Compensation Committee Handbook (2001)

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COMPENSATION COMMITTEE HANDBOOK JAMES F. REDA

JOHN WILEY & SONS, INC. New York • Chichester • Weinheim • Brisbane • Toronto • Singapore

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COMPENSATION COMMITTEE HANDBOOK

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COMPENSATION COMMITTEE HANDBOOK JAMES F. REDA

JOHN WILEY & SONS, INC. New York • Chichester • Weinheim • Brisbane • Toronto • Singapore

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Copyright © 2002 by John Wiley & Sons, Inc. All rights reserved. Published simultaneously in Canada. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 750-4744. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 605 Third Avenue, New York, NY 10158-0012, (212) 850-6011, fax (212) 850-6008, E-Mail: [email protected]. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. Library of Congress Cataloging-in-Publication Data: Reda, James. Compensation committee handbook / James Reda. p. cm. Includes bibliographical references and index. ISBN 0-471-38980-3 (pbk. : alk. paper) 1. Compensation management—United States—Handbooks, manuals, etc. 2. Wages—Law and legislation—United States—Handbooks, manuals, etc. I. Title. HF5549.5C67 R435 2001 658.3′2—dc21 2001045523 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1

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Acknowledgments Most importantly, I thank my family, who provided the encouragement and patience that allowed me to make the necessary time commitments to create this book. I want especially to thank my wife, Deborah, without whose unwavering and loving support and advice this book would have not been possible. Though I am the named author, I cannot receive full credit for this book, as many others contributed to its creation. First, I want to thank those who gave of their time and energy to train me in the business of compensation consulting. Joe Bachelder, the preeminent employment law attorney based in New York City, provided me with a solid foundation in executive compensation, as well as a strong sense of how to build a world-class compensation consulting practice in my nine years with him. Bruce Benesh, David Leach, and Andrea Sellars have also helped me in my career and provided me with the opportunity to learn and progress in my career. Other influential people in my life and career, such as Bob Stucker, the other preeminent employment law attorney based in Chicago, have also taken their time to help me in various ways in my career. To these great professional service advisors, I give many thanks. Next, I offer unending thanks to my extremely competent subject matter editors, Timothy Burgard and Sheck Cho at John Wiley & Sons, who kept me on track and added immeasurably to the final product. Finally, I thank the CEOs, compensation committee members, and legal advisors of the companies I have had the good fortune to advise, who have provided a wealth of information that engendered this book.

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Preface This book is written for compensation committee members themselves; senior executives, such as the chief executive officer, general counsel, and chief financial officer, who interact with the committee; corporate staff that support the committee, such as the compensation manager and senior legal counsel; and outside professional advisors, such as legal advisors and compensation consultants. This is the first book of its kind, as it has assembled various information of concern to compensation committees all in one place. Certainly, there are books on finance, compensation, legal issues, and the recruitment and training of directors. Yet, this book puts all this information at the fingertips of the compensation committee member, management, and associated professional service advisors. All types of companies can use the information in this book. However, it focuses on the smaller and emerging company that needs to form a compensation committee with associated responsibilities, select and train members, conduct effective meetings, keep members abreast of current trends and events, and, most importantly, continually provide the best compensation programs given the short- and long-term business strategies. The mid- to large-sized companies can also benefit greatly from the information in this book, particularly the information on training of compensation committee members. This text provides a perspective that will help the members of the compensation committee develop the appropriate, requisite knowledge with respect to such matters as: • • • • •

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Understanding the role and responsibilities of the compensation committee. Reviewing alternative committee structure. Identifying the developments that affect compensation committee practices. Discovering the latest techniques and strategies for committee meetings. Understanding the latest, most authoritative sources that enable compensation committee members to develop a repertoire of effective strategies to help the board of directors discharge its fiduciary responsibility to the stockholders.

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• Developing a comprehensive professional development program that enables committee members to prepare a periodic assessment of their activities and an informed review of the compensation committee process. • Understanding the legal aspects of the compensation committee. The book is divided into four parts. Part One provides information on the compensation committee member’s basic responsibilities and includes discussions of corporate accountability; the various ways to organize a committee; the legal position of the compensation committee; and the recruitment, selection, and training of members. In addition, it covers the broad framework of accounting, tax, and securities rules, as well as the basics of compensation programs. Part Two covers five current issues: executive employment agreements, option repricing, reload stock options, pooling-of-interests accounting, and new accounting rules. Part Three puts it all together and relates how this book can be of use to the typical company, with specific emphasis on the small- to medium-sized company. It also gives the reader a glimpse into the future of compensation committees. Part Four provides detailed information on rules and regulations, comparison charts to monitor the progress of your compensation strategies, a comprehensive glossary, and resources to provide information and training to your compensation committee. The glossary is extremely comprehensive and includes information on finance, compensation, benefits, and legal issues that apply to compensation committees today. This book seeks to provide useful information and guidance for the compensation committee and to point out opportunities for legal advisors, consultants, and management to better serve the compensation committee.

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About the Author James F. Reda is a Principal and Compensation Practice Leader with Buck Consultants, Inc. in Atlanta. Jim works with organizations in planning, creating and implementing incentive programs as well as advising companies on senior executive employment arrangements, change-in-control metrics, business combinations, shareholder rights, and corporate governance issues, for both public and private companies. Mr. Reda has over 13 years of experience specifically in the area of senior executive compensation. He has completed over 1,000 consulting engagements and advised approximately 200 chief executive officers in matters concerning their compensation. Prior to rejoining Buck Consultants in 2000, Mr. Reda worked at two other large consulting firms. He began his consulting career at The Bachelder Group in 1987 where he worked nine years, and then at Buck Consultants in their New York City office. He has a BS degree in industrial engineering from Columbia University, Foo Foundation School of Engineering and Applied Science and a SM in management from Massachusetts Institute of Technology, Sloan School of Management. Mr. Reda is a member of the American Society of Corporate Secretaries, WorldatWork, The National Association of Stock Plan Professionals, National Association of Corporate Directors, and New York Society of Security Analysts, on which he serves on the Corporate Governance and Shareholders Rights Committee. He is President of the Atlanta Chapter of NACD and is also a member of the advisory board for the National Corporate Governance Center and the Executive Compensation Advisory Service Newsletter. He is also listed in the current edition of Who’s Who in America and Who’s Who in Finance and Industry. Jim is frequently quoted in Smart Money, USA Today, The Wall Street Journal, Business Week, Forbes, Investor Relations, EuroMoney, Financial Analyst’s Journal, Atlanta-Journal Constitution, Catalyst, Crain’s Business, The London Mail, Director’s Alert and The Conference Board publications. He has written numerous articles on executive compensation, stock award programs, new economy compensation, merger and acquisition issues, and compensation committees in publications such as The Corporate Board, Directorship, Directors & Boards, Journal of Deferred Compensation, ACA Journal, Director’s Monthly, Journal of Taxation of Employee Benefits, and Journal of Compensation & Benefits. viii

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Contents PART ONE BASIC RESPONSIBILITIES

1

Chapter 1

Structuring the Compensation Committee

3

Chapter 2

Selecting and Training Compensation Committee Members 25

Chapter 3

Responsibilities, Functions, and Roles of the Compensation Committee 55

Chapter 4

Legal and Regulatory Considerations

Chapter 5

Overview of Executive Compensation Issues and Strategies 98

89

PART TWO CURRENT ISSUES

131

Chapter 6

Repricing Stock Options

133

Chapter 7

Executive Employment Arrangements

Chapter 8

Reload Stock Options

Chapter 9

Pooling-of-Interests Accounting

Chapter 10

Accounting for Executive Stock Awards

143

154 163 175

ix

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x

Contents

PART THREE MAXIMIZING RESULTS

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Chapter 11

Compensation Committees as a Performance Tool, with Emphasis on Small to Mid-Sized Companies 185

Chapter 12

A Glimpse into the Future

194

PART FOUR SELECTED RESOURCES

219

Appendix A

Summary of Associated SEC Regulations, Rules, Schedules, and Forms 221

Appendix B

Summary of Accounting Standards

Appendix C

Definitions Pertaining to Tax Rules and Regulations 264

Appendix D

Organizations and Periodicals

Appendix E

List of Directors Colleges and Other Training Opportunities 282

Appendix F

Best Practices of a Typical Top-Performing Company 293

Glossary

297

Bibliography Index

351

343

247

269

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Part One

Basic Responsibilities

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Structuring the Compensation Committee One of the most important factors in the best-performing companies is the quality of the compensation committee. The committee is charged with putting into play one of the key principles of successful business leadership: designing and implementing compensation systems that make sense and that are tied to an organization’s well-conceived objectives. Outstanding, well-integrated compensation strategy does not just happen. Rather, it is the product of the hard work of independent, experienced compensation committee members. A well-designed incentive compensation program provides a sustainable strategic advantage for a company. As with any means of communication, the compensation system shapes and alters behaviors of the CEO and management in general. The key is to distill the essence of the business strategy and to provide an incentive system that will encourage direct participation in achievement of the core company objectives. The best practices of compensation committees may be found by reviewing the 100 best-performing companies, according to the annual Business Week survey. Of the 100 best-performing companies, all but one of the compensation committees was made up of independent outside directors. This is a must for companies large and small, as only outsiders can provide the independent review necessary to put the edge on a compensation strategy that will motivate the CEO in the best way possible. Your company may not expect to have someone on the board of directors who is also, for example, on the board of one of the largest banks. However, skillful executives from winning companies may be available, as well as leaders of successful smaller or regional companies. Their skills and knowledge of winning practices can help your company become an industry leader (and transform you and your executives into members coveted by other winning companies). Although the composition of the compensation committees of these 100 winning companies varied at least as widely as other facets of their compensation

3

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programs in a recent year, some common elements appeared. In fact, many compensation committee members themselves appeared as common elements among the winning companies. BOARD STRUCTURE Much of the public scrutiny of corporate governance issues over the past 20 years has focused on structural issues as they relate to corporate boards: questions related to board size and makeup; the splitting of the chair and chief executive officer positions; the composition and function of board committees; and finally, new efforts to create structures in which independent outside members can most readily assert their independence from corporate management. Even the courts, which largely focus on director decision making rather than structural issues, have contributed to the public debate concerning board structure, stating concerns over the composition and functioning of compensation committees, as well as other committees. This chapter briefly addresses structural issues; the size of the board; its composition; and the role of oversight committees such as the compensation committee. Finally, it examines several model corporate governance plans and the directions that they suggest for corporate governance in the future. COMPENSATION COMMITTEE SIZE AND MEMBER TERMS State law has little to say about the size of a board of directors, and even less about the size of its oversight committees such as the compensation committee. Some states still impose a minimum number of directors, whereas some do not. Therefore, it is possible that a company could be run by a one-person board. Most state statutory law leaves the size of the board to be set in the certificate of incorporation or the bylaws of the company. Common practice is to define the minimum and maximum number of directors that can constitute the board in the company’s certificate of incorporation, and provide that the exact number will be set in the bylaws or by resolution of the board. As a practical matter, most medium to large corporations work with a board that reflects a diversity of viewpoints and talents, but is still not so large as to frustrate the accomplishment of business at meetings. The National Association of Corporate Directors estimates that, on average, large publicly held companies are likely to have a board composed of three or four members. Of course, the optimal size of any board depends on the nature of the business of the company and the personalities of the members of the board. Lipton and Lorsch argue that the size of a board should be limited to a maximum of ten members, stating a preference for boards of eight or nine members. The Corporate Governance Guidebook suggests an emerging consensus that smaller

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Compensation Committee Size and Member Terms

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boards (defined as those with 12 or fewer members) function more effectively than larger boards. Similarly, other commentators suggest that smaller boards are likely to behave more cohesively. Small board size may allow more interchange among directors who might not otherwise have an opportunity to explain their views in detail in a larger group, given the limited time available for board meetings. In considering the appropriate size for the public company board, it is also advisable to include a sufficient number of independent directors to staff the “oversight” (e.g., compensation) committees. Under most state corporation statutes, the members of a board of directors ordinarily are elected to one-year terms of office. Similarly, every state except California provides the option to institute a “staggered” board of directors, whose members are ordinarily divided into three separate classes, with each class serving a three-year term. Typically, a nine-member staggered board will have three directors up for election each year. Staggered boards have been widely used to repel hostile takeovers and to discourage proxy contests, largely because most statutes that allow the device protect staggered boards by providing that they may be removed only for cause. Staggered boards also tend to promote stability in corporate affairs, because they make precipitous change in the majority of the membership of the board less likely. As a practical matter, eight to fifteen members for large, publicly held companies is probably about right. Fewer than eight directors cannot staff audit, compensation, nominating, and other committees with enough outside directors. More than 15 members, however, almost always diffuses and cuts into productive debate, as few board meetings last longer than four hours. Most compensation committees will work best if they are limited to no more than five members. With regard to compensation committees of the top- 100 most successful companies in 1999, the smallest committees had two members and the largest had eleven, as can be seen in Exhibit 1.1. The median committee size was four, and the table shows that more than half (59) of the companies had either three or four members on their compensation committees. Only six companies had committees that listed seven or more members (and these six may have used subcommittees for some tasks). Thus, the winning companies seem to have found that small groups are most effective at planing compensation practice—although the smaller groups may be less sure of persuading the entire board of directors to approve their plans and proposals. In February 1994, the directors of the General Motors Corporation (GM) issued guidelines on significant corporate governance issues, which, in part, defined the role of outside directors of the company in monitoring management. These guidelines have received widespread attention and were enthusiastically received by institutional shareholders and their advisors. The guidelines endorse the current six GM committees: Audit, Capital Stock, Director Affairs, Finance, Incentive and Compensation, and Public Policy. The

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Exhibit 1.1 Size of Compensation Committees Number of Compensation Committee Members

Percentage of Top-100 Most Successful Companies

1

0%

2

8%

3

29%

4

30%

5

14%

6

13%

7

4%

8

1%

9

0%

10

0%

11

1%

guidelines also suggest that committee memberships be rotated periodically at approximately five-year intervals, although the guidelines make clear that there may be reasons why an individual director should continue as a member of a particular committee for longer. Finally, the guidelines mandate that each committee is to prepare an agenda of subjects to be discussed at the beginning of each year (to the extent possible) and share the agenda with the entire board. The guidelines expressly reject the notion of term limits for directors. Nonetheless, they do acknowledge that the GM Committee on Director Affairs, in consultation with the CEO and chairperson of the board, will review each director’s continuation on the board every five years. The guidelines also reaffirm GM’s current board retirement age of 70.

BOARD COMPOSITION AND DIRECTOR INDEPENDENCE It has become customary to differentiate between board members as inside or outside directors, or—with somewhat more elegance and accuracy—as management or unaffiliated directors. The terms have no inherent legal significance by themselves; more important from a legal standpoint is whether directors are regarded as interested or independent with respect to a particular transaction.

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Board Composition and Director Independence

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Inside Directors Inside or management director simply refers to someone who is also employed in a managerial capacity by the corporation. The firm’s chief executive officer (CEO) is customarily a member of the board directors, often serving as its chair. A significant number of other companies have other executives on the board, although many limit the number of management directors. The precise makeup of the management representatives on the board varies. Some firms tend to pick from key operating personnel, such as division heads; others choose from senior corporate personnel, such as the vice president of finance or general counsel. Still others prefer some mix of managerial experience. In firms with a controlling shareholder or shareholder group—whether an individual, a corporation, or a family member—board representatives of the controlling shareholder or shareholder group should ordinarily be regarded as management directors, even though they hold no official position with the corporation. Outside Directors Whereas management directors bring expertise and current information to board discussions, unaffiliated or outside directors are expected to contribute the fresh and sometimes broader perspectives of those who are not so intimately involved in daily operations. From this standpoint, retired executives and those who serve the corporation in other capacities, such as lawyers or investment bankers, may be in a position to make valuable contributions to the board. Senior executives of other businesses or those who have distinguished themselves in other fields are especially valuable as outside directors because they serve two important functions: They enrich the board’s deliberations, and they will probably qualify as independent directors in any situation where that distinction becomes important. Because of the increasingly important role played by independent directors, most firms restrict the outside positions on their board to persons who have no other significant relationship, financial or otherwise, with the corporation. Independent Directors The term independent is used in two different contexts and is given a slightly different meaning in each. For transactions between the corporation and other directors or senior managers, independent is synonymous with disinterested and includes all directors who do not have a personal financial interest, direct or indirect, in the same transaction. For example, if an outside director sells property to the corporation, all other directors, inside or outside, are normally regarded as independent or disinterested for purposes of approving the corporation’s purchase.

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In other instances, independent includes only those directors who have no financial interest at stake and are completely free of management influence. It is prudent to assume that no inside director will be regarded as independent for purposes of approving transactions in which management or controlling shareholders may be regarded as interested, and serious questions will be raised regarding the independence of company retirees, lawyers, investment bankers, or others who have significant relationships with the corporation outside the boardroom. Only directors who meet the stricter requirements should serve on the compensation committee. The federal Securities and Exchange Commission (SEC) requires disclosure of conflicted directors for good reason. A board’s value always comes back to the individual. Not much else really matters. It is never a good idea to add a new board member who has a conflict or a potential conflict of interest. Certainly, it is not illegal to have conflicted, affiliated, or “gray” directors on a board, and it is far from uncommon to have a conflicted board. However, there are many advantages to a truly independent board. Affiliated directors are sometimes referred to as “6b” directors because of SEC Regulation 14A, Item 6(b), which requires that directors with such relationships be reported in the company’s proxy statement materials. Relationships that are considered conflicted relationships include: • Employment by the corporation or an affiliate within the last five years • Any family relationship by blood or marriage closer than second cousin • Affiliation with a concern in the last two years that has had a customer, supplier, broker, or creditor relationship with the corporation • Affiliation with an investment banker who has performed services for the company within two years or will do so within one year • A control person (based on amount of shareholdings as detailed in federal securities laws) • Association with a law firm engaged by the corporation As stated earlier, the list of affiliated directors includes your investment banker, your venture capital investors, your commercial banker, your lawyer, your accountant, your management consultant, and anyone else who stands to have his or her income affected by a decision of the board. It is not considered a conflict if directors are compensated for extra time spent carrying out their board duties. For instance, such arrangements were made with directors at Pharmacia & Upjohn, Johns Manville, Aetna, and Levitz Furniture for time-consuming succession planning efforts. Committee chairs typically receive extra “overtime” pay for spending more time in their duties as chairs.

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Board Composition and Director Independence

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The board should be composed entirely of outside directors (except for the CEO, of course). The overwhelming majority of compensation committees are composed of outside directors, because of the imposition of Internal Revenue Code (IRC) § 162(m) in 1992 that required an outside board to allow for full deduction of compensation of more than $1 million to a named executive officer of a publicly traded company. A study by the National Association of Corporate Directors (NACD), entitled 1999–2000 Public Company Governance Survey and published in October 1999, reported that 87 percent of all companies maintain a fully independent compensation committee. Of the top 100 most successful companies, only one CEO was on his own compensation committee. All other compensation committees are made up of independent directors. Who serves on these committees? Compensation committees include only members of boards of directors, who are generally experienced executives and others with distinguished service records. Many of the 100 winning companies used compensation committee members in common with the other winning companies. Some critics may view this sharing of members as contributing to the preservation of current authority. The consequence of this is that board members are at least nominally elected by the shareholders, and the major incentive plans themselves must be approved by the shareholders. Also, the returns to shareholders (as well as employment growth and customer approval expressed through purchases) of the 100 winning companies were more than satisfactory. Further, shared membership is advantageous in that it allows shared knowledge of methods that contribute to these success stories. The lists of interlocking CEO/compensation committee memberships, sorted in member order and in company order, give some indication of the extent of sharing among the 100 corporations: • Ten CEOs are on compensation committees of other winning companies (excluding Carnival Cruise Lines’ Mickey Arison, who is CEO and was on the compensation committee of that company). These executives obviously provide excellent opportunities for both companies involved to benefit from experience on winning teams. • Another 11 individuals are members of compensation committees of more than one winning company. Potential benefits are also apparent when examining the company list. Bank One, for instance, shares its CEO and two compensation committee members with General Dynamics, Masco, and Ameritech, which has a link to AON and, through AON, to Lucent Technologies. Here is a chance for a company in the staid banking industry to benefit from experience at some of the most successful technology companies in the country. Nearly one-third of the companies (31, again not counting Carnival) shared members on this select list alone. Clearly, at this level in the

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corporation and with these trusted members, they were not overly concerned that some other company will steal their secrets. The GM guidelines, along with the IRC requirements, had a dramatic impact on corporate governance in the United States. Because of broad institutional investor support for the guidelines, they were carefully considered and in some cases adopted, in whole or in part, at major corporations across the country. The guidelines suggest that outside directors play a significant role in corporate governance. The GM bylaws require that a majority of the board be outside directors. The guidelines go further and endorse the concept of lead director. This director is chosen by the outside directors only and has the responsibility for chairing meetings of outside directors, in addition to other functions that the outside directors may delegate. According to the 1999 NACD survey on corporate governance issues, the concepts of a separate lead director and chair appear to be waning. Based on the results of this survey, a rule of thumb is that out of ten boards, one will have a lead director and two will have a separate chairperson. The guidelines also mandate that the outside members of the board meet in executive session at least three times each year. Although the guidelines expressly state that the format of these meetings is to include a “discussion” with the chief executive officer on each occasion, the outside directors will be able to discuss company business outside the presence of management.

COMPENSATION COMMITTEE OVERVIEW The compensation committee is second only to the audit committee in its prevalence. A recent NACD study reflects that 97 percent of reporting companies have audit committees, and 91 percent have compensation committees*. The next most prevalent standing committee is the nominating committee, which is reported by 55 percent of companies. The primary purpose of the compensation committee is clear and not in dispute. Most commentators and practitioners agree that the compensation committee should have responsibility for approving and disapproving (or recommending approval or disapproval to the full board) the compensation arrangements for senior management of the corporation, and often the committee also addresses issues concerning compensation of the board itself. Although most commentators suggest that the compensation committee be comprised entirely of outside, independent directors (nonmanagement and not af*National Association of Corporate Directors. 1999–2000 Public Company Governance Survey. Washington, D.C.: NACD, 1999.

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Permissible Scope of Compensation Committee Activity

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filiated with the company), neither state nor federal law mandates that only nonmanagement directors serve on the committee. However, if the compensation committee does not have at least two outside directors (as defined earlier), the Internal Revenue Service (IRS) may not allow deduction of amounts over $1 million. This tax rule will be discussed later in greater detail. The work of the compensation committee has been the subject of intense public scrutiny by activist institutional investors since the early 1990s. This scrutiny has resulted in many shareholder proposals related to executive pay, including a large number that sought restrictions on additional disclosure about executive pay. Furthermore, these institutional investors also vote no on a substantial number of proposals for additional equity awards. In late 1992, the Securities and Exchange Commission amended its rules to require particular disclosure of certain relationships of members of the compensation committee, and for the first time imposed specific disclosure requirements on the compensation committees of public companies. Companies that are registered under the Securities Exchange Act of 1934, other than so-called “small business issuers,” are subject to the new regulations. The regulation requiring disclosure of certain relationships does not require that the compensation committee be comprised entirely of independent directors, but does require disclosure from any member who was, at any time during the preceding fiscal year, an officer or director of the company or any of its subsidiaries, who was formerly an officer of the company or its subsidiaries, or who had certain transactional relationships with the company. The regulations also require disclosure of other so-called “interlocks” when an executive officer of one company serves on the compensation committee of another company that has an executive officer on the first company’s board.

PERMISSIBLE SCOPE OF COMPENSATION COMMITTEE ACTIVITY Every state corporation statute authorizes the use of board committees. Many state corporation law statutes, notably that of Delaware, place certain restrictions on the scope of the activities that may be conducted by a committee of less than the entire board. Under Delaware law, a duly appointed committee may exercise all those powers delegated to it by the full board of directors (or provided for in the bylaws or certificate of incorporation) except as follows. No committee has the authority to: • Recommend that shareholders act to amend the certificate of incorporation of the company • Adopt a merger agreement

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• Recommend that shareholders approve the sale of all or substantially all of the corporation’s assets • Advise shareholders to vote to dissolve the corporation (or revoke its dissolution) or amend the bylaws of the corporation Apart from the limitations on significant corporate action, a committee of the board of directors may take any action that could be taken by the full board under Delaware law.

RESPONSIBILITIES AND ELECTION OF THE COMPENSATION COMMITTEE CHAIRPERSON The basic functions of the compensation committee chairperson are: • To present findings and recommendations to the board after reviewing and deciding upon matters that exert major influence on the manner in which the corporation’s executives are paid • To perform such duties as may be conferred by the full board The responsibilities of the board compensation committee chairperson are to: • Prepare the agenda for and convene and conduct regular and special meetings of the committee • Advise and give counsel to other board members of the corporation; review plans for major activities such as offsite visits and expert presentations; provide leadership in conformance with the board’s views on corporate compensation philosophy and policy • Carry out special assignments • Counsel collectively and individually with members of the board, utilizing their capacities to the fullest extent necessary to secure optimum benefits for the corporation • Nominate directors for committee assignments • Present any proposed changes in major policies of the corporation for board action • Retain and work with outside consultants, when necessary Members of the compensation committee should elect their own chair, as opposed to having the chair selected by the chief executive officer. Alternatively, outside directors may elect the chair of the compensation committee. In summary, the

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Procedural Voting Rules and Board Minutes

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compensation committee should be made up exclusively of independent outside directors selected by the outside directors and approved by the whole board. Some companies require that all outside directors approve any compensation committee action prior to approval by the whole board. Committee chairs are most often nominated by the CEO-chair (40 percent in 1999, up from 38 percent in 1997, according to the 1999 NACD survey). In some cases, though, members of the committee or the nominating committee select the committee chair. In some companies, as in the case of committee membership selection, the governance or human resources committee selects the committee chair.

PROCEDURAL VOTING RULES AND BOARD MINUTES Although some may view it as not important and obvious, committee procedural voting rules and recordkeeping issues can have an enormous impact on a company. This impact can be good or bad and the committee has substantial influence over the outcome. Importance of Compensation Committee Meeting Minutes It is very important that board members record their decisions in the minutes in a clear and concise manner. What actually happened in a meeting of a board ultimately consists of whatever the minutes say happened. Moreover, if the minutes are silent on an issue, the legal record states that it never arose. For example, if a director is not on record as abstaining from discussion, due to a conflict, one may assume that he or she was central to the discussion and was pivotal in the decision. Directors should never discuss board proceedings outside the boardroom. Such conversation, or worse, writings can be misinterpreted and used to undermine the official board minutes. As expert witnesses know from court proceedings and other situations requiring the interpretation of board or committee meeting minutes (such as when a company or the Internal Revenue Service tries to determine the intention of a board or committee), there are many instances in which minutes could be improved. Some ways to improve board or committee minutes are: • Minutes should state the discussion topic and the approximate time that the matter was considered by the board. Stay away from judgmental terms that may inaccurately characterize the type and nature of the discussion. For example, avoid phrases such as “after extensive discussion” or “concerns were voiced.” If approval of an item was unanimous, just say so and move on. There is no need to elaborate.

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• Make sure that both the board minutes and external statements are in harmony. It is also important, if material issues were raised in the board meeting, that these issues be disclosed to the public. • Most legal experts argue that it is not a good idea to allow board members to take their own notes during a board meeting. Most large publicly held companies also require that board members bring all materials to the board meeting and leave them behind. These notes and materials are destroyed on a routine basis, which leaves the minutes as the official record. If the minutes are lengthy and detailed, the board must have fully discussed the issue. If the minutes reflect a long discussion of why a decision was reached, then it can be assumed that the board had real doubt about the issue and its decision. This can be a boon to lawyers in a multitude of later legal disputes, including shareholder lawsuits relating to executive pay and fired executives’ suits against the company for lost compensation. The formal minutes are the legal record of a meeting. In court proceedings, discovery and deposition may turn up contradictory evidence, but it is very hard to refute clear, concise board minutes. This is why it is very important for directors not to make personal notes that survive the meeting. Parliamentary Rule of Order for Compensation Committee Meetings The compensation committee members must vote on most matters in their area of responsibility. It is very important that there be full and complete discussion of all matters coming to vote. The business judgment rule requires that the board be fully informed about the decision at hand and that the issues be fully discussed before a vote is taken on the resolution. It is also important that the compensation committee conduct meetings in an organized and predictable manner. Most people familiar with this issue reject Roberts’ Rules of Order as too formal and bound to detract from rather than enhance committee meetings. In place of the cumbersome Roberts rules, boards should construct basic procedures in board bylaws or charters that meet the needs of the committee. Here is a checklist of suggestions to improve committee meetings: ⻫

Specify a set of procedures and stick to them. It is both startling and horrifying to discover that most companies do not follow the parliamentary procedure specified in their bylaws. Committee members should find out what procedure is specified. If you do not like that particular set of procedures, change them. If you cannot change them, use them. This is another area that can be embarrassing and troublesome if raised in future legal proceedings.

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Groups of fewer than 12 (almost every compensation committee) can use a less formal set of parliamentary procedures and rules. For example, Roberts’ Rules of Order (1990 ed.) expressly permits a less formal set of rules for smaller boards. Examples of these parliamentarian-lite rules are as follows: • Members can make motions and speak while seated. • Motions need not be seconded. • The committee chair can speak without leaving his or her chair. • The committee chair can make its own motions and can vote on the motion. Allow adequate time for discussion and debate, but always keep in mind the need to dispose of the items on the agenda in an expeditious and thorough manner. For example, when voting, the chair should ask in advance if there are any objections to passing the motion with unanimous consent. If there are none, you can record the measure as passed unanimously. This keeps objections and debate out of the minutes, where they may create a record for future legal action. Minutes should focus on the result of the parliamentary discussion, not on the debate. This will also allow the efficient recording of minutes, and require less review when the board approves such minutes.

Other tips for effective board meetings and using procedural rules for the good of all, are as follows: ⻫

⻫

⻫

⻫

The chairperson should control the flow of the meeting. The power to set the agenda will set the tone of the meeting; the chair can encourage the committee to act, as well as divert ideas that will not further an efficient meeting. The chairperson should focus the committee on an issue. Committee discussions have a tendency to get off track by straying from the issue, or by repeating the same point without adding information. In the first case, the chair needs to remind the committee what they are voting on, the point made before the diversion, to encourage discussion to get back on track. In the second case, the chair should take over and remind the committee that unless there is any new information or discussion, the discussion must wrap up for an immediate vote. The chairperson may have to remind the members what the issue is and what they are voting on. In the worst case, the discussion goes so far off track that the committee members do not know what they are voting on. Assign a time in minutes for each agenda item. These minutes should reflect the relative importance and immediacy of each item. Another good idea is to request that each member keep his or her comments within a time limit (e.g., one or two minutes). This time limit will allow the chair to better control the flow and to reach an end of meaningful discussion. Some committees may

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agree that a particular issue needs more than the allocated time; thus, they will schedule a special conference-call meeting to allow a more full discussion of the issue, if they can put off a decision on this matter to a future date. To allow a complete discussion of the matter at hand, some companies formulate the committee motion prior to the committee meeting. This focuses discussion of the issue, as the committee members should be prepared in advance. The crafting of a motion can make a difference in the time required to discuss the issue and pass the motion.

DIVERSITY OF COMMITTEE MEMBERS Simply put, diversity of the compensation committee brings a variety of experiences and knowledge to bear on the issue before the committee. Some say that a diverse board is a stronger board, as decisions will be considered from a variety of perspectives. The move toward organizational diversity must begin with commitment and open-mindedness. As companies demand more of their board members, as Standard & Poors’ 500 stock index company directors become scarce, and as stockholders become more active in governance, the pressures are intensifying to diversify and broaden board membership. Diversity means that one has access to the best, period. It means that one is not arbitrarily limited to a single subset of one’s overall constituency. Major institutional investors are using diversity as a criterion in making or maintaining investment positions. For TIAA-CREF, diversity is a key investment criterion, because they believe a diverse board will be less beholden to management. They divide companies into four groups. The “in compliance” group consists of companies that have at least one woman or minority director or are about to nominate one to their boards. The “actively looking” group consists of companies who have hired an outside consultant/recruiting firm to recruit suitable women or minority board candidates. “Passively looking” describes firms seeking women or minority candidates without outside help. Finally, the “get lost” group is made up of companies who are not searching for minorities as directors. Companies continue to seek outside of their peer groups for qualified directors. According to the 1999 NACD survey, very few (6 percent in 1999, down from 16 percent in 1997) reported an all-CEO board. For most, less than 50 percent of their board members are current or retired CEOs. The remainder of companies in this survey indicated a preponderance but not a dominance of CEOs. The controversial practice of having one’s attorney as a director continues in some companies, but with decreasing frequency. Also, the practice of having constituency directors—board members named as representatives for a special interest group—is on the decline.

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The top two choices in 1999, as in the past two decades, for board service were senior managers with experience outside the company’s industry, followed by senior managers with experience inside the industry. Of course, outside experience may be more popular because of federal antitrust laws prohibiting director interlocks by competitors in some industries. The boardroom continues to be a male-dominated area. Although some survey results indicate a modest increase in the number of women on boards, other surveys show no gain in female representation on boards. In contrast, racial diversity has increased over the latter half of the 1990s. Professional expertise, gender, and race form only part of a director’s profile, however. Boards also look at character when building or helping to rebuild their boards.

EXAMPLES OF DIFFERENT COMPENSATION COMMITTEE STRUCTURES Indeed, independent oversight of compensation matters mixed with strong leadership will align pay and performance as much or more than any new form of compensation. Boards are reshaping themselves by creating oversight committees to cover human resource issues, staffing these committees with independent directors, and letting them do the good work of the board. In 1998 there was a movement to separate the positions of chair and chief executive officer, and a push for the concept of lead directors. Both of these concepts have since been superseded by strong, independent oversight at the committee level. A strong nominating committee is a key ingredient to effective management of human resources. How can we expect committees to do their work if they do not have experienced, intelligent, available, and (more importantly) independent outside directors who can properly evaluate the role of management in relation to shareholder value? The nominating committee, of course, searches for new committee members, evaluates current members for renomination to the board, and assigns or reassigns compensation committee members, including the chairperson. We are always reading about best practices as though there were only one kind of organization for the compensation committee. But surely boards vary. Certainly, there are different oversight formulas for different types of companies. Here is an outline of the predominant types of committee organization: • The compensation committee oversees senior executive compensation, director compensation, and associated retirement benefits. • The full board (steered by the group of outside directors) oversees senior executive succession planning.

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• The nominating committee oversees director nomination and renomination, committee assignment, selection of chairperson, and, in some cases, the director evaluation process. Another likely combination of duties and responsibilities is for the compensation committee to handle the duties listed here and also executive succession. Some of these duties, such as director selection and especially the selection of committee chairperson, should be assigned to the nominating committee. If there is no nominating committee, these duties should fall to an ad hoc committee of outside directors. Major committee oversight duties are as follows: • Executive pay • CEO only • Corporate officers only • All executive officers • Retirement, benefits, and perquisites • Nonqualified plans such as supplemental executive retirement plans, nonqualified deferred compensation, and pension restoration plans • All benefits offered by the company, including medical, life, accident, death, and disability (both short- and long-term) insurance; profit-sharing and savings plans, and employee stock purchase plans • Executive benefits such as supplemental medical coverage and supplemental life insurance • Perquisites such as club memberships, tax and estate tax planning, transportation conveyances, and other types of benefits reserved for senior executives • Stock award plans • Executive officers • Directors • All employees by plan year • Human resources issues • Discrimination, diversity, and equal opportunity issues • Director pay • Cash-based programs, retirement, and benefits • Stock programs • Executive succession • CEO only

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• Corporate officers only • All executive officers • Director evaluation issues The number and type of committees will determine the duties of the compensation committee. It is very possible to fully assign all of these responsibilities to the compensation committee. The first task is to determine what should be subject to the oversight of the board; the second task is to determine how to divide such responsibilities. As the scope of board oversight increases, the need to divide responsibilities also increases. For example, if it is determined that the board need only provide oversight for corporate officer pay, stock award plans as they relate to all executive officers, supplemental retirement and benefits, director pay, and CEO succession, it should be fairly easy to assign these responsibilities to the compensation committee. However, as board oversight is extended to include all executives, retirement plans, human resources issues, succession planning for all executive officers, and director evaluations, it may make sense to create additional committees and subdivide responsibilities accordingly. The decision as to how far board oversight should go also depends on a multitude of diverse factors, including: • The corporate culture • Strength of management • Number of outside directors and the maximum number of outside directors allowed by the certificate of incorporation and corporate bylaws • Regulatory environment • Current and past court actions • Prior corporate performance in these areas For example, if your company has recently been found to discriminate against minorities in hiring and promotion decisions, it may make sense to create a human resources committee, and charge that committee with overseeing and keeping track of such complaints and actions. This committee should consist of at least three outside directors. By far the most prevalent form of the committee with responsibility for executive compensation, stock awards, benefits, and other human resources issues is the “compensation committee.” According the NACD 1999 corporate governance survey, 91 percent refer to this committee as the “Compensation Committee”; 23 percent also have an “Employee Benefits Committee.”

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There are many ways to allocate the functions of a compensation committee. Some companies refer to the compensation committee as the human resources committee. Other companies maintain a stock option plan committee in addition to the compensation committee. This may be helpful for a larger board that can afford to assign a different set of independent directors to the stock option plan committee, while the board approves awards for employees below office level. In the case of emerging companies prior to the initial public offering, the board must approve all stock option awards. A well-organized compensation committee should be able to handle all aspects of the compensation planning and administration process. Of course, this may take time and planning on the part of the compensation committee. We present a typical compensation committee calendar later in this book. One of the most important duties of the board is succession planning, especially for the CEO, and her or his direct reports (e.g., CFO, COO, GC, etc.). Some boards delegate this important function to regular meetings of the outside directors. Other companies place this highly important responsibility with a compensation committee. Other types of committees appear in the lexicon of publicly held companies, such as human resources committee, stock award committee, salary committee, compensation and benefits committee, and succession planning committee. Of course, the most prevalent title for such a committee, as indicated earlier, is “compensation committee.” The following examples show how these other types of committees relate to other oversight committees of the board. A review of the various forms is included. Human Resources Committee—Emerson Electric Company Emerson Electric Company combines the term compensation with human resources, referring to this group as the compensation and human resources committee. The functions of the compensation and human resources committee are to review and approve: • • • •

Salaries of all officers of the company Salaries above a specified level to be paid to nonofficer employees Salaries of all division presidents Additional compensation plans

The compensation and human resources committee also does the following: • Grants awards under and administers the company’s stock option and incentive shares plans

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• Determines, if necessary, when service by officers and directors with another entity is eligible for indemnification under the company’s bylaws • Monitors the senior management and director succession plans and reviews new director nominees • Authorizes company contributions to benefit plans, and adopts and terminates benefit plans not the prerogative of management This committee consists of four outside directors, and they meet at each scheduled board meeting. Stock Award Committee—American Biltrite, Inc. and Rollins Truck Leasing Corp. Some companies have a stock option committee or an equity committee, which is substantially similar to the stock award committee. Two examples of such types of committees are discussed here. American Biltrite has a stock award committee in addition to a compensation committee. The company’s stock award committee consists of three outside directors. The function of the committee is to grant stock options and other employee incentives to executive officers of the company (including, without limitation, the company’s chief executive officer and the company’s four other most highly compensated officers). The compensation committee consists of three outside directors. The committee administers the company’s overall compensation strategy in an attempt to relate executive compensation appropriately to the company’s overall growth and success, to the executive’s duties, demonstrated abilities, and (as appropriate) to the performance of the operating division or subsidiary for which the executive is responsible. American Biltrite does not have a nominating committee. Rollins Truck has three committees that deal with compensation issues: executive, compensation, and stock option committees: • Executive committee—Has the power to exercise all of the powers and authority of the board of directors in the management of the business and affairs of the company in accordance with the provisions of the company’s bylaws. During the past fiscal year, the executive committee has performed all the functions of a compensation committee of the board of directors. • Compensation committee—Functions include the determination of salary, incentive, and other forms of compensation for key executives of the company, excluding stock options, which are granted and administered by the stock option committee.

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• Stock option committee—Administers the company’s outstanding stock option plans, including the granting of options to various employees of the company and its subsidiaries. Rollins Truck does not have a nominating committee of the board of directors. Salary Committee—United Parcel Service, Inc. United Parcel Service, Inc. (UPS) has an executive committee, an audit committee, a compensation committee, a salary committee, and a nominating committee. The primary responsibility of the compensation committee is to set the compensation of UPS’s chairperson and chief executive officer and to set the compensation of other executive officers based upon the recommendation of the chief executive officer. The committee is also responsible for administering the annual incentive plan. This committee, which was formerly known as the officer compensation committee, assumed its current name in 1999. The salary committee determines the compensation for all management employees other than executive officers. The compensation committee consists of three outside directors: the salary committee consists of two inside directors (chief executive officer and chief financial officer). Compensation and Employee Benefits Committee—AT&T Corp. and Becton, Dickinson & Company The key distinction is the addition of “employee benefits” in the title of the committee, and the additional responsibility for administration of benefits and benefits plans. The oversight task for the administration of employee benefits and benefit plans can be one of advising the full board of such plans, as in the case of AT&T, or that of being fully responsible for such plans, as for Becton, Dickinson (B&D). AT&T has established a number of committees, including a compensation and employee benefits committee and a governance and nominating committee. The compensation and employee benefits committee administers incentive compensation plans, including stock option plans, and informs and advises the board regarding employee benefit plans. The committee establishes the compensation structure for senior managers of the company and makes recommendations to the board with respect to compensation of the top five named executive officers. The committee consists of five nonemployee directors. The governance and nominating committee advises and makes recommendations to the board on all matters concerning directorship and corporate governance practices, including compensation of directors and the selection of candidates as

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nominees for election as directors. It also provides guidance with respect to matters of public policy. The committee consists of four nonemployee directors and one employee director. AT&T goes on to state, in a proxy statement: In recommending AT&T Board candidates, this committee seeks individuals of proven judgment and competence who are outstanding in their respective fields. The Committee considers such factors as experience, education, employment history, special talents or personal attributes, anticipated participation in AT&T Board activities, and geographic and other diversity factors. Shareholders who wish to recommend qualified candidates should write to the company stating in detail the qualifications of such persons for consideration by the committee.

B&D has created three committees to address corporate governance as it relates to human resources issues: the corporate responsibility committee, the compensation and benefits committee, and the corporate governance committee. Note that board oversight includes these functions: • Equal employment opportunity as part of the corporate responsibility committee. • The administration of employee benefits plans and benefits plans for the company as part of the compensation and benefits committee. • The performance of directors as part of the corporate governance committee. The following are excerpts from the company’s 1999 proxy statement filed with the Securities and Exchange Commission on December 17, 1999: The Corporate Responsibility Committee reviews the Company’s policies and procedures affecting its role as a responsible corporate citizen, including those relating to issues such as equal employment opportunity and community relations, as well as health, safety and environmental matters and proper business practices. . . . The Compensation and Benefits Committee reviews annually the overall compensation program for the Company’s corporate officers, approves the compensation of the executive officers and approves all employment and consulting contracts of the Company or any subsidiary with corporate officers who are not also directors. In addition, this Committee serves as the granting and administrative committee for the Company’s stock option plans and its Stock Award Plan. This Committee also oversees the administration of employee benefits and benefit plans for the Company. . . . The Corporate Governance Committee recommends candidates for election as directors to the Board. It also reviews and makes recommendations concerning the composition, organization, structure and function of the Board and its committees, as well as the performance and compensation of directors and other matters of corporate governance and board practices.

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Succession Planning Committee—Great Lakes Chemical Company Great Lakes Chemical has “Compensation and Incentive” and “Succession Planning” committees. The compensation and incentive committee makes recommendations to the board with respect to compensation for the corporation’s executives, and establishes eligibility and award levels under the corporation’s stock award program. The succession planning committee monitors and evaluates the corporation’s management resources, structure, succession planning, executive development, and selection processes. It recommends to the board criteria for board membership and identifies candidates for election as directors. It also considers candidates recommended by shareholders for election as directors. Any such recommendation is forwarded to the corporate secretary of the corporation.

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Chapter 2

Selecting and Training Compensation Committee Members The quality of board performance is intimately related to the quality of its outside directors. Nomination and selection of new compensation committee members is hard work, but can be very rewarding to the member, the board, the company, and the company’s constituencies. The selection of new compensation committee members is only the first step in developing a highly competent board member. The next steps are orientation and ongoing training of the compensation member. The company should be continually engaged in improving the compensation committee by improving the ability of the committee to make complex and important decisions regarding executive pay. The compensation committee not only relies on its members to assist in achieving its mission, but also relies on outside advisors. The selection of outside compensation consulting advisors is of utmost importance. NOMINATING COMMITTEE Every board should have a nominating committee, made up of entirely outside directors, to handle future board searches. According to a 1999 NACD survey, though, only about half of surveyed companies have nominating committees (55 percent). Such committees meet about twice per year. Moreover, 16 percent of companies have a corporate governance committee; 10 percent have both a nominating and a corporate governance committee. Thus, almost three-fifths of all companies (61 percent) have some form of nominating committee (National Association of Corporate Directors, 1999–2000 Public Company Governance Survey [Washington, D.C.: NACD, 1999]).

25

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In contrast with the other oversight committees, the focus of the nominating committee (also sometimes called the governance committee) is on the board itself. The committee’s principal responsibility is to devise criteria for board membership and to identify specific individuals for nomination to the board. The nominating committee may also be asked to devise methods for evaluating the performance of individual directors and to periodically review them and make recommendations regarding the size of the board, committee structure and committee assignments, and frequency of regular board and committee meetings. In some cases, the nominating committee also specifies the roles and responsibilities of each committee, in conjunction with the corporate bylaws and rules of incorporation. Although composition of the nominating committee is not subject to regulatory oversight, as is the case with the audit and compensation committees, the perceived independence and stature of its nominees will be enhanced if the majority of the committee consists of independent directors. As with other oversight committees, the nominating committee should solicit and give appropriate weight to recommendations of the chief executive officer on important matters. The 1999 NACD survey showed that a slight majority of all nominating committees are fully independent (57 percent). This is a substantial increase from 1997 (30 percent), and 1995 (27 percent), and it reflects the overall trend of board independence during that same period. CEO-chairpersons continue to play an important role in director selection, but they are increasingly unlikely to monopolize this important process, For example, as reported by the NACD survey, one-fourth (27 percent) of the CEOs surveyed identified themselves as the sole source of board nomination and selection. In 1997, this sole-source approach decreased by half (to 14 percent). In 1999, the number of CEOs going it alone on director selection halved again (to 7 percent.). Thus, the practice of the CEO-chair being the sole source of director nominations has dropped precipitously from 1995 to 1999, and is currently an unusual practice. The NACD survey goes on to show that a minority of companies reported using outside directors only to nominate directors (7 percent in 1999). The remainder use an independent board committee (e.g., nominating or corporate governance committee) with CEO input (46 percent), or the full board (39 percent). In the early 1990s, three major institutional investors—CalPERS, the New York State Retirement Fund, and the Connecticut State Treasurer—wrote to approximately 300 corporations in which they held stock, suggesting that future directors be nominated by nominating committees comprised solely of outside board members. Recently, Institutional Shareholder Services, a proxy voting advisory firm engaged by a large number of institutional investors, imposed a rule to recommend a “no” vote on any proposal favorable to management, as long as the company does not have an independent nominating committee. It is too early to tell how successful this initiative has been.

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NOMINATION AND SELECTION OF NEW COMPENSATION COMMITTEE MEMBERS Compensation committee members are drawn from the pool of outside directors. As discussed earlier, the minimum number of members is two, with an optimum number of approximately four. Compensation committee members are often chosen by the full board (41 percent, according to the 1999 NACD survey). A close second is for the CEO and/or chairman to make the choices (35 percent). Often substituting for the CEO is the nominating committee, now choosing members for board committees in nearly one out of four companies (24 percent). In a handful of cases, the governance or human resources committee does the selection. Committee chairs are most often nominated by the CEO-chairperson (40 percent in 1999) or the full board (29 percent). In some instances, members of the committee (18 percent) or the nominating committee (14 percent) select the chairperson. Finding and selecting outside directors is one of the most challenging and rewarding dimensions of building active compensation committees. Before you search for directors, you should develop a board prospectus. The board prospectus, which can be as short as a one- to three-page document and may take a few days to prepare, becomes useful almost immediately. It can be a helpful tool in recruiting director candidates, and it can assist the company in networking with lenders, advisers, and others who might know attractive director candidates. See Appendix 2A at the end of this chapter for a sample prospectus. The prospectus can also assist others who share the purpose of forming an independent and active board. It can be of great help in allaying doubts among key people who are unfamiliar with the board’s role or suspicious of others. The board prospectus should clearly describe the purpose and goals of the board. It should convey the qualities and capabilities the board is seeking in directors, and it should describe the board structure, director compensation, and time demands on members. Like the statement of corporate philosophy, the board prospectus should be a unique and distinctive document illuminating the culture, philosophy, and values of the company. Typically, this prospectus includes the information listed in Exhibit 2.1. The search for a new compensation committee member typically begins with the nominating committee, which requests candidates from the chief executive officer and other outside directors. The nominating committee should carefully evaluate each candidate. Politics, bolstering egos, repaying debts, conveying thanks, rewarding performance, and satisfying interest groups should not play a role in the selection of directors. Indeed, the nominating committee should select new board

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Exhibit 2.1 Typical Elements of a Board Prospectus I. Overview of the Company A. Industry B. Most important products and types of consumers C. Size D. List of major shareholders II. Board Profile A. Character of business • Stage of life cycle (rapidly growing, mature, no longer growing) • Relative strengths or weaknesses (highest quality producer in the region, need to develop more cost-conscious culture) • Strategic thrust (developing an international presence, seeking to grow by acquisition, committed to increasing market share) B. Purpose(s) of the board C. Personal criteria • Desired background, personal characteristics, and experience of board candidates III. Structure of the Board A. Number of outsiders and investor/shareholders on the board B. Number of meetings C. Time commitment D. Participation in committees or company activities E. Compensation F. Director liability provisions G. Term of office H. Mandatory retirement age or term limitations I. Powers of the nominating committee (if any)

members—and renominate existing board members, for that matter—with one purpose in mind: to meet the needs of the company. A typical outside, independent director search begins with an overview of the needs of the board based on major characteristics such as diversity, business sector (academic, public-service, business, not-for-profit, etc.), potential for future service, and major areas of expertise (if applicable). For example, recently a middlemarket financial data services firm began a search for two outside, independent directors to replace two retiring directors. They decided to search for two types of directors: the first was a minority female (diversity), and the second was an academic with strong technology skills (business sector and major areas of expertise). This specification allowed them to effectively communicate their needs to the general business community and really provided substantial definition of the new director candidates. Let us look at the strengths and weaknesses of various types of outside board candidates.

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Competitors

Competitors or potential competitors should never be directors, because of their obvious conflict of interest. Directors of competitors should also be ruled out. Another risk of seeking directors within the industry is that the CEO and the other board members reduce their chances of breaking out of traditional industry thinking—something they already know well. The board should seek fresh perspectives and new insights from directors, not an affirmation of what is already known. Some say the best place to find such insight is in different industries facing analogous challenges and problems. Consultants

Paid advisors are not usually good candidates for board service. The services of consultants are already available to the board, and they bring to the boardroom an inherent conflict of interest. The board can always invite trusted advisers to attend board sessions and treat them with as much respect and appreciation as they deserve. However, it is usually not necessary to make them directors to reap the benefits of their knowledge. Some boards make an exception for advisors who have broad exposure to top executives of a wide range of companies. These professionals often develop executive skills and can be a valuable resource, even if they lack experience starting or running a company. Paid advisors should not dominate the board, though. Friends

Trusted friends are not good choices as directors, either. Friends are harder to find than directors and their advice and counsel are usually freely available anyway. Why jeopardize a good friendship by subjecting it to the stresses of the boardroom? On a personal basis, one obstacle in recruiting your friends and acquaintances is that it is awkward (or impossible) to objectively interview and review their references. Yet, no board search is complete without an in-depth and objective interview with a comprehensive review of the directors’ references. Retirees

Another common temptation among boards is to focus on retirees as candidates. After all, many retirees are highly visible and available and have abundant experience. Although retirees can be excellent directors, the CEO should be cautious in overusing them. One risk, of course, is that many retirees eventually lose touch with the mainstream of business. Another drawback to a retiree candidate is that directorships can become too important to the retiree. If holding seats on corporate boards is a major source of ego support and stimulation, the retiree can become timid and too eager to please the

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chairperson and chief executive officer. This compulsion to please may compromise the independent contribution the retiree might otherwise make, and if unchecked may rise to the level of being a conflict of interest. Academics

The board should be equally cautious about packing the board with representatives of academic institutions. Certainly, academics can be an excellent source of intellectual capital, and they tend to be more available than chief executive officers. Nevertheless, the performance-driven corporate board runs a risk in selecting someone without experience in a profit-making organization. Academics can sometimes be excellent choices for a board that is in transition from an insider-dominated board to a more independent board. Academic leaders tend to be more tactful and effective in working with political factions. They certainly can stake out a position of being independent and nonaligned. In some cases, academic leaders find themselves in supreme mediator positions on a board. They can also act as a lightning rod for outside inquiry should the company become embroiled in a controversy. People Who Hold Other Directorships

People who have served on other boards, or outside boards of their own firms, are often the best director candidates. However, there is some disadvantage to experienced outside directors. Many of the issues that boards face are complex and time-consuming, as they require the integration of market, business, financial, and legal knowledge. Constraints on time can become a serious problem during a crisis, such as a hostile takeover. Clearly, a key issue to consider in the selection of board members is time availability. Certainly, board members who do not have time to attend critical board meetings and to undertake the necessary preparation for board meetings will contribute to an ineffective board. Clearly, committees enable directors to cope with two of the most important problems they face—the limited time they have available, and the complexity of the information with which they must work. In general, there is a positive relationship between board experience and board effectiveness. Yet, there is also a positive relationship between time available to attend and prepare for board meetings and board effectiveness. The question is whether the prospective director can effectively contribute to the board given their time constraints. At a minimum, to attend four meetings per year including travel to and from the meetings, and preparation for the meetings will take five to six days per year. However, to meet with senior management, visit company sites, attend training sessions, and take a leadership role for special projects, this time commitment can

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quickly balloon to 14 to 16 days, or even more, per year. This level of time commitment is far more than the minimum of five to six days, but the additional time spent can be crucial in determining success or failure when the board is making decisions on a crucial issue involving the strategic plan of the company. As a practical solution to this problem of time commitment, it is important that the board be classified as to those board members who have the time and are willing to commit it to the work of the board, and others. The others are more likely those that have demanding full-time positions, but sometimes they include those that have free time, but choose to use it for other purposes. A review of the available time of board members will reveal how much time availability is required from a new board member. In general, boards want to seek out a few individuals who have some slack time, most likely those who are retired or are about to retire, and who have substantial experience in areas of need of the board. However, if the board needs corporate finance expertise, it would not usually make sense to nominate a professor of computer technology with no prior board experience or corporate finance experience, no matter how much slack time they have. These decisions are not usually so clear as in this example. It is usually a matter of degree. That is, the professor of computer technology was an investment banker ten years ago, and is on the board of another company and has a working knowledge of corporate finance. It is not exactly what is needed, but it may satisfy the need. Having a few board members with slack time is especially important during a major crisis such as a legal investigation, a SEC investigation, a takeover bid, a major executive hiring/firing, or other situations that demand heavy board involvement for a period of time. A major, unexpected crisis, the deadlines imposed by laws and regulations, with external factors, and with great media attention, puts directors in the spotlight, obliging them to sacrifice other activities to meet their responsibilities. This is a practical problem of governance that cannot be avoided. Such directors are compelled to devote the time, regardless of personal or professional inconvenience, to deal with crises, particularly since their only compensation is a sense of accomplishment and personal learning as standard director compensation programs do provide for corresponding increased compensation in such situations. Board members who hold full-time jobs may have difficulty getting away for the days required to address a major issue. In contrast, directors who have slack in their schedules can often free up the time. It makes good sense to have a variety of individuals on the board, some of whom have full-time positions and some who have flexible schedules. Boards continue to believe in the value of outside board service, within limits. According to the NACD survey, only 1 percent (down from 3 percent in 1997) favor a zero boards policy. A limit of two outside boards, in addition to the current board opportunity (for a total of three outside boards), is about right. For retired

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CEOs, a total of four outside boards (one more than for a sitting CEO) is about right. As the number of outside board memberships increases, the learning opportunities afforded by board membership dim for the multiple-serving person. Other CEOs, Entrepreneurs, or Business Owners

Risk-taking peers often make the best directors. CEOs from other companies who have weathered crises, and surmounted the hurdles for their own companies, are the best candidates of all. However, the business owner should avoid any CEO on whose board he or she serves and any CEO who holds a directorship that overlaps with the owner’s on another board. Overlapping (or interlocking) directorships risk compromising the director’s independence and creating an incestuous situation. It only makes sense that if a director has, in the back of his or her mind, the relationship with the CEO as a director on another company’s board, that director may temper decisions and comments to protect that other relationship. A study by University of Illinois professor Kevin Hallock found that in companies with interlocking directorships, CEO compensation was up to 17 percent higher on average than in companies without interlocking directorships. Another issue that applies to director CEOs is the “kindred spirit” phenomenon. Because CEOs do not generally like their boards criticizing them, they are disinclined to be critical of the CEO on whose company board they service. FINDING CANDIDATES Quality boards and quality companies attract quality directors. To attract quality, directors should not have any worry about legal irregularities. There should also be outstanding outside advisors (Big Five accounting auditor, top legal advisor, and well-recognized compensation consultant). Make sure that directors never get surprised or blindsided. Diversity of industries represented on your board is also a big plus to attract senior executives from outside your industry. It is a real bonus when a CEO gets something out of board service that he or she can bring back to his or her company. These take-away nuggets of information can include ways to solve problems associated with people and new technology. The following factors attract good directors: • • • •

Quality of management. Ethics of the company. Prospect of serving with respected peers. Opportunity to learn—both personal learning and take-away learning.

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Using a Search Firm

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• Opportunity to make a difference—to make an impact on the future direction of an organization in a measurable way. • Opportunity to use what one knows. • Opportunity to network with top business leaders. • Ego gratification of serving in a prestigious and powerful position. • Compensation—but only as a measure. This is usually not an issue for qualified directors. Most companies pay within competitive practice according to company size and industry. • Entrepreneurial spirit; an opportunity to create something special. • Personal challenge. If your board is well positioned, and if director candidates are approached in the right way, you can attract outstanding and superlative directors. A proactive, enthusiastic approach goes a long way toward attracting world-class directors.

USING A SEARCH FIRM Search firms can be helpful, and a few conduct director searches on a regular basis. The company should be prepared to pay the equivalent of one year’s director’s fees for the service. Some companies value search firms because they can act as third-party recruiters, making it less awkward for both candidate and company to break off discussions if one party is not interested. A director search also takes a lot of time, when you take into account the basic research to find qualified candidates and the initial screening interviews. The initial screening interviews may take a great deal of time and effort to inform the board candidate about the opportunity. In practice, large publicly held companies use search consultants to find new directors. Conversely, small to mid-sized firms and private companies use search firms only sparingly. Experience with director candidate search practices showed that a substantial number of companies selected directors who were personally known to them. The next best source of referrals is board members of other companies or service professionals. You should also use professional trade organizations, such as the National Association of Corporate Directors, local chambers of commerce, business roundtables, and other similar organizations in your area, to find board candidates. However, you should approach the president of such an organization, as he or she has the visibility to recommend select members of the respective organizations, and prescreen them with the company before raising expectations of board service. Presidents of these organizations typically keep electronic copies of biographies for just

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this purpose. Also, the NACD has a directory service that it makes available for companies recruiting directors. This service is free and highly confidential. The use of a search firm may be critical when the board is moving to expand the board and include additional independent directors. This is especially the case when an external event triggers increased public and shareholder scrutiny. The amount of work and effort required in this situation most likely will warrant the engagement of a search consultant. A major reason for devoting resources to a new director search is the problem of poor directors. CEOs will tell you that the most formidable part of the entire governance issue is “firing” a director. This can be a very disruptive process. Extreme care should be taken to find the best-qualified directors for your firm. Search consultants can do the hard work of finding, evaluating, and serving up to the board a list of highly qualified candidates. Ultimately, you get what you ask for and the quality of the candidate is directly correlated to the amount of work put into the search. Too often, though, it takes a crisis before a company pays attention to its board. It is not unusual, in a typical search for a company in transition, to consider 20 to 25 candidates and derive a list of 3 to 5 finalists, all of whom are acceptable for board service. Next, the nominating committee (if one exists), a lead outside director, or an ad hoc committee reviews the list for those that may be intolerable, for one reason or another. It is also a good idea to have the CEO review this finalist list prior to the interview process. After that, the CEO and search firm should meet with the finalists. Some of the 3 to 5 candidates may drop out at the end of this review. A search for new board members can take nine to twelve months. This process can be shortened by (1) hiring a search firm, and (2) making board recruiting an ongoing process. Board members should always have three to five solid candidates in mind should the board need to expand or replace members. If you want an executive recruiter, it is always best to use a well-known, wellrecognized, objective recruiter. The advantages to outside recruiting are that it: • • • •

Allows you to proactively recruit to your strategic plan and your critical issues. Gives you access to the broadest spectrum of targeted best candidates. Allows you to move beyond your own circle of influence. Gives you access to a higher level of individual than is attainable through informal networks. • Provides a choice among highly qualified candidates. • Multiplies the search effort by reaching deep into the relationship network of the first-choice candidates. • Validates the board to potential director candidates.

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How To Approach Candidates

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• Validates the board to the company’s constituencies (e.g., shareholders, senior officers, alliance partners). • Provides an objective point of reference and interview process. • Promotes integrity, confidentiality, and discretion in the director search. • Increases efficiency for the CEO and existing directors, as they will not waste time on less qualified candidates. • Maintains and in most cases promotes the goodwill of the CEO, candidates, directors, and constituencies. The search committee’s time is best used to select among prequalified, available candidates, focusing on the culture, the fit, and the vision. An intermediary such as a search consultant (or lead director) validates the process, and, at the same time, demonstrates the company’s commitment and regard for the new board member.

HOW TO APPROACH CANDIDATES You have done the hard work of preparing to approach candidates, and you have a long list of prospects. What is the next step? Begin with the following questions to ask prospective compensation committee members: • Why do you want to serve on the compensation committee? • What is your opinion of our company? (Does the candidate have some knowledge of how you compete, how you market, who the competition is, who your customers are, what your critical issues are?) • How will you contribute to the board? Ask for clear and simple examples of how the candidate can contribute. • What are your specific areas of expertise? How will your expertise add value to the board? • What is your financial acumen? Each director need not be a certified public accountant. They must, however, have the ability to monitor and manage financial analysis. • How many other boards do you sit on? (List for profit and not-for-profit separately.) What role do you play on those boards? • What is your view of the role of the board, compensation committees, and corporate governance? • Do compensation committees add value? How? • What are the downsides of serving on the committee?

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• • • • • • •

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How do you use your board (if applicable)? What was your most rewarding experience with board service? How specifically have you added value? Give examples. What was your most difficult experience as a director? Are you willing to commit to the level of participation and support that we need? What other committees do you want to serve on? Why? What are your concerns?

CEO VETO CONCEPT Certainly, there is a trend for others beside the CEO to take the lead in nominating and renominating directors, assigning directors to oversight committees such as the compensation committee, and selecting committee chairs. However, the CEO should always have an opportunity to react to these decisions. The CEO should be especially cautious that all key constituencies are comfortable with the process. If the CEO senses that constituents do not trust this process to produce a good, trustworthy director, the CEO should advocate rejection of the candidate. The process works a little like jury selection, in that the CEO should have the ability to reject a certain number of the director candidates. This process helps ensure that the new board member will begin on a positive footing, as the CEO participated in their selection. At the same time, the CEO should guard against letting the director selection/ assignment process deteriorate into a battle among various constituencies or a popularity contest. This can yield a splintered board, with each director feeling a sense of responsibility to a particular shareholder group or other constituency, such as a related labor union, social cause, or the like. If left unchecked, such a board composition can cause major problems in the event of a shareholder dispute or a major external crisis. This can lead to utter gridlock in board decisions. Sometimes, the board can designate the corporate secretary, general counsel, search consultant, or outside legal counsel to act as an objective facilitator for the board selection process, to ensure that the selection/assignment process goes smoothly. HOW TO SAY NO Many boards worry about how to say no to candidates they have rejected. Saying no not only may be painful to the board, but may also result in a disaffected board candidate. A rigorous and thorough prescreening process will reduce the incidence of rejections. The board should not let the screening process go too far unless the

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board is strongly interested in the candidate. It would be a mistake, for example, to set up more than one meeting with a candidate, or to ask him or her to your company to “meet and greet” the board and senior executives, unless you are fairly certain that you want him or her as a director. When the time comes to say no, the best approach is to emphasize the goal you mentioned at the outset of the screening process: to select a complementary group of people with a mix of backgrounds and expertise to match the needs of the company.

MAKING THE FINAL SELECTION FOR BOARD NOMINATION AND COMMITTEE ASSIGNMENT In screening director candidates, the board above all should be both comfortable with and proud of the choices. Some of the most important qualities to consider are also the simplest. The candidate should evoke integrity, and he or she should be able to maintain confidentiality. The chemistry must be right. No matter how appealing a candidate’s background or experience, the existing board members should reject persons with whom they do not feel any affinity. Even if you cannot articulate the nagging feeling that a person is not quite right, trust your instincts and go with the feeling. The candidate should show candor, an eagerness to learn, and a lively interest in the business and work of the compensation committee. He or she should demonstrate a courage of conviction in readiness to say what he or she believes. The candidate should also demonstrate the kind of personality that can be effective in a boardroom setting—the ability to be a team player, for instance. The final selection should be from a group of director candidates who have been the subject of a comprehensive, intensive review. This review includes scrutiny of their background and experience, an exhaustive personal interview, and comparison of the findings with the needs of the board. As you can see, the process is both exhaustive and exhausting—but quite worth the effort, as this new board member and compensation committee member can make the difference in the company’s success or failure in the next three to five years. Remember, every compensation committee member you recruit is a reason for other members to stay . . . or to stay away. Identifying and selecting directors for an active outside board can be both stimulating and challenging, and the process may take several months to complete. There are six major criteria to consider in your search for a new compensation committee member: 1. Availability. The issue of a candidate’s ability to help your board versus the availability for service is always present. The Walt Disney Company board has

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very publicly announced that they value availability and intelligence more than any other criteria, as its board is made up of nontraditional board members who have a direct relationship to the chairman. Michael Eisner has stated that some of these board members put in 30 hours per month on board duties. Indeed, you will not be able to get 30 hours of work from a CEO of a major company who sits on two other boards. You will be fortunate to get 5 hours per month. 2. Intelligence. Intelligence is impossible to fake and is very scarce. An intelligent director may offer a fresh look at an old problem. In some cases, an inexperienced yet highly intelligent director can really move the issue forward and provide a breakthrough idea. Should you have an intelligent and available director who is not experienced in your business sector, or even with board service, you may be able to provide additional education and training opportunities to make him or her more effective as a director. This training might include an intensive introduction to the workings of the company and/or the industry, and a three-day director training session. These sessions are offered by many educational institutions, such as Harvard, Wharton, University of Chicago, Stanford, Yale, and Duke University. Other universities, such as University of Georgia and Emory, are planning to provide high-quality director education courses through their executive education departments. 3. Reputation. Reputation is especially important when selecting an independent, outside director for an emerging company, a company that is in a turnaround situation, or a company that is moving toward a broadly held shareholder base or heavily concentrated institutional shareholder holdings. Usually, there is a tradeoff between reputation and availability. You must determine what is important to your board. Reputation is always hard to measure. However, a good place to start is to determine the number of books, articles, feature articles, and references to the candidate in the media. (Of course, the media exposure has to be categorized as favorable or unfavorable!) Next, a representative of your company should check the references of the outside director candidate, and also check with senior people in the candidate’s own field. For example, if you are assessing the reputation of a lawyer, you might call a prominent law school dean who is a personal friend and ask whether he or she has heard of the lawyer, the lawyer’s work, important cases that the firm is involved with, and the firm. These phone calls should be made by a senior representative because the calls are being made to senior people who are the pillars of their respective fields. Please keep in mind, though, that professional jealousy may creep into comments made by other professionals in the same or similar field of work. 4. Communication skills. The ability to communicate, especially verbally in a group setting, is an extremely important criterion and valuable skill, which should be assessed by the personal interview. It is sometimes dangerous to assume, if someone is a polished public speaker, that he or she is also an effective communicator in a group setting when discussing a difficult issue on a extemporaneous basis.

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5. Experience. There are three major types of experience that could be helpful to your board: (1) direct experience in your industry; (2) board experience as an outside, independent director; and (3) high-level managerial experience, such as chief executive officer of a substantial company. The weight placed on each of these factors depends on your needs, other board candidates, and the urgency of finding a new board member. Board experience is usually the most important experience factor, as it usually cuts down the training time. High-level management experience (which almost always comes with a board seat, albeit an inside director seat) is a close second. Direct experience in the industry is usually the third most important experience factor, for three main reasons: (a) Directors who are highly knowledgeable about your industry are most likely affiliated with a competitor, which will usually disqualify them from further consideration for board candidacy. (b) Other directors on the board will have direct experience in your industry. (c) New directors can learn what they need to know about your industry through on-the-job training and seminars. Of course, if a potential director does not have experience in any of these three areas, he or she would not be an ideal board candidate. One exception could be retiring military leaders. In this case, they will have to immerse themselves in business life anyway, so they will be receiving substantial training. As a rule of thumb for planning purposes, allow an additional three days of training activities per year for each type of experience that is lacking. 6. Leverage. Leverage, as used here, is the ability of the director to (a) expand the relationships of the board, such as an investment banker who can expand the company’s relationship with capital markets; and (b) provide additional management expertise in areas identified as lacking, such as marketing in the case of an industrial company expanding into consumer products. In some cases, especially for emerging companies or companies that are remaking themselves, leverage is a very important factor. To organize your evaluation of each director, you could rank the criteria and then rank the candidates. An illustration of this evaluation for the following example appears in Exhibit 2.2. A middle-market, publicly held company is searching for an outside director. They already have a stellar board consisting of high-profile, professional directors drawn from locally based, large, publicly traded companies. One of the reasons for the new board member search is that one recently retired director has agreed also to retire from the company’s board. This retired CEO was also chair of the compensation committee. One issue has been that the compensation committee chair did not have the appropriate amount of time to devote to her duties as chairperson.

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Exhibit 2.2 Illustration of a Candidate Evaluation Summary

Weight

Outside Director Candidates A B C

D

Availability

10

4

10

7

9

Communication skills

10

8

6

8

7

Intelligence

8

6

10

10

6

Reputation

7

8

4

7

7

Experience

4

10

4

6

8

Leverage

2

8

3

7

4

410

280

290

317

297

Total weighted score (weight times score)

The nominating committee of this board decides that the new outside director must have available time to serve the board. They are searching for a highly intelligent director with an outstanding reputation in his or her chosen career. Experience and leverage are not strong criteria. The candidates that made the final cut were as follows: • Candidate A. The CEO successor to the retiring board member. This candidate came from outside the company and even outside the local area. He is very well regarded and gets high marks for experience. • Candidate B. A business school professor in her mid-forties. She has a moderately successful academic career, and has a Ph.D. in economics from Stanford University. She has very little experience except that she has served as a department chair for her college. • Candidate C. A local lawyer who does no work for the company and specializes in intellectual property law (a particularly important matter with the company). This lawyer also serves on the board of another publicly held company. She is a Rhodes Scholar who graduated first in her class at Harvard University. She also has served as head of her law firm’s executive committee. • Candidate D. A prematurely retired senior executive from a very large local company. This executive went on to run an emerging company for two years, and has since left that firm. He is in his late fifties, currently serves on two boards, and wants to serve on one more to round out his work schedule. According to Exhibit 2.2, candidate C is the best qualified, closely followed by candidates B and D. Although candidate C does not have as much availability as B or D, she ranks high in intelligence and moderately high in reputation. Note that these weighted scores are in comparison to a maximum of 410.

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WHAT IF THE NEW DIRECTOR DOES NOT WORK OUT? Despite the favorable odds associated with a well-planned and well-thought-out director search or committee assignment, boards sometimes make mistakes in selecting or assigning directors. Errors usually do not become clear immediately. It typically takes a year or two for a board to conclude that a director simply is not making a contribution. A director evaluation process will greatly assist in making this determination. Once mistakes are discovered, some boards act promptly. Generally, most boards replace a director when they become dissatisfied, however uncomfortable that process may be. Most boards find the best way to deal with mistakes is to approach the candidate directly and ask him or her to step down. Sometimes the board can explain to the director that the needs of the business are changing and that skills and background different from his or her own are needed on the board. Other times, the board has to say, more directly, “Look, we really appreciate your contribution, but we just don’t feel this is working out as we had planned. Please accept our appreciation for all that you have done.” In other cases, boards turn to professional advisers when remaking their boards, particularly if more than one director must be removed. Executive search recruiters and boutique firms have this capability. In some cases, they not only perform the director assessment, they also meet with the soon-to-be-removed director to take some pressure off the board in this highly delicate situation. In most cases, it makes sense for the board member not to stand for reelection when his or her term is up (typically, a three-year term). A well-thought-out “public” reason, such as the need to focus on a primary business, cut down travel, spend more time with family, and so on, will make it easier for both the director and the company.

BENEFITS OF AN EDUCATED BOARD The impact of boards is vast and not restricted to the company on which the board member serves. It is critical that a board member be able to discuss a multitude of complicated issues that in most cases require substantial preparation. Board members must work just to stay in the same position relative to the level of required knowledge. Membership on a board is more than just a position of honor; it is a profound trust, and effective participation on a board is something that can be learned. The education of board members should be ongoing for several reasons: • Organizations are complex and changing; boards need to adapt to new technologies, new methods of operation, and new developments in their fields.

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• The role of board members changes along with the organization they serve. • New approaches to effective organizational leadership and governance (e.g., CEO and board evaluations, organization of the board, etc.) continually arise. Although boards generally expect their organizations’ staffs to be professionally trained, it is important that board members enhance their own leadership skills and competencies and increase their knowledge through systematic training. This improvement in board members’ skills results in an organization better able to serve its shareholders and other interested parties such as employees, suppliers, and the communities of which they are a part. ORIENTATION OF NEW MEMBERS The director recruitment process is actually the initial stage of orientation. Some boards collapse the orientation into a brief form to be completed by the new director, quick introductions to other board members and management, and a summary of the logistics of conducting a board meeting. However, does it not make sense for the new director to know the company’s market space, its people, its facilities, and current issues before voting on policies affecting the company? Even with thorough training, it takes about a year for a director to reach her or his capacity as a compensation committee member. Without this type of training, it may take longer than a year. Prospective board members should be introduced to the organization’s mission, goals, products, services, and programs, as well as to the role of the board of directors. Some organizations conduct orientation sessions for prospective members; others hold them for new members only after they have joined the board. The purpose of board orientation is to give new members information about the organization’s operations and programs, to clarify their roles as board members. It is important that the background knowledge of a new director be carefully assessed. This is especially true for the chairperson. Some boards require the chair to be selected from current compensation committee members who have at least one year of service. Outside consultants are a great source of training. A large percentage of companies provide training as part of the board meeting process. A typical board schedule would be for the compensation committee to convene for dinner the evening before the compensation committee meeting, which in turn is followed by the board meeting. For example, say the compensation committee meets four times per year. The first meeting may be attended by the firm’s outside benefits counsel, who will brief the members on latest developments that may affect the company in the area of pension and benefits. The second meeting may include the outside compensation con-

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sultant. The third meeting may feature the firm’s actuary. The fourth meeting may host a business school professor. Some large companies literally have a checklist for new board members to ensure that they spend time with various executives throughout the firm, especially legal counsel, human resources executives, and the corporate secretary. Other companies provide paid educational opportunities for directors to attend training sessions offered by major universities and organizations such as the National Association of Corporate Directors. Because of the high-level nature of such meetings, a senior staff officer (such as the corporate secretary or the general counsel) should personally oversee and manage this process. This level of oversight will ensure that the proper attention is paid to the process. This behind-the-scenes maestro has the power of the editor, who assembles the board and agenda materials, the person who knows how to reach every director at all times, and who makes the compensation committee run smoothly. A planned, systematic approach to orientation is best. Exhibit 2.3 suggests one approach that can be modified to suit different circumstances.

