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Myron S. Scholes and Mark A. Wolfson "Employs" 1998 № 3 "Employee Stock Ownership Plans and Corporate Restructuring: Myths and Realities"
During the first six months of 1989, U.S. corporations acquired over $19 billion of their own stock to establish employee stock ownership plans (ESOPs). This compares to only $5.6 billion for all of 1988 and less than $1.5 billion per year from the passage of the Employee Retirement Security Act in 1974 through 1987.1
Special tax advantages appear to be available to companies using ESOPs. For example, such firms can sometimes deduct dividends paid on ESOP shares, as well as benefit from a tax subsidized borrowing rate on loans used to buy ESOP shares. There are also important nontax considerations, such as the claimed incentive advantages of employees owning company stock and the use of ESOPs to defend against hostile tender offers by placing shares in the hands of relatively friendly employees. The analysis that follows brings into question the notion that ESOPs provide unique tax and incentive advantages. Depending on the benchmark against which they are compared, ESOPs can be inferior along both di-mensions.
The analysis suggests that, particularly for large firms in whom the greatest growth in ESOPs has occurred, the case is very weak for tax provisions being the primary motiva-tion in establishing an ESOP. Yet Congress apparently believes that tax benefits explain the growth in popularity of ESOPs over the last few years, since the 1989 Tax Act cur-tailed tax benefits relating to ESOPs. The cane is also weak for employee incentives being the driving force behind the establishment of ESOPs. The main motivation for the growth of ESOPs appears to have been their antitakeover characteristics, although the presence of special tax provisions has enabled management to justify the formation of ESOPs to their boards of directors and to the courts.
I. Overview of Tax and Nontax Motivations for Adopting ESOPs
The ESOP is a special type of defined contribution pension plan-like an individual retirement account, a Keogh account, or a Code Sec. 401 (k) plan. The corporation makes tax-deductible annual contributions to the ESOP, which are generally used to buy com-pany stock or to pay down a loan that was used to acquire1 company stock when the pro-gram was initiated. Each year employees are allocated tax-free company shares, and any investment income accumulates tax free within the ESOP. Employees pay tax when they receive dividend distributions on ESOP shares during their working lives, when they re-ceive other distributions from the ESOP during retirement, or when they otherwise leave the firm. (However, when employees leave the firm they can "roll" their ESOP shares into an IRA to continue to defer payment of any tax.)
Unlike most other defined contribution plans, the ESOP is required to invest pri-marily in the stock of the company establishing the plan, and this is commonly taken to mean that the ESOP must hold at least 50% of its assets in the stock of the sponsoring company. Unlike any other defined contribution plan, the ESOP can borrow using the company's credit to buy company stock to prefund the required number of shares that the firm expects to credit to its employees over the term of the loan. Such plans are called "leveraged ESOPs." At the firm contributes to the ESOP, shares are credited to employees' accounts. Moreover, qualified lenders can exclude 50% of the interest that they receive on the ESOP loan (only if the ESOP owns a majority of the employer's stock, after the 1989 Tax Act), and the corporation can deduct any dividends that are used to pay down the ESOP loan or are paid directly to employees* on their ESOP shares. As seen below, these tax benefits must be balanced against both tax and neonate costs of establishing an ESOP.
Among the reasons offered in the popular press for the recent popularity of ESOPs are the following: (I) there are several important tax benefits that are available through an ESOP that are not available through other tax qualified and nonqualified compensation programs; (ii) ESOPs can be used to restructure employee work incentives and retirement benefits; and (Hi) ESOPs can be used in corporate finance strategies as substitutes for, or in conjunction with, recapitalizations (changes in corporate capital structures) and lever-aged buyouts. For example, ESOPs have been used to sell company divisions to employ-ees. In addition, prior to the 1989 Tax Act, the deductibility of net operating losses (both existing and so-called "built-in losses") against future taxable income were not restricted if a corporate control change occurred through ownership interests acquired by an ESOP. The 1986 Act restricted the deductibility of such losses upon certain control changes when ownership interests are sold to parties other than ESOPs.
Moreover, ESOPs have been used to secure tax deductions on the payment of divi-dends, to achieve a subsidized borrowing rate on ESOP loans, and to defer the capital gains tax incurred by owners of private companies on the sale of their shares to the ESOP. ESOPs have also been used to allocate interest payments domestically to free up foreign tax credit limitations.
