-----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, GYdkujY1RT/pyLSpIS3MbG0vpRDZezQafpmAlpXrmCPAGJZfSpiRDDmlI6geU0Eo F68SrWu43qkJrTNUErrMKQ== 0000950152-07-001629.txt : 20070228 0000950152-07-001629.hdr.sgml : 20070228 20070228165745 ACCESSION NUMBER: 0000950152-07-001629 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 13 CONFORMED PERIOD OF REPORT: 20061231 FILED AS OF DATE: 20070228 DATE AS OF CHANGE: 20070228 FILER: COMPANY DATA: COMPANY CONFORMED NAME: EATON CORP CENTRAL INDEX KEY: 0000031277 STANDARD INDUSTRIAL CLASSIFICATION: MISC INDUSTRIAL & COMMERCIAL MACHINERY & EQUIPMENT [3590] IRS NUMBER: 340196300 STATE OF INCORPORATION: OH FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-01396 FILM NUMBER: 07658726 BUSINESS ADDRESS: STREET 1: EATON CTR STREET 2: 1111 SUPERIOR AVE CITY: CLEVELAND STATE: OH ZIP: 44114-2584 BUSINESS PHONE: 2165235000 MAIL ADDRESS: STREET 1: 1111 SUPERIOR AVENUE CITY: CLEVELAND STATE: OH ZIP: 44114 FORMER COMPANY: FORMER CONFORMED NAME: EATON YALE & TOWNE INC DATE OF NAME CHANGE: 19710822 10-K 1 l24244ae10vk.txt EATON CORPORATION 10-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the year ended December 31, 2006 ------------------------------------ Commission file number 1-1396 ----------------------------- EATON CORPORATION ------------------------------------------------------ (Exact name of registrant as specified in its charter) Ohio 34-0196300 ------------------------------- ----------------------------------- (State or other jurisdiction of (IRS Employer Identification Number) incorporation or organization)
Eaton Center Cleveland, Ohio 44114-2584 - ---------------------------------------- ---------- (Address of principal executive offices) (Zip code)
(216) 523-5000 --------------------------------------------------- (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act:
Name of each exchange on Title of each class which registered - ------------------- --------------------------- Common Share ($.50 par value) The New York Stock Exchange The Chicago Stock Exchange
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes X ----- Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. No X ----- 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 and (2) has been subject to such filing requirements for the past ninety days. Yes X ----- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. (Check one): Large accelerated filer X ----- Page 1 Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). No X ----- The aggregate market value of Common Stock held by non-affiliates of the registrant as of June 30, 2006 was $11.3 billion. As of January 31, 2007, there were 146.2 million Common Shares outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Proxy Statement for the 2007 annual shareholders meeting are incorporated by reference into Part III. Page 2 PART I ITEM 1. BUSINESS Eaton Corporation (Eaton or Company) is a diversified industrial manufacturer having 2006 sales of $12.4 billion. Eaton was incorporated in Ohio in 1916, as a successor to a New Jersey company incorporated in 1911. The Company is a global leader in the design, manufacture, marketing and servicing of electrical systems and components for power quality, distribution and control; fluid power systems and services for industrial, mobile and aircraft equipment; intelligent truck drivetrain systems for safety and fuel economy; and automotive engine air management systems, powertrain solutions and specialty controls for performance, fuel economy and safety. Headquartered in Cleveland, Ohio, Eaton had 60,000 employees at year-end 2006 and sells products in more than 125 countries. More information regarding the Company is available at http://www.eaton.com. Eaton electronically files or furnishes reports pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (Exchange Act) to the United States Securities and Exchange Commission (SEC), including annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, as well as any amendments to those reports. As soon as reasonably practicable, these reports are available free of charge through the Company's Internet web site at http://www.eaton.com. These filings are also accessible on the SEC's Internet web site at http://www.sec.gov. RECENT DEVELOPMENTS In light of its strong results for 2006 and future prospects, on January 22, 2007, Eaton announced that it was taking the following actions: - - Increasing the quarterly dividend on its Common Shares by 10%, from $.39 per share to $.43 per share, effective for the February 2007 dividend - - Making a voluntary contribution of $150 million to its qualified pension plan in the United States - - Authorizing a new 10 million Common Share repurchase program, replacing the 1.3 million shares remaining from the 10 million share repurchase program authorized in April of 2005. In 2006, Eaton acquired certain businesses in separate transactions for a combined net cash purchase price of $256 million. The Statements of Consolidated Income include the results of these businesses from the effective dates of acquisition. A summary of these transactions for 2006 follows (millions of dollars):
Date of Business Acquired business acquisition segment Annual sales - ----------------- ------------------ ----------- ------------- Schreder-Hazemeyer December 1, 2006 Electrical $9 for 2006 Eaton acquired the remaining 50% ownership of the Belgium manufacturer of low and medium voltage electrical distribution switchgear Diesel fuel processing technology & associated assets of October 26, 2006 Truck NM Catalytica Energy Systems Inc. A U.S. developer of emission control solutions for Trucks Senyuan International Holdings Limited September 14, 2006 Electrical $47 for 2005 A China-based manufacturer of vacuum circuit breakers and other electrical switchgear components Ronningen-Petter business unit of Dover Resources, Inc. September 5, 2006 Fluid Power $30 for 2005 A U.S.-based manufacturer of industrial fine filters and components Synflex business unit of Saint-Gobain Performance Plastics March 31, 2006 Fluid Power $121 for 2005 Corp. A U.S.-based manufacturer of thermoplastic hose and tubing Marina Power & Lighting March 24, 2006 Electrical $11 for 2005 A U.S. manufacturer of marine duty electrical distribution products
