-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, DL8S7l2X2IXrMWdKnAarvu9P5Dm4TnB5jz3d1LSYQXV6QxFp2yv8lXx1XhpPeHaU SgigpgnuG1ix24A9zG2eRw== 0000950128-02-000775.txt : 20021112 0000950128-02-000775.hdr.sgml : 20021111 20021112114823 ACCESSION NUMBER: 0000950128-02-000775 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 20020928 FILED AS OF DATE: 20021112 FILER: COMPANY DATA: COMPANY CONFORMED NAME: TOLLGRADE COMMUNICATIONS INC \PA\ CENTRAL INDEX KEY: 0001002531 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-TELEPHONE INTERCONNECT SYSTEMS [7385] IRS NUMBER: 251537134 STATE OF INCORPORATION: PA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-27312 FILM NUMBER: 02816079 BUSINESS ADDRESS: STREET 1: 493 NIXON RD CITY: CHESWICK STATE: PA ZIP: 15024 BUSINESS PHONE: 4122742156 10-Q 1 j9710001e10vq.txt PERIOD ENDED 9/28/2002 ------------------------------- SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC ------------------------------- FORM 10-Q (Mark One) [X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the quarterly period ended September 28, 2002 [ ] Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from ___________ to ____________ Commission file number 0-27312 TOLLGRADE COMMUNICATIONS, INC. (Exact Name of Registrant as Specified in its Charter) PENNSYLVANIA 25-1537134 (State or Other Jurisdiction (I.R.S. Employer of Incorporation or Organization) Identification Number) 493 NIXON RD. CHESWICK, PA 15024 (Address of Principal Executive Offices, including zip code) 412-820-1400 (Registrant's telephone number, including area code) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No --- --- As of November 1, 2002, there were 13,552,736 shares of the Registrant's Common Stock, $0.20 par value per share, and no shares of the Registrant's Preferred Stock, $1.00 par value per share, outstanding. This report consists of a total of 61 pages. The exhibit index is on page 34. TOLLGRADE COMMUNICATIONS, INC. QUARTERLY REPORT ON FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 28, 2002 TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION PAGE NO. - ------------------------------ -------- ITEM 1 CONDENSED CONSOLIDATED FINANCIAL STATEMENTS: CONDENSED CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 28, 2002 AND DECEMBER 31, 2001 .........................................................................3 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE-MONTH AND NINE-MONTH PERIODS ENDED SEPTEMBER 28, 2002 AND SEPTEMBER 29, 2001 ...................................4 CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDER'S EQUITY FOR THE THREE-MONTH AND NINE-MONTH PERIODS ENDED SEPTEMBER 28, 2002 AND SEPTEMBER 29, 2001 ........5 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE NINE-MONTH PERIODS ENDED SEPTEMBER 28, 2002 AND SEPTEMBER 29, 2001..................................................6 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.......................................7 REPORT OF INDEPENDENT ACCOUNTANTS.........................................................14 ITEM 2 MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION.......................................................................15 ITEM 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK................................27 ITEM 4 CONTROLS AND PROCEDURES...................................................................27 PART II. OTHER INFORMATION - --------------------------- ITEM 1 LEGAL PROCEEDINGS.........................................................................28 ITEM 2 CHANGES IN SECURITIES.....................................................................28 ITEM 3 DEFAULTS UPON SENIOR SECURITIES...........................................................28 ITEM 4 SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.......................................28 ITEM 5 OTHER INFORMATION.........................................................................28 ITEM 6 EXHIBITS AND REPORTS FILED ON FORM 8-K....................................................29 SIGNATURE...............................................................................................30 - --------- CERTIFICATIONS..........................................................................................31 - -------------- EXHIBIT INDEX...........................................................................................34 - -------------
2 PART I. FINANCIAL INFORMATION ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS
SEPTEMBER 28, 2002 DECEMBER 31, 2001 * - -------------------------------------------------------------------------------------------------------------- ASSETS (UNAUDITED) CURRENT ASSETS: Cash and cash equivalents $ 33,056,359 $ 32,105,845 Short-term investments 13,945,043 6,489,323 Accounts receivable: Trade 10,893,693 9,296,551 Other 559,318 320,501 Inventories 16,169,767 22,183,616 Prepaid expenses and deposits 749,353 916,723 Refundable income taxes 873,9750 1,396,736 Deferred tax assets 1,393,580 1,116,756 - -------------------------------------------------------------------------------------------------------------- TOTAL CURRENT ASSETS 77,641,088 73,826,051 Long-term investments -- 150,000 Property and equipment, net 7,982,263 8,012,546 Deferred tax assets 2,867,715 2,812,987 Intangibles 38,500,000 38,500,000 Goodwill 16,161,763 16,161,763 Capitalized software costs, net 5,874,103 6,935,000 Other assets 262,146 231,614 ============================================================================================================== TOTAL ASSETS $ 149,289,078 $ 146,629,961 ============================================================================================================== LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 171,939 $ 805,398 Accrued warranty 2,272,265 2,068,000 Accrued expenses 720,679 691,697 Accrued salaries and wages 725,582 329,126 Accrued royalties payable 107,174 397,451 Income taxes payable 1,355,936 1,433,554 Deferred income 939,731 472,674 - -------------------------------------------------------------------------------------------------------------- TOTAL CURRENT LIABILITIES 6,293,306 6,197,900 Deferred tax liabilities 1,194,033 293,477 - -------------------------------------------------------------------------------------------------------------- TOTAL LIABILITIES 7,487,339 6,491,377 Commitments and contingent liabilities -- -- Shareholders' equity: Common stock, $.20 par value; authorized shares, 50,000,000; issued shares, 13,552,736 and 13,513,119, respectively 2,710,547 2,702,624 Additional paid-in capital 70,394,275 70,010,254 Treasury stock, at cost, 461,800 and 386,800 shares, respectively (4,790,783) (3,164,975) Retained earnings 73,487,700 70,590,681 - -------------------------------------------------------------------------------------------------------------- TOTAL SHAREHOLDERS' EQUITY 141,801,739 140,138,584 ============================================================================================================== TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 149,289,078 $ 146,629,961 -------------------------------------------
* Amounts derived from audited financial statements The accompanying notes are an integral part of the condensed consolidated financial statements. 3 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
- ---------------------------------------------------------------------------------------------------------------------------- FOR THE FOR THE THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 28, SEPTEMBER 29, SEPTEMBER 28, SEPTEMBER 29, 2002 2001 2002 2001 - ---------------------------------------------------------------------------------------------------------------------------- REVENUES: Products $11,260,585 $15,077,227 $38,207,243 $63,718,147 Services 2,691,611 960,730 7,851,137 2,085,979 - ---------------------------------------------------------------------------------------------------------------------------- TOTAL REVENUES: 13,952,196 16,037,957 46,058,380 65,804,126 - ---------------------------------------------------------------------------------------------------------------------------- COST OF PRODUCT SALES: Products 5,645,694 7,158,355 16,577,424 28,057,498 Services 867,969 507,826 2,722,795 1,448,516 Amortization of intangibles 366,298 ----- 1,096,767 ----- - ---------------------------------------------------------------------------------------------------------------------------- 6,879,961 7,666,181 20,396,986 29,506,014 - ---------------------------------------------------------------------------------------------------------------------------- GROSS PROFIT: 7,072,235 8,371,776 25,661,394 36,298,112 - ---------------------------------------------------------------------------------------------------------------------------- Selling and marketing 2,162,734 2,022,930 6,804,876 6,965,250 General and administrative 1,216,570 1,019,748 4,011,415 3,612,046 Research and development 3,370,548 2,638,680 10,761,258 8,747,326 Severance and related expense ----- ----- ----- 400,000 - ---------------------------------------------------------------------------------------------------------------------------- TOTAL OPERATING EXPENSES 6,749,852 5,681,358 21,577,549 19,724,622 - ---------------------------------------------------------------------------------------------------------------------------- INCOME FROM OPERATIONS 322,383 2,690,418 4,083,845 16,573,490 Interest and other income, net 150,767 800,436 588,766 2,497,971 - ---------------------------------------------------------------------------------------------------------------------------- INCOME BEFORE INCOME TAXES 473,150 3,490,854 4,672,611 19,071,461 Provision for income taxes 179,798 1,361,000 1,775,592 7,383,012 - ---------------------------------------------------------------------------------------------------------------------------- NET INCOME $ 293,352 $ 2,129,854 $ 2,897,019 $11,688,449 ============================================================================================================================ EARNINGS PER SHARE INFORMATION: Weighted average shares of common stock and equivalents: Basic 13,090,936 13,065,809 13,096,496 13,017,819 Diluted 13,216,502 13,377,544 13,340,724 13,392,507 - ---------------------------------------------------------------------------------------------------------------------------- Net income per common and common equivalent shares: Basic $ .02 $ .16 $ .22 $ .90 Diluted $ .02 $ .16 $ .22 $ .87 ============================================================================================================================
The accompanying notes are an integral part of the condensed consolidated financial statements. 4 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY FOR THE NINE MONTHS ENDED SEPTEMBER 28, 2002 (Unaudited)
ADDITIONAL PREFERRED COMMON STOCK PAID-IN TREASURY RETAINED SHARES AMOUNT SHARES AMOUNT CAPITAL STOCK EARNINGS TOTAL - ----------------------------------------------------------------------------------------------------------------------------------- Balance at December 31, 2001 ---- $ ---- 13,513,119 $ 2,702,624 $ 70,010,254 $ (3,164,975) $ 70,590,681 $ 140,138,584 Exercise Of common stock option ---- ---- 39,617 7,923 270,252 ---- ---- 278,175 Tax benefit from exercise of stock options ---- ---- ---- ---- 113,769 ---- ---- 113,769 Purchase of treasury stock ---- ---- ---- ---- ---- (1,625,808) ---- (1,625,808) Net Income ---- ---- ---- ---- ---- ---- 2,897,019 2,897,019 - ----------------------------------------------------------------------------------------------------------------------------------- Balance at September 28, 2002 ---- $ ---- 13,552,736 $ 2,710,547 $ 70,394,275 $ (4,790,783) $ 73,487,700 $ 141,801,739 - -----------------------------------------------------------------------------------------------------------------------------------
The accompanying notes are an integral part of the condensed consolidated financial statements. 5 TOLLGRADE COMMUNICATIONS, INC. AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
Nine Months Ended Sept. 28, 2002 Sept. 29, 2001 - ------------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 2,897,019 $ 11,688,449 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 2,820,998 1,738,537 Tax benefit from exercise of stock options 113,769 1,065,801 Refundable income taxes paid 522,761 8,417,270 Deferred income taxes 569,004 (268,523) Provision for losses on inventory 1,308,000 164,963 Provision for allowance for doubtful accounts 100,000 175,000 Changes in assets and liabilities: (Increase) decrease in accounts receivable-trade (1,697,142) 6,191,178 (Increase) decrease in accounts receivable-other (106,317) 438,392 Decrease in inventories 4,705,849 7,263,838 Decrease in prepaid expenses and deposits 167,370 391,314 Decrease in accounts payable (633,459) (1,645,462) Increase in accrued warranty 204,265 940,000 Increase (decrease) in accrued expenses and deferred income 363,539 (222,609) Increase (decrease) in accrued salaries and wages 396,456 (2,040,933) Decrease in accrued royalties payable (290,277) (803,240) Decrease in income taxes payable (77,618) (206,511) - ------------------------------------------------------------------------------------------------------------------------- Net cash provided by operating activities 11,364,217 33,287,464 - ------------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES: Redemption/maturity of investments 7,284,312 46,473,811 Purchase of investments (14,590,032) (27,822,448) Capital expenditures (1,729,818) (2,661,504) Purchase of treasury stock (1,625,808) -- Investments in other assets (30,532) (328,991) - ------------------------------------------------------------------------------------------------------------------------- Net cash used in investing activities (10,691,878) 15,660,868 - ------------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from exercise of stock options 278,175 1,058,210 - ------------------------------------------------------------------------------------------------------------------------- Net cash provided by financing activities 278,175 1,058,210 - ------------------------------------------------------------------------------------------------------------------------- Net increase in cash and cash equivalents 950,514 50,006,542 Cash and cash equivalents at beginning of period 32,105,845 30,423,783 - ------------------------------------------------------------------------------------------------------------------------- Cash and cash equivalents at end of period $ 33,056,359 $ 80,430,325 =========================================================================================================================
The accompanying notes are an integral part of the condensed consolidated financial statements 6 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements included herein have been prepared by Tollgrade Communications, Inc. (the "Company") in accordance with accounting principles generally accepted in the United States of America for interim financial information and Article 10 of Regulation S-X. The condensed consolidated financial statements as of and for the three-month and nine-month periods ended September 28, 2002 should be read in conjunction with the Company's consolidated financial statements (and notes thereto) included in the Company's Annual Report on Form 10-K for the year ended December 31, 2001. Accordingly, the accompanying condensed consolidated financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements, although the Company believes that the disclosures are adequate to make the information presented not misleading. In the opinion of Company management, all adjustments considered necessary for a fair presentation of the accompanying condensed consolidated financial statements have been included, and all adjustments are of a normal and recurring nature. Operating results for the three-month and nine-month periods ended September 28, 2002 are not necessarily indicative of the results that may be expected for the year ending December 31, 2002. 2. ACQUISITION AND INTANGIBLE ASSETS On September 30, 2001, the Company acquired certain assets and assumed certain liabilities of the LoopCare(TM) Product line from Lucent Technologies, Inc. ("Lucent") for approximately $62,029,000 in cash which includes approximately $2,200,000 of acquisition-related costs. The acquisition has been recorded under the purchase method of accounting and, accordingly, the results of operations of the LoopCare product line since October 1, 2001 have been included in the consolidated financial statements. The Company has utilized the transitional guidance of Statement of Financial Accounting Standards (SFAS) No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets" which were issued in July 2001. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 and that goodwill, as well as any intangible assets believed to have an indefinite useful life, shall not be amortized for financial reporting purposes. In connection with the acquisition, $45,800,000 of intangible assets were identified, of which $7,300,000 were related to capitalized software and determined to have a definite life, while the remaining $38,500,000 of the identified intangible assets, as well as goodwill of approximately $16,162,000, are not being amortized as they have been determined to have an indefinite useful life. As of January 1, 2002, the Company fully adopted the provisions of SFAS No. 142. SFAS 142 requires that goodwill be analyzed for impairment under a two-step process. The first step of the goodwill impairment test is to identify potential impairment by comparing the fair value of the reporting unit with its carrying amount, including goodwill. The second step, used to measure the potential impairment loss of the goodwill, is to compare the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. The 7 Company has determined that it has only one reporting segment and has completed the first step of the goodwill impairment test as of June 29, 2002 by comparing the aggregate market value of the Company's stock with its carrying value, including goodwill. This test indicated that there was no impairment of goodwill carrying value and, accordingly, step two of the test was not required. Future changes in circumstances, including a sustained decline in the aggregate market value of the Company's stock, could necessitate a reconsideration of whether an impairment of goodwill carrying value has occurred. Developed product software costs are being amortized over a five-year useful life. An annual review for impairment of these assets will be made following the guidance of SFAS 144. Specifically, the sum of the undiscounted future cash flows expected to be derived from the developed product software will be compared with the carrying value. If the carrying value is greater than the sum of the projected cash flows, an impairment loss will be recorded equal to the excess of the carrying value over the fair value of the assets. The fair value will be determined by a separate test utilizing the discounted present value of the expected cash flow stream from the software. In addition, other intangible assets that are not subject to amortization will be tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test for non-amortizable intangible assets will consist of a comparison of the fair value of an intangible asset with its carrying amount. The Company intends to test the value of intangible assets other than goodwill as of December 31, 2002 using the same testing methodology employed by independent consultants in making the initial valuation in 2001. Specifically, the relief-from-royalty method will be used to test the value of the LoopCare trade name and discounted cash flow analyses will be used to value the base software and post warranty maintenance service agreements. The Company is currently in the process of negotiating the renewal of three of its four RBOC LoopCare software maintenance agreements, which expire on December 31, 2002. One of these customers has notified the Company of its desire to negotiate a need based, time and materials fee instead of the fixed maintenance fee arrangement. The Company has agreed to negotiate in good faith towards this type of arrangement but fully intends to maintain the value of this contract, as well as the other contracts renewing at the end of December. Therefore, at this point, the Company believes the value and non-amortizing characteristics of this intangible asset to be preserved. However, if through negotiations, new maintenance agreements with one or more RBOC customers cannot be reached, or if one or more new agreements are reached that are believed will result in less revenue to the Company than the current fixed fee agreements, the current fair value of the maintenance service agreements may be determined to be less than the $32,000,000 carrying value, perhaps materially so, resulting in a charge against operating income for 2002 and/or commencement of amortization of the remaining fair value over its determined useful life. 8 The following condensed proforma results of operations reflect the proforma combination of the Company and the acquired LoopCare business as if the combination occurred on January 1, 2001; compared with the actual results of operations for the third quarter and first nine months of 2002, which included the LoopCare operations:
(In thousands, Except per Share Data) Three Months Ended Nine Months Ended Historical Proforma Historical Proforma Sept. 28, 2002 Sept. 29, 2001 Sept. 28, 2002 Sept. 29, 2001 -------------- -------------- -------------- -------------- Revenues $13,952 $19,386 $46,058 $75,848 - -------------------------------------------------------------------------------------------------- Income from operations 322 3,752 4,084 19,759 - -------------------------------------------------------------------------------------------------- Net income 293 2,614 2,897 13,140 - -------------------------------------------------------------------------------------------------- Net income per share: - -------------------------------------------------------------------------------------------------- Diluted $ 0.02 $ 0.20 $ 0.22 $ 0.98
The proforma results of operations for the three months and nine-months ended September 29, 2001 reflected above include one-fourth and three-fourths, respectively, of the annual audited results of the LoopCare product line business for 2001. Proforma adjustments made include an estimated allocation of selling, general and administrative expenses to the LoopCare operations based upon budgeted costs for 2002 and proforma amortization of the developed product software over five years. Proforma adjustments were also made to take into account the cost of money in connection with the acquisition costs. This was estimated by reducing interest income at historical earning rates for working capital deemed to have been available to apply to the acquisition costs and estimating interest expense on borrowed funds for residual acquisition costs at the historical prime rates of interest plus 1.5%. Adjustments were also made to reflect the tax consequences of the foregoing proforma adjustments. The following information is provided regarding the Company's intangible assets: As of September 28, 2002 ------------------------ Gross Carrying Accumulated Amount Amortization ---------------------------------- Amortized intangible assets: Developed product software $ 7,335,870 $1,461,767 =========== ========== Unamortized intangible assets: LoopCare trade name $ 1,300,000 Base software 5,200,000 Post warranty maintenance service agreements 32,000,000 ----------- $38,500,000 9 As of December 31, 2001 ----------------------- Gross Carrying Accumulated Amount Amortization ----------- ----------- Amortized intangible assets: Developed product software $ 7,300,000 $ 365,000 =========== =========== Unamortized intangible assets: LoopCare trade name $ 1,300,000 Base software 5,200,000 Post warranty maintenance service agreements 32,000,000 ---------- $38,500,000 Aggregate amortization expense: For year ended December 31, 2001 $ 365,000 =========== Estimated amortization expense: For year ended December 31, 2002 $1,463,082 For year ended December 31, 2003 $1,467,174 For year ended December 31, 2004 $1,467,174 For year ended December 31, 2005 $1,467,174 For year ended December 31, 2006 $1,102,174 Actual amortization expense: For the nine-month period ended September 29, 2001 $ -0- For the nine-month period ended September 28, 2002 $ 1,096,767 Actual net income: For the nine-month period ended September 29, 2001 $11,688,449 For the nine-month period ended September 28, 2002 $ 2,897,019 3. INVENTORIES At September 28, 2002 and December 31, 2001, inventories consisted of the following:
(Unaudited) September 28, December 31, 2002 2001 ----------- ----------- Raw materials........................ $ 10,538,442 $ 11,697,886 Work in progress..................... 4,975,820 6,443,549 Finished goods....................... 3,074,505 5,153,181 ----------- ----------- $ 18,588,767 $ 23,294,616 Reserves for slow moving and obsolete inventory................ (2,419,000) (1,111,000) ----------- ----------- $ 16,169,767 $ 22,183,616 ===========- ===========
10 4. SHORT-TERM AND LONG-TERM INVESTMENTS Short-term investments at September 28, 2002 and December 31, 2001 consisted of individual municipal bonds stated at cost, which approximated market value. These securities have a maturity of one year or less at date of purchase and/or contain a callable provision in which the bonds can be called within one year from date of purchase. Long-term investments are comprised of individual municipal bonds with a maturity of more than one year but less than eighteen months and are stated at cost, which approximated market value. The primary investment purpose is to provide a reserve for future business purposes, including acquisitions and capital expenditures. Realized gains and losses are computed using the specific identification method. The Company classifies its investment in all debt securities as "held to maturity" as the Company has the positive intent and ability to hold the securities to maturity which is in accordance with Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities." The estimated fair values of the Company's financial instruments are as follows:
(Unaudited) September 28, December 31, 2002 2001 ----------------------------------- ---------------------------------- Fair Carrying Carrying Fair Amount Value Amount Value ------------ ------------ ----------- ------------ Financial assets: Cash and cash equivalents...................... $33,056,359 $33,056,359 $32,105,845 $32,105,845 Short-term and long-term investments........... 13,945,043 13,874,775 6,639,323 6,658,247 ------------ ------------ ----------- ------------ $47,001,402 $46,931,134 $38,745,168 $38,764,092 =========== =========== =========== ===========
11 5. INCOME PER COMMON SHARE Net income per share is calculated by dividing net income by the weighted average number of common shares plus incremental common stock equivalent shares (shares issuable upon exercise of stock options). Incremental common stock equivalent shares are calculated for each measurement period based on the treasury stock method, which uses the monthly average market price per share. The calculation of net income per common and common equivalent shares follows (unaudited):
- ----------------------------------------------------------------------------------------------------------------------------------- Three Months Three Months Nine Months Nine Months Ended Ended Ended Ended September 28, 2002 September 29, 2001 September 28, 2002 September 29, 2001 - ----------------------------------------------------------------------------------------------------------------------------------- Net income $ 293,352 $ 2,129,854 $ 2,897,019 $11,688,449 - ----------------------------------------------------------------------------------------------------------------------------------- Common and common equivalent shares: Weighted average number of common shares outstanding during the period ........................ 13,090,936 13,065,809 13,096,496 13,017,819 Common shares issuable upon exercise Of outstanding stock options: Diluted ............................... 125,566 311,735 244,228 374,688 Common and common equivalent shares Outstanding during the period: - ----------------------------------------------------------------------------------------------------------------------------------- Diluted ............................... 13,216,502 13,377,544 13,340,724 13,392,507 =================================================================================================================================== Earnings per share data Net income per common and common Equivalent shares: Basic ................................. $ .02 $ .16 $ .22 $ .90 Diluted ............................... $ .02 $ .16 $ .22 $ .87 ===================================================================================================================================
12 6. DEFERRED AND REFUNDABLE TAX ASSETS The Company's current refundable tax assets as of December 31, 2001 included a tax benefit of $1,396,736 resulting from the exercising of nonqualified stock options under the Company's stock option programs during 2001. The Company is entitled to a tax deduction equal to the difference between the fair market value of the shares received by the option holders upon exercise and the exercise price of the nonqualified stock options. The Company received $8,417,270 in 2001 in federal and state refunds in taxes paid in prior years. During the first and third quarter of 2002, the Company received $900,000 and $331,000, respectively, in federal income tax refunds associated with prior year taxes paid. The remaining current federal refundable tax assets consist primarily of estimated tax payments for 2002 which will be substantially utilized in early 2003 either through refunds from taxing agencies or applied to estimated taxes for 2003. 7. STOCK REPURCHASE PROGRAM On April 19, 2001, the Company announced its Board of Directors authorized the continuation of a share repurchase program that was originally initiated on April 22, 1997. Prior to the extension, the Company had repurchased 382,400 shares of common stock. The Company was authorized to repurchase a total of one million shares of its common stock. Through December 31, 2001, no additional shares were repurchased under this extended program. On January 24, 2002, the Board of Directors authorized the continuation of the share repurchase program under which the Company may repurchase a total of one million shares of its common stock before December 31, 2002. During the quarter ended March 30, 2002, the Company purchased an additional 75,000 shares of the Company's common stock under this program. No additional shares were repurchased through the third quarter of 2002. 8. ACCOUNTING PRONOUNCEMENTS In June 2002, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 146, "Accounting For Costs Associated With Exit Or Disposal". SFAS No. 146 nullifies Emerging Tax Issues Task Forces (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)". The new Statement requires that a liability for a cost associated with an exit or disposal activity be recognized and measured initially at fair value only when the liability is incurred. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. The Company does not believe that this statement will have an effect on the Company. 13 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Tollgrade Communications, Inc. and subsidiaries: We have reviewed the accompanying condensed consolidated balance sheet of Tollgrade Communications, Inc. and its subsidiaries as of September 28, 2002 and the related condensed consolidated statements of operations for each of the three-month and nine-month periods ended September 28, 2002 and September 29, 2001 and the condensed consolidated statement of cash flows for the nine-month periods ended September 28, 2002 and September 29, 2001 and the statements of changes in shareholders' equity for the nine-month period ended September 28, 2002. These financial statements are the responsibility of the Company's management. We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to the accompanying condensed consolidated interim financial statements for them to be in conformity with accounting principles generally accepted in the United States of America. We previously audited in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet as of December 31, 2001, and the related consolidated statements of operations, shareholders' equity and of cash flows for the year then ended (not presented herein), and in our report dated January 21, 2002 we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2001, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived. /s/ PricewaterhouseCoopers LLP Pittsburgh, Pennsylvania October 14, 2002 14 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and Notes thereto appearing elsewhere in this report. CAUTIONARY STATEMENT FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. This Quarterly Report on Form 10-Q contains statements relating to future events that are considered "forward-looking statements." These statements, which may be expressed in a variety of ways, including the use of future or present tense language, relate to, among other things, projected cash flows used in the valuation of intangible assets, the anticipated results of negotiations for new maintenance service agreements, as well as purchase orders and other customer purchase agreements, the ability to utilize current deferred and refundable tax assets, opportunities which the Company's professional services offer to customers, the potential loss of certain customers, the timing of orders from customers, the effect of consolidations in the markets to which the Company sells, the effects of the economic slowdown in the telecommunications industry, the possibility of future provisions for slow moving inventory, and the effect on earnings and cash flows of changes in interest rates. These forward-looking statements, and other forward-looking statements contained in other public disclosures of the Company which make reference to the cautionary factors contained in this Report, are based on assumptions that involve risks and uncertainties and are subject to change based on the considerations described below. The Company does not undertake any obligation to publicly update any forward-looking statements. General economic conditions and the economic conditions of the telecommunications industry, including the effect of subscriber line loss and competition for the Company's RBOC customers from wireless, cable providers and other carriers entering the local telephone service market can and have affected the capital budgets of the Company's customers. If such conditions result in a further reduction of such budgets, the Company's revenues can be adversely affected. If the Company's customers find themselves unable to meet their established purchase forecasts and their own growth projections, such customers may curtail their purchase of the Company's products, which would adversely affect the Company's revenues. If the financial strength of certain of the Company's major customers should deteriorate or such customers encounter difficulties in accessing capital, the ability of such customers to purchase and pay for the Company's products could be impaired, with a corresponding adverse effect on the Company's revenues. If third parties with whom the Company has entered into sales and marketing partnerships should fail to meet their own performance objectives or (in some cases) prove unable to continue to provide vendor financing to certain local exchange carriers, customer demand for the Company's products could be adversely affected, which would have an adverse effect on the Company's revenues. Seasonal fluctuations in customer demand for the Company's products can create corresponding fluctuations in period to period revenues, and any increases in the rate of order cancellation by customers could adversely affect future revenues. The carrying value of certain intangible assets, including goodwill, acquired by the Company from Lucent Technologies, Inc. ("Lucent") could be impaired if changing market conditions indicate that lower than anticipated cash flows will be produced by such intangible assets. If the Company were to encounter a shortage of key manufacturing components from limited sources of supply, or experience manufacturing delays caused by reduced manufacturing capacity, loss of key assembly 15 subcontractors or other factors, the Company's ability to produce and ship its manufactured products could be adversely affected, with an adverse effect upon revenues. The introduction of improved products or services or reduced prices by the Company's competitors could reduce the demand for the Company's products and services and adversely affect revenues. If the Company proves unable to respond effectively to technological change in its industry, such as an evolution of the telephone network from circuit to packet-based, by developing new products and services and obtaining customer approval and acceptance of its products and services, demand for the Company's products and services could be adversely affected, which would adversely affect revenues. The Company is dependent on a relatively narrow range of products and a small number of large customers. As a result, the failure of one or a small number of the Company's products to gain or maintain acceptance in the marketplace, or the decision by one or a few of the Company's customers to curtail their purchases of the Company's products could have an adverse effect on revenues. If one or more of a small number of key employees of the Company were to cease to be associated with the Company, the Company's future results could be adversely affected. If the Company is unable to successfully assert and defend its proprietary rights in the technology utilized in its products, its future results could be adversely affected. If third parties were able to successfully assert that the Company's use of technology infringed upon the proprietary rights of others, the future results of the Company could be adversely affected. If one or more of the Company's products were to prove defective, the Company's relationships with its customers could be jeopardized and the Company could be subject to potential liability, adversely affecting the Company's future results. If for any reason demand for the Company's products should continue to decrease, including the successful development of a secondary market for the Company's products by a third party, the Company could continue to find itself with excess inventory and obsolescent parts on hand, which could adversely affect future results. Changes in government regulation, such as modification or repeal of The Telecommunications Act of 1996, increasing the costs of doing business by the Company or its customers, or preventing the Company or its customers from engaging in business activities they may wish to conduct could adversely affect the Company's future results. OVERVIEW The Company was organized in 1986 and began operations in 1988. The Company designs, engineers, markets and supports test system, test access and status monitoring products for the telecommunications and cable television industries. Effective September 30, 2001, the Company purchased certain assets of the LoopCare(TM) product business from Lucent. These assets consisted of LoopCare software base code and developed enhancements, as well as the rights to existing maintenance contracts for the LoopCare software. Effective September 30, 2001, revenues from the sales of either software base code or developed enhancements are either reported separately or as part of the Company's revenues attributable to test system products to which they synergistically relate, while the revenues from maintenance contracts are reflected as part of the Company's Professional Services revenues. The Company has determined that its business has one reportable segment in the test assurance industry. All product sales are considered components of the business of testing infrastructure and networks for the telecommunications and cable television industries. While the Company does internally develop sales results associated with the various product categories, this information is not considered sufficient for segment reporting purposes nor does the chief operating decision maker make critical decisions or allocate assets based solely on this information. Its products and services have similar economic characteristics, the same or similar production processes and are sold to similar types or classes of customers in, or entering into, the telecommunications business through similar distribution means. The LoopCare software product line business was acquired by the Company to broaden its DigiTest(R) test platform into a system level offering and as a competitive defense to protect the Company's MCU(R) and DigiTest products market share. 16 The Company's telecommunications proprietary test access products enable telephone companies to use their existing line test systems to remotely diagnose problems in "Plain Old Telephone Service" ("POTS") lines containing both copper and fiber optics. The Company's MCU product line, which includes POTS line testing as well as alarm-related products, represented approximately 32% of the Company's revenue for the third quarter ended September 28, 2002. The Company's MCU product line is expected to continue to account for a substantial portion of the Company's revenues. The Company's DigiTest centralized network test system platform, which includes certain LoopCare software base code and developed enhancements, focuses on helping local exchange carriers conduct the full range of fault diagnosis, along with the ability to qualify, deploy and maintain next generation services that include Digital Subscriber Line ("DSL") service and Integrated Services Digital Network ("ISDN") service. The Company's DigiTest system is designed to provide the complete solution for testing POTS and performing local loop prequalification for DSL services. The system currently consists of the comprehensive LoopCare diagnostic software, as well as three integrated pieces of hardware, the Digital Measurement Node ("DMN"), the Digital Measurement Unit ("DMU"), and the Digital Wideband Unit ("DWU"). When used in an integrated fashion, the DigiTest system permits local exchange carriers to perform a complete array of central office testing including POTS, DSL line prequalification, bridged tap detection, data rate prediction, and in-service wideband testing. Sales of the DigiTest product line accounted for approximately 30% of the Company's revenue for the third quarter of 2002. The Company's Digital Access Unit ("DAU") provides automated test access of locally non-switched, two wire circuits and helps facilitate the line sharing or the spectral unbundling process for both incumbent (ILEC) and competitive local exchange carriers (CLEC). Although sales of the DAU have been significant in prior periods, sales of this product line represented less than 1% of total revenue for the current quarter. The Company's LoopCare software products consist primarily of engineered enhancements to the LoopCare base code software, which result in increased connectivity and versatility of LoopCare within the customers' existing quality assurance systems. Sales of stand-alone LoopCare software accounted for approximately 5% of total third quarter 2002 revenue. During the third quarter of 2002, the Company completed its first major central office test system upgrade package delivery, which included hardware resale and services. This project contributed approximately 7% of revenues for the quarter. The Company's LIGHTHOUSE(R) cable products consist of a complete cable status monitoring system that provides a broad testing solution for the Broadband Hybrid Fiber Coax distribution system. The status monitoring system includes a host for user interface, control and configuration, a head-end controller for managing network communications and transponders that are strategically located within the cable network to gather status reports from power supplies, line amplifiers and fiber-optic nodes. Sales of the LIGHTHOUSE product line accounted for approximately 6% of the Company's revenue for the third quarter of 2002. The cornerstone of the Company's professional services offering is the Testability Improvement Initiatives. These services may offer the customer the opportunity to make improvements in testability levels, while training their own staffs in targeted geographic regions over a defined period of time. In this way, the customers' internal repair technicians can make use of automated systems to diagnose and repair subscriber loop problems, thereby automatically eliminating the need for the involvement of several highly trained people. The services business was considerably expanded upon the acquisition of software maintenance contracts related to the LoopCare software product line. Effective October 11, 2002, however, an RBOC canceled a significant network testability services initiative which had accounted for revenue of approximately $980,000 17 for the nine months ended September 28, 2002. The cancellation could also adversely affect sales of MCU products that are driven by these testability programs. Including the software maintenance revenues, services revenue accounted for approximately 19% of the Company's revenue for the third quarter ended September 28, 2002. The Company's telecommunication product sales and services are primarily to the four Regional Bell Operating Companies ("RBOCs") as well as major independent telephone companies and to certain digital loop carrier ("DLC") equipment manufacturers. For the third quarter ended September 28, 2002, approximately 79% of the Company's total revenue was generated from sales to these four RBOCs. During the third quarter of 2002, sales to two RBOCs (SBC and Verizon) individually exceeded 10% of consolidated revenues and on a combined basis, comprised approximately 67% (53.0% and 14%, respectively) of the Company's net sales. Although not 10% customers in the current quarter, in past periods Bell South and Qwest have been 10% customers. Due to the Company's present dependency on these key customers including Bell South and Qwest, the potential loss of one or more of them as a customer or the reduction of orders for the Company's products by them could materially and adversely affect the Company. The Company's operating results have fluctuated and may continue to fluctuate as a result of various factors, including the timing of orders from, shipments to, and acceptance of software by the RBOCs and significant independent telephone companies. This timing is particularly sensitive to various business factors within each of the RBOCs, including the RBOCs relationships with their various organized labor groups and an increasing tendency for the RBOCs to place large orders for shipment of hardware and software toward the end of a quarter. In addition, the markets for the Company's products, specifically, LoopCare, DigiTest and LIGHTHOUSE, are highly competitive. Although not yet completed, the acquisition of AT&T, one of the Company's primary LIGHTHOUSE customers, by Comcast may adversely affect sales of product to that customer. Due to the rapidly evolving market in which these products compete, additional competitors with significant market presence and financial resources could further intensify the competition for these products. The Company believes that recent changes within the telecommunication marketplace, including industry consolidation, as well as the Company's ability to successfully penetrate certain new markets, have resulted in some discounting and more favorable terms granted to certain customers of the Company. In addition, certain customers have consolidated product purchases that have translated into large bulk orders. As stated earlier, there is an increasing trend, in response to some of these discounting programs, for these customers to place large bulk orders toward the end of a quarter for shipment of large quantities of hardware and software in the last month of the quarter. Although the Company will continue to strive to meet the demands of its customers, which include delivery of quality products at an acceptable price and on acceptable terms, there are no assurances that the Company will be successful in negotiating acceptable terms and conditions in its purchase orders or its customer purchase agreements. Additionally, continuing consolidation efforts among the RBOCs, and their ability to consolidate their inventory and product procurement systems could cause fluctuations or delays in the Company's order patterns. Also, recent efforts in the cable industry to consolidate as well as to standardize transponders among status monitoring systems could cause pricing pressure as well as affect deployment within certain customers of the Company's cable products. These standards were adopted by the standards setting body in the year 2001 and may adversely affect the Company's revenues from such products in the year 2002 and in subsequent periods. In addition, markets for the Company's LIGHTHOUSE products have been, and may continue to