Split Personality

An ESOP is a retirement plan. No, it's an ownership investment. Wait -- it's neither one.

In the wake of the spectacular bankruptcies of Enron, United Airlines, and Polaroid, employee stock ownership plans have come under intense media scrutiny during the past year. The staggering losses of employees’ retirement savings have prompted pundits to predict the demise of ESOPs, and politicians to call for regulatory overhaul.

Pundits notwithstanding, ESOPs won’t disappear anytime soon. While the total number of plans has indeed declined in recent years — from 11,500 in 2000 to 10,000 in 2002, according to the nonprofit ESOP Association — private-company plans have increased as a percentage of the total, from 90 percent private in 1997 to between 95 and 97 percent private in 2002.

Experts say the decline in the number of total plans is the result of changes to tax laws governing public-company ESOPs, and of the increased use of alternative methods of delivering equity into employee hands, like stock options.

On the other hand, reasons for the private-ESOP increase include the current depressed market for initial public offerings, business combinations, and partial-interest sales, which means there is a dearth of exit strategies for private owners.

“Almost every ESOP I’ve ever done has been done after the owner tried to do an IPO or a strategic sale,” says Vaughn Gordy, senior vice president and trust officer of LaSalle Bank NA, in Chicago. “Something doesn’t go right, so instead they try an ESOP. In fact, I’ve got more proposals outstanding [for ESOPs] right now than I ever have.”

Also behind the private-ESOP surge are the challenges that small public companies face complying with the corporate-governance and reporting rules of the Sarbanes-Oxley Act of 2002. Many may choose instead to go private using an ESOP, says Gordy. ESOPs are also a particularly viable business model when the company converts to an S corporation. Finally, an ESOP remains a potentially effective vehicle for building employee wealth. For example, at Appleton, a coated-paper manufacturer in Appleton, Wisconsin, employee-owners have seen the value of their stock double since 2001, according to CFO and vice president of finance Dale Parker.

But if ESOPs are in no danger of dying, they do need immediate medical attention. The disasters at Enron and elsewhere have underscored their fundamental conflicts — and risks.

The most obvious conflict resides in an ESOP’s basic structure. Because they are covered under the Employee Retirement Income Security Act of 1974, ESOPs are considered retirement vehicles. Under ERISA requirements, the trustee (or trustee committee) must manage the plan for the sole benefit of the members and to preserve the value of the plan assets. But this flies in the face of the plan’s mandate: to invest solely in the shares of a single company.

Such a nondiversified, high-risk portfolio is considered the worst possible design for a retirement vehicle — a fact that was made clear as State Street Bank and Trust Co., the ESOP trustee for both United and Polaroid, dumped the companies’ nearly worthless shares as they neared insolvency (see “What’s Wrong with This Picture?” January). Plan experts say ESOPs should never be the sole retirement vehicle for employees, and in ESOP-owned companies they usually aren’t. But this doesn’t resolve the fundamental conflict.

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