South Bend Lathe: What Can We Learn from an ESOP “Failure”?

by Norman G. Kurland

South Bend Lathe, the bête noire of the ESOP movement, may forever hold the dubious distinction as the company where “owners went on strike against themselves.” While this popular characterization has long diverted attention from the hidden issues involved, the South Bend Lathe experience offers a useful cautionary tale for companies seeking to build a lasting ownership culture.

Ironically, in terms of saving jobs and demonstrating the power of leveraged ESOP financing, the story of South Bend Lathe remains a landmark. South Bend Lathe was the world’s first 100% employee-owned company that was purchased by 100% of its employees on a 100% capital credit, no-down-payment loan. It showed how a dying company could be transformed into a dynamic success. The company was profitable for most of the years following its employee buyout in 1975 when its 500 workers adopted their ESOP and saved their jobs. Arguably, without South Bend Lathe we may never have seen the successful ESOP buyouts at Weirton Steel, Avis Rent-A-Car, and United Airlines.

This model, however, also shows what can go wrong as long as management, unions, and workers cling to “wage-system” thinking. In August 1980, the world was shocked to hear that employee owners had gone on strike against top management who controlled the voting power of the company. The strike finally ended ten weeks later, even though many issues remained unresolved. Twelve years following the strike-after repeated downsizing, the shifting of operations overseas, and several changes in leadership-South Bend Lathe terminated its ESOP and was sold to a Los Angeles corporation.

Roots of an ESOP Tragedy

The South Bend Lathe Company, founded in 1906 by John and Miles O’Brien in South Bend, Indiana, once set the standard for excellence as a producer and worldwide distributor of basic metal lathes. Foreshadowing its own troubles to come, the company took over the old Studebaker auto plant when that company shut down in the early 1960s-leaving many workers without jobs or retirement benefits. (Studebaker’s underfunded pension plan was often cited as the reason Congress enacted its pension reform laws in 1974.)

In the wave of acquisitions in the 1960s, South Bend Lathe was converted from a family-owned business to a division of Amsted Industries, a large conglomerate. In the 1970s, faced by imports from lower-wage economies, profits at South Bend Lathe dropped along with the decline of the American machine tool industry. In December 1974, soon after the United Steelworkers won what they thought was a lucrative labor contract, Amsted Industries decided to liquidate the company. This decision threatened the jobs of 500 people.

In February 1975, Richard Boulis, the president of South Bend Lathe, and Robert McGinty, a local banker, walked into my office in Washington, D.C. At that time I served as Washington counsel for Louis Kelso, who had just appeared on the popular television program 60 Minutes. The telecast, entitled “A Piece of the Action,” brought the ESOP and our accomplishments into national prominence.

Our South Bend visitors offered us a challenge: to raise $9.2 million before Amsted sold the company’s assets to liquidators. We had only a few months’ window of opportunity. In a near-miraculous five months our team — with the cooperation of top management, local bankers, local union leaders, a Kelsonian within the U.S. Economic Development Administration, city officials, and Senator Russell Long — devised and implemented a financing strategy to save the company. The existing labor deal was repackaged (replacing a cash-draining pension plan) and an ESOP was put in place with a combination of public sector and local bank credit. Meeting Amsted’s deadline, the company was back in business, saved by the ESOP. But for tragic reasons explained in this chapter, in 1992, 17 years after adopting its ESOP, South Bend Lathe abandoned employee ownership.

The Unasked Question

Was South Bend Lathe’s fatal flaw that its ESOP was “undemocratic,” as charged by the media and other critics? What most people have overlooked is that South Bend Lathe had the first ESOP in a closely held, unionized corporation which passed through the vote to all employees on the shares they earned. In terms of business longevity and profitability, South Bend Lathe far surpassed such so-called democratic ESOPs as Rath Meatpacking and Hyatt-Clark Bearing.

