Focus List 2002

The Council of Institutional Investors today released its 12th annual Focus list of underperforming companies. There are 25 companies profiled - 10 from the S&P 500 index, 10 from the S&P MidCap 400 and five from the S&P SmallCap 600. In recent years, the Council has expanded its analysis beyond the S&P 500 to the mid- and small-cap indices, to reflect our members' interest in these companies.

The 25 companies that underperformed their respective broad market index and their S&P industry peer group over the one- three- and five-year periods ending July 15, 2002 are:

Just as last year, five of the 2002 Focus List companies - Atlas Air, Computer Associates, Conseco, Parametric Technology, and Toys 'R' Us - have been on previous Focus Lists. Atlas, Computer Associates and Conseco were on last year's list; Toys 'R' Us appeared in 1995 and 1999; and Parametric in 1998 and 1999.

Methodology

The methodology for selecting the 2002 Focus List companies is unchanged from past years. Companies were candidates for the list if their total stock returns lagged their broad market index and their S&P industry group over one-, three- and five-year periods.

Specifically, S&P's Compustat service identified the companies that underperformed their respective broad market index (S&P 500, MidCap or SmallCap) for the five-year period ending July 15, 2002, and their industry peer group medians for the one, three and five years ending July 15, 2002.

S&P Compustat then ranked those companies based on their "returns deficit"-the difference between the industry group's annualized five-year median return and the company's annualized five-year return. The 10 S&P 500 companies, 10 MidCap companies and five SmallCap companies with the highest "returns deficit" were named to the 2002 Focus List.

Council members and the Focus List

The Focus List is, and always has been, purely informational. It is not a "target" list or a "hit" list. The Council publishes the list to supplement members' in-house efforts to screen their portfolios to identify underperformers. Members and sustainers use the list in a number of ways. Some members add a handful of the Focus List companies to their lists of companies marked for special attention during the upcoming year. Others do nothing with the list.

Council members and sustainers may submit shareholder resolutions to selected Focus List companies. Or they may send letters and/or request meetings with management and outside directors to discuss performance and governance issues. Some may simply pay closer attention to these companies during the upcoming year.

Some funds publicize the names of the companies they select for special attention. Others engage in "quiet diplomacy," opting to keep the names of the selected companies confidential.

Eight of the 25 companies on the 2001 Focus List were selected for special attention in 2002 by several Council members and sustainers. One company, Aetna, faced a proxy contest led by Providence Capital, a Council sustainer. Initially Providence targeted all three of the open board seats, but it later reduced its slate to one nominee. The firm lost its bid to get its candidate elected to the board.

Member-sponsored resolutions came to votes at two 2001 Focus List companies in 2002. The New York City Police Department Pension Fund won a majority vote on its resolution calling on PacifiCare Health Systems to repeal its classified board. Conseco's proxy ballot included resolutions sponsored by two Council members. A resolution sponsored by the Massachusetts Laborers' Pension Fund calling for two-thirds of the board to be independent won 21.5 percent of the votes cast for and against, and a resolution co-sponsored by New York City Employees' Retirement System and the New York City Teachers' Retirement System calling on the company to grant performance-based options to senior executives won 22.4 percent.

Several companies on the 2002 Focus List are familiar to Council members. Six were on members' 2002 focus lists, with member-sponsored resolutions being voted on at two companies in 2002: Gateway (destagger-the-board resolution sponsored by CalPERS), and Conseco (performance-based options and director independence resolutions described above). Provident Financial and Toys 'R' Us were on a few members' 2000 focus lists.

Other investors and the Focus List

Council members aren't the only investors interested in the Focus List. Each year, the Council receives numerous calls from other investors interested in learning more about the list. As in past years, the Council will publish the names of the 2002 Focus List companies on its web page (www.cii.org). For the second year, nearly all company responses will also be available on the web site.

One investment house has created a special product featuring the Focus List companies. Morgan Stanley Dean Witter has marketed the "Select Turnaround Focus List," a unit trust featuring the Focus List companies. Returns for the 2001 trust aren't available, but we've been told that prior trust returns have outpaced various broad indexes. Morgan Stanley Dean Witter says it plans to market another unit trust based on the 2002 Focus List.

