tional tax credit provided by the new bill will increase the benefit from a motivational point of view. It is likely to double the stake employees have in their companies.

The "Expanded Employee Stock Ownership Act of 1978" also would provide a 1 percent tax credit based on payroll as an alternative for companies which traditionally do not make significant capital expenditures. This should be a major incentive for service companies to establish ESOPS. This tax credit is based on payroll, as service companies presently are, in effect, denied the advantages of the tax credit ESOP simply because they generally do not have large capital expenditures. Although service industries are more labor intensive and, therefore, can take advantage of sheltering more taxes through the 15 percent of covered payroll limitations on contributions, they otfen do not have sufficient hard assets to enable them to obtain the traditional forms of financing. As a banker, most of my experience is with companies, such as manufacturing companies, which have hard assets. However, I can identify with service industries in that my particular job is very people-oriented. Labor intensive service companies are logically interested in motivating their workers, since well motivated employees are likely to contribute much more to a company's profits.

THE LEVERAGE ESOP

There are four uses of leveraged ESOPs, apart from the tax credit ESOP: (1) new stock issue capital formation; (2) transfer of ownership and creation of a market for the sponsoring company's stock; (3) corporate "spin-offs"; and (4) taking a public company private by repurchase of public shares. I have found the classic leveraged ESOP, where the loan is made to the trust, to make more sense to companies, primarily the middle market companies which have revenues from $5-200 million that need to borrow money.

The larger companies, those in the Fortune 500, which range from $355 million to $55 billion in revenues, I have found to be generally more conscious than the middle market companies of the effect ESOPS have on dilution. The concept of dilution is a complex one, but most commonly it refers to the dilution of earnings per share. In short, this kind of dilution means there are more shares outstanding because of a new issue and consequently less earnings per share, all things equal. This may not necessarily be unwise, provided the company can justify the additional shares with future earnings.

The very large publicly-held companies are particularly concerned with how their public stockholders perceive them. Therefore, dilution may be an important consideration when setting up an ESOP. Very often such companies have access to other inexpensive forms of capital. For that reason I have found that the leveraged ESOP is usually more appropriate to middle market companies, and that the tax credit ESOP is more suitable for the larger companies which have large capital expenditures enabling them to take advantage of the tax credit for ESOP contributions. Middle market companies generally do not have as much access to the equity markets and may find an ESOP to be an excellent alternative means of raising capital.

My experience in lending money to the ESOP trust of a company listed on the American Stock Exchange was very encouraging, mainly because of the assumptions involved in the leveraged ESOP transaction.

The ESOP in this case was replacing a profit sharing plan to provide ownership in the company to employees. With newly issued stock sold to the trust, the company's stockholders' equity will increase over the life of the loan, and the plan will provide funds for the company's expansion.

Moreover, the company's yearly profit sharing expenses were about equivalent to the yearly principal amortization of the term loan so that by substituting stock ownership of the company to employees by way of a leveraged ESOP instead of choosing traditional profit sharing as a benefit, the balance sheet became more favorable. Equity increases with a leveraged ESOP (given the new issuance of stock) as the debt decreases. Furthermore, if one assumes that the new capital generated by the ESOP is being used for "profitable opportunities" as well as generating increased employee productivity, income will also improve. There is still dilution with the new issued stock, but perhaps to a lesser extent.

Dilution possibly can be reduced for ESOP companies by the recently proposed legislation as well as through possible changes by the accounting profession. First, the provision in the "Expanded Employee Stock Ownership Act of

1978" which would allow tax deductions for dividends paid by a corporation on shares of its stock held by an ESOP would provide a major financial incentive for companies to set up an ESOP. For tax reporting purposes (based on new legislation) the company would, of course, reduce its taxes by deducting dividends paid on ESOP stock.

Therefore, the company's cash flow improves while there is no earning reduction for financial reporting purposes. The additional cash flow should improve a company's overall earnings.

