NOTICE OF ANNUAL MEETING OF STOCKHOLDERS

 

April 24, 2007

 

 

To Our Stockholders:

 

The Annual Meeting of Stockholders (the “Annual Meeting”) of Smith International, Inc. (the “Company”) will be held on Tuesday, April 24, 2007, at 9:00 a.m. local time, at 700 King Street, Wilmington, Delaware, to consider and take action on the following:

 

 

Your Board of Directors recommends a vote “FOR” Proposals 1, 2, and 3.

 

The Board of Directors has fixed the close of business on February 28, 2007 as the record date for determining stockholders who are entitled to notice of and to vote at the meeting.

 

By Order of the Board of Directors

 

Richard E. Chandler, Jr.

Secretary

 

Houston, Texas

March 22, 2007

 

YOUR VOTE IS IMPORTANT.

 

Please vote your proxy promptly so that your shares will be represented, even if you plan to attend the Annual Meeting. You can vote by Internet, by telephone, or by using the proxy card that is enclosed. Please see your proxy card for specific instructions on how to vote.

 

 

PROXY STATEMENT

 

TABLE OF CONTENTS

 

P. O. Box 60068

Houston, TX 77205-0068

 

PROXY STATEMENT

 

The Board of Directors of Smith International, Inc. is soliciting your proxy to vote your shares of common stock at the 2007 Annual Meeting. We are distributing this Proxy Statement and the accompanying proxy card beginning on or about March 22, 2007. We solicit proxies to give all stockholders of record an opportunity to vote on matters that will be presented at the Annual Meeting. In this Proxy Statement, you will find information to assist you in voting your shares. Your vote is very important.

 

Who may vote?

 

You are entitled to vote your shares of our Common Stock if you are a stockholder of record on February 28, 2007. At the close of business on February 28, 2007, a total of 200,025,778 shares of Common Stock were outstanding and entitled to vote. Each share of Common Stock has one vote. The enclosed proxy card shows the number of shares that you are entitled to vote.

 

How do I vote?

 

Stockholders of record may vote in person or by telephone, internet or mail. If you are voting by mail, please sign, date and mail the enclosed proxy card. If you are voting by telephone or internet, please follow the instructions on the enclosed proxy card.

 

Whether or not you plan to attend the meeting, we encourage you to vote by proxy as soon as possible.

 

If you hold your shares in more than one type of account or your shares are registered differently, you may receive more than one proxy card. We encourage you to vote each proxy card that you receive.

 

How will my shares be voted?

 

If you vote by proxy, the individuals named on the proxy card (your proxies) will vote your shares in the manner you indicate. You may specify on your proxy card whether your shares should be voted for all of the nominees for director or your vote may be withheld with respect to one or more of the nominees. You may also specify whether you approve, disapprove or abstain from the other proposals.

 

If you sign and return your proxy card without indicating your voting instructions, your shares will be voted FOR the election of all nominees for director and FOR Proposals 2 and 3.

 

What if my shares are held by a broker?

 

If your Common Stock is held by a broker, bank or other nominee (in “street name”), your broker must vote those shares in accordance with your instructions. However, if you do not give voting instructions to your broker within ten days of the meeting, your broker may vote your shares for you on any matter that the New York Stock Exchange determines to be routine. If the broker cannot vote on a particular matter because it is not routine, there is a “broker non-vote” on that matter. Broker non-votes do not count as votes for or against any proposal; however, an abstention counts as a vote against a proposal. Abstentions and broker non-votes have no effect on the outcome of the election of directors.

 

If you hold your shares in street name and you wish to vote in person at the Annual Meeting, you will need to obtain a proxy from the broker or nominee that holds your shares. If the meeting is adjourned, your Common Stock will be voted as specified on your proxy card on the new meeting date, unless you have revoked your proxy instructions.

 

May I revoke or change my vote?

 

You may revoke or change your proxy at any time before it is exercised by submitting written notice of revocation to Smith’s Corporate Secretary in time for him to receive it before the Annual Meeting; voting again by telephone, internet or mail; or voting in person at the Annual Meeting.

 

Attendance at the Annual Meeting will not by itself revoke a previously granted proxy. If you hold your shares in street name and you wish to change your vote at the Annual Meeting, you will need to obtain a proxy from the broker or nominee that holds your shares.

 

What constitutes a quorum?