Exhibit 2.3 Suggestions for Director Orientation Program I. Plan the orientation program. A. During recruitment, prospects should have learned what is generally expected of them as members of the board of directors. The board’s written job description should include a statement that participation in orientation is mandatory, so it will not come as a surprise when one or two days (not necessarily consecutive) are spent on orientation activities. B. Plan the distribution of materials in accordance with each orientation activity. Too much written material too soon is overwhelming. For example, it is not necessary to hand out product/service brochures and information on employees and clients until the tour of the company’s headquarter facilities. C. Use the background data gathered during recruitment to tailor presentations according to the new member’s personal and professional interests. D. Consider assigning a sponsor (a more experienced board member) to each new member; make sure the purpose of this relationship is clear to both board members. II. Orient new members to the organization. A. Schedule a meeting with the chief executive officer. Of course, the new board member would have met the chief executive officer during the recruitment process. This conference gives the new board member an opportunity to ask specific questions about the organization’s operations, culture, and most important current issues. For the chief executive officer, meeting with new board members provides a chance to establish a good working relationship early on. (continued)

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Exhibit 2.3 Continued B. Board members will be called upon to make decisions regarding the company’s physical plant and employees, so onsite visits are vital to the role of the director. With this in mind, plan a tour of the company. If the organization is a far-flung, worldwide organization, as are most large companies, visit one facility of every type (e.g., factory, headquarters building, training facility, sales office, distribution warehouse, etc.). Even if the organization is not a facility-based business, a visit to the office where the organization conducts its business is highly recommended. Over a longer period of time, board members should visit a large number of facilities. C. Prepare a brief two- or three-page synopsis of key organizational demographics: number of clients/employees/suppliers, company milestones, major changes over the past five to ten years, executive officer roster (with photos and detailed biographies), trends, and other appropriate data to supplement oral presentations. D. Arrange for new members to attend a CEO staff meeting or briefing session by the CEO’s staff. They should have the opportunity to meet other key personnel, learn about their respective areas of responsibility, and ask questions. III. Orient members to the board. A. Have the board chairperson make a welcoming call or visit to all new members. B. Distribute a biographical sketch of the new member to the full board, including the member’s terms on the board, offices held, committee assignments, places and positions of employment, addresses and telephone numbers, and other relevant information. C. Hold an informal social function to help integrate new members with the rest of the board. D. Schedule a meeting for all new board members with the executive committee and other committee chairpersons. This gives newcomers an opportunity to become acquainted with the board’s leadership and with the activities of the committees. A discussion of board procedures; directors’ roles, responsibilities, and liabilities; and major issues facing the organization provides new members with additional perspectives on the whole organization. E. Distribute the board manual (or briefing book) to the new director. The manual should include information as follows: 1. Organization chart, with biographies 2. Mission statements 3. Strategic plans 4. Proxy statement and prospectus, if applicable 5. Core strategies 6. Company history 7. Board materials, including the board charter, structure, needs matrix, directors’ biographies, meeting dates, locations, committee assignments, summaries and processes, and profiles for any open board seats 8. Marketing materials 9. Customer profiles 10. Articles, information sources on the industry 11. Competition data

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Exhibit 2.3 Continued 12. Financial statements 13. Insider trading policy 14. Analyst reports 15. Corporate bylaws and compensation committee bylaws 16. Corporate calendar 17. Board and committee meeting minutes 18. Director compensation package 19. Director evaluation program (if any) 20. Succession plan (if any) 21. Short-term and long-term incentive plans F. Provide time for a debriefing among the new members, board chairperson, and chief executive officer so any remaining questions and concerns can be clarified before they become larger issues later on. Debriefing sessions also can be an opportunity to ask new board members which parts of the orientation were most helpful, which were the least helpful, and how future board orientations might be improved.

Large, multinational U.S. corporations typically have a one-year director orientation, during which they meet with the new director to answer any questions about the board, its members, support staff, and any other issues of concern. In addition, they schedule a one-on-one meeting (usually at breakfast, lunch, or dinner) with each of the top executive officers (approximately 10 to 12 meetings). The scheduling of these meetings, especially if more than one new director is going through the orientation process, is a time-consuming and complicated effort. The ultimate example of a company encouraging board members to visit its sites is Home Depot, which requires directors to visit at least 20 stores a year. Each visit takes about two hours.

TRAINING AND SUSTAINING COMPENSATION COMMITTEE MEMBERS New member orientation is only the first phase in the board member’s education and development. It is followed by systematic communications between the board and organization’s staff, regularly scheduled retreats or renewal sessions, and occasional training programs or workshops on special topics. New member orientation topics should revolve around emerging trends, and include sessions aimed at moving a director to a better understanding of technologies vital to the company’s success. A medium-sized or large board can charge its nominating/development committee with the responsibility for board education. A

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smaller board may elect to form an ad hoc committee to plan board educational activities as needed. Either type of planning group can more effectively fulfill its function by adhering to the following principles of board development: • Carefully formulate a purpose for all board development activities. • Set realistic training objectives. • When planning an activity, consider the unique needs and interests of all members of the board. • Consider different types of development activities, such as in-house training, guest speakers or consultants, and workshops or conferences. • Evaluate each educational activity. The full board should be involved in the selection of issues to be addressed in board development training; the committee should set specific training objectives, decide on appropriate content and formats, manage the logistics, and perform other related tasks. Approaching board development in this way increases the likelihood of full participation. In addition to helping a board learn how to operate more effectively, a good program of board development sustains members’ interest in the organization and in the board. When board members are well informed and trained to carry out the board’s primary functions, they are more comfortable with, and are more likely to remain committed to, their roles. The use of a development program by a board sends a positive message to its members that the organization values their contributions enough to invest extra time and funds. Development programs give board members an opportunity for self-renewal and for quality time away from business as usual. In short, the ongoing education of a board is an excellent strategy for nurturing and motivating board members. A development program can also include the introduction of an outside advisor/expert at each board meeting. This introduction should also include participation in a dinner or lunch with the directors. Introduction of the outside advisor/ expert in this way fosters trust and cooperation among the board members, corporate staff, and outside advisor/expert. For example, here is an illustration of an outside advisor/expert introduction schedule: January April June September November

Executive Compensation Consultant Outside Legal Counsel Outside Auditor Engagement Partner Leading Expert on Corporate Governance Prominent Business School Professor

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Other areas of continual development are as follows: • • • • • •

Information directors should have Exposing directors to the company’s industry and business Providing effective reports Encouraging site visits Communicating between meetings Briefing directors on technology

EXPERT/OUTSIDE ADVISORS Outside advisors to compensation committees are on the increase. A growing number of shareholders, especially institutional investors, are requesting that compensation committees engage an outside compensation advisor to assist in their review of compensation matters. The shift toward outside advice to compensation committees began in 1992 with the introduction of IRC § 162(m), which (among other initiatives) requires that the compensation committee be comprised of at least two outside, independent directors. Shareholders are wary of work product provided by compensation consultants who are engaged by management, and argue that the compensation committee should be as well. Some shareholder advisors would prefer that the compensation consultant be engaged by and work for the board. The result may be that the compensation consultant owes its allegiance to the board and not management, thus moderating the growth in executive pay. Outside consultants are used to validate pay scales and performance awards and thereby help to protect directors from lawsuits. Some critics, though, perceive that the role of outside consultants is simply to advocate higher pay for management. Other arguments are that consultants will always try to avoid conflict with management, and thus will not present a well-balanced report of compensation. This criticism points out that the outside compensation consultant should be engaged by the compensation committee. Furthermore, at the end of the day, it is the job of the compensation committee to make the decision on pay, not of the outside compensation consultant. The search for such an advisor should start with an intensive and objective analysis following a thorough search of pertinent facts. Reliance on expert advice and competent, independent, and unbiased research is necessary to select an expert outside advisor. Board members are not expected to be experts in all areas of compensation. Most state laws expressly allow directors to rely upon information and advice provided by experts.

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Fair data interpretation and tabulation are essential, and presentation/report formatting is critical. The compensation committee could certainly take on more responsibility. Current compensation committees occupy themselves with how much top management should be paid, the proportion represented by salary, and the formulas used to govern short-term and long-term incentives such as stock options. Yet there are many ways to perform these duties more effectively. The outside compensation consultant should be hired by and work for the compensation committee, not the human resources officer, as is almost always the case. The consultants will thus be less likely to make recommendations that favor management. SELECTING AN OUTSIDE COMPENSATION CONSULTANT Outside advisors should possess characteristics, capabilities, knowledge, and skills as follows: • Industry expertise. This expertise should include a solid understanding of the overall industry, its competitive market forces, key dynamics that influence the individual company, overall industry performance, and the competitive talent pools. • Direct and relevant experience. Advisors should be highly experienced and have successful track records in assisting similar companies. The prospective consultant should have at least 10 years of executive compensation consulting experience. • Executive compensation consulting resources. The firm should have an extensive survey library, data resources, and, most importantly, secondary consulting resources in the event the lead consultant is not available. • Visibility, publications, and good reputation. The consulting firm and lead consultant should be nationally recognized, well published, and well regarded. Ask whether the firm sponsors national conferences, and if the lead consultant presents at national conferences and on what subjects. The two major conferences for compensation are those of the World at Work and the National Association of Stock Plan Professionals. • Seamless integration of resources. The lead consultant and consulting firm should be able to deliver accounting, tax, actuarial, financial, pension, and personal financial advice in a seamless manner. If your company has international operations, you should also include international consulting services. • Nationwide and worldwide coverage. If your company has multiple locations in the United States, or in more than one country, inquire about the consultant’s number of offices, both inside and outside of the United States. You should also

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•

•

•

•

49

inquire about whether other countries will have the appropriate consulting services, according to need. Proficiency in all elements of total compensation. Ask questions about the consulting firm and consultant’s knowledge of salary, short-term incentive programs, long-term incentive programs, benefits, perquisites, and retirement programs. It is unlikely that you will find a single consultant who is proficient on all elements of total compensation; however, the consultant should be able to access expertise in the other areas of compensation. Also, ask about surveys and other data sources produced by the consulting firm. Business goals and executive compensation strategy alignment. Ask about the philosophy of the consulting firm and check for compatibility with the company’s philosophy. Some consultants and consulting firms have a specific philosophy and approach toward compensation and will not alter their views. This may put the consultant in conflict with the committee. Performance measurement expertise. The consultant must be expert at interpreting financial statements and correctly applying financial ratios and measures in light of the industry, business plans, and other pertinent facts and circumstances. Creativity and capability to create custom designs. The consulting firm must be able to provide creative solutions in light of shifting economic trends and business models.

The compensation committee can increase the likelihood that its reliance on expert advice will be protected under the business judgment rule by first getting the best consultant. Assure that the person or firm advising the committee has recognized expertise in the executive compensation field. Second, listen carefully to the consultant. Consider the advice provided so that the committee is in a position to determine if it may be relied upon.

GENERAL DIFFERENCES AMONG TYPES OF COMPENSATION EXPERTS The compensation committee should select, hire, manage, and control the work of the outside compensation consultant in almost every case. The committee chairperson should retain full control over the entire consultative process. Management’s representatives (internal corporate human resources staff such as compensation professionals) should participate in this process in a collaborative and nonconfrontational manner. One helpful quality of the outside compensation consultant is the ability to get along with board members as well as management and management’s representatives. Large companies tend to use more than one outside consultant, to seek second

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opinions and enhance the objectivity of the consultative process. It may also be a good idea to occasionally try new consultants for stand-alone, independent projects for fresh opinions and outlook. Some firms even give the same project to two different consulting firms and compare the suggestions. The choice of consulting firms is very important. Before a specific firm can be selected, the type of professional services firm should be considered. Consulting firms are very different. Part of the difference is attributable to the type of professional service firm, its size and breadth, and its underlying philosophy. A summary of the various types of firms, general advantages, and general disadvantages follows. Law Firm

A law firm can provide a thorough knowledge of corporate legal and regulatory requirements, employment contracts, and technical plan document expertise. They are also very helpful in tax-related matters, and issues concerning proper corporate records. However, there may be a conflict of interest for a law firm used in this way. In addition, a law firm’s focus may be too narrow, and they will not have a command of best practices. Finally, they are not expert in areas related to compensation plans and methodologies. Human Resources/General Compensation and Benefits Firm

These types of firms can provide services at a lower cost per hour, because of their sharp focus, lower entry requirements, and lower overhead. In addition, these firms can provide actuarial, benefits, compensation, and organizational dynamics advice; outsourcing of human resources functions; pension plan advice; merger and acquisition services; and employee communications advice. These firms may not be specialized enough in technical/regulatory areas. Also, their legal advice will not be as rich as that of a law firm, particularly as to technical tax and contract law matters. Specialized Executive Compensation Consulting Firm, Group, or Individual

In some cases, specialized entities can emerge from a larger law, accounting, or other type of professional services firm. These firms can be very effective and helpful to compensation committees. They have experienced and senior staff. They are also very independent and thus are less likely to have a conflict of interest, as might a law or accounting firm. These kinds of firms have a tendency to overbook their time, as they do not have multiple U.S. offices and extensive staff. They usually charge very high rates, and are managed by founding members whose egos and work ethic may become an obstacle to their relationships with the board, management, and management’s rep-

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resentatives. In numerous instances in recent years, managing partners of boutique firms have actually hindered the resolution of difficult board matters. Insurance Specialist

This type of professional firm is usually very acceptable to management and the board, as their members often join this type of firm following a successful business career. These firms are also very innovative and can work around obstacles. However, they are product-oriented, as the majority of fees for insurance specialists ultimately come from the sale of insurance products. The combination of the excellent personal relationships with management and the board and the high level of resources needed to implement such programs may result in a conflict of interest. Accounting Firm

Accounting firms are an outstanding source of technical know-how, as they have subject matter experts in all aspects of business and commerce. This is especially true with respect to accounting and tax rules. Accounting firms are very disciplined and work very hard to provide consistent delivery of services, and they maintain very thorough working papers. They have extensive resources in the area of technology and administrative support. The major drawback to the use of accounting firms is the potential conflict of interest if the company is an audit client. The Securities and Exchange Commission has approved new regulations in November 2000 that require the disclosure of fees paid to auditors for audit fees and fees paid for other services, such as human resources and compensation consulting. (SEC Final Rule 33-7919 of November 18, 2000). The new SEC rule prohibits accounting firms from advising or participating in the selection (or review of performance) of employees of audit clients. Specifically, under those rules, an accountant’s independence would be impaired if the accountant: • Searches for or seeks out prospective candidates for managerial, executive, or director positions with audit clients; • Engages in psychological testing, or other formal testing or evaluation programs; • Undertakes reference checks of prospective candidates for executive or director positions with audit clients; • Acts as a negotiator on the audit client’s behalf, such as in determining position, status, or title, compensation, fringe benefits, or other conditions of employment; or

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• Recommends, or advises an audit client to hire, a specific candidate for a specific job. In addition, auditors no longer can offer their clients services involving contingent fees. Although the new rules for the most part took effect February 5, 2001, certain restrictions within them will become effective over an 18-month transition period. Companies began to comply with this rule commencing with the 2001 proxy season. According to a review of 563 Fortune 1000 companies, companies on average pay $2.69 in non-audit fees for every $1 that went to their audits.*

*Taub, Stephen, “Most Auditing Fees Not Used for Auditing.” CFO.COM, 28 June 2001, www.cfo.com.

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Sample Board Prospectus

Appendix 2A

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Sample Board Prospectus

We seek outside, independent directors to help us manage the future of our successful corporation. We believe our business and industry will face more complex issues and challenges than those we have confronted before. We believe a board to be an invaluable resource to aid us in providing the very best return to shareholders. The following describes our company and the roles and purpose we envision for our board. Our Company We are the largest company of its kind in the southeastern part of the United States. We have 25 locations and a significant investment in real estate through 3 realestate holding companies. We have several separate but related lines of business. In all, we are a $450 million enterprise with 3,200 employees. We provide the highest quality and broadest line of high-end products and services to our customers. We are proud to have recently received the very first “Blue Ribbon” award our industry has ever conveyed. We reach our customers through a valued 100-year-old reputation and very active public relations. Market reputation in this business, however, can be overturned by only one year of poor performance. The Immediate Needs of the Board The company’s local and traditional market has matured. The changes in attitudes of consumers to our industry and products require major changes to our company. Recent federal legislation will greatly affect the structure of our industry and how firms in our industry compete. The company must invent new ways of designing, manufacturing, distributing, selling, and servicing our products. To do this the company needs to remake the company while at the same time raising large amounts of capital. The Purpose of the Board The primary purpose of the board will be to help management increase shareholder value. The company will greatly benefit from highly successful people whose only interest is what is best for the company. The board will help management evaluate the key issues and decisions facing our business. The board will offer a forum to discuss the important and strategic

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decisions. The board brings with it a fresher perspective that will encourage corporate management to consider additional alternatives and to challenge management’s proposal if found lacking. The Nature of the Board Our board will comprise eight members: the CEO and seven outside directors. You will be replacing a 62-year-old director who is not standing for renomination due to personal reasons. Of the six other outside directors, four are current or former CEOs, one is a head of a major local university, and the last one is the managing partner of a large, local law firm. Our board will formally meet four times per year at a morning meeting. The day usually begins very early, at 7:30 A.M., and ends in mid-afternoon. Conclusion We believe an independent, outside director will assist corporate management in this time of great need.

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Chapter 3

Responsibilities, Functions, and Roles of the Compensation Committee The United States is unique in its vast numbers of very high-earning executives, entrepreneurs, entertainers, athletes, lawyers, consultants, Wall Street traders, bankers, analysts, investment managers, and other professionals. However, it is the pay levels of corporate executives, especially CEOs, at the large, publicly traded companies that stir the most heated debate and controversy. One news report estimated that the bull market that began in 1993 has created 160,000 high-tech millionaires in 1999 by cashing in stock options, and $500 billion in wealth that same year. Compensation philosophy is the key to a successful pay strategy. Pay strategy is the glue that holds the overall business strategy together. A well-designed pay strategy should be simple in design and easy to communicate to a large number of executive managers. The pay program for the chief executive officer (CEO) should be in line with pay programs for other executives and broad-based incentive programs. In other words, there should be no conflict in the achievement of objectives, and the potential rewards should be as meaningful to the CEO as to others in the company. The compensation committee reports and executive pay sections of the topperforming companies’ proxy statements provide full disclosure. This is an indication of a well-organized and well-functioning compensation committee. The compensation committee should winnow the multitude of pay, other related initiatives, and “noise” into a few initiatives and communicate this information to shareholders and potential investors in a clear, concise, unequivocal manner. This chapter is intended to help guide boards and their compensation committees in their deliberation on executive pay programs and in the evaluation of appropriate executive compensation policies and practices for their organizations. Though the overall duties and responsibilities of the compensation committee are similar from company to company, style and methods of operation vary. Duties 55

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should be closely tailored to the objectives, business needs, and circumstances of the company. The compensation committee is established through a formal board resolution, often in the form of a written charter. The charter outlines the organization, policy, and responsibilities of the compensation committee with sufficient flexibility to allow the committee to work out its own role while enabling the board to evaluate the committee’s work. For regulated industries, such as banking, some states have rules governing the development of a charter. See Appendix 3A for an illustration of a compensation committee charter.

ROLES OF THE COMPENSATION COMMITTEE The burden of fairly defining pay falls to the board’s compensation committee, although the responsibility is the full board’s. Directors and others familiar with board activities say that without a doubt, the compensation committee is the most difficult board assignment. The compensation committee must, according to most corporate bylaws, ensure that compensation bears a reasonable relation to services performed for the corporation. Any amount unrelated to services rendered may constitute a waste or taint of corporate assets and may be actionable by the shareholders. The primary role of the compensation committee is to provide a forum for directors to have a fuller discussion of compensation matters than would be practical for the full board. Indeed, the decisions and actions of the compensation committee may make the difference between mediocre and outstanding corporate performance. The role of the compensation committee varies from company to company. Its role is contingent on various factors, such as ownership structure, shareholder concerns (and perhaps stakeholders, as broadly defined), director capabilities, board values, market dynamics, company maturity, financial condition of the firm, and a myriad of other intrinsic and extrinsic factors. Almost every notable publicly held company has a compensation committee: 91 percent of companies have compensation committees, according to a 1999 NACD survey (National Association of Corporate Directors, 1999–2000 Public Company Governance Survey, Washington, D.C.: NACD, October 1999). Some companies have employee benefits committees (23 percent) and human resources committees (10 percent). Other committees that appear in corporate America are “salary administration” or “stock option.” Other related committees are the governance committee and nominating committee, which are sometimes responsible for senior management succession planning. The compensation committee of the board of directors plays a crucial role in overseeing the compensation plans for the company’s top executives, and often for directors as well. The members of that committee forge the key link between the

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board and management by balancing the interests of shareholders with those of management. The essential conflict between these two interests is not over pay level, but over the relationship of pay to performance. Shareholders want a compensation plan that is strongly tied to corporate performance, whereas managers have a natural tendency to want a compensation plan with maximum security.

FUNCTIONS OF THE COMPENSATION COMMITTEE The compensation committee of the board should establish a compensation philosophy, set performance goals, ensure that pay is in line with performance, and obtain any necessary outside counsel and advice. The purpose of the compensation committee is to review and report to the board on compensation and personnel policies, programs, and plans, including management and succession plans; and to approve employee compensation and benefit programs. The compensation committee should provide oversight in the following general areas: • Compensation strategy • Compensation policies and programs • Compensation levels of directors, CEO, president and top officers, and management group (full board usually must approve compensation of directors, CEO, and president) • Management development • Compensation and employee benefit plans • Administration of stock bonus plans, stock option plans, and nonemployee director stock plans More specifically, the function of the compensation committee is: • • • • •

To consider and approve overall executive compensation program objectives To review and approve pay levels for corporate officers To evaluate the CEO’s performance To advise the full board as to necessary action(s) and exposure issues To investigate competitive practices and trends to determine the adequacy of the organization’s executive compensation programs • To review who should participate in the various elements of the total executive compensation package

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• To approve contractual arrangements, employment agreements, and the like • To consider outside director compensation matters

DUTIES AND RESPONSIBILITIES OF THE COMPENSATION COMMITTEE Compensation committee responsibilities can be grouped into six primary areas: 1. Adherence to good corporate procedural rules. Before the committee can accomplish meaningful results, the members must pay close attention to the details of running a compensation committee, such as advance reading and preparation, a good meeting agenda, and focused minutes for the record. 2. Knowledge of the big picture. The compensation committee must relate compensation matters to the overall strategy of the company and view them from the perspective of the shareholder. 3. Decisions on how much compensation is enough. Compensation committees are continually being challenged as to the basis for their companies’ executive compensation programs. 4. Review of programs from the shareholder’s perspective. The compensation committee must constantly ask how the shareholders will react. This is especially important, of course, for actions that require shareholder approval, such as new incentive plans or programs. In support of effective incentive program planning, several questions must be answered: • What is the most appropriate measure of performance? • What is the most appropriate target level of performance? • How should rewards be linked to performance? • Is senior management, especially the CEO, doing an adequate, great, or outstanding job? • What level of equity awards (e.g., stock overhang) is adequate for the company? For growth-oriented smaller companies, options are an excellent way to preserve cash while giving employees a piece of future growth. However, one of the most pressing issues facing compensation committees is determination of the proper allocation of increase in value between shareholders and executives. A company’s stock overhang is generally defined as the number of shares underlying all outstanding stock-based awards plus the number of shares still available for grant under all incentive plans of the company. 5. Review of complex plans and programs. A daunting task, to be sure, is to review and communicate to shareholders, in plain English, about complex stock and

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other types of programs, such as reload stock options and shareholder valueadded programs. 6. Review of controversial plans and programs. A company must avoid the appearance of impropriety with regard to employment arrangements, stock option awards, and especially excess benefits and perquisites programs. See Exhibit 3.1 for a checklist of compensation committee duties. Regulatory changes have propelled the compensation committee to the front of the stage of corporate America. Over the past several years, compensation committees have evolved from an administrative requirement, mandated by the Securities and Exchange Commission (SEC) in 1992 and encouraged by the introduction of the $1 million executive pay deduction cap in 1993, to a true strategic asset of the business.

Exhibit 3.1 Checklist for the Compensation Committee • • • • • • • • • • • • • • • • • • • • •

Clarify authority delegated by the board Ensure disinterest and independence from company Retain, and maintain direct access to outside experts/consultants Review and approve company compensation policy Give special attention to CEO pay Create compensation committee report (for annual proxy statement) Understand purpose of various pay elements Consider timeframe associated with pay element Be sensitive to external pressures Pay special attention to areas of controversy Compare pay programs with relevant peer group Evaluate executive caliber, degree of difficulty of performance objectives, risk exposure, and executive potential Assess the real dollar value/cost of the executive total pay package Ensure that owner and corporate economic values are prime drivers of the executive pay program Coordinate payments with performance goals Balance fixed versus variable rewards Define equity (stock option) participation strategy Make full and required disclosures Deliberate and resolve, with special consideration, items that will have to be stated in the compensation committee report Review and revise compensation philosophy and policy Carefully select recognized industry index and/or an appropriate peer group for the performance group

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The pertinent regulations relating to compensation committee actions are: • SEC Rules 16b-3(d) and (e), exempting certain stock awards or dispositions from § 16 “short swing” profit liability if approved by the compensation committee. • Treasury Regulation § 1.162-27, requiring compensation committee determination of performance goals in order to invoke the exemption for “performancebased compensation” from the IRC § 162(m) $1 million deduction limitation on executive compensation. • SEC Regulation S-K, which requires disclosure in the following areas: • Item 402(i), requiring the committee to disclose and explain the reasons for any repricing of stock options or stock appreciation rights. • Item 402(j), requiring disclosure of compensation committee interlocks when any member of the committee is an officer, former officer, or has certain other relationships to the company. • Item 402(k), requiring that the committee report disclose executive compensation criteria, including an in-depth discussion of CEO compensation and all underlying performance measures. These heightened disclosure requirements, stipulated by the reformation of the proxy statement disclosure rules and followed by rules as to the nondeductibility of nonperformance-related compensation in excess of $1 million, compelled publicly traded companies to design and implement truly incentive-based compensation programs. The rise of the importance of institutional shareholders has also raised the general corporate awareness of executive compensation best practices. At the same time, executive pay levels are increasing at an unprecedented rate; Wall Street analysts are becoming quite interested in executive compensation practices in their review of overall corporate governance. Another related issue is the availability of executive compensation information, with the advent of the SEC’s EDGAR project and the increase in Internet availability. For example, the AFL-CIO’s “CEO Pay Watch” Web site highlights CEO pay trends and provides illustrations of disfavored pay practices. This makes executive compensation information readily available to any analyst, investment banker, business school professor, or lawyer, as well as interested private or institutional shareholders. Outside directors bring a wealth of intellectual capital and thought leadership to a company. The outside directors who constitute the compensation committee are in an ideal position to bring new ideas to the company based on their experiences with other companies. In fact, most members sit on more than one board; they may sit on the compensation committees of those other companies and typically are proactive in executive pay programming at their own companies.

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Members of the compensation committee are in a fishbowl of both shareholder and public opinion. The major decisions of the committee inevitably are reported in a proxy statement, filed in advance of the next annual shareholders’ meeting or as an attachment to SEC Form 10-K (in the case of employment agreements). The form, substance, and timing of such disclosures should be part of the committee’s discussion and decision-making process, as well as its concern about the implications of tax, accounting, securities, and insurance regulations and laws, valuation principles, and overall executive compensation trends. In summary, the committee’s responsibilities are important and frequently in the spotlight. To execute its responsibilities, the committee must synthesize much technical information, as well as apply sound business judgment. As the environment becomes more complicated and uncertain, the committee must adapt accordingly. Adherence to Good Corporate Governance Principles To accomplish meaningful results, committee members must adhere to sound corporate governance principles. A rule of thumb in this area is to make sure that each and every matter before the committee is reviewed and discussed in a professional manner commensurate with the effect the proposal will have on the company. Fully Discuss and Decide Matters with the Appropriate Inside and Outside Advice

Most importantly, the compensation committee has a duty and obligation to conduct a full and comprehensive discussion of decisions made by the committee. This review should include practices of other publicly traded companies and the best available inside and outside advice. Of course, this review must be conducted within the parameters of time, value, and expense to the company. In some cases, committees engage consultants to advise them in such reviews. Provide for an Executive Succession Plan

The compensation committee often must compel the company to create and adhere to a reasonable and efficient senior executive succession plan. In some cases, the board has a separate nominating committee. In other cases, the board assigns the compensation committee the task of recommending senior executive appointments to the entire board. The compensation committee should take reasonable care to review the succession plan; if the company has none, the committee should recommend that a plan be put in place as soon as possible. A company without a focused succession plan is more vulnerable to substantial impairment of corporate value, as the best and brightest executive talent may

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not succeed top leadership. Corporate America is littered with examples of companies that were forced to go outside for a senior executive, with disastrous results. The danger of going outside the firm for executive talent is that the senior executive will not be steeped in the corporate culture and the associated value system. An example of a temporarily impaired company was AT&T, as its stock lagged under the leadership of Robert Allen in the early 1990s. At the same time, top talent was leaving the company with the departure of Alex Mandl, Joseph Nacchio, and others. AT&T then reached out to John Walter, who had no telecommunications experience. Within a year, Mr. Walter resigned, taking with him a hefty severance package. Compensation decisions should be made with full regard to the company’s succession plan, especially with respect to special retirement benefits, long-term incentive awards, and employment agreements. Any or all of these, if well timed, may ensure retention of a critical executive over a critical period. Provide for a Meaningful CEO Evaluation Program

The compensation committee should encourage the company to create and maintain a CEO evaluation program. A well-functioning evaluation program is essential to the formulation of the compensation committee report relating to CEO compensation, as well as to fulfillment of the committee’s responsibility of recommending compensation to the CEO for his or her services. It is difficult to judge two CEO’s performance without clear performance objectives. There are a number of techniques to conduct CEO evaluation, such as the balanced scorecard approach. The best approach sets clear and measurable performance expectations and tracks performance relative to these targets. See Exhibit 3.2 for an illustration of a CEO evaluation form. Provide for a Viable Board Evaluation Program

The implementation of a board evaluation program is an increasing practice and reflects leadership by the board. The compensation committee should encourage a board evaluation program with predetermined expectations and feedback solicited from other directors, the CEO, other senior executives, and other interested parties (perhaps even other stakeholders such as union leaders (if applicable), or major suppliers). See Appendix 3E for a sample form for board evaluation. Review the Impact of a Change in Control of Ownership on Plans and Programs

Over the past 12 years, change-in-control (CIC) arrangements have become common practice for senior executives. The CIC protections have also been extended

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Exhibit 3.2 Sample CEO Evaluation Form Section 1.

2.

3.

4.

5.

6.

Major Topics and Description

Rating*

Strategic Planning • Ensures the development of a long-term strategy. • Establishes objectives and plans that meet the needs of shareholders, customers, employees, and all other corporate stakeholders, and ensures consistent and timely progress toward strategic objectives. • Obtains and allocates resources consistent with strategic objectives. • Reports regularly to the board on progress toward strategic plan milestones. Leadership • Develops and communicates a clear and consistent vision of the company’s goals and values. • Ensures that this vision is well understood, widely supported, and effectively implemented within the organization. • Fosters a corporate culture that encourages, recognizes, and rewards leadership, excellence, and innovation. • Ensures a culture that promotes ethical practice, individual integrity, and cooperation to build shareholder value. Financial Results • Establishes and achieves appropriate annual and longer-term financial performance goals. • Ensures the development and maintenance of appropriate systems to protect the company’s assets and assure effective control of operations. Management of Operations • Ensures high-quality, cost-effective management of the day-today business affairs of the company. • Promotes continuous improvement of the quality, value, and competitiveness of the company’s products and business systems. • Encourages and rewards creative solutions to business and management solutions. Management Development • Develops, attracts, retains, and motivates an effective and unified senior management team. • Ensures that programs for management development and succession planning have the required resources and direction to grow the future leaders of the company. Human Resources • Ensures the development of effective programs for the recruitment, training, compensation, retention, and motivation of employees. (Continued)

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64 Responsibilities, Functions, and Roles of the Compensation Committee

Exhibit 3.2 Sample CEO Evaluation Form Section

7.

8.

Major Topics and Description

Rating*

• Ensures that adequate human resources are available to meet the needs of the company. • Establishes and monitors programs to promote workplace diversity. • Provides for appropriate recognition of the achievements of individuals and groups. Communications • Serves as a chief spokesperson for the company, communicating effectively with shareholders, prospective investors, employees, customers, suppliers, and consumers. • Effectively represents the company in relationships with industry, the government, and the financial community. • Effectively represents the company in relationships with the financial community, including major investor groups and financial services firms. Board Relations • Works closely with the board to keep directors informed as to the state of business on critical issues relating to the company. • Works closely with the board to keep the directors informed as to the company’s programs toward the achievement of operating plan and strategic plan milestones. • Provides effective support for board operations, including board materials and advisory services.

*Ranking system is as follows: 1—Substantially below expectations 2—Slightly below expectations and progressing toward meeting expectations 3—Meets expectations 4—Well above expectations 5—Clearly exceeds expectations in all aspects

deeper and deeper into employee ranks, and in some cases cover all employees. A CIC payment of between 1 and 3 percent of the transaction amount is not uncommon, with the largest reported CIC amounts being $150 million to a group of executives and $50 million to one executive, respectively. Programs related to changes in control, such as enhanced cash severance programs and accelerated vesting of certain stock programs, might pose an obstacle to a prospective CIC. As previously noted, it is the obligation of the directors to compare their plans and programs with those of other publicly traded companies in their lines of business and overall industry. In addition, they should assess the potential impact of certain stock awards on the company’s ability to account for business combinations using pooling-of-interests accounting. Trends such as the

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inclusion of long-term incentive awards in the severance multiple, which is usually two to three times salary and bonus, and post-CIC employment agreements are examples of the types of issues that must be addressed. Monitor the Intentions of Management

The compensation committee must continually ask whether senior executives are acting in their own interests to the detriment of shareholders. Academic studies refer to this effect as “agency effect creep.” That is, the agent (e.g., the management) that is hired to manage property (e.g., the company) acts in his or her own best interest, causing a loss of company value. Knowledge of the Big Picture The compensation committee must relate compensation matters to the overall strategy and financial condition of the company, and view these from the perspective of the shareholder. It must include this perspective in its communication to shareholders (e.g., the required compensation committee report in the proxy statement). Compensation Plans and Programs Should Be Consistent with the Achievement of Corporate Strategy

This is especially true for incentive-based compensation. It makes little sense for the compensation programs to be motivating executives to achieve goals and objectives that differ from overall corporate objectives. It takes at least 18 to 24 months to reposition the strategic direction of a company. As a result, the compensation program must be an equal partner in directing the company. Shareholder Value Is the Key

In general, additional compensation should add to shareholder value; otherwise, it might not be justifiable. Certainly, new, innovative programs should be discussed by the compensation committee in this context. Pro forma financial results, with proposed compensation levels, should be constructed. Moreover, this analysis should include the effects on shareholder dilution. To keep up with the increasing levels of equity compensation, the compensation committee should be concerned about the mitigation of the diluting effects of stock award program on shareholder interests. For example, issuing new shares or buying back shares may satisfy stock equity awards. This decision is not usually in the domain of the compensation committee, as it cuts into the turf of the strategic corporate finance plan. However, with the doubling of stock overhang levels, a plan to satisfy these equity awards when they are exercised should always be considered when the awards are made.

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Take Control of the Compensation Committee Report

Do not let the outside or inside legal advisor or compensation consultant take over the writing of the compensation committee report, as occurs in many companies. This shareholder communication is too important to let others speak for the committee. Boilerplate language is not a substitute for the actual voice of the committee. Too many compensation committee reports are exactly the same from year to year, even when the company has drastically changed over the same period. A straightforward explanation of the committee’s actions and philosophy is the best policy, and is critical to a meaningful report. Although the board must review practices of other relevant companies, there is no reason to adopt these practices if they are not right for your company. Of the approximately 10,000 publicly traded companies, every situation is unique. There are different industries, different corporate strategies, different CEO and management styles, different corporate cultures, different board makeup, and a multitude of other factors that influence board deliberations. The committee must rely on a considered, thoughtful review to select the best and most appropriate policy or program. Additional information on the drafting of the compensation report is at the end of this chapter. Understand and Consider Institutional Shareholder Concerns

Institutional shareholder concerns cannot be ignored even for companies with low institutional investor ownership. Shareholder activism has come a long way from its roots in the 1970s. Organizations ranging from institutional shareholder advisor groups (e.g., ISS) to large pension funds (e.g., AFL-CIO, TIAA-CREF, CALPERS, and SWIB) to shareholder activist funds (e.g., LENS) have formed a powerful voting and economic bloc that cannot be ignored. Companies should be proactive on institutional investor issues. Corporate governance issues, such as the independence of directors, organization of the board, incentive plans and programs, CEO selection and succession, employment agreements, executive ownership, insider trading actions, compensation levels, and other related issues, are all fair game for shareholder comment. Decisions on How Much Compensation Is Enough A secondary challenge to the determination of how much is enough is to develop a basis for compensation. Executive compensation levels have drastically increased in recent years. Highlights of this phenomenal increase include: • The value of employment agreement packages, which has soared from a modest (by today’s standards) $15 to $20 million package offered to Lou Gerstner in 1993 to the $100 to $200 million packages offered to some new CEOs today.

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• Failure payments (e.g., severance payments offered to senior executives who have not performed well), which have been, in some rare cases, in the tens and hundreds of millions of dollars. • Long-term incentive awards, which have increased greatly. For CEOs, annual long-term incentive awards have almost doubled in the past two years. • Stock overhang (e.g., the percentage of stock allocated to executive incentive plans) has increased from 8.73 percent in 1992 to 15.23 percent in 2000 (according to Pearl Meyer & Partners, Inc., statistics on the 200 largest public companies*). The jump in stock overhang from 1999 (13.70 percent) to 2000 (15.23 percent) represents the largest annual increase in more than a decade. The committee must review the ever-increasing value of employment arrangement proposals. This is especially true when hiring a CEO from outside the firm. Back in 1993, when one of the co-authors advised Lou Gerstner, as he became CEO of IBM, the question was asked: How much is enough? An old-line chief executive, James Burke—retired CEO of Johnson & Johnson—recruited Mr. Gerstner to turn IBM around. Mr. Burke was familiar with the old way to reward CEOs and was not about to give in to Mr. Gerstner’s demands easily. The committee thought the employment package offered to Lou Gerstner was the biggest employment agreement ever offered to a CEO—and they were right. It appeared that this agreement could not be topped. However, by 1997, Mr. Gerstner’s agreement barely made the top 20 employment agreements. Agreements leapfrogged one another in the dizzying search for the next best CEO talent. The problem is, how do you know if you have a Lou Gerstner or a CEO wanna-be? The stakes for superior executive talent are becoming greater as the potential for explosive growth increases. Corporate values are rising at phenomenal rates. For example, $10,000 invested in Microsoft in 1988 would be worth about $1,000,000 today. This escalation of wealth creation is complicated by the creation of wealth from services rather than industrial products. Telecommunications, computer software, and business services (such as Internet-related products and services) fueled a nationwide renaissance. Review of Programs from the Shareholder’s Perspective The compensation committee must constantly ask, “Is this in the shareholders’ best interests, and how will the shareholders react?” This is especially important,

*Pearl Meyer & Partners, Inc. 2000 Equity Stake, Study of Management Equity Participation in the Top 200 Corporations. New York: Pearl Meyer, 2001.

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of course, for actions that require shareholder approval, such as new incentive plans or programs. Know and Follow the Rules for Effective Compensation Planning

In support of effective incentive program planning, three questions must be answered: 1. What are the expected levels of performance? 2. What are the most appropriate measures of performance? 3. How should rewards be linked to performance? The answers to these questions may be different for corporate-level executives than for division-level executives. Set Goals

The committee should demand “stretch” goals and be prepared to pay commensurate with achieving this level of performance. Setting goals does not mean accepting management’s lowest estimate of what can be achieved. Stretch goals, like those envisioned by Lou Gerstner at IBM and Larry Bossidy at Allied-Signal, are an integral part of a high-performing corporate culture and ultimate success. One very vocal proponent is Jack Welch at General Electric. Mr. Welch offered the following observation on stretch goals (“Jack Welch Lets Fly on Budgets,” Fortune, May 29, 1995): “Stretch means that we try for huge gains while having no idea how to get there—but our people figure out a way to get there.” Stretch goals are not just for high-performing companies like General Electric and IBM. They are critical to any business in increasing shareholder value in any meaningful way. Executives must be compensated, in particular, for achieving stretch goals. Without exception, each of the top 50 performing companies over the past 5 years got there by setting and achieving stretch goals that were out of the comfort zone. Without stretch goals, high performers are transformed into mediocre companies. New Equity-Related Executive Compensation Proposals

In recent years, Wall Street, institutional shareholders, and shareholder-interest groups have advocated such ideas as indexed stock options, limits on restricted stock awards, performance-vested stock grants, and prohibitions on option repricings. These trends should at least be discussed by the compensation committee. If appropriate, these new ideas should be adopted and integrated into the firm’s compensation plans and programs. Some critics say that stock options do not meet the test of adequate executive incentive. Based on the meteoric rise of the use of stock options, corporate boards

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have determined that they are the surest way to align executive incentives with shareholder interests. But are they? Option spreads can increase in value even when performance is substandard. The exercise price, which is typically the market price on the day the options are granted, remains fixed over the entire option period. Executives thus profit from any share price appreciation, even if the return is below those of other peer-group companies or the overall market. Institutional shareholder views have to be reviewed and considered, collectively or individually. Collective views as expressed by organizations such as Institutional Shareholder Services, Investor Research Responsibility Center, and the Council of Institutional Investors must be noted, as they may be quickly adopted by important shareholder groups. It is much better to be proactive in these matters than to react defensively on the eve of the annual shareholders’ meeting when the outcome of the shareholder vote may be in doubt. Review of Complex Plans and Programs The review of complex stock or other types of programs, such as reload stock options and shareholder value-added programs, is certainly a daunting task. These programs require knowledge of corporate finance and valuation principles. Compensation practices have come a long way from the standard stock option and other simpler programs. The multitude of wealth-creating vehicles, estate planning devices, and schemes to preserve the tax advantages of deferred compensation while securing the benefit has made the job of reviewing such proposals very difficult. Reload Stock Options (RSOs)

Boards of directors, their executive compensation advisors, and Wall Street investment managers and financial analysts are all confused about and interested in a fairly new and increasingly popular form of stock option called the reload stock option. A debate has emerged from the boardroom and from consulting reports and is now making its way into the business media, as reported in Business Week and the Wall Street Journal. An RSO is a stock option award with an additional feature that stipulates that a new option grant be made to an executive at the time the executive exercises the stock option award. The reloaded option grant will typically have an exercise price equal to the then-current market price and expire at the same time as the initial grant. Commonly, an RSO is granted for each share tendered by the executive in payment of the exercise price. The option spread is paid to the executive in the form of full shares of stock. These shares are sometimes referred to as profit shares. One of the most complicated committee tasks is the review of significant executive benefit programs such as deferred compensation programs, supplemental

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executive retirement plans (SERPs), and insurance programs such as split-dollar life insurance. This can be especially difficult when a trust is used and the committee must decide on the level and type of trust funding. Unusual Perquisites

Another important role is to review significant perquisite programs, such as use of corporate aircraft, premium automobiles, charitable contributions, and other unusual perquisites. As reported in the Wall Street Journal (“Relocating Mom: A Primer of New Perks,” Wall Street Journal, June 23, 1998), senior executives have received some rather exotic perquisites: • One company moved an executive’s mother-in-law closer to him. • Another company paid for the relocation of an executive’s horses. • Other companies have paid for an executive’s housekeeper’s medical insurance. Although these items were clearly very important to the executive, they look very odd when reported to the public (in the form of a proxy statement and/or SEC Form 10-K). Such confusing and negative disclosures, though not material to the overall profitability of the firm, raise issues of propriety in the minds of shareholders, business reporters, and other interested parties. The stinging criticism, which is very difficult to refute, is that these executives could and should have paid for these items themselves out of their compensation packages. Review of Controversial Plans and Programs The committee should ensure that the company avoids the appearance of impropriety with regard to employment arrangements, stock awards, director compensation, and especially excess benefits and perquisites programs. One of the most publicized recent controversies has been repricing of stock options. Stock Option Repricings

Companies must balance the need to attract and retain executives and other employees with shareholder interests, because repricings effectively separate the interests of management and the interests of shareholders. Studies have shown some support for the traditional justifications for rich executive stock awards, but a weak correlation between executive ownership and stock performance has been observed in a number of these studies. In March 1999, the Financial Accounting Standards Board (FASB) issued an exposure draft of an interpretation to Accounting Principles Board (APB) 25, “Accounting for Stock Awards,” which required a company to take a charge against earnings for repricing stock options. In August 1999, the FASB issued a public announcement that reiterated its resolve to require a charge against earnings.

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On March 31, 2000, the Financial Accounting Standards Board (FASB) issued its Interpretation No. 44 (FIN 44), “Accounting for Certain Transactions Involving Stock Compensation—An Interpretation of APB Opinion No. 25.” This Interpretation provides guidance on certain problem areas that have arisen in practice since the issuance of APB 25 in October 1972. APB 25 provides the favorable intrinsic method of accounting for stock option grants to employees. This is distinguished from the fair value model (i.e., using an option pricing model) for stock option grants to consultants, vendors, customers, or other non-employees. An early word of caution: the quid pro quo for the favorable intrinsic method of accounting is that even minor variations from the norm, or modifications after the award date, often have significant adverse consequences. The most publicized effect of FIN 44 is the end, for all practical purposes, of the repricing of stock options. The FASB has made it clear that repriced options will result in variable accounting (i.e., re-measurement of intrinsic value until the repriced option is exercised, forfeited, or expires unexercised). There are other significant changes, however, and it is important to understand these other changes given that FIN 44 became effective July 1, 2000. The new Interpretation will generally be applied prospectively for grants or modifications to existing stock options or awards made after June 30, 2000. However, the guidance on repricing and determining whether the grantee is an employee is effective after December 15, 1998; the guidance for modifying a fixed option or award to add a reload feature is effective after January 12, 2000. It is interesting to note that TIAA-CREF stated, in its “Executive Compensation Program Guidelines,” that it would support an option repricing if “the company has not repriced options in the past, or has excluded senior executives from any repricing, or has tied any repricing to a significant reduction in the total number of outstanding options.” (See Appendix 12B) Director Compensation and Programs

Director compensation has changed significantly over the past three years, as cash fee payments have often been replaced by equity-based programs consisting of stock grants, restricted stock, and stock option awards. In addition, director pensions have been substantially eliminated in favor of stock awards. Some companies have even provided severance benefits, reload stock options, repriced stock options, annual incentives, and cash-based long-term incentives. These director programs have understandably resulted in increased media and shareholder scrutiny. Unusually Large and Complex Excess Benefit Plans

Split-dollar life insurance illustrates the complexity of the review of a big-ticket, nonqualified excess benefit. Simply put, deferred compensation account balances can be secured with split-dollar life insurance (other methods, including other types of insurance products, may also be used).

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Split-dollar life insurance is an arrangement whereby life insurance premiums are split between the corporation and the covered executive, with any excess premiums returned to the company at some point in the future. In reality, the corporation pays 90 percent or more of the premiums. The executive usually owns the policy and the company normally has a collateral right to get back all premiums that have been paid on the insurance policy. The company, in effect, provides an interest-free loan to provide the life insurance benefit to the executive, and often the cash surrender value of the policy is substantial. Issues associated with split-dollar life insurance policies are the life-insurance premiums charged against the life insurance policy and the investment return earned by the invested funds. The compensation committee should review the insurance premiums against other available insurance products. Moreover, the company should discuss the types of investments and investment direction of the invested funds. Trust arrangements, funding policies, and other interrelated matters make the task of benefits review even more complex. As mentioned earlier, these matters are quite complex and may require a considerable amount of time and effort to review. Since the inception of widespread committee use in 1992, the job of the compensation committee has become increasingly more complex. The compensation committee has a prominent board role. In reality, the decisions and actions of the compensation committee can make the difference between mediocre and outstanding corporate performance.

CEO EVALUATION AND SUCCESSION PLANNING The primary responsibility of directors is management succession and the hiring and firing of the CEO. To do this effectively, the board must take the high ground, and make clear its relationship with the CEO. A meaningful board evaluation includes the following important items: • • • •

Regular sessions culminating in a formal annual evaluation Good planning Objectivity Linkage of the evaluation to the CEO’s pay package

An effective CEO evaluation process includes all four elements. If one of the elements is missing or weak, it may jeopardize the effectiveness of the CEO evaluation process. The board or a representative of the board should meet with the CEO on a regular basis to go over the evaluation and the evaluation process. These evaluation sessions should be a part of the board process, and not hurried or shortened. As discussed earlier see Exhibit 3.2 for a sample CEO evaluation form.

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CEO Evaluation and Succession Planning

73

To make the process objective, the board should create a job description for the CEO and a solid basis for performance measures and targets. The job description and performance targets should be finalized within the first three months of the year. That will provide an objective reference against which to evaluate the CEO once the year is complete. Progress against these objective reference points will be used to provide feedback to the CEO. The CEO’s job description should explicitly state what the board wants from the CEO. A basic CEO job description stipulates the executive’s duties and powers, and should also include a set of priorities. The job description should provide a good basis for the performance evaluation system. It is always a good idea to fix the standards by which you will measure the CEO as soon as possible. This can preclude potential disappointment and miscommunication that might otherwise arise during the evaluation process. A CEO job description should focus on the actual tasks of the CEO. For example, a list of tasks can be included in a job description, as shown in Exhibit 3.3. The need for great board relations cannot be overstated. This chemistry starts with an excellent attitude that fosters a sense of respect, recognition of worthiness, and high levels of communication. Once the board and CEO bond, they can more easily share their visions of the future and get buy-in from one another. This meeting of the minds goes a long way toward keeping the company on track in the face of adversity and conflict. The last, and very important, part of the evaluation process is to tie the evaluation process into the CEO’s pay package. This is especially important when corporate success is not synchronous with CEO pay. For example, care should be taken to avoid large stock grants, bonus payments, salary increases, and other perceived compensation windfalls when there is an employee layoff, stock slump, or earnings drop. Directors should continually ask themselves: • Is our CEO the best for our company—at this time and this place? • Are there gaps in expectations, goals, and commitments? If so, is the CEO addressing them? • Does the CEO understand the gaps in expectations, goals, and commitments and his or her responses to them? • Has the board specifically discussed the performance measurement criteria with the CEO? The recent spate of forced CEO departures reflects the rise of independent boards that are both willing to act and continually reviewing the performance of CEOs. In the evaluation of the CEO, the directors should ask: • What does the CEO have to do to succeed? Is he or she doing it? • Do we have the right CEO? Why?

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Exhibit 3.3 Illustrative CEO Job Description Major Task

Benchmark for Achievement

Corporate leader

Lead the innovative process that takes the company into new, more profitable markets. Lead the business planning process.

Chief communicator

Be the chief spokesperson for the company. Keep visions, values, and missions in front of the general public, shareholders, stock analysts, employees, suppliers, and alliance members. Promote quality communication within the company. Be able to express ideas, plans, strategies, and reasons for change in a clear, persuasive, concise, and effective manner.

Attitude leader

The CEO must always have a great attitude toward the board, with a particular emphasis on the need to engage the board. Behaviors that encourage good board relations are: • Providing enough information for board members to be effective and timely in their input. • Staying in touch with the board. • Fostering honesty, candor, frankness, and openness in communications with all board members. • Responding to the board’s advice in a clear and convincing manner. If the CEO and the board agree on something to be done, the CEO should make sure that it happens. • Being willing to be held accountable. • Sharing the credit with the board when the company is successful.

Cultural leader

Set the tone of the company’s culture by example. Encourage behavior that will grow the business, such as ensuring entrepreneurial spirit and accountability for results.

Executive team leader

Lead the executive team. Demand success, and reorganize and/or change the executive team based on results.

Corporate resource manager

Use corporate resources effectively and efficiently. Strike an optimum balance between long-term and short-term needs. Pay particular attention to human resources issues, especially executive succession planning. Ensure that proper measurement and control processes are in place, especially the performance appraisal system.

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Compensation Committee Report

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Exhibit 3.3 Continued Major Task

Benchmark for Achievement

Continual learner

Seek ways to improve the company, as reflected in improved corporate results. Always seek feedback for the purpose of positive change and improvement.

Strategic planner

Form the company’s structure and processes to fit the strategy and culture sought by the board. Encourage various corporate sectors to work together for a common, strategic goal. Be willing to restructure the company, when necessary, based on clear strategic needs.

• Is a strong succession plan in place? Do we pay enough attention to succession issues? • Are the proper strategies in place? • What two or three strategies can most affect the company, such as price increases, changes in the product mix, adding value to products? • Are things getting better or worse? • Where is the new top-line growth in the company going to come from? • Does the CEO develop, attract, retain, and motivate an effective management team? • Is there high quality, cost-effective management of the operations?

COMPENSATION COMMITTEE REPORT The compensation committee report (the report) must include the company’s philosophy on compensation, and must be part of the annual proxy statement to shareholders. Points to be covered in the compensation philosophy are as follows: • The rationale underlying the determination of elements of compensation (e.g., number of stock options) • How levels of compensation relate to corporate performance • The peer group used by the compensation committee to determine competitive levels of compensation See Chapter 5 for information on creating a compensation philosophy appropriate to your company.

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The committee report for the proxy should clearly state: • A disclosure of executive compensation policies • The specific basis for CEO compensation (e.g., factors and criteria, relationship of company’s performance to CEO’s compensation, and description of each measure) • Committee member names, at the end of the report Once the compensation committee completes the report, the board reviews it. If no change is required, no further action is taken. If material modifications are made in which the compensation committee does not concur, the board role is substituted for the committee role, and board names are listed at the end of the final report. The report should also answer the following questions, among others: • • • •

Why did the committee determine to pay this piece of compensation? How were bonuses determined? Why was this amount of stock options awarded? Were past option grants considered in issuing new option grants? What shareholders look for in the report:

• Relationship between executive potential gains and shareholder returns (over the long term) • Potential costs to the corporation and shareholders • Articulations of shareholder interests in the process of rationalizing pay practices and levels See Appendix 3D for an outstanding example of a thorough compensation committee report.

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Illustrative Compensation Committee Charter

Appendix 3A

77

Illustrative Compensation Committee Charter

Purpose To review and report to the Board on compensation and personnel policies, programs, and plans, including management development and success plans, and to approve employee compensation and benefit programs. Membership The Compensation Committee should consist of no less than three members and no more than five members and be composed entirely of outside, independent directors. The definition of independence is according to Internal Revenue Service Code Section 162(m). The Nominating Committee shall appoint the appropriate director to the Compensation Committee. This appointment shall last no less than one year and no more than six years, with a typical tenure of three years. The Nominating Committee shall also select the Chair of the Compensation Committee. Oversight Areas The Securities and Exchange Commission has imposed on the Compensation Committee the duty to issue, in connection with the annual proxy statement relating to the annual meeting at which directors are elected, a report “made over” the names of each member of the committee that discusses • The committee’s compensation policies applicable to all of the company’s executive officers. • The committee’s bases for determining the CEO’s compensation for the most recently completed fiscal year, including the factors and criteria upon which the compensation was based. • The relationship of executive and CEO compensation to company performance for the most recently completed fiscal year. • If executive officers’ stock options or stock appreciation rights were repriced during the most recently completed fiscal year, the committee is required to explain the basis for such repricing. • Approve the peer groups used for the stock performance graph.

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See the attached agenda for the assignment of responsibility of various items between the committees of the board. Other areas of oversight for the Compensation Committee are as follows: • Compensation philosophy and strategy • Compensation policies and programs. • Compensation levels of directors, chief executive officer, president and top officers, and management group. • Management development. • Compensation and employee benefit plans. • Administration of stock bonus plans, stock option plans, nonemployee director stock plans. The function of the Compensation Committee is as follows: • • • • •

To consider and approve overall executive compensation program objectives. To review and approve pay levels for corporate officers. To evaluate the Chief Executive Officer’s performance. To advise the full Board as to necessary action(s) and exposure issues. To investigate competitive practices and trends to determine the adequacy of the organization’s executive compensation programs. • To review who should participate in the various elements of the total executive compensation package. • To approve contractual arrangements, employment agreements, and the like. • To consider outside director compensation matters. Agenda Items The Committee, in consultation with the Chief Executive Officer, develops the activities of the Compensation Committee from year to year. The Compensation Committee typically meets in person three times a year, but may meet by telephonic means on a more regular basis.

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Illustrative Compensation Committee Agenda

Appendix 3B

79

Illustrative Compensation Committee Agenda

Event

Meeting Date

Recurring Agenda Items

End of year

Late February

• Approve minutes prior to meeting. • Review prior-year operating results presented as required by bonus plan criteria.

Note: Meeting dates shown are for a company with a fiscal year ending in December.

• Evaluate performance of CEO for prior year, and review and approve recommended bonus plan payments. • Review and approve recommendations related to current-year participation in bonus plan, and supplemental executive retirement plan (SERP). • Review and approve current-year bonus plan targets for organization units and plan participants. • Review and approve personal goals of CEO for current year. • Review draft of Compensation Committee responsibilities for inclusion in proxy statement report. • Review draft of explanation of CEO compensation for inclusion in proxy statement report.

After annual shareholders’ meeting and approval of stock-related plans

June/July or September/ October

• Approve minutes of prior meeting. • Review and approve recommendations for stock option and restricted stock grants. • Review and approve mid-year promotions, new hires. • Receive consultant’s report on fringe benefits and benefit costs. Report to include: —Competitive practices, and —Recommended changes and costs. • Receive annual management development and succession planning overview from CEO.

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Event

Meeting Date

Recurring Agenda Items • Engage outside studies for various matters. • Review performance of outside consultants. • Consider approval of officer for nomination to the Board.

Late in year

November/early December

• Approve minutes of prior meeting. • Receive consultant’s report on compensation levels, current levels, and competitive pay practices. • Review and approve recommended changes in salary structure and bonus plan provisions. • Approve additions and removals from bonus plan participation. • Review executive compensation budget, and approve annual salary increases for next year. • New ideas session (planning session for new ideas, plans, and programs). • Discuss incentive measures for upcoming year. • Annual review of executive severance plans. • Review corporate compensation philosophy and pay strategies.

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Board/Compensation Committee Responsibility Matrix

Appendix 3C

81

Board/Compensation Committee Responsibility Matrix Approval/Review Required Full Board

Committee

Corporate Organization □ Corporate bylaws (adoption or amendment)

X

□ Certificate of incorporation/amendments

X

□ Stock: all authorization to issue or buy back shares

X

Board Organization □ Board membership qualification

Nominating

□ Board committee memberships

Nominating

□ New member selection

Nominating

Compensation Matters: Base Salary □ Salaries of CEO and corporate officers

Compensation

Officer Employment Agreements □ Severance agreements

X

□ Retention agreements

X

□ Change in control agreements

X

Fringe Benefits □ Establishment of new plans or amendments to existing plans Compensation Incentive Compensation □ All arrangements for corporate officers □ Approval of specific financial targets □ Determination of award funds

Compensation X Compensation

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Approval/Review Required Full Board

Committee

Long-term (Cash) Incentive Plans □ Establishment of performance targets

X

□ Award sizing

Compensation

Stock Plans □ Establishment of, or amendment to, stock plans (stock options, restricted stock, stock purchase, etc.)

X

□ Administration of stock plans

Compensation

□ Grants of all stock plans

Compensation

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Appendix 3D

83

Illustration of an Outstanding Compensation Committee Report

ACME CORPORATION’S 1999 NOTICE OF ANNUAL MEETING OF SHAREHOLDERS Executive Compensation Committee Report Executive Compensation Policy The Company’s executive compensation program is administered under the direction of the Executive Compensation Committee of the Board of Directors (the “Committee”). The Committee is comprised of four independent, non-employee directors. The executive compensation program is designed to promote the following objectives: □ Attract, retain, and motivate executives who can significantly contribute to the success of the Company. □ Reward the achievement of business objectives that have been approved by the Board. □ Provide a rational, consistent, and competitive executive compensation system that is well understood by those to whom it applies. □ Tie a significant portion of executive compensation to the long-term performance of the Company’s Common Shares. The Committee believes that if these objectives are consistently achieved, shareholder value will be enhanced over time.

EXECUTIVE COMPENSATION PROGRAM Salary Component Executive officers receive a salary based on their responsibilities and potential at market levels indicated by compensation survey data. The Company’s objective is to set executive salaries at or near the midpoint of the survey range of salaries for similar positions at other companies judged to be comparable. Salaries are reviewed

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annually and adjusted upward or downward for changes in those factors and the individual’s performance. Better performance generally results in an increased salary, subject to the limits of the salary range established by the Company. For executives who exceed expectations, some part of the increase will be paid in a single lump sum, as a merit cash award, rather than becoming a part of the future salary base. Annual Bonus Component In 1998, Messrs. Doe and Roe participated in the 1997 Executive Bonus Plan (“Executive Bonus Plan”). This Plan has been designed to reward participants appropriately for current corporate and/or business unit performance. Under the Executive Bonus Plan, a target annual bonus amount, which varied by position, was established for each participant. In 1998, Mr. Doe’s target annual bonus amount equaled 135% of salary; for Mr. Roe, the target was 125% of salary. Awards under the Executive Bonus Plan were determined by reference to two quantitative components: a Core Business Gainsharing Component and an Investment Component. The Core Business Gainsharing Component was based on a performance matrix (“Gainsharing Matrix”) which assigned a performance score to various combinations of profitability and growth outcomes for the Company’s Personal Lines segment (excluding ABC, Inc.) and the commercial vehicle business unit (collectively, the “Core Business”). Under the Gainsharing Matrix, profitability was measured by comparing the combined ratio (“CR”) achieved by the Core Business, determined in accordance with generally accepted accounting principles (“GAAP”), against a target combined ratio, while growth was measured in terms of the yearto-year change in net written premiums, subject to a weighting factor to provide additional incentives to encourage growth in specified product lines. The Investment Component compared the performance of individual segments of the Company’s investment portfolio against the range of performance results achieved by selected groups of comparable investment funds. The weighting of the two components differed for the participating executives, depending on the nature and scope of their assigned responsibilities. A bonus award equal to the target annual bonus resulted if designated goals were met. Actual awards could range from 0% to 200% of the target annual bonus amount, depending on the extent to which performance fell short of or exceeded the designated goals. In 1998, all other officers and qualified employees (approximately 15,150) of the Company, participated in the Company’s 1997 Gainsharing Plan (“Gainsharing Plan”). The Gainsharing Plan is substantially similar to the Executive Bonus Plan, but does not include an Investment Component. Under the Gainsharing Plan, awards were based on performance in achieving profitability and growth targets, as mea-

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sured by the Gainsharing Matrix, for both the Core Business and the individual participant’s business unit or product. Long-Term Incentive Component In 1998, the executive compensation program included long-term incentives through the grant of non-qualified stock options. This component is designed to encourage the long-term retention of key executives and to align executive compensation directly with the long-term enhancement of shareholder value. Stock option grants are intended to focus the executive on managing the Company from the perspective of an owner. The named executive officers and approximately 400 other management employees of the Company currently participate in the long-term incentive program. The stock options have an exercise price which is equal to the market price of the Company’s Common Shares on the date of grant, contain provisions which defer vesting of the options for up to five years and may be exercised at any time during the five years following vesting. The value of a stock option depends directly on the future performance of the Company’s Common Shares, since it has value to the recipient only if and to the extent that the price of the Company’s Common Shares increases above the option exercise price. Stock option awards are normally made annually. A target award value, which varies by position, is established for each executive officer in order to bring total targeted compensation to the top of the survey range. In 1998, for the Company’s executive officers, these target award values ranged from 100–275% of salary, depending on job classification. The target award value is then divided by a value per share developed through a modified Black-Scholes pricing model, to determine the number of option shares to be awarded. In 1998, the pricing model valued the stock options awarded to executive officers at $53.618 per share, which is 43.24% of the per share exercise price of $124.00. The following assumptions were used to derive the ratio: 10-year option term, .2587 annualized volatility rate, 5.7% risk free rate of return and .21% dividend yield, and an assumed annual attrition factor of 3% for each of the 5 years prior to vesting.

CHIEF EXECUTIVE OFFICER COMPENSATION John Doe, the Company’s Chief Executive Officer, received cash compensation in the amount of $2,457,800 for 1998, consisting of an annual salary of $800,000 and an annual bonus award of $1,657,800, in addition to the non-cash compensation disclosed in the Summary Compensation Table and related footnotes on page 10. Mr. Doe’s salary has been reduced from a high of $1,198,077 in 1991, because the

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Committee desires to place more emphasis on the variable components of executive pay. Mr. Doe’s annual bonus target for 1998 was $1,080,000, an amount equal to 135% of his salary. For Mr. Doe, 80% of his bonus target was based on the Core Business Gainsharing Component and 20% was based on the Investment Component. For 1998, a Gainsharing Matrix that measures profitability and growth in net written premiums for the Company’s Core Business determined the Core Business Gainsharing Component. In 1998, the Company’s Core Business achieved a CR of 91.4, with 32% adjusted growth in net written premiums (calculated by applying certain pre-established multipliers to encourage growth in selected product categories), resulting in a performance score of 1.815 for the Core Business Gainsharing Component. In addition, the Investment Component score was .417 compared to a target of 1.0. Applying the weighting factors to the performance scores for each of the components, and then combining the results, produced a Performance Factor of 1.535. Mr. Doe therefore earned 153.5% of target, or $1,657,800, as his annual bonus. For the long-term incentive component of his compensation, on March 18,1998, Mr. Doe was awarded stock options to purchase 41,000 of the Company’s Common Shares at an exercise price of $124.00 per share. This award vests on January 1, 2003, and was determined in accordance with the stock option formula described above.

OMNIBUS BUDGET RECONCILIATION ACT OF 1993 In 1993, the Internal Revenue Code of 1986 was amended by the Omnibus Budget Reconciliation Act of 1993 (“Budget Reconciliation Act”), which limits to $1 million per year the deduction allowed for Federal income tax purposes for compensation paid to the chief executive officer and the four other most highly compensated executive officers of a public company (“Deduction Limit”). This Deduction Limit, which became effective in 1994, does not apply to compensation paid under a plan that meets certain requirements for “performance-based compensation.” To qualify for this exception, (a) the compensation must be payable solely on account of the attainment of one or more pre-established objective performance goals; (b) the performance goals must be established by a compensation committee of the board of directors that is comprised solely of two or more “outside directors”; (c) the material terms of the performance goals must be disclosed to and approved by shareholders before payment; and (d) the compensation committee must certify in writing prior to payment that the performance goals and any other material terms have been satisfied. Compensation attributable to a stock option award is deemed to satisfy the requirements for “performance-based compensation” if the award is made by a com-

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pensation committee comprised solely of two or more “outside directors,” the plan under which the award has been granted is approved by shareholders and states the maximum number of shares with respect to which options may be granted during a specified period to any employee and, under the terms of the option, the amount of compensation the employee could receive is based solely on an increase in the value of the stock after the date of the award. Generally, the Deduction Limit does not apply to any compensation payable under a written contract that was in effect on February 17, 1993, or pursuant to a plan or arrangement approved by shareholders prior to December 20, 1993, provided certain requirements are met. It is the Company’s policy to structure its incentive compensation programs to satisfy the requirements for the “performance-based compensation” exception to the Deduction Limit and, thus, to preserve the full deductibility of all compensation paid thereunder, to the extent practicable. The Company’s stock incentive plans, as well as the Executive Bonus Plan, have been submitted to and approved by the Company’s shareholders. Compensation awards under these Plans are designed to satisfy the requirements of the “performance-based compensation” exception to the Deduction Limit. Salaries and any perquisites are subject to approval of the Committee, but will not be submitted to a vote of shareholders, and thus will not be deductible if and to the extent that such compensation exceeds $1 million per year for any such executive. SUMMARY The Committee believes that executive compensation should be linked to the creation of shareholder value. The Company’s executive compensation program thus includes significant long-term incentives, through equity-based awards, which are tied to the long-term performance of the Company’s Common Shares. The Committee recognizes, however, that while stock prices may reflect corporate performance over the long term, other factors, such as general economic conditions and varying investors’ attitudes toward the stock market in general, and specific industries in particular, may significantly affect stock prices at any point in time. Accordingly, the annual cash components of the program, consisting of salary and annual bonus, emphasize individual performance and the realization of defined business objectives, which are independent of short-range fluctuations in the stock price. The executive compensation program thus has been designed to align executive compensation with both the Company’s business goals and long-term shareholder interests. The Committee believes that the program, as implemented, is balanced and consistent with these objectives. The Committee will continue to monitor the operation of the program and cause the program to be adjusted and refined, as necessary, to ensure that it continues to support both corporate and shareholder goals. /s/ EXECUTIVE COMPENSATION COMMITTEE [names]

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Appendix 3E

Sample Form for Board Evaluation

Rate the following statements in relation to our board of directors: Topic 1.

2. 3.

4. 5. 6. 7.

8. 9.

10. 11. 12.

Description The board knows and understands the company’s beliefs, values, philosophy, mission, strategic plan, and business plan, and reflects this understanding on key issues throughout the year. The board has and follows procedures for effective meetings. Board meetings are conducted in a manner that ensures open communication, meaningful participation, and timely resolution of issues. Board members receive timely minutes or drafts. Board members receive accurate minutes. The board reviews and adopts annual capital and operating budgets. The board monitors cash flow, profitability, net revenue and expenses, productivity, and other financially driven indicators to ensure that the company performs as expected. The board monitors company performance with industry comparative data. Board members stay abreast of issues and trends affecting the company, and use this information to assess and guide the company’s performance, not just year to year, but in the long term. Board members comprehend and respect the difference between the board’s policy-making role and the CEO’s management role. The board acts to help the CEO by setting clear and well-understood policy. Board goals, expectations, and concerns are honestly communicated to the CEO.

*Rating 1 to 5, with 1 = “not performing” to 5 = “outstanding”

Rating*

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Chapter 4

Legal and Regulatory Considerations The compensation committee operates in an extremely complex, highly confusing, and ever-changing legal and regulatory environment. This chapter reviews legal considerations related to performing duties as a compensation committee member. It also reviews tax considerations involved in executive compensation. Accounting considerations are covered in Chapter 10. The two major legal and regulatory considerations are (1) the director’s role as a fiduciary to the shareholder’s interests; and (2) the director’s need to comply with Internal Revenue Code (IRC) § 162(m) to ensure that all compensation payments are deductible by the corporation they serve.

LEGAL CONSIDERATIONS Directors are fiduciaries—persons in whom others place special trust and confidence. As such, they are subject to common-law duties of care and loyalty. The duty of care, as the name implies, involves the concern, attention, and diligence that directors are expected to exercise in discharging their duties. The duty of loyalty involves the ethical nature of the director’s position and, more particularly, the director’s obligation to subordinate self-interest to the interest of the corporation whenever the two conflict.

LEGAL OBLIGATIONS OF DIRECTORS AND THE BUSINESS JUDGMENT RULE It is important that the board and/or its compensation committee review and consider executive officer compensation carefully and diligently in order for the deliberations to fall under the business judgment rule. The broad parameters of this rule are: 89

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• Payments to executive officers can raise “interested director” issues. The transactions under consideration may not be exempt from SEC or IRS rules. The basic reason why all compensation committee members must be independent is to ensure disinterested decision making. Other significant reasons include exemption of the transaction from “short-swing” profit liability exposure under SEC § 16 and deductibility of the transaction under IRC § 162(m). • Compensation committee members can be held to a higher duty of care when dealing with executive compensation. This higher level of care requires directors to review executive compensation matters more closely and carefully than other matters. • Even if an executive compensation arrangement has been approved by informed, disinterested directors, courts sometimes hold executive compensation arrangements to be a “waste” or “gift” of corporate assets, thereby depriving the directors of the protection of the business judgment rule. • Executive compensation arrangements adopted in the face of a threatened takeover or change in control may be held to the “reasonable response” standard. In summary, the business judgment rule serves as the primary cornerstone in assessing the duties of a director. Our legal system places the burden of proof regarding dereliction of duty on the plaintiff who is suing the directors. A successful challenge based on the business judgment rule should show failure to: • Act in good faith • Exercise prudent judgment • Act in the best interests of the corporation.

DEFINING CARE Although the duty of care is a common-law doctrine—that is, one created by judicial decisions—some state statutes now codify the essential elements of the duty. Section 8.30(a) of the revised Model Business Corporation Act provides: A director shall discharge his duties as a director, including his duties as a member of the committee: (1) In good faith; (2) With the care an ordinarily prudent person in a like position would exercise under similar circumstances, and (3) In a manner he reasonably believes to be in the best interest of a corporation.

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As this language makes clear, care has a rather specialized meaning in this context. It certainly is not synonymous with caution. Taking risks is an essential part of doing business and, by definition, not all risk taking turns out positively. Directors must be afforded considerable latitude in deciding which business risks are reasonable. The courts have, by and large, been sensitive to this need. In interpreting the duty of care, courts have generally focused on the behavior and thought processes of the directors at the time decisive action was taken, and have placed less weight on the actual outcome of the decision. By refusing to equate disappointing outcomes with director carelessness, the courts have preserved the board’s ability to innovate and take risks.

DUTY OF LOYALTY The duty of loyalty requires the director to avoid personal conflicts of interest. In the area of compensation, this duty becomes an issue whenever the compensation committee is considering a compensation strategy or program from which a committee member may personally benefit, whether directly or indirectly. Interested directors must fully disclose their interests to shareholders. Questions regarding a director’s duty of loyalty may arise in any number of contexts, and they frequently do arise in the context of sales to or purchases by the corporation from directors or related entities; dealings by a parent corporation with a subsidiary; insider trading and other misuse of corporate information; financing opportunities for the company or related companies; and usurpation of corporate opportunities. Under common law, self-dealing transactions are considered voidable. However, many states have adopted so-called “safe harbor” statutes, which generally provide that a conflict transaction is not voidable solely because it is between the corporation and the director and officers if: (1) it is approved by either informed, disinterested directors or shareholders, or (2) the transaction is shown to be fair to the corporation. Critical to the operation of the Delaware safe-harbor statute (and all of those based on the Delaware model) is the concept of full disclosure of all facts material to the transaction. Although directors or shareholders may approve an otherwise conflicted transaction, their approval has no legal effect without full disclosure. In several cases, directors have been found liable for a breach of duty of care in the decision-making (as opposed to oversight) area, most notably in the TransUnion case, Smith v. Van Gorkum, 488 A.2d 858, 872 (Del. 1985). More recently, the board of directors of Paramount Communications saw its preferred merger with Viacom, Inc., imperiled when a reviewing court found that the directors had given “insufficient attention” to the potential consequences of their combination.

