Do ESOPs Aid Workers or Managers?

That the employees of Hall-Mark Electronics got to own one-third of the company’s stock through their retirement plan should hearten those who believe in the dream of worker capitalism.

That three Hall-Mark executives arranged to have the retirement plan’s shares sold back to the company for $4 each shortly before they helped arrange to sell the company for $100 a share shows that the dream is not quite perfect.

The sale of the Hall-Mark employee shares back to the company is currently at issue in federal courts in Atlanta and Huntsville, Ala., where a U.S. district judge has clamped a gag order on all parties in the case and sealed the case file.

After the judge approved an out-of-court settlement between a group of workers and the company worth between $3 million and $5 million, the Labor Department, contending that the settlement was too small and unfairly excluded too many workers, persuaded the U.S. Court of Appeals in Atlanta to review the case. That review is pending.

Government officials and other professionals regard Hall-Mark as an illustration, if a particularly egregious one, of the pitfalls that arise when employees become stockholders in their own companies--and when those holdings are managed, as commonly happens, by executives of the same company.

Popular Ideal

Employee participation in company ownership has long been a popular ideal, envisioned as a way to give the nation’s work force a stake in American business. Employee ownership theoretically makes workers more productive by giving them a direct interest in their company’s success.

Studies have suggested that employee-owned firms are less likely to relocate from their home communities and more likely to have positive management-labor relations.

Executives also rely on employee-shareholders to show considerable loyalty when a company is under attack by a hostile takeover bidder, not least because the workers often fear an acquirer will pare jobs.

The security of having a large block of stock in an employee fund is only enhanced when that stock is in a fund managed by the company’s own executives, as is frequently the case.

The fastest-growing program for employee ownership today is the employee stock ownership plan, or ESOP. An ESOP is customarily structured as a retirement fund to which the company makes regular contributions on behalf of its participating workers; the fund is required to invest this money primarily in the company’s own stock and bonds.

The tax advantages for companies forming ESOPs are considerable. The company’s contributions are generally tax-deductible. Individuals with a large stake in small companies, such as retiring founders, can transfer their holdings to an ESOP tax free.

Employees pay taxes on their shares only when they receive them after retiring or leaving the company.

Finally, companies can raise money for themselves by borrowing through the plans. Lenders can deduct from their taxable income half of the interest they receive from these loans, meaning that the loans can be issued at lower interest rates.

Today there are more than 7,000 ESOPs with 10 million employees participating. According to the National Center for Employee Ownership, an Arlington, Va., trade group, the typical ESOP owns between 20% and 40% of its company’s stock. About 260 ESOPs own majority interests in their employer companies, and at least 16 own 100%.

Not even in fully ESOP-controlled companies do workers exert much management control of their company. That generally remains in the hands of professional executives. But the workers are expected to receive the financial gains that come from owning a corporation.

“I do not believe in workplace democracy at the board of directors level,” says Joseph S. Schuchert, managing director of Kelso & Co., the investment firm that pioneered ESOPs and remains the dominant force in the field today. “But I do believe in full pass-through (of profits) and in employees having a say in the workplace.”

Yet as their popularity has grown, so have the indications that ESOPs can produce disturbing conflicts of interest for the corporate executives who create the plans and subsequently manage their assets.

The temptation to treat ESOP assets as corporate or even private funds, court records around the country indicate, sometimes overwhelms plan trustees, who by law are required to manage ESOP assets as “fiduciaries”--that is, as agents working exclusively for the financial benefit of the workers.

Labor Department officials maintain that once a company contributes money or arranges a bank loan to its ESOP, that money must be managed as mandated by the federal Employee Retirement Income Security Act of 1974 (ERISA)--strictly as the workers’ own money.

Want Use of Funds

But corporate managers and their financiers say they often need much more freedom in managing capital. They argue that money contributed to an ESOP should be available for a range of corporate purposes, some of which might bear little immediate relation to the financial rights of the employees. If an ESOP’s funds are used to finance a company’s hostile takeover defense, for instance, the value of the company’s stock might drop with the disappearance of the threat; that means the employees’ assets have diminished in value.

Says Schuchert: “The only way an ESOP can be successful is if it is an effective investment banking device.” Schuchert maintains that his view is backed by a series of private rulings in which the Internal Revenue Service consistently “treats the ESOP as a technique of corporate finance and only incidentally as an employee benefit plan.”

With millions of dollars at stake in leveraged buyouts--where firms are purchased with loans secured by the target company’s assets and repaid from their cash flow--even philosophical differences carry a large price tag. When the Labor Department last year blocked an ESOP-financed $500-million leveraged buyout of Scott & Fetzer, publisher of the World Book Encyclopedia on grounds that the employee fund would pay a disproportionately high price for its stock compared to management investors, Labor Secretary William E. Brock III got an angry letter from Louis O. Kelso, the firm’s founder. Kelso complained that in questioning the buyout, Brock’s underlings had “delivered a mighty blow against democratizing capitalism.”