There was one key question that critics never seriously explored which would have shed light on the problems at South Bend Lathe: Why did the regional and international representatives of the United Steelworkers refuse to assist their local members in negotiating on ownership issues, both at the inception of the ESOP and during the 1980 strike? Even after repeated invitations to union officials to participate in the ESOP’s design, the union allowed management (who had invested no more in the buyout than the workers) to assume power over the control block of “unearned” shares in the ESOP.

The regional and international USW representatives made it clear. They wanted nothing to do with South Bend Lathe, particularly not in 1975 in the midst of a national election for the presidency of the USW. Because the existing defined benefit pension plan had to be terminated in order for the ESOP buyout to succeed, South Bend Lathe had set a dangerous precedent for the union (which historically has viewed the defined benefit pension plan as the “sacred cow” of collective bargaining) — even though the jobs of 500 USW members had been saved.

When the strike erupted in 1980, the ostensible reason was a cost of living increase. As the strike dragged on, the real reason became apparent. Management refused to be held accountable to the employee owners, who learned, much to their dismay, that their vote was insufficient to exercise their power as shareholders. (Their votes on the paid-for allocated shares were still a minority of the total shares.) When it was pointed out to the union that the ESOP’s provisions on voting of the unallocated shares could be amended, the union merely replied that it did not believe that this was a legitimate issue for collective bargaining.

While it is easy to focus exclusively on the labor-management problems at South Bend Lathe, we should not lose sight of a crucial aspect of this story. South Bend Lathe proved the fundamental importance of capital credit, even under a “worst-case” example, for converting employees into owners. Despite its flaws, this “basket-case” company proved that even diluted ownership opportunities can save jobs. And in the short run, a job is more critical to an employee’s income security than participation through the vote.

But South Bend Lathe also demonstrated that a taste of justice only whets the appetite for more. South Bend Lathe was a classic case of how employee ownership can generate new expectations and create a whole new set of problems for management, employees, and labor unions. It revealed that the greatest challenge that we face is in abandoning old mind-sets-making the leap from the false security and highly concentrated power of the wage system to the shared risks, responsibilities, and rewards of the ownership system. And South Bend Lathe showed that in the long run, management and employee representatives in an ESOP company can ignore the ownership participation rights of employee-shareholders only at the expense of the company and everyone with a stake in its success.

Lessons Learned

For those of us searching for successful approaches for building more productive and people-oriented workplaces, the South Bend Lathe story offers some valuable lessons:

Crisis may present opportunity.

What appears to be a hopeless situation, may allow for a radical restructuring of a failing company within a more competitive ownership participation framework. Companies undergoing “Chapter XI” reorganizations may be prime candidates for a “new labor deal.” This would trade off increases in fixed wage and pension costs for flexible but potentially far greater ownership benefits linked to productivity and profits. A crisis situation may also provide workers greater leverage in helping to design the ESOP’s ownership participation system.

Financing follows feasibility.

If a company has a technically feasible strategy and an economically viable operation, leveraged financing can generally be obtained. Many people cannot find sufficient funding simply because they have not put together a package that can convince a lender that the loan can be repaid. As the South Bend Lathe buyout demonstrated, four crucial elements should be present in any ESOP financing strategy:

1. A management/entrepreneurial team capable of competing in the global marketplace and commanding respect from the banking community, organized labor, and suppliers and customers

2. A detailed feasibility study of the company and prospects for the future

3. A willingness on the part of organized labor to adopt an innovative productivity-oriented labor contract, based on sharing the ownership risks and future gains from the “ownership system” while holding the line on inflationary or nonproductive “wage system” gains

4. Access to sufficient capital credit, at low interest rates to meet up to 100 percent of the capitalization needs of the company as an independent operating unit

Where you are forced to restructure a closely-held company, reexamine its existing pension plan. Most healthy companies keep their pension plans when they adopt an ESOP. In an emergency situation, however, consider trading in the “security” of job-destroying pension promises for the opportunities of growing co-ownership. Under the conventional “defined benefit” pension plan, the company becomes locked into a fixed and increasing liability, even when company profits and pension plan assets are shrinking. This may cause a potentially fatal cash drain from the company, none of which can be used to meet the company’s own growth and modernization needs.

