THE CHANGING LANDSCAPE OF EXECUTIVE COMPENSATION

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THE CHANGING LANDSCAPE OF EXECUTIVE COMPENSATION Powered By Docstoc
					ROCKY MOUNTAIN COMPENSATION ASSOCIATION




        THE CHANGING LANDSCAPE OF
         EXECUTIVE COMPENSATION


                                   Robert S. Timmerman
                             Consultant, New York Office
                             Frederic W. Cook & Co., Inc.
                                       February 13, 2003
Recent Significant Developments


Completed
   Sarbanes-Oxley Act of 2002
   Expanded disclosure of stock plan dilution levels
   Conference Board Commission on Public Trust And Private
    Enterprise
   New proposed golden parachute rules
Pending
   Accounting for stock-based compensation
   Stock exchange rules




                                                              2
Today’s Presentation Focus


   Sarbanes-Oxley Act of 2002
   Accounting for stock-based compensation
    –   Opinion 25 versus FAS 123
          Focus on employee stock options in particular
    –   FASB Statement No. 148
          Transition and disclosure provisions of FAS 123




                                                             3
Sarbanes-Oxley Act of 2002

   Prohibition of company-provided/arranged loans to executive
    officers and directors (effective July 30, 2002)
     –   Existing loans are grandfathered unless materially
         modified or renewed
     –   Uncertain implications for certain arrangements (e.g.,
         split-dollar life insurance policies)
   Requires insiders to report stock trades in company stock on
    Form 4 within two business days of trade (effective August
    29, 2002)
     –   Act calls for electronic filings and postings of filings to
         company website by July 30, 2003
     –   SEC to release clarified requirements (e.g., for
         discretionary transactions under employee benefit
         plans and programmed buy/sell arrangements)


                                                                       4
Sarbanes-Oxley Act of 2002 (cont’d)

   Requires CEOs and CFOs to reimburse company for prior
    compensation and stock sale gains if financial statements
    are restated
     –   Applies to bonus, equity-based compensation and gain
         from stock sales in 12 months after issuance of
         financial statements that were subsequently restated
   Prohibits officers and directors from buying or selling any
    company stock during a benefit plan black-out/quiet period
    (e.g., when 401(k) administrators are being changed)
   Criminal penalties (specified fines and jail time) for ERISA
    violations




                                                                   5
Accounting for Stock-Based Compensation


   Background
     –   Opinion 25 versus FAS 123
   Implications
     –   Possible Outcomes and Reaction
   Action Steps
     –   How to Respond
   Focus on employee stock options in particular




                                                    6
Background

   Current U.S. GAAP permits stock option expense to be
    determined under either:
     –   APB Opinion No. 25 – published October 1972
           Interpretation No. 44 issued in March 2000
     –   FASB Statement No. 123 – published October 1995
           Choice with disclosure
           FASB Statement No. 148 amends the transition and
            disclosure provisions of No. 123 (December 31, 2002)
   Generally no expense recognized under Opinion 25, assuming:
     –   Option exercise price equals FMV at grant (“intrinsic value
         accounting”)
     –   Vesting is contingent solely on the passage of time
   Significant accounting bias in favor of plain vanilla option awards


                                                                          7
Executive Long-Term Incentive Grant
Type Usage Percent of Top 250 Companies


                    99%
     100%

      80%

                                56%
      60%                             51%
                                            43%
      40%                                           32% 33%
                                                              30%
                                                                    24%   21%
      20%

        0%
             Stock Options     Restricted          Performance Performance
                                 Stock                Shares       Units

                                 1999       2000    2001

     Source: Frederic W. Cook & Co.
                                                                                8
Executive Stock Option Variations
Percent of Top 250 Companies



     20%       18%
                      16%

     15%

                                        9%
     10%
                                               6%

      5%
                                                         2%


      0%
              Performance        Premium Options Discount Options
                Options

                                1999    2000   2001
       Source: Frederic W. Cook & Co.                               9
Background (cont’d)

   FAS 123 is based on “fair value accounting” such that expense
    equals the “fair value” of the option at grant and is recognized over
    the vesting schedule
     –   Fair value is generally determined using an option pricing
         model (e.g., Black-Scholes, binomial)
     –   Model includes 6 valuation inputs (stock price, exercise price,
         dividend yield, interest rate, option term and volatility)
     –   Also includes forfeiture rate factor
   Implications:
     –   Opinion 25: must disclose the pro forma impact under FAS
         123 as a footnote in the annual report
     –   FAS 123: the decision applies to all equity compensation
         awards and is irrevocable
   How do reported financial results differ as a result of a company’s
    election?


