ROCKY MOUNTAIN COMPENSATION ASSOCIATION THE CHANGING LANDSCAPE OF

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ROCKY MOUNTAIN COMPENSATION ASSOCIATION THE CHANGING LANDSCAPE OF EXECUTIVE COMPENSATION Robert S. Timmerman Consultant,

ROCKY MOUNTAIN COMPENSATION ASSOCIATION THE CHANGING LANDSCAPE OF EXECUTIVE COMPENSATION Robert S. Timmerman Consultant, New York Office Frederic W. Cook & Co. , Inc. February 13, 2003

Recent Significant Developments Completed l Sarbanes-Oxley Act of 2002 l Expanded disclosure of stock

Recent Significant Developments Completed l Sarbanes-Oxley Act of 2002 l Expanded disclosure of stock plan dilution levels l Conference Board Commission on Public Trust And Private Enterprise l New proposed golden parachute rules Pending l Accounting for stock-based compensation l Stock exchange rules 2

Today’s Presentation Focus l Sarbanes-Oxley Act of 2002 l Accounting for stock-based compensation –

Today’s Presentation Focus l Sarbanes-Oxley Act of 2002 l Accounting for stock-based compensation – Opinion 25 versus FAS 123 Þ Focus on employee stock options in particular – FASB Statement No. 148 Þ Transition and disclosure provisions of FAS 123 3

Sarbanes-Oxley Act of 2002 l l Prohibition of company-provided/arranged loans to executive officers and

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

Sarbanes-Oxley Act of 2002 (cont’d) l Requires CEOs and CFOs to reimburse company for

Sarbanes-Oxley Act of 2002 (cont’d) l Requires CEOs and CFOs to reimburse company for prior compensation and stock sale gains if financial statements are restated – Applies to bonus, equity-based compensation and gain from stock sales in 12 months after issuance of financial statements that were subsequently restated l Prohibits officers and directors from buying or selling any company stock during a benefit plan black-out/quiet period (e. g. , when 401(k) administrators are being changed) l Criminal penalties (specified fines and jail time) for ERISA violations 5

Accounting for Stock-Based Compensation l Background – l Implications – l Possible Outcomes and

Accounting for Stock-Based Compensation l Background – l Implications – l Possible Outcomes and Reaction Action Steps – l Opinion 25 versus FAS 123 How to Respond Focus on employee stock options in particular 6

Background l Current U. S. GAAP permits stock option expense to be determined under

Background l Current U. S. GAAP permits stock option expense to be determined under either: – APB Opinion No. 25 – published October 1972 Þ Interpretation No. 44 issued in March 2000 – FASB Statement No. 123 – published October 1995 Þ Choice with disclosure Þ FASB Statement No. 148 amends the transition and disclosure provisions of No. 123 (December 31, 2002) l l Generally no expense recognized under Opinion 25, assuming: – Option exercise price equals FMV at grant (“intrinsic value accounting”) – Vesting is contingent solely on the passage of time Significant accounting bias in favor of plain vanilla option awards 7

Executive Long-Term Incentive Grant Type Usage Percent of Top 250 Companies Source: Frederic W.

Executive Long-Term Incentive Grant Type Usage Percent of Top 250 Companies Source: Frederic W. Cook & Co. 8

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

Executive Stock Option Variations Percent of Top 250 Companies Source: Frederic W. Cook & Co. 9

Background (cont’d) l l l FAS 123 is based on “fair value accounting” such

Background (cont’d) l l l FAS 123 is based on “fair value accounting” such that expense equals the “fair value” of the option at grant and is recognized over the vesting schedule – Fair value is generally determined using an option pricing model (e. g. , Black-Scholes, binomial) – Model includes 6 valuation inputs (stock price, exercise price, dividend yield, interest rate, option term and volatility) – Also includes forfeiture rate factor Implications: – Opinion 25: must disclose the pro forma impact under FAS 123 as a footnote in the annual report – FAS 123: the decision applies to all equity compensation awards and is irrevocable How do reported financial results differ as a result of a company’s election? 10

