Transcript Executive and Director Compensation Update

The Future of Executive Compensation
George B. Paulin
President & CEO, F.W. Cook & Co., Inc.
October 6, 2004
Background
OVERVIEW
5-year transition in executive compensation . . .
1st Phase
2nd Phase
Period
2002-03
2004-06
Catalysts
Sarbanes-Oxley, stock
exchange rules,
institutional investor
initiatives
New FASB rules, optionvaluation refinements,
political/labor pressure
Focus
Corporate governance
Program design
Impact
Board compensation
committee process
Use of stock options
1
Background
TODAY’S DISCUSSION
Implications and outcomes from 3 areas . . .
1. 2nd-phase market trends in executive compensation
transition
2. New and proposed regulations
3. Shareholder initiatives and voting
2
Background
METHODOLOGY
Competitive data used for illustrations . . .

Comes from the F.W. Cook & Co. data base
—
—

Generally, large-caps (i.e., Fortune 250)
But representative of broader public-company
practice
Values options based on the Binomial model and
standard assumptions
3
Market Trends
TOTAL DIRECT COMPENSATION
Top-quartile outliers are moving back toward the middle (75th
percentile as percent of median) . . .
175%
153%
145%
150%
133%
142%
131%
127%
125%
100%
75%
50%
CEO
Top 5
1996
CEO
Top 5
2002
CEO
Top 5
2004
4
Market Trends
LONG-TERM GRANTS
Share usage as a percent of outstanding shares
(“run rates”) continues to decrease. . .
Share Usage as % Outstanding Shares
1996
2002
2004
Options
0.94%
1.38%
1.01%
Other
0.05%
0.03%
0.10%
Total
1.07%
1.46%
1.09%
Options
1.32%
1.82%
1.43%
Other
0.16%
0.13%
0.24%
Total
1.45%
1.87%
1.55%
Median
75th P
5
Market Trends
LONG-TERM GRANTS (cont’d.)
Look carefully beyond the survey numbers . . .


Run rates (and dilution overhang) are no longer
meaningful as grant value shifts from options
Grant-value changes are from 2 sources
—
—

Stock price variability
Discounting in conversion from options for full-value
grants
Reduction in lower-level grants only partially complete
—
Driven by stock-exchange rules (not accounting), and
many board-approved plans still have shares available
6
Market Trends
LONG-TERM STRUCTURE
Shift from options to full-value grants (i.e., restricted
and performance stock/cash) . . .
Annual Mix
Year
Level
Options
Full
Value
1996
CEO
Top-5
73.7%
73.2%
26.3%
26.8%
2002
CEO
Top-5
79.2%
78.0%
20.8%
22.0%
2004
CEO
Top-5
51.5%
49.8%
48.5%
50.2%
7
Market Trends
OPTION STRUCTURE: More Prevalent
Some forms of options will be winners under new
accounting . . .
Grant Type
Advantage to
Plain-Vanilla Options
Stock-only SARs
Fewer shares issued
Discount Options
Low cost to intrinsic value
Options with Dividend Rights
Low cost to intrinsic value
Performance Options
Pay-for-performance
Indexed Options
Pay-for-performance
8
Market Trends
OPTION STRUCTURE: Less Prevalent
Other forms will be losers . . .
Grant Type
Disadvantage to
Plain-Vanilla Options
ISOs
No tax benefit
Reloads
Additive expense
Cash-only SARs
Variable cost
Premium Options
High cost to intrinsic value
ESPPs
Fair value expense (no
expense now)
9
Market Trends
OPTION PROVISIONS
Regulatory and shareholder considerations will affect
option design . . .




3-4 year vesting will continue to spread expense
accruals
10-year terms will continue because the cost effect of
shorter terms is not linear
Post-termination exercise may become more limited
to conserve shares
Grant dates may be moved to late in the year so value
aligns with annual TSR under new ISS guidelines
10
Market Trends
LONG-TERM GRANT DETERMINATION
A new approach for determining grant size is
necessary but controversial . . .
Old Method
Determine competitive
individual grant values
Convert to company shares
(or cash)
Add individual grants to
determine total grants
New Method
Start with competitive
aggregate grant value as a
percent of company market
cap
Allocate to individuals based
on competitive percent of
total grant value
11
Market Trends
SHAREHOLDER APPROVED PLANS
Flexible omnibus-type structure will become the
standard . . .






Employees and outside directors eligible
All possible grant types
Administrative provisions in grant agreements, not
the plan
As-issued share count
“Fungible” share pool for trading-off options and
full-value grants
Potential for 3rd-party option transfers
12
Market Trends
SHAREHOLDER APPROVED PLANS (cont’d.)
Fungible share pool works best under ISS-type
voting guidelines . . .

