ESOPs, takeover protection, and corporate decision-making

ESOPs, takeover protection, and corporate decision-making

Pugh, William N


ESOPs have the potential to align the interests of employees and owners and may increase firm value. However, employee ownership may also strengthen the position of entrenched management. The literature predicts that firms newly protected from takeover threat will tend to ( 1 ) increase long-term investment and (2) require additional external monitoring, and/or (3) may use leverage as part of an overall antitakeover strategy. We examined firms that have adopted ESOPs and find that firms raise the level of capital expenditures, research and development expenditures, and dividends. (JEF G320)


The original intent of Congress when it legislated the Employee Stock Ownership Plan (ESOP) was to provide a mechanism for employees to acquire equity in their places of employment. Employee ownership potentially can align the interests of owners and workers in much the same way that stock options give managers a greater stake in the firm’s performance. However. as hostile takeovers became more common in the late 1980s, the potential abuse of the ESOP as a takeover defense became more recognized. ESOPs may increase the percentage of shares that are likely to side with management in a pitched takeover fight. The increased cost of raising a voting majority among the remaining, non-inside, shareholders makes a hostile acquisition less likely. Thus, an ESOP may have an effect similar to that of more explicit takeover deterrents such as anti-takeover charter amendments and state anti-takeover laws or less obvious deterrents such as increased leverage or extraordinary dividends.

The objective of this study is, drawing from the anti-takeover literature, to examine changes in an adopting firm’s financial decisions associated with the adoption of an ESOP. We look for any changes in debt leverage, in the level of long-term investing in the firm, and in dividend policy. Several studies examine the usefulness of leverage as an anti-takeover strategy. That is, increasing leverage makes a firm more costly and less desirable as a takeover target. In terms of the long-term investment strategy of a firm, Stein’s (1988) myopia theory suggests that reducing the takeover threat will lead management to adopt a longerterm investment strategy. Finally, if a firm, by adopting an ESOP, is more insulated from a takeover, then investors may require higher dividends to force the firm to resort to outside capital and the subsequent monitoring of investment bankers. We examine changes in relevant financial ratios and compare these changes with changes in industry controls. The sample of adopting firms is also separated into two groups, by whether or not the press or others have identified them as apparent takeover targets.

The next section will discuss the broader takeover issues and their similarity to the effect of ESOPs on firm decision-making. The third section will focus more directly on ESOPs and the related literature. The fourth section will present the research methodology, while the fifth section will discuss the models, the data variables, and the data. The sixth section presents the empirical results, with the final section offering a summary and conclusions.

ESOPs and the Takeover Defense Dilemma

The view that ESOPs provide benefits to both shareholders and the employee-owners has been at least partially replaced by the position that ESOPs can serve to disrupt the market for corporate control by making a takeover more costly and difficult. Critics of anti-takeover strategies warn that by sheltering management from a potentially hostile takeover, management may become “entrenched” and less likely to act in the best interest of shareholders. Thus, rather than mainly serving to align the interests of employees and owners, ESOPs may be set up to thwart hostile takeovers and may do existing shareholders more harm than good. Indeed, several studies have noted a negative market reaction to news of an ESOP adoption when the motivation appears mainly to put more shares in friendly hands (See Gordon and Pound 1990; Chang 1990; and Chang and Myers 1991). However, other studies such as Chaplinsky and Niehaus 1990 find no such reaction. Since an ESOP may serve to make a hostile takeover more unlikely, it can serve as a substitute for or a complement to other takeover defenses such as state laws and anti-takeover charter amendments (ATCAs). Moreover, since ESOPs rarely require an amendment to the corporate charter and presumably enjoy a generally positive reputation, ESOPs could easily become the takeover defense of choice among threatened managers.

To provide a framework for ESOPs as a takeover defense, a review of the related work on takeover defenses is in order. As with ESOPs, studies of the market reaction to the enactment of ATCAs have yielded mixed results. Earlier works either find that ATCAs do not affect firm value (DeAngelo and Rice 1983) or they enhance the firm’s stock price (Linn and McConnell 1983). Jarrell and Poulsen (1987) find that all but fair-price ATCAs reduce firm value. McWilliams (1990) reports a positive impact for firms with low insider ownership (for all but fair-price ATCAs), while Agrawal and Mandelker (1990) find a positive reaction for firms with high institutional ownership.