25 LARGEST U. S. COMPANIES 1 IMPACT OF FAS STATEMENT 1232 Company Name General

25 LARGEST U. S. COMPANIES 1 IMPACT OF FAS STATEMENT 1232 Company Name General Electric Microsoft Exxon Mobil Wal-Mart Stores Pfizer Citigroup American International Group Johnson & Johnson Intel Coca-Cola Intl Business Machines Procter & Gamble Merck Berkshire Hathaway Bank Of America Philip Morris Cisco Systems SBC Communications Verizon Communications Wells Fargo Chevron. Texaco Pepsico Fannie Mae Home Depot Viacom 75 th Percentile Median 25 th Percentile Reported Diluted EPS 3 $1. 41 1. 38 2. 18 1. 49 1. 22 2. 75 2. 07 1. 84 0. 19 1. 60 4. 35 2. 07 3. 14 521. 00 4. 18 3. 88 (0. 14) 2. 14 0. 22 1. 97 3. 70 1. 47 5. 89 1. 29 (0. 13) EPS Impact FAS 123 Cost Diluted Per Share EPS 3 ($0. 03) (0. 41) (0. 04) (0. 02) (0. 09) (0. 11) (0. 05) (0. 08) (0. 15) (0. 08) (0. 70) (0. 22) (0. 17) 0. 00 (0. 22) (0. 08) (0. 23) (0. 07) (0. 18) (0. 08) (0. 17) (0. 24) (0. 10) (0. 08) $1. 38 0. 97 2. 14 1. 47 1. 13 2. 64 2. 02 1. 76 0. 04 1. 52 3. 65 1. 85 2. 97 521. 00 3. 96 3. 80 (0. 37) 2. 07 0. 04 1. 89 3. 62 1. 30 5. 65 1. 19 (0. 21) Percentage Change -2% -29% -2% -1% -7% -4% -3% -5% -79% -5% -16% -11% -6% 0% -5% -2% -168% -3% -83% -4% -2% -12% -4% -8% -60% -3% -5% -12% 1 Based on market capitalization Based on most recent 10 -k 3 Before extraordinary items 2 7 11

Background (cont’d) l IASB Exposure Draft – November 7, 2002 – l New standard

Background (cont’d) l IASB Exposure Draft – November 7, 2002 – l New standard effective January 1, 2004 FASB’s Invitation to Comment – November 18, 2002 – Aim is global convergence 1. Differences between FAS 123 and IASB’s ED Ø Forfeitures Ø Tax benefits Ø Private company volatility assumption Ø IASB’s proposed principles-based valuation approach l – Ideas on “ways to improve consistency and comparability of option grant values” – Option valuation methodologies up for reevaluation By the 1 st quarter of 2003, the FASB will decide whether to undertake a project leading to mandatory expensing of employee stock options in conformance with the IASB 12

Black-Scholes Overestimates Option Value l Designed for traded options – l Employee options are

Black-Scholes Overestimates Option Value l Designed for traded options – l Employee options are illiquid Use of “expected” (instead of maximum) term does not adequately reflect nontransferability – Penalizes companies with high volatility l Does not recognize value impairment from non-exercisability before vesting and truncated terms at termination of employment l Employees cannot hedge or “borrow stock and short it against the option” 13

Black-Scholes Overestimates Option Value (cont’d. ) l l Employees discount Black-Scholes values – Risk

Black-Scholes Overestimates Option Value (cont’d. ) l l Employees discount Black-Scholes values – Risk aversion and portfolio diversification reasons – Value differential between company cost and employee’s perceived value Option gains are taxable income and deductible – l No so for traded options Executives’ options often have restrictive features – Blackouts, no sales, holding periods, forfeitures for competing, etc. 14

Comparative Black-Scholes Option Values DJIA 30 B-S as Volatility % FMV Nasdaq 100 Volatility

Comparative Black-Scholes Option Values DJIA 30 B-S as Volatility % FMV Nasdaq 100 Volatility B-S as % FMV 75 P 40. 0% 40. 3% 86. 6% 78. 2% 50 P 35. 6% 35. 2% 71. 5% 70. 2% 25 P 31. 1% 29. 8% 52. 7% 57. 5% Note: Assumes 7 -year term, 4% interest rate and average 5 -year volatility 15

Primary Criticisms of Opinion 25 l l General public perception that stock options, and

Primary Criticisms of Opinion 25 l l General public perception that stock options, and their accounting treatment, contributed to: – Recent corporate scandals (Enron, World. Com etc. ) – Speculative bubble in stock prices Critics contend that: 1. Absence of expense leads to: – Increasingly large grants – Excessive shareholder dilution – General lack of accountability for “cost” – Overstatement of earnings 16

Primary Criticisms of Opinion 25 (cont’d) l Critics further contend that: 2. Large annual

