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The Employee Ownership Update

Corey Rosen

October 2, 2006

(Corey Rosen)

ESOPs Result in Smoother Labor Relations

A recent study published by the University of Maryland and the Federal Reserve Bank of New York ("ESOP Fables: The Impact of Employee Stock Ownership Plans on Labor Disputes," by Peter Campton, Hamid Mehran, and Joseph Tracy, 2005) reports that unionized public companies saw a significant decline in strikes and other labor disputes after an ESOP was set up. Contrary to what a lot of people expect, workers in unionized companies are more likely to be covered by an ESOP than workers in nonunionized companies. The study looked at labor disputes between 1970 and 1995. Unionized companies that set up ESOPs had somewhat more contentious labor relations before the ESOP than companies that never set ESOPs. But things changed after the ESOP. Labor disputes other than strikes dropped 8%, while strike incidence dropped 18%, normalizing for these events in other companies. The effect was especially strong in the companies where the ESOP had more than the median ownership (8.5%), with strikes down 33.6%. Less robust ESOP companies saw only marginal changes.

SEC Issues Guidance on Accounting for Backdated Options

On September 19, the SEC's chief accountant issued guidance on the circumstances under which companies must restate their financials if they discover historical problems with the timing of their stock option grants. The guidance, which was not approved by the full SEC, applies to awards accounted for under APB 25, which allowed most stock options granted at fair market value to result in no accounting consequences for the company. Under the new guidance, companies that had short delays in the administrative procedures needed to finalize at-the-money grants will not face accounting consequences as long as the terms of the grant and the recipients were fixed and unchangeable on the date recorded as the grant date. In contrast, companies that set the exercise price of options at the stock's lowest price in a specified period (for example, by setting an exercise price of the lowest fair market value in a 30-day period) must record the difference between the exercise price and the stock's actual price on the last day of that period as an expense on their income statements. Further, companies that did not follow such a practice but changed the terms of their awards before all required granting actions were complete (for example, by reducing the exercise price) would have to expense the award between the date of the modification and the date the award was exercised, forfeited, or expired unexercised.

Company Stock in 401(k) Plans Drops

According to the authoritative data compiled annually by the Employee Benefit Research Institute and the Investment Company Institute, company stock held by employees in 401(k) plans continued to decline in 2005, standing now at just 13% of total 401(k) assets, down from 19% in 1996 and 16% in 2002. Employees in their 20s are about one-third less likely to hold company stock than employees in their 50s, and the percentage of recently hired employees investing in company stock has dropped from 60.5% in 1996 to 46.3% in 2005. Only 11% of new participants now hold more than 50% of their assets in company stock, compared to 23.8% (the peak) in 1997. Concerns about the problems employees suffered at Enron and other companies whose rapid declines in stock value decimated the account values of hundreds of thousands of participants, greater opportunities for employees to diversify out of company stock in 401(k) plans, and more education on the importance of diversification all have played a role. The new Pension Protection Act, which requires companies to provide diversification options in all 401(k) plans and KSOPs in public companies, will further accelerate the decline.

Social Venture Conference to Feature Discussion of Employee Ownership

The Social Venture Network will be holding its annual conference in Tucson April 12-15 and will have, for the first time, a session on employee ownership. The organization is made up of businesspeople involved in socially responsible enterprises. NCEO members Jerry Gorde of VATEX, Tom Schramski of Salience Consulting, and Mal Warwick Associates will be joining NCEO director Corey Rosen in discussing the topic. Gorde and Warwick currently head ESOP companies, while Schramski was CEO of CPES, a 100% ESOP we profiled in the newsletter.

IRS Issues Final Rules on Deductions for Repurchase of ESOP Shares

On August 30th, the IRS published final regulations disallowing deductions for the repurchase of ESOP shares (26 CFR, Part 1, TD 9282). The regulations were necessitated because of a Ninth Circuit Court of Appeals decision (Boise Cascade Corporation v. United States) in which Boise Cascade successfully argued that the repurchase of stock from departing ESOP participants was deductible under Section 404(k) of the Code, which allows deductions for dividends paid to ESOP participants. This novel argument was rejected by virtually the entire ESOP legal community as "double dipping" for the corporate deduction and potentially harmful to participants, who now would have to treat their distributions as taxable dividends.

The IRS issued field directives to disallow such deductions, and now has issued final regulations on the matter, effective August 30, 2006. Specifically, the regulations state that 404(k) does not apply in this case and that the reacquisition of stock falls under Section 162(k) of the Code (which generally disallows deductions for any corporate reacquisition of shares). The regulations apply to any stock reacquired on or after August 30, 2006. Meanwhile, a previous IRS ruling (Rev. Rul. 2001-6), which also barred such deductions, remains in effect except in the Ninth Circuit. The IRS advised agents in that circuit to contact the IRS national office if any cases come up in which a company tries to claim deductions (none have, as far as we know).

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