 

The holders of a majority of the outstanding shares of Common Stock entitled to vote constitutes a quorum for the transaction of business at the Annual Meeting. If you have returned valid proxy instructions or attend the meeting in person, your Common Stock will be counted for the purpose of determining whether there is a quorum, even if you wish to abstain from voting on some or all matters introduced at the meeting. “Broker non-votes” also count for quorum purposes.

 

How many votes are required to approve a proposal?

 

Directors (Proposal 1) must be elected by a plurality of the votes cast at the meeting. This means that the two nominees receiving the greatest number of votes will be elected. The affirmative vote of a majority of the shares represented at the meeting and entitled to vote on a particular matter is required to approve Proposals 2 and 3. Broker non-votes do not count as votes for or against any proposal; however, an abstention counts as a vote against a proposal. Abstentions and broker non-votes have no effect on the outcome of the election of directors.

 

What other matters will be acted upon at the meeting?

 

We do not know of any other matters that will be presented at the Annual Meeting, other than those mentioned in this Proxy Statement.

 

Who pays the cost of this proxy solicitation?

 

We will pay the cost of solicitation of proxies including preparing, printing and mailing this Proxy Statement. We have retained Morrow & Co. to help us in soliciting proxies for a fee of $7,500, plus reasonable out-of-pocket costs and expenses. We will also reimburse brokers, banks and other nominees for their costs in sending proxy materials to beneficial owners of our Common Stock. Other proxy solicitation expenses that we will pay include those for preparation, mailing, returning and tabulating the proxies.

 

At the 2007 Annual Meeting, stockholders will elect two persons as Class III directors to hold office until the 2010 Annual Meeting, or until they are succeeded by other qualified directors who have been appointed or elected. The nominees are James R. Gibbs and John Yearwood.

 

Directors must be elected by a plurality of the votes cast at the meeting. This means that the two nominees receiving the greatest number of votes will be elected. Votes withheld for any director will not be counted. We will vote your shares as you specify on your proxy card. If you properly execute and return your proxy card (in paper form, electronically via the internet or by telephone), but do not specify how you want your shares voted, we will vote them for the election of all of the nominees listed below.

Each of the nominees are current members of the Board of Directors and have consented to serve if elected. Mr. Yearwood was recommended as a director to the Nominating and Corporate Governance Committee in 2006 by our Chief Executive Officer and other members of senior management. Although management does not contemplate the possibility, in the event any nominee is not a candidate or is unable to serve as a director at the time of the election, the proxies will vote for any nominee who is designated by the present Board of Directors to fill the vacancy.

 

A brief biography of all directors is presented below:

 

Directors to be elected to Class III for a term expiring in 2010:

 

 

WE RECOMMEND A VOTE “FOR” THE ELECTION OF THE DIRECTOR NOMINEES.

 

Class I directors to continue in office until 2008:

 

 

 

Class II directors to continue in office until 2009:

 

 

 

The following table shows certain information about stock ownership of all persons known to the Company to own of record or beneficially more than 5% of the outstanding Common Stock of the Company as of March 5, 2007. This information is based upon information furnished to the Company by these persons and statements filed with the SEC:

 

 

 

The following table shows the number of shares of Common Stock beneficially owned as of March 5, 2007 by each director or nominee for director, the executive officers named in the Summary Compensation Table included later in this Proxy Statement and all directors and executive officers as a group. Except as otherwise indicated, the persons listed below have sole voting power and investment power relating to the shares shown.

 

 

 

 

Corporate Governance Guidelines

 

Our Corporate Governance Guidelines outline the functions of the Board, director qualifications and responsibilities, and various processes and procedures designed to ensure effective and responsive governance. The full text of the guidelines is published on our website at www.smith.com under the “Investor Relations” caption and link to “Governance.” Stockholders may also obtain a free copy upon request by contacting the Corporate Secretary, Smith International, Inc., 16740 Hardy Street, Houston, Texas 77032.

 

Board Structure

 

Our Board of Directors currently consists of eight directors. Board agendas include regularly scheduled sessions for the independent directors to meet without management present. The Board has designated Mr. Gibbs as Lead Director to chair executive sessions of the non-management directors.

 

Jerry W. Neely has reached retirement age pursuant to our Corporate Governance Guidelines and is, therefore, not standing for re-election as a director. Upon completion of Mr. Neely’s service as a director on the Board, the Board will reduce its size to seven members. At that time, it is anticipated that Mr. Neely will become an advisory director to the Board. In this capacity, Mr. Neely will attend meetings of the Board, but will not be entitled to vote at such meetings.

