Alan F. Zundel
Assistant Professor
Institute for Ethics and Policy Studies
Department of Political Science
University of Nevada, Las Vegas
(702) 895-4693 zundel@nevada.edu
President, Institute for the Public Good
www.publicgood.org IPGmail@aol.com
Presented at the Capital Ownership Group (COG) conference, Chicago, April 2000
ABSTRACT: The "Ownership" electronic forum of the Capital Ownership Group (COG) was instituted to inquire into why professional economists have not shown much interest in expanding ownership, and to develop arguments that could convince them of its importance. A start was made toward these aims, but a great deal of the discussion revolved around questions of social ethics as opposed to economics. I focus my attention in this paper on two major threads in the discussion, one on "who pays for ESOP shares?" and the other on "who has a right to residual claimancy?", both raised by Dr. David Ellerman. Dr. Ellerman intended his arguments to shift the focus of discussion away from the goal of expanding the ownership of the capital inputs of production, to a goal of changing the way the ownership of outputs is structured. I argue here that the results of his arguments are mixed, and neither discredit the former goal nor sufficiently justify the latter one. I conclude with a brief argument for the political desirability of justifying policies to expand ownership on the basis of simple concepts such as improving the financial security of citizens, rather than complex, unusual and potentially treacherous ethical arguments.
1. Introduction
The "Ownership" electronic forum of the Capital Ownership Group (COG) was instituted to inquire into why professional economists have not shown much interest in expanding ownership, and to develop arguments that could convince them of its importance. I was a participant in the discussion and have read all of the contributions. This paper represents my own reflections on two of the dominant threads in the discussion, and although I have attempted to be fair and accurate in presenting other people's arguments, this is not meant as a consensus statement, a "neutral" assessment, or a review of the discussion in its entirety.
On the question of why professional economists have not shown much interest in expanding ownership, some interesting hypotheses were raised. For example, Michael Harrington argued that what matters to professional economists is the efficient allocation of capital, not its distribution, and Shann Turnbull argued that the conceptual and terminological apparatus of contemporary economics is not precise enough to handle ownership issues adequately. But the most attention was given to the more limited and specific question of why professional economists have not been interested in Louis Kelso's theory of binary economics. The discussion led me and some other participants to conclude that this is because the proponents of binary economics are unable to adequately defend their notions of the relative productive contributions of capital and labor. The discussion also made clear that the proponents are attached to binary economics not only as economic theory, but as a theory of social ethics. From their economic premises they draw conclusions on matters such as the legitimacy of redistributive policies and the right of citizens to obtain credit to purchase capital. I have discussed the social ethics of binary economics elsewhere, so I have left this thread of the Ownership forum for Keith Wilde to discuss more fully.
On the second aim, that of developing arguments to interest economists in expanding ownership, a start was also made. Michael Harrington argued that linking expanded ownership to the aim of enhancing the financial security of citizens would attract the attention of economists, and questions about the relation of ownership patterns to growth and to the business cycle were also presented as of potential interest. These threads did not go very far though.
Apart from the discussion of binary economics, the most attention was given to two questions raised by David Ellerman: "who pays for ESOP shares?" and "who has a right to residual claimancy?" Discussion of these questions was similar to the discussion of binary economics in that it eventually dealt more with social ethics than with economics, particularly on the second question. Ellerman intended the first question to lead to the second, thereby shifting the focus of the discussion from expanding the ownership of the capital inputs of productive enterprises to changing the ownership of the outputs. That is, the question of who pays for ESOPs was meant to undermine interest in proposals to use credit to spread capital ownership, and the question about residual claimancy (RC) was meant to redirect interest to restructuring corporations so that workers become the sole claimants on the net output.
Ellerman's principal argument is rooted in ethics and jurisprudence, not economics, and I contend that it does not take him where he intends to go. He wants to demonstrate that workers should be sole residual claimants, but the conclusion I draw from his premises is that RC ought to belong to all stakeholders. This topic may be interesting from an academic standpoint, but as a practical matter it has less interest because RC could be sold by any party to any other party when contracting to participate in a productive enterprise. I examine his arguments in more detail in the sections that follow.
2. Who pays for ESOP shares?
The first question that Ellerman posed was, who pays for ESOP shares? He offered his answer to this question in a paper that he archived on the COG website as a response to the charge that economists have not given attention to Louis Kelso's theories about using credit to expand capital ownership. Ellerman challenges what he terms the "pollyanna" claims of boosters of leveraged ESOPs that they are a "win-win" proposition for both a corporation and its employees, financed by self-liquidating capital credit. He argues that they are actually financed by a combination of tax breaks and dilution. Ellerman contends that the correct answer to this question is important in determining the right strategy to achieve "economic democracy."
