignment of interests than in the current model: partners are beholden, ultimately, to shareholders, and associates are invested in the firm's bottom line, and are also beholden to shareholders. The ideal law firm?

A pipe dream, of course...

[n.e.hat]

hypo, In the firm there's more incentives than you might think. It's called "Making Partner". Which is based on finding clients, increasing billing hours, and showing a certain degree of competence and aptitude. As for creating shares, and selling why? That's why partnerships are set up as they are and not as corporations.

[Corey]

There is no longer a realistic chance of making partner at most large law firms. Some people still try because the payout is over a million a year. Many others start to view themselves as mercenary employees, the number of lateral hires is growing, and low level pay is shooting up in response.

Incidentally, those last three conditions were rampant in the computer engineering industry from 1997 to early 2001. Beyond increasing salaries, ESOPs and Stock Option grants to engineers were used to keep people in-house long enough to actually complete a design cycle. It was deferred compensation just like law firm partnership, only much more fine tuned and widely dispersed. I remember times at booming NASDAQ listed companies where the guy in the next cubical who started a year before me had $1M in unvested options and the boss in the office next to us had $3M. (Most of the people who could cash out did so and bought homes, those of us who missed the window are still renting.)

I predict that the next thing to happen with law firms is the creation of more graduated steps toward partnership. Non-equity "partner" at 5 years, full partner at 10... I hear some firms are even giving small equity shares to new associates, which grow over time.

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