                                                                            10
                                                                    1
                                    25 LARGEST U.S. COMPANIES
                                                                        2
                                   IMPACT OF FAS STATEMENT 123

                                                              EPS Impact
                                         Reported     FAS 123          FAS 123
                                          Diluted       Cost             Diluted      Percentage
Company Name                               EPS3       Per Share           EPS3         Change

General Electric                             $1.41        ($0.03)            $1.38           -2%
Microsoft                                     1.38         (0.41)             0.97          -29%
Exxon Mobil                                   2.18         (0.04)             2.14           -2%
Wal-Mart Stores                               1.49         (0.02)             1.47           -1%
Pfizer                                        1.22         (0.09)             1.13           -7%
Citigroup                                     2.75         (0.11)             2.64           -4%
American International Group                  2.07         (0.05)             2.02           -3%
Johnson & Johnson                             1.84         (0.08)             1.76           -5%
Intel                                         0.19         (0.15)             0.04          -79%
Coca-Cola                                     1.60         (0.08)             1.52           -5%
Intl Business Machines                        4.35         (0.70)             3.65          -16%
Procter & Gamble                              2.07         (0.22)             1.85          -11%
Merck                                         3.14         (0.17)             2.97           -6%
Berkshire Hathaway                          521.00          0.00            521.00            0%
Bank Of America                               4.18         (0.22)             3.96           -5%
Philip Morris                                 3.88         (0.08)             3.80           -2%
Cisco Systems                                (0.14)        (0.23)            (0.37)        -168%
SBC Communications                            2.14         (0.07)             2.07           -3%
Verizon Communications                        0.22         (0.18)             0.04          -83%
Wells Fargo                                   1.97         (0.08)             1.89           -4%
ChevronTexaco                                 3.70         (0.08)             3.62           -2%
Pepsico                                       1.47         (0.17)             1.30          -12%
Fannie Mae                                    5.89         (0.24)             5.65           -4%
Home Depot                                    1.29         (0.10)             1.19           -8%
Viacom                                       (0.13)        (0.08)            (0.21)         -60%

75th Percentile                                                                              -3%
Median                                                                                       -5%
25th Percentile                                                                             -12%
1
  Based on market capitalization
2
  Based on most recent 10-k
3
  Before extraordinary items
                                                                                                   7
Background (cont’d)

   IASB Exposure Draft – November 7, 2002
     –   New standard effective January 1, 2004
   FASB’s Invitation to Comment – November 18, 2002
     –   Aim is global convergence
          1. Differences between FAS 123 and IASB’s ED
               Forfeitures
               Tax benefits
               Private company volatility assumption
               IASB’s proposed principles-based valuation approach
     –   Ideas on “ways to improve consistency and comparability of
         option grant values”
     –   Option valuation methodologies up for reevaluation
   By the 1st quarter of 2003, the FASB will decide whether to
    undertake a project leading to mandatory expensing of employee
    stock options in conformance with the IASB

                                                                      12
Black-Scholes Overestimates Option Value


   Designed for traded options
    –    Employee options are illiquid
   Use of “expected” (instead of maximum) term does not
    adequately reflect nontransferability
    –    Penalizes companies with high volatility
   Does not recognize value impairment from non-exercisability
    before vesting and truncated terms at termination of
    employment
   Employees cannot hedge or “borrow stock and short it against
    the option”




                                                                   13
Black-Scholes Overestimates Option Value (cont’d.)


   Employees discount Black-Scholes values
     –    Risk aversion and portfolio diversification reasons
     –    Value differential between company cost and
          employee’s perceived value
   Option gains are taxable income and deductible
     –    No so for traded options
   Executives’ options often have restrictive features
     –    Blackouts, no sales, holding periods, forfeitures for
          competing, etc.




                                                                  14
Comparative Black-Scholes Option Values




                      DJIA 30              Nasdaq 100
                           B-S as                    B-S as
                Volatility % FMV        Volatility   % FMV

     75P        40.0%       40.3%        86.6%       78.2%
     50P        35.6%       35.2%        71.5%       70.2%
     25P        31.1%       29.8%        52.7%       57.5%



Note: Assumes 7-year term, 4% interest rate and average 5-year volatility



                                                                            15
Primary Criticisms of Opinion 25


   General public perception that stock options, and their
    accounting treatment, contributed to:
     –   Recent corporate scandals (Enron, WorldCom etc.)
     –   Speculative bubble in stock prices
   Critics contend that:
     1. Absence of expense leads to:
          – Increasingly large grants
          – Excessive shareholder dilution
          – General lack of accountability for “cost”
          – Overstatement of earnings



                                                              16
Primary Criticisms of Opinion 25 (cont’d)


   Critics further contend that:
     2. Large annual option grants lead to:
          – Excessive focus on short-term stock price
            performance
          – Diverging management and shareholders interests
          – Temptation to falsify financial results
          – May reward even poor-performing executives
            because a rising market lifts all stocks
   Expensing is the panacea to address current bad stock
    option practices