Many progressive companies have begun to shift away from the rigid and often uncontrollable old-style pension plans, to the more flexible “defined contribution” employee benefit plans like ESOPs and profit-sharing plans. A “defined contribution” type of retirement plan might conceivably provide greater job security, while linking workers more realistically to the productivity and profits of their company. Workers could thus begin to control their own destinies, rather than be left vulnerable to expensive pension overhead and the whims of Wall Street speculators, large institutional investors, and money managers.

Before designing the ownership and participatory machinery for an employee-owned company, there should be an understanding of and commitment to a basic set of core values and fundamental ownership rights, by all parties who will be involved. This includes legal and other professional consultants, top and middle management, employees, and all levels of their bargaining units. Obviously, in a desperate situation such as in South Bend Lathe, survival is the first order of business. There may not be time to get complete consensus. But effective employee ownership participation will ultimately rest upon the careful structuring of principles which everyone perceives as fair. Since “rule by the majority” does not always insure justice, certain fundamental ownership rights must be considered sacred and inalienable, and should not be vulnerable to violation by the majority or by a small elite.

While there are more immediate ways to motivate people on a material and emotional level, the most lasting way to reach them is through their minds. The process of educating employees to the ethics and mechanics of the ownership system, while difficult and slow, should be set into motion from the very first meeting, even in the tiniest of doses. The sooner all employees understand the superior logic and justice of the ownership system, and recognize their personal stake in it, the sooner the company will harness the fullest creative potential of each member of its team.

Negotiators should try to develop an ideal ownership blueprint from which to work. Bargain for the ideal. But be prepared to compromise if some of the elements are initially rejected. Keep the blueprint in a drawer to go back to for future reference, planning, and bargaining.

Employ “open book management” practices to start building an environment of transparency and accountability. Open book management is credited by Jack Stack, CEO of Springfield Remanufacturing Corporation in Missouri, for his company’s successful employee buyout and dramatic turnaround. This management approach is based on educating everyone in the company about the business, providing employees with company financial information, and sharing the risks and rewards of the enterprise. (Two good sources on open book management are Jack Stack’s The Great Game of Business [New York: Currency Doubleday, 1992] and John Case’s Open Book Management: The Coming Business Revolution [New York: Harper Business, 1995].)

Another new direction in management that builds upon Kelsonian principles of equity (ownership and justice) is called “Justice-Based Management(SM)” or “JBM(SM)” This management system for 21st century corporations combines open book management concepts and practices with principles for reshaping the business corporation and the roles of management and the labor union, within a high-technology, global economy. (See “Justice-Based Management: A Framework for Equity and Efficiency in the Workplace,” Chapter 12 of this book.)

The ESOP should always be supplemented with frequent economic feedback in the form of cash productivity bonuses linked to a formula based on profits To reinforce the gradual building of “ownership consciousness.” Once-a-year ESOP statements are insufficient for communicating ownership. A more effective ownership sharing program can be found at Allied Plywood Corporation of Alexandria, Virginia, where the average employee has in some years earned more from ownership than what he or she earned from wages-as much as three times more through monthly and annually determined cash productivity bonuses and ESOP contributions. While providing an objective measure of company, team, and individual performance on a monthly, quarterly, and yearly basis, this feedback merges each worker’s self-interest with the common good of the company.

Develop a just wage differential between the highest and lowest paid employee. In the Sony Corporation, for example, a chief executive officer’s income is only 6 to 7 times that of a newly hired college graduate. When integrated with formula-based productivity bonuses, everyone’s rewards rise and fall together. In some top-heavy American companies, where top corporate salaries run over $1 million annually and only executives enjoy productivity bonuses and ownership opportunities, that ratio can exceed 185 to 1. Too wide a gap between the highest-paid and lowest-paid employees creates an unbridgeable barrier which divides rather than unites the members of a company. Some smaller ESOP companies operate with a 3:1 differential, with modest fixed wages supplemented with more flexible ownership gains in the same ratio.