There is other nontax reasons why ESOPs have become popular. Perhaps the most important one is that they have been used effectively to thwart hostile takeover attempts, particularly in the state of Delaware.3 In early 1989, Polaroid won an important decision in the Delaware Chancery Court, which upheld Polaroid's issuance of 14% of its stock to an ESOP prior to the initiation of a hostile tender offer by Shamrock Holdings. The ESOP helped Polaroid's management defeat Shamrock's bid for its stock because employees voted their Polaroid shares with management. Delaware law requires that a firm wait three years after it acquires a 15% interest in a target before it can merge with the target, unless it can secure an 85% vote of the target's shareholders (or the board of directors and two-thirds of the disinterested stockholders vote in favor of the merger). The waiting period can impose substantial costs on the acquiring firm if it had plans to use the assets of the target as collateral for interim or longer-term loans to finance a leveraged buyout. Firm management might establish an ESOP because they believe that employee-shareholders are more likely to vote with them than are outside shareholders. As a result, Polaroid's use of an ESOP as a successful takeover defense stimulated considerable interest in ESOPs. (For a case study of Polaroid's ESOP, see Bruner and Brownlee in this issue.)
It is interesting to note that the New York Stock Exchange requires shareholder ap-proval for adoption of an ESOP only when ESOPs acquire more than 18.5% of employer stock (Bader and Hourihan [3]). In addition, while employees must be granted voting rights in public company ESOPs, acting on a tender offer is not a voting rights issue, so an ESOP provides a particularly strong tender offer defense. With respect to the Delaware 85% rule, however, stock held by an ESOP is counted as outstanding shares only if the participants have the right to tender their shares confidentially.
ESOPs are also being used to replace existing defined benefit pension programs, to replace other types of defined contribution programs, and to replace company contribu-tions to postretirement healthcare programs. In the case of the latter, some corporations are substituting an ESOP for their previous promise to fund the postretirement healthcare costs of their employees.4 Most postretirement healthcare programs are unfounded and are open-ended as to medical costs. In other words, the corporation makes an unsecured promise to provide healthcare for employees after they retire, whatever the costs might be. As an al-ternative, some companies contribute their stock to an ESOP and employees fund their own postretirement healthcare costs from their accumulation in the ESOP. By establishing an ESOP, the corporation transfers both the uncertainty of future health costs and the se-lection of the level of healthcare to employees.5 But the advance funding of postretirement benefits through an ESOP (or any other retirement plan) may reduce the risk that the em-ployer will default on the promise to provide the future benefits, if employees diversify out of company stock into other investments in the ESOP prior to their retirement (they can diversify up to 25% of their holdings if they are 55 and have participated in the plan for ten years, or up to 50% if they have reached the age of 60).
As pointed out by Freiman [9], however, advance funding of retiree medical bene-fits through an ESOP is not necessarily tax advantageous. While the employer secures an immediate tax deduction for the contribution into the pension trust, employees eventually pay tax on withdrawals from the fund. By contrast, pay-as-you-go retiree medical benefit plans allow employees to receive tax-free benefits in retirement, but at the expense of a de-ferred tax deduction for the employer and the loss of tax-free compounding for advance funding. Section 401(h) plans allow the firm to have the benefits both ways: immediate deduction for advance funding and tax-free compounding of investment returns, along with tax-free benefits to retirees. But it is not yet clear whether these benefits are available to defined contribution pension plans, and no more than 25% of a pension plan's contribu-tions (which may be nil for overfunded pension plans) can be invested in a tax-exempt ac-count to be used to provide for tax-free healthcare benefits.
That advance funding of retiree medical benefits through an ESOP may be domi-nated along the tax dimension by other funding alternatives is interesting, because it in-creases the likelihood that nontax factors (such as an enhanced takeover defense) have a first order effect on the decision to fund such benefits through an ESOP. Since tax consid-erations are reasonably complicated in the pension area in general, and in the ESOP area in particular, it is important that both independent members of corporate boards as well as the courts understand whether there really exist tax benefits for proposed retirement benefit plans, because the adoption of such plans may serve the interests of incumbent manage-ment, but not shareholders, along nontax dimensions.
