Executive Compensation And Restricted Stock

NIRI Philadelphia March 10, 2005 Bruce Brumberg, Editor-in-Chief myStockOptions.com

[email protected]

617-734-1979

Copyright 2005, myStockPlan.com, Inc.

Please do not distribute or copy without permission.

The Big Changes And Opportunities



Hewitt (HR consulting firm) Total Compensation Measurement Database: 2004 trends show the "biggest shifts ever seen in executive compensation”

The Big Shifts Noted by Hewitt

    Stock options represent 31% of the total compensation of a Fortune 100 senior executive, down from 50% two years ago.

Time-based restricted stock/restricted stock units are offered by 48% of surveyed companies (up from 29% in 2002), replacing former option grants.

Performance share or performance unit plans are in place at 50% of companies, up from 42% in 2002.

Fewer managers and director-level employees received stock options or other forms of long-term incentives: 33% received these awards, down from 50% in 2003. Hewitt has not seen companies "replacing this value with other forms of compensation."

Trends In Executive Compensation From 2004 Proxy Statements The Changing Landscape Of Equity Compensation And Long-Term Incentives For Senior Executives

(data provided by Equilar)      Importance of pay that creates long-term incentives Stock options Restricted stock Long-term incentive plans Stock ownership guidelines and holding periods

2003 CEO Compensation Analysis

Total Direct Compensation (TDC) Salary Bonus Value of Stock Options Restricted Stock Long-Term Incentive Plan Payouts Median Market Capital

S&P 500 Companies 2003

$6,629,958 $950,000 $1,078,040 $2,769,003 $1,978,102 $1,709,391 $9.0BN

Year Over Year Change

-7.1% +1.6% +18.9% -32.8% +31.9% +48.6%

Small Cap Companies 2003

$1,366,560 $482,004 $166,360 $364,900 $388,267 $301,490 $521MM

Year Over Year Change

-5.6% +2.1% -11.3% -28.7% +35.9% +43.3%

Notes:

Total Direct Compensation has been calculated for each individual CEO by summing salary + bonus + restricted stock + option awards + LTIP payouts. The TDC number provided in this chart is the median of the TDCs for all CEOs in the study.

TDC = Salary + Bonus + Value of Option Awards + Restricted Stock + LTIP Payouts.

Small Cap Companies include 396 companies in the S&P 1500 with market capitalization under $1.0 billion.

S&P 500 CEO analysis includes 414 companies that have filed their proxy for fiscal year 2003.

Value of stock options calculated using a standardized Black-Scholes methodology. All numbers are median values. Calculations of restricted stock and LTIP payout medians are based on those CEOs receiving such an award or payout.

Source: Equilar Analysis

Options 51%

Long-Term Incentives: S&P 500 CEO TDC

2003 Restricted Stock 15% Salary 10% Bonus 17% Options 66% LTIP 7%

Total = $3.8BN

2002 Restricted Stock 9% Salary 9%

Total = $4.3BN

Bonus 12% LTIP 4%

Long-Term Incentives: Prevalence Of Long-Term Awards (S&P 500)

Options Only Options & Restricted Stock Options & LTIP Only All Three Awards Restricted Stock Only LTIP Only Restricted Stock & LTIP Only None 2003

34.8% 19.3% 16.0% 11.1% 5.8% 2.4% 0.7% 9.9%

2002

39.6% 20.3% 17.1% 7.2% 2.7% 1.2% 1.4% 10.4%

2001

44.2% 19.8% 16.4% 7.5% 1.0% 2.4% 0.5% 8.2%

Options 42%

Long-Term Incentives: Mid- and Small-Cap CEO TDC

2003 2002 Restricted Stock 13% Restricted Stock 10% Salary 17% Salary 21% Options 54% Bonus 17% LTIP 3% Bonus 21%

Total = $2.2BN

LTIP 2%

Total = $2.6BN

Long-Term Incentives: Prevalence of Long-Term Awards (Small/Mid Cap)

Options Only Options & Restricted Stock Options & LTIP Only All Three Awards Restricted Stock Only LTIP Only Restricted Stock & LTIP Only None 2003

43.4% 16.9% 5.3% 3.5% 6.1% 1.9% 0.9% 22.1%

2002

52.2% 14.1% 6.7% 2.9% 4.8% 0.6% 0.4% 18.3%

2001

54.6% 14.5% 6.4% 2.5% 2.5% 0.4% 0.3% 18.8%

Analysis Of Stock Option Trends

Number of Options Granted Black-Scholes Value of Option Grants Percentage Receiving Options

2003 S&P500

232,608

Year Over Year Change

(7.9%)

Small Cap Companies 2003

42,858

Year Over Year Change

(28.6%) $2.7MM (32.8%) $364,900 (28.7%) 81.2% (3.1%) 67.1% (6.6%)

Source: Equilar Analysis of 414 S&P500 companies and 394 S&P 1500 companies with market capitalization under $1.0BN.

