The idea of employee ownership participation has been around for a long time. There is a fair amount of economic data that supports the case that employees with ownership stakes are more invested in the success of their businesses, and management is more in tune with the needs of their workers.
But ideas in theory can often make poor policy. Such is the case with the U.K.’s Labour Party, which this week unveiled a plan that would force public companies with more than 250 employees to hand over 10% of their total equity to their workers. The party is currently in opposition, and thus unable to enact policy due to the British parliamentary system, but it has been running close behind the ruling Conservatives in recent polls. While it is unclear when the next election will occur, the prospect of a Labour victory has become increasingly worrying to Britain’s financial sector.
The proposed share allocation policy trumpeted by John McDonnell, the Shadow Chancellor (the opposition finance spokesman), is supposed to create a more equitable system. But, if enacted, it would do irreparable harm to the British economy and its financial market, which, as the de facto financial center of Europe, is currently one of the deepest in the world.
Labour's proposal in brief
Here is a simple explanation of how Labour's policy proposal would work, courtesy of the Financial Times:
"Every company with more than 250 staff would have to set up an 'inclusive ownership fund', or IOF, holding 10 per cent of its equity on behalf of workers. The stake would be built up gradually, with a company handing over 1 per cent of its equity a year over a decade. Workers would not be able to buy or sell the shares held by the inclusive ownership fund, but would benefit from dividends — up to a maximum of £500 per person. The fund, run by a board of trustees made up of workers, would also have voting rights like other shareholders … One key aspect of the policy is that the government would collect any dividend payments above the £500-a-head threshold, and divert them to the state coffers. That would generate more than £2bn per annum after five years, Labour estimated."
So each year, for 10 years, each these companies will divert 1% of its equity into a special fund under the control of a panel of workers. Dividends paid to these shares will be paid in part to the workers, with the remainder being taken by the state.
It may sound straightforward, but the consequences would be dire.
Stock market decimation, literally
The term “decimation” comes from the Roman military practice of executing 10% of the soldiers of units that showed cowardice in the face of the enemy, or otherwise failed egregiously in their duty. In a sense, that is what Labour proposes doing to its stock market. Any U.K. public company (Labour had the good sense at least to know it could not force the policy on privately held companies) will essentially be forced to undertake a 10% dilution. Dilution may be commonplace in fast-growing businesses, but for dividend cash-cows, it is virtually unheard of except in poor circumstances.
Labour seems to think that pushing the dilution at 1% a year will be relatively painless. That is quite obviously silly. Stock markets may not be as efficient as some economists would like us to believe, but they are sufficiently efficient to price in well-telegraphed government policy. Indeed, while Labour is trying to sell the policy as a one-off event, it opens the Pandora’s Box of government-mandated share reallocation. Thus, the actual impact across British stocks would almost certainly be price drops of considerably more than 10%.
Driving companies away
Labour’s policy, if enacted as stated, would effectively cripple the U.K. stock market. It creates an ugly precedent for government meddling and redistribution of ownership, which will naturally have a chilling effect on the stock market and undoubtedly lead to steep price discounts from current valuations. That is especially troubling at the present time, as the U.K. struggles through its efforts to leave the European Union. Brexit is already threatening London’s place as Europe’s preeminent financial hub. This policy would virtually guarantee its marginalization.
London’s deep capital markets would undoubtedly get much shallower, and capital flows would become far less efficient. Many large public companies would likely pursue alternative options to ponying up 10% of their equity, such as delisting to become private companies exempt from government expropriation, switching to a foreign domicile, or both.
Choking off the tap
The policy would also have a serious chilling effect on IPOs, since no company would want to go public if it would then have to essentially hand over 10% of its equity for the privilege. London has already struggled to attract new public listings due to its refusal to recognize multiple share classes; this would be a far more serious black mark against London as a listing choice.
Public markets are important because they allow for efficient capital allocation and facilitate low-friction price discovery. With fewer public companies, new or old, the British economy would be slowed. With Brexit already putting the U.K.’s economy on precarious footing, hamstringing its financial sector seems like a particularly foolish proposition.
The foreigner problem
While a Labour government could enforce all manner of pain on domestic businesses, it would not legally be able to shake down foreign-owned companies, even ones with shares listed on the London Stock Exchange. Those companies would likely outperform their British peers, further hampering British companies’ ability to compete in a post-Brexit world.
More concerning, perhaps, is the very nature of U.K. share ownership. While Labour seems to be laboring under the illusion that British companies are overwhelmingly owned by British shareholders, this is not the case. Indeed, the depth, sophistication and stability of the U.K.’s capital markets have long attracted foreign investment in much the same way the U.S.'s capital markets have done.
Currently, more than 50% of shares in public British companies are held by foreign entities and individuals. Labour’s policy would not only dilute these foreign owners’ positions, but also add a level of trepidation at the potential of further capricious government expropriation. The inevitable result should be obvious: Foreign ownership will drop (probably rapidly), further pushing down the value of U.K. equities.
Backfiring on the little guy
Labour’s policy proposal would be disastrous if it were actually enacted into law. The British stock market would likely tank overnight, with little hope of recovery. Certainly, British equities would trade at a permanent steep discount compared to their present performance. Ironically, it would likely serve to worsen the financial security of the very working class and middle class citizens the policy is meant to be helping. Why? Because U.K. pension funds are heavily invested in domestic equities. A violent (and semi-permanent) downward correction in share prices across the board would deliver a crushing blow to many pension plans across the country.
Furthermore, the policy might actually worsen the exclusion of the working class and middle class citizens from participation in capital markets, since more companies would remain private. Thus, fewer citizens would be able to grow their wealth through personal investment, while their pension funds would face mounting difficulties in finding value-enhancing opportunities.
Verdict
Labour’s proposal is ill-conceived on virtually every level. We do not want to get political or suggest support for any of the leading political parties of the U.K. (or anywhere else), but if Labour does win the next election, it would be wise to shelve this particular idea. Putting it into law would weaken capital markets, drive public companies private and others out of the country entirely, and would hurt the financial wellbeing of the very people it is ostensibly designed to benefit.
From an investor’s perspective, if the policy is indeed enacted, shorting the FTSE would sound like a pretty smart move. A law that essentially crushes the stock market is a pretty cut-and-dried signal to take the short side. Or, if shorting is not to one’s taste, get out of British stocks as soon as there is even a whiff of this crazy idea becoming law.
Disclosure: No positions.
