Employee Benefits and Stock-Based Compensation

The Company records non-cash compensation expense for its outperform stock appreciation rights that it refers to as outperform stock options ("OSO"), restricted stock units and shares, 401(k) matching contributions, and other stock-based compensation associated with the Company's discretionary bonus grants. Total non-cash compensation expense related to these equity awards was $135 million in 2012, $101 million in 2011 and $67 million in 2010.

The following table summarizes non-cash compensation expense and capitalized non-cash compensation for each of the three years ended December 31, 2012, 2011 and 2010 (dollars in millions):



	2012			2011			2010
OSO	$	14		$	10		$	10
Restricted Stock Units and Shares	40			22			19
401(k) Match Expense	23			13			11
Restricted Stock Unit Bonus Grant	46			57			28
Management Incentive and Retention Plan	13			—			—
	136			102			68
Capitalized Non-Cash Compensation	(1		)	(1		)	(1		)
	$	135		$	101		$	67

The Company capitalizes non-cash compensation for those employees directly involved in the construction of the network, installation of services for customers or the development of business support systems.

OSOs and restricted stock units and shares are granted under the Level 3 Communications, Inc. Stock Plan, as amended (the "Stock Plan"), which term extends through May 20, 2020. The Stock Plan provides for accelerated vesting of stock awards upon retirement if an employee meets certain age and years of service requirements and certain other requirements. Under the Stock Compensation guidance, if an employee meets the age and years of service requirements under the accelerated vesting provision, the award would be expensed at grant or expensed over the period from the grant date to the date the employee meets the requirements, even if the employee has not actually retired. The Company recognized non-cash compensation expense for employees that met the age and years of service requirements for accelerated vesting at retirement of $9 million, $12 million and $8 million in 2012, 2011 and 2010, respectively.

Outperform Stock Options

The Company's OSO program was designed so that the Company's stockholders would receive a market return on their investment before OSO holders receive any return on their OSOs. The Company believes that the OSO program directly aligns management's and stockholders' interests by basing stock option value on the Company's ability to outperform the market in general, as measured by the Standard & Poor's ("S&P") 500® Index. Participants in the OSO program do not realize any value from awards unless the Company's common stock price outperforms the S&P 500® Index during the life of the grant. When the stock price gain is greater than the corresponding gain on the S&P 500® Index, the value received for awards under the OSO plan is based on a formula involving a multiplier related to the level by which the Company's common stock outperforms the S&P 500® Index. To the extent that Level 3's common stock outperforms the S&P 500® Index, the value of OSO units to a holder may exceed the value of non-qualified stock options.

The initial strike price, as determined on the day prior to the OSO grant date, is adjusted over time (the "Adjusted Strike Price"), until the settlement date. The adjustment is an amount equal to the percentage appreciation or depreciation in the value of the S&P 500® Index from the date of grant to the date of exercise. The value of the OSO increases for increasing levels of outperformance. OSO units have a multiplier range from zero to four depending upon the performance of Level 3 common stock relative to the S&P 500® Index as shown in the following table.



If Level 3 Stock Outperforms the S&P 500® Index by:		Then the Pre-multiplier Gain Is Multiplied by a Success Multiplier of:
0% or Less		—
More than 0% but Less than 11%		Outperformance percentage multiplied by 4/11
11% or More		4.00

The Pre-multiplier gain is the Level 3 common stock price minus the Adjusted Strike Price on the date of settlement.

Upon settlement of an OSO, the Company shall deliver or pay to the grantee the difference between the fair market value of a share of Level 3 common stock as of the day prior to the settlement date, less the Adjusted Strike Price (the "Exercise Consideration"). The Exercise Consideration may be paid in cash, Level 3 common stock or any combination of cash or Level 3 common stock at the Company's discretion. The number of shares of Level 3 common stock to be delivered by the Company to the grantee is determined by dividing the Exercise Consideration to be paid in Level 3 common stock by the fair market value of a share of Level 3 common stock as of the date prior to the settlement date. Fair market value is defined in the OSO agreement as the closing price per share of Level 3 common stock on the national securities exchange on which the common stock is traded. Settlement of the OSO units does not require any cash outlay by the employee.

