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THE CHANGING LANDSCAPE OF EXECUTIVE COMPENSATION
Robert S. TimmermanConsultant, New York OfficeFrederic W. Cook & Co., Inc.
February 13, 2003
ROCKY MOUNTAIN COMPENSATION ASSOCIATION
2
Recent Significant Developments
Completed
Sarbanes-Oxley Act of 2002
Expanded disclosure of stock plan dilution levels
Conference Board Commission on Public Trust And Private Enterprise
New proposed golden parachute rules
Pending
Accounting for stock-based compensation
Stock exchange rules
3
Today’s Presentation Focus
Sarbanes-Oxley Act of 2002
Accounting for stock-based compensation
– Opinion 25 versus FAS 123
Focus on employee stock options in particular
– FASB Statement No. 148
Transition and disclosure provisions of FAS 123
4
Sarbanes-Oxley Act of 2002
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)
5
Sarbanes-Oxley Act of 2002 (cont’d)
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
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)
Criminal penalties (specified fines and jail time) for ERISA violations
6
Accounting for Stock-Based Compensation
Background
– Opinion 25 versus FAS 123
Implications
– Possible Outcomes and Reaction
Action Steps
– How to Respond
Focus on employee stock options in particular
7
Background
Current U.S. GAAP permits stock option expense to be determined under either:
– APB Opinion No. 25 – published October 1972
Interpretation No. 44 issued in March 2000
– FASB Statement No. 123 – published October 1995
Choice with disclosure
FASB Statement No. 148 amends the transition and disclosure provisions of No. 123 (December 31, 2002)
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
8
Executive Long-Term Incentive GrantType Usage Percent of Top 250 Companies
99%
56%51%
43%
32% 33% 30%24% 21%
0%
20%
40%
60%
80%
100%
Stock Options RestrictedStock
PerformanceShares
PerformanceUnits
1999 2000 2001
Source: Frederic W. Cook & Co.
9
Executive Stock Option VariationsPercent of Top 250 Companies
18%
16%
9%
6%
2%
0%
5%
10%
15%
20%
PerformanceOptions
Premium Options Discount Options
1999 2000 2001
Source: Frederic W. Cook & Co.
10
Background (cont’d)
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?
25 LARGEST U.S. COMPANIES1
IMPACT OF FAS STATEMENT 1232
EPS ImpactReported FAS 123 FAS 123Diluted Cost Diluted Percentage
Company Name EPS3 Per Share EPS3 Change
General Electric $1.41 ($0.03) $1.38 -2%Microsoft 1.38 (0.41) 0.97 -29%Exxon Mobil 2.18 (0.04) 2.14 -2%Wal-Mart Stores 1.49 (0.02) 1.47 -1%Pfizer 1.22 (0.09) 1.13 -7%Citigroup 2.75 (0.11) 2.64 -4%American International Group 2.07 (0.05) 2.02 -3%Johnson & Johnson 1.84 (0.08) 1.76 -5%Intel 0.19 (0.15) 0.04 -79%Coca-Cola 1.60 (0.08) 1.52 -5%Intl Business Machines 4.35 (0.70) 3.65 -16%Procter & Gamble 2.07 (0.22) 1.85 -11%Merck 3.14 (0.17) 2.97 -6%Berkshire Hathaway 521.00 0.00 521.00 0%Bank Of America 4.18 (0.22) 3.96 -5%Philip Morris 3.88 (0.08) 3.80 -2%Cisco Systems (0.14) (0.23) (0.37) -168%SBC Communications 2.14 (0.07) 2.07 -3%Verizon Communications 0.22 (0.18) 0.04 -83%Wells Fargo 1.97 (0.08) 1.89 -4%ChevronTexaco 3.70 (0.08) 3.62 -2%Pepsico 1.47 (0.17) 1.30 -12%Fannie Mae 5.89 (0.24) 5.65 -4%Home Depot 1.29 (0.10) 1.19 -8%Viacom (0.13) (0.08) (0.21) -60%
75th Percentile -3%Median -5%25th Percentile -12%
1 Based on market capitalization2 Based on most recent 10-k3 Before extraordinary items 7
12
Background (cont’d)
IASB Exposure Draft – November 7, 2002
– 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
Forfeitures
Tax benefits
Private company volatility assumption
IASB’s proposed principles-based valuation approach
– Ideas on “ways to improve consistency and comparability of option grant values”
– Option valuation methodologies up for reevaluation By the 1st 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
13
Black-Scholes Overestimates Option Value
Designed for traded options
– Employee options are illiquid
Use of “expected” (instead of maximum) term does not adequately reflect nontransferability
– Penalizes companies with high volatility
Does not recognize value impairment from non-exercisability before vesting and truncated terms at termination of employment
Employees cannot hedge or “borrow stock and short it against the option”
14
Black-Scholes Overestimates Option Value (cont’d.)
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
– No so for traded options
Executives’ options often have restrictive features
– Blackouts, no sales, holding periods, forfeitures for competing, etc.
