(FORTUNE Magazine) – OVER THE PAST DECADE, an innovative financial maneuver known as the leveraged buyout helped rearrange the U.S. corporate landscape. Between 1983 and late last year, there were 55 U.S. companies that went private in LBOs and gave or sold substantial amounts of stock to employees. Many of these deals had in common eager and ingenious investment bankers, starry-eyed top managers, and unwary workers. Some LBOs have rewarded employees handsomely. Avis workers who bought the car-rental company in 1987 have already paid down more than half the debt incurred in the deal. The employee stock ownership plan has appreciated by over 300% in three years, while revenues and profits have climbed in defiance of the recession. The famous leveraged buyout of Weirton Steel in 1984, which saved the company and the town of Weirton, West Virginia, was doing well until a recent slackening of demand in the steel market. RJR Nabisco, whose $25 billion LBO was the biggest of all, defied skeptics and did a public offering in April. Other companies, like R.H. Macy, found their post-LBO debt loads nearly too much to handle. Yet even at Macy's, managers who bought shares when the retailer went private and then left the company were paid back all they invested. But breaking even is a far cry from the big payout many expected based on earnings projections in a prospectus issued at the time of the LBO. Some LBOs have had much nastier consequences. Employee-owners who were promised stock in newly private enterprises did not necessarily receive all of it; others wound up with worthless stock or with pension funds sunk into shaky shares; still others lost their jobs, their pensions, and their health benefits as well. Most outrageous of all, in many of these cases, top management cleaned up and investment bankers pocketed fat fees. As a result, legions of disgruntled employees are suing managements, and the courts are awash in bitter litigation. The outcome of several pending suits could produce fresh waves of plaintiffs. The Department of Labor, which oversees the administration of corporate pension plans, is stepping up scrutiny of leveraged buyouts, and Congress is pondering tougher laws. When workers get blindsided by LBOs going awry, the facile explanation is that they just weren't smart enough to see what was happening until it was too late. But if that's all there was to it, how do you explain this curious fact? When an investment bank that midwifed many of these transactions fashioned one for itself, its employees suffered too. For most of the past decade First Boston was a preeminent adviser to companies doing LBOs. When the firm went private in 1988, top management set up a quota system designed to put as many shares as possible into the hands of young go-getters. First Boston lent them each up to $1 million to buy their allotted shares and arranged bank loans for anything over that limit. The firm then created a Key Employee Profits Plan, nicknamed ''the Keep,'' to divvy up about one-third of each year's pretax profits among the most-valued employees. With this money, it was hoped, they could pay back their loans in as little as two years. The plan might have worked splendidly had not First Boston incurred huge losses on bridge loans and junk bonds. The firm had to recapitalize last year, with a cash infusion from its Swiss parent. The value of First Boston shares shrank from the mid-$60s to the mid-$30s, and the Keep was cut out altogether, leaving scores of young go-getters up to their gold collar studs in debt. As things turned out, the recap helped stem what had been a steady exodus of talent from the firm. According to sources who have left, First Boston has in effect said to some of its employees: Stay and we'll help you work out your debt. Bail out and you owe principal, interest, and up to 40% of last year's bonus. Says a banker who decamped anyway and is now a partner at another major firm: ''Having to come up with half a million or more in cash on the barrelhead is keeping a lot of unhappy people from leaving. It's what you might call a tarnished handcuff.'' AT LEAST these folks are being handcuffed to something. A breed of beast called an ESOP-linked LBO has sometimes left employees at other companies holding nothing but the bag. In an ESOP-linked LBO, management can terminate the company's overfunded pension plan, using some of the cash to buy annuities to cover the benefits promised retirees and accrued by current employees. Money left over reverts to management, which can use it for any purpose. The purpose is sometimes to buy company stock, take the company private, and keep it out of the hands of a raider. Since the reversion, as it is known, isn't enough to pay for all the outstanding shares, management borrows to acquire the rest and retires them. New shares go into a special escrow account, earmarked for the employee stock ownership plan (ESOP) that management sets up to replace the pension plan. Then, as the company makes annual contributions to the ESOP from pretax earnings, the ESOP pays back the company's bank loan and releases the stock to employee accounts.

