article is reprinted with permission from the
December 28, 1989
New York Law Journal.
© 1989 NLP IP Company.
New Equity Ideas
By Joseph E.Bachelder.
NEW VARIETIES of equity programs for executives continue to be developed. This column will discuss some recent ideas involving the use of equity as part of the executive compensation package: EXOPs (executive ESOPs), "mini" leveraged buyouts and stock as part of annual bonus programs.
During the 1980s there has been a growing use of ESOPs. ESOPs (employee stock option plans) are tax-qualified retirement plans designed to invest in employer stock. Provided an ESOP meets applicable requirements, it offers substantial tax benefits to employer and employee intended by Congress to encourage its use as a "corporate financing technique." Many well-known corporate recapitalizations (e.g., Weirton Steel) as well as takeover defenses (e.g., Polaroid) have been undertaken through the use of an ESOP.
The mechanics of an ESOP are relatively simple. In its basic form, a trust is established by an employer for the purpose of investing in employer stock as part of a tax-qualified defined contribution retirement plan. The ESOP "leverages" by borrowing from a bank and using the proceeds to invest in employer stock. The employer makes deductible contributions to the ESOP each year. The ESOP uses the contributions to meet its principal and interest obligations to the bank. The employees are not taxed until they receive distributions. There are numerous other tax benefits involved in ESOPs that can serve many corporate purposes.
EXOPs (Executive ESOPs)
The author would like to suggest a new concept -- a non-qualified ESOP for executives, here described as an EXOP. The comments in this column are intended as a brief introduction of this idea. Tax, accounting, ERISA and other issues are involved and discussion is invited. A later column will be devoted to a more complete discussion of these issues. 1 Following is an illustration of how an EXOP might work.
X Company has a supplemental executive retirement plan (SERP) intended to provide benefits to its senior management in excess of limitations imposed by ERISA, the Employee Retirement Income Security Act, on tax-qualified plans. The SERP is unfunded. X Company establishes an EXOP as a funded plan "coordinate" with the SERP ("coordinate" for this purpose means that any benefits paid out of the EXOP offset the benefits due under the SERP).
In its basic structure, an EXOP looks very much like an ESOP. The employer establishes a trust, an "EXOT," for the purpose of investing in employer stock. The term "EXOT" is used to distinguish this trust from a rabbi trust or a secular trust. Unlike a rabbi trust, it is not subject to the claims of the employer's creditors. Unlike a secular trust, its design is intended to avoid tax consequences to participants until distributions are made to them. These latter design considerations and some of the issues they raise are discussed below.
The EXOT would borrow from a bank for the purpose of purchasing employer stock. Convertible preferred stock would be used to avoid Federal Reserve margin requirements. 2 Costs of borrowing (principal and interest) would be paid out of future employer contributions. The intention would be that the EXOP provide a deduction to the employer at the time the distributions from the EXOT are paid out to the employees.
As already noted, the EXOP would be "coordinate" with a SERP. Funding might be done in a number of ways. Two examples follow:
Funding Version A. The EXOP would be funded by the EXOT's purchasing an amount of stock at the outset equal to the actuarial present values of the pensions due participants under the SERP. The intention of this funding approach presumably would be to deposit a value in the trust equivalent to present values of the respective pensions and to provide for distribution (assuming distribution was triggered as discussed below) at whatever values the stock ultimately achieves. Thus, the benefit of growth in value of the stock, for purposes of the current discussion, would be for participants in respect of whom distributions ultimately are made. Each year funding requirements would be reviewed but only in respect of benefits accruing during the year, including those of any new participants.
Funding Version B. The EXOT would purchase an amount of stock that, based on estimated growth in company stock, would provide funds that at the respective dates of retirement of participants would be sufficient to fund the SERP benefits. This approach, for purposes of the discussion, assumes a correspondence between the ultimate funding requirements and the anticipated growth in the value of the stock in the EXOT. It further assumes (again, for purposes of this discussion) that the benefit of growth in value of the stock above that contemplated in connection with the original funding would be for the benefit of the employer and any lesser growth would require additional funding. Each year the funding requirements would be reviewed.
