Ownership
Transfer Corporations
Capital Ownership Group Working Paper
May 7, 2001
Kent, OH USA
By David Binns, Associate Director
Foundation for Enterprise Development
In an
eponymous paper presented to the 8th International Conference on
Socio-Economics, Shann Turnbull poses the question “Should Ownership Last
Forever”? The paper proceeds to outline
Mr. Turnbull’s critique of share ownership rights and lays out his argument for
Ownership Transfer Corporations (OTCs), a concept he developed as a means of
placing temporal limits on property ownership rights to “improve equity and
efficiency by transferring the ownership of realty or firms to their
operational/strategic stakeholders.” This brief analysis of OTCs draws
liberally on many of the points outlined in Mr. Turnbull’s paper.
At
first glance the basic OTC concept seems radical: OTCs would restrict property
rights in corporations by placing time limits on ownership rights so that
ownership would be transferred from investors to other stakeholders over a set
period of time. While such a change would indeed represent a radical change to
accepted notions of ownership of corporate shares, ownership rights in other
areas of the law are commonly subject to time limitations.
Take
intellectual property rights (IPR), for example. Well-established legal
precedent dictates that the rights of the inventor to exclusive ownership of
his invention is time limited. Patent protection lasts for a maximum of 20
years after which time ownership rights dissolve and the invention can be
exploited by anyone in the public domain without paying royalties to the
inventor. Another good example commonly used in developing countries is the
Build-Own-Operate-Transfer (BOOT) approach to large development projects
whereby private investors are granted contractual rights to build, own and
operate the project to obtain revenues for a fixed time period after which
ownership transfers to the host government. Similarly, just as debt instruments
are time-limited, many hybrid derivatives commonly used in the financial
markets provide time limited contractual rights to preferred shareholders,
optionees, futures contracts, etc. As Turnbull notes, similar right are also
found in ESOPs which increase the equity entitlement of participants according
to the length and value of their service.
OTCs
would elevate the concept of time-limited ownership rights to apply to standard
investments in corporate shares (and land). They would work as follows:
A
corporation would convert its unlimited ownership shares into two classes of
time-limited shares. OTCs would be formed with one class of shares granted to
investors who would obtain all the initial economic rights, with the second
class of shares granted to stakeholders (defined as employees, customers,
suppliers and members of the host community who provide infrastructure
services) who would acquire rights after a specified time period.
Investor
shares could obtain monopoly, exclusive rights for a specified period of time,
say 10 years, with all rights transferring to stakeholders over the following
10 years at a rate of 10 percent per year (irrespective of the number of shares
issued). Reduced tax rates could be offered to encourage existing corporations
to convert to OTCs if their shareholders agree to transfer five percent of
their ownership rights each year to stakeholders. The tax revenue lost from the
corporate rate reduction would be offset by revenues at higher rates that would
be paid by individuals who receive the share transfers.
There
is at least one instance in which the OTC concept was given some consideration
in the context of economic reform programs.
In 1998-99 this author was involved in a program designed to introduce
broad-based ownership reforms in Zimbabwe. Part of that effort involved
designing legislation and regulation to promote the development of ESOPs and
similar ownership-sharing concepts.
The
entry point for the OTC proposal[1]
was the fact that the existing foreign investment regime in Zimbabwe was quite
restrictive. For some two dozen branches of economic activity – I even
including such businesses as barber shops and photograph development – a
foreign investor had to find a local partner for at least 30 percent of the
initial capital. For truly strategic branches such as insurance, agro-industry
etc., a foreign investor had to find a local partner for at least 70 percent of
the initial capital. Naturally these regulations were highly restrictive for
foreign investors who could not find an interested local partner with that kind
of money, or one that they would care to team up with.
Based
on this situation it was proposed that foreign investors may invest 100 percent
of the capital without having to bring in a local partner. The investor would
have full control of the enterprise during the capital recuperation period
(between 5 and 10 years, to be determined separately for every project
according to its business plan), on condition that from the end of that period
they sell 10 percent of the enterprise shares to their employees every year at
the initial par value (in practical fact, employees would have been given
options on 10 percent of the companies shares for each year following the
initial investment period). The transfer date would be deferred for any
investments made subsequent to the initial investment.
This
proposal was presented to the director of the Zimbabwe Investment Centre (ZIC)
who gave the proposal a completely favorable reception and arranged for a presentation
to other members of the ZIC. They also welcomed the proposal and there was no
“ideological” objection of any kind – their questions revolved mostly around
how to enforce the agreement to turn over shares to the employees 5 to 10 years
after the original investment had been made. It was suggested that the
obligation to turn shares over to the employees could be written in as one of
the conditions to be verified by the Central Bank of Zimbabwe for its annual
permission to repatriate the dividends of the enterprise.
Surprisingly,
the OTC proposal, was from a legal perspective the easiest to introduce of any
of the proposed employee ownership reforms. It did not require any legislative
action by Parliament but only a modification in the regulations of the ZIC,
which could be changed by a decision of its board.
Unfortunately,
politics entered into the picture and the debate over the budget bill, which
included the proposed ESOP reforms, got bogged down in Parliament. Shortly
thereafter all hell broke loose when the government began to confiscate
privately owned farms and Zimbabwe started on the downward spiral it’s been on
ever since. No formal action was ever taken by Parliament on either the ESOP
reforms or the OTC proposal.
