DEBORAH GROBAN OLSON
ATTORNEY AT LAW
1021 Nottingham Road
Grosse Pointe Park, Michigan 48230
Telephone (313) 331 7821
Fax (313) 331 2567
Email dgo@esoplaw.com
ESOP law should be changed to reward long-term locally anchored investment and employee participation while providing modest incentives for more conservative companies to try employee ownership.
Competitiveness on the world market is crucial to the survival of the United States as a world economic power. If this is done purely by wage competition, our quality of life will sink to an international lowest common denominator. Preservation or development of an acceptable quality of life in the U.S. requires that economic competitiveness be achieved in a manner that does not impoverish working Americans. Flexible compensation tied to profitability, job security, and a voice in workplace decision-making (such as that provided by participative employee ownership) may serve some of these purposes.
Many changes are necessary to bring about competitiveness with a human face. American industry needs to make long-term investments in research and development. Federal, state, and local governments need to make significant investments in both physical infrastructure (roads, transportation systems, and environmental protection) and in the social infrastructure (education, health care, substance abuse prevention, and self-esteem development for those with little hope). Therefore, legislative policy must change the tax and regulatory incentive system away from the seize-the-quick-buck-and-damn-the-consequences-to-others attitude, and toward a system in which tax incentives bring long-range benefits.
To the extent that Congress has expressed some of this mood, various members have targeted ESOP tax incentives for repeal or amendment. Many ESOPs have provided major players with significant savings at taxpayer expense without providing the employees with the real benefits of ownership. The Congressional desire to curb these abuses is wise. However, the methods Congress has thus far chosen are not those best suited to fulfilling that goal, nor do they provide the incentives to employee participation which are crucial building blocks for future competitiveness. This article focuses on alternatives.
The federal government needs to encourage (1) more majority employee ownership and (2) more worker participation in decision-making.
In the 1990s, unlike the 1980s, highly leveraged buyouts have become almost non-existent. Employee ownership often requires participation by equity investors. ESOP legislation must meet this challenge by finding ways to reward sellers who enable majority employee ownership, while still encouraging minority employee ownership where that is the only possibility.
Participative employee ownership is one of a small number of developments which has shown much promise as a means of increasing the competitiveness of U.S. companies and ensuring that companies remain domestically owned. 1
The legislative proposals herein are intended to provide a means of giving employees a voice in workplace issues as a quid pro quo for ESOP tax incentives. More specifically the proposals are intended to (1) anchor the businesses in domestic ownership with long-range growth objectives, (2) limit tax dollar expenditure to socially useful ESOPs, (3) provide a sliding scale of tax incentives based on the amount of employee ownership to encourage owners who wish to experiment with employee ownership but provide greater rewards for majority employee ownership, (4) unleash the full potential in the work force, and (5) recognize the unique role of employee ownership in collective bargaining. 2
Employee ownership subsidized by tax dollars should provide employees with substantial shareholder rights and aid them in operating as a shareholder group. Employee owners should not be viewed as incapable of properly instructing trustees on what is in their best interest and should be allowed to directly instruct trustees on the voting of their stock without creating a fiduciary liability for the ESOP trustee.
Companies providing employees with a larger portion of ownership should be rewarded more than those providing less ownership. Special incentives should be provided to companies in which employees receive controlling interest.
Valuation methodology should be readily open to participant inspection.
The following legislative proposals to peg ESOP tax incentives to provisions for greater employee rights are based on the above premises. They provide a floor for employee protection where there is no union to speak for employees. Where there is a union, it may negotiate different provisions to safeguard employee interests. For example, unionized employees may be better represented through union representation on some issues where individual employee rights are proposed herein.
Make the ESOP lender deduction (IRC Section 133) contingent upon the following requirements, any or all of which may be waived if the ESOP is created through collective bargaining.
These changes presume a corresponding exception be made in ERISA to permit employee owners to direct trustees to vote allocated and unallocated shares as directed, without putting them in the fiduciary bind (created by current law) of having to override those directions if they do not believe them to be in the participants' best interests.3
Make ESOP tax benefits for the corporation and selling shareholder available on a sliding scale based on the amount of voting stock meeting the above requirements, or contributed to the plan pursuant to a collective bargaining agreement. For example, if taxpayers sell or contribute 10% of their stock to an ESOP, they would receive 20% of the ESOP benefits for which they were otherwise eligible. (The term "taxpayers" is used to refer to any selling shareholders, estates, or corporate plan sponsors.) If taxpayers sell or contribute 20%, they would get 40% of the benefits, etc. The benefits would increase so that once taxpayers sell or contribute 50% or more, they would be eligible for 100% of the ESOP benefits.