Second, dilution could be minimized if the accounting profession could be persuaded to change its approach toward the calculation of earnings per share. I am not an accountant. However, after discussions with associates in the accounting profession, I see possible changes which might further improve the financial effects of leveraged ESOPS. Presently, the accounting profession generally believes that all shares held by an ESOP should be treated as outstanding shares in the determination of earnings per share. However, the American Institute of Certified Public Accountant's Accounting Standards Division has issued a "Statement of Position on Accounting Practices for Certain Employee Stock Ownership Plans" which recognizes an important minority view among the Division. The division stated that:

"The minority within the Division believes that when trust debt proceeds are transferred to the employer corporation, a transaction of a predominantly financing nature has occurred. The minority believes that the shares should be considered outstanding for earnings per share calculations only to the extent that they become constructively unencumbered by repayments of debt principal. To do otherwise according to this minority view, would result in an inconsistent and initially excessive effect on earnings per share in that the total number of shares purchased by the ESOP would be immediately included in the calculation of earnings per share, even though the related compensation expense would be spread over a period of time on the basis of the employer's contribution to the trust.'

The recommendation of the American Insttiute of Certified Public Accountants, of which this minority view is a part, has not yet been adopted by the Financial Accounting Standards Board, and no final opinion has been issued. I recommend that the Senate Committee on Finance open communications, if possible, with the Accounting Standards Division, as the adoption of the minority position discussed above would have significant impact in reducing dilution and thereby creating further incentives for companies (particularly publicly-held companies) to adopt leveraged ESOPS.

In addition, I would like to recommend to the Senate Committee on Finance future legislation in respect to Section 404(a)(3) of the Code. Presently, the deductions for contributions to an ESOP trust may not be greater than 15% of the covered payroll. Since interest paid on loans has always been deductible, it is lost when the loan is made to the ESOT. This is due to the fact that interest deductions have been merged into the ESOP contributions. Consequently, there may be adverse effects on a company's financial position after contributions pass 15% of covered payroll. After that point, under present law, neither principal nor interest is deductible. Accordingly, either increasing the deductible contribution as a percentage of payroll, or by allowing the interest on the ESOP loan, over and above presently allowable deductible contributions, would offer greater flexibility to companies establishing ESOPs. It is my understanding that Senator Gravel's recently introduced bill addresses this problem.

Three uses of leveraged ESOPS which I have not discussed specifically have tremendous possibilities as tools of corporate finance. Although the previous discussion related to the new issuance of shares with capital formation, the ESOP also has other practical financial uses.

The ESOP provides excellent opportunities for the closely held companies. It is estimated that there are in this country more than 200,000 privately owned corporations with revenues of $1 million or more. An ESOP can be particularly useful to these companies to create a market for their stock where no market exists and for major owners of a privately owned company when they are concerned with estate planning. Owners of stock in publicly-held companies often can sell their stock on the market to create the necessary liquidity. Private

2 Accounting Standards Division of the American Institute of Certified Public Accountants, "Statement of Position on Accounting Practices for Certain Employee Stock Ownership Plans." Recommendation to the Financial Accounting Standards Board (December 20, 1976): 5-6.

companies have seen the desirability of their traditional methods of raising capital, such as going-public, decrease in the 1970's as the stock market has become less attractive. On the one hand, an ESOP offers a privately-held company the ability to borrow for an employee benefit with tax deductible dollars. My experience with management of privately-held companies is that they are not as concerned with reducing their companies' financial reporting earnings with ESOP contributions as they are with the need to shelter taxes. On the other hand, the majority shareholders may find an ESOP a better tax option for estate planning. When a corporation purchases stock of a majority shareholder, the transaction may not satisfy the redemption rules of the Internal Revenue Code and the shareholder may be taxed as if the corporation had paid him income; that is, the shareholder may be taxed at ordinary income rates. However, when an ESOT purchases the stock under certain circumstances, the shareholder can receive capital gains treatment. Finally, I have found in my discussions with owners of privately held companies that they would rather have the ownership of their company in the hands of their employees as opposed to their competition.

The third use of the ESOP which has valuable application as an instrument of corporate finance is to facilitate a corporate spin-off. When spinning off a subsidiary or division, a company may thus create a buyer in lieu of one which otherwise would be difficult to locate or disadvantageous. An example of a corporate spin-off ESOP was seen when 500 employees of South Bend Lathe, Inc. purchased that subsidiary from Amsted Industries for $10 million dollars in cash from a loan by the Federal Economic Development Administration.