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DUTY OF DIRECTORS TO SHAREHOLDERS The board of directors has the exclusive authority to determine the value of services performed by executives and to compensate them accordingly. As discussed earlier, the board usually delegates this authority to the compensation committee, due to the complexity of compensation issues and the time constraints on developing sufficient data to satisfy the fiduciary duty of care in such determinations. Shareholders, the SEC, and the IRS also weigh in on the oversight of executive compensation. Indeed, it seems like the whole world is watching, and the compensation committee must sometimes make decisions under extreme pressure in a short period of time. Shareholders and their advisors continue to vigorously and actively express concern to directors regarding the amount and form of compensation paid to executives. A majority of companies prepare to answer questions about their pay practices at their annual shareholder meetings. In addition, shareholders continue to put resolutions to vote on executive pay issues. Examples of recent shareholder proposals include: • To compel the compensation committee to hire its own outside compensation consultant • To require shareholder approval for repricing of stock options • To limit the pay of the CEO to a multiple of the typical worker’s pay • To require shareholder approval for severance agreements. Shareholder concern about excessive executive pay also influences their votes on new executive compensation programs (typically new stock award allocation requests). This concern results in proxy voting contests in which the company has to rally support for a plan, and in some cases has to change the proposal to win shareholder approval. Why should a company care if an executive compensation program presented for shareholder approval passes by an overwhelming majority or just barely passes? On the one hand, almost all corporate documents require only a majority shareholder vote to pass a new executive stock award allocation. Therefore, a simple majority is a win for the executive officer corps, because they will have additional stock to award. Or is it? Some institutional investors may sell some or all of their stock holdings as a sign of their displeasure with management. This sell-side pressure will cause a reduction in stock price. If there are any other negative bits of information at the same time as the contested executive pay program, they may combine to cause a substantial reduction in stock price. In summary, it is very important for a company to keep its shareholders satisfied with its performance and to avoid large blocks of negative votes.

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If shareholder dissatisfaction results in a shareholder lawsuit against directors, the shareholder generally seeks to hold the directors of the defendant company personally liable to the corporation for the repayment of any excess compensation paid to executives. The primary accusation of the shareholders’ claim is that a portion of the compensation paid to executives is excessive (in relation to the asserted value of the executive to the corporation) and is therefore a waste of corporate assets. Other shareholder assertions in such actions may include director self-dealing, breach of fiduciary duties, and unlawful board actions. Although it is not possible to prevent shareholders from commencing a legal action against the corporation and directors, it is possible to minimize the risk of exposure to director liability. To immunize itself from further legal action, the compensation committee should consider taking the following actions: • Regularly review all officer, director, and executive compensation/benefit programs for objectivity, equity, level of external competitiveness, and reasonableness. • Be disinterested by taking a neutral view of management’s executive compensation, actively participating in committee meetings, and being well prepared for each meeting. • Be aware of all issues that are before the committee, and participate in opportunities to learn more about compensation issues. • Assure that compensation relates positively to important business performance measures. • Make necessary changes to plans and programs as conditions warrant. • Obtain the best possible legal, compensation, and accounting advice. • Allow adequate time to discuss and vote on issues. • Assure that committee actions strictly comply with applicable laws and rules. What a Director Needs to Know about IRC § 162(m) Internal Revenue Code § 162(m) was enacted as part of the Revenue Reconciliation Act of 1993. In effect, the intent of this new law was to deny publicly held companies any tax deduction for annual compensation in excess of $1 million paid to executive officers. Under IRC § 162(m)(3), these executives include the CEO and the top four highest paid executive officers. Under IRC § 162(m)(4), covered compensation includes all cash and noncash benefits for services except for: individual commissions; certain performance-based pay; payments to qualified pension plans; amounts excludable from income, such as

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health and insurance plans; and any remuneration payable under a contract in effect on February 17, 1993. Section 162(m) applies only to corporations that are publicly held on the last day of the taxable year. A corporation is publicly held if it has any class of common stock that must be registered under § 12 of the Securities Exchange Act of 1934. Therefore, the existence of registered preferred stock and debt instruments resulting in the corporation being a reporting entity will not by itself classify the corporation as publicly held for purposes of § 162(m). The 162(m) regulations, however, provide a three-year grace period after an initial public offering (IPO) during which shareholder approval of performancebased plans is not required, provided the plans are adequately disclosed in the IPO prospectus. For purposes of IRC § 162(m), performance-based pay must meet the following requirements: • It must be paid solely for satisfaction of one or more preestablished objective performance goals. A performance goal is objective if it meets two third-party tests: (1) a third party having knowledge of the relevant facts could determine whether the goal has been met, and (2) a third party having knowledge of the relevant performance results could calculate the amount to be paid to the employee if the goal is attained. • A compensation committee made up exclusively of two or more outside directors must establish performance goals. The definition of outside director is more narrowly interpreted than in other definitions and thus is more difficult to meet. • Shareholders must review and approve performance objectives before payout. • The compensation committee must certify in writing that goals were met. To be considered preestablished, a performance goal must be established, in writing, by the compensation committee no later than 90 days after the commencement of the period of service to which the goal relates, provided that the outcome is substantially uncertain at the time the committee establishes the goal. The regulations provide that the performance goal need not be based on increased results; rather, it can be based on maintaining the status or limiting losses. Nevertheless, the performance-based exception is not satisfied unless the compensation is paid under a preestablished, objective standard that does not involve positive discretion of the compensation committee (although the compensation committee may have the right to reduce the amount payable). Restricted stock cannot qualify as performance-based compensation unless the grant or vesting of stock is based on the attainment of a performance goal and satisfies the requirements for performance-based compensation.

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One of the most controversial aspects of the proposed IRS regulations involves the definition of outside director. A director is an outside director if he or she: • Is not a current employee of the publicly held corporation, • Is not a former employee of the publicly held corporation receiving compensation for prior services during the taxable year (other than benefits under a qualified retirement plan), • Has never been an officer of the publicly held corporation, and • Does not receive remuneration, either directly or indirectly, from the corporation other than as a director. See Exhibit 4.1 for a summary and clarification of the significant provisions of IRC § 162(m).

Exhibit 4.1

Significant Clarifications of IRS Section 162(m)

Stock Plans

Bonus Plans

Outside Directors

• None of the compensation resulting from a stock option that is not based solely on an increase in the stock values would be considered performancebased.

• Corporations may express the maximum individual bonus payment in the form of a base salary percentage without specifying a maximum dollar amount, as long as the dollar amount of base salary on which the maximum percentage is based is fixed.

• A former officer or director of either a spinoff or a liquidated corporation that was an affiliate of a publicly held company is not precluded from serving on the compensation committee.

• Dividend equivalents attached to stock options will not cause the option to be non-performancebased, as long as payment of the dividend equivalents is not conditioned on the employee exercising the option. Dividends attached to performancebased restricted stock do not affect the deductibility determination.

• When bonuses to be paid to each executive are stated in terms of a bonus pool percentage, the sum of the individual percentages for all eligible pool participants cannot exceed 100 percent.

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Legal and Regulatory Considerations

Stock Plans Generally, stock options and stock appreciation rights would be considered performance-based compensation, provided that the outside director and shareholder requirements are met, because the amount of compensation paid is always deemed based on an increase in the company’s stock price.

Performance-Based Compensation Must Be Approved by Shareholders In the case of compensation paid pursuant to a stock option plan, the shareholder approval requirement is satisfied if the shareholders approve the general terms of the plan, the class of executives to which it applies, the option price, and the maximum number of shares that can be awarded to any executive. Companies that acknowledge that they have exposure because of the size or design of their executive compensation programs sometimes find that conformance to IRC § 162(m) requires a basic change in their management practices. A common reaction by management, when confronted with the potential loss of deductibility, is that it may not be material in a financial sense, and thus they take no action. Subsequently, many of these companies have recognized the adverse impact that inaction may have on shareholders and have reversed their position on this issue. Eligible Individuals

Although particular individuals need not be identified by name, a general description of the class of eligible employees (for example, the chief executive officer and vice presidents, all salaried employees, or all executive officers) must be disclosed to, and approved by, shareholders. Business Criteria

A description of the business criteria on which the performance goal is based must be disclosed to and approved by shareholders. The regulations provide that disclosure of the business criteria need not include the specific targets that must be satisfied under the performance goal. The rationale for this exemption is to allow the company not to disclose competitive data to competitors. Maximum Compensation or Formula

Either the maximum amount of compensation to be paid, or the formula used to calculate the amount of compensation to be paid, if the performance goal is attained must be disclosed to, and approved by, shareholders. If the formula is not disclosed, the disclosure must be specific enough that shareholders can determine the maxi-

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97

mum amount of compensation that could be paid to any employee during a specific period. Compensation Committee Certification

The final requirement for compensation to qualify as performance-based states that the compensation committee must certify in writing, prior to payment of the compensation, that the performance goals and any other material terms were in fact attained. Approved minutes of the compensation committee meeting at which the certification is made are treated as written notification.

BOARD ACTION MAY BE REQUIRED IRC § 162(m) and the regulations thereunder became effective more than five years ago. Therefore, for many companies, shareholder reapproval must be obtained in an upcoming proxy season in order to preserve the performance-based compensation exception. If the necessary shareholder reapproval prior to the first shareholder meeting that occurs in the fifth year following the year of the initial shareholder approval is not received, performance-based compensation awarded thereafter will no longer be exempted from the $1 million deduction limitation.

TAX ISSUES RELATED TO PRIVATE COMPANIES In most closely held firms, controlling shareholders determine their own pay packages. The Internal Revenue Service is vigilant as to the issue of avoiding taxes by paying above-market amounts to shareholders instead of paying at market levels and paying the rest in dividends. The IRS has allowed only a fraction of these payments as deductible, and may also assess large penalties and interest payments. See Appendix C for additional information on pertinent tax rules.

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Chapter 5

Overview of Executive Compensation Issues and Strategies This chapter provides an overview of executive compensation strategies, and how to apply these strategies to your company.

IMPORTANCE OF A COMPENSATION PHILOSOPHY Compensation philosophy is the key to a successful pay strategy. Pay strategy is the glue that holds the overall business strategy together. A well-designed pay strategy should be simple in design and easy to communicate to a large number of executive managers. The pay program for the CEO should be in line with pay programs for other executives and broad-based incentive programs. In other words, there should be no conflict in the achievement of objectives, and the potential rewards should be as meaningful to the CEO as to others in the company. The compensation committee of the board should establish a compensation philosophy, set performance goals, ensure that pay is in line with performance, and obtain necessary outside counsel and advice. The purpose of the compensation committee is to review and report to the board on compensation and personnel policies, programs, and plans, including management and succession plans; and to approve employee compensation and benefit programs. The top-performing companies’ proxy statements provided full disclosure in the compensation committee reports and executive pay sections. This is an indication of a well-organized and well-functioning compensation committee. As consultants, we recommend that the compensation committee reduce the multitude of pay issues, other related initiatives, and noise to a few initiatives and communicate this information to shareholders and potential investors in a clear, concise, and unequivocal manner. 98

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MODERN ERA OF EXECUTIVE COMPENSATION The modern executive compensation scheme has its roots in practices introduced in the early 1900s when E.I. Dupont de Nemours, Inc., launched the first stock bonus plan. In 1915, Computer Tabulating Recording Company (CTRC), the predecessor to IBM, introduced a CEO bonus program in which the CEO received 5 percent of corporate profits. General Motors introduced a similar program in 1918. The 1970s Modern executive compensation began to take shape in the 1970s. Stagflation and weak stock price performance characterized the stagnant 1970s. CEO pay levels increased, on a nominal basis, but were undercut by high levels of inflation. The implication for CEO compensation was a steady movement away from the use of stock options. By 1980, the average face value of annual CEO option grants had dropped to just over one times salary. Greater emphasis was placed on long-term cash plans such as performance share and unit plans. Phantom stock plans with a formula stock price also emerged in this era. Management consulting firms began to emphasize strategic planning and the importance of shareholder value creation. New economic measurement methods, such as economic value added (EVA) and cash flow return on investment (CFROI), were developed to track shareholder value. These were incorporated into both annual and long-term incentive plans. Fischer Black and Myron Scholes developed the Black-Scholes option valuation model in 1973, although it was not immediately used for either capital markets or executive compensation programs. Fischer Black and Robert Merton, of the Massachusetts Institute of Technology, and Myron Scholes, from the University of Chicago, originally developed option-pricing models in 1973. Merton and Scholes eventually went on to be awarded the Nobel Prize for economics for this groundbreaking work in the mid1990s (sadly, Black died prior to this recognition). Black, Merton, and Scholes first used their creation to price the put and call options traded at the newly formed Chicago Board Options Exchange. Even though Merton participated in the creation of this valuation model and received the Nobel Prize for his work, it is always referred to as the Black-Scholes option valuation model or formula. The BlackScholes formula was an immediate success and was widely adopted by practitioners and option traders as a practical and useful tool for understanding the price and price movement of options. The formula incorporates both the intrinsic value (the spread in the option) and the time value of the option (the term of the option) to determine the option’s total market value. For example, in general, an option grows in value the more the option is in the money; it decreases in value the more the option is out of the money. Furthermore, in general, the option is worth more the longer the period to expiration

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of the option term (e.g., a 10-year option is worth more than a 5-year option, all other factors being equal). The Black-Scholes option valuation model is based on a mathematical equation that must hold true. That is, the price of the stock option is equal to the price of the stock times a stochastic variable which is based on the volatility of the stock and the time left to expire on the option less the present value of the exercise price of the stock option multiplied by a stochastic variable based on the volatility of the stock and time left to expire on the option. Another important event in the 1970s was the adoption of the Employee Retirement Income Security Act of 1974 (ERISA). This legislation was introduced in response to lack of pension safeguards that became apparent in the 1960s. ERISA gave favored tax treatment to certain pension benefits, but the tax-favored plans limited benefit accruals and payments to higher paid employees. After ERISA, CEO compensation would never be the same again, as programs such as excess pension benefits restoration plans and supplemental executive retirement plans were introduced in response to the legislation. These “nonqualified” programs were designed to provide executive benefits in excess of those allowed under the tax-favored pension plans. The 1980s A bullish stock market and changing government regulations rekindled an interest in stock options in the opulent 1980s. The total cumulative return on the S&P 500 Stock Index averaged 16 percent per year. New legislation lowered the capital gains and ordinary income tax rates in 1986. The incentive stock option (ISO) was introduced, and a “golden parachute” excise tax was also introduced in 1984. The net result was that CEO pay skyrocketed, particularly with respect to the longterm incentive component. Important results from the 1980s are summarized as follows: • By the end of the decade, the face value of annual incentive grants, primarily stock option awards, for CEOs rose to approximately 3.5 times salary (from a one-times level from the beginning of the 1980s). • Omnibus stock incentive plans became commonplace, allowing maximum flexibility in granting types of long-term incentive plans. • The typical Fortune 250 company was simultaneously using, on average, 2.5 different types of long-term incentive plans. • Mega-grants, reload stock options (RS0s), dividend equivalents, and stock withholding added panache (and attractiveness) to CEO pay packages but at the same time made them much more complicated.

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A watershed event of the 1980s was the 1987 stock market crash, because the aftermath was a greater use of stock options and other equity awards designed to align executives’ pay with shareholders’ interests, especially characterized by the proliferation of mega-options. Michael Eisner, CEO of the Walt Disney Company, is a good example of this trend. He received 2 million shares (pre-split) in 1989, before his contract was due to expire in 1990, when the grant would ordinarily have been made. The 1990s Over the past few years compensation committees have evolved from a required nuisance—mandated by the Securities and Exchange Commission (SEC) in 1992 and encouraged by the introduction of the $1 million pay deduction cap in 1994— to a strategic asset. The increased pay disclosures required by the reformation of proxy statement disclosure rules, together with the denial of corporate tax deductions for nonperformance-related compensation in excess of $1 million, have compelled most publicly traded companies to design and implement truly incentivebased compensation programs. Three major events in the 1990s combined to encourage companies to articulate performance contracts with CEOs: 1. Revision of proxy statement disclosure rules in 1992 brought more complete disclosure of executive employment arrangements. 2. Enactment of IRC § 162(m) shifted more pay into performance-based types of compensation. The nature of CEO compensation was largely transformed from entitlement to performance-based. 3. Creation of a compensation committee of outside directors resulted in a negotiating environment that was more arm’s-length. Each event was important, but it was the combination that coalesced to allow companies to make effective CEO performance contracts. During the 1990s the economy became global, as worldwide events began to have immediate effects in the United States. The Internet and the PC revolution dramatically increased the instantaneous flow of information worldwide. The number of Internet users doubled every 100 days. CEO performance contracts combined with an unprecedented bull market triggered huge CEO compensation payouts. Executive pay closely followed the stock market upward. The bullish 1990s seemed to be the crown to the prior 90 years. The economy had never been better. The stock market rushed ahead, setting continual records. Inflation and unemployment defied conventional economic theory by remaining consistently at historic lows. The long-held economic theory referred to as the “Philips curve” (which holds that one cannot have low unemployment and low in-

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flation at the same time) had to be reformulated in the face of this extraordinary economic growth. 2000 and Beyond First and foremost, the most startling and pronounced trend was the shift to the “new economy” that permeated almost every sector of the U.S. economy. Information, investment, and service firms, in general, became the source of U.S. economic growth. Founders and inventors of emergent companies, such as Bill Gates and Steven Jobs, created enormous wealth for shareholders. New technologies such as the Internet, fiber optics, computer storage media, PCs, operating systems, and application software pushed the U.S. economy to new heights. The U.S. economy has traditionally leveraged new technology into the next big thing. For example, in the 1960s, the next big thing was transistors and electronics. Along the way, capital markets have been instrumental in fueling this expansion. As the electronics explosion transformed the computer from a behemoth of vacuum tubes and paper punch cards to microprocessors, CD-ROMs, and Internet technology, the U.S. capital markets and executives provided the necessary capital and management to lead the worldwide computer industry. This flight to new technology eventually focused squarely on the new economy—that is, anything connected with the Internet. Internet fever swept corporate America and changed everything. A second gold rush captivated the country as young and old alike left home for Silicon Valley, New York, northern Virginia, Boston, and Atlanta to join the Internet revolution. Venture capital funds became gorged with cash, institutional investors invested substantial funds in the Internet community, and financing rounds were completed more quickly and for more than expected. Moreover, the time from startup to IPO was compressed from four to two years, and the lockup period (the time the executive and pre-IPO investors are required to hold their stock prior to selling post-IPO) decreased from 18 months to 6 months. Thus, the period from the birth of a new idea to the cash-out of that idea was reduced from 5.5 years to 2.25 years. Since that period of exuberance, IPO startups have proven to be very risky. The NASDAQ has dropped to less than half of what it was at its peak, and investors have become much more cautious. At the end of 1999, a typical CEO at a pre-IPO Internet company was paid about $200,000 in salary with no annual bonus, and received between 300,000 and 500,000 stock options representing between 5 percent and 7 percent of the common shares outstanding. These numbers were unimaginable just four years before. According to a study by Arthur Andersen, at the time of a company’s initial public offering, approximately 13 percent of outstanding common stock was awarded to employees, with another 10 percent reserved for future awards, for a total of 23 percent of common outstanding shares.

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The shift in the U.S. economy is causing confusion in the compensation structure as companies strive to pay old- and new-economy executives under the same umbrella. Corporate America is reviewing alternatives such as tracking stock, stock options on wholly owned subsidiaries, spinning out Internet subsidiaries, and creating freestanding new enterprises with venture capital partners. The frenzy on the part of most companies to be involved in the new economy is enormous. A major reason for the exploration of new ways to organize Internet initiatives is to provide a currency to attract and retain the newly trained and scarce Internet executive workforce. Brick-and-mortar executives left in droves to join Internet startups. This was especially true of financial and legal executives, as Internet companies needed credible and experienced professionals in these two critical areas. For example, as was reported in the New York Times, this effect forced law firms to provide substantial raises to senior associates in an attempt to retain their services. In addition, accounting and consulting firms also experienced the draw of the Internet. The full effect of the downturn in technology stocks remains to be seen. Shift to Equity Awards

In the late 1990s, and continuing in 2000 and 2001, there was a shift to equity awards with corresponding increases in stock overhang and stock award rates. Levels of long-term incentive opportunity increased threefold as a percentage of salary. Pay for performance is the current watchword of corporate America. The use of stock ownership guidelines continues to increase. Stock overhang (total shares allocated for outstanding and potential employee equity awards) has continued to explode (for example, it went from 7 percent in 1987 to 14 percent in 1998) and shows no signs of abating in the next two years. This is the longest economic expansion in U.S. history, but the performance of the stock market is choppy and mixed, as large market capitalization stocks—with most other stocks left out— pull up the stock market indexes. Stock indexes are weighted by market capitalization, so they tend to track the performance of the large capitalized stocks; thus, when large caps stock do well they skew the stock index upward. Stock overhang has continued to increase at a dramatic pace over the past two years, for the following reasons: • Stock programs are becoming more broad-based, with equity-based awards being pushed further and further down the organization. • At companies that are not enjoying the recent stock successes—and there are many with the choppy stock market—stock holdings expand, as there is no incentive to exercise options. • Mega-grants continue to be popular, especially with the large number of IPOs, spinoffs, and other restructurings. This includes the effects from dotcom companies.

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• As the large demand for experienced senior executives continues, large retention stock awards are being made to attract and retain these persons. In particular, large stock awards often must be made to keep recruited executives whole on their equity packages. • There is a downward stickiness of stock awards as the stock price increases. That is, as stock prices increase, award sizes do not decrease, even though the size of the award times the market price at the time of award determines the value of the stock option award. Therefore, as the stock price increases and the stock option award number remains the same, the stock option award value also increases. This trend will continue as the overall stock market and large economic sectors continue to grow at a record pace. The two biggest innovations in the 1990s were the creation of reload stock options and shareholder value-added programs. However, the use of these programs has apparently peaked. The biggest development in 1999 was the debate over use of the indexed stock option, in which the exercise price changes with the general market index or a more specific index, thus requiring the executive to beat the market in order to profit from the stock option. Despite the support of major financial executives, such as Federal Reserve Chairman Alan Greenspan, recently retired Vanguard chairman and founder Jack Bogle, and a few institutional shareholders, indexed stock options remain unpopular. As reported in one issue of Business Week, only one major company, Level 3 Communications, Inc., uses indexed stock options. The major reason for rejection of indexed stock options is that senior executives do not like them, for obvious reasons. Furthermore, the Financial Accounting Standards Board (FASB) has not found a way to give indexed stock options a favorable accounting treatment to avoid a charge against earnings for the option spread. The year 2000 could easily be dubbed the year of interpretations. Just when we thought the FASB had concluded its 3.5-year project on providing guidance on how to interpret Opinion 25, with the release of Interpretation 44 on March 31, 2000, the Emerging Issues Task Force (EITF) was back in two months to “interpret” Interpretation 44. The result is a trail of more than 30 practice issues and questions, some of which have been addressed and others of which await yet another meeting. Interpretation 44 is intended by the FASB to provide additional clarification and guidance, within the existing framework of Opinion 25, in several areas of accounting for stock compensation that have emerged in practice over the past years. The Interpretation was effective as of July 1, 2000, and applies to grants of new stock awards and changes that occur on or after that date (exceptions: stock option repricings and grants to nonemployees that occur after December 15, 1998, and stock options modified to add a reload feature after January 12, 2000). See Chap-

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ter 6 for additional information on repricing stock options, Chapter 8 for reload stock options, Chapter 10 for accounting for stock awards, and Appendix B for a summary of accounting standards. As a result of the SEC’s approval of the New York Stock Exchange’s (NYSE) definition of broadly based on June 4, 1999, shareholder concern centered around the potentially unlimited dilution that could result from non-shareholder-approved employee equity plans. In response, the SEC requested that the NYSE work with the NASDAQ to develop acceptable shareholder approval requirements for broadly based plans during a pilot period that was to last until September 30, 2000 (now under extension). The NYSE has developed and submitted for review to NASDAQ a proposal that would potentially replace the existing exemptions for broadly based plans with more rigorous standards. The main points of the NYSE proposal include: • Requiring shareholder approval of all stock option plans in which officers and directors participate. • Capping the number of shares in non-shareholder-approved plans and arrangements (including broadly based plans, new hire grants, and merger awards) at 10 percent of aggregate shares currently available in all shareholder-approved programs maintained by the company. • Requiring grants funded through treasury shares to be subject to shareholder approval requirements (i.e., elimination of the treasury stock exemption that currently exists only at the NYSE). Before responding to the SEC, the NASDAQ has requested public comment on the proposal and is now developing its response. In addition, the SEC is proposing revisions to proxy disclosure requirements contained in Regulation S-K. Currently, companies do not have to disclose the total number of securities they have authorized for their equity compensation programs on an ongoing basis (unless this information is material, in which case disclosure is necessary under GAAP), unless new plans are proposed or modified. The SEC is proposing that equity compensation plan information be disclosed in an amended table format, to include: • Number of securities authorized for issuance under each plan, whether shareholder-approved or not. • Number of securities awarded plus the number of securities to be issued upon exercise of options, warrants, or rights granted during the last fiscal year. • Number of securities to be issued upon exercise of outstanding options, warrants, or rights. • Number of securities remaining available for future issuance.

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These changes would result in shareholders and analysts receiving more detailed information on stock option and other equity plans, so that dilution calculations could be made easily. Effective October 23, 2000, the SEC adopted Rule 10b5-1 to help clarify issues related to insider trading. This new ruling allows insiders and other investors (such as top executives and board members) to buy or sell stock in their companies regardless of the inside information they have, as long as they have committed in advance with no insider information at the time of the commitment. The SEC provides three illustrative instances in which executives can buy or sell securities and not violate insider-trading laws: 1. Executive enters into a binding contract to purchase or sell the security prior to his or her becoming aware of inside information. 2. Executive demonstrates that the trade was executed in advance of his or her becoming aware of the inside information. 3. Executive demonstrates that a written plan for trading securities was adopted prior to his or her becoming aware of the inside information. The new insider-trading rule remains consistent with § 10(b) of the Securities Exchange Act of 1934, which makes it unlawful for any person to employ any deceptive or manipulative device in connection with the purchase or sale of a security. The rules allow executives to be free from prosecution if they can demonstrate that material nonpublic information was not a factor in making a trading decision. The new policy will allow large shareowners (e.g., founders) to use a formulaic policy to sell shares over a period of time. This could potentially help companies avoid large selloffs that adversely affect stock price, which can occur when a large shareowner retires. The Senate passed a bill, titled the “Worker Economic Opportunity Act,” that would exempt stock option gains from overtime calculations proposed by the Fair Labor Standards Act (FLSA) on broadly based grants if the terms and conditions of the program included: • Communication to employees when they were hired or when they received the grant. • Options and stock appreciation rights (SARs) have a minimum six-month vesting period and a purchase price of at least 85 percent of the stock’s fair market value on the date of the grant. • Participation is voluntary. • Awards cannot be dependent on future performance of any individual.

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The legislation is a win for the business community, as companies will be able to continue granting stock options throughout broadly based employee groups without including stock option gains in the base rate to calculate overtime pay for their employees. CEOs Are Super Stars

One of the most important outcomes of the 1980s and 1990s is the emergence of the star CEO system, as top executives began to be perceived as star business players. CEOs now routinely appear on the covers of both business and general media publications and are inextricably identified with their companies and their companies’ products. Two of the most prominent CEO stars exemplifying this trend are shown in Exhibit 5.1. Good, old-fashioned competition has an overriding effect on most CEOs. The American way is to be as competitive as possible, with the CEO being the most competitive of all executives. When this highly competitive nature of a CEO is combined with a more efficient system of tracking market levels of pay, the result is a sort of tournament in which CEOs try to outdo each other—with pay as the scorecard. The disclosure rule revisions only contribute to this tournament effect. More rigorous and uniform disclosure requirements make it easier for CEOs to pinpoint what the competition is making and then demand at least the same. Since 1987, the pressure has intensified on boards to hire the right CEO, regardless of cost. The uniform disclosure has now made it impossible for CEOs not to know what the competition is paying. Therefore, the leapfrogging of larger and larger pay packages was inevitable.

Exhibit 5.1 Examples of Superstar CEOs • Michael Eisner—CEO of the Walt Disney Company. After becoming CEO in 1984, Eisner received approximately 16 million stock options (adjusted for stock splits) between 1984 and 1989. During that same period, Disney stock rose at a compounded annual rate of 52 percent, triggering a huge windfall of stock option gain. Eisner hosted Walt Disney’s popular shows and prominently appeared in various public events and promotions. • Lee Iacocca—CEO of the Chrysler Corporation. After being hired in 1978 from Ford Company at a salary rate of $360,000 plus $1 million for benefits lost, he accepted a reduced salary of $1 per year, with stock options in lieu of salary. Iaccoca was instrumental in turning Chrysler around by gaining approval for a government bailout package. By 1993, he owned 792,180 shares outright and held options for an additional 2,098,500 shares. Iaccoca also hosted Chrysler car commercials.

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Emphasis on Corporate Governance

With the 1990s’ new emphasis on corporate governance, compensation committees emerged as a critical success factor. The rise of the importance of institutional shareholders raised the general corporate awareness of executive compensation best practices. At the same time, executive pay levels increased at an unprecedented rate. Wall Street analysts became more aware of executive compensation practices, primarily in their review of overall corporate governance. This movement toward stronger corporate governance systems continues unabated in 2001. The compensation committee has become a crucial part of the board of directors, particularly as the U.S. economy adopted the Internet into every facet of business, commerce, and life. In addition to this dramatic shift are the effects of emphasis on pay for performance and corporate governance and the emergence of compensation committees as a corporate strategic asset. CREATING SHAREHOLDER VALUE One of the most important tasks confronting compensation committees is to ensure that the appropriate relationship exists between executive pay and shareholder performance. It is also critical that this process result in better understanding and acceptance by the shareholders. The ultimate test is the amount of shareholder value created over the long term. Expectations of shareholders and how the company ranks against industry-sector peer-group companies must be of utmost concern to the compensation committee. The SEC reporting requirements for publicly held companies (SEC Rule 402) mandate that both the compensation committee report and the five-year stock performance graph show the linkage between corporate performance and executive pay. This stock performance graph typically appears toward the end of the proxy statement (SEC Form 14A). The compensation committee report and amounts paid to executives are shown earlier in the Form 14A report. This statement of performance shows beyond doubt the performance of the company as well as the compensation paid to its senior executives. This pay-for-performance linkage is unmistakable and irrefutable. The ideal goal of executive plans should be to promote behavior and decisions that will create real corporate economic value that results in greater shareholder return. Some shareholders argue that some compensation plans encourage management to achieve short-term goals that do not create real economic or shareholder value. Other observers hold that a primary determinant of shareholder value is the adequacy of the company’s return on invested capital or total capital in relation to the carrying cost of the same capital. However, the most important criterion in the determination of executive pay is the excess of shareholder return in comparison to shareholders’ expectations.

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DEVELOPING A COMPENSATION PHILOSOPHY AND STRATEGY Each company should have an executive pay philosophy that fits its particular industry and culture. The compensation philosophy consists of three main parts: 1. Program structure and mix of compensation elements 2. Compensation market objective (also referred to as competitive positioning) 3. The role and weight of corporate performance. Pay practices for executives are much more complex than those for others. Typically, executive pay packages place a larger amount of the total pay package at risk to corporate performance. Ideally, executive incentive programs should be part of comprehensive performance management that: • • • •

Conforms to the corporate economics, culture, and life cycle Enhances shareholder value Reinforces strategic and business plans and strategies Balances short-term and long-term performance and compensation.

These issues must be objectively and independently reviewed and approved by the compensation committee. The first step in the process of developing a compensation strategy is to determine the life cycle stage of your company (see Exhibit 5.2). A compensation strategy that makes sense for an emerging company may not make sense for a more mature company. Furthermore, compensation strategy should change with the stage of the company’s development. The three major components of compensation are salary, short-term incentive, and long-term incentive (see Exhibit 5.3). In some cases, other types of compensation, such as pension and retirement plans and benefits and perquisites, provide a significant amount of compensation that should be taken into account when analyzing a firm’s compensation program. Base Salary Base salary has traditionally been the largest single component of top executive pay. However, this has changed drastically over the past decade, as annual incentives and especially stock award programs have exploded, resulting in a much smaller role for base salary, especially for chief executive officers. Whether or not base salary is a relatively small component of executive pay, it should be carefully determined and reviewed annually, for two reasons: • First, base salary is a certain and fixed component of pay. Base salary receives a lot of attention, especially when an executive is contemplating a job move and

110

Substantially below market

Somewhat below market

At market

At/Above market

Above market

Startup

Initial public offering

Growth

Emerging

Mature

Minimal

Basic medical insurance only

Benefits

Layered plans

Total cash concept with unit variations Rich

Average to above Average

More formal and more Average closely tied to business plan

“Boilerplate” plans

Unusual

Formal Annual Incentives

Above average

Average

Average

Significantly below average

None

Perquisites and Special Benefits

Overlapping programs

Equity and cash plans (Options & PUPs)

Combination stock programs (2 to 3 plans)

Stock options

Founders’ stock

Capital and Wealth Accumulation

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Corporate LifeCycle Stage

Exhibit 5.2 Compensation Programs in Relation to Corporate Life-Cycle Stages

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Exhibit 5.3 Basic Elements of Compensation Compensation Element

Purpose

Base salary

Pays for overall job requirements, accountability, complexity of tasks, and diversity of tasks.

Short-term incentive

Variable component to reward contribution to annual business plan. The most effective measures are revenue growth, earnings, earnings growth, and measures of profitability. Some portion of this bonus is also contingent on individual performance and division or group performance.

Long-term incentive

Used to focus attention on longer-term strategic imperatives, as well as to identify more closely with strategic goals, particularly increase in shareholder value. This element is crucial in attracting and retaining employees.

Special nonqualified plans and benefits/perquisites

Provides special payments and programs that may set the organization apart from others (may include such items as first-class air travel, company car, enhanced medical care, and supplemental retirement programs).

particularly when the industry or general economy is in a down cycle. Also, base salary decisions can cause internal equity issues, particularly between corporate staff and operations executives and between operating divisions. • Second, base salary is an index for other compensation and benefit values. For example, annual bonus is usually a percentage of base salary, and long-term incentive awards are a multiple of base salary. Some companies even make stock option awards based on base salary. Other programs, such as insurance benefits, are often a multiple of salary. So, the determination of base salary is a very important decision. The following example will show how an adjustment in base salary can have a large effect on net total compensation when annual bonus and long-term incentive are taken into account. Most salary decisions involve three basic issues: the scope of the position (e.g., duties and responsibilities); the accountability of the position (e.g., reporting re-

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sponsibilities and autonomy of action); and the relative performance of the incumbent executive. Most organizations have a merit increase program that can add between 0 and 4 percent to a salary increase. Most medium-size or larger organizations have written job descriptions for all managers, including senior executives. These job descriptions, combined with personal knowledge of both the company’s organization and competitive compensation, provide a basis for determining the relative importance of each management position. Once the management positions are ranked in order of importance, a base salary can be determined for each position. Most organizations develop a formal salary structure with salary grade levels. Each salary grade level has a minimum and maximum salary payable for each executive in that particular band. It is not unusual for a large company to have approximately 40 salary levels. The number of levels decreases to approximately 20 for mid-sized companies, and even fewer for smaller companies. Typically, each level spans approximately 15 to 20 percent and also overlaps the salary grade levels above and below it. Some larger companies also assign a quadrant within each salary grade level. They use these quadrants to allow for higher or lower salary increases for the first and fourth quadrant. Each year, or in some cases every two years, these salary structure marks are increased to reflect general inflation levels. There are surveys available for purchase that summarize the movement of salary grade structures. The compensation committee should satisfy itself that the company is adequately market-pricing every executive position and accurately assigning executives within the salary grade structure. Publicly available and private surveys are abundant and should all be used as references to make sure that a job is properly assigned. It is not uncommon for three or four surveys to be used to determine the salary level for an executive. Typically, for a medium-sized or larger company, a regional adjustment is not applied to reflect a lower cost of living. However, for less senior managers and for smaller companies, a downward adjustment should be applied to reflect a lower cost of living. In some high-cost-of-living areas, such as New York City or San Francisco, an upward adjustment may be required. In addition to an upward salary adjustment, senior executives may also receive lowinterest loans to fund comparable housing. These loans typically are repaid over a three- to five-year period. The goal is to assign each manager to the proper salary grade level. When a job cannot be compared to competitive salary information, it can be placed in the structure on a judgment basis. Competitive survey data must be considered based on the size of the organization. Size is usually measured by sales revenue, assets, or in some cases employees. This is especially important for divisions, groups, and other business units that have comparable positions such as finance, operations, marketing, and the top executive. Sometimes, market capitalization is more appropriate to determine the

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competitive compensation level. For example, in a startup or pre-IPO situation, the market capitalization may be a more effective indicator than size. As an alternative, the company can impute a revenue size based on market capitalization or appraised value. It is very important that the top executives relate to one another based on prevalent market practice. However, there may be good reasons for a deviation from market practice. Larger companies have greater stratification of the top five executives. For a smaller company, the second-ranked executive may earn a salary of 80 to 85 percent of the chief executive officer’s. In contrast, a larger company may pay its number two executive 65 to 70 percent of the chief executive officer’s salary. Annual Incentives Annual incentives are payments for the achievement of annual performance objectives. Short-term incentive plans focus on performance objectives that can be achieved in one year. In contrast, long-term incentive plans focus on performance objectives that span more than one year (typically, three to five years). There are two general types of short-term, annual incentive programs: formal plans that provide for regular payment of supplemental awards, which can be referred to as incentive compensation; and substantially discretionary plans under which bonuses are paid at the determination of the board. Formal, nondiscretionary plans are much more common than informal plans that permit discretionary bonuses. In some cases, compensation committees use negative discretion to reduce a bonus payment. See Chapter 4 for additional information on compliance with IRS regulations concerning performance compensation. Some companies have more than one type of annual incentive plan. For example, they may have an “Executive Incentive Plan” that covers executive offers (usually, those by SEC Rule 16(a) as insiders for purposes of determining insider trades). In addition, they may have a “Management Incentive Plan” that covers all other executive officers. Some other firms have still other plans, with names such as “Performance Management Incentive Plan,” that cover other key manager roles such as store managers, corporate staff, and the like. Basic Annual Incentive Design Principles

There are basic design principles to consider in incentive plan design: • The plan should help achieve organizational objectives by providing rewards that are tied directly to the achievement of clearly defined and attainable goals in such areas as profit, growth, and returns. The performance results should be specific, quantifiable, and irrefutable.

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• Annual incentive plans should be extended only to those executives and key managers whose duties and responsibilities give them the opportunity to have a substantial effect on the achievement of broad corporate or business unit goals. • The incentive plan should provide for payment of meaningful awards. The plan should also distinguish among the performance contributions of executives by providing financial recognition for individual as well as team and group performance. As a rule of thumb, the minimum level of annual incentive should be at least 3 percent of base salary for a broad-based incentive plan. • Individual awards should fluctuate appreciably in clear and direct relationship to contributions to company and unit/function achievement. • The annual incentive plan should be integrated with the total compensation program, particularly base salary and other direct compensation elements. • The plan should be revised and improved upon to respond to changing corporate/ unit goals, shifts in the nature of the business, and external changes. A formal administration program for an annual incentive plan is recommended, as it makes the process fairer and more objective. Ways to improve the process are shown in Exhibit 5.4.

Exhibit 5.4 Formal Incentive Plan Administration Program Before Beginning of Plan Year

After Plan Year End

• Select plan participants.

• Review actual overall company results to determine overall total incentive pool. The compensation committee should approve the actual dollar amount of the pool. This amount is the maximum amount payable.

• Determine incentive criteria appropriate to your company and participants (for example, revenue, growth, profitability, quality goals, and market share). • Choose an incentive funding formula that relates to the appropriate funding pool. • Determine competitive target and maximum annual incentives for each position. • Sum all target incentives to calculate the annual target incentive pool. This pool can be expensed (or accrued) on a quarterly basis to allow better projections of annual net income.

• The compensation committee should determine the individual award to those executives it is responsible for. In some cases, this will be the CEO only. In other cases, it will be all executive officers. • The remaining pool should be allocated to senior management to be distributed accordingly.

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The incentive funding formula should be very clear and easily calculable. This is especially important if the calculations deviate from standard accounting or financial ratio analysis. Tips from recent experience for calculating annual incentive plans include: • Net income should clearly specify whether extraordinary gains or losses should be included or excluded from net income for purposes of the bonus calculation. Also, amortization of goodwill that results from an acquisition should be accounted for by the purchase accounting method. • Growth formulas should clearly specify the base year. This is especially important when the base year is negative. • Return formulas should clearly specify the denominator. For example, goodwill should be specified as included or excluded from assets. It is very important for the compensation committee to review the incentive formula and to make sure that it is clear, unambiguous, and understandable. Once the amounts are paid for the prior plan year, the performance cycle begins anew as a performance plan is developed for each participant for the current year. An important feature of an incentive program is the performance/payoff matrix. A typical performance/payoff matrix is shown in Exhibit 5.5. The three major decisions with respect to formulating a payoff matrix are: 1. Setting the minimum threshold value. As shown in Exhibit 5.5, 85 percent of budget is typical; however, some plans set a higher goal, whereas a lot of firms set a lower threshold payoff floor. For example, some companies set a 70 percent threshold payoff level, and perhaps pay off 10 percent of the incentive pool. The payoff amounts increase from there. Some other plans do not pay off until performance achieves 90 percent of the budget. 2. Setting the maximum threshold value. Most plans call for a maximum payoff amount, though some do not limit the payoff amount. However, institutional shareholders usually require that the incentive plan be capped at some amount, say 300 percent of budget for truly outstanding performance. 3. Setting target payoff value. It is almost always a good idea to set target performance at 100 percent of budget, and to tie the budget goals into the business plan. In some cases, when your company has very aggressive business plans, you should take that into account when setting the target and minimum threshold levels. The compensation committee should be careful not to leverage the incentive program too highly. Some recent cases have shown that a highly leveraged incentive program may lead to aberrant and unethical behavior that substantially reduces

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Exhibit 5.5 Typical Performance/Payoff Matrix Actual performance versus growth and profit performance goal

Percentage of target incentive pool to be paid out

Maximum 130% of budget

200%

125% of budget

175%

120% of budget

160%

110% of budget

140%

105% of budget

125%

100% of budget

100%

98% of budget

95%

95% of budget

85%

90% of budget

50%

At Plan

Threshold 85% of budget Less than 85% of budget

25% 0%

shareholder value. The high leverage or pressure can come from three primary sources: • Unreasonable target incentive payoff goals • Unusually high minimum threshold payoff • Unusually large maximum payoffs. The purpose of incentive programs is to encourage the right behaviors that will increase shareholder value. In some cases, highly leveraged programs can cause aberrant behavior that triggers a firestorm of SEC inquiry, shareholder lawsuits, and perhaps even a proxy fight for control of the company. Performance goals must be reasonable, although the compensation committee should set high (stretch) goals. Incentive Program Eligibility Requirements

Executive incentive plans should be limited to employees who have a major impact on company or business-unit results. Therefore, the plan should have formal eligibility requirements, which often are expressed in terms of minimum salary, organizational level, title, salary grade, or a combination of these factors. In companies

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with both long- and short-term incentive plans, more management levels usually are included in the short-term plan than in the long-term plan. Some companies, especially larger companies, have two- or three-tiered annual incentive plans. It is sometimes difficult to assign employees to each of these plans, especially for senior executives who are on the cusp for inclusion in the executive incentive plan. The task of making this selection usually falls to the board, in conjunction with the chief executive officer. In some cases, the executive may have to be declassified as an executive officer or even a corporate officer. This is usually not a very pleasant decision or conversation with the affected executive. Nevertheless, remember that the plan should be limited to employees who have a major impact on company or business-unit results. Corporate Goals versus Business-Unit Goals

Although organizations may decentralize to foster a more entrepreneurial attitude among division or subsidiary executives, these executives still are responsible for the overall success of the company. On some basis, unit executives should also share in the failures and successes of other business units. Therefore, business units should consider initiating their own funding formulas in addition to the company’s overall formula for their total annual incentive. The allocation between corporate and business-unit performance can be simple or very complicated. The basic allocation is typically set at 25 percent corporate and 75 percent business-unit for division executives. It is very important that the incentive funding formulas for the business-unit and corporate incentive plans be compatible and function well together. The business-unit executives should devote the majority of their efforts and energy to making a success out of their business units. The goal of a combined corporate/business-unit incentive plan is to help top management gain cooperation from the business-unit executives, who must depend on the success of their company as a whole for part of their incentive award. Bonus Payment Alternatives Cash is king with respect to bonus payments. However, many companies are paying bonuses partially in stock or deferred compensation. For example, cash payments could be made either in cash or in stock up to the target bonus amount, at the election of the executive prior to the plan year. In excess of the target amounts, payments could be made in the form of deferred compensation contributions, restricted stock, fair-market-value stock options, discounted stock options, or (in some cases) premium-priced stock options. Payments of restricted stock are very common in the financial services/brokerage industry, as they both provide a substantial retention incentive and promote interest in the company’s stock price (in instances when the retention balance is in the form of stock).

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The choice of currency for bonus payments has some of the same pitfalls as long-term incentive programs. Another major issue with using stock as a basis for the bonus account is that it more highly concentrates the holdings of the executive in the company stock. This may not provide the appropriate incentive for the executive, especially if the stock market is not responding favorably to outstanding corporate performance, because of external market circumstances that conspire to hold down the stock price. However, let us review the alternative currencies that can be used to pay out an excess bonus. Deferred Compensation

Part of the cash bonus is deferred into a deferred compensation program. Prior to the beginning of the plan year, the executive elects to defer an amount of his or her bonus. This amount is then put into a deferred compensation account where it earns a competitive interest rate (prime interest rate plus one or more percentage points). The executive must work an additional number of years (e.g., two to three years) to gain the rights to the deferred compensation balance. If the executive leaves voluntarily before retirement, or before a substantial amount of time (e.g., five years), the annual interest rate drops down to a government Treasury-bill index rate (e.g., in the range of 6 to 6.5 percentage points). Thus, if the executive left after four years, he or she would lose the unvested deferred compensation, plus the favorable interest rate credit. Restricted Stock

Restricted stock certainly has a role in the modern compensation package. It is a great substitute for cash, and is used for retention purposes as well as make-whole awards for incoming executives. It is important that the rationale for restricted stock awards be disclosed in the proxy statement, as such awards are not favored by institutional investors and pay critics. Companies can conserve cash by paying bonuses in stock. These stock payments can be restricted somewhere in the range of two to seven years. In some cases, the restrictions lapse upon attainment of retirement age. The conversion from cash to restricted stock is one-to-one or slightly more in light of the restrictions. Typically, the premium for stock restrictions ranges from 10 to 50 percent of the cash payment forgone. For example, for a $10,000 cash payment, the executive may receive $11,000 for 2-year restricted stock, and $15,000 for 7-year restricted stock. Fair-Market-Priced Stock Options

Typically, part of the bonus is exchanged for part of the cash bonus. This ratio is typically between 3 or 4 to 1. For example, in lieu of a $12,000 bonus, with a stock price of $48, the executive would receive 1,000 stock options.

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The advantages include: • • • • •

Higher leveraged investment Lower cash cost to company Favorable accounting Enhanced shareholder identification (increased executive ownership) Retention.

Disadvantages may include: • Risk to executive • Dilution of company stock • Market fluctuations. Discounted Stock Options

A discounted stock option is a hybrid of a stock option and restricted stock. The investment community does not usually favor discounted stock options. However, the discounted stock option is usually easier to sell to executives, who are giving up cash, than fair-market-value options. The major disadvantage of discounted stock options is the charge against earnings for the aggregate discount of the option, which should be charged to earnings over the vesting schedule of the option award. Premium-Priced Options

This is a great opportunity to align the interests of shareholders with those of executives. At the same time, these premium-priced options must be exchanged for cash, and it is less appealing to exchange cash for out-of-the-money stock options. Another variation on premium-priced options is the performance-accelerated option, which makes the vesting of a stock option award contingent on achievement of performance criteria. This criterion is typically related to stock price performance, but in some cases is based on fundamental corporate performance criteria such as earnings growth. Cash versus Stock A very important question is whether the company wants to pay in cash or stock. Contrary to Accounting Principle Board (APB) Opinion Number 25, stock options do have a cost associated with them, as reflected in a dilution of shareholder interests. Companies continually have to value earnings charge versus stock dilution— it has to be one or the other. Each company must constantly monitor this very basic relationship.

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Equity analysts who recommend buying, selling, holding, or limiting stock positions are more likely to review the earnings-per-share data, that is, earnings (e.g., after-tax or net income) over the average number of common shares outstanding in the period under review. The methodology is very simple. Cash payments will come directly out of the earnings number. Stock options will increase the number of common shares outstanding by the amount of spread in the stock options. This is called the treasury stock method of accounting for stock options. Simply put, this method calculates the amount of cash it will take to buy the appropriate number of shares on the open market to satisfy the exercise of the stock option award. The tradeoff between stock and cash is a very important one indeed. To further illustrate this point, let us work through an illustration to calculate the tradeoff. For example, suppose that a stock option grant will be made in lieu of a cash payment of $3 million, which may be part of the annual cash bonus, or even a planned salary rollback, and the total number of shares outstanding is 200 million shares for a total market capitalization of $2 billion. Furthermore, assume that the Black-Scholes model valuation for the option award is 30 percent of the aggregate exercise price. In exchange for the cash payment, the company will make a stock option award of 1 million shares (1 million times 10 million times 30 percent). The company saves $3 million in cash and in most cases $2.15 million ($3 million less 35 percent in corporate tax) in compensation expense in return for making an award equal to 0.5 percent of total outstanding common shares, which typically does not result in a charge against earnings. Over the next five years the stock doubles to $20 per share. That is, the market capitalization has also doubled from $2 billion to $4 billion (the shares outstanding remain the same in our example). In our simple example, all option holders exercise their options resulting in a realized option spread of $10 million ($10 option spread times 1 million options). Assuming a corporate tax rate of 35 percent and that the stock award was non-qualified, the tax benefit to the company is $3.5 million. Thus, the company has a potential cash outflow of $6.5 million. Taking into account, the aggregate exercise price of $10 million, the company must account for 325,000 shares (the after-tax cash outflow of $6.5 million divided by the share price of $20). The company has one of two alternatives to satisfy this need for 325,000 shares. First, they can “buy” back shares from option holders and incur a net negative cash flow of $6.5 million, or issue 325,000 new shares. In both cases, there is a definite cost of shareholders associated with either of these alternatives. The $6.5 million in cash is more than triple the original after-tax cash outlay of $2.15 million, and the new issue of 325,000 shares represents 0.1625 percent of outstanding shares which will dilute the share price of existing shareholders. Thus, stock options are not cost free. Cash payments that are made or accrued for future payment are a direct charge against earnings. When the cash payment is coincident with the accrual expense, it will also be tax-deductible.

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Each publicly held company has to ask itself six basic questions: 1. 2. 3. 4. 5.

Do we want to award stock to executives and other employees? What type of stock award programs should we offer? Do we want to offer a cash-based long-term incentive award opportunity? If so, what is the division between cash and stock? What are the company’s competitive stock award overhang and annual stock award burn rate? 6. Where should we fall in relation to competitive data? And, more importantly, why? The answers to these questions will determine, in large part, the compensation committee’s approach to long-term incentive programs. Importance of a Peer Group The first step in determining competitive compensation levels is to carefully select a peer group for the purpose of benchmarking your company against the peer group. This peer group should be at least 13 companies and usually no more than 17 companies. The considerations for selection of this peer group are as follows (in order of importance): • Direct competitor companies. Companies that you compete with directly in the marketplace for your product (for example, Ford Motor Company as compared with General Motors Company). • Same-industry companies. There are many cases in which companies do not compete directly but exist in the same industry. A good example is the specialty chemical industry, whose market is segmented and fragmented; companies may produce only a narrow list of chemicals that cannot be substituted for one another. • Companies ranked by stellar corporate performance or shareholder return. This practice has been deemed somewhat controversial, as it is less likely that executives will jump industries. • Companies that you gained executives from or lost executives to in the past 18 months. In numerous cases, job skills are transferable from one industry to another. For example, a controller of a specialty chemicals company can fill the needs of another basic process company, such a food processor. • Companies in the same business sector, such as nondurable goods or durable goods. • Companies in the same local business area. Although in most cases the executive search market is national in scope, it is also true that local business people tend to know each other well through local business organizations and social and charitable activities and events.

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Compensation analysis can be accomplished in one of two ways. The first way is to perform a median analysis. This approach requires that the companies in the peer group be fairly close in revenue size to the company of interest. A rule of thumb for selecting companies is to select companies at between 50 to 200 percent of the size of the company in interest. Also, about one-half of the companies should be larger and the other half should be smaller. The net result will be that the median revenue size will be equal to the size of the company in question. The average revenue of these companies should be about the same size. This will be a good indication of the appropriateness of the selected group. The second approach to compensation analysis is to use regression analysis, using revenue as the dependent variable and compensation levels as the independent variable. This approach works very well for narrowly focused companies with a lot of competitors. It also works the best for base salary, as there is usually a statistically significant correlation between company size and base salary. As a rule of thumb, the base salary increases by 15 percent when the size of the company doubles. This increases from 12 to 18 percent depending on the size of the company and the specific industry. For example, a $400 million company in the pharmaceutical industry may have an 18 percent increase factor for base salary as the size doubles to $800 million. In contrast, a $2 billion company in the retail food industry may have only a 12 percent increase factor as the size doubles to $4 billion. However, regression analysis does not work well in mixed peer groups and for other compensation elements such as short-term and long-term target bonus opportunities. In general, the peer group should reflect the current makeup and size of the company of interest. However, if the company of interest will have a high rate of growth, it usually makes sense to use the revenue size projections two or three years out. This strategy works well with emerging companies, though it does not usually work well with larger, more established companies. Most companies prefer to use a trailing revenue figure and let the compensation follow the growth of the company. The most vexing problem in constructing an effective peer group arises when the company of interest is a diversified business services company, or when there are no other similar, freestanding companies. For example, because of industry consolidation or the vertical or horizontal integration of industries, larger, diversified companies often purchase freestanding companies. The compensation data and other specific information will not be filed with the Securities and Exchange Commission. However, a peer group for a diversified company can be constructed by selecting companies for the peer group in the same proportion as the products or services provided by the company of interest. For example, take a diversified company that has various products and services as follows (ranked by percentage of revenues): • 40 percent paper and forest products • 25 percent consumer products

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• 20 percent chemicals • 15 percent transportation services. To construct a 15-company peer group, use a breakdown by industry is as follows: • • • •

6 paper and forest product companies 4 consumer products companies 3 chemicals companies 2 transportation services companies.

When using this approach, it is more likely that you will use regression analysis to estimate the market level of compensation for the company of interest. Again, the peer-group comparison should be used for the current breakdown of the company’s business and not the projected breakdown. The selection of the peer group is extremely important to a compensation philosophy. In some cases, compensation committees will select a different peer group for their chief executive officer than other executives, and a different peer group for less senior employees. Some rationales for this are as follows: • There are numerous examples where chief executive officers have changed industries (such as Mullin at Delta Air Lines and McInerney at Home Depot). This can also be the case for the chief financial officer and general counsel. In marketing, sales, and operations positions, more industry-specific knowledge is necessary to properly prepare for the position. • Executive searches for senior executives are national and in some cases international. As one moves down the organization chart, the focus shifts from national to regional and, for relatively junior management positions, to a local basis. • It may be easier to justify to shareholders that you are paying the CEO according to a high-performing, non-industry-specific peer group. However, the rationale becomes less clear the further down the organization chart one goes. Importance of Benchmarking In view of the reality of human limitations, it makes obvious sense to consider the experiences of others rather than continually reinventing the wheel. By systematically studying the best business practices, operating tactics, and winning strategies of others, an individual, team, or organization can accelerate its own progress and improvement. Benchmarking is simply the systematic process of searching for best practices, innovative ideas, and highly effective operating procedures that lead to superior

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performance. What could be more straightforward? No one individual or organization can continually come up with great new ideas. Individuals and organizations, no matter how creative, motivated, hard-working, and qualified, cannot possibly create or champion all innovation—nor should they be expected to. History has shown that most innovations were simply a composite of earlier advances. The history of innovative adaptation is arguably as old as the human species. For thousands of years people have adapted good ideas taken from their environment to meet their needs. This ability to adapt ideas is itself an innovation. Numerous examples of innovative adaptation can be found throughout recent business improvements. A good example is the U.S. textile industry’s adaptation of British textile mills’ practices in the early 1800s. Other examples are the Japanese auto and steel industries in the early 1960s, as they transplanted U.S. best practices into their own processes. Ironically, another good example of innovative adaptation is the importation of Japanese practices by U.S. auto and steel industries in the 1980s and 1990s. In view of these historical examples of innovative adaptation, the advantages of studying others’ best practices should be clear. Learning by borrowing from the best and adapting their approaches to fit your needs is the essence of benchmarking. Indeed, this simple concept does not appear to be new, complicated, or revolutionary. Or is it? The term benchmark has its roots in land surveying; a benchmark was a distinctive mark made on a rock, wall, or building. In this context, a benchmark served as a reference point in determining one’s current position or altitude in topographical surveys. In general, a benchmark was originally a sighting point from which measurements could be made or a standard against which others could be measured. In the 1970s and 1980s, the concept of a benchmark evolved beyond the technical term signifying a reference point. Benchmark came to signify the measurement process by which to conduct comparisons. Best-practices benchmarking has come to be described as the process of seeking out and studying the best internal and external practices that produce superior performance. The object of this book is to benchmark the best practices of 100 superior performing companies, in order to transfer these best practices to others. Benchmarking benefits cited by practitioners include: • Assures the board of directors and investors that the company is doing its best to adapt the best available practices. • Creates buy-in for change. • Exposes executives and directors to new ideas. • Creates an open corporate culture that will be more receptive to new ideas. • Serves as a catalyst for learning.

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• • • • •

125

Tests the rigor of current practices. Improves organizational quality. Leads to lower cost practices. Creates an external business view. Raises the organization’s level of maximum potential performance.

In the high-stakes 1990s and beyond, no organization can afford to ignore best practices of highly successful companies. Ask yourself three important questions before you proceed further into this book: • Can my organization afford to stop improving? • Can my organization afford to stop learning? • Can my organization afford to stop competing for its position in the marketplace? If you answered “yes,” then stop here. Otherwise, read further for some ideas on ways to make for a more effective board. Pay Positioning Strategy The starting point for pay positioning strategy is to consider what the firm’s policy should be for total compensation positioning. If superior levels of corporate goals are planned, it is necessary to position and target compensation levels accordingly. Exhibit 5.6 shows a typical pay positioning strategy, structured by management level. Peer group proxy data and survey data should be analyzed at least annually to assure cohesive policy and compensation practices. Percentile ranking in comparison to the market is a very important concept in communicating a compensation philosophy, as it allows management to translate the board’s intention into practice. Base salary should be compared against the market on a percentile basis. For example, the 50th percentile is also referred to as the median, that is, 50 percent of the salaries of the peer group are above the salary of interest, and 50 percent of the salaries in the peer group are below the salary of interest. Why would one ever want to pay above the 50th percentile? That is, why would one ever want to pay above market levels of compensation? In addition to wasting resources, overpaying also distorts the compensation system and may also cause overpayment of other positions. The objective of this competitive pay positioning strategy is to appropriately compensate employees of the firm. Of course, the more you pay your employees, the greater likelihood that you will be able to effectively attract and retain

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Exhibit 5.6 Pay Positioning Strategy Total Direct Compensation

Base Salary

Total Short-Term Long-Term Compensation Incentive Target Incentive Target Potential

Chief executive officer

40th to 50th percentile

60th percentile

60th percentile

50th to 60th percentile

Other executive officers

40th to 50th percentile

55th percentile

55th percentile

50th to 55th percentile

Senior managers

45th to 55th percentile

50th to 55th percentile

50th to 55th percentile

50th to 55th percentile

Other management and key employees

45th to 60th percentile

50th to 55th percentile

50th to 55th percentile

50th to 55th percentile

employees. However, there are limits to this strategy: it quickly becomes very expensive, and certainly has diminishing returns. The purpose of a pay strategy is to increase the company’s profitability. Therefore, you do not want to undercompensate employees, as they will leave the company due to low pay; you do not want to overcompensate employees, as that will result in corporate waste. There is a relationship between turnover rate and competitive market positioning. The more you pay, the lower the turnover rate. With lower turnover rates come lower recruitment costs, higher productivity, lower training costs, and lower opportunity costs, which should result in higher profits. For example, a company that is within the top 100 most successful companies in the S&P 500 Stock Index might want to compare itself against other companies within that same group for purposes of paying the chief executive officer. The firm commissions a study of the pay practices of these companies for 1999 from an outside compensation consulting firm, with results as shown in Exhibit 5.7. Once the company has the competitive market positioning and the data, then it is a matter of combining the two to determine the appropriate compensation levels. For example, the target compensation package for the chief executive officer of this company would be as shown in Exhibit 5.8. The net total compensation opportunity is between the 50th and 55th percentile, which is on the lower range of the projected compensation philosophy. As you can see from this example, the range of net total compensation is from $7.8 million to $10.0 million. The $8.4 million compensation opportunity is slightly below the midpoint of this range. Certain other factors, such as tenure as CEO, al-

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Exhibit 5.7 Summary of CEO Pay Practices for the Top 100 Best-Performing Companies (1999)

Percentile Ranking

Salary ($)

Short-Term Incentive as a % of salary

Long-Term Incentive as a % of salary

Net Total Compensation ($)

40th

$800,001

142.5%

431.1%

$6,016,282

50th

$885,417

151.6%

543.5%

$7,812,175

55th

$900,000

158.3%

605.6%

$8,710,500

60th

$955,269

171.7%

778.9%

$10,005,624

70th

$1,000,000

200.0%

973.2%

$11,797,634

75th

$1,037,014

218.4%

1,094,4%

$13,514,376

Note: This data has not been aged to reflect current market conditions. The data should be aged to bring it up to date for 2000 and 2001 using an annual rate of between 4 and 6 percent, depending on the industry and current market conditions (e.g., 40th percentile salary of $800,001 aged for two years at 4% per year will be $865,281).

Exhibit 5.8 Illustration of the Makeup of a Typical Top-Performing CEO’s Compensation Compensation Element Salary

% of Base Salary 100%

$ $800,000

Short-term incentive

175%

$1,400,000

Long-term incentive

775%

$6,200,000

1,050%

$8,400,000

Net total compensation

ternative job opportunities, recent and prior chief executive evaluations, and a general sense of how to position the chief executive officer compensation in light of all facts and circumstances, will, of course, be part of the decision. As you can see, the two most important elements of market positioning are (1) the selection of the peer group, and (2) the positioning of the compensation elements within that peer group. With a different peer group and different positioning, one would get a much different result. See Exhibit 5.9 for a summary of excerpts of pay philosophies from some of the best performing companies.

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Exhibit 5.9 Excerpts from Some Best-Performing Companies’ Pay Philosophies (proxy statements published in 2001) Walgreen Co. Compensation philosophy:

“Offering market-comparable pay opportunities allows the Company to maintain a stable, successful management team.” Compensation programs “allow the Company to communicate specific goals that are of primary importance during the coming year to motivate executives to achieve these goals.”

Compensation market objective:

Option grants are targeted at median of peer group. Uses outside compensation consultant. Peer group consists of companies that have business operations in the retail drug industry, as well as companies within broader retail and wholesale industries. The peer group used for compensation purposes is not the same as the peer group used for the stock performance graph. Target bonus awards are targeted at the median.

The Progressive Corporation Compensation philosophy:

“Provide a rational, consistent and competitive executive compensation system that is well understood by those to whom it applies.”

Compensation market objective:

Company tries to pay at or near median of survey, with variable pay that can be in the high end of the survey range.

Gannett Co., Inc. Compensation philosophy:

“Stock awards mature and grow in value over time and for that reason represent compensation which is attributable to service over a period of years. This focuses attention on managing the Company from the perspective of an owner with an equity stake in the business.”

Compensation market objective:

Company’s base salaries are “above median for competitors,” but its competitors are smaller and perform less well. Peer group consists of companies of Gannett’s size and companies in news and information industries and companies in other industries with similar revenues and profits. The comparison spans one to four years. A job grading system is used to make equitable grants.

Abbott Laboratories Compensation philosophy:

“Integrates compensation programs which link total shareholder return with both the corporation’s annual and long-term strategic planning and measurement processes.”

Compensation market objective:

Company targets total compensation in the upper range of peers when merited by performance.

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Exhibit 5.9 Continued International Business Machines Corp. Compensation philosophy:

“Leadership and motivation of the Company’s executives are to establishing IBM’s preeminence both in the marketplace and as an investment for stockholders.”

Compensation market objective:

Total compensation is targeted to the 75th percentile of comparator companies. Uses outside compensation consultants. Peer groups consist of information technology companies and the largest U.S. market-capitalized companies. These peer groups are broader and a more diverse set of companies than those included in the Standard & Poors’ Computers (Hardware) used for the stock performance graph.

FDX Corporation Compensation philosophy:

Compensation programs are intended to be relatively simple and straightforward and to be tied directly to short- and longterm business plans.

Compensation market objective:

Base salary is targeted to the 75th percentile of peer companies with sales over $10 billion, although CEO is currently at the median. If the objectives are met, CEO’s base and bonus together would be at the 75th percentile of the peer group. Uses two major compensation consulting firms. Peer group consists of a group of companies in general industry with annual sales in excess of $10 billion.

TAX CONSIDERATIONS IN EXECUTIVE PAY Since the cuts in capital gains tax rates in mid-1998, executives are more likely to pursue capital gains tax treatment. Capital gains rates can be as low as 18 percent, whereas the highest marginal individual income tax rate is 39.6 percent. These new capital gains tax developments have set the stage for a new wave of executive compensation programs that take advantage of the lower tax rate. (Note, though, that the top federal tax rate will be reduced from 39.6 percent to 35.0 percent, effective December 1, 2006, as part of the 2001 tax legislation). Refer to Appendix C for additional information of definitions pertaining to tax rules and regulations.

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Part Two

Current Issues

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Chapter 6

Repricing Stock Options Because of recent volatility in the stock market, many U.S. publicly traded companies are considering repricing stock option awards for their executives. • Companies must balance the need to attract and retain executives with shareholder interests; repricings effectively separate the interests of management and the interests of shareholders. • Studies have shown little support for the traditional justifications for rich executive stock awards, such as a weak correlation between executive ownership and stock performance. • Because market conditions have changed, the opportunity arises to restructure executive compensation in line with expected stock market returns and company needs. With stock markets resembling a roller-coaster ride, compensation committees and boards of directors of many U.S. publicly traded companies are considering repricing existing stock option awards. On the one hand, companies must attract and retain executive talent, and underwater stock options provide little (if any) incentive. On the other hand, most shareholders, especially institutional shareholders, vehemently oppose repricings because they completely realign the interests of management with the interests of shareholders (who as a group generally have lost a lot of money). A stock option repricing is exactly what it sounds like: an outstanding compensatory stock option with an exercise price of $x is repriced at an exercise price of $y. Usually, if not always, $y is less than $x. Mechanically, repricing a stock option is a very simple act, provided that the stock option plan and/or stock option grant agreement does not preclude repricing. All a compensation committee (or other body of authority that granted the option) has to do is issue a letter to the optionee that his or her stock option has been repriced. Most stock option plans provide that the committee administering the plan

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(usually the compensation committee) may amend the terms of a stock option grant. This would include amending the exercise price. Some plans, however, may not allow a simple repricing if the plan expressly requires the exercise price to be equal to or greater than the fair market value of the stock on the date of grant. Because the grant date has not changed, the repricing must be accomplished by a cancellation of the existing stock option and a grant of a new stock option, with all the same terms and conditions of the canceled stock option other than the lower exercise price (in other words, a regrant). Generally, the availability of shares under a plan is not addressed because most plans allow shares underlying a canceled stock option to be available for future grants. In addition, depending on the corporate bylaws or other customs and practices of a company, the compensation committee or board may need to approve a board resolution for the repricing.

TAX ISSUES For federal income tax purposes, a repricing of an incentive stock option under IRC § 422 will be a modification of the option and be treated as a new grant of an incentive stock option—provided that the new exercise price is equal to or greater than the fair market value of the stock on the date of repricing. Pursuant to IRC § 83, a nonqualified stock option generally is taxed when it is exercised. Thus, the repricing of a nonqualified stock option should not have any tax effect. Under IRC § 162(m), which imposes a $1 million limitation on a corporation’s annual tax deduction for compensation paid to each of certain executives, a repriced option will be counted twice in determining whether an executive has received the maximum number of shares under a plan. This occurs with respect to the performance-based exemption under that statute.

ACCOUNTING PROCEDURES The repricing issue was initially addressed by the Emerging Issues Task Force (EITF) of the Financial Accounting Standards Board after the stock market crash of 1987. The EITF concluded that a repricing should be treated as a cancellation and regrant under Accounting Principles Board Opinion No. 25 (APB 25), which is the accounting standard that almost all companies apply to their stock option grants. Thus, if the exercise price of the repriced stock option is equal to or greater than the quoted market price of the stock on the repricing date, and if the number of shares underlying the repriced stock option is fixed so that there is a “measurement date” in accordance with the rules under APB 25, there should be no charge to earnings.

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This result, however, may change dramatically. In August 1998, the FASB, as part of its interpretation of APB 25, stated that: If the terms of an option (originally accounted for as fixed) are modified during the option term to change the exercise price, the modified option should be accounted for as variable [and] variable-plan accounting should be applied to the modified option from the date of modification until the date of exercise. The cancellation of an option and the issuance of a new option grant with a lower exercise price shortly thereafter (for example, within six months) to the same individual should be considered in substance a modified (variable plan) option.

When and if this conclusion will be applied is uncertain; however, the FASB intended to release the exposure draft of this interpretation in the first quarter of 2000.

SECURITIES LAW ISSUES Like the tax and accounting rules, securities laws generally treat the repriced stock option as a cancellation and regrant. However, under Item 402 of SEC Regulation S-K, if a stock option held by any “named executive officers” (generally the five highest-paid executives) is repriced, the compensation committee generally must issue a report that “explain[s] in reasonable detail any such repricing of options and/or SARs held by a named executive officer in the last completed fiscal year, as well as the basis of each such repricing.” In addition, the proxy statement must contain a table detailing all repriced stock options and stock appreciation rights (SARs) held by any executive over the past 10 years.

EXECUTIVE RETENTION Although executive retention is a fundamental issue facing boards of directors and their compensation committees who contemplate or implement repricings, this issue often eludes shareholders. Among the factors that affect executive retention are: • Over the past 10 years, long-term incentives (consisting primarily of stock options granted at or above fair market value) have constituted an ever-larger part of total compensation. • The trend has been to award stock options deeper and deeper into the organization. • Recipients of incentive stock options and nonqualified stock options appreciate the tax-deferral advantages built into these compensation delivery vehicles.

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• The vesting and expiration provisions of stock option awards are specifically designed to create “golden handcuffs,” so that a company competing for talent must offer an amount at least equal to the spread in the outstanding stock options held by the sought-after executive. When a stock price falls, the incentive and retention drivers of a stock option fail. If a stock price has fallen significantly below the option exercise price (making it an underwater option), the option holder most likely will regard the option as a lost cause, as even a substantial increase in the stock price will result in only a small gain (if any) to the holder. Moreover, even if the stock price has fallen significantly but not below the stock option exercise price, the loss of the accumulated wealth attributable to vested and unvested options removes the option handcuffs and may encourage the option holder to look to another company that is willing to provide a meaningful long-term incentive compensation package. It would appear that a company has little choice but to reprice stock options, or at least replace the failed long-term incentive compensation program with a new one. Of course, the company could simply grant new options without canceling the underwater options. The problem with this is that many companies exhaust the shares available to them under their long-term incentive compensation plans, and proposals to increase the number of shares available for stock-based awards often meet with stiff resistance from institutional shareholders, who protect against dilution of their ownership interests. Although a company theoretically could grant new options up to all available shares, and then six months later (to satisfy the new FASB rules) cancel the underwater options so that the shares underlying the canceled options are once again available for awards, certain logistical and legal concerns must be addressed and resolved. Overall, a company with stock that has fallen significantly in price must accept the fact that its long-term compensation program is probably in shambles and has most likely become completely ineffective. Thus, the company must take immediate corrective action to provide incentives to and retain its executives. Otherwise, the company faces a loss of motivation by its executive workforce, which may further lower the value of the company, as well as increase the likelihood of personnel raiding by competitors.

CORPORATE GOVERNANCE AND SHAREHOLDER RIGHTS From the company’s perspective, a repricing is the simple solution when a stock price falls precipitously. However, from the shareholders’ perspective, a repricing may represent more poison than panacea. As always, the company’s board of directors is caught in the crossfire.

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Perhaps the most important aspect of corporate governance in the 1990s was the rise of the powerful activist shareholder, whether it be strategic investor or pension fund, who constantly reminds the company’s directors who the company’s owners are. Of course, many, if not most, directors are hand-picked by the company’s CEO. Only about 15 percent of corporate boards separate the positions of chair and CEO, and only 40 percent of boards have an independent director nomination committee. Moreover, only about 5 percent have a separate chairperson who is neither a current nor former employee; of these, only a fraction have a chairperson with a significant ownership position. Significantly, the hand-picked outside directors are often the ones who end up serving on the company’s compensation committee. Thus, although the compensation committee is comprised of seemingly independent outside directors, there is little resistance to most executive plans and programs, including new stock plan award authorizations. Thus, most management proposals to adopt a new long-term incentive compensation plan, or to increase the number of shares available under such plans, are approved by the committee or board of directors without substantial revision. However, the trend is for boards to be increasingly more independent of management and more active as shareholder advocates. The view of the shareholder community, as articulated by large institutions and representative organizations such as Institutional Shareholder Services, reinforces the will of boards as they face the task of changing the composition of corporate ownership. These trends serve only to compound the problems associated with repricings, because a repricing is diametrically opposed to the shareholder-alignment model used for most executive compensation programs. In other words, most companies state that the purpose of their stock-based executive compensation programs is to align the interests of management with the interests of shareholders, and thus all concerned are focused on stock price and dividends. However, when options are repriced, the paths of management and shareholders diverge, as shareholders do not receive the benefits of repricing. Perhaps the fundamental issue that shareholders must address is the balance between keeping underwater options underwater, to punish management, while implementing repricings as a necessary compensation tool. Two important points emerge from this dilemma. First, the drop in the company’s stock may be part of an industry or broad market recession; this should be distinguished from a company’s stock price falling because of poor performance and inefficient management. Second, sometimes a stock’s fallen price is the result of a specific act associated with a specific group of managers—for example, Cendant’s accounting problem or Oxford’s systems problem. In such instances, the thinking is that the executives who are responsible should be punished by not having their options repriced, whereas those who were not directly involved are candidates for repricing.

