THE EMPLOYEE SHARE OWNERSHIP PLAN (ESOP):

GENERAL EXPLANATION, TOGETHER WITH SPECIAL APPLICATION TO SRI LANKA.

by Dr. Itil E. Asmon, International Consultant

NOTE: THIS ARTICLE WAS WRITTEN FOR A SRI LANKA CONFERENCE. HOWEVER, ITS PRINCIPLES CAN BE EQUALLY WELL APPLIED TO ISRAEL.

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Contents:

Introduction

I. ESOPs

II. THE ESOP PRINCIPLES

III. THE "CLASSICAL" ESOP MECHANISM

IV. ESOP ACHIEVEMENTS IN INDUSTRIALISED COUNTRIES

V. ESOP ACHIEVEMENTS IN DEVELOPING COUNTRIES

VI. CASE STUDY: PEOPLE'S PROVINCIAL BUS COMPANY, U.K.

VII. CASE STUDY: THE ALEXANDRIA TYRE CO., EGYPT

VIII. POSSIBLE APPLICATION OF THE ESOP IN SRI LANKA

APPENDIX: Issues Related to the Implementation of ESOPs in Sri Lanka

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INTRODUCTION

Employee Share Ownership Plans (ESOPs) are a new financing technique which is experiencing phenomenal growth in the U.S. Since 1974, over 11 millions of U.S. employees have become through ESOPs part owners of over 11,000 corporations, including some of the largest in the U.S. The innovation of ESOPs is that employees acquire individual shares on credit, without any cash payment or salary deduction on their part. The credit is repaid over a number of years through the increased revenue of the company - the employees pay for their shares through increased productivity. The employees receive their shares upon retirement, but from the first year obtain dividends on their shares if the company shows a profit. The U.S. Congress has passed over 20 acts containing provisions which encourage employee ownership. Some 300 ESOPs have likewise been established in the U.K. ESOPs are advantageous to and are supported by employees, management, present owners, the banks, the government, and the major political parties. Research has shown that companies with significant employee ownership have much better labor relations and productivity increases than comparable companies without employee ownership.

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I.
ESOPs:

ESOPs are fast becoming a topic of actuality in developing countries. A pilot ESOP has been successfully installed in Egypt (the $150 million Alexandria Tire Company, with 30% employee ownership). Argentina has recently legislated many ESOP provisions. ESOPs are being actively studied in Mexico, Guatemala, Costa Rica, the Philippines, Poland, Czechoslovakia, and even the Soviet Union. Many developing countries look to employee ownership as a politically acceptable way to end or reduce government involvement in ailing public-sector enterprises.

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II.
THE ESOP PRINCIPLES:

The ESOP is merely the best-known application of an economic system called "ownership economics" (sometimes known as "binary economics" or "economic democracy"). Ownership economics focuses on the questions of who owns the productive assets of society, and how can ownership be better distributed. It is a third economic system which transcends both conventional capitalism (ownership of most productive assets by a wealthy minority) and socialism (ownership of most productive assets by the state). It advocates economic policies which lead to ownership of productive assets, in the form of significant individual holdings of corporate shares, by a broad base of employees and other citizens.

The inventor of the ESOP is Louis Kelso, a San Francisco financier and corporate lawyer, who established the principles of ownership economics in his 1967 book entitled "Two-Factor Economics: How to Turn 80 Million Workers into Owners on Borrowed Capital". The basic principle of ownership economics is to create new owners at the same time that new capital is being created, through the use of production credit. The ESOP and similar financial mechanisms create access to productive credit for employees and other citizens who normally do not have such access due to lack of collateral. The ESOP allows employee share purchase with no money down, no salary deduction, no commitment of the employees' pension funds and no personal liability. The shares are acquired through credit which is organised for a group of employees and repaid out of its own profits and company contributions. Technically, the ESOP is a 100% leveraged buyout in favor of the employees (and Louis Kelso is indeed the inventor of the leveraged buyout).

It is also important to note what the ESOP is not. The ESOP is not any kind of collective ownership, cooperativism, syndicalism (ownership by trade unions), nor the German "co- determination" model (union representation on the company board) or the Yugoslav "worker management" model (politically-driven management by committee). The ESOP results in private-sector, profit-maximising corporations, in which a large number of their own employees and other citizens have individual share ownership. The ESOP makes employees feel like owners and behave with the care typical of an owner, while leaving management to professional managers under the authority of a board of directors.