be, difficult for the foreseeable future. The Company cannot predict such future events or business conditions and the Company's results could be adversely affected by these industry trends in the primary markets its serves. International sales in the third quarter ended September 28, 2002 were approximately 8% of total revenues and the Company believes that certain international markets may offer further opportunities. The addition of the LoopCare software product line has enhanced the Company's ability to penetrate this market. The Company 18 recorded its initial LoopCare software sale in the international market in the first quarter of 2002 with two additional sales in each of the second and third quarters of 2002. The Company also recorded a large international sale of LoopCare software bundled with DigiTest products during the third quarter of 2002. However, the international telephony markets differ from those found domestically due to the different types and configurations of equipment used by those international communication companies to provide services. In addition, certain competitive elements are found internationally which do not exist in the Company's domestic markets. These factors, when combined, have made entrance into these international markets very difficult. From time to time, the Company has utilized the professional services of various marketing consultants to assist in defining the Company's international market opportunities. With the assistance of these consultants and through direct marketing efforts by the Company, it has been determined that its present MCU technology offers limited opportunities in certain international markets for competitive and other technological reasons. The Company continues to actively pursue opportunities for its other products including its LoopCare Software products in international markets. However, there can be no assurance that any continued efforts by the Company will be successful or that the Company will achieve significant international sales. In addition, Lucent Technologies announced recently that it is freezing its efforts relating to DSL services, which may have an adverse effect on the Company's deployment of LoopCare internationally through the Lucent OEM channel. Further, the international markets introduce the risk of loss from currency fluctuations. While the Company endeavors to price its products in U. S. dollars, this may not always be possible. Many International customers are also small and undercapitalized presenting possible exposure to credit losses to a greater degree than domestic customers. The Company believes that its future growth will be affected as a result of the economic slowdown in the telecommunications industry whereby established RBOC and large ILEC customers continue to reduce their capital and operating expense budgets with direct impact on ordering patterns and quantities. The Company believes that the RBOC and large ILEC customers are being adversely affected by deteriorating line growth and the after-effects of overspending in 1999 and 2000, as well as by competition from cable and wireless carriers and other carriers entering the local telephone service market. In addition, certain emerging carriers are continuing to be hampered by financial instability caused in large part by a lack of access to capital. Due to this uncertainty, the Company will continue to evaluate its investments in production, marketing and research and development expenses and monitor, control or decrease expense levels, as appropriate. The Company also believes that continued growth will depend, in part, on its ability to design and engineer new products and, therefore, spends a significant amount on research and development. Research and development expenses as a percentage of revenues were 24% for the third quarter of 2002 compared to 17% for the third quarter of 2001. Future operating results may also be affected by anticipated higher renewal premiums for directors and officers liability insurance The Company is currently negotiating such premium renewals with several companies. The risk exists that the Company could be required to reduce its existing coverage to maintain affordability of this coverage. 19 RESULTS OF OPERATIONS - THIRD QUARTER REVENUES Revenues for the third quarter of 2002 of $13,952,196 were $2,085,761, or 13%, lower than the revenues of $16,037,957 reported for the third quarter of 2001, despite the inclusion of LoopCare revenues in the 2002 period which were not available in 2001. The revenue performance by product line for the third quarter of 2002 compared to the prior year period follows. The decrease in revenues for the third quarter of 2002 is due primarily to slower deployments of the MCU product-line caused by the continuing budget restrictions of the RBOCs, as well as to the effects of subscriber line loss and diminishing DLC deployment. Sales of the MCU product line decreased from three RBOCs as a result of slow-downs in capital spending programs to upgrade DLC systems within certain regions with MCU technology. Further, as the product life cycle for the MCU product continues to mature, there is a continuing possibility that customer requirements for certain legacy MCU products may be satisfied at some point. Sales of the Company's core MCU products were $4,551,000 for the third quarter of 2002, a decrease of $7,965,000 from the year earlier period. MCU sales comprised 32.6% of total third quarter 2002 revenues compared to 78.0% for the year earlier quarter. Sales of Tollgrade's DigiTest system products, which include LoopCare software, increased substantially between quarterly periods due to a major centralized test head replacement and augmentation program at an RBOC. Sales of DigiTest products of $4,132,000 included LoopCare revenues which were not available in the year earlier quarter and represented 29.6% of total revenue for the current quarter compared to 4% for the year earlier quarter. Sales of the Company's DAU product line, which accounted for 6.4% of revenue in the third quarter of 2001, were not significant during the third quarter 2002. Sales of LoopCare software products of $686,000 in the third quarter of 2002 were made to RBOC customers and certain international customers. This included the first sale to an RBOC of the Company's Interactive Voice Response system, developed for its LoopCare product. The Company acquired this product line from Lucent Technologies, Inc. on September 30, 2001 and thus had no comparable sales in the third quarter of 2001. These sales comprised 4.9% of total revenues during the third quarter of 2002. During the third quarter of 2002, the Company recognized sales of $977,000 or 7.0% of revenues from its first major central office test system upgrade package delivery, which included hardware resale and services. The Company's third quarter 2002 service revenues were $2,691,000, which represents 19.3% of total quarterly revenue and an increase of $1,730,000 over the third quarter of 2001. The increase is due to the inclusion of $1,934,000 from software maintenance and services related to the new LoopCare product line. The balance of professional services revenue relates to installation oversight and project management services. Service revenues were provided primarily to RBOC customers. LIGHTHOUSE cable product sales of $790,000 decreased $131,000 or 14.2% from the prior year's quarter, however, the Company benefited from higher sales to AT&T BIS. Sales of LIGHTHOUSE cable status monitoring system products amounted to 5.7% of total third quarter 2002 revenue. Periodic fluctuations in customer orders and backlog result from a variety of factors, including but not limited to, the timing of significant orders from, shipments to, and acceptance of software by the RBOCs, and are not necessarily indicative of long-term trends in sales of the Company's products. 20 GROSS PROFIT Gross profit for the third quarter of 2002 was $7,072,235 compared to $8,371,776 for the third quarter of 2001; a decrease of $1,299,541 or 15.5%. Gross profit as a percentage of revenues decreased to 50.7% in the third quarter of 2002 compared to 52.2% in the same quarter last year. The decrease in gross profit as a percentage of sales resulted primarily from increased cost per unit sold due to substantially lower hardware production, the product mix of hardware sales during the quarter relative to last year and $751,000 provided for slow moving inventory, partially offset by higher margins associated with the sales of LoopCare software products. The provisions for inventory were due in part to LIGHTHOUSE cable products and the general slowdown in sales and production. The Company will continue to monitor and aggressively manage its inventory stock, but no assurances can be made that further provisions for slow moving inventory will not be required. The Company's gross margin is and will continue to be highly sensitive to the mix of products shipped, the level of operations and the level of reserves required for slow moving and obsolete inventory should current difficult economic conditions persist. SELLING AND MARKETING EXPENSE Selling and marketing expense for the third quarter of 2002 was $2,162,734 compared to $2,022,930 for the third quarter of 2001. The increase of $139,804 or 6.9% is primarily due to the addition of personnel and consulting expenses of the LoopCare operations. As a percentage of revenues, selling and marketing expenses increased to 15.5% in the third quarter of 2002 from 12.6% in the third quarter of 2001. GENERAL AND ADMINISTRATIVE EXPENSE General and administrative expense for the third quarter of 2002 was $1,216,570, an increase of $196,822, or 19.3% from the $1,019,748 recorded in the third quarter of 2001. The increase is attributable to the addition of LoopCare and other personnel and higher general and health insurance costs. As a percentage of revenues, general and administrative expenses increased to 8.7% in the third quarter of 2002 from 6.4% in the third quarter of 2001. RESEARCH AND DEVELOPMENT EXPENSE Research and development expense in the third quarter of 2002 was $3,370,548, an increase of $731,868 or 27.7% over the $2,638,680 recorded in the third quarter of 2001. The increase results from the addition of approximately 29 LoopCare engineering personnel and related expenses, partially offset by reductions in temporary labor and consulting expenses. As a percentage of revenues, research and development expense increased to 24.2% in the third quarter of 2002 from 16.5% in the third quarter of 2001. INTEREST AND OTHER INCOME Interest and other income consists of interest income in both quarterly periods. Interest income was $150,767 in the third quarter of 2002 compared to $800,436 for the third quarter of 2001, a decrease of $649,669, or 81.2%. This decrease results from the decrease in funds available for investment due to the LoopCare acquisition for $62,029,000 in cash at the beginning of the fourth quarter of 2001 and the general decline in interest rates. PROVISION FOR INCOME TAXES The provision for income taxes for the third quarter of 2002 was $179,798, a decrease of $1,181,202 or 76.8% from the $1,361,000 recorded for the third quarter of 2001. The effective income tax rate for both periods was approximately 38% of pretax income. NET INCOME AND EARNINGS PER SHARE As a result of the above factors, net income for the third quarter of 2002 was $293,352, a decrease of $1,836,502 or 86.2% from the $2,129,854 recorded in the third quarter of 2001. Basic and diluted earnings per common share of $.02 for the third quarter of 2002 decreased by $.14 or 87.5% from the $.16 earned in the third quarter of 2001. Basic and diluted weighted average common and common equivalent shares outstanding were 21 13,090,936 and 13,216,502, respectively, in the third quarter of 2002 compared to 13,065,809 and 13,377,544, respectively, in the third quarter of 2001. As a percentage of revenues, net income for the third quarter of 2002 decreased to 2.1% compared to 13.3% for the third quarter of 2001. RESULTS OF OPERATIONS YEAR-TO-DATE REVENUES For the first nine months of 2002, revenues were $46,058,380 compared to $65,804,126 for the first nine months of 2001, a decrease of $19,745,746, or 30.0%, despite the inclusion of LoopCare revenues in the 2002 period which were not available in 2001. The revenue performance by product line for the first nine months of 2002 compared to the prior year period follows. Revenues for the first nine months of 2002 decreased from the prior year period primarily due to reduced deployments of the MCU product line caused by the continuing budget restrictions of the RBOCs as well as from the effects of subscriber line loss and diminishing DLC deployment. The decrease in sales of the MCU product line resulted from decreased sales to all RBOCs, which is primarily associated with slowdowns in capital spending programs to upgrade DLC systems within certain regions with MCU technology. Further, as the product life cycle for the MCU product continues to mature, there is a continuing possibility that customer requirements for certain legacy MCU products may be satisfied at some point. For similar reasons, the Company's OEM resellers shipped fewer Digital Loop Carrier systems to their end customers, which reduced MCU product sales to these customers. Sales of the Company's core MCU products, which decreased by $25,518,000 to $21,610,000 between the nine month periods, comprised 46.9% of total revenue for the first nine months of 2002 compared to 71.6% for the year earlier period. Sales of Tollgrade's DigiTest system products in 2002, which include LoopCare software, declined by $3,105,000 to $6,650,000 between nine month periods despite the inclusion of LoopCare revenues in the 2002 period which were not available in 2001. This decrease is due to a lack of sales of DigiTest hardware to Nortel for international applications and a decline in sales to Sprint USA as a result of the discontinuation of its ION project. The declines from these customers were offset in part by sales in the third quarter of 2002 resulting from a major centralized test head replacement and augmentation program at an RBOC. Sales of DigiTest products represented 14.4% of total revenue for the first nine months of 2002. Sales of the Company's DAU product line, which accounted for 6.1% of revenues in the first nine months of 2001, were not significant during the first nine months of 2002 as a result of the discontinuation of Sprint's ION project. Sales of stand alone LoopCare software products of $6,148,000 for the first nine months of 2002 were made primarily to RBOC customers and certain international customers. The Company acquired this product line from Lucent Technologies, Inc. on September 30, 2001 and thus had no comparable sales in the first nine months of 2001. These sales comprised 13.3% of total revenues during the first nine months of 2002. During the first nine months of 2002, the Company recognized sales of $977,000 or 2.1% of revenues from its first major central office test system upgrade package delivery, which included hardware resale and services. The Company's service revenues for the first nine months of 2002 were $7,850,000 and 17.0% of total nine month revenue, which is an increase of $5,764,000 over the similar period in 2001. The increase is due to the inclusion of $5,832,000 from software maintenance related to the new LoopCare product line. The balance of professional services revenue relates to installation oversight and project management services. Service revenues were provided primarily to RBOC customers. 22 LIGHTHOUSE cable product sales were $2,456,000 during the first nine months of 2002, a decrease of 10.7% or $293,000 from the prior year period. Cable sales amounted to 5.3% of total revenue for the first nine months of 2002. GROSS PROFIT Gross profit for the first nine months of 2002 was $25,661,394 compared to $36,298,112 for the first nine months of 2001, resulting in a decrease of $10,636,718 or 29.3%. Gross profit as a percentage of revenues increased to 55.7% in the first nine months of 2002, compared to 55.2% in the same period last year. The increase in gross profit as a percentage of sales resulted primarily from higher margins associated with the sales of LoopCare software products, offset by increased cost per unit sold due to substantially lower hardware production, the product mix of hardware sales during the period relative to the previous period and $2,049,000 provided for slow moving and obsolete inventory and $254,000 for warranty items. The increase in slow moving and obsolete inventory were due in large part to LIGHTHOUSE cable inventory, products manufactured by Tollgrade for OEM partners who have seen substantial declines in business levels as a result of current difficult market conditions and due to the general decline in sales and production. The Company will continue to monitor and aggressively manage its inventory stock, but no assurances can be made that further provisions for slow moving inventory will not be required. The Company's gross margin is and will continue to be highly sensitive to the mix of products shipped, the level of operations and the level of reserves required for slow moving and obsolete inventory should current difficult economic conditions persist. SELLING AND MARKETING EXPENSE Selling and marketing expense for the first nine months of 2002 was $6,804,876 compared to $6,965,250 for the nine months of 2001. This decrease of $160,374 or 2.3% is primarily due to decreases in commissions, consulting fees and various promotions and related marketing programs offset by increases caused by the addition of LoopCare personnel. As a percentage of revenues, selling and marketing expenses increased to 14.8% in the first nine months of 2002 from 10.6% in the same period last year. GENERAL AND ADMINISTRATIVE EXPENSE General and administrative expense for the first nine months of 2002 was $4,011,415, an increase of $399,369 or 11.1% from the $3,612,046 recorded in the first nine months of 2001. The increase is partially mitigated by a reduction in force undertaken by the Company in April 2001. The increase is attributable to the addition of LoopCare and other personnel, higher general insurance costs and higher professional services expenses. As a percentage of revenues, general and administrative expenses increased to 8.7% in the third quarter of 2002 from 5.5% in the same period of 2001. RESEARCH AND DEVELOPMENT EXPENSE Research and development expense for the first nine months of 2002 was $10,761,258, an increase of $2,013,932 or 23.0% over the $8,747,326 recorded in the first nine months of 2001. The increase results from the addition of approximately 29 LoopCare engineering personnel and related expenses, increased facilities expense associated with the Bridgewater office and increased software maintenance expense, partially offset by reduced materials and supplies expenditures. As a percentage of revenues, research and development expense increased to 23.4% in the first nine months of 2002 from 13.3% in the similar period of 2001. SEVERANCE AND RELATED EXPENSE On April 19, 2001, the Company announced a cost realignment initiative. The restructuring program resulted in workforce reduction charges of $400,000 which are separately stated in the Company's accompanying Condensed Consolidated Statements of Operations in the second quarter of 2001. These costs represent 23 estimates for severance and related benefits for the termination of approximately 80 employees, as well as exit costs consisting of consulting and legal fees. INTEREST AND OTHER INCOME Interest and other income consists of interest income in both nine month periods. For the first nine months of 2002, interest was $588,766 compared to $2,497,971 for the first nine months of 2001, a decrease of $1,909,205, or 76.4%. This decrease results from the decrease in funds available for investment due to the LoopCare acquisition for $62,029,000 in cash at the beginning of the fourth quarter of 2001 and the general decline in interest rates. PROVISION FOR INCOME TAXES The provision for income taxes for the first nine months of 2002 was $1,775,592, a decrease of $5,607,420 or 76.0% from the $7,382,012 recorded for the first nine months of 2001. The effective income tax rate for both periods was approximately 38% of pretax income. NET INCOME AND EARNINGS PER SHARE As a result of the above factors, net income for the first nine months of 2002 was $2,897,019, a decrease of $8,791,430, or 75.2%, from the $11,688,449 recorded in the first nine months of 2001. Basic and diluted earnings per common share of $.22 for the first nine months of 2002 decreased by $.68 and $.65, or 75.6% and 74.7%, from the $.90 and $.87, respectively, earned in the first nine months of 2001. Basic and diluted weighted average common and common equivalent shares outstanding were 13,096,496 and 13,340,724, respectively, for the first nine months of 2002 compared to 13,017,819 and 13,392,507 respectively, in the first nine months of 2001. As a percentage of revenues, net income for the first nine months of 2002 decreased to 6.3% compared to 17.8% for the first nine months of 2001. Periodic fluctuations in customer orders and backlog result from a variety of factors, including but not limited to, the timing of significant orders from, shipments to, and acceptance of software by the RBOCs, and are not necessarily indicative of long-term trends in sales of the Company's products. CRITICAL ACCOUNTING POLICIES The Company's financial statements are prepared in conformity with accounting principles generally accepted in the United States of America. Certain of these accounting principles are more critical than others in gaining an understanding of the basis upon which the Company's financial statements have been prepared. In addition to those policies discussed elsewhere in this report, a comprehensive review of these policies is contained in the Company's 2001 Annual Report on Form 10-K filed on March 22, 2002. There have been no significant changes in these policies or the application thereof during the third quarter of 2002. LIQUIDITY AND CAPITAL RESOURCES The Company had working capital of $71,347,782 as of September 28, 2002, an increase of $3,719,631 or 5.5%, from the $67,628,151 of working capital as of December 31, 2001. The increase in working capital is a result of operating cash flows, the deferral of tax liabilities and proceeds from the exercise of stock options exceeding cash requirements for the purchase of property and equipment and approximately $1,625,000 of treasury stock. The Board of Directors has authorized the continuation of a share repurchase program initiated in 1997. Under the current extension, the Company may repurchase a total of one million shares of its common stock before December 31, 2002. Since the initial repurchase program was instituted in April of 1997, and as of September 28, 2002, the Company has repurchased 461,800 shares of common stock. The repurchased shares are authorized to be utilized under certain employee benefit programs. The number of shares the Company 24 intends to purchase and the timing of such purchases will be determined by the Company at its discretion. The Company will use existing cash and short-term investments to finance the purchases. Effective December 20, 2001, the Company executed a five-year $25.0 million Unsecured Revolving Credit Facility (the "Facility") with a bank. In accordance with the terms of the Facility, the proceeds must be used for general corporate purposes, working capital needs, and in connection with certain acquisitions, as defined. The Facility contains certain standard covenants with which the Company must comply, including a minimum fixed charge ratio, a minimum defined level of tangible net worth and a restriction on the amount of capital expenditures that can be made on an annual basis, among others. Commitment fees are payable quarterly at 0.25% of the unused commitment. As of September 28, 2002, there were no outstanding borrowings under the Facility and the Company is in compliance with all debt covenants. No borrowings for working capital are currently anticipated, as the Company believes internally generated funds will be sufficient to sustain working capital requirements for the foreseeable future. The Company's days sales outstanding (DSO) in accounts receivable trade, based on the past twelve months rolling revenue, was 66 and 43 days as of September 28, 2002 and December 31, 2001, respectively. The DSO increased as a result of a higher level of sales occurring later into the quarter ended September 28, 2002. The Company's inventory turnover ratio was 1.3 turns at both September 28, 2002 and December 31, 2001. Management believes that operating cash flow and cash reserves are adequate to finance currently planned capital expenditures and to meet the overall liquidity needs of the Company. OTHER MATTERS On September 30, 2001, the Company acquired certain assets and assumed certain liabilities of the LoopCare Product line from Lucent Technologies, Inc. ("Lucent") for approximately $62,029,000 in cash which includes approximately $2,200,000 of acquisition-related costs. The acquisition has been recorded under the purchase method of accounting and, accordingly, the results of operations of the LoopCare product line since October 1, 2001 have been included in the consolidated financial statements. The Company has utilized the transitional guidance of Statement of Financial Accounting Standards (SFAS) No. 141, "Business Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets" which were issued in July 2001. SFAS No. 141 requires that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 and that goodwill, as well as any intangible assets believed to have an indefinite useful life, shall not be amortized for financial reporting purposes. In connection with the acquisition, $45,800,000 of intangible assets was identified, of which $7,300,000 were related to capitalized software and determined to have a definite life, while the remaining $38,500,000 of the identified intangible assets, as well as goodwill of approximately $16,162,000, are not being amortized as they have been determined to have an indefinite useful life. As of January 1, 2002, the Company fully adopted the provisions of SFAS No. 142. SFAS 142 requires that goodwill be analyzed for impairment under a two-step process. The first step of the goodwill impairment test is to identify potential impairment by comparing the fair value of the reporting unit with its carrying amount, including goodwill. The second step, used to measure the potential impairment loss of the goodwill, is to compare the implied fair value of the reporting unit goodwill with the carrying amount of that goodwill. The Company has determined that it has only one reporting segment and has completed the first step of the goodwill impairment test as of June 29, 2002 by comparing the aggregate market value of the Company's stock with the Company's book carrying value, including goodwill. This test indicated that there was no impairment of goodwill carrying value and, accordingly, step two of the test was not required. Future changes in circumstances, including a sustained decline in the aggregate market value of the Company's stock, could necessitate a reconsideration of whether an impairment of goodwill carrying value has occurred. 