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CORPORATE FINANCE AND STOCK PRICE PERFORMANCE What is the proper allocation of the increase in value between shareholders and executives? How certain is it that the stock will not bounce back on its own? What impact will accounting rules have on the decision to reprice? Stock overhang is generally defined as the number of shares underlying all outstanding stock-based awards plus the number of shares still available for grant under all incentive plans of the company. Studies have shown that overhang has generally increased dramatically. This has been fueled by three primary factors: 1. The significant total returns to shareholders over the period, which made shareholders more agreeable to sharing the wealth. 2. The popularity of stock option award programs. 3. The much larger size of awards. In addition, the increase may be associated with the change in proxy statement disclosure rules in 1992; the imposition of the $1 million cap under IRC § 162(m); the cost-less nature of stock options; and the “tournament effect,” which ratcheted up the level of long-term incentive awards. The improved proxy statement disclosure had two effects. First, by more fully disclosing large stock awards, companies felt comfortable informing shareholders while shareholders were tacitly approving such awards. Second, companies became more aware of the compensation practices of other firms. These more descriptive disclosure rules have created a tournament effect, whereby companies must continually outdo each other in award sizes. This is especially prevalent in turbulent industries, such as the telecommunications and software industries, where large stock awards may also serve as retention devices. The most startling trend in the past five years has been the unusual behavior of boards and senior management in determining stock awards. The fixed-share methodology, which works fairly well with normal 8 to 10 percent stock growth, fails miserably when the stock market growth accelerates to 20 or 25 percent per year, as it has been doing over the past five years. The stock overhang represents the percentage of future value to be allocated to management. The actual amount awarded to management is less, usually about one-half to two-thirds of the approved allocation. For purposes of this discussion, we use the approved level of stock awards as the percentage of stock awarded to management. Shareholders are more likely to allow management to participate in an opportunity for 13 percent (recent stock overhang) of future wealth creation if the future return is significantly higher than (1) the historical return of 10.96 percent (the 72year annual return of the S&P 500) and (2) the return on an alternative investment

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with similar risk. However, shareholders are less likely to approve a similar level of increase in value should the stock market go sideways or downward. The authors of this book constructed a simple corporate finance model that compared amounts of increase shared by management and shareholders at different stock award rates, stock overhang, and expected future total shareholder return. At an expected total return of 23.2 percent, 13.5 percent was allocated to management and the rest to shareholders, leaving shareholders a net return of 20.06 percent. When the expected total shareholder return reverted to historical levels of 12 percent per year, management’s allocation jumped to 18.93 percent, leaving shareholders with a net return of 9.73 percent. To restore the net return to shareholders to precorrection levels, the award rate was reduced from 1.8 to 1.18 percent (a reduction of 35 percent). Of course, this simple model does not take into account the possible positive effects of executive ownership on corporate return. Just as a matter of good corporate practice, options should not even be considered for repricing unless the current stock performance has stayed well below the exercise price for prolonged periods of time. A rule of thumb is that if the highest stock price is 40 percent below the exercise price two years after the correction, then maybe the stock should be repriced. A 40 percent bounce in stock price is almost a natural pattern for a large number of stocks. For example, it is common for the 52-week high to be at least twice the 52-week low for listed stocks.

BENEFITS OF EXECUTIVE STOCK OWNERSHIP The survey data indicate that, at best, executive ownership has a weak positive relationship to corporate performance, as measured by total return to shareholders. Furthermore, stock options—the main holdings of executives—are further removed from stock ownership, with a limited downside risk to executives. Most executives exercise the stock option and liquidate their position and so do not hold the underlying stock. The net result is that the executive seldom has a significant stock ownership position. The results of studies differ on this subject, and it is unproven that a long-term incentive grant with no real downside risk will compel management to work harder or make better decisions. Certainly, a competitive level of compensation is needed to attract the right executive. Once the executive commits to a position, however, intrinsic qualities such as work ethic, curiosity, and the challenge of meeting corporate goals are far more powerful than executive ownership. Indeed, if the executive’s total compensation level (including salary, bonus, and long-term incentive) were kept at the same level, with a larger percentage of compensation based on performance of the company’s stock, the shareholders would applaud. Over the past five years, however, salary and bonus levels have remained relatively constant, with larger and

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larger amounts of long-term incentive being granted to a larger percentage of management than ever before. In effect, these awards of larger levels of stock are given to the executive in addition to other levels of compensation. This results in a weak correlation between excess compensation levels and corporate performance. Increase in corporate value may be more related to good corporate governance than to executive ownership. Effective management is based not only on successful management of operational issues, but also (and more importantly) on the management of strategic issues. Many recent studies have concluded that an active board, in full and frequent communication with management on strategic issues, adds substantial shareholder value. In fact, more value can be gained by effective strategic planning. Similarly, studies have shown that corporate governance may be strongly correlated with corporate performance. Therefore, proactively strong boards may provide a higher return than does executive ownership.

EXECUTIVE COMPENSATION TRENDS Recent trends indicate that executive equity opportunity will pay the executive an amount in relation to overall corporate performance and return to shareholders. However, the level of stock opportunity has exploded over the past eight to ten years and perhaps should be reduced to levels more appropriate to the current environment. As with the stock market itself through most of the 1990s, the fundamentals of executive compensation were significantly above historical or logical levels. The increased levels of compensation over the past five years do not appear to have any basis in the marketplace. It appears that the high levels of executive compensation can be attributed to management’s aversion to stock awards set by the Black-Scholes model, which places a higher value on stock at higher levels. Of the Fortune 100 companies, about half awarded the same or more stock options even though Standard & Poor’s 500 Stock Index increased at the annual rate of approximately 20 percent over the same period.

SUGGESTED APPROACHES It is up to corporate boards to address the very important, multifaceted issue of option repricing. Boards of directors can disrupt the out-of-control spiral of large stock awards that has been growing over the past ten years. Before we suggest what can be done, let us discuss what should not be done. A company should not reprice an option award unless there is imminent danger of losing important and irreplaceable senior executives. However, if a company must reprice, we certainly do not suggest a one-for-one repricing of option awards. Fur-

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thermore, we do not recommend future, larger option awards to make up for underwater options, even if there are options available in the stock kitty. This action will further distort the already high levels of long-term incentive awards. The suggested approach is two-pronged: 1. Current levels of option awards should be cut back to pre-dotcom-mania growth levels. We recommend reducing current awards to more reasonable levels of long-term incentive awards. 2. Underwater options should either be left alone or exchanged for new options at a significantly less than even exchange. We suggest that options be repriced for a significantly lower number of options. For example, for an option with a stock price that is 40 percent underwater (a $6 stock price with an exercise price of $10), the Black-Scholes methodology does not result in an adequate discount. We recommend taking an aggressive discount and letting the executives decide if they want to cancel the underwater options for the repriced option award or keep the existing underwater award. In our example, even a dramatically underwater option that is early in its 10year life will result in an almost even exchange. If the Black-Scholes method is used, the remaining term, for valuation purposes, should be reduced to 50 percent or less of the actual figure. This should result in an exchange of two-to-one, or better. Another method is to use a growth model with a low future appreciation rate of 5 percent per year. The repricing should result in the cancellation of forfeited options that will not be reawarded in a new stock option grant. In this way, the repricing procedure will conclusively reduce the level of stock overhang. An interesting example of repricing is Cendant Corporation. Cendant’s stock price plunged from a 52-week high of 41 11/16 to a price of about $15. The cause of the drop was the disclosure of material accounting irregularities and the need to restate earnings. In response to this significant loss in shareholder value, the board agreed to reprice 17 million options, slashing some strike prices in half. Rather than repricing the options that were underwater, the board canceled one-third, repriced one-third at current prices, and repriced the final third at a 50 percent premium. As a result, the stock overhang was reduced by one-third, and the executives were provided with a new incentive. Critics are split on the efficacy of Cendant’s actions. Executive pay experts, such as Graef Crystal, see Cendant’s actions as commendable, as reported by Business Week; a Wall Street Journal editorial called the Cendant actions as right and just. However, institutional shareholders and representative groups criticized the action as unnecessary and anti-shareholder in nature. Possibly the shareholder criticism is that the cancellation of existing awards did not go far enough. Perhaps, if Cendant had cancelled 50 percent of the options, and repriced the other 50 percent with a 100 percent premium, the repricing would have gained greater support from

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shareholder rights groups. Certainly, something must be done in such extraordinary circumstances. Each board must determine the composition of each repricing. As discussed, this is a function of: • The importance of current management in the success of the enterprise. • The likelihood that current management will leave for a better opportunity, which may include managing their accumulated wealth. • The degree to which stock options are underwater, which includes the ratio of current stock price to strike price, the length of the price depression, and the prospects for improvement in the stock price. • The level of stock overhang. • The level and concentration of stock option holdings. If boards of directors are uniformly firm on this issue, a greater portion of the postcorrection stock dilution will begin to recede to more rational levels, in agreement with lower expected levels of total return. Thus, shareholders will realize a greater portion of the stock market return. With the board of directors as a proactive participant, the stock market correction should result in an orderly correction in executive compensation practices.

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Chapter 7

Executive Employment Arrangements

CHANGE IN CONTROL EMPLOYMENT ARRANGEMENTS Golden parachutes and other executive compensation payments that are triggered by a change in control are often an essential part of an executive’s compensation package. The design of these arrangements can save or cost shareholders of the combining companies millions of dollars. Extreme care and foresight should be applied to these types of arrangements before, during, and after the change in control. Over the past 13 years, change-in-control (CIC) arrangements have become standard operating gear for senior executives. The CIC protections have also been extended deeper and deeper into employee ranks and, in some cases, cover all employees. A CIC payment of between 1 and 3 percent of the transaction amount is not uncommon, with the largest currently reported CIC amounts being $150 million to a group of executives and $50 million to one executive. The purpose of this chapter is to group similar problems arising from the business combination of companies in connection with their CIC severance programs. Specifically, this chapter reviews typical problems associated with CIC program designs and also with implementation of such programs. An important dynamic with regard to CIC severance arrangements is that these programs typically are drafted in advance of a potential business combination, and thus the protections are often weighted in favor of the pre-CIC executive group. Although a generous CIC severance program serves the objective of making executives neutral to future business combinations that could reduce or eliminate their jobs, it creates challenges for combining companies in the pursuit of retaining key executive talent. The optimum result is to balance the CIC severance protection at a level that is rich enough to quell resistance to a potential business combination, but not so 143

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generous as to entice valued executives to jump ship in the aftermath of the transaction. Competitive levels of CIC severance protections are effective in helping to ensure that executives support pending business combinations, but also tend to heighten the post combination retention challenges of the new organization. The design, approval, and implementation of CIC agreements is one of the most important tasks of the compensation committee. A list of provisions that must be considered when doing so appears in Exhibit 7.1. Some of these items deserve much discussion and thought prior to final approval by the board. It is recommended that CIC agreements be discussed and approved by the compensation committee, then by all outside directors, and then by the full board. Furthermore, CIC agreements are certainly at least a two-meeting issue. It is very difficult and perhaps too rushed to discuss and approve these types of arrangements all in one meeting. CIC agreements should also be accompanied by cost estimates under various scenarios of change in control of ownership of the corporation. Experience has shown that such costs can be very high. There have also been some disputes after the transaction as to the appropriateness of certain high-cost arrangements in the face of a CIC. The pitfalls of CIC agreements are numerous, the rest of this chapter reviews just some of these pitfalls.

Exhibit 7.1 List of Provisions in a CIC Agreement Design • Type and number of executives covered by CIC arrangements • Tiers of CIC coverage • Effective period of agreement • Protective period following CIC • Constructive termination definition applicable following CIC • CIC trigger definition • Type of trigger initiating severance benefits • Potential CIC or pre-CIC protections • Cash severance payment multiple and components • Annual incentive payable in year of CIC • Long-term incentive payable in year of CIC • Pension enhancement • Continuation of welfare benefits (life, medical, etc.) • IRC § 280G excise tax treatment

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TYPE AND NUMBER OF EXECUTIVES COVERED BY CIC ARRANGEMENTS A host of common design problems exacerbate the loss of the retentive power of the pre-CIC programs and post-CIC severance. This section summarizes the design features of programs that have worked in ways counter to the intentions of those who implemented the programs. All of the programs cited here were in place at large, publicly traded companies. Though the identity of specific participants cannot be revealed, because of confidentiality concerns, the examples include many high-profile business combinations of the recent past. The design issues are summarized in chronological order, before and after the CIC. The first issues manifest themselves prior to the business combination, in some cases thwarting a business combination that otherwise would have occurred. The second category of issues creates challenges immediately upon the closing of the transaction, and the third category creates longer-term, post combination problems.

PRETRANSACTION CIC SEVERANCE DESIGN CONSIDERATIONS The following CIC program features have to either thwarted a desired business combination, enhanced the likelihood that key executives would voluntarily leave before the closing of the transaction, or increased the CIC-related liabilities: • Lack of CIC executive severance protection. • Interruption of retention protection prior to closing. • Lack of specific guidance for determination of incentive payout amounts. Lack of CIC Severance Protection The lack of a competitive CIC severance program may create a significant disincentive to potential business combinations. Several proposed, large business combinations were not completed primarily because of the lack of sufficient severance protection of top executives. Similarly, it is likely that key corporate decision makers who are without strong CIC severance coverage will be less vigilant in their search for business combinations that could jeopardize their roles as company leaders. Some companies facing a proposed business combination overcompensate for the lack of an existing severance program. Companies that hastily adopt a CIC severance program in response to a known possibility for a business combination tend

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to establish protections that exceed median market practices. This is especially so when the business combination partner has preestablished CIC protections in place. The typical response to such a situation is for the company without CIC protections to create a new program that meets or exceeds its erstwhile partner’s protections. Programs that are adopted in the face of a known business combination not only tend to create larger liabilities, but also threaten the ability to qualify for pooling-of-interests accounting treatment for the business combination (discussed later in this chapter). In several cases, last-minute protections had to be rescinded because of the threat to pooling-of-interests accounting—in all such cases, the rescission created severe unrest among the affected executive community. Interruption of Retention Protection Prior to Closing In some instances, the vesting of a long-term incentive award is tied to shareholder approval of a transaction, rather than the closing of the business combination. When the timing of shareholder approval and closing of the business combination are relatively close, the distinction becomes unimportant. However, when there is a significant time difference between the two dates, the early vesting of awards may create a substantial retention challenge. The problem is exacerbated for companies in industries that may expect potentially lengthy regulatory review of proposed business combinations (e.g., banking, transportation, and telecommunications). In at least a few cases, long-term incentives vested, the business combination was called off, and the surviving company was left with a severely reduced retention program, thus making its executives vulnerable to other opportunities. Regardless of whether the business combination is closed, vesting of incentives before the actual combination provides executives with (1) a large payment of compensation and (2) a window of opportunity to leave the firm without leaving large amounts of wealth behind. For executives who might already be prone to leave the company (for example, through retirement, because of uncertainty about their future roles, or to pursue high-risk opportunities), the newly available incentive value may be their golden opportunity to leave the company. In virtually every case where such an early vesting feature existed, management of the uncertain period ending with the closing of the business combination has been very difficult. Lack of Specific Guidance for Determination of Incentive Payout Amounts Many CIC programs fail to effectively describe the methodology for the payout of outstanding incentive-based pay. Although most programs provide for full vesting of incentive awards upon a CIC, the determination of the deemed payout levels for

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the shortened periods is often incomplete and in most cases unworkable. When specific guidance is lacking, some companies deem that performance objectives have been met. This leap of faith sometimes results in millions of additional dollars of cost, especially when the executive is entitled to a full gross-up for parachute excise tax. Some companies stipulate that upon a CIC, performance goals are deemed to be at maximum payout levels. In one highly publicized case several years ago, the assumption of maximum payouts resulted in payouts of more than $80 million to top executives, despite the fact that actual performance had significantly lagged behind the targets. In that case, institutional shareholders reacted strongly and sought to vote down a requested approval for a new stock-based incentive plan. Although the new measure was not voted down, the dissatisfied institutional shareholders succeeded in mustering a substantial “no” vote. One corresponding issue raised by an assumption of full payouts of outstanding incentives is that future incentives may have to rise to the level achieved in the year of the CIC. Many CIC severance contracts contain a provision mandating that future incentive awards be at least equal those in the year of the CIC. Accordingly, a high CIC-year payout may force future payouts to sustain the same level of incentive awards.

CONSIDERATIONS ARISING IMMEDIATELY UPON CLOSING OF TRANSACTION Issues that arise immediately upon closing of the transaction most typically relate to the degree of ease with which an executive may voluntarily leave and collect severance benefits. Severance triggers that are too easy to trip may result in millions of dollars of added cost, typically paid in the nature of retention incentives. Examples of issues encountered include: • Undue shift of negotiating power to executive, due to single-trigger CIC arrangements. • Overly sensitive good-reason termination trigger. • Unintended CIC payments based on size of combination partners. Undue Shift of Negotiating Power to Management due to SingleTrigger Arrangements Heightened executive negotiating power often gets translated into costly renegotiation of CIC protections. Single- and modified single-trigger arrangements place an enormous amount of negotiating power in the hands of executives (particularly

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when severance benefits are grossed up for excise taxes). This is especially wasteful for executives whose employment was to be continued following a change in control. A single-trigger arrangement is one that allows an executive to voluntarily quit after a CIC—for virtually any reason—and receive severance benefits. A modified single trigger is similar, except that the window for leaving for any reason is typically limited to a one-month period that commences some time after the CIC. At all other times within a modified single-trigger arrangement, an involuntary termination (or a constructive termination) is required to receive CIC severance coverage. In one situation, executives of the dominant combining company had singletrigger arrangements, which were tripped by a proposed business combination. The executives took the position that the company now owed them the full value of their parachute payments (even though they intended to remain employed and their jobs would remain intact) and, as a group, demanded payment in exchange for staying and continuing employment. Payment of these amounts would have resulted in tens of millions of dollars of additional expense. Overly Sensitive Good-Reason Termination Trigger In most CIC programs, the definition of a good reason for termination by the executive is so loose that the provision becomes essentially a single-trigger arrangement. Constructive termination provisions may be designed to be very favorable to the executive by stipulating a very tight definition of duties, responsibilities, reporting relationships, pay and benefits levels, reporting relationships, and in some cases actual place of work. The tighter the definition of constructive termination, the more costly it may be to negotiate away these existing protections. Although it is often desirable to place limits on the types of pay changes that may be made, many good-reason definitions constrain the successor organization from making necessary changes. For example, the inability to transition health and welfare benefit programs to one system may negatively affect integration of the two companies’ programs. Similarly, changes in incentive arrangements and retirement programs are often desirable, but not possible, when doing so raises the specter of substantial severance liabilities. In some cases, the CIC arrangements stipulate that the executive’s reporting relationship must remain intact. This provision may sometimes be interpreted to include specific executives. A more flexible approach is to prohibit reductions in the amount of pay and benefits, but to allow changes in design. Similarly, subtle changes in job responsibilities are sometimes allowed, as long as there are no material reductions, and certainly there should be no mention of any changes in the reporting relationship. One common concern with respect to a good-reason provision is how it applies to future incentive arrangements. Often the provision is worded ambiguously, re-

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sulting in confusion about whether historical incentive opportunities or payouts have to be maintained. The distinction may be significant, particularly when the CIC results in heightened payouts for the year of the CIC, essentially substantiating this elevated level indefinitely. A similar problem arises when the dominant company is either foreign or private, and past practices of awarding stock-based incentives cannot be continued. In such cases, the successor company is often forced to negotiate away the goodreason provision, even though the successor company intended to hold incentive levels at or even above prior levels. Unintended CIC Payments Based on Size of Combination Partners The market practice with respect to the threshold for determining whether a CIC has occurred is established at a point where even the dominant company is deemed to have undergone a CIC. Specifically, if a company’s continuing shareholders (after the business combination) represent less than 65 percent of the total shareholders, a CIC will typically be deemed to exist. Under this system, a business combination of near-equals would result in a CIC not only of the smaller company, but also of the larger company. This is often the intended operation of the CIC program design, but it can result in perceived inequities for executives of the dominant company who continue in their pre-CIC roles. This issue is exacerbated when the threshold is set at a higher percentage; for example, if the percentage is set at 80 percent, then the executives of a company that buys a company one-fourth its size could become eligible for CIC benefits after the business combination. Similarly, long-term incentives would vest under such a program, resulting in a loss of retention incentive programs.

POST-CIC DESIGN The types of post-CIC design problems we have seen are less susceptible of categorization. Some of them relate to severance protections that are so high that they make retention of covered executives virtually impossible. Others relate to ambiguous drafting and poor planning. Examples appear in Exhibit 7.2. Potential Disqualification from Using Pooling-of-Interests Accounting Method Many traditional executive pay practices threaten the ability of a business combination to qualify for pooling-of-interests accounting treatment. In summary, pooling of interests is generally a preferred accounting method, because of the positive earnings effects associated with the large savings from writeoffs of goodwill following

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Exhibit 7.2 Examples of Potential Post-CIC Design Issues • Potential disqualification from using pooling-of-interests accounting method • Ill-fated negotiations out of parachute arrangements • Inappropriate mix of severance payments • Inadequately defined supplemental retirement protections • Overlapping severance programs • Ambiguous or inflexible continued long-term incentive rights • Overly generous reimbursement of legal fees

a business combination. The implications of qualifying for pooling treatment are significant enough that most large, stock-for-stock business combinations are made contingent on the ability to take advantage of pooling. Despite the importance of pooling, the great majority of companies involved in pooling business combinations have one or more pay practices that threaten pooling. The most typical such practices are cash-outs of stock option values (or other equitybased awards); recently adopted (or amended) pay programs that materially change historical practices; new CIC severance protections (adopted within two years prior to the CIC); and recent, unusually large grants of equity-based awards. Where such pooling threats exist, companies often are required to rescind existing compensation arrangements, without consideration of the affected employees. Ill-Fated Negotiations out of Parachute Arrangements It is common practice, after a business combination transaction has closed, to renegotiate away CIC severance agreements and replace them with less costly programs. Done properly, such renegotiations can result in tens of millions of dollars of savings in lost deductibility and gross-up payments. However, if done incorrectly, these negotiations can add to the after-tax cost to the company. In its search for lower after-tax costs, a company may negotiate itself into a position of higher after-tax costs should the negotiated arrangement not hold up to IRS scrutiny. A company typically vies for the conversion of a CIC payment arrangement into a much lower CIC payment arrangement, payable at time of the CIC, and a reasonable level of compensation for services performed (including consulting arrangements and noncompetition agreements). A bargaining point used by the company is liberal interpretation of CIC agreement provisions, allowing higher levels of payments to be spread out over a one-

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to five-year period in exchange for consideration, which is typically services or a noncompetition agreement. If the Internal Revenue Service were to question future payments, the entire amount might be considered a parachute payment, resulting in higher after-tax costs due to lost deductibility and gross-up payments. The company could saved substantial amounts of money if it bundled all concessions into one negotiated resolution, rather than giving in on some issues and hoping for fair treatment from others. However, the company may be better off if it sticks to an interpretation of the plans and programs that results in lower parachute payments. For example, it is not unusual for executives to continually push for concessions when they negotiate with a company in these matters. This push for concessions and additional payments may get out of control if it is allowed to go unchecked. Despite generous interpretations of contractual ambiguities by the company, the executives may continue to push for added value in exchange for agreeing to forgo existing parachute amounts (in exchange for equal value or more through replacement programs). Inappropriate Mix of Severance Payments To instill executive objectivity regarding potential business combinations, CICrelated severance is, by design, intended to be greater than typical severance. Thus, the higher the cost of CIC-related severance programs, the higher the cost of the post-CIC retention programs. That is, severance protections that exceed market practice, and that are fairly easily accessible after a business combination, tend to result in costly retention programs. The challenge of retaining employees following a business combination may also be influenced by the executive’s proximity to retirement age. Although it may not be appropriate (or in some cases legal, under age discrimination rules) to tailor the amount of severance benefit to the executive’s age, it should be considered as a design issue to align the severance payments with the type of termination following a CIC. For example, a $5 million dollar benefit may be large enough to convince an executive in his or her mid-fifties to retire from an active career, whereas the same amount of money may not be sufficient to convince an executive in his or her early forties to feel comfortable about retiring. Some CIC programs provide, albeit unintentionally, long-term incentives in the payout multiple. Most CIC programs specify a multiple of base salary and bonus to be paid upon a qualifying termination. However, some CIC severance multiples make ambiguous reference to base pay plus “incentives,” creating uncertainty about whether long-term incentives are intended to be included. In addition to ambiguous language, the inclusion of long-term incentives in the severance multiple are on the rise.

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Inadequately Defined Supplemental Retirement Protections Enhancements to existing supplemental retirement arrangements often are drafted in ways that are not easily interpreted across the array of typical retirement programs. For example, adding three years of age and service credits to supplemental retirement rights is fairly straightforward with respect to supplemental retirement benefits, but it can create confusion with respect to how the enhancement affects early retirement programs and the timing of benefit payouts. Another common drafting ambiguity lies in the assumptions to be applied to the addition of future age and service credits. An executive’s assumption that the final average pay calculation is to be extrapolated into the future (rather than relying on the final average pay that exists as of the severance date) can result in a dramatically higher benefit than anticipated by the company. Overlapping Severance Programs Some companies adopt new severance programs without clearly superseding and replacing existing severance protections. When this occurs, executives may claim that these programs work in tandem, resulting in duplicate coverage and thus duplicate severance payments. The likelihood of creating potentially duplicative severance entitlements increases with the number of programs and contracts covering executives. For example, many companies have employment agreements, long-term incentive plans, short-term incentive plans, general severance programs, and CIC-related severance agreements, all of which potentially cover benefits upon employment termination. It is crucial to have all of these arrangements working consistently and clearly identifying which arrangement covers each element of severance. Ambiguous or Inflexible Continued Long-Term Incentive Opportunities In an attempt to provide ostensibly fair and equitable employment arrangements, many CIC programs stipulate equal or better long-term incentive opportunities. Many CIC programs not only cover rights to severance upon termination, but also attempt to clarify continuing employment rights. When this is the case, executives’ rights to long-term incentive values are typically protected for a given period of time after the CIC (usually two years). Prospective guarantees of long-term incentive value can be costly, as well as troublesome from a design perspective. The year of the CIC often results in abnormally high payout values for long-term incentives, and using the CIC year as the base year for future guarantees fixes the liability at that high level. From the design perspective, if the successor company is either foreign-based or nonpublic, a guar-

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antee of future stock-based incentives will not be possible (usually resulting in constructive terminations and the corresponding severance liabilities). In several situations, a foreign-based successor company fully intended to provide historical levels of long-term incentive opportunities, but was unable to offer equity. In several of these cases, the executives of the target company forced difficult negotiating procedures due to their claims of constructive termination, despite offers by the successor to maintain historical target award levels. Overly Generous Reimbursement of Legal Fees One of the most significant contributors to the cost of resolving CIC program disputes is a full legal fee reimbursement feature. Executives who are covered by an unconditional and unlimited reimbursement provision are presented with a no-risk method for pressing aggressive interpretations of their CIC coverage. Many companies mitigate this potential problem either by limiting the maximum reimbursement, or by conditioning reimbursement on winning one or more elements of the claim. Such conditions can save millions of dollars in fees and concessions which otherwise would have to be made to avoid costly litigation. Another common alternative for approaching this issue is to contractually require binding arbitration as the method for dispute resolution.

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Chapter 8

Reload Stock Options Boards of directors, their executive compensation advisors, and Wall Street investment managers and financial analysts are all very confused about—and at the same time very interested in—a fairly new and increasingly popular form of stock option called a reload stock option. The debate has moved from the boardroom and consulting reports to the business media as reported in Business Week and The Wall Street Journal. The purpose of this chapter is to make a contribution to this debate and to clear up misconceptions about reload stock options. Reload stock options (RSOs) have existed as a compensation vehicle for more than 10 years. Over this period they have steadily gained in popularity. According to a study by Frederic W. Cook & Co., about 19 percent of the 250 largest companies in the United States use RSOs as a means to compensate executives. Given the time RSOs have been in use, the recent increase in use of RSOs, the trend for institutional investors (in particular) to scrutinize executive compensation, and the academic research into the use and valuation of RSOs, it is curious that the debate about RSOs is so confused. Whereas opponents focus on the added cost and the additional downside protection provided by RSOs, proponents’ arguments consist mainly of examples that appear to contradict their own claims. The arguments made on both sides of the RSO debate have not provided a complete representation of the issue, so there is a need for clarification. The following discussion should make the debate about the advantages and disadvantages of RSOs more meaningful.

STANDARD RSO DESIGN An RSO is a stock option award with an additional feature stipulating that a new option grant will be made to an executive at the time the executive exercises the original stock option award. The reloaded option grant typically has an exercise

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price equal to the then-current market price and expires at the same time as the initial grant. Commonly, an RSO is granted for each share tendered by the executive in payment of the exercise price. The option spread is paid to the executive in the form of full shares of stock. These shares are sometimes referred to as profit shares. In summary, a standard RSO option program consists of the following design criteria: • The number of subsequent RSOs is equal to the shares tendered in the exercise of the option. • The exercise price of the RSO is the current price at time of the reload. • The term of reloaded option is the same as that of the original award (typically 10 years). Not all RSOs are alike. Additional design features that favor the executive are as follows: • • • •

More RSOs are granted to make up for taxes. RSOs have a full 10-year term (the perpetual RSO). Some allow for multiple reloads. The number of reloads is the same as the number of options exercised (the full RSO).

A list of RSO design features that favor the company is as follows: • • • •

Restrictions on the sale of the profit shares. Performance vesting requirement on the exercisability of the RSOs. RSOs start a new vesting schedule. Exercise price of the RSO is at a premium (e.g., above the current fair market value).

Here is an example of a simple RSO award and the subsequent RSO. Assume that an executive owns 1,000 shares and uses them to exercise a 2,000-share option grant when the stock price has doubled. Before the exercise, the executive had carried interest in 3,000 shares, whereas after exercise and without a reload feature, the carried interest is only 2,000 shares (1,000 shares held plus 1,000 shares represented by the option spread). With a reload feature, the executive ends up with 2,000 shares and 1,000 options, for a total carried interest of 3,000 shares. This example ignores taxes for purposes of illustration.

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SIMPLE RSO VALUATION MODEL To answer this question—as well as the other related questions—as intuitively as possible, we rely on a simple numerical example. We shall assume that there are only four relevant dates: • • • •

Today (date 0) Tomorrow (date 1) The day after (date 2) The end (date 3)

We assume that an option is granted to an executive today, at date 0, and that this option expires at the end, at date 3. Between date 0 and date 3, the stock price of the company in question is assumed to follow a geometric binomial random walk (a standard assumption in any option pricing model such as the Black-Scholes model). If we assume that today’s stock price is $200 and that the stock price can either double or be cut in half over each period, the stock prices at date 3 will range from $25 to $1,600 (see Exhibit 8.1). In the example summarized in Exhibit 8.1, there are a number of price/action combinations. First, it is clear that the option recipient (in the interest of brevity, we will call this individual “the executive” henceforth) would never want to exercise at date 3 if the price of the stock is less than the $200 initial stock price (also known as the exercise price). This is certainly the case whether the options are standard stock options (SSOs) or RSOs. Exhibit 8.1 Potential future stock prices used in numerical examples.

$1,600 $800 $400 $200

$400 $200

$100

$100 $50

Date:

0

1

2

$25 3

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Second, it is equally clear that if the strike price is less than the exercise price, the executive will indeed exercise his or her options before date 3, when the options are about to expire. Further, if, in the interest of simplicity, we concentrate on a non-dividend-paying stock and assume the executive to be risk-neutral, it follows from Merton (1973) that if the executive is granted a SSO, he or she will never want to exercise prior to date 3. As shown by Hemmer et al. the opposite is true in the case of an RSO (T. Hemmer, S. Matsunaga, and T. Shevlin, “Optimal exercise and the cost of employee stock options with a reload provision,” Journal of Accounting Research 36 (Fall 1998): 231–35). To verify that it is indeed optimal to exercise a RSO whenever it is in the money, consider the scenario where the price of the stock at date 2 is $800. Suppose the executive did not exercise at date 1 when the stock price was $400. If he exercises now he must surrender 1/4 of a share in the exercise. In return, he receives 1 share and 1/4 of an option with an exercise price of $800. At date 3 the price is either $1,600, in which case the executive exercises his options for a net gain of 1/8 share so that his total holdings are 7/8 of a share at a market value of $1,400. In case the price at date 3, falls to $400, he will not exercise and thus have only gained 3/4 new shares with a market value of $300. The wealth gains resulting from the early exercise strategy is to be compared with the payoffs the executive faces if she delays exercise to date 3, as she would if she were holding an SSO. In that case, she will surrender 1/8 of a share to pay the exercise price at date 3 when the stock price goes up to $1,600 and she will receive 1 share back. Her net gain is then 7/8 shares with a market value of $1,400, exactly as it was in the case where she exercised at date 2. However, if the stock price declines between date 2 and date 3, it is a different story. By delaying, the executive must now deliver 1/2 share to exercise his option at date 3. Thus, his net gain is 1/2 share with a market value of $200, 50 percent less than in the case where he exercised at “date 2”. As shown by Hemmer et al. (1998), exercising an RSO that is in the money always leads to at least the same gains as delaying exercise; if the price declines over the next period, exercising an in-the-money RSO immediately is strictly better than a wait-andsee approach. The dominance of early exercise result for RSOs provides the foundation for addressing most, if not all, issues of controversy in the RSO debate. ADVANTAGES AND DISADVANTAGES OF RSOS The advantages of RSOs are as follows: • Result in an increase in actual share ownership. • Provide the executive with dividend and voting rights.

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• Dampen (but do not eliminate) the effect of a subsequent decline in stock price on option value. • Allow further appreciation on the option profit to be taxed as a capital gain rather than as ordinary income. The disadvantages of RSOs are as follows: • • • •

More costly to shareholders. Take the control from the company in making stock awards. Provide an unfair hedge to executives. Increase stock overhang from stock award programs.

A discussion of the advantages and disadvantages of RSOs follows (in no particular order). RSOs Provide an Unfair Hedge to Executives It is, we hope, clear from the preceding discussion that RSOs provide executives with an incentive to exercise whenever stock price exceeds the exercise price. By doing so, an executive will indeed lock in profits when stock prices are high and, in turn, not be subject to the downside risk exposure that is the reality for shareholders or other investors who may be investing in a derivative instrument. Given that RSOs are designed to encourage early exercise and executive stock ownership, it seems out of place to label early exercise by executives holding RSOs as abusive. Indeed, unless an executive reloads over time, there is no point in attaching the reload provision to an SSO. If it were never reloaded, an RSO would be identical to an SSO. RSOs Provide a Different Executive Incentive Because the RSO offers the executive an incentive to lock in gains whenever possible, there can be no question that the executive who holds RSOs has a “hedge” that investors (holding shares) do not. Two issues arise, however. First, executives holding an SSO also have downside protection (i.e., a hedge) that shareholders do not. Second, and more importantly, although RSOs do provide more of a hedge than SSOs do, this by no means suggests that RSOs make executives’ interests less aligned with the interests of shareholders. To see the flaw in this logic, compare the incentives for an executive who is granted an RSO with the incentives of an executive who is granted an SSO. It is clear that both executives (except in cases when the option is so far out of the money that there is no hope of future exercise) at any date (0, 1, or 2) would like to see the

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stock price increase over the remaining life of the option. Indeed, if the executive with the RSO must hold onto shares gained by reloading, it is easily verified from Exhibit 8.1 that the only scenario in which the executive will have nothing to gain from working to improve stock price performance is when at date 2, the price of the stock is $50. Whether the price goes up or down from all but this particular stock price, and whether the executive has an RSO or an SSO, he or she will benefit from higher prices. It is important to note, however, that the holder of an SSO is indifferent as to how the price moves between grant and expiration, as long as the price ends up higher. In contrast, the holder of an RSO actually prefers the price to be as high as possible over the entire life of the option. To see this, consider the scenario in Exhibit 8.1 where the price ends up at $400 on date 3. Because the holder of an SSO here delays exercise to that date, the net gain is 1/2 share with a market value of $200, whether the price reached $800 on date 2 and then declined; reached a low of $100 on date 1 and then increased thereafter; or went up and down between $200 and $400 over the life of the option. With the RSO, however, the executive is strictly better off if the price peaks at $800 at date 3 than under either of the two other scenarios. If the price peaks at $800 in this example, the executive will have a net gain of 3/4 shares over the life of the option with a date 3 market value of $300. In the other two scenarios, the executive’s net share gain over the life of the reload will be only 1/2 share. Accordingly the added hedge of an RSO contributes an incentive not inherent in an SSO: namely, for the executive to ensure, if possible, that share price stays as high as possible over the entire time horizon and, equivalently, to avoid temporary stock price depression. Clearly, it is in the interest of short- and medium-term investors for stock prices to stay as high as possible in the interim. It is also clear that this has (at least in this example) no adverse implications for long-term investors. Accordingly, the additional hedge provided by the reload feature gives the executive an additional incentive not present in an SSO; an RSO thus may work better to align the interest of executives and investors than will the more limited downside protection provided by an SSO. Cost of an RSO The proponents of RSOs argue that RSOs are no more dilutive, or costly, than SSOs. The basis of this contention is that the maximum number of additional shares that executives can gain is the same whether they are holding RSOs or SSOs. Our analysis shows, however, that an RSO is 25 percent or more costly than an SSO. In Exhibit 8.1, the maximum gain in the executive’s share portfolio occurs when the date 3 stock price is $1,600. As previously calculated, this gain works out

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to be 7/8 additional shares for each RSO granted. Accordingly, accounting rules require the reporting of “Fully Diluted Earnings Per Share” that is based on the worst-case scenario (from the perspective of the shareholders), which is the same in the case of RSOs as it is in the case of SSOs. Although the maximum dilution is the same for these two forms of stock awards, the problem is that from an economic perspective, “Fully Diluted Earnings Per Share” is not the right measure. Rather, the appropriate construct is the difference in expected dilution to shareholders’ claims caused by an RSO versus an SSO. Measured this way, it is clear that the RSO is the more dilutive of the two. Consider again the case in which the date 3 stock price is $400. With an SSO, the net gain to the executive is new shares. In the case of a reload, the 1/2 share is the minimum net gain to the executive that can occur. This will happen when the date 1 price is $100 and, though this is the worst the executive can do when the date 3 stock price is $400, he or she can actually end up doing better. If at date 2 the stock price is $800 instead, the executive’s net gain is again 3/4 shares. As is easily verified, the executive never gets fewer shares (net) with an RSO than with an SSO; on occasion, he or she will actually get more. Therefore, average dilution is indeed higher for RSOs. This additional average dilution caused by RSOs most certainly represents an economic cost to the shareholders. The question is therefore not whether an RSO cost shareholders more than an SSO; the question is, how much more? To answer this question, we need to be able to give the value for both types of stock awards. Hemmer et al. (1998) provides the counterpart to the standard binomial option-pricing model (Cox et al. 1976) to value RSOs. The reader is referred to these articles for details on the derivation of the binomial valuation techniques. However, as illustrated by Hemmer et al., using basically the same assumptions about volatility, terms, and so on as in Standard Financial Accounting Statement (SFAS) 123, the RSO is about 25 percent more costly than is an SSO, assuming it is held to maturity. The value of an RSO as compared with an SSO may even be greater than 25 percent. The preceding comparison is a bit misleading, however, because empirically SSOs have an expected life of about six years. (This is documented by T. Hemmer, S. Matsunaga, and T. Shevlin, An empirical examination of reload employee stock options, working paper [University of Washington, October 1996], among others.) Using this information in the valuation, the comparison reveals that the RSO is approximately 70 percent more costly than the straight SSO. Moreover, RSOs that provide for additional profit shares to relieve the executive’s tax burden and RSOs that extend the option term can be substantially more costly than the simple unrestricted RSO underlying this comparison.

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We can come to this same result by using simple examples of likely stock price movements and comparing the number of RSOs and profit shares required by the company for a certain level of stock incentive with what would be required for SSOs. Effect of RSOs on Stock Overhang The proponents of RSOs argue that the use of RSOs results in less stock overhang than the use of SSOs. Based on the example provided at the start of this section, it is clear that this is indeed true. However, when one considers the profit shares resulting from the exercise of an RSO, it is clear that RSOs are more dilutive than SSOs in most cases. It is equally clear that the reduction in overhang is not a benefit to the shareholders. In contrast to what is normally implied by the term reduction of overhang, when the reduction is due to reloading this effect is actually more of a cost. Consider again the example in Exhibit 8.1. At the time of grant, date 0, the overhang is the same for an SSO and for an RSO. However, the SSO remains overhung until late in the game. Specifically, in this example, an SSO is part of the overhang until date 3, except when the stock price at date 2 is $50 and the option therefore has effectively expired. RSO grants, in contrast, are converted into smaller grants whenever they are exercised. So, if the stock price at date 2 reached $400, the RSO would be exercised and the executive would receive shares and only 1/2 reload back. The reduction in options outstanding of course translates directly into a lower overhang. The point is, however, that satisfying the claim that caused the overhang to go up in the first place reduces the overhang. In other words, rather than having a potential liability, the firm liability has been realized. Paying out earlier and paying out for sure clearly is worse for the shareholders than paying out late and potentially not at all.

OPTIMUM RSO DESIGN As discussed earlier, an RSO has a higher value than an SSO. Thus, you should award fewer RSOs to an executive than SSOs. However, a well-designed RSO, incorporating features as follows, should minimize the premium of an RSO over an SSO: • Require the executive to use mature shares (held for at least six months) to exercise the RSO.

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• Impose a stock price and/or minimum time vesting period before the RSO can be reloaded. • Limit the entire life of the RSO to 10 years. • Restrict the sale of the profit shares to a minimum of two to three years. • Impose strict ownership guidelines to encourage retention of shares. The most widely debated issue in RSO design is the tax-reload feature. For all practical purposes, this feature is necessary for the program to be viable. The bite taken from the RSO will be so great as to make the reload impractical. The Financial Accounting Standards Board has required the tax reload to apply at the 28 percent federal tax rate.

SUMMARY The purpose of this chapter was to clear up some of the confusion about RSOs, not to suggest that RSOs are bad for investors. An executive RSO award program may in fact be better for investors. Although RSOs are more costly than SSOs, they also provide different executive incentives to encourage behavior that will enhance shareholder value. The value of SSOs is more easily quantifiable than RSOs; hence, we need to perfect our valuation models to include RSOs (and the many design variations) so that we can do a better job of designing RSO programs. Just as one cannot argue that a Mercedes is a worse buy than a Kia based on the purchase price alone, one cannot argue that RSOs are less desirable than SSOs based on a simple cost comparison.

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Chapter 9

Pooling-of-Interests Accounting

TWO VIEWS “We will not do any deals without pooling of interests accounting.” —Barry Diller Chairman, USA Networks, Inc. 2000 “Accounting for business combinations is immaterial. The cash flow is exactly the same.” —Unnamed Finance Professor Anytown, USA 2000

Please note that the current pooling-of-interests accounting rules have been revised. The underlying accounting rule (APB 16) will be phased out in favor of modified purchase accounting rules as of July 1, 2001. However, to maintain pooling-ofinterests accounting tax treatment, the reporting company must adhere to specific rules and behavior. The dos and don’ts to avoid disruption of pooling will be discussed later in this chapter. An interesting aspect of the current merger mania gripping corporate America is the influence that human resources (HR) decisions can have on the choice of pooling-of-interests versus purchase accounting. The HR function can affect the financial performance of the company in many ways, ranging from incentive plans that truly motivate employees to increase shareholder value to the selection of compensation and benefits programs and their attendant accounting, tax, and securities implications. One very important and, up until recently, obscure way to influence the eligibility of the company for pooling or purchase accounting is by the careful implementation of human resources plans and programs. 163

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This chapter addresses the following questions: • • • • • •

What is pooling? Why is pooling important? How does pooling work? How does pooling affect the HR professional? What can an HR professional do? What are current practices?

The intention of this chapter is not to advocate the use of pooling. The purpose is to point out the differences between the two methods of accounting for business combinations and to provide insight and suggestions on ways to preserve use of the pooling-of-interests method. The use of pooling-of-interests accounting is more important for large mergers in which the purchase price is high in relation to the net fair market value of the assets.

WHAT IS POOLING? Pooling-of-interests accounting allows the simple addition of the income and balance sheet statements. Accounting Principles Board (APB) Opinion No. 16 specifies 12 criteria that must be met to use the pooling-of-interests accounting method. If all 12 of these criteria are met, the business combination must be accounted for by using the pooling-of-interests method. Otherwise, purchase accounting is applicable. A partial list of the criteria is as follows: • Autonomy. The combining companies cannot be or have been a division or subsidiary of another division within past two years. The combining companies must be independent from one another. • Single transaction. The combination is effected in a single transaction, with a specific plan, within one year after the plan is initiated. • Substantially a stock-only transaction. The target-company purchase price must consist of at least 90 percent of the acquiring company’s stock. • No change in equity structure. This is the most important criterion for HR professionals. Neither of the combining companies can alter the voting common stock interests in contemplation of the combination within two years of initiation of the proposed combination. Note: As discussed earlier, APB 16 is under review and may change.

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To more fully understand pooling-of-interests accounting, we must explain the subject of business combinations in general, and we must also contrast pooling-ofinterests accounting with the purchase method of accounting for a business combination. If you are comfortable with the subject of business combinations, please skip to the next section. In total, there are four legal procedures that a firm can use to combine with another firm. The types, listed in order of prevalence, are merger, consolidation, stocktender offer, and asset purchase. A merger, the most popular form of business combination, is where one firm completely absorbs another firm. A consolidation is where two firms combine to create one entirely new firm. The rules for consolidation are essentially the same, in that assets and liabilities are combined—the only difference is that in a consolidation, a new legal entity is created. A big drawback to both the merger and consolidation methods is that the stockholders of both firms must approve the business combination. Most corporate rules and bylaws require a two-thirds voting stock shareholder majority to approve a merger. To get around this requirement and to gain approval for the business combination, the acquiring company goes straight to the shareholder by using the sharetender offer method. The fourth and least used form of business combination is the asset purchase method, whereby the acquirer purchases the assets of the target firm. To make sense to shareholders a business combination must result in what is sometimes called synergy. Indeed, the value of the business combination must be greater than the sum of the individual firms, or else why bother? The synergy between the newly combined firms must ultimately result in an increase in cash flow available to shareholders. The way to increase cash flow and subsequently increase shareholder value is for the combined firm to show an incremental improvement over the two formerly separate parts, as follows: • • • •

Revenue enhancement (including new products/services) Cost reductions Tax reductions Capital needs reductions

An important objective of a business combination is to qualify as a tax-free exchange with respect to shareholders and the combining firms. IRC § 368 lists the conditions for taxable and nontaxable exchanges. In general, if payment is received in stock, the transaction is not a taxable transaction for either the shareholder or the combining corporations. Alternatively, if the payment is received in cash, or property other than stock, the transaction most likely is a taxable event for the shareholder to the extent of the cash payment and may cause a step-up in basis in the target company’s assets, resulting in taxable gain.

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HOW DOES POOLING WORK? To illustrate the advantage of pooling over purchase, we will use a $240 million stock transaction in which either pooling or purchase accounting is used. This example will show the effect on the financial statements and, more importantly, the financial performance ratios, should pooling treatment be disallowed by the Securities and Exchange Commission, forcing the use of purchase accounting. As you will see, the financial results will appear significantly less in the case of purchase accounting. POOLING VERSUS PURCHASE: ILLUSTRATION On December 31, 2000, there was a business combination of Company A (the buying company) and Company B (the selling company). Company A acquired all of the net assets of Company B through the exchange of 6 million newly issued Company A common shares (with a market price of $40 per share) for all 5 million Company B common shares outstanding. See Exhibits 9.1–9.3 for information on Company A and Company B. The name of the new entity will be Big Company. For purposes of this illustration, we assume that the transaction costs are negligible. In a real deal, the transaction costs, investment-banking fees, legal fees, accounting fees, and other consulting fees would be between 3 and 6 percent of the transaction price. In the case of purchase accounting treatment, the goodwill is amortized over 40 years and net fixed asset revaluation is depreciated over 10 years using Exhibit 9.1 Company A (Acquiring Company) Income Statement ($ millions) Revenues

$400

Less expenses

$360 ——

Net income

$ 40 —— ——

Balance Sheet ($ millions) Assets Cash

Liabilities $100

Current liabilities

$110

Other current

$150

Noncurrent liabilities

$ 90

Fixed assets

$150 ——

Stockholder equity

$200 ——

Total

$400 –––– ––––

Total

$400 —— ——

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Exhibit 9.2 Company B (Target Company) Income Statement ($ millions) Revenues

$200

Less expenses

$175 ——

Net income

$ 25 —— ——

Balance Sheet ($ millions) Assets

Liabilities

Cash

$ 30

Current liabilities

$ 20

Other current

$ 40

Noncurrent liabilities

$ 10

Fixed assets

$ 50 ——

Stockholder equity

$ 90 ——

Total

$120 –––– ––––

Total

$120 —— ——

Exhibit 9.3 Fair Market Values and Other Information for Company A and Company B As of December 31, 2000 Company A

Company B

FMV Assets Other current assets

$100

$50

Fixed assets

$200

$90

Current liabilities

$110

$20

Noncurrent liabilities

$100

20

Corporate income tax rate

35%

35%

Average number of shares

10,000,000

10,000,000

$4

$5

$40

$48

FMV Liabilities

Other

EPS Stock price

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straight-line depreciation. Please note that it is possible to take an income tax deduction for the goodwill on a 15-year straight-line basis. However, this would be allowed only when the business combination did not qualify for a tax-free exchange, which is highly undesirable and therefore highly unlikely. The pooling method is simply the addition of financial statements. The most important difference between the two methods is the creation and subsequent amortization of goodwill in the case of purchase accounting and the increase in depreciation expense. In this example, goodwill equals $110 million and the fixed assets equal $240 million (see Exhibit 9.4), which represents an increase in depreciable assets of $40 million over the corresponding pooling-of-interest amount of $200 million (see Exhibit 9.5). The financial ratios are much better in the case of pooling (see Exhibits 9.6 and 9.7). Not only is the earnings per share (EPS) significantly better, but the Exhibit 9.4 Big Company (Purchase Method) Income Statement ($ millions) Revenues

$400

Less expenses

$360 ——

Net income

$ 40 —— ——

Balance Sheet ($ millions) Assets

Liabilities

Cash

$3301

Current liabilities

$1302

Other current

$1103

Noncurrent liabilities

$1104

5

Fixed assets

$240 ——

Stockholder equity

$4406 ——

Total

$680 –––– ––––

Total

$680 —— ——

1

Equals Co. A’s and Co. B’s cash ($100 plus $30) plus Co. A’s current assets, at historical cost ($150), and Co. B’s current assets, at fair market value ($50). 2

Equals Co. A’s current liabilities, at historical cost ($110), plus Co. B’s current liabilities, at fair market value ($20). 3

Equals amount paid for Co. B ($240), less fair market value of net assets of Co. B ($130).

4

Equals Co. A’s noncurrent liabilities, at historical cost ($90), plus Co. B’s noncurrent liabilities, at fair market value ($20). 5

Equals Co. A’s fixed assets, at historical cost ($150), plus Co. B’s noncurrent liabilities, at fair market value ($90). 6

Equals Co. A’s stockholders’ equity, at historical cost ($200), plus purchase price paid for Co. B ($240).

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Exhibit 9.5 Big Company (Pooling Method) Income Statement ($ millions) Revenues

$600

Less expenses

$535 ——

Net income

$ 65 —— ——

Balance Sheet ($ millions) Assets

Liabilities

Cash

$130

Current liabilities

$130

Other current

$190

Noncurrent liabilities

$100

Fixed assets

$200 ——

Stockholder equity

$290 ——

Total

$520 –––– ––––

Total

$520 —— ——

Exhibit 9.6 Financial Results for 2000 (Year of Business Combination) Big Company ($ millions) Company A

Purchase

Pooling

Net income

$40

$40

$65

EPS

$4.00

$2.50

$4.06

Return on equity

20.0%

9.1%

22.4%

Return on assets

10.0%

5.9%

12.5%

Exhibit 9.7 Financial Results for 2001 (Full Year of Operation after Business Combination) Big Company ($ millions)

Net income

Company A

Purchase

Pooling

$40.00

$58.85*

$65.00

EPS

$4.00

$3.74

$4.06

Return on equity

20.0%

13.6%

22.4%

Return on assets

10.0%

8.8%

12.5%

*$65.00 less $2.75 (goodwill amortization) and $2.40 (depreciation of net fixed asset revaluation).

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profitability ratios are astoundingly better. In 2000, the purchase method results in an EPS of 38 percent less and profitability ratios of less than half (e.g., a return on equity (ROE) of 9.1 percent versus 22.4 percent). In 1998, the results would not have been quite so dramatic, but would have been significantly less in the case of the purchase method. An important point to note is that Big Company’s EPS actually increased from $4 to $4.06, a 1.5 percent increase!

WHY IS POOLING IMPORTANT? As shown in the preceding illustration, pooling-of-interests accounting results in higher net income and more favorable profitability ratios. The higher net income is derived from lower income statement expenses (as shown in Exhibits 9.4 and 9.5) associated with the pooling, as compared with the purchase method. Another attractive feature for acquiring companies is a boost in earnings per share. In general, the EPS of the acquiring company will increase upon the acquisition of a company with a lower price-to-earnings multiple (P/E). For example, Tyco International has used pooling to acquire more than ten companies over the past five years. Each acquisition has boosted Tyco’s EPS. Not only will Tyco not make an acquisition without pooling, but also they will not make an acquisition without an immediate increase in EPS. Business combinations soared to more than $1.6 trillion in late 1990s, more than 50 percent greater than in the mid-1990s. There were 156 deals of $1 billion or more in 1997. The recent merger craze has been characterized as a watershed event not unlike the wave of industrial takeovers that created General Motors, U.S. Steel, and Standard Oil in the early 1900s. In the last 3 years, more than 27,600 companies combined, which was more than in the entire decade of the 1980s, the decade with the next highest activity. Pooling-of-interests accounting is the method of choice for larger business combinations. In 1997, more than 500 business combinations were accounted for by pooling-of-interests accounting. This is up from 2 only 10 years ago. In 1997, the dollar volume of poolings exceeded purchases by more than 20 times. Gillette and Cisco Systems suspended their ongoing stock buyback plans so that they could keep pooling treatment. The Securities and Exchange Commission spends more time on answering questions about pooling than about any other accounting rule. In some cases, though, purchase accounting would actually be preferable. For example, when the purchase price is equal to or below the fair market value of the assets, the goodwill created at the time of the business combination will be immaterial. Another instance of use of purchase accounting is when the acquirer is concerned about diluting shareholder value, as was the case when the Walt Disney Company acquired Capital Cities/ABC in 1995. Disney paid $18.9 billion for Capital Cities/ABC, $10.1 billion in stock and $8.8 billion in cash. The 10 percent

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cash limit required by APB 16 (see earlier discussion) would have required Disney to offer an additional 70 percent in stock; that is, $17.0 billion in stock and $1.9 billion in cash. Disney deemed a 90 percent stock proposal to be too dilutive to Disney shareholders. After the merger, the fair market value of Capital Cities/ABC was ultimately determined to be close to zero, with the result that the entire purchase price of $18.9 billion was considered goodwill. Under the ensuing purchase accounting method, the goodwill-related charge against earnings was $438 million in 1997, and will most likely continue at that level over about the next 39 years. POSSIBLE CRITICISMS OF POOLING Pooling-of-interests accounting has been criticized for distorting the financial performance of the postcombination company. A list of criticisms of pooling is as follows: • • • •

Includes earnings of acquired company prior to date of combination. Does not recognize fair market value of assets and liabilities. Does not recognize excess paid over fair market value of acquired net assets. Seldom represents a combination of equals, which violates a key argument justifying the pooling method. • Seldom used outside the United States, which makes international comparisons more difficult. • Tends to cause overpayment for the acquisition, which may harm long-term investors. RESPONSE TO CALLS FOR CHANGE The Financial Accounting Standards Board (FASB) has adopted new rules effective July 1, 2001 to more closely conform to international standards. This action was taken in early 2001, and was effective in July 1, 2001. The SEC has ruled that companies that want to use pooling must suspend ongoing stock buyback programs for two years. This ruling makes pooling of interests accounting less attractive, as it requires companies to suspend ongoing stock buyback program. However, these anti-pooling SEC rulings will most likely continue. HOW DOES THIS AFFECT YOU? The most important lesson of this chapter is to be extremely careful in your deliberation of new HR programs and policies. The availability of pooling-of-interest accounting can make or break a proposed combination. The price to pay for the

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preclusion of pooling-of-interests accounting treatment is the lowering of the new entity’s EPS by a substantial amount (in our example, 8 percent). The lowering of the EPS potentially invites criticism from the board, investors, and analysts. Here is a brief summary of ways to kill pooling: • Upon a business combination — Cashing out of an equity arrangement (not pursuant to an equity plan approved two years prior to the business combination). — Acceleration of equity awards on a discretionary basis. — Surrendering shares to cover taxes on an option exercise (unless already allowed under option plan). • Within two years (before and after) of business combination — Increasing stock award grants. — Adopting unusually large employment, severance, or change-in-control (CIC) agreements. — Adopting a tax gross-up provision for CIC agreements. The majority of difficulties with pooling involve the acceleration and cash-out of unvested or unexercisable stock-based awards. Most stock-based programs fully waive the restrictions on stock-based awards as of the business combination. One recent survey indicated that 70 percent of stock option plans fully waive restrictions on stock-based awards as of the business combination; 2 percent vesting is continued and accelerates upon termination; and in 26 percent the determination is discretionary.* WHAT CAN YOU DO? As was discussed earlier, even though pooling-of-interests accounting treatment has been eliminated for new transactions after June 30, 2001, care must be taken to preserve a pre-existing pooling. Lack of care may result in the disruption of pooling treatment and reversion to purchase accounting which may result in substantial charges against earnings due to impaired goodwill. There are many ways for companies to preserve pooling. However, the SEC reserves the right to consider all applications for pooling-of-interests accounting and may ultimately rule against your position. With this in mind, here is a list of suggestions on ways to preserve pooling-of-interests accounting: • Instead of cashing out unexercisable options, convert these options into new stock options (see Exhibit 9.8 for an illustration). *Alpern, Richard. Guide to Change of Control: Protecting Companies and Their Executives. Alexandria, Virginia: Executive Compensation Advisory Services, 2001.

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Exhibit 9.8 Preferred Option Conversion Method Conversion of 1,000 old-company stock option award, exercise price of $20 for new-company stock option award: Old Company Stock price

New Company

$48.00

$40.00

$20.00 ——–—

$16.67 ——–—

$28.00

$23.33

Number of options

× 1,000 ——–—

× 1,200 ———–

Aggregate spread

$28,000 ———– ———–

$28,000 ———– ———–

Exercise price Spread

Note: Ratio of exercise price to FMV must be preserved and option spread cannot increase. Other option provisions must also carry over, including the vesting schedule and the remaining option term.

• Alternatively, instead of cashing out unexercisable options, convert these options into new company stock (see Exhibit 9.9 for an illustration). • Provide severance protection for senior target-company executives through agreements that are substantially similar to those of acquiring-company executives (e.g., comparable change-in-control agreements, restricted stock awards, and provisions). • Make agreements that have business substance (e.g., noncompetition, retention, and consulting arrangements), in general. Replace existing agreements with ones of substantially similar economic value or cost.

Exhibit 9.9 Preferred Method of Cashing Out Unexercisable Stock Options Spread of Old-company unexercisable stock options

$28

Number of options Aggregate fair market value

1,000 –——— $28,000

New-company stock price Number of new-company shares issued in shareout

÷ $40 —–—— $700

Note: The acquiring company shares can be vested at time of transfer even if the options were unexercisable at time of business combination. In this example, the option holder receives $28,000 of value. The fair market value of the unexercisable option spread may be more or less, as it represents the option spread plus premium attributable to future growth of options less discount due to risk of forfeiture.

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• Review your company’s plans and programs and create a list of revisions. Be prepared to make the necessary changes on a cue from the board of directors that the chance of business combination is relatively low. • Do not wait until the safe period (two years prior the agreement to combine) is upon you. This may not give you sufficient time to do an adequate review. The earlier you start, the better your company will be prepared for the next round of business combinations.

REBUTTING THE PRESUMPTION Pooling is not available if any change in the voting common equity interests of either entity is made in contemplation of a business combination. The presumption is that a change within two years of a business combination is made in contemplation of a combination. This presumption can be overcome if a valid business purpose is established. It is very important to maintain complete documentation of the business purposes involved in compensation and benefits decisions, as this rebuttal is a fact-specific analysis. In general, a material change to equity for good business purposes six months or more prior to a combination may not be held to be in contemplation of the combination; however, a change within six months is highly presumptive.

THE DEMISE OF POOLING OF INTERESTS ACCOUNTING As of June 30, 2001, FASB changed the rules for the mergers and acquisitions game. Companies no longer may use the pooling-of-interests accounting method for business combinations. Nor will they account for mergers on their financial statements under the traditional purchase method, which required them to amortize goodwill assets over a specific time period. Instead purchased goodwill will remain on the balance sheet as an asset subject to impairment reviews. FASB’s new standards, FAS 141, Accounting for Business Combinations, and FAS 142, Accounting for Goodwill and Intangible Assets, are a radical change, and now management accountants, auditors and financial executives must understand and work with a very different accounting process. Some believe FASB eliminated amortization to make purchase accounting techniques more appealing to corporate America. Traditional purchase accounting required companies to amortize “purchased” goodwill on a periodic basis, for as long as 40 years. Now companies will be able to make acquisitions without being forced to take large periodic earnings write-downs, which some corporate executives view as an unnecessary drag on earnings.

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Chapter 10

Accounting for Executive Stock Awards Recently, a great deal of attention has been paid to executive/director stock option awards, particularly the repricing of stock options. The Financial Accounting Standards Board (FASB) released a new interpretation of Accounting Principles Board Opinion Number 25 (APB 25) in 1999. The final interpretation was issued in September 1999 after a 90-day comment period. The most important interpretative changes by the FASB were with respect to repriced options. A repriced option is considered a variable-price grant, thus incurring a charge to earnings to reflect option gains at time of exercise. Other important changes include accounting for awards made to nonemployee directors, and the exchange of stock option awards upon a business combination. This chapter covers seven areas of the interpretation: • • • • • • •

Scope of APB 25 Definition of noncompensatory plan Requirement for new measurement date Variable plan accounting Business combinations Other issues Effective date and transition to new rules.

Please also refer to Appendix B for additional information on accounting for stock awards.

175

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SCOPE OF APB 25: WHO FALLS UNDER THE ACCOUNTING RULE? Currently, APB 25 applies to stock options of the employer used to reward an employee. In practice, APB 25 has been extended to people other than employees, such as nonemployee directors and various types of consultants and independent contractors. The FASB concluded that the term employee, as used in APB 25, should be based on the common-law definition of an employee. As a result, options granted to individuals who are not employees under federal tax law as applicable to payroll withholding taxes would not be accounted for under APB 25. In addition, employees of joint ventures would not be considered employees under this new interpretation. This interpretation will ostensibly preclude a company from treating an individual contributor as an independent contractor for purposes of withholding payroll taxes and an employee for purposes of accounting for stock awards. In summary, the new interpretation states that the company designated as responsible for payroll tax reporting purposes is presumed to be the company responsible for compensating the employee, in the absence of evidence to the contrary.

DEFINITION OF NONCOMPENSATORY PLAN The FASB’s decisions on the definition of noncompensatory plan are consistent with current practice. The decision thus provides clear guidance on current interpretation of APB 25. The four criteria that are essential to a noncompensatory plan, as listed in paragraph 7 of APB 25, are: 1. Substantially all full-time employees meeting limited employment qualifications may participate (employees owning a specified percent of the outstanding stock and executives may be excluded). 2. Stock is offered to eligible employees equally based on a uniform percentage of salary or wages (the plan may limit the number of shares of stock that an employee may purchase through the plan). 3. The time permitted for exercise of an option or purchase right is limited to a reasonable period. 4. The discount from the market price of the stock is no greater than would be reasonable in an offer of stock to shareholders or others. Paragraph 7 of APB 25 states these four criteria for a noncompensatory plan. It also states that “a[n] example of a non-compensatory plan is a statutory employee stock purchase plan that qualifies under Section 423 of the Internal Revenue Code.”

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However, the FASB has determined that APB 25’s four criteria prevail over the statutory reference. A discount of up to 15 percent would meet the criterion in APB 25 that the discount from the market price of the stock be no greater than would be reasonable in an offer of stock to stockholders or others. The FASB concluded that a plan with a look-back feature that meets the four criteria of paragraph 7 qualified as noncompensatory. However, this conclusion was a reversal from the FASB’s initial position that a plan with a look-back feature would not qualify as non-compensatory. A look-back feature permits employees to buy shares at the lesser of the market price of the shares on two different dates. For example, if an amount were withheld from salaries for six months to accumulate funds to buy shares under the plan, the employees would purchase at 85 percent of the price at either the beginning or the end of the withholding period, whichever is less.

VARIABLE PLAN ACCOUNTING AND REQUIREMENTS FOR NEW MEASUREMENT DATE This section addresses the FASB’s decisions with respect to modifications to outstanding awards, option repricing, and cancellations and reissuances of outstanding awards. The FASB has decided that a new measurement date should be required if a plan modification results in more than a de minimis increase in the fair value of the option. Any additional compensation will still be measured and recognized based on the intrinsic value method. That is, the change in fair value, as calculated under widely recognized option valuation models such as the Black-Scholes model, should be used to determine whether an award modification results in an increase in fair value of the option. The FASB also decided that, for purposes of evaluating the effect of a plan modification on the fair value of an option, the remaining contractual term should be used, rather than the remaining expected life, as suggested in FAS 123. When a new measurement date is required (for example, in certain types of plan modifications and the cancellation and reissuance of stock-based awards), compensation expense should be measured and recognized as follows. Expenses should be recognized for the original intrinsic value of the option, if any. If the modification of the award consists of a cancellation of an option and the issuance of a different type of equity instrument (e.g., restricted stock for stock options), additional expense should be recognized to the extent that the new award exceeds the current intrinsic value of the original award. If the modification of the award does not directly relate to a change to either the exercise price or the number of shares to be issued, additional expense should be recognized to the extent that the intrinsic value of the new award exceeds the original

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intrinsic value. For example, this requirement would clearly apply to an extension or renewal of the option term. However, it is less clear if this application will apply to a favorable modification to a termination provision (e.g., time to exercise option upon disability). BUSINESS COMBINATIONS The issue is the accounting treatment of stock options in a business combination. The two types of accounting methods are (1) pooling of interests and (2) purchase. Furthermore, for purposes of this discussion, stock options are segregated into two categories: vested (or exercisable) options, and unvested (or unexercisable) options. The FASB announced that pooling-of-interests accounting will not be allowed after the final standard is issued late in 2000. The new standard was to apply to all business combinations effective January 1, 2001. The FASB decided that no new measurement date should be required for an exchange of stock options in a business combination accounted for under the pooling-of-interests accounting method, provided the following criteria are met: • The aggregate intrinsic value (difference between market value per share and exercise price) of the options immediately after the material change is not greater than the aggregate intrinsic value of the options before the material change. • The ratio of the exercise price per option to the market value is not reduced. If required (that is, if the terms of the outstanding option are modified), the new measurement date should occur at the date of the exchange. In a purchase-method business combination, the FASB concluded that the options granted by the acquiring entity in exchange for outstanding vested options of the target company should be considered part of the purchase transaction and accounted for under APB Opinion Number 16. Accordingly, the value of the new (acquiring-entity) options should be included as part of the consideration paid by the acquiring entity. However, unvested options granted by the acquiring entity in exchange for unvested options of the target company should continue to be accounted for under APB 25. When options are accounted for under APB 25, a new measurement date is required if the exchange of options results in more than a de minimis increase in fair value. If a new measurement date is required, additional compensation expense should be measured and recognized to the extent that the intrinsic value of the new options exceeds the current intrinsic value of the outstanding options immediately before the exchange. The requirement that the converted option award be of similar value to the old award may require a close review of existing option award programs, especially

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with respect to termination provisions such as constructive termination and involuntary termination following a change in control. The addition of such a provision after the conversion of an award may be considered an increase in value and thus trigger a new measurement date and variable accounting treatment.

OTHER ISSUES The FASB has provided decisions regarding three other issues: definition of grant date, accounting for deferred taxes, and cash bonus plans linked to stock-based plans. Definition of a Grant Date

If grants are subject to shareholder approval, is the measurement delayed until such approval is obtained? The FASB decided, consistent with its conclusion in FAS 123, that the measurement date is delayed unless approval is a formality. In other words, awards made under a plan that is subject to shareholder approval should not be deemed granted until that approval is obtained, unless the approval is essentially a formality (for example, if management and the members of the board of directors control enough votes to approve the plan). Accounting for Deferred Taxes

The FASB concluded that deferred tax assets should be determined by the compensation expense recognized for financial reporting rather than by reference to the expected future tax deduction. For example, if a company awards restricted stock, compensation expense for accounting purposes is measured at the grant date, and the compensation deduction for income tax purposes is measured at the date the risk of forfeiture lapses. The company typically will record deferred tax assets related to compensation expense as charged to expense for accounting purposes over the vesting period, in advance of receiving an income tax deduction. The FASB concluded, “A valuation allowance to reduce the carrying value of those deferred tax assets should be established only if the entity expects future taxable income will be insufficient to recover the deferred tax assets in the periods in which the tax deduction will be recognized for tax purposes.” Cash Bonus Plans Linked to Stock-Based Plans

The FASB concluded that variable-plan accounting should apply to any plan that links cash bonus payments to a stock option grant. A cash bonus plan is considered to be linked with a stock option grant if payment of the cash bonus is contingent upon vesting or exercise of the option.

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EFFECTIVE DATE AND TRANSITION On March 31, 2000, the Financial Accounting Standards Board (FASB) issued its Financial Interpretation No. 44 (FIN 44), “Accounting for Certain Transactions Involving Stock Compensation—An Interpretation of APB Opinion No. 25.” This Interpretation provides guidance on certain problem areas that have arisen in practice since the issuance of Accounting Principle Board (APB) 25 in October 1972. APB 25 provides the favorable intrinsic method of accounting for stock option grants to employees. This is distinguished from the fair value model (i.e., using an option pricing model) for stock option grants to consultants, vendors, customers, or other non-employees. The new interpretation will generally be applied prospectively for grants or modifications to existing stock options or awards made after June 30, 2000. However, the guidance on repricing and determining whether the grantee is an employee is effective after December 15, 1998; the guidance for modifying a fixed option or award to add a reload feature is effective after January 12, 2000. We advise that employers review option plans and grants to ensure that adequate provision is made for various future events. A detailed review now may reduce the need for discretionary changes at a later date that might trigger variable accounting treatment. In addition, the FASB’s interpretation requires variable-award accounting in the following cases: • Stock options are modified to add a reload feature. Variable-award accounting would apply from the date of the modification until the date of exercise, forfeiture, or expiration of the original award. Variable accounting also would apply to the reload option if it, too, has a reload feature. Variable accounting does not apply if the reload provision is included in the original terms of the stock option, as long as other requirements under EITF Issue No. 90-7 are satisfied (i.e., the exercise price of the reload option equals market price on its grant date and the optionee used shares owned at least six months to exercise the grant). • A stock option is repriced in the following ways: — A change is made to the exercise price or number of shares. — The option is cancelled and a new option at a lower exercise price is issued within six months before or after the cancellation. This would include when the new option with a lower exercise price is granted outside the six-month window but there is an agreement to “compensate” the employee for increases in stock price during the waiting period (e.g., with stock appreciation rights) or when the optionee agrees to cancel the original, underwater option on a future date in consideration for receiving the new grant.

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If variable accounting is required, it applies up to the number of new option shares granted that equals the number of old option shares cancelled. In addition, canceling a fixed-accounting stock option and replacing it with an award such as restricted shares results only in a new measurement date for the restricted stock, not in variable accounting for that award. A new measurement date is required if a stock option is modified to provide for accelerated vesting (i.e., acceleration that is discretionary or not stipulated in the original option terms). The new measurement date is the date discretion is used or the award is modified, but compensation cost is recognized only when vesting actually accelerates. The cost is measured by the intrinsic value of the award as of the modification date. Variable-award accounting is not required for changes to the exercise price of a stock option and/or the number of shares as a result of stock splits, stock dividends, or other equity restructuring, as long as requirements under EITF Issue No. 90-9 are satisfied. This means essentially that the intrinsic value of the award does not increase and the terms of the award do not change. This also applies to awards held by employees who change status due to a restructuring, such as a spinoff. Compensation cost must be remeasured for nonvested stock options or other awards if the holder continues to provide services after a change in employment status. Compensation cost is also remeasured if cash is paid out to settle a stock option or stock award, or to repurchase the shares within six months after the option is exercised or shares are issued.

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Part Three

Maximizing Results

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Compensation Committees as a Performance Tool, with Emphasis on Small to Mid-Sized Companies The capital markets in the United States are predicated on the wise, judicious, effective, and productive use of capital entrusted to the care of thousands of publicly held corporations. At the heart of these productive companies are boards of directors, and at the inner core of these boards are formal or ad hoc committees dedicated to the design and administration of pay programs. There is a direct correlation between the success of the company and the success of the decision-making processes of the compensation committee. There are many ways to improve the performance of your board and company through compensation committee activities. Certainly, compensation is an important decision, but there are also other ways to improve corporate performance, such as CEO evaluation, director evaluation, and executive succession planning. It is not enough to design and administer the best compensation programs; you also have to back it up with evaluation programs and executive planning and utilization programs such as succession planning. Compensation is an extremely important medium for changing the behavior of employees, and thus the performance of the company. When the additional performance levers of CEO evaluation, executive succession, and in some cases board evaluation are added, the role of the compensation committee as an agent of change is crucial. A review of the duties and responsibilities of the compensation committee can improve the ability and capability of the committee members to do their jobs better and more effectively. Some of these changes may require a resolution of the board, or sometimes changes to the corporate bylaws. However, it is worth the effort to allow the committee to do its job better. 185

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THE BIG PICTURE Corporate governance refers to the blend of law, regulation, and appropriate voluntary private-sector practices that enables the corporation to attract financial and human capital, perform efficiently, and thereby perpetuate itself by generating longterm economic value for its shareholders, while respecting the interests of stakeholders and society as a whole. The principal characteristics of effective corporate governance are: transparency; protection and enforceability of the rights and prerogatives of all shareholders; and directors capable of independently approving the corporation’s strategy and major business plans and decisions, and of independently hiring management, monitoring management’s performance and integrity, and replacing management when necessary.

EXCELLENT MEETINGS ARE PRECEDED BY EXCELLENT PREPARATION The compensation committee should schedule regular meetings, typically four meetings per year, and special meetings when necessary. Regular meetings can take place just before board meetings (either early in the morning or the afternoon on the eve of the board meeting). Most companies’ bylaws allow the special board meetings to be held by telephone. Items added to the regularly scheduled agenda include review and approval of incentive plans, executive contracts, change-in-control agreements, and succession programs. Attendance at board or committee meetings is imperative to keep directors informed, on a regular basis, about the corporation’s pay philosophy and strategies. This also provides directors with the opportunity for meaningful input into the decision-making process. One way to assure attendance is to establish regular meeting dates well in advance (at least a full year’s schedule) of the meetings. In this way, directors will be able to lock in the dates on their schedules. To the extent possible, directors should be advised of the matters to be discussed at the meeting, whether it is a regular or special meeting. Such advice may, in fact, be required by applicable bylaws. At a minimum, the committee should insist that adequate information concerning important matters requiring its attention be distributed to members in time to permit review of the information before any vote is taken. Thus, procedures and resources should be put in place to assure that the committee has adequate, appropriate, and timely information to provide a basis for its decisions. It is the practice of some organizations to mail information to committee members at least 10 days in advance of a regular meeting. This 10-day notice should be adequate to provide directors with sufficient time to consider the information and

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be prepared to discuss and vote on matters at hand; however, it is not legally required and less time may be appropriate. For a special meeting, circumstances may not permit as much advance planning as for a regular meeting. Whenever possible, however, efforts should be made to provide information to directors before the meeting. These efforts should be specified in the minutes of the compensation committee coincident with the meeting. If directors did not receive materials well in advance of the meeting, additional time should be set aside at the meeting to permit directors to review and understand the pertinent information. The various types of information typically provided to compensation committees are: • Reports or memoranda from the chief executive officer. These communications should describe the action to be voted upon, carefully set forth the CEO’s recommendations, and outline the reasons underlying the recommendations. • Copies of the operative documents relating to the matter under consideration (e.g., contracts, employment agreements, offer letters, plan documents, etc.), whether in draft or final form. If the operative document is particularly long, complex, or technical, the directors should also be provided with an executive summary detailing all key points of the matter. Directors need not read every legal document in detail; rather, they should get a clear presentation of the substance of the document as it relates to the matter under consideration. • Written reports from outside advisors, such as lawyers, accountants, or compensation consultants, consulted in connection with the particular matter under consideration. Though such written reports are not always required, they may avoid later questions as to the nature of the advice given and the level of diligence attained by the board in consideration of the matter. • Proposed resolutions. By including the form of resolution for a particular matter, the company can greatly assist the committee members in deliberating what action they are being asked to take, so they can act or react accordingly.