A Suspense Fund
The funds held in the EXOT would be held in a suspense fund rather than allocated to accounts of individual participants except as noted below. The EXOP would provide that benefits under it would be paid out only under certain circumstances. Amounts would be allocated out of the suspense fund if, and only if, a trigger event occurs as described in paragraph (i) or (ii).
(i) For any year in which the employer failed to make payment due under the regular SERP to any given employee, the EXOT would pay out an amount equal to the individual executive's allocable share of one "unit" of the suspense fund held in the EXOT. 3 This amount would offset the amount otherwise due under the SERP. A trigger event under this paragraph (i) could apply to either Funding Version (A) or Funding Version (B).
(ii) An executive could elect to "cash out" his interest, in part or in full, in the EXOP. (This election would be much more relevant to an EXOT using Funding Version A.) Following are two ways in which that election might be made:
At least 12 months prior to any year in which the executive was entitled to a pension under the SERP, he could make an irrevocable election to receive payment for that year equal to one "unit" in the EXOP (in consequence of which he would give up a corresponding interest in the SERP). This election would be subject to his concurrent payment to the company of an amount equal to, say, 10 percent of the value of such "unit." 4
* The executive could elect to purchase his entire interest in the EXOP by an irrevocable election at least one taxable year prior to retirement and concurrent payment of an amount equal to, say, 10 percent of the then value of such interest. In that event, the entire amount would be paid out to him upon retirement and his interest in the SERP would be cancelled.
Any election under this paragraph (ii) would be subject to the risk of decline in value of the "unit" or interest between the time of election (including the required election payment) and the time of pay out.
If the stock of Company X grows faster than the anticipated growth used in calculating the actuarial present value of the pension in SERP, the participant in an EXOP using Funding Version A would elect his benefit under the EXOP. At the same time, participants under an EXOP using either funding version have the security of a fund set aside in an irrevocable trust beyond the reach of creditors to fund their retirement benefits. Even under Funding Version A, Company X should not suffer from the growth in value in Company X stock beyond the value of the SERP pension benefit. If payment is made under the EXOP, the company will, at the very least, save itself the after-tax cash cost of paying the pension under the SERP less the after-tax cost of its contributions to the EXOP.
A recent article in the Harvard Business Review notes the dramatic difference between the typical percentage of employer equity held by a chief executive officer of a company subject to an leveraged buyout (LBO) as compared with a chief executive officer of a publicly owned company. 5 According to that article, the median percentage of the equity owned by the chief executive officer of a company subject to an LBO is 6.4 percent whereas the median percentage of the equity owned by the chief executive officer of a publicly owned company is only 0.25 percent.
A "mini LBO" involves a significant, leveraged acquisition of stock by management of a public company that is not, in fact, taken private. One example is the sale of a large block of stock to management with favorably arranged financing as was done by The Henley Group in 1986. In that case, approximately 5 percent of the common stock outstanding was acquired by senior management pursuant to an "equity purchase program." Management invested 10 percent of the purchase price in the form of cash with the remainder a non-recourse note from the company.
To the extent that the debt is nonrecourse, the stock purchase plan, in effect, provides the executive with an option to purchase stock if it increases in market value. If the stock price declines, the executive can walk away from the borrowing since the lender has recourse only to the stock securing the loan. The executive's risk is limited to the amount of the cash down payment. Cash dividends on the pledged stock are "offset" against interest due on the company's loan. The remaining interest on the loan is generally deferred until maturity, unless the company expects to provide bonuses to fund it. The term of such a loan might be for, say, five years. The shares would "vest" as the executive repays portions of his loan during specified periods at which time the executive would be taxable on the value realized in excess of the loan payment. To the extent that the interest rate on the loan is less than an IRS prescribed rate, the executive also will be deemed to have taxable income.