Stock Options: Performance

IBM’s recent announcement about premium-priced options.

Other examples of companies with similar plans:

Company Name

Tesoro Petroleum Electronic Data Systems Chubb Insurance Liz Claiborne Computer Associates Ecolab, Inc. Lennar Corp. Briggs & Stratton

Premium of Exercise Price Over Fair Market Value

55% - 133% Premium 30% Premium 25% Premium 25% Premium 20% - 68% Premium 18% Premium 10% Premium 6% - 8% Premium Other examples of performance hurdles built into option grants:

Becton Dickinson:

adjust target # of options based on relative TSR

Level 3 Communications:

outperform stock option (OSO)

Chiron:

Performance-accelerated vesting based on relative TSR

Restricted Stock Analysis: Prevalence Of Restricted Stock Awards

 Steady increases in restricted stock awards over the past three years: S&P 500 and Small/Mid Cap CEOs

Year

2003 2002 2001

Year

2003 2002 2001

# of Companies

153 131 119

# of Companies

217 176 157

% of Total

37.0% 31.6% 28.7%

% of Total

27.4% 22.2% 19.8%

Local Companies Are Using It

 Comcast’s equity-based incentive compensation is in the form of stock options and awards of restricted stock . We believe that reliance upon these types of incentives is advantageous to Comcast because they foster a long-term commitment by the recipients and motivate the recipients to seek to improve the long-term market performance of the company’s stock. In 2003, neither Mr. Brian L. Roberts nor any of the named executive officers received any grants of restricted stock.

 Proxy statement a year earlier: The Company’s equity-based incentive compensation is in the form of stock option grants . The Committee believes that reliance upon such incentives is advantageous to the Company because it fosters a long-term commitment by the recipients to the Company and motivates these individuals to seek to improve the long-term market performance of the Company’s stock.

Restricted Stock Analysis: CEO Stock Grant Values

The value of individual stock grants grew significantly in 2003: S&P 500 and Small/Mid-Cap CEOs

Year

2003 2002 2001

Median Value

$1,978,102 $1,500,000 $1,818,413

25 th Percentile

$1,000,288 $685,644 $967,478

75 th Percentile

$4,200,900 $3,840,295 $3,324,351

Year

2003 2002 2001

Median Value

$538,496 $419,163 $500,000

25 th Percentile

$268,200 $171,785 $224,400

75 th Percentile

$1,287,200 $510,625 $873,400

Restricted Stock Analysis: Vesting Schedule

60

Most restricted stock has restrictions that lapse over 3-5 years.

55 50 40 Number of CEOs 30 20 10 5 0 1 6 25 26 4 3 4 1 7 Number of Years 0 2 10 17 4 3 Indeterminate

Restricted Stock Analysis: Performance Metrics



Performance-Accelerated Vesting



Schwab

  These shares will vest earlier, either three or four years after the grant date in 2006 or 2007, respectively, only if certain performance criteria are met.

Guidant

 The grants further provided that vesting would accelerate to three years from the date of grant if targets for Guidant’s share price performance were achieved. 

Performance-Contingent Vesting



PG&E

  25% of each year’s increment is subject to forfeiture if PG&E fails to be in the top quartile of the comparator group as measured by total shareholder return.

25% is subject to forfeiture if PG&E fails to be in the top half of the comparator group.



Robert Half

 These grants vest at a rate of 25% per year over the first four years after the grant and are also subject to a performance condition .

Restricted Stock Analysis: Summary Of Findings

    LTI mix shifting away from options for CEOs  Value of options as percentage of Total Direct Compensation (TDC) dropped from 66% to 51% in 2003 for S&P 500 CEOs.

 Value of option grants as percentage of TDC dropped from 54% to 42% in 2003 for Small-/Mid-Cap CEOs.

Significant increase in prevalence of restricted stock in 2003   37% of S&P 500 Executives received a stock grant in 2003, up from 32% in 2002. Latest Equilar S&P 500 study showed over 40% of companies had awarded restricted stock in most recent fiscal year 27% of Small-/Mid-Cap Executives received a stock grant in 2003, up from 22% in 2002.