As part of a comprehensive review of its long-term compensation program completed in the first quarter of 2007, beginning with awards made on or after April 1, 2007, OSO units were awarded monthly to employees in mid-management level and higher positions, have a three year life, vest 100% and fully settle on the third anniversary of the date of the award and are valued as of the first day of each month. Recipients have no discretion on the timing to exercise OSO units granted on or after April 1, 2007, thus the expected life of all such OSO units is three years. During the first quarter of 2010, the Company revised the eligibility criteria and grant schedule for its non-cash compensation. Effective April 1, 2010, the Company's OSOs are granted quarterly to certain levels of management. There were no changes to the vesting schedule, or any other aspects of the non-cash compensation plans.

As of December 31, 2012, there was $21 million of unamortized compensation expense related to granted OSO units. The weighted average period over which this cost will be recognized is 2.16 years.

The fair value of the OSO units granted is calculated by applying a modified Black-Scholes model with the assumptions identified below. The Company utilized a modified Black-Scholes model due to the additional variables required to calculate the effect of the market conditions and success multiplier of the OSO program. The Company believes that given the relative short life of the OSOs and the other variables used in the model, the modified Black-Scholes model provides a reasonable estimate of the fair value of the OSO units at the time of grant.



	Year Ended December 31,
	2012	2011	2010
S&P 500 Expected Dividend Yield Rate	2.05%	1.83%	2.00%
Expected Life	3 years	3 years	3 years
S&P 500 Expected Volatility Rate	23%	30%	30%
Level 3 Common Stock Expected Volatility Rate	39%	44%	51%
Expected S&P 500 Correlation Factor	0.32	0.39	0.40
Calculated Theoretical Value	110%	120%	132%
Estimated Forfeiture Rate	20%	20%	20%

The fair value of each OSO unit equals the calculated theoretical value multiplied by the Level 3 common stock price on the grant date.

As described above, recipients have no discretion on the timing to exercise OSO units. Thus the expected life of all such OSO units is three years. The Company estimates the stock price volatility using a combination of historical and implied volatility as Level 3 believes it is consistent with the approach most marketplace participants would consider using all available information to estimate expected volatility. The Company has determined that expected volatility is more reflective of market conditions and provides a more accurate indication of volatility than using solely historical volatility. In reaching this conclusion, the Company has considered many factors including the extent to which its future expectations of volatility over the respective term is likely to differ from historical measures, the absence of actively traded options and the Company's ability to review volatility of its publicly traded convertible debt with similar terms and prices to the securities the Company is valuing.

The fair value for OSO units awarded to participants during the years ended December 31, 2012, 2011 and 2010 was approximately $29 million, $12 million and $10 million, respectively.

Transactions involving OSO units awarded are summarized in the table below. The Option Price Per Unit identified in the table below represents the initial strike price, as determined on the day prior to the OSO grant date for those grants.



	Units		Initial Strike Price Per Unit					Weighted Average Initial Strike Price		Aggregate Intrinsic Value		Weighted Average Remaining Contractual Term (years)
										(in millions)
Balance January 1, 2010	1,056,627		$	10.50	-	$	91.50	$	44.25	$	5.2	1.55
Options granted	511,082		14.10		-	24.30		19.50
Options forfeited	(117,362	)	10.50		-	91.50		25.80
Options expired	(393,955	)	45.45		-	91.50		76.95
Options exercised	—		—		-	—		—
Balance December 31, 2010	1,056,392		$	10.50	-	$	51.60	$	22.05	$	—	1.73
Options granted	498,618		14.70		-	36.60		23.96
Options forfeited	(96,174	)	10.50		-	51.60		22.36
Options expired	(140,655	)	31.80		-	51.60		44.64
Options exercised	(29,469	)	14.10		-	15.75		14.93
Balance December 31, 2011	1,288,712		$	10.50	-	$	36.60	$	20.51	$	1.8	1.53
Options granted	1,195,452		16.99		-	27.53		24.65
Options forfeited	(72,335	)	12.00		-	36.60		21.80
Options expired	(278,111	)	15.00		-	22.65		18.45
Options exercised	(67,299	)	10.50		-	13.80		12.48
Balance December 31, 2012	2,066,419		$	14.10	-	$	36.60	$	23.40	$	6.6	1.73