There are many substitute vehicles through which the corporation can achieve the many nontax and tax benefits of ESOPs listed above. However, there is some special tax benefits available to an ESOP that are not available elsewhere. For example, under certain circum-stances (far fewer after the 1989 Tax Act than before it), an ESOP can borrow to finance its purchase of company stocks at a tax subsidized rate and deduct the interest on the loan. No other pension plan can do this. Moreover, a corporation can take a deduction for divi-dends it pays on the stock held in the ESOP if the dividends are paid directly to the em-ployees in cash, or if the dividends are used to pay down part of an ESOP loan that was used to acquire the company's shares. The ability to deduct from corporate taxable income both dividends on ESOP shares and the interest payments on the ESOP loan enables a part of corporate income to avoid an entity-level tax (as in S corporations, partnerships, and proprietorships). This has become particularly important with the passage of the 1981 and 1986 Tax Acts.
The tax laws in the U.S. have always treated debt- and other claims that give rise to tax-deductible payments to the corporation such as obligations to employees, lessors, and suppliers-differently from corporate equities. Whereas interest paid on debt is tax-deductible to corporate borrowers, dividends paid on common and preferred stock are not. In addition, whereas gains and losses on the repurchase of corporate bonds are taxable events to corporate issuers, the same is not true of share repurchases. On the investor side, interest from bonds is taxable as ordinary income whether paid out currently or not, while dividends and changes in the value of stocks are taxable only when realized. Moreover, dividends receive tax-favored treatment to corporate shareholders, and capital gains, be-sides being granted favorable tax-deferral treatment, have also in the past been taxed (and may again in the future) at rates well below that of ordinary income to many shareholders.
Since the returns to corporate stock are tax-favored relative to bonds, investors are willing to accept lower pretax equity returns, on a risk-adjusted basis, to invest in them. This is similar to what is observed in the market for tax-exempt bonds, where the pretax yields are substantially below those of fully taxable bonds. The same can readily be ob-served in the market for adjustable-rate preferred stocks, held almost exclusively by corpo-rations for whom the dividend income is largely tax-exempt. This reduction in rates exacts an implicit tax from investors. Symmetrically, the rate reduction represents an implicit tax subsidy to issuers of corporate stocks that compensates, at least partially, for the nonde-ductibility of dividends
Note that holding everything else constant, increasing the tax rate to investors on in-come from share ownership reduces the pretax wedge between shares and bonds (and therefore reduces the implicit tax subsidy to issuing shares). This makes stock more ex-pensive for corporations to issue relative to bonds. Similarly, increasing corporate tax rates relative to personal tax rates favors corporate debt financing, to the extent that such fi-nancing moves taxable income from the corporate sector to the noncorporate sector.
Prior to 1981, top marginal tax rates in the corporate sector were well below top marginal personal tax rates. Top personal rates were 70% from 1965-1981, whereas top corporate rates were in the 50% range. In the two decades preceding 1965, top personal rates were in the 90% range. During this period of time, top long-term capital gains rates to individuals ranged from 25%-35%. Such a configuration of tax rates should have caused common stocks to bear substantial implicit taxes, and corporate debt financing might not have been the least bit tax-favored for many corporations during this period.
With the passage of the Economic Recovery Tax Act in 1981, personal tax rates were reduced dramatically, while corporate rates were not. But at the same time, capital gains rates were also slashed. Moreover, with interest rates at record levels, the tax ad-vantage of capital gain deferral was particularly high at this time. With top personal tax rates set at a level just above top -corporate tax rates, the 1981 Tax Act began to move in-centives in the direction of increased corporate borrowing, although this effect was miti-gated by the reduction in capital gains tax rates and high interest rates. By 1984, interest rates had subsided dramatically, reducing the tax-sheltered nature of common stocks to some extent, further promoting debt financing over equity. Financing by corporations.
As always, important nontax factors were also bearing on the corporate financing decisions during the early 1980s. In particular, mature corporations were discovering that it was efficient, from a corporate control 'Standpoint, to restructure by buying back equity with the proceeds of debt issues - thereby committing to distribute "free cash flows" to in-vestors through bond interest and principal repayments (Jensen [11]). Moreover, increased reliance on strip financing (where institutional investors acquire combinations of junior debt along with equity and/or senior debt to reduce conflicts of interest among classes of investors) and the rise of active bondholders enabled more debt to be issued without the prospect of incurring excessive deadweight restructuring and bankruptcy costs in the event of default on corporate commitments to creditors (Jen-sen [12]). But it does not seem ap-propriate to view these developments as being completely independent of the evolution of the tax law. The tax law may well have provided important incentives for the proliferation of these institutional arrangements.