As Congress seeks necessary revenues for much needed social programs, Wall Street has used some ESOPs as a corporate finance mechanism, without concern for employees. This narrow approach not only ignores the benefits ESOPs bring to transactions, but also has the effect of draining much needed resources from other programs.
Employees and their unions have used ESOPs to save jobs, anchor businesses in their communities, and insure companies' futures by separating them from unproductive businesses. ESOPs can help maintain revenue bases by keeping alive businesses that might otherwise close or relocate to other countries. Some ESOPs provide a further measure of protection by giving employees control over the company's future. Inappropriate use of ESOP tax benefits can be curbed by requiring that employees and their unions have more rights.
If Congress is going to encourage employee ownership, employees should get enough control over investment, disinvestment, employment, and other significant corporate policies to make employee ownership a meaningful method of anchoring business in local communities.
Create state and/or federal tax credits to encourage individual investment of IRA or 401(k) funds in state and labor sponsored venture capital funds that focus on employee ownership. In the current environment, it is difficult to obtain the highly leveraged financing needed to create majority employee owned companies. Employees frequently need equity partners to purchase companies. But traditional venture capitalists are primarily concerned with obtaining their profits and exiting target companies. (Which does not foster local ownership or stable capital investment.)
Several Canadian provinces, including Quebec, Manitoba, British Columbia, Saskatchewan, and Ontario have created labor-sponsored venture capital funds which provide provincial and federal tax credits to individuals who invest the equivalent of their IRA money in these funds. The Canandian funds are aimed at investing within their own provinces in companies with a proven track record and expected future long-range profitability. To the extent that they have an employee ownership focus, they particularly seek out retiring owner situations where there is no succession plan. Their primary focus is retaining jobs and control of businesses within the provinces. A national or provincial labor federation must sponsor these funds to obtain the tax credits, although they invest in non-union as well as in unionized companies.
Similar legislation in the U.S., or in a state, could provide employees with a much needed source of capital for employee ownership.
Due to the extremely high fiduciary standards required for ERISA funds, Labor has, thus far, had no success in raising a U.S. venture capital fund using pension money. With some IRA or 401(k) funds (structured pursuant to new regulations under ERISA Sec. 404[c] or Participant-Directed Investments, 29 C.F.R. §2550.404), individuals can make personal investment decisions to place a portion of the IRA or 401(k) in a venture fund without creating fiduciary liability for plan trustees. It would be wise to restrict individual investors from investing more than 25% of their retirement savings in a venture fund.
Change ESOP amendments that do not serve employee rights. Congress made a number of amendments in the Omnibus Budget Reconciliation Act of 1989 intending to increase revenues and encourage employee ownership in ESOPs that provide real benefits and ownership to employees, while limiting or removing their use solely as financial tax avoidance devices. Unfortunately, several of the amendments do not serve Congressional purposes very well.
For example, Congress repealed the estate tax deduction (IRC Section 2057) that provided tax-advantaged means for a surviving family to turn over a business to employees by allowing a 50% estate tax deduction of proceeds from the sale of employer securities to an ESOP. Many family owned businesses cease to exist upon the death of the owner if there is no easy way to turn the business over to experienced employees. Partial employee ownership combined with the estate tax deduction is one avenue for allowing full employee ownership to evolve over time. Without benefit of the estate tax deduction repealed by Congress, employee ownership in ESOPs certainly is not furthered, and businesses that might otherwise continue to produce tax revenue are lost. The ESOP estate tax deduction should be restored on a sliding scale along the lines of the above-outlined proposal (See page 9).
The requirement that the Section 133 lender interest exclusion is only available to plans where over 50% of voting stock is in an ESOP is a clumsy method for addressing Congressional concerns.4 This requirement, simultaneously, impedes the creation of some good employee-driven ESOPs, which need to attract senior equity partners to finance a deal, and encourages others who might set up ESOPs to turn to other vehicles, like stock purchase plans, that have fewer employee rights. The above-outlined sliding scale would better meet the country's needs for locally owned businesses and tax revenues.
Additionally, by inadventure, Section 133(b)(7) was drafted so that it did not allow a Section 133 loan to a company providing one participant, one vote. This section should be amended in the next tax act to add a reference to IRC Section 409(e)(5). IRC Section 133(b)(7)(A) would then read:
The employee stock ownership plan meets the requirements of Section 409(e)(2) or 409(e)(5) with respect to all employer securities acquired by, or transferred to, the plan in connection with such loan (without regard to whether or not the employer has a registration-type class of securities), and . . .
One participant, one vote is not generally used in the large tax-exemption driven deals which caused Congress to pass the restrictions on Section 133. In fact, few ESOPs use it. However, some people believe it is the fairest way to distribute voting rights.5 Whether or not this is best in all circumstances, people should have the right to choose a flatter and more egalitarian voting system.