25 Developed product software costs are being amortized over a five-year useful life. An annual review for impairment of these assets will be made following the guidance of SFAS 144. Specifically, the sum of the undiscounted future cash flows expected to be derived from the developed product software will be compared with the net book carrying value. If the carrying value is greater than the sum of the projected cash flows, impairment loss will be recorded equal to the excess of the carrying value over the fair value of the assets. The fair value will be determined by a separate test utilizing the discounted present value of the expected cash flow stream from the software. In addition, other intangible assets that are not subject to amortization will be tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. The impairment test for non-amortizable intangible assets will consist of a comparison of the fair value of an intangible asset with its carrying amount. The Company intends to test the value of intangible assets other than goodwill as of December 31, 2002 using the same testing methodology employed by independent consultants in making the initial valuation in 2001. Specifically, the relief-from-royalty method will be used to test the value of the LoopCare trade name and discounted cash flow analyses will be used to value the base software and post warranty maintenance service agreements. As previously discussed, at the date of the LoopCare acquisition, the Company established a non-amortizing intangible asset based primarily on the value of RBOC service maintenance agreements whose fees are fixed and which renewal is assumed to be for perpetuity. The Company is currently in the process of negotiating the renewal of three of its four RBOC LoopCare software maintenance agreements which expire on December 31, 2002. One of the Company's four RBOC customers has notified the Company of its intention to negotiate a need based, time and materials fee instead of the fixed maintenance fee when its current service agreement expires on December 31, 2002. The Company has agreed to negotiate in good faith towards this type of arrangement but fully intends to maintain the value of this contract. Therefore, at this point, the Company believes the value and non-amortizing characteristics of this intangible asset to be preserved. However, if through negotiations, new maintenance agreements with one or more RBOC customers cannot be reached, or if one or more new agreements are reached that are believed will result in less revenue to the Company than the current fixed fee agreements, the current fair value of the maintenance service agreements may be determined to be less than the $32,000,000 carrying value, perhaps materially so, resulting in a charge against operating income for 2002 and/or commencement of amortization of the remaining fair value over its determined useful life. A similar analysis of the fair value of the maintenance service agreements could be required if any of the Company's RBOC customers reduce or terminate their maintenance service agreements due to the RBOC customers' own financial difficulties. SUBSEQUENT EVENT On September 30, 2002, the Company announced its second reduction in force in two years to remain as competitive as possible amid spending pullbacks by telecom customers. The realignment reduced the Company's work force by approximately 47 positions, primarily in research and development, production and support areas. This year's initiative is expected to generate annual cost savings of approximately $3,600,000, adjusted by any cost increases the Company may incur as a result of increased premiums from the Company's health care insurance providers. The Company expects to record a charge of $200,000 or $ .01 per share for severance and related costs in the fourth quarter of 2002 in connection with this reduction in force. BACKLOG The Company's backlog consists of firm customer purchase orders and signed software maintenance agreements. As of September 28, 2002, the Company had a backlog of $4,451,078 compared to $4,936,448 at December 31, 2001 and $3,604,105 at September 29, 2001. The September 28, 2002 backlog includes approximately $2,570,599 related to software maintenance contracts. This maintenance and support will be provided for and billed on a straight-line basis through the remaining terms of the agreements. Including the 26 scheduled maintenance services, approximately 78.7% of the current backlog is expected to be recognized as revenue in the fourth quarter of 2002. Periodic fluctuations in customer orders and backlog result from a variety of factors, including but not limited to the timing of significant orders and shipments. While these fluctuations could impact short-term results, they are not necessarily indicative of long-term trends in sales of the Company's products. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's current investment policy limits its investments in financial instruments to cash and cash equivalents, individual municipal bonds, and corporate and government bonds. The use of financial derivatives and preferred and common stocks is strictly prohibited. The Company believes it minimizes its risk through proper diversification along with the requirements that the securities must be of investment grade with an average rating of "A" or better by Standard & Poor's. The Company holds its investment securities to maturity and believes that earnings and cash flows are not materially affected by changes in interest rates, due to the nature and short-term investment horizon for which these securities are invested. ITEM 4. CONTROLS AND PROCEDURES The Chief Executive Officer and the Chief Financial Officer of the Company (its principal executive officer and principal financial officer, respectively) have concluded, based on their evaluation as of a date within 90 days prior to the date of the filing of this Report, that the Company's disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in the reports filed or submitted by it under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and include controls and procedures designed to ensure that information required to be disclosed by the Company in such reports is accumulated and communicated to the Company's management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosure. There were no significant changes in the Company's internal controls or in other factors that could significantly affect these controls subsequent to the date of such evaluation. 27 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS None. ITEM 2. CHANGES IN SECURITIES None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 5. OTHER INFORMATION None. 28 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits: The following exhibits are being filed with this report: Exhibit Number Description ------ ----------- 10.31 1995 Long-Term Incentive Compensation Plan, amended and restated as of January 24, 2002, filed herewith. 10.32 1998 Employee Incentive Compensation Plan, amended and restated as of January 24, 2002, filed herewith. 15 Letter re unaudited interim financial information (b) Reports on Form 8-K: The Company filed two current reports on Form 8-K during the quarter ended September 28, 2002. On August 7, 2002, the Company disclosed certain information in the Form 8-K pursuant to Regulation FD (17 CFR 243.100.243.103). On August 13, 2002, the Company filed a report on Form 8-K to provide the certification required by Section 302 of the Sarbanes-Oxley Act of 2002. 29 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. TOLLGRADE COMMUNICATIONS, INC. (REGISTRANT) Dated: November 12, 2002 /s/ CHRISTIAN L. ALLISON -------------------------------------- CHRISTIAN L. ALLISON CHAIRMAN AND CHIEF EXECUTIVE OFFICER Dated: November 12, 2002 /s/ SAMUEL C. KNOCH -------------------------------------- SAMUEL C. KNOCH CHIEF FINANCIAL OFFICER AND TREASURER Dated: November 12, 2002 /s/ CHARLES J. SHEARER -------------------------------------- CHARLES J. SHEARER CONTROLLER 30 CERTIFICATION I, Christian L. Allison, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Tollgrade Communications, Inc. 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and (c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function); (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and(b) 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 12, 2002 /s/ Christian L. Allison - ------------------------ Name: Christian L. Allison Title: Chief Executive Officer 31 CERTIFICATION I, Samuel C. Knoch, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Tollgrade Communications, Inc. 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and (c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function); (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 12, 2002 /s/ Samuel C. Knoch - -------------------- Name: Samuel C. Knoch Title: Chief Financial Officer 32 Certification Pursuant to 18 U.S.C. Section 1350, the undersigned officer of Tollgrade Communications, Inc. (the "Corporation"), hereby certifies that the Corporation's Quarterly Report on Form 10-Q for the quarter ended September 30, 2002 (the "Report") fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Corporation. Dated: November 12, 2002 /s/ Christian L. Allison - ------------------------ Name: Christian L. Allison Title: Chief Executive Officer Certification Pursuant to 18 U.S.C. Section 1350, the undersigned officer of Tollgrade Communications, Inc. (the "Corporation"), hereby certifies that the Corporation's Quarterly Report on Form 10-Q for the quarter ended September 30, 2002 (the "Report") fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the Securities Exchange Act of 1934 and that the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Corporation. Dated: November 12, 2002 /s/ Samuel C. Knoch - ------------------- Name: Samuel C. Knoch Title: Chief Financial Officer 33 EXHIBIT INDEX (Pursuant to Item 601 of Regulation S-K)
Exhibit Number Description 10.31 1995 Long-Term Incentive Compensation Plan, amended and restated as of January 24, 2002, filed herewith. 10.32 1998 Employee Incentive Compensation Plan, amended and restated as of January 24, 2002, filed herewith. 15 Letter re unaudited interim financial information
34 EX-10.31 3 j9710001exv10w31.txt 1995 LONG-TERM INCENTIVE COMPENSATION PLAN EXHIBIT 10.31 TOLLGRADE COMMUNICATIONS, INC. 1995 Long-Term Incentive Compensation Plan (AS AMENDED THROUGH JANUARY 24, 2002) ARTICLE 1. ESTABLISHMENT, OBJECTIVES, AND DURATION 1.1 ESTABLISHMENT OF THE PLAN. Tollgrade Communications, Inc., a Pennsylvania corporation (hereinafter referred to as the "Company"), hereby establishes an incentive compensation plan to be known as the "Tollgrade Communications, Inc. Long-Term Incentive Compensation Plan" (hereinafter referred to as the "Plan"), as set forth in this document. The Plan permits the grant of Nonqualified Stock Options, Incentive Stock Options, Stock Appreciation Rights, Restricted Stock, Performance Shares and Performance Units. Subject to approval by the Company's stockholders, the Plan shall become effective as of November 15, 1995 (the "Effective Date") and shall remain in effect as provided in Section 1.3 hereof. 1.2 OBJECTIVES OF THE PLAN. The objectives of the Plan are to optimize the profitability and growth of the Company through incentives which are consistent with the Company's goals and which link the personal interests of Participants to those of the Company's stockholders; to provide Participants with an incentive for excellence in individual performance; and to promote teamwork among Participants. The Plan is further intended to provide flexibility to the Company in its ability to motivate, attract and retain the services of Participants who make significant contributions to the Company's success and to allow Participants to share in the success of the Company. 1.3 DURATION OF THE PLAN. The Plan was adopted by the Board of Directors on October 16, 1995, subject to approval by the Company's stockholders, and shall commence on the Effective Date, as described in Section 1.1 hereof, and shall remain in effect, subject to the right of the Board of Directors to amend or terminate the Plan at any time pursuant to Article 15 hereof, until all Shares subject to it shall have been purchased or acquired according to the Plan's provisions. However, in no event may an Award be granted under the Plan on or after October 15, 2005. ARTICLE 2. DEFINITIONS WHENEVER USED IN THE PLAN, THE FOLLOWING TERMS SHALL HAVE THE MEANINGS SET FORTH BELOW, AND WHEN THE MEANING IS INTENDED, THE INITIAL LETTER OF THE WORD SHALL BE CAPITALIZED: 2.1 "APPROPRIATE ADMINISTRATOR" means, in the case of any Awards to Employees, the Committee, and in the case of any Awards to Nonemployee Directors, the Board. 2.2 "AWARD" means, individually or collectively, a grant under this Plan of Nonqualified Stock Options, Incentive Stock Options, Stock Appreciation Rights, Restricted Stock, Performance Shares or Performance Units. 2.3 "AWARD AGREEMENT" means an agreement entered into by the Company and each Participant setting forth the terms and provisions applicable to Awards granted under this Plan. 2.4 "BENEFICIAL OWNER" OR "BENEFICIAL OWNERSHIP" shall have the meaning ascribed to such term in Rule 13d-3 of the General Rules and Regulations under the Exchange Act. 2.5 "BOARD" OR "BOARD OF DIRECTORS" means the Board of Directors of the Company. 2.6 "CAUSE" shall mean with respect to the termination of an Employee's employment, unless otherwise determined by the Committee at the time of the grant of the Award (i) in the case where there is no employment agreement, change of control agreement or similar agreement in effect between the Employee and the Company at the time of the grant of the Award (or where there is such an agreement but it does not define "cause" or words of like import), termination due to an Employee's dishonesty, fraud, conviction of a felony, insubordination, willful misconduct, refusal to perform services, or unsatisfactory performance of his or her duties for the Company as determined by the Committee in its sole discretion; or (ii) in the case where there is an employment agreement, change in control agreement or similar agreement in effect between the Employee and the Company at the time of the grant of the Award that defines "cause" (or words of like import), as defined under such agreement. 2.7 "CHANGE IN CONTROL" of the Company shall be deemed to have occurred (as of a particular day, as specified by the Board) if the Board, by a majority vote, agrees that a Change in Control has occurred, or is about to occur. Such a change shall not include, however, a restructuring, reorganization, merger, or other change in capitalization in which the Persons who own an interest in the Company on the Effective Date (the "Current Owners") (or any individual or entity which receives from a Current Owner an interest in the Company through will or the laws of descent and distribution) maintain more than a fifty percent (50%) interest in the resultant entity. Regardless of the Board's vote, a Change in Control will be deemed to have occurred as of the first day any one (1) or more of the following paragraphs shall have been satisfied: (a) Any Person (other than the Person in control of the Company as of the Effective Date of the Plan, or other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company, or a corporation owned directly or indirectly by the stockholders of the Company in substantially the same proportions as their ownership of stock of the Company), becomes the Beneficial Owner, directly or indirectly, of securities of the Company representing more than fifty percent (50%) of the combined voting power of the Company's then outstanding securities; or (b) The stockholders of the Company approve: (i) A plan of complete liquidation of the Company; or (ii) An agreement for the sale or disposition of all or substantially all of the Company's assets (other than one in which in the stockholders of the Company, as determined immediately prior to such transaction, hold, directly or indirectly, as determined immediately following such transaction, a majority of the voting power of each surviving, resulting or acquiring corporation which, immediately following such transaction, holds more than 10% of the consolidated assets of the Company immediately prior to the transaction); or (iii) A merger, consolidation, or reorganization of the Company with or involving any other corporation, other than a merger, consolidation, or reorganization that would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least fifty percent (50%) of the combined voting power of the voting securities of the Company (or such surviving entity) outstanding immediately after such merger, consolidation, or reorganization. However, in no event shall a Change in Control be deemed to have occurred, with respect to a Participant, if that Participant is part of a purchasing group, which consummates the Change in Control transaction. The Participant shall be deemed "part of a purchasing group" for purposes of the preceding sentence if the Participant is an equity participant or has agreed to become an equity participant in the purchasing company or group (except for (i) passive ownership of less than five percent (5%) of the voting equity securities of the purchasing company; or (ii) ownership of equity participation in the purchasing company or group which is otherwise deemed not to be significant, as determined prior to the Change in Control by a majority of the nonemployee continuing Directors). 2.8 "CODE" means the Internal Revenue Code of 1986, as amended from time to time. 2.9 "COMMITTEE" means the Compensation Committee of the Board, as specified in Article 3 herein, or such other Committee appointed by the Board to administer the Plan with respect to grants of Awards. 2.10 "COMPANY" means Tollgrade Communications, Inc., a Pennsylvania corporation, and any successor thereto as provided in Article 18 herein. 2.11 "DIRECTOR" means any individual who is a member of the Board of Directors of the Company. 2.12 "EFFECTIVE DATE" shall have the meaning ascribed to such term in Section 1.1 hereof. 2.13 "EMPLOYEE" means any full-time, active employee of the Company. Directors who are not employed by the Company shall not be considered Employees under this Plan. 2.14 "EXCHANGE ACT" means the Securities Exchange Act of 1934, as amended from time to time, or any successor act thereto. 2.15 "FAIR MARKET VALUE" shall be the mean between the following prices, as applicable, for the date as of which fair market value is to be determined as quoted in The Wall Street Journal (or in such other reliable publication as the Committee, in its discretion, may determine to rely upon): (i) if the Common Stock is listed on the New York Stock Exchange, the highest and lowest sales prices per share of the Common Stock as quoted in the NYSE Composite Transactions listing for such date, (ii) if the Common Stock is not listed on such exchange, the highest and lowest sales prices per share of Common Stock for such date on (or on any composite index including) the principal United States securities exchange registered under the 1934 Act on which the Common Stock is listed or (iii) if the Common Stock is not listed on any such exchange, the highest and lowest sales prices per share of the Common Stock for such date on the National Association of Securities Dealers Automated Quotations System or any successor system then in use ("NASDAQ"). If there are no such sale price quotations for the date as of which fair market value is to be determined but there are such sale price quotations within a reasonable period both before and after such date, then fair market value shall be determined by taking a weighted average of the means between the highest and lowest sales prices per share of the Common Stock as so quoted on the nearest date before and the nearest date after the date as of which fair market value is to be determined. The average should be weighted inversely by the respective numbers of trading days between the selling dates and the date as of which fair market value is to be determined. If there are no such sale price quotations on or within a reasonable period both before and after the date as of which fair market value is to be determined, then fair market value of the Common Stock shall be the mean between the bona fide bid and asked prices per share of Common Stock as so quoted for such date on NASDAQ, or if none, the weighted average of the means between such bona fide bid and asked prices on the nearest trading date before and the nearest trading date after the date as of which fair market value is to be determined, if both such dates are within a reasonable period. The average is to be determined in the manner described above in this Section 2.15. If the fair market value of the Common Stock cannot be determined on any basis previously set forth in this Section 2.15 for the date as of which fair market value is to be determined, the Committee shall in good faith determine the fair market value of the Common Stock on such date. Fair market value shall be determined without regard to any restriction other than a restriction which, by its terms, will never lapse. 2.16 "FREESTANDING SAR" means an SAR that is granted independently of any Options, as described in Article 7 herein. 2.17 "INCENTIVE STOCK OPTION" OR "ISO" means an option to purchase Shares granted under Article 6 herein and which is designated as an Incentive Stock Option and which is intended to meet the requirements of Code Section 422. 2.18 "INSIDER" shall mean an individual who, immediately prior to the grant of any Award, owns stock possessing more than ten percent (10%) of the total combined voting power of all classes of stock of the Company. For purposes of this Section 2.18, an individual (i) shall be considered as owning not only Shares of stock owned individually but also all Shares of stock that are at the time owned, directly or indirectly, by or for the spouse, ancestors, lineal descendants and brothers and sisters (whether by whole or half blood) of such individual and (ii) shall be considered as owning proportionately any Shares owned, directly or indirectly, by or for any corporation, partnership, estate or trust in which such individual is a stockholder, partner or beneficiary. 