 

Board Meetings

 

The Board and its committees meet throughout the year on a set schedule, and also hold special meetings and act by written consent from time to time as appropriate. The Board of Directors held six meetings during 2006. All directors attended at least 75% of the meetings of the Board of Directors and of all committees on which they served. The Company does not have a policy regarding directors’ attendance at the Annual Meeting of Stockholders. No directors attended the 2006 Annual Meeting.

 

Director Independence

 

The Board annually evaluates the independence of the directors and has affirmatively determined that all directors (including Mr. Bailar who served during the 2006 year) are independent except Doug Rock and Loren Carroll. The Board’s determination regarding independence and financial expertise of its members is based on applicable laws and regulations, Smith’s Corporate Governance Guidelines, the rules of the New York Stock Exchange and a review of any direct or indirect relationship between each director or his immediate family and Smith. To be considered independent, the Board of Directors must affirmatively determine that a director has no material relationship with Smith. In each case, the Board of Directors broadly considers all relevant facts and circumstances, including the director’s commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships and such other criteria as the Board of Directors may determine from time to time. In evaluating the independence of each non-management director, the Board evaluated the following:

 

(1) Mr. Gibbs is Chairman of the Board, President & Chief Executive Officer of Frontier Oil Corporation and Mr. Buck is a director of Frontier Oil. Smith’s Wilson business unit distributes maintenance, repair and operating supplies and equipment to Frontier Refining and Smith’s Services and Technologies business units sell products and services to Frontier Well, both of which are subsidiaries of Frontier Oil.

 

(2) Mr. Fraser is a director of Forest Oil Corporation to which all of the Company’s business units sell equipment, products or services.

 

(3) Mr. Kelley is a director of Cabot Oil and Gas Corporation and OGE Energy Corp. All of the Company’s business units sell equipment, products or services to one or both of these companies. Mr. Kelley is also a director of Lone Star, from which Wilson purchases products.

 

(4) Mr. Yearwood is a director of Logan Oil Tools, from which Smith Services purchases products, and an employee of Schlumberger, with which all of the Company’s business units sell or buy equipment, products

or services. Schlumberger is also the minority partner in our M-I SWACO business unit, a 60 percent-owned joint venture.

 

With respect to each of the most recent three completed fiscal years, none of the payments to or payments received from any of the companies for which our directors are employees exceeded the greater of $1.0 million or 2% of such company’s consolidated gross revenues. All of these companies expect to continue their business relationship in 2007.

 

Communication with the Board

 

Stockholders and employees who wish to communicate with the directors, the Lead Director, or with any individual director, may do so by contacting Smith’s Corporate Secretary at 16740 Hardy Street, Houston, Texas 77032. Smith’s Corporate Secretary will then relay all communications to the appropriate director.

 

Committees of the Board

 

The Board has delegated various responsibilities and authority to different Board Committees as described in this section of the Proxy Statement. The Board has determined that all committee members are independent and satisfy the relevant additional independence requirements for the members of such committees imposed by the SEC or the Company. Each committee operates under a formal charter adopted by the Board, the full text of which may be found on our website at www.smith.com under the “Investor Relations” caption and link to “Governance.”

 

Members of the Committees of the Board.

 

 

 

 

Audit Committee.  During 2006, the Audit Committee met nine times, including telephone meetings, to discuss relevant accounting, auditing, internal control and disclosure matters. The Audit Committee’s responsibilities, discussed in detail in the charter include, among other duties, the responsibility to:

 

 

The Board of Directors has determined that all members are financially literate and all members qualify as audit committee financial experts. In addition, the Board has determined that Mr. Kelley’s simultaneous service on three other public company audit committees does not impair his ability to effectively serve on Smith’s Audit Committee.

 

Compensation and Benefits Committee.  During 2006, the Compensation and Benefits Committee met five times. The Compensation and Benefits Committee charter permits the Compensation and Benefits Committee to

delegate its authority to sub-committees. The Compensation and Benefits Committee’s responsibilities, discussed in detail in the charter include, among other duties, the responsibility to:

 

 

Nominating and Corporate Governance Committee.  During 2006, the Nominating and Corporate Governance Committee met four times. The Nominating and Corporate Governance Committee’s responsibilities, discussed in detail in the charter include, among other duties, the responsibility to:

 

 

Director Qualifications and Nominations

 

The Nominating and Corporate Governance Committee will consider nominees proposed by stockholders. To recommend a prospective nominee for the Nominating and Corporate Governance Committee’s consideration, you may submit the candidate’s name and qualifications to Smith’s Corporate Secretary at 16740 Hardy Street, Houston, Texas 77032. Recommendations from stockholders for nominees must be received by Smith’s Corporate Secretary not later than the date set forth under the section “Stockholders’ Proposals” that follows.