Provide greater job security by maximizing rewards based on ownership sharing for every member of the corporate team. Fixed labor costs (or at least future increases) should be set at levels to insure survival of jobs under hardship conditions, with everyone receiving regular cash bonuses during normal conditions based on an agreed-upon gain- sharing formula. In times of economic crisis, reduce hiring levels by attrition and avoid layoffs by across-the-board “hardship sharing,” cuts in base compensation, and work-sharing. Offer relocation assistance, compensatory ownership benefits, and sufficient severance payments to help those unable or unwilling to share in the burdens of corporate “belt-tightening.”

Make sure there is a structure for following up and continuing the dialogue on ownership issues. Unions or employee organizations should insure that employees have continued access to and assistance from top-flight professional and legal consultants. However, to add to the dignity of ownership participation, like involvement in the political process, ownership meetings and discussions should be voluntary and generally held after working hours.

Clearly define the expanding role of the union within the new ownership framework. Where there is a union or an employee organization involved, it should not wait for management to take the initiative for designing and overseeing any ownership participation strategies. Typically, when the initiative comes from the bottom up, rather than from the top down, the ESOP will be more participatory in its design and operation. The union should assume the responsibility to negotiate with management on the ownership incentive systems, participatory structures, accountability systems, voting rights, allocation rights, vesting schedules, mutual assessment systems, etc. While protecting the basic wage rights and working conditions of each employee, the union in an employee-owned company should also begin promoting and protecting its members’ ownership interests. Union advocacy is vital in resolving such crucial issues as employees’ voting rights on unallocated stock in a leveraged ESOP situation.

To prevent weakening its specialized institutional role or building unchecked power into its own leadership, the union should:

1. Avoid any role in hiring and firing management. Instead the union should insure that its members, through access to the right to vote for board directors, can participate in the process of hiring and firing management.

2. Avoid taking on a managerial role. Instead the union should encourage decentralized decision making within all operational levels of a company.

3. Avoid voting as a bloc where the votes of dissenting individuals are not counted. Rather, the union should insure that each of its members has a vote, educate its members as to the rights and responsibilities of ownership, make sure that employees have access to vital financial information entitled to any shareholder, and trust that informed employee owners will apply common sense in assessing the best alternatives.

Begin linking union revenues to the expanding ownership pie. The traditional checkoff on wage system benefits sends out all the wrong signals. The wage checkoff contradicts the union’s interest in holding the line against inflationary increases in fixed labor costs. And it signals the union’s reluctance toward enabling employees to gain significant private property ownership of corporate equity. To realize its own stake in the growth pie of expanding ownership, the union should explore ways to expand its checkoff system to cover new capital formation, and the employee’s growing stake in cash bonuses, dividends, and company stock. Potentially, a checkoff on ownership system benefits offers the union a much bigger revenue pie than the counterproductive checkoff on wage system benefits.

Determine management’s “new” role vis-a-vis the employee owners. Managers, to be effective in an employee-owned company, must begin to think more like teachers than bosses. They have to abandon “rule by the whip” methods and become genuine leaders who command the support of their fellow employee owners by setting examples of excellence. And by sharing some of the “headaches” as well as the rewards of ownership, management can be freed of daily detail work in order to concentrate on corporate strategy, research, and development.

Balance continuity and efficiency of the firm with justice and accountability for the employees. Developing checks and balances is easier said than done. But the principle is clear enough. While professional managers are vital and must be free to make day-to-day operational decisions, they should not expect to be accountable only to themselves. They must be willing to make full disclosures and be accountable to a board of directors elected by the employees themselves. To achieve a reasonable degree of continuity and security for top executives, board directors should serve on a staggered-term basis and top executives should protect themselves with carefully drafted long-term employment contracts.

To sustain the union’s effectiveness as a tool for protecting the rights of individual employees against arbitrary management or even majority actions, and to minimize possible conflicts of interest, try to maintain a “wall of separation” between the institutional roles of management and the union.

