Debating the risks and rewards of ESOP participation
by Martin Staubus
In June, Employee Ownership News published a commentary from Bret Keisling, It’s Time to Reconsider Bankruptcy Protections for ESOP Participants. In the face of an unprecedented economic recession, Keisling, host of the ESOP Podcast, raised crucial questions regarding the risk bankruptcy poses for Employee Stock Ownership Plan (ESOP) participants. In the following article, Martin Staubus, former executive director of the Beyster Institute, offers a counterargument, suggesting that a certain degree of risk is inescapable when investing in equity and can’t be structured away through new bankruptcy rules. And, he says, that may not be entirely a bad thing.
In June, Fifty by Fifty’s Employee Ownership News laid out some thoughtful new ideas for advancing the practice of employee ownership. It’s encouraging and inspiring to see all these creative juices flowing. We certainly need new ideas in our field.
Still, I have to confess that some of the proposals for action left me scratching my head. I didn’t quite follow, for example, the proposal from my friend Bret Keisling for new protections for ESOP participants where their company files for bankruptcy protection. He proposes that in the case of bankruptcy, the ESOP participants should have the status of “secured creditors” rather than simply equity holders (as Bret explains, equity holders are last in line to receive any value in the case of a bankruptcy, and since the funds run out before the end of the line is reached, the equity holders typically come away with nothing at all).
So, if the bankrupt company’s shares are worth zero, how would it help the participants to get a higher priority claim status as a secured creditor?
First, it’s worth establishing one point — which is that every employee’s ESOP account is already completely protected in bankruptcy situations, in the sense that the assets in the ESOP do not belong to the company (the ESOP itself is actually a separate, independent entity that does not belong to the company), so the company’s creditors cannot take the ESOP assets. So, if the ESOP participants, for example, have some cash (or money market investments, etc.) in their accounts, they will receive every penny of that money — not a dime will be taken by the company’s creditors. The focus of Keisling’s idea, then, is specifically on the shares of company stock that will be in the employees’ ESOP accounts. Should the employees receive some money as compensation for the shares they will lose as a result of the bankruptcy process?
Working through this well-intentioned idea inevitably gets us into the arcane world of ESOP distribution rules. There are situations, for example, in which a participant has already terminated employment and surrendered her shares back to the company or the trust, and is simply awaiting the installment payments for those shares. In that case, yes, that participant is a creditor, and some form of priority claim over general creditors would be a very nice idea. And in fact, such participants often receive security for the money that is due to them, meaning that they already have the status in bankruptcy that Bret advocates for.
But that situation is relatively rare as compared with the far more common bankruptcy situation involving participants who, at the time of the bankruptcy filing, are still employees of the company (or who have terminated employment but still had shares in their ESOP account). Those employees have shares of company stock in their ESOP accounts. As I understand the proposal, it recommends that those employee-owners would get priority over other creditors so that the company assets would be used to pay those participants for their shares before other creditors get paid. The problem is, what is the value of those shares? In the case of bankruptcy, the shares are worth zero. After all, in bankruptcy, virtually by definition the company’s assets are worth less than its debts — thus, the negative value of the whole company.
So, if the bankrupt company’s shares are worth zero, how would it help the participants to get a higher priority claim status as a secured creditor? Their claim, after all, is worth zero no matter how much priority their claim is given. Should a value other than zero be assigned to the ESOP’s shares, but not to the shares of any other shareholders? On what basis, and what amount?
Finally, even assuming that there might be some way to set a “value” on the worthless shares in the ESOP, where would the money come from to pay the participants? Keisling suggests that the ESOP participants should be given the status of “secured” creditors. By that term, we mean that specific assets of the company have been set aside legally to be claimed by those creditors. A simple example of this arrangement is the traditional home mortgage loan. The bank makes the mortgage loan on the condition that, if the borrower fails to make the loan repayments, the bank can take ownership of the house. Businesses borrow on similar terms. So in the case of a bankrupt business, most of its assets are already committed as security for its debts. To suggest that the ESOP participants should be given a “secured creditor” status begs the question of what company assets would secure any amounts that the participant might be due. In fact, many ESOPs are formed at companies in service industries, so they really have very little in the way of physical assets in any event. If they run out of cash — which is always what precipitates bankruptcy — there is nothing left with which to pay anyone else, including ESOP participants.
From a broader philosophical perspective, we have to recognize that investing in equity — that is, buying company stock, as an ESOP does — is a high-risk/high-reward proposition. The risks and rewards are necessarily, inextricably linked. There is no such thing as a high-reward investment opportunity that does not also involve high risk. If that were that case, that’s the only thing people would ever invest in. So, if we want to create the opportunity for ordinary working people to get in on the capital investment game that fuels wealth-building for the privileged — which is what ESOPs do — we have to accept that not every ESOP will work out. The really good news here is that, research shows that ESOP companies are far less likely to go bankrupt than traditionally owned companies, since employee-owners take better care of their businesses. And if they are wise, they will have continued to contribute to their company’s 401k plan (which will be completely protected in the event of bankruptcy because the plan is not invested in the company’s stock). So ESOPs remain an incredibly positive opportunity for those in the 99 percent to get in on the wealth-building strategy of the 1 percent.
Martin Staubus is a senior consultant and former executive director of the Beyster Institute, part of the Rady School of Management at UC San Diego, where he advises business leaders on the design and operation of employee stock ownership programs to build stronger companies and provide liquidity to owners.