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Chapter 15
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ESOPs and MLPs
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Pension Plans
• Pension plans established to provide for
payments to plan participants after
retirement
– Individual firm responsible for setting up
pension fund
– Firm makes dollar contributions to pension
fund
– Contributions are tax-deductible expenses at
time of payment by company
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– Employees' wages are reduced to some
degree to offset contributions by company to
pension fund on behalf of its employees
– Pension fund uses dollar contributions to
make wide-range investments
– Benefits of pension fund accrue to and are
finally paid to pension beneficiaries who are
company's employees
– Benefits received are taxable to the
recipients; dollar flows were not taxable at
time of contribution
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• Plans subject to federal government
regulation by the Employee Retirement
Income Security Act (ERISA) of 1974
• Types of pension plans
– Defined benefit plans
• Amounts participants receive in retirement
specified by formula set in advance
• Two major types
– Flat benefit formula — fixed amount per year of service
– Unit benefit formula — fixed percentage of earnings per
year of service
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• Plan must meet federal fiduciary standards to
qualify for favorable tax treatment
• Plan subject to minimum funding standards
• Plan guaranteed by Pension Benefit Guarantee
Corporation (PBGC)
– Defined contribution plans
• No fixed commitment to pension level
• Contributions are specified and participants
receive over period of retirement what is in their
account when they retire
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• Three major types
– Stock bonus plan — firm contributes annually
specified number of shares of its common stock
– Profit-sharing plan — contribution in cash based on
profitability rates
– Money purchase plan — contribution based on
specific schedule
• Required by law to make "prudent" investments
• Plans not subject to minimum funding
standards
• Plans not covered by PBGC
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Employee Stock Ownership
Plans (ESOPs)
• Definition:
– Defined contribution employee benefit pension
plans designed to invest at least 50% of its
assets in qualifying employer securities
– ESOPs may be
• Stock bonus plans
• Combined stock bonus plans and money purchase
plans
• May also provide for employee contributions
• May represent portion of profit-sharing plan
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– ESOPs different from:
• Employee stock purchase plans
– Enable employees to buy company stock at discount
– Participation of all or most employees
– Shares sold at 85% or more of prevailing market price
of shares
• Executive incentive programs
– Provided mainly to top management and other key
employees
– Part of executive compensation packages
– Two types
• Incentive stock options
• Stock appreciation rights
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• Types of ESOPs
– Leveraged
• Recognized under ERISA in 1974
• Leveraged ESOP operation
– ESOP fund or trust borrows funds from financial
institutions
– Lender transfers cash to ESOP trust in return for written
obligation
– Sponsoring (employer) firm generally guarantees loan
– ESOP trust uses borrowed funds to purchase securities
from sponsoring firm
– Sponsoring firm transfers stock to name of ESOP trust
as portions of principal are repaid
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– Source of payment of both interest and principal to
financial institution is cash contributed to ESOP trust by
sponsoring firm
– Both interest and principal amount transferred by
company are deductible expenses for tax purposes
subject to some limitations
– Leveragable
• Recognized under ERISA
• Plan authorized but not required to borrow funds
– Nonleveraged
• Recognized under ERISA
• Plan does not provide for borrowing of funds
• Essentially stock bonus plan
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– Tax credits ESOPs
• Provided by Tax Reduction Act of 1975; known as
Tax Reduction Act ESOPs or TRASOPs
• In addition to regular investment credit in existence
at that time, additional investment credit of 1% of
qualified investment in plant and equipment could
be earned by contribution of that amount to ESOP
• In 1976, additional 0.5% credit added for
companies that matched contributions of
employees of same amount to TRASOP
• In 1983, basis for credit was changed from plant
and equipment investments to 0.5% of covered
payroll — plans called payroll-based ESOPs or
PAYSOPs
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Uses of ESOPs
• Corporate restructuring activities
– Buy private companies (59% of leveraged
ESOPs)
– Divestitures (37% of leveraged ESOPs)