Several factors may account for the mixed market reactions to both ATCAs and ESOPs. First, an ATCA may signal investors that the firm is a likely takeover target. Establishment of an ESOP would provide a weaker signal, but the action may lend some credibility to takeover rumors. Also, anything that makes a hostile takeover less likely may strengthen management’s ability to negotiate a higher takeover premium. Scherer (1988) claims a takeover threat harms economic efficiency as it may move management toward “short-sighted” decision-making. Under Stein’s (1988) “myopia” hypothesis, informational asymmetry leads shareholders to undervalue assets with long-term cash flows. Consequently managers, concerned that investors’ setting a low firm value will result in unwanted takeover attempts, will sacrifice profitable longterm investments for short-term ones. Stein predicts that, by adopting a takeover defense, managers will feel secure enough to take a longer-run strategy by increasing expenditures on fixed capital and on research and development (R&D). For example, Pugh, Page, and Jahera (1992) provide empirical evidence that R&D and fixed capital expenditures do indeed increase after the passage of anti-takeover charter amendments.

Financial leverage may also be an effective weapon in the battle for corporate control. Certain ESOPs are “leveraged” in that the trust fund borrows funds in order to quickly place a large number of the firm’s shares in friendly hands. The debt is a corporate obligation as appears on the consolidated balance sheet. Prior research has documented the relationship between leverage and probability of a takeover. Dann and DeAngelo (1988) report that the probability of a successful takeover decreases with firm leverage and that when a firm takes on significantly higher debt it is effectively insulated from a hostile takeover. Stulz (1988) argues that when leverage is increased because of the firm’s buying out other (passive) shareholders, the percentage of non-insider shares that an acquirer would need to purchase increases. The acquirer would thus need to offer a higher price to gain the necessary shares than otherwise. Israel’s (1991) model assumes that increasing leverage transfers wealth from existing debtholders to equityholders, resulting in a rise in the stock price and raising the cost to an acquirer. Jensen (1986) suggests that financial leverage may, by committing future cash flows for payment of debt obligations, reduce agency costs and consequently make the firm a less desirable takeover target.

Pugh, Jahera, and Page (1995) empirically examine the relationship between adoption of a takeover defense and subsequent capital structure decisions. They find that firms that adopted anti-takeover charter amendments also increased debt relative to their industry peers. Further, those amendment firms that were subsequently merged/acquired did not increase leverage. Managers probably have mixed feelings about increasing leverage. While providing some degree of implicit protection against a hostile bid, the leverage could increase the chance of bankruptcy. More so than a diversified shareholder, managers have at risk a large part of their ‘wealth in the form of job security, pension rights, stock options, professional reputation, etc. Management may also under-leverage to avoid added scrutiny (or monitoring) by banks and investment bankers. This under-leveraging hypothesis is supported by Friend and Lang (1988), who find an inverse relationship between the debt ratio and management’s ownership share. In contrast, however, Amihud, Lev, and Travlos ( 1990) and Kim and Sorensen ( 1986) find a positive relationship between the degree of insider ownership and the level of financial leverage, supporting the position that the owner/manager’s goal is maximizing firm value, rather than managerial job protection.

Easterbrook ( 1984) suggests that owners can monitor managerial activity either directly (internal auditors, etc.) or indirectly to insure that their interests are protected. One indirect means would be shareholders forcing management to approve a higher dividend. This means of monitoring management activity has a drawback as higher income taxes to the owner, although institutional owners usually do not pay this cost directly. The lower level of retained earnings forces management into the security markets or to banks for any additional (probably debt) capital. Following this scenario, the involved banker or bond rating agency now serves as the monitor. Another twist to the indirect monitoring, of course, would have management pile on significantly more debt-which also involves greater scrutiny by lenders.2

An Overview of the Relevant ESOP Literature

ESOPs allow for a fraction of ownership in a firm to be placed in the hands of employees, giving them both residual claims and voting rights. Much discussion and speculation have surrounded the increase in the number of ESOP implementations. While the original intent of the ESOP was to expand stock ownership among workers in a firm, federal legislation passed in 1973 has increased the incentive for adopting ESOPs by establishing favorable legal parameters and tax treatment unique to this type of plan. Subsequent legislative action by the Delaware Supreme Court has increased the attractiveness of ESOPs as an anti-takeover measure (Beatty 1994; Manoocheri and Jizba 1990; Scholes amd Wolfson 1990). Among the other reasons for ESOP adoption are tax advantages, employee benefit, increased productivity, turnover reduction, ownership transfer to employees, raising capital for investments, avoidance of unionization, saving a failing company, and taking a company private (Bruner 1988; Chaplinsky and Niehaus 1990; Manoocheri and Jizba 1990; Rosen 1990; Ryterband 1991).