 

The process for identifying and evaluating director nominees includes the following steps:

 

(1) the Nominating and Corporate Governance Committee, Chairman of the Board or other Board members identify a need to fill vacancies or add newly created directorships;

 

(2) the Chairman of the Nominating and Corporate Governance Committee initiates a search and seeks input from Board members and senior management and, if necessary, hires a search firm or obtains advice from legal or other advisors;

 

(3) director candidates, including any candidates properly proposed by stockholders in accordance with the Company’s Bylaws, are identified and presented to the Nominating and Corporate Governance Committee;

 

(4) initial interviews of candidates are conducted by the Chairman of the Nominating and Corporate Governance Committee;

 

(5) the Nominating and Corporate Governance Committee meets to consider and approve final candidate(s) and conduct further interviews as necessary; and

 

(6) the Nominating and Corporate Governance Committee makes recommendations to the full Board for inclusion in the slate of directors at the annual meeting.

 

The evaluation process will be the same whether the nominee is recommended by a stockholder or by a member of the Board of Directors. The Nominating and Corporate Governance Committee is responsible for establishing the selection criteria for candidates from time to time and reviewing with the Board such criteria and the appropriate skills and characteristics required of Board members in the context of the then current make-up of the Board. At a minimum, the Nominating and Corporate Governance Committee must be satisfied that each nominee for director has the necessary business and/or professional knowledge and experience relevant to the Company, its business and the goals and perspectives of its stockholders; is well regarded in the community, with a

long term, good reputation for high ethical standards; has good common sense and judgment; has a positive record of accomplishment in present and prior positions; has an excellent reputation for preparation, attendance, participation, interest and initiative on other boards on which he or she may serve; and has the time, energy, interest and willingness to become involved in the Company and its future.

 

Compensation Committee Interlocks and Insider Participation

 

During 2006, Messrs. Bailar (until April 24, 2006), Buck, Fraser, Gibbs and Kelley (since April 24, 2006) served as members of the Company’s Compensation and Benefits Committee. None of the Compensation and Benefits Committee members has served as an employee or officer of the Company, and none of the Company’s executive officers has served as a director or member of the compensation committee of another entity, which has an executive officer serving as a member of the Company’s Board.

 

Code of Business Conduct

 

All of our officers, employees and directors are required to comply with our Code of Business Conduct and Ethics to help ensure that our business is conducted in accordance with the highest standards of ethical behavior. Our Code of Business Conduct and Ethics covers all areas of professional conduct, including customer relationships, conflicts of interest, insider trading, financial disclosure, intellectual property and confidential information, as well as requiring strict adherence to all laws and regulations applicable to our business. Employees may report any violations or suspected violations of the Code by using Smith’s ethics hotline. The Code includes an anti-retaliation statement. The full text of the Code of Business Conduct and Ethics, as well as any waiver of a provision of the Code granted to any senior officer or director or material amendment to the Code, if any, is published on our website at www.smith.com under the “Investor Relations” caption and link to “Governance.” Stockholders may also obtain a free copy upon request by contacting the Corporate Secretary, Smith International, Inc., 16740 Hardy Street, Houston, Texas 77032.

 

Overview

 

Compensation Objectives.  The general objectives of our executive compensation program are to attract and retain the best available individuals to serve on our executive team, to motivate our executives to achieve our short-term and long-term financial and operational goals, and to align our executives’ interests with those of our other stockholders.

 

Pay for Performance.  Our executive compensation program is designed to reward our executives based on Company, business unit and individual performance. We maintain a pay-for-performance compensation philosophy that provides executives with direct financial incentives in the form of cash awards and long-term equity awards that are earned by achieving financial performance objectives established by the Board of Directors for each fiscal year based upon either consolidated or business unit financial results. In addition, we reward individual performance through adjustments in annual base salary.