Corporate restructuring took a decided turn in 1984. Net new borrowing by corpo-rations exploded to nearly $160 billion a year during 1984-1986, from $66 billion per year during 1978-1983. At the same time, there was a quantum jump in the magnitude of both share repurchases ($37 billion per year from 1984-1986 versus $5 billion per year during 1978-1983) and other equity retirements via corporate acquisitions ($75 billion per year during 1984-1986 versus $15 billion per year during 1980-1983).6
The 1986 Tax Reform Act had an even more dramatic impact on favoring corporate debt financing. -Personal rates were reduced to a level well below that of corporations (28% for wealthy individuals versus 34% for corporations by 1988) and capital gains tax rates were increased dramatically. This, in conjunction with relatively low interest rates, substantially reduces the implicit tax on shares, thereby making equity financing a par-ticularly expensive way to finance corporate investment.
That debt financing has become more tax-favored with the 1981 and 1986 Tax acts is closely related to noncorporate forms of organization becoming more tax-favored rela-tive to the corporate form. If all corporate earnings before interest and taxes could be dis-tributed to investors as interest (or interest subset tutus), the corporation would essentially be converted to a partnership for tax purposes. There would be no entity-level tax imposed on-the corporation, and all owners would pay tax at the personal level on interest income (see Scholes and Wplfson [20] for a further discussion).
There are many ways in which the firm can "lever up." One method that has re-ceived considerable attention is leveraged buyouts, or LBOs. Other* include: (i) debt-for-equity swaps, (ii) dividend-for-debt exchanges, (Hi) cash redemption of stock financed with debt, (iv) deferred compensation plans, (v) partnership arrangements involving de-ferred payments, and (vi) leveraged ESOPs. AH of these alternatives are limited in their ability to eliminate the corporate-level tax. Although a fully employee-owned ESOP firm can pay out all of its before-tax income in the form of compensation payments to employ-ees or dividend payments on ESOP stock or interest payments on ESOP loans, there are enough tax rule restrictions, natural market frictions, or other nontax costs to prevent the elimination of the entity-level tax.
II. A Closer Look at the Operational Characteristics of ESOPs A. Contribution Limits
It is often claimed that an important tax advantage of an ESOP is that the corpora-tion can make tax-deductible contributions to fund it. This advantage, however, is not unique to an ESOP. Contributions to other pension plans are also tax-deductible. In fact, so is straight salary.
Because employees can earn the before-tax rate of return on assets invested in a pension plan, it is generally tax-advantageous to provide at least a portion of compensation in the form of a qualified retirement plan.8 An ESOP might be more tax-advantageous than other types of pension plans if the corporation can make
If the before-tax rate of interest is Rb and the employee's marginal tax rate today is t and on retirement in n years is t1, then for each 1$ of after-tax income contributed to the retirement plan the employee realizes a return of
If the marginal tax rate is expected to remain constant, the employee would prefer pension over salary if the before-tax rates of return on assets invested in the retirement plan were greater than the after-tax rates of return from investing outside the retirement plan. Even if the before-tax rates of return were greater in the retirement plan, the em-ployee might prefer to invest outside the retirement plan if the 'marginal tax rate was ex-pected to increase in the future or if there was a particularly strong demand for current consumption and the em-ployec'i borrowing rate was high.
More generous contributions to an ESOP than to this alternative pension plans. But this is generally not the case. ESOP contributions are limited, as are other defined contribution plans, to 25% percent of compensation.
As a tax-qualified pension plan, an ESOP cannot discriminate in favor of highly compensated employees. Indeed, because ESOPs cannot be integrated with social security benefits while other plans can be, ESOPs face tougher antidiscrimination rules. Therefore, it is difficult for senior management to control a large fraction of the shares of an ESOP. Even if the ESOP owns the entire company (as is true of AVIS Corp.), senior management might find Difficult to control a large fraction of the company's stock.
