SCHEDULE 14A
(Rule 14a)
INFORMATION REQUIRED IN PROXY STATEMENT
SCHEDULE 14A INFORMATION
Proxy Statement Pursuant to Section 14(a) of the Securities
Exchange Act of 1934
(Amendment No.     )

 

Filed by the Registrant  x

 

Filed by a Party other than the Registrant  o

 

Check the appropriate box:

 

EATON CORPORATION

(Name of Registrant as Specified in its Charter)

 

XXXXXXXXXXXXXXXX

(Name of Person(s) Filing Proxy Statement, if other than the Registrant)

 

Payment of Filing Fee (Check the appropriate box):

o  Fee computed on table below per Exchange Act Rules 14a-6(i)(4) and 0-11.

 

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(2)  Aggregate number of securities to which transaction applies:  ­ ­

 

 

(4)  Proposed maximum aggregate value of transaction: ­ ­

 

(5)  Total fee paid:  ­ ­

 

o  Fee paid previously with preliminary materials.

 

 

(1)  Amount Previously Paid: ­ ­

 

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NOTICE OF MEETING

 

The 2008 annual meeting of Eaton Corporation shareholders will be held Wednesday, April 23, at 10:30 a.m. local time at Eaton Center, 1111 Superior Avenue, Cleveland, Ohio, for the purpose of:

 

 

6. Approving a proposed Senior Executive Incentive Compensation Plan;

 

 

These matters are more fully described in the following pages.

 

The record date for the meeting has been fixed by the Board of Directors as the close of business on February 25, 2008. Shareholders of record at that time are entitled to vote at the meeting.

 

By order of the Board of Directors

 

-s- Earl R. Franklin

 

Earl R. Franklin

Vice President and Secretary

 

March 14, 2008

 

 

 

 

Important Notice Regarding the Availability of Proxy Materials for the Annual Meeting of Shareholders to be held on April 23, 2008: This proxy statement and the Company’s 2007 Annual Report to Shareholders are available on Eaton’s website at www.eaton.com/proxy and www.eaton.com/annualreport, respectively.

CONTENTS

 

PROXY STATEMENT

 

Eaton Corporation

1111 Superior Avenue

Cleveland, Ohio 44114-2584

216-523-5000

 

This proxy statement, the accompanying proxy form and Eaton’s annual report for the year ended December 31, 2007 are scheduled to be sent to shareholders on or about March 14, 2008.

 

 

Proxy Solicitation

 

Eaton’s Board of Directors solicits your proxy, in the form enclosed, for use at the 2008 annual meeting of shareholders and any adjournments thereof. The individuals named in the enclosed form of proxy have advised the Board of their intention to vote at the meeting in compliance with instructions on all forms of proxy tendered by shareholders and, where no contrary instruction is indicated on the proxy form, for the election of the individuals nominated to serve as directors; for the proposed increase in the authorized number of common shares; for the proposal to adopt majority voting in director elections; for the proposal to authorize the Board of Directors to amend the Amended Regulations; for the proposed 2008 Stock Plan; for the proposed Senior Executive Incentive Compensation Plan; for the proposed Executive Strategic Incentive Plan; and for ratification of the appointment of Ernst & Young LLP as independent auditor for 2008.

 

Any shareholder giving a proxy may revoke it by giving Eaton notice in writing or by fax, email or other verifiable communication before the meeting or by revoking it at the meeting. All properly executed or transmitted proxies not revoked will be voted at the meeting.

 

In addition to soliciting proxies through the mail, certain employees may solicit proxies in person or by telephone or fax. Eaton has retained The Proxy Advisory Group, LLC, 18  East 41^st Street, Suite 2000, New York, New York 10017, to assist in the solicitation of proxies, primarily from brokers, banks and other nominees, for a fee of $8,500, plus reasonable out-of-pocket expenses. Brokerage firms, nominees, custodians and fiduciaries may be asked to forward proxy soliciting material to the beneficial shareholders. All reasonable soliciting costs will be borne by Eaton.

 

Voting at the Meeting

 

Each Eaton shareholder of record at the close of business on February 25, 2008 is entitled to one vote for each share then held. On February 25,           Eaton common shares (par value, 50¢ each) were outstanding and entitled to vote.

 

At the 2008 annual meeting, the inspector of election appointed by the Board of Directors for the meeting will determine the presence of a quorum and tabulate the results of shareholder voting. As provided by Ohio law and Eaton’s Amended Regulations, Eaton shareholders present in person or by proxy at the meeting will constitute a quorum. The inspector of election intends to treat as “present” for these purposes shareholders who have submitted properly executed or transmitted proxies that are marked “abstain.” The inspector will also treat as “present” shares held in “street name” by brokers that are voted on at least one proposal to come before the meeting.

 

Director nominees receiving the greatest number of votes will be elected directors. Votes withheld in respect of the election of directors will not be counted in determining the outcome of the election. (However, please see “Majority Voting Policy” on page 4.) Adoption of all other proposals to come before the meeting will require the affirmative vote of the holders of a majority of the outstanding Eaton common shares, consistent with the general vote requirement in Eaton’s Amended Articles of Incorporation. The practical effect of this vote requirement will be that abstentions and shares held in “street name” by brokers that are not voted in respect of those proposals will be treated the same as votes cast against those proposals.

 

As provided by Ohio law, each shareholder is entitled to cumulative voting rights in the election of directors if any shareholder gives

written notice to the President or a Vice President or the Secretary of Eaton at least 48 hours before the time fixed for the meeting, requesting cumulative voting, and if an announcement of that notice is made at the beginning of the meeting by the Chairman or Secretary, or by or on behalf of the shareholder who gave the notice. If cumulative voting is in effect with respect to the election of directors, each shareholder has the right to cumulate his or her voting power by giving one nominee that number of votes which equals the number of directors to be elected multiplied by the number of the shareholder’s shares, or by distributing his or her votes on the same principle among two or more nominees, as the shareholder sees fit. If cumulative voting is in effect with respect to the election of directors, and if the shareholder has not given contrary voting instructions, the individuals named in the proxy will vote the shares cumulatively for those nominees that they may determine in their discretion.

 

Majority Voting Policy — Ohio law provides that, in director elections, the nominees receiving the greatest number of votes are elected unless the Articles of Incorporation provide for a different voting standard. The Company’s Board of Directors has adopted a written policy to assure that, in an uncontested election, a director who fails to receive a majority of shareholder votes cast will not continue to serve, except with the express consent of the Board.

 

The Board policy provides that, in an uncontested election, a director nominee who receives more “withhold” votes than “for” votes will promptly offer to resign from the Board. With advice from the Governance Committee, the Board will decide, within 90 days after the voting results are certified, whether to accept the resignation offer, and the Company will promptly disclose the Board’s decision in a press release. If the Board decides to reject the resignation offer, the press release will indicate the reasons for that decision. The Majority Voting Policy is included in this proxy statement as Appendix A and is available on the Company’s website (www.eaton.com). Under “Company Quick Links” click on “Corporate Responsibility,” then “Corporate Governance.”

 

The Company is seeking shareholder approval of an amendment to the Amended Articles of Incorporation adopting majority voting as now permitted under Ohio law along with a related amendment to the Amended Regulations. If these amendments are approved by the shareholders, majority voting will apply to uncontested director elections occurring after the 2008 Annual Meeting. Please see page 47 for a description of the proposal.

 

1. ELECTION OF DIRECTORS

 

Our Board of Directors is presently composed of eleven members. The terms of four directors will expire in April 2008, and those directors have been nominated for re-election. Each of those nominees were elected at the 2005 annual meeting. (See page 5.)

 

If any of the nominees become unable or decline to serve, the individuals named as proxies in the enclosed proxy form will have the authority to appoint substitute nominees. Eaton’s management, however, has no reason to believe that this will occur.

 

Following is biographical information about each nominee and each director.