                                                              17
Arguments Against Expensing

   The “cost” of options is already reflected in diluted EPS and
    reduced share prices (double-counting argument)
     –   Reflects the share equivalents attributable to
         outstanding “in-the-money” options
   Options are a capital transaction between shareholders and
    employees (transaction is a division not a subtraction)
   There are no cash flow costs associated with stock options
     –   Rather, options provide positive cash flow (exercise
         price, tax benefit)
   There is no way to “accurately” value stock options, so doing
    so will undermine the credibility of financial statements in
    terms of comparability and transparency
   Expensing of options would discourage their use and
    mitigate creative thinking and innovation, especially for
    entrepreneurial start-up companies
                                                                    18
Arguments For Expensing

   Stock options are compensation and compensation is an
    expense
     –   “If options aren’t a form of compensation, what are they? If
         compensation isn’t an expense, what is it? And if expenses
         shouldn’t go into the calculation of earnings, where in the
         world should they go?” (Warren Buffet argument)
   Options have value when granted, and retain value even if
    they fall underwater
   Sale of stock at less than current FMV results in an
    opportunity cost to the company, which depletes assets
   The accounting treatment for options under Opinion 25 is
    inconsistent with that of all other forms of compensation
   Stock options do create cash flow expenses if shares are
    bought back in market to neutralize dilution effect




                                                                        19
Arguments For Expensing (cont’d)

A simple example – “cost” of 100 options versus 100 SARs
   Assume $10 exercise price; award exercised at $20; 35% corporate
    tax rate
   Economic impact to employee - $1,000 gain
     –   [$20-$10] x 100
   Dilutive effect to Company
     –   None under SAR
     –   100 shares under option (neutral if shares bought back)
   Cash Flow analysis
                                       SAR       Option
          Payment of exercise price         0     $1,000
          Payment to employee         ($1,000)         0
          Tax benefit                     350        350
          Cost of share purchase            0    ($2,000)
          Total cash flow cost          ($650)     ($650)

                                                                       20
Possible Outcomes

   3 possible scenarios
    1. Voluntary adoption – investor pressure and competitive
       precedent
    2. SEC or FASB mandate – likelihood increasing daily
         – Widespread political support
         – IASB – need for a global standard and call for fair
           value approach
         – Leverage attributable to voluntary adoptions
    3. Status quo – seems highly unlikely, but perhaps
       possible
   Outcome may largely depend on “herd mentality” in keeping
    up with competitive compensation practices


                                                                 21
Companies Recently Adopting FAS 123

   As of the end of 2002, approximately 170 public companies
    are “early adopters”
   High profile companies include:

    American Express                  General Electric
    American International Group      General Motors
    Citigroup                         Goldman Sacs
    Coca-Cola                         Home Depot
    Computer Associates               Procter & Gamble
    Dow Chemical                      United Parcel Service
    Emerson Electric                  Wal-Mart Stores



                                                                22
    How to Respond

    What to do now
      1. Examine the impact of adopting FAS 123 based on the 3
         transition approaches under new FASB Statement No. 148
          A. Prospective method (new grants only, but sunset approach for
             companies not adopting in fiscal years beginning after
             December 15, 2003)
          B. Modified Prospective method (new statements reflect all
             grants subject to vesting)
          C. Modified Retroactive method (full restatement of prior results)
      2. Compare impact relative to peers
      3. Discuss issue with industry peers
          – If a trend develops, could it be resisted?


                                                                               23
How to Respond (cont’d)

   What to do now (cont’d)
    4. Examine financial efficiency of existing program under
       FAS 123
         – For example, do reloads remain affordable?
         – Only elect FAS 123 if it reduces otherwise disclosed
           expense
    5. Consider alternative option and full-value LTI designs
    6. Start voluntary quarterly pro forma option expense
       disclosure
    7. Use lowest reasonable Black-Scholes value for expense
    8. Adopt dilution-based grant guidelines
    9. Run ISS methodology if you need more shares

                                                                  24
Black-Scholes Input Assumptions


 We must all become better informed quickly


           Pfizer base case option @ $33 on 9/1/02, 5 year term, 5 year
           monthly volatility/yield, and 5 year STRIP interest-rate


                                                              +/- Base Case
                                  Option Value    per          Total for        Intrinsic
                                   per Share     Share        79.1M Shs.         Value


 Base Case Option                        $7.91           --                --               --
 Weekly 5 Yr. Volatility/Yield          $10.44    +$2.53         +$200.1M                   --

 Monthly 3 Yr. Volatility/Yield          $6.99      -$.92         -$72.8M                   --

 Base Case @ $10 Discount               $13.00    +$5.09         +$402.6M       +$791.0M

 Base Case @ $10 Premium                 $4.75    -$3.16         -$250.0M        -$791.0M