The leveraged ESOP is a complex mechanism, easy for non-specialists to misunderstand. Ellerman's concern is to separate appearances and propaganda from reality. An ESOP is a trust established by a company as part of an employee benefit plan; the employees are beneficiaries of the trust. The leveraged ESOP borrows money from a financial institution and uses the money to purchase shares in the employing company. The company, which uses this money to expand its productive facilities, guarantees repayment of the loan and receives tax breaks on the loan payments. Once the loan is repaid, the employees become the owners of the shares in the trust, and each may receive his or her portion of the assets in the trust when leaving the company. The boosters of the leveraged ESOP claim that this is "win-win" because the company gets to expand its facilities while the employees become owners of these new assets. They also claim that it is the cash flow from the new investment that pays off the principal and interest on the loan, thus illustrating the principle of self-liquidating capital credit.
To assess these claims, Ellerman compares the ESOP case with that of a company obtaining a conventional loan directly rather than through the intermediacy of an trust device, while holding a number of conditions constant (for example, that the ESOP does not inspire greater worker productivity). If a company obtains a loan directly, uses it to invest in new productive facilities, and repays the principal and interest on the loan with the cash flow from the new facilities, then the original shareholders own the expanded equity. If the same company sets up an ESOP to obtain the loan, invests in new facilities, and repays the principal and interest with the cash flow from the new investment, then the employees become the owners of the expanded equity. An essential difference is that in the ESOP case the company has "paid twice," once by selling shares for the loan money to the ESOP and a second time by repaying that same loan to the lending institution. Ellerman argues that the ESOP shares have been paid for by the company's loan repayment at the expense of its original shareholders, which constitutes dilution. Insofar as the ESOP has been given preferential tax treatment as compared to the conventional loan, the ESOP equity is partially paid by tax breaks, with the rest paid by dilution.
Ellerman's description of the leveraged ESOP mechanism is correct, but I believe the inference he draws from this is misleading. The inference is that this "dilution" contradicts the claims that the leveraged ESOP represents the principle of self-liquidating capital credit working for employees rather than the original shareholders. That is, Ellerman argues that the capital does not pay for itself, the original shareholders pay for it.
The problem is that in considering the idea of self-liquidating capital credit, the ESOP case should not be contrasted with the case of the conventional loan, because both cases illustrate the idea. The ESOP boosters do not claim that the ESOP case is unique in utilizing self-liquidating capital credit, only that it uses it for the benefit of people other than those for whom it is normally used. In both cases loan money is used for new investment, and the cash flow from this investment repays the principal and interest on the loan. In both cases the new capital can accurately be termed "self-financing," and the credit used to purchase the capital "self-liquidating" (assuming that the business plan for the new investment was successful.) If the capital is self-financing, then why did the original shareholders have to "pay twice"?
The side by side comparison of the ESOP case and the case of the conventional loan shows that, in the end, the original shareholders in the ESOP case have lost something. But a before and after comparison of the ESOP case taken alone, before the new investment and after it, shows that the original shareholders lost none of their original equity. (The equity of the new employee shareholders equals the value of the new investment.) What the original shareholders have lost, what they have "paid" with, is the opportunity to use their own assets (the company's equity and earning power) as collateral to obtain self-liquidating capital credit for a new investment opportunity. Their assets have been used as collateral on behalf of the employees. This may be unfair to the original shareholders, but it is not clear to me that the word "dilution" is the most helpful term for understanding what has transpired. The term could imply that the ownership of the original equity has been redistributed, while only one ownership right (to use this equity as collateral for a loan) has been only temporarily redistributed. Use of the term ought to at least be qualified this way.
One could also make a (weaker, in my opinion) case that a qualified use of the term "win-win" could be justified. After the loan is repaid, any additional income from the new investment will be shared by both the original shareholders and the new employee shareholders, so the original shareholders are better off than they were before the ESOP transaction took place. On the other hand, they would have been even better off with a conventional loan.
In sum, I think Ellerman is wrong that ESOPs do not utilize self-liquidating capital credit, and misleading in using the term "dilution" without qualification. On the other hand, ESOP boosters are wrong if they claim that there is no dilution involved, and misleading if they make an unqualified claim that ESOPs are a "win-win" proposition.
A lot of this discussion would seem to be a matter of semantics, and one might wonder what difference these rather obscure points could make. Ellerman argues that they matter in assessing alternative strategies for achieving economic democracy. He wants to deflate some of the more extreme claims about leveraged ESOPs to clear the way for advancing an alternative strategy for achieving economic democracy. The argument for his alternative strategy is considered in the next section.
