Thursday, July 20, 2017

Correcting a Few Distributist Non-Facts

Yesterday we looked at the complaint of a “distributist economist” whom we are calling “Tom Steele,” who claims that workers purchasing a company on credit can never repay the loan principal because all earnings go to pay the interest.  There are a few things wrong with that claim (like everything), but Steele’s associate, whom we are calling “John Wide,” made a few statements about ESOPs that are not, strictly speaking, accurate.  We promised to look into those “alternative facts” today.

"Not 'Kelsonian'? I invented the ESOP!"
One, Wide asserted that the AT&T ESOP was not “Kelsonian” because “the shares of a Kelsonian firm are never traded at all, much less publicly traded.”
Not so.  All ESOPs are “Kelsonian” for the simple fact that Louis O. Kelso invented the ESOP.  There are many ESOPs that own only a portion of the outstanding shares of the company, with the rest of the shares being publicly or privately traded.
Furthermore, every ESOP trades in company shares, or it wouldn’t be an ESOP.  There are internal trades whenever there is a diversification option exercised, or the ESOP rebalances or reshuffles shares.
A distribution of benefits almost always includes both shares and cash, unless the share balances of terminated participants were repurchased earlier.  Most ESOPs repurchase shares immediately so that all the participant sees is the cash.  Some, however, distribute shares, which the participant can retain or sell to other parties unless the ESOP has retained the right of first refusal.  Wide and Steele appear to have no real conception of either ESOP theory or practice.
This is a "coupon bond." ESOPs do not issue these or any other bond.
Two, Wide asserted that “The hopeful new owner/operators would have to sell enough bonds . . . [and] they’d have to pay the bond coupons.”
On the contrary, the usual practice is for an ESOP trust to obtain a loan from a commercial bank.  It signs a note from a lender; it does not issue bonds for sale to investors.  An investor buys either debt (bonds) or equity (shares).  An investor does not issue bonds to purchase shares, or issue shares to purchase bonds.  An ESOP cannot issue either bonds or shares in any event.  It’s not that kind of institution.
Further, “coupon bonds” are almost never used these days; the term is nearly an anachronism.  We would say “absolutely never,” but it’s possible someone somewhere is issuing coupon bonds, although one would have to question his or her business acumen or financial sanity.
This is because “coupon bonds” are unregistered bearer instruments.  Anyone who presents the coupons to the issuer will receive the interest payment whether or not that person is the actual owner of the bond.  Coupon bonds thereby offer substantial opportunities for tax evasion and fraud.
The IRS says an ESOP needs an independent valuation, not an "ideal price."
Three, any ESOP holding non-publicly traded securities (company shares) is required by law to have a “proper valuation” at least once a year, and any time there is a transaction involving a significant proportion of the outstanding shares of the company.  According to IRS regulations, this valuation cannot be decided by the parties to the transaction(s), but must be the result of an independent appraisal when there is no value set by an established security market:  (08-29-2016)
Valuation in Defined Contribution Plans
In a profit sharing, money purchase or stock bonus plan, the valuation of assets will determine the value of a participant’s account, and ultimately, a participant’s distribution.
In an Employee Stock Ownership Plan (ESOP), the valuation will affect both the deduction and distribution. For employer securities that are not readily tradable on an established securities market, IRC 401(a)(28)(C) requires all valuations with respect to activities carried on by the plan to be made by an independent appraiser. See Notice 2011-19, 2011-11 IRB 550 and 26 CFR 1.401(a)(35)-1(f)(5) for the definition of readily tradable on an established security market.
Four, the chief problem Wide and Steele have with ESOPs, however, is that they claim the workers can never repay the acquisition loan principal — not bond issue — because total cash flow goes to pay the interest on the acquisition loan (not bond coupons).  They also seem to believe that the ESOP must purchase all outstanding shares of the company at once, or it isn’t really an ESOP, a demonstrably false assumption.
Steele seems to think all bankers are inherently dishonest.
And why do Wide and Steele believe that?
Because many people who purchase capital use what is called the “discounted cash flow method” to determine if the price of the company asked by the seller is less than or equal to the value of the company to the buyer.  In effect, Wide and Steele tacitly assume that the discount rate used by the prospective buyer is the same as the return to the company on invested capital (“Return on Investment,” or ROI), and is also the same as the interest rate on the acquisition loan.
Therefore (Wide and Steele reason), assuming that the buyer and seller disregard the legal requirement of an independent appraisal and agree on the value of the company by the discounted cash flow method, and since the lender will take all profits as interest, the buyer of the company — an ESOP trust on behalf of the workers — will never have a cent extra to repay any of the loan principal, but will be paying interest in perpetuity.
We are now in a position to examine Wide’s and Steele’s four principal errors, which we will begin looking at on Monday.

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