Nominees for election to terms ending in April 2011 or when a successor is elected and has qualified:

 

Directors whose present terms continue until April 2009:

 

Directors whose present terms continue until April 2010:

 

 

Director Nomination Process — The Governance Committee of the Board, comprised entirely of directors who meet the independence standards of the Board of Directors and the New York Stock Exchange, is responsible for overseeing the process of nominating individuals to stand for election as directors. The Governance Committee charter is included in this proxy statement as Appendix B and is available on the Company’s website (www.eaton.com). Under “Company Quick Links” click on “Corporate Responsibility,” then “Corporate Governance.” Printed copies will also be provided free of charge upon request. Requests for printed copies should be directed to the Company’s Investor Relations Office, Eaton Corporation, 1111 Superior Avenue, Cleveland, Ohio 44114-2584.

 

Any director candidates recommended by the Company’s security holders are given consideration by the Governance Committee, consistent with the process used for all candidates. Security holders may submit recommendations in the manner described on this page under the heading “Security Holder Recommendations of Director Candidates.”

 

All potential director candidates are reviewed by the Governance Committee in consultation with the Chairman and Chief Executive Officer, typically with the assistance of a professional search firm retained by the Committee. The Committee decides whether to recommend one or more candidates to the Board of Directors for nomination. Candidates who are ultimately nominated by the Board stand for election by the shareholders at the annual meeting. Between annual meetings, nominees may also be elected by the Board itself.

 

In order to be recommended by the Governance Committee, a candidate must have the following minimum qualifications, as described in the Board of Directors Governance Policies: personal ability, integrity, intelligence, relevant business background, independence, expertise in areas of importance to the Company’s objectives, and a sensitivity to the Company’s corporate responsibilities. In addition, the Governance Committee from time to time looks for individuals with specific qualifications so that the Board as a whole may maintain an appropriate mix of experience, background, expertise and skills, and of age, gender, ethnic and racial diversity. These specific qualifications may vary from one year to another, depending upon the composition of the Board at that time.

 

The Board of Directors Governance Policies are included in this proxy statement as Appendix C and are available on the Company’s website (www.eaton.com). Under “Company Quick Links” click on “Corporate Responsibility,” then “Corporate Governance.” Printed copies will also be provided free of charge upon request. Requests for printed copies should be directed to the Company’s Investor Relations Office, Eaton Corporation, 1111 Superior Avenue, Cleveland, Ohio 44114-2584.

 

Security Holder Recommendations of Director Candidates — The Governance Committee will consider individuals for nomination to stand for election as directors who are recommended to it in writing by any Eaton security holder. Any security holder wishing to recommend an individual as a nominee for election at the annual meeting of shareholders to be held in 2009 should send a signed letter of recommendation, to be received before November 7, 2008, to the following address: Eaton Corporation, 1111 Superior Avenue, Cleveland, Ohio 44114-2584, attention Corporate Secretary. Recommendation letters must state the reasons for the recommendation and contain the full name and address of each proposed nominee as well as a brief biographical history setting forth past and present directorships, employments, occupations and civic activities. Any such recommendation should be accompanied by a written statement from the proposed nominee consenting to be nominated and, if nominated and elected, consenting to serve as a director.

 

Director Independence — The Board of Directors Governance Policies provide that all of the Company’s outside directors should be independent. These Policies are attached as Appendix C to this proxy statement and are available on the Company’s website (www.eaton.com). Under “Company Quick Links” click on “Corporate Responsibility,” then “Corporate Governance.” Printed copies will also be provided free of charge upon request. Requests for printed copies should be directed to the Company’s Investor Relations Office,

Eaton Corporation, 1111 Superior Avenue, Cleveland, Ohio 44114-2584. The listing standards of the New York Stock Exchange state that no director can qualify as independent unless the Board of Directors affirmatively determines that the director has no material relationship with the Company, and the Board’s determination in that regard, along with the basis for that determination, is disclosed in the Company’s annual proxy statement. Additional, and more stringent, standards of independence are required of Audit Committee members. The Company’s annual proxy statement discloses the Board’s determination as to the independence of the Audit Committee members as well as its determination as to all outside directors.

 

As permitted by the New York Stock Exchange listing standards, the Board of Directors has determined that certain relationships between an outside director and the Company will be treated as categorically immaterial for purposes of determining a director’s independence. These categorical standards are included in the Board of Directors’ independence criteria. The independence criteria for outside directors and members of the Audit Committee are included in this proxy statement as Appendix D and are available on the Company’s website (www.eaton.com). Under “Company Quick Links” click on “Corporate Responsibility,” then “Corporate Governance.” Printed copies will also be provided free of charge upon request. Requests for printed copies should be directed to the Company’s Investor Relations Office, Eaton Corporation, 1111 Superior Avenue, Cleveland, Ohio 44114-2584.

 

Since directors’ independence might be influenced by their use of Company planes and other Company-paid transportation, the Board has adopted a policy on this subject. This policy is included in Appendix D to this proxy statement and is available on the Company’s website (www.eaton.com). Under “Company Quick Links” click on “Corporate Responsibility,” then “Corporate Governance.”

 

In their review of director independence, the Board of Directors and its Governance Committee have considered the following circumstances:

 

 

After reviewing the circumstances described above (which are the only relevant circumstances known to the Board of Directors), the Board has affirmatively determined that none of the Company’s outside directors has a material relationship with the Company and that each of the following directors qualifies as independent under the Board’s independence criteria and the New York Stock Exchange standards: C. M. Connor, M. J. Critelli,
C. E. Golden, E. Green, N. C. Lautenbach, D. L. McCoy, J. R. Miller, G. R. Page, V. A. Pelson and G. L. Tooker. The basis of the Board’s independence determination was that each of these directors had either no

relationship at all with the Company for the past three years (other than as a director and shareholder) or that none of their relationships with the Company would likely be sufficient to compromise their independence as directors.

 

The Board has also affirmatively determined that each member of the Audit Committee, i.e., C. E. Golden, E. Green, N. C. Lautenbach, V.A. Pelson and G. L. Tooker, meets the special standards of independence required of them under the criteria of the New York Stock Exchange and the Company’s Board of Directors.

 

Review of Related Person Transactions — Our Board of Directors has adopted a written policy to identify and evaluate “related person transactions,” that is, transactions between the Company and any of our executive officers, directors, director nominees, 5%-plus security-holders or members of their “immediate families,” or organizations where they or their family members serve as officers or employees. The Board policy calls for the disinterested members of the Board’s Governance Committee to conduct an annual review of all such transactions. At the Committee’s direction, a survey is made annually of all transactions involving related persons, and the results are reviewed by the Committee in January of each year. As to any such transaction, the Committee is responsible to determine whether (i) it poses a significant risk of impairing, or appearing to impair, the judgment or objectivity of the individuals involved; (ii) it poses a significant risk of impairing, or appearing to impair, the independence of an outside director or director nominee; or (iii) its terms are less favorable to the Company than those generally available in the marketplace. Depending upon the Committee’s assessment of these risks, the Committee will respond appropriately. In addition, as required by the rules of the Securities and Exchange Commission, any transactions that are determined to be material to the Company or a related person are disclosed in the Company’s proxy statement.

 

In January 2008, the Governance Committee conducted an annual survey and found that the only related person transactions were those described under the heading “Director Independence” beginning on page 8 and that none of the Company’s executive officers engaged in any such transactions. The Committee also concluded that none of the related person transactions posed risks to the Company in any of the areas described in items (i), (ii) or (iii) above.

 

Board Committees — The Board of Directors has the following standing committees: Audit, Compensation and Organization, Executive, Finance and Governance.

 

Audit Committee. The functions of the Audit Committee include assisting the Board in overseeing the integrity of the Company’s financial statements and its systems of internal accounting and financial controls; the independence, qualifications and performance of the Company’s independent auditor; the performance of the internal auditors; and the Company’s compliance with legal and regulatory requirements. The Audit Committee exercises sole authority to appoint, compensate and terminate the independent auditor and pre-approves all auditing services and permitted non-audit services to be performed for the Company by the independent auditor. Among its other responsibilities, the Committee meets regularly with the Company’s Chief Financial Officer, Vice President – Internal Audit, independent auditor, General Counsel, and Director – Global Ethics in separate executive sessions; prepares the Committee’s report to be included in the Company’s annual proxy statement; assures that performance evaluations of the Audit Committee are conducted annually; and establishes procedures for the proper handling of complaints concerning accounting or auditing matters.