                                                                                                 25
Option Provisions


 Relatively more attractive under FAS 123


               Provision             Advantage to NQSOs


  Stock SARs                    Fewer shares issued
  Discount Price                Low cost to intrinsic value
  Combined Dividend Rights      Low cost to intrinsic value
  Performance Vesting           Pay-for-performance
  Indexed Price                 Pay-for-performance




                                                              26
Option Provisions (cont’d)


 Relatively less attractive under FAS 123


             Provision              Disadvantage to NQSOs


   ISOs                         No tax benefit
   Reloads                      Additive cost
   Cash SARs                    Variable cost
   Premium Price                High cost to intrinsic value




                                                               27
Conversion of Option Values


Converting high Black-Scholes values to cash, full-value
shares, and SERPs is appealing but wrong without discount


                     Recent   Black-Scholes   Equivalent Cash/
                      Price     Multiple      Full-Value Shares


  AOL                $13.00       52.37%           $6.81
  Citigroup          $30.00       22.15%           $6.65
  Intel              $16.00       49.53%           $7.92
  3M                $120.00       25.08%          $30.10
  United Airlines     $2.50       34.49%            $.86




                                                                  28
Full-Value Shares


 Better than options for matching disclosed or real expense
 with delivered after-tax value

         Assume 40% Black-Scholes value, 35% company
         tax rate, and 45% individual rate

                                     Per $1 of Grant Value
                             NQSOs                   Full-Value Shares
                       FAS 123       Pay          FAS 123         Pay
        Stock Price    Expense   Delivered        Expense       Delivered


       Declines 50%       $.65          $.00           $.65          $.28
       No Change          $.65          $.00           $.65          $.55
       Increases 50%      $.65          $.69           $.65          $.83
       Doubles            $.65         $1.38           $.65         $1.10




                                                                            29
Likely Impact on Incentive Design

   Short-term (irrespective of FAS 123)
     –   Decreased use of options in aggregate, even in the absence
         of a direct earnings charge
           Investors, rating agencies, and Wall Street analysts
            already considering pro forma FAS 123 impact
     –   Reduced use of reload stock options
     –   Reduced share usage will Increase use of cash- and stock-
         based “full value” LTI alternatives, particularly among senior
         executives
           Risk that middle management and rank-and-file are left
            behind (also made worse with FAS 123 ESPP treatment)
     –   Heavy emphasis on time-based restricted stock, with
         mandatory hold and delayed payout
     –   Decreased use of surveys to determine grant levels
           More reliance on dilution-based approaches

                                                                          30
Likely Impact on Incentive Design (cont’d)

   Anticipated stock option evolution (assuming FAS 123 mandate)
     –   Significant changes in the design of option awards (maybe)
           Performance contingent vesting
           Indexed exercise price
           Shorter terms, perhaps with immediate vesting, but longer
            vesting helps spread expense
           Barrier options such as exercise trigger options
     –   Replacement of traditional options with stock-based SARs and
         variations
           Same accounting treatment under FAS 123
           Simpler to administer (no cashless exercise)
           Less burden on equity plan share reserve (profit shares)
     –   Replacement of FMV options with discount options
           Fair value is less than sum of discount plus fair value of
            option at 100% of FMV

                                                                         31
Macro Impact

   Overall assessment
    –   Expensing of options creates level playing field for all
        incentives (positive result for private companies)
    –   Earnings charge raises level of accountability for “cost”
    –   Long-term result should be less options and more
        performance-based full-value approaches
    –   Enhanced focus on long-term operating results
    –   Greater line of sight between executive performance and
        wealth creation opportunities
    –   Improved retention and decreased pressure to make special
        awards to address unexpected circumstances (e.g.,
        underwater options, industry recession)
    –   Decreased pressure from institutional investors regarding
        potential share dilution
    –   Improved public perception regarding executive pay;
        restoration of investor confidence
                                                                    32
 Company Profile

Frederic W. Cook & Co., Inc. provides management compensation consulting services to
business clients. Formed in 1973, our firm has served over 1,300 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           • Incentive Grant Guidelines       • Performance Measurement
  Review                       • Executive Ownership              • Globalization
• Strategic Incentives           Programs                         • Privatization
• Specific Plan Reviews        • All-Employee Plans               • Compensation Committee
• Restructuring Services       • Directors’ Compensation            Advisor
• Competitive Comparisons      • Equity Instruments               • Stock Option Enhancements

Our offices are located:
New York                       Chicago                            Los Angeles
90 Park Avenue                 19 South LaSalle Street            2029 Century Park East
35th Floor                     Suite 400                          Suite 1130
New York, New York 10016       Chicago, Illinois 60603            Los Angeles, California 90067
212-986-6330 (phone)           312-332-0910 (phone)               310-277-5070 (phone)
212-986-3836 (fax)             312-332-0647 (fax)                 310-277-5068 (fax)

                                  Website address:
                                  www.fwcook.com                                                      33