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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

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
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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?

Continued Investor Concerns


Higher average potential dilution from stock plans
S&P 500 S&P Mid Cap S&P Small Cap Total Super 1500

1997 10.0% 10.5% 13.8% 11.6%

2001 13.7% 15.6% 17.0% 14.1%

% change 37.0% 48.5% 23.2% 21.6%

Continued scrutiny from institutional investors


Source: Stock Plan Dilution, 2002: Overhang from Stock Plans at S&P Super 1,500 CompaniesInvestor Responsibility Research Corp

Continued Investor Concern


120 100 22% 18% 18% 40 20 0 < 10% 10-15% 15-20% 20%-30% > 30% Total Potential Dilution Range
% Negative Votes-2001
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35% 32% 31% 25% 20% 15% 10% 37 95 97 81 35 5% 0%

# of plans

80 60

No. of Companies-2001

Source: Stock Plan Dilution, 2002: Overhang from Stock Plans at S&P Super 1,500 CompaniesInvestor Responsibility Research Corp

% Negative Votes

30%

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:
CFO:

Restated on Instructions of Counsel


Chief Fraud Officers

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 Tax Gross-Up $15,000,000 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 Disney Cisco Systems WorldCom $72.8 $28.7 $10 million stay bonus Layoffs 4,000 8,500 6,000

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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
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

Companies Considering Expensing Options


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

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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 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

1. Compensation Committee Governance Committee Charter


100% Disinterested (Audit Standard) Compensation Literacy and Experience Strong Chair, Periodic Rotation Code of Conduct (conflicts of interest; sales) Total Compensation Oversight Access to Outside Advisors and Staff Support Legal Representation Executive Sessions CEO Pay Determination

x x

x x x x

x x x x x x x x
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Possible Change Areas

2. Annual and LTIP Design Relevant Metrics x

Audit Confirmation of Formula Results


Negative Discretion Strategic and Qualitative Factors Recapture for Restatements Operational vs. Market Goals x

x
x x x x
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Possible Change Areas

3. Stock Options

SFAS 123 Accounting


Managed Run Rate and Overhang Nonshareholder Approved Plans Mega Grants Performance Vesting Ownership Intent Inside Information Repricings

x
x

x x x x

x x x
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Possible Change Areas

4. Ownership Standards Code of Conduct Timely Sale Disclosure Retention Ratio Cashless Exercises Proxy Disclosure of Option Sales Recapture of Gains in Bankruptcy Hedging Rule 10b5-1(c) Sell Programs Loans, Margin, Collateral x x x x x x
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x x x x x x

Possible Change Areas

5. Deferred Compensation
SERP Accrual Disclosure Lump Sum Settlements Recapture for Bankruptcy Stock Account Switching x x x x x x

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Possible Change Areas

6. Directors Compensation Stock Options Restricted Stock Committee Chair Fees Ownership Standards x x x x

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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 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