Page 3 On December 28, 2006, Eaton announced it had reached an agreement to purchase AT Holdings Corporation, the parent of Argo-Tech Corporation, for $695 million. This transaction is expected to close in the first quarter of 2007. Argo-Tech's U.S.-based aerospace business, which had sales for the fiscal year ended October 28, 2006 of $206 million, is a leader in high performance aerospace engine fuel pumps and systems, airframe fuel pumps and systems, and ground fueling systems for commercial and military aerospace markets. This business will be integrated into the Fluid Power segment. On January 5, 2007, the Company announced it had reached an agreement to purchase the Power Protection Business of Power Products Ltd., a Czech distributor and service provider of Powerware and other uninterruptible power systems, for $2 million. The transaction closed in February 2007. This business, which had 2006 sales of $3 million, will be integrated into the Electrical segment. BUSINESS SEGMENT INFORMATION Information by business segment and geographic region regarding principal products, principal markets, methods of distribution, net sales, operating profit and assets is presented in "Business Segment & Geographic Region Information" on pages 47 through 51 of this report. Additional information regarding Eaton's segments and business is presented below. ELECTRICAL Seasonal Fluctuations - Sales of this segment are historically lower in the first quarter, and higher in the third and fourth quarters of a year. Competition - Principal methods of competition in this segment are performance of products and systems, technology, customer service and support, and price. Eaton has a strong competitive position in relation to the many competitors in this segment and, with respect to many products, is considered among the market leaders. FLUID POWER Seasonal Fluctuations - Sales of this segment are not affected by seasonal fluctuations. Competition - Principal methods of competition in this segment are product performance, geographic coverage, service, and price. Eaton has a strong competitive position in relation to the many competitors in this segment and, with respect to many products, is considered among the market leaders. TRUCK Seasonal Fluctuations - Sales of this segment are not affected by seasonal fluctuations. Significant Customers - Approximately 78% of this segment's sales in 2006 were made to five large manufacturers of heavy-, medium-, and light-duty trucks and off-highway vehicles. Competition - Principal methods of competition in this segment are product performance, service, and price. Eaton has a strong competitive position in relation to the many competitors in this segment and, with respect to many products, is considered among the market leaders. AUTOMOTIVE Seasonal Fluctuations - Sales of this segment historically are lower in the third quarter than in other quarters during the year, as a result of the normal seasonal pattern of automotive industry production. Significant Customers - Approximately 56% of this segment's sales in 2006 were made to six large manufacturers of vehicles and components. Competition - Principal methods of competition in this segment are product performance, service, and price. Eaton has a strong competitive position in relation to the many competitors in this segment and, with respect to many products, is considered among the market leaders. INFORMATION CONCERNING EATON'S BUSINESS IN GENERAL RAW MATERIALS - Eaton's major requirements for raw materials include iron, steel, copper, nickel, aluminum, brass, silver, molybdenum, titanium, vanadium, rubber, plastic and insulating materials. Materials are purchased in various forms, such as extrusions, castings, powder metal, metal sheets and strips, forging billets, bar stock and plastic pellets. Raw materials, as well as parts and other Page 4 components, are purchased from many suppliers and, under normal circumstances, the Company has no difficulty obtaining them. In 2006, prices increased for some basic metals purchased by Eaton, and in some cases dramatically, due to raw materials supply shortages resulting from higher global demand. The Company maintained appropriate levels of inventory to guard against basic metals shortages, and did not experience the general availability constraints experienced in 2005. PATENTS AND TRADEMARKS - Eaton views its name and mark as significant to its business as a whole. Eaton's products are marketed with a portfolio of patents, trademarks, licenses or other forms of intellectual property that expire at various dates in the future. Eaton develops and acquires new intellectual property on an ongoing basis and considers all of its intellectual property to be valuable. Based on the broad scope of Eaton's product lines, management believes that the loss or expiration of any single intellectual property right would not have a material effect on the results of operations or financial position of Eaton or its business segments. Eaton's policy is to file applications and obtain patents for its new products including product modifications and improvements. ORDER BACKLOG - Since a significant portion of open orders placed with Eaton by original equipment manufacturers of trucks, off-highway vehicles and passenger cars are historically subject to month-to-month releases by customers during each model year, these orders are not considered firm. In measuring backlog of orders, the Company includes only the amount of these orders released by customers as of the dates listed. Using this criterion, total backlog at December 31, 2006 and 2005 was approximately $2.2 billion and $2.0 billion, respectively. Backlog should not be relied upon as being indicative of results of operations for future periods. RESEARCH AND DEVELOPMENT - Research and development expenses for new products and improvement of existing products in 2006, 2005 and 2004 (in millions) were $321, $285 and $259, respectively. Over the past five years, the Company has invested approximately $1.3 billion in research and development. PROTECTION OF THE ENVIRONMENT - Operations of the Company involve the use and disposal of certain substances regulated under environmental protection laws. Eaton continues to modify certain processes on an ongoing, regular basis in order to reduce the impact on the environment, including the reduction or elimination of certain chemicals used in, and wastes generated from, operations. Compliance with Federal, State and local provisions which have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment, are not expected to have a material adverse effect upon earnings or the competitive position of the Company. Eaton's