It’s October and that means it’s Employee Ownership Month. Our guest today on the podcast is Dr. Corey Rosen, the founder of the National Center for Employee Ownership. NCEO is the foremost resource and catalyst for employee ownership and ESOPs. We discuss his new book, Ownership: Reinventing Companies, Capitalism, and Who Owns What, and we look at the history of ESOPs, the bipartisan support they receive, and current proposals that make me optimistic about the future of employee ownership.
Kevin:
The new golden age of ESOPs. As an optimist, I certainly hope so. Speaking of benefits, this is Kevin Long. ESOPs have been around a long time and they’re the product of numerous pieces of legislation in the Internal Revenue Code and ERISA. Of course, there are regulations and there is even litigation by which the regulators have attempted to make law. Although the litigation threat has never really been a significant force in thwarting ESOPs. In my view, it’s more of a boogeyman than a real statistical exposure. But, many people don’t know it.
ESOPs have always been supported as a matter of public policy on both sides of the aisles even though they may not be cherished by the enforcement arms of the agencies. My hope is that the more current pronounced evidence of public policy support in legislation and other movements will have a long-term, significant boost to ESOP’s profile and support even within those agencies for a positive movement for employee ownership. We’ll talk about that today with our special guest.
We’re going to chat with Dr. Corey Rosen, the founder of the National Center for Employee Ownership in Oakland, California. The NCEO is the foremost resource and employee ownership in the U.S. and quite frankly, around the world. Corey has a distinguished history of developing the NCEO into a catalyst for ESOP nationally. I do not think I’d be practicing exclusively in the ESOP area if it wasn’t for the NCEO and its effect on the ESOP community and the employee ownership practitioner community in particular. Thanks for joining us, Corey.
Corey:
Thanks, Kevin. It’s an honor and you’ve been a terrific supporter and great source of wisdom for us for many years. It’s really appreciated.
Kevin:
I guess now I do have to pay you for appearing on the show, right?
Corey:
That’s right.
Kevin:
This man is not a shill. He wasn’t asked to say that. Before we jump in, I want to give you the shameless opportunity to tell everybody listening about your new book that just came out.
Corey:
John Case is a business writer and long time friend and colleague. I wrote a book called Ownership: Reinventing Companies, Capitalism, and Who Owns What. The basic idea of the book is when we think about the economy and society today, we often talk about inadequate income. We talk about social inequality and all sorts of ills that the economy and the polity face. But, we rarely talk about ownership and what sorts of systems have been created in this country to allow people to own capital. Employee ownership is one of the few ways that addresses the problem.
What’s the problem? If you go back 50 years ago (and 50 years ago was one year before the enactment of ERISA, which created a statutory framework for ESOPs), Louis Kelso, the inventor of ESOPs, was talking to Paul Samuelson on 60 Minutes. Louis Kelso said, “You know what’s going to happen in the next generations? People, who work for a living, are going to find their wages are stagnant. And people who own stuff and own the companies those people work for, they’re going to be doing great.”
Paul Samuelson said, “That has never happened in economic history and modern industrial economies.” Whenever capital investment and returns to equity grow, wages grow in step. Louis Kelso said, “That’s not going to be true.” Paul Samuelson went on to say, “Well, you’re not even an economist, you’re just a kook.” Paul Samuelson was the most famous economist of the time. So what happened?
Since 1973, real median wages are the same as they were back then. For many sectors of the workforce, wages are lower. In the auto strike today, their wages are lower in real terms now than they were 50 years ago.
What happened to the folks who own stuff, who own the automobile companies, or the CEOs who have stock options and restricted stock in those companies? These people are doing extraordinarily well. The CEOs are getting tens and sometimes even hundreds of millions of dollars, mostly through their equity ownership. The real value of equity ownership’s has grown 8% per year since 1973. Meanwhile, people who are working for a living are running faster and faster to stay in place. So they legitimately think the system is broken and not fair.