The Focus List has been the subject of various academic studies. A study published in the July/August 2001 issue of the Financial Analysts Journal found that some companies may produce improved stock returns after being included on the Focus List. But companies the authors say have little chance of improvement don't tend to post improved returns, according to the study by Gary L. Caton of Washington State University, Jeremy Goh of Drexel University and Singapore Management University, and Jeffrey Donaldson of the University of Tampa.

Companies on the Council's Focus List frequently show up on other investors' lists of companies selected for special attention. Several 2001 Focus List companies were identified by other investors for special attention. One company, Computer Associates, faced a proxy contest for board seats in 2001 led by Sam Wyly. Wyly threatened another battle in 2002, but he backed off in exchange for a $10 million payment and the company's promise to add another independent director.

Company responses

As is our custom, the Council invited the CEOs of Focus List firms to provide up to four pages of comments that members and other shareholders might find valuable in helping assess the companies' past and current performance.

To ensure that each company received a copy of the Council's invitation to comment, the Council overnighted letters to each CEO and separately mailed copies of the letters to the heads of the companies' investor relations departments. The Council tracked signatures confirming receipt of the overnight letters, then sent a follow-up letter reminding companies of the deadline for responses.

As of Sept. 16, 2002, the Council had received 18 responses. Late responses will be summarized in a future Alert and forwarded to members. Responses received by Sept. 16 are reproduced in the Focus List 2002 book, and nearly all received are on the Council web site at www.cii.org.

Last year's award for brevity went to Conseco; we have a repeat winner this year. Last year's response from the executive VP and CFO comprised only two sentences. This year's comment from CEO Gary C. Wendt totaled three: "I am in receipt of your August 7, 2002, letter indicating that Conseco is 'in the bottom 10 companies of the S&P 500.' You should be aware that Conseco was dropped by S&P from its 500 companies and replaced by Anthem. Because of this, I assume you no longer need a response from us to your August 7th letter." The Council answered Wendt, telling him that Conseco remains on the Focus List, as the data is generated by Standard and Poor's as of a specific date, and inviting him to respond. A follow-up response had not been received as of Sept. 16, 2002.

Most responses were considerably longer. We set a limit of four pages; some companies creatively pushed that envelope with "attachments." Case in point is Joseph Saunders, chairman, president and CEO of Providian, who attached biographies of new board and management personnel, including himself. According to Saunders, Providian's underperformance was based entirely on 2001 results; the management team responsible is no longer with the company. Saunders outlined a five-point strategic plan, which curtailed lending, tightened credit line increases, refocused the company's marketing strategy, strengthened its balance sheet and liquidity, and created a plan to reduce expenses through closing a number of operations centers and reducing the workforce.

A four-pronged strategy to return Aspen Technology to profitability was highlighted in its Letter to Shareholders - Fiscal 2002. As new CEO David McQuillen takes over on Oct. 1, 2002, the company plans to: organize the company around two primary business units, engineering and supply chain manufacturing; segment software into three families; partner with other industry leaders; and pursue vertical markets beyond chemicals and petroleum.

In bemoaning the state of the company's finances when he took office in May 2001, William H. Joyce, chairman and CEO of Hercules, detailed his firm's turnaround strategy - an initiative he calls "Work Process Redesign." The centerpiece of the strategy was the sale of the BetzDearborn water treatment business to General Electric for $1.8 billion, dramatically improving the company's financial health, according to Joyce. Ironically that sale was the subject of great criticism by the minority directors, who addressed shareholders with their concern at the company's annual meeting. See "Contested situations" later in this report for details.

Champion Enterprises attributed its recent poor performance to a downturn in the housing market in general and especially to a loosening of credit standards in the 1990s that resulted in an unprecedented number of repossessions. The company is repositioning itself for what it terms the inevitable upturn in the market, both by closing or consolidating its manufacturing and retail sales centers, and by creating a subsidiary, HomePride Financial, which provides home-only loans for Champion sales centers.