 

Decision Process.  Executive compensation decisions are made solely by our Compensation and Benefits Committee (which we refer to in this section as the “Compensation Committee”). The Compensation Committee has retained Frederic W. Cook & Co., Inc. (which we refer to in this section as “Cook”), an independent compensation consultant that reports solely to the Compensation Committee, to assist it in making executive compensation decisions. Cook presents current and comparative compensation data, including benchmarking results as discussed below, and preliminary compensation recommendations to the Compensation Committee in October of each year. For all executive officers other than the CEO, the Compensation Committee discusses Cook’s recommendations with and receives additional recommendations from our CEO and our Senior Vice President of Human Resources. For CEO compensation, Company management has no input. In December of each year, Cook, with the support of our CEO and Senior VP of Human Resources, presents its final compensation data and recommendations to the Compensation Committee. These final recommendations are timed to correspond to the Board of Directors’ approval of the upcoming fiscal year’s business plan and with the Compensation Committee’s

evaluation of executive performance for the current year. The Compensation Committee reviews not only the final compensation data and recommendations but also Company performance, individual executive performance, the Company’s overall compensation objectives and other relevant matters and the value of equity held by each of the executive officers. The Compensation Committee then makes its final executive compensation decisions to become effective January 1 of the upcoming fiscal year. With the exception of equity incentive awards for new hires or promotions, which are granted at the next regularly scheduled Compensation Committee meeting following the hire or promotion date, equity incentive awards are granted only in December.

 

Benchmarking Group.  The Compensation Committee seeks to design the compensation of the Company’s executives to be competitive within the worldwide energy industry in order to maintain a high level of expertise within the Company. In setting the current year’s total executive compensation, the Compensation Committee reviewed compensation data from the following companies whose executives have similar duties and responsibilities: Baker Hughes Incorporated, BJ Services Company, Cameron International Corporation, FMC Technologies, Inc., Grant Prideco, Inc., Halliburton Company, Maverick Tube Corporation, McDermott International, Inc., Nabors Industries Ltd., National Oilwell Varco, Inc., Schlumberger Ltd., and Weatherford International Ltd. In addition to public information available for this benchmarking group, Cook reviewed data from the Oilfield and Manufacturing Services survey, a Towers Perrin survey covering oil and gas companies and a Towers Perrin survey covering the Company’s general industry.

 

Fixed v. Variable Pay.  Our compensation program is divided into two general categories, fixed and variable pay. The fixed pay component, or base salary, represents only about 20% of each named executive officer’s total target compensation, whereas 80% of target compensation is based upon consolidated or business unit financial performance, relative to established annual financial targets approved by the Compensation Committee. Because a substantial portion of total compensation is tied to the Company’s financial performance and is not earned unless these goals are met, we view it “at-risk” to the executive.

 

The financial performance targets for executive officers are determined at the beginning of each fiscal year based on the financial results and returns established in the Company’s annual business plan, as approved by the Board of Directors. On an annual basis and within 90 days after the start of the year, the Compensation Committee approves the consolidated and business unit matrices established for the variable pay component of executive compensation. We expect that each member of our senior management team will produce outstanding results and have established performance targets that are generally achievable under the annual business plan.

 

Alignment of Interests with Stockholders.  Equity-based compensation constitutes approximately 62% of our total target executive officer compensation, with performance measures tied in large part to overall stockholder wealth. Our emphasis on equity- and performance-based compensation provides our executives with incentive to create long-term stockholder value while keeping fixed base salary costs as one of the smallest components of total compensation potential. Further, it is consistent with our compensation philosophy that our executive management should be rewarded when financial targets are met or exceeded, thereby creating value for our stockholders.

 

Executive Compensation Components

 

Below is a summary of the various components of executive compensation. Although Mr. Carroll is a named executive officer, he is no longer an executive officer of the Company and, unless otherwise noted, is not included in any executive officer compensation discussion.

 

Annual Base Salary.  The Compensation Committee targets base salaries between the 60th and 75th percentile of the range of executive salary paid by comparable companies or business operations. The Compensation Committee does not use a specific formula for evaluating individual performance. Instead, executives are assessed primarily by the CEO based upon how they contributed to the Company’s business success in their respective areas of responsibility. The criteria used in evaluating individual performance vary depending on the executive’s function, but generally include leadership inside and outside the Company; advancing the Company’s interests with customers, vendors and in other business relationships; product quality and development; advancement in skills and responsibility; and financial results. The Compensation Committee, therefore, sets each executive’s base salary in light of their individual performance and the salary range paid by the benchmarking

group. Effective January 1, 2007, all named executive officers received merit increases to base salary in a range of 6% to 8%.

 

Annual Cash Bonus.  Our executive officers participate in the Executive Officer Annual Incentive Plan (“AIP”) which provides for annual cash bonuses. The Compensation Committee ties approximately 18% of each named executive officer’s total target compensation to the achievement of financial performance goals under the AIP.