estimated capital expenditures for environmental control facilities are not expected to be material for 2007 and 2008. Information regarding the Company's liabilities related to environmental matters is presented in "Protection of the Environment" on page 41 of this report. FOREIGN OPERATIONS - Financial information related to Eaton's foreign operations is presented in "Business Segment & Geographic Information" on page 49 of this report. Information regarding risks that may affect Eaton's foreign operations is presented in Item 1A of this Form 10-K. ITEM 1A. RISK FACTORS Among the risks that could materially adversely affect Eaton's businesses, financial condition or results of operations are the following: DOWNTURNS IN THE END MARKETS THAT EATON SERVES MAY NEGATIVELY IMPACT EATON'S SEGMENT REVENUES AND PROFITABILITY. Eaton's segment revenues, operating results and profitability have varied in the past and may vary from quarter to quarter in the future. Profitability can be negatively impacted by volatility in the end markets that Eaton serves, although the Company has undertaken measures to reduce the impact of this volatility through diversification of markets it serves and expansion of geographic regions in which it operates. Future downturns in any of the markets that Eaton serves could adversely affect the Company's revenues, operating results, and profitability. EATON'S OPERATING RESULTS DEPEND IN PART ON CONTINUED SUCCESSFUL RESEARCH, DEVELOPMENT AND MARKETING OF NEW AND/OR IMPROVED PRODUCTS AND SERVICES, AND THERE CAN BE NO ASSURANCE THAT EATON WILL CONTINUE TO SUCCESSFULLY INTRODUCE NEW PRODUCTS AND SERVICES. Page 5 The success of new and improved products and services depends on their initial and continued acceptance by Eaton's customers. The Company's businesses are affected, by varying degrees, by technological change and corresponding shifts in customer demand, which could result in unpredictable product transitions or shortened life cycles. Eaton may experience difficulties or delays in the research, development, production and/or marketing of new products and services which may prevent Eaton from recouping or realizing a return on the investments required to bring new products and services to market. The end result could be a negative impact on the Company's operating results. EATON'S OPERATIONS DEPEND ON PRODUCTION FACILITIES THROUGHOUT THE WORLD, MANY OF WHICH ARE LOCATED OUTSIDE THE UNITED STATES AND ARE SUBJECT TO GREATER RISKS OF DISRUPTED PRODUCTION. Eaton manages businesses with manufacturing facilities worldwide. The Company's manufacturing facilities and operations could be disrupted by a natural disaster, labor strike, war, political unrest, terrorist activity or public health concerns. Eaton's non-United States manufacturing facilities also may be more susceptible to economic and political upheaval than Eaton's United States facilities. Any such disruption could cause delays in shipments of products and the loss of sales and customers, and insurance proceeds may not adequately compensate the Company. EATON'S SUBSTANTIAL FOREIGN SALES SUBJECT IT TO ECONOMIC RISK AS EATON'S RESULTS OF OPERATIONS MAY BE ADVERSELY AFFECTED BY CHANGES IN LOCAL GOVERNMENT REGULATIONS AND POLICIES AND FOREIGN CURRENCY FLUCTUATIONS. As noted above in Item 1 "Foreign Operations", a significant portion of Eaton's sales are outside the United States, and the Company expects sales in foreign markets to continue to represent a significant portion of its total sales. Foreign sales and operations are subject to changes in local government regulations and policies, including those related to tariffs and trade barriers, investments, property ownership rights, taxation, exchange controls, and repatriation of earnings. Changes in the relative values of currencies occur from time to time and could affect Eaton's operating results. While the Company monitors exchange rate exposures and attempts to reduce these exposures through hedging activities, these risks could adversely affect the Company's operating results. EATON USES A VARIETY OF RAW MATERIALS AND COMPONENTS IN ITS BUSINESSES, AND SIGNIFICANT SHORTAGES OR PRICE INCREASES COULD INCREASE OPERATING COSTS AND ADVERSELY IMPACT THE COMPETITIVE POSITIONS OF EATON'S PRODUCTS. Eaton's major requirements for raw materials are described above in Item 1 "Raw Materials". In 2006, prices increased for some basic metals purchased by Eaton, and in some cases dramatically, due to raw materials supply shortages resulting from higher global demand. The Company maintained appropriate levels of inventory to guard against basic metals shortages, and did not experience the general availability constraints experienced in 2005. Significant shortages in excess of those experienced in 2005 and 2006 could affect the prices Eaton's affected businesses are charged and the competitive position of their products and services, all of which could adversely affect Eaton's results of operations. EATON ENGAGES IN ACQUISITIONS AND JOINT VENTURES, AND MAY ENCOUNTER UNEXPECTED DIFFICULTIES IDENTIFYING, PRICING OR INTEGRATING THOSE BUSINESSES. Eaton seeks to grow, in part, through strategic acquisitions and joint ventures intended to complement or expand the Company's businesses, and will continue to do so in the future. The success of this strategy will depend on Eaton's ability to identify, price and complete these transactions or arrangements. Success will also depend on the Company's ability to integrate the businesses acquired in these transactions and to develop satisfactory working arrangements with the Company's strategic partners in the joint ventures. Eaton may encounter unexpected difficulties in completing and integrating acquisitions with Eaton's existing operations, and in managing strategic investments. Furthermore, the Company may not realize the degree, or timing, of benefits Eaton anticipated when it first entered into a transaction. Any of the foregoing could adversely affect the Company's business and results of operations. EATON MAY BE UNABLE TO ADEQUATELY PROTECT ITS INTELLECTUAL PROPERTY RIGHTS, WHICH COULD AFFECT THE COMPANY'S ABILITY TO COMPETE. Protecting Eaton's intellectual property rights is critical to its ability to compete and succeed as a company. The Company owns a large number of United States and foreign patents and patent Page 6 applications, as well as trademark and copyright registrations that are necessary, and contribute significantly, to