Two other Focus List companies in the manufactured home business also responded. Clayton Homes sent a shareholder letter that detailed the year's successes. The Manufactured Housing Institute named the company "Manufacturer of the Year" for the third consecutive year. In addition, the company operated all 20 plants profitably; same-store retail stores increased by 12 percent; the company reduced foreclosure inventory for the second consecutive year, expanded its financial services, improved operating margins and increased shareholder equity by 10 percent. Fleetwood's news was not as sanguine. In a Sept. 5 press release, the company announced its manufactured housing group generated operating income of $3 million in the first quarter of fiscal 2003 compared to $21 million in the prior year. Like Champion, Fleetwood cited industry financing as the primary problem for the downturn. The company has had, however, a significant increase in sales in its RV division, earning $17.7 million in the quarter compared to a $17.8 million loss in first quarter 2001. Overall losses were $1.5 million for the quarter compared to a loss of $91.8 million in the quarter last year.

Vertex's response was mildly critical of the Focus List methodology. According to Michael Partridge, director of corporate communications, if the analysis had been taken from April 15, 1997 to April 15, 2002, the company's five-year annualized return would have been measured at 10.52 percent, rather than the negative 3.518 percent reached by choosing July 15 as the target date. Similarly, Sanjay Kumar, president and CEO of Computer Associates, asked investors to use "additional metrics" to evaluate CA's past, current and potential performance. Kumar also detailed new initiatives in corporate governance and marketing and client strategies.

Paul Surdez, the director of investor relations at Covance, also suggested a change in metrics, specifically a 50-day moving average rather than one pinpoint date. Covance's "moving average" on July 15, 2002, would have been $18.06, rather than the actual $14.35 July 15th closing price. Surdez wrote that Covance divested two capital-intensive businesses in 2001, strengthening its balance sheet and repurchasing all of its debt while maintaining cash reserves.

According to CEO Paul Friedman, Incyte, a company that specializes in information systems that aid biotechnology and pharmaceutical companies, was misclassified in the Focus List study as a biotechnology stock. The company's peer group is genomic technology, Friedman wrote, and has outperformed several such peer companies with similar or greater market capitalizations. In addition, the company is discontinuing some of its genomic product lines and is pursuing core information products and drug development, a strategic shift in its direction.

Beginning a multiyear program to lower risk and improve internal capital generation, in October 2000, Provident changed the structure of its securitizations and no longer uses gain-on-sale accounting. Since that time, it has focused on increasing fee-based income in commercial and retail banking. According to executive VP and CFO Christopher J. Carey, the events of Sept. 11, 2001, had a detrimental effect on Provident's aircraft lend and lease program, resulting in an overall reduction of net earnings by $53 million.

Timing was a critical factor for Qwest's new chairman and CEO Richard C. Notebaert. When he wrote his letter on Aug. 30, he had been with Qwest less than 90 days. He wrote that he had already achieved his goal of a positive cash flow in the second quarter, and pointed to the announced sale of the company's directory business, QwestDex, to fund the company through 2005.

Another new chairman and CEO, Ken Whipple of CMS Energy, attributed his company's recent stock decline to a highly leveraged balance sheet after rapid growth in the 1990s, and an investigation into the company's practice of "round trip" trading, wherein electricity was simultaneously sold and repurchased at the same price. Recorded as equal amounts of revenue and expense, there was no effect on net income. The company's then-auditor, Arthur Andersen, informed the company its historical audit opinions for 2000 and 2001 could not be relied upon. Ernst & Young is slated to conduct a restatement; meanwhile the company has completed or announced the sale of $2.6 billion in assets and reduced its stock dividend to save cash.

Citing 2001 as a year of transition for Gateway, Senior VP and CFO Joseph Burke described the company's three key priorities: to grow its core PC business, to grow other revenue streams, and improve its cost structure. Like Parametric Technology, it has been deeply affected by a generalized softness in the computer industry. C. Richard Harrison, Parametric's president and CEO, detailed his company's plans to transform its business in difficult times. Until technology spending begins to recover, the company is focused on controlling its spending, maintaining a breakeven cash flow and pursuing its key initiatives.

The past three years have been a critical time for Toys 'R' Us, according to John H. Eyler, chairman and CEO. By the end of the current fiscal year, the company hopes to have remodeled all stores nationwide in the company's new "Mission Possible" format, a layout that their research shows is "enthusiastically" preferred by customers; remodeled stores show a 7 percent bump in sales over non-remodeled ones.