 

Each Committee member meets the independence requirements, and all Committee members collectively meet the other requirements, of the New York Stock Exchange, the Sarbanes-Oxley Act of 2002, and rules adopted thereunder by the Securities and Exchange Commission. Further, Committee members are prohibited from serving on more than two other public company audit committees. The Board of Directors has determined that each member of the Audit Committee is financially literate and that C. E. Golden qualifies as an audit committee financial expert (as defined in Item 407(d)(5)(ii) of Regulation S-K under the Securities Exchange Act of 1934) and that all members of the Audit Committee have accounting or related

financial management expertise. The Audit Committee held eleven meetings in 2007. Present members are Messrs. Golden (Chair), Green, Lautenbach, Pelson and Tooker.

 

Compensation and Organization Committee. The functions of the Compensation and Organization Committee include reviewing proposed organization or responsibility changes at the officer level; with input from all outside directors, evaluating the performance of the Chief Executive Officer and reviewing the performance evaluations of the other senior officers; reviewing succession planning for key officer positions including the position of Chairman and Chief Executive Officer, and reviewing the Company’s practices for the recruitment and development of a diverse talent pool. The Committee is also responsible for annually determining the salary of each senior officer of the Company; establishing performance objectives under the Company’s short-term and long-term incentive compensation plans and determining the attainment of such performance objectives; annually determining the aggregate amount of awards to be made under the Company’s short-term incentive compensation plan (the Executive Incentive Compensation Plan) and adjusting that amount as the Committee deems appropriate within the terms of that plan; annually determining the awards to be made to the Company’s senior officers under the Company’s short-term and long-term incentive compensation plans; administering stock plans; reviewing compensation practices as they relate to key employees to confirm that those plans remain equitable and competitive, as well as reviewing significant new employee benefit plans or significant changes in such plans or changes with a disproportionate effect on the Company’s officers or primarily benefiting key employees; and preparing an annual report for the Company’s proxy statement regarding executive compensation. Additional information on the Committee’s processes and procedures is contained in the Compensation Discussion and Analysis under “Executive Compensation” beginning on page 14. The Compensation and Organization Committee held eight meetings in 2007. Present members are Ms. McCoy and Messrs. Connor, Critelli (Chair), Miller and Page.

 

Executive Committee. The functions of the Executive Committee include all of the functions of the Board of Directors other than the filling of vacancies in the Board of Directors or in any of its committees. The Executive Committee acts upon matters requiring Board action during the intervals between Board meetings. The Executive Committee held two meetings during 2007. Mr. Cutler is a member of the Committee for the full twelve-month term and serves as Committee Chair. Each of the non-employee directors serves a four-month term.

 

Finance Committee. The functions of the Finance Committee include the periodic review of the Company’s financial condition and the recommendation of financial policies to the Board; analyzing Company policy regarding its debt-to-equity relationship; reviewing and making recommendations to the Board regarding the Company’s dividend policy; reviewing the Company’s cash flow, proposals for long- and short-term debt financing and the risk management program; meeting with and reviewing the performance of management pension committees and any other fiduciaries appointed by the Board for pension and profit-sharing retirement plans; and reviewing the key assumptions used to calculate annual pension expense. The Finance Committee held four meetings in 2007. Present members are Ms. McCoy and Messrs. Critelli, Golden, Green and Page (Chair).

 

Governance Committee. The responsibilities of the Governance Committee include recommending to the Board improvements in the Company’s corporate governance processes and any changes in the Board Governance Policies; advising the Board on changes in the size and composition of the Board; making recommendations to the Board regarding the structure and responsibilities of Board committees; and annually submitting to the Board candidates for members and chairs of each standing Board committee. The Governance Committee, in consultation with the Chief Executive Officer, identifies and recommends to the Board candidates for Board membership, reviews the nomination of directors for re-election; oversees the orientation of new directors and the ongoing education of the Board; recommends to the Board compensation of non-employee directors; administers the Board’s policy on director retirements and resignations; administers the directors’ stock ownership guidelines; and recommends to the

Board guidelines and procedures to be used by the directors to evaluate the Board’s performance. The responsibilities of the Governance Committee also include providing oversight regarding significant public policy issues with respect to the Company’s relationships with shareholders, employees, customers, competitors, suppliers and the communities in which the Company operates, including such areas as ethics compliance, environmental, health and safety issues, community relations, government relations, charitable contributions, shareholder relations and the Eaton Philosophy — Excellence through People. The Governance Committee held six meetings in 2007. Present members are Messrs. Connor, Lautenbach (Chair), Miller, Pelson and Tooker.

 

Committee Charters and Policies — The Board of Directors most recently revised the charter of the Governance Committee in September 2007 (attached as Appendix B), the charter of the Audit Committee in January 2008 (attached as Appendix E), the charter of the Compensation and Organization Committee in October 2007 (attached as Appendix F), and the charter of the Finance Committee in October 2007 (attached as Appendix G). These charters also are available on the Company’s website (www.eaton.com). Under “Company Quick Links” click on “Corporate Responsibility,” then “Corporate Governance.” Printed copies will also be provided free of charge upon request. Requests for printed copies should be directed to the Company’s Investor Relations Office, Eaton Corporation, 1111 Superior Avenue, Cleveland, Ohio 44114-2584.

 

In addition to the Board of Directors Governance Policies, certain other policies relating to corporate governance matters are adopted from time to time by Board Committees, or by the Board itself upon the Committees’ recommendation.

 

The Board of Directors held nine meetings in 2007. Each of the directors attended at least 93% of the meetings of the Board and its committees. The average rate of attendance for all directors was 98%.

 

Audit Committee Report — [The Audit Committee report will be issued after the Committee completes its normal process, which will be described in the report and will include providing its recommendation to the Board regarding the inclusion of the Company’s 2007 audited financial statements in the Annual Report on Form 10-K.]

 

Board of Directors Governance Policies — The Board of Directors revised the Governance Policies most recently in September 2007, as recommended by the Governance Committee of the Board. The revised Governance Policies are included in this proxy statement as Appendix C and are available on the Company’s website (www.eaton.com). Under “Company Quick Links” click on “Corporate Responsibility,” then “Corporate Governance.” Printed copies will also be provided free of charge upon request. Requests for printed copies should be directed to the Company’s Investor Relations Office, Eaton Corporation, 1111 Superior Avenue, Cleveland, Ohio 44114-2584.

 

Executive Sessions of the Non-Management Directors — The policy of the Board of Directors is that the non-management directors meet in Executive Session at each regular Board meeting, without the Chairman and Chief Executive Officer or other members of management present, to discuss whatever topics they may deem appropriate. The non-management directors who chair the Audit Committee, Compensation and Organization Committee, Finance Committee and Governance Committee chair the Executive Sessions on a rotating basis. Shown below are the months when Board meetings are held and the non-management director who chairs each Executive Session:

 

 

The policy of the Board of Directors is that at least one such Executive Session is held every year attended only by directors who meet the independence criteria of the Board of Directors and of the New York Stock Exchange. At the

present time, all non-management directors meet these criteria.

 

At each meeting of the Audit, Compensation and Organization, Finance and Governance Committees, an Executive Session is held at which only the Committee members (all of whom qualify as independent) are in attendance, without any members of the Company’s management present, to discuss whatever topics they may deem appropriate.

 

Security Holder Communications to the Board — The Board of Directors provides the following process for security holders and other interested parties to send communications to the Board or outside directors:

 

Security holders and other interested parties may send such communications by mail or courier delivery addressed as follows:

 

Corporate Secretary

Eaton Corporation

1111 Superior Avenue

Cleveland, Ohio 44114-2584

 

In general, the Corporate Secretary forwards all such communications to the Chair of the Governance Committee. The Governance Committee Chair in turn determines whether the communications should be forwarded to other members of the Board and, if so, forwards them accordingly. However, for communications addressed to a particular member of the Board (e.g., the director who will chair a particular Executive Session), the Chair of a particular Board Committee or the outside directors as a group, the Corporate Secretary forwards those communications directly to those individuals.

 

Director Attendance at Annual Meetings — The policy of the Board of Directors is that all directors should attend annual meetings, and all outside directors are compensated for their attendance. At the Company’s 2007 annual meeting, held April 25, 2007, all members of the Board were in attendance.