The spin-off technique also can make sense from the parent company's perspective, since the divestiture is for cash and the stock issued is from the new company, so that there is no dilution of the parent company's earnings or equity.

Finally, the ESOP which serves as a mechanism to transfer all or most of the ownership of a company to its employees requires a great deal of borrowing by the ESOT. Therefore, it needs to take advantage of greater tax deductible contribuitons to the trust. As mentioned earlier, under present law, there is need to increase the amount of the tax deductive contribution to the trust for more flexibility.

The fourth use enables a public company to go private by repurchase of publicly-held shares. During the 1960's a great wave of middle market companies went public, but many of the companies that went public found that being publicly held created more disadvantages than advantages. In many cases public middle market companies have a worth which is not reflected in the market price of their stock, since the market value is below their book or real value because of the present nature of the stock market. Therefore, even though these companies are public, they find that they do not have real access to the public markets for additional equity offerings. Moreover, there is an increasing cost burden on small public companies to maintain themselves as public companies under the present regulatory environment, in terms of legal and accounting fees. The going-private ESOP, for the reasons just mentioned, would have a great deal of potential for the expansion of employee ownership. However, there are still many problems surrounding this highly specialized area, practical and regulatory, and a great deal will depend on the SEC's treatment of such transactions.

WHY BANKS HAVE RELUCTANT OR SLOW IN GETTING INTO THE AREA OF ESOP FINANCING

The answer to the question of why banks have not been active in ESOP financing is complex. I am sure that the initial problem was that the legislation was new and the concept complex. This atmosphere of confusion and mystery has been dispelled. A great deal of excitement and interest by corporation occurred during the initial stages, when the ESOP concept was included in two very important pieces of legislation, the Employee Retirement Income Security Act of 1974 (EFISA) and the Tax Reduction Act of 1975.

Many lectures and seminars are being given on the subject. The financial and even general press continues to cover the subject. There have been several books written on the subject and more on the way. Moreover, many consultants, lawyers, and some accountants and even fewer bankers have been educating themselves with the ESOP's potential and technical aspects.

However, prior to the late 1977 final Internal Revenue Code regulations, it was very difficult, if not impossible, for banks to lend to ESOPS.

Bank lenders generally look for hard assets and an ability to generate earnings and cash flow to support the proposed loan. The new final Internal Revenue Code regulations relating to ESOPS should be a major incentive for banks participating in ESOP loan transactions, because they provide definitive rules relating to ESOPs. A lender can now look to the corporation for payment

Prior to the final regulations it was hard for banks to make an ESOP loan under traditional lending standards. For example, prior to the final regulations, banks would inappropriately take the ESOP stock as collateral. The lender would then be in danger of violating Regulation U margin requirements.

Moreover, while banks must look to the trust for actual payment of principal and interest of the loan, the cash flow really is generated by the sponsoring company, on which the bank must put its real reliance. Therefore, prior to the final ESOP Regulations, a bank might simply have been relying on the sponsoring company to make contributions to the trust for repayment of the loan, without direct recourse to the company. In general, most bankers and lawyers did not understand how to position themselves as creditors in the traditionally understood lending procedures.

In summary, the final ESOP regulations should enable lending institutions to feel more comfortable from the traditional lending point of view. Now lenders, although lending through the ESOT, can look directly to the company for repayment of the loan though guarantee arrangements which can have the normal financial covenants and default provisions usually found in bank term loan agreements. It is also possible, if necessary, to take hard collateral from the sponsoring ESOP company.

FEDERAL GUARANTEE OF ESOPS

As a corporate lender, one of the common questions I get pertaining to ESOPS is: "Does an ESOP make a company more credit worthy?" The answer is yes, provided the company is continually profitable. That is, the ability of the company to shelter taxes by way of the ESOP occurs, of course, when the company generates taxable earnings. To this extent the company's cash flow improves as well as its ability to pay debt. However, a struggling older company with an uneven earnings record, paying taxes in one year and getting a refund in another, is not a likely loan prospect.