2.19 "NAMED EXECUTIVE OFFICER" means a Participant who, as of the date of vesting and/or payout of an Award, as applicable, is one of the group of "covered employees," as defined in the regulations promulgated under Code Section 162(m), or any successor statute. 2.20 "NONEMPLOYEE DIRECTOR" means an individual who is a member of the Board of Directors of the Company but who is not an Employee of the Company. 2.21 "NONQUALIFIED STOCK OPTION" OR "NQSO" means an option to purchase Shares granted under Article 6 herein and which is not intended to meet the requirements of Code Section 422. 2.22 "OPTION" means an Incentive Stock Option or a Nonqualified Stock Option, as described in Article 6 herein. 2.23 "OPTION PRICE" means the price at which a Share may be purchased by a Participant pursuant to an Option. 2.24 "PARTICIPANT" means an Employee or a Nonemployee Director who has outstanding an Award granted under the Plan. 2.25 PERFORMANCE-BASED EXCEPTION" means the performance-based exception from the tax deductibility limitations of Code Section 162(m). 2.26 "PERFORMANCE SHARE" means an Award granted to a Participant, as described in Article 9 herein. 2.27 "PERFORMANCE UNIT" means an Award granted to a Participant, as described in Article 9 herein. 2.28 "PERIOD OF RESTRICTION" means the period during which the transfer of Shares of Restricted Stock is limited in some way (based on the passage of time, the achievement of performance goals, or upon the occurrence of other events as determined by the Appropriate Administrator, at its discretion), and the Shares are subject to a substantial risk of forfeiture, as provided in Article 8 herein. 2.29 "PERSON" shall have the meaning ascribed to such term in Section 3(a)(9) of the Exchange Act and used in Sections 13(d) and 14(d) thereof, including a "group" as defined in Section 13(d) thereof. 2.30 "RESTRICTED STOCK" means an Award granted to a Participant pursuant to Article 8 herein. 2.31 "RETIREMENT" shall mean any voluntary termination of employment by an Employee following the attainment of age 65. 2.32 "SHARES" means the shares of Common Stock of the Company. 2.33 "STOCK APPRECIATION RIGHT" OR "SAR" means an Award, granted alone or in connection with a related Option, designated as an SAR, pursuant to the terms of Article 7 herein. 2.34 "TANDEM SAR" means an SAR that is granted in connection with a related Option pursuant to Article 7 herein, the exercise of which shall require forfeiture of the right to purchase a Share under the related Option (and when a share is purchased under the Option, the Tandem SAR shall similarly be canceled). Article 3. Administration 3.1 THE COMMITTEE. Except as set forth in Section 3.5 below, the Plan shall be administered by the Compensation Committee of the Board, or by any other Committee appointed by the Board consisting of not less than two (2) Directors who (i) are "non-employee" directors and otherwise meet the "disinterested administration" rules of Rule 16b-3 under the Exchange Act and (ii) are "outside directors" under Section 162(m)(4)(C) of the Code, or any successor provision. The members of the Committee shall be appointed from time to time by, and shall serve at the discretion of, the Board of Directors. 3.2 AUTHORITY OF THE COMMITTEE. Except as set forth in Section 3.4 below, except as limited by law or by the Articles of Incorporation or Bylaws of the Company, and subject to the provisions herein, the Committee shall have full power to grant Options (with or without SARs) and to award Restricted Stock, Performance Shares and Performance Units as described herein and to determine the Employees to whom any such Award shall be made and the number of Shares to be covered thereby; determine the sizes and types of Awards; determine the terms and conditions of Awards in a manner consistent with the Plan; construe and interpret the Plan and any agreement or instrument entered into under the Plan as they apply to Employees; and establish, amend, or waive rules and regulations for the Plan's administration as they apply to Employees; and (subject to the provisions of Article 15 herein) amend the terms and conditions of any outstanding Award except for Incentive Stock Options to the extent such terms and conditions are within the discretion of the Committee as provided in the Plan. Further, the Committee shall make all other determinations, which may be necessary or advisable for the administration of the Plan, as the Plan applies to Employees. As permitted by law the Committee may delegate its authority as identified herein. 3.3 DECISIONS BINDING. All determinations and decisions made by the Committee pursuant to the provisions of the Plan and all related orders and resolutions of the Board shall be final, conclusive and binding on all persons, including the Company, its stockholders, Employees, Participants, and their estates and beneficiaries. 3.4 NON-COMPETITION. If a grantee of an Option, Restricted Stock, Performance Units or Performance Shares (i) engages in the operation or management of a business (whether as owner, partner, officer, director, employee or otherwise and whether during or after termination of employment) which is in competition with the Company, (ii) induces or attempts to induce any customer, supplier, licensee or other individual, corporation or other business organization having a business relationship with the Company to cease doing business with the Company or in any way interferes with the relationship between any such customer, supplier, licensee or other person and the Company or (iii) solicits any employee of the Company to leave the employment thereof or in any way interferes with the relationship of such employee with the Company, the Appropriate Administrator, in its discretion, may immediately terminate all outstanding Options held by the grantee, declare forfeited all Restricted Stock held by the grantee as to which the restrictions have not yet lapsed and/or immediately cancel any award of Performance Units or Performance Shares. Whether a grantee has engaged in any of the activities referred to in the preceding sentence which would cause the outstanding Options to be terminated, and/or the Restricted Stock to be forfeited and/or any award of Performance Units or Performance Shares to be cancelled shall be determined, in its discretion, by the Appropriate Administrator, and any such determination by the Appropriate Administrator shall be final and binding. 3.5 GRANTS TO NONEMPLOYEE DIRECTORS. Notwithstanding the foregoing, unless otherwise determined by the Board, the Board shall grant Nonqualified Stock Options (with or without SARs) and award Restricted Stock, Performance Shares and Performance Units, and otherwise exercise the same authority as the Committee as described in Section 3.2 above, with respect to Nonemployee Directors. ARTICLE 4. SHARES SUBJECT TO THE PLAN AND MAXIMUM AWARDS 4.1 NUMBER OF SHARES AVAILABLE FOR GRANTS. Subject to adjustment as provided in Section 4.3 herein, the number of Shares hereby reserved for issuance to Participants under the Plan shall be 2,685,000; provided however, that, of that total, the maximum number of Shares of Restricted Stock granted pursuant to Article 8 herein, shall be 300,000. The following rules shall apply to grants of such Awards under the Plan: (a) The maximum aggregate number of Shares that may be granted or that may vest, as applicable, pursuant to any Award held by any one Named Executive Officer shall be 200,000 during any calendar year of the term of the Plan; (b) The maximum aggregate cash payout received during any fiscal year by any one Named Executive Officer with respect to Awards granted shall be $1 million. 4.2 LAPSED AWARDS. If any Award granted under this Plan is canceled, terminates, expires, or lapses for any reason (with the exception of the termination of a Tandem SAR upon exercise of the related Option, or the termination of a related Option upon exercise of the corresponding Tandem SAR), any Shares subject to such Award again shall be available for the grant of an Award under the Plan. 4.3 ADJUSTMENTS IN AUTHORIZED SHARES. In the event of any change in corporate capitalization, such as a stock split, or a corporate transaction, such as any merger, consolidation, separation, including a spin-off, or other distribution of stock or property of the Company, any reorganization (whether or not such reorganization comes within the definition of such term in Code Section 368) or any partial or complete liquidation of the Company, such adjustment shall be made in the number and class of Shares which may be delivered under Section 4.1 and as to the number of Shares which may be awarded under the Plan to any Named Executive Officer during the term of the Plan, and in the number and class of and/or price of Shares subject to outstanding Awards granted under the Plan, as may be determined to be appropriate and equitable by the Committee, in its sole discretion, to prevent dilution or enlargement of rights; provided, however, that the number of Shares subject to any Award shall always be a whole number. ARTICLE 5. ELIGIBILITY AND PARTICIPATION 5.1 ELIGIBILITY. Persons eligible to participate in this Plan include all Employees of the Company (including, but not limited to, Employees who are members of the Board, covered employees as defined in Section 162(m)(3) of the Code, or any successor provision) and all Nonemployee Directors of the Company. 5.2 ACTUAL PARTICIPATION. Subject to the provisions of the Plan, the Committee may, from time to time, select from all eligible Employees those to whom Awards shall be granted and shall determine the nature and amount of each Award and the Board may, from time to time, select from all eligible Nonemployee Directors those to whom Awards shall be granted and shall determine the nature and amount of each Award. ARTICLE 6. STOCK OPTIONS 6.1 GRANT OF OPTIONS. Subject to the terms and provisions of the Plan, the Committee may grant Incentive Stock Options or Nonqualified Stock Options or both types of Options (but not in tandem) to Employees and the Board may grant Nonqualified Stock Options to Nonemployee Directors in such number, and upon such terms, and at any time and from time to time as shall be determined by the Appropriate Administrator. 6.2 AWARD AGREEMENT. Each Option grant shall be evidenced by an Award Agreement that shall specify the Option Price, the duration of the Option, the number of Shares to which the Option pertains, and such other provisions as the Appropriate Administrator shall determine. The Award Agreement also shall specify whether the Option is intended to be an ISO within the meaning of Code Section 422, or an NQSO whose grant is intended not to fall under the provisions of Code Section 422. 6.3 OPTION PRICE. The Option Price at which each Option may be exercised shall be no less than one hundred percent (100%) of the fair market value per share of the Common Stock covered by the Option on the date of grant, except that in the case of an Incentive Stock Option granted to an Insider, the option price shall not be less than one hundred ten percent (110%) of such fair market value on the date of grant. For purposes of this Section 6.3, the fair market value of the Common Stock shall be as determined in Section 2.15 6.4 DURATION OF OPTIONS. Each Option granted to a Participant shall expire at such time as the Appropriate Administrator shall determine at the time of grant; provided, however, that no Option shall be exercisable after the expiration of ten years (five years in the case of an Incentive Stock Option granted to an Insider) from the date of grant. 6.5 EXERCISE OF OPTIONS. Options granted under this Article 6 shall be exercisable at such times and be subject to such restrictions and conditions as the Appropriate Administrator shall in each instance approve, which need not be the same for each grant or for each Participant. Notwithstanding any other provision contained in the Plan or in any Award Agreement referred to in Section 2.3, but subject to the possible exercise of the Committee's discretion contemplated in the last sentence of this paragraph, the aggregate fair market value, determined as provided in Section 2.15 on the date of grant, of the Shares with respect to which Incentive Stock Options are exercisable for the first time by an Employee during any calendar year under all plans of the corporation employing such Employee, any parent or subsidiary corporation of such corporation and any predecessor corporation of any such corporation shall not exceed $100,000. If the date on which one or more of such Incentive Stock Options could first be exercised would be accelerated pursuant to any provision of the Plan or any Award Agreement, and the acceleration of such exercise date would result in a violation of the limitation set forth in the preceding sentence, then, notwithstanding any such provision, but subject to the provisions of the next succeeding sentence, the exercise dates of such Incentive Stock Options shall be accelerated only to the date or dates, if any, that do not result in a violation of such limitation and, in such event, the exercise dates of the Incentive Stock Options with the lowest Option Prices shall be accelerated to the earliest such dates. The Committee may, in its discretion, authorize the acceleration of the exercise date of one or more Incentive Stock Options even if such acceleration would violate the $100,000 limitation set forth in the first sentence of this paragraph and even if such Incentive Stock Options are thereby converted in whole or in part to Nonqualified Stock Options. 6.6 PAYMENT. Options granted under this Article 6 shall be exercised by the delivery of a written notice of exercise to the Company, setting forth the number of Shares with respect to which the Option is to be exercised, accompanied by full payment for the Shares. The Option Price upon exercise of any Option shall be payable to the Company in full either: (a) in cash in United States dollars (including check, bank draft or money order), or (b) by tendering previously acquired Shares having an aggregate Fair Market Value at the time of exercise equal to the total Option Price, or (c) by a combination of (a) and (b). The Company will also cooperate with any person exercising an Option who participates in a cashless exercise program of a broker or other agent under which all or part of the Shares received upon exercise of the Option are sold through the broker or other agent or under which the broker or other agent makes a loan to such person. Notwithstanding the foregoing, unless the Appropriate Administrator, in its discretion, shall otherwise determine at the time of grant in the case of an Incentive Stock Option, or at any time in the case of a Nonqualified Stock Option, the exercise of the Option shall not be deemed to occur and no Shares of Common Stock will be issued by the Company upon exercise of the Option until the Company has received payment of the Option Price in full. 6.7 RESTRICTIONS ON SHARE TRANSFERABILITY. The Appropriate Administrator may impose such restrictions on any Shares acquired pursuant to the exercise of an Option granted under this Article 6 as it may deem advisable, including, without limitation, restrictions under applicable Federal securities laws, under the requirements of any stock exchange or market upon which such Shares are then listed and/or traded, and under any blue sky or state securities laws applicable to such Shares. 6.8 TERMINATION OF EMPLOYMENT. Subject to the provisions of Section 6.5 in the case of Incentive Stock Options, unless the Committee, in its discretion, shall otherwise determine: (i) If the employment of an Employee who is not disabled within the meaning of Section 422(c)(6) of the Code (a "Disabled Grantee") is voluntarily terminated with the consent of the Company or an Employee retires under any retirement plan of the Company, any outstanding Incentive Stock Option held by such Employee shall be exercisable by the Employee (but only to the extent exercisable by the Employee immediately prior to the termination of employment) at any time prior to the expiration date of such Incentive Stock Option or within three months after the date of termination of employment, whichever is the shorter period; (ii) If the employment of an Employee who is not a Disabled Grantee is voluntarily terminated with the consent of the Company or an Employee retires under any retirement plan of the Company, any outstanding Nonqualified Stock Option held by such Employee shall be exercisable by the Employee (but only to the extent exercisable by the Employee immediately prior to the termination of employment) at any time prior to the expiration date of such Nonqualified Stock Option or within one year after the date of termination of employment, whichever is the shorter period; (iii)If the employment of an Employee who is a Disabled Grantee is voluntarily terminated with the consent of the Company, any outstanding Option held by such Employee shall be exercisable by the Employee in full (whether or not so exercisable by the Employee immediately prior to the termination of employment) at any time prior to the expiration date of such Option or within one year after the date of termination of employment, whichever is the shorter period; (iv) Following the death of an Employee during employment, any outstanding Option held by the Employee at the time of death shall be exercisable in full (whether or not so exercisable by the Employee immediately prior to the death of the Employee) by the person entitled to do so under the Will of the Employee, or, if the Employee shall fail to make testamentary disposition of the stock option or shall die intestate, by the legal representative of the Employee at any time prior to the expiration date of such stock option or within one year after the date of death of the Employee, whichever is the shorter period; (v) Following the death of an Employee after termination of employment during a period when an Option is exercisable, the Option shall be exercisable by such person entitled to do so under the Will of the Employee by such legal representative (but only to the extent exercisable by the Employee immediately prior to the termination of employment) at any time prior to the expiration date of such Option or within one year after the date of death, whichever is the shorter period; (vi) Unless the exercise period of a stock option following termination of employment has been extended as provided in Section 14.1, if the employment of an Employee terminates for any reason other than voluntary termination with the consent of the Company, retirement under any retirement plan of the Company or death, all outstanding Options held by the Employee at the time of such termination of employment shall automatically terminate. provided, however, that if the employment of an Employee is involuntarily terminated by the Company without Cause, any Option held by such Employee at the time of such termination that was granted to Employee on or after May 3, 2001, shall be exercisable by the Employee (but only to the extent exercisable by the Employee immediately prior to the termination of employment) at any time prior to the expiration date of such Option or within one year after the date of termination of employment, whichever is the shorter period. Whether termination of employment is a voluntary termination with the consent of the Company or an involuntary termination with or without cause shall be determined, in its discretion, by the Committee and any such determination by the Committee shall be final and binding. 6.9 TERMINATION OF BOARD SERVICE. Unless the Board, in its discretion, shall otherwise determine: (i) If a Nonemployee Director ceases to be a Director of the Company for any reason other than resignation, removal for cause or death, any then outstanding stock option held by such Nonemployee Director shall be exercisable by the Nonemployee Director (but only to the extent exercisable by the Nonemployee Director immediately prior to ceasing to be a Director) at any time prior to the expiration date of such stock option or within one year after the date the Nonemployee Director ceases to be a Director, whichever is the shorter period; (ii) If during his or her term of office as a Director a Nonemployee Director resigns from the Board (which shall not include not standing for reelection at the end of his or her then current term) or is removed from office for cause, any then outstanding stock option held by such Nonemployee Director shall be exercisable by the Nonemployee Director (but only to the extent exercisable by the Nonemployee Director immediately prior to ceasing to be a Director) at any time prior to the expiration date of such stock option or within 90 days after the date of resignation or removal, whichever is the shorter period; (iii)Following the death of a Nonemployee Director during service as a Director of the Company, any outstanding stock option held by the Nonemployee Director at the time of death (whether or not exercisable by the Nonemployee Director immediately prior to death) shall be exercisable by the person entitled to do so under the Will of the Nonemployee Director, or, if the Nonemployee Director shall fail to make testamentary disposition of the stock option or shall die intestate, by the legal representative of the Nonemployee Director, at any time prior to the expiration date of such stock option or within one year after the date of death, whichever is the shorter period; (iv) Following the death of a Nonemployee Director after ceasing to be a Director, any outstanding stock option held by such Nonemployee Director at the time of death shall be exercisable (but only to the extent exercisable by the Nonemployee Director immediately prior to death) by such person entitled to do so under the Will of the Nonemployee Director or by such legal representative at any time prior to the expiration date of such stock option or within one year after the date of death, whichever is the shorter period. Interpretation of the foregoing shall be done by the Board and any determination by the Board shall be final and binding. 6.10 NONTRANSFERABILITY OF OPTIONS. No Option granted under the Plan may be sold, transferred, pledged, assigned, or otherwise alienated or hypothecated, other than by Will or if the Participant dies intestate by the laws of descent and distribution of the state of domicile of the Participant at the time of death. Further, all Options granted to a Participant under the Plan shall be exercisable during his or her lifetime only by such Participant. ARTICLE 7. STOCK APPRECIATION RIGHTS 7.1 GRANT OF SARS. Subject to the terms and conditions of the Plan, SARs may be granted to Participants at any time and from time to time as shall be determined by the Appropriate Administrator, provided however that any SAR granted in conjunction with an Incentive Stock Option may only be granted at the time the related Incentive Stock Option is granted. The Appropriate Administrator may grant Freestanding SARs, Tandem SARs, or any combination of these forms of SARs. The Appropriate Administrator shall have complete discretion in determining the number of SARs granted to each Participant (subject to Article 4 herein) and, consistent with the provisions of the Plan, in determining the terms and conditions pertaining to such SARs. The grant price of a Freestanding SAR shall equal the Fair Market Value of a Share on the date of grant of the SAR. The grant price of Tandem SARs shall equal the Option Price of the related Option, as provided in Section 6.3. 7.2 EXERCISE OF TANDEM SARS. Tandem SARs may be exercised for all or part of the Shares subject to the related Option upon the surrender of the right to exercise the equivalent portion of the related Option. A Tandem SAR may be exercised only with respect to the Shares for which its related Option is then exercisable. Notwithstanding any other provision of this Plan to the contrary, with respect to a Tandem SAR granted in connection with an ISO: (i) the Tandem SAR will expire no later than the expiration of the underlying ISO; (ii) the value of the payout with respect to the Tandem SAR may be for no more than one hundred percent (100%) of the difference between the Option Price of the underlying ISO and the Fair Market Value of the Shares subject to the underlying ISO at the time the Tandem SAR is exercised; and (iii) the Tandem SAR may be exercised only when the Fair Market Value of the Shares subject to the ISO exceeds the Option Price of the ISO. 7.3 EXERCISE OF FREESTANDING SARS. Freestanding SARs may be exercised upon whatever terms and conditions the Appropriate Administrator, in its sole discretion, imposes upon them. 7.4 SAR AGREEMENT. Each SAR grant shall be evidenced by an Award Agreement that shall specify the grant price, the term of the SAR, and such other provisions as the Appropriate Administrator shall determine. 