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Practising Law Institute

Practising Law Institute. Developments and Trends in Compensation Practices – Aftermath of Enron. Jeffrey M. Kanter Max J. Schwartz Scott P. Spector. Things We’ll Discuss. The Environment Worst Practices Best Practices Possible Change Areas. The Environment. Enron/Andersen collapse

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Practising Law Institute

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  1. Practising Law Institute Developments and Trends in Compensation Practices – Aftermath of Enron Jeffrey M. Kanter Max J. Schwartz Scott P. Spector

  2. Things We’ll Discuss • The Environment • Worst Practices • Best Practices • Possible Change Areas

  3. 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 • What’s in the numbers? • Re-thinking director compensation • Are options right?

  5. Continued Investor Concerns • Higher average potential dilution from stock plans 19972001% 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 investors Source: Stock Plan Dilution, 2002: Overhang from Stock Plans at S&P Super 1,500 Companies—Investor Responsibility Research Corp

  6. Continued Investor Concern Source: Stock Plan Dilution, 2002: Overhang from Stock Plans at S&P Super 1,500 Companies—Investor Responsibility Research Corp

  7. 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

  8. New Financials EBIT: Earnings Before Irregularities and Tampering ROIC: Restated on Instructions of Counsel CFO: Chief Fraud Officers

  9. 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

  10. 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

  11. 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”

  12. 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

  13. 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

  14. 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

  15. 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

  16. Worst Practices • Layoffs with big pay PayLayoffs Disney $72.8 4,000 Cisco Systems $28.7 8,500 WorldCom $10 million 6,000 stay bonus

  17. Best Practices (?) Coca-Cola • Interesting approach • Valuation better than FAS 123

  18. 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 Best Practices (?) • Others: Companies Expensing Options Companies Considering Expensing Options

  19. Best Practices Pepsi • Enrico reduced salary to $1 • Money went for scholarships for children of front-line employees

  20. 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

  21. 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

  24. Regulatory Requirement Enhanced Disclosure Best Practices • 1. Compensation Committee Governance • Committee Charter x x • 100% Disinterested (Audit Standard) x x • Compensation Literacy and Experience x • Strong Chair, Periodic Rotation x • Code of Conduct (conflicts of interest; sales) x x • Total Compensation Oversight x • Access to Outside Advisors and Staff Support x x • Legal Representation x x • Executive Sessions x • CEO Pay Determination x Possible Change Areas

  25. Regulatory Requirement Enhanced Disclosure Best Practices 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

  26. Regulatory Requirement Enhanced Disclosure Best Practices • 3. Stock Options • SFAS 123 Accounting x x • Managed Run Rate and Overhang x • Nonshareholder Approved Plans x x • Mega Grants x • Performance Vesting x • Ownership Intent x • Inside Information x • Repricings x x Possible Change Areas

  27. Regulatory Requirement Enhanced Disclosure Best Practices • 4. Ownership Standards • Code of Conduct x • Timely Sale Disclosure x • Retention Ratio x • Cashless Exercises x • Proxy Disclosure of Option Sales x • Recapture of Gains in Bankruptcy x • Hedging x x • Rule 10b5-1(c) Sell Programs x x • Loans, Margin, Collateral x x Possible Change Areas

  28. Regulatory Requirement Enhanced Disclosure Best Practices • 5. Deferred Compensation • SERP Accrual Disclosure x • Lump Sum Settlements x x • Recapture for Bankruptcy x • Stock Account Switching x x 10 Possible Change Areas

  29. Regulatory Requirement Enhanced Disclosure Best Practices • 6. Directors’ Compensation • Stock Options x • Restricted Stock x • Committee Chair Fees x • Ownership Standards x Possible Change Areas

  30. 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 212-986-3836 fax Chicago 19 South LaSalle Street Suite 400 Chicago, Illinois 60603 312-332-0910 phone 312-332-0647 fax Los Angeles 2029 Century Park East Suite 1130 Los Angeles, California 90067 310-277-5070 phone 310-277-5068 fax Website address: www.fwcook.com

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