Observations on Employee Ownership
What Will Happen to the ESOP in the Tribune Bankruptcy?
December 2008In 2007, the Tribune Company was acquired by billionaire investor Samuel Zell in conjunction with an employee stock ownership plan (ESOP). On December 8, 2008, the Tribune Company filed for bankruptcy protection. In this article, we look at common questions about the ESOP and bankruptcy as they relate to the Tribune Company.
Who Paid for the Shares Held by the ESOP?Probably the most common misconception about ESOPs is the idea that they are that they are funded by employees; in fact, they are not, except in very rare cases. Generally speaking and at the Tribune Company specifically, ESOP participants did not make direct investments, did not take wage concessions, and did not transfer assets from existing retirement plans into the ESOP. Instead, ESOPs are funded by the company just as the company would fund other benefit plans.
The company sets up a trust for the benefit of employees, then funds it either by contributing cash to buy shares, contributing shares it already owns, or, most often (and as in the Tribune case) by having the trust borrow money to buy shares. The trust has no funds of its own to pay back the loan; instead, the company makes deductible annual contributions to the trust equal to the loan payments. To underline the point, no existing employee retirement money was used to fund the ESOP, no direct investments by employees were made, and no wage concessions were traded for the ESOP.
Shares in the trust are allocated to individual employee accounts as the loan is repaid. So if 20% of the shares are paid for, 20% are allocated to individual accounts. The remaining percentage (80% in this example) is held by the trust pending repayment. This is much like a mortgage. You borrow money to by a house, then repay the loan out of future earnings. You own 100% of the house from day one, but you do not have 100% of the equity in the house until you repay the loan. In the ESOP case, it is as if someone bought the house for you and paid for your ownership out of his or her earnings.
Although there are some exceptions, generally all full-time employees over 21 participate in the plan. Allocations are made either on the basis of relative pay or some more equal formula. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting. Employees must be 100% vested within three to six years, depending on whether vesting is all at once (cliff vesting) or gradual.
How Was the Tribune Transaction Structured?The transaction was complicated and involved two stages: (1) redemption of shares and issuance of new shares, and (2) taking the company off the public market. At the outset of the transaction, the ESOP borrowed $250 million to buy Tribune Company stock at $28 per share. That bought 100% of the common stock of the company. Sam Zell provided additional financing in return for a subordinated note and for warrants potentially worth 40% of the company (warrants are a kind of claim on the equity of the company). Zell effectively paid $34 per share for these rights. Thirty-eight executives were given phantom stock rights worth potentially 8% of the company.
How Much Will the Stock in the ESOP Be Worth?The ESOP owns all the common stock of the company. Holders of common stock are paid after debt holders are repaid. So in bankruptcy, common stock is usually worth nothing. Sam Zell's warrants would also likely be worth nothing, although some reorganizations provide a way for owners to recapture some part of their ownership value later on. Zell also holds a note, however, which may retain some value even if the stock becomes worthless.
How Will Employee Retirement Assets Be Affected?The company's prior retirement plans were changed somewhat when the ESOP was established. For most employees, the prior plan provided a company contribution to a 401(k) plan that could be as much as 4% of pay if an employee deferred at least 4% of his or her own pay into the plan, plus an additional variable contribution of up to 5% of pay if the company made enough profit. While this was the most common arrangement, different properties owned by the Tribune Company had had different arrangements. With the ESOP, the company contributed an amount equal to 5% of pay to the ESOP. As is typical with ESOPs, employee contributions were not required or permitted. Employee ESOP accounts hold Tribune stock.
In addition to the ESOP, the Tribune Company also makes a fixed 3% per year contribution to a cash balance retirement plan. A cash balance plan is a kind of hybrid pension/defined contribution plan in which employees have accounts that receive contributions each year, plus interest set by the company in accordance with federal guidelines. The employee is guaranteed to receive whatever is in the account at retirement, either in the form of a lump-sum distribution or an annuity, even if the value of the company's investments made to fund the plan declines. Insurance for this is provided by the Pension Benefit Guaranty Corporation. Assets held in this additional retirement plan are not subject to bankruptcy claims and will not be affected by bankruptcy.
Together, the current mix of the 401(k) plan, the cash balance plan and the ESOP mean that employees will generally receive more from the company overall than they would have, but they will be somewhat less diversified.
Given that under any conceivable scenario the Tribune would have not made any profit this year, no matter who ended up owning the company (and all the proposals involved massive debt), there is no reason to think that employees would have done better than the 4% match to the 401(k) plan had there been no ESOP. In other words, even if the value of the Tribune Company shares allocated to their accounts in 2008 falls to zero, employees will receive a 3% contribution to the cash balance plan. Absent the ESOP-linked restructuring, they would have received a 4% match to their 401(k). The net loss to employees, then, is equal to 1% of compensation. So the bankruptcy will have little effect on employee retirement relative to there not being an ESOP.
ESOPs in ContextThere are about 10,000 ESOPs in the U.S. involving about 11 million employees (details are in A Statistical Profile of Employee Ownership). ESOPs are rarely started in troubled companies. Overall, the data show that:
Of course, these are averages. There are stories of extraordinary success and dismal failure. The Tribune Company ESOP was clearly a gamble on a business that was already facing a difficult market, only to face the worst recession in decades, one especially hard on media companies. Consequently, drawing generalizations of any sort about ESOPs from this case is dangerous.
- Employees in ESOPs have almost three times the total retirement assets in company sponsored plans, relative to employees in comparable companies.
- ESOP participants, on average, have diversified assets that are roughly equal to the total retirement assets of comparable employees in comparable companies.
- ESOP companies are much more likely to have additional retirement plans than comparable companies are to have any retirement plans.
- ESOP companies grow about 2.5% per year faster post-ESOP than would have been expected without an ESOP.
- 95% of ESOPs are set up in closely held companies, often to buy out retiring owners.
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