David
Ellerman of the World Bank notes that a similar idea was proposed by
development economist Albert O. Hirschman as a means of overcoming borrower
country resistance to permanently allowing foreigners to control domestic
capacity in certain industries. In an
article written about a quarter a century ago on divesting foreign investors
from Latin American countries after a certain number of years, Mr. Hirschman
proposed a Disinvestment Corporation to operate throughout the region that
would fund those transfers. The article repeatedly referred to employee
ownership as one option for facilitating ownership transfer.[2]
The
following are intended to raise issues for discussion in terms of considering
the viability of introducing OTC reforms:
1)
Ownership
Reforms vs. Negotiated Contracts
To
state the obvious, any notion of vitiating ownership rights in a global
economic regime that is triumphantly promoting the sanctity of private
ownership and the victory of capitalism over socialism is fraught with
difficulties. OTCs would require a new form of ownership and/or a total
recapitalization to introduce the transfer mechanism. Is it necessary to
overhaul the entire concept of private ownership rights or could similar goals
be achieved through negotiated contracts as with BOOTs or similar mechanisms?
Might that help avoid resistance to a perceived attack on private property
rights?
2)
Surplus
Value
The
OTC concept is predicated upon the notion that “surplus profits” – those
profits obtained in excess of the incentive to invest – are neither efficient
nor equitable. Because investors discount the value of future cash flows for
both the opportunity cost of alternative equity investments and the risk of not
achieving the projected cash flows, the expected Net Present Value (NPV) of any
cash flows for competitive firms will not be significant after 10 years. The
OTC is therefore based on identifying the appropriate NPV for a given project,
price the investor’s share accordingly, an implement a planned transfer of the
shares once reasonable investment returns have been realized.
As
Turnbull states, “[t]he analysis of surplus profits requires the adoption of a
cash flow paradign, which considers the valued [sic] added by income producing
assets over their economic life and the procedures of modern investment
analysis”. But that very analysis – at least from the investor’s perspective –
will take into account exogenous factors such as their overall investment
portfolio. Defining “reasonable” returns therefore seems problematic. Industry
norms might provide some help, but what of increased risk for entering
developing markets? What of the investor’s risk management profile? Higher
returns might be justifiable in successful companies to mitigate the risk of failed
investments elsewhere.
3)
Transaction
Costs
Requiring companies to begin
recapitalizing and/or transferring their ownership on an annual basis after 10
years would introduce significant transaction costs in OTCs. Valuing the shares
during the transfer period might be complex and could result in differing
values for the investors with “wasting” assets and the stakeholders with
“growth” assets. Add on the intervening ownership transactions that may occur
between willing buyers and willing sellers and the problem of tracking
ownership rights may become overly burdensome. At the very least it would
require a rather sophisticated IT system.
4)
Problems
With BOOTs
The closest thing to an OTC
in current practice is the Build-Own-Operate-Transfer (BOOT) concept, which has
run into practical problems in terms of actual implementation. Several BOOT
ventures have had problems due to cost over-runs, unrealistic price and income
projections and legal disputes between private operators and the state. In
virtually all of these cases it has been the state and the general public, not
the private operators who have ultimately shouldered the cost of failure. The
use of sole-sourcing means that equity holders are able to sell their
materials, technology and services to the project in the absence of any
tendering process or competition, or any assurance that the government is
getting the best value for money. Perhaps of greatest concern, there may be
little incentive for the developer to ensure that the facility remains financially
or technically viable after it has been transferred to the government.
Maintenance and capital replacement costs are likely to be kept to a minimum,
particularly as the date for handover draws near. Could the same problems
hamper OTCs nearing the 10-year transition stage?
5)
Ownership Distribution Among
Stakeholders
The Turnbull paper uses the
Stanford Research Institute (SRI) definition of strategic stakeholders as
“employees, customers, suppliers and members of the host community who provide
infrastructure services”. How would ownership be diffused among the latter?
Would that require governments to obtain an ownership stake? (How else would
the value of infrastructure be distributed among local stakeholders?) How would
the ownership benefits be distributed among the stakeholders, some of whom
(employees) have already been extracting salary and benefits from the firm,
some of whom (customers) have purchased or supplied products and services
(suppliers), and some of whom provide “infrastructure services”?
6)
Ownership
Is Often Impermanent, Not Perpetual
OTCs are meant to address the
problem of unlimited and/or perpetual ownership rights. Yet a commonly-cited
problem in the public markets is the ephemeral nature of ownership, with
investors moving in and out of equity and the click of a button. The ownership
of many public companies completely changes hand in a matter of a few years.
How would OTC transfer mechanisms work in such a fluid market? To what extent
might the OTC diminish the liquidity of the markets? How would new entrants be
treated – new investors? New employees? New community residents?
7)
Ownership
Is Often Hard To Track
The explosive growth of stock
options – particularly among technology companies – underscores the difficulty
of fixing specific times for ownership transfers. With “overhang” rates” (the
percentage by which a company’s shareholding would be diluted were all
outstanding options to be exercised) approaching 30%, 40% and even more in some
technology companies, ownership transfer mechanisms of different sorts are
already at work. Many option holders have a claim to ownership value but have
no ownership rights until the option is exercised. As a practical matter, many
of the options are exercised and sold immediately, meaning that the actual
share ownership of a company can be somewhat ephemeral and difficult to track.
Couple that with the dilutive impact of bond holders, preferred shareholders,
etc., and factoring in timed transfers of investors stock via OTCs becomes
problematic.
8)
Might
OTCs Be Most Appropriate For Privatization Transactions Or Foreign Direct
Investments?
OTCs have an advantage over
BOOTs in that the ownership at transfer is directed towards private
stakeholders rather than the government. OTCs would therefore better promote
efficiency and equity. A guaranteed transfer mechanism could also help host
countries overcome fears of a permanent takeover by foreign economic interests.
The more stable ownership structure of newly privatized companies and/or large
foreign direct investment projects would make it easier to manage the
administrative requirements of OTC ownership tracking.