7.5 TERM OF SARS. Except as otherwise provided in Section 7.2 in the case of a Tandem SAR granted in conjunction with an ISO, the term of an SAR granted under the Plan shall be determined by the Appropriate Administrator, in its sole discretion; provided, however, that such term shall not exceed ten (10) years. 7.6 PAYMENT OF SAR AMOUNT. Upon exercise of an SAR, a Participant shall be entitled to receive payment from the Company in an amount determined by multiplying: (a) The difference between the Fair Market Value of a Share on the date of exercise over the grant price; by (b) The number of Shares with respect to which the SAR is exercised. At the discretion of the Appropriate Administrator, the payment upon SAR exercise may be in cash, in Shares of equivalent value, or in some combination thereof. 7.7 RULE 16b-3 REQUIREMENTS. Notwithstanding any other provision of the Plan, the Appropriate Administrator may impose such conditions on exercise of an SAR as may be required to satisfy the requirements of Section 16 of the Exchange Act (or any successor rule). 7.8 TERMINATION OF EMPLOYMENT. Each SAR Award Agreement shall set forth the extent to which the Participant shall have the right to exercise the SAR following termination of the Participant's employment with the Company and/or its Subsidiaries or the Participant's termination of Board Service, as the case may be. Such provisions shall be determined in the sole discretion of the Appropriate Administrator, shall be included in the Award Agreement entered into with Participants, need not be uniform among all SARs issued pursuant to the Plan, and may reflect distinctions based on the reasons for termination of such employment or service. 7.9 NONTRANSFERABILITY OF SARS. No SAR granted under the Plan may be sold, transferred, pledged, assigned, or otherwise alienated or hypothecated, other than by will or, if the grantee dies intestate, by the laws of descent and distribution of the state of domicile of the grantee at the time of death. Further, all SARs granted to a Participant under the Plan shall be exercisable during his or her lifetime only by such Participant. ARTICLE 8. RESTRICTED STOCK 8.1 GRANT OF RESTRICTED STOCK. Subject to the terms and provisions of the Plan, the Appropriate Administrator, at any time and from time to time, may grant Shares of Restricted Stock to Participants in such amounts as the Appropriate Administrator shall determine. 8.2 RESTRICTED STOCK AGREEMENT. Each Restricted Stock grant shall be evidenced by a Restricted Stock Award Agreement that shall specify the Period(s) of Restriction, the number of Shares of Restricted Stock granted, and such other provisions as the Appropriate Administrator shall determine. 8.3 TRANSFERABILITY. Except as provided in this Article 8, the Shares of Restricted Stock granted herein may not be sold, transferred, pledged, assigned, or otherwise alienated or hypothecated until the end of the applicable Period of Restriction established by the Appropriate Administrator and specified in the Restricted Stock Award Agreement, or upon earlier satisfaction of any other conditions, as specified by the Appropriate Administrator in its sole discretion and set forth in the Restricted Stock Award Agreement. All rights with respect to the Restricted Stock granted to a Participant under the Plan shall be available during his or her lifetime only to such Participant. 8.4 OTHER RESTRICTIONS. Subject to Article 11 herein, the Appropriate Administrator shall impose such other conditions and/or restrictions on any Shares of Restricted Stock granted pursuant to the Plan as it may deem advisable including, without limitation, a requirement that Participants pay a stipulated purchase price for each Share of Restricted Stock, restrictions based upon the achievement of specific performance goals (Company-wide, divisional, and/or individual), time-based restrictions on vesting following the attainment of the performance goals, and/or restrictions under applicable Federal or state securities laws. The Company shall retain the certificates representing Shares of Restricted Stock in the Company's possession until such time as all conditions and/or restrictions applicable to such Shares have been satisfied. Except as otherwise provided in this Article 8, Shares of Restricted Stock covered by each Restricted Stock grant made under the Plan shall become freely transferable by the Participant after the last day of the applicable Period of Restriction. 8.5 VOTING RIGHTS. During the Period of Restriction, Participants holding Shares of Restricted Stock granted hereunder may exercise full voting rights with respect to those Shares. 8.6 DIVIDENDS AND OTHER DISTRIBUTIONS. During the Period of Restriction, Participants holding Shares of Restricted Stock granted hereunder may be credited with regular cash dividends paid with respect to the underlying Shares while they are so held. The Appropriate Administrator may apply any restrictions to the dividends that the Appropriate Administrator deems appropriate. Without limiting the generality of the preceding sentence, if the grant or vesting of Restricted Shares granted to a Named Executive Officer is designed to comply with the requirements of the Performance-Based Exception, the Committee may apply any restrictions it deems appropriate to the payment of dividends declared with respect to such Restricted Shares, such that the dividends and/or the Restricted Shares maintain eligibility for the Performance-Based Exception. In the event that any dividend constitutes a "derivative security" or an "equity security" pursuant to Rule 16(a) under the Exchange Act, such dividend shall be subject to a vesting period equal to the remaining vesting period of the Shares of Restricted Stock with respect to which the dividend is paid. 8.7 TERMINATION OF EMPLOYMENT. Each Restricted Stock Award Agreement shall set forth the extent to which the Participant shall have the right to receive unvested Restricted Shares following termination of the Participant's employment with the Company or service on the Board, as the case may be. Such provisions shall be determined in the sole discretion of the Appropriate Administrator, shall be included in the Award Agreement entered into with each Participant, need not be uniform among all Shares of Restricted Stock issued pursuant to the Plan, and may reflect distinctions based on the reasons for termination of such employment or service; provided, however that, except in the cases of terminations connected with a Change in Control and terminations by reason of death or disability the vesting of Shares of Restricted Stock which qualify for the Performance-Based Exception and which are held by Named Executive Officers shall occur at the time they otherwise would have, but for the employment termination. ARTICLE 9. PERFORMANCE UNITS AND PERFORMANCE SHARES 9.1 GRANT OF PERFORMANCE UNITS/SHARES. Subject to the terms of the Plan, Performance Units and/or Performance Shares may be granted to Participants in such amounts and upon such terms, and at any time and from time to time, as shall be determined by the Appropriate Administrator. 9.2 VALUE OF PERFORMANCE UNITS/SHARES. Each Performance Unit shall have an initial value that is established by the Appropriate Administrator at the time of grant. Each Performance Share shall have an initial value equal to the Fair Market Value of a Share on the date of grant. The Appropriate Administrator shall set performance goals in its discretion which, depending on the extent to which they are met, will determine the number and/or value of Performance Units/Shares that will be paid out to the Participant. For purposes of this Article 9, the time period during which the performance goals must be met shall be called a "Performance Period." 9.3 EARNING OF PERFORMANCE UNITS/SHARES. Subject to the terms of this Plan, after the applicable Performance Period has ended, the holder of Performance Units/Shares shall be entitled to receive payout on the number and value of Performance Units/Shares earned by the Participant over the Performance Period, to be determined as a function of the extent to which the corresponding performance goals have been achieved. 9.4 FORM AND TIMING OF PAYMENT OF PERFORMANCE UNITS/SHARES. Payment of earned Performance Units/Shares shall be made in a single lump sum within seventy-five (75) calendar days following the close of the applicable Performance Period. Subject to the terms of this Plan, the Appropriate Administrator, in its sole discretion, may pay earned Performance Units/Shares in the form of cash or in Shares (or in a combination thereof) which have an aggregate Fair Market Value equal to the value of the earned Performance Units/Shares at the close of the applicable Performance Period. Such Shares may be granted subject to any restrictions deemed appropriate by the Appropriate Administrator. At the discretion of the Appropriate Administrator, Participants may be entitled to receive any dividends declared with respect to Shares which have been earned in connection with grants of Performance Units and/or Performance Shares which have been earned, but not yet distributed to Participants (such dividends shall be subject to the same accrual, forfeiture, and payout restrictions as apply to dividends earned with respect to Shares of Restricted Stock, as set forth in Section 8.6 herein). In addition, Participants may, at the discretion of the Appropriate Administrator, be entitled to exercise their voting rights with respect to such Shares. 9.5 TERMINATION OF EMPLOYMENT DUE TO DEATH, DISABILITY, OR RETIREMENT. Unless determined otherwise by the Appropriate Administrator and set forth in the Participant's Award Agreement, in the event the employment or the Board service of a Participant is terminated by reason of death, disability, or Retirement during a Performance Period, the Participant shall receive a payout of the Performance Units/Shares which is prorated, as specified by the Appropriate Administrator in its discretion. Payment of earned Performance Units/Shares shall be made at a time specified by the Appropriate Administrator in its sole discretion and set forth in the Participant's Award Agreement. Notwithstanding the foregoing, with respect to Named Executive Officers who retire during a Performance Period, payments shall be made at the same time as payments are made to Participants who did not terminate employment during the applicable Performance Period. 9.6 TERMINATION OF EMPLOYMENT OR BOARD SERVICE FOR OTHER REASONS. In the event that a Participant's employment or Board service terminates for any reason other than those reasons set forth in Section 9.5 herein, all Performance Units/Shares shall be forfeited by the Participant to the Company unless determined otherwise by the Appropriate Administrator, as set forth in the Participant's Award Agreement. 9.7 NONTRANSFERABILITY. Performance Units/Shares may not be sold, transferred, pledged, assigned, or otherwise alienated or hypothecated, other than by will or if the grantee dies intestate by the laws of descent and distribution of the state of domicile of the grantee at the time of death. Further, a Participant's rights under the Plan shall be exercisable during the Participant's lifetime only by the Participant or the Participant's legal representative. ARTICLE 10. PERFORMANCE MEASURES Unless and until the Appropriate Administrator proposes for shareholder vote and shareholders approve a change in the general performance measures set forth in this Article 10, the attainment of which may determine the degree of payout and/or vesting with respect to Awards to Named Executive Officers which are designed to qualify for the Performance Based Exception, the performance measure(s) to be used for purposes of such grants shall be chosen from among the following alternatives: (a) Revenues of the Company or any specified division; (b) Percentage increase over a specified period in revenues of the Company or any specified division; (c) Expenses or any designated category of expenses of the Company or any specified division; (d) Percentage decrease over a specified period in expenses or any designated category of expenses of the Company or any specified division; (e) Pretax or after-tax income of the Company or any specified division; and (f) Percentage increase over a specified period in pretax or after-tax income of the Company or any specified division. The Appropriate Administrator shall have the discretion to adjust the determinations of the degree of attainment of the preestablished performance goals; provided, however, that Awards which are designed to qualify for the Performance Based Exception, and which are held by Named Executive Officers, may not be adjusted upward (the Committee shall retain the discretion to adjust such Awards downward). In the event that applicable tax and/or securities laws change to permit the Appropriate Administrator discretion to alter the governing performance measures without obtaining shareholder approval of such changes, the Appropriate Administrator shall have sole discretion to make such changes without obtaining shareholder approval. In addition, in the event that the Appropriate Administrator determines that it is advisable to grant Awards, which shall not qualify for the Performance-Based Exception, the Appropriate Administrator may make such grants without satisfying the requirements of Code Section 162(m). ARTICLE 11. BENEFICIARY DESIGNATION Each Participant under the Plan may, from time to time, name any beneficiary or beneficiaries (who may be named contingently or successively) to whom any benefit under the Plan is to be paid in case of his or her death before he or she receives any or all of such benefit. Each such designation shall revoke all prior designations by the same Participant, shall be in a form prescribed by the Company, and will be effective only when filed by the Participant in writing with the Company during the Participant's lifetime. In the absence of any such designation, benefits remaining unpaid at the Participant's death shall be paid to the Participant's estate. ARTICLE 12. DEFERRALS The Committee may permit or require a Participant to defer such Participant's receipt of the payment of cash or the delivery of Shares that would otherwise be due to such Participant by virtue of the exercise of an Option or SAR, the lapse or waiver of restrictions with respect to Restricted Stock, or the satisfaction of any requirements or goals with respect to Performance Units/Shares. If any such deferral election is required or permitted, the Appropriate Administrator shall, in its sole discretion, establish rules and procedures for such payment deferrals. ARTICLE 13. RIGHTS OF EMPLOYEES AND NONEMPLOYEE DIRECTORS 13.1 EMPLOYMENT AND BOARD SERVICE. Nothing in the Plan shall interfere with or limit in any way the right of the Company to terminate any Participant's employment at any time, nor confer upon any Participant any right to continue in the employ of the Company, nor shall it confer any right to a person to continue as a Director of the Company or interfere in any way with the rights of shareholders of the Company or the Board to elect and remove Directors. 13.2 PARTICIPATION. No Employee or Nonemployee Director shall have the right to be selected to receive an Award under this Plan, or, having been so selected, to be selected to receive a future Award. ARTICLE 14. CHANGE IN CONTROL 14.1 TREATMENT OF OUTSTANDING AWARDS. Upon the occurrence of a Change in Control, unless otherwise specifically prohibited under applicable laws, or by the rules and regulations of any governing governmental agencies or national securities exchanges: (a) Any and all Options and SARs granted hereunder shall become immediately exercisable, and shall remain exercisable throughout their entire term; (b) Any restriction periods and restrictions imposed on Restricted Shares shall lapse; (c) The target payout opportunities attainable under all outstanding Awards of Restricted Stock, Performance Units and Performance Shares shall be deemed to have been fully earned for the entire Performance Period(s) as of the effective date of the Change in Control. The vesting of all Awards denominated in Shares shall be accelerated as of the effective date of the Change in Control, and there shall be paid out in cash to Participants within thirty (30) days following the effective date of the Change in Control an amount equal to one hundred percent (100%) of all targeted cash payout opportunities associated with outstanding cash-based Awards; and (d) Subject to Article 15 herein, the Appropriate Administrator shall have the authority to make any modifications to the Awards as determined by the Appropriate Administrator to be appropriate before the effective date of the Change in Control. 14.2 ACCELERATION OF AWARD VESTING. Notwithstanding any provision of this Plan or any Award Agreement provision to the contrary, the Appropriate Administrator, in its sole and exclusive discretion, shall have the power at any time to accelerate the vesting of any Award granted under the Plan to a Participant, including without limitation acceleration to such a date that would result in said Awards becoming immediately vested, except that the Appropriate Administrator shall not have the authority to accelerate any Award that would otherwise qualify for the Performance-Based Exception in any manner that would cause the Award to fail to qualify as such. 14.3 TERMINATION, AMENDMENT, AND MODIFICATIONS OF CHANGE IN CONTROL PROVISIONS. Notwithstanding any other provision of this Plan or any Award Agreement provision, the provisions of this Article 14 may not be terminated, amended, or modified on or after the date of a Change in Control to affect adversely any Award theretofore granted under the Plan without the prior written consent of the Participant with respect to said Participant's outstanding Awards; provided, however, the Board of Directors, upon recommendation of the Committee, may terminate, amend, or modify this Article 14 at any time and from time to time prior to the date of a Change in Control. ARTICLE 15. AMENDMENT, MODIFICATION, AND TERMINATION 15.1 AMENDMENT, MODIFICATION, AND TERMINATION. The Board may at any time and from time to time, alter, amend, suspend or terminate the Plan in whole or in part; provided, however, that no amendment which requires shareholder approval in order for the Plan to continue to comply with Rule 16b-3 under the Exchange Act, including any successor to such Rule, shall be effective unless such amendment shall be approved by the requisite vote of shareholders of the Company entitled to vote thereon. 15.2 ADJUSTMENT OF AWARDS UPON THE OCCURRENCE OF CERTAIN UNUSUAL OR NONRECURRING EVENTS. The Committee may make adjustments in the terms and conditions of, and the criteria included in, Awards in recognition of unusual or nonrecurring events (including, without limitation, the events described in Section 4.3 hereof) affecting the Company or the financial statements of the Company or of changes in applicable laws, regulations, or accounting principles, whenever the Committee determines that such adjustments are appropriate in order to prevent dilution or enlargement of the benefits or potential benefits intended to be made available under the Plan; provided that no such adjustment shall be authorized to the extent that such authority would be inconsistent with the Plan's meeting the requirements of Section 162(m) of the Code, as from time to time amended. 15.3 AWARDS PREVIOUSLY GRANTED. No termination, amendment, or modification of the Plan shall adversely affect in any material way any Award previously granted under the Plan, without the written consent of the Participant holding such Award. 15.4 COMPLIANCE WITH CODE SECTION 162(M). Compliance with Code Section 162(m). At all times when Code Section 162(m) is applicable, all Awards granted under this Plan shall comply with the requirements of Code Section 162(m); provided, however, that in the event the Committee determines that such compliance is not desired with respect to any Award or Awards available for grant under the Plan, then compliance with Code Section 162(m) will not be required. In addition, in the event that changes are made to Code Section 162(m) to permit greater flexibility with respect to any Award or Awards available under the Plan, the Committee may, subject to this Article 15, make any adjustments it deems appropriate. ARTICLE 16. WITHHOLDING 16.1 TAX WITHHOLDING. The Company shall have the power and the right to deduct or withhold, or require an Employee to remit to the Company, an amount sufficient to satisfy Federal, state, and local taxes, domestic or foreign, required by law or regulation to be withheld with respect to any taxable event arising as a result of this Plan. 16.2 SHARE WITHHOLDING. With respect to withholding required upon the exercise of Options or SARs, upon the lapse of restrictions on Restricted Stock, or upon any other taxable event arising as a result of Awards granted hereunder, Employees may elect, subject to the approval of the Committee, to satisfy the withholding requirement, in whole or in part, by having the Company withhold Shares having a Fair Market Value on the date the tax is to be determined equal to the minimum statutory total tax which could be imposed on the action. All such elections shall be irrevocable, made in writing, signed by the Employee, and shall be subject to any restrictions or limitations that the Committee, in its sole discretion, deems appropriate. ARTICLE 17. INDEMNIFICATION Each person who is or shall have been a member of the Committee, or of the Board, shall be indemnified and held harmless by the Company against and from any loss, cost, liability or expense that may be imposed upon or reasonably incurred by him or her in connection with or resulting from any claim, action, suit, or proceeding to which he or she may be a party or in which he or she may be involved by reason of any action taken or failure to act under the Plan and against and from any and all amounts paid by him or her in settlement thereof, with the Company's approval, or paid by him or her in satisfaction of any judgment in any such action, suit, or proceeding against him or her, provided he or she shall give the Company an opportunity at its own expense, to handle and defend the same before he or she undertakes to handle and defend it on his or her own behalf. The foregoing right of indemnification shall not be exclusive of any other rights of indemnification to which such persons may be entitled under the Company's Articles of Incorporation or Bylaws, as a matter of law, or otherwise, or any power that the Company may have to indemnify them or hold them harmless. ARTICLE 18. SUCCESSOR All obligations of the Company under the Plan with respect to Awards granted hereunder shall be binding on any successor to the Company, whether the existence of such successor is the result of a direct or indirect purchase, merger, consolidation, or otherwise, of all or substantially all of the business and/or assets of the Company. ARTICLE 19. LEGAL CONSTRUCTION 19.1 GENDER AND NUMBER. Except where otherwise indicated by the context, any masculine term used herein also shall include the feminine; the plural shall include the singular and the singular shall include the plural. 19.2 SEVERABILITY. In the event any provision of the Plan shall be held illegal or invalid for any reason, the illegality or invalidity shall not affect the remaining parts of the Plan, and the Plan shall be construed and enforced as if the illegal or invalid provision had not been included. ARTICLE 20. REQUIREMENTS OF LAW. The granting of Awards and the issuance of Shares under the Plan shall be subject to all applicable laws, rules, and regulations, and to such approvals by any governmental agencies or national securities exchanges as may be required. ARTICLE 21. SECURITIES LAW COMPLIANCE. With respect to (i) a Director of the Company, (ii) an executive officer of the Company or other person who is required to file reports pursuant to the rules promulgated under Section 16 of the Exchange Act and (iii) Insiders, transactions under this Plan are intended to comply with all applicable conditions or Rule 16b-3 or its successors under the Exchange Act. To the extent any provision of the Plan or action by the Appropriate Administrator fails to so comply, it shall be deemed null and void, to the extent permitted by law and deemed advisable by the Appropriate Administrator. ARTICLE 22. GOVERNING LAW. To the extent not preempted by Federal law, the Plan and all agreements hereunder, shall be construed in accordance with and governed by the laws of the Commonwealth of Pennsylvania. EX-10.32 4 j9710001exv10w32.txt 1998 EMPLOYEE INCENTIVE COMPENSATION PLAN EXHIBIT 10.32 TOLLGRADE COMMUNICATIONS, INC. 1998 EMPLOYEE INCENTIVE COMPENSATION PLAN (AS AMENDED THROUGH JANUARY 24, 2002) ARTICLE 1. ESTABLISHMENT, OBJECTIVES AND DURATION. 