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III.
THE "CLASSICAL" ESOP MECHANISM

The basic mechanism of a U.S. "leveraged ESOP" (i.e. an ESOP financed through bank credit) functions as follows:

1. The company establishes an ESOP trust, which is a legal entity distinct from the company and legally considered to be an employee provident fund.

2. The ESOP borrows funds from a lender. Since the ESOP has no collateral, the loan is usually guaranteed by the company.

3. The ESOP uses the loan proceeds to buy company shares (newly- issued shares if the company uses the loan to acquire productive assets, or old shares if the ESOP buys from an existing owner).

4. The ESOP shares may be pledged to the lender as additional security.

5. Every year the company deposits enough money into the ESOP trust to service the loan. Since the ESOP is regarded as a provident fund, through an ESOP the company can repay the loan with pre-tax dollars.

6. Whenever a part of the loan principal is repaid, a correspon-ding number of shares is released from pledge and deposited in employees' individual accounts in the ESOP trust. The number of shares allocated to each employee is usually proportional to salary; seniority and other factors may also be considered.

7. Of any dividends distributed on the shares in the ESOP trust, a part is retained to help service the loan and another part is paid out to employees in proportion to the number of shares in each employee's account.

8. Employees normally receive their shares only at retirement. Depending on the trust provisions, retiring employees may receive either the shares themselves or their fair market value in cash.

9. If an employee terminates service before retirement age, and has been in service less than 5-7 years, he receives only a part of the value of his account, according to a "vesting schedule" included in the articles of the trust.

10. The ESOP trust is voted by its trustees, who may include company and bank officers, professional trustees, and/or employee representatives. For major decisions (e.g. merger, liquidation) the vote is passed through the trust to the employees.

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IV.
ESOP ACHIEVEMENTS IN INDUSTRIALISED COUNTRIES

ESOPs became a significant movement in the U.S. since 1974, when the ERISA (Employee Retirement Income and Security Act) gave the ESOP legal recognition and fiscal advantages. Since 1974, over 11,000 ESOPs have been established in the U.S. This includes most airlines, most petroleum companies, most major money centre banks, and household names like Xerox and Polaroid. The employees' share in ESOP companies typically ranges from 15% to 100%, and the trend is towards majority ownership by the employees. Avis, the world's second largest car rental company, was 100% purchased for US$ 1.75 billion by its 20,000 employees. After the employee buyout, Avis changed its motto from "we try harder" to "owners try harder", and has become more successful than ever.

Over 20 acts promulgated by the U.S. Congress since 1974, and many more acts passed by state legislatures, contain provisions which promote ESOPs. The net effect of this legislation is that at present in the U.S., the cheapest way for a corporation to finance expansion is to borrow through an ESOP trust by selling shares on credit to its employees, and the most advantageous way for an owner who wants to sell for any reason, is to sell his shares to his employees.

It has been shown by comparative studies that companies which have introduced significant employee ownership perform better than comparable companies which have not. In very general terms, it can be said that the percentage of added profitability is of the same order of magnitude as the percentage of employee ownership: for example, if a company becomes 50% employee-owned, it can expect to become 50% more profitable.

While headlines have been made by employee buyouts which turned failing companies around and saved them from liquidation, employee buyouts of troubled companies comprise only about 2% of all U.S. ESOPs. Some 98% of ESOPs have been established in going concerns, and usually helped to make them more successful than before. Of particular significance to Sri Lanka is the fact that ESOPs have been quite successful in factories with a large immigrant labor force whose educational level was lower than the average in Sri Lanka. Ownership is something which even illiterate workers can understand.

These economic effects were parallelled by the beneficial social effect of ESOPs. Where employee ownership was introduced strikes stopped, petty theft disappeared, and labor-management confrontations were replaced by mutual search for increased profitability.

 ESOPs enjoy support by management (which usually initiates the ESOP), present owners, organised labor, the government, and naturally the employees. Politically, the ESOP concept cuts across the traditional division between right and left and enjoys support across the political spectrum - from both Democrats and Republicans in the U.S., from both the Conservative and the Labor Party in the U.K.

In the U.K., the ESOP movement has become significant since 1987. ESOP legislation was enacted in 1989 and again in 1990. Some 300 ESOPs have been established so far, and the number is rapidly growing. The U.K. ESOP closely resembles the U.S. model.

