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ESOP Fundamentals By Stephen J. Butler

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The United Airlines saga is especially troubling for me because 55 % of the company was owned by its employees in an Employee Stock Ownership Program or "ESOP." I know quite a bit about ESOPs because I used to be a weekend ski instructor with Marti Kelso, the daughter of Louis Kelso who claimed to have been the inventor of the concept. Driving to and from Tahoe on weekends thirty years ago, Marti, with her captive audience, would proselytize unmercifully drawing from her father's book which was entitled "The Capitalist Manifesto." That title suggests the atmosphere in my car. At the time, I just wanted to listen to "Wolfman Jack" in peace and quiet, but what I was forced to learn actually launched my career in the pension business years several years later.

Louis Kelso claimed to have invented the "ESOP" which, in the early days, was known as "The Kelso Plan." This larger-than-life guy later claimed to have taught Kolberg, Kravis and Roberts everything they knew about leveraged buyouts. While Mr. Kelso was a great promoter of both himself and the concept, Sears Roebuck had actually "invented" one of the earliest ESOP's back in the 1930's and had paved the way to wealth for many of its employees. Another example was United Parcel which owed much of its early success to the widely-held ownership of the company by its employees through their ESOP.

To understand the basics, an ESOP is a retirement plan sponsored by a company that chooses to purchase its own company's stock as one of the retirement plan investments. Since the Employee Retirement Security Act (ERISA) was passed in 1974, companies have been barred from so-called "party-in-interest" transactions with their retirement plans. Laws carefully restrict companies or their owners from using plan assets in any way.

With an ESOP, those restrictions get thrown right out the window, and to his credit, Louis Kelso prevailed upon Wilber Mills of the Ways and Means Committee to create the exemption that ESOP's enjoy. Special tax laws actually encourage company owners to sell stock to their employees. In the aggregate, it is a good thing. Statistics maintained at Oakland's national Center for Employee Ownership will show that broad-based employee ownership sets up a powerful win-win environment.

In a typical situation, a public or private company that might have had a taxable profit contributes the profit amount, instead, as a tax-deductible contribution to a retirement plan. Let's say the dollar amount is equal to 10% of the entire annual payroll. Next, this cash contribution is used to purchase company stock either from current owners or from a supply of corporate treasury stock. If they purchase from owners, the number of shares outstanding remains the same. If they purchase from newly-issued treasury stock, the current stockholders who once owned 100% of the company may now only own, say, 95% because a new additional "shareholder" may have walked in the door with additional money that amounts to 5% of the company's value. This "dilution" is not necessarily bad if the original shares, in the end, are worth more. After all, "10% of something is better than 100% of nothing." A company that uses this tool routinely can manage to keep capital in the business that would otherwise have disappeared in taxes. In the process, it spreads out ownership to all employees.

So-called "leveraged" ESOP's are set up so that the retirement plan borrows money to buy a large block of stock or even the entire company. Then, the company makes annual contributions to the retirement plan that the plan uses to retire the bank loan over several years. This "accelerated" ESOP, or "AESOP" offers the only opportunity for corporate America to pay both the interest AND THE PRINCIPAL of a loan with tax-deductible dollars. Remember, the entire contribution to the retirement plan is deductible as employee compensation, and then this money is used to meet the loan payments.

So, the employees of United Airlines owned over 55% of the airline through what began as a leveraged ESOP. Initial reports indicated that the company culture embraced the employee ownership concept and some excellent synergy was reputedly taking place. Unfortunately, top management allowed the culture to unravel. Three CEO's in five years and a bloated senior management allowed the ESOP culture to dissipate. Bloated senior management? Well how about the nine senior people they just sent out to pasture to save a reported $10 million a year. How important could those people with $1,000,000 plus salaries have been in the first place if they could have been let go so easily? Flight attendants were never part of the ESOP and new employees hired after 2000 were not allowed to participate. In short, the ESOP took on an aura of entitlement and ceased to be a motivating factor.

Bad management can mess up a company regardless of who owns the stock. While many ESOP's have been extremely successful, they do not guarantee a company's success.

Berkeley's The North Face offers another story. At one time, the employees owned roughly one third of the company through an ESOP that purchased what some banks and venture firms had owned back in the early 70's. My company actually designed and installed that plan. Years later, a controversial Bill Simon (no relation to the gubernatorial candidate.) wrested control of the company and borrowed heavily to expand before driving the company into receivership. Employees who once had healthy values in their North Face stock got nothing.

ESOP's, then, are valuable financial tools that Louis Kelso championed as a route to ownership of capital for the average employee. Since capital is more profitable than labor, it tends to become concentrated. ESOP's, with their powerful tax incentives, balance the equation by making employees the owners of capital and thereby enhancing their worth beyond just their ability to perform skills and services.

I would argue that 401(k) plans, more than ESOP's, have effectively created what Louis Kelso envisioned. The only difference, which represents an improvement, is that employees can own capital in the form of equity mutual funds that offer diversification. They can own capital without having all their eggs in one basket. Using diversification to reduce risk is an investment fundamental. If you don't believe it, ask a few Enron employees who wish they had heeded that bit of ancient financial wisdom.

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