This is causing a lot of social and economic problems. It also means that we have tremendous wealth insecurity in this country where 50% of the population do not have $1,000 in an emergency. 50% of the private sector workforce is not in a retirement plan. As our research director, Nancy Wiefek is fond of saying, “The median retirement account balance in a private company is zero. Half the population has zero or less.” If the real action has been in ownership, not in wages, why aren’t we addressing that problem? Why aren’t we finding a way to make that happen?
It turns out that there is a way with employee stock ownership plans, and other approaches to employee ownership, but especially ESOPs. You say, “Okay, well there’s a way.” Lots of books end with a final chapter that is if we ruled the world, these things would happen. You read that chapter and say, “That’s great. You don’t rule the world. And there’s no way politically those things will happen.” But, the authors think that’s not their problem. John and I said, “Wait a minute, here’s something that not only works to address the problem,” and we can talk about how effective it’s been. It not only works, but it’s politically feasible. It’s the kind of legislation where two years ago, Elizabeth Warren and Tommy Tuberville co-sponsored a piece of legislation. You will never, I suspect, see their name on any other piece of legislation again. Employee ownership is that rare bird these days that’s not just nonpartisan. It’s universally approved by politicians and largely by the public. Everybody thinks it’s a good idea and very few people stand on the rooftops shouting what they should be saying – it’s an important idea – and that’s what the book is about.
Kevin:
I guess we’re here to shout, Corey.
Corey:
Yes, we are.
Kevin:
We do a little shouting here on the podcast. I think the history is great and I think that’s the right setting for my hope, I guess, that things are in fact shifting. We may be making headway on the hill, and hopefully, culturally it takes hold. But, that’s a tall order and a big dose of optimism.
I see things that are happening compared to 1987 when I worked on my first ESOP in public accounting. The law had just changed at that point when Congress added the tax deferred rollover provision of the Internal Revenue Code. I think everybody shared about that. You can sell stock to an ESOP and you can defer your capital gains taxes. In my industry point of view, that was probably the single most important change to the Internal Revenue Code and it drove the growth of ESOPs around the country.
Whether you call it enlightened self-interest or just self-interest, people investigated ESOPs because of tax incentives. Although you didn’t talk about it, it wasn’t in the sweet spot of the question, it really was tax driven incentives that helped ESOPs grow. Thankfully, we have a community of ESOP companies now that are high-minded and those are the ones that ultimately do ESOPs, but it’s been propelled by quantitative legislation.
Now, you had a very special role in that change in the law. And surprisingly, I don’t think that a lot of even ESOP practitioners really know. Can you give us a short story about how you were involved in getting that 1042 piece of legislation into the books?
Corey:
In 1979, I was working on Capitol Hill on a staff and I got interested in ESOPs. Someone I knew who owned a business nearby, a lumberyard, he was going to sell his business to an ESOP. He came to my office and said, “You know, Corey, I’m going to sell to the ESOP, but I could sell to John Deere and I would get John Deere stock. If I got John Deere stock, I don’t have to pay any taxes until I sell it. But, if I sell to the ESOP, I have to pay taxes right away. Now, changing the law won’t help me because it’ll be too late, but that doesn’t seem right.” And I said, “You know Ed, that makes a lot of sense.” So I drafted a piece of legislation. You can blame me for all its faults. I was 29 years old and arguably didn’t know what I was doing. Some of the things in that law though were just a function of the time. For instance, you have to be a C corporation for that to apply. In 1979, you couldn’t be an S corporation and have an ESOP, so that wasn’t an option. If you got a seller note and you reinvested a little bit at a time as the note was repaid, that didn’t work either. You only had 12 months.
In 1979, people were not doing seller notes, so it just wasn’t a thing. That’s how the law was written and it hasn’t been updated very much to change that. I went to my boss who was Gaylord Nelson, the chair of the Senate Small Business Committee. He was one of the most influential and important liberal senators in Congress. He was the founder of Earth Day and other things. I said, “Senator Nelson, here’s this great idea.” He said, “Huh, sounds like communism to me.” And I said, “No, no, no. This is the ultimate in capitalism. And in fact, I’ve already talked to Senator Goldwater’s office and they liked the idea.” And he said, “Oh, okay. Well, let’s do it.” So I wrote the bill.
