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The Employee Ownership Update

Corey Rosen

August 16, 2007

(Corey Rosen)

One-Third of Large Public Companies Dropped ESOPs Between 2004 and 2005

According to an NCEO analysis, one third of the largest 900 companies that had ESOPs in 2004 (the Fortune 500 and the Russell 400) had reduced the stock held in the plan to zero or close to it by the end of 2005. The analysis was done as part of a project for the Heron Foundation and the Innovest Group.

The data are based on an analysis of Form 5500 filings that looked at ESOP asset holdings in 2004 and 2005. If we found that the assets had moved into a master trust or 401(k) plan, we assumed that the ESOP was still in place, but as part of another plan. It is possible that inaccuracies in filings or the movement of the assets into other plans that we could not easily track would make these numbers somewhat smaller than they would have otherwise been, but only by a handful of companies. Overall, about 6% of the largest companies had ESOPs in 2005, all but 17 of which own less than five percent of company stock.

It is likely that the change is a direct result of concerns about legal fallout from the Enron, WorldCom, RiteAid, and other "stock drop" lawsuits that began earlier in the decade.

A list of the S&P largest 900 companies with ESOP or broad-based individual equity compensation plans (mostly options and restricted stock) is available from the NCEO for $100 to members and $150 to non-members. Note that the current list uses a somewhat different definition of the largest 900 companies than last year's version.

Third Circuit Rules Former Employee Has Standing Even Though Cashed Out of a Plan That Invested in Company Stock

In an important decision, the U.S. Circuit Court of Appeals for the Third Circuit ruled that an employee who had been cashed out of a 401(k) plan nonetheless had standing to sue over questions about the prudence of investments in company stock. The decision in Graden v. Conexant Systems Inc. (No. 06-2337, 7/31/07) follows one by the Seventh Circuit, Harzewski v. Guidant Corp. (No. 06-3752, 6/5/07), that also allowed a cashed-out employee to sue. Both overturned lower court rulings. In Graden, the court rejected the distinction between "benefits" and "damages." Many lower courts have ruled that cashed out employees could not sue for damages, only for denied benefits. But Judge Thomas Ambro, writing for the court, argued that if the employee can reasonably contend that benefits were denied because of imprudent practices, then he or she should have standing. To do otherwise, he concluded, would allow fiduciaries to engage in all sorts of imprudent behaviors, avoiding any responsibility simply by paying people out. With two circuits now reaching similar conclusions, even district courts in other circuits may find it difficult to prevent employees from making claims.

Are REITs Qualified Replacement Property?

In the August 7 issue of the BNA Pension Reporter, noted tax analyst Robert Willens, a managing director at Lehman Brothers, argued that real estate investment trusts (REITs) that perform active and substantial management duties should be eligible as qualified replacement property under Section 1042 of the Code (the section that defines eligible investments for private C corporation owners who sell to an ESOP and take a tax deferral on the gain). The article is as notable for the argument as for the fact that Willens is writing it, suggesting that there may be a move afoot to use REITs for the kind of major transaction that would be of interest to a firm such as Lehman Brothers.

Using a Percentage of the Company as a Guide for Equity Awards

Many closely held companies, especially those aiming for a sale or an IPO, base their grants of equity awards on a percentage of the company. Very commonly, for instance, the company decides to make 10% of its shares available, then gives various individuals a percentage of the total based on compensation surveys. That seems problematic to us. Ten percent of a company with no profits and a product in development is very different than 10% of a company that has attracted investors, is making money, and has successfully launched one or more products. Moreover, by fixing a percentage in advance, a company may end up with little equity to award to new employees as it grows. A better approach, we think, is more dynamic, giving away ownership based on sharing part of its growth in excess of annual targets. That way, the award of equity becomes an ongoing incentive, not an entitlement, and it can grow or shrink with the company.

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