The Challenge of ESOPs in Publicly Traded Companies

Should more publicly traded companies have an ESOP, and should employee-ownership advocates spend time and resources figuring out ways to make that happen?

At first glance, the answer to both questions is, “Of course they should.” But the issue is murkier than it might appear.

Let’s look first at top-of-the-head reasons for the “of course” answer. The 3,600 public companies in the US employ about one-third of the nonfarm private-sector workforce. Most of these companies are sizable. Thanks to their products’ ubiquity and to widespread coverage of the stock market, they are the most prominent part of the US economy.

The lure of stock-market ownership, moreover, shapes the operation of many privately held businesses. Founders of growth companies dream of an initial public offering, or IPO. Private equity firms act as farm teams for the public markets, grooming their portfolio companies for an IPO or acquisition by a publicly traded corporation.

Widespread use of ESOPs in stock-market companies might make employee ownership far more visible than it is now, easier to refer to in conversations and policy debates and hence more influential. It would also spread more of the wealth, though no more than an equivalent amount of employee ownership in privately held companies.

A second reason for favoring ESOPs in this context is the short-term bias that pervades the public markets. Executives of stock-market companies feel constant pressure to boost quarterly earnings. If the share price flatlines or falls, after all, analysts may sour on the stock, and corporate raiders—sorry, activist investors—may begin circling. (Executive compensation may decline, too—hardly a trivial factor in encouraging the short-term mentality.)

Short termism of this sort arguably has deleterious effects on innovations and business strategies that require long-term investments. It thereby harms the US economy. A sizable ESOP—by definition an owner with a long time horizon—might act as a source of patient capital, discouraging activist takeovers and encouraging management to develop longer-term strategies for profitable growth.

As to other effects, who knows? Executives who feel themselves partially accountable to employee owners might not jump quite so quickly to layoffs and plant closures when the bottom line needs a boost. They might be more receptive to “good jobs” strategies like those described by MIT’s Zeynep Ton and Harvard Business School’s Dennis Campbell and his coauthors. They might seek to create employee-centric ownership cultures like those at Southwest Airlines and Herman Miller. Research has already revealed that public companies with ESOPs hire more slowly and fire more slowly, creating a more stable—and presumably more loyal—workforce. (This article reviews the research on ESOPs in public companies; the relevant section begins about halfway down.)

Maybe an ESOP would even have a dampening effect on executive pay. Once upon a time, unionized companies felt constrained as to how much they could pay their CEOs and other top executives, knowing that some of those same execs would have to sit across the table from labor in collective bargaining negotiations. The presence of a good-sized ESOP might act as a similar restraint.

Publicly traded companies do have plenty of other mechanisms for getting shares into employees’ hands. They can hand out equity grants and stock options. They can sponsor employee stock purchase plans, which offer shares at a discount. But there is nothing quite like an ESOP. ESOPs are designed to include everyone, not just a small group at the top (as is often the case with stock grants and options). They force employees to accumulate shares rather than simply cashing them in on receipt, so they lead to a long-term shift in the distribution of corporate wealth. They act as that source of patient capital. And unlike employees who sign up for a stock-purchase plan, ESOP participants get their shares for nothing.  

But then, on the other side of the ledger, there’s the remarkable history of public-company ESOPs. It raises some thorny questions.

Louis Kelso sold Louisiana senator Russell Long on the idea of ESOPs at a famous dinner (page 5 of the pdf) in late 1973. In 1974 Long wrote ESOPs into ERISA, the law that has governed corporate retirement programs ever since. But that turned out to be just the beginning. In 1975, 1983, and again in 1984, Long and his congressional allies provided companies with various tax advantages for setting up and contributing to ESOPs. Under the 1984 law—known as Section 133 of the tax code—lenders to ESOPs also got tax breaks on a portion of the interest they earned. Banks promptly set up ESOP desks and began selling ESOP-related loans to their customers, passing along part of the savings.

By 1986 ESOPs were fast becoming an accepted part of public companies’ financial toolkit. Five years later, Joseph Blasi and Douglas Kruse of Rutgers University published a comprehensive account of the phenomenon in a book called The New Owners. It had a telling subtitle: The Mass Emergence of Employee Ownership in Public Companies and What It Means to American Business. “Today,” they wrote, “there are over 1000 publicly traded corporations in which the employees own substantial stock in the company.” A large fraction of this ownership was in the form of an ESOP. The authors expected the trends toward more and more ESOPs—and more and more employee ownership—to continue.

Instead, the trends came to a crashing halt. In 1989, even as Blasi and Kruse were working on their book, Congress amended Section 133. The move came partly in response to perceived abuses, though there weren’t really very many, and partly in response to budget-cutting pressure. Once the law took effect, the tax breaks would apply only to plans that held at least 50% of a company’s shares and offered full voting rights. Around the same time, accounting rules changed, with the effect that operating an ESOP could hurt a company’s reported earnings. Beginning in 1990, the number of new ESOPs in public companies plunged. In 1996, Section 133 was abolished completely.

So what did we learn?

One obvious lesson is that incentives are essential. This lesson holds for privately held companies as well; without the so-called 1042 rollover, there would be many fewer ESOPs in the US than there are today. But it applies with particular force to publicly traded companies, because without incentives they have no reason to pursue an ESOP. ESOPs are cumbersome. Companies must observe the relevant government regulations. Depending on how an ESOP is funded, it may raise issues of shareholder dilution or breach of fiduciary responsibility, and thus invite lawsuits. If a company wants employees to “think like owners” and therefore offers long-term incentive compensation tied to corporate performance, a profit-sharing plan or a program of equity grants is far easier to administer—though these, too, may run into objections from Wall Street.

A second lesson: given sufficient incentives, however, public companies will indeed establish ESOPs. The trick here is to figure out what incentives might actually work. Section 133 was a powerful incentive in its time: interest rates were sky high, borrowers had good reason to pursue lower-cost loans, and lenders had good reason to sell them. In today’s low-interest-rate environment, the incentive might still work. But it wouldn’t be as strong.

Finally, we learned that ESOPs will spread ownership—a good thing in itself—but in many cases won’t lead to any further changes in the workplace. Most ESOP companies in the 1980s didn’t take many steps to inculcate a culture of ownership or participation. Possibly that would have changed over time, but we can’t be sure.

One hopeful sign: a few years ago, Blasi and his coauthors studied a set of 780 companies, most of them public, that had applied for listing on Fortune’s annual list of the 100 Best Companies to Work For. (The resulting paper is available in typescript here; publication information is here.) About one-sixth of these companies had an ESOP, and many more had profit-sharing or stock-option plans. On average, these companies “allow greater employee participation in decisions and greater information sharing than other firms.” They also have “a more positive workplace culture.” The combination of group incentive pay, participation, and a positive culture “increases employee intent to stay with a firm, lowers voluntary turnover, and raises return on equity.”

That conclusion contains a recipe for a successful publicly traded business, and for spreading at least some of the nation’s corporate wealth. The recipe doesn’t necessarily include an ESOP, though it must include some sort of shared-capitalism compensation system. Unless and until Congress passes a new set of ESOP incentives, the number of plans is unlikely to expand. Designing the right incentives is a compelling job for the policy mavens among us.

In the long run, the idea of public ownership—like the idea of any kind of financial or absentee ownership—may run its course. As David Ellerman has pointed out, it makes no sense to have ownership separate and disconnected from the business for which the owners are legally responsible. Legal ownership should reside in the people who are in fact responsible—that is, the executives and employees who actually work in the company. Until that day comes, however, we will have to contend with publicly traded entities, and we will have to figure how best to encourage them to share their wealth.