The legislative proposals above attempt to create a more finely-tuned instrument. They provide concrete employee rights and protections without narrowing the already limited financial ability of employee groups to structure deals. They also recognize the significant value of collective bargaining representation in protecting employee rights in structuring ESOPs. The proposals give selling shareholders, corporations, and outside investors incentives to increase the percentage of employee ownership, without removing the incentives for partial employee ownership.
Initially, employee ownership legislation was driven by a theory that broadening the base of ownership was important, but that employees were not really capable of exercising their rights as shareholders without the paternalistic protection of a trustee who could be appointed and, therefore, actually (if not legally) controlled by the corporate board or selling shareholder.6 This theory is outdated as proven by General Accounting Office (GAO) studies.7 In addition, these studies have found that employee owned companies only surpass their traditional competitors in productivity and profitability when they include significant employee participation programs.8
The future for employee ownership as a means of improving American competitiveness, increasing profitability, and generating jobs and greater tax revenues, is to release the full creativity and effort of employee owners by increasing their rights and voice in employee owned companies.
The very positive experience of union led employee ownership at such companies as Weirton Steel, White Pine Mines, Republic Container, and Republic Engineered Steels are further evidence of the ability to create excellent employee ownership through collective bargaining. Accordingly, future legislation should acknowledge the findings of the GAO, and the experience of companies which provide employee owners a strong voice, and further enable union negotiation of employee ownership.
1. Robert B. Reich, Tales of a New America (1987), pp. 247-248 and Education and the Next Economy (National Educational Association Professional and Organizational Development Research Division, 1988), pp. 13-14; Robert Stern, "Investing in People: A Strategy to Address America's Workforce Crisis," U.S. Department of Labor Report of the Commission on Workforce Quality and Labor Market Efficiency, pp. 1782-1785.
2. In a unionized facility, collective bargaining provides employees with a voice and access to technical expertise. In the statement of "[f]indings and declaration of policy" incorporated into the Labor Management Relations Act, 1947, it states that this strikes a balance of "bargaining power between employees who do not possess full freedom of association or liberty of contract, and employers who are organized in the corporate or other forms of ownership association . . . ." (29 USC Sec. 151 et seq. [1947]) This balance of power, resulting from the economic power of each side, the expertise each may employ, and the bargaining information to which the bargaining agent is entitled (29 USC Sec. 158[a][5]) gives union represented employees the wherewithal to negotiate a fair ESOP deal. It is Federal labor policy not to dictate the terms of the bargain, but simply to require bargaining.
Unlike negotiation of employee ownership in a non-union firm where employee ownership creates a new relationship, employee ownership through collective bargaining is but one of a multitude of complex relationships and understandings between the parties. Non-unionized employee owners have few ways of obtaining significant corporate information or influence and thus need specific rights outlined in the law; unionized employees, although they assume new roles, can get this knowledge and power through collective bargaining.
3. Danaher Corp. v. Chicago Pneumatic Tool Co., 635 F. Supp. 246 (S.D.N.Y. 1986); DOL Op. Ltr. (Apr. 30, 1984), Profit Sharing Retirement Income Plan for Employees of Carter Hawley Hale Stores, Inc. (CCH Pension Plan Guide, p. 653F, paragraph 23 and BNA Pension Reporter, 11, p. 663); and DOL Op. Ltr. (Feb. 23, 1989), Polaroid Stock Equity Plan (BNA Pension Reporter, 16, p. 390).
4. IRC Secs. 133(b)(6)(A)(i) and (ii), 133(b)(7)(1990).
5. For example, some union groups believe this is a good balance to allocation based on pay.
6. The April 30, 1984, letter from the Administrator of the Office of Pension and Welfare Benefit Programs (reorganized as the Pension and Welfare Benefits Administration) to John Welch, attorney for the trustee of the profit sharing and retirement plan for employees of Carter Hawley Hale Stores, Inc. in connection with pending tender offer by The Limited, Inc. (Profit Sharing Retirement . . . , supra endnote 3). The letter expresses DOL opinion that the extent to which a trustee may follow action approved by plan participants is limited. See also Danaher Corp. v. Chicago Pneumatic Tool Co., 633 F. Supp. 1066 (S.D.N.Y. 1986) indicating that a fiduciary has an obligation beyond following the passed-through vote of plan participants. (EBC, 7, pp. 1616-1620)
7. GAO, ESOPs: Benefits and Costs of ESOP Tax Incentives for Broadening Stock Ownership (December 1986), p. 38.
8. "The only statistically significant coefficient is for employee participation in corporate decision making, which is positively related to changes in [the] measure of productivity." GAO, ESOPs: Evidence of Corporate Performance (October 1987), p. 30.