Overview of Executive and Overview of Executive and Director Compensation and Director Compensation and Related TrendsRelated Trends

Third Annual Advanced Third Annual Advanced

ALI-ABA Course of StudyALI-ABA Course of StudyJune 8, 2000June 8, 2000

Michael A. ThompsonMichael A. Thompson

FFREDERIC REDERIC W. CW. COOK &OOK & C CO.O.

The Places We’ll GoThe Places We’ll Go

• The EnvironmentThe Environment

• Trends in Executive PayTrends in Executive Pay

– Internet and E-commerceInternet and E-commerce

• Trends in Director PayTrends in Director Pay

The EnvironmentThe Environment

• Volatile and uncertain stock marketVolatile and uncertain stock market• Investor dilution concernsInvestor dilution concerns• FASB Interpretation 44FASB Interpretation 44• Corporate transactionsCorporate transactions• Re-emergence of venture capitalRe-emergence of venture capital

Volatile Stock MarketVolatile Stock Market

• Nasdaq down 1/3Nasdaq down 1/3• Dow back around 10,000Dow back around 10,000• Many companies have lost 50% or more Many companies have lost 50% or more

of their valueof their value– XeroxXerox MattelMattel– ArmstrongArmstrong Bank OneBank One– Sara LeeSara Lee R.R. DonnelleyR.R. Donnelley– SearsSears Toys R UsToys R Us– E-ToysE-Toys Red HatRed Hat

• Higher “burn rates” and “overhang”Higher “burn rates” and “overhang”

• More scrutiny from institutional investorsMore scrutiny from institutional investors

Stock Plan DilutionStock Plan Dilution

% Outstanding SharesTop-200 (P. Meyer Survey)

1989 1999

Annual Grants 1.1% 2.1%

Potential Dilution 6.9% 13.7%

Stock Plan DilutionStock Plan Dilution

• Smaller more Smaller more frequent share frequent share authorizationsauthorizations

• Shares counted on Shares counted on net, as issued basis, net, as issued basis, not gross, as granted not gross, as granted basisbasis

• Add back shares re-Add back shares re-purchased with purchased with option proceedsoption proceeds

• Board approved Board approved plans for non-officersplans for non-officers

• Best voting outcome Best voting outcome because of dilution because of dilution teststests

• Add back shares to Add back shares to pool from stock-swap pool from stock-swap exercises, etc.exercises, etc.

• Particularly with Particularly with prevalent buy-back prevalent buy-back programsprograms

• Possible under stock Possible under stock exchange rulesexchange rules

FASB Interpretation 44FASB Interpretation 44

• Separate presentation tomorrowSeparate presentation tomorrow• Creates some upheavalCreates some upheaval

– Re-pricingRe-pricing– ReloadsReloads– Tax withholdingTax withholding

• Subsidiary stock and optionsSubsidiary stock and options– Including pre-IPO optionsIncluding pre-IPO options

• Restricted stock for u/w optionsRestricted stock for u/w options– Be careful of share for share matchingBe careful of share for share matching

Corporate TransactionsCorporate Transactions

• MergersMergers

• AcquisitionsAcquisitions

• Divestitures/ SalesDivestitures/ Sales

• IPOsIPOs

• Spin-offsSpin-offs

• Tracking StockTracking Stock

Rise of Venture CapitalRise of Venture Capital

• Corporate Venture Capital and Corporate Venture Capital and Private Equity FundsPrivate Equity Funds

• Creates significant pressure on Creates significant pressure on executive compensationexecutive compensation– Internal venture managersInternal venture managers

• Raises issues regarding “friends Raises issues regarding “friends and family” shares on IPOand family” shares on IPO

Hot TopicsHot TopicsExecutive PayExecutive Pay

• Retention, Retention, RetentionRetention, Retention, Retention• Equity use expansion continuesEquity use expansion continues• Stock/options for cashStock/options for cash• Deferred stock option gainsDeferred stock option gains• Impact of Internet companiesImpact of Internet companies

Retention, etc.Retention, etc.

• Way underwater optionsWay underwater options• Restore retention & motivationRestore retention & motivation• Avoid re-pricing “penalties”Avoid re-pricing “penalties”• Implementing “claw-backs”Implementing “claw-backs”• Reducing post-termination exerciseReducing post-termination exercise

– But expanding for retirement, death But expanding for retirement, death and disabilityand disability

Retention AlternativesRetention Alternatives

• Front-load future optionsFront-load future options• Increase in restricted stockIncrease in restricted stock• Price-recovery restricted stockPrice-recovery restricted stock• Dividend-equivalents on optionsDividend-equivalents on options• ““Claw-back” provisionsClaw-back” provisions• ““Premium” elective share conversionsPremium” elective share conversions• Extended stock option vestingExtended stock option vesting

Equity Use ExpansionEquity Use Expansion

• Grant sizes explodeGrant sizes explode– Million option grants now commonMillion option grants now common

• Annual share usage over 2%Annual share usage over 2%• Broader participation in regular Broader participation in regular

annual grantsannual grants• Continued use of broad-based Continued use of broad-based

grantsgrants

Stock/Options for CashStock/Options for Cash

• 28% of Top 25028% of Top 250• Mostly voluntaryMostly voluntary

– Some mandatorySome mandatory• BankBoston-25% of bonus over $300kBankBoston-25% of bonus over $300k

• Often includes premium to playOften includes premium to play– Alcoa and Gen’l Mills-one add’l share Alcoa and Gen’l Mills-one add’l share

for every four electedfor every four elected– Dell-discounts from market valueDell-discounts from market value