 

Code of Ethics — The Company has a Code of Ethics that was approved by the Board of Directors. The Company provides training globally for all employees on its Code of Ethics. Eaton requires that all directors, officers and employees of Eaton, its subsidiaries and affiliates abide by the Company’s Code of Ethics, which is included in this proxy statement as Appendix H and is available on the Company’s website (www.eaton.com). Under “Company Quick Links” click on “Corporate Responsibility,” then “Corporate Governance.” Printed copies will be provided free of charge upon request. Requests for printed copies should be directed to the Company’s Investor Relations Office, Eaton Corporation, 1111 Superior Avenue, Cleveland, Ohio 44114-2584.

 

 

EXECUTIVE COMPENSATION

 

Compensation Discussion and Analysis

 

Introduction

 

The Compensation and Organization Committee of the Board of Directors (the “Committee”) determines the compensation for our executive officers, and reviews, approves and oversees the administration of all of our executive compensation plans and programs. The Committee consists of five independent non-employee directors and is supported by the Company’s Human Resources Department as well as one or more independent executive compensation consultants retained and directed by the Committee. The Compensation and Organization Committee’s charter and key responsibilities are included in this proxy statement as Appendix F and are available on the Company’s website (www.eaton.com). Under “Company Quick Links” click on “Corporate Responsibility,” then “Corporate Governance.” Please note that the use of the terms “we,” “us” or “our” throughout this Compensation Discussion and Analysis refers to the Company and/or its management.

 

An Overview of Our Executive Compensation Philosophy

 

Under our executive compensation philosophy, which was last reviewed and updated by the Committee in 2007, we design our executive compensation plans and programs to help us attract, motivate, reward and retain highly qualified executives, to align well with the interests of shareholders and to fairly reflect, in the judgment of the Committee, our performance, and the responsibilities and personal performance of individual executives.

 

 

Use of Compensation Consultants

 

As warranted, we employ a variety of outside compensation, benefit and actuarial consultants to support various types of technical and administrative work in these disciplines. Typically, this includes data analysis, broad-based employee compensation and benefit plan benchmarking and design, actuarial work, drafting selected employee communications, business process and administrative recordkeeping services, and assistance with acquisition and divestiture due diligence. We choose firms for individual consulting and service assignments based upon their specific project capabilities and the proposed price for their work. To support our market analysis of professional, managerial, operating and senior executive positions, we have, for many years, participated in and used the annual surveys sponsored by three separate national compensation consulting firms: Hewitt Associates, Towers Perrin and Hay Associates. Each survey provides comprehensive compensation data covering hundreds of companies across a range of industries. In the analysis that we prepare for the Committee, we focus on the median and mean data reported in the surveys for “similarly-sized” industrial companies, which the Committee currently defines as companies with annual sales of $5 billion to $20 billion.

The Committee also selects and retains the services of an independent executive compensation consultant when it deems it appropriate to support its oversight and management of our executive compensation program. The Committee validates our executive compensation plans and programs by periodic comprehensive studies conducted with the assistance of the consultant retained by the Committee. To support the annual process of conducting a performance evaluation for our Chairman and Chief Executive Officer, the Committee has engaged Dr. David Hofrichter, a senior consultant with Hewitt Associates (see the section entitled “Other Key Executive Compensation Principles” below for further details on this process). The Committee has also selected Peter Egan, a senior consultant with Hewitt Associates, as its primary advisor and to assist the Committee in its review of our executive compensation policies, programs and processes. In 2007, Mr. Egan performed the following assignments for the Committee:

 

 

To ensure the Committee’s continued access to qualified independent advice on executive compensation and governance matters, we will first obtain the Committee’s review and approval prior to awarding any material consulting assignment to any firm that has already been engaged by the Committee. In 2007, the Committee reviewed a report of the consulting work performed for the Committee by Hewitt Associates compared to the total annual consulting work on compensation, benefits and actuarial matters performed for the Company and has determined that each of their senior consultants may provide independent advice to the Committee.

 

Competitive Analysis and Benchmarking Processes

 

To support the Committee in overseeing our executive compensation plans and programs, we have for many years employed two primary analytical processes, which follow separate, but complementary, approaches. The first is our Total Compensation Analysis and Planning Process and the second is our Peer Group Pay and Performance Analysis Process.

 

 

As a key part of this process, each year our Chairman and Chief Executive Officer prepares a proposed total compensation plan (consisting of base salary, the target annual cash incentive

opportunity, the target long-term cash incentive opportunity and equity-based incentive awards (consisting of stock options, restricted shares or both) for each executive officer (except with respect to his own compensation). Initially, he meets individually with his senior management team to discuss the performance assessment for each of their respective executive officer direct reports and to formulate initial recommendations as to an appropriate total compensation plan for each executive. After considering this input, and following a subsequent review with the Vice President — Human Resources, our Chairman and Chief Executive Officer decides upon and submits to the Committee a draft total compensation plan for each executive officer (other than with respect to his own compensation). He then meets with the Committee to discuss the performance of each executive officer and highlights the rationale for recommending any compensation element for any executive officer that is significantly higher or lower than the reported survey median (if any) for the executive’s position.

 

Following this discussion, the Committee decides upon and establishes a total compensation plan for each executive officer. The Committee also meets in executive session (with no members of our management in attendance) to review the same comprehensive market data for our Chairman and Chief Executive Officer’s position and to establish a total compensation plan for him. In 2007, the Committee reviewed and discussed the proposed total compensation plans for the Company’s executive officers with its compensation consultant prior to finalizing these plans.

 

 

 

This analysis is conducted to provide the Committee with the relevant compensation data reported by each Peer Group company for its chairman and chief executive officer, its chief financial officer and, to the extent available, for its chief legal officer and any positions equivalent to our Group President position. The analysis compares our performance with that of the Peer Group over one-year, three-year and five-year time periods using a wide range of performance metrics. This provides the Committee with insight into how each of the Peer Group companies has actually rewarded its executive officers in the form of base salaries, short-term and long-term incentive awards and annual equity-based awards in light of the returns that it has produced for its investors. Prior to reviewing this data with the Committee, the Committee’s compensation consultant reviews the analysis and provides the Committee with his views and commentary. The Committee has indicated that it finds this insight to be very valuable in helping them to assess whether our pay for performance profile is appropriate and aligned with industry and peer group practices. In addition, management and the Committee use this comprehensive peer group financial analysis each year to support the process of reviewing and establishing short-term and long-term incentive plan goals intended to drive and reward top quartile performance by the Company.

 

  Use of Tally Sheets

 

In February of each year, prior to making decisions about the compensation of our Chairman and Chief Executive Officer and the other Named Executive Officers, we provide the Committee with a comprehensive tally sheet for each executive officer that sets forth

the dollar amount of all components of his or her current compensation, including base salary, annual incentive compensation, long-term incentive compensation, retirement and savings programs, health and welfare programs and the cost of personal executive benefits. In reviewing these tally sheets, the Committee also reviews potential compensation payments to our Chairman and Chief Executive Officer and the other Named Executive Officers under various termination of employment scenarios, including in the event of a change of control of the Company. This process includes a review of potential severance payment obligations, the potential values of vested and unvested restricted stock and stock options, and accumulated balances and projected payment obligations in connection with our retirement and savings programs, including our deferred compensation and limited service supplement and restoration retirement income plans. Based upon this review, in 2007 the Committee determined the total compensation, in the aggregate (including the total payments of accrued benefits and separation payments that would be made under the various termination scenarios), for our Chairman and Chief Executive Officer and the other Named Executive Officers to be competitive, reasonable and not excessive. This analysis did not suggest the need for any material changes to the Company’s executive compensation program or its administration and it did not prompt the Committee to make any substantive changes to any compensation elements for any of the Named Executive Officers.