the preservation of Eaton's competitive position in the market. Although management believes that the loss or expiration of any single intellectual property right would not have a material effect on the results of operations or financial position of Eaton or its business segments, there can be no assurance that any one, or more, of these patents and other intellectual property will not be challenged, invalidated or circumvented by third parties. Eaton enters into confidentiality and invention assignment agreements with the Company's employees, and into non-disclosure agreements with Eaton's suppliers and appropriate customers so as to limit access to and disclosure of the Company's proprietary information. These measures may not suffice to deter misappropriation or independent third party development of similar technologies. Moreover, the protection provided to Eaton's intellectual property by the laws and courts of foreign nations may not be as advantageous to Eaton as the remedies available under United States law. EATON IS SUBJECT TO LITIGATION AND ENVIRONMENTAL REGULATIONS THAT COULD ADVERSELY IMPACT EATON'S BUSINESSES. At any given time, Eaton may be subject to litigation, the disposition of which may have a material adverse effect on the Company's businesses, financial condition or results of operations. Information regarding the Company's current legal proceedings is presented in "Protection of the Environment" and "Contingencies" on page 41 of this report. EATON PARTICIPATES IN MARKETS THAT ARE COMPETITIVE AND EATON'S RESULTS COULD BE ADVERSELY IMPACTED BY COMPETITORS' ACTIONS. Eaton's businesses operate in competitive markets. The Company competes against other global manufacturers on the basis of product performance, quality and price, in addition to other factors. While Eaton's product development and quality initiatives have been competitive strengths in the past, actions by Eaton's competitors could lead to downward pressure on prices and/or a decline in the Company's market share, either of which could adversely affect Eaton's results. ITEM 1B. UNRESOLVED STAFF COMMENTS None. ITEM 2. PROPERTIES Eaton's world headquarters is located in Cleveland, Ohio. The Company maintains manufacturing facilities at 202 locations in 32 countries. The Company is a lessee under a number of operating leases for certain real properties and equipment, none of which is material to its operations. Management believes that the existing manufacturing facilities are adequate for operations, and these facilities are maintained in good condition. ITEM 3. LEGAL PROCEEDINGS Information regarding the Company's current legal proceedings is presented in "Protection of the Environment" and "Contingencies" on page 41 of this report. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding executive officers of the Company is presented in Item 10 of this Form 10-K. PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES The Company's Common Shares are listed for trading on the New York and Chicago stock exchanges. Information regarding cash dividends paid and the high and low market price per Common Share for each quarter in 2006 and 2005 is presented in "Quarterly Data" on page 73 of this report. At December 31, 2006, there were 8,868 holders of record of the Company's Common Shares. Additionally, 20,356 current and former employees were shareholders through participation in the Eaton Savings Plan (ESP) and Eaton Personal Investment Plan (EPIP). Page 7 Information regarding equity compensation plans required by Regulation S-K Item 201(d) is provided in Item 12 of this Form 10-K. ISSUER'S PURCHASES OF EQUITY SECURITIES In fourth quarter 2006, Eaton repurchased 3.341 million Common Shares in the open market at a total cost of $255 million. These shares were repurchased under the plan announced on April 18, 2005, when Eaton's Board of Directors authorized the Company to repurchase up to 10 million of its Common Shares.
Total number of Maximum number (or shares purchased approximate dollar as part of value) of shares that Total number Average publicly may yet be purchased of shares price paid announced plans under the plans or Month purchased per share or programs programs ----- ------------ ---------- ---------------- --------------------- November 2006 2,966,877 $75.49 2,966,877 1,708,019 December 2006 373,800 77.00 373,800 1,334,219 --------- --------- Total 3,340,677 75.65 3,340,677 ========= =========
On January 22, 2007, Eaton announced that it had authorized a new 10 million Common Share repurchase program, replacing the 1.334 million shares remaining from the 10 million share repurchase program authorized in April of 2005, described in the table above. These shares will be repurchased over time, depending on market conditions, share price, capital levels and other considerations. ITEM 6. SELECTED FINANCIAL DATA Information regarding selected financial data is presented in the "Ten-Year Consolidated Financial Summary" on page 72 of this report. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS "Management's Discussion & Analysis of Financial Condition & Results of Operations" is presented on pages 52 through 71 of this report. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Information regarding market risk is presented in "Market Risk Disclosure & Contractual Obligations" on page 65 of this report. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The report of the independent registered public accounting firm, consolidated financial statements, and notes to consolidated financial statements are presented on pages 18 through 51 of this report. Information regarding selected quarterly financial information for the last two years is presented in "Quarterly Data" on page 73 of this report. ITEM 9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. ITEM 9A. CONTROLS AND PROCEDURES Evaluation of Disclosure Controls and Procedures - Pursuant to SEC Rule 13a-15, an evaluation was performed, under the supervision and with the participation of Eaton's management, including Alexander M. Cutler - Chairman and Chief Executive Officer; President and Richard H. Fearon - Executive Vice President - Chief Financial and Planning Officer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures. Based on that evaluation, Eaton's management concluded that the Company's disclosure controls and procedures were effective as of December 31, 2006. Disclosure controls and procedures are designed to ensure that information