Developments and Trends in Compensation Practices

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Practising Law Institute

• Developments and Trends in Compensation Practices
  Aftermath of Enron

Jeffrey M. Kanter Max J. Schwartz Scott P. Spector
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Things Well Discuss

• The Environment
• Worst Practices
• Best Practices
• Possible Change Areas

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The Environment

• Enron/Andersen collapse
• Depressed market despite stronger earnings
• Continued investor dilution concerns
• New disclosure for stock plans
• Continued concern about stock plan approval
• Finalization of EITF 00-23, but IASB is here
• Options continue to be underwater
• Missed incentive goals

4
Enron/Andersen Collapse

• Heavy scrutiny of stock options
• Distrust of financial disclosure
• Earnings comparisons less meaningful
• Whats in the numbers?
• Re-thinking director compensation
• Are options right?

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Continued Investor Concerns

• Higher average potential dilution from stock
  plans
• 1997 2001 change
• SP 500 10.0 13.7 37.0
• SP Mid Cap 10.5 15.6 48.5
• SP Small Cap 13.8 17.0 23.2
• Total Super 1500 11.6 14.1 21.6
• Continued scrutiny from institutional investors

Source Stock Plan Dilution, 2002 Overhang from
Stock Plans at SP Super 1,500 CompaniesInvestor
Responsibility Research Corp
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Continued Investor Concern
Source Stock Plan Dilution, 2002 Overhang from
Stock Plans at SP Super 1,500 CompaniesInvestor
Responsibility Research Corp
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Public Perceptions

• Executive greed and duplicity contributed to
  Enron debacle
• Mega-options drove management to falsify
  accounting to keep stock prices high and rising
• Executives used inside information to exercise
  and sell options while price high
• Stock option accounting contributed to the
  speculative bubble in stocks by inflating the
  growth rate in EPS
• Stock options cause short-term behavior and are
  misaligned with long-term interests of
  shareholders

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New Financials

• EBIT Earnings Before Irregularities and
  Tampering
• ROIC Restated on Instructions of Counsel
• CFO Chief Fraud Officers

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Worst Practices

• Enron
• Philosophy to reward shareholder value creation
• Stock options and restricted stock (50/50)
• RS vesting accelerated based on TSR performance
• 4 year reduced to 1 year
• Large grants (Lay 1.3 million in 2000)
• Limited partnership interests
• Executive loans and repayments

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Worst Practices

• Tyco
• Loans
• Stock sales
• Actions without compensation committee knowledge
• 20 million to director
• Chair of Corporate Governance and Nominating
  Committee
• Reloads with 10-year terms

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Worst Practices

• E-Trade
• CEO loan settlement
• Forgiveness 15,000,000
• Tax Gross-Up 15,211,481
• 30,211,481
• For elimination of certain contractual
  relocation benefits

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Worst Practices

• K-Mart
• Full recourse retention loans
• 2.5 - 5.0 million
• Made in 2000 2002
• Vest in 2004, i.e.,
• Forgiveness
• Tax gross-up

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Worst Practices

• WorldCom
• Stock options only
• Large grants (Ebbers 1.2-1.9 million per year)
• Loan arrangements
• Company guaranteed 195.6 million (B of A)
• Company paid at 198.7 million plus 35 million
  for LC
• Company direct loan of 165 million
• Why to avoid the need for Mr. Ebbers to sell
  large quantities of WorldCom stock

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Worst Practices - Other

• GE
• 3,000,000 stock options and 850,000 RSUs (48
  million) to Welch
• 1 year vesting
• Recognize 20 years of service and developing and
  implementing plans
• Conseco
• 45 million cash signing bonus to Gary Wendt

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Worst Practices - Other

• Dell and Oracle
• 38 million options from 1996 to 1998 to Michael
  Dell
• Already owned 353 million shares
• 20 million options to Larry Ellison
• Already owned 700 million shares
• Dynergy
• CEO severance 2.99x base and incentive
  compensation
• But incentive compensation includes stock options

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Worst Practices

• Layoffs with big pay
• Pay Layoffs
• Disney 72.8 4,000
• Cisco Systems 28.7 8,500
• WorldCom 10 million 6,000
• stay bonus

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Best Practices (?)

• Coca-Cola
• Interesting approach
• Valuation better than FAS 123

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Best Practices (?)

• Others

Companies Expensing Options
Companies Considering Expensing Options

• Amazon.com
• AMB Property Corp.
• Bank One
• Boeing
• Coca-Cola
• Dole Foods
• Fannie Mae
• Freddie Mac
• iStar Financial
• Level 3 Communications
• Sovereign Bancorp
• Washington Post
• Winn-Dixie

• Delta Air Lines
• Heinz
• Target Stores

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Best Practices

• Pepsi
• Enrico reduced salary to 1
• Money went for scholarships for children of
  front-line employees

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Best Practices

• Krispy Kreme
• Since 1937 public since early 2000
• Development rights agreements while private
• Also had franchise equity pool for management
• All pools and rights agreements terminated
• Return of original investment
• All sales through 10b5-1 plans

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Best Practices

• Ownership Guidelines
• 13 of Top 250
• Not a lot, but more considering
• Most use multiple of retainer
• 5x most common
• Comcast Ford multiple of retainer/fees

22
Best Practices

• Ownership Guidelines
• Other examples
• Citigroup 75 of shares granted
• Pitney-Bowes 350k owned in order to sell stock
• PNC Bank must use ¼ of retainer to purchase
  stock
• Tribune 5x most recent stock grant

23
Best Practices

• Director Performance Options
• Computer Associates based on ROE
• ADC Telecom grant only if 10 ROE
• SYSCO options granted only if 10 growth in EPS
• UP CapOne options vest on stock price

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Possible Change Areas
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Possible Change Areas

• 2. Annual and LTIP Design
• Relevant Metrics x
• Audit Confirmation of Formula Results x
• Negative Discretion x
• Strategic and Qualitative Factors x
• Recapture for Restatements x x
• Operational vs. Market Goals x

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Possible Change Areas
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Possible Change Areas
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Possible Change Areas
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Possible Change Areas
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Frederic W. Cook Co., Inc. provides management
compensation consulting services to business
clients. Formed in 1973, our firm has served
over 1,200 corporations in a wide variety of
industries from our offices in New York, Chicago,
and Los Angeles. Our primary focus is on
performance-based compensation programs which
help companies attract and retain key employees,
motivate and reward them for improved
performance, and align their interests with
shareholders. Our range of consulting services
encompasses the following areas

• Total Compensation Reviews
• Strategic Incentives
• Specific Plan Reviews
• Restructuring Services
• Competitive Comparisons

• Incentive Grant Guidelines
• Executive Ownership Programs
• All-Employee Plans
• Directors Compensation
• Equity Instruments

• Performance Measurement
• Globalization
• Privatization
• Compensation Committee Advisor
• Stock Option Enhancements

Our offices are located
New York 90 Park Avenue 35th
Floor New York, New York 10016 212-986-6330
phone [phone] fax
Chicago 19 South LaSalle Street Suite
400 Chicago, Illinois 60603 312-332-0910
phone [phone] fax
Los Angeles 2029 Century Park
East Suite 1130 Los Angeles, California
90067 310-277-5070 phone [phone] fax
Website address www.fwcook.com