With such a list of potential benefits, one would expect the announcement of an ESOP would positively affect shareholder value. Academic researchers and professionals have advanced two schools of thought concerning ESOPs’ effects on companies. First, Nasar (1989) warns that ESOPs could eventually damage shareholders because the plans could serve to entrench weak or ineffective management while offering little motivation for employees to become more productive. However, more traditionally, Rosen (1990) argues that ESOPs would increase firm productivity because workers would see the plans’ correlation with increased income. Corporate officials appear to hold to the positive view. For example, Roger Hemminghaus, CEO of Diamond Shamrock, when announcing his firm’s ESOP, stated that “… because the ESOP increases the stake of employees in the company, it more closely ties their interests to that of the shareholder and provides productivity incentives to help increase revenues and control costs” (PR Newswire 1989). While neither Nasar nor Rosen empirically support their positions, their opposing views have been well debated. Specifically, is the dominant effect of the ESOP simply to add to managerial voting strength and entrenchment, or does the ESOP better motivate the new owner/employees to maximize firm value? ESOPs are trusts established for benefit of the employees of a corporation. The trust is required to hold the majority of its assets in the establishing firm’s stock. The firm places shares of its stock into the trust or cash for the purpose of purchasing stock on the open market. The employer can deduct the value of these contributions if the payments do not exceed 25 percent of the firm’s total labor cost. If, however, the dividends are paid on the contributions, the 25 percent ceiling does not apply.3 An ESOP is said to be leveraged if the money used to purchase shares of stock is borrowed either from the employer or an outside lender.4 The maximum corporate tax benefits are realized when the ESOP pays out all dividends. That is, under the current tax code, a corporation may deduct dividends paid to an ESOP only if ESOP participants receive them as direct cash payments. The ESOP then distributes the dividends to participants within a certain time limit or it can use the dividends to repay an ESOP loan (See Scholes and Wolfson 1990). A study conducted by Chaplinsky and Niehaus (1990) finds that most ESOPs retain dividends paid on allocated shares within the trust, and therefore, are not managed to provide the maximum corporate benefit. It is speculated that firms take into account the personal tax consequences of paying dividends to employees.

The Employee Retirement Income Security Act of 1974 (ERISA) made ESOPs attractive as a takeover defense by exempting ESOPs from many of the limitations placed on other employee benefit plans regarding the percentage of plan assets that can be invested in employer’s securities (Freiman 1990; Manoocheri and Jizba 1990). Recent studies have shown that, for firms not presently under takeover pressure, average stock prices increased following the announcement of an ESOP (Chang and Mayer 1992; Chaplinsky and Niehaus 1994; Dhillon and Ramirez 1994). However, the evidence was mixed for those firms that were subject to takeover pressure.

In a study of more than 3500 ESOP firms, Ryterband (1991 ) found that employers perceived the ESOP as a vehicle for improving employee morale, providing tax savings, boosting productivity, reducing employee turnover, and improving profitability.5 The only major negatives cited were the cost of the program and dilution of corporate control.

In recent years, ESOPs have been increasingly used for employee buyouts and takeover defenses. For example, during the 1980s and coinciding with the initial cost crunch in the health care industry, ESOPs were used extensively in financing company growth. Hospital Corporation of America (HCA) and American Medical International (AMI), two of the nation’s largest investor-owned hospital corporations at the time, sold a large percentage of their rural facilities to their respective ESOPs. Similar transactions took place at the company previously known as Charter Medical Corporation and Republic Health Corporation (Lutz 1994). This surge in hospital ESOPs was attributed to the desire to give employees a stake in the financial operations, while preventing a takeover at a minimal cost (Lutz 1994).

Worker buyouts of failing companies, likewise, are seen as an attempt to place more responsibility in the hands of employees. ESOP opponents, however, feel these buyouts are management’s way of “shortchanging employees and shifting the burden of failing companies to the employees” (Ryterband 1991).