Primary Criticisms of Opinion 25 (cont’d) l Critics further contend that: 2. Large annual option grants lead to: – Excessive focus on short-term stock price performance – Diverging management and shareholders interests – Temptation to falsify financial results – May reward even poor-performing executives because a rising market lifts all stocks l Expensing is the panacea to address current bad stock option practices 17

Arguments Against Expensing l The “cost” of options is already reflected in diluted EPS

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

Arguments For Expensing l Stock options are compensation and compensation is an expense –

Arguments For Expensing l Stock options are compensation and compensation is an expense – “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses shouldn’t go into the calculation of earnings, where in the world should they go? ” (Warren Buffet argument) l Options have value when granted, and retain value even if they fall underwater l Sale of stock at less than current FMV results in an opportunity cost to the company, which depletes assets l The accounting treatment for options under Opinion 25 is inconsistent with that of all other forms of compensation l Stock options do create cash flow expenses if shares are bought back in market to neutralize dilution effect 19

Arguments For Expensing (cont’d) A simple example – “cost” of 100 options versus 100

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

Possible Outcomes l 3 possible scenarios 1. Voluntary adoption – investor pressure and competitive

Possible Outcomes l 3 possible scenarios 1. Voluntary adoption – investor pressure and competitive precedent 2. SEC or FASB mandate – likelihood increasing daily – Widespread political support – IASB – need for a global standard and call for fair value approach – Leverage attributable to voluntary adoptions 3. Status quo – seems highly unlikely, but perhaps possible l Outcome may largely depend on “herd mentality” in keeping up with competitive compensation practices 21

Companies Recently Adopting FAS 123 l As of the end of 2002, approximately 170

Companies Recently Adopting FAS 123 l As of the end of 2002, approximately 170 public companies are “early adopters” l High profile companies include: American Express General Electric American International Group General Motors Citigroup Goldman Sacs Coca-Cola Home Depot Computer Associates Procter & Gamble Dow Chemical United Parcel Service Emerson Electric Wal-Mart Stores 22

How to Respond l What to do now 1. Examine the impact of adopting

How to Respond l What to do now 1. Examine the impact of adopting FAS 123 based on the 3 transition approaches under new FASB Statement No. 148 A. Prospective method (new grants only, but sunset approach for companies not adopting in fiscal years beginning after December 15, 2003) B. Modified Prospective method (new statements reflect all grants subject to vesting) C. Modified Retroactive method (full restatement of prior results) 2. Compare impact relative to peers 3. Discuss issue with industry peers – If a trend develops, could it be resisted? 23

How to Respond (cont’d) l What to do now (cont’d) 4. Examine financial efficiency

How to Respond (cont’d) l What to do now (cont’d) 4. Examine financial efficiency of existing program under FAS 123 – For example, do reloads remain affordable? – Only elect FAS 123 if it reduces otherwise disclosed expense 5. Consider alternative option and full-value LTI designs 6. Start voluntary quarterly pro forma option expense disclosure 7. Use lowest reasonable Black-Scholes value for expense 8. Adopt dilution-based grant guidelines 9. Run ISS methodology if you need more shares 24

Black-Scholes Input Assumptions We must all become better informed quickly Pfizer base case option

Black-Scholes Input Assumptions We must all become better informed quickly Pfizer base case option @ $33 on 9/1/02, 5 year term, 5 year monthly volatility/yield, and 5 year STRIP interest-rate +/- Base Case Option Value per Total for Intrinsic per Share 79. 1 M Shs. Value $7. 91 -- -- -- Weekly 5 Yr. Volatility/Yield $10. 44 +$2. 53 +$200. 1 M -- Monthly 3 Yr. Volatility/Yield $6. 99 -$. 92 -$72. 8 M -- Base Case @ $10 Discount $13. 00 +$5. 09 +$402. 6 M +$791. 0 M Base Case @ $10 Premium $4. 75 -$3. 16 -$250. 0 M -$791. 0 M 25

Option Provisions Relatively more attractive under FAS 123 Provision Advantage to NQSOs Stock SARs

Option Provisions Relatively more attractive under FAS 123 Provision Advantage to NQSOs Stock SARs Fewer shares issued Discount Price Low cost to intrinsic value Combined Dividend Rights Low cost to intrinsic value Performance Vesting Pay-for-performance Indexed Price Pay-for-performance 26

