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Good Governance For ESOPs

By: Perry Phillips

With shareholders demanding better corporate governance to protect their investments as a result of recent incidents of corporate greed, another group of stakeholders should be expecting similar levels of accountability. Perry Phillips, of ESOP Builders Inc., looks at governance practices for employee share ownership plans.

The last 10 years have seen a major shift in how direct and indirect stakeholders view the issue of corporate governance. In Canada and the United States, there have been incidents of out-of-control corporate greed which have shaken investor trust and confidence in the corporate world.

The perceived lack of standards in corporate governance only increases risk in our global corporate environment that, in turn, increases volatility and could precipitate a breakdown of a corporate capitalistic model that fuels world growth and living standards.

Employees can be both direct and indirect stakeholders, sometimes even at the same time. ESOPs (employee share ownership plans) is a term originally coined in the United States more than 30 years ago. ESOPs are now practiced in most countries of the western world and have even spread to the Asian tiger economy countries such as China and Japan.

While Canada has no federally mandated ESOP program in place, several provinces, such as British Columbia, do have provincial plans in effect on a limited scale. In British Columbia, there are 83 ESOP companies generating more than $31 million in business taxes.

The fact there is no federal Canadian program in place has not deterred either public or private companies from implementing such plans. The Canadian definition of an ESOP is any plan that through equity, options, and/or phantom shares transfers capital wealth to its employees. It includes both key-man and broad based plans as well as management buyouts (leveraged and unleveraged). Corporate employee size does not matter as these plans can include two, three, or 20,000 employees. The only issue is whether or not future capital wealth is transferred. A Canadian ESOP may represent anywhere from less than one per cent ownership to 100 per cent ownership of the shares of both private and public corporations.

Public company ESOPs are widespread in Canada. More than 90 per cent of TSE high-tech companies have some employee equity and/or stock option plans in place. A major reason is productivity. A study done by the Toronto Stock Exchange in 1986 found productivity improvement of four to five per cent on average in the year the ESOP is adopted. This is maintained in subsequent years.

In Canadian public companies, ESOP ownership percentage tends to be fairly low, usually one to three per cent of the market value of the company. Companies use ESOPs for a number of reasons including the retention and attraction of employees and as part of their compensation package.

In the U.S., ESOP plan assets frequently show up in Defined Contribution pension plans. At public companies, 28 per cent of assets totaling more than $330 billion of DC pension plans are invested in employee stock.

Private Company ESOPs
Canadian studies on private ESOP companies are virtually nonexistent due to the lack of federal legislation in this area. However, based on our experience with private companies over the last 10 years, we have anecdotal evidence that tends to support the U.S. studies in this area.

A study by Professor Douglas Kruse, at the Rutgers University School of Management & Labor Relations, estimates that in the U.S. 15.8 per cent of private sector employees are participants in either ESOPs, 401(k) plans, profit sharing, or other DC plans that hold employee stock, stock purchase programs, or worker co-operatives. U.S. studies have shown that 75 per cent of ESOP plans were put into place due to specific tax and pension legislation advantages.

Correlating this to Canada, we estimate less than five per cent of Canadian employees would be involved in privately held ESOPs. In the U.S., the average employee stock held is between $10,000 and $27,000. We believe Canadian statistics would be similar for the private sector.

Corporate Governance
Given this, the importance of corporate governance increases. Yet, every stakeholder (direct and indirect) in a company perceives corporate governance in a slightly different manner depending upon their personal (or institutional) risk/return profile.

The focal point for defining and evaluating corporate governance remains the same for all parties – the board of directors. Historically, these boards had two fundamental duties – a fiduciary duty and a duty of care to represent the vested interest of its stockholders. Over the last 25 years, however, this emphasis shifted. Only recently have boards gone back to their primary responsibility, enhancing value to the stakeholders. Amajor change in emphasis, however, is that the list of who constitutes a stakeholder has increased.

The United States has taken a hard line on corporate governance through the Sarbanes-Oxley Act passed by the U.S. Congress in 2002, which provides fines and jail time for non-compliance. In contrast, Canada does not have specific federal legislation. Instead, there are guidelines set by various provincial securities acts and stock exchanges across Canada. In addition, the Supreme Court of Canada, in the 2004 Peoples Department Store Inc. bankruptcy judgment, set out judicial standards as to what constitutes a director’s basic duties. As well, this decision sets out clear guidelines for directors to follow in this area.