In some cases, ESOPs have been established as a result of a subsidiary or division of a corporation being sold to an ESOP because it no longer fit with overall corporate strategy. The corporate motivation stems from the fact that the company is able to realize a fair selling price, while it avoids the cost of finding a buyer, the cost associated with the shutdown, and the cost associated with severance paid to employees of an unprofitable unit.

Some researchers, like Scholes and Wolfson (1990), argue that the primary reason for the recent increase in ESOPs is their anti-takeover characteristics. While many studies of ESOP firms show that the anti-takeover strategy was not their reason for adopting an ESOP, popular opinion supports Scholes and Wolfson (Ryterband 1991). A repurchase of the company’s stock through the ESOP allows the company to take advantage of the tax benefits while, at the same time, placing a large portion of the stock in the hands of “friendly” stakeholders. The company’s expectation is that employees will vote with management, making it more difficult for the acquiring company to obtain the required percentage of voting stock. Management can create an ESOP defense quickly and without shareholder approval (Manoocheri and Jizba 1990; Nasar 1989; Rice and Spring 1989; Rosen 1990).6

Manager-controlled firms are more likely to maximize sales rather than profits, have a lower profit rate but less variability, engage in activities to smooth income, and engage in conglomerate mergers (Amihud, Kamin, and Ronen 1979; Nyman and Silberston 1978; Smith 1986). These activities have the potential of shifting wealth from the owners to the managers, unless constrained by owners. Consequently, if managerial ownership promotes entrenchment, resources can potentially be inefficiently used and shareholder wealth may suffer.

By definition, ESOPs increase the percentage of “inside owners” in a company.7 If the new owners truly have decision-making authority, then, according to agency theory, efforts will be made to increase shareholder wealth. However, if the employee owners are merely “friendly” shareholders with little or no decision-making authority, management may, in effect, gain more control. That is, the employees, who are hired and evaluated by management, will align themselves with management out of concern over job security. As a result, one interpretation of the agency argument would be that the ESOP would facilitate management entrenchment (Chang and Mayers 1992).

An alternative perspective would suggest that ESOPs increase the voting power of the firm’s managers, if the ESOP shares are indeed “friendly” shares. Therefore, when faced with a potential takeover bid, managers would be in a more powerful position to elicit high bids, and, hence, a higher price for the company’s stock. In this situation, ESOPs would benefit the wealth of the shareholders. However, given that employees are still the owners of the shares in the ESOP, there are no guarantees that they will vote the shares in congruence with the wishes of management.

Most prevalent in the ESOP literature are those studies that examine the reaction of the stock price to the announcement of the ESOP. Beatty (1995) studied the tax, employee benefit, capital structure, and corporate effects of ESOPs by examining the stock market reaction to 145 ESOP announcements. The findings suggested that investors in ESOP firms expect to see an increase in tax savings and a reduction in the likelihood of takeover for companies subject to takeover attempts. Chang (1990) examined the abnormal stock returns associated with 165 ESOP announcements and found that, when used as an LBO, ESOPs increased rather than transferred wealth from shareholders to employees. However, when used as a takeover defense, ESOPs resulted in a reduction in shareholder wealth. Dhillon and Ramirez (1994) had similar results. Specifically, overall positive stock price effects were found following ESOP announcements. They also found that this reaction changed after the court ruling for Polaroid. In that case. Polaroid essentially controlled, through the ESOP, sufficient holdings to thwart any takeover attempt under the Delaware takeover statute. While these studies are of interest, they only capture the market’s immediate assessment of the implications of the ESOP, that of stock price changes.

Research Methodology

The sample for this study consists of 183 firms that adopted ESOPs through the year 1990. The sample firms were identified through the Wall Street Journal Index and the National Center for Employee Ownership’s (NCEO) Non-Majority Employee Finns report. This information was cross-referenced with data available from the Compustat Industrial tapes. Firms included in the Non-Majority Employee Firms report are all members of the National Center for Employee Ownership. The financial data is from the Compustat Industrial tapes. Firms included in the sample had to have one or more non-missing or nonzero– ratios in the base year. Therefore, we omit ratios when the numerator or denominator is listed by Compustat as zero, missing (coded .0001), or negligible (coded .0008). The sample of firms that have implemented ESOPs is combined into a single portfolio by using the number of years before or after the ESOP as the time variable.