Since then, only one ESOP-financed leveraged buyout has been completed, and that by a different firm, largely because Schuchert has taken Kelso & Co. temporarily out of the field.

“I will not do a public deal with a leveraged ESOP until the dust settles,” he says.

The price at which companies sell their stock to their ESOP is only one area where potential conflicts arise. It is the company management that creates the ESOP, funds it, appoints its ostensibly independent trustees and sells the ESOP company stock. The potential conflicts are legion.

Created Potential Conflict

When Chicago Pneumatic Tool Co. established its ESOP in 1985, for example, it placed its own chief executive, Thomas P. Latimer, in charge. That created a potential conflict in March of this year, when the company found itself the target of a hostile takeover bid from a group of Florida investors.

To defeat the bid, Latimer transferred 1 million shares from the company’s treasury to the ESOP and effectively into his own voting control. The transaction, which the Labor Department says Latimer executed without conferring with outside professional financial advisers, cost the ESOP $32.4 million for the shares, which were trading at about 30% above their historic level because of takeover speculation.

The ESOP participants’ financial interests went unprotected, the agency complained in federal court in New York. Latimer had made no attempt to negotiate the price of the shares and failed even to legally register the stock, meaning that it cannot be sold on the open market. Following the agency’s complaint, Latimer stepped down from the trusteeship, although the matter remains the subject of the court case.

Latimer declined to comment on the matter. “He’s no longer the trustee and he doesn’t have anything to do with the ESOP,” his secretary said.

“Too often ESOPs just remain the cat’s-paw of management,” says Leon Irish, a professor of law at the University of Michigan and a legal consultant to many plans. Except for the rare situations in which an ESOP buys stock on the open market, he says, “ESOPs seem always to buy the stock from an interested party.”

ESOP promoters say such conflicts produce problems in a tiny minority of cases. “You have to overlook 100 good ones to find two or three abusive ones,” says Schuchert. The Kelso firm takes particular care, he adds, to ensure that no parties are treated unfairly.

“Our guys generally have a strong philosophical commitment to spreading capital ownership,” he says. “We’ve never had a single adverse ruling by any court or any administrative agency on a case we’re responsible for. We’re pretty proud of that.”

Still, the prospect remains that corporate officials given control of the substantial stock holdings of an ESOP can engage in questionable transactions. In the Hall-Mark case, two of the company’s former employees charged in a class-action suit that the Dallas electronics company’s top executives used the plan to enhance their own stock holdings just before they sold the company to Tyler Corp., an industrial conglomerate, in 1981.

Hired Outside Appraiser

The Hall-Mark ESOP was created in 1977 and funded with 176,607 shares of company stock. Because the shares were only sporadically traded over-the-counter and thus of uncertain value, the company hired an outside appraiser who valued them at $20 each--a total of $3.5 million for the ESOP’s one-third stake.

Over a three-month period in 1980, according to court testimony cited in legal papers, the plan’s three trustees, who were Hall-Mark executives as well as owners of 40% of its stock, slashed the value of the stock as represented on the ESOP’s books--first to $12 per share, then $10, then $4--on the grounds that the company’s value was falling.

The Labor Department later questioned this writedown campaign by noting that on Oct. 29, 1980, Hall-Mark reported record sales and profits and a nearly one-third increase in the company’s net worth. Nevertheless, within a day, the trustees had made their final writedown to $4. Shortly thereafter, they sold the stock back to the company at that price, or $706,428.

The trustees contend that their sale was proper because $4 a share was the same as or more than the stock was then fetching in its occasional over-the-counter trades. But the federal agency argued in court papers that the trustees must have known better.

According to one deposition, trustee Jack Turpin, Hall-Mark’s chairman, had told a potential acquirer that the company was worth more than $30 million just two weeks after the final writedown placed its entire value at only $2.3 million. Six months later, Turpin was telling Tyler Corp. that his asking price was $50 million, the Labor Department alleged. That is the price that Tyler subsequently paid, a figure that would have given the ESOP a $13.1-million payoff had it held on to its stock.

With the retirement of the employee plan’s stock, the class-action lawsuit contended, the three trustees had become 68% owners of Hall-Mark. Their share of the final selling price, government officials later estimated, was $33.8 million. As fiduciaries to the ESOP participants, the department argues, the trustees bore “the highest (duty) known to the law” and should at least have sought another independent appraisal.

Turpin declined to comment on the allegations. “The file is sealed, discussion is sealed,” he said from his Dallas office. He did remark, however, that in approving the settlement, the Huntsville judge “has stated they (the plaintiffs) have a weak case.”