– Rescue operations of failing companies
– Raising new capital
– Takeover defense to hostile tender offers
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• ESOPs as alternatives to mergers — for
privately held firms
– Motives to merge
• All in one basket — no diversification
• Illiquid position — no market for shares
• Avoid hasty "fire sale" to pay estate taxes
– Mechanics of ESOP transaction
• Firm establishes ESOP
• ESOP borrows money in the amount the firm owner
requires to diversify his position in a portfolio of
publicly traded corporate securities
• Firm owner sells portion (over 30%) of his stock to
the ESOP; value of stock = amount borrowed
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• Owner may invest proceeds in securities of other
U.S. corporations and defer any federal tax on
transaction (tax-free rollover) if:
– Investment is made within 12 months
– ESOP owns at least 30% of firm's stock following sale
– Neither owner nor his family participates in ESOP
• Firm makes tax-deductible contributions to ESOP
sufficient to repay principal and interest
• Shares held by ESOP distributed to employees
over time as loan repaid
• Results for firm owner:
– Tax-free liquidity without selling firm to outsiders
– May be able to retain control depending on amount of
cash needed/proportion of stock sold to ESOP
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– ESOP considerations (for and against)
•
•
•
•
Employee loyalty enhanced
Liquidity and diversification for firm owner
Minimizes dilution of control
Establishes market value for privately held stock
which could be used to value estate
• Provides a market for privately held stock —
avoids "fire sale" of shares if stock needs to be
sold to pay estate taxes
• Tax-free rollover is actually only a tax deferral
until securities are sold
• 50% of proceeds from sale of securities to
ESOP may be excluded from estate's value
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• ESOPs in lieu of subsidiary divestiture
– Alternatives for divesting a subsidiary
• Sell to another corporation — must find a buyer at
an acceptable price
• Liquidate subsidiary's assets — disruptive to
employees, customers, suppliers
• ESOP alternative — subsidiary's employees
willing purchasers of subsidiary through ESOP
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– Mechanics of ESOP alternative
• Set up shell corporation which establishes ESOP
• Use debt capacity of shell corporation and ESOP
(guaranteed by parent) to arrange financing to
purchase subsidiary from parent
• Shell corporation (now no longer a shell) operates
former subsidiary; ESOP holds stock
• As income is generated, tax-deductible
contributions are made to ESOP so it can service
debt
• As debt is paid off, shares are allocated to
employee accounts
• Former subsidiary ends up owned by its
employees
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Tax Advantages
• Scholes and Wolfson (1992)
– Tax advantages of ESOPs may be illusory
– Full deductibility of payments to ESOP for
amortization of debt claimed to have tax
advantages
– Alternative pension benefit plans yield
substantially same tax benefits
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• Interest exclusion
– Beatty (1995) — some tax provisions apply
only to leveraged ESOPs
• Bank, insurance company, investment company
can exclude from taxable income 50% of interest
income earned on loans to ESOPs that own more
than 50% of employer's equity
• Competitive markets would result in lower interest
rates on ESOP loans than on non-ESOP loans
– Interest loan exclusion was repealed in 1996
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• Dividend deduction
– Employer can deduct dividends paid on ESOP
shares if they are allocated to employee
accounts or used to repay ESOP debt
– If dividends used to repay ESOP debt
• Value of ESOP shares declines by amount of
dividend
• Net worth of ESOP contribution reduced by balance
of ESOP loan that was repaid by dividend proceeds
• Employer can deduct entire market value of shares
at time they are placed in ESOP which is higher
than current value of ex-dividend shares
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• Defer capital gains tax
– Owner of closely held firm can defer capital
gains from sale of firm by selling shares to
ESOP
– Sale must be for at least 30% of outstanding
shares
• Tax loss carryforwards
– Tax Reform Act of 1986 placed a number of
restrictions on use of loss carryforwards after
a change in control
– Exception in case of an ESOP purchase of at
least 50% of equity
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• Excess pension asset reversion
– In 1986, excise tax placed on reversions of
excess assets from defined benefit plan
– Lower excise tax rate if excess pension
assets placed in ESOP
• Smaller expected present value tax
deduction (disadvantage)
– Smaller expected present value tax
deduction for leveraged ESOPs compared