CONDUCT OF THE MEETING Who should attend (in addition to committee members)? • The chief executive officer and, perhaps, in-house counsel or human resources executive/compensation staff who have been involved in and are knowledgeable about the matter under consideration. The CEO should, however, leave the meeting when (1) he or she is asked to do so by any member of the compensation

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committee, or (2) the committee deliberates matters that directly affect his or her compensation. • Outside advisers/consultants who have assisted the committee. The presentation will vary from situation to situation, but normally will require a full presentation of all relevant details to the directors. Clearly, if the directors have not had adequate advance opportunity to review material related to their decisions, more in-depth presentations will have to be made before the directors can vote on a matter. All key features of the issues under consideration should be presented, whether or not information has been provided in advance. In addition, any dissenting management views should be disclosed in order to provide a balanced presentation for the directors. Another important means of protecting directors from liability is to assure that their reliance on information is justified. They should have confidence in the person(s) providing the information, and should have no reason to suspect a biased or questionable report that would make reliance unwarranted. Though the quantity of time spent on a particular issue does not necessarily equate to quality of time, it is important to schedule adequate time for directors to completely address the matters under consideration. Discussion of significant matters should not be arbitrarily cut off, and no director should be deprived of an opportunity to question any aspect of any matter. Though no definitive rule can be set, the amount of time spent has been a consideration in shareholder litigation when matters under consideration become the subjects of lawsuits. Outside advisors are not required for every issue, but their use is particularly important when management may not be entirely disinterested. It is essential to establish the credentials of the advisors, outline the scope of their involvement in the process, and provide other relevant information to support the board’s reliance on their presentations. It is also appropriate that meeting procedures provide ample opportunity for directors to actively question members of management and any outside advisors. The maintenance of accurate and complete minutes of corporate deliberations is another method of protecting directors from liability. At the least, the minutes should document the matters discussed, record any instructions given to management, and set forth any resolutions passed or actions taken. The level of detail needed in the minutes will depend on the significance of the matter under discussion. For example, less detail may be more appropriate for routine committee matters; for nonroutine matters, such as long-term incentive awards, purchases of expensive long-term insurance contracts, and the like, more detail should be included. The compensation committee minutes should generally follow the same style as minutes of the board meetings. They may, however, have to be tailored to reflect the committee’s unique functions.

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The business judgment rule does not shield compensation committee members who do not act in good faith and on an informed basis after investigation of all material information reasonably available to them. If a controversial executive compensation arrangement is to be considered, the following steps should be taken: • Circulate agenda documents well before the committee meeting to allow for adequate preparation. • Allow sufficient discussion time at the meeting. • Have an expert advisor inform the committee as to important plan provisions and explain both the expected benefits to the corporation and how the plan or arrangement will provide such benefits. • Provide a detailed cost analysis of the matter under consideration. • Consider using two meetings (one for discussion and the next to vote on the matter). • Avoid making executive compensation program changes too close to a potential change in control of corporate ownership. • Obtain additional outside advisor/consultant opinions when in doubt.

HOW DO YOU KNOW THE STRATEGY IS WORKING? An excellent pay strategy is an art, not a science. Nevertheless, there are questions you can ask to determine if your pay strategy is appropriate. Companies should develop plans and programs that will move them to the next level. Once there, it often takes even more work to maintain a match between pay and business strategies than it took to get there. Indeed, the work and inquiry never end. You know your pay strategy is working when: • The company is meeting fundamental financial performance targets and is providing superior total return to shareholders. • The talent pipeline is full of CEO candidates. • The CEO, board, investors, and analysts are all communicating in a meaningful way. • The board is using its resources by tapping the experiences and the wisdom of diverse directors. • The board is acting in a collective way and is not breaking down into factions. • There are no surprises. • Both the CEO and long-term investors are creating substantial levels of wealth.

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There is no substitute for a well-planned and thoroughly disclosed pay strategy—taking an easy way out almost always causes bigger problems later on. It is understandable that companies tend to avoid providing any information to shareholders that may result in a flurry of communication or controversy, it is almost always better to tackle this sooner rather than later. For example, companies typically ask for trouble when they give in to temptation and award stock or make an incentive award that does not qualify under IRC § 162(m). Noncompliance with this performance standard usually indicates trouble within the organization. This practice sometimes begins in an innocent way: perhaps awards are being made in advance of revising the plan in the next couple of years. When the plan is not revised, the company continues its practice to avoid explaining its actions to shareholders or imposing objective performance standards. Essentially, the company and the board have been seduced by convenience into abnormal behavior which then becomes standard operating procedure. This can be particularly troublesome in the case of a potential change in control of the company, as the entire value associated with incentive payouts (including stock award programs) may be nondeductible. In some cases, large nondeductible payments can stop or delay a proposed business combination. In other cases, these payments adjust the purchase price, reducing shareholder value.

BEST PRACTICES FOR SMALL AND MID-SIZED COMPANIES The concepts suggested in this book are better suited to help small- and mid-sized companies than large-sized companies. The larger companies are usually more widely held, and come under greater institutional investor influence. These differences reveal opportunities for greater changes in the less-than-large companies. A relatively recent shift has been for institutional investors to require that companies provide continuing education for directors. It has been widely reported that the State of Wisconsin Investment Board will strongly urge that all companies in which it has a greater than 5 percent ownership position (reported to be about 150 companies) require that their new directors participate in director orientation program. The smaller the company, the more quickly the company can change, in general. However, mid-sized companies are usually better candidates for change in their corporate governance practices, as they (1) are usually more widely held and have less concentration in management, and (2) often have more resources to attract, retain, and train highly qualified independent, outside directors. It may be more difficult for small, emerging companies to install a performance-enhancing compensation committee, as they must first return capital to their original investors as the companies mature. Typically, small, emerging companies are controlled by seed capital providers such as investment banks, venture

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capital firms, merchant banks, larger alliance partners, and other major investors. In these cases, the compensation committee is composed of these original investors. Once the company goes public, and they sell substantially all their investment holdings, they will quickly leave the board. This is an excellent opportunity to recruit outside directors for the compensation committee. Middle-sized companies have already progressed through the emerging company stage, and typically are widely held without substantial involvement from bankers (except in a traditional banking role). Also, middle-sized companies have more of the resources, such as corporate staff, outside advisors, a substantial track record, and other very important factors, necessary to attract and retain outside directors. Smaller, emerging companies offer a great opportunity to start fresh and install incentive programs that are right for the company and the current business environment. Larger, more established companies suffer a great deal of inertia in their pay practices because their current long-term incentive programs have set the tone and tenor of current pay decisions, and in some cases, actually limit the actions that may be taken by the company. For example, a middle-sized company has built up a stock overhang well over the level of its competitors. At the same time, the company has a very generous all-employee stock award plan and a stock option bonus exchange program. Furthermore, the stock has been flat over the past three years. The compensation committee in this case has very limited opportunities to change the currently bleak situation. Customizing Best Practices It is one thing to know best practices in your industry and general industry overall; it is another to know which is appropriate to your situation. Once you have determined what everyone else is doing, you still must determine whether it is right for your company. The best way to determine this is to take the pulse of senior management, especially the CEO and CFO, the board of directors, major shareholders, and Wall Street analysts who follow your company. If Wall Street investment firms do not yet cover your company, select two or three companies in your peer group and read their analyst reports. You can get these reports directly from the company, from the brokerage house, or (for a nominal fee) from Internet-based investment firms. To find out if a particular pay strategy is best for your corporate culture or particular situation, conduct structured interviews on subjects such as risk tolerance, carried interest versus stock ownership, confidence in senior management, confidence in the board, and propensity to hold the stock or sell at first opportunity. These structured interviews will give you a basis for selecting among various longterm incentive alternatives.

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Small companies should not be afraid to take risks. High risks mean high potential. A fail-safe mentality does not serve anyone’s interests. One caution is that your recommended pay strategy and subsequent programs should match the risk/ reward profile of your company. Take a position and effectively communicate it. The CEO and board will respect you for doing so. Good Shareholder Relations Small and mid-size companies, in particular, want to create and maintain the best possible shareholder relations. Good shareholder relations translate into lower cost of capital, increased capital-raising capabilities, and less time spent defending your company and more time spent explaining your successful business strategy. Overall, a proactive rather than reactive approach is best in relations with shareholders, and a well-defined pay strategy encourages good shareholder relations. Investors must be informed that the board is working well. Good corporate governance enhances shareholder value. Shareholders and potential shareholders (a very universe indeed) need to know that the company’s compensation plans and programs are the best possible under the circumstances. An excellent method of accomplishing this is to eliminate any doubt about board independence; provide a clear and concise compensation committee report; and maintain effective communication with shareholders, analysts, and others as to the compensation philosophy and other executive compensation issues. Major Differences between Large and Small Companies Directors can have a greater impact on smaller companies. Yet, at the same time, smaller-company directors tend to be less experienced and have less access to corporate staff or outside consultants. Moreover, small companies tend to have lean corporate staff. The net result is that small-company directors need to overcome some obstacles if they are to become effective directors. Small-company directors need to take advantage of training opportunities, and to urge the point of contact (usually the corporate secretary or the general counsel) to provide timely and effective information and counsel. Training and Education Are Key To unlock good performance of small-company directors, it is necessary to complete a three-step process. First, candidly assess the skills and capabilities of the outside directors. Second, review the needs of the board. Third, conduct a gap analysis to determine what training is necessary.

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This book provides additional information on sources of training. The following reviews some of the appendixes and how they may be of help to your company. Appendix D lists numerous organizations, publications, and Web sites that can be used by a smaller company to learn more about the compensation committee and all related matters. A smaller company should join at least two organizations and subscribe to some of the least expensive publications. The two best organizations to join are the National Association of Corporate Directors and the American Society of Corporate Secretaries. Both offer reasonable membership fees, a regular newsletter, additional training opportunities for no cost or reasonable cost, and local meeting opportunities to network with staff of other companies in the same situation as yours. This is time and money well spent for companies that are trying to improve the effectiveness of their compensation committees. Appendix E lists eight directors colleges that provide excellent educational opportunities for directors. Small to mid-sized companies should offer this level of training to their directors once every two years. The knowledge and tips gained from such training can be returned to and shared with the board. For example, in one company a recently educated director who was the swing vote on many issues such as CEO succession, board evaluation, and creation of a nominating committee returned to the board with a renewed appreciation for these issues and well prepared to discuss them. Appendix F lists the best practices of a typical top-performing company. These best practices are scaleable from large to small companies. Study these characteristics and manage your board accordingly. Four main areas are covered in this checklist of best-performing companies: two are the CEO and the compensation committee itself. With the selection of a quality CEO, the creation of a welldesigned performance management system, and a quality compensation committee, the other items will typically fall into place. This book provides a start into the world of compensation; now it is up to you to learn more. The glossary and bibliography provide additional information on common terms and abbreviations that compensation committees need to become familiar with, as well as a list of publications for further reading.

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A Glimpse into the Future Compensation committees have come a long way in the past eight years, but they have a long way to go. There are many initiatives that almost every compensation committee can take to improve its performance. Some of these initiatives involve the composition of the committee, the oversight duties of the committee, the education and awareness of the committee members, the administration and processes of the committee, and the relationships of the committee with the company, board, shareholders, investment managers, analysts, and the general public. There is much to do and little time. In addition to the continuous reformation of compensation committees, executive compensation practices will also evolve, primarily for the same reasons. For example, the push toward pay for performance has substantially altered the mix of a typical executive compensation package to riskier and more highly leveraged forms such as stock equity. This book has suggested some changes that will improve the performance of your compensation committee. However, you cannot implement change all at once. Initiatives for change must be prioritized, layered, and phased in over a long period of time. The progress associated with change has to be monitored and compared against a benchmark of some type. Compensation committees are changing as rapidly as the companies they oversee, and the emerging trends seem to presage best practices. Future corporate governance trends include: • Ethics. Compensation committee members will continue to be more proactive in avoiding, deterring, and reducing the risk associated with any practice that may have the appearance of impropriety. This movement is a way to immunize directors against a potential deluge of shareholder litigation, SEC review, public criticism, and shareholder activism. As they should be, directors are increasingly concerned about shareholders’ perception of board actions, especially in relation to an ethical issue. • Fewer inside directors. 194

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• More outside directors. • Strategic compensation committees. There will be more engagement of compensation committee members in the evaluation of CEOs, and in some cases director evaluation, succession planning, and other key governance processes. Boards will be better informed and play a more active role in evaluating and tracking strategy and its implementation. More time will be spent on compensation philosophy and strategy. • Director compensation. There will be higher compensation for directors, to reflect increased obligations, time commitment, and liabilities. • Executive compensation. There will be a decreased emphasis on equity compensation as the market returns to “normal” levels of total shareholder return of 12 percent per year (total return is stock price appreciation plus dividends). High levels of market volatility and the depressed capital markets in 2000 and 2001 have dampened executives’ appetite for more highly leveraged pay packages. The stock overhang should mediate in 2001 for the first time since 1987. • Equity for all employees. • Director recruitment. The nominating committee will become an essential element of the modern publicly held corporation. Directors will be selected as much for how they think, what they know, and how they deliver their knowledge and experience as for who they know. An abundance of new leaders, drawn from women, minorities, and others from a range of disciplines and backgrounds, will make up for the projected shortfall of chief executive officers, who will be in short supply for a variety of reasons stated in this chapter. The nominating committee will take the lead in proactively identifying and nominating directors. Directors will be held strictly accountable for their responsibilities and behavior. The use of executive recruiting firms to recruit outside directors will increase. However, for those boards that do not use directors, the members of the nominating committee, as well as all outside directors, will spend substantial time and energy on the recruitment of new directors. • Diversity. An increase in women and minority representation on boards is inevitable. In early 2001 it was reported that women now constitute a slight majority in law schools, a significant increase from a 20 percent representation in the early 1980s. Women also make up a substantial, and increasing, percentage of business school student bodies, though not yet the majority. The large representation of women in business and law schools will result in a large increase of senior executive women 30 years from today. Moreover, more executive and professional women are starting and raising families while continuing their highprofile careers. Dual-career families are now the norm, and are here to stay. The additional director sources, such as women and minorities, are just in time for companies seeking to provide the best and brightest talent to serve on their compensation committees. With the move to more independent boards,

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limitations on the number of boards on which a director can serve, mandatory retirement ages (usually in the late sixties or age 72), more committees, and the scarcity of CEOs who are willing and able to serve on boards, the ascension of women and minorities is very timely and necessary to assist publicly traded companies in their quest to optimize shareholder value. Fewer chief executive officers will be available, because of time pressures and the exigencies of technology and change. For a variety of reasons, including the imposition of mandatory retirement age, directors will be younger and boards will seek those with financial, management, governance, and technology expertise. There will be more international representation on U.S. boards, and more U.S. executives will serve on non-U.S. boards. Contested director elections. Driven by shareholder activism and the ability to communicate more effectively and quickly over a large group, the election of directors will no longer be a “done deal” when it comes to shareholder vote. This is especially true when the director candidate is anointed by the CEO without adequate review from the nominating committee. Institutional investors and advisors are already achieving unprecedented efficiency in the review of shareholder proposals, including election of directors. Evaluations will become standard practice. CEO evaluations will become standard practice over the next five years, and director evaluations will become more prevalent, especially board-wide evaluations. Committees will increase in number and become more independent. The number of committees will increase as more and more boards add a truly independent nominating committee or a corporate governance committee. The responsibilities and accountability of committees (existing and new) will increase sharply, especially in the areas of nomination, succession, evaluation, and compensation. The increase in number of committees is being encouraged by shareholders. In fact, institutional investors and their advisors, such as Institutional Shareholder Services, are requiring that companies institute independent, nominating committees. This requirement manifests itself in a “no” vote for any proposal that benefits management (such as a new stock award or incentive program) for any company that does not have an independent nominating committee to propose the nomination and renomination of directors. Director training will increase. Director orientation programs have emerged across the country to fill the need for new director training. Ongoing training and enrichment will be integrated into the corporate governance process. This training will take place either offsite at a university, or provided as part of a board or committee meeting or retreat. Board cultures will change, for the better. Boards will become more businesslike, more results-oriented, more involved and productive, more efficient, and more sensitive to time pressure. They will have less tolerance for unprepared directors

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and blind voting blocs. Existing board cultures will be upended in this process. This change process will be accelerated by the increased use of board evaluations and nominating committees. • CEO searches will become global and will continue to be industry-wide. CEO searches will continue to try to ferret out the best candidates, no matter where they are. In the past decade, there has been a trend to hire more international executives and certainly to hire CEOs outside of the industry. Notable examples of this are Lou Gerstner at IBM Corporation, who came from RJR Nabisco and American Express before that. • Global markets and economies will merge. The move toward better corporate governance continues on a worldwide basis. To compete, every economy will be fostering better boards as a means to better corporate performance. The hundred-member Japanese board will be an antiquity. Thailand, Brazil, and Poland are evolving better board practices, symbolic of the breadth of the corporate governance revolution. Great Britain’s reliance on independent nonexecutive chairs has already affected U.S. practices. U.S. equities markets will flow across borders. The executive job market will also tend to merge, spurring more intercontinental CEO searches. • Litigation. The number of shareholder lawsuits will continue to grow, especially in the areas of audit and compensation. Technology companies will continue to draw criticism and lawsuits because of their volatility and the speculative nature of their future cash flow projections. • Increased responsiveness to shareholders. There will be greater transparency and greater interaction between shareholders and boards of directors. Boards will form shareholder relations committees and elevate the board’s focus on creation of shareholder value. Some say this will rival the audit, nominating, and compensation committees in importance. In turn, shareholders will insist on more private audiences with directors to encourage reforms of one type or another. Concurrently, directors will learn more about the critical ingredients that motivate shareholders to buy or sell their stock holdings, and shareholders, analysts, and investment managers will gain an appreciation of the impact directors have on corporate growth. • Succession planning. CEO turnover will continue to rise, as it has over the past three years. There will be greater and more proactive board involvement in succession planning, and the process will become continuous and integrated into the strategic planning process. Boards will be more willing to replace nonperforming CEOs. • Financial analyst activism. Analysts on both the buy and sell sides will recognize the role governance can play in creating shareholder value, and they will prioritize governance as a measure of corporate success.

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• Transparency. Shareholders will expect to be informed about governance and where their companies stand on the strategic board continuum. If shareholders are patronized—if best practices are hidden from those they purport to help, as is the case with many governance guidelines and charters—shareholders will assume laxity and passivity on the part of the board. Instead, there will be increasing communication in annual reports, proxy statements, and electronic bulletin boards about board practices and activities. There will be more interaction between boards and all corporate constituencies. • Certification of directors. This is a significant trend outside the United States. Some certifications in the United States will gain support, but it is unlikely there will be any form of national certification empowering “professional” directors. However, institutional investors, such as the State of Wisconsin Investment Board, are encouraging directors of companies that they invest in to attend director orientation programs. SWIB is teaming up with the National Association of Corporate Directors to provide this education. Although this training does not result in a certification, it does satisfy the request made by a major shareholder. Change and implementation of initiatives for change should be undertaken over a reasonable and appropriate period of time. This is especially important for changes that affect the board, such as composition and oversight responsibilities. The part-time nature of board membership and the senior stature of its members require care as to how, why, and when you should communicate with the committee about changes. Perhaps a board retreat is best, where the issues of reform and change can be discussed, with an emphasis on the rationale for change and a realistic timeline for change. SHAREHOLDER ACTIVISTS WILL CONTINUE TO PUSH FOR CHANGE TIAA-CREF, CALPERS, and other large institutional investors have well-staffed and very capable corporate governance departments. The large pension fund managers, as well as other large institutional investors, truly believe that stock ownership is an ongoing event with ongoing oversight responsibilities. In addition to the very large pension funds, there is a growing swell of shareholder activists of various types waiting for an opportunity to effect change. TIAA-CREF is the largest pension fund manager in the United States, with more than $500 billion under management. The corporate governance branch of TIAA-CREF is very active in managing its investments. This involvement occurs in three major ways. First, they publish guidelines on what they expect of publicly held corporations (see Appendix 12A). This is especially important for companies that are contemplating potentially controversial issues such as overuse of equity awards, option repricing, or change-in-control agreements. Second, TIAA-CREF

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carefully reviews all shareholder proposals and votes its shares accordingly. Third, they visit companies that are underperforming relative to stock indexes and may be overlooking ways to improve corporate performance. These visits are handled discretely and are often effective in encouraging changes by the company of interest. In Appendix 12B, please note the red-flag items that will cause concern for TIAA-CREF. One of the most important reform initiatives that any board can accomplish is to appoint independent, outside directors to the compensation committee. Once these outside directors are in place, if there is an excellent infrastructure and information flow, the directors can accomplish many great initiatives. THE EMERGENCE OF THE ROLE OF CORPORATE GOVERNANCE OFFICER There have been various calls to action to designate one person in each publicly held company as the “Corporate Governance Officer” (the “CGO”). As other “C” titles that have come before, most recently the Chief Information Officer, the CGO will be responsible for keeping senior management, the board, and in some cases shareholder apprised of the company’s corporate governance posture in the ever changing field. Some say—such as the American Society of Corporate Secretaries’ President David Smith—that the corporate secretary is well qualified to assume the role as CGO. Every publicly held company currently has a secretary, and most mid-sized and larger companies have fully-dedicated corporate secretaries. This issue of corporate governance is becoming more important as Institutional Shareholder Services has recently announced the creation of a new standard of evaluating a firm’s corporate governance structure and system. This “corporate governance quotient” will be measured on a scale of zero to one hundred. This ranking will then be compared against a peer-group average, and an industry average. Some clients of ISS will use this index to vote their proxy shares, invest in a company, or sell interest in a company. CONTINUOUS EDUCATION OF COMPENSATION COMMITTEE MEMBERS Directors colleges are forming around the United States to provide education and training to outside, independent directors. Currently, there are about six centers for director education. These range from business schools, such as Harvard Business School, Fuqua School of Management at Duke University, University of Chicago, and Terry School of Business, to law schools, such as Stanford University, to directors’ organizations such as the National Association of Corporate Directors. See Appendix E for additional information on these programs.

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Institutional investors are increasingly urging the companies in their investment portfolios to send new directors to director orientation training. Larger boards tend not to send their directors to specialized training; instead, they provide specific training sessions as part of their board sessions. With the advent of these new ISS guidelines discussed earlier in this chapter that will allow for up to a 5-point upward adjustment to the corporate governance quotient, the number of colleges will double or triple in the next two to three years. CEO AND DIRECTOR EVALUATIONS WILL BECOME MORE PREVALENT AND MORE MEANINGFUL Everyone needs a standard or a benchmark and everyone needs to be evaluated. It is a simple axiom of performance management. If someone knows that someone else is watching and will comment on their performance, the performance will most likely improve. It is also misleading for a director to advocate performance management programs for management, especially the CEO, and not adhere to such a program. The big question is what form these evaluations will take. Will they be an evaluation of the board as a whole, or evaluations of individual directors? Certainly, most boards seem to be more comfortable with collective evaluations. Some of the arguments against individual evaluation are: • It could create an unfavorable legal record that may be discoverable in litigation, such as a shareholder lawsuit or a wrongful termination claim. • It pits directors against one another and does not foster teamwork. • It is unenforceable, because there is usually no one board member that can provide performance counseling. Some boards are putting a collective board evaluation process in place, with a plan to implement individual director evaluations later. It is too early to tell whether or not this will work. EXECUTIVE COMPENSATION PRACTICES WILL CONTINUE TO EVOLVE Executive compensation will continue to be one of the top issues of discussion by a board, via the compensation committee. This discussion will shift with the evolution of executive compensation. • CEO compensation packages will become more standardized on a global basis. During the 1990s the economy became global, as worldwide events began to

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have immediate effects in the United States. The Internet and the PC revolution dramatically increased the instantaneous flow of information worldwide, as the number of Internet users doubled every 100 days. As a single worldwide economy develops, CEO compensation will become more standardized. This standardization will also apply to capital markets, accounting practices, shareholders, and other important parties. Annual cash compensation (salary and bonus) will continue to keep pace with inflation. Although CEO cash compensation (salary and annual bonus) in the short term will continue to increase, it will be relatively flat in the long term (as has been the case since the 1930s) when adjusted for inflation. Long-term incentive growth will continue to track the stock market. The types of long-term incentives will also follow the market. In up markets, stock options will prevail. In down markets, cash-based, long-term incentives keyed to fundamental corporate performance will prevail. Chief executive officer ownership levels will increase. CEO ownership, not just pay, will be necessary to retain top talent. Ownership will revert to the level of importance it enjoyed in the early 1900s. Shareholders will continue to be more active in CEO compensation matters. Institutional investors will continue to review executive compensation practices, and director pay practices will receive heightened scrutiny. There will be greater support for shareholder value and pay-for-performance concepts, both overseas and at lower levels in the corporation. Executive talent will hold its premium value. Companies will continue to pay higher amounts for executive talent, as there will be greater emphasis on innovation, creativity, and relationships of executives. The trend of paying premiums for executive talent is in line with that of current general industry practice. CEO compensation will be a mainstay of corporate governance. CEO compensation will be considered the essence of corporate strategy as it becomes increasingly expensive to shareholders, and it will provide the foundation for long-term corporate strategy. Financial analyst reports will include a section on corporate governance, which will cover CEO and director pay and implications for shareholder value and long-term corporate strategy.

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2000 TIAA-CREF Corporate Governance Policy Statement

Teachers Insurance and Annuity Association–College Retirement Equities Fund, as a responsible long-term investor, recognizes the overriding stake that our society and our economy have in the development and vitality of public corporations. We acknowledge that even an ideal system of corporate governance does not guarantee superior performance. Conversely, superior performance can be achieved despite a governance system that is less than perfect. Nevertheless, TIAA-CREF believes that certain principles are the hallmark of an equitable and efficient corporate governance structure. Good corporate governance must be expected to maintain an appropriate balance between the rights of shareholders—the owners of the corporation—and the need of the board and management to direct and manage the corporation’s affairs free from non-strategic short-term influences. TIAA-CREF acknowledges a responsibility to be an advocate for improved corporate governance and performance discipline. This statement is offered as a basis for dialogue with senior corporate management and boards of directors with the objective of improving corporate governance practices. It represents the TIAA-CREF perspective on what we believe are important elements of good corporate governance, and it identifies our voting guidelines on certain proxy issues. This is the third edition of an evolving document, which TIAA-CREF and our boards’ Corporate Governance and Social Responsibility Committees revise over time. Of particular importance, this edition presents a more extensive policy statement on the governance of executive compensation practices than did earlier editions. Although broad principles articulated in this policy statement apply generally to public corporations, most of the specifics relate principally to U.S.-incorporated companies. Recognizing that TIAA-CREF has been diversified internationally for many years and that improved global standards of corporate governance have been developed, we have added a section on global standards. Board of Directors The primary responsibility of the board of directors is to foster the long-term success of the corporation consistent with its fiduciary responsibility to the shareholders. TIAA-CREF supports the primary authority of the board in such areas as the selection of the chief executive officer, review and ratification of the corporation’s long-term strategy, assurance of sufficient financial resources and maintenance of

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financial integrity, and selection of nominees for election to the board. It is recognized that the manner in which boards discharge their responsibilities can vary according to circumstances. However, in order to sharpen the accountability of directors to shareholders, we believe: • The board should be composed of a substantial majority of independent directors. The board committee structure should include audit, compensation, and nominating and/or governance committees consisting entirely of independent directors. For this purpose, independence means no present or former employment by the company or any significant financial or personal tie to the company or its management that could compromise the director’s objectivity and loyalty to the shareholders. An independent director does not regularly perform services for the company, if a disinterested observer would consider the relationship material. It does not matter if the service is performed individually or as a representative of an organization that is a professional adviser, consultant, or legal counsel to the company. However, a director might be considered independent if it is clear to TIAA-CREF that the person is involved in commercial transactions that are being carried out at arm’s length in the ordinary course of business and the relationship should not interfere with the individual’s ability to exercise independent judgment. All monetary arrangements with directors for services outside normal board activities should be approved by a committee of the board that is composed of independent directors and should be reported in the proxy statement. • The board should establish a fixed retirement policy for directors, and a requirement that all directors have a direct and material cash investment in common shares of the company. A reasonable minimum ownership interest could be defined as stock holdings equal to approximately one year’s compensation as a board member, but we recognize that what constitutes a “material” amount will necessarily vary widely from one director to another. TIAA-CREF advocates payment of directors at least partially in stock or restricted stock. • The board should be composed of qualified individuals and should reflect diversity of experience, gender, race and age. Each director should be able and prepared to devote sufficient time and effort to his or her duties as a director. Each director should represent all shareholders; therefore, TIAA-CREF opposes the nomination of specific representational directors and the practice of cumulative voting in the election of directors, except if necessary to protect the interests of minority shareholders where there is a single dominant shareholder. • TIAA-CREF recognizes the responsibility of the board to organize its functions and conduct its business in the manner it deems most efficient, consistent with these or similar governance principles. Therefore, in the absence of special circumstances, we would not support shareholder resolutions concerning separation

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of the positions of CEO and chairman, designation of a lead director, the formation of shareholder advisory committees, the requirement that candidates for the board be nominated by shareholders, or a requirement that directors must attend a specific percentage of board meetings, unless the board supports such measures. The corporation should be free to indemnify directors for legal expenses and judgments in connection with their service as directors and eliminate the directors’ liability for ordinary business judgments. Directors should be held liable to the shareholders and the corporation for violations of their duty of loyalty or their fiduciary duty involving gross or sustained and repeated negligence. Staggered election of directors can provide legitimate benefits to the board. However, a classified board structure at a public company also can be a significant impediment to a free market for corporate control, particularly in combination with other takeover defenses, such as a “poison pill” shareholder rights plan. We analyze the pattern of defenses in determining whether to support shareholdermandated election of directors on an annual basis, and generally will not support such a mandate if shareholders are permitted to remove directors without cause. The board should have mechanisms to evaluate and improve its performance in representing the shareholders in governing the corporation. At a minimum, there should be an annual review by the board of its performance overall, including the effectiveness of its committees, measured against criteria defined in committee charters. The board should hold periodic executive sessions at which management, including the CEO, is not present. Although TIAA-CREF normally votes for the board’s nominees, we vote for alternative candidates when our analysis indicates that those candidates will better represent shareholder interests. We may withhold our vote from unopposed candidates when their record indicates that their election to the board would not be in the interest of shareholders. We may also withhold our vote from unopposed directors when the composition of the board as a whole raises serious concerns about board independence.

Shareholders’ Rights and Proxy Voting Unlike other groups that have dealings with the corporation—customers, suppliers, lenders, and labor—common shareholders do not have contractual protection of their interests. They must rely on the board of directors—whom they elect—and on their right to vote on proposals the corporation is required to submit for shareholder approval. The proxy vote is thus the key mechanism by which shareholders play a role in the governance of the corporation. In voting its proxies, TIAA-CREF takes the position that the corporation should adhere to the following principles:

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• The board should adopt confidential voting for the election of directors and all other matters voted on by shareholders. • The board should adhere to the principle that each share of common stock has one vote and matters submitted for shareholder consideration generally should require approval of a majority of the shares voting “For” or “Against.” Therefore, the board should not create multiple classes of common stock with disparate voting rights. Similarly, we generally oppose super-majority voting requirements, except if necessary to protect the interests of minority stockholders where there is a single dominant shareholder. • The board should not issue any previously authorized shares—with voting rights to be determined by the board—unless it has prior shareholder approval for the specific intended use. • The board should adopt equal financial treatment for all shareholders. TIAACREF supports “fair price” provisions and measures to limit the corporation’s ability to buy back shares from a particular shareholder at higher-than-market prices. TIAA-CREF also supports proposals that eliminate preemptive rights, except where our analysis indicates that such rights have value to shareholders. • The board should submit for prior shareholder approval any action that alters the fundamental relationship between shareholders and the board. This includes antitakeover measures. In evaluating proposals with anti-takeover implications, TIAA-CREF will consider the broad context of takeover defenses at a particular company—including charter and bylaw provisions and applicable state laws— with a view that the market for corporate control provides appropriate mechanisms for disciplining management, and that takeover defenses should not make a board impregnable. TIAA-CREF specifically opposes shareholder rights plans that contain “continuing director” or “deferred redemption” provisions that seek to limit the discretion of a future board to redeem the plan. • TIAA-CREF recognizes that many states have adopted statutes that protect companies from unfriendly takeovers, in some cases through laws that obscure or dilute directors’ fiduciary obligations to shareholders, as owners of the corporation. Proposals to change the corporation’s domicile generally will be opposed if the reason for the reincorporation is to take advantage of protective statutes. Furthermore, where possible, the board should opt out of coverage under state laws mandating anti-takeover protection. • The board should not combine disparate issues and present them for a single vote. Normally, TIAA-CREF votes against an entire proxy issue proposal if it opposes any of the constituent parts. • The board should request an increase in the authorized number of common shares only if they are intended for a valid corporate purpose and are not to be used in a manner inconsistent with shareholder interests—for example, an excessively

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generous stock option plan. TIAA-CREF does not oppose an increase in the authorized number of preferred shares unless they can be used without further shareholder approval as part of an anti-takeover program. For example, they should not fund a poison pill plan that has not been approved by shareholders, or confer super-voting rights on particular shareholders friendly to management. Executive Compensation The governance of the executive compensation process is a critically important and highly visible responsibility of the board of directors of a corporation. In a real sense, it represents a window through which the effectiveness of the board may be viewed. A soundboard of directors, representing the most fundamental long-term interests of the shareholders, will ensure that a rational compensation program is in place. Conversely, weak compensation practices—clearly excessive cash pay, dilutive and unfairly enriching stock plans, or loose and subjective bonus awards— are strongly suggestive of weakness and the need for fresh perspective at the board level. With shareholders’ interest and fairness in mind, TIAA-CREF has developed these five principles of compensation governance. We will apply them as new concepts of compensation are introduced, and in voting proxies related to compensation and to board composition. To further clarify our views on this complicated topic, TIAA-CREF has developed specific program guidelines in addition to the broad principles articulated here. These are set forth in the Appendix to this policy statement. Five Fundamental Principles of Compensation Governance 1. Compensation Philosophy

Management leadership, ability, and effort are critical to the long-run success of all businesses. The overall compensation program for managerial positions therefore must attract, retain, and motivate the very best leaders and managers within industry standards. Alignment of the rewards of employees—rank and file as well as executives— with those of the shareholders is at the core of the long-term performance of the corporation. Compensation programs play the critical role in this alignment. This can be done with well-designed salary, bonus, and stock programs that are clearly understood by management and shareholders. Each company should thus describe clearly its overall compensation philosophy in the company’s proxy statement. It also should explain the rationale for the salary levels, incentive payments, and stock option grants of top executive officers.

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2. The Role of Cash Pay

Cash pay—salaries and incentive payments—is traditionally the largest element of compensation for all except the most senior executives, and an important part of the total compensation of all employees. The cash pay of top management is published and broadly surveyed, and thus establishes the critical standard by which the fairness of a company’s compensation program is judged. Therefore in principle cash pay for top management should: • Stand the tests of reasonableness and fairness by prevailing industry standards and under the critical scrutiny of investors, employees throughout the company, and the public at large. • Provide compensation levels that are understandable relative to scale, complexity, and performance. By scale, we mean the size of the business as measured by sales, assets, number of employees, and total market capitalization. By performance, we mean achievement of tangible financial measures: earnings, return on invested capital or equity, growth, and other measurable benchmarks. 3. The Role of Stock

Stock-based compensation plans also can be a critical element of compensation programs, and can provide the greatest opportunity for the creation of wealth for the managers whose efforts contribute to the creation of wealth for shareholders. In evaluating the suitability of these plans, considerations of reasonableness, scale, linkage to performance, and fairness to shareholders and all employees also apply. Proper stock-based plans should: • Allow for creation of executive wealth that is reasonable in view of the creation of shareholder wealth. Management should not prosper through stock while shareholders suffer. • Have measurable and predictable outcomes that are directly linked to the company’s performance. • Be market oriented, within levels of comparability for similar positions in companies of similar size and business focus. • Be straightforward and clearly described so that investors and employees can understand them. • Be fully disclosed to the investing public, and be approved by shareholders. 4. Fringe Benefits

Soft elements of executive compensation programs—pension plans, supplemental executive retirement plans (SERPs), perquisites, and the like—should be reasonable

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and fair in the context of industry practice and relative fairness to all employees. All plans that materially benefit executive management should be fully and clearly disclosed and explained to shareholders in the proxy statement. 5. The Compensation Committee’s Mission

The company’s executive compensation program should be under the direction and oversight of a committee of the board of directors consisting of independent directors who are knowledgeable in the field of executive compensation. Through this committee, the board of directors should ensure that the program is structured consistent with the above principles, complies with all ethical, regulatory and legal imperatives, and is reasonable relative to the shareholder value created. CEO Performance Evaluation and Succession Planning Ensuring continuity of strong leadership is a primary and exclusive responsibility of the board of directors. Accordingly, evaluation of a corporation’s chief executive officer is critical. A clear understanding between the board and the CEO regarding the corporation’s expected performance and how that performance will be measured is very important. We believe: • The leadership of the corporation should set a high standard of performance accountability and ethical behavior. • The board should establish a specific set of performance objectives for the CEO annually. These should include concerns of shareholders, other investors, employees, customers, and the community in which the company is located. Performance objectives should include both annual and multi-year time periods. • The board should establish an annual review process that incorporates CEO performance evaluation in executive session. Results of the evaluation should be conveyed to the CEO. • Processes should be in place to: • Assure an adequate pool of competent, qualified managers throughout the organization. • Permit the board to review the performance and potential of key executives. • Identify and develop high potential individuals. • Ensure continuity of top leadership, including CEO succession. Strategic Planning Every company needs to plan strategically to ensure future economic success. The strategic allocation of corporate resources to each of the company’s businesses is

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critical to its future success and to the increased shareholder value needed for efficient capital formation. The board should discuss the strategic plan of each of the company’s major businesses at least annually. The strategic plan can be expected to include many of the following components, though TIAA-CREF recognizes that each company will need to fashion its own specific blend: • An assessment of markets, products, and customers for each major business segment. • A review of the competitive strengths and weaknesses of the company along with opportunities and threats to its position in the marketplace. • A review of key success factors—including technological leadership, product attributes, and other elements necessary to maintain a competitive advantage. • A review of human resource management issues. • A projection of the financial flexibility and strength of the firm, including capital formation and financial needs to achieve its strategic objectives. Fiduciary Oversight The board has a primary duty to exercise its fiduciary responsibility in the best interests of the corporation and its shareholders. This includes periodic review to ensure that corporate resources are used only for appropriate business purposes. To address some of the most important areas of fiduciary responsibility, the board should: • Assure a corporate environment of strong internal controls, fiscal accountability, high ethical standards, and compliance with all applicable laws and regulations. • Develop appropriate procedures to ensure the board is advised of alleged or suspected violations of corporate standards or of noncompliance and management’s resolution thereof, on a timely basis. • Appoint an audit committee of at least three independent directors, all of whom are financially literate, as is now required by rules of the New York Stock Exchange and the National Association of Securities Dealers. The audit committee should develop its charter of responsibilities and publish it in the company’s proxy statement. The audit committee has both the authority and the responsibility to select and evaluate the outside auditor and to assure its independence, to review quarterly and annual audit statements, and to assess the adequacy of internal controls and internal risk management processes. The committee should take care to discuss the quality of accounting principles used by the company with the outside auditors, and act to ensure the objectivity and independence of the auditor. • Install a mechanism to review corporate operating and expense reimbursement policies and practices (e.g., travel and entertainment policy, executive perquisites), to ensure proper use of corporate resources.

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Global Standards of Corporate Governance As a shareholder that is diversified internationally in most major markets, TIAACREF believes that good governance practices are important to encourage investments in countries and companies in a global economy where gaining access to capital markets is increasingly seen as very much in each nation’s self-interest. As a consequence, there are now accepted principles of global corporate governance that we support, such as those promulgated by the International Corporate Governance Network and others. These principles recognize that not every country needs to adopt a one-size-fits-all code of practice. Nevertheless, shareholders may reasonably expect country and company practice to include the following: • Appropriate structures of accountability of the company to its owners. • Independent oversight of managers and accounts (including independent audits of financial statements based on high quality accounting principles). • Fair and equitable treatment for all shareholders (an issue that can be particularly relevant when there is a controlling shareholder). • Fair voting processes that in practice assure disclosure of all facts material to each vote being taken, and that enable shareholders to exercise their ownership rights in relation to their economic interest. • Prohibition of insider trading and abusive self-dealing. • Open, efficient, and transparent markets for corporate control. • Timely disclosure of financial and operating results of the company, material developments and foreseeable risk factors, and matters related to corporate governance. Disclosures related to corporate governance should include interested transactions and any capital structures or arrangements that enable certain shareholders to obtain control disproportionate to their equity ownership; significant information about board members and key executives, including their compensation; and information describing governance structure and policies. • Regulatory and legal recourse if principles of fair dealing are violated. As in the United States, TIAA-CREF advocates the strengthening of corporate governance both through serious and widely publicized statements of policy and principle, and through direct communication with portfolio companies. Social Responsibility Issues TIAA-CREF believes building long-term shareholder value is consistent with directors giving careful consideration to social responsibility issues and the common good. Boards of both U.S. and international companies should develop policies and practices to address the following issues:

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The environmental impact of the corporation’s operations and products. Equal employment opportunities for all segments of the population. Employee training and development. Evaluation of corporate actions that can negatively affect the common good of the corporation’s communities and its constituencies.

Each company should avoid the deliberate and knowing exploitation of any of the non-shareholder constituencies and should establish open channels of communication permitting employees, customers, suppliers, and the community to express their concerns. Dialogue between TIAA-CREF and Companies TIAA-CREF believes that its policies on corporate governance should be shaped and allowed to evolve in collaboration with the companies in which it invests. Accordingly, we will continue to take the following steps, which have proven valuable in the past: • Provide copies of these guidelines and their updates to companies in which we invest. We will suggest that the companies distribute the guidelines to all executive officers and directors. • Periodically seek suggestions from companies and knowledgeable observers for ways to improve the guidelines. • Arrange for occasional informal forums for company managers, directors, and TIAA-CREF managers to review the guidelines. • Send copies of the guidelines to other large institutional investors, make them available upon request, and send them to appropriate information clearinghouses, and publish them for TIAA-CREF participants and participating institutions to review and offer suggestions for change. • Enter into private discussions with companies regarding perceived shortcomings in governance structure or policies. Conclusion TIAA-CREF disseminates this policy statement to encourage more widespread adoption of effective corporate governance practices. We encourage dialogue to create a better understanding of corporate governance issues with the hope these issues can be addressed and resolved in a spirit of cooperation.

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Executive Compensation Program Guidelines

Cash Pay TIAA-CREF endorses the widespread practice of using surveys of industry pay levels as an influence on cash pay decisions. In setting salary levels and incentive opportunities, the compensation committee should have access to accurate comparative information and competent professional guidance in its interpretation. Independent access to professional consultants should be made available if requested by the compensation committee. The compensation committee should direct the process of setting cash pay levels and guide the selection and use of consultants. Variable cash incentive compensation has become a major element of total cash pay. Properly structured, it can make a significant difference in how people behave and maximize efforts to achieve performance objectives, and in so doing, create shareholder wealth. A proper cash incentive plan should: • Ensure that incentive payments are objectively linked to appropriate parameters of company performance: earnings, return on capital, or other relevant financial or operational measures. • Ensure that incentive payments are reasonable and affordable within overall company economics. • Provide for measures of individual performance that can be controlled or materially influenced by the executives who will receive the incentive pay. • Provide for an incentive performance measurement cycle that is consistent with the business cycle of the corporation. • Lead to total cash compensation for the chief executive officer and other senior executives that is understandable and reasonable in view of performance compared with that of executives in similar positions in comparable companies; and compared with all pay levels within the organization. The Role of Stock Shareholder interests are vitally affected by stock-based compensation plans. Inherently, they provide the greatest opportunities for incentives, and for abuse. Failure of advisory and regulatory organizations to require realistic accounting of the cost of stock-based plans to measure this real cost to the company, and thus to shareholders, has contributed to excesses that encourage extremes and reduce the use-

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fulness to shareholders of these plans. As public policy, TIAA-CREF advocates comprehensive disclosure and more realistic accounting of stock-based plans, the cost of which should be charged to the income statement. Further, we suggest the following guidelines for consideration by companies in which we hold an investment position: • The provisions of stock-based plans should be fully disclosed to shareholders. This disclosure should include the size of grants, potential value to recipients and cost to the company, and plan provisions that could have a material impact on the number and value of shares distributed. Information on grants to and holdings by individual members of management, where required, should be accompanied by disclosure of the extent to which these individuals have hedged or otherwise reduced their exposure to changes in the price of the company’s stock. • All plans that provide for the distribution of stock or stock options to employees and/or directors should be submitted to shareholders for approval. • All stock-based plans should specifically prohibit or severely restrict “megagrants,” which are grants of stock or stock options of a value at the time of grant greater than a reasonable and explainable multiple of the recipient’s total cash compensation. • Grants of stock or stock options should not be timed to take advantage of nonpublic information with significant positive short-term implications for the stock price. We support the use of fixed price options that are reasonable in size. In certain circumstances, it may be desirable for a company to explore alternatives that may more closely link pay to performance, such as performance-based options, which set performance hurdles to achieve vesting; premium (out-of-the-money) options, with vesting dependent on attainment of a pre-determined appreciation of stock; and indexed options—i.e., those with a strike price tied to an index. Accounting rules should provide a level playing field for consideration of these alternatives; fixed price options should not receive more favorable accounting treatment. Restricted stock awards, which can be simple and straightforward, have certain advantages over option programs, as long as they are reasonable in size. Restricted stock more closely aligns the interests of executives with shareholders (as opposed to option holders), and the value to the recipient and cost to the corporation can be computed easily and tracked continuously. TIAA-CREF expects that all stock-based plans for which executives and directors are eligible, and any plan that could result in significant dilution, will be submitted to shareholders for approval. TIAA-CREF has developed decision-rules to guide its voting of proxies related to these proposals.

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Stock-Based Award Voting Guidelines Issue: Potential Dilution from Stock-Based Plans

Red Flag: Total potential dilution from existing and proposed compensation plans exceeds 15% over duration of plan(s) or 2% in any one year. Override: Increase threshold to 25% for plans proposed by companies in human-capital-intensive industries in which coverage extends through at least middle management levels. Increase threshold to 20% for firms at the lower range of market equity capitalization. Comment: The two override conditions are each designed to address a specific consideration. The first addresses the needs of human-capital-intensive industries where generous stock-based grants may be necessary to retain personnel and where significant contributions are made by individuals outside the ranks of senior management. The second override addresses the need to provide packages with sufficient value at lower capitalization firms, since a given level of dilution has a lower economic value the lower the market capitalization of the firm. Issue: Excessive Run Rate from Actual Grants

Red Flag: In the most recent three years, potential dilution from stock and stock option grants averaged in excess of 2% per year. Override: Increase threshold to 3% for plans proposed by companies in human-capital-intensive industries. Comment: The “potential dilution” test described above is a snapshot at a given point in time. That test can miss excessive transfer over time of stock ownership, through stock plans, to executives and employees at companies that repeatedly return to the well for more options. This red flag for excessive run rates is based on actual grants at companies requesting shareholder approval for additional share authorizations for employee stock plans. Issue: Reload Options

Red Flag: Proposal provides for granting reload options. Override: Plan (i) limits the frequency with which options can be reloaded; (ii) provides for a reload only if market price increases a specified percent; and (iii) prohibits resale of shares purchased for which options were reloaded. Comment: Reload options are automatically reloaded after exercise at the then-current market price. They enable the individual receiving them to reap the maximum potential benefit from option awards by allowing him or her to lock in increases in stock price that occur over the duration of the option with no attendant risk. This creates an additional divergence of interests between the outside shareholders and the option recipient.

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Issue: Evergreen Option Plans

Red Flag: Plan contains an evergreen feature that has no termination date and reserves a specified percentage of the outstanding shares for award each year. Override: None. Issue: Option Mega-grants

Red Flag: Option grants that are excessive in relation to other forms of compensation, are out of proportion to compensation of other executives of the corporation, and/or are abnormal compared to awards of peer group CEOs are permitted and have been made. Override: Clear and credible rationale for such awards given by an independent compensation committee, provided the proposed plan specifically prohibits mega-grants. Issue: Option Pricing

Red Flag: Unspecified exercise price or exercise price below 85% of fair market value on the date of the grant. Override: None. Issue: Restricted Stock

Red Flag: A plan limited to restricted stock exceeds 3% dilution, or, for an omnibus plan that potentially would allow award of restricted stock exceeding this level, the company has made grants of restricted stock exceeding 1% of outstanding shares over the last three years. Override: Arguments for higher dilution from restricted stock may be considered on a case-by-case basis for small-cap companies. Issue: Coverage

Red Flag: Plan is limited to a small number of senior employees. Override: Permits awards to a small number of employees at firms at the lower range of market equity capitalization. Issue: Repricing Options

Red Flag: An option plan gives the company the ability to lower the exercise price of options already awarded where the market price of the stock has declined below the original exercise price (“underwater options”).

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Override: The company has not repriced options in the past, or has excluded senior executives from any repricing and has tied any repricing to a significant reduction in the total number of outstanding options. Comment: Repricing options after a decline in the stock price undermines the rationale for establishing an option plan in the first place. Repricing gives management a benefit unavailable to shareholders and thereby reduces the alignment of interests between shareholders and management. Issue: Excess Discretion

Red Flag: Significant terms of awards—such as coverage, option price, or type of award provided for the proposed plan—are not specified in the proposal. Override: None Issue: Bundling

Red Flag: Vote on executive compensation plan is coupled with vote on one or more unrelated proposals. Override: None “Fringe” Benefits Public companies should provide full and clear disclosure of all significant compensation arrangements with senior management in a form such that shareholders can evaluate the reasonableness of the entire compensation package. Full and clear disclosure is particularly important for specific elements of deferred compensation such as supplemental executive retirement plans (SERPs), which may be significant and which may impose a liability on the company for many years after an executive’s retirement. Additionally, contractual arrangements granting significant other benefits to executives, including payment of certain non-business expenses, should be disclosed. Pension plan provisions (including SERPs), perquisites, executive contracts and other “soft” elements of total compensation are reviewed especially carefully by TIAA-CREF. This area merits especially close compensation committee direction and control, for the field is highly complex, and the potential for unintended and unearned wealth transfer to management, and unanticipated cost to the company, is high. Pension Plans Executive pension plans should provide for retirement income that is comparable (as a percentage of final average pay) to that of employees throughout the organization. SERPs may be used to supplement “qualified” pension entitlement to allow this total to be achieved. In this context:

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• The eligibility requirements and terms of all SERPs should be fully disclosed. • The value of the supplemental payment to which each eligible proxy-level executive is entitled should be estimated, and disclosed. • “Constructive credit” should be used to replicate full service credit, not exceed it. • “Lump sum” distributions of the SERP should be allowed; the discount rate used to calculate the lump-sum value of the pension entitlement should approximate the reinvestment rate available at retirement, and should be disclosed. • The total cost of all supplemental plan obligations should be estimated and disclosed.

Executive Contracts Executive contracts are an established element of the arrangements with senior executives in many industries, and if crafted properly can be of substantial value to the corporation and its shareholders. As in other areas, reasonableness, competitive practice, and full disclosure are requirements, and such contracts should protect the interests of the company as well as the executive. TIAA-CREF opposes any outright ban on “golden parachute” severance agreements. We abstain on shareholder resolutions calling for prior shareholder ratification of golden parachute severance agreements, but TIAA-CREF supports resolutions that call for shareholder approval of golden parachutes that exceed IRS guidelines.

Other Perquisites Country clubs, corporate drivers, personal use of corporate aircraft, and other similar perquisites have been restricted by shifts in tax regulations and enforcement. In general, basic principles of industry practice, reasonableness, and full disclosure of the benefits, recipients and cost, apply in this area as well.

The Compensation Committee’s Mission The compensation committee of the board of directors is the critical link in the establishment and administration of a sound and effective executive compensation program. This committee executes the linkage between shareholder interests and executive activities. Members of the committee, and especially its chairman should be: • Independent, not only formally as defined by the SEC, but free of substantial ties to the company and its executives, especially the chief executive officer.

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• Experienced, and well informed in compensation management, from other activities as a director, executive, or participant in compensation programs. • Tough-minded, and fully committed to representing the long-term interests of the shareholders in compensation matters. • Knowledgeable of the company’s business, or businesses, and personally knowledgeable of senior executives. The chairman of the compensation committee should be a senior, experienced director who meets these requirements and is available to work with committee members and management extensively beyond meeting requirements. The chairman of the compensation committee should clearly meet the above requirements, and should be especially experienced in the area of corporate executive compensation governance. TIAA-CREF in principle supports the concept of a strong compensation committee. • Care should be taken to avoid interlocking compensation committee membership with other boards. • A compensation committee calendar should be established and circulated to all members. It should specify the dates of meetings, subjects to be covered at each meeting, and material to be provided to members for preparation before each meeting. • A basic agenda listing the topics to be covered at each meeting should also be prepared. All related material should be made available to committee members well before meetings. • The compensation committee should develop and publish in the proxy a statement of its “charter,” and a description of the criteria used to evaluate the performance of the chief executive officer, and the rationale for his or her compensation.

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Part Four

Selected Resources

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Appendix A

Summary of Associated SEC Regulations, Rules, Schedules, and Forms As discussed previously, the Securities and Exchange Commission (SEC) has oversight responsibilities for disclosure of executive compensation and other information material to shareholders. This appendix reviews SEC regulations, rules, schedules, and forms, with particular emphasis on the presentation standards for disclosure of executive compensation. Please also refer to the glossary for more detailed definitions of some of these regulations, rules, and forms.

SEC REGULATIONS, RULES, SCHEDULES, AND FORMS Securities Act of 1933 Regulations Regulation A

— Conditional Small Issues Exemption from Registration Under the Securities Act of 1933 Regulation C — Registration and Filing Requirements Regulation CE — Coordinated Exemption for Certain Issues of Securities Exempt Under State Law Regulation D — Rules Governing the Limited Offer and Sale of Securities Without Registration Under the Securities Act of 1933 Regulation M-A — Mergers and Acquisitions Regulation S — Rules Governing Offers and Sales Made Outside the United States Without Registration Under the Securities Act of 1933 221

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Regulation S-B

— Part 228—Integrated Disclosure System for Small Business Issuers Regulation S-K — Part 229—Standard Instructions for Filing Forms Under Securities Act of 1933, Securities Exchange Act of 1934 and Energy Policy and Conservation Act of 1975 Regulation S-T — Part 232—General Rules and Regulations for Electronic Filings Regulation S-X — Part 210—Requirements for Financial Statements Under the Securities Act of 1933, and the Securities Exchange Act of 1934 Rules and Schedules Rule 144 and Form 144 Rule 144

—

Persons Deemed Not To Be Engaged in a Distribution and Therefore Not Underwriters Rule 701 — Exemption for Offers and Sales of Securities Pursuant to Certain Compensatory Benefit Plans and Contracts Relating to Compensation Rules 800, 801, 802 — Exemptions for Cross-Border Rights Offerings, Exchange Offers and Business Combinations Forms Form F-1 Form F-2 Form F-3 Form F-4 Form F-6

— — — — —

Form F-7

—

Form F-8

—

Form F-9

—

Form F-10

—

Registration Statement under the Securities Act of 1933 Registration Statement under the Securities Act of 1933 Registration Statement under the Securities Act of 1933 Registration Statement under the Securities Act of 1933 Registration Statement under the Securities Act of 1933 for Depositary Shares Evidenced by American Depositary Receipts (forthcoming) Registration Statement under the Securities Act of 1933 (forthcoming) Registration Statement under the Securities Act of 1933 (forthcoming) Registration Statement under the Securities Act of 1933 (forthcoming) Registration Statement under the Securities Act of 1933 (forthcoming)

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Form F-80

—

Form F-X Form F-N Form S-1 Form S-2 Form S-3 Form S-4 Form S-8 Form S-11 Form S-20 Form SB-1 Form SB-2 Form 1-A

— — — — — — — — — — — —

Form 2-A

—

Form CB Form D

— —

223

Registration Statement under the Securities Act of 1933 (forthcoming) Appointment of Agent for Service of Process and Undertaking (forthcoming) Registration Statement Under the Securities Act of 1933 Registration Statement Under the Securities Act of 1933 Registration Statement Under the Securities Act of 1933 Registration Statement Under the Securities Act of 1933 Registration Statement Under the Securities Act of 1933 Registration Statement Under the Securities Act of 1933 (forthcoming) Registration Statement Under the Securities Act of 1933 Registration Statement Under the Securities Act of 1933 Registration A Offering Statement Under the Securities Act of 1933 Report of Sales and Uses of Proceeds Pursuant to Rule 257 of Regulation A Tender Offer/Rights Offering Notification Form Notice of Sale of Securities Pursuant to Regulation D, Section 4(6), and/or Uniform Limited Offering Exemption

Rule 144 and Form 144 Rule 144

— Persons Deemed Not To Be Engaged in a Distribution and Therefore Not Underwriters Form 144 — Notice of Proposed Sale of Securities Pursuant to Rule 144 Under the Securities Act of 1933 Rule 701 — Exemption for Offers and Sales of Securities Pursuant to Certain Compensatory Benefit Plans and Contracts Relating to Compensation Form ET — Transmittal Form for Electronic Format Documents Under the EDGAR System Form ID — Uniform Application for Access Codes to File on EDGAR Form SE — Form for Submission of Paper Format Exhibits by Electronic Filers Form TH — Notification of Reliance on Temporary Hardship Exemption

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SEC REGULATION S-K. ITEM 402. PROXY STATEMENT DISCLOSURE RULES PERTAINING TO EXECUTIVE COMPENSATION Reg. § 229.402. Item 402 (a) General. (1) Treatment of Specific Types of Issuers. (i) Small Business Issuers. A registrant that qualifies as “small business issuer,” as defined by Item 10(a)(1) of Regulation S-B [17 CFR 228.10(a)(1)], will be deemed to comply with this item if it provides the information required by paragraph (b) (Summary Compensation Table), paragraphs (c)(1) and (c)(2)(i)-(v) (Option/SAR Grants Table), paragraph (d) (Aggregated Option/SAR Exercise and Fiscal Year-End Option/SAR Value Table), paragraph (e) (Long-Term Incentive Plan Awards Table), paragraph (g) (Compensation of Directors), paragraph (h) (Employment Contracts, Termination of Employment and Change in Control Arrangements) and paragraph (i)(1) and (2) (Report on Repricing of Options/ SARs) of this item. (ii) Foreign Private Issuers. A foreign private issuer will be deemed to comply with this item if it provides the information required by Items 11 and 12 of Form 20-F [17 CFR 249.220f], with more detailed information provided if otherwise made publicly available. (2) All Compensation Covered. This item requires clear, concise and understandable disclosure of all plan and non-plan compensation awarded to, earned by, or paid to the named executive officers designated under paragraph (a)(3) of this item, and directors covered by paragraph (g) of this item by any person for all services rendered in all capacities to the registrant and its subsidiaries, unless otherwise specified in this item. Except as provided by paragraph (a)(5) of this item, all such compensation shall be reported pursuant to this item, even if also called for by another requirement, including transactions between the registrant and a third party where the primary purpose of the transaction is to furnish compensation to any such named executive officer or director. No item reported as compensation for one fiscal year need be reported as compensation for a subsequent fiscal year. (3) Persons Covered. Disclosure shall be provided pursuant to this item for each of the following (the “named executive officers”): (i) All individuals serving as the registrant’s chief executive officer or acting in a similar capacity during the last completed fiscal year (“CEO”), regardless of compensation level; (ii) The registrant’s four most highly compensated executive officers other than the CEO who were serving as executive officers at the end of the last completed fiscal year; and

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(iii) up to two additional individuals for whom disclosure would have been provided pursuant to paragraph (a)(3)(ii) of this item but for the fact that the individual was not serving as an executive officer of the registrant at the end of the last completed fiscal year. Instructions to Item 402(a)(3). 1. Determination of Most Highly Compensated Executive Officers. The determination as to which executive officers are most highly compensated shall be made by reference to total annual salary and bonus for the last completed fiscal year (as required to be disclosed pursuant to paragraph (b)(2)(iii)(A) and (B) of this item), but including the dollar value of salary or bonus amounts forgone pursuant to Instruction 3 to paragraph (b)(2)(iii)(A) and (B) of this item, provided, however, that no disclosure need be provided for any executive officer, other than the CEO, whose total annual salary and bonus, as so determined, does not exceed $100,000. 2. Inclusion of Executive Officer of Subsidiary. It may be appropriate in certain circumstances for a registrant to include an executive officer of a subsidiary in the disclosure required by this item. See Rule 3b-7 under the Exchange Act [17 CFR 240.3b7]. 3. Exclusion of Executive Officer due to Unusual or Overseas Compensation. It may be appropriate in limited circumstances for a registrant not to include in the disclosure required by this item an individual, other than its CEO, who is one of the registrant’s most highly compensated executive officers. Among the factors that should be considered in determining not to name an individual are: (a) the distribution or accrual of an unusually large amount of cash compensation (such as a bonus or commission) that is not part of a recurring arrangement and is unlikely to continue; and (b) the payment of amounts of cash compensation relating to overseas assignments that may be attributed predominantly to such assignments. (4) Information for Full Fiscal Year. If the CEO served in that capacity during any part of a fiscal year with respect to which information is required, information should be provided as to all of his or her compensation for the full fiscal year. If a named executive officer (other than the CEO) served as an executive officer of the registrant (whether or not in the same position) during any part of a fiscal year with respect to which information is required, information shall be provided as to all compensation of that individual for the full fiscal year. (5) Transactions With Third Parties Reported under Item 404. This item includes transactions between the registrant and a third party where the primary purpose of the transaction is to furnish compensation to a named executive officer. No information need be given in response to any paragraph of this item, other than paragraph (j), as to any such third-party transaction if the

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transaction has been reported in response to Item 404 of Regulation S-K (§229.404). (6) Omission of Table or Column. A table or column may be omitted, if there has been no compensation awarded to, earned by or paid to any of the named executives required to be reported in that table or column in any fiscal year covered by that table. (7) Definitions. For purposes of this item: (i) The term stock appreciation rights (“SARs”) refers to SARs payable in cash or stock, including SARs payable in cash or stock at the election of the registrant or a named executive officer. (ii) The term plan includes, but is not limited to, the following: any plan, contract, authorization or arrangement, whether or not set forth in any formal documents, pursuant to which the following may be received: cash, stock, restricted stock or restricted stock units, phantom stock, stock options, SARs, stock options in tandem with SARs, warrants, convertible securities, performance units and performance shares, and similar instruments. A plan may be applicable to one person. Registrants may omit information regarding group life, health, hospitalization, medical reimbursement or relocation plans that do not discriminate in scope, terms or operation, in favor of executive officers or directors of the registrant and that are available generally to all salaried employees. (iii) The term long-term incentive plan means any plan providing compensation intended to serve as incentive for performance to occur over a period longer than one fiscal year, whether such performance is measured by reference to financial performance of the registrant or an affiliate, the registrant’s stock price, or any other measure, but excluding restricted stock, stock option and SAR plans. (8) Location of Specified Information. The information required by paragraphs (i), (k) and (l) of this item need not be provided in any filings other than a registrant proxy or information statement relating to an annual meeting of security holders at which directors are to be elected (or special meeting or written consents in lieu of such meeting). Such information will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference. (9) Liability for Specified Information. The information required by paragraphs (k) and (l) of this item shall not be deemed to be “soliciting material” or to be “filed” with the Commission or subject to Regulations 14A or 14C [17 CFR 240.14a-1 et seq. or 240.14c-1 et seq.], other than as provided in this item, or to the liabilities of Section 18 of the Exchange Act [15 U.S.C. 78r], except to the extent that the registrant specifically requests that such information be treated as soliciting material or specifically incorporates it by reference into a filing under the Securities Act or the Exchange Act.

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(b) Summary Compensation Table. (1) General. The information specified in paragraph (b)(2) of this item, concerning the compensation of the named executive officers for each of the registrant’s last three completed fiscal years, shall be provided in a Summary Compensation Table, in the tabular format specified below.

SUMMARY COMPENSATION TABLE Annual Compensation

Long Term Compensation Awards

(a) Name and Principal Position CEO CEO

(b)

Year

(c)

Salary ($)

Payouts

(d)

(e)

(f)

(g)

(h)

(i)

Bonus ($)

Other Annual Compensation ($)

Restricted Stock Awards(s) ($)

Securities Underlying Options/ SARs (#)

LTIP Payouts ($)

All Other Compensation ($)

___ ___ ___

A

___ ___ ___

B

___ ___ ___

C

___ ___ ___

D

___ ___ ___

(2) The Table shall include: (i) The name and principal position of the executive officer (column (a)); (ii) Fiscal year covered (column (b)); (iii) Annual compensation (columns (c), (d) and (e)), including:

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(A) The dollar value of base salary (cash and non-cash) earned by the named executive officer during the fiscal year covered (column (c)); (B) The dollar value of bonus (cash and non-cash) earned by the named executive officer during the fiscal year covered (column (d)); and Instructions to Item 402(b)(2)(iii)(A) and (B). 1. Amounts deferred at the election of a named executive officer, whether pursuant to a plan established under Section 401(k) of the Internal Revenue Code [26 U.S.C. 401(k)], or otherwise, shall be included in the salary column (column (c)) or bonus column (column (d)), as appropriate, for the fiscal year in which earned. If the amount of salary or bonus earned in a given fiscal year is not calculable through the latest practicable date, that fact must be disclosed in a footnote and such amount must be disclosed in the subsequent fiscal year in the appropriate column for the fiscal year in which earned. 2. For stock or any other form of non-cash compensation, disclose the fair market value at the time the compensation is awarded, earned or paid. 3. Registrants need not include in the salary column (column (c)) or bonus column (column (d)) any amount of salary or bonus forgone at the election of a named executive officer pursuant to a registrant program under which stock, stock-based or other forms of non-cash compensation may be received by a named executive in lieu of a portion of annual compensation earned in a covered fiscal year. However, the receipt of any such form of non-cash compensation in lieu of salary or bonus earned for a covered fiscal year must be disclosed in the appropriate column of the Table corresponding to that fiscal year (i.e., restricted stock awards (column (f)); options or SARs (column (g)); all other compensation (column (i)), or, if made pursuant to a long-term incentive plan and therefore not reportable at grant in the Summary Compensation Table, a footnote must be added to the salary or bonus column so disclosing and referring to the Long-Term Incentive Plan Table (required by paragraph (e) of this item) where the award is reported. (C) The dollar value of other annual compensation not properly categorized as salary or bonus, as follows (column (e)): (1) Perquisites and other personal benefits, securities or property, unless the aggregate amount of such compensation is the lesser of either $50,000 or 10% of the total of annual salary and bonus reported for the named executive officer in columns (c) and (d);

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(2) Above-market or preferential earnings on restricted stock, options, SARs or deferred compensation paid during the fiscal year or payable during that period but deferred at the election of the named executive officer; (3) Earnings on long-term incentive plan compensation paid during the fiscal year or payable during that period but deferred at the election of the named executive officer; (4) Amounts reimbursed during the fiscal year for the payment of taxes; and (5) The dollar value of the difference between the price paid by a named executive officer for any security of the registrant or its subsidiaries purchased from the registrant or its subsidiaries (through deferral of salary or bonus, or otherwise), and the fair market value of such security at the date of purchase, unless that discount is available generally, either to all security holders or to all salaried employees of the registrant. Instructions to Item 402(b)(2)(iii)(C). 1. Each perquisite or other personal benefit exceeding 25% of the total perquisites and other personal benefits reported for a named executive officer must be identified by type and amount in a footnote or accompanying narrative discussion to column (e). 2. Perquisites and other personal benefits shall be valued on the basis of the aggregate incremental cost to the registrant and its subsidiaries. 3. Interest on deferred or long-term compensation is abovemarket only if the rate of interest exceeds 120% of the applicable federal long-term rate, with compounding (as prescribed under Section 1274(d) of the Internal Revenue Code, [26 U.S.C. 1274(d)]) at the rate that corresponds most closely to the rate under the registrant’s plan at the time the interest rate or formula is set. In the event of a discretionary reset of the interest rate, the requisite calculation must be made on the basis of the interest rate at the time of such reset, rather than when originally established. Only the above-market portion of the interest must be included. If the applicable interest rates vary depending upon conditions such as a minimum period of continued service, the reported amount should be calculated assuming satisfaction of all conditions to receiving interest at the highest rate. 4. Dividends (and dividend equivalents) on restricted stock, options, SARs or deferred compensation denominated in stock (“deferred stock”) are preferential only if earned at a rate higher

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than dividends on the registrant’s common stock. Only the preferential portion of the dividends or equivalents must be included. (iv) Long-term compensation (columns (f), (g) and (h)), including: (A) The dollar value (net of any consideration paid by the named executive officer) of any award of restricted stock, including share units (calculated by multiplying the closing market price of the registrant’s unrestricted stock on the date of grant by the number of shares awarded) (column (f)); (B) The sum of the number of securities underlying stock options granted (including options that subsequently have been transferred), with or without tandem SARs, and the number of freestanding SARs (column (g)); and (C) The dollar value of all payouts pursuant to long-term incentive plans (“LTIPs”) as defined in paragraph (a)(7)(iii) of this item (column (h)). Instructions to Item 402(b)(2)(iv). 1. Awards of restricted stock that are subject to performance-based conditions on vesting, in addition to lapse of time and/or continued service with the registrant or a subsidiary, may be reported as LTIP awards pursuant to paragraph (e) of this item instead of in column (f). If this approach is selected, once the restricted stock vests, it must be reported as an LTIP payout in column (h). 2. The registrant shall, in a footnote to the Summary Compensation Table (appended to column (f), if included), disclose: a. The number and value of the aggregate restricted stock holdings at the end of the last completed fiscal year. The value shall be calculated in the manner specified in paragraph (b)(2)(iv)(A) of this item using the value of the registrant’s shares at the end of the last completed fiscal year. b. For any restricted stock award reported in the Summary Compensation Table that will vest, in whole or in part, in under three years from the date of grant, the total number of shares awarded and the vesting schedule; and c. Whether dividends will be paid on the restricted stock reported in column (f). 3. If at any time during the last completed fiscal year, the registrant has adjusted or amended the exercise price of stock options or freestanding SARs previously awarded to a named executive officer, whether through amendment, cancellation or replacement

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grants, or any other means (“repriced”), the registrant shall include the number of options or freestanding SARs so repriced as Stock Options/SARs granted and required to be reported in column (g). 4. If any specified performance target, goal or condition to payout was waived with respect to any amount included in LTIP payouts reported in column (h), the registrant shall so state in a footnote to column (h). (v) All other compensation for the covered fiscal year that the registrant could not properly report in any other column of the Summary Compensation Table (column (i)). Any compensation reported in this column for the last completed fiscal year shall be identified and quantified in a footnote. Such compensation shall include, but not be limited to: (A) The amount paid, payable or accrued to any named executive officer pursuant to a plan or arrangement in connection with: (1) The resignation, retirement or any other termination of such executive officer’s employment with the registrant and its subsidiaries; or (2) A change in control of the registrant or a change in the executive officer’s responsibilities following such a change in control; (B) The dollar value of above-market or preferential amounts earned on restricted stock, options, SARs or deferred compensation during the fiscal year, or calculated with respect to that period, except that if such amounts are paid during the period, or payable during the period but deferred at the election of a named executive officer, this information shall be reported as Other Annual Compensation in column (e). See Instructions 3 and 4 to paragraph 402(b)(2)(iii)(C) of this item; (C) The dollar value of amounts earned on long-term incentive plan compensation during the fiscal year, or calculated with respect to that period, except that if such amounts are paid during that period, or payable during that period at the election of the named executive officer, this information shall be reported as Other Annual Compensation in column (e); (D) Annual registrant contributions or other allocations to vested and unvested defined contribution plans; and (E) The dollar value of any insurance premiums paid by, or on behalf of, the registrant during the covered fiscal year with respect to term life insurance for the benefit of a named executive officer, and, if there is any arrangement or understanding, whether formal or informal, that such executive officer has or will receive or be allocated an interest in any cash surrender value under the insurance policy, either

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(1) The full dollar value of the remainder of the premiums paid by, or on behalf of, the registrant; or (2) If the premiums will be refunded to the registrant on termination of the policy, the dollar value of the benefit to the executive officer of the remainder of the premium paid by, or on behalf of, the registrant during the fiscal year. The benefit shall be determined for the period, projected on an actuarial basis, between payment of the premium and the refund. Instructions to Item 402(b)(2)(v). 1. LTIP awards and amounts received on exercise of options and SARs need not be reported as All Other Compensation in column (i). 2. Information relating to defined benefit and actuarial plans should not be reported pursuant to paragraph (b) of this item, but instead should be reported pursuant to paragraph (f) of this item. 3. Where alternative methods of reporting are available under paragraph (b)(2)(v)(E) of this item, the same method should be used for each of the named executive officers. If the registrant chooses to change methods from one year to the next, that fact, and the reason therefor, should be disclosed in a footnote to column (i). Instruction to Item 402(b). Information with respect to fiscal years prior to the last completed fiscal year will not be required if the registrant was not a reporting company pursuant to Section 13(a) or 15(d) of the Exchange Act at any time during that year, except that the registrant will be required to provide information for any such year if that information previously was required to be provided in response to a Commission filing requirement. (c) Option/SAR Grants Table. (1) The information specified in paragraph (c)(2) of this item, concerning individual grants of stock options (whether or not in tandem with SARs), and freestanding SARs (including options and SARs that subsequently have been transferred) made during the last completed fiscal year to each of the named executive officers shall be provided in the tabular format specified on the next page:

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OPTION/SAR GRANTS IN LAST FISCAL YEAR Potential Realizable Value at Assumed Annual Rates of Stock Price Appreciation for Option Term

Individual Grants (a)

(b)

(c)

Number of Securities Underlying Options/ SARs Granted (#)

Percentage of Total Options/ SARs Granted to Employees in Fiscal Year

(d)

(e)

Exercise of Base Price Expiration (#/Sh) Date

(f)

(g)

5% ($) 10% ($)

Alternative to (f) and (g): Grant Date Value (h)

Grant Date Present Value: ($)

CEO A B C D

(2) The Table shall include, with respect to each grant: (i) The name of the executive officer (column (a)); (ii) The number of securities underlying options and SARs granted (column (b)); (iii) The percent the grant represents of total options and SARs granted to employees during the fiscal year (column (c)); (iv) The per-share exercise or base price of the options or SARs granted (column (d)). If such exercise or base price is less than the market price of the underlying security on the date of grant, a separate, adjoining column shall be added showing market price on the date of grant; (v) The expiration date of the options or SARs (column (e)); and

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(vi) Either (A) the potential realizable value of each grant of options or freestanding SARs or (B) the present value of each grant, as follows: (A) The potential realizable value of each grant of options or freestanding SARs, assuming that the market price of the underlying security appreciates in value from the date of grant to the end of the option or SAR term, at the following annualized rates: (1) 5% (column (f)); (2) 10% (column (g)); and (3) If the exercise or base price was below the market price of the underlying security at the date of grant, provide an additional column labeled 0%, to show the value at grant-date market price; or (B) The present value of the grant at the date of grant, under any option pricing model (alternative column (f)).

