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THE ASSOCIATION OF EXECUTIVE SEARCH CONSULTANTS THE ASSOCIATION OF EXECUTIVE SEARCH CONSULTANTS The Brave New World of Executive Compensation Daniel J.

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Presentation on theme: "THE ASSOCIATION OF EXECUTIVE SEARCH CONSULTANTS THE ASSOCIATION OF EXECUTIVE SEARCH CONSULTANTS The Brave New World of Executive Compensation Daniel J."— Presentation transcript:

1 THE ASSOCIATION OF EXECUTIVE SEARCH CONSULTANTS THE ASSOCIATION OF EXECUTIVE SEARCH CONSULTANTS The Brave New World of Executive Compensation Daniel J. Ryterband Managing Director Frederic W. Cook & Co., Inc. April 10, 2003

2 2 Today’s Discussion Current State of Executive Compensation Current State of Executive Compensation Timeline of Reform Initiatives Timeline of Reform Initiatives The Clear Messages The Clear Messages Summary of Major Trends Summary of Major Trends I.Voluntary Expensing of Options II. Changes in CEO and Top Executive Compensation III.Redesign of Long-Term Incentives IV.Redesign of Non-Executive Director Compensation V.Redesign of Executive/Director Stock Ownership Policies The Key to Reform - The Decision Making Process The Key to Reform - The Decision Making Process

3 3 Current State of Executive Compensation Numerous scandals with significant executive compensation implications: Numerous scandals with significant executive compensation implications: — Enron — Global Crossing — Tyco — WorldCom Widespread practices on the “slippery slope” Widespread practices on the “slippery slope” — Option repricings without shareholder approval — Equity grants from plans not approved by shareholders — Change in control severance pay to executives not severed — Loan forgiveness following stock price declines — Special “retention” awards in conjunction with declining operating results and share price depreciation The result – widespread shareholder and public skepticism The result – widespread shareholder and public skepticism — Perception of executive compensation perhaps never lower

4 4 Timeline of Executive Compensation Reform Initiatives 5/24/02 Nasdaq approves new corporate governance rules 6/27/02 SEC requires certification by CEO/CFO of financial statement accuracy 7/16/02 IASB announces decision to develop global option expense rules 7/30/02 7/30/02 Sarbanes-Oxley Act 8/1/02 8/1/02 NYSE approves new corporate governance rules 9/17/02 9/17/02 Conference Board releases “best practice” guidelines 9/18/02 9/18/02 FASB announces intention to revisit option expensing 3/12/03 3/12/03 FASB announces new options expensing requirement likely effective for /21/01 SEC releases disclosure rules applicable to equity compensation plans Overall Depth and Scope is Expansive and Comprehensive

5 5 The Clear Messages Constrain executive compensation Constrain executive compensation Increase executive/director accountability Increase executive/director accountability Shift control over dilution to shareholders Shift control over dilution to shareholders Improve transparency and reliability of financial disclosures Improve transparency and reliability of financial disclosures Disable insider ability to profit from non-public information and fraudulent financial results Disable insider ability to profit from non-public information and fraudulent financial results Increase independence of executive compensation decision making Increase independence of executive compensation decision making

6 6 I. Voluntary Expensing of Options GAAP currently allows choice between two standards: GAAP currently allows choice between two standards: — APB Opinion 25 – intrinsic value → Generally no expense for traditional options — FAS statement 123 – fair value → Expense generally equal to “Black-Scholes” value at grant Historically, only a small handful of companies had elected FAS 123 Historically, only a small handful of companies had elected FAS 123 Now, however, over 200 companies have voluntarily elected to expense options Now, however, over 200 companies have voluntarily elected to expense options — But, group includes virtually no high technology companies Mandated expensing highly likely in near future Mandated expensing highly likely in near future

7 7 I. Voluntary Expensing of Options (cont’d) American Express* American Express* American International Group American International Group AT&T* AT&T* Boeing* Boeing* Citigroup* Citigroup* Coca-Cola* Coca-Cola* ConocoPhillips ConocoPhillips DuPont* DuPont* Emerson Electric Emerson Electric Ford Ford General Electric* General Motors* Home Depot* JP Morgan Chase* Lowe’s Companies Merrill Lynch Morgan Stanley Procter & Gamble* United Parcel Wal-Mart Stores* * Component of the Dow Jones Industrial Average High Profile Company Sample

8 8 II. Changes in CEO and Top Executive Compensation CEO and top executive compensation has peaked and is declining CEO and top executive compensation has peaked and is declining — Greatest decline in area that exhibited fastest rise → Long-term incentives - stock options in particular — Little change in salaries and bonus opportunity → But some companies paying low or no bonuses — Some increases, however, attributed to special “retention” grants and other one-time awards Factors driving decline Factors driving decline — Falling share prices, which affect Black-Scholes values — Growth in “overhang” and resulting inability to increase grant sizes — Cost considerations applicable to option substitutes

9 9 III. Design of Long-Term Incentives During 1990s, many companies used stock options as sole or predominant long-term incentive During 1990s, many companies used stock options as sole or predominant long-term incentive — In some cases, options constituted 80% or more of senior executive compensation opportunity Drivers behind 1990s trend: Drivers behind 1990s trend: — Absence of P&L charge for traditional options — Highly leveraged nature – substantial wealth creation opportunity in bull market

10 10 III. Design of Long-Term Incentives (cont’d) Companies reducing reliance on options and replacing opportunity with “full-value” cash and/or equity grants Companies reducing reliance on options and replacing opportunity with “full-value” cash and/or equity grants — Restricted shares: time vesting, perhaps with performance acceleration — Performance shares: performance-based, 2 to 5-year cycle — Performance units: cash-denominated multi-year bonus Rationale for “full-value” movement: Rationale for “full-value” movement: — Market volatility – underwater options create a retention/performance disincentive — Option accounting – voluntary or mandated option expensing eliminates financial efficiency options have historically enjoyed