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V.
ESOP ACHIEVEMENTS IN DEVELOPING COUNTRIES

Two countries, for their own social and political reasons, have applied on a large scale the principles of ownership economics, through mechanisms different from the U.S. ESOP model:

- In Mexico, after the general failure of cooperatives and collectives in the land reform sector, the farmers were reorganised in "smallholder agricultural corporations". This is a private-sector corporation in which each farmer has a double role: as worker and as shareowner. His share holding corresponds to the land area which he voluntarily puts at the disposal of the corporation (while retaining the title). Over 10,000 such smallholder corporations were established in Mexico (notably for sugar, cotton and oilseeds), and they have been quite economically successful.

- In Malaysia, the government's "bumiputera" initiative aims to give more economic power to the Malay majority. To this end, state-owned estates have been divested to their (predominantly Malay) labor force, with private-sector management. In this case as well, the results are reported to be quite favorable.

The first developing country to apply the U.S. ESOP model was Egypt, where a pilot enterprise - the Alexandria Tyre Company, discussed below - was initiated in 1988. The ESOP concept, adapted to Egyptian legal and social conditions, was actively embraced by the Egyptian government. The government regards ESOP as a way to divest itself of troubled state-owned enterprises without the political liability attached to sale to already wealthy persons or to foreign corporations. Three such divestitures are now being studied, with USAID and IBRD support. The ESOP receives wide coverage in the government press, and favorable treatment in both right and left opposition newspapers. At the same time, several Egyptian private-sector leaders started installing ESOPs in their own enterprises.

Argentina passed in July 1989 an economic reform law containing many expanded-ownership provisions. The national carrier, Aerolineas Argentinas, is presently being privatised, and one of the criteria for choice of purchaser is the percentage of ownership he will provide to the employees. Guatemala, Costa Rica, Mexico and South Africa are actively studying the application of ESOP. In the Philippines, President Aquino sold through an ESOP shares to all workers in her family estate, Hacienda Luisita (a sugar plantation). In the former East Block, ESOP-like setups are being promoted in Poland, Czechoslovakia, Hungary and even in the Soviet Union.

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VI.
CASE STUDY: PEOPLE'S PROVINCIAL BUS COMPANY, U.K.

The current initiative for peoplisation of the Sri Lanka Transport Board may draw an example from Provincial Bus Co. in the U.K. Provincial Bus was 100% acquired in 1987 by its 200 employees from its parent company, the state-owned National Bus Co., and renamed People's Provincial Bus Co. Through an ESOP trust, the employees borrowed ú580,000 (from Barclays Bank and Unity Trust) to finance 80% of the acquisition cost. The other 20% were financed by each of the employees purchasing preference shares for ú700 (redeemable after 5 years) and ordinary shares for ú50. (The purchase of preference shares by employees was a condition of the lenders for agreeing to finance 80% of the employee buyout; in some other ESOPs, 100% credit financing has been arranged).

The ESOP trust is managed by seven trustees, of whom three are employees elected by all employees, two represent the two lenders (these two will step down after five years), one represents the community and one is a professional financial manager.

The London Financial Times discussed the experience in an article entitled "Workers' drive helps company turn the corner". The newspaper reported that "...the ESOP at People's Provincial seems to have been remarkably successful. Absenteeism has dropped significantly, and internal theft has stopped altogether. Despite a passenger drop of 7% per year, revenues have remained fairly steady. This has been achieved through major cost trimming and some employment attrition. Most importantly... the attitude at People's has changed dramatically. Drivers are now very concerned about the business. The take an interest in delivery schedules and marketing, and have expanded service".

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VII.
CASE STUDY: THE ALEXANDRIA TYRE CO., EGYPT

The first ESOP in a developing country is the Alexandria Tyre Company (ATC) in Egypt. ATC will construct and operate a manufacturing plant for all-steel radial truck tyres. ATC is a $150 million joint venture between the Pirelli Tyre Company of Italy, the Egyptian-owned tyre manufacturer TRENCO, ten Egyptian banks and an insurance company, and the ATC Employee Shareholders' Association (ESA). Through the ESA, the employees acquired 30.5% of the founding shares of this new company and thus became as a group the largest shareholder. The employees' shares were 100% financed by a $18 million loan from the Ministry of International Cooperation. The loan funds originated from sale of U.S. commodities through the USAID. Until the ESA is legally established, the National Investment Bank has assumed the loan as a temporary borrower on behalf of the employees.

Through the ESA, the share holding of every ATC employee will exceed eight times his annual salary. His dividend income is projected to reach 50% of his salary once the factory reaches full production, and exceed 100% of his salary after a several years.