The 1986 Tax Act requires that employee participants in an ESOP be 100% vested at the end of five years (cliff vesting) or after two years of employment with the firm, at least at the rate of 20% for each year of employment. A potential nontax cost of these vesting requirements is that, with employee turnover, the remaining employees of the firm might receive an unintended benefit. Indeed, remaining employees might have an incen-tive to promote employee turnover for this reason. An employee can factor expected turn-over into his calculations of the amount of current compensation, that he is willing to forgo for these expected future benefits. Because of both risk aversion and imperfect informa-tion, however, employers might be willing to give up far less in current compensation than
An ESOP is defined in Code Section 4975 as a stock bonus plan (in which contribu-tions may be discretionary or contingent on measures of performance, like company proits) or as a combination stock bonus plan and money purchase pension plan (in which contributions are neither discretionary nor conditioned on performance measures). If the ESOP is set up as a stock bonus plan only, annual contributions are limited to 15% of em-ployee compensation. ESOPs that are a combination of stock bonus and money purchase pension plans face annual contribution limits equal to 25% of employee compensation.
This amount cannot exceed $30,000 for any employee, and only up to $200,000 (in-dexed for inflation after 1989) of compensation is taken into account in determining the percentage allocation to an employee. This $30,000 limit will increase over time with in-flation adjustments. That is, the maximum contribution must be less than 25% of $90,000, indexed to inflation after 1986 once this amount exceeds $30,000. In some cases employ-ees can contribute more to an ESOP than to other defined contribution programs. For ex-ample, since these limits are based on the value of stock acquired at the time. A leveraged ESOP was established advances In stock price might result in employees being allocated snares whose current market value far exceeds $30,000.
Their costs of these benefits, despite tax-favored treatment.
Given these antidiscrimination-funding requirements, many ESOPs are funded with contribution percentages far less than the allowable 25% of compensation. For example, Marsh and McAllister [15] indicate that in over 80% of the ESOP plans in firms with over 500 employees, contributions to the ESOP amount to 10% or less of compensation. In a more recent study, Conte and Svejnar [6] find that ESOP contributions average 10% of salary and wages.
The primary reason that these contributions are modest relative to contribution lim-its, despite the tax advantage of increasing contributions and reducing salary, is that the benefits are not valued highly by lower-level employees. The main reason is that such em-ployees (particularly young employees) have a relatively strong preference for current over future consumption; they do not wish to save 25% of their compensation to secure future pension benefits. If the firm did contribute a large fraction of their compensation into an ESOP, such employees would be forced to borrow on personal account each year to meet their current consumption needs. Given the dead-weight costs of originating and administering such a loan, a lending institution would require that the borrowing rate sub-stantially exceed its lending rate, even if the lender took into account the fact that an em-ployee will realize a future pension benefit that could be used to pay off the loan.
Note that it is not possible to secure a loan with the future proceeds of a pension benefit without disqualifying the pension plan. Moreover, interest incurred on debt to fi-nance personal consumption may be non-deductible. Given these costs, many employees could ' not borrow at all, and others might feel that they are still better off with current sal-ary than with deferred ESOP income. Although the corporation could still, make pension contributions for these employees.
The percentage of nonhighly compensated employees must be at least 70% of the percentage of highly compensated employees covered in the ESOP. The 1986 Tax Act de-fines "highly compensated employees" as those who own 5% or more of the company stock, those who earn more than $75,000 in compensation from the company, those who earn over $50,000 and are in the top 20% of employee compensation in the corporation, and officers whose compensation exceeds 150% of the contribution limit specified in the Code (curremly $45,000 or 1.5 x $30,000). Union employees can be excluded from the ESOP (and typically an) tf the company and the union bargain over contract provisions such as salary, health, and retirement programs.
Competitive labor market might force the firm to supplement employee compensation if it is to retain the services of such employees. This extra cost constrains the level of ESOP funding.
Prior to the 1986 Tux Act, the contribution limits were more generous for a defined benefit pension plan than for an ESOP. Generally, a defined benefit pension plan provides the participant with a retirement benefit that depends on the level of final salary and/or the number of years of service. Various funding rules allow the corporation to accelerate the funding of its defined benefit retirement plan. This is not possible with a defined contribu-tion plan.