Public Company Corporate Governance
The TSX has issued 14 guidelines to cover areas of disclosure which, if followed, would tend to strengthen corporate performance. These guidelines specify corporate governance issues along with both required disclosure and enhanced disclosure requirements. Public companies can institute an escape clause by justifying why their policies differ from these guidelines.

The major question both in the U.S. and Canada is whether the new rules will solve the problems created by Enron and World- Com or will they create new problems? Some commentators have suggested that we are bureaucratizing boards to the point where fewer risks will be taken or decisions will be deferred and delayed causing both short-term and long-term reductions in value to the very stakeholders these rules were meant to protect. Only time will tell if we have really put into place a system that enhances trust, confidence, and shareholder value.

Private Company Corporate Governance
Although the issue of corporate governance resonates most clearly in the public company domain, its repercussions are also being felt within private companies. The major impact on the private company side is not government legislative changes, but accounting changes. Major accounting pronouncements in areas such as stock options, financial disclosure, and auditor independence will have a profound impact on privately held companies in Canada.

The Canadian Accounting Standards Board has proposed significant changes to accounting standards for public and private companies that will take effect over a five-year transition period from 2006 to 2011. These changes will involve identifying which financial reporting models meet the needs of private and public business owners, issues of differential reporting models, and new protocols for GAAP. Due to these changes, large privately held companies may find themselves in the same position as publicly-held corporations in terms of corporate governance.

One very positive outcome of the heightened awareness of corporate governance is private companies may start to implement and use boards in a manner that will strengthen their value to their own stakeholders.

ESOP Corporate Governance
While ESOPs exist both in Canadian public and private corporations, public and private company ESOPs are, in fact, completely different animals.

Table 1 delineates some major differences between public and private companies in the area of corporate governance. It is difficult to ascertain to what extent public companies are addressing recent corporate governance issues as they relate specifically to key stakeholders such as the ESOP shareholders, and what impact this debate will have on both large and small private companies with fairly significant levels of employee ownership.

Public Company Governance
Corporate governance in relation to an ESOP is unusual in the sense that each individual employee owns a negligible amount of the stock. However, in total, one to three per cent can be significant in a public company, especially if voted en bloc. For example, it could be used to thwart hostile takeovers. From the employee’s view, the risk they face from an Enron or World- Com fiasco is very different than that of an institutional or individual investor. The latter can only lose their investment. The employee not only loses their investment, but also potentially their livelihood and, possibly, their pension.

Employees have every right and more to be particularly upset when corporate governance standards are lacking or circumvented by their board.

Further, since the primary purpose of a board is to protect and enhance the value of its direct stakeholders, ESOP members should require not only adherence to the new standards, but demand levels far exceeding these standards of care and duty.

There are several ways to more closely align the interests of the board with those of the ESOP. For example, the board can strategically use the ESOP as a tool for not only the retention and attraction of employees, but as an effective means of increasing profitability by increasing productivity per employee. To achieve this, however, requires focusing on expanding the ESOP as well as creating a participative ESOP environment where employees start to act as owners of their own destiny. While this is easier said than done, it has been done successfully many times over.

Private Company Governance
When ESOPs are layered into a private company – large or small – they, from a governance standpoint, tend to become more like public companies than private corporations.

Adding the complexity of corporate governance issues to private companies may seem as an argument against the use of ESOPs. However, I would suggest the benefits far outweigh the costs. One benefit is ESOP companies outperform non-ESOP companies. More than 35 studies in Canada and the U.S. over the last 25 years have consistently reported the same fact.

A majority of investors will avoid companies with ‘poor’ governance policies in place. This may impact the ability of privately held firms to raise capital and eventually to sell to third parties.

Proper corporate governance through an effective board should enhance value for all stakeholders. In our opinion, good corporate governance for privately held companies would include:

Good corporate governance, whether for public or private companies, means effective stewardship of assets and increased value to shareholders. ESOP members, due to their dual role as employee and investor, require a diligent pursuit of good corporate governance. Aligning the interests of the board and the ESOP will serve both constituencies well, as it will all other stakeholders who will benefit from this practice.

Perry Phillips is president and founding member of the ESOP Association Canada and president of ESOP Builders Inc.

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