This is a charmed scheme in several ways. First, the company is now private and shielded from raiders. Second, the tax advantages are dazzling: Companies can write off the interest due the banks along with the cash they contribute to their ESOPs and the dividends they pay on ESOP stock. As for lenders, they can deduct half the interest income on an ESOP loan made between 1984 and 1989, and half the interest on loans made after 1989, provided that the ESOP owns more than 50% of the stock. The advantages to the employees are less obvious. A study of the deals done between 1985 and 1988 conducted by the National Center for Employee Ownership shows that ESOP-linked buyouts were less likely to file for bankruptcy than conventional LBOs. But David Bowers, a finance professor at Case Western Reserve University, notes that investing heavily in their employer's shares can still put workers at risk: ''Betting all, or most, of your retirement savings on the stock of the company you work for is the ultimate in antidiversification,'' says Bowers. ''If the company runs into serious trouble, you can lose your job and your pension money.'' That is precisely what happened at Thomson McKinnon. The brokerage firm, 77% employee-owned, hit the skids after the 1987 stock market crash and is now in liquidation. In 1986 its ESOP was worth $140 million, and many Thomson brokers and other senior employees valued their stakes at $100,000 or more. By mid- 1989 the firm's fortunes had sunk so low that management sent out a letter saying the stock plan might soon be worthless. Thomson's brokers and other staff members -- out of work, with their nest eggs in smithereens -- are now suing the plan trustees on the grounds of mismanagement. CONFUSION REIGNS over whether employees are fairly treated in a buyout. When a company goes private, it must settle the question of ''adequate consideration,'' as the lawyers call it. This issue involves how much of a stake in the enterprise should go to workers and how much to top management and outside investors who might also put money into the buyout. Under the Employee Retirement Income Security Act of 1974, the Department of Labor can sue to dismantle deals that seem to enrich top management and investors while pauperizing pension plans. The regulatory thinking is that an ESOP, particularly if it is a company's only retirement fund, should not have to pay astronomical prices for shares that top executives and others get cheap. Unfortunately, the Labor Department has never set forth firm rules on ''adequate consideration,'' and proposed versions are fuzzy. That's where Kroy Inc., a maker of lettering and labeling machines in Scottsdale, Arizona, has run into trouble. When the company went private in 1986, its newly established ESOP took out a $35.5 million nonrecourse loan to buy Kroy stock. Meanwhile, eight company officers and three outside investors chipped in $4.5 million of their own. Though its investment amounted to 89% of the equity, the ESOP got only 60% of the shares. By contrast, management and investors received 40% of the shares for just 11% of the money. Put another way, the pension plan paid $5.92 per share; the brass, $1.13. Kroy and the ESOP's trustee, Valley National Bank of Arizona, contend that these terms were fairer than meets the eye. For one thing, managers invested their own money, while employees didn't. Terms of the ESOP's loan ensure that if Kroy gets into financial trouble, the workers aren't personally liable for repayment. Nevertheless, the Labor Department sued Kroy and Valley National, charging that the ESOP didn't receive ''adequate consideration.'' Valley National's defense counsel, Chris Todd of the law firm Johnson & Gibbs, is a former federal prosecutor who nailed Victor Posner for tax evasion in Miami and worked for a time on the Iran-contra investigations. He sees the suit as a cautionary tale for managers at other companies who may be contemplating a Kroy-like transaction. ''The people at Valley and Kroy sent all the documents to the Department of Labor before the buyout was done, so their investigators could review it for 'adequate consideration' problems, if any,'' he says. ''Labor said to go ahead with the deal. Then three years later it turned around and sued.'' If the government wins, the Kroy case could set a precedent that will topple other ESOP-linked LBOs. Some ESOPs have gotten stuck with shares in two-tiered deals that are separate but unequal. Cone Mills of Greensboro, North Carolina, the largest U.S. denim manufacturer, fended off a raider in 1983 with a $460 million ESOP- linked LBO, paying $70 a share for the 5.5 million shares then outstanding. ''We were scared of being taken over,'' recalls Willie Jones, 44, a worker in Cone's spinning department. ''So when management proposed using some of our pension money to fund the LBO, we felt right at home with the idea.'' Cone terminated its old pension plan, scooped up $69 million in a reversion, and established a new defined-benefit plan. It was to be funded by a newly created ESOP that held 360,000 shares of something called ''junior preferred'' stock, which had no voting rights but was valued at $100 a share. At the same time, 