One motivation for overfunding a pension plan is that it enables the corporate spon-sor to earn the be-fore-tax rate of return on investment. The corporation can reduce fund-ing in later years to realize the benefit of overfunding. With the 1986 and 1988 Tax Acts, it became less desirable, as well as more difficult, to overfund defined benefit pension plans. Moreover, it now seems more likely that marginal tax rates will increase than de-crease. This further reduces the incentive to overfund. All else equal, it is preferable to fund the pension plan when tax rates are high. As a result, defined contribution pension plans have become more competitive with defined benefit pension plans. This might be another reason why firms have established ESOPs.
Some of the advantages of tax-free accumulation in an ESOP is lost, however, since it is necessary for an . ESOP to hold at least 50% of its assets in its company's stock, and common stock is not the most tax-favored security to hold in a retirement plan. This may have been particularly so prior to the 1986 Tax Act. At that time, shares might have borne a high implicit tax as discussed earlier. That is, the before-tax rate of return on shares on a risk-adjusted basis might have been far below the risk adjusted returns on fully taxable bonds.
With the 1986 Tax Act, 100% of realized capital gains became taxable. In addition, the corporate dividend-received deduction was reduced from 85% to 80%°(and reduced further to 70% in many circumstances following passage of the 1987 Act). As a result, the implicit tax on shares is likely to have fallen and the required risk adjusted, before-tax rate on shares is likely to have increased. This generally means that the tax penalty for holding company stock in the pension plan has become smaller, This is another reason that F.SOI's might have become more popular after the 1986 Tux Act, Moreover, contribution limits and an tidiscrimination rules became more uniform across different types of pension plans. Because these rule often represent-binding constraints, many corporations have substituted defined contribution plans for their defined benefit plans. Defined contribution plans are simpler, less costly to operate, and less vulnerable to attack by the firm's many constitu-ents.
The 1986 Tax Act imposed an excise tax of 10% on the excess assets of a termi-nated defined benefit pension plan. This rate was increased to 15% with the 1988 Tax Act. Prior to 1989, however, corporations were allowed to transfer such excess assets to an ESOP without paying this excise tax. Merrill Lynch, for example, established an ESOP on the termination of its defined benefit pension plan in 1988. In addition, Figgie Interna-tional, Transco Energy, ENRON, and Ashland Oil terminated defined benefit pension plans and transferred the surplus to a company sponsored ESOP.
B. Risk-Sharing Considerations
ESOPs provide a form of employee ownership in the corporation. This is an impor-tant reason why such members of Congress as retired Senator Long have championed ESOPs. Employee stock ownership is presumed to align the interests of the employee more closely with the overall goals of the shareholders, relative to a pure salary contract. AVIS, which is 100% owned by an ESOP, emphasizes employee ownership in advertise-ments. By implication, customers are meant to feel that AVIS's employee-owners are working harder to meet their needs.
While employee ownership of shares may succeed in promoting a commonality of interests between employees and owners relative to straight salary contracts, it might be more efficient to provide these incentives in alternative ways. Where employees are risk-averse relative to shareholders, efficient risk sharing requires that employees bear little risk of change in the value of the firm. But where their activities affect the value of the firm, and these actions are unobservable to shareholders except at a prohibitive cost, it is desirable (for incentive reasons) to require employees to bear some risk of changes in the value of the firm. Risk-averse
Avis claims that its customer complaints have dropped by 40% since its ESOP was formed. It also claims that its costs are now well below those of Hertz, its competitor, al-though Hertz's costs used to be lower. There is conflicting evidence, however, as to whether ESOP plan adoption are associated with increased "productivity." For a discus-sion of the evidence see Blasi [4], Conte and Svejnar [6], and Cooper I?].
employees will require additional compensation, however, if they are exposed to risk that is beyond their control. Efficient incentive contracting, therefore, requires a judicious trading-off of risk sharing and incentives. (Holmstrom [10] provides a particularly clear statement of the problem, as well as its solution.)
It is useful to think of stock prices as an indirect monitor of employee inputs. The value of the firm can be viewed as being determined jointly by employee actions and ac-tions chosen by others, such as competitors, customers, and Nature (that is, random fac-tors). Oftentimes it is possible to devise accounting measures of performance (e.g., divi-sional profits or physical output measures) that serve as less "noisy" indirect monitors of employee inputs. The reliance on such measures through incentive compensation ar-rangements is often a more efficient way (relative to measures based on stock market value) to align the interests of employees with those of shareholders. More generally, both types of measures (stock based and accounting based) contain information that is useful in drawing inferences about the effectiveness of employee performance, but stock based measures are likely to prove far more "informative" with respect to senior management performance than with respect to lower-level employees (see Lambert and Larcener [14] for a comparison of the two measures of performance in incentive contracting). As a con-sequence, the implementation of an ESOP may exact a cost along the incentive contracting dimension.