It took another five years to convince people on Capitol Hill that this was really important. It snuck by in a midnight negotiation in a conference committee between the two Houses on an ESOP bill. Because at that time, the ESOP community was focused on ESOPs in public companies. They didn’t really think the use of ESOPs as a business transition mechanism was the future. Talking to people like Ed, I kind of thought it would be.
It did pass and become an important way to introduce people to this idea and to make the sale to an ESOP competitive with sales to other buyers. I think that is what is really important. It’s not that this is going to make you a lot richer than if you did something else, but it’s going to make it competitive. As you say, most business owners who come to ESOP certainly now say, “You know, I’ve got a legacy in this business. I worked all my life to build this business. These people helped me build it. I’m rooted in this community and I care about this community. It would be great if this business could go on after me or I could continue to work in this business as long as I want.” An ESOP provides a way to do that in a way that’s financially good for them.
Kevin:
That history, that vignette I think is really the touchstone for the thrust of the rest of the discussion today. It takes legislation and it takes getting it through committee. Those dark smoky rooms. Well, they don’t smoke anymore. Those dark rooms in the middle of the night where staffers haggle over what’s going to be in the markup bill and something comes out that maybe the senators didn’t even understand, but policy-wise it tends to make sense.
Like I said, I’m a bit of an optimist, but we’re seeing a lot of things happen. I want to get your perspective and some explanations of what’s going on in Congress and in the states that demonstrates what I hope is a renaissance movement for ESOPs across the country. Maybe not 1042, but we’ve heard for years from advisors that they’re wondering whether ESOPs are still around and still popular and what if Congress just legislates them out of existence? I think the future looks brighter than it has in quite some time.
What do you think about the different pieces of legislation and the movement in the agencies and whatnot, regarding the future of ESOPs? Maybe you can give us an overview from your perspective, potentially most tectonic, down then to most marginal.
Corey:
Let’s think about why there aren’t more ESOPs because that explains what’s important legislatively right now. The biggest problem for ESOPs as I know you can avert Kevin and probably even some of your listeners will relate to, is that a business owner who might be a great candidate for an ESOP is thinking about what to do and goes to their accountant or maybe a broker or an M&A advisor, and says, “Hey, I’m looking at transition. Any ideas?” What’s the chance that that advisor is going to say, “You should do an ESOP?” Zero. Because number one, I don’t know about ESOPs, so you may not hire me. Number two, it’s a human tendency if you don’t know how something works to think, “That must be a bad idea.” And number three, if I sell you to somebody else, I can charge you a finder’s fee, a success fee. If you come to me and you say, “I already decided who’s going to buy the company.” You’ll say, “Great, I can set this up for you and I’ll only charge you 3% of the transaction for you having found the buyer.” That’s not going to work for them. So they say, “No, you can’t do that. It’s too complicated, not for your kind of business.” The biggest obstacle is people don’t even know you can do it.
The second biggest obstacle is sellers who do know they can do it, but they can’t finance the whole deal with a bank because no bank is typically going to fund 100% of a transaction. So they have to take a seller note. For many sellers, that’s great. They get a nice rate of interest, maybe they get some warrants. They’re not in that big a hurry, they’re ready to go. But other people say, “No, I want the money sooner. I want it upfront.” That’s the second obstacle.
When you look at that first obstacle, the big legislative change was a bill I actually wrote 35 years ago for Senator Sasser called the Work Act, which amazingly enough actually became law last year. What the Work Act does is it gives money to states to set up state employee ownership centers to do outreach to business owners about ESOPs. There’s a few of these now and they are doing great work. We need a lot more. The Work Act passed, but unfortunately, it hasn’t gotten an appropriation yet, and we don’t know whether it will or not. So that’s a big if.
States are now starting to act on their own to do this. Most notably Washington and Colorado. We’re hoping that some other states will follow along, which would be a big deal.
