Looking At The Employee Share Ownership Plans (ESOP)
They are employee share ownership plans or employee share ownership trusts; the type run by large companies is generally the so-called ‘non-statutory ESOP’, which attracts no special tax benefits. It works like this.
The ESOP buys shares in the sponsoring company, financing them with bank loans guaranteed by the company or with loans from the company direct. The shares are bought in the market, so no new shares are created. These shares are then available for allocation to employees as part of a bonus scheme, profit-sharing scheme, option scheme, or whatever.
The rules will usually say that all employees can benefit from the ESOP, but in practice they are used predominantly to provide further benefits for directors and senior executives. They are not without risk to the company and therefore to its owners. If the share price falls, the ESOP may end up with shares worth less than the loans it raised and the loss will generally fall on the company in one way or another.
This happened with, among others, a container-leasing group then called Tiphook, which suffered a share price collapse and had to write off more than £20m on guarantees for loans to its ESOP.
Golden handshakes also hit the headlines. Directors are often employed under rolling contracts of three years. This means that there will always be three years of their contract outstanding. There is pressure now from institutional shareholders to reduce this to two years, but the process has a long way to go. If a director is forced out, he will be able to claim for most of what would have been due to him had he completed his contract.
Companies are usually anxious to avoid litigation and want to wind the affair up as quickly as possible. Thus, even directors who have run their companies into the ground frequently depart with a ‘golden handshake’ of something approaching three years’ salary. Cynical observers have a rule of thumb: the bigger the cock-up, the bigger the payoff mainly because the company wants to get rid of the director in question with the minimum of fuss.
The declared objective behind bonus schemes and the like is to ‘incentivize’ management so that it produces improved performance from which shareholders and the economy also benefit. This poses a second paradox. Why is it that the highest-paid people in a company need extra payments to persuade them to give of their best?
But there are detailed objections to some of the incentive schemes in force today. Annual bonuses focus on short-term performance, may encourage short-term attitudes, and the basis on which they are granted may be far from clear. It is also fairly easy to manipulate earnings per share in the short term, and this is often the measure on which the bonus is based.
Executive share options are open to the objection that they may reward even poor management when the share price is carried up by a bull market though the company itself has underperformed. They also dilute the interests of existing shareholders and provide little long-term incentive since the director almost always immediately sells the shares he receives from exercise of his options.
Institutional shareholders have tried to pressure managements to introduce some further performance criterion before options can be exercised, but have left it to companies to select the criterion. As a result, most of them are undemanding. Options can only be exercised if the company’s earnings per share have risen faster than retail prices over a three-year period, and the like.
The longer-term share incentive plans were introduced to counter some of the objections to share options though many companies operate the two in tandem. They do encourage a slightly longer-term view on the part of company management and sometimes introduce a more realistic performance criterion than share option schemes.
But the criteria are again often relatively undemanding. Since these schemes are fairly new, it remains to be seen whether directors will demonstrate confidence in their company by holding on to the free shares that they are given.
ESOPs are open to the objection that the company is exposing itself to a risk in the movement of its own share price. A second objection is that they are often remarkably opaque shareholders may know little if anything about them.
But the overriding criticism voiced of virtually all incentive schemes is that they offer directors a carrot, but no stick. Directors collect extra loot if the company or the share price does well. They do not suffer as shareholders in the company suffer if the company does badly.
This may, it is sometimes argued in the press and elsewhere, encourage directors to take excessive risks with the company. If it works, they benefit. If it does not, shareholders suffer. And there is always the golden handshake at the end of the day as the ultimate reward for failure.
Mike McCaffery is a common cold and influenza enthusiast. He is an expert on nose bleed causes.
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