©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1 - - - - - - - - Chapter 15 - - - - - - - - ESOPs and MLPs

©2001 Prentice Hall Takeovers, Restructuring, and Corporate

Governance, 3/e Weston - 1

- - - - - - - - Chapter 15 - - - - - - - -

ESOPs and MLPs



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



– 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



• 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



• 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



• 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



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



– 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



• 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



– 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



– 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



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



• 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



• 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



– 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



• 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



– 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



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



• 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



• 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



• 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



• 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



– 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



• 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



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



– 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



• 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



• 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



– 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



– 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



• 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



– 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



• 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



– 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



– 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



– 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



– 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



– 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



• 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



– 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



– 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



• 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



• 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



– 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



• 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



– 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



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



– 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



– 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



• 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



• 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



Master Limited Partnerships (MLPs)

• Business organizational forms in general– Proprietorships and partnerships

• Most numerous• Mostly small businesses

– Corporations • Dominant in terms of total assets



• 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



• 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



• 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



• 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



• 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



– 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



– 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



• 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



– Moore, Christensen, and Roenfeldt (1989)• Two-day return of 4.61% (significant)• Reasons for positive market reaction

– Tax advantages– Reduced information asymmetry– Improved asset management– Information signaling



• 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

Documents

©2001 Prentice Hall Takeovers, Restructuring, and Corporate Governance, 3/e Weston - 1 - - - - - - - - Chapter 15 - - - - - - - - ESOPs and MLPs