STANFORD CLOSER LOOK SERIES

Topics, Issues, and Controversies in Corporate Governance and Leadership

A Historical Look at Compensation and Disclosure: Cool and Refreshing!

By David F. Larcker and Brian Tayan June 15, 2010

Compensation and Disclosure

The board of directors determines the level and structure of compensation paid to the CEO and other named executive officers (NEO).1 Compensation packages should be designed to attract, retain, and motivate executives to perform in accordance with the long-term financial objectives of shareholders. SEC regulations require that companies disclose compensation, so that shareholders can assess the suitability of pay packages. The guidelines for compensation disclosure are stipulated by Regulation S-K, Item 402. Companies are to provide clear, concise, and understandable disclosure of all compensation. This includes a summary of total compensation paid, elements of the pay package, the peer group used for comparative purposes in designing compensation, performance metrics used to award variable pay, the fair value of equity-based awards realized and outstanding, stock ownership guidelines, clawback policies, and post-retirement compensation. Companies are also expected to provide material information that is necessary to an understanding of the registrants compensation policies and decisions regarding the named executive officers.2 Amendments and interpretations by the SEC in recent years have emphasized clarity of disclosure (plain English) and ensuring that the relationship between pay and performance is properly explained to shareholders.
Compensation and Disclosure at Lorillard

Lorillard is best known for producing Newport cigarettes, the top-selling menthol brand in the country. Other famous brands include Old Gold

(blended cigarette first introduced in 1926) and Kent (filtered cigarette, 1952).3 The company was originally founded in 1760, making it the oldest tobacco company in the country. In the 1890s, it was absorbed into the trust controlled by the American Tobacco Company, and following the dissolution of the trust in 1911 once again became a freestanding company. In 1968, the company was taken over by the Tisch brothers who merged it into their corporate holdings. In 2008, Lorillard separated from its parent Loews Corporation and became an independently traded company. By 2009, it was the third largest tobacco company in the U.S. with an 11 percent market share. As a company with a long-running history, it is interesting to compare Lorillards compensation and disclosure from several decades ago to today. Take, for example, 1948. That year, Lorillard had revenues of $140 million and net income of $5.6 million.4 President Herbert Kent earned a salary of $60,000 and had $13,000 paid into his pension account. The company introduced a new incentive compensation program, under which Kent would receive a bonus equal to 1 percent of Lorillards net income, executive vice presidents 0.8 percent of net income, and other vice presidents 0.6 percent. The program was simple in design and the specificity of disclosure consistent with what the SEC is encouraging of companies today (see Exhibit 1). By 2009, both compensation levels and mix had changed. That year, Lorillard had revenues of $5.2 billion and net income of $950 million.5 Chairman and CEO Martin Orlowsky earned total compensation of $10.5 million. This comprised $1.2 million salary, $1.6 million stock awards, $3 million
stanford closer look series 1

a historical look at compensation and disclosure: cool and refreshing!

stock appreciation rights, $3.9 million in annual incentive awards, and $0.7 million pension and other. The pay packages of other named executive officers ranged from $2.2 million to $3.4 million. Compensation levels were based on individual factors, industry benchmarks, and a combination of financial and nonfinancial performance metrics, including revenue, net income, market share, market share performance, and change in shipments. Both the program design and disclosure were substantially more complicated than they had been 60 years before (see Exhibit 2).
Why This Matters

The authors would like to thank Michelle E. Gutman for research assistance in the preparation of these materials. The Stanford Closer Look Series is a collection of short case studies that explore topics, issues, and controversies in corporate governance and leadership. The Closer Look Series is published by the Center for Leadership Development and Research at the Stanford Graduate School of Business and the Rock Center for Corporate Governance at Stanford University. For more information, visit: http://www.gsb.stanford.edu/cldr. Copyright 2012 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.

1. Compensation packages have grown increasingly complex over time. Is this complexity necessary to attract and motivate qualified executive talent? Is it time for companies to reduce the complexity of their compensation programs? 2. Compensation disclosure has grown more extensive in length and detail, and yet the relationship between performance and compensation is perhaps less clear than it was years ago. There seems to be a disclosure problem for companies and an understanding problem for shareholders. Where does the problem lie: with compensation consultants (who help create the plans), board members (who approve them), or lawyers (who draft the disclosure)? Is it time to simplify things?
Named executive officer (NEO) is an SEC designation that includes the chief executive officer, the chief financial officer, and the three most highly compensated executive officers. 2 Regulation S-K, Item 402, Available at: http://www.law.uc.edu/ CCL/regS-K/SK402.html. 3 See: L. Gruber, Lorillard and Tobacco 200th Anniversary. Jun. 5, 1998. Available: http://tobaccodocuments.org/lor/91708377-8444. html?zoom=750&ocr_position=above_foramatted&start_ page=11. 4 Moodys Manual of Investments, 1949. 5 Lorillard, form 10-K for the year ending Dec. 31, 2009, filed Feb. 25, 2010 with the SEC.
1

David Larcker is the Morgan Stanley Director of the Center for Leadership Development and Research at the Stanford Graduate School of Business and senior faculty member at the Rock Center for Corporate Governance at Stanford University. Brian Tayan is a researcher with Stanfords Center for Leadership Development and Research. They are coauthors of the books A Real Look at Real World Corporate Governance and Corporate Governance Matters.

stanford closer look series

a historical look at compensation and disclosure: cool and refreshing!