11 11 III. Design of Long-Term Incentives (cont’d) — Institutional investors – pressure to constrain growth in “overhang” → Challenges in securing approval to replenish exhausted share reserves — Public criticism – options in “disgrace” → General belief that options foster a short-term focus − In worst cases, may encourage falsified financial statements — Regulatory initiatives – pending rule changes at NYSE/Nasdaq require shareholder approval of virtually all equity awards → Also prohibits “repricing” without shareholder approval

12 12 III. Design of Long-Term Incentives (cont’d) Bottom line: Bottom line: — All companies will continue to use options (or their equivalent) → But at reduced levels and for less employees — Stock price declines unlikely to be addressed through repricings or higher award levels — Attempt to better balance overall program through “full-value” awards

13 13 IV. Redesign of Non-Executive Director Compensation Widespread recognition that: Widespread recognition that: 1. Purpose of director pay different than executives: — Foster independence and objectivity, as opposed to retention — Protect shareholder interests, as opposed to increasing shareholder value 2. Attraction of directors more difficult due to: — Increased financial exposure and risk to reputation — Greater demands and expected level of commitment — Specific credentials required to serve in various capacities

14 14 IV. Redesign of Non-Executive Director Compensation (cont’d) Resulting trends: Resulting trends: 1. Increased compensation at many companies — Particularly small to mid-sized companies 2. Enhanced fees for directors serving in critical roles — Higher retainers/meeting fees for chair/members of key committees → For example: audit and compensation

15 15 IV. Redesign of Non-Executive Director Compensation (cont’d) 3. Replacement of stock options with deferred or restricted share awards — Short (e.g., 1-year) or immediate vesting, versus longer schedules 4. Elimination of service-based and non-business- related perks — Such as life insurance, pension and medical plans 5. Adoption of stringent stock ownership guidelines — Often more onerous than those applicable to executives

16 16 V. Redesign of Executive/Director Stock Ownership Policies Historic programs based on a multiple of salary (executives) or annual Board retainer (directors) Historic programs based on a multiple of salary (executives) or annual Board retainer (directors) — Short-term reaction to investor pressure to retain outsized option profits in 1990s bull market Historic standard not well designed Historic standard not well designed — Too easy in bull market — Too tough in bear market

17 17 V. Redesign of Executive/Director Stock Ownership Policies (cont’d) Investor concerns over management ownership escalated due to recent corporate scandals Investor concerns over management ownership escalated due to recent corporate scandals — The “Winnick” factor – perceived management abuse of inside information → Capture profit attributable to temporary appreciation or insulate from downside risk Developing trends Developing trends — Increased use of guidelines incorporating “retention ratio” → Requirement to hold all or a portion of after-tax profits − Option gains or vesting/earn-out of other long term incentives — Minimum absolute standards replaced with continuous accrual models

18 18 V. Redesign of Executive/Director Stock Ownership Policies (cont’d) Application to executives Application to executives A. Coupled with minimum salary guidelines — For example, CEO salary multiple of 500% → Until 500% guideline met, retention ratio is 100%, dropping to 50% thereafter B. Salary guideline plus mandatory holding period — For example, CEO salary guideline of 500%; mandatory 1-year hold on equity gains C. Stand-alone retention ratio — For example, CEO retention ratio is 75%, irrespective of total ownership level

19 19 V. Redesign of Executive/Director Stock Ownership Policies (cont’d) Application to non-executive directors Application to non-executive directors — In some cases, programs mirror those of executives — In others, a more substantial standard → Delivery of greater portion of compensation in full- value equity (e.g., deferred stock units) → “No sale” requirement applicable until first anniversary of retirement or termination from Board

20 20 The Key to Reform – The Decision Making Process Good behavior and high ethical standards cannot be mandated Good behavior and high ethical standards cannot be mandated — Must be embraced on a widespread basis Factors critical to reform Factors critical to reform — Informed and interested decision makers — Less reliance on competitive precedent — Reduced attention to entitlement attitude

21 21 The Key to Reform – The Decision Making Process (cont’d) Best Practice Principles Best Practice Principles 1. Action supported by business rationale 2. Action is reasonable, fair and appropriate to circumstances 3. Action can be disclosed without embarrassment 4. Action is easily understood 5. Action aligns management interest with shareholders Common Historic Standards 1. Action is competitive based on external precedent 2. Action is legally permissible 3. Action need not be disclosed or can be camouflaged 4. Action can be complicated to avoid scrutiny 5. Action is needed to keep management satisfied Conclusion: Impact of reform and resulting new standards won’t be fully known until at least Spring of 2004 Conclusion: Impact of reform and resulting new standards won’t be fully known until at least Spring of 2004 “Principled Decision” making framework “Principled Decision” making framework

22 Frederic W. Cook & Co., Inc. provides management compensation consulting services to business clients. Formed in 1973, our firm has served over 1,200 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 Reviews Strategic Incentives Specific Plan Reviews Restructuring Services Competitive Comparisons Incentive Grant Guidelines Executive Ownership Programs All-Employee Plans Directors’ Compensation Equity Instruments Performance Measurement Globalization Privatization Compensation Committee Advisor Stock Option Enhancements Our offices are located: New York 90 Park Avenue 35 th Floor New York, New York phone fax Chicago One North Franklin Suite 910 Chicago, Illinois phone fax Los Angeles 2029 Century Park East Suite 1130 Los Angeles, California phone fax Website address:


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