The booming early 1990s was the ideal environment for Franklin Covey's organizational and motivational product line, but as the decade matured, HR training budgets diminished; desktop software and PDAs replaced paper-based organizational products and the company's centerpiece book, "7 Habits of Highly Effective People," no longer drove training programs. In response, the company made a number of acquisitions in non-core areas, which it is now liquidating in order to improve cash balances and reduce debt. The company expects a profit turnaround in fiscal 2003.

Industry considerations

Last year's Focus List was published on Sept. 10, 2001, one day before the terrorist strike affected so many aspects of our lives, including an already-shaky economy. While the economy has generally continued its downturn, the technology sector, including computer, telecommunications, and biotechnology firms, has been hit harder than others. In an attempt to ensure that industry-specific factors don't shape the Focus List, the methodology evaluates company performance relative to S&P-determined peer groups.

Although the 2002 Focus List represents companies from 20 different industry groups as categorized by S&P, several closely aligned categories are represented, reflecting the areas where the economy was off. Indeed, all but five of the Focus List companies may be accounted for with only four broad categories. Ten companies, or 40 percent, are technologically oriented: Aspen, Computer Associates, Gateway, Hercules, Incyte, Parametric, Qwest, RSA, Vertex, and Vitesse. Four are financial services: Conseco, E*Trade, Provident and Providian; three are utilities: Aquila, CMS and Sierra Pacific; and three are home building companies: Champion, Clayton and Fleetwood.

Management considerations

Like last year, many Focus List companies are characterized by changes in leadership. About 60 percent of the companies - Aquila, Aspen, Atlas, CMS, Computer Associates, Conseco, Fleetwood, Gateway, Hercules, Incyte, Parametric, Provident, Providian, Qwest, RSA, Sierra Pacific, and Toys 'R' Us - have had a change in CEO since 2000. Many were inside CEO appointments. Robert K. Green, the new Aquila CEO, is the brother of chairman and former CEO Richard C. Green Jr., and had been president and COO. Richard H. Shuyler, CEO of Atlas, had been the VP for strategic planning. Sanjay Kumar had been on the Computer Associates board for eight years and with the company since 1987 when he became CEO in 2000. Gateway CEO Theodore W. Waitt resumed the title in Jan. 2001 after serving as CEO from Feb. 1993 - Dec. 1999. C. Richard Harrison, who became CEO and president of Parametric in 2000, had been COO and president since 1994; RSA's new CEO Arthur W. Coviello had been an executive since 1995. And Sierra Pacific's CEO Walter M. Higgins III resumed his chairman, president and CEO role in 2002 after serving in those positions from 1994 to 1998,

Aspen will have a new president and CEO on October 1, 2002, when David McQuillen begins his tenure; former chairman and CEO Lawrence B. Evans will remain as chairman. McQuillen has been the executive VP of worldwide sales and marketing since 1997.

Eight companies have brought in outside CEOs since 2000: CMS, Conseco, Fleetwood, Hercules, Incyte, Providian, Qwest and Toys 'R' Us.

At CMS, new chair and CEO Kenneth Whipple was a former executive VP of Ford Motor. Conseco's new chair and CEO, Gary C. Wendt was the former president of GE Capital Services.

It was a big year of change for Fleetwood, as Edward B. Caudill was named president and CEO on July 26, 2002, replacing Nelson W. Potter, who resigned as president and CEO in February 2002. Caudill had been VP of Paccar. Glenn F. Kummer, who had been chairman since 1998 and an employee of the company since 1965, retired in February 2002, but remained on the board. Fleetwood is no stranger to board turmoil. In 1999, after learning he wouldn't be nominated for re-election to the board, Andrew Crean, son of the company's founder and former chair and CEO, asked for proxy statement disclosure of his resignation letter. He wrote that he lacked confidence in current management and was selling most of his holdings back to the company.

More tumult characterized Hercules' management. William H. Joyce was named CEO in May 2001, replacing Thomas Gossage, who resigned in the midst of a heated proxy fight for board seats led by International Specialty Products (ISP), the company's largest shareholder. Joyce became Hercules' fifth CEO in 29 months; he had been chair and CEO of Union Carbide from 1996 through May 2001.