The adaptation of the ESOP model to Egyptian conditions contains several modifications with respect to the U.S. model:

-The Employee Shareholders' Association, which was invented as a substitute for the U.S. ESOP trust (since trusts are not recognised under Egyptian law), by its nature involves the employees more closely and is expected to give them a more tangible sense of ownership.

-Employees are being consulted regarding design of the ESA from the very beginning.

-Through the ESA, full voting rights in the employees' shares are passed to the employees.

-Since the $18 million worth of shares financed for the employees, if allocated only to ATC's 750 employees, would have created a disproportionately large share holding per employee, the government decided to allocate 40% of these shares to employees of TRENCO, the Egyptian "mother company" of ATC. (Where there is a problem of redundant employees, shares could be similarly allocated to retrenched employees).

-To reconcile USAID's insistence on market-related interest rates with the Egyptian Civil Code which prohibits a non- banking institution such as the Ministry of International Cooperation from charging an interest rate exceeding 7%, itwas agreed that in lieu of principal and interest payments, the Ministry will receive during the first ten years of full production 50% of the dividends distributed on the shares purchased with the loan. This is projected to repay the Ministry the actual purchasing power of its loan, plus a certain administrative charge and risk premium, regardless of the rate of inflation.

The ATC transaction has other aspects of particular interest for a developing country such as Sri Lanka:

-A multinational company - in this case Pirelli - agreed to provide state-of-the-art technology and to assure performance through a ten-year technical management contract, while possessing only 10% of the shares. The remaining 90% are owned by Egyptians, including 30.5% owned by employees.

-The Italian government provided a $59 million loan to the company - and thus indirectly to the employee-owners - at a nominal interest rate of 1%. Thus bilateral (and multi- lateral) credits can be used to finance employee ownership.

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VIII.
POSSIBLE APPLICATION OF THE ESOP IN SRI LANKA:

The ESOP, properly adapted to Sri Lanka realities, can be a powerful means to accomplish the goal of Sri Lanka's peoplisation programme: to transfer the share ownership of state-owned enterprises to their employees and a broad base of other citizens (including former employees). Through the ESOP, share purchase for employees is accomplished without cash down payment, salary deductions, personal liability by the employees, or use of their pension funds. Nevertheless, there is no giveaway of national assets: employees do pay the fair market price of their shares. The innovation of ESOP is that employees do not pay for their shares out of past savings, which they don't have, but out of future earnings which they help to generate.

The ESOP can be equally useful in Sri lanka's existing private sector, to expand the ownership base of companies while increasing their profitability through greater employee motivation.

A Possible Scenario for ESOP Implementation in Sri Lanka.

In Sri Lanka, the ESOP could be implemented as follows:

1. In each enterprise to be peoplised, an ESOP trust to purchase shares for employees is legally established. (ESOP participants may include employees who must be retrenched since in a restructured company there is no physical work for them, but through the ESOP they may stay on as "capital workers").

2. The trust obtains credit to purchase shares on behalf of employees. The source of credit may be from banks, from the Government outside of the banking system, from international agencies or from international corporate investors. The key aspect of financing the ESOP is discussed in more detail below.

3. The loan is paid back over a number of years out of company contributions to the ESOP - which constitutes a new employee pension fund - and from a part of the dividends on employee shares. (This implies that an ESOP can be established only in a company which is profitable or which can be made profitable. But if a company cannot be made profitable, it will not find a private-sector buyer either).

4. Another part of the dividends on the employees' shares is distributed to the employees in cash, so that they perceive an immediate benefit from the ESOP and become motivated to increase company profits.

5. Whenever the ESOP makes a repayment of the loan principal, a corresponding number of shares is allocated to the individual account of each participant, according to a formula embodied in the articles of the ESOP trust.

6. The trust holds the shares for each employee until his/her retirement or other separation from the company. At that time, depending on the articles of the ESOP, the employee either receives the shares, or the fair market value of the shares in cash.

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APPENDIX:
Issues Related to the Implementation of ESOPs in Sri Lanka.

Legal status: Sri Lanka, unlike most countries in the world, is fortunate in that the legal mechanism for implementing ESOPs is already in place. In Sri Lanka the employee pension trust is a recognised legal entity. Furthermore, Section 55(1)(b) of the Companies Act No. 17 of 1982 specifically provides an exemption from the general prohibition against a company providing loans, guarantees or other financial assistance to purchase company shares, in the case where the company provides money for the purchase of company shares to be held by, or for the benefit of, employees of the company.