The analysis is performed on the full sample and also two subsamples. In the first subsample we remove firms that have been identified as takeover targets, either according to the National Center for Employee Ownership ( 1989) or when the firm is mentioned as a possible target in the Wall Street Journal near the time of the plan’s creation. If the firm is a potential takeover target, then management may have set up the ESOP primarily as a takeover defense with the potential for further management entrenchment.

A number of financial ratios are examined to assess the effect of ESOP establishment. To capture changes in longer-run investment, we examine capital expenditures to assets and then to sales and research and development expenditures to assets and then to sales. Both capital expenditures and research and development expenditures are considered given that both reflect a commitment to a longer-run position by management as opposed to the position of myopia that many believe occurs. While dividend policy is usually expressed in the measurement of the traditional payout measure, dividends to earnings, we find this ratio to be especially noisy. While one can screen all ratios for negative data, a sharp drop in earnings while maintaining a dividend (a common practice, especially during a recession) results in massive payout ratios which affect our control samples. Thus we rely more on changes in dividends as a percentage of sales and assets consistent with our other tests. To assess changes in leverage, the total debt to total asset ratio is analyzed.

For the years following and including the year of implementation of the ESOP, each of the ratios is compared with the corresponding value at the end of the year before implementation (referred to as the base year). This base year is noted as year -1, the year of ESOP implementation is year 0, etc. Therefore, a [-1, 0] time window presents the change in the financial ratio from the end of year – 1 to the end of year 0, thus, the change in the ratio that is concurrent with the implementation of the ESOP. A two-year [–1, 1] time window shows the change from the end of the base year to the end of the year following the ESOP implementation. Changes are tested up to five years in some cases, but longer time periods result in fewer observations. That is, the more recent the ESOP, the fewer post-event years are available for analysis. All event windows represent the firm’s fiscal rather than calendar year.

To control for industry effects and, indirectly, any market effects through its impact on the industry, we adjust the ratio changes by the equivalent change for the population of all those firms, by industry, on the Compustat Active and Research database. We use, but do not report any results on, an alternative control sample that excludes those firms in the ESOP sample. These results do not vary appreciably from full control results. Industry controls are formed based on both two- and three-digit SIC codes (only the two-digit results are presented). We require that each industry control group have at least five members. To be included in the control sample, firms must have nonzero financial ratios in both the base year and the comparison year. An industry-adjusted indicator is found by subtracting the control indicator from the ESOP firm indicator, i.e.,

industry-adjusted change = (RT^sub t^-RT^sub -1^) – (RC^sub t^-RC^sub -1^). (1)

RT refers to the appropriate ratio for the ESOP firm while RC refers to the corresponding ratio for the industry control. Simply put, this expression measures the change in the ESOP firm’s financial ratio from the period prior to the ESOP through as many as four years after, and from this we subtract the equivalent change in the overall industry ratio. If the ESOP had no effect, then one would expect the change in the ESOP firm ratio to be no different, on average, than the change in the overall industry. Thus, the null hypothesis is that the industry-adjusted ratio is not significantly different from zero. A positive change would indicate a rise in the ESOP firm’s ratio, over time, compared with any change in the average of the corresponding ratio for the control sample firms.

We conduct tests of significance using the mean and standard deviation of the adjusted ESOP firms for each ratio and for each event-window. We also conduct a binary test to see whether the proportion of positive adjusted ratios differs significantly from 50 percent (the null hypothesis). This last test serves to evaluate whether or not any results were primarily driven by a few outliers.

The change from the base year (t = -1) to the implementation year (t = 0), and each year following up to the fourth after implementation (+ 1, +2, +3, and +4), is reported. The control for the base year is unique for each comparison year: to be included in that year’s comparison, a control firm must not have missing data in either the base year or the comparison year.

Empirical Results

Table I presents the industry-adjusted change in the ratios of capital expenditures to sales and capital expenditures to assets. We present results for all of the ESOP firms and then for the identified takeover target firms and finally the nonthreatened firms. Each cell in the table consists of the industry-adjusted change, the t-statistic, the proportion of industry-adjusted changes that are positive, the binomial test statistic for this proportion, and the sample size, respectively. In all cases, the industry-adjusted ratio is calculated relative to the year before the implementation of the ESOP (t = -1). For example, the change denoted for year 0 in the tables refers to the change from t = -1 to t = 0.