Exhibit 1 Lorillard: Compensation and Disclosure (1948) Remuneration of All Directors and nominees during fiscal year ending, Dec. 31, 1947
(1) Herbert A. Kent George D. Whitefield Edgar S. Bowling Todd Wool William J. Halley Frank Hopewell James A. Glascock Irvin H. Peak (2) $ 60,000 45,000 36,000 36,000 36,000 36,000 20,400 23,000 (3) $4,038 3,000 (4) $ 29,177 24,608 21,337 21,337 21,337 21,337 14,558 15,837 (5) $ 12,780 11,657 1,817 2,984 4,759 5,790 7,250 2,536 (6) $ 17,539 12,339 1,999 8,299 14,330 12,354 7,281 6,250

President Exec. VP Director VP, Secretary VP, Treasurer VP Manager Manager

1. The name of such person; 2. The aggregate remuneration received by such person from the Company and its subsidiaries, directly or indirectly; 3. The amount of the excess remuneration received for the fiscal year ended Dec. 31, 1947, over the remuneration received for the fiscal year ended Dec. 31, 1946, in all cases where such excess exceeds 10%; 4. The net amount each person would receive after payment of Federal income taxes, assuming that each person had no other income and was a married man with two children; 5. The amount paid into the Employees Retirement Plan by the Company for each such person during the fiscal year ended Dec. 31, 1947. In no case did such payment exceed by more than 10% the payments made during the fiscal year ended Dec. 31, 1946; 6. The amount each such person will receive annually upon retirement, assuming the attainment of retirement age and the continuation of the salary rate in effect Dec. 31, 1947.

The proposed new By-law, which is being submitted by the management for the vote of the stockholders, reads as follows:
Article XII: Incentive Compensation for Officers and Key Personnel Section 1. As soon as reasonably may be after the end of the calendar year 1948, and of each

calendar year of the Companys existence thereafter, the Treasurer shall submit to the Board of Directors a certificate [] certifying the amount of incentive compensation income for such calendar year, which incentive compensation income shall be an amount equal to the consolidated net income of the Company [] in accordance with generally accepted principles of accounting [] minus the sum of (a) an amount equal to the dividends for such calendar year [] and (b) an amount equal to $1.20 per share on the average number of shares of Common Stock of the Company []
Section 2. The Board of Directors shall cause the following payments and distributions to be made

from the incentive compensation income as thus certified and approved:

To the President: 1% of such income; To the Executive Vice President: 8/10 of 1% of such income To each of the other Vice Presidents: 6/10 of 1% of such income, but not in excess of 2.4% to all Vice Presidents. To other key personnel: 5.8% of such income, but not in excess of 4/10 of 1% to any one person.

[] in each year 10% of incentive compensation income shall be paid to Management under this By-law.
Source: Lorillard, Proxy Statement, 1948.

stanford closer look series

a historical look at compensation and disclosure: cool and refreshing!

Exhibit 2 Lorillard: Compensation and Disclosure (2010) Summary Compensation Table

Stock Awards 1,600,058 400,060 300,060 300,060 260,060 NonEquity Incentive 3,900,000 1,248,000 858,000 858,000 702,000 Change in Pension 632,681 143,825 380,971 193,970 130,268

Salary Martin Orlowsky Chairman, CEO David Taylor CFO Randy Spell EVP Marketing Ronald Milstein General Counsel Charles Hennighausen EVP Operations 1,212,308 872,219 663,837 639,298 631,277

SARs 3,015,528 753,887 565,416 565,416 490,027

All Other 109,401 33,883 299,321 129,125 22,444

Total 10,469,976 3,451,874 3,067,605 2,685,869 2,236,076

Base Salary.We pay base salaries in order to attract and retain leadership talent and to provide

a competitive basis of compensation that recognizes the executives skills and experience relative to his or her responsibilities in the position. During 2009, the Peer Group and Survey Data were used to construct base salary ranges for all salaried employees, including the Named Executive Officers. The minimum and maximum of each range were set at 75% and 125% of the range midpoint, respectively. This standard grade range spread of 50percentage points provided a market relevant base salary range for similar company positions with salary growth potential. Individual base pay may deviate from the range midpoint due to specific individual factors applicable to each executive, such as seniority, individual performance, experience level, scope of responsibility, or a unique combination of functional responsibilities.
Annual Incentive Awards.Our annual incentive plan (AIP) ensures that a significant portion of