Deferred Option GainsDeferred Option Gains

• Deep in-the-money options expiringDeep in-the-money options expiring• Offers opportunity to protect some Offers opportunity to protect some

carried interestcarried interest• Must use stock-swap exerciseMust use stock-swap exercise• Deferral in stock units payable in sharesDeferral in stock units payable in shares• Irrevocable election 6 months in Irrevocable election 6 months in

advanceadvance• Still owe FICA/Medicare taxStill owe FICA/Medicare tax

Internet ImpactInternet Impact

• Changing the gameChanging the game– Focus on carried interest, not Black-Focus on carried interest, not Black-

Scholes valueScholes value– Equity interest in E-commerce unitsEquity interest in E-commerce units

• Raises the ante for retentionRaises the ante for retention• Significant salary increases in some Significant salary increases in some

sectors, e.g., law firmssectors, e.g., law firms

Generic Job ComparisonsGeneric Job Comparisons

$0

$500

$1,000

$1,500

$2,000

$2,500

Salary Bonus Long-Term

CEO CFO Top Sales General Counsel

GI

GIGI

GI

Internet

Internet

Internet

Internet

($000)

Run Rate ComparisonsRun Rate Comparisons

1.1%

5.0% - 7.0%

2.1%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

8.0%

Old Economy New Economy

1989 1999

An

nu

al G

ran

ts a

s a

% o

f O

uts

tan

din

g S

har

es

91% Growth

Dilution ComparisonsDilution Comparisons

6.9%

13.7%

20.0% - 25.0%

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

Old Economy New Economy

1989 1999

Pot

enti

al D

ilu

tion

as

a %

of

Ou

tsta

nd

ing

Sh

ares

99% Growth

Director CompensationDirector Compensation

• Keep the stock comingKeep the stock coming• Away from meeting feesAway from meeting fees• Flexibility ReignsFlexibility Reigns• Ownership guidelinesOwnership guidelines• Interesting variationsInteresting variations

Increasing StockIncreasing Stock

• Interpretation 44 finalizedInterpretation 44 finalized– Directors considered employees so no Directors considered employees so no

P&L chargeP&L charge

• Pension debate is overPension debate is over– Replaced with stock grantsReplaced with stock grants

Director Stock UsageDirector Stock UsageTop 250 CompaniesTop 250 Companies

0%

20%

40%

60%

80%

100%

Any

Type

Elective

Grants

Stock

Options

Rest.

Stk

Unrest

Stk

1996 1997 1998

Source: FWC&Co. 1999 Top 250

Retainer-Only PlansRetainer-Only Plans

• Move away from meeting feesMove away from meeting fees• Paying for governance, not time spentPaying for governance, not time spent• More complete disclosure encourages More complete disclosure encourages

attendanceattendance• Eliminates administrative complexityEliminates administrative complexity• Facilitates conversion of compensation Facilitates conversion of compensation

to stockto stock

Flexibility ReignsFlexibility Reigns

• Trade off everything for everythingTrade off everything for everything• Directors from increasingly diverse Directors from increasingly diverse

backgroundsbackgrounds

Ownership GuidelinesOwnership Guidelines

• 16% of Top 25016% of Top 250– Not a lot, but increasingNot a lot, but increasing

• Most use multiple of retainerMost use multiple of retainer– 5x most common5x most common

• Other examplesOther examples– Citigroup—75% of shares grantedCitigroup—75% of shares granted– Comcast—60% of vested valueComcast—60% of vested value– Airtouch--$100k owned before option grants Airtouch--$100k owned before option grants

mademade

Other VariationsOther Variations

• Performance OptionsPerformance Options– Computer Associates--# based on ROEComputer Associates--# based on ROE– SYSCO—options granted only if 10% SYSCO—options granted only if 10%

growth in EPSgrowth in EPS– UP—options vest on stock priceUP—options vest on stock price

• Reloads for directorsReloads for directors– Includes Abbott, Allstate, Sara Lee, US Includes Abbott, Allstate, Sara Lee, US

Bancorp, Wells FargoBancorp, Wells Fargo

Overview of Executive and Overview of Executive and Director Compensation and Director Compensation and Related TrendsRelated Trends

Third Annual Advanced Third Annual Advanced

ALI-ABA Course of StudyALI-ABA Course of StudyJune 8, 2000June 8, 2000

Michael A. ThompsonMichael A. Thompson

FFREDERIC REDERIC W. CW. COOK &OOK & C CO.O.

Frederic W. Cook & Co., Inc. provides management compensation consulting services to business clients.Formed in 1973, our firm has served over 1,000 corporations in a wide variety of industries from our offices in NewYork, Chicago, and Los Angeles. Our primary focus is on performance-based compensation programs which helpcompanies attract and retain key employees, motivate and reward them for improved performance, and align theirinterests with shareholders. Our range of consulting services encompasses the following areas:

Total Compensation Reviews Incentive Grant Guidelines Performance Measurement Strategic Incentives Executive Ownership Programs Globalization Specific Plan Reviews All-Employee Plans Privatization Restructuring Services Directors’ Compensation Compensation Committee Advisor Competitive Comparisons Equity Instruments Stock Option Enhancements

Our offices are located:

New York Chicago Los Angeles90 Park Avenue35th floor

19 South LaSalle StreetSuite 400

2029 Century Park EastSuite 1130

New York, New York 10016 Chicago, Illinois 60603 Los Angeles, California 90067212-986-6330 phone 312-332-0910 phone 310-277-5070 phone212-986-3836 fax 312-332-0647 fax 310-277-5068 fax

Web site address:www.fredericwcook.com