At Incyte, Paul Friedman took the reins in 2001, having been president of DuPont Pharmaceuticals Research Laboratories, as did Providian's Joseph W. Saunders, who was formerly chairman and CFO of Fleet Credit Card Services.

Recent changes abound at Qwest Communications. The company is under investigation by federal prosecutors for suspected criminal activities; chairman and CEO Joseph Nacchio resigned in June and was replaced by Richard C. Notebaert, former chair and CEO of Ameritech.

Toys 'R' Us president and CEO John H. Eyler Jr. was formerly chairman and CEO of FAO Schwartz.

Three Focus List companies - Covance, E*Trade and Vertex - have CEOs with tenure between five and 10 years; only two, Champion and Vitesse, have had the same CEO for more than 10 years; Walter R. Young of Champion for 12 years, and Louis R. Tomasetta of Vitesse for 15 years.

In 10 out of 25 corporations on the List, companies are led by a separate chair and CEO: Aquila, Aspen (the corporate roles are to separate October 1st), Atlas, Clayton, Computer Associates, Incyte, Parametric, Providian, RSA and Vitesse. Three of those, Brian H. Rowe of Atlas, J. David Grissom of Providian, and Pierre R. Lamond of Vitesse, are independent chairmen. Of the other seven, all but Noel G. Posternak of Parametric are either current or former executives; Posternak provides legal services to the company. The remaining CEOs of Focus List 2002 chair their companies' boards.

Board tenures

The average tenure for a board member in a Focus List company is just under eight years. Only eight companies have boards with tenures averaging 10 years or more: Provident, average tenure 16.2 years; Clayton, 15.3 years; Aquila, 13.7 years; Sierra Pacific, 11.1 years; Aspen, 11 years; Gateway, 10.7 years; Vitesse, 10.5 years; and Parametric, 10.2 years. Provident also has the highest percentage of persons with 10 or more years on the board, with five of six; followed by Sierra Pacific, with seven of 10; Gateway and Vitesse, each with four of six; and Aquila, with five of 10. Four of those five have been on Aquila's board 20 years or more, the highest percentage on the Focus List. Chairman Richard C. Green Jr. and his aunt Avis G. Tucker, an emeritus director, are among them, as are former vice chairman John R. Baker and Robert F. Jackson Jr. Green's brother, Robert K. Green, is president and CEO, but has only been on the board nine years.

Companies with the newest boards include Conseco, with an average tenure of 2.7 years and no members of 10 or more years, Atlas with a 3.2 year average, Providian with 3.4, Hercules with 3.9 and Qwest with a 4.5-year average, all with no 10-year members. Incyte, with a 4.6-year average tenure, has a very skewed board - out of 10 members, two have 11 years' tenure, two have nine, and the rest all have one year. RSA's board tenure also has a wide range: with an average 4.9 years' tenure, individual tenures range from brand-new this year to one member with 15 years.

Contested situations

As mentioned earlier, Computer Associates faced a contested election of directors at its 2001 annual meeting, when Sam Wyly ran an alternative slate of directors. Wyly initially proposed replacing the entire board, but he subsequently decided to remove his name from the slate and propose replacing just four directors. Management's candidates won the election.

The company averted another proxy fight in 2002 when it promised to add another independent director to the board following the 2002 meeting and agreed to pay Wyly $10 million to extend his non-compete agreement with the company through July 2007. Wyly also agreed to a five-year standstill prohibiting involvement in a proxy contest with the company. Some governance experts have criticized the payment, calling it greenmail. The company has said the payment was intended to save the cost and distraction of dealing with another proxy contest.

In the aftermath of Hercules' 2001 proxy fight, in which ISP candidates Samuel J. Heyman, Sunil Kumar, Gloria Shaffer and Raymond S. Troubh were elected to the board, Heyman delivered a report at the company's June 27, 2002, annual meeting on behalf of the minority directors. In the report, Heyman criticized the board and detailed the uphill battle fought by dissident directors. For example, Heyman wrote that the company's majority directors and management display "a remarkable indifference to the interest of its shareholders." As evidence, he wrote that CEO Joyce and the nominating committee filled a board vacancy with a director who had just been defeated for reelection. Three more of Joyce's associates were subsequently chosen; all four voted with Joyce on every issue, according to Heyman.