each Named Executive Officers annual compensation is at risk and dependent upon our overall performance and individual performance criteria intended to align the executives interests with shareholder interests. [] 2009 Annual Incentive Plan.[] In establishing the 2009 payout targets for the Named Executive Officers, the Compensation Committee targeted the 75th percentile of market practice for total cash compensation (comprising base salary and annual incentive compensation) for executives in comparable positions at companies in the Peer Group and Survey Data. The Compensation Committee established incentive plan funding equal to 0.75% of our net income for 2009 for each Named Executive Officer,* subject to the negative discretion of the Compensation Committee based on, among other things, the Companys performance in three categories Newports performance in the menthol segment expressed in terms of market share; total domestic relative market share performance as compared with our primary competitors; and our wholesale unit shipments rate of change compared with our primary competitors. [] In March 2010, the Compensation Committee evaluated the Companys performance for purposes of determining incentive payouts for the 2009 AIP for the Named Executive Officers using the [metrics above ]. The Compensation Committee also considered the Companys performance on other metrics, including revenue growth and net income as well as the performance of the Named Executive Officers against their individual performance factors. The Company considers
* Authors note: It

is interesting to note that the sharing parameter is roughly equal to what it was 60 years before.
stanford closer look series 4

a historical look at compensation and disclosure: cool and refreshing!

Exhibit 2 continued

R. J. Reynolds Tobacco Company (Reynolds), a subsidiary of Reynolds American Inc., and Philip Morris USA Inc. (Philip Morris), a subsidiary of Altria Group, Inc., as its primary competitors. The Compensation Committee concluded that the Company significantly outperformed its primary competitors in 2009 on the three key incentive metrics for the 2009 AIP as shown in the table below.
Newports Retail Market Share in the Menthol Segment 2009 2008 35.05share 34.55share 2009 Domestic Wholesale Market Share Change Lorillard: Philip Morris: Reynolds: 0.55share growth 1.96share decline 0.05share decline Domestic Wholesale Unit Shipments Rate of Change for 2009 Lorillard: Philip Morris: Reynolds: 3.9% decline 12.2% decline 8.7% decline

[] Based on these factors, the Compensation Committee determined that the Company had exceeded the performance target set forth in the 2009 AIP by 70% relative to the payout range (representing 80% of the target payout) and that each Named Executive Officer had achieved his or her individual performance factors for 2009 (representing 20% of the target payout). Accordingly, the Compensation Committee awarded 2009 AIP payouts equal to 156% of the payout target for Messrs.Orlowsky, Taylor, Spell, Milstein and Hennighausen. []
Name Martin Orlowsky David Taylor Randy Spell Ronald Milstein Charles Hennighausen 2009 AIP Target Payout $2,500,000 800,000 550,000 550,000 450,000 2009 AIP Actual Payout $3,900,000 1,248,000 858,000 858,000 702,000

Long-Term Incentive Awards.The third principal element of our compensation program for Named Executive Officers is stock awards which recognize performance over a longer term than annual incentive compensation and encourage the Named Executive Officers to continue their employment with the Company. Stock Award Process.The Compensation Committee approves and grants annual equity awards to eligible executives, including the Named Executive Officers, at its first regular meeting of the year following the release of the Companys earnings for the prior year. [] 2009 Stock Awards. [] In March 2009, upon consultation with Committees Compensation Consultant, the Compensation Committee determined that the value of the 2009 Stock Award would be allocated 60% in SARs and 40% in service based restricted stock. The SAR awards were granted in four equal quarterly installments with an exercise price equal to the closing price of our Common Stock on each date of grant. The SAR awards will vest in one-quarter increments beginning on the first anniversary of the annual award date (March12, 2009)and each anniversary date for the following three years. The restricted stock award will vest on the third anniversary of the annual award date, subject to the executive officers continued employment with the Company. The SAR awards will expire on the tenth anniversary of the annual award date. These awards generally are non-transferable. The value of each SAR award is directly linked to the amount of appreciation in the price of our Common Stock from the date of grant and have no value if the

stanford closer look series

a historical look at compensation and disclosure: cool and refreshing!

Exhibit 2 continued

price of our Common Stock does not rise following the date of grant, which serves to align the executives interests with those of our shareholders. The Compensation Committee determined that this structure provided an appropriate balance between providing performance and retention incentives to the Named Executive Officers and other participating employees and aligning their interests with those of our shareholders. In determining the amount of stock to be awarded to the Named Executive Officers, the Compensation Committee targeted the 75th percentile of market practice for our Peer Group and Survey Data for annual equity awards taking into consideration internal equity, individual performance, promotion potential, retention risk and other factors. Based on this evaluation and the advice of the Committees Compensation Consultant, the Compensation Committee established the following award values for the Named Executive Officers. []
Name Martin Orlowsky David Taylor Randy Spell Ronald Milstein Charles Hennighausen Targeted Value of 2009 Stock Awards $4,000,000 1,000,000 750,000 750,000 650,000

[] The following table sets forth the 2009 Stock Awards for the Named Executive Officers awarded on March12, 2009 based on the closing price of our Common Stock on the grant date.
Name Martin Orlowsky David Taylor Randy Spell Ronald Milstein Charles Hennighausen 2009 SARs 271,838 67,960 50,970 50,970 44,174 2009 Service Based Restricted Stock 26,641 6,661 4,996 4,996 4,330

Source: Lorillard, form DEF-14A, filed Apr. 5, 2010 with the SEC. Edited for length.

stanford closer look series