					OSO units Outstanding at December 31, 2012				OSO units Exercisable at December 31, 2012
Range of Exercise Prices					Number Outstanding	Weighted Average Remaining Life (years)	Weighted Average Initial Strike Price		Number Exercisable	Weighted Average Initial Strike Price
$	14.10	-	$	20.85	496,213	1.04	$	15.95	—	$	—
$	22.05	-	$	24.30	793,617	1.76	$	22.68	—	$	—
$	27.53	-	$	36.60	776,589	2.14	$	28.89	—	$	—
					2,066,419	1.73	$	23.40	—	$	—

In the table above, the weighted average initial strike price represents the values used to calculate the theoretical value of OSO units on the grant date and the intrinsic value represents the value of OSO units that have outperformed the S&P 500® Index as of December 31, 2012. As noted above, all of the outstanding OSO units granted have an expected life of three years. The total intrinsic value of OSOs outstanding based on the Company's performance against the S&P 500® Index was zero, zero, and zero, as of December 31, 2012, 2011 and 2010, respectively.

The total realized value of OSO units settled was $0.8 million, $0.4 million and zero for the years ended December 31, 2012, 2011 and 2010, respectively. The Company issued zero, 13,742 and zero shares of Level 3 common stock upon the exercise of OSO units for the years ended December 31, 2012, 2011 and 2010, respectively. The Company paid cash in lieu of shares of Level 3 common stock for the realized value of OSO units settled for the year ended December 31, 2012. The number of shares of Level 3 common stock issued upon settlement of an OSO unit varies based upon the relative performance of Level 3 stock price and the S&P 500® Index between the initial grant date and settlement date of the OSO unit.

As of December 31, 2012, based on the Level 3 common stock price and post-multiplier values, the Company was obligated to issue no shares for vested and exercisable OSO units. As of December 31, 2012, there were no exercisable OSO units.

Restricted Stock and Units

Effective April 1, 2010, restricted stock units and shares are annually granted on July 1 to certain eligible recipients, including the Board of Directors, at no cost. Restrictions on transfer lapse over one to four year periods. The fair value of restricted stock units and shares awarded totaled $69 million, $35 million and $21 million for the years ended December 31, 2012, 2011 and 2010, respectively. The fair value of these awards was calculated using the value of the Level 3 common stock on the grant date and are being amortized over the periods in which the restrictions lapse. As of December 31, 2012, unamortized compensation cost related to nonvested restricted stock and restricted stock units was $43 million and the weighted average period over which this cost will be recognized is 2.8 years.

The changes in restricted stock and restricted stock units are shown in the following table:



	Number		Weighted Average Grant Date Fair Value
Nonvested at January 1, 2010	1,595,245		$	33.30
Stock and units granted	1,182,353		17.55
Lapse of restrictions	(594,580	)	38.70
Stock and units forfeited	(161,311	)	26.55
Nonvested at December 31, 2010	2,021,707		$	22.95
Stock and units granted	1,030,676		33.99
Lapse of restrictions	(845,717	)	27.79
Stock and units forfeited	(175,883	)	27.06
Nonvested at December 31, 2011	2,030,783		$	26.25
Stock and units granted	2,869,584		24.13
Lapse of restrictions	(1,048,757	)	26.06
Stock and units forfeited	(214,634	)	24.92
Nonvested at December 31, 2012	3,636,976		$	24.71

The total fair value of restricted stock and restricted stock units whose restrictions lapsed in the years ended December 31, 2012, 2011 and 2010 was $27 million, $24 million and $23 million, respectively.