1.1 ESTABLISHMENT OF THE PLAN. Tollgrade Communications, Inc., a Pennsylvania corporation (hereinafter referred to as the "Company"), hereby establishes an incentive compensation plan for all employees excluding officers and directors of the Company, to be known as the "Tollgrade Communications, Inc. 1998 Employee Incentive Compensation Plan" (hereinafter referred to as the "Plan"), as set forth in this document. The Plan permits the grant of Nonqualified Stock Options, Stock Appreciation Rights, Restricted Stock, Performance Shares and Performance Units. The Plan shall be effective as of January 29, 1998 (the "Effective Date") and shall remain in effect as provided in SECTION 1.3 hereof. 1.2 OBJECTIVES OF THE PLAN. The objectives of the Plan are to optimize the profitability and growth of the Company through incentives which are consistent with the Company's goals and which link the personal interests of Employees to those of the Company's stockholders; to provide Employees with an incentive for excellence in individual performance; and to promote teamwork among Employees. The Plan is further intended to provide flexibility to the Company in its ability to motivate, attract, and retain the services of Employees who make significant contributions to the Company's success and allow Employees to share in the success of the Company. 1.3 DURATION OF THE PLAN. The Plan was adopted by the Board of Directors on January 29, 1998, and shall commence on the Effective Date, as described in SECTION 1.1 hereof, and shall remain in effect, subject to the right of the Board of Directors to amend or terminate the Plan at any time pursuant to ARTICLE 14 hereof, until all Shares subject to it shall have been purchased or acquired according to the Plan's provisions. However, in no event shall an Award be granted under the Plan on or after January 29, 2008. ARTICLE 2. DEFINITIONS Whenever used in the Plan, the following terms shall have the meanings set forth below, and when the meaning is intended, the initial letter of the word shall be capitalized: 2.1 "AWARD" means, individually or collectively, a grant under this Plan of Nonqualified Stock Options, Stock Appreciation Rights, Restricted Stock, Performance Shares or Performance Units. 2.2 "AWARD AGREEMENT" means an agreement entered into by the Company and each Employee setting forth the terms and provisions applicable to Awards granted under this Plan. 2.3 "BENEFICIAL OWNER" OR "BENEFICIAL OWNERSHIP" shall have the meaning ascribed to such term in Rule 13d-3 of the General Rules and Regulations under the Exchange Act. 2.4 "BOARD" OR "BOARD OF DIRECTORS" means the Board of Directors of the Company. 2.5 "CAUSE" shall mean with respect to the termination of an Employee's employment, unless otherwise determined by the Committee at the time of the grant of the Award (i) in the case where there is no employment agreement, change of control agreement or similar agreement in effect between the Employee and the Company at the time of the grant of the Award (or where there is such an agreement but it does not define "cause" or words of like import), termination due to an Employee's dishonesty, fraud, conviction of a felony, insubordination, willful misconduct, refusal to perform services, or unsatisfactory performance of his or her duties for the Company as determined by the Committee in its sole discretion; or (ii) in the case where there is an employment agreement, change in control agreement or similar agreement in effect between the Employee and the Company at the time of the grant of the Award that defines "cause" (or words of like import), as defined under such agreement. 2.6 "CHANGE IN CONTROL" of the Company shall be deemed to have occurred (as of a particular day, as specified by the Board) if the Board, by a majority vote, agrees that a Change in Control has occurred, or is about to occur. Such a change shall not include, however, a restructuring, reorganization, merger or other change in capitalization in which the Persons who own an interest in the Company on the Effective Date (the "Current Owners") (or any individual or entity which received from a Current Owner an interest in the Company through will or the laws of descent and distribution) maintain more than a fifty percent (50%) interest in the resultant entity. Regardless of the Board's vote, a Change in Control will be deemed to have occurred as of the first day any one (1) or more of the following paragraphs shall have been satisfied: (a) Any Person (other than the Person in control of the Company as of the Effective Date of the Plan, or other than a trustee or other fiduciary holding securities under an employee benefit plan of the Company, or a corporation owned directly or indirectly by the stockholders of the Company in substantially the same proportions as their ownership of stock in the Company), becomes the Beneficial Owner, directly or indirectly, of securities of the Company representing more than fifty percent (50%) of the combined voting power of the Company's then outstanding securities; or (b) The stockholders of the Company approve: (i) A plan of complete liquidation of the Company; or (ii) An agreement for the sale or disposition of all or substantially all of the Company's assets (other than one in which the stockholders of the Company, as determined immediately prior to such transaction, hold, directly or indirectly, as determined immediately following such transaction, a majority of the voting power of each surviving, resulting or acquiring corporation which, immediately following such transaction, holds more than 10% of the consolidated assets of the Company immediately prior to the transaction); or (iii) A merger, consolidation, or reorganization of the Company with or involving any other corporation, other than a merger, consolidation, or reorganization that would result in the voting securities of the Company outstanding immediately prior thereto continuing to represent (either by remaining outstanding or by being converted into voting securities of the surviving entity) at least fifty percent (50%) of the combined voting power of the voting securities of the Company (or such surviving entity) outstanding immediately after such merger, consolidation or reorganization. However, in no event shall a Change in Control be deemed to have occurred, with respect to a Employee, if that Employee is part of a purchasing group which consummates the Change in Control transaction. The Employee shall be deemed "part of a purchasing group" for purposes of the preceding sentence if the Employee is an equity participant or has agreed to become an equity participant in the purchasing company or group (except for (i) passive ownership of less than five percent (5%) of the voting equity securities of the purchasing company; or (ii) ownership of equity participation in the purchasing company or group which is otherwise deemed not to be significant, as determined prior to the Change in Control by a majority of the nonemployee continuing Directors). 2.7 "CODE" means the Internal Revenue Code of 1986, as amended from time to time. 2.8 "COMMITTEE" means the Compensation Committee of the Board, as specified in ARTICLE 3 herein, or such other Committee appointed by the Board to administer the Plan with respect to grants of Awards. 2.9 "COMPANY" means Tollgrade Communications, Inc., a Pennsylvania corporation, any successor thereto as provided in ARTICLE 17 herein. 2.10 "DIRECTOR" means any individual who is a member of the Board of Directors of the Company. 2.11 "EFFECTIVE DATE" shall have the meaning ascribed to such term in SECTION 1.1 hereof. 2.12 "EMPLOYEE" means any full-time active employee of the Company who is not an Officer, as defined in SECTION 2.18 hereof. Directors shall not be considered employees under the Plan. 2.13 "EXCHANGE ACT" means the Securities Exchange Act of 1934, as amended from time to time, or any successor act thereto. 2.14 "FAIR MARKET VALUE" shall be the mean between the following prices, as applicable, for the date as of which fair market value is to be determined as quoted in The Wall Street Journal (or in such other reliable publication as the Committee, in its discretion, may determine to rely upon): (i) if the Common Stock is listed on the New York Stock Exchange, the highest and lowest sales prices per share of the Common Stock as quoted in the NYSE Composite Transactions listing for such date, (ii) if the Common Stock is not listed on such exchange, the highest and lowest sales prices per share of Common Stock for such date on (or on any composite index including) the principal united States securities exchange registered under the 1934 Act on which the Common Stock is listed or (iii) if the Common Stock is not listed on such exchange, the highest and lowest sales prices per share of the Common Stock for such date on the National Association of Securities Dealers Automated Quotations System or any successor system then in use ("NASDAQ"). If there are no such sale price quotations for the date as of which fair market value is to be determined but there are such sale price quotations within a reasonable period both before and after such date, then fair market value shall be determined by taking a weighted average of the means between the highest and lowest sales prices per share of the Common Stock as so quoted on the nearest date before and the nearest date after the date as of which fair market value is to be determined. The average should be weighted inversely by the respective number of trading days between the selling dates and the date as of which fair market value is to be determined. If there are no such sale prices quotations on or within a reasonable period both before and after the date as of which fair market value is to be determined, then fair market value of the Common Stock shall be the mean between the bona fide bid and asked prices per share of Common Stock as so quoted for such date on NASDAQ, or if none, the weighted average of the means between such bona fide bid and asked prices on the nearest trading date before and the nearest trading date after the date as of which fair market value is to be determined, if both such dates are within a reasonable period. The average is to be determined in the manner described above in this SECTION 2.14. If the fair market value of the Common Stock cannot be determined on any basis previously set forth in this SECTION 214 for the date as of which fair market value is to be determined, the Committee shall in good faith determine the fair market value of the Common Stock on such date. Fair market value shall be determined without regard to any restriction other than a restriction which, by its terms, will never lapse. 2.15 "FREESTANDING SAR" means an SAR that is granted independently of any Options, as described in ARTICLE 7 herein. 2.16 "INSIDER" shall mean an individual who, immediately prior to the grant of any Award, owns stock possessing more than ten percent (10%) of the total combined voting power of all classes of stock for the Company. For purposes of this SECTION 2.16, an individual (i) shall be considered as owning not only Shares of Stock owned individually but also all Shares of stock that are at the time owned, directly or indirectly, by or for the spouse, ancestors, lineal descendants and bothers and sisters (whether by whole or half blood) of such individual and (ii) shall be considered as owning proportionately any Shares owned, directly or indirectly, by or for any corporation, partnership, estate or trust in which such individual is a stockholder, partner or beneficiary. 2.17 "NONQUALIFIED STOCK OPTION" OR "NQSO" means an option to purchase Shares granted under ARTICLE 6 herein and which is not intended to meet the requirements of Code Section 422. 2.18 "OFFICER" means any person serving as an officer on behalf of the Company, as defined in the Company's bylaws and by requirements of Pennsylvania corporate law, and by the requirements of the rules of the National Association of Securities Dealers, Inc. 2.19 "OPTION" means a Nonqualified Stock Option, as described in ARTICLE 6 herein. 2.20 "OPTION PRICE" means the price at which a Share may be purchased by a Employee pursuant to an Option. 2.21 "PERFORMANCE-BASED EXCEPTION" means the performance-based exception from the tax deductibility limitations of Code Section 162(m). 2.22 "PERFORMANCE SHARE" means an Award granted to an Employee, as described in ARTICLE 9 herein. 2.23 "PERFORMANCE UNIT" means an award granted to an Employee, as described in ARTICLE 9 herein. 2.24 "PERIOD OF RESTRICTION" means the period during which the transfer of Shares of Restricted Stock is limited in some way (based upon the passage of time, the achievement of performance goals, or upon the occurrence of other events as determined by the Committee, at its discretion), and the Shares are subject to a substantial risk of forfeiture, as provided in ARTICLE 8 herein. 2.25 "PERSON" shall have the meaning ascribed to such term in Section 3(a)(9) of the Exchange Act and used in Sections 13(d) and 14(d) thereof, including a "group" as defined in Section 13(d) thereof. 2.26 "RESTRICTED STOCK" means an award granted to an Employee pursuant to ARTICLE 8 herein. 2.27 "RETIREMENT" shall mean any voluntary termination of employment by an Employee following the attainment of age 65. 2.28 "SHARES" means the shares of Common Stock of the Company. 2.29 "STOCK APPRECIATION RIGHT" OR "SAR" means an Award, granted alone or in connection with a related Option, designated as an SAR, pursuant to the terms of ARTICLE 7 herein. 2.30 "TANDEM SAR" means an SAR that is granted in connection with a related Option pursuant to ARTICLE 7 herein, the exercise of which shall require forfeiture of the right to purchase a Share under the related Option (and when a Share is purchased under the Option, the Tandem SAR shall similarly be canceled). ARTICLE 3. ADMINISTRATION 3.1 THE COMMITTEE. Except as set forth in SECTION 3.5 below, the Plan shall be administered by the Compensation Committee of the Board, or by any other Committee appointed by the Board consisting of not less than two (2) Directors who (i) are "non-employee" directors and otherwise meet the "disinterested administration" rules of Rule 16b-3 under the Exchange Act and (ii) are "outside directors" under Section 162(m)(4)(C) of the Code, or any successor provision. The members of the Committee shall be appointed from time to time by, and shall serve at the discretion of, the Board of Directors. 3.2 AUTHORITY OF THE COMMITTEE. Except as set forth in SECTION 3.4 below, except as limited by law or by the Articles of Incorporation or Bylaws of the Company, and subject to the provisions herein, the Committee shall have full power to grant Options (with or without SARs) and to award Restricted Stock, Performance Shares and Performance Units as described herein and to determine the Employees to whom any such award shall be made and the number of Shares to be covered thereby; determine the sizes and types of Awards; determine terms and conditions of Awards in a manner consistent with the Plan; construe and interpret the Plan and any agreement or instrument entered into under the Plan as they apply to Employees; and (subject to the provisions of ARTICLE 14 herein) amend the terms and conditions of any outstanding Award to the extent such terms and conditions are within the discretion of the Committee as provided in the Plan. Further, the Committee shall make all other determinations which may be necessary or advisable for the administration of the Plan, as the Plan applies to Employees. As permitted by law the Committee may delegate its authority as identified herein. 3.3 DECISIONS BINDING. All determinations and decisions made by the Committee pursuant to the provisions of the Plan and all related orders and resolutions of the Board shall be final, conclusive and binding on all persons, including the Company, its stockholders, Employees, and their estates and beneficiaries. 3.4 NON-COMPETITION. If a grantee of an Option, Restricted Stock, Performance Units or Performance Shares (i) engages in the operation or management of a business (whether as owner, partner, officer, director, employee or otherwise and whether during or after employment) which is in competition with the Company, (ii) induces or attempts to induce any customer, supplier, licensee or other individual, corporation or other business organization having a business relationship with the Company to cease doing business with the Company or any in any way interferes with the relationship between any such customer, supplier, licensee or other person and the Company or (iii) solicits any employee of the Company to leave the employment thereof or in any way interferes with the relationship of such employee with the Company, the Committee, in its discretion, may immediately terminate all outstanding Options held by the grantee, declare forfeited all Restricted Stock held by the grantee as to which the restrictions have not yet lapsed and/or immediately cancel any award of Performance Units or Performance Shares. Whether a grantee has engaged in any of the activities referred to in the preceding sentence which would cause the outstanding Options to be terminated, and/or the Restricted Stock to be forfeited and/or any award of Performance Units or Performance Shares to be canceled shall be determined, in its discretion, by the Committee, and any such determination by the Committee shall be final and binding. ARTICLE 4. SHARES SUBJECT TO THE PLAN 4.1 NUMBER OF SHARES AVAILABLE FOR GRANTS. Subject to adjustment as provided in SECTION 4.3 herein, the number of Shares hereby reserved for issuance to Employees under the Plan shall be 990,000; provided that, of that total, the maximum number of Shares of Restricted Stock granted pursuant to ARTICLE 8 herein, shall be 50,000. 4.2 LAPSED AWARDS. If any Award granted under this Plan is canceled, terminates, expires or lapses for any reason (with the exception of termination of a Tandem SAR upon exercise of the related Option, or the termination of a related Option upon exercise of the corresponding Tandem SAR), any Shares subject to such Award shall again be available for the grant of an Award under the Plan. 4.3 ADJUSTMENTS IN AUTHORIZED SHARES. In the event of any change in corporate capitalization, such as a stock split, or a corporate transaction, such as any merger, consolidation, separation, including a spin-off, or other distribution of stock or property of the Company, any reorganization (whether or nor such reorganization comes within the definition of such term in Code Section 368) or any partial or complete liquidation of the Company, such adjustment shall be made in the number and class of Shares which may be delivered under SECTION 4.1 and in the number and class of and/or price of Shares subject to outstanding Awards granted under the Plan, and in the number and class of and/or price of Shares subject to outstanding Awards granted under the Plan, as may be determined to be appropriate and equitable by the Committee, in its sole discretion, to prevent dilution or enlargement of rights; provided, however, that the number of Shares subject to any Award shall always be a whole number. ARTICLE 5. ELIGIBILITY AND PARTICIPATION 5.1 ELIGIBILITY. Persons eligible to participate in this Plan shall include all Employees of the Company, excluding Officers and Directors. 5.2 ACTUAL PARTICIPATION. Subject to the provisions of the Plan, the Committee may, from time to time, select from all eligible Employees those to whom Awards shall be granted and shall determine the nature and amount of each Award. ARTICLE 6. STOCK OPTIONS 6.1 GRANT OF OPTIONS. Subject to the terms and provisions of the Plan, the Committee may grant Nonqualified Stock Options in such number, and upon such terms, and at any time and from time to time as shall be determined by the Committee. 6.2 AWARD AGREEMENT. Each Option shall be evidenced by an Award Agreement that shall specify the Option Price, the duration of the Option, the number of Shares to which the Option pertains, and such other provisions as the Committee shall determine. 6.3 OPTION PRICE. The Option Price at which each Option may be exercised shall be no less than one hundred percent (100%) of the fair market value per share of the Common Stock covered by the Option on the date of grant. For purposes of this SECTION 6.3, the fair market value of the Common Stock shall be as determined in SECTION 2.15. 6.4 DURATION OF OPTIONS. Each Option granted to an Employee shall expire at such time as the Committee shall determine at the time of grant; provided, however, that no Option shall be exercisable after the expiration of ten years from the date of grant. 6.5 EXERCISE OF OPTIONS. Options granted under this Article 6 shall be exercisable at such times and be subject to such restrictions and conditions as the Committee shall in each instance approve, which need not be the same for each grant or for each Employee. 6.6 PAYMENT. Options granted under this Article 6 shall be exercised by the delivery of a written notice of exercise to the Company, setting forth the number of Shares with respect to which the Option is to be exercised, accompanied by full payment for the Shares. The Option Price upon exercise of the Option shall be payable to the Company in full either: (a) in cash in United States Dollars (including check, bank draft or money order), or (b) by tendering previously acquired Shares having an aggregate Fair Market Value at the time of exercise equal to the total Option Price, or (c) by a combination of (a) and (b). The Company will also cooperate with any person exercising an Option who participates in a cashless exercise program of a broker or other agent under which all or part of the Shares received upon exercise of the Option are sold through the broker or other agent or under which the broker or other agent makes a loan to such person. Notwithstanding the foregoing, unless the Committee, in its discretion, shall otherwise determine at the time of grant the exercise of the Option shall not be deemed to occur and no Shares of Common Stock will be issued by the Company upon exercise of the Option until the Company has received payment of the Option Price in full. 6.7 RESTRICTIONS ON SHARE TRANSFERABILITY. The Committee may impose restrictions on any Shares acquired pursuant to the exercise of an Option granted under this ARTICLE 6 as it may deem advisable, including, without limitation, restrictions under applicable Federal securities laws, under the requirements of any stock exchange or market upon which such Shares are then listed and/or traded, and under any blue sky or other state securities laws applicable to such Shares. 