Instructions to Item 402(c). 1. If more than one grant of options and/or freestanding SARs was made to a named executive officer during the last completed fiscal year, a separate line should be used to provide disclosure of each such grant. However, multiple grants during a single fiscal year may be aggregated where each grant was made at the same exercise and/or base price and has the same expiration date, and the same performance vesting thresholds, if any. A single grant consisting of options and/or freestanding SARs shall be reported as separate grants with respect to each tranche with a different exercise and/or base price, performance vesting threshold, or expiration date. 2. Options or freestanding SARs granted in connection with an option repricing transaction shall be reported in this table. See Instruction 3 to paragraph (b)(2)(iv) of this item. 3. Any material term of the grant, including but not limited to the date of exercisability, the number of SARs, performance units or other instruments granted in tandem with options, a performance-based condition to exercisability, a reload feature, or a tax-reimbursement feature, shall be footnoted. 4. If the exercise or base price is adjustable over the term of any option or freestanding SAR in accordance with any prescribed standard or formula, including but not limited to an index or premium price provision, describe the following, either by footnote to column (c) or in narrative accompanying the Table: (a) the standard or formula; and (b) any constant assumption made by the registrant regarding any adjustment to the exercise price in calculating the potential option or SAR value. 5. If any provision of a grant (other than an antidilution provision) could cause the exercise price to be lowered, registrants must clearly and fully

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disclose these provisions and their potential consequences either by a footnote or accompanying textual narrative. 6. In determining the grant-date market or base price of the security underlying options or freestanding SARs, the registrant may use either the closing market price per share of the security, or any other formula prescribed for the security. 7. The potential realizable dollar value of a grant (columns (f) and (g)) shall be the product of: (a) the difference between: (i) the product of the pershare market price at the time of the grant and the sum of 1 plus the adjusted stock price appreciation rate (the assumed rate of appreciation compounded annually over the term of the option or SAR); and (ii) the per-share exercise price of the option or SAR; and (b) the number of securities underlying the grant at fiscal year-end. 8. Registrants may add one or more separate columns using the formula prescribed in Instruction 7 to paragraph (c) of this item, to reflect the following: a. the registrant’s historic rate of appreciation over a period equivalent to the term of such options and/or SARs; b. 0% appreciation, where the exercise or base price was equal to or greater than the market price of the underlying securities on the date of grant; and c. N% appreciation, the percentage appreciation by which the exercise or base price exceeded the market price at grant. Where the grant included multiple tranches with exercise or base prices exceeding the market price of the underlying security by varying degrees, include an additional column for each additional tranche. 9. Where the registrant chooses to use the grant-date valuation alternative specified in paragraph (c)(2)(vi)(B) of this item, the valuation shall be footnoted to describe the valuation method used. Where the registrant has used a variation of the Black-Scholes or binomial option pricing model, the description shall identify the use of such pricing model and describe the assumptions used relating to the expected volatility, risk-free rate of return, dividend yield and time of exercise. Any adjustments for nontransferability or risk of forfeiture also shall be disclosed. In the event another valuation method is used, the registrant is required to describe the methodology as well as any material assumptions. (d) Aggregated Option/SAR Exercises and Fiscal Year-End Option/SAR Value Table. (1) The information specified in paragraph (d)(2) of this item, concerning each exercise of stock options (or tandem SARs) and freestanding SARs during the last completed fiscal year by each of the named executive officers and the fiscal year-end value of unexercised options and SARs, shall be provided on an aggregated basis in the tabular format specified below:

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AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR AND FY-END OPTION/SAR VALUES

Shares acquired Value realized on exercise (#) ($)

Name (a)

(b)

(c)

Number of securities underlying unexercised options/SARs at FY-end (#) Exercisable/ Unexercisable

Value of unexercised inthe-money options/SARs at FY-end ($) Exercisable/ Unexercisable

(d)

(e)

CEO. . . . A. . . . B. . . . C. . . . D. . . .

(2) The table shall include: (i) The name of the executive officer (column (a)); (ii) The number of shares received upon exercise, or, if no shares were received, the number of securities with respect to which the options or SARs were exercised (column (b)); (iii) The aggregate dollar value realized upon exercise (column (c)); (iv) The total number of securities underlying the unexercised options and SARs held at the end of the last completed fiscal year, separately identifying the exercisable and unexercisable options and SARs (column (d)); and (v) The aggregate dollar value of in-the-money, unexercised options and SARs held at the end of the fiscal year, separately identifying the exercisable and unexercisable options and SARs (column (e)). Instructions to Item 402(d)(2). 1. Options or freestanding SARs are in-the-money if the fair market value of the underlying securities exceeds the exercise or base price of the option or SAR. The dollar values in columns (c) and (e) are calculated by determining the difference between the fair market value of the securities underlying the options or SARs and the exercise or base price of the options or SARs at exercise or fiscal year-end, respectively.

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2. In calculating the dollar value realized upon exercise (column (c)), the value of any related payment or other consideration provided (or to be provided) by the registrant to or on behalf of a named executive officer, whether in payment of the exercise price or related taxes, shall not be included. Payments by the registrant in reimbursement of tax obligations incurred by a named executive officer are required to be disclosed in accordance with paragraph (b)(2)(iii)(C)(4) of this item. (e) Long-Term Incentive Plan (“LTIP”) Awards Table. (1) The information specified in paragraph (e)(2) of this item, regarding each award made to a named executive officer in the last completed fiscal year under any LTIP, shall be provided in the tabular format specified below:

LONG-TERM INCENTIVE PLANS—AWARDS IN LAST FISCAL YEAR

Name (a)

Estimated future payouts under non-stock price-based plans

Number of shares, units or other rights (#)

Performance or other period until maturation or payout

Threshold ($ or #)

Target ($ or #)

Maximum ($ or #)

(b)

(c)

(d)

(e)

(f)

CEO. . . . A. . . . B. . . . C. . . . D. . . .

(2) The Table shall include: (i) The name of the executive officer (column (a)); (ii) The number of shares, units or other rights awarded under any LTIP, and, if applicable, the number of shares underlying any such unit or right (column (b)); (iii) The performance or other time period until payout or maturation of the award (column (c)); and (iv) For plans not based on stock price, the dollar value of the estimated payout, the number of shares to be awarded as the payout or a range of es-

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timated payouts denominated in dollars or number of shares under the award (threshold, target and maximum amount) (columns (d) through (f)). Instructions to Item 402(e). 1. For purposes of this paragraph, the term “long-term incentive plan” or “LTIP” shall be defined in accordance with paragraph (a)(7)(iii) of this item. 2. Describe in a footnote or in narrative text accompanying this table the material terms of any award, including a general description of the formula or criteria to be applied in determining the amounts payable. Registrants are not required to disclose any factor, criterion or performance-related or other condition to payout or maturation of a particular award that involves confidential commercial or business information, disclosure of which would adversely affect the registrant’s competitive position. 3. Separate disclosure shall be provided in the Table for each award made to a named executive officer, accompanied by the information specified in Instruction 2 to this paragraph. If awards are made to a named executive officer during the fiscal year under more than one plan, identify the particular plan under which each such award was made. 4. For column (d), “threshold” refers to the minimum amount payable for a certain level of performance under the plan. For column (e), “target” refers to the amount payable if the specified performance target(s) are reached. For column (f), “maximum” refers to the maximum payout possible under the plan. 5. In column (e), registrants must provide a representative amount based on the previous fiscal year’s performance if the target award is not determinable. 6. A tandem grant of two instruments, only one of which is pursuant to a LTIP, need be reported only in the table applicable to the other instrument. For example, an option granted in tandem with a performance share would be reported only as an option grant, with the tandem feature noted. (f) Defined Benefit or Actuarial Plan Disclosure. (l) Pension Plan Table. (i) For any defined benefit or actuarial plan under which benefits are determined primarily by final compensation (or average final compensation) and years of service, provide a separate Pension Plan Table showing estimated annual benefits payable upon retirement (including amounts attributable to any defined benefit supplementary or excess pension award plans) in specified compensation and years of service classifications in the format specified on the next page.

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PENSION PLAN TABLE Years of Service Remuneration

15

20

25

30

35

125,000 150,000 175,000 200,000 225,000 250,000 300,000 400,000 450,000 500,000

(ii) Immediately following the Table, the registrant shall disclose: (A) The compensation covered by the plan(s), including the relationship of such covered compensation to the annual compensation reported in the Summary Compensation Table required by paragraph (b)(2) of this item, and state the current compensation covered by the plan for any named executive officer whose covered compensation differs substantially (by more than 10%) from that set forth in annual compensation columns of the Summary Compensation Table; (B) The estimated credited years of service for each of the named executive officers; and (C) A statement as to the basis upon which benefits are computed (e.g., straight-life annuity amounts), and whether or not the benefits listed in the Pension Plan Table are subject to any deduction for Social Security or other offset amounts. (2) Alternative Pension Plan Disclosure. For any defined benefit or actuarial plan under which benefits are not determined primarily by final compensation (or average final compensation) and years of service, the registrant shall state in narrative form: (i) The formula by which benefits are determined; and (ii) The estimated annual benefits payable upon retirement at normal retirement age for each of the named executive officers.

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Instructions to Item 402(f). 1. Pension Levels. Compensation set forth in the Pension Plan Table pursuant to paragraph (f)(1)(i) of this item shall allow for reasonable increases in existing compensation levels; alternatively, registrants may present as the highest compensation level in the Pension Plan Table an amount equal to 120% of the amount of covered compensation of the most highly compensated individual named in the Summary Compensation Table required by paragraph (b)(2) of this item. 2. Normal Retirement Age. The term “normal retirement age” means normal retirement age as defined in a pension or similar plan or, if not defined therein, the earliest time at which a participant may retire without any benefit reduction due to age. (g) Compensation of Directors. (1) Standard Arrangements. Describe any standard arrangements, stating amounts, pursuant to which directors of the registrant are compensated for any services provided as a director, including any additional amounts payable for committee participation or special assignments. (2) Other Arrangements. Describe any other arrangements pursuant to which any director of the registrant was compensated during the registrant’s last completed fiscal year for any service provided as a director, stating the amount paid and the name of the director. Instructions to Item 402(g)(2). The information required by paragraph (g)(2) of this item shall include any arrangement, including consulting contracts, entered into in consideration of the director’s service on the board. The material terms of any such arrangement shall be included. (h) Employment Contracts and Termination of Employment and Change-inControl Arrangements. Describe the terms and conditions of each of the following contracts or arrangements: (1) Any employment contract between the registrant and a named executive officer; and (2) Any compensatory plan or arrangement, including payments to be received from the registrant, with respect to a named executive officer, if such plan or arrangement results or will result from the resignation, retirement or any other termination of such executive officer’s employment with the registrant and its subsidiaries or from a change-in-control of the registrant or a change in the named executive officer’s responsibilities following a change-in-control and the amount involved, including all periodic payments or installments, exceeds $100,000. (i) Report on Repricing of Options/SARs.

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(1) If at any time during the last completed fiscal year, the registrant, while a reporting company pursuant to Section 13(a) or 15(d) of the Exchange Act, has adjusted or amended the exercise price of stock options or SARs previously awarded to any of the named executive officers, whether through amendment, cancellation or replacement grants, or any other means (“repriced”), the registrant shall provide the information specified in paragraphs (i)(2) and (i)(3) of this item. (2) The compensation committee (or other board committee performing equivalent functions or, in the absence of any such committee, the entire board of directors) shall explain in reasonable detail any such repricing of options and/or SARs held by a named executive officer in the last completed fiscal year, as well as the basis for each such repricing. (3)(i) The information specified in paragraph (i)(3)(ii) of this item, concerning all such repricings of options and SARs held by any executive officer during the last ten completed fiscal years, shall be provided in the tabular format specified below:

TEN-YEAR OPTION/SAR REPRICINGS

Name (a)

Date (b)

Number of securities underlying options/ SARs repriced or amended (#)

Market price of stock at time of repricing or amendment ($)

Exercise price at time of repricing or amendment ($)

(c)

(d)

(e)

New exercise price ($)

Length of original option term remaining at date of repricing or amendment

(f)

(g)

(ii) The Table shall include, with respect to each repricing: (A) The name and position of the executive officer (column (a)); (B) The date of each repricing (column (b)); (C) The number of securities underlying replacement or amended options or SARs (column (c)); (D) The per-share market price of the underlying security at the time of repricing (column (d)); (E) The original exercise price or base price of the cancelled or amended option or SAR (column (e)): (F) The per-share exercise price or base price of the replacement option or SAR (column (f)); and

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(G) The amount of time remaining before the replaced or amended option or SAR would have expired (column (g)). Instructions to Item 402(i). 1. The required report shall be made over the name of each member of the registrant’s compensation committee, or other board committee performing equivalent functions or, in the absence of any such committee, the entire board of directors. 2. A replacement grant is any grant of options or SARs reasonably related to any prior or potential option or SAR cancellation, whether by an exchange of existing options or SARs for options or SARs with new terms; the grant of new options or SARs in tandem with previously granted options or SARs that will operate to cancel the previously granted options or SARs upon exercise; repricing of previously granted options or SARs; or otherwise. If a corresponding original grant was canceled in a prior year, information about such grant nevertheless must be disclosed pursuant to this paragraph. 3. If the replacement grant is not made at the current market price, describe the terms of the grant in a footnote or accompanying textual narrative. 4. This paragraph shall not apply to any repricing occurring through the operation of: a. a plan formula or mechanism that results in the periodic adjustment of the option or SAR exercise or base price; b. a plan antidilution provision; or c. a recapitalization or similar transaction equally affecting all holders of the class of securities underlying the options or SARs. 5. Information required by paragraph (i)(3) of this item shall not be provided for any repricings effected before the registrant became a reporting company pursuant to Section 13(a) or 15(d) of the Exchange Act. (j) Additional Information with Respect to Compensation Committee Interlocks and Insider Participation in Compensation Decisions. Under the caption “Compensation Committee Interlocks and Insider Participation,” (1) The registrant shall identify each person who served as a member of the compensation committee of the registrant’s board of directors (or board committee performing equivalent functions) during the last completed fiscal year, indicating each committee member who: (i) was, during the fiscal year, an officer or employee of the registrant or any of its subsidiaries; (ii) was formerly an officer of the registrant or any of its subsidiaries; or (iii) had any relationship requiring disclosure by the registrant under any paragraph of Item 404 of Regulation S-K. In this event, the disclosure required by Item 404 shall accompany such identification.

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(2) If the registrant has no compensation committee (or other board committee performing equivalent functions), the registrant shall identify each officer and employee of the registrant or any of its subsidiaries, and any former officer of the registrant or any of its subsidiaries, who, during the last completed fiscal year, participated in deliberations of the registrant’s board of directors concerning executive officer compensation. (3) The registrant shall describe any of the following relationships that existed during the last completed fiscal year: (i) an executive officer of the registrant served as a member of the compensation committee (or other board committee performing equivalent functions or, in the absence of any such committee, the entire board of directors) or another entity, one of whose executive officers served on the compensation committee (or other board committee performing equivalent functions or, in the absence of any such committee, the entire board of directors) of the registrant; (ii) an executive officer of the registrant served as a director of another entity, one of whose executive officers served on the compensation committee (or other board committee performing equivalent functions or, in the absence of any such committee, the entire board of directors) of the registrant; and (iii) an executive officer of the registrant served as a member of the compensation committee (or other board committee performing equivalent functions or, in the absence of any such committee, the entire board of directors) of another entity, one of whose executive officers served as a director of the registrant. (4) Disclosure required under paragraph (j)(3) of this item regarding any compensation committee member or other director of the registrant who also served as an executive officer of another entity shall be accompanied by the disclosure called for by Item 404 with respect to that person. Instruction to Item 402(j) For purposes of this paragraph, the term “entity” shall not include an entity exempt from tax under Section 501(c)(3) of the Internal Revenue Code [26 U.S.C. 501(c)(3)]. (k) Board Compensation Committee Report on Executive Compensation. (1) Disclosure of the compensation committee’s compensation policies applicable to the registrant’s executive officers (including the named executive officers), including the specific relationship of corporate performance to executive compensation, is required with respect to compensation reported for the last completed fiscal year. (2) Discussion is required of the compensation committee’s bases for the CEO’s compensation reported for the last completed fiscal year, including

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the factors and criteria upon which the CEO’s compensation was based. The committee shall include a specific discussion of the relationship of the registrant’s performance to the CEO’s compensation for the last completed fiscal year, describing each measure of the registrant’s performance, whether qualitative or quantitative, on which the CEO’s compensation was based. (3) The required disclosure shall be made over the name of each member of the registrant’s compensation committee (or other board committee performing equivalent functions or, in the absence of any such committee, the entire board of directors). If the board of directors modified or rejected in any material way any action or recommendation by such committee with respect to such decisions in the last completed fiscal year, the disclosure must so indicate and explain the reasons for the board’s actions, and be made over the names of all members of the board. Instructions to Item 402(k). 1. Boilerplate language should be avoided in describing factors and criteria underlying awards or payments of executive compensation in the statement required. 2. Registrants are not required to disclose target levels with respect to specific quantitative or qualitative performance-related factors considered by the committee (or board), or any factors or criteria involving confidential commercial or business information, the disclosure of which would have an adverse effect on the registrant. (l) Performance Graph. (1) Provide a line graph comparing the yearly percentage change in the registrant’s cumulative total shareholder return on a class of common stock registered under Section 12 of the Exchange Act (as measured by dividing (i) the sum of (A) the cumulative amount of dividends for the measurement period, assuming dividend reinvestment, and (B) the difference between the registrant’s share price at the end and the beginning of the measurement period; by (ii) the share price at the beginning of the measurement period) with (i) the cumulative total return of a broad equity market index assuming reinvestment of dividends, that includes companies whose equity securities are traded on the same exchange or NASDAQ market or are of comparable market capitalization; provided, however, that if the registrant is a company within the Standard & Poor’s 500 Stock Index, the registrant must use that index; and (ii) the cumulative total return, assuming reinvestment of dividends, of: (A) a published industry or line-of-business index; (B) peer issuer(s) selected in good faith. If the registrant does not select its peer issuer(s) on an industry or line-of-business basis, the registrant shall disclose the basis for its selection; or

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(C) Issuer(s) with similar market capitalization(s), but only if the registrant does not use a published industry or line-of-business index and does not believe it can reasonably identify a peer group. If the registrant uses this alternative, the graph shall be accompanied by a statement of the reasons for this selection. (2) For purposes of paragraph (l)(1) of this item, the term “measurement period” shall be the period beginning at the “measurement point” established by the market close on the last trading day before the beginning of the registrant’s fifth preceding fiscal year, through and including the end of the registrant’s last completed fiscal year. If the class of securities has been registered under section 12 of the Exchange Act for a shorter period of time, the period covered by the comparison may correspond to that time period. (3) For purposes of paragraph (l)(1)(ii)(A) of this item, the term “published industry or line-of-business index” means any index that is prepared by a party other than the registrant or an affiliate and is accessible to the registrant’s security holders; provided, however, that registrants may use an index prepared by the registrant or affiliate if such index is widely recognized and used. (4) If the registrant selects a different index from an index used for the immediately preceding fiscal year, explain the reason(s) for this change and also compare the registrant’s total return with that of both the newly selected index and the index used in the immediately preceding fiscal year. Instructions to Item 402(l). 1. In preparing the required graphic comparisons, the registrant should: a. use, to the extent feasible, comparable methods of presentation and assumptions for the total return calculations required by paragraph (l)(1) of this item; provided, however, that if the registrant constructs its own peer group index under paragraph (l)(1)(ii)(B), the same methodology must be used in calculating both the registrant’s total return and that on the peer group index; and b. assume the reinvestment of dividends into additional shares of the same class of equity securities at the frequency with which dividends are paid on such securities during the applicable fiscal year. 2. In constructing the graph: (a) The closing price at the measurement point must be converted into a fixed investment, stated in dollars, in the registrant’s stock (or in the stocks represented by a given index), with cumulative returns for each subsequent fiscal year measured as a change from that investment; and (b) Each fiscal year should be plotted with points showing the cumulative total return as of that point. The value of the investment as of each point plotted on a given return line is the number of shares held at that point multiplied by the then-prevailing share price.

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3. The registrant is required to present information for the registrant’s last five fiscal years, and may choose to graph a longer period; but the measurement point, however, shall remain the same. 4. Registrants may include comparisons using performance measures in addition to total return, such as return on average common shareholders’ equity, so long as the registrant’s compensation committee (or other board committee performing equivalent functions or, in the absence of any such committee, the entire board of directors) describes the link between that measure and the level of executive compensation in the statement required by paragraph (k) of this Item. 5. If the registrant uses a peer issuer(s) comparison or comparison with issuer(s) with similar market capitalizations, the identity of those issuers must be disclosed and the returns of each component issuer of the group must be weighted according to the respective issuer’s stock market capitalization at the beginning of each period for which a return is indicated.

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Appendix B

Summary of Accounting Standards This appendix provides a list and brief summary of the authoritative pronouncements covering accounting for compensation plans and programs. This handy reference tool provides an excellent summary and reference to the applicable accounting rule and standard for further research. For ease of reference, the accounting proclamations are divided into four parts, as follows: 1. 2. 3. 4.

Stock-Based Executive Compensation Arrangements Employee Stock Ownership Plans Deferred Compensation Arrangements Cross-Reference of Accounting Proclamations

Part I is further divided into five subsections covering various aspects of accounting rules. Please refer to the glossary for definitions of terms used in this appendix.

PART I. STOCK-BASED EXECUTIVE COMPENSATION ARRANGEMENTS The key accounting issues that must be addressed for equity-oriented compensation arrangements are as follows: • Is the stock award tantamount to a compensation expense that must be recognized under current accounting principles? • When should one measure compensation cost? • How should one measure compensation expense? • In what accounting period should compensation cost be recognized as expense? 247

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• What are the related tax effects of the stock plan? • How will this stock award affect the financial statement balance sheet? • How will this stock award affect the earnings per share? This brief review of accounting proclamations is divided into five sections, as follows:

Section 1

Principal Area of Interest

Accounting Proclamations

Primary stock award (APB Opinion No. 25 and related EITF and SAB proclamations)

FIN 28

APB 25 FIN 38 FTB 82-2 EITF 84-18 EITF 84-34 EITF 87-6 EITF 87-33 EITF 90-7 SAB 1 FIN 44

2

EPS

APB 15 FIN 31

3

Business combination and capital restructuring

EITF 84-13 EITF 85-45 EITF 90-9

4

Pre-IPO and private company

EITF 87-23 SAB 83 EITF 83-6

5

Investor and principal stockholder

AAI 25 EITF 85-1 SAB 79

Section 1. APB Opinion Number 25 and Related Proclamations APB Opinion No. 25 (APB 25), “Accounting for Stock Issued to Employees”

APB 25 is the primary accounting source that addresses accounting for compensation. Except for broad-based plans that offer stock to substantially all employ-

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ees at no greater than a reasonable discount from market, all stock plans are compensatory. Compensation is measured by the quoted market price of the stock at the measurement date, less any amount the employer must pay. The measurement date is the first date the number of shares and price-per-share are known. Some of the more pertinent measurement date principles include: • Renewing the option or extending its period establishes a new measurement date. • Cash paid to settle an earlier award, including stock reacquired shortly after issuance, measures compensation cost. • Combination plans are accounted for separately; if an employee can elect only one part, the accounting should be based on the part most likely to be elected. Compensation should be recognized over the period that the employee performs services. Unearned compensation should be deducted from equity. The benefit from tax deductions that are permanent differences should be credited to the paid-in-capital account. FASB Interpretation No. 28 (FIN 28), “Accounting for Stock Appreciation Rights and Other Variable Stock Option or Award Plan”

Compensation for these plans should be measured at the end of each period as the amount by which the quoted market value exceeds the option price. Compensation should be charged to expense over the periods in which the employee performs the related services, but must be recognized by the time the employee is vested. Changes in the quoted market value should be measured in the periods in which the changes occur until the date the number of shares and prices are both known. FASB Interpretation No. 38 (FIN 38), “Determining the Measurement Date for Stock Option, Purchase, and Award Plans Involving Junior Stock”

The measurement date is the date on which the number of shares of the employer’s regular common stock that an employee is entitled to receive in exchange for the junior stock is known. FASB Technical Bulletin No. 82-2 (FTB 82-2), “Accounting for the Conversion of Stock Options into Incentive Stock Options as a Result of the Economic Recovery Tax Act of 1981”

If the exercise price of a nonqualified stock option is increased to equal or exceed the fair market value at the original grant date, in order to qualify as an incentive stock option, any previously recorded compensation is reversed; the new terms are evaluated as of the original grant date. If a tandem stock appreciation right (SAR) is cancelled, previously recognized compensation expense is not reversed.

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EITF Issue No. 84-18 (EITF 84-18), “Stock Option Pyramiding”

When an employee exercises a stock option by exchanging shares, unless the employee has held the shares for at least six months (i.e., the shares are “mature”), the option award is, in substance, a variable plan (or a stock appreciation right). EITF Issue No. 84-34 (EITF 84-34), “Permanent Discount Restricted Stock Purchase Plan”

In these plans, the company has a right of first refusal to repurchase the shares at the current market price less the original discount. EITF Issue No. 87-6 (EITF 87-6), “Adjustments Relating to Stock Compensation Plans”

The EITF addressed four separate issues, listed here as EITF 87-6A, B, C, and D. EITF Issue No. 87-6A. “Changes in Stock Option Plans Arising From the Tax Reform Act of 1986”

Minor technical changes linked to the 1986 act would not create a new measurement date if the aggregate effect on the value of the option is de minimis from the perspective of the employee. Changes to the option beyond the minimum necessary for disqualification would presumptively lead to a new measurement date. Because eliminating or changing a sequential exercise requirement may give the employee an economic benefit, such a change may not be de minimis. EITF Issue No. 87-6B. “Stock Option Plan with Tax-Offset Cash Bonus”

Plans with tax-offset cash bonuses must be accounted for as variable plans. EITF Issue No. 87-6C. “Use of Stock Option Shares to Cover Tax Withholding”

An option plan that allows the use of option shares to meet tax withholding requirements may be considered a fixed plan. Compensation expense must be recorded for all shares to satisfy withholding if the fair value of the shares withheld exceeds the reported tax withholding. EITF Issue No. 87-6D. “Phantom Stock-for-Stock Exercise”

An employee presents mature shares (see EITF Issue No. 84-18) to satisfy the exercise price. The company allows the employee to retain the shares presented and issues a certificate for the net shares. This plan remains a fixed plan.

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EITF Issue No. 87-33 (EITF 87-33), “Stock Compensation Issues Related to Market Decline”

This EITF addressed five separate issues: 1. If the exercise price of an option is reduced, or an option is cancelled in exchange for the issuance of a new option that contain identical terms except for a reduced exercise price, then the following rules will apply. If any originally measured compensation is not reversed, then any unamortized amount should continue being amortized. A new measurement date occurs, and compensation is measured using the current market price and the new exercise price. Any compensation in excess of the original amount measured should be amortized. 2. If an option is repurchased in contemplation of the issuance of a new option containing identical terms to the remaining terms of the old option, the guidance in item 1 of this list should be applied. The cash paid represents additional compensation that should be expensed. 3. The conclusions about issues 1 and 2 should also apply to restricted stock awards. 4. A new option is granted for a proportionally fewer number of shares at a lower exercise price, with a stipulation that each share acquired under the new grant is for a proportionate number of shares under the original grant and vice versa. These awards are variable plans because the number of shares and the exercise price are not known. Compensation is measured as the amount by which the market price exceeds the exercise price under the new grant. No additional compensation is recognized after the point that the employee will receive more value from exercising the original grant. 5. If an option contains a tandem stock indemnification right, the right should be accounted for separately only if (a) the individual is subject to the SEC’s sixmonth insider trading restrictions and (b) the right is effective for six months. If the two criteria are not met, the entire arrangement (option plus right) is accounted for as a variable plan. EITF Issue No. 90-7 (EITF 90-7), “Accounting for Reload Stock Options”

A reload stock option automatically awards additional options at the then-current market price whenever existing options are exercised by tendering owned shares. These plans should be accounted for as fixed plans provided that shares tendered are mature as defined by EITF No. 84-18 and that the total number of shares that can be issued net of shares tendered is limited to the shares in the original grant.

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SEC Staff Accounting Bulletin No. 1 (Topic 4E) (SAB 1), “Receivables from Sale of Stock”

Deferred compensation or receivables arising from the issuance of stock or options to employees should be presented in the balance sheet as a deduction from stockholders’ equity. FASB Interpretation No. 38 (FIN 44)

Interpretation 44 is intended by the FASB to provide additional clarification and guidance, within the existing framework of Opinion 25, in several areas of accounting for stock compensation that have emerged in practice over the past years. FIN 44 was effective as of July 1, 2000, and applies to grants of new stock awards and changes that occurred on or after that date. The two exceptions to this rule are (a) stock option repricings and grants to nonemployees that occur after December 15, 1998 and (b) stock options modified to add a reload feature after January 12, 2000. Although the FASB, EITF, and SEC issued many rulings dealing with stock compensation, many of these rulings do not affect executive compensation professionals, because of the limited situations in which they apply. Here is a list (through March 31, 2001) of the 10 rulings that have the most far-reaching effects on stock option practices: 1. Direct and indirect repricing. Variable-award accounting is required for otherwise fixed stock options that are modified to directly or indirectly reduce the exercise price of the award. For example, this would apply to a grant of new stock options with an exercise period that expires upon the earlier of (1) 10 years, or (2) 30 days after the date at which the company’s stock price reaches the exercise price of previously granted underwater stock options. In addition, the EITF clarified that variable-award accounting will not apply to time-based restricted stock issued in exchange for canceling an option. 2. Retroactive reload feature. Adding a reload feature to an already outstanding grant results in variable accounting being required, not only for the existing grant but also for the reload. 3. Modifying terms/conditions of outstanding award. Changing the terms and conditions of an outstanding grant results in either a new measurement date or a requirement for variable accounting. A new measurement date occurs if further changes to the exercise price or number of shares will not occur in future, and variable-award accounting applies if there is no practical way to ascertain whether further changes to the exercise price or number of shares will occur in the future. 4. Exchange of parent options for subsidiary options (and vice versa). The exchange of parent options for subsidiary options in a reciprocal transaction

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5.

6.

7.

8. 9.

10.

253

(e.g., as part of an initial public offering of the subsidiary’s stock) results in a new measurement date but not variable-award accounting. Two conditions must be met: (a) No increase in aggregate intrinsic value (or decrease in aggregate intrinsic loss). (b) No reduction in the ratio of exercise price per share to market price per share. Change in status. A new measurement date must be derived if employees retire and continue to vest in their stock options while providing services to the company. There is no impact if there are no continued services and continued vesting was part of the original terms. Stock-for-tax withholding. Variable-award accounting applies if more than the minimum required statutory withholding is allowed in a stock-for-tax withholding transaction at the volition of the employee or consistently by the grantor company. Privately held company grants. Privately held companies must grant stock options at the fair value of the stock to avoid a profit-and-loss (P&L) charge. In addition, the company must ensure that shares issued upon stock option exercises are not repurchased within six months of exercise if the company wants to avoid P&L charges for the options. Nonemployee directors really employees. Nonemployee directors are considered employees for purposes of stock option accounting under Opinion 25. Consolidated subsidiaries. Parent-company stock grants to employees of consolidated subsidiaries qualify for favorable option accounting under Opinion 25. However, parent-company grants to employees of nonconsolidated subsidiaries result in accounting under FAS 123. Stock option rescission. The rescission of a stock option exercise and reinstatement of the original option will result in variable accounting for the reinstated option.

SEC Staff Announcement Topic No. D-93 (SA D-93), “Accounting for the Rescission of the Exercise of Employee Stock Options”

A stock option exercise rescission will result in adverse accounting consequences for companies that participate in stock option rescission transactions. Specifically: • The forgone tax benefit (if any) must be recognized as additional compensation cost. • The reinstated stock options are subject to variable-award accounting treatment until such time as it is not possible to further rescind a future exercise of the reinstated options (e.g., until expiration or forfeiture of the reinstated options or the end of the tax year in which the reinstated options are exercised).

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• The terms of the rescission must be disclosed in the stock option footnotes to the financial statements, regardless of materiality. • The initial exercise and subsequent rescission should be separately identified in the statement of changes in stockholders’ equity. • The rescinded shares should be included in the calculation of basic earnings per share during the period the shares are outstanding. • The cash-flow consequences of the rescission may in some instances warrant disclosure in “Management’s Discussion and Analysis.” The SEC’s rationale for requiring variable-award accounting for the reinstated stock is that the rescission, in essence, provides the employees with a “put” to the company at a stock price that could be at other than fair value. Under FASB Interpretation No. 44 and EITF Issue No. 00-23, such a repurchase feature requires variable-award accounting. The SEC has provided relief from variable-award accounting treatment for rescission transactions that occurred prior to January 1, 2001. Companies may account for such rescissions as a new measurement date, provided the employee delivers to the company the same shares that were issued upon a previous option exercise. A new measurement date means that companies will generally recognize compensation cost only for the forgone tax benefit at the rescission date, and not for future increases in intrinsic value after that date. Section 2. EPS-Related Accounting Proclamations APB Opinion No. 15 (APB 15), “Earnings Per Share” and Related AICPA Accounting Interpretations of APB Opinion No. 15

The dilutive effect of outstanding stock options and similar arrangements should be calculated using the treasury-stock method. Under that method, earnings-pershare data are computed as if the options had been exercised at the beginning of the period (or date of grant, if later) and as if the funds obtained thereby had been used to purchase the corporation’s own common stock. FASB Interpretation No. 31 (FIN 31), “Treatment of Stock Compensation Plans in EPS Computations”

Funds used in applying the treasury-stock method are the sum of the cash to be received upon exercise, the currently measurable compensation to be charged to expense in the future, and any tax benefits to be credited to capital. FIN 31 also provides guidance on how to account for variable plans, combination plans, or plans payable in stock.

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Section 3. Business Combinations and Capital Restructuring Related Proclamations EITF Issue No. 84-13 (EITF 84-13), “Purchase of Stock Options and Stock Appreciation Rights in a Leveraged Buyout”

The target company must record as compensation expense the amount that it pays to acquire stock options and other stock rights. EITF Issue No. 85-45 (EITF 85-45), “Business Combinations: Settlement of Stock Options and Awards”

If a target company settles stock options voluntarily, at the direction of the acquiring company, or as part of the plan of acquisition, the target must recognize compensation expense. EITF Issue No. 90-9 (EITF 90-9), “Changes in Fixed Employee Stock Option Plans as a Result of Restructuring”

As a result of restructuring in the form of a spinoff or a large, special, nonrecurring dividend, an employee changes outstanding options to offset the effects of the resulting dilution. Any consideration paid should be expensed. Other changes do not result in a new measurement date if (1) the aggregate intrinsic value does not increase, (2) the ratio of option price to the market price of the shares is not reduced, and (3) the vesting and other provisions do not change.

Section 4. Pre-IPO and Private Company Related Proclamations EITF Issue No. 87-23 (EITF 87-23), “Book Value Stock Purchase Plans”

This task force proclamation, which relates primarily to private companies, addresses private-company plans that set the purchase price based on a formula such as book value or earnings and provide for repurchase upon termination or a determinable date using the same formula. If the employee makes a substantial investment that will be at risk for a reasonable period of time, no compensation expense should be recorded for changes in the formula buyback price. Variable-plan accounting must be used between the grant date and exercise date for options to purchase restricted stock based on a formula price. No substantial investment is at risk prior to exercise. Formula stock option plans for public companies are variable plans, although fixed-plan accounting is permitted for grants prior to January 28, 1988, that had been previously accounted for as fixed plans.

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SEC Staff Accounting Bulletin No. 83 (Topic 4D) (SAB 83), “Cheap Stock”

If stock or stock options have been issued below the IPO price within one year of filing an IPO registration statement or in contemplation of the IPO, the stock options should be considered outstanding for all periods presented for the purposes of computing earnings per share. The SEC staff will permit use of the treasurystock method to determine the dilutive effect of options. Registrants must also consider whether compensation should be recognized for these awards. EITF Issue No. 88-6 (EITF 88-6), “Book Value Stock Plan in an Initial Public Offering”

A book-value stock purchase plan of a publicly held company is a performance plan. As such, variable-plan accounting must be used to account for this plan (see EITF 87-23). Book value can provide value for the underlying units for both stock options and stock. These formula-based units are termed book-value stock options and book-value stock. Book-Value Stock Options (BVSO) in an IPO. For BVSOs that do not change

after the IPO, the company should continue variable-plan accounting and expense any increase in book value due to the IPO. For BVSOs that convert to market-value options, compensation expense should be recognized for the difference between market value and book value at the date of the IPO. Because the conversion to a market-value option establishes a new measurement date, no further compensation should be recognized. Book-Value Stock (BVS) in an IPO. If the stock retains its book-value buyback provisions after the IPO, no compensation expense is recognized as a result of the IPO. However, compensation expense should be recognized for subsequent changes in book value. If the restrictions lapse so that the book-value stock converts to marketvalue stock, no compensation expense is recognized at the date of the IPO or in future periods. In either case, if shares were issued within one year or in contemplation of the IPO, compensation expense must be recognized for the increases in book value since the issuance date.

Section 5. Investor and Principal Stockholder Related Proclamations AICPA Accounting Interpretation of APB 25 (AAI 25), “Stock Plans Established by a Principal Stockholder”

In most circumstances, the corporation should account for principal stockholder plans as a contribution of capital by the principal stockholder, with the offsetting

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charge accounted for in the same manner as if the corporation had established the plan. A principal stockholder is an investor that either (1) owns 10 percent or more of an entity’s common stock; or (2) has the ability, directly or indirectly, to control or significantly influence the entity. EITF Issue No. 85-1 (EITF 85-1), “Classifying Notes Received for Capital Stock”

When the entity receives a note rather than cash as a contribution to equity, reporting the note as an asset is generally inappropriate. An exception to this accounting guidance is that, in very limited circumstances, when there is substantial evidence of ability and intent to pay within a reasonably short period of time, the note can be accounted for as an asset. SEC Staff Accounting Bulletin No. 79 (Topic 5T) (SAB 79), “Accounting for Expenses or Liabilities Paid by Principal Stockholder(s)”

When a principal stockholder pays an expense for a registrant, the registrant should reflect the expense and a corresponding capital contribution, unless the stockholder’s action is caused by a relationship or obligation completely unrelated to the stockholder’s position as a stockholder or the registrant clearly does not benefit from the transaction. PART II. EMPLOYEE STOCK OWNERSHIP PLANS An employee stock ownership plan (ESOP) is a special form of tax-qualified defined contribution retirement plan. ESOPs are special in two respects: they are typically issued in the form of the employer’s common or convertible preferred stock, and they are typically purchased with a loan. ESOPs differ from most compensation arrangements because they are tax-qualified plans for large groups of employees rather than management-oriented plans. Unlike most other broad-based compensation arrangements, however, ESOPs invest in and generally distribute to employees the employer’s stock. There are two types of ESOPs, nonleveraged and leveraged. AICPA Statement of Position 76-3 (ASP 76-3), “Accounting Principles for Certain Employee Stock Ownership Plans” This is the primary literature covering the accounting for ESOPs. For leveraged ESOPs, the employer should record the obligation if the employer guarantees the debt or is committed to future contributions sufficient to service debt (also see EITF

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89-10). Expense should be recognized for the contribution to a leveraged ESOP, split into compensation and interest components (also see EITF 89-8). Dividends on ESOP shares should be charged to retained earnings. ESOP shares should be considered outstanding in the earnings per share calculation. FASB Statement No. 96 (FASB 96), “Accounting for Income Taxes” An income tax benefit for the tax deductibility of dividends is recognized as a reduction of income tax expense and is not credited directly to stockholders’ equity. EITF Issue No. 85-11 (EITF 85-11), “Use of an Employee Stock Ownership Plan in a Leveraged Buyout” The EITF did not reach a consensus on this issue of what value should be assigned to the stock purchased by a leveraged ESOP for measuring future compensation expense. EITF Issue No. 86-4 (EITF 86-4), “Income Statement Treatment of Income Tax Benefit for Employee Stock Ownership Plan Dividends” For companies under APB 11, the income tax benefit for the tax deductibility of ESOP dividends should be credited to retained earnings. EITF Issue No. 86-27 (EITF 86-27), “Measurement of Excess Contributions to a Defined Contribution Plan or Employee Stock Ownership Plan” An employer terminates a plan and contributes the excess assets to an ESOP that purchases stock. The amount in excess of the annual contribution is not allocated to participants. The unallocated shares should be reported as treasury stock. Compensation expense should be recognized at the allocation date at the then-current market price; any difference from the purchase price is reflected in equity. Dividends used to purchase more stock should be charged to treasury stock rather than retained earnings. Dividends paid to participants on unallocated shares should be charged to compensation expense. The sponsor should report its own debt securities owned by the ESOP as both an asset and a debt. Unallocated shares will not be outstanding shares for earnings per share purposes.

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EITF Issue No. 87-23 (EITF 87-23), “Book Value Stock Purchase Plans” When the employees of a private company sell their ESOP shares to the company or the ESOP for cash using a formula price, the employer should not recognize compensation expense at the time of the buyback. EITF Issue No. 88-27 (EITF 88-27), “Effect of Unallocated Shares in an Employee Stock Ownership Plan on Accounting for Business Combinations” Unallocated shares held by an ESOP should not be considered tainted for purposes of determining if pooling-of-interests accounting is appropriate unless: 1. There is more than a remote chance that such shares would revert to the sponsor, 2. The sponsor has agreed to repurchase shares (except if required by law to provide liquidity to the participant), or 3. The shares were acquired to circumvent the APB 16 requirements. EITF Issue No. 89-8 (EITF 89-8), “Expense Recognition for Employee Stock Ownership Plans” Companies must use the shares-allocated method for all stock acquired by a leveraged ESOP after December 14, 1989. Under the shares-allocated method, interest expense is recorded as incurred and compensation expense is recorded equal to the ratio of shares allocated for the period to total shares purchased, times the original cost of the shares purchased. Dividends on ESOP shares are charged to retained earnings and, if used to service the ESOP debt, reduce reported expense. EITF Issue No. 89-10 (EITF 89-10), “Sponsor’s Recognition of Employee Stock Ownership Plan Debt” ESOP debt should be recorded as a liability in the sponsor’s balance sheet, even if the sponsor does not guarantee it. EITF Issue No. 89-11 (EITF 89-11), “Sponsor’s Balance Sheet Classification of Convertible Preferred Stock with a Put Option Held by an Employee Stock Ownership Plan” Public companies should classify these shares outside of equity if the employer is required to satisfy the put option partly or wholly in cash. If a combination of

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common stock and cash may be used, the sponsor may either split the classification based on the market price of common or classify the entire amount outside of equity. The deferred compensation debit should be classified consistent with and in the same proportion as the preferred stock. EITF Issue No. 89-12 (EITF 89-12), “Earnings-Per-Share Issues Related to Convertible Preferred Stock Held by an Employee Stock Ownership Plan” The numerator of the EPS computation under the “if converted” method should reflect a reduction for an employer contribution equal to the difference between the dividends on the convertible preferred stock and the common stock. EITF Issue No. 90-4 (EITF 90-4), “Earnings-Per-Share Treatment of Tax Benefits for Dividends on Stock Held by an Employee Stock Ownership Plan” The tax benefit on convertible preferred stock dividends should be reflected in the computation of primary earnings per share, because the preferred dividend itself is deducted from earnings available for common stock (this assumes that the convertible preferred stock is not a common-stock equivalent). SEC Staff Announcement on the Impact of Tainted Shares (SSA—Sep 89) As of the September 1989 meeting of the EITF, the SEC staff stated its position with respect to whether the treasury stock purchased in conjunction with the formation of a leveraged preferred stock ESOP, in order to satisfy future conversion or puts, is “tainted” for pooling-of-interests purposes. The staff would not consider shares tainted if certain requirements are met. One of the requirements is that the decision to acquire shares coincide with the creation of the ESOP.

PART III. DEFERRED COMPENSATION ARRANGEMENTS Cash-oriented deferred compensation arrangements are agreements between the employer and one or more selected or key employees whereby the employer agrees to make cash payments to the employee at some future date, frequently after the employee retires. The cash payments may be in the form of delayed payments, re-

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tirement benefits, or death benefits. The agreement frequently provides that payments and/or the level of payments will be contingent on the occurrence of certain events, such as the employee remaining with the company until a certain age or normal retirement age. Cash-deferred compensation arrangements include simple cash deferral contracts, profit-sharing plans, life insurance arrangements, golden parachutes, and other common forms of deferred compensation. Under a deferred compensation arrangement, an employer promises to exchange future cash payments for an employee’s current services. The employer’s obligation to provide benefits arises as the employee renders the service necessary to earn the benefits pursuant to the plan. Accordingly, the discounted present value of the estimated future payments should be accrued in a systematic and rational manner during the period that the employee renders service and becomes eligible for the benefit. Interest accrues on the recorded liability, just as for any other liability recorded at a discounted present value.

APB Opinion No. 12 (APB 12), “Omnibus Opinion—1967” APB 12 is the primary literature that addresses cash-based deferred compensation contracts. The present value of estimated amounts payable under each individual contract should be accrued in a systematic and rational manner over the service period that ends at the full eligibility date. Benefits that include periodic payments for life should be based on individual life expectancy or the cost of an annuity contract.

FASB Technical Bulletin 85-4 (FTB 85-4), “Accounting for Purchases of Life Insurance” Life insurance premiums should be charged to expense. Cash surrender value (CSV) should be reported as an asset. The change in CSV or contract value adjusts premium expense each period. If the increase in CSV or contract value in a period exceeds the premium, the net amount is an income credit.

EITF Issue No. 88-23 (EITF 88-23), “Lump-Sum Payments under Union Contracts” When union employees receive a lump-sum payment in connection with a new union contract, a portion of that payment may be deferred and amortized if the payment clearly benefits future periods in the form of lower wages than otherwise would have existed.

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FASB Statement No. 43 (FAS 43), “Accounting for Compensated Absences” A liability that must be accrued for vacation benefits earned but not taken. A liability is not accrued for sick pay or holidays until the employee is absent.

PART IV. CROSS-REFERENCE OF ACCOUNTING PROCLAMATIONS Accounting Proclamation

Reference

AAI 25

Part I/Section 5

APB 12

Part III

APB 15

Part I/Section 2

APB 25

Part I/Section 1

ASP 76-3

Part II

EITF 84-13

Part I/Section 3

EITF 84-18

Part I/Section 1

EITF 84-34

Part I/Section 1

EITF 85-1

Part I/Section 5

EITF 85-11

Part II

EITF 85-45

Part I/Section 3

EITF 86-4

Part II

EITF 86-27

Part II

EITF 87-6

Part I/Section 1

EITF 87-23

Part I/Section 4, Part II

EITF 87-33

Part I/Section 1

EITF 88-6

Part I/Section 4

EITF 88-23

Part III

EITF 88-27

Part II

EITF 89-8

Part II

EITF 89-10

Part II

EITF 89-11

Part II

EITF 89-12

Part II

EITF 90-4

Part II

EITF 90-7

Part I/Section 1

EITF 90-9

Part I/Section 3

FASB 43

Part III

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Accounting Proclamation

Reference

FASB 96

Part II

FIN 28

Part I/Section 1

FIN 31

Part I/Section 2

FIN 38

Part I/Section 1

FIN 44

Part I/Section 1

FTB 82-2

Part I/Section 1

FTB 85-4

Part III

SAB 1

Part I/Section 1

SAB 79

Part I/Section 5

SAB 83

Part I/Section 4

SSA—Sep 89

Part II

263

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Appendix C

Definitions Pertaining to Tax Rules and Regulations Here is a list of definitions relating to the tax treatment of compensation. These definitions are also included in the glossary. Alternative Minimum Tax (AMT). An alternative method of calculating income tax liability that requires the taxpayer to include in his or her taxable income a number of tax preference items that are deductions under the regular income tax rules. The AMT rates start at 26 percent (28 percent at higher income levels). You compare your AMT to the regular tax owed and pay the higher amount to the government. Upon the exercise of incentive stock options (ISOs), the excess of the fair market value of the option shares over the option exercise price, though not taxable for the regular income tax liability calculation, is a tax preference item that must be taken into account in your AMT calculation. No AMT applies when you sell the stock in the year of exercise. If you do have AMT, you will have an AMT credit that will reduce the taxes you owe in future years. AMT credit. If you owe AMT for your ISO exercise, all or a part of the excess of the amount of your AMT liability over your regular tax liability for that year could generate a tax credit. It is applied against your regular taxes in one or more later years. The calculation is not simple and requires a tax professional. The credit could be available to you if exercising ISOs instead of other tax events triggered the AMT you paid in prior years. Tax items that trigger AMT because they result in an exclusion of income for regular tax purposes rather than a deferral of taxation (such as payment of state taxes) do not result in tax credits. If you are eligible for a tax credit resulting from the exercise of your ISOs, that credit may be applied directly against your tax liability in years in which your regular tax liability exceeds your AMT liability. The AMT tax credit can only be used to reduce your regular tax liability by the amount it exceeds your AMT liability for each year. The balance of the credit carries forward and may be used in subsequent years. Applicable federal rate (AFR). If you are receiving or making payments for a loan or installment sale, but little or no interest is stated on the contract, the IRS assumes a rate of interest based on the published applicable federal rate. For instance, if an employee received a loan repayable over five years, and the interest rate charged to the employee was less than 264

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the AFR, then the IRS would determine the amount of imputed interest, which will be equal to the AFR less the interest rate of the loan. See also imputed interest. Basis. Cost of stock for calculating your gains or losses for tax purposes. For equity compensation, the basis includes the costs plus any compensation income reported (e.g., amount for ordinary income tax on NQSO spread). To calculate your capital gains, subtract your basis from the amount realized on the sale of stock. If you sell stock through a broker, the Form 1099-B will report the entire amount received that you use to determine the capital gain or loss. Capital gain (loss). Profit (or loss) from the sale of a capital asset, such as stock received upon exercise of options. Capital gains may be short-term (held 12 months or less) or longterm (held more than 12 months). Capital losses are used to offset capital gains to establish a net position for tax purposes. Only $3,000 of net capital losses can be deducted in any one year; the remaining balance is carried over to future years indefinitely. The long-term capital gains tax rate is generally 20 percent. If you are in the 15 percent tax bracket for regular tax purposes, then your capital gain rate is only 10 percent. Lower long-term capital gains tax rates (18 percent and 8 percent, respectively) apply to stock sales after December 31, 2000, if the stock has been held for more than five years. If you are in a tax bracket higher than 15 percent, the five-year holding period for this purpose does not start to run until January 1, 2001. The 18 percent rate will apply only to gains on stock you purchase after 2000, or stock received on exercise of options granted after 2000. Short-term capital gains are taxed at the same rates as wages and other ordinary income. When you have multiple securities transactions, additional rules on netting them apply. Note that you must file a Schedule D, Capital Gains and Losses, with your federal IRS 1040 tax return for any tax year in which you sell stock, regardless of whether you have a capital gain. Capital loss limitation. Net long-term capital losses and net short-term capital losses may be used to offset up to $3,000 of ordinary income. To reach the net amounts to determine deductibility, total all capital gains and losses. Amounts of more than $3,000 can be carried forward to future years until all of the net capital losses are used. Constructive receipt. Refers to when compensation is taxable to the employee. The recipient has control over and access to the payment. Constructive sale. Tax term that allows the IRS to recharacterize as a sale a transaction that eliminates the risk of loss and the opportunity for gain. This concept, which first appeared in the 1997 Taxpayer Relief Act, eliminated certain viable long-term stock hedging strategies, such as short-against-the-box and many equity swaps. Properly structured equity collars and prepaid forwards do not trigger constructive sale treatment, although the IRS could issue additional regulations. Deemed sale. Technique that allows you to take advantage of the lower capital gains rule for stock held more than five years by resetting the holding period start date and tax basis to the beginning of 2001, when this provision on five-year holdings went into effect. Lower long-term capital gains tax rates (18 percent and 8 percent, depending on your tax bracket) apply to sales after December 31, 2000. If you are in a tax bracket higher than 15 percent, your five-year holding period for this purpose does not start to run until January 1, 2001.

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This strategy involves the factitious selling of an asset at its current value, buying it back at the same price, and paying the appropriate taxes on the sale without actually going through the process of doing it. The deemed sale is treated as having occurred on January 2, 2001, for securities, and January 1, 2002, for all other assets. De minimis benefit. Services that an employer provides to employees that are considered too minimal to be subject to taxable income. Disqualifying disposition (incentive stock options). A sale, gift, or exchange of ISO shares within two years from the grant date or one year from the exercise date. Upon a disqualifying disposition, the employee recognizes taxable ordinary income, and the company is entitled to claim a deduction equal to the excess of the fair market value on the exercise date or the sale price, whichever is lower, over the exercise price. Early exercisable options. Options that are immediately exercisable (i.e., early), but that typically do not start vesting until six months to a year after grant. The underlying shares received at exercise are restricted and subject to a repurchase right by the company at the exercise price until they are vested. Early exercise starts the capital gain clock ticking for a later resale. No gains are realized on the spread from the option exercise until vesting or until a Section 83(b) election is filed. Availability of this feature is becoming common among pre-IPO company stock plans and is sometimes referred to as “reverse vesting.” Economic Recovery Tax Act (ERTA) of 1981 (1981 Tax Act). ERTA emphasized the deferral of compensation, and also reduced ordinary income tax rates. It introduced the concept of the incentive stock option (ISO). Employee stock purchase plan (ESPP). A type of broad-based stock plan that permits employees to use payroll deductions accumulated over a 3-, 6-, 12-month, or longer purchase period to acquire stock from the company, generally at a 15 percent discount. A popular type of ESPP is also known as a “Section 423 plan,” after the applicable tax code section governing this type of plan. Form 1099-B. Form from a broker showing how much you received from securities sales, such as the proceeds from a cashless exercise. You use this amount, along with your tax basis, to calculate your gain or loss for tax purposes on Schedule D. Form 1099-MISC. Tax form that nonemployees (e.g., consultants, independent contractors) receive that reports income/compensation; similar in concept to the Form W-2 for employees. For nonemployees, withholding does not apply when NQSOs are exercised. The spread at exercise is compensation for services. Thus, self-employment tax, along with state and federal income tax, applies when you file your tax return. Golden parachute. An employment agreement that assures compensation and benefit payments in the event of a change of control or ownership. One or several events are necessary to trigger parachute payments. IRC §§ 280G and 4999 limit deductibility and govern amounts subject to 20 percent excise tax and corporate tax deductions. Imputed interest. Interest that the IRS assumes has been paid on a loan if the stated interest is below a minimum interest rate (the applicable federal rate). Incentive stock option (ISO). A stock option that has met certain tax requirements that entitle the option holder to favorable tax treatment. Such an option is free from regular tax at the date of grant and the date of exercise (when a nonqualified option would become taxable).

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If two holding-period tests are met (two years between grant date and sale date and one year between the exercise date and sale date), the profit on the option qualifies as a long-term capital gain rather than ordinary income. If the holding periods are not met, there has been a disqualifying disposition. Individual retirement account (IRA). An individual pension fund that anyone may open with a bank. An IRA permits investment of contributed funds through intermediaries such as mutual funds, insurance companies, and banks; or directly in stocks and bonds, through stockbrokers. Because it is intended for retirement, money in an IRA enjoys many tax advantages over traditional investments, but may not be withdrawn early without heavy penalty fees. Look-back feature. Provision in an IRC § 423 employee stock purchase plan (ESPP). The purchase price (with or without a discount) is based on the lower of the market price at the beginning or end of the purchase period (a typical plan purchase period might run for six months). For example, for a plan with a look-back feature and a 15 percent discount, if the stock price is $10 at the beginning of the purchase period and goes up to $20 at the end, your purchase price is just $8.50 ($10 minus 15 percent). Nonqualified stock option (NQSO). An employee stock option not meeting the IRS criteria for ISOs (incentive stock options) and therefore triggering a tax upon exercise. This type of option requires withholding of state and federal income tax, Medicare, and FICA/FUTA on the excess of the fair market value over the exercise price on the exercise date. Qualified plan. Generally, a plan that meets qualifications under the applicable sections of the Internal Revenue Code. A plan whereby the employer can take a tax deduction with respect to accrual of an as-yet unpaid benefit. For example, a qualified defined benefit pension allows a company to take a tax deduction for the accrual of a pension benefit. Qualified stock option (QSO). A stock option that meets the requirements established by IRC § 422. A QSO is also referred to as an ISO. Qualifying disposition. Transfer (e.g., by gift or sale) of ISO or ESPP shares after the required holding period of two years from the grant date or one year from the purchase/exercise date. Section 162(m). The section of the IRC establishing tax regulations related to the $1 million cap on deductible business expense for non-performance-based compensation to a publicly held corporation’s named executive officers. Section 83(b) election. A tax filing within 30 days of grant that allows employees given restricted stock to pay taxes on the grant date instead of on the date restrictions lapse. If an employee files the election, taxes are based on the fair market value on the grant date, with any future appreciation taxed as a capital gain. If the employee does not file an election, taxes are based on the fair market value on the date the restrictions lapse, which will be higher assuming the stock has appreciated in value. For early exercise options, the election essentially says that you agree to recognize now, as ordinary income for NQSOs and as an AMT item for ISOs, any spread between the fair market value of the stock and your exercise price. In this way, the future appreciation on the company’s stock can be taxed at favorable long-term capital gains rates upon sale of the underlying stock.

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Short-against-the-box. A short sale by an investor who also owns the stock being sold is referred to as a sale “against the box,” meaning it is a sale versus the broker’s “box” position, not the stock in the account of the person who is short-selling. Strategies of this type are generally referred to as hedging strategies. To defer capital gain recognition until the next tax year, the short sale must be: • Covered before the end of January of the next year. • The shares held must continue to be held for at least 60 days after the short is closed. • The shares held must not be otherwise protected from loss by an alternate hedge strategy. Thus, the short is closed by buying back the stock (to cover) and, in order to get the favorable tax treatment, holding the owned stock for at least 60 days. Substantial risk of forfeiture. Tax term that applies when rights to compensation are conditioned upon future performance of services (e.g., working X years for a company) or the occurrence of some activity (e.g., reaching a performance or stock price goal). As it relates to restricted stock and early exercise stock options, income is not recognized while the stock is subject to a risk of forfeiture (e.g., vesting), unless a Section 83(b) election is filed with the IRS within 30 days of when a grant is received or an option is exercised. W-2. Form received from your employer that shows amounts of ordinary income you received and any amounts withheld. For stock options, it includes gains from NQSO exercises, gains from ISO exercises if you made a disqualifying disposition, and amounts withheld for NQSOs. W-8. Certificate of Foreign Status form required by the IRS to tell the payer, transfer agent, broker, or other intermediary that an employee is a nonresident alien or foreign entity that is not subject to U.S. tax reporting or backup withholding rules. W-9. Request for Taxpayer Identification Number and Certification form required by the IRS to furnish the payer, transfer agent, broker, or other intermediary with an employee’s social security or taxpayer identification number. The filing of this form allows the employee not to be subject to backup withholding because of underreporting of interest and dividends on his or her tax return. Wash sale. When you sell stock at a loss and buy the same company’s stock within 30 days before or after the sale, you cannot claim the loss on the sale. The disallowed loss and holding period from the old stock are added to the basis and holding period of the new stock.

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Appendix D

Organizations and Periodicals Many organizations provide information to compensation committee members. This appendix lists organizations that provide information on compensation, the roles of the board and directors, corporate governance, and shareholder issues of various types. You can join some of these organizations for a nominal annual fee; for others, you can just access their Web sites. In addition, there is a list of relevant periodicals, some of which are free. Please also refer to the bibliography for further reading. ORGANIZATIONS

Organization

Address and Other Information

Contacts

American Management Association

1601 Broadway New York, NY 10019-7420 www.amanet.org Tel#: (800) 262-8699 Fax#: (212) 903-8168

Contact Customer Service at (800) 262-8699

The American Society of Corporate Secretaries

521 Fifth Avenue New York, NY 10175 [email protected] www.ascs.org Tel#: (212) 681-2000 Fax#: (212) 681-2005

David W. Smith, President

Business Roundtable

1615 L Street, NW, Suite 1100 Washington, DC 20036 www.brt.org Tel#: (202) 872-1260 Fax#: (202) 466-3509

John Dillon, Chairman and CEO of International Paper Company

Deborah Fox, Administrator, Membership

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270

Organization

Organizations and Periodicals

Address and Other Information

Contacts

California Public Employees Retirement System (CalPERS)

Lincoln Plaza 400 P Street Sacramento, CA 95814 www.calpers.org Tel#: (916) 326-3000 Fax#: (916) 326-3507

Dr. William Dale Crist, President, Board of Administration

The Center for Corporate Law at the University of Cincinnati Law School

POB 210040 Cincinnati, OH 45221-0040 www.law.uc.edu/grafsite/ cntrs/corp.html Tel#: (513) 556-6805 Fax#: (513) 556-2391

Professor Peter V. Letsou, Director

The Conference Board

845 Third Avenue New York, NY 10022-6679 www.conference-board.org info@conference_board.org Tel#: (212) 759-0900 Fax#: (212) 980-7014

Richard E. Cavanagh, President and CEO

Corporate Governance

2461 Second Avenue Sacramento, CA 95818 www.corpgov.net

Mr. James McRitchie

Corporate Governance Center at Kennesaw State College

1000 Chastain Road Kennesaw, GA 30144 www.coles-kennesaw.edu Tel#: (770) 423-6587 Fax#: (770) 423-6606

Professor Paul Lapides

The Corporate Library

Nell Minow, Suite 800 Editor 1200 G Street NW Washington, DC 20005 www.thecorporatelibrary.com nminow@thecorporate library.com Tel#: (202) 434-8723 Fax#: (202) 783-3316

Council of Institutional Investors

1730 Rhode Island Avenue, NW Suite 512 Washington, DC 20036 www.ciicentral.com [email protected] Tel#: (202) 822-0800 Fax#: (202) 822-0801

Randall E. Poe, Executive Director, Communications

Sarah A. B. Teslik, Executive Director

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Organizations

Organization

271

Address and Other Information

Contacts

Family Held Enterprise

2433 Livingston Road SW Roanoke, Virginia 24015 www.afhe.com [email protected] Tel#: (540) 772-0255

Sarah E. Ratliff, Executive Director [email protected]

Foundation for Enterprise Development

2020 K Street, NW, Suite 400 Washington, DC 20006 [email protected] www.fed.org Tel#: (202) 530-8920 Fax#: (202) 530-5702

Stan Lundine, Executive Director (716) 488-1911

1730 Rhode Island Avenue, NW Suite 1008 Washington, DC 20036 [email protected] www.hacr.org Tel#: (202) 835-9672 Fax#: (202) 457-0455

Ms. Anna Escobado Cabral, President and Chief Executive Officer

Institutional Shareholder Services

1455 Research Boulevard Fourth Floor Rockville, MD 20850 www.iss.cda.com Tel#: (301) 545-4555 Fax#: (301) 545-4509

Patrick S. McGurn, Vice President, Corporate Programs

Investment Company Institute

1401 H Street NW Washington, DC 20005 www.ici.org Tel#: (202) 326-5800

Matthew P. Fink, President

Investor Responsibility Research Center

1350 Connecticut Avenue, Suite 700 Washington, DC 20036-1702 www.irrc.org Tel#: (202) 833-0700 Fax#: (202) 833-3555

Mr. Scott Fenn, Executive Director

1707 L Street, NW, Suite 560 Washington, DC 20036 [email protected] www.nacdonline.org Tel#: (202) 775-0509 Fax#: (202) 775-4857

Roger W. Raber, President and CEO

Hispanic Association on Corporate Responsibility

National Association of Corporate Directors

David Binns, Associate Director

[email protected]

Ms. Carol Bowie, Director of Corporate Governance Services

Alexandra R. Lajoux, Director of Publications & Research Lois S. Morton, Manager of Membership & Education

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272

Organization

Organizations and Periodicals

Address and Other Information

Contacts

P.O. Box 21639 Concord, CA 94521-0639 www.nasspp.com Tel#: (925) 685-9271 Fax#: (925) 685-5402

Mr. Jesse Brill, Chairperson

1736 Franklin Street 8th Floor Oakland, CA 94612-1217 [email protected] www.nceo.org Tel#: (510) 208-1300 Fax#: (510) 272-9510

Corey Rosen, Executive Director

National Investor Relations Institute

8045 Leesburg Pike, Suite 600 Vienna, VA 22182 www.niri.org Tel#: (703) 506-3570 Fax#: (703) 506-3571

Mr. Louis M. Thompson, Jr., President & CEO

The New York Society of Security Analysts

One World Trade Center Suite 4447 New York, NY 10048 www.nyssa.org Tel#: (212) 912-9249 Fax#: (212) 912-9310

Wayne Whipple, Executive Director

TIAA-CREF

730 Third Avenue New York, NY 10017 www.tiaa-cref.org Tel#: (212) 490-9000

Mr. John H. Biggs, Chairman, President and CEO

World at Work (formerly known as American Compensation Association)

1440 N. Northsight Boulevard Scottsdale, AZ 85260-3601 [email protected] www.worldatwork.org Tel#: (480) 922-2020 (800) 951-9191 Fax#: (480) 483-8352

Anne C. Ruddy, CPCU, Executive Director

National Association of Stock Plan Professionals

The National Center for Employee Ownership

Ms. Sandra Sussman, Executive Director

Ed Carberry, Director of Communications Ryan Weeden, Project Director

Nancy Cass, Director of Programs

Charles Allen, Director of Compensation Group

Publisher The Conference Board

Jossey-Bass Publisher

National Center for Nonprofit Boards

Ralph Ward

Name of Periodical

Across The Board

Board Leadership: A bimonthly workshop with John Carver

Board Member

Boardroom INSIDER

PERIODICALS

Ralph Ward

Monthly or as needed

273

(Continued)

10686 W. Lincoln Road Riverdale, MI 48877 www.boardroominsider.com Tel#: (517) 833-7615 Fax#: (517) 833-7615

2000 L Street NW, Suite 510-L Washington, DC 20036-4907 www.ncnb.org Tel#: (202) 452-6262 Fax#:

Tel#: (404) 728-9444 Fax#: (404) 728-0060

P.O. Box 13007 Atlanta, GA 30324-0007 [email protected] www.carvergoverance.com

845 Third Avenue New York, NY 10022-6679 www.conference-board.org [email protected] Tel#: (212) 759-0900 Fax#: (212) 980-7014

Address/E-mail/Web site Telephone Number

2:00 PM

Bimonthly

Monthly

Frequency

10/26/01

John and Miriam Carver

A. J. Vogl

Editor(s)

3804 P-16 (APPD) Page 273

274 Publisher Business Week

Vanguard Publications

The National Association of Stock Plan Professionals

The National Association of Stock Plan Professionals

Name of Periodical

Business Week’s Annual Executive Compensation Survey

The Corporate Board

The Corporate Counsel

The Corporate Executive

Jesse Brill or Michael Gettelman

Jesse Brill or Michael Gettelman

Bimonthly

Bimonthly

P.O. Box 21639 Concord, CA 94521-0639 [email protected] www.nasspp.com Tel#: (925) 685-9271 Fax#: (925) 685-5402

P.O. Box 21639 Concord, CA 94521-0639 [email protected] www.nasspp.com Tel#: (925) 685-9271 Fax#: (925) 685-5402

4440 South Hagadorn Road Okemos, MI 48864 www.corporateboard.com [email protected] Tel#: (517) 336-1700 Fax#: (517) 336-1705

1221 Avenue of the Americas New York, NY 10020-1095 www.businessweek.com Tel#: (212) 512-2511 Fax#: (212) 512-4589

Address/E-mail/Web site Telephone Number

2:00 PM

Monthly

Annually published in early April

Frequency

10/26/01

Judy Scheidt

Louis Lavelle

Editor(s)

3804 P-16 (APPD) Page 274

Corporate Governance.Net

Aspen Law & Business/ Aspen Publications

Investor Responsibility Research Center

Mark Latham

The American Society of Corporate Secretaries

Corporate Governance

Corporate Governance Advisor

Corporate Governance Bulletin

Corporate Monitoring Newsletter

The Corporate Secretary

David Smith

Mark Latham

Quarterly

Quarterly

275

(Continued)

521 Fifth Avenue New York, NY 10175 [email protected] www.ascs.org Tel#: (212) 681-2000 Fax#: (212) 681-2005

10 Miller Place, #1701 San Francisco, CA 94108 [email protected] www.corpmon.com Tel#: (415) 391-7198 Fax#: (415) 680-1521

1350 Connecticut Avenue, Suite 700 Washington, DC 20036-1702 www.irrc.org Tel#: (202) 833-0700 Fax#: (202) 833-3555

1185 Avenue of the Americas New York, NY 10036 www.aspenpublishers.com [email protected] Tel#: (800) 638-8437 Fax#: (202) 467-0539

2461 Second Avenue Sacramento, CA 95818 [email protected] www.corpgov.net Tel#: (530) 542-5338

2:00 PM

Quarterly

Bimonthly

As needed

10/26/01

Maryanne Moore

Amy L. Goodman (attorney, Gibson, Dunn & Crutcher, LLP) (202) 955-8653

James McRitchie

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276 Publisher Bloomberg Information

Tower Media, Inc.

MLR Holdings LLC

The National Association of Corporate Directors

Name of Periodical

Crystal Column

Director’s Alert

Directors & Boards

Director’s Monthly

Alexandra R. Lajoux

Monthly

Quarterly

1707 L Street, NW, Suite 560 Washington, DC 20036 [email protected] www.nacdonline.org Tel#: (202) 775-0509 Fax#: (202) 775-4857

1845 Walnut Street Suite 900 Philadelphia, PA 19103-4709 www.directorsandboards.com [email protected] Tel#: (800) 637-4464 Fax#: (215) 405-6078

211 East 43rd Street, 20th Floor New York, NY 10017 www.directorsalert.com [email protected] Tel#: (212) 949-4288 Fax#: (212) 949-6121

3519 Daybreak Court Santa Rosa, CA 95404-2042 www.crystalreport.com [email protected] Tel#: (707) 591-0464 Fax#: (707) 591-0645

Address/E-mail/Web site Telephone Number

2:00 PM

James Kristie

Monthly

Monthly

Frequency

10/26/01

Barbara Ettorre

Graef Crystal

Editor(s)

3804 P-16 (APPD) Page 276

Directorship, Inc.

Executive Compensation Advisory Services

Foundation for Enterprise Development

Forbes

Directorship

Executive Compensation Reports

FED Newsletter

Forbes’s Magazine Annual Executive Compensation Survey

Scott DeCarlo

Annually published in May

(Continued)

60 Fifth Avenue New York, NY 10011 www.forbes.com [email protected] Tel#: (212) 620-2338 Fax#: (212) 620-1863

2020 K Street, NW, Suite 400 Washington, DC 20006 [email protected] www.fed.org Tel#: (202) 530-8920 Fax#: (202) 530-5702

1737 King Street Suite 330 Alexandria, VA 22314 [email protected] www.ecasonline.com Tel#: (703) 837-9019

8 Sound Shore Drive Greenwich, CT 06830 www.directorship.com [email protected] Tel#: (203) 618-7000 Fax#: (203) 618-7007

2:00 PM

Quarterly

Twice monthly

Monthly

10/26/01

Cindy Payne

David L. Haase

Bruce E. Beebe

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277

278 Publisher Aspen Law & Business/ Aspen Publications

Securities Data Publishing

Kennedy Information, Inc.

National Investor Relations Institute

Name of Periodical

Insights: Corporate Securities Law Advisor

Investor Relations Business

Investor Relations Newsletter

IR Quarterly

Beth Carty

Quarterly

Monthly

8045 Leesburg Pike Suite 600 Vienna, VA 22182 www.niri.org [email protected] Tel#: (703) 506-3570 Fax#: (703) 506-3571

One Kennedy Place Fitzwilliam, NH 03447 http://www.kennedyinfo.com [email protected] Tel#: (800) 531-8007 Fax#: (603) 585-9555

40 West 57th Street New York, NY 10019 www.tfn.com [email protected] Phone:(212) 765-5311 Fax: (212) 956-0112

1185 Avenue of the Americas New York, NY 10036 www.aspenpublishers.com [email protected] Tel#: (800) 638-8437 Fax#: (202) 467-0539

Address/E-mail/Web site Telephone Number

2:00 PM

Bimonthly

Monthly

Frequency

10/26/01

David Beck

Amy L. Goodman (attorney, Gibson, Dunn & Crutcher, LLP) (202) 955-8653

Editor(s)

3804 P-16 (APPD) Page 278

National Investor Relations Institute

Institutional Shareholder Services

West Group

The National Center for Employee Ownership

IR Update

The ISS Friday Report

The Journal of Compensation and Benefits

Journal of Employee Ownership

Scott Rodrick

Quarterly

Bimonthly

(Continued)

1736 Franklin Street 8th Floor Oakland, CA 94612-1217 [email protected] www.nceo.org Tel#: (510) 208-1300 Fax#: (510) 272-9510

West Group 155 Pfingsten Road Deerfield, IL 60015 Tel#: 1-800-328-4880

1455 Research Boulevard Fourth Floor Rockville, MD 20850 www.iss.cda.com Tel#: (301) 545-4555

8045 Leesburg Pike Suite 600 Vienna, VA 22182 www.niri.org [email protected] Tel#: (703) 506-3570 Fax#: (703) 506-3571

2:00 PM

Jeffrey D. Mamorsky

Weekly

Monthly

10/26/01

Patrick McGurn

Beth Carty

3804 P-16 (APPD) Page 279

279

280 Publisher Foundation for Enterprise Development

The National Association of Stock Plan Professionals

The National Center for Employee Ownership

The Wall Street Journal

Name of Periodical

Leading Companies (Internet publication)

The NASPP Advisor

NCEO Newsletter

The Wall Street Journal’s Annual Chief Executive Officer Compensation Survey

Joann S. Lublin

Scott Rodrick

Annually published in early April

Bimonthly

200 Liberty Street New York, NY 10281 www.wsj.com Tel#: (212) 416-2000 Fax#: (212) 416-2653

1736 Franklin Street 8th Floor Oakland, CA 94612-1217 [email protected] www.nceo.org Tel#: (510) 208-1300 Fax#: (510) 272-9510

P.O. Box 21639 Concord, CA 94521-0639 [email protected] www.nasspp.com Tel#: (925) 685-9271 Fax#: (925) 685-5402

2020 K Street, NW, Suite 400 Washington, DC 20006 [email protected] www.fed.org Tel#: (202) 530-8920 Fax#: (202) 530-5702

Address/E-mail/Web site Telephone Number

2:00 PM

Monthly

Monthly

Frequency

10/26/01

Sandra Sussman or Bruce Brumberg

Brett Pollak

Editor(s)

3804 P-16 (APPD) Page 280

World at Work

World at Work

World at Work Journal

Workspan

Barbara Parus

Dan Cafaro

Monthly

Quarterly

440 N. Northsight Boulevard Scottsdale, AZ 85260-3601 [email protected] www.worldatwork.org Tel#: (480) 922-2050 Fax#: (480) 483-8352

1440 N. Northsight Boulevard Scottsdale, AZ 85260-3601 [email protected] www.worldatwork.org Tel#: (480) 348-7226 Fax#: (480) 483-8352

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Appendix E

List of Directors Colleges and Other Training Opportunities Sponsoring Organization

Harvard Business School Executive Education

Name of Program

Making Corporate Boards More Effective

Length of Program

3 days

Cost of Program

$5,250

Description of Course

The program addresses critical issues facing boards today, including: • Changing legal responsibilities of directors • Board composition and director selection • Setting time-efficient agendas • Conducting dynamic, constructive board meetings • Effective use of committees • Role of the board in strategic planning and as an agent of positive change • Designing performance scorecards to monitor business strategy and management performance • Role of the board and audit committee in formulating an external financial reporting disclosure strategy • CEO evaluation and compensation • CEO succession • Evaluation of the board and stock ownership These issues will be examined in the overall context of structuring a corporate governance system that facilitates cooperation between the board and management, thereby achieving real benefits for the enterprise. Particular attention will be devoted to

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List of Directors Colleges and Other Training Opportunities

283

helping participants develop action plans for improving their own boards. Participants will have the opportunity to discuss their plans with both their peers and the faculty. Contact Information

Executive Education Programs Harvard Business School Soldiers Field Boston, MA 02163-9986 E-mail: [email protected] Phone: 1-800-HBS-5577 (1-617-495-6555) Fax: 1-617-495-6999 http://www.exed.hbs.edu/programs

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List of Directors Colleges and Other Training Opportunities

Sponsoring Organization

National Association of Corporate Directors

Name of Program

Director Orientation

Length of Program

1 day (10 A.M. to 4 P.M.)

