Jeffrey M. KanterMax J. SchwartzScott P. Spector

Developments and Trends in Compensation Practices –

Aftermath of Enron

Practising Law Institute

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Things We’ll 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

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Enron/Andersen Collapse

• Heavy scrutiny of stock options

• Distrust of financial disclosure

• Earnings comparisons less meaningful

– What’s 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

– S&P 500 10.0% 13.7% 37.0%

– S&P Mid Cap 10.5% 15.6% 48.5%

– S&P Small Cap 13.8% 17.0% 23.2%

– Total Super 1500 11.6% 14.1% 21.6%

• Continued scrutiny from institutional investorsSource: Stock Plan Dilution, 2002: Overhang from Stock Plans at S&P Super 1,500 Companies—Investor Responsibility Research Corp

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Continued Investor Concern

35819737 95

32%31%22%

18%

18%

0

20

40

60

80

100

120

< 10% 10-15% 15-20% 20%-30% > 30%Total Potential Dilution Range

# of

pla

ns

0%

5%

10%

15%

20%

25%

30%

35%

% N

egat

ive

Vot

es

No. of Companies-2001 % Negative Votes-2001

Source: Stock Plan Dilution, 2002: Overhang from Stock Plans at S&P Super 1,500 Companies—Investor 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 6,000stay bonus

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Best Practices (?)

Coca-Cola

• Interesting approach

• Valuation better than FAS 123

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Best Practices (?)

Amazon.comAMB Property Corp.Bank OneBoeingCoca-ColaDole FoodsFannie MaeFreddie MaciStar FinancialLevel 3 CommunicationsSovereign BancorpWashington PostWinn-Dixie

Delta Air LinesHeinzTarget Stores

• Others:Companies

Expensing OptionsCompanies Considering

Expensing Options

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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

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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

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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

Regul

ator

y

Requi

rem

ent

1. Compensation Committee Governance

• Committee Charter x x

• 100% Disinterested (Audit Standard) x x

• Compensation Literacy and Experiencex

• Strong Chair, Periodic Rotationx

• Code of Conduct (conflicts of interest; sales) x x

• Total Compensation Oversightx

• Access to Outside Advisors and Staff Support xx

• Legal Representation xx

• Executive Sessionsx

• CEO Pay Determinationx

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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

3. Stock Options

• SFAS 123 Accounting x x

• Managed Run Rate and Overhang x

• Nonshareholder Approved Plans x x

• Mega Grantsx

• Performance Vesting x

• Ownership Intentx

• Inside Information x

• Repricings x x

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Possible Change Areas

4. Ownership Standards

• Code of Conduct x

• Timely Sale Disclosure x

• Retention Ratiox

• Cashless Exercisesx

• Proxy Disclosure of Option Sales x

• Recapture of Gains in Bankruptcy x

• Hedging xx

• Rule 10b5-1(c) Sell Programs x x

• Loans, Margin, Collateral xx

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Possible Change Areas

5. Deferred Compensation

• SERP Accrual Disclosure x

• Lump Sum Settlements xx

• Recapture for Bankruptcy x

• Stock Account Switching xx

Regul

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Possible Change Areas

6. Directors’ Compensation

• Stock Optionsx

• Restricted Stockx

• Committee Chair Feesx

• Ownership Standardsx

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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 Avenue35th FloorNew York, New York 10016212-986-6330 phone212-986-3836 fax

Chicago

19 South LaSalle StreetSuite 400Chicago, Illinois 60603312-332-0910 phone312-332-0647 fax

Los Angeles

2029 Century Park EastSuite 1130Los Angeles, California 90067310-277-5070 phone310-277-5068 fax

Website address:www.fwcook.com