3. Who has a right to residual claimancy?
Ellerman contrasts two strategies for achieving economic democracy: (1) an ownership strategy, and (2) a human rights strategy. The ownership strategy would make more people owners of capital without necessarily restructuring rights within business enterprises. The human rights strategy would give workers the right to govern the enterprises they work in, and to claim the net output. He makes an analogy with the earlier movement for political democracy. The right to vote was at one time attached to property ownership, and proponents of political democracy thus advocated spreading property ownership. Later it became clear, though, that the proper strategy to achieve political democracy was to separate voting rights from property ownership and assign the former as a human right. In a similar way, the Kelso strategy makes the mistake of focussing on spreading capital ownership, rather than examining assumptions about the connection between capital ownership, corporate governance, and residual claimancy (RC) on the net output of production.
To examine the connection between capital ownership and corporate governance, Ellerman offers analogies with slavery and the way women were once treated as property. In those cases, society eventually came to recognize that those institutions violated human rights by treating people as property, and that the slaves and women should be free to govern their own lives. Similarly, workers are treated as property when they rent themselves out in a labor contract. Rather than capital owners governing corporations and renting workers, workers should govern corporations and hire or purchase capital. Ellerman's argument for the workers' right of self-governance was not discussed very thoroughly in the Ownership forum, but I am skeptical of the analogies. It seems to me that there is an important difference between institutions in which one person governs another virtually permanently and in every area of their life (as in slavery and the way women were once treated), and those in which some people govern others temporarily (while employed there) and partially (only in regards to the work done there). I would argue that a worker could accept a labor contract without compromising their human right of self-governance.
RC is the claim to the net output of production after all costs have been paid. If capital providers, workers, and suppliers were all paid a market rate for their contribution, who would have the legitimate claim on what is left over? (If the business is successful the net output will be an asset rather than a liability.) Under current conditions, capital providers typically forego being paid for their contribution initially, pay off the other factor providers, and then assume RC. Ellerman argues that workers, as they should not be rented as property (see above), should be the ones who pay off the other factor providers, including contributors of capital, and assume RC.
He further argues that the workers are responsible for the net output, and the responsible party is the one who should assume RC. He offers an analogy with a gang that works together to commit a crime, and borrows a car to use in the commission of the crime. The gang members would be held responsible for the crime, and thus liable to punishment, but the person who provided property for the enterprise, innocently lending a car, would not be. In a similar way, workers should be held responsible for a productive enterprise and assume RC, not those who provide property for it.
My counter-argument is that if the person who lent the car knew it was to be used in the commission of a crime, they would also be responsible and liable to punishment. On the other hand, if someone took part in the activity without realizing that a crime was being committed (for example, she drove the car but the gang lied to her about what they were up to), this person would not be held responsible. The proper distinction is not between providing property and personally participating in the activity, but between knowing involvement and unwitting involvement. The analogy then would lead us to say that RC should go to those who are knowingly involved in the productive enterprise, which would include not only workers but, in many cases, capital providers, suppliers, host communities and perhaps even customers. RC would be divided up proportionate to the degree of knowing participation.
There is a further point worth making. Even were we to accept Ellerman's premises about responsibility and RC, and either his conclusions or mine about who is responsible, as a practical matter the RC of any party could be purchased by another party. That is, even if workers had an exclusive right to RC, capital owners could buy RC from them in return for compensation, such as a fixed wage. Although Ellerman contends that RC is an "inalienable" right, that is clearly not true, because it is a claim on a marketable product. The point of production is to sell something. If you have a claim on the output, you can sell that claim just as you could sell the output.
In sum, Ellerman's human rights arguments for his strategy to achieve economic democracy seem to have serious problems. The argument about the workers' right to corporate governance, in its present form at least, is not convincing. The argument about the right to RC does not lead to Ellerman's conclusion about the workers' exclusive right to it, and it would not preclude wages in lieu of RC even if it did.
4. Conclusion
Much time in the Ownership forum thus far has been spent discussing Kelso's ideas on the one hand, and Ellerman's on the other. These two topics have at least three things in common: (1) they were more about social ethics than economics, (2) the ethical arguments were complex, and (3) the theories being advanced had identifiable problems. As interesting as they were to me personally, they often seemed a distraction from our professed goals of inquiring into why professional economists have not shown much interest in expanding ownership, and developing arguments that could convince them of its importance. (I was at least as guilty of this as anyone.)
My recommendation to COG would be that it avoid endorsing any particular ethical theory, or set of ethical principles, to justify its program of expanding capital ownership. The best justification in the political arena is often the simplest and most familiar; in this case, for example, the importance of enhancing the financial security of people who own little productive property. COG participants will want to continue to debate their views of social ethics, and shouldn't be censored from doing so, but the aim should be to reach agreement on workable policies, not agreement on a system of social ethics.