Percentage of employee ownership: An a priori determination of the percentage of company shares allocated to employees is not likely to be optimal. The guiding principle should be that employees must have a significant stake in the company in order to feel and behave like owners. Research has shown that what matters most to an employee is not the percentage of company shares held by all employees, but the value of his/her individual share account. To provide significant motivation, the employee's share value should ideally equal 3-5 years' worth of salary or more. Thus it is recommended that the value of company shares allocated to the employees (including retrenched employees) in the course of peoplisation should equal 3 to 5 times the payroll or more. In different companies this would amount to different percentage of the company shares, depending on the capital intensity of each company.

Voting of shares by the employees: As long as the shares are in the trust, they are voted by the trustees. These may be company, lender or employee representatives, or professional trustees. There is considerable latitude regarding the voting rights to be passed through the trust to employees. The ESOP is a very flexible instrument which can be designed to accommodate any concerns of its founders. Proper checks and balances can be built into the trust to safeguard against irresponsible employee representatives as well as against unscrupulous managers or trustees.

Moreover, research has shown that what matters most to the individual employees is not their voting rights in the general assembly, but the control they have over their immediate working environment. Systems such as "quality circles" which allow employee groups to formulate and implement their own ideas about how to improve their work, coupled with ESOP which motivates the employees, have resulted in large increases in company profitability as well as employee satisfaction.

Sources of financing for employee ownership: The entire ESOP scheme hinges on credit. Four sources for financing the ESOP may be envisaged:

1. Banks may provide loans to ESOP trusts to purchase company shares. Such a loan may be backed by company guarantee, in addition to pledging the purchased shares to the lender. If the company to be peoplised is not credit-worthy, the loan may be backed by a Government guarantee.

2. The Government is potentially the most important finance source for peoplising state-owned enterprises, by selling its shares to an ESOP trust against an obligation of the trust to pay for the shares in installments out of future cash flow, without recourse to bank credit. This is analogous to a car dealer selling a taxi to an individual at no down payment, to be paid in installments out of future income earned by use of the taxi. All sales of existing assets to employees can be done in this way.

3. International finance organisations such as the World Bank or the Asian Development Bank provide credit for acquiring productive industrial assets. State-owned enterprises subject to peoplisation will usually need fresh funds for rehabilitation. Credits provided by multilateral or bilateral finance organisations can be used to create employee ownership if they are not channelled to the government as in the past, but to the ESOP trust with Government guarantee. (A recent ADB report recommended 100% employee acquisition of Sri Lanka's sugar refineries through ESOPs). This is the most appropriate way to create employee ownership of new assets.

4. International corporate investors may in certain cases have to acquire a majority position in an ailing company in order to insulate it from the factors which obstruct its performance and to provide the financial, technical and managerial resources necessary to put it back on its feet. In such a case, ownership by the foreign investors need not be permanent. The objective of a corporate investor is not to retain perpetual ownership, but to recover its investment in a given period of time with an acceptable return. Thus the sale of shares may contain "sunset clauses" which provide that the foreign investor's rights in the shares are gradually extinguished without additional payment in favor of the employees and other citizens. Normally quite a small discount from the present sale price, or favorable tax treatment, will be sufficient inducement for the investor to cede his shares 10 or 20 years hence. For example, if the original divestiture is 60% to a foreign investor, 30% to the general public and 10% to the employees, a "sunset clause" may provide that from year 10 to 20, in each year the investor will cede 5% of the total shares to the employees at no cost, or through a call option at a nominal price. Thus final ownership will be 60% by the employees, 30% by the public and 10% by the investor.Conclusion.

Employee ownership through ESOP is a powerful means to accomplish the Government's goal of peoplisation. The ESOP offers both the economic efficiency of a private-sector, profit- maximising firm, and wide distribution of the profits to employees and other citizens. The ESOP has been successful wherever it was tried, in both industrialised and developing countries. The performance of ESOP companies is generally higher than of conventionally-owned private-sector companies, because of the added employee motivation. Beside its good economic results, the ESOP has been shown to be beneficial socially (fostering industrial peace, eliminating strikes) and politically (being supported by both the traditional right and left).

In Sri Lanka there are no legal impediments to the installation of ESOPs. Finance for peoplising companies through ESOPs can be found in different cases from local banks, international finance organisations, foreign investors, and most importantly the Government itself by agreeing to be paid in installments. The ESOP is a very flexible tool, which can be designed to accommodate any particular concerns in a specific situation. The ESOP road to peoplisation is wide open, and success depends only on the will of government decision-makers to take it.