Traditional Pool: 10 million option shares with up to 3.3 million full value
shares

Fungible Pool: 16.6 million option shares with each full value share granted
counted as 3 options (assuming 33% Binomial option value):
ISS “Cost” in
Option Equivalents
Shares Available for Grant
Traditional Pool
6.7 + 9.9 = 16.6 million
10 Million
Fungible Pool
16.6 million
5.5 to 16.6 million depending
on mix of options and full
value shares
13
Market Trends
EXECUTIVE OWNERSHIP
Pressure from shareholder groups will increase
prevalence and enforcement sanctions . . .
“Best Practice”
Reality
Ownership
Guidelines
Real ownership of
specified salary multiple
or number of shares;
usually after 5 years
About half of large caps;
few small caps and techs or
West of the Mississippi
Retention
Guidelines
Hold net shares from
compensation program
for at least 1 year (i.e., no
run-up and flipping)
GE, Citicorp, Lilly and a
couple of other early
adopters; few followers
14
Market Trends
MISCELLANEOUS
More time will be spent on . . .



Setting goals for annual bonuses to better balance pay for
performance and pay for results
Valuing SERPs, above-market interest on deferred
compensation, and severance arrangements
Aligning outside directors’ compensation with their
current responsibilities and risks
—
And compensation committees again taking charge of
directors’ compensation, where it has moved to
nominating/governance committees
15
New and Proposed Regulations
IN GENERAL
3 areas will be covered . . .


NYSE rules effective 6/30/03 (Nasdaq rules are
generally in parallel)
FAS 123 proposal on accounting for equity-based
compensation
—

Exposure Draft (ED) issued 3/31/04
Legislation pending on taxation of deferred
compensation
16
New and Proposed Regulations
STOCK EXCHANGE RULES
Old “loopholes” from shareholder approval eliminated . . .
Former Exemptions
Current Exemptions
Broad-based plans
New-hire grants
Certain share authorizations not
exceeding 5%, i.e., “Broker NoVote”
Shares in lieu of cash
“Immaterial” plan amendments
Grants in Treasury shares
New-hire grants
Plan amendments other than
participant eligibility, grant types,
and share limit
17
New and Proposed Regulations
FAS 123 STATUS
Outcome could have been worse . . .
Bad News
Good News
Proposed rules will be adopted
Possibly later (1/1/06) than sooner
(1/1/05)
Option pricing models will be
basis for expense
Flexibility in modeling will reduce
option expense
Transition is inherently painful
Choice between “modified
prospective” and restatement, plus
other steps to moderate original
ED
18
New and Proposed Regulations
FAS 123 STATUS (cont’d.)
Steps to moderate ED . . .




Straight-line accruals for installment vesting
Lattice-binomial no longer specifically preferred
Current accounting treatment for corporate
income taxes retained
Safe-harbor for qualified ESPPs
—
Purchase discount no greater than 5%
19
New and Proposed Regulations
TAX DEFERRAL STATUS
Timing is uncertain and changes to current
proposals are likely . . .

Many elections for bonuses earned (whole or part)
in 2004 and paid in 2005 could be invalid
—
—

If annual compensation, elections must pre-date
1/1/04
If multi-year, must pre-date 2005 payment date by at
least 12 months
Elections for compensation earned in 2005 and
paid in 2006 must be before 1/1/05
20
New and Proposed Regulations
TAX DEFERRAL STATUS (cont’d.)
Other possible (probable) effects . . .



No event-driven distribution triggers
Amounts originally deferred before effective date
grandfathered, if no further deferral under
subsequent election
General scope will have unintended consequences
—
e.g., impact on SARs, RSUs, and SERPs likely to
necessitate administrative rulings to clarify
21
Investor Initiatives and Voting
IN GENERAL
Initiatives by the following organizations are likely to
be influential . . .



ISS (Institutional Shareholder Services)
Glass Lewis & Co.
CalPERS (California Public Employee Retirement
System)
—
Significant to a lesser extent because of perceived labororiented political agenda
22
Investor Initiatives and Voting
ISS
New voting guidelines effective for annual meetings
after 1/31/04 . . .

Oppose any proposed plan and committee member reelection if
—
—
—


CEO pay “disconnect” from sustained company performance
More than 50% of CEO pay increase from equity awards
CEO participates in proposed plan
Disconnect if 1 and 3 year TSR is negative, but CEO’s
total direct pay is above prior year
Applies to Russell 3000, publicly traded 3 years, and CEO
in place at least 2 years
23
Investor Initiatives and Voting
GLASS LEWIS & CO.
Proxy advisory company, and direct competitor to
ISS, formed in 2003 . . .

Equity compensation plans are evaluated based on qualitative
and quantitative review
—
—

Qualitative review looks at plan administration, method and
term of exercise, repricing history, and other factors
Qualitative review includes 20 different weighted analyses
Employs a pay-for-performance model with assigned grades
based on CEO pay and performance relative to peer company
median practice
—
No information provided on how information is used in
developing voting recommendations
24
Investor Initiatives and Voting
CALPERS
They are working in close conjunction with Glass
Lewis & Co. . . .


Model to identify U.S. portfolio companies that are both high pay and
low performance, and are opening dialogue with these companies to
get them to change their practices
Want companies to develop executive compensation policies for
shareholder approval
—

Include compensation philosophy; targeted mix of salary and
incentives; methodologies for alignment of employee and shareholder
interest; and parameters for employment contract
provisions/severance
Advocate all equity compensation tied to performance criteria
including options and restricted stock
25
CONCLUSION . . .




Lead or follow
Look beyond the data
Understand new and proposed regulations
Listen to shareholders
26