We find that ESOP firms, as a group, increase capital spending as a percentage of sales and possibly as a percentage of assets in the years following the ESOP adoption (relative to their industry-control group). Both the four-period and five-period industry-adjusted change in capital expenditures to sales are positive and significant at the one-percent level. Further, when examining firms are divided into reputed takeover targets and nontargets, we observe stronger capital spending gains for the nontarget firms. In most cases the target firms’ gains are not significantly positive. One interpretation of this difference goes back to the controversy over myopia vs. entrenchment, where, if the takeover defense simply serves to allow management to enjoy the quiet life, then there is no reason to expect changes in investment policy. Since increases in capital spending mainly accrue to the nontarget group, one interpretation is that the ESOP is associated with a longer-run investment strategy. That is, since most firms are potential targets, the dominant effect on nontarget management is a greater comfort with long-term projects. This longer-term increase in capital expenditures to sales for the nontarget firms appears significant for the periods from -I to +3 and from -I to +4. For all periods for the nontarget firms, the proportion of positive changes exceeds fifty percent.

We report much stronger increases in long-term investment in Table 2 as R&D expenditures (relative to both assets and sales) rise sharply for all ESOP groups, consistent with the myopia hypothesis. Note, that sample size decreases, however, as R&D expenditures are not complete on the Compustat database. However, there is no consistent difference in R&D spending between the target and nontarget ESOP firms.

We report the results measuring the change in leverage in Table 3. While the non-target firms show an increase in the level of the debt-to-asset ratio, it is only significant in the fourth year (t=1.98) and is not supported by the binomial test results. In contrast, by the year after the adoption, the target firms had increased their debt-to-asset ratios by more than nine percent of assets (not simply a nine-percent increase in the previous debt). Such a sharp gain is consistent with the position that the firm’s motivation is largely to create barriers to a hostile takeover. The debt level is relatively stable after the initial year. Considering that this subsample of firms has been identified as comprising potential takeover targets, the implication is that those firms are, in addition to the establishment of the ESOP, pursuing a greater level of leverage to further defend against a hostile acquisition. Over seventy-four percent of the changes in the debt to asset ratio for the target firms were positive when looking at the five-year, -1 to +4 window. This compares to only fifty-four percent for the non-target firms.

In Table 4, we observe higher industry-adjusted dividends as a percentage of either assets or sales. For the full sample, the dividends are significantly higher by the second year and remain so throughout the remainder of the analysis period. The binomial results confirm the t-tests. Full sample results for dividends as a percentage of sales are essentially the same. Analyzing the threatened and nonthreatened firms separately still appears to indicate a higher dividend payout policy, but the results are significant in fewer of the time periods, the results perhaps diluted by the sample split. Threatened firms show evidence of higher industry-adjusted dividends over the time periods ending in the second and third years. Results are similar for dividends as a percentage of sales. Firms not under a takeover threat also exhibit a rise in some of the time periods.

We also analyzed, but do not report, dividends as percentage of earnings and found, for the full sample, little evidence of a policy change. The target firms alone showed significant drops in the payout ratio, indicating a reduction of monitoring and contradicting the dividend to asset and dividend to sales ratios results. Although we screened out ratios with negative earnings, that still left in firms with sharp reductions in earnings combined with a higher existing dividend and thus an unsustainable payout ratio well over one. Second, these high payout ratios were mainly in the control sample and thus subtracting them from the actual target ratios largely drove the results. The actual (not industry-adjusted) payout ratios indicated no significant policy change.

Summary and Conclusions

ESOPs are often credited for their role in creating owner-like incentives for employees. Nevertheless, such plans, by putting more of the firm’s stock in friendlier hands, can reduce the firm’s vulnerability to a hostile takeover. This study attempts to provide an assessment of the similarities in financial decision-making that result from ESOP adoption to that of other potential takeover defenses such as ATCAs, leveraging, and state anti-takeover laws.

Stein and others predict that managers, when worried about a takeover threat, will focus on projects with short-term and reasonably sure returns as these managers believe that investors overly discount distant cash flows. This excessive discounting would lower the firm’s price, thus increasing its vulnerability to a hostile bid. However, once relieved of takeover threat, managers may adopt those positive NPV projects that were shelved because of their longer-term cash flows. R&D should also rise. This study finds some evidence that ESOP firms raise their capital spending relative to firms in the industry, but that there is little evidence that firms under the threat of a takeover do so. R&D spending, however, rises strongly for both groups of ESOP firms.