47 top managers of Cone and a clutch of outside investors bought 8.25 million shares of common stock, with voting rights, priced at $1 a share. According to a Cone newsletter to employees and other internal publications, the junior preferred stock in the ESOP was supposed to appreciate as Cone's profits rebounded. That hasn't happened. Instead, Cone's earnings fluctuated through the decade, but in 1990 the company reported in its 10-K that the common stock had appreciated to $4. Though Cone has paid out $95 in dividends in eight years on the junior preferred, the shares are still valued in Cone's pension fund accounting at their 1983 price. Each employee's stake is now worth about $7,600, while each of the top 20 officers owns shares and options valued at over $1 million. The textile workers' union says that the real windfall to management could come if Cone goes public again. They speculate Cone common could fetch $10 a share in a public offering -- a 900% gain -- while the junior preferred lies doggo in the ESOP. Blue-collar types aren't the only Cone workers upset. Last May the U.S. District Court in Greenville, South Carolina, granted class-action status to a suit by two former salaried employees who claim Cone lied to managers about the fate of their retirement benefits and sharply reduced the company's mandatory contributions after the buyout. The suit also alleges that Cone promised to contribute an amount to the ESOP that was equal to the reversion but gave it only $55 million, or $14 million less. Cone denies the allegations and replies that since 1983 it has paid more than $102 million to the ESOP in the form of stock, stock dividends, and cash.

SECOND-RATE though junior preferred shares may be, they are better than what the 375 employees of Morse Tool got after the company went private in the early Eighties. The electrical workers' union, which represented Morse Tool's employees, says they were promised $1.5 million in stock. But instead they lost their jobs and supplemental health benefits when the New Bedford, Massachusetts, machine tool maker shut down last year. Though the Pension Benefit Guaranty Corp. took over the obligation for their pensions, they're still out $1.5 million, and many of them feel Morse betrayed their trust. Says Dennis Brady, 56, former shop steward and a Morse employee for 33 years: ''It was the kind of company where several generations of families worked. There was a real family feeling about the place.'' Now Brady is looking for a job. His son Russell and daughter-in-law Cathy, also ex-Morse employees, have found work as a maintenance man and a nurse's aide, earning a fraction of their old pay. The story goes back to 1984, when a Michigan businessman purchased the company from Gulf & Western for $10.7 million, borrowing most of it. The company wound up with a debt-to-equity ratio of 150 to 1, and its cash flow, never strong, was sucked dry servicing this debt load. A U.S. bankruptcy court in Boston is now trying to sort out what went wrong. Meanwhile, Morse's bankruptcy trustee, convinced the LBO should never have been done, is suing Barclays Bank for about $5 million for having lent the money for the deal. The trustee is using a longstanding but so far little-used doctrine, embodied in so-called fraudulent conveyance laws, which holds that courts can reverse deals and award damages if a lender knew or should have known that the enterprise was too shaky to sustain a heavy load of IOUs. Barclays lawyers maintain the bank thoroughly scrutinized Morse's financial statements. But Allen Michel, a finance professor at Boston University School of Management who is an expert witness for the ESOP's side in the case, charges that Barclays was careless in its analysis of Morse's financial condition before the buyout. Says Michel: ''I get calls every week from lawyers around the country who are either putting together fraudulent-conveyance cases or advising clients who are involved in leveraged buyouts. This issue is dominating the minds of everyone who is now doing an LBO.'' At Kelso & Co., whose founder Louis Kelso invented the ESOP, Joseph Schuchert, the chief executive, has taken to including a fraudulent-conveyance warning among the cautionary notes to investors in prospectuses for new LBOs outlining the pitfalls for parties involved in a deal. NOW THAT the get-rich-quick Eighties have subsided into the wait-and-see Nineties, the number of ESOP-linked LBOs and other going-private schemes is fast declining. But the turmoil stirred up by the past ten years' frenzy can teach a couple of timeless lessons.

First, a simple rule for employees: Any deal that would put more than 10% of your company's pension fund into a single stock -- especially your own company's shares -- requires independent legal and financial advice to judge if it is prudent. Second, a rule for top executives that comes from Ennius Bergsma, a finance consultant at McKinsey & Co.: Don't tell employees they own the company when, in fact, they are only partial owners. Otherwise, as unions catch on to their legal rights and as precedent-setting cases reach the lawbooks, the odds are high that you'll end up with some costly explaining to do.