Size of individual awards rose in 2003    S&P 500 cohort saw a 31.8% increase in median value of grant.

Small-/Mid-Cap executives saw their median stock grant increase by 28.5%.

Distribution analysis indicates that size of awards continues to migrate towards larger awards.

Overwhelming majority of stock awards continue to have time-based vesting.

Long-Term Incentive Plans

Trends

  Long-Term incentive plans (LTIP) are becoming more prevalent (over 30% in 2003).

Improved company performance led to increased payouts.

  S&P500 CEOs: Median payout rose 48.6% to $1,709,391.

Small Cap CEOs: Median payout rose 43.3% to $301,490.

Design

 Typically have threshold, target, and maximum performance levels.

   Use 1-3 performance criteria per grant (internal/external focus).

Payout can be in stock (performance shares) or cash (performance units): 50% cash, 40% stock, 10% units Companies often use overlapping plans so that each year starts a new three-year cycle.

Long-Term Incentive Plans: Number Of Metrics In Plan

80 70 60 50 40 30 20 10 0 71 1 35 9 2 3 # of Metrics Used 4 6 9 None

Long-Term Incentive Plans Award Metrics

2003 LTIP Award Metrics 60 50 40 30 20 10 0 55 TSR 48 43 EPS 12 12 8 ROA/ROE EBITDA Revenue Operating Income 2 EVA 14 7 Other Not disclosed

Stock

Ownership Guidelines



Approximately half of S&P 500 disclosed these in compensation committee reports:

 Cigna: We expect CIGNA executives to demonstrate confidence in the company’s future by sustained ownership of a substantial amount of CIGNA stock. In particular, we expect the executive officers to own stock valued at between three and five times their base salaries. The Committee reviews ownership levels annually.

Mandatory Holding After Exercise



Must keep net shares after exercise: Less than 10% of S&P.



Toll Brothers Inc:

The options have significant restrictions, typically for a period of three years from the date of grant, on the executive officer's ability to exercise the options and sell the shares acquired upon exercise……..

Combination Of Ownership Guidelines And Mandatory Retention

CDI Corp

To further achieve the objective of aligning the interests of the company’s executives with those of its shareholders, the Committee in 2002 established minimum CDI stock ownership and stock holding requirements for executives. Minimum stock ownership levels range from four times base salary for the CEO to one times base salary for the CAO (with the other Named Executive Officers at two times base salary). These minimum ownership levels are being phased in over a five-year period that began in 2003. Until the minimum levels are achieved, executives are required to retain 75% of the shares of CDI stock they obtain from option exercises, restricted stock and other sources.

Additional measures will be imposed in the event an executive fails to attain the minimum ownership requirements.

Flexible Choices



Sovereign Bancorp Inc

New Long-Term compensation determination policy On February 18, 2004, the Compensation Committee recommended to the Board of Directors and the Board of Directors approved the implementation of a new “leading edge” customized approach to Sovereign’s long-term incentive compensation policy. This new long-term incentive approach is designed to provide team members throughout Sovereign with maximum flexibility and more meaningful long-term incentive compensation opportunities. Team members throughout Sovereign will be eligible to receive a combination of either stock options, restricted stock or a cash bonus only after the five-year incentive vesting period has elapsed from an award date .

Restricted Stock Grant v. Stock Options

• • • • • • • Often has been part of senior executives’ comp. with options.

Popularity with institutional investors runs in cycles: “Pay for pulse.” Historically most useful in employee recruitment/retention when leaving behind valuable options or when stock price flat.

Big increase expected with option expensing at levels below senior management, although not as broadly granted as options.

Accounting treatment becomes similar between types of equity compensation: “level playing field.” Less dilution than with options because fewer granted.

Value in down and volatile markets: never underwater, gets dividends, but less upside compared with options.

Local Company Disclosures



Jones Apparel Group Inc.

Performance contingent restricted shares have advantages over stock option grants. The awards utilize substantially fewer shares, reducing potential dilution executives an . The awards give the immediate economic interest in Jones that will vary up and down with stock price performance minimum financial targets . In addition to reinforcing the link between executive compensation and the performance of Jones' stock, the awards also require that are achieved, adding to the incentive value. The vesting period of the replacement awards extends into 2006, approximately one year longer than the vesting that applied to the original option grants, increasing retention. Finally, the awards are cost effective , particularly since Jones has elected to expense stock options beginning in 2003.