There have been a number of cases where a federal guarantee of the ESOT's debt has encouraged bank participation where a lack of adequate earnings history and other factors, made a loan to the ESOT a high risk transaction by ordinary banking standards. A number of knowledgeable observers, including the former Assistant Secretary of Commerce for Economic Development, William W. Blunt, Jr., have told me that they see a legitimate and useful role for such federal guarantees where necessary to make possible ESOPS which help agencies such as E.D.A. and the Farmers Home Administration to carry out their congressional mandates.

Of course, a broader application of federal guarantees to ESOP transactions where justified by the credit situation could be achieved by extending the mandate of these agencies to include support of ESOPS as such. I assume this would take amending legislation. It would certainly serve to encourage bank involvement in those ESOPs where prospects are good, but the existing credit record does not justify unsupported bank participation. Needless to say, if the transaction simply is not a sound one, the government should not be involved any more than the banks.

SUMMARY

The use of the leveraged ESOP, in my opinion, should increase dramatically. First, in the difficult regulatory period just discussed, a UCLA survey of Employee Stock Ownership Plans in December, 1977 found that of 180 ESOP companies surveyed, 16 percent had leveraged ESOPS and 84 percent were non-leveraged ESOPS. I feel that the percentage of leveraged ESOPS in this study is encouragaging considering the prior regulatory environment.

3 UCLA Graduate School of Management Field Study Team, "Survey of Employee Stock Ownership Plan," Summary of the Results (December, 1977): 6.

Second, notwithstanding the perceived motivational advantages of ESOP, the concept must make good business sense to an employer, particularly from the financial perspective. As a banker and ESOP specialist I have found that it is necessary to educate my corporate customers as well as prospective customers to the advantages of ESOP. In discussions with senior management of companies, primarily with chief financial officers and treasurers, I have found the educational process necessary because of the newness of the concept as well as the complexities surrounding the financial impact of ESOP. Presently there are many incentives for establishing ESOPS; however with the changes in the recently introduced "Expanded Employee Stock Ownership Act of 1978" coupled with other changes mentioned in the testimony, I have no doubt that many more companies will adopt ESOPs. The sense of permanence in ESOP legislation will also be a major step in this direction. Accordingly, what makes good sense to business would surely make good sense to the banks in this country.

The CHAIRMAN. Now, next we will hear from Mr. Kenneth R. Cunningham, chairman of the Board of Metropolitan Contract Services.

To all the witnesses remaining, let me just say this. Conducting these hearings while the Senate is in session and voting makes it difficult to have as many members present as we would like to have, but we are going to see to it that this information is made available to all of those who want it and should have it, and I fully anticipate that there be a very broad distribution of all the information made available at the hearings and that it will result in action, both legislatively and perhaps administratively.

Mr. Cunningham, we are pleased to have you, and you may proceed with your statement.

STATEMENT OF KENNETH R. CUNNINGHAM, CHAIRMAN OF THE BOARD OF METROPOLITAN CONTRACT SERVICES, INC.

Mr. CUNNINGHAM. Honorable chairman and members of this distinguished committee, I am indeed pleased to be here to present to you some of the experiences I have had with my employee stock ownership plan. Senator, some of these experiences have been good.

I started out in 1956 as a truck driver with one truck and built the company. I started from scratch, so to speak, and built my company up through the years.

Today, our company has grown to the point where we serve customers now in over 20 cities, major retail customers. We handle their delivery operations.

We run 327 trucks and we employ 730 people. We formed a base maintenance service for NASA at the Langley Research Center.

Early in 1975, I was negotiating with a company to acquire my stock in Metropolitan Contract Services, and it was my desire at that time, for estate planning and other purposes, to receive some cash for my stock. It was at that time that I learned about the employee stock ownership concept through my accountants and my attorneys. It seemed like a real good deal to me. I could receive my money over a period of time. The employees, in effect, would become the owners of the company, and I could see that that would accelerate the growth of the company because, as owners, they would do a better job and help us expand our business.

Well, I think the record will clearly show that that is exactly what happened. After the implementation of the employee stock ownership