Governance issues

With 2002 likely to be recorded as the year when the term "corporate governance" was emblazoned onto the public's consciousness, we analyzed our Focus List companies for their governance policies.

Board independence: One of the Council's core corporate governance policies is that at least two thirds of the board should qualify as independent under the Council's strict definition limiting independent directors to those whose non-trivial professional, familial or financial connection to the company or the CEO is their directorship.

On last year's Focus List, only 20 percent of the companies met the Council's standard. This year, 15 of 25, or 60 percent, have boards which are two-thirds independent. The ten that fail the standard are: from the S&P 500, Computer Associates, Conseco, Parametric and Qwest; from the MidCap, Atlas Air, Clayton, E*Trade and Incyte; and from the SmallCap, Fleetwood and Franklin Covey.

Hercules has the highest percentage of independent directors, with 12 of 13 classified as independent. Atlas Air has the least independent board of the 2002 Focus List, with only two of its nine directors qualifying as independent under the Council's definition. Parametric and E*Trade are not far behind, with two of six and three of eight independent directors respectively.

Committee independence: Another of the Council's core corporate governance policies states that all companies should have nominating, compensation and audit committees, composed entirely of independent directors. Only four Focus List companies meet this standard: Aquila, Hercules, Providian and Vertex.

Five companies have all-independent nominating committees: Aquila, Fleetwood, Hercules, Providian and Vertex. Companies that have a nominating committee with one or more non-independent members are: CMS, Computer Associates, Conseco, Covance, E*Trade, Franklin Covey, Gateway, Incyte, Qwest, RSA, Sierra Pacific and Toys 'R' Us. Eight companies have no nominating committee at all: Aspen, Atlas Air, Champion, Clayton, Cygnus, Parametric, Provident and Vitesse.

Just over half of the Focus List companies have independent compensation committees. Twelve companies have at least one non-independent member: Atlas Air, Clayton, CMS, Conseco, Fleetwood, Franklin Covey, Incyte, Parametric, Qwest, RSA, Sierra Pacific, and Toys 'R' Us.

In response to a number of auditing irregularities in public companies, Congress passed the Sarbanes-Oxley Act of 2002 this summer that, among other things, increases auditor oversight. One of its provisions is to mandate all-independent audit committees. The act defines independence as accepting no consulting, advisory or other compensation from the company, other than compensation as a board member, nor may the member be affiliated with the company or its subsidiaries. The Council policy on independence is tougher, so companies may be in compliance with the legal standard but not be in compliance with the Council's standard.

Nine of the Focus List companies' audit committees are not composed entirely of independent directors: Atlas Air, Computer Associates, Conseco, E*Trade, Gateway, Incyte, Parametric, Qwest and RSA.

Conseco, Incyte, Qwest and RSA share the Focus List award for least independent committees - they each have all three committees, but none are composed of all independent members.

Classified board: Another Council governance policy is that all board members should stand for re-election each year, as opposed to the so-called classified, or staggered, board. While companies defend the classified board as a way to promote board and managerial continuity, many shareholders believe it fosters entrenchment and reduces director accountability.

Sixty percent of Focus List companies maintain a classified board structure. From the S&P 500, Conseco, Gateway, Hercules, Parametric, Providian, Qwest, and Vitesse; from MidCap, Aquila, Covance, E*Trade, RSA, Sierra Pacific, and Vertex; and from SmallCap, Aspen, Fleetwood and Franklin Covey.

Council members have expressed their desire to declassify boards at two Focus List companies. At Conseco, the American Federation of State, County and Municipal Employees sponsored shareholder resolutions to declassify in 2000 and 2001. Both resolutions failed by a margin of about three to one. In 2002, CalPERS sponsored a resolution to declassify Gateway's board that failed by a similar margin. The vote tallies in favor of the resolutions are relatively low; the large opposing vote at Gateway may be attributable to CEO Waitt's reported beneficial ownership of 31.7 percent of the outstanding shares.

All but seven companies on this year's List have a poison pill in effect. The companies protected by the pill are, from the S&P 500: Computer Associates, Gateway, Hercules, Parametric, Providian and Toys 'R' Us; from the MidCap, Aquila, Atlas Air, Covance, E*Trade, Incyte, RSA, Sierra Pacific and Vertex; and from the SmallCap, Aspen, Champion, Cygnus and Fleetwood.