‘No Wrongful Conduct’

In a letter to employees last year after the U.S. attorney’s office in Dallas opened an investigation into the case, Turpin wrote that the Internal Revenue Service and the Labor Department investigated the matter in 1982 and found “no wrongful conduct,” according to a report in Electronics News. The U.S. attorney’s investigation last year resulted in no action.

Other complaints raise the question of whether company managements have taken to simply unloading failing subsidiaries on their employees under the guise of fulfilling the ESOP goal of spreading ownership.

That is at issue in the 1985 sale by Ogden Corp., a food service and waste recovery company, of a handful of subsidiaries known as Avondale Industries to an ESOP for $282 million in cash. The ESOP’s trustees say they discovered later that Ogden overstated the value of the subsidiaries by nearly $100 million, mostly by concealing losses of a major unit.

“They weren’t worth what we paid for them,” contends James St. Clair, the ESOP’s attorney.

One problem with the Ogden deal is that the ESOP was not even created until Sept. 1, 1985, less than a month before the sale closed, although Ogden had established its sale price as early as April--thus rendering the ESOP less than a fully participating party to the negotiations. For his part, St. Clair charges that the ESOP trustees “were not properly advised by (Ogden’s) auditors,” Deloitte, Haskins & Sells, who also advised the ESOP and are defendants in its lawsuit.

Ogden, in an April 8 filing with the Securities and Exchange Commission, said it might be willing to reduce the sale price by as much as $28.8 million but does not comment on the lawsuit beyond stating that the sale “has given rise to a difference of opinion” between the ESOP-owned Avondale and Ogden over the subsidiary’s value on the sale date.

“That’s as much as we want to say,” company spokesman said.

Key Issue Is Price

Still, the key issue in ESOP-financed buyouts remains the one at the center of the Labor Department’s battle with Kelso & Co. over the Scott & Fetzer buyout: What price will the ESOP pay for its stake?

As the agency’s auditors saw the 1985 buyout proposal, Scott & Fetzer’s ESOP was to put up $182 million in borrowed funds to receive 41% of the company in a leveraged buyout. A group made up of Scott & Fetzer’s top management and Kelso & Co. were to put up $15 million, including $9 million at the time of the deal. They would get 29% of the company. For financing the entire transaction (including the $182-million ESOP loan), General Electric Credit Corp. would get the remaining 30%.

Thus, the agency figured that the ESOP was going to put up more than 92% of the equity investment for only 41% of the company. The Labor Department considered this result a violation of the ESOP’s legal duty to pay only fair market value for its interest in Scott & Fetzer.

Kelso maintained throughout the negotiations that its analysis demonstrated that the ESOP was getting exactly what it paid for. That analysis, Schuchert says, regards the ESOP’s $182-million contribution as a loan from the company--not as the plan’s equity contribution.

“The only thing the ESOP brings to the table is the present value of its future tax benefits (that is, the value of the tax breaks that Scott & Fetzer receives by doing its funding through an ESOP rather than without one),” he says. That interpretation of the deal brings the ESOP’s payment for its share of the company much more into line with the other participants’.

“As a matter of economics, there’s a great deal to be said for (Schuchert’s interpretation),” says Leon Irish, the University of Michigan law professor. “But it’s a non-starter from the legal point of view.” ERISA, Irish says, provides that “once the ESOP borrows that money, it becomes the plan’s assets: It’s obligated to repay it. It would be a gross violation of the plan fiduciary’s duty to give up, say, $1 million in cash and only get $100,000 in stock for it.”

Balked at Proposal

This clash of economics and legalisms was lethal to Scott & Fetzer’s ESOP proposal. After about a month of negotiations, the company’s lawyers proposed an altered deal in which the ESOP would get 50.1% and the management and outside investors a combined 19.9%. Although the agency indicated that it would approve those terms, the company’s board balked and eventually sold the company to a group of outsiders without any worker participation.

Louis Kelso, who completed the very first ESOP in 1956, saw the implications of the Scott & Fetzer fight broadly. In his August, 1985, letter to Brock, the financier wrote: “Scott & Fetzer will be sold to other buyers and the employees will own none of it. After the closing, employees will work at the same wages, with the same fringe benefits; the employees will be more alienated than ever.”

Schuchert contends that most of the ESOP-financed buyout proposals opposed by the Labor Department on valuation grounds would produce great profits for the participating workers, a result that justifies making such deals particularly appealing to outside investors.

“You’re going to see massive accounts for employees coming out of some of these (ESOP-financed buyouts),” Schuchert says. “It’s pretty hard to come to the conclusion that the purpose of ESOPs is not what we’re using it for.”