Deal with the one-person, one-vote vs. the one-share, one-vote issue, but realize that the issue of “control” in an ownership framework can become very complex. Discuss the pros and cons and comparative democratic impact of both alternatives. In a small company, direct or “democratic” participation in policy and daily operational decision making may be appropriate. And it makes good sense from a management and motivational standpoint to allow each person a meaningful degree of control over his or her immediate area of responsibility. In a corporation with thousands of employees, however, constant voting by all company members on all management decisions is clearly unwieldy and absurd. A corporate “republic” demands a new type of corporate “constitution,” so that the major functional branches of corporate government can serve as a check on one another, while remaining responsive to the immediate and long-term interests of the new employee-stockholders.

Develop strategies and programs for helping employees adapt to and welcome new technology and the “age of the robot.” Provide a special stock and profit-sharing pool and job retraining programs for technologically displaced employees. Diversify the company’s products and services to afford more job security and career transfers among employees. Figure out ways of keeping the team together during hard times. But when the company is forced to re-engineer or down-size, involve employees in the change process and challenge them to come up with fair solutions. Work out arrangements with temporary agencies or create units in the company to lease employees to other employers in the community. Begin redefining the concepts of “work” and “the workplace” in the context of the expanding ownership system. Create systems for encouraging individual creativity, initiative, and responsibility within the framework of a self-sustaining, more humane, and mutually profitable business organization. Combining efficiency with justice is a never-ending challenge.

Conclusion

People want justice. Around the world, employees are demanding secure jobs, livable wages, and greater participation in decision making, while companies are downsizing and exporting their operations to improve the “bottom line.” However, these demands are shortsighted and insufficient. They merely mask the fundamental injustice of the wage system which pits the ordinary employee against advancing technology and lower-cost employees. Alone, such demands fail to add constituents for a private property, free market economy.

A system of broad-based ownership, history suggests, is the essential economic foundation for a democratic order that empowers all its members and holds its leaders accountable. Whether we speak of an enterprise or a society, true empowerment cannot be divorced from the means to secure it. Since power and property go hand in hand, “participation” can only be short lived among people without effective, personal access to income-producing property and full rights and responsibilities in it. Participation without power is a cruel hoax.

Old mind-sets change slowly; the transition to an ownership culture will be resisted. Yet there are hopeful signs that management and labor unions may eventually abandon-for their own self-interest and survival-the outmoded wage system paradigm based on concentrated power and conflict. Today the United Steelworkers are taking a more positive and proactive approach to the ESOP, initiating employee buyouts, forming an Employee Ownership Institute, and hiring ESOP experts of their own. Enlightened corporate leaders are discovering that educating, empowering, and rewarding their employee owners ultimately makes good business sense.

Perhaps the meaning of ownership may not become clear to an employee until he or she perceives he or she has some property of his or her own to lose. But once that threshold is reached, only force can keep that employee from exercising his or her full rights as an owner. Unless we begin connecting employees to property and power, we can only deal with the symptoms, not the causes, of economic injustice in the world. This is the most important lesson we can learn from South Bend Lathe.

Additional Sources on Justice-Based Management(SM)

For more information on Justice-Based Management(SM) and building an ownership culture, contact Equity Expansion International, Inc. at P.O. Box 40711, Washington, D.C. 20016, (Tel) 703-243-5155, (Fax) 703-243-5935, (Eml) info@eei-consultants.com, (Web) http://www.eei-consultants.com.

Also see:

“Justice-Based Management: A Framework for Equity and Efficiency in the Workplace” [pp. 189-210 in Curing World Poverty: The New Role of Property. [Originally titled, "Value-Based Management: A Framework for Equity and Efficiency in the Workplace."] Available for $15 plus $3.00 shipping and handling (in U.S.) from the Center for Economic and Social Justice, P.O. Box 40711, Washington, D.C., (Tel) 703-243-5155, (Fax) 703-243-5935, (Eml) thirdway@cesj.org, (Web) http://www.cesj.org.

Journey to an Ownership Culture: Insights from the ESOP Community, ed. Dawn Kurland Brohawn, published by Scarecrow Press and The ESOP Association, 1997. Available from CESJ, $35.00 plus $3.00 shipping and handling (in U.S.).