 

 

We use the following balanced components to achieve our objectives relating to hiring, motivating, retaining and rewarding executive officers:

 

 

Payouts are not strictly formulaic but are based upon the consideration of both objective and subjective factors. As in past years, we based the annual cash incentive awards paid to the executive officers for 2007 on individual target opportunities expressed as a percentage of the participant’s base salary, the level of our achievement of pre-established stretch financial goals set by the

Committee and individual performance ratings that reflected a discretionary assessment by the Committee of each executive’s contributions during the year (which are discussed in greater detail below). In 2007, we based performance goals on our operating EPS, which exclude acquisition integration charges, and cash flow return on gross capital employed in the business (“CFR”), weighted equally, in addition to individual and business unit performance objectives. We use these goals because, over time, they bear a statistical correlation to the market trading price of our shares. We do not make payouts under the EIC Plan unless we achieve a predetermined minimum level of CFR (except for the possible discretionary award described below). If we achieve the predetermined minimum level of CFR, but do not achieve the predetermined minimum level of EPS, payouts are limited to the minimum level, which is an amount equal to 25% of the incentive target. In setting demanding annual EPS and CFR goals under the EIC Plan, the Committee reviews market analyses, our annual profit plan as approved by the Board of Directors, and external research reports and comparative analyses of our Peer Group companies (as shown above). The Committee, in its sole discretion, may increase or decrease the total amount available for payout under the EIC Plan by up to 20%, based upon its assessment of our performance against other financial and non-financial factors. The Committee did not exercise this discretion for the 2007 plan year. The EIC Plan also gives the Committee the discretion to pay up to 20% of the target incentive fund to recognize contributions to the Company in a year when awards would not otherwise be payable, which was not the case for 2007. We also base awards on individual performance ratings. In setting individual performance ratings, the Committee reviews a recommendation from our Chairman and Chief Executive Officer for each executive officer (other than himself). Individual ratings may result in payouts ranging from zero to 150% of the amount otherwise payable to any given participant, except that the total awards payable to all eligible participants cannot exceed 100% of the EPS and CFR performance adjusted incentive fund. Under the EIC Plan terms, the incentive fund does not include any award to an “employee director” (currently limited to our Chairman and Chief Executive Officer) for purposes of this “zero-sum” calculation. In executive session, the Committee establishes an individual EIC Plan rating for our Chairman and Chief Executive Officer for each year after discussing the results of the Board of Directors’ annual appraisal of his or her performance. We describe this process in more detail below under “Other Key Executive Compensation Principles — Chairman and Chief Executive Officer Annual Appraisals.”

 

In 2007 each Named Executive Officer’s target award opportunity was multiplied by 175% to reflect the Company’s actual performance compared against the Committee-established EPS and CFR goals. The executive’s adjusted target award opportunity was then multiplied by the executive’s individual performance rating for the year to determine the amount of the final incentive award payout.

 

In establishing the 2007 individual performance ratings for each Named Executive Officer, the Committee took into consideration a variety of objective and subjective factors as described in the process outlined below.

 

In preparing the recommended individual performance ratings for each Named Executive Officer who reports to him, our Chairman and Chief Executive Officer reviewed each individual Senior Vice President and Group President’s performance in four basic operations-oriented goal categories (which impacts approximately 75% of the final recommended performance rating):

 

 

 

In addition to these operating goals, three of our four Senior Vice President and Group Presidents (Messrs. Arnold, Carson and Sweetnam) also have one or more corporate staff responsibilities. Performance against goals set for these staff functions impact approximately 25% of their final recommended performance rating. For 2007, these included:

 

 

In preparing the recommended individual performance rating for Mr. Fearon, our

Executive Vice President and Chief Financial and Planning Officer, our Chairman and Chief Executive Officer took into consideration the following:

 

 

In developing his recommended performance ratings for the Named Executive Officers, our Chairman and Chief Executive Officer does not follow a formulaic approach but develops a recommended rating based upon his subjective view of each executive’s overall performance against this wide range of both objective and subjective goals for the year. While reviewing and discussing each executive’s performance and recommended performance rating with the Committee, he and the Committee also discuss an assessment of additional subjective factors which includes each executive’s:

 

 

The actual individual performance ratings for the Named Executive Officers ranged from 110% to 130% for purposes of the 2007 EIC Plan awards which, when combined with the 175% adjustment related to the Company’s EPS and CFR performance, resulted in final incentive awards that ranged from 193% to 228% of the executives’ original target incentive opportunities.

 

Executive officers may defer payment of their annual cash incentive payments under a plan described in more detail in the narrative accompanying the Nonqualified Deferred Compensation table on pages 37 and 38 of this proxy statement.

 

 

We believe that stock options are effective in aligning the interests of our executives with those of our shareholders by having a significant component of executive compensation tied directly to changes in the value of our common shares. Stock options

also aid executive retention because they are earned over a period of several years.

 

For a number of years and again in 2007, we established our annual stock option grant guidelines by first determining the Black-Scholes value (or a value set by a comparable market pricing model) of a share of our common stock as reported in the Hewitt, Towers Perrin and Hay surveys for our most recently completed annual stock option grant (February 2006). This value is compared to the fair market value on this same grant date to determine a percentage. This percentage is then multiplied by the average price for a share of our common stock over the last 90 trading days of 2006. The resulting dollar value is then divided into the median long-term incentive compensation values, as determined by the surveys, to establish our recommended median grant sizes for the February 2007 grant.

 

Starting with this basis for determining appropriate median stock option grant levels, as part of the annual Total Compensation Analysis and Planning Process, the Committee then reviews our Chairman and Chief Executive Officer’s recommended stock option grants for each Named Executive Officer. Based on individual factors such as the level of sustained personal performance, long-term career potential, and competitive market conditions, the Committee may adjust an individual executive’s stock option grant, if any, to a level that is at, above or below median market practice. Using this same process, in executive session the Committee determines the size of the annual stock option grant, if any, that it will make to our Chairman and Chief Executive Officer.

 

In 2007, the Committee approved stock option grants for the Named Executive Officers which were at approximately 50% of the median long-term grant values provided to similar positions as reported in the most recent data for similarly-sized industrial companies in the Hewitt, Towers Perrin and Hay annual surveys. Grants at this level were deemed by the Committee to be appropriate when considered in the aggregate with the other compensation elements approved for these executives.

 

We set the strike price for all stock option grants at the fair market value of our common shares on the date of the grant (using the process described below). We have never selected strike prices or otherwise timed the grant of stock options to enable executives to profit from an artificially low strike price.

 

Our grant recommendation and approval processes have always been disciplined, straightforward, and consistent. In 1995, under a stock plan approved by the shareholders, we added annual grants of stock options to the compensation provided to non-employee directors, and the process for making these grants is set forth in the stock plan document and is described below.

 

Under the various Company stock plans, all of which have been approved by the shareholders, a committee of independent directors has exclusive authority to fix the date and all terms and conditions of equity grants to executive officers. Currently, the Committee has this responsibility.

 

 

In the case of annual stock option grants to executives, our grant practices have not changed materially since we began granting options. We grant stock options at the same time each year, except in the case of newly hired executives, as described below. We set the strike price for all stock options at the fair market value of our common shares on the date of grant, determined as described below.

 

Key stock option grant practices are as follows:

 

 

 

 

 

Absent any unusual circumstances, the Committee typically sets performance hurdles for each four-year award period such that: (a) payment at approximately 100% of the target incentive opportunity would be made if our performance over the four-year period is at or above the projected median of the performance of the peer group and (b) payment at or above 150% of the target incentive opportunity would be made if our performance over the four-year period is at or above the projected 75th percentile of the performance of the peer group. Prior to the 2005-2008 performance period, we expressed these incentive awards in the form of contingent share units. Contingent share units aligned the interests of the executives with those of the shareholders because the units reflected appreciation or depreciation and earnings on our common shares during the performance period. Beginning with awards for the 2005-2008 performance period, the Committee amended the plan to provide that incentive awards would not be expressed in the form of contingent share units. The Committee made this change at that time because it felt that the executive compensation portfolio was overly-weighted in favor of equity-based compensation. The Committee annually reviews this element of the design of the ESIP to ensure that it aligns

well with competitive practice and provides an effective long-term incentive structure.

 

For the 2004–2007 performance period, each Named Executive Officer’s target contingent share award opportunity was multiplied by 200% to reflect the fact that the Company’s actual performance exceeded the maximum EPS and CFR goals established by the Committee at the start of this four-year period. The executive’s adjusted contingent share award opportunity was then multiplied by his or her individual performance rating for the four-year period to determine his or her actual ESIP award payout. As in prior years, the individual performance ratings established by the Committee for each Named Executive Officer were set at approximately the average of their individual annual EIC Plan performance ratings for each of the four years in this performance cycle. Actual individual ratings ranged from 110% to 120%. When combined with the 200% adjustment related to the Company’s EPS and CFR performance, the final adjusted contingent share awards ranged from 220% to 240% of the executives’ original target incentive opportunities.

