Esop Firm Performance Pre- and Post- Market Peak: Empirical Evidence

INTRODUCTION Ownership in a company is generally regarded as a key motivational tool to reduce agency problems. It should develop within employees and managers, through ownership, the desire to maximize shareholder value rather than to pursue self-serving objectives, such as building managerial fiefdoms, under-investing in capital assets, or allowing other agency problems to materialize that divert or destroy shareholder wealth. Therefore, many companies provide access to ownership in the company as a benefit of employment in a variety of ways. Companies can offer employees a chance to own stock in the company by granting employees stock options that give employees the right to purchase stock at a specified price over a pre-determined time frame. Companies can also allow employees to purchase stock at a discount through formal Stock Purchase Plans. A third option, authorized under the Employee Retirement Income and Security Act of 1 974 (ERISA), provides for the establishment of Employee Stock Ownership Plans, or ESOPs. These plans offer substantial advantages to the employee and the employer beyond those available through either stock options or stock purchase plans. In general, the adoption of an ESOP is considered a productivity and value enhancing action, increasing market price and creating wealth for the firm's owners and employees. This view is supported by most empirical work performed subsequent to the 1974 legislation that created the plan. However, in addition to increased value derived from reduced agency problems, ESOPs can provide significant tax savings to the company, benefiting both current stockholders and employees. TAX BENEFITS OF ESOPS Profitable companies have an obligation to pay taxes, but the government encourages companies to grow so they can hire more employees and provide greater stability to the economy. The government accomplishes this through various business tax incentives. A reduction in taxes provides liquidity to companies for growth and potentially more profitability. The original concept of the ESOP was to promote stock ownership among rank and file workers of US companies to make the capitalist system stronger, and lawmakers became convinced that tax benefits "should be permitted and encouraged under employee benefit law" (NCEO, 2005). Through the years, the legislature passed various enhancements to the original 1974 legislation, including the leveraged ESOP, in order to encourage firms to establish these plans. As a result, firms can now enjoy substantial tax savings from ESOPs. Most recently, the Reconciliation Act of 2001, exempted employees' elective deferrals to their retirement plans from the calculation of total employer contribution to defined-contribution plans such as ESOPs and 401(k)s. In addition, the maximum contribution percentage was raised to 25% from 15% of total eligible pay. The act also allowed the firm to take a tax deduction for reasonable dividends paid on ESOP shares when employees elect to reinvest the dividends in additional shares of stock (Girard, 2002). The company remained eligible for a tax deduction equal to the value of stock contributions, and the company can deduct 25% of the principal and interest payments due on loans that provide funding for ESOPs. These new allowances further augmented the initial tax benefits provided by the 1974 ERISA and by subsequent legislation. NOT WITHOUT COSTS The benefits of an ESOP do not come without some potential costs to its participants, some affecting employees and some affecting the firm and its value. The employee, as an owner, may have a different sense of motivation from that of a worker. This motivation should increase shareholder value since the employee's personal wealth is now impacted directly, and the employee has a personal stake in increasing efficiency and productivity. Additionally, the employee's wealth can grow tax-free during employment since employees' shares held in the trust are not taxable until distribution upon retirement or termination. …