required to be disclosed in Company reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Commission's rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information Page 8 required to be disclosed in Company reports filed under the Exchange Act is accumulated and communicated to management, including the Company's Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. "Management's Report on Internal Control Over Financial Reporting" is presented on page 21 of this report. "Report of Independent Registered Public Accounting Firm" relating to "Management's Report on Internal Control Over Financial Reporting" is presented on page 20 of this report. Changes in Internal Control Over Financial Reporting - During fourth quarter 2006, there was no change in Eaton's internal control over financial reporting that materially affected, or is reasonably likely to materially affect, the Company's internal control over financial reporting. ITEM 9B. OTHER INFORMATION None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information required with respect to the directors of the Company is set forth under the caption "Election of Directors" in the Company's definitive Proxy Statement to be filed on or about March 16, 2007, and is incorporated by reference. A listing of Eaton's elected executive officers, their ages, positions and offices held over the past five years, as of January 31, 2007, follows:
Name Age Position (Date elected to position) - ---- --- ----------------------------------- Alexander M. Cutler 55 Chairman and Chief Executive Officer; President (August 1, 2000 - present) Director (September 22, 1993 - present) Richard H. Fearon 50 Executive Vice President - Chief Financial and Planning Officer (April 24, 2002 - present) Partner, Willow Place Partners LLC (2001-2002) Craig Arnold 46 Senior Vice President and President - Fluid Power Group (October 25, 2000 - present) Stephen M. Buente 56 Senior Vice President and President - Automotive Group (August 21, 2000 - present) Randy W. Carson 56 Senior Vice President and President - Electrical Group (January 1, 2000 - present) James E. Sweetnam 54 Senior Vice President and President - Truck Group (July 1, 2001 - present) William W. Blausey, Jr. 42 Vice President - Chief Information Officer (January 25, 2006 - present) Vice President - Information Technology, Fluid Power (January 1, 2005 - January 24, 2006) Group Director - IT (August 16, 2001 - December 31, 2004) Susan J. Cook 59 Vice President - Human Resources (January 16, 1995 - present)
Page 9 Earl R. Franklin 63 Vice President and Secretary (April 24, 2002 - present) Secretary and Associate General Counsel (September 1, 1991 - April 23, 2002) Richard D. Holder 43 Vice President - Eaton Business System (May 1, 2006 - present) Vice President and General Manager, Power Distribution and Assemblies Division, Electrical Group (August 1, 2004 - April 30, 2006) Vice President, Supply Chain and Operational Excellance, Electrical Group (July 16, 2001 - July 31, 2004) Donald J. McGrath, Jr. 54 Vice President - Communications (January 25, 2006 - present) Vice President, Corporate Communications, BASF Corporation (2002 -2005) Mark M. McGuire 49 Vice President and General Counsel (December 1, 2005 - present) Vice President and Deputy General Counsel, International Paper Company (2003 - 2005) Associate General Counsel, International Paper Company (March 2001 - 2003) John S. Mitchell 50 Vice President - Taxes (November 22, 1999 - present) Billie K. Rawot 55 Vice President and Controller (March 1, 1991 - present) Ken D. Semelsberger 45 Vice President - Corporate Development and Treasury (February 22, 2006 - present) Vice President - Strategic Planning (April 28, 1999 - February 21, 2006) Yannis P. Tsavalas 51 Vice President and Chief Technology Officer (February 14, 2005 - present) General Manager, Global Lighting Technology, General Electric Company (2004 - 2005) Global Technology Leader, GE Lighting, General Electric Company (2003-2004) Global Product Line Manager, GE Lighting, General Electric Company (August 2000 - 2003)
There are no family relationships among the officers listed, and there are no arrangements or understandings pursuant to which any of them were elected as officers. All officers hold office for one year and until their successors are elected and qualified, unless otherwise specified by the Board of Directors; provided, however, that any officer is subject to removal with or without cause, at any time, by a vote of a majority of the Board of Directors. Information required with respect to compliance with Section 16(a) of the Exchange Act is set forth under the caption "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's definitive Proxy Statement to be filed on or about March 16, 2007, and is incorporated by reference. The Company has adopted a Code of Ethics, which applies to the Directors, officers (including its Chairman and Chief Executive Officer; President, Executive Vice President--Chief Financial and Planning Officer, and Vice President and Controller) and employees worldwide. This document is available on the Company's website at http://www.eaton.com. Page 10 There were no changes during fourth quarter 2006 to the procedures by which security holders may recommend nominees to the Company's Board of Directors. Information related to the Company's Audit Committee, and members of the Committee that are financial experts, is set forth under the caption "Board Committees - Audit Committee" in the Company's definitive Proxy Statement to be filed on or about March 16, 2007, and is incorporated by reference. ITEM 11. EXECUTIVE COMPENSATION Information required with respect to executive compensation is set forth under the caption "Executive Compensation" in the Company's definitive Proxy Statement to be filed on or about March 16, 2007, and is incorporated by reference. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS Information required with respect to security ownership of certain beneficial owners is set forth under the caption "Share Ownership Tables" in the Company's definitive Proxy Statement to be filed on or about March 16, 2007, and is incorporated by reference. EQUITY COMPENSATION PLANS The following table summarizes information, as of December 31, 2006, relating to equity compensation plans of the Company pursuant to which grants of options, restricted stock, deferred compensation units or other rights to acquire Company Common Shares may be granted from time to time.