Firms seeking to avoid a hostile bid can usually increase leverage, which has been shown to be an effective takeover deterrent.Only the threatened firms increase leverage, where, typically, total debt rises by ten percent of the total assets (not simply a ten-percent increase in the previous debt). Such a sharp gain is consistent with the position that the motivation of these firms is largely to create barriers to a hostile takeover.

If a barrier to a takeover is put into place, such as an ATCA or an ESOP, shareholders may wish to replace the outside monitoring, formerly provided by the market for corporate control, with some alternative. By requiring that managers raise the level of dividends, the owners can help insure that the firm has to face the review process provided by outside monitors such as lenders, as the firm must rely more on outside capital for expansion. Overall, the industry-adjusted changes in dividends as a percentage of either assets or sales is higher, indicating increased external monitoring. However, there was no difference between the two sub-samples.

Pulling these effects together, one can suggest the following: that for ESOP firms as a group, particularly the non-target firms, ESOPs reduce managerial short-termism and the additional long-term projects are in part funded by increasing the retention rate. This may be a benign effect, however, as owners apparently feel the need for increased outside monitoring. Target firm behavior is affected by the greatly increased debt load, created from the desire to throw up immediate barriers to some perceived threat. These firms appear less likely to raise investment levels, perhaps, in part, because the increased debt is diverting operating earnings to interest payments. Both groups’ results are consistent with previous theories on the effects of takeover protection on corporate behavior. One can conclude that ESOPs have the similar effect as other takeover defenses and shareholders should view them as another implicit takeover measure if adopted. However, these results should not necessarily indicate that ESOPs, and other such barriers to takeovers, work against the shareholder’s interest. In the case of the nonthreatened firms, the improvement in longterm spending, if these are truly profitable projects, may improve shareholder wealth. The threatened firm’s leveraging may possibly signal a move toward a more optimal capital structure. Note these firms are also moving toward a longer-term investment strategy. Finally, the shift in monitoring to providers of outside capital should be especially pronounced with the leveraging firms as they face the additional scrutiny from lenders resulting from the higher debt load. This, along with the additional monitoring indicated by the increase in dividend policy, may be sufficient to offset much of the potential agency problem that could result from an ESOP adoption.

1 For empirical work supporting the role of dividends in the agency monitoring process, see Rozeff 1982: Lloyd, Jahera and Page 1985; Dempsey and Laber 1992; Dempsey, Laber, and Rozeff 1993.

2 The Deficit Reduction Act of 1984 (DEFRA) allowed a company to deduct dividends paid on ESOP stock if the dividends were distributed to employees within 90 days. Additionally, the Tax Reform Act of 1986 permitted the company to deduct dividends paid on ESOP stock if the dividends are used to repay the ESOP Loan. For further information on the tax advantages of ESOPs, see Chaplinsky and Niehaus 1990.

3 “Leveraged ESOPs are uniquely able to borrow funds to purchase securities, while standard stock bonus plans generally must be financed with operating capital or through issuance of treasury stock” (Ryterband 1991).

4 No empirical data supported this survey data.

5 Recent trends have seen a reversal of support for ESOPs. For example, HealthTrust converted to a traditional pension plan in 1991. Charter’s ESOP saw its value drastically decrease to a fraction of its original worth when it reorganized under Chapter II bankruptcy. Epic’s ESOP ended in 1994 with its sale to HealthTrust (See Lutz 1994).

6 This defense is effective primarily because the state of Delaware, where most of the Fortune 500 firms are incorporated, passed a strict anti-takeover law in 1988 requiring that hostile takeovers are approved by 85 percent of all nonaligned (stock owners who are not corporate insiders) shareholders. If the approval is not received, the corporate raider must wait three years to gain possession of the company. ESOP employees are considered nonaligned as long as they can vote their share confidentially. An ESOP, however, cannot be established or substantially modified after a hostile bid has been made (Manoocheri and Jizba 1989).

7 Inside ownership is most often measured in terms of stock holdings of both officers and directors (see Lloyd, Jahera, and Goldstein 1986; Kim, Lee, and Francis 1988) because of their decision-making positions, and does not include employee owners who do not fall in the above categories.


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William N. Pugh, John S. Jahera, Jr., and Sharon Oswald*

* William N. Pugh and John S. Jahera, Jr., Department of Finance, and Sharon Oswald, Department of Management, Auburn University, Auburn Alabama 36849-5245,

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