 

Participants in the AIP can earn a cash bonus based upon the achievement of established financial performance goals for each fiscal year. The target percentages for the named executive officers, which ranged from 60% to 100% of annual base salary for the 2006 performance year and range from 65% to 120% of annual base salary for the 2007 performance year, are determined based upon the grade level of the executive position. The actual payout relative to the target amount for any fiscal year is variable and tied to consolidated or business unit performance. The financial performance goals are measured using two metrics, generally (i) earnings per share and (ii) return on equity; however, for certain business unit management, the metrics are defined as operating earnings for that business unit and return on operating assets of that business unit. When consolidated, the business unit operating income targets and return on operating assets targets equal the consolidated corporate earnings per share and return on equity targets. For the 2006 fiscal year, the corporate earnings per share target was $1.80 and the return on stockholder equity target was 21.3%. Upon the achievement of the target performance goals, participants earn 100% of the target amount. Depending upon performance, the payout can range from zero to 200% of the target amount. Generally, the actual financial performance achieved must be 80% or more of both target metrics in order to earn any payout under the AIP and must be 120% or more of both target metrics in order to earn a payout under the AIP of 200% of the target amount. For the fiscal year ended December 31, 2006, the actual performance levels achieved by the Company and business units were above the target goals, resulting in each named executive officer earning between 175% and 200% of their target percentage.

 

The Compensation Committee has chosen return on stockholder equity and earnings per share (and the related operating income and return on operating assets for the business units) as the performance measures for the AIP because these metrics are tied to overall stockholder wealth, are readily understood by the executives and provide a balanced incentive to increase income while managing the Company’s investment in its net assets.

 

The payout award, if any, earned by each executive officer is determined by multiplying the actual bonus percentage earned by the executive’s base salary in effect as of the beginning of the AIP’s fiscal year. The Compensation Committee has no discretion to increase any award once the performance targets have been established, but may decrease or eliminate any annual bonus award due to unacceptable individual performance even if the financial performance targets are met. The AIP is intended to comply with Section 162(m) of the Internal Revenue Code of 1986 and, as such, amounts paid under the AIP are fully deductible by the Company for federal income tax purposes.

 

Annual Performance-Based Restricted Stock Unit Award.  The annual performance-based restricted stock unit (“Unit”) award is the largest potential component of total annual compensation. The executive officers are awarded Units in December of each year under the Amended and Restated Smith International, Inc., 1989 Long-Term Incentive Compensation Plan (“LTICP”). Units represent the right to receive shares of common stock in the future subject to the attainment of an established consolidated return on equity performance goal in the coming year. The monetary value of the award is determined by the Compensation Committee utilizing competitive data provided by Cook. The number of target Units granted is determined based on the closing price of the common stock on the date of grant. Shares subject to Unit awards are not owned until the performance goal is obtained and the awards have vested, accordingly participants have no voting rights on the shares and do not receive dividends until the shares are earned and vested. If the Units are earned at year end, they vest in equal installments over a three-year period, based on continued employment requirements.

 

For the 2006 fiscal year, the return on equity goal was 21.3%. Upon the achievement of the return on equity target goal, participants earn 100% of the Units awarded. Participants can earn up to 115% of the target number of Units awarded to them. In order for the participant to earn any Units, at least 80% of the financial goal must be met and in order for the participant to earn 115% of the target award, 110% of the financial goal must be met. After performance goals have been set, the Compensation Committee does not exercise any discretion in the amount of

Units awarded. For fiscal year ended December 31, 2006, the actual performance level achieved by the Company was above the maximum target goal, resulting in each individual earning 115% of their target award.

 

In 2005, the Company made the decision to award Units rather than Non-Qualified Stock Options, which had been issued under the LTICP since 1989. In reaching the decision to award Units, the Compensation Committee evaluated, among other considerations, changes to the required accounting treatment of stock option awards and other tax and accounting implications of various types of equity awards. Awarding Units instead of Non-Qualified Stock Options reduces stockholder dilution because the Company can offer equal long term value while issuing fewer shares. In addition, because Unit awards are only granted when the performance goal is met, contain a retention element and align executive management with stockholder interests, the Compensation Committee has determined that they are the most appropriate long-term equity based incentive for our Company and are the only type of equity incentive that the Company currently awards to its executive officers.