Weirton Steel's 100% employee-owned ESOP decided to take Weirton public again after a successful revitalization of the company. Part of the reason for the sale of company stock was that many of the vested employees in the ESOP did not want to risk undertaking a $500 million expansion of the firm's steel-producing capacity. They preferred a safer po-sition.12
It is interesting to note that employee stock ownership was quite common in the 1920s (Patard [18]). But due to the market crash in 1929, 90% of the stock ownership plans in place before the crash were discontinued by the mid-1930s. Those not terminated restricted participation exclusively to highly paid employees. This evidence suggests that risk-sharing considerations are very important.
The tax rules require that employers allow employees to diversify their holdings at age 55 or 10 years of participation, whichever is later. In the first four years following the passage of this milestone, employees must be permitted to diversify up to 25% of their holdings, and in the fifth year they can invest up to 50% of their holdings in nonemployer securities.
If employees receive nontraded company stock when they retire or leave the com-pany, they have the right to put the stock back to the company for cash. Depending on the demographics, it might be very costly for the corporation to redeem these shares. Addi-tional funds might have to be raised at a time when it is very costly to do so. Moreover, the release of shares to the employees of a private company might force the corporation to comply with Securities and Exchange Commission reporting requirements-the threshold is 500 shareholders. This is also costly.
Prior to the 1987 Tax Act, many ESOP sponsors provided their employees with a defined benefit pension plan floor. Examples include Ashland Oil, Bank of New York, and Hartmarx (Forbes [8]). In these arrangements, the defined benefit plan might guarantee employees a retirement benefit of, say, 50% of their terminal salary during each year of retirement, but distributions to employees would be made from the defined benefit plan only if the ESOP failed to provide at least that same level of benefits. The defined benefit promise serves as a guaranteed floor. This reduces the employee's risk by essentially pro-viding the employee with a put option. Note that shielding employees from risk also means sacrificing incentives. The 1987 Tax Act restricted the use of these offset provi-sions.
Firms have discovered other means to reduce the employee's risk of holding com-pany stock in an ESOP. The ESOP can invest up to 50% of its assets in other than com-pany stock, although a comprehensive survey conducted by the U.S. General Accounting Office in 1986 showed that four-fifths of ESOPs invested 75% or more of their assets in sponsoring company stock. The ESOP can also be supplemented with other types of com-pensation plans to reduce risk. For example, an ESOP might be combined with another de-fined con-' tribution plan invested entirely in bonds.
Many firms have started to fund the ESOP with convertible voting preferred stock.13 Holding preferred shares is generally less risky than holding the company's common stock in the ESOP. Given its superior
13Our analysis of ESOP announcements in the first four months of 1989 from the Dow Jones New Retrieval Service indicates that more than half of all new securities acquired by ESOPs are employer -convertible preferred stocks. Why are grateful to Karen Wnick for assistance in securing these data.
Dividend yield, the preferred will tend to sell at a premium over the common (if converti-ble into at least one share of common) and retain more of its value than the common stocfcifthe value of the company should fall. If the preferred issue represented a substan-tial majority of the company's stock, however, it would have little protection in the event that the company does poorly.
Moreover, some ESOP sponsors provide employees with a put option. That is, if the preferred stock happens to be selling below the conversion price when the employee re-tires or leaves the firm, the employee can put the stock back to the company for the con-version price. This put option is valuable to employees and protects them against the risk of a decline in the price of the common stock.
In summary, an ESOP provides a pension savings alternative to more conventional tax-qualified retirement plans, one that provides employees with an ownership interest in the firm. Employee ownership might lead the firm's "productivity" to improve as employ-ees' interests become better aligned with the firm's other. Shareholders. But such compen-sation arrangements may be at the expense of other more efficient forms (ignoring taxes), both for risk-sharing and incentive reasons.
Moreover, there can be severe nontax costs if an ESOP must refinance to repurchase shares from de- o parting employees. Shares that are initially contributed to the trust must eventually be cashed out, and high transaction costs might be incurred to accomplish this task, particularly in smaller businesses.