Cost of Program

$795 for NACD members $1,395 for others

Description of Course

This intensive program helps new directors learn about their roles and responsibilities. The program is limited to 12 participants to allow for a focused discussion on the corporate governance issues unique to each participant. The faculty will provide examples and best practices on a variety of corporate governance topics. To keep as a reference going forward, a comprehensive notebook will be provided as part of the program. Topics: • Creating and Sustaining Board Value • Characteristics and Core Competencies • Knowledge of Industry and Company Affairs • Board and Director Independence • Role of the Board in Strategic Planning • Board Responsibilities; Moving Target • Assessment of Board/Director Effectiveness • Evaluation of the CEO • Relationship of the Board to Management • Succession Planning: Relation to Profitability • Enhancing Shareholder and Stakeholder Relations • Setting Agendas, Defining Discussion Parameters, and Achieving Consensus • Best Practices in Board Governance: 1999–2000 • Top Priorities for CEOs • Critical and Emerging Board Issues • Board Size, Structure, and Composition • Board Tenure: Term Limits, Staggered Terms, and Mandatory Retirement • Board Reforms • Shareholder Activism Stakeholder Relations • Board Committees: Charter, Composition, Responsibilities, and Best Practices • Audit Committee • Compensation Committee • Nominating Committee • Special Purpose Committee

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List of Directors Colleges and Other Training Opportunities

Fiduciary Responsibilities • Business Judgment Rule • Duty of Care • Duty of Loyalty • Distinguishing Care and Loyalty Violations • High-Risk Transactions • Shareholders Contact Information

Christine Lenihan, Program Coordinator National Association of Corporate Directors 1828 L Street, NW Suite 801 Washington, DC 20036 Phone: (202) 775-0509 Fax: (202) 775-4857 [email protected] http://www.corpdirectors.org

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List of Directors Colleges and Other Training Opportunities

Sponsoring Organization

Stanford University School of Law Executive Education

Name of Program

Directors’ College

Length of Program

2 days

Cost of Program

$3,500

Description of Course

Target Audience Directors’ College is particularly relevant for directors of publicly traded companies and executives with board-related responsibilities. Counsel may attend only when accompanying a director. Objective of the Program An intensive two-day program that brings together corporate executives and board members from a range of industries, distinguished jurists, and key regulators [to] debate, discuss, and challenge some of the crucial issues surrounding governance, liability, compliance, and bottom-line corporate performance. Renowned keynote speakers and panelists join experienced educators to explore real world solutions to real world problems. Strength of the Program The program draws on the expertise and research of Stanford University law and business faculty, as well as the strength of the executives and board members of world-class companies who attend each year as participants and speakers. Directors’ College is a unique opportunity for board members and corporate executives to learn from and share with their peers, experts, and role models. Method of Instruction This program combines plenary and seminar sessions that focus on specific areas of interest to participants, emphasizing peer discussions and problem-solving exercises. Program Preparation In addition to plenary sessions, participants choose among an array of small group sessions, covering topics drawn from the classics of governance—ethics and legal compliance, for example—as well as issues taken from today’s headlines. Case studies, support materials, and the participants’ own experiences, ground the discussions in the reality of the boardroom and executive offices.

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Contact Information

Stanford Law School Executive Education Crown Quadrangle 559 Nathan Abbott Way Stanford, CA 94305-8610 Phone: (650) 723-5905 Fax: (650) 725-1861 E-mail: [email protected] Catherine E. Nardone, Director of Executive Education http://lawschool.stanford.edu/execed/programs

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Sponsoring Organization

Terry College of Business Executive Education (University of Georgia) and the National Association of Corporate Directors (Atlanta Chapter)

Name of Program

Terry/NACD Directors’ College

Length of Program

2 days 10 A.M. to 5 P.M. (day 1) 8 A.M. to 12 noon (day 2)

Cost of Program

$600

Description of Course

The Terry College of Business/NACD Director’s College focuses on the increasingly critical and challenging role corporate boards play in business organizations. The program develops the skills and insight needed to function as an informed, contributing board director. By combining the practical knowledge of experienced business executives with conceptual frameworks developed by highly acclaimed Terry College of Business faculty, the program highlights the strategic significance of the corporate board and the tools required to effectively monitor company performance. An overview of the course materials is as follows: • Compliance issues • Shareholder lawsuits • Business judgment rule • Recent court cases and how they may apply to you • Board minutes • D&O liability coverage • What do financial statements show and what directors should know about them • Brief overview of financial statements • Case studies relating to fraud and legal actions • Signs of trouble and indications of fraud • What the board can do about it • Ways in which the Board can improve corporate performance • Relationship between corporate governance and corporate performance • Executive compensation • CEO evaluation • Succession planning • Board evaluation • Importance of independence and diversity • Roles, responsibilities and expectations of directors

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• Legal obligations under Delaware and Georgia law • Duty of care and loyalty • Different oversight committees • Emerging issues • Regulation FD • SEC actions and rules • Institutional investor activism • Stock analysts’ focus on the board • Size and composition of the board Contact Information

Richard L. Daniels Associate Dean for Executive Programs, Professor of Management Terry College of Business 278 Brooks Hall Athens, GA 30602-6262 Phone: (706) 542-1964 Fax: (706) 542-8374 [email protected] http://www.terry.uga.edu/exec_ed

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Sponsoring Organization

University of Chicago Graduate School of Business Executive Education

Name of Program

Directors’ College: Concepts, Methods and Applications

Length of Program

2 days

Cost of Program

$2,950

Description of Course

This program is designed to meet the needs of new board directors, as well as experienced board directors. It focuses on developing skills and insight necessary to be an informed, contributing board director. The program blends the best practices of the real world with world-class scholarly research to provide high impact development. The curriculum combines the wisdom of experienced business executives, including current and former chairmen and chief executive officers, with the conceptual framework of the Chicago GSB’s highly regarded business school. The GBS’s faculty includes Nobel laureates, as well as professors who have been singled out by BusinessWeek magazine as being among the nation’s best teachers in the world of business. In this session you will learn to: • Define principles of a good board member • Develop strategic consensus skills • Analyze corporate restructuring proposals • Evaluate the role of the CEO • Predict performance • Identify ethical problems facing boards • Understand crisis management and control at the board level • Determine litigation trouble • Understand earnings management and the audit committee’s responsibilities • Understand the strategic implications of e-business

Contact Information

Michael Malefakis Associate Director University of Chicago Graduate School of Business 1101 East 58th Street Chicago, IL 60637 Phone: (312) 464-8732 Fax: (312) 464-8731 [email protected] http://gsb.uchicago.edu

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Sponsoring Organization

Wharton Business School (The University of Pennsylvania)

Name of Program

Wharton/SpencerStuart Directors’ Institute & Directors’ Forum

Length of Program

2 days

Cost of Program

$6,500

Description of Course

The Directors’ Institute and Directors’ Forum are 2-day programs developed by Wharton and SpencerStuart to provide board members with fresh perspectives on their work. The Directors’ Institute was designed for U.S. board members, and the Directors’ Forum was developed for European participants serving on plc boards. During these programs, participants serve on the board and committees of MegaMicro. Although MegaMicro is a fictitious company, its board has grappled with many of the real challenges executives face in their work on corporate boards. Over the years, MegaMicro directors have addressed issues such as major acquisitions, CEO succession, executive compensation and evaluation, board composition, Y2K problems, and electronic commerce. The board and committee meetings that comprise the program are run like actual meetings, followed by discussions with faculty and participating executives. Participants have a unique opportunity to observe a board in action, gain insights into their own participation, and understand firsthand some of the common pitfalls and effective strategies for boards. The program closes with a discussion of best practices drawn from the experience of participants, faculty, and executive advisors. This offers an opportunity to share effective strategies across boards and to identify creative solutions to issues such as keeping board members informed between meetings, removing underperforming board members, avoiding micromanagement, evaluating board performance, and giving board members contact with up-and-coming executives to facilitate succession planning. The “real-world” feel of the MegaMicro board meeting is heightened by the participation of senior executives who serve as CEOs of MegaMicro. MegaMicro, while fictitious, has taken on a life of its own. The company issues an annual report and is tracked by real analysts. The actions of each successive board, as well as real market conditions, shape the issues and preconditions that are presented to participants at subsequent sessions. The unfolding story of the company, and insights from each Directors’ Institute session, are conveyed to past participants through corporate minutes and a regular newsletter, Directors’ Notes.

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While board decisions shape the future of MegaMicro, the far more significant effect is on the board members themselves. Serving on the MegaMicro board is an experience that will change how you approach every other board assignment. • The board’s role in strategy and long-range planning • Board liability and the role of outside counsel • Chairperson/CEO performance review • Succession planning • Compensation, including incentive plans and stock options • Severance protection for senior executives • Term requirements for board members • Evaluation of board performance • The internal audit function • The role of institutional investors Contact Information

Elaine Calabrese Coordinator 255 S. 38th Street Philadelphia, PA 19104-6359 Phone: (215) 898-2594 Fax: (215) 386-4304 [email protected] http://aresty-direct.wharton.upenn.edu/execed

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Appendix F

Best Practices of a Typical Top-Performing Company Company

Direct Result

Quality of the CEO

Choosing a CEO is the board’s most important function. Because of the multitude of decisions and actions necessary to manage a modern corporation, the board must trust the CEO completely to make decisions in the best interests of shareholders. The eight characteristics of a superior CEO include: 1. Integrity, maturity, and energy—the foundation on which everything else is built. 2. Business acumen—a deep understanding of the business and a strong profit orientation; an almost instinctive feel for how the company makes its money. 3. People acumen—judging, leading teams, growing and coaching people; cutting losses and changing directions when necessary. 4. Organizational acumen—engendering trust, sharing information, and listening expertly; diagnosing whether the organization is performing at full potential; delivering on commitments; changing, not just running, the business, being decisive and incisive. 5. Curiosity, intellectual capacity, and a global mindset—being externally oriented and hungry for knowledge of the world; adept at connecting developments and spotting patterns. 6. Superior judgment. 7. An insatiable appetite for accomplishment and results. 8. Powerful motivation to grow and convert learning into practice. Grow the CEO from within to improve chances for success. Provide a succession plan to ensure continuity of excellent corporate performance. 293

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Company

Direct Result

Quality of the compensation committee

The board of directors is charged with representing shareholder interests. The primary responsibilities of the board are: • hiring, firing, evaluating, and setting compensation levels of senior management, especially the CEO • ratifying and approving major management decisions • monitoring management’s implementation of those decisions. The hiring, firing, evaluating, and setting of compensation levels are the primary means for the board to enforce its authority over management. Nominate the best possible group of four outside directors. Pay particular attention to the compensation committee all-stars. Ideally, each compensation committee member can individually assert his or her opinion to each board member and senior management with conviction, passion, and without fear of losing his or her position as director. Ensure that the board is selected, trained, and prepared to address the following major issues: • Adhere to good corporate governance principles • See the big picture • Know how much compensation is enough • Review programs from the shareholder’s perspective • Review complex plans and programs • Review controversial plans and programs

Quality of integration of the compensation strategy into the business strategy

Canvass Wall Street as to the predominant valuation methodology and incorporate those measurement criteria into your company’s short-term and long-term incentive pay programs. If there is no consensus on factors used to value your company, then employ multiple measurement criteria in line with Wall Street’s views. Create pay strategies to accomplish important business objectives. Pay incentives to partially reward executives for both fundamental corporate performance and total return as compared to an industry peer group. Indeed, performance may be relative. You certainly want to keep your CEO interested and motivated even when the industry or equity markets are adverse to the success of the company.

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Direct Result Create a pay strategy that is simple in design and easy to communicate to a large number of executive managers. The pay program for the CEO should be in line with pay programs for other executives and broad-based incentive programs. There should be no conflict in the achievement of objectives, and the potential rewards should be as meaningful to the CEO as to others in the company.

High-leverage and high-risk CEO compensation package with an emphasis on long-term incentive awards

Determine whether stock ownership or carried interest is the objective of your pay program, and design pay programs accordingly. If stock ownership is deemed important, then deliver shares to executives in the most efficient ways possible. Set salary (including benefits and perquisites) to lowest possible levels. Provide the remainder of compensation in highly focused long-term incentive programs. Set compensation opportunities at median levels; pay extraordinary compensation only for extraordinary performance.

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Glossary ABA. Abbreviation for American Bar Association. Accounting Principles Board (APB). A board convened in 1959 by the American Institute of Certified Public Accountants (AICPA) to determine and publish accounting principles. This group was terminated in 1973 and replaced by the Financial Accounting Standards Board (FASB). All opinions of the APB remain in effect unless superseded by FASB announcements. Accredited investors. Sophisticated investors who, under the securities laws, can buy private placements and unregistered securities. Individuals fall into this category if they have certain wealth and income characteristics, such as a net worth (alone or with a spouse) of $1 million. Accrued compensation expense. Incurred and charged expense that has not yet been paid. This expense would be reflected on the balance sheet and will show on the income statement. Accumulated funding deficiency. With respect to the minimum funding standards of ERISA, refers to the surplus of all charges to a funding standard account for total plan years over total credits to the account for a designated number of years. If less, the surplus of all charges on an alternative minimum funding standard account for such plan years will be over the total credits to such account for a designated number of years. Failure to make minimum contributions to a covered plan will result in an accumulated funding deficiency. A plan must adhere to a minimum funding standard for a plan year if it does not have an accumulated funding deficiency at the end of a year. Actuarial assumptions. An actuary’s prediction of unclear future measures that will have an impact on pension cost. Examples include life expectancy, investment returns, inflation, and mortality rates. Actuary. Mathematician employed by a life insurance company or consulting firm to calculate life insurance premiums, reserves, policy dividend payments, insurance, pension amounts, pension balances, annuity rates, and the like, using mortality rates and other risk factors obtained from experience. These experience tables of mortality are based on mortality and life insurance claims. ADEA. Abbreviation for Age Discrimination in Employment Act of 1967. ADR. Abbreviation for American depositary receipt. Affiliate. An individual in a position to influence corporate policies. Includes directors, officers, 10 percent or more owners, members of families that own more than 10 percent, and close associates of these groups. The term also applies to people who live in the same household. Restrictions and reporting requirements on company stock sales under Rule 144 apply to affiliates. Also known as a “control person.” 297

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AFL-CIO. Voluntary federation of America’s labor unions, formed in 1955 by the merger of the American Federation of Labor and the Congress of Industrial Organizations. Its purpose is to give America’s working class a voice and power in bringing about economic and social reforms. AFR. Abbreviation for applicable federal rate. Age Discrimination in Employment Act (ADEA) of 1967 (amended 1978, 1986, and 1990). Makes nonfederal employees age 40 and over a protected class relative to treatment in pay, benefits, and other personnel actions. The 1990 amendment is called the Older Workers Benefit Protection Act. Agency theory. A theory of motivation that depicts exchange relationships in terms of two parties: agents and principals. According to the theory, both sides of the exchange will seek the most favorable exchange possible, and will act opportunistically if given a chance. As applied to executive compensation, agency theory expects the executive (agent) to act in the best interests of the shareholders (principals), rather than in the executive’s own self-interests. Agent. Individual authorized by another person, called the principal, to act on the latter’s behalf in transactions involving a third party. In a corporation the agent is management, and the principal is the board (which is elected by the owners). Agents (management) have three basic characteristics: (1) they act on behalf of and are subject to the control of the principal (board or shareholders); (2) they do not have title to the principal’s (shareholders’) property; and (3) they owe the duty of obedience to the principal’s (board’s) orders. Aggregate exercise price. A term used in connection with stock option awards to reflect the relative size of the option award. This measure equals the number of stock options awarded at the fair market value on the date of the award multiplied by the number of stock options. For example, a stock option award of 1,000 options at an exercise price of the then fair market value of $40 per share has an aggregate exercise price of $40,000. American Institute of Certified Public Accountants (AICPA). The national, professional organization for all certified public accountants. Its mission is to supply members with the resources, information, and leadership that enable them to provide valuable services in the highest professional manner, to benefit the public as well as employers and clients. Alternative minimum tax (AMT). An alternative method of calculating income tax liability that requires the taxpayer to include in his or her taxable income a number of tax preference items that are deductions under the regular income tax rules. The AMT rates start at 26 percent (28 percent at higher income levels). You compare your AMT to the regular tax owed and pay the higher amount to the government. Upon the exercise of incentive stock options (ISOs), the excess of the fair market value of the option shares over the option exercise price, though not taxable for the regular income tax liability calculation, is a tax preference item that must be taken into account in your AMT calculation. No AMT applies when you sell the stock in the year of exercise. If you do have AMT, you will have an AMT credit that will reduce the taxes you owe in future years. American Bar Association (ABA). An association that oversees the legal profession in the United States. American depositary receipt (ADR). Receipt for the shares of a foreign-based corporation held in the care of a U.S. bank and entitling the shareholder to all dividends and capital gains of the stock. Instead of buying shares directly on the foreign stock exchange, ADR shareholders buy shares in the United States in the form of an ADR. ADRs are available on hundreds of stocks on numerous exchanges. The SEC requires limited disclosure for ADRs. ADRs are also called “American depositary shares.”

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American option. An option contract that may be exercised at any time between the date of purchase and the expiration date of the option. American Stock Exchange (AMEX). An open-auction market similar to the New York Stock Exchange, where buyers and sellers compete in a centralized marketplace. The AMEX typically lists small- to medium-cap stocks of younger or smaller companies. Until 1921 it was known as the New York Cumulative Exchange. The AMEX merged with NASDAQ in the late 1990s. AMEX. Abbreviation for American Stock Exchange. AMT. Abbreviation for alternative minimum tax. AMT credit. If you owe AMT for your ISO exercise, all or a part of the excess of the amount of your AMT liability over your regular tax liability for that year could generate a tax credit. It is applied against your regular taxes in one or more later years. The calculation is not simple and requires a tax professional. The credit could be available to you if exercising ISOs instead of other tax events triggered the AMT you paid in prior years. Tax items that trigger AMT because they result in an exclusion of income for regular tax purposes rather than a deferral of taxation (such as payment of state taxes) do not result in tax credits. If you are eligible for a tax credit resulting from the exercise of your ISOs, that credit may be applied directly against your tax liability in years in which your regular tax liability exceeds your AMT liability. The AMT tax credit can only be used to reduce your regular tax liability by the amount it exceeds your AMT liability for each year. The balance of the credit carries forward and may be used in subsequent years. Analyst. Person in a brokerage house, bank trust department, or mutual fund group who studies a number of companies and makes buy or sell recommendations on the securities of particular companies and industry groups. Most analysts specialize in a particular industry, but some investigate any company that interests them, regardless of its line of business. Some analysts have considerable influence, and can affect the price of a company’s stock when they issue a buy or sell recommendation. Some commentators report that analysts for brokerage houses affiliated with large investment banks are less critical, for fear that a negative report may damage a relationship with a large investment-banking client. Annual incentive. A lump-sum payment (cash, stock, etc.) made in addition to base salary for a fiscal year, based on achievement of performance target goals. Annual meeting. Once-a-year meeting where the managers of a company report to stockholders on the years’ results and the board of directors stand for election for the next year. The chief executive officer usually comments on the outlook for the coming year and, with other senior executives, answers questions from shareholders. Stockholders can also request that all those owning stock in the company vote on resolutions regarding corporate policy. Stockholders unable to attend the annual meeting may vote for directors and pass on resolutions through the use of proxy material, which is legally required to be mailed to all shareholders of record. Annual report. A publication that is issued yearly by all publicly held corporations and is freely available to all shareholders. It reveals the company’s assets, liabilities, revenues, expenses, and earnings for the past year, along with other financial data. This is often accompanied by a glossy presentation of the company’s achievements and philosophy, but it is the accounting information that is required by law to allow investors to gauge the financial health of the company.

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Annuity. Form or contract sold by life insurance companies that guarantees a fixed or variable payment to the annuitant at some future time, usually retirement. In a fixed annuity, the amount will ultimately be paid out in regular installments, varying only with the payout method elected. In a variable annuity, the payout is based on a guaranteed number of units; unit values and payments depend on the value of the underlying investments. All capital in the annuity grows tax-deferred. Key considerations when buying an annuity are the financial soundness of the insurance company, the returns it has paid in the past, and the levels of fees and commissions paid to insurance salespeople. APB. Abbreviation for Accounting Principles Board. Applicable federal rate (AFR). If you are receiving or making payments for a loan or installment sale, but little or no interest is stated on the contract, the IRS assumes a rate of interest based on the published applicable federal rate. For instance, if an employee received a loan repayable over five years, and the interest rate charged to the employee was less than the AFR, then the IRS would determine the amount of imputed interest, which will be equal to the AFR less the interest rate of the loan. See also imputed interest. Appreciation. Increase in value of an asset (typically the price of publicly traded stock). Appreciation rights. The award of cash based on the increase in the economic value of a company’s shareholder interests. Arbitrage. A technique used by alert traders, now aided by sophisticated computer programs, to profit from minute price differences for the same security on different markets. For example, if a computer monitoring markets notices that ABC stock can be bought on a New York exchange for $10 a share and sold on a London exchange at $10.12, the arbitrageur or a special program can simultaneously purchase ABC stock in New York while selling the same amount of it in London, pocketing the difference. Arm’s-length transaction. An exchange between parties who are independent of each other, and who are acting in their own best interests. Articles of incorporation. Document filed with a U.S. state by the founders of a corporation. After approving the articles, the state issues a certificate of incorporation; the two documents together become the charter that gives the corporation its legal right to exist. The charter includes such information as the corporation’s legal name, business purpose, amount of authorized shares, and number and identity of directors. The corporation’s powers derive from the laws of the state and the provisions of the charter. Rules governing the internal management of the company are set forth in the bylaws, which are drawn up by the founders. Attestation. An affidavit or declaration of share ownership by which an option holder exercising an option by a stock swap can avoid surrendering a physical stock certificate for the shares used to exercise the option. Audit report. Often called the “accountant’s opinion”; the statement of the accounting firm’s work and its opinion of a corporation’s financial statements, especially if they conform to the normal and generally accepted practices of accountancy. Average. Arithmetic mean of reported compensation data; sum of the values divided by the number of cases. Balance sheet. A financial statement that shows total assets, total liabilities, and owners’ equity. Also referred to as a “statement of financial position.” Bargain element. Represents the difference between the option exercise price (i.e., what you pay to purchase stock) and the market price of stock at the time of exercise. Also referred to as the option “spread.”

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Barone-Adesi and Whaley value. The value arrived at by a method for pricing tradable call options on dividend-paying stock. Uses the stock price, the exercise price, the risk-free interest rate, the time to expiration, the expected standard deviation of the stock return, and the dividend yield. Developed by Giovanni Barone-Adesi and Robert E. Whaley. See Giovanni Barone-Adesi and Robert E. Whaley, “Efficient Analytic Approximation of American Option Values,” Journal of Finance 42 (1987): 301–320. Base salary. A major element of compensation; the basic compensation that an employer pays for work performed. Tends to reflect the value of work itself and typically ignores differences in individual contributions. Basis. Cost of stock for calculating your gains or losses for tax purposes. For equity compensation, the basis includes the costs plus any compensation income reported (e.g., amount for ordinary income tax on NQSO spread). To calculate your capital gains, subtract your basis from the amount realized on the sale of stock. If you sell stock through a broker, the Form 1099-B will report the entire amount received that you use to determine the capital gain or loss. Bear. An investor who believes that a stock or the overall market will decline. A bear market is a prolonged period of falling stock prices, usually by 20 percent or more. Bear market. Any market in which prices are in a declining trend, usually accompanied by a drop in stock prices of 20 percent or more. Bearish. A viewpoint or person that anticipates a price decline, referring either to an individual security or to the entire market. Benchmarking. A company’s use of information about other firms in the same industry; used for comparisons and to set standards and goals. Beneficial owner. For most purposes under the federal securities laws, any person or entity with sole or shared power to vote or dispose of the stock. This SEC definition is intended to include a holder who enjoys the economic benefits of ownership although the shares may be held in another name. For example, one spouse is generally deemed the beneficial owner of shares held by the other spouse. Best pay practices. Compensation practices that allow employers to gain preferential access to superior human resources talent, which in turn influences the strategies the organization adopts. Beta. A mathematical measure of the sensitivity of rates of return on a stock compared with the broader stock market. Higher betas indicate higher stock price volatility. In specific, a coefficient measuring a stock’s relative volatility. The beta is a covariance of the stock in relation to the rest of the stock market. The Standard & Poor’s 500 Stock Index has a beta coefficient of 1. Any stock with a higher beta is more volatile than the market, and any with a lower beta can be expected to rise and fall more slowly than the market. A conservative investor whose main concern is preservation of capital should focus on stocks with low betas, whereas one willing to take high risks in an effort to earn high rewards should look for highbeta stocks. Binomial option pricing model. A model for pricing stock options. It can be shown that the Black-Scholes value is a special limiting case of the binomial option pricing model. Fundamental to the binomial option pricing model is the idea that stock price movements are well approximated by assuming the stock price can only move to two possible values in a short interval of time. The first step is to construct a price tree that describes the probability of future stock price movements.

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Black-Scholes model. A formula that incorporates both the intrinsic value (the spread in the option) and the time value of the option (the term of the option) to determine the option’s total market value. For example, in general, an option grows in value the more the option is in the money and decreases in value the more the option is out of the money. Furthermore, in general, the option is worth more the longer the period to expiration of the option term (e.g., a 10-year option is worth more than a 5-year option, all other factors being equal). The Black-Scholes option valuation model is based on a mathematical equation that must hold true. In summary, the price of the stock option is equal to: (A) The product of (i) the price of the stock and (ii) a stochastic variable which is based on the volatility of the stock and the time left to expire on the option, (B) Less the product of (i) the present value of the exercise price of the stock option and (ii) a stochastic variable based on the volatility of the stock and time left to expire on the option. Blackout period. A period of time prior to the release of annual or quarterly financial information by a publicly held company during which insiders are restricted from trading the company’s stock. BLS. Common abbreviation for Bureau of Labor Statistics. Blue chip. Common stock of a nationally known company that has a long record of profit growth and dividend payments and a reputation for quality management, products, and services. Examples of blue-chip stocks include IBM, General Electric, and DuPont. Blue-chip stocks typically are relatively high priced and low yielding. Blue sky laws. A popular name for various state laws enacted to protect the public against securities fraud. The term is believed to have originated when a judge ruled that a particular stock had about the same value as a patch of blue sky. Board of directors. The governing body of a corporation, as elected by the stockholders. Among other things, the board of directors has the power to appoint the corporation’s officers, to appoint committees, to issue shares of stock, to grant stock options, and to adopt stock plans. Board of trustees. A group of people responsible for the oversight of a nonprofit organization. Bonus plan. An annual program established to regulate the funding and distribution of annual or short-term cash bonus payments. Also referred to as “short-term incentive plan.” Book value (BV). The value of the net assets as represented on the balance sheet. Typically refers to shareholders’ equity or plant and equipment net of depreciation. Book-value plan. Typically, the employer sells restricted stock to eligible employees at a price determined by book value. The sale or transfer of the stock to other than the employer is prohibited. At a future date, usually termination or retirement, the employer agrees to buy back the stock from the employee at the then book value of the stock. Many publicly held companies offer these plans so that the executive award is not subject to the vagaries of stock market fluctuations that do not always reflect the attainment of fundamental corporate financial goals. Similarly, multidivisional companies may wish to relate incentive awards for certain line executives. Also referred to as a formula plan. Book-value stock (BVS). Stock for which the exercise price is based on a formula such as book value.

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Book-value stock option (BVSO). Options for which the exercise price is based on a formula such as book value. Broad-banding. A compensation strategy that collapses salary grades or classes into a few salary bands. The bands are usually 70 to 150 percent wide and encompass numerous occupational groups at a comparable organizational level. Broad-bands are often used to support skill/competency-based or -influenced pay programs. The effect of broad-banding is to shift the focus from vertical to horizontal career movement and place more responsibility for salary administration at the manager level. Budget. A plan or a schedule that a businessperson seeks to meet. Also, a standard against which managers’ actual expenditures, revenue, or profit are evaluated. Bureau of Labor Statistics (BLS). The principal fact-finding agency for the federal government in the broad field of labor economics and statistics. The BLS is a major source of compensation data. It also publishes the Consumer Price Index. All of the bureau’s programs are established to meet statutory responsibilities assigned to the bureau or the Department of Labor. The legislation that established the bureau in the late 1800s (found in 29 U.S.C. § 1) states that “[t]he general design and duties of the Bureau of Labor [Statistics] shall be to acquire and diffuse among the people of the United States useful information on subjects connected with labor, in the most general and comprehensive sense of that word, and especially upon its relation to capital, the hours of labor, the earnings of laboring men and women, and the means of promoting their material, social, intellectual, and moral prosperity.” Burn rate. The percentage of options a company grants per year of either the total number of options authorized or shares outstanding. Buy-Sell agreement. An arrangement between two or more parties that obligates one party to buy the business and another party to sell the business upon the death, disability, or retirement of one of the owners. Bylaws. Rules governing the management of an organization, which are usually drawn up at the time of incorporation. The charter is concerned with such broad matters as the number of directors and the number of authorized shares. The bylaws, which usually can be amended by the directors themselves, cover such points as the election of directors, the appointment of executive and finance committees, the duties of officers, and how share transfers may be made. Cafeteria benefit plan. A benefit plan that gives employees a choice as to the benefits they receive, within some dollar limit. Usually a common core benefit package is required (e.g., specific minimum levels of health, disability, retirement, and death benefit) plus elective programs from which the employee may elect a set dollar amount. Additional coverage may be available through employee contributions. Also referred to as a “flexible benefit plan.” Call option (call). A derivative security giving the holder the right to buy the underlying securities at a fixed price. An employee stock option is a type of call option, in that the employee has the right to buy the stock at a fixed price for a set number of years (see put option). Holders of concentrated stock positions sometimes sell call options against their shares to generate cash. Of course, if the stock is above the call price at expiration, the holder will either have to hand over the stock or pay the difference between the market and call strike price. Many companies do not allow employees to sell calls against their stock, as this could force them to sell shares during a blackout period.

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Capital. Permanent money invested in a business. Also can mean the long-term assets of a company. Capital Asset Pricing Model (CAPM). A model used to evaluate a publicly held stock. The underlying principle of the model is that investors demand a return that equals the risk-free rate of return plus a nominal risk premium for equity investment times the risk factor (beta) of the particular stock. In other words, higher investor risk requires higher investor return. Capital gain (loss). Profit (or loss) from the sale of a capital asset, such as stock received upon exercise of options. Capital gains may be short-term (held 12 months or less) or longterm (held more than 12 months). Capital losses are used to offset capital gains to establish a net position for tax purposes. Only $3,000 of net capital losses can be deducted in any one year; the remaining balance is carried over to future years indefinitely. The long-term capital gains tax rate is generally 20 percent. If you are in the 15 percent tax bracket for regular tax purposes, then your capital gain rate is only 10 percent. Lower long-term capital gains tax rates (18 percent and 8 percent, respectively) apply to stock sales after December 31, 2000, if the stock has been held for more than five years. If you are in a tax bracket higher than 15 percent, the five-year holding period for this purpose does not start to run until January 1, 2001. The 18 percent rate will apply only to gains on stock you purchase after 2000, or stock received on exercise of options granted after 2000. Short-term capital gains are taxed at the same rates as wages and other ordinary income. When you have multiple securities transactions, additional rules on netting them apply. Note that you must file a Schedule D, Capital Gains and Losses, with your federal IRS 1040 tax return for any tax year in which you sell stock, regardless of whether you have a capital gain. Capital loss limitation. Net long-term capital losses and net short-term capital losses may be used to offset up to $3,000 of ordinary income. To reach the net amounts to determine deductibility, total all capital gains and losses. Amounts of more than $3,000 can be carried forward to future years until all of the net capital losses are used. CAPM. Abbreviation for Capital Asset Pricing Model. Carried interest. Total shares in which the owner or option holder has an interest or financial stake in the appreciation of the value of the company. Cash balance pension plan. A defined benefit plan that maintains individual employee accounts like a defined contribution plan. Cash flow. Total funds that are generated internally for investment and working capital. Cash flow is often calculated as operating profits (e.g., profits before interest, taxes, depreciation, and amortization). Cash surrender value. The amount that an insurance policyholder is entitled to receive when he or she discontinues coverage. Policyholders are usually able to borrow against the surrender value of a policy from the insurance company. Loans that are not repaid will reduce the policy’s death benefit. Cashless exercise/same-day sale. A transaction in which an option holder exercises a stock option and simultaneously sells some or all of the shares, with a portion of the sale proceeds delivered to the company by the broker to pay the exercise price. CBOE. Abbreviation for Chicago Board Options Exchange. COBT. Abbreviation for Chicago Board of Trade. CEO. Common abbreviation for chief executive officer.

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Certified public accountant (CPA). An accountant who has met specified professional requirements established by the AICPA and local state societies. A key service provided by CPAs is the performance of independent audits of financial statements for publicly traded companies. CFO. Common abbreviation for chief financial officer. Chairman (chairperson). Sometimes referred to as “Chairman of the Board.” A member of a corporation’s board of directors who presides over its meetings and who is the highestranking officer in the corporation. The chairman may or may not have the most actual executive authority in a company. Change in control (CIC) of ownership agreement. A contractual agreement that specifies certain guarantees to the covered executive when ownership of the company changes as specified by a CIC trigger. This is sometimes referred to “change of control of ownership,” although CIC is the prevalent term. Charitable remainder trust. Involves the irrevocable transfer of assets, such as company stock, to a trust. The income stream from the assets goes to an individual or individuals (who may include the transferee of the assets); a qualified charity receives the assets at the expiration of the trust period. The contributor of the assets receives a charitable tax deduction at the time of the transfer, equal to the present value of the charity’s remainder interest. The transferred property will escape federal estate tax, as it is removed from the donor’s estate. Cheap stock. Stock options granted to employees at too low an exercise price relative to a planned IPO offering price. The SEC will require an IPO company to take an earnings charge as a compensation expense for part of the spread between the exercise price and the offering price. IPO companies routinely receive comments from (and negotiate with) the SEC on cheap-stock issues before the SEC approves the registration statement (i.e., S-1) and before the companies can go public. Chicago Board of Trade (CBOT). Formed in 1948 as a central marketplace for the midwestern grain trade, the CBOT is now the oldest and largest futures exchange in the world. Chicago Board Options Exchange (CBOE). Founded in 1973, the CBOE was established for the trading of call options on listed stock. Today it is the second largest securities exchange in the country and the largest options exchange in the world. Chief executive officer (CEO). The officer of a company principally responsible for its activities and performance. The CEO usually holds the additional title of chairman of the board, president, and/or chief operating officer. Chief financial officer (CFO). The executive officer who is responsible for handling funds, signing checks, keeping financial records, and financial planning for the company. The CFO is in charge of accounting, finance, budgeting, tax, and cash management functions of a company. Chief operating officer (COO). The officer of a company principally responsible for day-to-day management. The COO reports to the CEO, and most likely will not sit on the board. CIC. Abbreviation for “change in control.” Civil Rights Act. Title VII of the Civil Rights Act of 1964 prohibits discrimination in terms and conditions of employment (including benefits), based on race, color, religion, sex, or national origin.

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Civil Rights Act of 1991. Reestablishes the standards for proving discrimination that had been in general use before the 1989 Supreme Court rulings. Allows jury trials and damage awards. Classified board. A corporate board structure in which only a portion of the board of directors is elected each year, usually to discourage takeover attempts. Claw-back. Option grant provision that requires option holder to pay back to the company any exercise gains if the holder goes to work for a direct competitor within x months of the exercise. These provisions have gained in popularity and seem to be legal based on court victories by IBM. Cliff vesting. All or a large portion of a grant vests at once and then the remainder, if any, vests on a monthly or quarterly schedule (assuming the option holder is still employed). For example, 0 percent would vest at the grant date, 50 percent at one year, and then the remainder monthly over the next three years. Closing price. The last price paid for a security on any trading day. COBRA. Common abbreviation for Consolidated Omnibus Budget Reconciliation Act. COC. Abbreviation for change of control. See change in control. Code. Abbreviation for Internal Revenue Code. Coefficient of correlation (r). Measures the strength of a relationship between the independent and dependent variables in a regression (e.g., an element of compensation and revenues). This figure of merit ranges from –1 to 1. A correlation of 0 denotes that there is no relationship between the independent and dependent variables. A correlation of –1 denotes that there is a perfect inverse relationship, and a correlation of +1 denotes that there is a perfect positive relationship. Coefficient of determination (r2). Measures the ability of the regression to explain the variance in a regression. It is equal to the square of the coefficient of correlation. COLA. Abbreviation for cost of living adjustment. COLI. Abbreviation for corporate-owned life insurance. Combination plan. An award with two (or more) separate components, all of which can be exercised. Each part of the award is actually a separate grant, and compensation cost is measured and recognized for each grant. Common stock. Units of ownership of a corporation. Common stockholders are typically entitled to vote on the selection of directors and other matters. Distinguished from preferred stock, which generally has more favorable dividend and liquidation rights, although more limited voting rights. Compa-Ratio. An index that helps assess how managers actually pay employees in relation to the midpoint of the pay ranges established for jobs. It estimates how well actual practices correspond to intended policy. Compensable factors. Job attributes that provide the basis for evaluating the relative worth of jobs inside an organization. A compensable factor must be work-related, business-related, and acceptable to the parties involved. Compensation. All forms of financial returns and tangible services and benefits employees receive as part of an employment relationship. Compensation elements include salary, bonus, long-term incentive, health and welfare benefits, pension entitlements, and perquisites.

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Compensation committee. At many public companies, a committee of the board of directors, generally made up of outside directors, that is responsible for executive compensation matters, including stock plans. The committee’s report on executive compensation appears in the proxy statement each year. Competency. Basic units of knowledge and abilities employees must acquire or demonstrate in a competency-based plan in order to successfully perform the work, satisfy customers, and achieve business objectives. Compression. Very narrow pay differentials among jobs at different organization levels as a result of wages for jobs filled from the outside increasing faster than the entire pay structure. Consolidated Omnibus Budget Reconciliation Act (COBRA). A federal law requiring employers with more than 20 employees to offer terminated or retired employees the opportunity to continue their health insurance coverage for 18 months at the employee’s expense. Coverage may be extended to the employee’s dependents for 36 months in the case of divorce or death of the employee. Constructive receipt. Refers to when compensation is taxable to the employee. The recipient has control over and access to the payment. Constructive sale. Tax term referring to when the IRS recharacterizes as a sale a transaction that eliminates the risk of loss and the opportunity for gain. This concept, which first appeared in the 1997 Taxpayer Relief Act, eliminated certain viable long-term stock hedging strategies, such as short-against-the-box and many equity swaps. Properly structured equity collars and prepaid forwards do not trigger constructive sale treatment, although the IRS could issue additional regulations. Consumer Price Index (CPI). An index published by the Bureau of Labor Statistics U.S. Department of Labor. The CPI measures the changes in prices of a fixed basket of goods and services purchased by a typical average family. Control stock. Stock held by affiliates that must be sold under Rule 144. Stock can be acquired by open-market purchases or option exercises. COO. Common abbreviation for chief operating officer. Corporate governance. The relationship between the shareholders, directors, and management of a company, as defined by the corporate charter, bylaws, formal policy, and rule of law. Corporate owned life insurance (COLI). An insurance policy of which an organization is the beneficiary. Should the executive die while covered, the company pays a comparable noninsured sum to selected survivors. Policy loans associated with the insurance are accessible to the organization. Cost of living adjustment (COLA). Across-the-board wage and salary increases or supplemental payments based on changes in some index of prices, usually the Consumer Price Index. If included in a union contract or an employment agreement, COLA adjustments will automatically increase compensation levels for the life of the contract/agreement. Costless Collar. Hedging strategy used for high-value, concentrated stock positions, now more technically referred to as a “zero premium collar” for legal reasons. You purchase put options and sell call options on your stock through a securities firm that is experienced in these transactions. This essentially locks in the trading range upside and downside (i.e., the “collar”). It is costless to an individual in that no net out-of-pocket costs result from the totaling of the prices of puts and calls.

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This strategy allows you to hold the stock after an option exercise for long-term capital gains, and minimizes the risks of stock price fluctuations. The hedged position can be monetized with a loan (if you are not a senior executive, director, or affiliate). However, the strategy has uncertain legal and tax ramifications; it is prohibited by many companies, and you give up the benefit of future price increases beyond the collar price. Council of Institutional Investors. Founded in 1985, the Council of Institutional Investors (CII) is “an organization of large public, Taft-Hartley and corporate pension funds formed to address investment issues that affect the size or security of plan assets.” CPA. Abbreviation for certified public accountant. CPI. Common abbreviation for Consumer Price Index. Credited service. A length of employment prior to or subsequent to the effective plan date that is recognized as service for plan purposes. This would include such issues as determination of benefit amounts, benefits entitlement, and/or vesting. Cumulative voting. A method of stock voting that permits shareholders to cast all votes for one candidate. A voting system that gives minority shareholders more power, by allowing them to cast all of their board-of-director votes for a single candidate, as opposed to regular or statutory voting, in which shareholders must vote for a different candidate for each available seat. Current ratio. Current assets divided by current liabilities. This ratio measures liquidity as it measures a company’s ability to pay current liabilities from current assets. CUSIP. The trademark for a system that uniquely identifies securities trading in the United States. It was developed in the late 1960s by the American Bankers Association as a way to standardize the identification and tracking of securities. The CUSIP number consists of nine digits—the first six identify the issuer and the last three identify the issue. CUSIP numbers are a trademark of the American Bankers Association . Davis-Bacon Act of 1931. Requires most federal contractors to pay wage rates prevailing in the area where the work is performed. DCF. Abbreviation for discounted cash flow. De minimis benefit. Services that an employer provides to employees that are considered too minimal to be subject to taxable income. Dead-hand poison pill. An antitakeover device designed to prevent the acquisition of a company even if a majority of shareholders favor the acquisition. Dead-hand poison pills can be removed only by incumbent directors or their chosen successors. Deemed sale. Technique that allows you to take advantage of the lower capital gains rule for stock held more than five years by resetting the holding period start date and tax basis to the beginning of 2001, when this provision on five-year holdings went into effect. Lower long-term capital gains tax rates (18 percent and 8 percent, depending on your tax bracket) apply to sales after December 31, 2000. If you are in a tax bracket higher than 15 percent, your five-year holding period for this purpose does not start to run until January 1, 2001. This strategy involves the fictitious selling of an asset at its current value, buying it back at the same price, and paying the appropriate taxes on the sale without actually going through the process of doing it. The deemed sale is treated as having occurred on January 2, 2001, for securities, and January 1, 2002, for all other assets. DEF 14A. An SEC document sent by publicly listed corporations to their shareholders providing material information on corporate matters subject to vote at the annual meeting.

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Also referred to as the proxy statement. The “DEF” designation means that the proxy statement is the definitive version. The definitive version of the proxy statement is sometimes preceded by the preliminary version, referred to as the “PRE” version. Deferred compensation. Earned compensation that is payable in the future. May include contributions to retirement plans. Deferred compensation program. Provides income to an employee at some future time as compensation for work performed now. Defined benefit pension plan. A pension plan that promises to pay a specified amount to each person who retires after a set number of years of service. Such plans pay no taxes on their investments. In almost all cases, the employer makes all contributions to this plan. Defined contribution pension plan. Pension plan that specifies the employer’s contribution based on a formula that includes such factors as age, length of service, employer’s profits, and compensation levels. FASB Statement No. 87 does not deal with these types of plans except for disclosure requirements. The pension expense is the amount funded each year. Department of Labor (DOL). A full department in the U.S. executive branch, responsible for the administration and enforcement of more than 180 federal statutes. These legislative mandates and the regulations produced to implement them cover a wide variety of workplace activities for nearly 10 million employers and well over 100 million workers. In specific, the DOL protects workers’ wages, health and safety, employment and pension rights; equal employment opportunity; job training, unemployment insurance, and workers’ compensation programs; and free collective bargaining. It also collects, analyzes, and publishes labor and economic statistics. Depository Trust Company (DTC). The world’s largest securities depository, with more than $10 trillion worth of securities in custody. In 1995, DTC processed $41 trillion of securities through its book-entry settlement system. DTC is a national clearinghouse for the settlement of trade in corporate and municipal securities and performs securities custodyrelated services for its participating banks and broker-dealers. Members of the financial industry own the DTC and their representatives are its users. DTC is 35.1 percent owned by the New York Stock Exchange on behalf of the Exchange’s members. It is operated by a separate management and has an independent board of directors. It is a limited-purpose trust company and is a member of the Federal Reserve. Derivative security. An option, warrant, convertible security, stock appreciation right, or similar right with an exercise or conversion privilege at a price related to an equity security, or similar securities with a value derived from the value of an equity security. Dilution. Refers to the effect that the grant of stock options has upon the other shareholders of a company. Each time an option is granted, an existing shareholder’s ownership interest in the company is potentially reduced. This reduction occurs because at exercise, the value of the stock is greater than the cash paid to exercise the option, which, in effect, results in a transfer of economic value from existing shareholders to the option holder. Institutional investors in a public company, such as pension plans and mutual funds, generally oppose new stock option plans. This opposition includes proposals to increase the number of shares available for plan option grants if the dilution from all company plans exceeds 15–25 percent, depending upon the company, the industry, and the plan’s other terms. For older companies in mature industries, institutional investors may be concerned about dilution even if it is less than 10 percent. Another type of dilution is voting dilution, if not all shares have the same voting rights.

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Direct compensation. Pay received directly in the form of cash (e.g., salary and annual bonus). Director. Person elected by shareholders, usually during an annual meeting, to serve on the board of directors of a corporation. The directors appoint the president, vice president, and all other operating officers. Directors decide, among other matters, if and when dividends shall be paid. Directors and officers (D&O) liability insurance. Professional liability coverage for legal expenses and liability to shareholders, bondholders, creditors, or others due to actions or omissions by a director or officer of a corporation or nonprofit organization. Disclosure. The reporting of the details of a transaction in the notes to the financial statement or in other documents filed with the SEC. Companies sometimes attempt to lessen the level of disclosure by not putting information in the Summary Compensation Table, but in a narrative disclosure or as a footnote to the table. Discount stock option. The opposite of premium options; discount stock options have an exercise price below market value at the time of grant. They are often used when cash compensation is to be deferred by converting it into stock options. Discounted cash flow (DCF). Present value of future expected cash flow. The discount rate is an important factor in this analysis. The accuracy and validity of a DCF analysis diminish with the time horizon of the analysis, because the discount rate and/or the future cash flow will be more likely to deviate from actual amounts. Discretionary bonus. An informal incentive award not based on a performance-related formula or specific measurable criteria. Disqualifying disposition (incentive stock options). A sale, gift, or exchange of ISO shares within two years from the grant date or one year from the exercise date. Upon a disqualifying disposition, the employee recognizes taxable ordinary income, and the company is entitled to claim a deduction equal to the excess of the fair market value on the exercise date or the sale price, whichever is lower, over the exercise price. Dividend. The payment designated by the board of directors to be distributed pro rata among the shares outstanding. For preferred shares, the dividend is usually a fixed amount. For common shares, the dividend varies with the fortunes of the company and the amount of cash on hand, and may be omitted if business is poor or if the directors determine to withhold earnings to invest in plants and equipment. Sometimes a company will pay a dividend out of past earnings even if it is not currently operating at a profit. Dividend equivalent rights. The right to be credited with additional shares under a stock option or other stock award for the value of dividends that the company has paid on its shares while the option or award is being held. DJIA. Abbreviation for Dow Jones Industrial Average. D&O. Abbreviation for directors & officers. Usually used in context of D&O liability insurance. DOL. Abbreviation for Department of Labor. Dollar cost averaging. A system of buying securities at regular intervals with a fixed dollar amount. Under this system, investors buy by the dollars’ worth rather than by the number of shares. If each investment is of the same number of dollars, payments buy more shares when the price is low and fewer when it rises. Temporary downswings in price benefit investors if they continue periodic purchases in both good times and bad and the price at which the shares are sold is more than their average cost.

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Double trigger. A term used in connection with a change in control of ownership; refers to how a CIC, together with a subsequent event, such as termination of the employee by the company or termination by the employee for good reason, might trigger accelerated vesting of a stock option. A double trigger means that vesting will not occur until the second event takes place. Dow Jones Industrial Average (DJIA). An index used to measure the performance of the U.S. financial markets. Introduced on May 26, 1896, by Charles H. Dow, it is the oldest stock price measure in continuous use. Over the past century, “the Dow” has become the most widely recognized stock market indication in the United States and probably in the entire world. The 30 stocks included in today’s Dow are listed on the New York Stock Exchange, except for Microsoft and Intel, and are all large blue-chip companies that reflect the health of the U.S. economy. All but a handful of these have major business operations throughout the rest of the world, thus providing some insight into the economic well-being of the global economy. The Dow has been repeatedly updated over the decades to reflect changes in corporate America. From the original 12 stocks used in 1896, it was increased to 20 stocks in 1916 and then 30 stocks in 1928. The most recent modification occurred on November 1, 1999, when Home Depot, Intel, Microsoft, and SBC replaced Chevron, Goodyear, Sears, and Union Carbide, respectively. Intel and Microsoft, which both trade on the NASDAQ stock market, are the first Dow 30 components that are not listed on the New York Stock Exchange since the Dow Jones Industrial Average was created in 1896. Though it is only the unweighted average of 30 stock prices, over the long run the DJIA’s tracking of market movements has closely paralleled more broadly based capitalization-weighted indexes like the New York Stock Exchange Composite, the Standard & Poor’s 500, and the Wilshire 5000. In 1896 the Dow was computed as the sum of the prices of 12 stocks divided by the number of stocks. Since then the divisor has been adjusted to compensate for stock splits and other distributions that would create distortions in the average that did not reflect a change in value of the stocks. The value of the adjusted divisor as of November 1, 1999, was 0.20435952. Its current value is printed in the Wall Street Journal every day. DTC. Abbreviation for Depository Trust Company. Due diligence. An investigation into the financial, legal, and business affairs of a company undertaken by the underwriters and their counsel prior to a public offering by the company, or the purchase of a company. Early exercisable options. Options that are immediately exercisable (i.e., early), but that typically do not start vesting until six months to a year after grant. The underlying shares received at exercise are restricted and subject to a repurchase right by the company at the exercise price until they are vested. Early exercise starts the capital gain clock ticking for a later resale. No gains are realized on the spread from the option exercise until vesting or until a Section 83(b) election is filed. Availability of this feature is becoming common among pre-IPO company stock plans and is sometimes referred to as reverse vesting. Earnings before interest and taxes (EBIT). All profits (operating and nonoperating) before deduction of interest and income taxes. Earnings before interest, taxes, depreciation, and amortization (EBITDA). Concerns the cash flow of a company; by not including interest, taxes, depreciation, and amortization, one can see clearly the amount of money a company is bringing in. This is especially useful

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when a company wants to take over another company, because the EBITDA would cover any loan payments needed to finance the takeover. Earnings per share (EPS). Net income for the fiscal year divided by the total number of shares outstanding, with adjustments for common stock equivalents. EBIT. Abbreviation for earnings before interest and taxes. EBITDA. Abbreviation for earnings before interest, taxes, depreciation, and amortization. EBP. Abbreviation for excess benefit plan. Economic indicator. A key statistic in the overall economy that may be used as a yardstick to predict the performance of the stock market. Economic profit. A calculation of profits that exceed the expected return to shareholders. Normally calculated by subtracting the cost of capital from an adjusted profit number. Many variations of the calculation exist. Economic Recovery Tax Act (ERTA) of 1981 (1981 Tax Act). ERTA emphasized the deferral of compensation, and also reduced ordinary income tax rates. It introduced the concept of the incentive stock option (ISO). Economic value added (EVA). A concept copyrighted by Stern Stewart & Co. EVA is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. As such, EVA is an estimate of true “economic” profit, or the amount by which earnings exceed or fall short of the required minimum rate of return that shareholders and lenders could get by investing in other securities of comparable risk. EDGAR—Electronic Data Gathering, Analysis and Retrieval System. The system through which companies electronically file reports and registration statements with the SEC. This requires converting the paper or word-processing document to be filed into a universal ASCII format, a process known as “EDGAR-izing” the document. The public can then access the filings through the SEC’s Web site on the Internet. EEOC. Abbreviation for Equal Employment Opportunity Commission. EITF. Abbreviation for Emerging Issues Task Force. Emerging Issues Task Force (EITF). Organization affiliated with FASB that addresses new and emerging accounting issues. The EITF was formed in 1984 in response to the recommendations of the FASB’s task force on timely financial reporting guidance and an FASB Invitation to Comment on those recommendations. Task force members are drawn primarily from public accounting firms, but also include representatives of large companies and major associations of preparers, such as the Financial Executives Institute and the Institute of Management Accountants. The chief accountant of the Securities and Exchange Commission attends EITF meetings regularly as an observer with the privilege of the floor. The FASB director of research and technical activities is chairman of the task force. Makeup of the task force is designed to include persons in a position to be aware of emerging issues before they become widespread and before divergent practices regarding them become entrenched. Therefore, if the group can reach a consensus on an issue, usually that is taken by the FASB as an indication that no board action is needed. If no consensus is possible, it may be an indication that action by the FASB is necessary. Employee benefits. That part of the total compensation package, other than pay for time worked, provided to employees in whole or in part by employer payments (e.g., life insurance, pension, workers’ compensation, vacation).

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Employee Retirement Income Security Act of 1974 (ERISA). An act regulating private employer pension and welfare programs. The act has provisions that cover eligibility for participation, reporting, and disclosure requirements; establish fiduciary standards for the financial management of retirement funds; and establish the Pension Benefit Guaranty Corporation to insure pension plans against financial failures. ERISA preempts many similar state laws and is administered by the Pension and Welfare Benefits Administration (PWBA). Under the statute, employers must fund an insurance system to protect certain kinds of retirement benefits, with premium payments to the federal government’s Pension Benefit Guaranty Corporation. Pension plans must meet a wide range of fiduciary, disclosure, and reporting requirements. Employee welfare plans must meet similar requirements. PWBA also administers reporting requirements for continuation of health-care provisions, required under the Comprehensive Omnibus Budget Reconciliation Act of 1985. Employee stock ownership plan (ESOP). A special form of tax-qualified defined contribution retirement plan. ESOPs are special in two respects: they are typically issued in the form of the employer’s common or convertible preferred stock and they are typically purchased with a loan. ESOPs differ from most compensation arrangements because they are tax-qualified plans for large groups of employees rather than management-oriented plans. Unlike most other broad-based compensation arrangements, however, ESOPs invest in and generally distribute to employees the employer’s stock. There are two types of ESOPs, nonleveraged and leveraged. With regard to a nonleveraged ESOP, the employer may either contribute shares (treasury shares or newly issued shares) or cash to the ESOP. If the employer contributes cash, the ESOP trustee will use the cash to buy shares on the open market or newly issued shares from the employer. The contributed or purchased shares are allocated to the employee’s accounts by the end of the ESOP’s fiscal year. For a leveraged ESOP, a company borrows money from a financial institution using its stock as collateral for the loan. Principal and interest loan repayment are tax-deductible. With each loan repayment, the lending institution releases a certain amount of stock being held as security. The stock is then placed into an employee stock ownership trust for distribution at no cost to all employees. The employees receive the stock upon retirement or separation from the company. TRASOPs and PAYSOPs are variants of ESOPs. Employee stock purchase plan (ESPP). A type of broad-based stock plan that permits employees to use payroll deductions accumulated over a 3-, 6-, 12-month, or longer purchase period to acquire stock from the company, generally at a 15 percent discount. A popular type of ESPP is also known as a “Section 423 plan,” after the applicable tax code section governing this type of plan. Employment agreement. A legal agreement between a company and an executive that specifies total remuneration arrangements and terms for specific duties under set conditions, for a stipulated period of time. EPA. Abbreviation for Equal Pay Act. EPS. Abbreviation for earnings per share. Equal Employment Opportunity Commission (EEOC). A commission of the federal government charged with enforcing the provision of the Civil Rights Act of 1964 and the EPA of 1963 as it pertains to sex discrimination in pay. Equal Pay Act (EPA) of 1963. An amendment to the Fair Labor Standards Act of 1936, prohibiting pay differentials on jobs that are substantially equal in terms of skills, efforts,

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responsibility, and working conditions, except when the variances are the result of bona fide seniority, merit, or production-based systems, or any other job-related factor other than gender. Equity collar. Hedging strategy used for high-value, concentrated stock positions. You purchase put options and sell call options on your stock through a securities firm that is experienced in these transactions. This essentially locks in the trading range upside and downside (i.e., the “collar”). The collar can be structured so that the premium received for the sale of the call and the money paid for purchase of the put net each other out. The hedged position can be used as collateral for a loan (if you are not a senior executive, director, or other affiliate). This strategy allows you to hold the stock after an option exercise for long-term capital gains, minimizes the risk of stock price fluctuations, finances the cost of the put (zerocost collar), or brings in more or less cash than the cost of the put. However, it has uncertain legal and tax ramifications; it is prohibited by many companies, and you give up the benefit of future price increases beyond the collar price. Equity security. An ownership interest in a company. Common and preferred stock are types of equity securities. Equity securities can be distinguished from debt securities, such as bonds, and from derivative securities, such as stock options. ERISA. Abbreviation for Employee Retirement Income Security Act of 1974. ERISA excess plan. A type of pension plan for key executives to restore benefits that were reduced by the enactment of ERISA. The company makes up the difference between what an executive accrues under the company pension plan and the amount he or she is allowed to receive under ERISA restrictions. ESOP. Abbreviation for employee stock ownership plan. ESPP. Abbreviation for employee stock purchase plan. European option. A stock option that may be exercised only on its expiration date. EVA. Abbreviation for economic value added. Evergreen agreement. An agreement that does not expire. The agreement is usually automatically renewed if not canceled by a certain date each year. Evergreen stock option reserve. An employee stock plan funding mechanism that authorizes annual increases (generally expressed as a percentage of outstanding common stock) to the number of shares available for stock grants and awards. Excess benefit plan. See ERISA excess plan. Ex-Dividend. A synonym for “without dividend.” The buyer of an ex-dividend stock is not entitled to the next dividend payment. Dividends are paid on a set date to all those shareholders recorded on the books of the company as of a previous date of record. For example, a dividend may be declared as payable to stockholders of record on a given Friday. Since three business days are allowed for delivery of stock in a regular transaction on the New York Stock Exchange, the Exchange would declare the stock “ex-dividend” as of the opening of the market on the preceding Wednesday. That means anyone who bought it on or after that Wednesday would not be entitled to that dividend. When stocks go ex-dividend, the stock tables include the symbol “x” following the name. Executive perquisite. Special benefit made available to top executives (and sometimes other managerial employees). May be taxable income to the executive. Company-related perquisites may include company-paid club memberships, first-class air travel, use of cor-

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porate aircraft, company car, home computer, cellular phone, and other amenities related to work. Personal perquisites include such items as low-cost loans for various reasons, and personal tax planning and legal counsel. Since 1978, the IRS has required companies to value these special benefits and require executives to pay tax on the imputed income associated with the benefit. Companies have resisted the IRS in this regard. In addition, some companies gross up executives for the additional taxes imposed by this imputed income. Exercisable. Describes options that, because of the passage of time or the meeting of specified performance targets, have vested and may now be exercised by the option holder. Options often become exercisable in increments over time. In some option plans at pre-IPO companies, one can exercise unvested options subject to a company repurchase right under a vesting-like schedule. Exercise. The act of acquiring the underlying securities subject to a stock option by paying the Exercise Price. Exercise period. The date or dates specific stock options are available for exercise. Expatriate. Employee assigned outside of the base country for any period of time in excess of one year. Face value. Refers to the number of shares times the share price. For example, 100 shares at $50 per share have a face value of $5,000. Fair Labor Standards Act of 1936 (FLSA). A federal law that establishes minimum wage, overtime pay, recordkeeping, and child labor standards that affect more than 100 million full- and part-time workers in the private sector and in federal, state, and local governments. FLSA applies to enterprises that have employees who are engaged in interstate commerce; producing goods for interstate commerce; or handling, selling, or working on goods or materials that have been moved in or produced for interstate commerce. FLSA prescribes standards for wages and overtime pay, which affect most private and public employment. The act is administered by the Wage and Hour Division of the Employment Standards Administration. It requires employers to pay covered employees the federal minimum wage and overtime of one-and-one-half times the regular wage. It prohibits certain types of work in an employee’s home. It restricts the hours that children under the age of 16 can work and forbids their employment in certain jobs deemed too dangerous. The Wage and Hour Division also enforces the workplace provisions of the Immigration and Nationality Act that apply to aliens authorized to work in the United States. Fair market value (FMV). For tax purposes, the price, based on the current market value, determined by supply and demand or a valuation method, at which a buyer and seller would willingly undertake a transaction. You need to know the fair market value to determine the amount of income to report for the exercise of options and sale of the stock. For a public company, the stock market sets the fair market value, which could be the average trading price for the day. With a private company, the fair market value measure is more subjective. It could be based on a recent round of financing or set by an outside valuation company. Fair value. The amount for which an asset could be bought or sold in a current transaction between willing parties; that is, other than in a forced liquidation sale. Quoted market prices in active markets are the best evidence of fair value and are to be used as the basis for measurement, if available. If quoted market prices are not available, the estimate of fair value is based on the best information available. The estimate of fair value considers prices for similar amounts and the results of valuation techniques to the extent available. Examples of valuation techniques include the present value of estimated future cash flows using

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a discount rate commensurate with the risks involved, option-pricing models, matrix pricing, option-adjusted spread models, and fundamental analysis. Family Medical Leave Act (FMLA) of 1993. Entitles an eligible employee to receive unpaid leave of up to 12 weeks per year for specified family or medical reasons, such as caring for ill family members or adopting a child. FAS. Abbreviation for “Financial Accounting Statement.” FASB. Abbreviation for Financial Accounting Standards Board. Federal Insurance Contributions Act (FICA). The statute that established social security contribution withholding requirements. The FICA payments are made equally by the employer and employee. Federal Unemployment Tax Act (FUTA). A law enacted more than 60 years ago to guarantee financing for a national employment security system. The idea was that employers would pay the cost of administering the new unemployment compensation system, along with a national job placement system, to help them recruit new workers and to get laid-off workers and unemployment compensation claimants into new jobs as quickly as possible. FUTA is administered by the DOL. FICA. Abbreviation for Federal Insurance Contributions Act. Financial Accounting Standards Board (FASB). An organization that develops accounting standards on a wide range of financial topics, including stock compensation. Since 1973, the FASB has been the designated organization in the private sector for establishing standards of financial accounting and reporting. Those standards govern the preparation of financial reports. These accounting standards are officially recognized as authoritative by the Securities and Exchange Commission (Financial Reporting Release No. 1, Section 101) and the American Institute of Certified Public Accountants (Rule 203, Rules of Conduct, as amended May 1973 and May 1979). The FASB is part of a structure that is independent of all other business and professional organizations. Before the present structure was created, financial accounting and reporting standards were established first by the Committee on Accounting Procedure of the American Institute of CPAs (1936-59) and then by the Accounting Principles Board, also an arm of the AICPA (1959-73). Pronouncements of those predecessor bodies remain in force unless amended or superseded by the FASB. Financial Accounting Statement No. 123 (FAS 123). An accounting rule effective for fiscal years ending on or after December 15, 1996. Requires companies to estimate the dollar value of their stock-based compensation and either (1) disclose the value in a financial statement footnote or, at the company’s option, (2) recognize that value as compensation expense on the income statement. Financial statements. The balance sheet, income statement, statement of changes in financial position, statement of changes in owners’ equity accounts, and notes thereto. Fiscal year. Any consecutive 12-month period of financial accountability for a corporation or government. For example, because of the Christmas rush, many department stores find it easier to wind up their yearly accounting on January 31 instead of December 31. Fiscal year is often abbreviated FY with a date. For example, FY May 31 means that the company’s fiscal year goes from June 1 to May 31 of the following year. Fixed accounting. An award of stock-based employee compensation for which vesting is based solely on an employee’s continuing to render service to the employer for a specified

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period of time; that is, an award that does not specify a performance condition for vesting. FAS 123 uses the term “fixed award” in an somewhat different sense than APB Opinion 25, which distinguishes between fixed awards and variable awards. FAS 123 only distinguishes between fixed awards and performance awards. Fixed award. See fixed accounting. Fixed grant guidelines. Guidelines under which a company determines grant size according to a set number of shares or a set percentage of shares outstanding rather than a value for the shares granted. FLSA. Abbreviation for Fair Labor Standards Act of 1936. FMLA. Abbreviation for Family Medical Leave Act of 1993. FMV. Abbreviation for fair market value. Forgivable stock option exercise loan. A full-recourse loan extended by the company to employee (or company-secured third-party financing) for purchase of company stock. The loan must be repaid upon voluntary termination and may be forgiven based on future company service and/or performance. Form 3. The initial form filed with the SEC, the issuer, and the issuer’s stock exchange pursuant to Section 16(a) of the Securities Exchange Act of 1934 by all directors, officers, and holders of 10 percent or more of any class of equity securities of the issuer. Form 3 details the direct and indirect holdings of the issuer’s stock as well as the number of options, warrants, rights, and convertible stock or bonds. Form 3 must be filed within 10 calendar days after a person becomes a Section 16 insider, whether or not the insider owns any shares. Form 4. Form filed periodically with the SEC, the issuer, and the issuer’s stock exchange when there has been a nonexempt change in an insider’s ownership of company stock, such as a purchase, sale, or option exercise. Form 4 must be filed by the insider by the tenth calendar day of the month after the month in which the change took place. Form 5. Year-end form filed with the SEC, the issuer, and the issuer’s stock exchange to report certain transactions exempt from Form 4 reporting and any changes not previously reported by the insider on Form 3 or Form 4. Form 5, if required, must be filed within 45 days after the end of the issuer’s fiscal year. Form 8-K. A report required to be filed with the SEC to publicly disclose certain material corporate events, such as a change in control, a significant acquisition, a bankruptcy, or a change in the company’s fiscal year or accounting firms. Form 10-K. Annual report required to be filed with the SEC within 90 days after the end of the fiscal year. The 10-K includes a description of the company’s business and properties, the audited financial statements, and management’s discussion and analysis (MD&A) of the financials. The 10-K must be signed by a majority of the board of directors. Form 10-Q. Quarterly report required to be filed with the SEC within 45 days after the end of each of the first three fiscal quarters. Form 10-Q is less comprehensive than the Form 10-K annual report and does not require that financial statements be audited. It covers the specific quarter and the year to date. Form 144. The notice of sale required when an executive officer, director, or other affiliate of a company sells that company’s stock. It must be filed with the SEC at the time an order is placed with a broker to sell the stock. Form 144 is not required if both the number of shares does not exceed 500 and the aggregate sale price does not exceed $10,000.

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Form 1099-B. Form from a broker showing how much you received from securities sales, such as the proceeds from a cashless exercise. You use this amount, along with your tax basis, to calculate your gain or loss for tax purposes on Schedule D. Form 1099-MISC. Tax form that nonemployees (e.g., consultants, independent contractors) receive that reports income/compensation; similar in concept to the Form W-2 for employees. For nonemployees, withholding does not apply when NQSOs are exercised. The spread at exercise is compensation for services. Thus, self-employment tax, along with state and federal income tax, applies when you file your tax return. Form S-1. A registration statement under the Securities Act of 1933, which a company files with the SEC to register its stock for sale. Form S-1 is generally the form used by a private company that is going public. It contains the prospectus, along with a number of exhibits and other information about the company. The SEC staff reviews the Form S-1 and provides comments that must be resolved with the staff before the public offering can go forward. Form S-3. A shorter form of registration statement than the Form S-1, that can be used by certain already-public companies to sell additional shares. It is also the form most often used to cover resales of restricted securities by selling stockholders. Form S-4. A form of registration statement used when a company is issuing its shares in connection with a merger or acquisition. Form S-8. A very brief form of registration statement filed with the SEC to register shares to be issued under a stock plan. Does not require filing of a prospectus. Form W-2. See W-2. Form W-8. See W-8. Form W-9. See W-9. Formula plan. A plan in which both the recipients and the number of shares to be granted are set by the terms of the plan itself rather than being left to the discretion of the compensation committee. The most prevalent form is the book-value plan. Formula-value stock. Simulated stock, also called phantom shares, used to measure the performance of companies or business units that do not have publicly traded shares. The value of the stock is determined by a formula. Founders’ stock. A pre-IPO stock grant. Fundamental research. Analysis of industries and companies based on such factors as sales, assets, earnings, products or services, markets, and management. As applied to the economy, fundamental research includes consideration of gross national product, interest rates, unemployment, inventories, savings, and so forth. Funding formula. The performance level required, as defined by the board, for bonuses to be paid and the percentage of profits above the threshold that will go toward bonuses. FUTA. Abbreviation for Federal Unemployment Tax Act. Going public. When a privately held company first offers its shares to the investing public; also known as an IPO or initial public offering. Golden bungee. Refers to executive “severance” benefits after a change in control of ownership when the executive agrees to stay with the new organization and receive additional pay in various forms. Golden handcuffs. Refers to compensation and benefits that could be lost upon voluntary termination of the executive.

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Golden hello. See sign-on Bonus. Golden parachute. An employment agreement that assures compensation and benefit payments in the event of a change of control or ownership. One or several events are necessary to trigger parachute payments. IRC §§ 280G and 4999 limit deductibility and govern amounts subject to 20 percent excise tax and corporate tax deductions. Grant. The issuance of an award under a stock plan, such as a stock option or shares of restricted stock. Grant date. The date on which a stock award is granted. That is, the grant date is the date at which an employer and employee have a mental understanding of the terms of a stockbased compensation award. The employer is obligated on the grant date to issue equity instruments or transfer other assets to employees usually subject to vesting requirements. Awards are made under a plan that is subject to shareholder approval. These awards are not granted until that approval is obtained unless approval is essentially a formality (for example, when management and the board of directors control enough votes to approve the plan). Grant multiple. The multiple of aggregate stock option award (options shares times option exercise price) to salary. Grant price. The price per share at which a stock option is granted and that must be paid to exercise the stock option. The grant price is typically the fair market value of the stock on the date of grant. Also known as the “exercise price” or strike price. Hedging. As it relates to employee stock options, transactions that protect your option gains without the full tax consequences of exercising and selling the stock. Various hedging strategies may allow you to exercise the options, hold the stock to get long-term capital gains, and protect your stock from large price swings. Holders of large, concentrated stock positions with a low cost basis also enter into these types of transactions to defer the tax consequences of sale, minimize their risk of price declines, and even borrow against their hedged position (i.e., monetize it) to create liquidity and diversify. These strategies include buying put options, a short sale against the box (i.e., selling borrowed stock and later delivering option stock you do hold to close out the short position), and zero premium collars (i.e., buy put and sell call options). All of these transactions involve complicated and unresolved legal and tax rules, and may be prohibited by your company. Hold. Refers to an exercise transaction in which the option holder holds the shares received upon exercise (rather than selling them for the cash). Immaculate option exercise. A form of cashless exercise in which the option exercise price is paid by instructing the company to withhold from the total number of shares issuable upon an option exercise a number of shares equal to the exercise price. The option holder is left with just the number of shares equal to the option spread. As a result of the advent of broker-assisted cashless exercise/same-day sale programs, and concerns over the potential for a negative accounting charge, the immaculate exercise has fallen out of favor. Imputed interest. Interest that the IRS assumes has been paid on a loan if the stated interest is below a minimum interest rate (the applicable federal rate). Incentive stock option (ISO). A stock option that has met certain tax requirements that entitle the option holder to favorable tax treatment. Such an option is free from regular tax at the date of grant and the date of exercise (when a nonqualified option would become taxable). If two holding-period tests are met (two years between grant date and sale date and one year between the exercise date and sale date), the profit on the option qualifies as a

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long-term capital gain rather than ordinary income. If the holding periods are not met, there has been a disqualifying disposition. Indexed-priced stock option. Stock options with an exercise price that is adjusted periodically to a stock index (e.g., the Standard & Poor’s 500 Stock Index). Indexed Stock Option. Option that has an exercise price which may fluctuate above or below market value at grant, depending on the company’s stock price performance relative to a specified index or the movement of the index itself. Indexed options differ from performance options in that the exercise price of indexed options typically remains variable until the option is exercised. Individual Retirement Account (IRA). An individual pension fund that anyone may open with a bank. An IRA permits investment of contributed funds, through intermediaries such as mutual funds, insurance companies, and banks; or directly in stocks and bonds, through stockbrokers. Because it is intended for retirement, money in an IRA enjoys many tax advantages over traditional investments, but may not be withdrawn early without heavy penalty fees. Initial public offering. The process of going public. Insider. An officer, director, or principal shareholder of a publicly owned company and members of his or her immediate family. This category may also include other people who obtain nonpublic information about a company and owe a duty not to use it for personal gain. Insider trading. Trading in a company’s securities by company insiders or others with access to material, nonpublic information. Insider Trading and Securities Fraud Enforcement Act of 1988. Federal legislation that greatly increased the penalties for trading on material inside information. Installment exercise. A form of stock option exercise right that can be executed at certain times and with certain limits during its term. Institutional investor. Organization whose primary purpose is to invest its own assets or those entrusted to it by others. The most common are employee pension funds, insurance companies, mutual funds, university endowments, and banks. Internal equity. Refers to the pay relationships among jobs or skill levels within a single organization and focuses attention on employee and management acceptance of those relationships. It involves establishing equal pay for jobs of equal worth and acceptable pay differentials for jobs of unequal worth. Internal Revenue Service (IRS). U.S. agency charged with collecting nearly all federal taxes, including personal and corporate income taxes, social security taxes, and excise, estate, and gift taxes. The IRS administers the rules and regulations that are the responsibility of the U.S. Treasury Department and investigates and prosecutes (through the U.S. Tax Court) tax illegalities. Intrinsic value. The difference between the exercise price and/or strike price of an option and the market value of the underlying security. Investment Advisers Act of 1940. This act, which falls under the purview of the SEC, regulates investment advisers. With certain exceptions, this act requires that firms or sole practitioners compensated for advising others about securities investments must register with the SEC and conform to regulations designed to protect investors. Since the act was amended in 1996, generally only advisers who have at least $25 million of assets under management or advise a registered investment company must register with the SEC.