to other retirement plans
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– Smaller deduction due to method of
allocating ESOP assets to employees'
account through a suspense account
• Shares purchased by leveraged ESOP initially
placed in suspense account
• Shares are allocated to employees on percentage
basis based on schedule of repayment of principal
and interest in each year of loan
• Retirement plans, other than ESOPs, provide for
immediate allocation of assets to employees
• Value of ESOP tax deduction based on market value
of shares when placed in ESOP
• ESOP tax deduction cannot be taken until debt is
repaid and assets are allocated some years in future
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• Net tax benefits
– Beatty (1995) — average net tax benefit
was 0.3% of equity value for ESOPs
established in 1987 and later
– General Accounting Office (1986)
• Federal revenue losses from ESOPs about $13
billion for period 1977-1983
• Average of $1.9 billion per year
– Net tax benefits would cause positive event
returns for ESOP announcements
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Performance of ESOPs
• ESOPs as a takeover defense
– Polaroid vs. Shamrock Holdings
• Delaware "freeze-out" law prevents hostile
acquirer from merging with target unless 85% of
target's voting shares are tendered
• Polaroid created ESOP which purchased 14% of
its common stock
• Shamrock unable to obtain necessary 85% in 1988
tender offer
• After Polaroid, ESOPs became widely used as
antitakeover strategy
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– Beatty (1995)
• Sample of 145 ESOP announcements
• 57% of transactions took place in 1988 and
1989 after Polaroid decision
• Negative returns on announcement of ESOP
when firm subject to takeover attempt
• No change in returns on announcement of
ESOP when firm is not subject to takeover
attempt and size of ESOP provides effective
blocking percentage ownership
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• ESOPs versus alternative methods of
raising funds
– Corporate financing
• ESOPs provide benefits midway between debt
and equity financing
• Can bring additional debt capacity to highly
leveraged firms
• Debt interest expense under leveraged ESOP
had been lower than straight debt financing
when interest exclusion was permitted
• Provide market for equity financing for closely
held firms
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• Useful device for transferring ownership
• Most leveraged ESOP funds used to buy back
stock from existing shareholders and not for
capital expansion
– Control of stock
• Management continues to control ESOP
• Employees who wish to maintain status quo or
who do not want an outside company to take
over firm, more likely to support management
when ESOPs are used as takeover defense
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– Economic dilution
• ESOPs potentially transfer shareholders' wealth to
employees
• If ESOP contribution not offset by reduction in
other payments to workers, employees gain at
expense of shareholders
• Any borrowing by ESOP uses some debt capacity
of firm
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– Equity position dilution
• Infrequent use of ESOP loans suggests that
nontax costs of using ESOP are high
• Large equity stake that goes to contributing
employees significantly reduces equity stake to
managers and buyout promoter
• Potential advantage: Shares can be sold at higher
prices over the years as ESOP contributes to
higher earnings through tax advantages and
improved motivations of employees
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• Comparison with profit sharing (Mitchell,
1995)
– Deferred profit sharing plans in 16% of all
firms compared with only 3% for ESOPs
– ESOP's coverage of workers relatively small
despite tax subsidies
– Noninsured private pensions held $1.2 trillion
in equity in 1991 compared with equity
holdings of $47 billion for ESOPs
– Compared to other pension plans, ESOPs
have lesser impact on helping workers
achieve equity holdings
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– Profit sharing has economic advantages over
ESOPs
• Flexibility in worker compensation — improves
stability of employment
• ESOP does not add to pay flexibility because it
involves a form of bonus to employment
– Owners have incentive to overvalue stock
assigned to employees in ESOP plans in
order to increase tax subsidy
– Profit sharing schemes are more worthy of
favorable tax treatment since they provide
macroeconomic benefits
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• Effects on company productivity
– ESOP and stock voting rights
• Most studies indicate ESOP's stock ownership
percentages of 10% or less
• Voting rights associated with stock of ESOP
accounts may be exercised by plan trustees
(usually company management) without input by
participants
• ESOPs can be used by management to obtain