(C) Number of securities (A) (B) remaining available Number of Weighted-average for future issuance securities to be exercise price under equity issued upon of outstanding compensation plans exercise of options, (excluding securities outstanding options, warrants reflected in Plan category warrants and rights and rights column (A)) - ------------- -------------------- ---------------- --------------------- Equity compensation plans approved by security holders (1) 13,647,357(3) $48.01(5) 5,184,978 Equity compensation plans not approved by security holders (2) 1,749,829(4) N/A N/A ---------- --------- Total 15,397,186 $48.01(5) 5,184,978 ========== =========
(1) These plans are the Company's 2004 Stock Plan, 2002 Stock Plan, 1998 Stock Plan, 1995 Stock Plan, and the Incentive Compensation Deferral Plan (the "IC Deferral Plan"). (2) The 2005 Non-Employee Director Fee Deferral Plan (the "2005 Plan"), the 1996 Non-Employee Director Fee Deferral Plan (the "1996 Plan"), the Deferred Incentive Compensation Plan (the "DIC Plan"), the Deferral Incentive Compensation Plan II (the "DIC Plan II") and the Incentive Compensation Deferral Plan II (the "IC Deferral Plan II") are not considered "equity compensation plans" requiring shareholder approval under the rules of the New York Stock Exchange. Under the 2005 Plan, all non-employee directors are entitled to defer payment of their fees and allocate the deferred amounts between short-term deferred fees and retirement deferred fees, which differ in terms of earnings and method and timing of distribution. Short-term deferred fees are credited with interest based on the quarterly average yield of the 13-week U.S. Treasury bill and are distributable in cash. As specified by the director, between 50% and 100% of deferred amounts allocated to retirement deferred fees are converted into Company share units that earn Company Common Share price appreciation plus dividend equivalents, and are distributable in Company Common Shares. The portion of a Director's retirement deferred fees that are not converted to Company share units earn 10-year U.S. Treasury note returns plus 300 basis points and are distributable in cash. Under the 2005 Plan, plan participants must elect the method and timing of payment with respect to the fees that are to be deferred. For short-term deferred fees, participants may elect to receive distributions in a lump sum or in equal annual installments over a period not to exceed five years commencing in the year selected by the plan Page 11 participant, which cannot be earlier than the second year following the calendar year in which fees are deferred. For retirement deferred fees, plan participants may elect to receive distributions in a lump sum or in equal annual installments over a period not to exceed 15 years following retirement. Director fees earned subsequent to December 31, 2004 are not eligible for deferral under the 1996 Plan. Instead, the 2005 Plan is available for the deferral of these fees. Under the 1996 Plan, the Governance Committee determines, upon the participant's retirement or other termination of services as a director, whether fees deferred are distributable in a lump sum or in equal annual installments and whether the amounts converted to Company share units are distributable in cash or Company Common Shares. Both the 2005 Plan and the 1996 Plan provide for accelerated payout upon the occurrence of certain events, including those involving a change in control of the Company. Under the DIC Plan, participants, including officers and other eligible executives, were able to defer receipt of their annual incentive compensation award as either short-term deferrals (to be paid out in five years or less) or retirement compensation. Amounts deferred as retirement compensation earn the greater of Company share price appreciation plus dividend equivalents or 13-week U.S. Treasury bill returns until paid. This determination is made at the time of each payment, whether made in a lump sum or installments. Short-term deferrals earn 13-week U.S. Treasury bill returns. Amounts deferred as retirement compensation which are converted to Company share units are payable in Company Common Shares, either in a lump sum or periodic installments, as determined by the Company's Corporate Compensation Committee which is comprised of Company officers. Annual incentive compensation earned subsequent to December 31, 2004 is not eligible for deferral under the DIC Plan. Instead, the DIC Plan II is available for the deferral of this compensation. Compensation deferred under the DIC Plan II is credited with earnings in the same manner as the DIC Plan, as described above. However, participants under the DIC Plan II, prior to the beginning of each calendar year, must elect the method and timing of payment with respect to the compensation to be earned in that year that is subject to the deferral election. Similarly, long-term incentive compensation earned subsequent to December 31, 2004 is not eligible for deferral under the IC Deferral Plan. Instead, the IC Deferral Plan II is available for the deferral of this compensation. Under the IC Deferral Plan II, participants, including officers and other eligible executives, may defer the receipt of awards received under long-term incentive compensation plans as either short-term deferrals (to be paid out in five years or less) or retirement compensation. As selected by the participant, between 50% and 100% of awards deferred as Retirement Compensation are credited as Company share units that earn Company Common Share price appreciation plus dividend equivalents and that are distributed in the form of Company Common Shares. The portion of a participant's Retirement Compensation that is not converted to Company share units earns interest at a rate equal to the average yield on 10-year U.S. Government Treasury Notes plus 300 basis points. Amounts deferred as short-term deferrals earn interest at a rate equal to the quarterly average yield of 13-week U.S. Government Treasury Bills. Under the IC Deferral Plan II, prior to the beginning of any award period for which an award may be earned, participants must elect the method and timing of payment with respect to compensation to be earned during that award period and that is subject to the deferral election. Participants were able to defer the full amount of eligible cash compensation under the 2005 Plan, the 1996 Plan and the EIC Plan. To the extent cash compensation is deferred pursuant to any of the Plans described herein, the Company may be able to preserve the deductibility of the compensation under Section 162(m) of the Internal Revenue Code that otherwise may be unavailable. (3) Includes an aggregate of 228,965 restricted shares, 1,988,714 performance-vested stock options and 441,897 shares underlying stock units, payable on a one-for-one basis, credited to accounts as of December 31, 2006 under the Incentive Compensation Deferral Plan. (4) Represents shares underlying stock units, payable on a one-for-one basis, credited to accounts as of December 31, 2006 under the 2005 Plan, the 1996 Plan, the DIC Plan, the DIC Plan II and the IC Deferral Plan II. (5) Weighted average exercise price of outstanding stock options; excludes restricted stock and deferred compensation share units. