Airline Industry ESOPs and the Impact of September 11th

Introduction and Background

This paper examines the effects of the September 11th tragedy on employees' Employee Stock Ownership Plans (ESOPs) in the airline industry. The following background information is provided before addressing the central issue.

In the United States, the main vehicle for employee ownership in a company is the Employee Stock Ownership Plan, which first became a recognized plan in 1974. Between 17 and 20 million U.S. employees participate in large ESOPs or other contribution plans that hold stock. Employees may own stock directly in their companies through stock purchase programs or by being members of worker cooperatives.

Studies find that employee ownership has a positive impact on performance even in adverse times. September 11th adversely affected the majority of domestic carriers in the United States. Industry revenues dropped drastically, and President Bush signed a Stabilization Act that provided up to $5 billion in cash grants and $10 billion in loan guarantees to compensate for losses resulting from the attacks.

United Airlines was one of the largest employee-owned companies in the nation and was part of the megatrend that swept the airline industry in the 1990s. Northwest and Continental followed suit, giving their employees the ability to be "owners" of the company. Making owners of employees stimulates interest in productivity and operating efficiency. Since September 11th, and in the face of weaker demand for air service, most carriers announced significant reductions in both markets served and workforce size.

The Airline Industry Before September 11th

September 11th had a dramatic effect on the nation's airline industry, which in turn negatively impacted the ESOPs of most airline employees. The airline industry had been turbulent for several years, and it was the hope of many carriers in the 1990s that ESOPs would make a marked difference.

Historically, the airline industry has been losing altitude since deregulation was enacted in 1978. Hubs were built, carriers were merged, costs rose, prices fell, and profit margins all but collapsed. Most investors and lenders realized this was a losing proposition as the industry lost all the money it had made, and Wall Street was quick to downgrade its debt to junk status. It was almost inevitable that employees would become the next source of funding.

The airline industry is as turbulent and unpredictable as any flight can be. This highly competitive and volatile industry has attracted employee ownership advocates for many years. As a complete service industry linked to both business and leisure travel, it seems well suited to improvement at the hands of its own employees. Yet many factors outside employee control have doomed numerous airlines, and even ESOPs could not save them from their fate.

For any company that embraces employee ownership, it can be a godsend or merely a temporary reprieve from the inevitable. Market forces have long been pushing the industry toward consolidation or collapse. Stock shares cannot replace wages, and if the underlying proposition is a losing one, not only the company's profitability suffers — so do the employees themselves. There is no guarantee in the airline industry, or in any other. After the September 11th attacks, airline stocks were among the most volatile in any sector.

United Airlines: The ESOP Under Pressure

Not long after the September 11th tragedy, the investment manager for United Airlines' employee stock ownership plans began selling some stock in parent company UAL as the threat of bankruptcy loomed. State Street Bank and Trust stated in a regulatory filing that it might sell up to 20% of the plan's UAL shares while the airline's financial outlook remained so uncertain.

UAL, the parent company, is the third largest employee-owned company in the United States. The carrier — the second largest in the U.S. — was 55% owned by pilots, machinists, and salaried and management workers. Each of those groups held a seat on the board of directors. The ownership vehicle operated through retirement plans holding preferred stock for workers who participated in a 1994 buyout. Although considered by many accounts a dismal failure, the ESOP was adopted with the idea that employee ownership would foster harmony between labor and management at the huge airline.

According to Corey Rosen, executive director of the National Center for Employee Ownership, labor saw the ESOP as a way to prevent the company from being broken up under then-CEO Stephen Wolf. Management saw it as a way to extract wage concessions. "It's one of the worst ESOPs I've encountered," Rosen said. "I think a large part of that is because it was a short-term fix for a long-term problem."

If United Airlines defaulted on its loans and declared bankruptcy, shares of common and preferred stock would be rendered worthless. Generally, ESOP shares are not sold during bankruptcy proceedings, but United Airlines was considering that as an option. Since the September 11th attacks, shares had dropped and lost approximately 85% of their value.

Airlines have traditionally been among the most likely acquirers of other airlines, but because U.S. airlines posted nearly $10 billion in losses in 2001 following the September 11th attacks, they were no longer viable takeover targets. With demand for air travel drastically reduced, the threat of bankruptcy became a real possibility.

In late September 2001, State Street filed a document with the Securities and Exchange Commission indicating it might sell up to 10.9 million UAL common shares over the next three months. The common stock would be issued when the ESOP shares were converted and released to State Street on a private placement basis. The ESOP committee included three members appointed by the pilots' union, two by the machinists' union, and one by the company. As of October 24, State Street had converted 2.1 million shares of ESOP preferred stock into an equivalent of 8.4 million common shares and had begun selling some of them on the open market.

In practice, the UAL ESOP worked against its participants because the employee ownership caused plan participants to be less diversified than most investment advisers would recommend. Both their jobs and a large part of their investment portfolios were tied to a single company, as noted by Robert Mann, airline analyst and consultant at R.W. Mann & Co. Pilots owned 25% of the UAL stock, machinists held 20%, and nonunion salaried and management workers owned a combined 9.2%. Those shares were acquired in the 1994 ESOP in which employees agreed to wage and benefit cuts to help UAL restructure. The ownership plan did not allow individual workers to sell their investments until retirement.

Despite an early boost to employee morale and a temporary reduction in labor costs, the employee buyout provided UAL with only a temporary solution.

The airline industry as a whole is highly competitive and susceptible to price discounting. Profits are extremely sensitive to changes in fuel costs, fare levels, and passenger demand. Passenger demand and fare levels are influenced by, among other things, the state of the global economy, domestic and international events, airline capacity, and pricing actions taken by competing carriers. The weak U.S. economy, turbulent international events, and extensive price discounting contributed to unprecedented losses for U.S. airlines from 1990 to 1993. Since September 11, 2001, these same factors — combined with the effects of the terrorist attacks and the industry's subsequent reduction in capacity — resulted in dramatic losses across the airline industry.