tax benefits without sharing control with
employees
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– General Accounting Office study (1987)
• No significant gains in either profitability or
productivity
• Significant improvement in growth rate of sales in
one study
• No significant improvement in growth rate of
employment
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– Park and Song (1995)
• On average, firms with ESOPs improve
performance
• Sample firms partitioned into firms with large
outside blockholders (block firms) and firms
without (nonblock firms)
– Improvement in performance only in block firms
– For nonblock firms, negative relation between
fraction of ownership held by ESOPs and changes in
performance
– No systematic relationship for block firms
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– Conte, Blasi, Kruse, and Jampani (1996)
• Returns of firms with ESOPs significantly higher
than comparable non-ESOP companies
• Financial returns decline after companies adopt
ESOPs
• Results consistent with ESOPs used as takeover
defenses
• Adoption of ESOPs in large companies lowers
financial returns but no significant effect in
smaller firms
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– Systematic studies of ESOPs in U.S. do
not document performance improvement
– Anecdotal evidence of positive effects on
individual companies, e.g., United Airlines
– Many cases where management has been
unwilling to grant employees full
shareholder rights when ESOPs are
formed
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– ESOPs in Japan
• Positive results in sample of manufacturing firms
for period 1973-1988
• Number of publicly traded firms with ESOPs
jumped from 61% to more than 90% since 1973
• Three to four years after creation of ESOPs,
companies averaged 4-5% increase in
productivity
• 10% increase in employee bonuses relative to
bonuses of competitors resulted in 1% increase
in productivity in next year
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• Economic issues
– Bargaining model (Ben-Ner and Jun, 1996)
• ESOPs analyzed in a bargaining game with
asymmetric information
– Management has superior information about firm's
future cash flows
– Employees attempt to overcome information
disadvantage by making simultaneous offers on wages
and purchase price for firm
• Owners of relatively unprofitable firms will
establish ESOPs in lieu of higher wages
• Owners of more profitable firms will prefer to pay
higher wages than dilute control by establishing
ESOPs
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– ESOP may be used by management to
increase control or conduct financial
transactions in their own interest
• Hall-Mark Electronics — executives arranged
ESOP to sell shares back to company for $4 per
share before sale of company for $100 per share
• Chicago Pneumatic Tool Company — CEO
transfers shares from company to ESOP under his
own voting control to thwart hostile takeover
• Scott & Fetzer — ESOP-financed leveraged
buyout; ESOP was putting more than 92% of
equity investment for only 41% of equity
ownership of the company
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– Chen and Kensinger (1988)
• If management controls ESOP — no increase in
motivation for workers or better relation
between workers and management
• If workers receive substantial increases in
control over firm through ESOP — workers may
use power to redistribute wealth away from
other shareholders
• Appropriate employee ownership level should
be better determined by market forces and not
through use of tax subsidies
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• Tax subsidies may cause misallocation of
resources
– Inefficient firms may "limp along"
– Inefficient diversification of employees' capital may
foster overly cautious attitude, discouraging investments
– May cause distortions and departures from what would
occur under unrestricted operation of market forces
• Greatest potential gains from employee ownership
are in smaller high-growth companies — but in such
companies, growth and profitability provide ample
incentives
• Mature, diversified firms with few growth
opportunities likely to be best candidate for ESOPs
—- but ESOP financing should be compared with
other alternatives that do not involve the same kind
or same degree of tax subsidies
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• ESOP Event Returns
– Chang (1990)
• Sample of 165 employee stock ownership plans
• Two-day announcement abnormal return for
overall sample was positive 11.5%
• If ESOP used as LBO or as a form of wage
concession, announcement results in small
positive returns
• If ESOP established as takeover defense
– Event returns are negative
– Managers hold smaller ownership interest in their firms
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– Sellers, et al. (1994)
• Sample of ESOPs in which tax benefits not
expected to be major influence
• Positive two-day return of 1.5%.