15
Comparative Black-Scholes Option Values
75P 40.0% 40.3% 86.6% 78.2%
50P 35.6% 35.2% 71.5% 70.2%
25P 31.1% 29.8% 52.7% 57.5%
B-S as B-S asVolatility % FMV Volatility % FMV
DJIA 30 Nasdaq 100
Note: Assumes 7-year term, 4% interest rate and average 5-year volatility
16
Primary Criticisms of Opinion 25
General public perception that stock options, and their accounting treatment, contributed to:
– Recent corporate scandals (Enron, WorldCom 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
17
Primary Criticisms of Opinion 25 (cont’d)
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
Expensing is the panacea to address current bad stock option practices
18
Arguments Against Expensing
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
Options are a capital transaction between shareholders and employees (transaction is a division not a subtraction)
There are no cash flow costs associated with stock options
– Rather, options provide positive cash flow (exercise price, tax benefit)
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
Expensing of options would discourage their use and mitigate creative thinking and innovation, especially for entrepreneurial start-up companies
19
Arguments For Expensing
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)
Options have value when granted, and retain value even if they fall underwater
Sale of stock at less than current FMV results in an opportunity cost to the company, which depletes assets
The accounting treatment for options under Opinion 25 is inconsistent with that of all other forms of compensation
Stock options do create cash flow expenses if shares are bought back in market to neutralize dilution effect
20
Arguments For Expensing (cont’d)
A simple example – “cost” of 100 options versus 100 SARs Assume $10 exercise price; award exercised at $20; 35% corporate
tax rate
Economic impact to employee - $1,000 gain
– [$20-$10] x 100
Dilutive effect to Company
– None under SAR
– 100 shares under option (neutral if shares bought back)
Cash Flow analysis
SAR Option
Payment of exercise price 0 $1,000 Payment to employee ($1,000) 0 Tax benefit 350 350 Cost of share purchase 0 ($2,000) Total cash flow cost ($650) ($650)
21
Possible Outcomes
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
Outcome may largely depend on “herd mentality” in keeping up with competitive compensation practices
22
Companies Recently Adopting FAS 123
As of the end of 2002, approximately 170 public companies are “early adopters”
High profile companies include:
American Express
American International Group
Citigroup
Coca-Cola
Computer Associates
Dow Chemical
Emerson Electric
General Electric
General Motors
Goldman Sacs
Home Depot
Procter & Gamble
United Parcel Service
Wal-Mart Stores
23
How to Respond
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?
24
How to Respond (cont’d)
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
25
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 Share
per
Share
Total for
79.1M Shs.
Intrinsic
Value
Base Case Option $7.91 -- -- --
Weekly 5 Yr. Volatility/Yield $10.44 +$2.53 +$200.1M --
Monthly 3 Yr. Volatility/Yield $6.99 -$.92 -$72.8M --
Base Case @ $10 Discount $13.00 +$5.09 +$402.6M +$791.0M
Base Case @ $10 Premium $4.75 -$3.16 -$250.0M -$791.0M
Black-Scholes Input Assumptions
26
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
Option Provisions
27
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
Option Provisions (cont’d)
28
Converting high Black-Scholes values to cash, full-value shares, and SERPs is appealing but wrong without discount
Recent
Price
Black-Scholes
Multiple
Equivalent Cash/
Full-Value Shares
AOL $13.00 52.37% $6.81
Citigroup $30.00 22.15% $6.65
Intel $16.00 49.53% $7.92
3M $120.00 25.08% $30.10
United Airlines $2.50 34.49% $.86
Conversion of Option Values
29
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
Stock Price
FAS 123
Expense
Pay
Delivered
FAS 123
Expense
Pay
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
Full-Value Shares
30
Likely Impact on Incentive Design
Short-term (irrespective of FAS 123)
– Decreased use of options in aggregate, even in the absence of a direct earnings charge
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 stock-based “full value” LTI alternatives, particularly among senior executives
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
More reliance on dilution-based approaches
31
Likely Impact on Incentive Design (cont’d)
Anticipated stock option evolution (assuming FAS 123 mandate)
– Significant changes in the design of option awards (maybe)
Performance contingent vesting
Indexed exercise price
Shorter terms, perhaps with immediate vesting, but longer vesting helps spread expense
Barrier options such as exercise trigger options
– Replacement of traditional options with stock-based SARs and variations
Same accounting treatment under FAS 123
Simpler to administer (no cashless exercise)
Less burden on equity plan share reserve (profit shares)
– Replacement of FMV options with discount options
Fair value is less than sum of discount plus fair value of option at 100% of FMV
32
Macro Impact
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
33
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
• Performance Measurement• Globalization• Privatization• Compensation Committee
Advisor• Stock Option Enhancements
Our offices are located:
New York90 Park Avenue35th FloorNew York, New York 10016212-986-6330 (phone)212-986-3836 (fax)
Chicago19 South LaSalle StreetSuite 400Chicago, Illinois 60603312-332-0910 (phone)312-332-0647 (fax)
Los Angeles2029 Century Park EastSuite 1130Los Angeles, California 90067310-277-5070 (phone)310-277-5068 (fax)
Website address:www.fwcook.com