April 8, 2007
Employee Ownership Through ESOPS:A Bad Bargain
Employee Ownership Through ESOPS:A Bad Bargain-BECKER
Recently Sam Zell, a leading Chicago businessman, arranged to buy the Tribune company, owner of the Chicago Tribune, Los Angeles Times, other newspapers, and many TV and radio stations. Aside from the low price that he paid, which reflected the rapidly declining fortunes of the print media and conventional TV stations, the most noteworthy aspect of the deal is that he plans to take the company private through the creation of an ESOP, or employee stock ownership plan.
The number of American ESOPs has grown substantially during the past 30 years, and they are currently estimated to hold more than ¬Ω trillion dollars in assets and cover over 10 million workers. Probably the main reason for their growth is that ESOPs had during this period sizeable tax advantages that include deductibility from federal taxes not only of the interest payments but also of much of the principal used to finance creation of an ESOP. The argument made for these special privileges is that employee ownership is a good thing for workers that should be encouraged, but is that true?
In reality, the creation of an ESOP is often a management tool to fend off unfriendly takeover bids. This was certainly the case behind the pilot-led ESOP created by United Airlines, and may have played a role in the ESOP to be created at Tribune company. ESOPs that help keep poorly performing management in power would contradict the claim that this organizational form improves rather than contributes to poor performance.
Employee ownership is said to induce employees to work harder because they then have a financial stake in the company where they work. If that were true, owners would not need a tax advantage to create a sizable employee ownership since they would subsidize stock ownership by employees in order to improve productivity. Employees in a small closely held company with few workers may feel part of a family and work harder when they own an interest in the company. But in large companies with thousands of employees, such as Tribune company and other ESOPs like Science Applications International, ownership is not likely to be a strong motivating factor because hard working employees would then mainly benefit the many other employees and stockholders. Between 1995 and 2000 United Airlines was an ESOP with employee representatives on its board. Soon after 2000 the company entered bankruptcy with employees and management not known either for their great effort.
Careful studies that compare the productivity of employee-owned companies with those owned by general stockholders are limited in number and scope, and advocates of ESOPs often get quite emotional in reacting to criticisms of the concept. Still, there is little hard evidence indicating that ESOPs are better run than normal companies. Reputable studies of employee ownership in the United States and other countries generally indicate that both profits and productivity remained about the same after companies introduced employee ownership. This is not surprising since most ESOP-owned companies are not run by employees, and for the reasons I gave employee ownership does not usually better motivate workers of larger companies.
However, the most powerful argument against the view that employee ownership improves efficiency is that new firms would tend to take this form if it improved efficiency, and many older firms would convert to employee ownership on their own, even without tax advantages from doing so. Yet despite the competitive nature of American industry, with substantial rates of entry and exit of companies, less than 10 percent of employees in the United States work in firms that have ESOPs despite the considerable tax advantages to this organizational form. This more than all the highly imperfect comparisons between the performance of ESOPs and other companies is persuasive evidence that ESOPs would not usually be more efficient. Indeed, given the tax advantages, there would be many more ESOPs if they were equally efficient.
Various types of employee-ownership of enterprises are found in many other countries. Usually they are the result of legislation that either forces or encourages this form of ownership through regulations and tax advantages, sometimes when public enterprises are privatized. The evidence on their efficiency as determined by their spread and performance in these countries is similar to that for the United States: even with special privileges, employee ownership has not become the dominant organizational form of enterprises. This suggests again that employee-owned companies would tend to under perform more conventional ownership structures that have stockholders who either manage the enterprise, or are largely independent of both employees and managers.
The biggest and most obvious drawback of employee ownership from the perspective of the financial wellbeing of employees is that they hold their assets in one basket, the company where they work. Even without ownership of equity the wealth of experienced employees is still poorly diversified since it is largely in the form of human capital whose value depends on the success of the company that employs them. When the company does well, earnings from their human capital tend to rise more quickly, while the opposite occurs when the company does poorly. Ownership of shares in the company exacerbates the economic dependence on the company's performance since now the value of the financial assets of employees also rises and falls with the company's fortunes. The same problem arises with the many corporate pension plans that mainly hold bonds and stock that they have issued. When the company does poorly, the value of pension assets, and thus of the retirement incomes of employees, go down along with earnings, employment and profits of the company. Forcing top management to hold much of their financial assets in the stock of the companies they run through stock option and stock ownership plans reduces their financial diversification too, but that may be beneficial to the company's performance since the decisions of CEOs and others at the top do greatly impact company performance. As I indicated earlier, that is not the case for typical employees of large corporations.
The disadvantages of being poorly diversified is not simply hypothetical, but was sadly brought home to employees of companies like Enron and United that had substantial stock ownership by employees. After these companies went into bankruptcy, mainly due in Enron's case to mismanagement and corruption, many employees not only lost their jobs but employees lost much of their other wealth as well.
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.