• Finding consistent with other favorable effects of
ESOPs such as improvements in employee
productivity
– Chang and Mayers (1992)
• Nontax influences on event returns from
establishment of ESOPs
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• Initial ownership level of officers and directors
– Between 10% and 20% of total shares — largest
positive returns
– Less than 10% or more than 20% of total shares —
smaller positive returns
– More than 40% of total shares — negative association
between event returns and fraction of shares added to
ESOP
– Beatty (1994)
• Companies that adopt ESOPs likely to have
adopted other types of takeover defenses
• Companies that adopt ESOPs likely to have
characteristics consistent with tax and incentive
effects
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– Beatty (1995)
• Sample of 122 ESOP announcements during
1976-1989
• Average 1% two-day positive return reflects
primarily tax effects
• Relation between positive share price reaction and
size of ESOP benefits
• Equity values decline for firms subject to takeovers
– Chaplinsky, Niehaus, and Van de Gucht
(1998)
• Positive three-day abnormal return of 13.3% for
ESOPs
• Compared to 14.9% for management buyouts
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Evaluation of ESOPs
• Comparison of ESOPs with management
buyouts (MBOs) — (Chaplinsky,
Niehaus, and Van de Gucht, 1998)
– In MBOs officers and directors substantially
increase their percentage ownership
– In ESOPs workers do not effectively
increase their control rights
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– Prior to buyout transaction
• Transaction size (measured by median):
ESOPs = $209 million, MBOs = $172 million
• Stock price performance: ESOP have poorer
record
• Leverage (long-term debt to total capitalization):
ESOPs = 12%, MBOs = 27%
• Takeover threats: more likely experienced by
ESOP firms
• Ownership by officers and directors: ESOP had
lower ratios
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– After buyout transaction
• Compensation to employees: ESOP = reduced
by 56%, MBO = reduced by 2.6% — ESOPs are
used to reduce direct employment cost
• Leverage ratio (median)
– ESOPs = 80% (include effects of reversion of excess
pension fund assets), MBOs = 75%
– ESOP firms use higher proportion of bank debt —
greater tax subsidy to institutional lenders
• Industry adjusted employment growth over 3 to
5 year period: no great difference between
ESOP and MBO firms
• Employees fail to obtain substantial control
rights through ESOP formation
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• Effects on firm performance depend on
how ESOPs are employed
– For example, in industries (steel and airlines)
where economic circumstances forced
employees to give up portion of wages for
partial equity position in firm
• Management continued to exercise major control
• Employees have not received full shareholder rights
• Ownership incentives have been severely diminished
• Many ESOPs established as takeover
defenses, but proliferation of other
defense methods has reduced their role
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• Tax advantages
– Major tax advantage for owners of closely
held corporations, but no clear effects on
employee incentives
– Tax subsidies involved with ESOPs might
have negative consequences
– Any positive effect of tax subsidies might
be achieved more effectively through
alternative compensation plans
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Master Limited Partnerships
(MLPs)
• Business organizational forms in general
– Proprietorships and partnerships
• Most numerous
• Mostly small businesses
– Corporations
• Dominant in terms of total assets
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• Four advantages in raising large sums of
money
– Limited liability for shareholders
– Unlimited life
– Ownership divided into many shares — limits risk
exposure
– Shares freely tradable for liquidity, diversification,
transferability of ownership
– MLPs — relatively new form of business
organization
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• Master Limited Partnerships
– Type of limited partnerships whose interests
are divided into units that are traded on
organized exchanges
– First developed in oil and gas industry
– Some advantages
•
•
•
•
Unit tradability similar to stock
Limited liability (for limited partners)
Continuity of life
No double taxation of business earnings