 

Executive officers may defer payment of their ESIP award payouts under a plan described in more detail in the narrative accompanying the Nonqualified Deferred Compensation Table on pages 37 and 38.

 

 

After reviewing the 2007 Peer Group Pay and Performance Analysis (described on page 16), the Committee determined that, despite the fact that the competitive position of the Company’s total compensation for its key executives was at or near the median of market practices as reported for similarly-sized industrial companies in the Hewitt, Towers Perrin and Hay surveys, our executives’ total compensation was not competitive with the median total compensation reported for our Peer Group. In response, the Committee approved additional restricted stock grants for key executives with such awards having shorter vesting schedules than the Committee has typically approved for previous restricted stock awards. Additional details about the Company’s stock plan and these restricted stock awards to the Named Executive Officers may be found in the table and footnotes for the Outstanding Equity Awards at Fiscal Year-End Table on pages 33 and 34.

 

 

Our executives do not engage in financial hedging of their investment risk in shares of the Company common stock and the Company actively and strongly discourages and does not provide executives with any advice or assistance related to such practices.

 

 

The tax-qualified pension plans that we maintain for our U.S. salaried and non-union employees define the term “compensation” to include base salary, overtime pay, pay premiums and awards under any annual variable pay or incentive compensation pay (including amounts deferred for receipt at a later date). We use this same definition for calculating pension benefits under the non-qualified retirement income arrangements described below.

 

 

In response to typical market practices and to enhance our ability to attract and retain key executives, the Board of Directors also has adopted plans which provide supplemental annual retirement income to certain executives who are hired in mid-career and would therefore not have the opportunity to accumulate significant credited service with us under our tax-qualified retirement income or non-qualified restoration plans, provided that they either retire at age 55 or older and have at least 10 years of service with us or retire at age 65 or older regardless of the years of service.

 

Additional details on our retirement income programs can be found in the narrative discussion and footnotes accompanying the Pension Benefits Table on pages 35 and 36.

 

These qualified and non-qualified retirement income plans are the only compensation or benefit plans or programs that we provide to executive officers which take into consideration the amounts realized by the executive from prior compensation awards. For example, any previously-paid awards under annual or long-term incentive plans and any gains realized upon the exercise of employee stock options do not affect the amounts payable as a future award under any other of our compensation plans or programs. Moreover, we do not take these past payouts or stock gains into consideration when we set the level of any future incentive targets or equity award opportunities.

 

accompanying the Potential Payments Upon Termination section beginning on page 39.

 

 

To ensure his personal security and enhance his productivity, the Board of Directors has directed that our Chairman and Chief Executive Officer use our aircraft for all business and personal travel whenever feasible. The Board of Directors also has directed that we provide full tax protection to him with respect to the imputed income attributable to the personal use of such aircraft. In addition, it is our policy that our aircraft not to be used for personal travel by other executives except with the express approval of our Chairman and Chief Executive Officer.

 

Other Key Executive Compensation Principles

 

 

 

 

The Director inputs on these performance areas, along with any narrative commentary, are compiled anonymously by the consultant who then prepares a draft consensus evaluation for review and approval by the Committee. This evaluation is also reviewed in an executive session of the Board of Directors and shared with our Chairman and Chief Executive Officer prior to a performance evaluation discussion with the Chair of the Committee. The Committee uses this appraisal as a factor to determine, with respect to our Chairman and Chief Executive Officer’s compensation, the payouts under our

short-term and long-term incentive plans together with, and as part of the Total Compensation Analysis and Planning Process, any increase in base salary, new short and long term incentive targets and equity awards.

 

 

In 2007, the Committee again reviewed the short- and long-term incentive plans in light of Section 162(m) and determined that a new Senior Executive Compensation Incentive Plan (an annual incentive plan) and an amended Executive Strategic Incentive Plan (a multi-year incentive plan), both of which would be intended to qualify incentive payments under the Plans as deductible compensation under Section 162(m), should be submitted for shareholder approval at the 2008 Annual Meeting. These proposed plans are included in this proxy statement.

 

Policy on Incentive Compensation, Stock Options and Other Equity Grants Upon the Restatement of Financial Results — In 2007, our Audit and Compensation and Organization Committees, along with the Board of Directors, thoroughly reviewed current market practices and the issues related to compensation recovery practices in the event of a material restatement of financial results due to executive misconduct. Following these deliberations, the Board of Directors adopted a formal policy stating that, if the Board determines that an Executive engaged in any fraud, misconduct or other bad-faith action that, directly or indirectly, caused or partially caused the need for a material accounting restatement for any period as to which a Performance-based Award was paid or credited to the Executive during the twelve month period following the first public issuance of the incorrect financial statement, such award shall be subject to reduction, cancellation or reimbursement to the Company at the discretion of the Board. As used in this Policy, the term “Executive” means any Eaton executive who participates in either the Executive Strategic Incentive Plan I or the Executive Strategic Incentive Plan II, or both, or any successor plans. Our incentive compensation plans, stock plans and deferral plans will be amended during 2008 to include provisions reflecting this policy. Additional details regarding this policy and related processes may be found on our website (www.eaton.com). Under “Company Quick Links” click on “Corporate Responsibility,” then “Corporate Governance.”

Chairman and Chief Executive Officer Compensation in 2007

 

As part of its annual Total Compensation Analysis and Planning Process in February 2007, and its review of the December 31, 2006 tally sheet, the Committee reviewed all components of our Chairman and Chief Executive Officer’s compensation, including base salary, target annual cash incentive opportunity, long-term cash incentive opportunity and equity based incentives. Based upon these reviews, the Committee concluded that our Chairman and Chief Executive Officer’s total compensation (including compensation payable upon employment termination whether in connection with a change of control of the Company or otherwise) in the aggregate was reasonable and not excessive.

 

The Committee confirmed that the 2007 compensation for our Chairman and Chief Executive Officer was earned pursuant to the procedures, policies and factors described in earlier sections of this Compensation Discussion and Analysis. Following the completion of the 2007 performance evaluation, the Committee Chair advised our Chairman and Chief Executive Officer that the Board of Directors had given him a very favorable overall performance evaluation and that, as in past years, this overall performance appraisal was a key factor used by the Committee in reviewing and approving his annual and long-term incentive awards that were determined at year-end and that it would be one element considered by the Committee when it reviews and approves any future annual compensation adjustments, awards and grants under the Committee’s Total Compensation Analysis and Planning Process.

 

In the February 2007 Total Compensation Analysis and Planning Process, the Committee increased our Chairman and Chief Executive Officer’s annual base salary by 3.9% effective April 1, 2007 in order to better align his base salary with market practices. This was the first base salary adjustment for him since March 2005 and, following this adjustment, his base salary approximated the median annual salary level as reported in the Hewitt, Towers Perrin and Hay surveys for similarly-sized industrial companies.

 

The Committee confirmed that it had maintained our Chairman and Chief Executive Officer’s 2007 annual cash incentive target opportunity at 105% of his base salary (unchanged from his 2005 and 2006 target incentive opportunities) and that this incentive opportunity was positioned at approximately the market median reported in the Hewitt, Towers Perrin and Hay surveys for similarly-sized industrial companies. It also reported that his actual 2007 annual cash incentive award was based on our actual reported EPS and CFR results compared to the targets set by the Committee for 2007, along with the Committee’s evaluation of his individual performance. In establishing our Chairman and Chief Executive Officer’s individual performance rating, the Committee reported that it took into account the results of the annual Chairman and Chief Executive Officer Performance Appraisal process and such factors as:

 

 

 

The Committee noted that, for 2007, our Chairman and Chief Executive Officer earned 228% of his target annual cash incentive opportunity, which is based on the product of 175% (the 2007 EPS and CFR performance adjusted incentive fund factor), and an individual performance multiplier of 130% established by the Committee following the Board of Directors’ 2007 Performance Appraisal process. This percentage, when applied to his 2007 approved incentive target opportunity of 105% of his base salary, resulted in a bonus payout of 239% of his base salary.