The pill is also often the subject of shareholder resolutions. Shareholders, including many Council members, want the right to approve poison pill shareholder rights plans. Council corporate governance policies call for such approval.

Two 2002 Focus List companies have recently received shareholder resolutions on their poison pills. LongView Collective Investment Fund sponsored one at Toys 'R' Us in 2000 that garnered an extraordinary 88.4 percent of the votes in favor of the resolution to either redeem or get shareholder approval of the pill. At Aspen Technology, after shareholder resolutions in each of three consecutive years, 1999-2001, the last two with votes more than 50 percent in favor of the resolution, the board amended the poison pill in October 2001to increase the trigger from 15 percent to 20 percent and add a three-year director evaluation (TIDE) provision.

Compensation issues

Council members do not want to micromanage or second-guess boards' decisions in executive compensation issues. Fairness, logic and transparency are key components, as is the Council's policy of an all-independent compensation committee, a goal met by just over half of our Focus List companies.

Stock option accounting was in the news more than ever this year as investors increasingly called for more transparent financial disclosure. As recently as a year ago, only a handful of companies recorded stock options as an expense, contrary to Council policy. Recently companies have been scrambling over each other to report that they will expense options in the future. On July 29, 2002, Computer Associates announced it would expense the cost of all new stock options granted, commencing with options granted in fiscal 2003.

It is a Council policy that shareholders should approve the repricing or replacing of "underwater" options - options with exercise prices higher than the current market price. A few 2002 Focus List companies repriced without shareholder approval in recent years.

One Focus List company, Franklin Covey, used a novel approach in fiscal 2000 for dealing with underwater options. During the third quarter, when the stock traded between $6 7/8 and $11 3/16 a share, the company offered to repurchase all options with exercise prices exceeding $12.25 per share. Options covering 2.3 million shares were repurchased for $6.9 million-the value based on a market valuation methodology. The company said this program and other buybacks during the year were designed to "to reduce the potentially dilutive effect of outstanding options."

On Oct. 1, 2001, Qwest Communication's board offered to reprice underwater options priced at more than $35 per share. Union employees and 15 senior executives were excluded from the program. To avoid an accounting charge, the company replaced surrendered options six months and a day later. Options covering 29 million shares were repriced. In June 2002, when Richard C. Notebaert replaced CEO Joseph C. Nacchio, Notebaert was granted 200,000 shares of stock and 5 million stock options with a strike price of $5.10 as a "welcome aboard package."

In November 2001, RSA used the same six-months-and-a-day approach to avoid accounting charges when it offered to reprice underwater options held by all employees and non-employee directors. That exchange was done on a three-for-five share basis; the company had also repriced options in August 1998.

Rather than repricing options, in 2000 Toys 'R' Us exchanged options priced at more than $22 per share for an economically equivalent grant of restricted stock. Options covering around 14.4 million shares were swapped for 1.7 million restricted shares.

At Champion Enterprises in 2000, the top five executives voluntarily forfeited stock options for 2.3 million shares with an average exercise price of $20 per share. As a result, the company made two separate option grants priced at $3.07 and $10.15 per share to executives in 2001, with one as a special incentive in light of the earlier forfeitures.

Council members are also concerned about the total potential dilution resulting from stock-based incentive programs, including outstanding options and shares available for future award. Based on information provided in the most recently filed 10-Ks, 11 Focus List companies reported total potential dilution levels exceeding 20 percent: Aspen, Champion, E*Trade, Fleetwood, Gateway, Inctye, Parametric, RSA, Toys 'R' Us, Vertex and Vitesse.

Auditor changes

In the wake of its role in document destruction at Enron and its conviction in June of obstructing the government's investigation into Enron's collapse, accounting firm Arthur Andersen ceased auditing public companies in late August. Seven 2002 Focus List firms employed Andersen as their auditor; all switched to other large firms this spring. Aquila, Franklin Covey and Qwest switched to KPMG; Aspen to Deloitte & Touche, and Atlas, CMS and Fleetwood to Ernst & Young.

Deborah Davidson wrote this Alert.