Regarding the financing problem. There’s a bill called the Employee Equity Investment Act that I was involved in helping to conceptualize, but it’s really being driven by a wonderful group called Ownership America. The basic concept is you set up something like small business development investment corporations. You have an employee business investment corporation, employee ownership business investment corporation. It’s a way to get government backing for secondary finance, for that second piece that is junior to the bank that will let you get more money at a reasonable rate of interest and hence sell more of the company upfront. It’s a really big deal.
Kevin:
That’s important because that’s really prevalent in the ESOP community. In particular for the smaller ESOP companies, which are about 50% of the ESOP market if I understand the statistics right, there’s always some portion of seller subordinated debt that’s necessary to make the deal go because the banks will only lend about 40% of it.
Corey:
Right. This would be a big deal if it passes and it does have bipartisan support. Who knows? It’s very difficult. There are about 20,000 bills introduced in Congress every year and about 100 pass. It’s a big hill to climb, but it’s off to a good start. Employee ownership has been something that has relatively easily passed, so I think there’s at least a shot at getting this done.
The other thing it would do is it would also make it more possible for divisions of public companies to be sold to ESOPs for that same reason that the public company doesn’t want to divest a company and finance the sale. If more of the money could come upfront, you might see more of that and that’s an immense market.
Kevin:
Basically funding spinoffs, parts of businesses that the companies just want to divest, and creating another market of competitive buyers?
Corey:
We hope so.
Kevin:
What’s going on in terms of hidden nuggets in the legislation to prompt the Department of Labor, in particular, to do something about ESOPs? I have a jaundice view of the Department of Labor. I hope you’re listening, but what would we hope to see in terms of some changes with their policymaking?
Corey:
The Work Act had two other provisions. One provision, which was in the original bill 35 years ago, was to create an employee ownership initiative within the department. When it was drafted, the idea was this would be an office within the Department of Labor that would research and talk about best practices in employee ownership, so that the grants to the state organizations could be based on their ability to make those best practices happen.
The Department of Labor has already moved on this and started to create this initiative. A number of us have met with the people who are heading that effort in the Department of Labor. Whatever you’ve heard about the Department of Labor, our experience with these folks has been extremely positive and encouraging. We’re hopeful about how that office is going to play out. I don’t think that’s going to be a major driver because business people aren’t going to look to the Department of Labor for figuring out how to sell their businesses.
What it could do is establish some concepts about employee ownership for the federal government. For instance, one of the big barriers to ESOPs in minority-owned businesses is that you don’t qualify for set asides if you are more than 49% owned by an ESOP because the owner is a trust not a qualifying individual. Maybe there’s a way that that could be done, so that employee owned companies can qualify. Those are the kinds of things that department office may do.
The second big part and one that’s really of concern to the ESOP companies is setting up valuation standards. The ESOP Association wanted to get into the law a requirement that the Department of Labor come up with regulations on how to do valuation. As you know, for all these decades, the valuation has been regulated essentially by litigation in an inconsistent and often very unrealistic way.
The hope is that these valuation guidelines will be more realistic and more in line with how businesses really operate. I’m concerned that we may not be happy with what we wished for. But hopefully, it’ll turn out better than what we may at least fear.
Kevin:
I haven’t been involved in any of those discussions, Corey. If you talk to 100 ESOP practitioners, you’ll get 101 answers, conjectures as to what may happen. In 1989 when they issued those proposed regulations and then re-proposed them when they were expiring, I took a look at them. I’ve always told the attorneys that work for us, look at the case law that’s described in the preambles for those regulations. Don’t even bother to read the regulation because it’s just a set of platitudes about fair market value. The real standards for what is fair and what is market and what are the methods that could be used, in the cases leading up to that.
My take on it, one of my conjectures is that when they issue these new regulations, they’re going to try to compile something that they’ve learned in litigation in terms of what is acceptable and what’s not. Because we’ve seen in this litigation, the battle of the experts and every fact pattern, it’s a bit different. But maybe, that’s what we’re going to get when these regulations when they come out.
Corey:
I think you’re right. The Department of Labor, surprisingly to us, said they’re going to issue these regulations by the end of the year. That’s absolute speed of light for regulatory development. It usually takes a year or two to develop a regulation on anything and there’s an extensive comment period.