 

As part of the Total Compensation Analysis and Planning Process in February 2007, the Committee established our Chairman and Chief Executive Officer’s target long-term cash incentive opportunity at 169% of base salary for the 2007-2010 performance period which, together with his Committee-approved stock option grant (which will vest in equal installments over a four-year period), positioned the value of the total long-term incentive compensation elements at approximately the market median as reported in the Hewitt, Towers Perrin and Hay surveys for similarly-sized industrial companies. The Committee also approved a restricted stock grant for 17,000 shares for our Chairman and Chief Executive Officer in 2007 which will vest in equal installments over a two-year period. While we use restricted stock awards from time to time to provide an additional level of retention, the Committee also noted that, in addition to retention, it wanted this award to better align our Chairman and Chief Executive Officer’s total compensation to that which is paid to similar executive’s in the Company’s diversified industrial peer group.

 

At year-end 2007, the Committee reported that our Chairman and Chief Executive Officer earned a long-term performance plan award for the 2004-2007 performance period based upon our EPS and CFR performance as described above and his Committee-approved individual rating. Our Chairman and Chief Executive Officer earned contingent share units equal to 240% of his target share unit opportunity. This percentage was based upon actual cumulative CFR results and our EPS growth over the 2004-2007 period, which exceeded the maximum pre-established EPS growth and cumulative CFR goals for the period, thus generating an initial 200% contingent share unit adjustment and the individual performance rating of 120% established by the Committee. The Committee also noted that this individual performance rating percentage was approximately equal to his average individual performance rating for each of the four annual incentive plan years in this award period and that it appropriately reflected his sustained individual performance over this period. The final cash value of the contingent share units also reflected the sustained growth in the market value of our common shares over this period.

 

As a result of the Committee’s decisions with respect to our Chairman and Chief Executive Officer’s compensation, his total compensation is significantly higher than any of the other Named Executive Officers. This reflects the accumulated difference found in competitive market practices for chief executive officers of large industrial organizations and the very different relative job responsibilities of this position as compared to the job responsibilities and pay practices for other executive positions, as well as increases in the value of his accumulated pension benefits (which are driven by his pay history and long tenure with us).

 

Compensation and Organization Committee Report — The Compensation and Organization Committee of the Board of Directors has reviewed and discussed with the Company’s management the Compensation Discussion and Analysis required by Item 402(b) of Regulation S-K and, based on this review and discussion, the Compensation and Organization Committee recommended to the Board that the Compensation Discussion and Analysis be included in this proxy statement.

 

COMPENSATION AND ORGANIZATION COMMITTEE

 

Michael J. Critelli, Chair

Christopher M. Connor

Deborah L. McCoy

John R. Miller

Gregory R. Page

 

SUMMARY COMPENSATION TABLE

 

The following table sets forth the total compensation of our Chairman and Chief Executive Officer, our Executive Vice President–Chief Financial and Planning Officer and the three other of our most highly compensated executive officers in 2007 (the “Named Executive Officers”). We have not entered into any employment agreements with any of the Named Executive Officers, other than the change of control agreements described beginning on page 42. Prior to setting total compensation for each of the Named Executive Officers, the Committee reviews tally sheets which show the executive’s current compensation, including equity and non-equity based compensation. “Salary,” as shown in column (c), consists of base salary, which accounted for approximately 13% of the total cash compensation of the Named Executive Officers. The Named Executive Officers were not entitled to receive “Bonus” payments under column (d) for 2007 (“Bonus” payments are defined under the disclosure rules as discretionary payments that are not based on any performance criteria). The “Non-Equity Incentive Compensation” provided by us, as shown in column (g), is performance-based and accounted for approximately 87% of the total cash compensation of the Named Executive Officers. Column (e), “Stock Awards,” consists of the amount recognized for financial statement reporting purposes with respect to grants of restricted shares under our stock plans. Column (f), “Option Awards,” consists of the amount recognized for financial statement reporting purposes with respect to grants of stock options under our stock plans. Column (g), “Non-Equity Incentive Plan Compensation,” is comprised of two cash components that do not involve any “share-based payment” for financial reporting purposes. One component is the amount paid as annual executive incentive compensation for 2007. The other component is the amount paid under the four-year executive incentive plan for the 2004-2007 award period. These payments were approved by the Committee at its January 22, 2008 meeting and, to the extent not deferred by the executive, will be paid on March 15, 2008. Column (h), “Change in Pension Value and Nonqualified Deferred Compensation Earnings,” contains two distinct components. “Change in Pension Value” represents the total change in the actuarial present value of each Named Executive Officer’s accumulated benefit under all of our defined benefit pension plans (both tax qualified and non-qualified) from the measurement date used for financial reporting purposes. “Nonqualified Deferred Compensation Earnings” include earnings on deferred compensation that exceed 120% of a specified rate of interest for long-term debt instruments established by the Internal Revenue Service. Column (i), “All Other Compensation,” consists of compensation that does not fit within any of the foregoing definitions of compensation. This compensation includes personal benefits, tax “gross-up” payments, our contributions to defined contribution plans, the value of insurance premiums, and the value of any dividends paid on restricted shares since they are not factored into the grant date fair values reported in columns (e) or (f).

 

 

 

 

GRANTS OF PLAN-BASED AWARDS

 

The following table summarizes the potential awards payable to the Named Executive Officers with respect to the short-term and long-term incentive award opportunities granted in 2007.

 

 

 

OUTSTANDING EQUITY AWARDS AT FISCAL YEAR-END

 

The following table summarizes the outstanding equity awards held by the named executive officers at year-end 2007. The closing price of our shares on the last trading day in 2007 ($96.95) was used to determine the market value of unvested restricted shares shown in column (h).

 

 

 

 

 

OPTION EXCERCISES AND STOCK VESTED

 

The following table provides information regarding exercises of stock options and vesting of restricted shares during the year ended December 31, 2007 with respect to the Named Executive Officers. The values reflect (a) in the case of exercised stock options, the difference between the aggregate option exercise price and the market price of the applicable number of our common shares on the date of exercise, and (b) in the case of any stock award that vested during 2007, the per share closing price of our common shares on the vesting date multiplied by the shares that vested.

 

 

 

PENSION BENEFITS

 

The following table shows the estimated present value of the benefits payable under each of our retirement income plans to each Named Executive Officer. We maintain three basic types of retirement income plans for our U.S. salaried employees: (a) a tax-qualified defined benefit pension plan (referred to as the Pension Plan for Eaton Corporation Employees in the Pension Benefits table) that has two separate benefit formulas: a final average pay formula and a cash balance formula, (b) two defined benefit restoration plans (collectively referred to as the DB Restoration Plan in the Pension Benefits table) and (c) a plan that allows us to supplement the pension benefits earned under our qualified pension plan and non-qualified DB Restoration Plan to executives who are recruited by us in mid-career (referred to as the Limited Service Supplemental Plan in the Pension Benefits table).

 