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Investment bank. Also known as underwriter; investment banks serve as intermediaries between corporations issuing new securities and the buying public. Normally one or more investment banks buy the new issue of securities from the issuing company for a negotiated price. The company walks away with this new supply of capital, while the investment banks form a syndicate and resell the issue to their customer base and the investing public. Investment banks perform a variety of other financial services, such as merger and acquisition advice and market analysis. Investment company. A company or trust that uses its capital to invest in other companies. There are two principal types: the closed end and the open end, also known as a mutual fund. Shares of closed-end investment companies, most of which are listed on the NYSE, are readily transferable in the open market and are bought and sold like shares of stock. Capitalization of these companies remains the same unless action is taken to change, which is rare. Open-end funds sell their own new shares to investors, stand ready to buy back their old shares, and are not listed. Open-end funds are so called because their capitalization is not fixed; they issue more shares as people want them. Investment Company Act of 1940. This act, which falls under the purview of the SEC, regulates the organization of companies, including mutual funds that engage primarily in investing, reinvesting, and trading in securities and whose own securities are offered to the investing public. The regulation is designed to minimize conflicts of interest that arise in these complex operations. The act requires these companies to disclose their financial condition and investment policies to investors when stock is initially sold and, subsequently, on a regular basis. The focus of this act is on disclosure to the investing public of information about the fund and its investment objectives, as well as on investment company structure and operations. It is important to remember that the Act does not permit the SEC to directly supervise the investment decisions or activities of these companies or judge the merits of their investments. IRA. Abbreviation for individual retirement account. IRC. Abbreviation for Internal Revenue Code. Irrevocable trust. Trust that cannot be changed or terminated by the one who created it without the agreement of the beneficiary of the trust. IRS. Common abbreviation for Internal Revenue Service. ISO. Common abbreviation for incentive stock option. Job evaluation. The process for determining the relative worth of a position within an organization based on the factors valued by the organization. The end result of the job evaluation process is the assignment of jobs to some form of pay hierarchy. Job family. A collection of jobs that have common skills, occupational qualifications, technology, working conditions, and so on. Often a job family represents increasingly complex levels of a job. Joint and survivor (J&S) annuity. Most pension plans must offer this form of pension plan payout, which pays over the life of the retiree and his or her spouse after the retiree dies. The retiree and his or her spouse must specifically choose not to accept this payment form. J&S. Abbreviation for joint & survivor. Junior stock. Stock with limited or no voting stock or dividend rights; convertible into regular common stock if performance goals (or other stated events such an initial public offering) are met.

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Labor-Management Reporting and Disclosure Act. Law dealing with the relationship between a union and its members. It safeguards union funds and requires reports on certain financial transactions and administrative practices of union officials, labor consultants, and the like. The Office of Labor-Management Standards administers the act, which is part of the Employment Standards Administration. This act is also known as the Landrum-Griffin Act. LCN. Abbreviation for Local Country National. Legend. A notice on a stock certificate that the shares represented by that certificate are restricted securities. Leverage. Any means of increasing value and return by borrowing funds or committing less of one’s own. For corporations, it refers to the ratio of debt (in the form of bonds and preferred stock outstanding) to equity (in the form of common stock outstanding) in the company’s capital structure. The more long-term debt there is, the greater the financial leverage. Shareholders benefit from this financial leverage to the extent that the return on the borrowed money exceeds the interest costs of borrowing it. The market value of the company rises and so do its shares. Because of this effect, financial leverage is popularly called “trading on the equity.” For individuals, leverage can involve debt, as when an investor borrows money from a broker on margin and so is able to buy more stock than he or she otherwise could. If the stock goes up, the investor repays the broker the loan amount and keeps the profit. By borrowing money, the investor has achieved a higher return on his or her investment than if he or she had paid for all the stock personally. Rights, warrants, and option contracts also provide leverage, not through debt but by offering the prospect of a high return for little or no investment. Leveraged stock option. Often used after the restructure of a corporation; the company will match some multiple of stock options to the employee’s purchase of a fixed number of shares (e.g., company provides four options for one share purchased). Liquidity. (1) How easily an asset can be converted into cash. For example, money in an account that cannot be withdrawn for 10 years is not very liquid. (2) The ability of the market in a particular security to absorb a reasonable amount of buying or selling at reasonable price changes. Liquidity is one of the most important characteristics of a good market. Limited offering. Sales of securities exempt from registration pursuant to certain exemptions that limit the size of the offering and the number of purchasers. Limited stock appreciation right (LSAR). Similar to a SAR, but only exercisable in the case of a change in control or up to a certain value. Usually granted in tandem with a stock option. Listed stock. The stock of a company that is traded on a securities exchange. The various stock exchanges have different standards for listing. Some of the guides used by the New York Stock Exchange for an original listing are national interest in the company and a minimum of 1.1 million shares publicly held among not less than 2,000 round-lot stockholders. The publicly held common shares should have a minimum aggregate market value of $18 million. The company should have net income in the latest year of over $2.5 million before federal income tax and $2 million in each of the preceding two years. Living trust. A trust created by a person during his or her lifetime. Local Country Nationals (LCNs). Citizens of countries in which a U.S. foreign subsidiary is located. LCNs’ compensation is tied either to local wage rates or to the rate of U.S. expatriates performing the same job. Each practice of paying LCNs has different internal equity and external equity implications.

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Lock-up. An agreement between investment bankers and the companies that they bring public. This agreement restricts the resale of shares owned by founders, employees, and venture capitalists immediately after the IPO. Typically lasts for 180 days, but could last for a shorter or longer period. Long-term incentive (LTI) plan. A program providing for a payout of incentive awards based on a performance period of more than one year. Long-term incentive plans include but are not limited to stock options, stock option appreciation rights, phantom stock, performance unit, performance share plans, and restricted stock. Eventual payment depends on achievement of goals. Look-back feature. Provision in an IRC § 423 employee stock purchase plan (ESPP). The purchase price (with or without a discount) is based on the lower of the market price at the beginning or end of the purchase period (a typical plan purchase period might run for six months). For example, for a plan with a look-back feature and a 15 percent discount, if the stock price is $10 at the beginning of the purchase period and goes up to $20 at the end, your purchase price is just $8.50 ($10 – 15 percent). Margin. The amount paid by the customer when using a broker’s credit to buy or sell a security. Under Federal Reserve regulations, the initial margin required since 1934 has ranged from 40 percent of the purchase price up to 100 percent. The current rate of 50 percent has been in effect since 1974. Market share. Sales of a particular product or product line as a percentage of total sales of the product or product line. Materiality. An important constraint underlying the reporting of accounting information: it relates to how large an item is in terms of dollar amount. Accounting standards do not have to be applied to items that are considered immaterial. With regard to insider trading, material information relates to information that, if disclosed, may cause the market value to change. Mean. The sum of a set of data reported divided by the number of observations. Also referred to as the average. Measurement date. When the fair value of a stock-based employee award is known and fixed, according to current FASB rules, the first date on which the stock award can be measured. It is the first date on which both the number of shares and the option or purchase price are known. Median. The middle value of a variable in a distribution of numbers. Thus, the median of (1, 2, 3, 10, and 100) is 3. The mean (or average) of these values is 23.2. The median is generally preferred to the mean as a measure of typical values, because extreme values (very high or very low) will tend to skew the mean. Medical savings account (MSA). The general concept of a medical savings account is for an employer, or the government in the case of Medicare, to enable an insured individual to obtain and pay for a high-deductible catastrophic health insurance policy. The employer or the government would pay a fixed premium to the catastrophic insurance company, and the insured individual would share the cost of the premium. The difference between what the employer or government would customarily pay for traditional coverage and the premium of the catastrophic health insurance coverage would be put into an individual’s MSA for his or her qualified medical expenses. The Health Insurance Portability and Accountability Act of 1996 created a four-year experimental MSA program, effective January 1, 1997, allowing a maximum of 750,000

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individuals in businesses with 50 or fewer employees as well as self-employed and uninsured individuals, to receive favorable tax treatment for the MSA. Mega-grant. An exceptionally large stock award; an aggregate exercise price of $10 million or greater. Merger. A combination of two or more corporations. Minimum value. An amount attributed to an option that is calculated without considering the expected volatility of the underlying stock. Minimum value may be computed without using a standard option-pricing model and a volatility of zero. It also may be computed as (1) the current price of the stock reduced to exclude the present value of any expected dividends during the option’s life minus (2) the present value of the exercise price. Different methods of reducing the current price of the stock for the present value of the expected dividend payments, if any, may result in different computed minimum values. Minimum value stock valuation model. A model that estimates the value of a stock option; it considers the same factors as the Black-Scholes model, with the exception of (1) the stochastic estimation of future stock price, and (2) the volatility of the stock. This model is defined as the current stock price less the present value of (a) expected dividends, and (b) exercise price. Monetize. To convert illiquid value such as stock option spread to cash. See hedging, costless collar, and zero premium collar. MSA. Abbreviation for medical savings account. Mutual fund. A portfolio of stocks, bonds, or other securities administered by a team of one or more managers from an investment company who make buy and sell decisions on component securities. Capital is contributed by smaller investors who buy shares in the mutual fund rather than the individual stocks and bonds in its portfolio. The return on the fund’s holdings is distributed back to its contributors, or shareholders, minus various fees and commissions. This system allows small investors to participate in the reduced risk of a large and diverse portfolio that they could not otherwise build themselves. They also have the benefit of professional managers overseeing their money who have the time and expertise to analyze and pick securities. There are two types of mutual funds: open end and closed end. Shares in closed-end funds, some of which are listed on the New York Stock Exchange, are readily transferable in the open market and are bought and sold like other stock. These funds do not accept new contributions from investors, but only reinvest the return on the existing portfolio. Open-end funds sell their own new shares to investors, stand ready to buy back their old shares, and are not listed on exchanges. Open-end funds are so called because their capitalization is not fixed; they issue more shares as people want them. Many openend funds allow contributors extra perks, such as the ability to write checks with their portion. Naked option. Sometimes called an uncovered option; an option whose seller does not maintain an equivalent position in the underlying security. For example, the owner of a call has the option to buy the underlying stock from the writer of the call. However, if the writer does not own that stock, the option is naked. When the holder decides to exercise the option, the writer will be forced to buy the stock on the open market, and then resell it at the lower strike price. This will result in a loss for the writer. For obvious reasons, writing naked options is risky and must be done in a margin account.

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Named executive officers (NEOs). The five highest paid executive officers, whose prior fiscal year compensation is reflected in the Summary Compensation Table in a publicly held company’s annual proxy statement, pursuant to SEC disclosure requirements. National Association of Securities Dealers (NASD). An association of securities broker/ dealers, including all of the major brokerage firms as members. The NASD establishes uniform practices in the securities industry for trading in the over-the-counter market in order to protect investors. The NASDR is the regulatory arm of the NASD. NASDAQ. The National Association of Securities Dealers Automated Quotation, a global intranet providing brokers and dealers with price quotations on trades over-the-counter. Unlike the NYSE auction market, where orders meet on a trading floor, NASDAQ orders are paired and executed on a computer network. Level I service provides the best bid and offer (BBO) in a given security without identifying the market maker. Level II service provides the BBO and identifies the market maker. Level III service allows registered market makers to compete and trade by entering their own bids and offers. National market system. A system mandated by the Securities Act Amendments of 1975, the most important federal securities legislation since the 1930s. Eight markets—the American, Boston, Cincinnati, Chicago, New York, Pacific, Philadelphia, and NASD over-thecounter markets—are linked electronically by computers. This allows traders at any exchange to seek the best available price on all other exchanges that a particular security is eligible to trade on. The national market system also includes a consolidated electronic tape, which combines last-sale prices from all markets into a single stream of information. Negative discretion. Provision in an incentive plan that permits the compensation committee to reduce, but not to increase an employee’s formula-generated bonus payment. New York Stock Exchange (NYSE). Oldest (established in 1792) and largest securities exchange in the United States. The NYSE marketplace blends public pricing with assigned dealer responsibilities. Aided by advanced technology, public orders meet and interact on the trading floor with a minimum of dealer interference. The result is competitive price discovery at the point of sale. Liquidity in the NYSE auction market system is provided by individual and institutional investors, member firms trading for their own accounts, and assigned specialists. The NYSE is linked with other markets trading listed securities through the Intermarket Trading System (ITS). NYSE-assigned dealers, known as specialists, are responsible for maintaining a fair and orderly market in the securities assigned to them. Most trading, however, is conducted by brokers acting on behalf of customers, rather than by dealers trading for their own account. For this reason, the NYSE is often described as an agency auction market. The interaction of natural buyers and sellers determines the price of an NYSE-listed stock. Nonqualified deferred compensation plan (NQDCP). Nonqualified stock option (NQSO). An employee stock option not meeting the IRS criteria for ISOs (incentive stock options) and therefore triggering a tax upon exercise. This type of option requires withholding of state and federal income tax, Medicare, and FICA/FUTA on the excess of the fair market value over the exercise price on the exercise date. NQDCP. Abbreviation for nonqualified deferred compensation plan. NQSO. Abbreviation for nonqualified stock option. NYSE. Abbreviation for New York Stock Exchange.

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NYSE Composite Index. Established by the NYSE in 1966 to provide a comprehensive measure of the market trend for the benefit of many investors who are concerned with general stock market price movements. The Composite Index consists of all common stocks listed on the NYSE and four subgroup indexes—Industrial, Transportation, Utility, and Finance. The indexes are basically a measure of the changes in aggregate market value of NYSE common stocks, adjusted to eliminate the effects of capitalization changes, new listings and delistings. The market value of each stock is obtained by multiplying its price per share by the number of shares listed. The aggregate market value, which is the sum of the individual market values, is then expressed relative to a base point market value. The base value was set at 50.00 on December 31, 1965, because this figure was reasonably close to the actual average price of all common stocks at that time. The arithmetic procedure in calculating the index is shown in the following simplified example: Year-end total market value of common stocks, $5,943.5 billion, divided by adjusted base market value, $901.9 billion, multiplied by 50.00 equals the index, 329.51 at year end. Every measure of changes in stock prices—index or average—must frequently be adjusted to reflect only movements resulting from auction market activity and eliminate the influence of corporate actions. Any change in the capitalization of an individual issue or of all issues in aggregate is dealt with in this index by making a proportionate change in the market value of the base figure. Occupational Safety and Health Act (OSH Act). The law administered by the Occupational Safety and Health Administration (OSHA). Safety and health conditions in most private industries are regulated by OSHA or OSHA-approved state systems. Employers must identify and eliminate unhealthful or hazardous conditions; employees must comply with all rules and regulations that apply to their own workplace conduct. Covered employers must maintain safe and healthful work environments in keeping with requirements of the law. Effective OSHA safety and health regulations supersede others originally issued under these other laws: the Walsh-Healey Act, the Service Contract Act, the Contract Work Hours and Safety Standards Act, the Arts and Humanities Act, and the Longshore and Harbor Workers’ Compensation Act. Off-hours trading. Trading that takes place after the close of the regular session. On June 13, 1991, the NYSE introduced off-hours trading in the form of two post-4:00 P.M. crosses. Crossing Session I introduced a 5:00 P.M. cross in individual stocks at the NYSE regular day closing price; Crossing Session II facilitates the crossing of portfolios until 5:15 P.M. Omnibus stock plan. A long-term incentive plan that provides the flexibility to use a number of long-term incentive vehicles, such as stock options, stock appreciation rights, restricted stock, performance shares, and performance units. A list of performance measures is included in such a plan. Option deferral. An election by an employee to receive all or a portion of his or her compensation (or fees) in stock options. Company directors, for example, might be able to choose to get some or all of their fees in unrestricted common shares, stock options, restricted stock, or a combination. Option holder. A person who has been granted a stock option. Also referred to as an optionee. Option spread. The amount by which the value of an option grant, at the time of exercise, exceeds its value at the time it was awarded. The spread is determined by multiplying the

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number of shares exercised by the amount by which the market price per share on the date of exercise exceeds the option’s stock price per share. Also referred to as intrinsic value. Optionee. A person who has been granted a stock option. Also referred to as an option holder. Out of the money. A term used to describe an employee stock option when the current market price is below the option exercise price. When an option is out of the money, it would cost more than the underlying stock is worth to exercise the option. Such options are also described as being underwater. Outside director. A board member who is neither a current employee nor a former employee. Over the counter. A market, including NASDAQ, in which securities transactions are conducted through a computer network connecting dealers in stocks and bonds, rather than on the floor of an exchange. Ownership guidelines. Requirements at some companies that executives, directors, and key employees own a specified amount of company stock so that their financial interests are clearly aligned with those of shareholders. The most commonly used guidelines require stock ownership with a value based on some multiple of salary (e.g., 3x salary). A minority of companies express ownership as a specific number of shares. The guidelines are tiered by position so that the CEO has the highest-level ownership requirement. PARSAP. Abbreviation for performance accelerated restricted stock award plan. Pay differential. Pay differences among levels within the organization, such as the difference in pay between adjacent levels in career path, between supervisors and subordinates, and between executive and nonexecutive employees. Penny stocks. Low-priced issues, often highly speculative, selling at less than $1 a share. Frequently used as a term of disparagement, although some penny stocks have developed into investment-caliber issues. Performance-accelerated restricted stock award plan (PARSAP). Also known as “performance-accelerated restricted stock (PARS)” and “time-accelerated restricted stock award plans (TARSAPs).” Grants of restricted stock or restricted stock units that may vest early upon attainment of specified performance objectives. Otherwise, a time-vesting schedule would remain in effect. Performance condition (performance award). FASB definition: An award of stock-based employee compensation for which vesting depends on both (a) an employee’s rendering services to the employer for a specified period of time, and (b) the achievement of a specified performance target. A performance condition may pertain either to the performance of the enterprise as a whole or to some part of the enterprise, such as a division. Performance share. Grants of actual shares of stock or phantom stock whose payment is contingent on performance as measured against predetermined objectives over a multiyear period of time; same as performance units except that the value paid fluctuates with stock price changes as well as performance against objectives. Payout may be settled in cash or stock. Performance stock option. Options for which some aspect of vesting or exercise price is subject to specified performance criteria. Options with performance vesting provisions generally become exercisable at or near the end of the option term, regardless of performance, to secure favorable accounting treatment.

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Performance unit. Cash earned by an executive at the end of a long-term performance period if certain preestablished financial objectives are achieved. Similar to performance shares, except that payments are not related to stock price and units are earned on the basis of internal financial performance measures. Permanent discount purchase plan. A stock purchase plan that enables employees to purchase restricted stock at a set dollar discount from the then-current market price of the stock. The discount is usually significant relative to the market price at the date of purchase. If the employee subsequently wishes to sell the stock, the employer has a right to repurchase the shares at the then market price, less the original discount. Perquisites. See executive perquisite. Phantom stock award. A type of incentive grant in which the recipient is not issued actual shares of stock on the grant date, but instead receives an account credited with a certain number of hypothetical shares. The value of the account increases or decreases over time based on the appreciation or depreciation of the stock price and the crediting of phantom dividends. Payout may be settled in cash or stock. Poison pill. A device designed to prevent a hostile takeover by increasing the takeover cost, usually through the issuance of new preferred shares that carry severe redemption provisions. Pooling of interests. A merger accounting method whereby the balance sheets of the two merging companies are combined line by line without a tax impact. Preferred stock. A type of stock that pays a fixed dividend, regardless of corporate earnings, and has priority over common stock in the payment of dividends. However, it carries no voting rights, and if earnings rise significantly the preferred holder is stuck with the same fixed dividend, while common holders collect more. The fixed income stream of preferred stock makes it similar in many ways to bonds. Pregnancy Discrimination Act of 1978. An amendment to Title VII of the Civil Rights Act. It requires a company to extend to pregnant employees or spouses the same disability and medical benefits provided other employees or spouses of employees. Premium-priced stock option. Options that have an exercise price above market value at the time of grant. Present value (PV). Value today of a future payment, or stream of payments, discounted at some appropriate compound interest or discount rate. The present-value method, also called the discounted cash-flow method, is widely used to compare alternative investments of cash-flow streams. Price earnings (P/E) ratio. A popular measure for comparing stocks selling at different prices in order to single out over- or undervalued issues. The P/E ratio is simply the price per share divided by the company’s earnings per share. However, P/E is not always an accurate guide to a stock’s quality. Some people tend to think that a stock is inflated and drastically overvalued if its price is many times its earnings. Yet that same stock may be quite accurately valued to reflect the company’s rapid growth and potential for high future earnings. When comparing P/Es, it is therefore important to choose stocks in the same industry, which are likely to face the same earnings prospects. Price index. Overall measure of how much prices have increased over a period of time. Prices are expressed as some percentage of the prices prevailing during a base period. Primary offering. An offering of unissued securities.

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Principal stockholder. An investor that either (1) owns 10 percent or more of an entity’s common stock or (2) has the ability, directly or indirectly, to control or significantly influence the entity. Private placement. Sales of securities not involving a public offering pursuant to certain exemptions. Program Trading. A wide range of portfolio trading strategies involving the purchase or sale of 15 or more stocks having a total market value of $1 million or more. Prospectus. A document that is disclosed to potential investors of publicly traded companies. The prospectus forms the heart of a registration statement filed with the SEC. Potential purchasers may be the investing public, in the case of an initial public offering, or the company’s employees, in the case of a stock plan. (According to the comic strip Dilbert, “prospectus” is actually a Latin word meaning “close your eyes and open your mouth.”) Proxy. Refers either to (1) a person, such as a member of management, who is designated by a stockholder to vote on behalf of the stockholder at a meeting; or (2) a signed card or other document that designates such a person. Corporate matters are typically voted on via proxy because it would be impossible to assemble all of the stockholders at one time to vote in person. Proxy battle. Strategy used by an acquiring company in a hostile takeover attempt, whereby the acquirer challenges the target company’s management and solicits support from the target company’s shareholders for proposals that would effectively give the acquiring company control of the target without having to pay a premium. Also known as a “proxy fight.” Proxy fight. See proxy battle. Proxy statement. Information document that the SEC requires to be provided to stockholders before they vote by proxy on corporate matters. The proxy statement contains biographical information on the members of the board of directors; the top five executive officers’ salaries, bonus, and stock compensation; and any proposals from management or stockholders to be acted upon at the meeting. Also referred to as DEF14A or PRE14A. Prudent man rule. An investment standard that dictates the type of security, or specific securities, in which a fiduciary or trustee may invest money. Generally, it implies that a fiduciary or trustee may invest in a security only if it is one that a prudent man of discretion and intelligence would buy. Public Utility Holding Company Act of 1935. Interstate holding companies engaged, through subsidiaries, in the electric utility business or in the retail distribution of natural or manufactured gas are subject to regulation under this act. These companies, unless specifically exempted, are required to submit reports providing detailed information concerning the organization, financial structure, and operations of the holding company and its subsidiaries. Holding companies are subject to SEC regulations on matters such as structure of their utility systems, transactions among companies that are part of the holding company utility system, acquisitions, business combinations, the issue and sale of securities, and financing transactions. Put option (put). A derivative security giving the holder the right to sell securities at a fixed price (see call option). A protective put strategy allows holders of concentrated stock positions to have protection against share price drops. By purchasing a put, if the stock price is below the strike price at expiration, the holder will receive a payment for the difference. For example, the current

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market price per share is $50, and a put is purchased with a $35 downside strike price. At expiration, when the price is $30, a $5 cash payment will be made. PV. Abbreviation for present value. Pyramid exercise. A type of stock swap option exercise in which a small number of previously owned shares is surrendered to the company to pay a portion of the exercise price, for which a slightly larger number of option shares may be purchased. The newly purchased shares are then immediately surrendered back to the company to pay additional amounts of the exercise price, and so on until the full option price has been paid and the option holder is left with just the number of shares equal to the option spread. With the advent of brokerassisted cashless exercise/same-day sale programs, pyramiding has fallen out of favor. Qualified plan. Generally, a plan that meets qualifications under the applicable sections of the Internal Revenue Code. A plan whereby the employer can take a tax deduction with respect to accrual of an as-yet-unpaid benefit. For example, a qualified defined benefit pension allows a company to take a tax deduction for the accrual of a pension benefit. Qualified stock option (QSO). A stock option that meets the requirements established by IRC § 422. A QSO is also referred to as an ISO. Qualifying disposition. Transfer (e.g., by gift or sale) of ISO or ESPP shares after the required holding period of two years from the grant date or one year from the purchase/ exercise date. Rabbi trust. A nonqualified fund for holding deferred compensation tax-free until either the company gives up the right to recall the money, the beneficiary collects, or the funds are made available to the general creditors of the company in the event of a bankruptcy. Real estate investment trust. See REIT. Record date. The date set by the board of directors for the transfer agent to close the company’s books to further changes in registration of stock, in order to identify the stockholders entitled to receive the next dividend or to vote at an upcoming meeting. A stockholder must officially own shares as of the record date to receive the dividend or vote at the meeting. Record owner. The stockholder of record of shares of stock, which may be different from the beneficial owner of those shares. Registration. Before a company may make a public offering of new securities, the securities must be registered under the Securities Act of 1933. A registration statement is filed with the SEC by the issuer. It must disclose pertinent information relating to the company’s operations, securities, management, and purpose of the public offering. Before a security may be admitted to dealings on a national security exchange, it must be registered under the Securities Exchange Act of 1934. The company issuing the securities must file the application for registration with the exchange and the SEC. Registration statement. A disclosure document filed with the SEC to register shares of stock for sale to the public. Forms S-1, S-2, S-3, and S-8 are common types of registration statements. Form S-8 is used for employee benefit plans. Companies and individuals who are reselling stock that they already own can use Form S-3 instead of Rule 144. Regression. A common statistical approach used to determine the relationship between pay and factors that may affect pay, such as revenue size, number of employees, and so on. The most common type of regression is a single regression. Regulation T. Federal Reserve Board regulations governing the extension of credit by broker/dealers, including their participation in cashless exercise/same-day sale transactions.

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REIT (real estate investment trust). An organization similar to an investment company in some respects, but concentrating its holdings in real estate investments. The yield is generally liberal because REITs are required to distribute as much as 90 percent of their income. Reload stock option (RSO). A replacement stock option granted by some companies to option holders upon a stock swap. The number of reload shares granted is equal to the number of shares delivered to exercise the option plus, in some cases, any shares withheld for tax withholding obligations. The exercise price of the new option is the current market price; the option generally expires on the same date that the original option would have. Repricing. The exchange of previously granted, now out-of-the-money stock options for lower-priced options at the current market price. The actual exchange can be structured in different ways and with different ratios of old-to-new stock options. Companies that do this will face shareholder wrath and an earnings charge, but believe it restores the employee retention value of stock options. Rescission. A rarely allowed, controversial practice that allows employees to cancel previous stock option exercises when the stock price later in the same year has dropped substantially from the market price at exercise. This wipes out the tax treatment based on the spread at exercise when the market price was much higher. The employee who chooses to rescind receives back the money paid at exercise in exchange for the stock. Both the SEC and FASB are examining this practice. Restricted securities. The term used under SEC Rule 144 for securities issued privately by the company, without the benefit of a registration statement. Restricted securities are subject to a holding period before they can be sold, under Rule 144. The term is also commonly used to refer to any securities held by affiliates that must be sold under Rule 144, regardless of whether the stock is registered. Restricted stock award. Grants of shares of stock subject to restrictions on sale and risk of forfeiture until vested by continued employment or by reaching a performance target. Restricted stock typically vests in increments over a period of several years. Dividends or dividend equivalent rights may be paid, and award holders may have voting rights during the restricted period. Return on assets (ROA). A profitability ratio measured by net income divided by assets, This is equivalent to return on sales multiplied by capital turnover. Return on equity (ROE). A profitability ratio measured by net income divided by equity. This is equivalent to return on assets (ROA) multiplied by leverage (the ratio of assets to shareholders’ equity). Return on invested capital (ROIC). Amount, expressed as a percentage, earned on a company’s total capital. Return on sales (ROS). Net income as a percentage of sales. ROS is a useful measure of overall operational efficiency when compared with prior periods or with other companies in the same line of business. It is important to recognize that ROS varies widely from industry to industry. Reverse vesting. A new technique (also known as early exercise) found in stock option plans offered by pre-IPO companies. Under this type of arrangement, you would be allowed to immediately exercise options when they are granted, by paying the option price. For each option exercised, you would receive a share of restricted stock, which is subject to a holding period (e.g., four years; 25 percent vests per year) that is based on the stock option plan’s original vesting schedule. With reverse vesting, even though you have paid for the options,

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you do not own the stock free and clear until the shares are vested. Your company will usually hold the restricted stock in an escrow account until vested. The company retains a right to repurchase any unvested restricted stock, usually at the exercise price, if you leave. To take advantage of reverse vesting, you should file a Section 83(b) election form within 30 days of exercise. A Section 83(b) election allows you to pay tax on the fair market value at the time of exercise, rather than when the restrictions lapse (when vesting is complete). The objective of this election is to tax any appreciation that is realized after the exercise of options at the lower capital gains rate. Revocable trust. Money held for a beneficiary that a company retains the right to recall. ROA. Abbreviation for return on assets. ROC. Abbreviation for return on capital. ROE. Abbreviation for return on equity. ROIC. Abbreviation for return on invested capital. ROS. Abbreviation for return on sales. ROSE. Abbreviation for return on shareholders’ equity. RSO. Abbreviation for reload stock option. Rule 10b-5. An SEC rule that prohibits trading by insiders on material nonpublic information. This is also the rule under which a company may be sued for false or misleading disclosure. Rule 13d. An SEC rule that requires holders of 5 percent or more of a company’s stock to disclose their security holdings and any changes in a Schedule 13d filing. Rule 144. An SEC rule that applies to public resales of restricted securities, as well as all sales by affiliates. The requirements include: 1. Current public information about the issuer. 2. A one-year holding period for restricted securities. 3. Unsolicited brokers’ transactions. 4. An amount limitation—the greater of 1 percent of the outstanding stock or the average weekly trading volume may be sold during any three-month period. 5. A Form 144 filing. Under Rule 144(k), a nonaffiliate individual who has held restricted securities for at least two years can sell his or her stock without meeting Rule 144 conditions. The seller cannot be or have been an affiliate at any time in the three months prior to the sale. Before the sale, under Rule 144(k), the holder of the securities will need to have the restricted legend removed from the stock. Rule 701. SEC registration exemption used for private company equity plans. SAB. Abbreviation for Staff Accounting Bulletin. Same-day sale. A same-day exercise and sale transaction, which an option holder would execute with the assistance of a broker. In a same-day exercise and sale, the exercise of the option and sale of the underlying shares take place simultaneously. The broker uses the proceeds of the sale to pay to (1) the company the exercise price and any tax withholding and (b) the option holder the net cash (less any brokerage commissions or fees). SAR. Abbreviation for stock appreciation right. Schedule 13D, 13G. Disclosure forms required to be filed with the SEC and the company by a shareholder or group of shareholders that owns more than 5 percent of a public com-

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pany. Schedule 13G is a short-form version of the 13D and may generally (but not always) be used only by institutional investors. SEC. Abbreviation for Securities and Exchange Commission. Section 16(a). Provision of the Securities Exchange Act of 1934 that requires company insiders to file periodic reports disclosing their holdings and changes in beneficial ownership of the company’s equity securities. See Forms 3, 4, and 5. Section 16(b). Provision of the Securities Exchange Act of 1934 that requires any profit realized by a company insider from the purchase and sale, or sale and purchase, of the company’s equity securities within a period of less than six months to be returned to the company. Section 16(b) is also known as the “short-swing profit rule.” Section 162(m). The section of the IRC establishing tax regulations related to the $1 million cap on deductible business expense for non-performance-based compensation to a publicly held corporation’s named executive officers (see also named executive officers); became effective on or after January 1, 1994. Section 423. The Internal Revenue Code section that regulates employee stock purchase plans. Section 83(b) election. A tax filing within 30 days of grant that allows employees given restricted stock to pay taxes on the grant date instead of on the date restrictions lapse. If an employee files the election, taxes are based on the fair market value on the grant date, with any future appreciation taxed as a capital gain. If the employee does not file an election, taxes are based on the fair market value on the date the restrictions lapse, which will be higher assuming the stock has appreciated in value. For early exercise options, the election essentially says that you agree to recognize now, as ordinary income for NQSOs and as an AMT item for ISOs, any spread between the fair market value of the stock and your exercise price. In this way, the future appreciation on the company’s stock can be taxed at favorable long-term capital gains rates upon sale of the underlying stock. Secular trust. A trust fund for holding deferred compensation. Differs from a rabbi trust in that contributions are taxable to the recipient as they accumulate. The trust usually begins to pay out when the trust beneficiary retires. The trust assets are not subject to claims of creditors in the event of a bankruptcy. Securities Act of 1933. Federal legislation enacted to protect potential purchasers of stock by requiring companies to register their public stock offerings and make full disclosure to purchasers. Often referred to as the “truth in securities” law, the Securities Act of 1933 has two basic objectives: • Require that investors receive financial and other significant information concerning securities being offered for public sale; and • Prohibit deceit, misrepresentations, and other fraud in the sale of securities. Securities and Exchange Commission (SEC). The government agency responsible for the supervision and regulation of the securities industry and markets, as well as public securities offerings and the ongoing disclosure obligations of public companies. Securities Exchange Act of 1934. Laws in which Congress created the Securities and Exchange Commission. The act gives the SEC broad authority over all aspects of the securities industry. This includes the power to register, regulate, and oversee brokerage firms, transfer agents, and clearing agencies as well as the nation’s securities self-regulatory organizations

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(SROs). The various stock exchanges, such as the New York Stock Exchange and American Stock Exchange, are SROs. The National Association of Securities Dealers, which operates the NASDAQ system, is also an SRO. The act also identifies and prohibits certain types of conduct in the markets and provides the SEC with disciplinary powers over regulated entities and persons associated with them. The act also empowers the SEC to require periodic reporting of information by companies with publicly traded securities. Security. Includes any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest, or participation in any profit-sharing agreement. Also includes collateral-trust certificate; preorganization certificate or subscription; transferable share; investment contract; voting-trust certificate; certificate of deposit for a security; fractional undivided interest in oil, gas, or other mineral rights; any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof); or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency. In general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase any of the foregoing. Self-funding/Self-insurance. A health care benefit financing technique in which an employer pays claims out of an internally funded pool, as permitted under ERISA. Self-funded companies might or might not also be self-administered, meaning they perform the administrative tasks associated with the benefit as opposed to purchasing such services from an outside firm. Sell side. A broker/dealer who sells expertise in research, order execution, or any other service to an individual or institution. Sequential exercise. The exercise of employee stock options in the order in which they were granted. SERP. Abbreviation for supplemental executive retirement plan. Seventy-fifth percentile. Also referred to as the “third quartile,” “upper quartile,” or “Q3”; represents the dividing point between the upper 25th percentile and the lower 75th percentile of reported data. Share repurchase plan. A program by which a corporation buys back its own shares in the open market. It is usually done when the common shares are undervalued. Because it reduces the number of shares and thus increases earnings per share, it tends to elevate the market value of the remaining shares held by stockholders. Shareholder proposal. A recommendation or requirement, proposed by a shareholder holding at least $2,000 market value or 1 percent of the company’s voting shares, that the company and/or its board of directors take action presented for a vote by other shareholders at the company’s annual meeting. Shareholder value. Usually calculated as market capitalization—the stock price multiplied by the number of shares. Changes in shareholder value reflect both dividends and appreciation of the stock. Shareholder value is also referred to as “shareholder wealth.” Shareholders’ agreement. The document in an acquisition of a company (such as a leveraged buyout) governing the purchase of equity, terms of stock options, and buyback of stock. All owners sign the agreement, including outside investors, managers, and creditors. Shares outstanding. The number of company shares currently held by shareholders, as tracked by the transfer agent.

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Short-against-the-box. A short sale by an investor who also owns the stock being sold is referred to as a sale “against the box,” meaning it is a sale versus the broker’s “box” position, not the stock in the account of the person who is short-selling. Strategies of this type are generally referred to as hedging strategies. To defer capital gain recognition until the next tax year, the short sale must be: • Covered before the end of January of the next year. • The shares held must continue to be held for at least 60 days after the short is closed. • The shares held must not be otherwise protected from loss by an alternate hedge strategy. Thus, the short is closed by buying back the stock (to cover) and, in order to get the favorable tax treatment, holding the owned stock for at least 60 days. Short sale. The sale of a security that is not owned by the seller at the time of the trade, necessitating a purchase or delivery some time in the future to cover the sale. Investors who believe the stock being sold will decline in value between the time it is sold short and the time it is covered use the strategy. By being able to cover at a price lower than the short sale price, the investor profits on the difference in price. To sell short, the investor must borrow stock from a broker in order to meet the delivery requirements of the sale, which has potential risks. Short-swing transaction. Any purchase and sale (or sale and purchase) of the issuer’s equity securities by an insider within a period of less than six months. See Section 16(b). SIC. Abbreviation for standard industrial code. Sign-on bonus. A large amount of cash or stock granted at the time an employment agreement is executed. Also referred to as a golden hello. S&P 500. A capitalization weighted index of 500 stocks. Standard and Poor’s 500 stock index represents the price trend movements of the major common stock of U.S. public companies. It is used to measure the performance of the entire U.S. domestic stock market. Spinoff. The separation of a subsidiary or division of a corporation from its parent by issuing shares in a new corporate entity. Shareowners in the parent receive shares in the new company in proportion to their original holding, and the total value remains approximately the same. Split. The division of the outstanding shares of a corporation into either a larger or smaller number of shares, without any immediate effect on individual shareholder equity. For example, a 3-for-1 forward split by a company with 1 million shares outstanding results in 3 million shares outstanding. Each holder of 100 shares before the split would have 300 shares (each worth less) after the split, although the proportionate equity in the company would stay the same. A reverse split would reduce the number of shares outstanding and each share would be worth more. Spread. Depending on the context, refers either to (1) the difference between the bid and ask prices for an over-the-counter stock, or (2) the difference between an option’s exercise price and the market price at the time of exercise (i.e., the profit component of the exercise). Staff Accounting Bulletin (SAB). Promulgation that reflects the SEC staff’s views regarding accounting-related disclosure practices. SABs represent interpretations and policies followed by the Division of Corporation Finance and the Office of the Chief Accountant in administering the disclosure requirements of the federal securities laws. SABs do not represent official positions of the SEC. Staggered board. A corporate board structure whereby only a portion of the board of directors is elected each year, usually to discourage takeover attempts.

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Stakeholders. All parties interested in the performance of a company. Stakeholders range from the owners of a company to the local taxing authorities, to company employees, and also to residents concerned about the company’s impact on the environment. Standard Industrial Classification Code (SIC). Four-digit code used by the Securities and Exchange Commission to categorize and identify a company’s type of business. STI. Abbreviation for short-term incentive. Stock appreciation right (SAR). A contractual right, often granted in tandem with an option, that allows an individual to receive cash or stock of a value equal to the appreciation of the stock from the grant date to the date the SAR is exercised. Stock award. A grant of unrestricted common shares to one or more selected employees. Stock bonus plan. A plan that provides for periodic awards of stock based upon the company’s performance. Stock depreciation right. A right that protects a stock option holder, who exercises a stock option, from price declines for a specified period (normally the first six months) that he or she holds the stock. These types of plans are designed to protect the employee from price declines during mandatory holding period requirements for either tax or regulatory purposes. The employer agrees to make a cash payment to the employee equal to the amount of any decline in the fair market value of the acquired stock from the date of exercise to the end of the six-month period. Also known as “stock indemnification right.” Stock dividend. A dividend paid in securities rather than cash. The dividend may be additional shares of the issuing company, or shares of another company (usually a subsidiary) held by the company. Stock exchange. Organized marketplace in which members of the exchange, acting as agents (brokers) and as principals (dealers or traders) trade stocks, common stock equivalents, and bonds. Such exchanges have a physical location where brokers and dealers meet to execute orders to buy and sell securities. Each exchange sets its own requirements for membership. Stock grant. The issuance of stock with no restrictions or conditions. Stock option. A contractual right granted by the company, generally under a stock option plan, to purchase a specified number of shares of the company’s stock at a specified price (the exercise price) for a specified period of time (generally five or ten years). Assuming that the exercise price is the same as the market price of a share of the company’s stock on the grant date, the option will become more valuable if the market price goes up. The option effectively gives the option holder the right to buy stock in the future at a discount. This definition describes an employee stock option, as distinguished from a listed or exchange-traded option. Stock options come in several forms, including the following, each of which is defined separately in this glossary: performance stock options, premium-priced stock options, discount stock options, and indexed stock options. Stock option Exercise Rescission. An agreement between a company and certain employees to rescind the previous exercise of a stock option. In the transaction, employees agree to return to the company shares acquired from an option exercise that occurred earlier in the same taxable year (plus any dividends received on those shares since exercise), and the company agrees to reimburse the employees for the previously remitted exercise price. The company then reinstates the previously exercised option according to the option’s original terms (i.e., the same number of shares, exercise price, vesting schedule, ex-

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ercise term, etc.). The intent of the transaction is to treat the previous exercise as if it had never occurred for income tax purposes (including the alternative minimum tax). This will eliminate employee tax liabilities incurred earlier in the year when stock prices were high, but which cannot be funded by sale of the underlying stock because of subsequent declines in stock price. A potentially negative consequence of the rescission is that the company loses the income tax benefit (or deduction) it would otherwise have received had the original exercise not been rescinded. Stock split. When a company increases the number of shares outstanding by splitting existing shares. A 2-for-1 split means that every stockholder gets two new shares for each one they own; a 3-for-2 split means they get three shares for every two they own. The price of an individual share falls, but stockholders do not lose money because they are being given the equivalent number of new shares. In a reverse stock split, a company reduces the number of the shares outstanding by consolidating existing shares. A 1-for-5 reverse split, for example, means that for each five shares owned, the stockholder receives a single new share instead. The price of the new shares is five times higher, but only to reflect the shortened supply. If a company’s stock is trading at a very low price, this process makes the company look more attractive to investors. Stock swap. Also known as a “stock-for-stock” exercise. A form of cashless exercise transaction in which shares of company stock already owned are delivered, either physically or by attestation, in lieu of cash to pay for the exercise of stock options. Stock withholding. A cashless method of satisfying the withholding taxes due upon the exercise of a stock option, by authorizing the company to withhold from the shares being exercised a number of shares the value of which is equal to the taxes. Street name. Securities held in the name of a broker instead of a customer’s name are said to be carried in “street name.” This occurs when the securities have been bought on margin or when the customer wishes the security to be held by the broker. Strike price. Also known as the “exercise price” or grant price, the price per share at which a stock option is granted and that must be paid to exercise a stock option. The strike price is typically the fair market value of the stock on the date of grant. Substantial risk of forfeiture. Tax term that applies when rights to compensation are conditioned upon future performance of services (e.g., working X years for a company) or the occurrence of some activity (e.g., reaching a performance or stock price goal). As it relates to restricted stock and early exercise stock options, income is not recognized while the stock is subject to a risk of forfeiture (e.g., vesting), unless a Section 83(b) election is filed with the IRS within 30 days of when a grant is received or an option is exercised. Summary Compensation Table. A required table for all publicly held companies as part of their proxy statement. This table should include salary, bonus earned in the prior fiscal year, number of stock options, all other annual compensation, and all compensation. The top five most highly paid executives who earn more than $100,000 in total salary and bonus should appear in this table. Supplemental executive retirement plan (SERP). A nonqualified (for purposes of taking corporate tax deduction) plan. TARSAP. Abbreviation for time-accelerated restricted stock award plan. Tax basis. Cost of stock for calculating your gains or losses for tax purposes. For equity compensation, the basis includes the costs plus any compensation income reported (e.g., amount for ordinary income tax on NQSO spread).

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To calculate your capital gains, subtract your basis from the amount realized on the sale of stock. If you sell stock through a broker, the Form 1099-B will report the entire amount received, which you use to determine the capital gain or loss. Tax preference items. Various tax breaks available under the regular income tax system that are added back to your income to determine alternative minimum tax (AMT). Upon the exercise of incentive stock options, the excess of the fair market value of the option shares over the option exercise price is an item of tax preference that must be taken into account in your AMT calculation (unless the stock is sold in the year of exercise). Without regard to the AMT calculation, the option spread is not included in the regular income tax liability calculation. Other preference items include state and local taxes, interest on second mortgages, and medical expenses. Tax Reform Act of 1976 (1976 Tax Act). Federal legislation that tightened several provisions and benefits relating to taxation, beginning in the 1976 tax year. Highlights of this act included creation of the individual retirement account, change of the treatment of the exercise of a stock option from capital gains to ordinary income, and increase of the maximum net capital loss to $3,000 starting in tax year 1978. TC. Abbreviation for total compensation. TCC. Abbreviation for total cash compensation. Teachers Insurance and Annuity Association–College Retirement Equities Fund (TIAACREF). The premier pension system among education and research institutions in the United States; the largest portable pension system in the world, with over $500 billion in total assets under management. Technical research. Analysis of the market and stocks based on supply and demand. The technician studies price movements, volume, trends, and patterns, which are revealed by charting these factors, and attempts to assess the possible effects of current market action or future supply and demand for securities and individual issues. Tender offer. An offer to purchase outstanding shareholders’ securities, usually made in an attempt to gain control of another company. Testamentary trust. A trust established by a will that takes effect upon death. A revocable trust is a trust in which the creator reserves the right to modify or terminate the trust; an irrevocable trust may not be modified or terminated by the trustor after its creation. Third-party administrator (TPA). An independent company or person who contracts with an employer to provide administrative functions associated with a benefit or benefits, but does not assume or underwrite risk. TIAA-CREF. Abbreviation for Teachers Insurance and Annuity Association–College Retirement Equities Fund. Tick. The direction in which the price of a stock moved on its last sale. An up-tick means the last trade was at a higher price than the one before it and a down-tick means the last sale price was lower than the one before it. A zero-plus tick means the transaction was at the same price as the one before, but still higher than the nearest preceding different price. Ticker symbol. A three- or four-letter abbreviation used to identify a security, whether on the floor, a television screen, or a newspaper page. Ticker symbols are part of the lore of Wall Street. They were originally developed in the 1800s by telegraph operators to save bandwidth. One-letter symbols were assigned to the most active stocks. Railroads were the dominant issues at the time, so they retain a majority of the one-letter designations.

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Ticker symbols today are assigned on a first-come, first-served basis. Each marketplace—the NYSE, the American Stock Exchange, and others—allocates symbols for the companies within its purview, working closely to avoid duplication. A symbol used for one company cannot be used for any other, even in a different marketplace. Time-accelerated restricted stock award (TARSAP). A restricted stock plan that combines both time-lapse and performance vesting restrictions while still allowing fixed accounting treatment. Under such an approach, the restricted stock will vest at the earlier of a stated period of time or upon the achievement of certain performance targets. Top-hat plan. A plan maintained by an employer that primarily provides deferred compensation for highly compensated employees or certain members of upper management. Total capital. Equal to common and preferred equity plus long-term debt. Long-term debt is debt due one or more years later. Total cash compensation (TCC). The total of salary and bonus. Total compensation (TC). The complete pay package for employees, including all forms of cash, stock, benefits, services, and in-kind payments. Net total compensation refers to salary, bonus, and long-term incentive. Total reward system. Includes financial compensation, benefits, opportunities for social interaction, security, status and recognition, work variety, appropriate work load, importance of work, authority/control/autonomy, advancement opportunities, feedback, hazard-free working conditions, and opportunities for personal and professional development. An effective compensation system will utilize many of these rewards. TPA. Abbreviation for third-party administrator. Transfer agent. An agent who keeps a record of the name of each registered shareowner, his or her address, and the number of shares owned, and sees that the certificates presented for transfer are properly cancelled and new certificates issued in the name of the new owner. Transferable stock option. Options providing, by their terms, that they may be transferred by the option holder, generally only to a family member or to a trust, limited partnership, or other entity for the benefit of family members, or to a charity. Tranche. A set of stock options as part of a larger grant. For example, if options vest in 25 percent blocs over 4 years, each 25 percent bloc of options is a tranche. Treasury stock. Stock reacquired by the issuing company and available for retirement or resale. It is issued but not outstanding. It cannot be voted and it neither pays nor accrues dividends. It is not included in any of the financial ratios measuring values per common share. Among the reasons treasury stock is created are: (1) to provide an alternative to paying dividends, because the decreased amount of outstanding shares increases the per-share value and often the market price; and (2) to provide for the exercise of stock options and warrants and the conversion of convertible securities. Trigger. As relates to stock compensation, an event that causes change or acceleration in the stock grant. For example, some stock plans accelerate vesting upon shareholder approval, closing of merger, or new management (i.e., change in control). Other plans may require a double trigger of merger plus firing, demotion, or relocation. Trust. A legal entity created by an individual in which one person or institution holds the right to manage property or assets for the benefit of someone else. Types of trusts include: • Testamentary trust—A trust established by a will that takes effect upon death. • Living trust—A trust created by a person during his or her lifetime.

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• Revocable trust—A trust in which the creator reserves the right to modify or terminate the trust. • Irrevocable trust—A trust that may not be modified or terminated by the trustor after its creation. Trust Indenture Act of 1939. This act, which falls under the purview of the SEC, applies to debt securities such as bonds, debentures, and notes offered for public sale. Even though such securities may be registered with the SEC, they may not be offered for sale to the public unless a formal agreement between the issuer of bonds and the bondholder, known as the “trust indenture,” conforms to the standards of this act. Trustee. An individual or institution appointed to administer a trust for its beneficiaries. Underwater. A term used to describe an employee stock option when the current market price is below the option exercise price. When an option is underwater, it would cost more than the underlying stock is worth to exercise the option. For example, the exercise price is $25 when the stock market price is $15. In this situation, it would be cheaper to buy the stock on the open market than to exercise the option. Such options are also described as being out of the money. Underwriter. An investment banking firm that actually buys the shares from the company in a public offering and then resells them (at a slightly higher price) to its customers. Uniformed Services Employment and Reemployment Rights Act. Certain persons who serve in the U.S. armed forces have a right to reemployment with the employer they were with when they entered service. This includes those called up from the reserves or National Guard. The Veterans’ Employment and Training Service administer these rights. Unreasonable (excessive) compensation. A potential tax issue in private companies. The IRS may challenge executive compensation in such organizations as excessive or unreasonable, and as a distribution of corporate profits rather than salary. Unvested. Unvested stock options have not vested and, therefore, are not exercisable. Variable accounting. As relates to stock compensation, means that the grant of options is not a fixed expense according to guidelines from the Financial Accounting Standards Board. When it is a fixed expense, the option grant has no impact on earnings, unless a company elects to disclose it beyond a footnote in their financial statement. Variable accounting occurs when the exercise price at grant is not certain, such as with index or repriced options. The grant thus must be expensed against company earnings in each quarter based on the spread between the exercise and market price of the stock. Variable annuity. A life insurance policy under which the annuity premium (a set amount of dollars) is immediately turned into units of a portfolio of stocks. Upon retirement, the policyholder is paid accordingly to accumulated units, the dollar value of which varies according to the performance of the stock portfolio. Its objective is to enhance, through stock investment, the purchasing value of the annuity, which otherwise is subject to erosion through inflation. Variable compensation. The portion of pay that is determined by performance. Typical variable compensation includes annual bonuses, options, and performance shares and units. Also referred to as “variable incentive pay.” This type of compensation is payable in cash or stock, or at a certain period of time. Variable grant guidelines. Under these guidelines, a company determines grant size according to a target dollar value rather than a target number of shares.

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Variable plan. See variable accounting. Variable stock award plan. A plan in which either the number of shares and/or the price at which they will be issued is not known on the grant date. Variable universal life insurance. A type of life insurance that combines a death benefit with a savings element that accumulates tax-deferred at current interest rates. Under a variable universal life insurance policy, the cash value in the policy can be placed in a variety of subaccounts with different investment objectives. The policyholder can transfer funds among the subaccounts as he or she wishes. Fees are charged after a certain number of transfers. Vesting period. A waiting period, after the award of a stock option, that must elapse before the option can be exercised. Vesting schedule. Schedule setting forth when, and to what extent, options become exercisable, or restricted stock or stock units are no longer subject to forfeiture (for example, 20 percent per year over 5 years). The schedule is usually based on passage of time, but occasionally can be accelerated for meeting performance targets (e.g., company stock price hits X price and stays at that level for 60 days). In some option plans at pre-IPO companies, one can exercise unvested options subject to a company repurchase right under a vesting-like schedule. Volatility. An amount, expressed as a percentage of the stock price, that reflects recent fluctuation of the stock price. The moving average of this parameter is used in certain option pricing models to calculate the fair value of options. Volatility is generally expressed as the annual standard deviation of the daily price changes in the security. The volatility of a stock is the standard deviation of the continuously compounded rates of return on the stock over a specified period. That is the same as the standard deviation of the differences in the natural logarithms of the stock prices plus dividends, if any, over the period. The higher the volatility, the more the returns on the stock can be expected to vary—up or down. Volatility is typically expressed in annualized terms that are comparable regardless of the time period used in the calculation (for example, daily, weekly, or monthly price observations). Volume. The number of shares or contracts traded in a security or an entire market during a given period. Volume is normally considered on a daily basis, with a daily average being computed for longer periods. Voting right. The common stockholders’ right to vote their stock in the affairs of a company. Preferred stock usually has the right to vote when preferred dividends are in default for a specified period. The right to vote may be delegated by the stockholder to another person. W-2. Form received from your employer that shows amounts of ordinary income you received and any amounts withheld. For stock options, it includes gains from NQSO exercises, gains from ISO exercises if you made a disqualifying disposition, and amounts withheld for NQSOs. W-8. Certificate of Foreign Status form required by the IRS to tell the payer, transfer agent, broker, or other intermediary that an employee is a nonresident alien or foreign entity that is not subject to U.S. tax reporting or backup withholding rules. W-9. Request for Taxpayer Identification Number and Certification form required by the IRS to furnish the payer, transfer agent, broker, or other intermediary with an employee’s social security or taxpayer identification number. The filing of this form allows the employee not to be subject to backup withholding because of underreporting of interest and dividends on his or her tax return.

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Waiting period. A specified length of time after an option has been granted during which the option cannot be exercised. WARN. Abbreviation for Worker Adjustment and Retraining Notification act. Warrants. Financial instruments that are usually given to financial backers, other corporations, and underwriters as part of a funding or business arrangement. In most respects, warrants are like stock options. The rules governing their exercise and sale often attempt to reflect the deal that was struck between the investors and management. Warrants are often very complex and each round of warrants may have its own peculiar rules. Wash sale. When you sell stock at a loss and buy the same company’s stock within 30 days before or after the sale, you cannot claim the loss on the sale. The disallowed loss and holding period from the old stock are added to the basis and holding period of the new stock. When issued. A short form of “when, as, and if issued.” The term indicates a conditional transaction in a security authorized for issuance but not as yet actually issued. All “when issued” transactions are on an “if” basis, to be settled if and when the actual security is issued and the exchange or National Association of Securities Dealers rules the transactions are to be settled. Whole life insurance. A type of life insurance that offers a death benefit and also accumulates cash value, tax-deferred, at fixed interest rates. Whole life insurance policies generally have a fixed annual premium that does not rise over the duration of the policy. Whole life insurance is also referred to as “ordinary” or “straight” life insurance. Wilshire 5000. A capitalization weighted index of all U.S.-headquartered companies (currently about 6,800). The capitalization of the portfolio is the sum of the market capitalizations of all the companies. Worker Adjustment and Retraining Notifications Act (WARN). Mandates that employees be given early warning of impending layoffs or plant closings. The DOL’s Employment and Training Administration administers this law. World at Work. World at Work, formerly the American Compensation Association, is a global, not-for-profit professional association of more than 26,000 compensation, benefits, and human resources professionals. Founded in 1955, World at Work is dedicated to knowledge leadership in compensation, benefits, and total rewards disciplines associated with attracting, retaining, and motivating employees. Yield. In general, the amount of current income provided by an investment. For stocks, the yield is calculated by dividing the total of the annual dividends by the current price. For bonds, the yield is calculated by dividing the annual interest by the current price. The yield is distinguished from the return, which includes price appreciation or depreciation. Zero premium collar. Hedging strategy used for high-value, concentrated stock positions, previously referred to as a “costless collar” (the name was changed for legal reasons). You purchase put options and sell call options on your stock through a securities firm that is experienced in these transactions. This essentially locks in the trading range upside and downside (i.e., the “collar”). It is costless to an individual in that no net out-of-pocket costs result from the totaling of the prices of puts and calls. This strategy allows you to hold the stock after an option exercise for long-term capital gains, and minimizes the risks of stock price fluctuations. The hedged position can be monetized with a loan (if you are not a senior executive, director, or affiliate). However, the strategy has uncertain legal and tax ramifications; it is prohibited by many companies, and you give up the benefit of future price increases beyond the collar price.

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Index A Abbott Laboratories, 129 Academics, as board candidates, 30, 31 Accounting firm, as consultant, 51–52 Accounting Principles Board (APB): Opinion No. 16, 164, 178 Opinion No. 25 business combinations, 178–179 cash bonus plans, 179 deferred taxes, 179 effective date and transition, 180–181 grant date definition, 179 noncompensatory plan definition, 176–177 option repricing, 134–135 scope of, 176 variable plant accounting and requirements for new measurement date, 177–178 Accounting standards, see also Accounting Principles Board (APB); Pooling-of-interests accounting proclamations, 263–264 summaries of deferred compensation arrangements, 260–262 employee stock ownership plans, 257–260 stock-based arrangements, 247–257 Advisers, see Consultants Agency effect creep, 65 Agenda, for meeting: example of, 79–80 in sample charter, 78

American Biltrite, Inc., 21–22 American Institute of Certified Public Accountants (AICPA), 172 American Society of Corporate Secretaries, 193 Annual incentives, 114–118 corporate versus business-unit goals and, 118 design of, 114–117 eligibility requirements for, 117–118 Arison, Mickey, 9 Asset purchase method, of business combination, 165 AT&T, 22–23, 62 Audit committee, 10 B Base salary, 110, 112–114 Becton, Dickinson & Company, 22–23 Benchmarking: importance of, 124–126 peer group for, 122–124 Benefits firm, as consultant, 50 Best practices: benchmarking, 125 committee membership, 3, 9–10 for small, medium companies, 190–193 typical, 290–292 Black, Fischer, 100 Black-Scholes option valuation model: explained, 100–101 repricing and, 140, 141 Board of directors, see also Members, of committee certification of, 198 351

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diversity of, 16–17, 195–196 evaluation of, 62, 199–200 sample form, 89 inside, management members of defined, 7, 8 future of, 194 liability to shareholders, 93–94 members of other, as candidates, 30–32 outside, independent members of compensation of, 8–9 defined, 7–8 future of, 195 importance of, 3, 60, 188 IRS definition of, 96 overlap with compensation committee duties, 81–82 prospectus of, 27, 28 sample, 53–54 recruitment of, 195 review of compensation for, 71 size of, 4–6 terms of, 5, 6 TIAA-CREF statement on, 202–204 training of, 41–45, 190, 192–193, 196 specific sites for, 38, 282–289 Bogle, Jack, 105 Bonus payment alternatives, 118–120 deferred compensation, 119 discounted stock options, 120 fair-market-priced stock options, 119–120 premium-priced options, 120 restricted stock, 119 Burke, James, 67 Business combinations, see Change-incontrol (CIC) arrangements; Pooling-of-interests accounting Business judgment rule, 90–91, 189 Business owners, as board candidates, 32 Business strategy, compensation and, 3, 55–56, 99 Business-unit versus corporate goals, 118 C CalPERS, 26 Candidates, see Selecting, of committee members Capital Cities/ABC, 171

Index

Care, see Duty of care Carnival Cruise Line, 9 Cash bonus plans: accounting for, 179 alternatives to, 118–120 versus stock plans, 120–122 TIAA-CREF on, 207, 212 Cendant Corporation, 141–142 Chairperson, of committee: director selection and, 26, 27 procedural rules for, 15 responsibilities and election of, 12–13 Change-in-control (CIC) arrangements, 143–153 design issues before business combination, 145–147 at closing, 147–149 long-term, 149–153 employees covered by, 143, 145 provisions of, 144 review of, 62, 64–65 Charter of committee, sample, 77–78 Chicago, University of, 287–288 Chief executive officers (CEOs), see also Succession plan attendance at committee meetings, 187–188 as board candidates, 32 as competitive super stars, 108 director selection and, 36 evaluation of, 62, 72–75, 199–200 sample form, 63–64 TIAA-CREF statement on, 208 job description of, 73–75, 113 searches for, 197 top-performing, 128 Cisco Systems, 170 Communication skills, of board members, 38 Compensation, see also specific types of plans evaluating levels of, 58, 66–67 future trends in, 200–201 CEOs as super stars, 108 emphasis on corporate governance, 109

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Internet’s effect on, 103–104 shift to equity awards, 104–108 history of recent 1970s, 100–101 1980s, 101–102 1990s, 102–103 oversight of, 18 TIAA-CREF statement on, 206 Competitors, as board candidates, 29 Conflicts of interest, 8, 11, 92 Connecticut State Treasurer, 26 Consolidation, 165 Consultants: as board candidates, 29 to compensation committee, 47–52 selecting of, 48–49 types of, 49–52 Contracts, executive, TIAA-CREF on, 217 D Deferred compensation, 119 accounting standards, 260–262 Delaware, 11–12, 92 Directors, see Board of directors Disclosure, see Securities and Exchange Commission (SEC) Discounted stock options, 120 Diversity, of board, 16–17, 195–196 Duties, of committee, 58–72 adherence to governance principles, 58, 61–65 decisions about compensation levels, 58, 66–67 disclosure, 59–61 knowledge of big picture, 58, 65–66 overlap with board of directors, 81–82 review from shareholder’s perspective, 58, 67–69 review of complex plans/programs, 58–59, 69–70 director compensation, 71 excess benefit plans, 71–72 reload stock options, 69–70 stock option repricing, 70–71 unusual perquisites, 70 review of controversial plans/programs, 59, 70–72 in sample charter, 77–78

353

Duty of care, 90, 91–92 Duty of loyalty, 90, 92 E Earnings per share, 170 Eisner, Michael, 38, 102, 108 Election of directors, contested, 196 Eligibility requirements, annual incentive, 117–118 Emerging Issues Task Force (EITF), 105–106 Issue No. 90-7, 180 stock option repricing and, 134–135 Emerson Electric Company, 20–21 Employee benefits committee, 22–23, 56 Employee Retirement Income Security Act of 1974 (ERISA), 101 Employee stock ownership plans, accounting standards, 257–260 Employees, FASB definition of, 176 Employment agreement packages, evaluating, 66–67 Entrepreneurs, as board candidates, 32 Equity awards, see Stock options; Stockbased plans Ethics, 194 Evaluation: of board of directors, 62, 199–200 sample form, 89 of CEO, 62, 72–75, 199–200 sample form, 63–64 TIAA-CREF on, 208 Excess benefit plans, review of, 71–72 Executive compensation consulting firm, 50–51 Experience, of board member, 39 F Failure payments, 67 Fair-market-priced stock options, 119–120 FDX Corporation, 130 Fiduciary oversight, TIAA-CREF on, 209 Financial Accounting Standards Board (FASB): indexed stock options and, 105 interpretations of APB 25, 180 pooling-of-interests accounting and, 171–172

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Financial Accounting Standards Board (FASB) (cont.) stock option repricing and, 70–71, 134–135 Friends, as board candidates, 29 Fringe benefits, TIAA-CREF on, 207–208, 216. See also Perquisites Functions and roles, of committee, 56–58. See also Duties, of committee G Gannett Co., Inc., 129 General compensation firm, as consultant, 50 General Motors Corporation (GM), guidelines on corporate governance issues, 5–6, 10 Georgia, University of, 285–287 Gerstner, Lou, 66–67 Gillette, 170 Global markets/economies, 197 Goals, “stretch,” 68 Golden parachute excise tax, 101 Governance: characteristics of effective, 186 future trends in, 194–198 new emphasis on, 109 principles of, 58, 61–65 stock option repricing and, 136–137 TIAA-CREF on, 206–208, 210 Grant date, definition of, 179 Great Lakes Chemical Company, 24 Greenspan, Alan, 105 H Hallock, Kevin, 32 Harvard Business School, 282–283 Human resources committee, 56 at Emerson Electric, 20–21 pooling of interests accounting and, 163 Human resources firm, as consultant, 50 Human resources, oversight of, 18 I Iacocca, Lee, 108 IBM, 130 Incentive awards: annual, 114–118

Index

long-term, 67 RSOs and, 158–159 shareholder approval required, 97–98 shareholder’s best interest and, 58, 67–69 Incentive stock option (ISO), 101 Independent directors, see under Board of directors Indexed stock option, 105 Initial public offering (IPO): grace period after, 95 IRC § 162 (m) requirements, 95 lockup period shortened, 103 Inside directors, see under Board of directors Insider trading issues, 107 Institutional investors, 198–199. See also Shareholders concerns of, 66 director training and, 199 diversity criteria of, 16 independent nominating committee and, 26 scrutiny of compensation committee, 10 Institutional Shareholder Services, 26 Insurance specialist, as consultant, 51 Interlocking directorships, 9, 11, 32 Internal Revenue Code (IRC): § 162 (m) committee membership requirements of, 47 deduction of compensation and, 9, 10, 11 effect of, 102 in general, 94–98 noncompliance with, 190 option repricing and, 134 requirements for performance-based pay, 95 § 368, 165 § 422, 134 § 83, 134 Internal Revenue Service (IRS), outside director defined by, 96. See also Internal Revenue Code (IRC); Taxation issues Internet, effect of, 103–104, 109

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Index

J Job description, of CEO, 73 base salaries and, 113 sample form, 74–75 L Law firm, as consultant, 50 Lead director concept, 10 Legal fees, reimbursement for, 153 Legal issues, see also Taxation issues of board size, 4–6 business judgment rule, 90–91, 189 committee activities, 11–12 duty of care, 90, 91–92 duty of loyalty, 90, 92 duty to shareholders, 93–98 minutes of meetings, 13–14, 15–16 Level 3 Communications, Inc., 105 Leverage, of board member, 39 Leverage, of incentive program, 116–117 Life insurance, 71–72 Lifecycle stage, of company, 110, 111 Litigation, future of, 197 Loyalty, see Duty of loyalty M Management, see also Chief executive officer (CEO) monitoring intentions of, 65 represented on board, 7 stock overhang and, 138–139 Measurement date: new, 177–178, 181 shareholder approval of, 179 Meetings, of committee: agenda for, 78–80 attendance at, 186, 187–188 conduct of, 187–189 minutes of, 13–14, 15–16, 188 preparation for, 186–187 Members, of committee, see also Board of directors; Structure, of committee compensation of, 8–9, 18 diversity of, 16–17 independent directors as, 3, 8, 9–11 optimal number of, 5–6 in sample charter, 77

355

selection of, 27–41 major criteria, 37–40 training of, 41–47, 199 specific sites for, 38, 282–289 Merger, 165 Merton, Robert, 100 Minutes, of meetings, 13–14, 15–16, 188 Mission, 217 Modified single trigger arrangement, for CIC, 148–149 N NASDAQ, 106 National Association of Corporate Directors, 33–34, 56, 193 training program information, 283–284 New economy, 103–104 New York State Retirement Fund, 26 New York Stock Exchange (NYSE), 106 Nominating committee, 10, 17–18 composition of, 25–26 future of, 196 role in director selection, 27–28 Noncompensatory plan, definition of, 176–177 Note taking, discouraged, 14 O Omnibus Budget Reconciliation Act of 1993, in sample committee report, 86–87 Option-pricing models, see Black-Scholes option valuation model Organizations, as resources, 269–272 Orientation, see Training Outside directors, see under Board of directors Overtime calculations, 107–108 P Paramount Communications, 92 Parliamentary rules of order, 14–16 Pay positioning strategy, 126–130 Peer group, for compensation analysis, 122–124 Pennsylvania, University of, 288–289 Pension plans, TIAA-CREF guidelines, 216–217

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Performance objectives, see Incentive awards; Strategy, of compensation Periodicals, as resources, 273–281 Perquisites, see also Fringe benefits TIAA-CREF guidelines, 217 unusual, 70 Philips curve, 102–103 Philosophy, of compensation, see Strategy, of compensation Pooling-of-interests accounting, 163–174 CIC and, 146, 149–150 criticism of, 171–172 defined, 164–165 versus purchase accounting, 166–170 stock awards and, 178 value of, 170–171 ways to preserve, 172–174 Premium-priced stock options, 120 Private companies, 98 Profit shares, see Reload stock options (RSOs) Profitability, compensation strategy and, 127 Progressive Corporation, 129 Prospectus, of board, 27, 28 sample, 53–54 Proxy voting, TIAA-CREF on, 204–206 Purchase accounting: contrasted to pooling-of-interests, 166–170 stock awards and, 178–179 R Reload stock options (RSOs), 105, 154–162 advantages/disadvantages of, 157–161 design of, optimum, 161–162 design of, standard, 154–155 review of, 69–70 valuation model, 156–157 variable-award accounting and, 180 Removal, of director, 34, 41 Report, of committee: contents of, 75–76 control of, 66 example of, 83–85 Repricing, see Stock option repricing

Index

Reputation, of board member, 38 Resources, for board: director training programs, 282–289 organizations, 269–272 periodicals, 273–281 Responsibilities, see Duties, of committee Restricted stock, 95, 119 Retention, of executives: CIC programs and, 143–153 stock option repricing and, 135–136 Retirees, as board candidates, 29–30, 31 Retirement benefits, see also Pension plans oversight of, 18 supplemental protections, 152 Roberts’ Rules of Order, 14, 15 Roles and functions, of committee, 56–58. See also Duties, of committee Rollins Truck Leasing Corp., 21–22 Rules of order, 14–16 S Safe harbor statutes, 92 Salary, base, 110, 112–114 Salary committee, 22 Scholes, Myron, 100 Search firms, 33–35 Securities Act of 1933, see Securities and Exchange Commission (SEC) Securities and Exchange Commission (SEC): Form 14A, 109 list of regulations, rules, schedules, forms, 221–223 NYSE, NASDAQ and shareholder approval requirements and, 106 pooling-of-interests accounting and stock buybacks, 172 Regulation 14A, Item 6(b), conflicted directors, 8, 11 Regulation S-K, Item 402, 60, 106–107, 135 instructions, 224–246 Rule 10b5-1, insider trading, 107 Rule 33-7919, audit fees, 51–52 Rules 16b-3(d) and (e), “short swing” profit liability, 60 Selecting, of committee members, 27–41 approaching candidates, 35–36

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Index

attracting candidates, 32–33 CEO and, 36 final criteria for, 37–40 nominating committee’s role in, 27–28 rejection of candidates, 36–37 search firm’s role in, 33–35 types of candidates, 28–32 Self-dealing transactions, 92 Severance, see Change-in-control (CIC) arrangements Share-tender offer, 165 Shareholder activists, see Institutional investors Shareholder value: Black-Scholes option valuation model and, 100–101 effects on, 65–66 RSOs and, 159–161 SEC reporting requirements and, 109 Shareholders, see also Institutional investors duty of directors to, 93–98 incentive plans and best interest of, 58, 67–69 increased responsiveness to, 197 IRC § 162 (m), 94–98 maintaining good relations with, 192 NYSE proposal for approval of, 106 performance-based compensation approved by, 97–98 Shareholders rights: stock option repricing and, 136–137 TIAA-CREF statement on, 204–206 Single-trigger arrangement, for CIC, 148–149 Smith v. Van Gorkum, 92 Social responsibility issues, TIAA-CREF on, 210–211 Split-dollar life insurance, 71–72 Stanford University School of Law, 284–285 Stock award committee, 21–22 Stock-based plans, see also Stock options accounting for, 175–181, 247–257 change-in-control (CIC) arrangements and, 64–65 corporate performance and, 56–57, 139–140

357

effects on shareholder value, 65 oversight of, 18 TIAA-CREF on, 207, 212–213 TIAA-CREF voting guidelines, 214–216 Stock option repricings, 70–71, 133–142 accounting procedures, 134–135 approaches to, 140–142 corporate finance, stock price performance and, 138–139 executive performance and, 139–140 executive retention and, 135–136 governance and shareholder rights and, 136–137 procedures for, 133–134 securities law issues, 135 tax issues, 134 variable-award accounting and, 180–181 Stock options, 68–69. See also Reload stock options (RSOs); Stock option repricings; Stock-based plans discounted, 120 fair-market-priced, 119–120 indexed, 105 premium-priced, 120 recent shift to, 104–108 restricted stock, 119 Stock overhang, 67, 138–139 growth of, 104–105 RSOS and, 161 Strategic planning, TIAA-CREF on, 208–209 Strategy, of compensation, 110–130 annual incentives, 114–118 corporate versus business-unit goals, 118 design principles, 114–117 eligibility requirements, 117–118 basic elements of, 110, 112 benchmarking and, 124–126 bonus payment alternatives, 118–120 deferred compensation, 119 discounted stock options, 120 fair-market-priced stock options, 119–120 premium-priced options, 120 restricted stock, 119

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Strategy, of compensation (cont.) business strategy and, 3, 55–56, 99 cash versus stock, 120–122 evaluation of, 189–190 excerpts from best-performing companies’, 129–130 lifecycle stage of business and, 110, 111 pay positioning and, 126–130 peer group and, 122–124 tax considerations, 128, 130 TIAA-CREF statement on, 206 Stretch goals, 68 Structure of committee, 3–24. See also Legal issues; Members, of committee chairperson of, 12–13 examples, 20–24 compensation and employee benefits committee, 22–23 human resources committee, 20–21 salary committee, 21 stock award committee, 21–22 succession planning committee, 24 minutes of meetings and, 13–14 oversight responsibilities and, 17–20 procedural rules for, 14–16 sample charter, 77–78 Succession plan, 24 CEO evaluation and, 73, 75 committee’s responsibility for, 61–62 future of, 197 oversight of, 18–19, 20 TIAA-CREF statement on, 208 Supplemental executive retirement plans (SERPS): CIC and, 152 TIAA-CREF guidelines, 216–217 T Taxation issues: business combinations, 165 capital gains rates, 128, 130 deferred taxes, 179 definitions pertaining to, 264–268 private company, 98 public company, 94–98 of stock option repricing, 134

Index

Termination trigger, for CIC, 148–149 Terry College of Business, University of Georgia, 285–287 TIAA-CREF (Teachers Insurance and Annuity Association-College Retirement Equities Fund): corporate governance branch of, 198–199 corporate governance policy statement of, 202–211 diversity and, 16 executive compensation program guidelines of, 212–213 on option repricing, 71 Trade organizations, board candidates and, 33–34 Training: of board members, 41–45, 190, 192–193, 196 of committee members, 41–47, 199 specific sites for, 38, 282–289 Treasury Regulation §1.162-27, 60 Treasury stock method of accounting, 121 Trigger arrangements, for CICs, 147–149 Tyco International, 170 U Underwater options, see Stock option repricing United Parcel Service, Inc., 22 V Variable plan accounting, 177–181 Vesting, of long-term incentive award, 146 Viacom, Inc., 92 W Walgreen Co., 129 Walt Disney Company, 37–38, 171 Welch, Jack, 68 Wharton School of the University of Pennsylvania, 288–289 Wisconsin Investment Board, 198 Worker Economic Opportunity Act, 107