 

Perquisites.  The Company has an interest in ensuring the physical and mental wellness of its employees and, therefore, provides for a reimbursement of up to $3,000 for an annual physical for each executive officer. In addition, in lieu of providing specific perquisites, the Company provides a set cash dollar amount based upon the value of specifically identified perquisites. This dollar amount is paid in 26 equal bi-weekly payments annually, as identified in the footnotes to the Summary Compensation Table. The executive officers do not need to spend their allowance on the specified items, but are free to use the allowance at their discretion. We believe that providing a set dollar amount allows our executive officers more flexibility and is more efficient to administer than reimbursing for each individual expense. The amount provided is reviewed periodically and is consistent with perquisites provided by the benchmarking group. In addition, our executive officers may receive personal administrative assistant services at no incremental cost to the Company. Perquisite amounts are not considered annual salary for bonus purposes or 401(k) contributions.

 

401(k) Plan.  The Company believes that financial security during retirement is an important benefit to provide to our executive management. For this reason, the Company offers a 401(k) plan to its employees, including its executive officers. Participants may contribute up to 12% of eligible compensation to the 401(k) plan, subject to federal limits. The Company makes various contributions to the plan, including age-weighted contributions ranging from 0.5% to 4% and performance-based matching contributions ranging from zero to 100% of employee salary deferrals, up to 12%. Although the majority of the Company’s peers have both defined benefit and defined contribution plans, the Compensation Committee elected to implement a defined contribution plan to control Company costs. The Company’s defined contribution plan is consistent with similar plans available generally in the energy industry. Executive officers participate in the 401(k) plan on the same basis as other employees.

 

Supplemental Executive Retirement Plan.  In addition to the 401(k) plan described above, Company officers, including all of the executive officers, are eligible to participate in the Company’s Post-2004 Supplemental Executive Retirement Plan (Post-2004 SERP). In connection with the adoption of the Post-2004 SERP, the Company suspended contributions to its previous SERP (SERP), except for guaranteed interest contributions discussed below. The SERP and Post-2004 SERP were implemented to allow Company officers to defer additional pre-tax compensation for retirement without regard to the limits placed on 401(k) plans under the Internal Revenue Code. We believe that the Post-2004 SERP is an important tool for the retirement planning efforts of our officers. Moreover, after reviewing data from the benchmarking group, our Compensation Committee determined that the Post-2004 SERP is important to remain competitive in the compensation arena.

 

The Company provides an age-based contribution to the Post-2004 SERP for all executive officers in the amount of 6% of each executive’s cash compensation (as defined in the Post-2004 SERP), regardless of the individual’s age and less any age-based contributions made in the individual’s 401(k) account. The Company will also match deferrals up to 6% of each executive’s cash compensation (as defined in the Post-2004 SERP), less any matching contributions made in the individual’s 401(k) account. Deferred funds are placed with the fund trustee and are invested at the direction of the participant in a variety of funds managed by the trustee, which includes a money market fund. To the extent deferrals remain in the money market fund of the SERP or Post-2004 SERP, the Company guarantees that the funds will yield interest at 120% of the Applicable Federal Long Term Rate as published by the U.S. Treasury. This percentage was selected as a reasonable rate of return when the original SERP was implemented. The Company does not guarantee return for any other SERP or Post-2004 SERP investment

option. Additional information regarding the SERP and Post-2004 SERP may be found in the footnotes and narrative disclosure following the Nonqualified Deferred Compensation Table.

 

Change of Control and Employment Agreements

 

Change of Control Employment Agreements.  The Company has entered into Change of Control Employment Agreements with nine executive officers, including all of the named executive officers. After benchmarking studies performed by outside legal counsel at the request of the Compensation Committee in 1999, the Compensation Committee adopted a form of Change of Control Agreement. In 2005, the Compensation Committee again retained outside legal counsel to perform an update of the benchmarking study to determine whether the Change of Control Agreements remained competitive in the Company’s industry. As a result of this analysis, the Compensation Committee revised the form of Change of Control Agreement to reduce the termination multiple for future agreements, as discussed in the section titled “Executive Compensation — Change of Control and Employment Agreements.” Benchmarking in 2006 shows that the Change of Control Agreements remain generally consistent with those of the benchmarking group.

 

The Compensation Committee has determined that the Change of Control Agreements are a necessary component of our compensation package in order for us to provide competitive compensation arrangements, particularly as such agreements are standard in our industry. Moreover, we believe that the Change of Control Agreements help us to attract and retain our named executive officers by reducing the personal uncertainty and anxiety that arises from the possibility of a future business combination. We selected objective criteria to determine whether a change of control has occurred for purposes of the Change of Control Agreements in order to reduce the likelihood of a dispute in the event of a change of control and to help ensure that the agreements are triggered only under circumstances when a true transfer of control or ownership has occurred. Additional information regarding the Change of Control Agreements may be found in the section titled “Executive Compensation — Change of Control and Employment Agreements.”