Tax-qualified Retirement Income Plans — Effective January 1, 2003, employees who were then earning benefits under the “Average Final Annual Compensation” benefit formula (the “AFAC benefit formula”) under the Pension Plan for Eaton Corporation Employees were given the option to either: (a) continue earning benefits under the AFAC benefit formula; or (b) commence earning benefits in an “Eaton Personal Benefits Account” under the cash balance formula (the “EPPA benefit formula”). Salaried employees hired on or after January 1, 2002 automatically earn benefits under the EPPA benefit formula upon becoming eligible for participation in the retirement plan. Under the AFAC benefit formula, annual normal retirement benefits are computed at the rate of 1% of average final annual compensation up to the applicable Social Security integration level ($48,816 for 2007 retirements) plus 11/2% of average final annual compensation in excess of the Social Security integration level, multiplied by the employee’s years of credited service. In addition, the employee receives a supplement equal to 1/2% of average final annual compensation up to the applicable Social Security integration level payable until the Social Security Normal Retirement Age. Finally, the employee receives an additional $26 per month starting at age 65. An employee’s average final annual compensation is the average annual amount of his or her eligible compensation (consisting of salary plus annual executive incentive compensation for service during the five consecutive years within the last 10 years of employment for which the employee’s total compensation was the greatest). Years of credited service includes the number of years of employment between age 21 and retirement, with a maximum of 44 years. Corporate policies require that Named Executive Officers retire at age 65. Under the EPPA benefit formula, a participant’s single sum retirement benefit is accumulated throughout his or her career with us. This single sum amount is represented as a notional account balance to which is regularly added credits equal to a percentage of his or her eligible compensation (consisting of salary plus annual executive incentive compensation) plus interest at a specified rate. The percentage of eligible compensation credited to the participant’s notional account balance varies over his or her career based on the sum of the participant’s age and service with us. For any period when that sum is less than 50, 5.0% of compensation is credited. For any period when the sum is between 50 and 59 (inclusive), 6.0% of eligible compensation is credited. When the sum is between 60 and 69 (inclusive), 7.0% of compensation is credited. When the sum is 70 or greater, 8.0% of compensation in credited. Upon termination of employment, the notional account balance is available as a single sum or may be converted to one of several annuity forms. As with the AFAC benefit formula, under the standard post-retirement surviving spouse option, the participant receives a reduced pension, and a pension equal to 50% of the reduced pension is payable to his or her surviving spouse. For example, the benefit for an employee electing that option at age 65 whose spouse is five years younger would be approximately 11.5% less than the amount of the participant’s annual benefit. This information assumes that the EPPA benefit formula in the retirement plan will be continued in its present form.

 

Non-Qualified Defined Benefit Retirement Plans — Certain provisions of the Internal Revenue Code, as amended, limit the annual benefits that may be paid from a tax-qualified retirement plan (including a limitation on the amount of annual compensation that may be taken into account in calculating a participant’s benefit under a qualified retirement plan ($225,000 in 2007)). As permitted under the Code, the Board of Directors has authorized the payment from our general funds of any benefits calculated under the provisions of the applicable retirement plan which may exceed those limits to any participant, including the Named Executive Officers, whose benefits are impacted by these provisions.

 

Limited Eaton Service Supplemental Retirement Income Plan  — The Board of Directors has adopted a plan which provides supplemental annual retirement income to certain executives who do not have the opportunity to accumulate significant credited service with us under our tax-qualified retirement income plans, provided that

they either retire at age 55 or older and have at least 10 years of service with us or retire at age 65 or older regardless of the years of service. The amount of the annual supplement is generally equal to the amount by which a percentage (described below) of the executive’s average final annual compensation exceeds his or her earned retirement income (which includes amounts receivable pursuant to the retirement plans described above). The percentage of average final annual compensation used for this purpose depends upon an executive’s age and years of service at retirement. The percentage ranges from 25% (for retirements at age 55 with less than 15 years of service) to 50% (for retirements at age 62 or older with 15 years or more of service).

 

Benefits accrued and vested before January 1, 2005 under either the non-qualified or the limited service plans (described above) generally are paid in one of the forms available under our qualified pension plans as elected by the participant. Benefits earned after 2004 are paid as single lump sum. With respect to all benefits, regardless of when accrued, the present value of the benefit will be paid in a single installment upon a change of control of the Company.

 

NONQUALIFIED DEFERRED COMPENSATION

 

We provide our executives with opportunities to defer the receipt of their earned and otherwise payable awards under our annual and long-term cash incentive plans. We offer these plans in order to (a) provide executives with a competitive opportunity to accumulate additional retirement assets, (b) provide a means for acquiring our shares in order to meet our share ownership guidelines and (c) provide an additional form of employment retention. Despite their popularity across our industry, we do not currently provide our executives with a non-qualified defined contribution plan that enables them to defer base salary amounts in excess of Internal Revenue Code limits that restrict such deferrals under our tax-qualified defined contribution plan. The table below includes not only amounts contributed, earned and distributed as deferred compensation in the last fiscal year, but also includes compensation that the Named Executive Officer elected to defer in all prior years. Therefore, the Aggregate Balance at Last Fiscal Year-End (column (f)) contains the total of all contributions and earnings since the Named Executive Officer began deferring compensation. The year in which the Named Executive Officer began deferring compensation is stated in the table immediately below the officer’s name. The plans covered by the Nonqualified Deferred Compensation table are as follows:

 

 

Annual incentive compensation earned after December 31, 2004 is not eligible for deferral under the DIC Plan. Instead, the DIC Plan II is available for the deferral of this compensation. Incentive compensation earned in 2005 through 2007 and that was deferred under the DIC Plan II was credited with earnings in the same manner as the DIC Plan, as described below. However, participants under the DIC Plan II, prior to the beginning of each calendar year, must elect the method and timing of payment with respect to the incentive compensation to be earned in the year that is subject to the deferral election. The creation of the DIC Plan II and the exclusion of deferrals under the prior plan of incentive awards earned after 2004 were implemented to satisfy the requirements of new Internal Revenue Code Section 409A under the American Jobs Creation Act of 2004 (the “Act”). Similarly, long-term incentive compensation earned after December 31, 2004 is not eligible for deferral under the IC Deferral Plan. Instead, the IC Deferral Plan II is available for the deferral of all or part of this compensation (subject to a minimum deferral requirement). Participants under the IC Deferral Plan II, prior to the beginning of any award period for which an award may be earned, or later if permitted by us in the case of performance-based compensation (as defined in the final regulations under the Act), must elect the method and timing of payment with respect to the incentive compensation to be earned during that award period and that is subject to the deferral election. As was the case with respect to the plans providing for the deferral of annual incentive compensation, these actions taken regarding the deferral of long-term incentive compensation were in response to satisfying the requirements of the Act.

 

In October 2007, our Board of Directors approved amendments to our deferral plans that are subject to the Act in order to comply with the final regulations under the Act and to remove the Quarterly Treasury Bill basis as an alternative investment measure for crediting earnings to retirement deferral accounts under the DIC Plan and the DIC Plan II. As a result of these amendments, annual incentive compensation awards earned before 2008 will have appreciation and earnings accrued solely on a phantom share basis (as if the deferred amount were invested in actual Eaton shares with earned dividends re-invested in shares) and, following retirement, account balances will be paid in actual Eaton shares. Beginning with deferrals of annual incentive compensation earned during 2008 and after for payment following retirement, each executive will have a choice of deferring up to 100% of his or her annual incentive compensation into either or both of (a) an account tracked on a phantom Eaton share basis and paid out in actual Eaton shares or (b) an account that earns interest equal to that paid on Ten-year Treasury Notes plus 300 basis points. Executives may also defer compensation under the DIC Plan II on a short-term basis for payment within 5 years or less (short-term deferrals were also available under the DIC Plan for compensation earned prior to 2005).

 

When an executive elects to defer a long-term incentive award under the IC Deferral Plan II for payment following his or her retirement, earnings on a minimum of 50% of the deferred amount must be tracked on a

phantom share basis. The remainder of the amount deferred to retirement earns interest equivalents equal to that paid on Ten-year Treasury Notes plus 300 basis points. At retirement, the portion of the executive’s account that is deferred into phantom shares is paid out in actual Eaton shares.

 

In amending its deferral plans to comply with the final regulations under the Act and taking into account the transition relief offered under the final regulations, our Board of Directors approved amendments to those of our deferral plans that are subject to the Act that would provide executives in 2007 a one-time opportunity to change the time of payment on any or all deferral elections made by them for incentive compensation earned from 2005 through 2007. As a result of these elections, any payments made to the Named Executive Officers beginning in 2008 or later will be shown in the Nonqualified Deferred Compensation Table for the respective years in which they are paid out.

 

Incentive compensation deferred pursuant to our deferral plans is unsecured, subject to the claims of our creditors and is exposed to the risk of our non-payment. As of December 2007, certain grantor trusts that we have established hold approximately $626,723 of marketable securities and 607,992 of our shares, in order to provide for a portion of our deferred compensation obligations with respect to deferred incentive compensation earned prior to 2005. The trust assets, which are subject to the claims of our creditors, will be used to pay those obligations in proportion to trust funding. The trust terms call for us to provide full funding upon a change of control of the Company and for accelerated lump sum or installment payments upon a failure by us to pay amounts due under the plans or upon a termination of employment in the context of a change of control. No comparable trust arrangements currently are in place with respect to deferred incentive compensation earned after 2004.