OIL INDUSTRY ROUNDTABLE DISCUSSION GROUP

OIL INDUSTRY ROUNDTABLE DISCUSSION GROUP

“Trends and Best Practices in Corporate Governance of Executive Compensation

Post-Enron”

June 4, 2002

“Trends and Best Practices in Corporate Governance of Executive Compensation

Post-Enron”

June 4, 2002

Frederic W. CookFrederic W. Cook & Co.,

Inc.

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PRESENTATION TOPICS . . .

A. COMPENSATION GOVERNANCE PRINCIPLES

B. BRT PRINCIPLES OF CORPORATE GOVERNANCE

C. FWC SUGGESTED BEST PRACTICES FOR EXECUTIVE COMPENSATION

D. STOCK OPTION ACCOUNTING

E. COMPENSATION COMMITTEE USE OF OUTSIDE ADVISORS

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COMPENSATION ISSUES . . .

“In the last decade, management has faced increased market pressures for short-term stock price performance and corresponding pressures to satisfy market expectations on a quarterly basis. This, coupled with increasing grants to senior executives of stock options and other incentives that are focused on short-term stock appreciation, may have created incentives that tipped the balance toward the promotion of self-interest rather than the protection and promotion of long-term shareholder value.”

Ira M. MillsteinWeil, Gotshal & Manges LLPCo-Chair of Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit CommitteesTestimony -- Senate Banking CommitteeFebruary 27, 2002

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PUBLIC PERCEPTIONS . . .

• Executive greed and duplicity contributed to Enron debacle

– Mega-options drove management to falsify accounting to keep stock prices high and rising

– Executives used inside information to exercise and sell options while price high

– Executives urged employees to buy while they were selling

• Stock option accounting contributed to the speculative bubble in stocks by inflating the growth rate in EPS

• Stock options cause short-term behavior and are misaligned with long-term interests of shareholders

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A. COMPENSATION GOVERNANCE PRINCIPLES . . .

Forces influencing change in executive compensationpractices

• Regulatory– Congress– SEC– NYSE/Nasdaq

• Investor Advocates– CalPers – CII– TIAA-CREF – ISS

• “Best Practices” Initiatives– The Business Roundtable (“BRT”)– Financial Executives Int’l– Frederic W. Cook & Co.– Wachtell Lipton– National Association of Corporate Directors

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B. BRT PRINCIPLES OFCORPORATE GOVERNANCE . . .

• Comprehensive statement issued May 20, 2002

– Replacing 1997 statement

• BRT represents CEOs of 150 large corporations

• Urges adoption of new governance principles by all U.S. public companies to restore public trust in American business

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BRT PRINCIPLES -- GENERAL . . .

• Companies should adopt and publicize statements of corporate governance principles

• Core committees (audit, compensation, governance) should be composed entirely of independent directors

• Committee members and chairs should be appointed by Board on recommendations of the Corporate Governance Committee

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BRT -- COMPENSATION COMMITTEE GOVERNANCE PRINCIPLES . . .

• Committee should have a written charter, approved by Board, clearly defining its responsibilities

• Core responsibilities of Compensation Committees

– Overseeing company’s overall compensation programs

– Setting CEO and senior management compensation

– Establishing director compensation

• Compensation and Governance Committees should evaluate CEO annually on behalf of Board

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BRT -- MANAGEMENT COMPENSATION PRINCIPLES . . .

• Adopt diverse mix of compensation and incentives

– Prevent short-term focus

– Avoid narrow focus on particular aspect of company’s business

• Carefully design equity compensation to avoid unintended incentives for short-term market value changes

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BRT -- MANAGEMENT COMPENSATION PRINCIPLES (cont’d) . . .

• Directly link interests of management to long-term interests of stockholders

• Require shareholder approval of all stock option and restricted stock plans in which directors and executive officers participate

• Engagement by the Committee of separate compensation consultants may be useful

– BRT believes access to outside advisors is an important element of effective governance system

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BRT -- DIRECTOR COMPENSATION PRINCIPLES . . .

• Directors should be incentivized to focus on long-term value

• Meaningful portion of total remuneration should be in long-term equity

• Equity compensation should be carefully designed to avoid unintended incentives for short-term market value changes

• Boards may wish to require directors to acquire and hold meaningful ownership positions while active

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C. FWC SUGGESTED BEST PRACTICES FOR EXECUTIVE COMPENSATION . . .

Financially-Driven Incentives

• Pick the critical and conservative measures of operating performance

• If formula driven, have audit firm confirm calculations

• Preserve discretion to deviate from accounting numbers

• Include strategic/qualitative measures

• Consider effect on current awards of prior-period restatements

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Suggested Regulatory Initiatives

• Increase frequency of reporting of OD stock transactions

– Gain control over shares

• Permit recapture of stock gains in bankruptcy

• Permit recapture of lump sum SERPs in bankruptcy

• Preclude option grants on inside information

C. FWC SUGGESTED BEST PRACTICES (cont’d) . . .

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“Best Practices” Initiatives

• Adopt policy on stock transactions and conflicts of interests by ODs

• Adopt stock “retention ratios” instead of ownership guidelines

• Prohibit 100% “cashless exercises” by ODs

• Use “reloads” only for ownership purposes

C. FWC SUGGESTED BEST PRACTICES (cont’d) . . .

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“Best Practices” Initiatives (cont’d)

• Prohibit loans for exercising options, purchasing stock or paying taxes

• Prohibit purchases of stock on margin and use of stock as collateral

• Prohibit “hedging” or similar techniques

• Encourage (or require) use of SEC 10b5-1(c) selling programs by ODs

• Prohibit incentives on piece-parts of business where conflicts exist

C. FWC SUGGESTED BEST PRACTICES (cont’d) . . .

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Directors’ Remuneration “Best Practices”

• Discontinue stock options*

– Use deferred stock instead

• Discourage (or prohibit) stock sales while an active director

C. FWC SUGGESTED BEST PRACTICES (cont’d) . . .

* Except for startups or pre-IPO companies

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D. STOCK OPTION ACCOUNTING . . .

• Intense debate underway whether to require P&L expense for option value:

For

Alan Greenspan

Arthur Levitt

Warren Buffet

New York Times

CII/TIAA-CREF

Against

President Bush

Chairman Pitt

Walter Schuetze

Business Week

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D. STOCK OPTION ACCOUNTING (cont’d)

Concerns of Change Advocates

• Present accounting leads to excessive use and dilution

• Earnings and EPS growth overstated

• Incentives misaligned

• Options have value; therefore must have a cost

• Expense is not zero

• Better design would result from expensing

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D. STOCK OPTION ACCOUNTING (cont’d)

Arguments for Status Quo

• Option “fair values” impossible to measure

• Black-Scholes overstates option value

• FV doesn’t meet conceptual definition of expense

• FV would be only expense estimate never trued up

• Cost to shareholders already measured by diluted EPS

– FV charge would be double counting

• Value of option privilege in financial instruments not expense

• No other country requires option expense

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E. COMPENSATION COMMITTEE’S USE OF INDEPENDENT ADVISORS . . .

• (Materials handed out at the meeting; not available for general distribution or on our website)

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OTHER LIKELY IMPLICATIONSOF “ENRON”

• More power to board/committees, less to management

• Harder to attract/retain qualified directors

– Smaller boards

• More staff time spent serving board/committees

• More transparency

• “Best Practices” statements

– Possible “comply or explain” disclosure