In connection with a discussion of the terms of a stock purchase plan, it should be noted that the following terms of the plan established by The Henley Group were challenged by shareholders: the "bargain" interest rate on the loan financing 90 percent of the purchase price; deferral of payment of principal and interest for seven years; and the "undervalued" price (in relation to book value) at which the shares were acquired. A settlement of the shareholder suit reduced the term of the loans to 4 1/2 years, limited the number of shares that could be sold to a single participant to a maximum of 200,000 and restricted future participation in other equity plans for a period of 4 1/2 years. Even after the settlement, the terms of the Henley plan were quite favorable to its executives.
For a number of years, another vehicle, a convertible debenture, has been used by a significant number of U.S. corporations to provide for investment in the enterprise by senior management. Essentially this arrangement provides for participating management to pay the purchase price of the debenture through a combination of cash and borrowing. The debenture then converts under certain circumstances into equity of the company, particularly favorable tax consequences are associated with such a program and, under current accounting rules, it may, like the Henley program, provide favorable accounting treatment for the employer. As in the Henley stock purchase program, the real leverage for the executive is the relationship between the cash investment required and the equity growth in the underlying stock.
Annual Bonus Programs
A recent example of an annual bonus program using stock is Morgan Stanley's 1988 program. This program, which provides for up to 25 percent of the annual bonus in the form of stock, covers a variety of possible stock awards including stock grants, stock options and stock units. It provides for the grant of stock at a discount of up to 50 percent, or a stock option can be awarded with an exercise price that is discounted by up to 50 percent from current market value.
Assuming an outright grant of stock in substitution for the cash bonus that otherwise would be paid, a charge against earnings presumably would be required equal to the value of the stock grant. An interesting question arises if the stock were subject to a requirement that the individual continue in employment for a period of two or more years in order to "earn out" the stock bonus. Perhaps that would justify spreading the accounting charge over the earn-out period.
According to the 1989 proxy statement, Morgan Stanley had outstanding 35,901,445 shares of common stock at that time. The proxy statement also reports that 2,005,882 shares of common stock, or rights to acquire shares, were granted as part of the bonus program, subject to shareholder approval.
Thus, the number of shares subject to the grants constituted approximately 5 percent of the outstanding shares as reported in the proxy statement. The proxy statement also reports that a total of 12 million shares were authorized under the equity program pursuant to which the grants just noted were made. If a company bought in stock with which to distribute bonuses under a program such as that described, the company very quickly could transfer a significant portion of its ownership into the hands of its managers.
1 The author wishes to thank James T. Tilton of Hunton & Williams for his very helpful suggestions in connection with the concept of EXOP as developed in this column.
2 Fed. Reserve Regulatory Service 5-919.1 (staff opinion Feb. 26, 1982) (available on LEXIS, Fedsec. library, FRRS file), interpreting definition of "margin stock" in Regulation U, 12 CFR §221.2(h).
3 A "unit" would be the annual amount that, taking into account the age of the participant, and interest assumptions, could be paid to him out of the fund associated with his interest in the ESOP (although such interest is not, infact, allocated to him at this point) in approximately equal annual installments over his projected life (adjusted to take into account a joint and survivor benefit, if applicable) without exhausting such fund until the projected mortality date.
4 The purpose of the required payment is to help support the position of the participant that there is no taxable income until distribution. Currently, the IRS ruling position with regard to discounted options, for example, suggests that the requirement of a 10 percent payment to trigger a payout would not, by itself, be ruled on favorably by the IRS at this time. Other circumstances, such as the fact that the participant would be at risk for 12 months between the date of the payment of the 10 percent election price and the date of payout (noted subsequently in the text) are intended to strengthen the taxpayer's position in this regard.
5 Jensen, "Eclipse of the Public Corporation," Harv. Business Rev. 61, 68 (Sept.-Oct. 1989).