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• Tax treatment of MLPs
– IRS focused on four characteristics to distinguish
between corporations and MLPs
•
•
•
•
Unlimited life
Limited liability
Centralized management
Transferability
– MLPs may have only two of four corporate
characteristics to avoid being taxed as corporation
— usually centralized management and
transferability
– MLPs typically specify limited life of 100 years
– MLPs have limited liability for limited partners but
unlimited liability for general partner or manager
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• General partner of MLPs
– General manager (partner) of MLPs has
unlimited liability
– Virtually autocratic power
– Difficult to change general partner in
absence of provable fraud
– Alignment of interests between general
partner and public unit holders
• Management incentive fees
• Ownership of significant number of limited
partnership units
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• Types of MLPs
– Roll-up MLPs
• Combine existing limited partnerships into one publicly
traded partnership
• First type of MLPs organized; began in oil industry by
Apache Petroleum Company in 1981
• Provide liquidity for nontraded limited partnerships
• Nature of roll-up
– Before roll-up, there are a number of limited partnerships in
existence
– General partners enter into agreement to combine a number of
previously sponsored limited partnerships; in return for their old
shares, units in new MLP are issued
– After MLP has been formed, there is a general partner and units
which are owned by limited partners; units may trade on stock
exchange or over the counter
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– Roll-out (spin-off) MLPs
• Formed by a corporation's contribution of operating
assets in exchange for general and limited partnership
interests in MLP
• Sold on a yield comparison basis
• First roll-out MLP created by Transco Corp in 1983
• Nature of roll-out
– Corporation holds a number of business segments
– Corporation places assets of one or more of its business
segments into MLP
• Avoid double taxation of corporate dividends
• Establish a new value on undervalued assets
– MLP transfers MLP units to corporation which in turn distributes
them to its shareholders
– Stockholder hold stock in corporation and own units in MLP
– Corporation could sell portion or all of units to outside public
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– Start-up (new issue, or acquisition) MLPs
• Formed by a partnership that is initially privately held
but offers its interests to the public in order to finance
internal growth
• Nature of start-up
– Existing entity transfers assets to MLP
– Management company may be involved that provides
services to MLP and probably will be its general partner
– In return, management company receives certain
percentage of cash flows of MLP
– General partner does not have to hold units in order to
receive income
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• Initial pricing of MLPs
– Muscarella (1988)
• Sample of initial public offerings (IPOs) of MLP
units in 1983 to 1987
• No significant under or overpricing
• Findings contrast with substantial underpricing of
IPOs for corporate securities (7.6 - 26.5% initial
average returns)
• Price performance of MLP units implies less
uncertainty in valuation of MLP units compared to
new corporate stock issues
©2001 Prentice Hall
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– Moore, Christensen, and Roenfeldt (1989)
• Two-day return of 4.61% (significant)
• Reasons for positive market reaction
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©2001 Prentice Hall
Tax advantages
Reduced information asymmetry
Improved asset management
Information signaling
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• Tax Law Changes
– Revenue Act of 1987 provided that MLPs would
be taxed as corporations except for partnerships
involving oil and gas, timber, and real estate
– MLPs existing on 12/17/87 would be
"grandfathered" until after 12/31/97
– After 12/31/97, MLPs could elect, as an
alternative to corporate taxes, to pay 3.5% of
gross income
– After 12/31/97, MLPs like Boston Celtics created
multiple corporations and limited partnerships
with cross-ownership relationships, apparently to
minimize the impacts of the tax law changes
©2001 Prentice Hall
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