6.8 TERMINATION OF EMPLOYMENT. Unless the Committee, in its discretion, shall otherwise determine: (i) If the employment of an Employee who is not disabled within the meaning of Section 422(c)(6) of the Code (a "Disabled Grantee") is voluntarily terminated with the consent of the Company or an Employee retires under any retirement plan of the Company, any Option held by such Employee shall be exercisable by the Employee (but only to the extent exercisable by the Employee immediately prior to the termination of employment) at any time prior to the expiration date of such Option or within one year after the date of termination, whichever is the shorter period; (ii) If the employment of an Employee who is a Disabled Grantee is voluntarily terminated with the consent of the Company, any outstanding Option held by such Employee shall be exercisable by the Employee in full (whether or not so exercisable by the Employee immediately prior to the termination of employment) at any time prior to the expiration date of such Option or within one year after the date of termination of employment, whichever is the shorter period; (iii) Following the death of an Employee during employment, any outstanding Option held by the Employee at the time of death shall be exercisable in full (whether or not so exercisable by the Employee immediately prior to the death of the Employee) by the person entitled to do so under the Will of the Employee, or, if the Employee shall fail to make testamentary disposition of the stock option or shall die intestate, by the legal representative of the Employee at any time prior to the expiration date of such stock option or within one year after the date of death of the Employee, whichever is the shorter period; (iv) Following the death of an Employee after termination of employment during the period when an Option is exercisable, the Option shall be exercisable by such person entitled to do so under the Will of the Employee by such legal representative (but only to the extent exercisable by the Employee immediately prior to the termination of employment) at any time prior to the expiration date of such Option or within one year after the date of death, whichever is the shorter period; (v) Unless the exercise period of a stock option following termination of employment has been extended as provided in SECTION 13.1, if the employment of an Employee terminates for any reason other than voluntary termination with the consent of the Company, retirement under any retirement plan of the Company or death, all outstanding Options held by the Employee at the time of such termination of employment shall automatically terminate ; provided, however, that if the employment of an Employee is involuntarily terminated by the Company without Cause, any Option held by such Employee at the time of such termination that was granted to Employee on or after May 3, 2001, shall be exercisable by the Employee (but only to the extent exercisable by the Employee immediately prior to the termination of employment) at any time prior to the expiration date of such Option or within one year after the date of termination of employment, whichever is the shorter period. Whether termination of employment is a voluntary termination with the consent of the Company or an involuntary termination with or without cause shall be determined, in its discretion, by the Committee and any such determination by the Committee shall be final and binding. 6.9 NONTRANSFERABILITY OF OPTIONS. No Option granted under the Plan may be sold, transferred, pledged, assigned, or otherwise alienated or hypothecated, other than by Will or if the Employee dies intestate by the laws of descent and distribution of the state of domicile of the Employee at the time of death. Further, all Options granted to an Employee under the Plan shall be exercisable during his or her lifetime only by the Employee. ARTICLE 7. STOCK APPRECIATION RIGHTS 7.1 GRANT OF SARS. Subject to the terms and conditions of the Plan, SARs may be granted to Employees at any time and from time to time as shall be determined by the Committee. The Committee may grant Freestanding SARs, Tandem SARs, or any combination of these forms of SARs. The Committee shall have complete discretion in determining the number of SARs granted to each Employee (subject to ARTICLE 4 herein) and, consistent with the provisions of the Plan, in determining the terms and conditions pertaining to such SARs. The grant price of a Freestanding SAR shall equal the Fair Market Value of a Share on the date of grant of the SAR. The grant price of Tandem SARs shall equal the Option Price of the related Option, as provided in SECTION 6.3. 7.2 EXERCISE OF TANDEM SARS. Tandem SARs may be exercised for all or part of the Shares subject to the related Option upon the surrender of the right to exercise the equivalent portion of the related Option. A Tandem SAR may be exercised only with respect to the Shares for which its related Option is then exercisable. 7.3 EXERCISE OF FREESTANDING SARS. Freestanding SARs may be exercised upon whatever terms the Committee, in its sole discretion, imposes upon them. 7.4 SAR AGREEMENT. Each SAR grant shall be evidenced by an Award Agreement that shall specify the grant price, the term of the SAR, and such other provisions as the Committee shall determine. 7.5 TERM OF SARS. The term of an SAR granted under the Plan shall be determined by the Committee, in its sole discretion; provided however, that such term shall not exceed ten (10) years. 7.6 PAYMENT OF SAR AMOUNT. Upon exercise of an SAR, an Employee shall be entitled to receive payment from the Company in an amount determined by multiplying: (a) the difference between the Fair Market Value of a Share on the date of exercise over the grant price; by (b) the number of Shares with respect to which the SAR is granted. At the discretion of the Committee, the payment upon SAR exercise may be in cash, in Shares of equivalent value, or in some combination thereof. 7.7 RULE 16B-3 REQUIREMENTS. Notwithstanding any other provision of the Plan, the Committee may impose such conditions on the exercise of an SAR as may be required to satisfy the requirements of Section 16 of the Exchange Act (or any successor rule). 7.8 TERMINATION OF EMPLOYMENT. Each SAR Award Agreement shall set forth the extent to which the Employee shall have the right to exercise the SAR following termination of the Employee's employment with the Company and/or its Subsidiaries. Such provisions shall be determined in the sole discretion of the Committee, shall be included in the Award Agreement entered into with Employees, need not be uniform among all SARs issued pursuant to the Plan, and may reflect distinctions based on the reasons for termination of such employment. 7.9 NONTRANSFERABILITY OF SARS. No SAR granted under the Plan may be sold, transferred, pledged, assigned, or otherwise alienated or hypothecated, other than by will or, if the grantee dies intestate, by the laws of descent and distribution of the state of domicile of the grantee at the time of death. Further, all SARs granted to an Employee under the Plan shall be exercisable during his or her lifetime only by such Employee. ARTICLE 8. RESTRICTED STOCK 8.1 GRANT OF RESTRICTED STOCK. Subject to the terms and provisions of the Plan, the Committee, at any time and from time to time, may grant Shares of Restricted Stock to Employees in such amounts as the Committee shall determine. 8.2 RESTRICTED STOCK AGREEMENT. Each Restricted Stock grant shall be evidenced by a Restricted Stock Award Agreement that shall specify the Period(s) of Restriction, the number of Shares of Restricted Stock granted, and such other provisions as the Committee shall determine. 8.3 TRANSFERABILITY. Except as provided in this ARTICLE 8, the Shares of Restricted Stock granted herein may not be sold, transferred, pledged, assigned or otherwise alienated or hypothecated until the end of the applicable Period of Restriction established by the Committee and specified in the Restricted Stock Award Agreement, or upon earlier satisfaction of any other conditions, as specified by the Committee in its sole discretion and set forth in the Restricted Stock Award Agreement. All rights with respect to the Restricted Stock granted to an Employee under the Plan shall be available during his or her lifetime only to such Employee. 8.4 OTHER RESTRICTIONS. Subject to ARTICLE 10 herein, the Committee shall impose such other conditions and/or restrictions on any Shares of Restricted Stock granted pursuant to the Plan as it may deem advisable including, without limitation, a requirement that Employees pay a stipulated purchase price for each Share of Restricted Stock, restrictions based upon the achievement of specific performance goals (Company-wide, divisional, and/or individual), time-based restrictions on vesting following the attainment of the performance goals, and/or restrictions under applicable Federal or state securities laws. The Company shall retain the certificates representing Shares of Restricted Stock in the Company's possession until such time as all conditions and/or restrictions applicable to such Shares have been satisfied. Except as otherwise provided in this ARTICLE 8, Shares of Restricted Stock covered by each Restricted Stock grant made under the Plan shall become freely transferable by the Employee after the last day of the applicable Period of Restriction. 8.5 VOTING RIGHTS. During the Period of Restriction, Employees holding Shares of Restricted Stock granted hereunder may exercise full voting rights with respect to those Shares. 8.6 DIVIDENDS AND OTHER DISTRIBUTIONS. During the Period of Restriction, Employees holding Shares of Restricted Stock granted hereunder may be credited with regular cash dividends paid with respect to the underlying Shares while they are so held. The Committee may apply any restrictions to the dividends that the Committee deems appropriate. In the event that any dividend constitutes a "derivative security" or an "equity security" pursuant to Rule 16(a) under the Exchange Act, such dividend shall be subject to a vesting period equal to the remaining vesting period of the Shares of Restricted Stock with respect to which the dividend is paid. 8.7 TERMINATION OF EMPLOYMENT. Each Restricted Stock Award Agreement shall set forth the extent to which the Employee shall have the right to receive unvested Restricted Shares following termination of the Employee's employment with the Company. Such provisions shall be determined in the sole discretion of the Committee, shall be included in the Award Agreement entered into with each Employee, need not be uniform among all Shares of Restricted Stock issued pursuant to the Plan, and may reflect distinctions based upon the reasons for termination of such employment. ARTICLE 9. PERFORMANCE UNITS AND PERFORMANCE SHARES 9.1 GRANT OF PERFORMANCE UNITS/SHARES. Subject to the terms of the Plan, Performance Units and/or Performance Shares may be granted to Employees in such amounts and upon such terms, and at any time and from time to time, as shall be determined by the Committee. 9.2 VALUE OF PERFORMANCE UNITS/SHARES. Each Performance Unit shall have an initial value that is established by the Committee at the time of grant. Each Performance Share shall have an initial value equal to the Fair Market Value of a Share on the date of grant. The Committee shall set performance goals in its discretion which, depending upon the extent to which they are met, will determine the number and/or value of Performance Units/Shares that will be paid out to the Employee. For purposes of this ARTICLE 9, the time period during which the performance goals must be met shall be called a "Performance Period." 9.3 EARNING OF PERFORMANCE UNITS/SHARES. Subject to the terms of this Plan, after the applicable Performance Period has ended, the holder of Performance Units/Shares shall be entitled to receive payout on the number and value of Performance Units/Shares earned by the Employee over the Performance Period, to be determined as a function of the extent to which the corresponding performance goals have been achieved. 9.4 FORM AND TIMING OF PERFORMANCE UNITS/SHARES. Payment of earned Performance Units/Shares shall be made in a single lump sum within seventy-five (75) calendar days following the close of the applicable Performance Period. Subject to the terms of this Plan, the Committee, in its sole discretion, may pay earned Performance Units/Shares in the form of cash or Shares (or a combination thereof) which have an aggregate Fair Market Value equal to the value of the earned Performance Units/Shares at the close of the applicable Performance Period. Such Shares may be granted subject to any restrictions deemed appropriate by the Committee. At the discretion of the Committee, Employees may be entitled to receive any dividends declared with respect to Shares which have been earned in connection with grants of Performance Units and/or Performance Shares which have been earned, but not yet distributed to Employees (such dividends shall be subject to the same accrual, forfeiture, and payout restrictions as apply to dividends earned with respect to Shares of Restricted Stock, as set forth in SECTION 8.6 herein). In addition, Employees may, at the discretion of the Committee, be entitled to exercise their voting rights with respect to such Shares. 9.5 TERMINATION OF EMPLOYMENT DUE TO DEATH, DISABILITY OR RETIREMENT. Unless otherwise determined by the Committee and set forth in the Employee's Award Agreement, in the event the employment of an Employee is terminated by reason of death, disability or Retirement during a Performance Period, the Employee shall receive a payout of the Performance Units/Shares which is prorated, as specified by the Committee in its discretion. Payment of earned Performance Units/Shares shall be made at a time specified by the Committee in its sole discretion and set forth in the Employee's Award Agreement. 9.6 TERMINATION OF EMPLOYMENT FOR OTHER REASONS. In the event that an Employee's employment terminates for any reason other than those reasons set forth in SECTION 9.5 herein, all Performance Units/Shares shall be forfeited by the Employee to the Company unless determined otherwise by the Committee, as set forth in the Employee's Award Agreement. 9.7 NONTRANSFERABILITY. Performance Units/Shares may not be sold, transferred, pledged, assigned or otherwise alienated or hypothecated, other than by will or if the grantee dies intestate by the laws of descent and distribution of the state of domicile of the grantee at the time of death. Further, an Employee's rights under the Plan shall be exercisable during the Employee's lifetime only by the Employee or the Employee's legal representative. ARTICLE 10. BENEFICIARY DESIGNATION Each Employee under the Plan may, from time to time, name any beneficiary or beneficiaries (who may be named contingently or successively) to whom any benefit under the Plan is to be paid in case of his or her death before he or she receives any or all of such benefit. Each such designation shall revoke all prior designations by the same Employee, shall be in a form prescribed by the Company, and will be effective only when filed by the Employee in writing with the Company during the Employee's lifetime. In the absence of any such designation, benefits remaining unpaid at the Employee's death shall be paid to the Employee's estate. ARTICLE 11. DEFERRALS The Committee may permit or require an Employee to defer such Employee's receipt of the payment of cash or the delivery of Shares that would otherwise be due to such Employee by virtue of the exercise of an Option or SAR, the lapse or waiver of restrictions with respect to Restricted Stock, or the satisfaction of any requirements or goals with respect to Performance Units/Shares. If any such deferral election is required or permitted, the Committee shall, in its sole discretion, establish rules and procedures for such payment deferrals. ARTICLE 12. RIGHTS OF EMPLOYEES 12.1 EMPLOYMENT. Nothing in the Plan shall interfere with or limit in any way the right of the Company to terminate any Employee's employment at any time, nor confer upon any Employee any right to continue in the employ of the Company. 12.2 PARTICIPATION. No Employee shall be entitled to have the right to be selected to receive an Award under this Plan, or having been so selected, to be selected to receive a future Award. ARTICLE 13. CHANGE IN CONTROL 13.1 TREATMENT OF OUTSTANDING AWARDS. Upon the occurrence of a Change in Control, unless otherwise specifically prohibited under applicable laws, or by the rules and regulations of any governing governmental agencies or national securities exchanges: (a) Any and all Options and SARs granted hereunder shall become immediately exercisable, and shall remain exercisable throughout their entire term; (b) Any restriction periods and restrictions imposed on Restricted Shares shall lapse; (c) The target payout opportunities attainable under all outstanding Awards of Restricted Stock, Performance Units and Performance Shares shall be deemed to have been fully earned for the entire Performance Period(s) as of the effective date of the Change in Control. The vesting of all Awards denominated in Shares shall be accelerated as of the effective date of the Change in Control, and there shall be paid out in cash to Employees within thirty (30) days following the effective date of the Change in Control an amount equal to one hundred percent (100%) of all targeted cash payout opportunities associated with outstanding cash-based Awards; and (d) Subject to ARTICLE 14 herein, the Committee shall have the authority to make any modifications to the Awards as determined by the Committee to be appropriate before the effective date of the Change in Control. 13.2 ACCELERATION OF AWARD VESTING. Notwithstanding any provision of this Plan or any Award Agreement provision to the contrary, the Committee, in its sole and exclusive discretion, shall have the power at any time to accelerate the vesting of any Award granted under the Plan to any Employee, including without limitation acceleration to such a date that would result in said Awards becoming immediately vested. 13.3 TERMINATION, AMENDMENT AND MODIFICATIONS OF CHANGE IN CONTROL PROVISIONS. Notwithstanding any other provision of this Plan or any Award Agreement provision, the provisions of this ARTICLE 13 may not be terminated, amended or modified on or after the date of a Change in Control to affect adversely any Award theretofore granted under the plan without the prior written consent of the Employee with respect to said Employee's outstanding Awards; provided, however, the Board of Directors, upon recommendation of the committee, may terminate, amend, or modify this ARTICLE 13 at any time and from time to time prior to the date of a Change in Control. ARTICLE 14. AMENDMENT, MODIFICATION AND TERMINATION 14.1 AMENDMENT, MODIFICATION AND TERMINATION. The Board may at any time and from time to time, alter, amend, suspend, or terminate the Plan in whole or in part. 14.2 ADJUSTMENT OF AWARDS UPON THE OCCURRENCE OF CERTAIN UNUSUAL OR NONRECURRING EVENTS. The Committee may make adjustments in the terms and conditions of, and the criteria included in, Awards in recognition of unusual or nonrecurring events (including, without limitation, the events described in SECTION 4.3 hereof) affecting the Company or the financial statements of the Company or of changes in applicable laws, regulations, or accounting principles, whenever the Committee determined that such adjustments are appropriate in order to prevent dilution or enlargement of the benefits or potential benefits intended to be made available under the Plan; provided that no such adjustment shall be authorized to the extent that such authority would be inconsistent with the Plan's meeting the requirements of Section 162(m) of the Code, as from time to time amended. 14.3 AWARDS PREVIOUSLY GRANTED. No termination, amendment, or modification of the Plan shall adversely affect in any material way any Award previously granted under the Plan, without the written consent of the Employee holding such Award. 14.4 COMPLIANCE WITH CODE 162(M). At all times when Code Section 162(m) is applicable, all Awards granted under this Plan shall comply with the requirements of Code Section 162(m); provided, however, that in the event the Committee determines that such compliance is not desired with respect to any Award or Awards available for grant under the Plan, then compliance with Code Section 162(m) will not be required. In addition, in the event that any changes are made to Code Section 162(m) to permit greater flexibility with respect to any Award or Awards available under the Plan, the Committee may, subject to this ARTICLE 14, make any adjustments it deems appropriate. ARTICLE 15. WITHHOLDING 15.1 TAX WITHHOLDING. The Company shall have the power and the right to deduct or withhold, or require any Employee to remit to the Company, an amount sufficient to satisfy Federal, state and local taxes, domestic or foreign, required by law or regulation to be withheld with respect to any taxable event arising as a result of this Plan. 15.2 SHARE WITHHOLDING. With respect to withholding required upon the exercise of Options or SARs, upon the lapse of restrictions on Restricted Stock, or upon any other taxable event arising as a result of Awards granted hereunder, Employees may elect, subject to the approval of the Committee, to satisfy the withholding requirement, in whole or in part, by having the Company withhold Shares having a Fair Market Value on the date the tax is to be determined equal to the minimum statutory total tax which could be imposed on the action. All such elections shall be irrevocable, made in writing, signed by the Employee, and shall be subject to any restrictions or limitations that the Committee, in its sole discretion, may determine. ARTICLE 16. INDEMNIFICATION Each person who is or shall have been a member of the Committee, or of the Board, shall be indemnified and held harmless by the Company against and from any loss, cost, liability or expense that may be imposed upon or reasonably incurred by him or her in connection with or resulting from any claim, action, suit or proceeding to which he or she may be a party or in which he or she may be involved by reason of any action taken or failure to act under the Plan and against and from any and all amounts paid by him or her in settlement thereof, with the Company's approval, or paid by him or her in satisfaction of any judgment in any such action, suit or proceeding against him or her, provided he or she shall give the Company an opportunity at its own expense, to handle and defend the same before he or she undertakes to handle and defend it on his or her own behalf. The foregoing right of indemnification shall not be exclusive of any other right of indemnification to which such persons may be entitled under the Company's Articles of Incorporation or Bylaws, as a matter of law, or otherwise, or any power that the Company may have to indemnify them or hold them harmless. ARTICLE 17. SUCCESSOR All obligations of the Company under the Plan with respect to Awards granted hereunder shall be binding upon any successor to the Company, whether the existence of such successor is the result of a direct or indirect purchase, merger, consolidation, or otherwise, of all or substantially all of the business and/or assets of the Company. ARTICLE 18. LEGAL CONSTRUCTION 18.1 GENDER AND NUMBER. Except where otherwise indicated by the context, any masculine term used herein shall also include the feminine; the plural shall include the singular and the singular shall include the plural. 18.2 SEVERABILITY. In the event any provision of the Plan shall be held illegal or invalid for any reason, the illegality or invalidity shall not affect the remaining parts of the Plan, and the Plan shall be construed and enforced as if the illegal or invalid provision had not been included. 18.3 REQUIREMENTS OF LAW. The granting of Awards and the issuance of Shares under the Plan shall be subject to all applicable laws, rules, and regulations, and to such approvals by governmental agencies or national securities exchanges as may be required. 18.4 SECURITIES LAW COMPLIANCE. With respect to (i) any person who is required to file reports pursuant to the rules promulgated under Section 16 of the Exchange Act and (ii) insiders, transactions under this Plan are intended to comply with all applicable conditions of Rule 16b-3 or its successors under the Exchange Act. To the extent any provision of the Plan or action by the Committee fails to so comply, it will be deemed null and void to the extent permitted by law and deemed advisable by the Committee. 18.5 GOVERNING LAW. To the extent not preempted by Federal law, the Plan and all agreements hereunder, shall be construed in accordance with and governed by the laws of the Commonwealth of Pennsylvania. EX-15 5 j9710001exv15.txt LETTER TO SEC EXHIBIT 15 November 11, 2002 Securities and Exchange Commission 450 Fifth Street, N.W. Washington, D.C. 20549 RE: Tollgrade Communications, Inc. and subsidiaries 1). Form S-8 (Registration No. 333-4290 and Registration No. 333-83007) 1995 Long-Term Incentive Compensation Plan and Individual Stock Options Granted to Certain Directors and Employees Prior to the Adoption of the Plan 2). Form S-8 (Registration No. 333-52907 and Registration No. 333-55470) 1998 Employee Incentive Compensation Plan Commissioners: We are aware that our report dated October 14, 2002 on our review of interim financial information of Tollgrade Communications, Inc. and subsidiaries as of and for the three month and nine month periods ended September 28, 2002 and included in the Company's quarterly report on Form 10-Q for the quarter then ended is incorporated by reference in the registration statements referred to above. Very truly yours, /s/ PricewaterhouseCoopers LLP -----END PRIVACY-ENHANCED MESSAGE-----