Option Provisions (cont’d) Relatively less attractive under FAS 123 Provision Disadvantage to NQSOs ISOs

Option Provisions (cont’d) Relatively less attractive under FAS 123 Provision Disadvantage to NQSOs ISOs No tax benefit Reloads Additive cost Cash SARs Variable cost Premium Price High cost to intrinsic value 27

Conversion of Option Values Converting high Black-Scholes values to cash, full-value shares, and SERPs

Conversion of Option Values Converting high Black-Scholes values to cash, full-value shares, and SERPs is appealing but wrong without discount Recent Black-Scholes Equivalent Cash/ Price Multiple Full-Value Shares AOL $13. 00 52. 37% $6. 81 Citigroup $30. 00 22. 15% $6. 65 Intel $16. 00 49. 53% $7. 92 3 M $120. 00 25. 08% $30. 10 $2. 50 34. 49% $. 86 United Airlines 28

Full-Value Shares Better than options for matching disclosed or real expense with delivered after-tax

Full-Value Shares Better than options for matching disclosed or real expense with delivered after-tax value Assume 40% Black-Scholes value, 35% company tax rate, and 45% individual rate Per $1 of Grant Value NQSOs Full-Value Shares FAS 123 Pay Stock Price Expense Delivered Declines 50% $. 65 $. 00 $. 65 $. 28 No Change $. 65 $. 00 $. 65 $. 55 Increases 50% $. 65 $. 69 $. 65 $. 83 Doubles $. 65 $1. 38 $. 65 $1. 10 29

Likely Impact on Incentive Design l Short-term (irrespective of FAS 123) – Decreased use

Likely Impact on Incentive Design l Short-term (irrespective of FAS 123) – Decreased use of options in aggregate, even in the absence of a direct earnings charge Þ Investors, rating agencies, and Wall Street analysts already considering pro forma FAS 123 impact – Reduced use of reload stock options – Reduced share usage will Increase use of cash- and stockbased “full value” LTI alternatives, particularly among senior executives Þ Risk that middle management and rank-and-file are left behind (also made worse with FAS 123 ESPP treatment) – Heavy emphasis on time-based restricted stock, with mandatory hold and delayed payout – Decreased use of surveys to determine grant levels Þ More reliance on dilution-based approaches 30

Likely Impact on Incentive Design (cont’d) l Anticipated stock option evolution (assuming FAS 123

Likely Impact on Incentive Design (cont’d) l Anticipated stock option evolution (assuming FAS 123 mandate) – Significant changes in the design of option awards (maybe) Þ Performance contingent vesting Þ Indexed exercise price Þ Shorter terms, perhaps with immediate vesting, but longer vesting helps spread expense Þ Barrier options such as exercise trigger options – Replacement of traditional options with stock-based SARs and variations Þ Same accounting treatment under FAS 123 Þ Simpler to administer (no cashless exercise) Þ Less burden on equity plan share reserve (profit shares) – Replacement of FMV options with discount options Þ Fair value is less than sum of discount plus fair value of option at 100% of FMV 31

Macro Impact l Overall assessment – Expensing of options creates level playing field for

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

Company Profile Frederic W. Cook & Co. , Inc. provides management compensation consulting services

Company Profile Frederic W. Cook & Co. , Inc. provides management compensation consulting services to business clients. Formed in 1973, our firm has served over 1, 300 corporations in a wide variety of industries from our offices in New York, Chicago, and Los Angeles. Our primary focus is on performance-based compensation programs which help companies attract and retain key employees, motivate and reward them for improved performance, and align their interests with shareholders. Our range of consulting services encompasses the following areas: • Total Compensation Review • Strategic Incentives • Specific Plan Reviews • Restructuring Services • Competitive Comparisons • Incentive Grant Guidelines • Executive Ownership Programs • All-Employee Plans • Directors’ Compensation • Equity Instruments • • New York Chicago Los Angeles 90 Park Avenue 35 th Floor New York, New York 10016 212 -986 -6330 (phone) 212 -986 -3836 (fax) 19 South La. Salle Street Suite 400 Chicago, Illinois 60603 312 -332 -0910 (phone) 312 -332 -0647 (fax) 2029 Century Park East Suite 1130 Los Angeles, California 90067 310 -277 -5070 (phone) 310 -277 -5068 (fax) Performance Measurement Globalization Privatization Compensation Committee Advisor • Stock Option Enhancements Our offices are located: Website address: www. fwcook. com 33