Management Incentive and Retention Plan

Effective March 2012, the Company adopted a Management Incentive and Retention Plan ("MIRP") as a means of encouraging key management personnel to remain employed with the Company or one of its subsidiaries and to reward the achievement of established performance criteria. The MIRP provides an opportunity to receive two types of awards: a retention award and an incentive award. Participants' retention and incentive awards can have a cash component only or a cash component and an equity component. The equity component is granted in the form of restricted stock units under the Stock Plan.

A summary of the retention restricted stock units granted under the MIRP is shown in the following table:



	Number	Weighted Average Grant Date Fair Value
Nonvested at January 1, 2012	—	$	—
Stock and units granted	465,000	25.92
Lapse of restrictions	—	—
Stock and units forfeited	—	—
Nonvested at December 31, 2012	465,000	$	25.92

In addition, the number of restricted stock units that would be granted under the incentive portion of the MIRP based on expected performance would be 418,500 as of December 31, 2012.

The total fair value of retention and incentive restricted stock units awarded during the period ended December 31, 2012 under the MIRP, assuming performance attained against the performance benchmark, was $23 million.

As of December 31, 2012, unamortized compensation cost related to the MIRP was $10 million and the weighted average period over which this cost will be recognized is 1 year.

As of December 31, 2012, $11 million had been accrued in other current liabilities for the cash component of the MIRP.

Warrants

As of December 31, 2012, there were warrants to purchase 45,593 shares of Level 3 common stock outstanding with an exercise price of $73.50, which expired in January 2013. All of the warrants were fully vested and compensation expense had been fully recognized in the consolidated statements of operations.

Defined Contribution Plans

The Company sponsors a number of defined contribution plans. The principal defined contribution plans are discussed individually below. Other defined contribution plans are not individually significant and therefore have been summarized in aggregate below.

The Company and its subsidiaries offer their qualified employees the opportunity to participate in a defined contribution retirement plan qualifying under the provisions of Section 401(k) of the Internal Revenue Code ("401(k) Plan"). Each employee is eligible to contribute, on a tax deferred basis, a portion of annual earnings generally not to exceed $17,000 in 2012 and $17,500 in 2013. Effective January 1, 2012, the Company matches 100% of employee contributions up to 4% of eligible earnings or applicable regulatory limits. Between March 6, 2009 and December 31, 2011, the Company matched 100% of employee contributions up to 3% of eligible earnings or applicable regulatory limits.

The Company's matching contributions are made with Level 3 common stock based on the closing stock price on each pay date. The Company's matching contributions are made through units in the Level 3 Stock Fund, which represent shares of Level 3 common stock. The Level 3 Stock Fund is the mechanism that is used for Level 3 to make employer matching and other contributions to employees through the Level 3 401(k) plan. Employees are not able to purchase units in the Level 3 Stock Fund. Employees are able to diversify the Company's matching contribution as soon as it is made, even if they are not fully vested, subject to insider trading rules and regulations. The Company's matching contributions will vest ratably over the first three years of service or over such shorter period until the employee has completed three years of service at such time the employee is then 100% vested in all Company matching contributions, including future contributions. The Company made 401(k) Plan matching contributions of $23 million, $13 million and $11 million for the years ended December 31, 2012, 2011 and 2010, respectively. The Company's matching contributions are recorded as non-cash compensation and included in selling, general and administrative expenses. Former U.S.-based Global Crossing employees became eligible to participate in the Level 3 401(k) plan starting January 1, 2012.

