An Owner Divided Against Himself Cannot Stand

As corporate governance structures adapt to guard against the type of corporate accounting scandals and high-profile bankruptcy filings witnessed over the past year, CEO compensation will be subject to far greater scrutiny than during the high-flying 90s. Conventional wisdom suggests that stock option grants encouraged executives to realize short-term gains through risky strategies and earnings manipulation at the expense of sustainable growth and the long run interests of shareholders.

While the value of such options, which in some cases ranged in the hundreds of millions of dollars, was based on the huge capital gains provided to shareholders, the fact that top executives could realize such ungodly sums for essentially failing at their jobs is compelling evidence that the corporate structure did not adequately align the interests of management and shareholders. The question now facing corporate boards is how best to encourage CEOs to seek long run shareholder value instead of transitory spikes in the company’s stock price.

Some suggest that instead of giving executives the option of purchasing a set number of shares at a predetermined price, they should be paid in company shares that could not be sold for a specified period of time. This would allow executives to share in any wealth they helped to accumulate while making them as sensitive to declines in the stock price as their shareholders. CEOs would be more cautious, less concerned about meeting quarterly earnings expectations, and unable to cash out just before their company plunges into bankruptcy.

However, as the case of UAL, parent of United Airlines evidences, long-term stock ownership is not the silver bullet many may suspect. In 1994, United Airlines employees agreed to a 16 percent pay cut and reduced benefits in exchange for an illiquid 55 percent stake in the company. The stock was intended to serve as the basis of employees’ retirement and could not be sold until the employee left the company.

The first six years of employee ownership was blissful: there were no work stoppages, the stock appreciated by over 200 percent, and employees enjoyed seats on the board and the ability to influence key decisions. This changed in 2000 when the Employee Stock Ownership Plan (ESOP) was up for renewal. To maintain its stake, employees had to agree to purchase the shares of retiring employees, something many did not want to do without increased flexibility.

Opportunistic union leaders highlighted the fact that United’s salaries were well below the industry average. In late 1999, United’s Air Line Pilots Association (ALPA) chapter elected bellicose Frederick C. Dubinsky, who promised big wage and benefit increases. At the same time, the International Association of Machinists (IAM), who represent the bulk of United’s non-flight attendant workforce, felt pressure from a rival union, the Aircraft Mechanics Fraternal Association (AMFA), to get wages above the industry average if it was to retain its membership. Yet both of United’s unions were committed to a continuation of the ESOP at 55 percent.

Of course, it was impossible for the unions to win huge wage increases and maintain their majority holding in the company without a steep decline in UAL’s stock price. The differential between wages at United and other airlines was the premium paid for ownership the company. By demanding that employees retain majority ownership and be given huge wage increases at the same time, the ALPA and IAM argued that its members should pay less than nothing for the stock.

Knowing that such dilution would lead to a stockholder exodus, CEO James Goodwin took a hard line during negotiations. But when ALPA members refused to work overtime, leading to tens of thousands of flight cancellations in the summer of 2000 and lost market share, he was forced to relent. Not only did United’s pilots maintain their ownership stake, they also secured the highest wages in the industry. When Goodwin tried to block a similar package for IAM members, it used the September 11 layoffs as an excuse to oust him.

Overall, United wages increased by 25 percent in 2000 and the company’s stock dropped by nearly 50 percent. What’s more, wage increases put downward pressure on the company’s bottom line. The company has lost well over $3 billion since the 2000 negotiations and labor costs now stand at an industry-high 41 percent of operating expenses. UAL’s stock price continues the freefall begun in 2000 as investors now await a bankruptcy filing.

Ironically, the government has offered a $1.8 billion loan to save the company, but its majority owners have scoffed at the $750 million in wage concessions the government requires before United can draw on it.

Labor unions have often been accused of cultivating an unnecessarily antagonistic relationship between employees and owners, but at United the unions have managed to turn owners against themselves. The idea behind employee ownership – like stock options for executives – was that allowing employees to share in the profits would align their interest to those of shareholders. Instead, unions succeeded in convincing employees that they could have their cake and eat it too.

United is a fascinating case study of an innovative corporate governance structure gone terribly wrong. While it does not have the ready-made corporate villains of the Enron and WorldCom scandals, it provides another example of how stock incentives for employees do not necessarily lead to an increase in shareholder value. Corporate boards would be well served to pay as close attention to United’s travails as those of Enron before pioneering the next generation of corporate governance schemes.