Professional Documents
Culture Documents
CH 15
CH 15
Chapter 15
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)
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Required by law to make "prudent" investments Plans not subject to minimum funding standards Plans not covered by PBGC
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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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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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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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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
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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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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 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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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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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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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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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
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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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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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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Corporations
Dominant in terms of total assets
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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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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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