Other defined contribution plans sponsored by the Company are individually not significant. On an aggregate basis the expenses recorded by the Company relating to these plans was approximately $7 million for the year ended December 31, 2012 and $2 million for the year ended December 31, 2011.

Non-Qualified Stock Options ("NQ Options")

On October 4, 2011, as part of the Amalgamation, the issued and outstanding options to purchase Global Crossing common shares were modified into options to purchase Level 3 common stock. There was no unrecognized compensation expense for NQ Options at the time of the Amalgamation and no additional NQ Options have been granted since the Amalgamation date.

Information regarding NQ Options outstanding is summarized below:



	Number Outstanding		Weighted Average Exercise Price
Balance at October 4, 2011	765,585		$	10.82
Exercised	(167,395	)	$	10.93
Balance at December 31, 2011	598,190		$	10.79
Exercised	(533,717	)	$	10.61
Forfeited	(2,149	)	$	14.39
Balance at December 31, 2012	62,324		$	12.18

The following table summarizes information concerning outstanding and exercisable NQ Options at December 31, 2012:



			Options Outstanding and Exercisable
Exercise Prices		Number Outstanding	Weighted Average Remaining Contractual Life (in years)	Weighted Average Exercise Price per Share
$	9.53	28,549	0.9	$	9.53
$	14.43	33,775	2.0	$	14.43
Total		62,324	1.5	$	12.18

The weighted average remaining contractual term was 1.5 years for NQ Options exercisable as of December 31, 2012. The total intrinsic value of NQ Options outstanding and exercisable was approximately $1 million as of December 31, 2012. The total intrinsic value of NQ Options exercised between January 1, 2012 and December 31, 2012 was $6 million and Level 3 received $5 million for the exercise of these options. The total intrinsic value of NQ Options exercised between October 4, 2011 and December 31, 2011 was $1 million and Level 3 received $2 million for the exercise of these options.

Defined Benefit Plans

The Company has certain contributory and non-contributory employee pension plans, which are not significant to the financial position or operating results of Level 3. The Company recognizes in its balance sheet the funded status of its defined benefit post-retirement plans, which is measured as the difference between the fair value of the plan assets and the benefit obligation. The Company is also required to recognize changes in the funded status within accumulated other comprehensive income, net of tax to the extent such changes are not recognized in earnings as components of periodic net benefit cost. The fair value of the plan assets was $146 million and $137 million as of December 31, 2012 and 2011, respectively. The total benefit obligation was $166 million and $152 million as of December 31, 2012 and 2011, respectively. One of the Company's pension plans split the costs 60%/40% between the Company and the employees, respectively. Therefore, the total funded status was an obligation of $20 million, $12 million attributable to the Company and $8 million attributable to employees, as of December 31, 2012. The total funded status was an obligation of $15 million as of December 31, 2011.

Annual Discretionary Bonus Grant

The Company's annual discretionary bonus program is intended to retain and motivate employees to achieve the Company's financial and business goals. Each participant is provided a target award expressed as a percentage of base salary. Actual awards under the program are based on corporate results as well as achievement of specific individual performance criteria during the bonus plan period, and may be paid in cash, restricted stock units, or a combination of the two, at the sole discretion of the Compensation Committee of the Board of Directors.

As of December 31, 2012, $103 million, had been accrued in other current liabilities for this bonus plan, including employer liability for payroll taxes and charges. The Company generally expects to pay out 40% in cash and 60% in immediately-vested restricted stock units and shares of Level 3 common stock in the first quarter of 2013.

As of December 31, 2011, $136 million had been accrued in other current liabilities for this bonus plan, including employer liability for payroll taxes and charges. The Company paid out $72 million cash and 2.4 million immediately-vested restricted stock units in 2012 for this plan.

As of December 31, 2010, $59 million had been accrued in other current liabilities for this bonus plan, including employer liability for payroll taxes and charges. The Company paid out $29 million cash and 1.7 million immediately-vested restricted stock units in 2011 for this plan.