You figure a couple years at least typically for regulations to get issued under most programs. It’s a lot faster. There will be a comment period. It’s not that these are going to go into effect as of January 1st, but it’s really fast to develop them. Which leads me to think that they’re going to be pretty general and they are going to refer to case law. They may in fact not move us a whole lot farther down the road in terms of what’s acceptable. I suspect there’ll be a few general principles that will help clarify things. I just hope they clarify things in a realistic way.
Kevin:
Being a tax and ERISA guy, I’m going to nerd out for a minute. One of the foundational principles of valuation in the IRS context is their revenue, the 59-60, and that’s even picked up by reference in these proposed regulations as to what is fair market value and what methods you can use. It’ll be interesting to see what they put in the Department of Labor’s regulations that is consistent or inconsistent with years of case law since 1959 about what is an acceptable valuation.
We have seen firsthand in cases where the IRS’ view of discounts or premiums is different than what the department would say. Because on the one hand, the IRS wants the value to be higher for state tax purposes and the Department of Labor do not want it be lower for the sake of persecution of well-meaning sellers and trying to get an ESOP done. I’m looking at it as a technician and I’m really curious to see how definite they can be. How can they digress from what’s been said by the IRS in terms of methods and such?
Corey:
I was an expert witness in a case three years ago. The Department of Labor was suing the board and the trustees for paying too much. The IRS was pursuing the seller for not charging enough. They said, “You underpaid your taxes because what you sold really was worth a lot more money and you sold it for less than it was worth.” We had two government agencies in the exact opposite direction.
Kevin:
It would be nice if the department was pushed a little closer to the IRS view of things.
Corey:
Right.
Kevin:
It would be very helpful for the formation of ESOPs. Of course, everything done within prudent guidelines. We’ve covered a lot of good ground here, Corey. This has been in line with everything we’ve talked about in other contexts over the recent months. I think we’re going to have to stay tuned to see what happens with all these changes. I want to leave with a discussion about the one piece of legislation that has passed and is going to take effect. This is something you pointed to earlier when you talked about your role in 1042 drafting, the tax deferred rollover provision or the sliver of the provision that’s now available for S corporations
Corey:
Starting in 2027, you can defer 10% of the tax if you sell to an ESOP in an S corporation. It isn’t a big deal, but it may get people’s attention. I think that’s its main virtue. People may wonder, “How come 10%? Why don’t you do it like you do for ESOPs, for C ESOPs?” The peculiar thing is the Department of Management, the OMB, and the Congressional Budget Office score the tax impact of legislative proposals. In their scoring, they make the assumption of what happens if every S corporation took advantage of this. This ends up being a huge number. Of course, that’s not even wildly realistic, but that’s how they score it.
Under congressional budget rules, in theory at least, if you take away money over here, you ought to provide it over there. That’s a lot of money to make up, so that’s why it is what it is. Hopefully over time, it’ll change. But, that’s a long way off and I think I’ll get people’s attention.
Kevin:
That’s the point of my optimism about that provision and the lobbyists that have been trying for more than a decade to get it into law. I don’t know exactly how many years, but they finally got it in. They’ve got a crack in the door. Maybe we are ultimately going to get there someday because that’s been a door that’s been locked and for no good reason. Hope springs eternal, right?
Corey:
Right. It’s just a coincidence legislatively that it didn’t happen that way because enabling S corporations to have ESOPs wasn’t so much about ESOPs as it was about creating a system where non-taxable entities could own S corporations and ESOP trusts were just one of those. That’s how that came about. It wasn’t, “Let’s create this provision specifically to help ESOP so much.”
Kevin:
I’ll take it any way I can get it, Corey.
Corey:
It worked out just great.
Kevin:
Thanks again for doing this. I really appreciate it.
If you need specific guidance on this topic, let’s start a conversation. This podcast is for general informational purposes only. It does not create an attorney-client relationship between Employee Benefits Law Group and the listener or reader and does not constitute legal advice for a specific situation.