Bill Gates on the Move From Options to Restricted Stock at Microsoft

• • • “When you win [with options], you win the lottery. And when you don't win, you still want it. The fact is that the variation in the value of an option is just too great.” “I can imagine an employee going home at night and considering two wildly different possibilities with his compensation program. Either he can buy six summer homes or no summer homes. Either he can send his kids to college 50 times, or no times.” “The variation is huge; much greater than most employees have an appetite for. And so as soon as they saw that options could go both ways, we proposed an economic equivalent. So what we do now is give shares, not options.”

What’s the Restriction?

 Confused with restricted securities, performance shares, or outright grants. Better term is “unvested stock grants.”  Restricted because you cannot sell stock until it has vested.

 Vested: when sale restrictions lapse.

 Lapse: no longer subject to “substantial risk of forfeiture.”  Not the early-exercise, pre-IPO options.

Vesting: Key Concept

 No money paid to company (no exercise) . Not exercising to own stock, as with options (unless pre-IPO early-exercise options/paying money).

 Unfettered ownership at vesting like any stock you own.

 Time-based most popular. Not eligible for performance-based exception under rules that limit deduction for compensation over $1 million [ Section 162(m) ].

 Performance targets: can trigger or accelerate vesting, and performance goal must be related to company.

 Termination: forfeit unvested shares.

Grant Size Trade Offs

Full value of shares at vest (not spread since grant), so fewer shares granted compared to options. The volatility of your company's stock and any dividend affect the value of options compared with restricted stock. Observations by consultants about the tradeoff ratios :

Type of company Ratio

High volatility / no dividends

(e.g., technology)

1 restricted share for 3 or 4 option shares Moderate volatility / moderate dividend yield Low volatility / high dividend yield 1 restricted share for 4 or 5 option shares 1 restricted share for 6 or 7 option shares

Tax Treatment Different from That of Options: Two Alternatives

Standard: Pay Tax At Vesting

 Taxed as ordinary income at vesting when forfeiture risk removed (with options not taxed at vest).

 Taxable income is the value of the stock when each slice vests. Stock price at grant does not matter unless second tax treatment alternative.

   If you sell the stock, you have capital gains or losses as with the sale of any shares.

Tax basis is the amount you included in income as compensation.

Capital gains holding period begins at the time of vesting.

Example: Let Shares Vest

     4,000 shares of restricted stock that vest at a rate of 25% a year; grant market price at $18.

year one: $20 (1,000 x $20 = $20,000 of ordinary income) year two: $25 ($25,000) year three: $30 ($30,000) year four: $33 ($33,000) total: $108,000    Each increment is taxable on its vesting date.

Sell all the stock two years after the last shares vest, when the price is $50 ($200,000 for the 4,000 shares).

Capital gain is $92,000 ($200,000 minus $108,000).

Second Tax Treatment: 83(b) Elections

       Make a Section 83(b) election with the IRS within 30 days of the grant.

No special tax form for a Section 83(b) election.

You send the local IRS office your election with information that identifies you and the property you include in your income. Still attach a copy of the election when you file your return.

Pay taxes on the value of all the stock at grant.

Remember: you cannot sell any shares until they vest.

Almost impossible to rescind election.

Advantage: tax for compensation income will (hopefully) be lower and start capital gains holding period.

Example with 83(b) Election

Same facts of the previous example for appreciating stock: You make a timely 83(b) election at grant:  Compensation income of $72,000 (4,000 x $18).

 Capital gain of $128,000 at sale ($200,000 minus $72,000).

 Election allowed you to convert $36,000 of ordinary income to the lower-taxed capital gains ($128,000 = $92,000 of capital gain in the prior example plus $36,000 that was ordinary income without the 83(b) election).

Risk with Election

 You left the company: restricted stock never vested.

 You cannot rescind your election or recover the taxes you paid.

 Stock price dropped by vesting: you cannot recover taxes paid with 83(b) election.

 You might be better off with using the tax dollars to buy stock on open market. Need to run the numbers with your advisor.

Restricted Stock Accounting

 Earnings charge fixed according to grant date value spread out over vesting/restriction lapse dates, unless 83(b) election made.

 Timing for tax deduction and earnings charge match taxable compensation to employee when yearly vesting.  Big difference for the accounting until option expensing is mandatory.  Need to make estimates on forfeitures (e.g., shares that never vest). Bigger issue for cliff vesting (e.g., shares all vest after 3 years).