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS None required to be reported. ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES Information required with respect to principal accountant fees and services is set forth under the caption "Audit Committee Report" in the Company's definitive Proxy Statement to be filed on or about March 16, 2007, and is incorporated by reference. Page 12 PART IV ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES (a) (1) The report of the independent registered public accounting firm, consolidated financial statements and notes to consolidated financial statements, included in this report are included in Item 8 above: Report of Independent Registered Public Accounting Firm - Page 18 Statements of Consolidated Income - Years ended December 31, 2006, 2005 and 2004 - Page 22 Consolidated Balance Sheets - December 31, 2006 and 2005 - Page 23 Statements of Consolidated Cash Flows - Years ended December 31, 2006, 2005 and 2004 - Page 24 Statements of Consolidated Shareholders' Equity - Years ended December 31, 2006, 2005 and 2004 - Pages 25 and 26 Notes to Consolidated Financial Statements - Pages 27 through 51 (2) All schedules for which provision is made in Regulation S-X of the SEC are not required under the related instructions or are inapplicable and, therefore, have been omitted. (3) Exhibits 3(i) Amended Articles of Incorporation (amended and restated April 27, 1994) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 3(ii) Amended Regulations (amended and restated April 26, 2000) - Incorporated by reference to the Form 10-Q Report for the six months ended June 30, 2000 4(a) Instruments defining rights of security holders, including indentures (Pursuant to Regulation S-K Item 601(b)(4), the Company agrees to furnish to the Commission, upon request, a copy of the instruments defining the rights of holders of long-term debt) 10 Material contracts (a) Master Purchase and Sale Agreement by and between PerkinElmer, Inc. and Eaton Corporation dated October 6, 2005 - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2005 (b) Purchase Agreement between V.G.A.T. Investors, LLC and Eaton Corporation dated as of December 24, 2006 - Filed in conjunction with this Form 10-K Report (c) Executive Incentive Compensation Plan (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2005 (d) 2005 Non-Employee Director Fee Deferral Plan (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2004 (e) Deferred Incentive Compensation Plan II (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2004 (f) Excess Benefits Plan II (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2004 Page 13 (g) Incentive Compensation Deferral Plan II (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2004 (h) Limited Eaton Service Supplemental Retirement Income Plan II (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2004 (i) Supplemental Benefits Plan II (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2004 (j) Form of Restricted Share Award Agreement - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2004 (k) Form of Stock Option Agreement for Executives - Filed in conjunction with this Form 10-K Report (l) Form of Stock Option Agreement for Non-Employee Directors - Incorporated by reference to the Form 8-K Report filed January 26, 2007 (m) 2004 Stock Plan - Incorporated by reference to the definitive Proxy Statement dated March 19, 2004 (n) Amendment to the Plan (originally adopted in 1985) for the Deferred Payment of Directors' Fees (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2004 (o) Plan for the Deferred Payment of Directors' Fees (originally adopted in 1985 and amended effective September 24, 1996, January 28, 1998, January 23, 2002, and February 24, 2004) - Incorporated by reference to the Form 10-Q Report for the three months ended March 31, 2004 (p) Limited Eaton Service Supplemental Retirement Income Plan (amended and restated January 1, 2003) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (q) Vehicle Allowance Program (effective January 1, 2003) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2003 (r) 2002 Stock Plan - Incorporated by reference to the definitive Proxy Statement dated March 15, 2002 (s) 1996 Non-Employee Director Fee Deferral Plan (amended and restated effective January 1, 2005 ) - Filed in conjunction with this Form 10-K Report (t) Form of Change of Control Agreement entered into with officers of Eaton Corporation - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (u) Form of Indemnification Agreement entered into with officers of Eaton Corporation - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (v) Form of Indemnification Agreement entered into with directors of Eaton Corporation - Incorporated by reference to the Form 8-K Report filed January 26, 2007 (w) Executive Strategic Incentive Plan I (amended and restated January 1, 2007) - Filed in conjunction with this Form 10-K Report Page 14 (x) Executive Strategic Incentive Plan II (effective January 1, 2001) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (y) Deferred Incentive Compensation Plan (amended and restated March 31, 2000) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2000 (z) 1998 Stock Plan - Incorporated by reference to the definitive Proxy Statement dated March 13, 1998 (aa) Incentive Compensation Deferral Plan (amended and restated October 1, 1997) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2000 (bb) Trust Agreement - Officers and Employees (dated December 6, 1996) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (cc) Trust Agreement - Outside Directors (dated December 6, 1996) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (dd) 1995 Stock Plan - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (ee) Group Replacement Insurance Plan (GRIP) (effective June 1, 1992) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 1992 (ff) 1991 Stock Option Plan - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (gg) Excess Benefits Plan (amended and restated effective January 1, 1989) (with respect to Section 415 limitations of the Internal Revenue Code) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (hh) Supplemental Benefits Plan (amended and restated January 1, 1989) (which provides supplemental retirement benefits) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 12 Ratio of Earnings to Fixed Charges - Filed in conjunction with this Form 10-K Report 14 Code of Ethics - Incorporated by reference to the definitive Proxy Statement to be filed on or about March 16, 2007 21 Subsidiaries of Eaton Corporation - Filed in conjunction with this Form 10-K Report 23 Consent of Independent Registered Public Accounting Firm - Filed in conjunction with this Form 10-K Report 24 Power of Attorney - Filed in conjunction with this Form 10-K Report 31.1 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of 2002, Section 302) - Filed in conjunction with this Form 10-K Report 31.2 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of 2002, Section 302) - Filed in conjunction with this Form 10-K Report 32.1 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of 2002, Section 906) - Filed in conjunction with this Form 10-K Report 32.2 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of 2002, Section 906) - Filed in conjunction with this Form 10-K Report Page 15 (b) Exhibits Certain exhibits required by this portion of Item 15 are filed as a separate section of this Form 10-K. (c) Financial Statement Schedules None required to be filed. Page 16 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. Eaton Corporation Registrant Date: February 28, 2007 /s/ Richard H. Fearon ---------------------------------------- Richard H. Fearon Executive Vice President - Chief Financial and Planning Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated. Date: February 28, 2007