 

Employment Agreements.  When the Company emerged from bankruptcy in 1987, it offered employment agreements to certain key officers. The only remaining executive officers with the 1987 employment agreements are Messrs. Rock and Dudman. These agreements were entered into primarily as a retention tool but also because the Board of Directors felt that Messrs. Rock and Dudman could provide extraordinary and unique management and strategy skills to maintain and grow the Company. The Compensation Committee has reviewed these contracts and has concluded that they should remain in place but no longer offers new employment agreements to executive officers. Both agreements contain severance provisions that would entitle each individual to receive a lump sum payment in cash equal to his current annual base salary and bonus through the end of the employment period in the event that such individual were to be terminated by the Company (other than for cause, death or disability) or if for any reason his position is eliminated or otherwise becomes redundant. The Company also has an employment agreement with Mr. Carroll. Additional information regarding these agreements may be found in the section titled “Executive Compensation — Change of Control and Employment Agreements.”

 

Pension Plan.  The Company has a defined benefit pension plan, which is currently frozen. The benefit accruals were frozen effective March 1, 1987, and the amount of the pension benefit was fixed for all eligible employees based only upon benefit accruals from September 1, 1985 to March 1, 1987. Any benefits under the pension plan are offset by benefits paid under a previous pension plan of the Company. The only named executive officers who have any benefit accruals under the plan are Messrs. Rock and Carroll. Additional information regarding the plan may be found in the narrative discussion following the Pension Benefits Table.

 

Stock Ownership Guidelines.  Our Compensation Committee encourages stock ownership by executive management and periodically reviews the ownership levels and considers the appropriateness of implementing stock ownership guidelines. Our Compensation Committee has chosen not to require stock ownership guidelines for the executive management. However, the value of common stock owned by our CEO and CFO are approximately 25 times and 16 times their current individual annual salaries. This level of stock ownership evidences the alignment of the interests of our CEO and CFO with our investor’s interests. Our Insider Trading Policy prohibits our executive officers from engaging in any hedging or monetization transactions involving Company securities.

 

The Compensation and Benefits Committee has reviewed and discussed the Compensation Discussion and Analysis with management. Based on such review and discussion, the Committee recommended to the Board of Directors that the Compensation Discussion and Analysis be included in this proxy statement.

 

Compensation and Benefits Committee:

 

James R. Gibbs, Chairman
G. Clyde Buck
Dod A. Fraser
Robert Kelley

 

The following tables show compensation for services to the Company of the persons who during 2006 were the Principal Executive Officer, Principal Financial Officer, the next three most highly compensated executive officers and one other person who was an executive officer during 2006 but who was not serving as an executive officer as of December 31, 2006 (the “Named Executive Officers”).

 

 

 

 

 

 

 

 

The following table provides information regarding incentive awards made to the Named Executive Officers during the 2006 fiscal year.

 

 

 

 

The following table shows the number of shares covered by exercisable and unexercisable options and unvested restricted stock units held by the Company’s Named Executive Officers on December 31, 2006.

 

 

 

 

 

The following table shows all stock options exercised and value received upon exercise, and all stock awards vested and value received upon vesting by the Named Executive Officers during the fiscal year ended December 31, 2006.

 

 

 

 

The following table shows the number of years of credited service of and present value of accumulated benefits payable to each of the named Executive Officers under the Company’s Restated Pension Plan.

 

 

The Company has a defined benefit pension plan (the “Restated Pension Plan”), which is currently frozen. The benefit accruals were frozen effective March 1, 1987, and the amount of the pension benefit was fixed for all eligible employees based only upon benefit accruals from September 1, 1985 to March 1, 1987. Since benefit accruals under the Restated Pension Plan have been frozen since March 1, 1987, the years of service for the Named Executive Officers include only the period from September 1, 1985 to March 1, 1987. The accumulated benefit presented above assumes a retirement age of 65, no pre-retirement decrements, a post-retirement mortality assumption based on the RP2000 Combined Healthy Mortality Table Projected by Scale AA to 2015, and payment in the form of a single life annuity.

 

The following table and narrative disclosure provides information regarding nonqualified deferred compensation with respect to each Named Executive Officer.