Accounting Example

4,000 shares of restricted stock vest at 25% a year (1,000 shares yearly); grant market price at $18 and no 83(b) election.

 year one: stock price $20 (1,000 x $18 = $18,000 earning charge and $20,000 tax deduction)  year two: $25 ($18,000 charge, $25,000 deduction)  year three: $30 ($18,000 charge, $30,000 deduction)  year four: $33 ($18,000 charge, $33,000 deduction)  83(b) election to be taxed at grant: $72,000 earnings charge and tax deduction

Withholding Taxes on Restricted Stock

 Subject to tax withholding at vesting or 83(b) filing.

 Compensation income similar to NQSO treatment on spread at exercise. Familiar W-2 reporting.

 Amount is withheld from salary, cash payment made, or company may allow (or require) share withholding.  Company needs to have the cash to use automatic share withholding/surrender, as no shares sold to generate funds need to pay IRS  With share withholding/surrender, employees may have additional reporting for securities sale on Schedule D of tax return (company has 1099-B obligation?).

Withholding Taxes on Restricted Stock

    Clear dates where actions and transactions will be occurring. Company needs to make decisions on: communications about 83(b) election at grant; withholding/lapse election process at vesting; timing for notifications on choices for withholding; what to do if no election made; elections on what to do with stock and cash Senior executives and directors Form 4 filing if share withholding at vesting even though no shares are “sold” into market. Normally file form 4 with grant and then with stock sale, not at vesting. Companies considering Rule 10b5-1 trading plans to cover share withholding. ALERT: Companies can no longer lend senior executives or directors the necessary funds for tax withholding or for buying restricted stock.

Dividends on Restricted Stock

 Dividends on unvested shares are compensation income reported on W-2. They are not “qualified dividends,” which are taxed at lower rates until vested.

 Dividends on 83(b) election are reported on 1099-DIV.

 Approximately 10% pay dividends in more shares, although not received until underlying shares vest.

Restricted Stock Units: Used by Amazon and Microsoft

    Stock itself is not issued or outstanding until the actual release of the shares at vesting. Holders of RSUs have no voting rights. Dividends not required as RSUholders are not shareholders. May be dividend equivalents based on the plan details. Microsoft does not pay dividends on RSUs. Made adjustments with large dividend payment.

Restricted Stock Units: Used by Amazon and Microsoft

    Share delivery occurs at vesting in broad-based plans, with share withholding for the taxes. Specialized RSU plans have a deferral feature that lets you select a date for share delivery, or one is specified by the company (e.g., retirement).

Until American Jobs Creation Act, no income tax until receipt of shares when election made six months or more in advance. Now need to follow ongoing AJCA guidance on elections. Social Security and Medicare at vesting with deferrals.

Why Use RSUs Instead of Restricted Stock For Grants?

     Eliminates 83(b) election. No administrative burdens for company and employee risks.

Can avoid paying cash dividends during the vesting period. Avoids tax at grant in countries where tax not delayed until vesting.

RSUs do not avoid the administrative issues for withholding taxes at vesting. Specialized RSU plans defer delivery of the shares (not at vesting) until date specified by executives or termination of employment. Need to follow AJCA guidance from IRS/Treasury.

Local Companies Using RSUs



Aramark Corp.

Restricted stock units also are granted to officers and key employees of the Company under the 2001 Equity Incentive Plan. Those grants are evidenced by the execution and delivery of an RSU Agreement and vest in four equal annual installments. Additional Restricted Stock Units are awarded through the Management Stock Purchase Program (MSPP). This plan provides officers and other key employees the opportunity to defer up to 50% of their annual bonus (25% in the case of Mr. Neubauer) and receive instead Restricted Stock Units (RSUs). The Company then awards additional RSUs with a face amount equal to the amount of bonus deferred. These matching RSUs vest in four equal annual installments

Local Companies Using RSUs

Pep Boys Manny Moe & Jack: New use of Restricted Stock Units

Beginning in fiscal 2004, we decided to replace 75% of the estimated value of new grants of stock options with restricted stock units, or RSUs, on a basis intended to provide comparable value to the executive at a comparable cost to us. RSUs will result in less dilution because, in the future, we will grant fewer RSUs than the number of stock options that they replace because, when granted, RSUs have more value than stock options. The grant of RSUs (a direct ownership vehicle) will also assist officers achieve newly-implemented Pep Boys stock ownership levels. RSUs will vest in 20% installments over four years beginning on the date of grant. While stock options issued in the future will continue to become exercisable in 20% installments over four years beginning on the date of grant, in order to further reduce potential dilution, their term has been reduced from ten years to seven. Finally, to ensure a more direct connection to an executive’s performance, the amount of future equity grants will be linked to such executive’s short-term bonus payout.

Restricted stock calculators and tracker

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