Signature Title - --------- ----- * Chairman and Chief Executive Officer; - ---------------------------------------- President; Director Alexander M. Cutler * Vice President and Controller; - ---------------------------------------- Principal Accounting Officer Billie K. Rawot * Director - ---------------------------------------- Christopher M. Connor * Director - ---------------------------------------- Michael J. Critelli * Director - ---------------------------------------- Charles E. Golden * Director - ---------------------------------------- Ernie Green * Director - ---------------------------------------- Ned C. Lautenbach * Director - ---------------------------------------- Deborah L. McCoy * Director - ---------------------------------------- John R. Miller * Director - ---------------------------------------- Gregory R. Page * Director - ----------------------------------------- Victor A. Pelson * Director - ---------------------------------------- Gary L. Tooker
* By /s/ Richard H. Fearon ----------------------------------- Richard H. Fearon, Attorney-in-Fact for the officers and directors signing in the capacities indicated Page 17 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors & Shareholders Eaton Corporation We have audited the accompanying consolidated balance sheets of Eaton Corporation as of December 31, 2006 and 2005, and the related statements of consolidated income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Eaton Corporation at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with United States generally accepted accounting principles. As discussed in "Retirement Benefit Plans" in the Notes to the Consolidated Financial Statements, effective December 31, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)". As discussed in "Stock Options" in the Notes to the Consolidated Financial Statements, effective January 1, 2006, Eaton adopted Statement of Financial Accounting Standards (SFAS) No. 123(R), "Share-Based Payment". We also have audited in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Eaton Corporation's internal control over financial reporting as of December 31, 2006, based on criteria established in INTERNAL CONTROL - INTEGRATED FRAMEWORK issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 23, 2007 expressed an unqualified opinion thereon. Ernst & Young LLP - ------------------------------------ Cleveland, Ohio February 23, 2007 Page 18 MANAGEMENT'S REPORT ON FINANCIAL STATEMENTS We have prepared the accompanying consolidated financial statements and related information of Eaton Corporation included herein for the three years ended December 31, 2006. The primary responsibility for the integrity of the financial information included in this annual report rests with management. The financial information included in this annual report has been prepared in accordance with accounting principles generally accepted in the United States based on our best estimates and judgments and giving due consideration to materiality. The opinion of Ernst & Young LLP, Eaton's independent registered public accounting firm, on those financial statements is included herein. Eaton has high standards of ethical business practices supported by the Eaton Code of Ethics and corporate policies. Careful attention is given to selecting, training and developing personnel, to ensure that management's objectives of establishing and maintaining adequate internal controls and unbiased, uniform reporting standards are attained. Our policies and procedures provide reasonable assurance that operations are conducted in conformity with law and with the Company's commitment to a high standard of business conduct. The Board of Directors pursues its responsibility for the quality of Eaton's financial reporting primarily through its Audit Committee, which is composed of five independent directors. The Audit Committee meets regularly with management, the internal auditors and the independent registered public accounting firm to ensure that they are meeting their responsibilities and to discuss matters concerning accounting, control, audits and financial reporting. The internal auditors and independent registered public accounting firm have full and free access to senior management and the Audit Committee. Alexander M. Cutler Richard H. Fearon Billie K. Rawot - ------------------- ----------------- --------------- Chairman and Chief Executive Vice President - Vice President and Executive Officer; Chief Financial and Planning Controller President Officer February 23, 2007 Page 19 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM To the Board of Directors & Shareholders Eaton Corporation We have audited management's assessment, included in the accompanying Management's Report on Internal Control Over Financial Reporting, that Eaton Corporation maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in INTERNAL CONTROL - INTEGRATED FRAMEWORK issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Eaton Corporation's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion. A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. In our opinion, management's assessment that Eaton Corporation maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also in our opinion, Eaton Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Eaton Corporation as of December 31, 2006 and 2005, and the related statements of consolidated income, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 2006 and our report dated February 23, 2007 expressed an unqualified opinion thereon. Ernst & Young LLP - ------------------------------------ Cleveland, Ohio February 23, 2007 Page 20 MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING The management of Eaton Corporation is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Exchange Act rules 13a-15(f)). Under the supervision and with the participation of Eaton's management, including our principal executive officer and principal financial officer, we conducted an evaluation of the effectiveness of the Company's internal control over financial reporting as of December 31, 2006. In conducting this evaluation, we used the framework set forth by the Committee of Sponsoring Organizations of the Treadway Commission in INTERNAL CONTROL - INTEGRATED FRAMEWORK. Based on this evaluation under the framework referred to above, management concluded that the Company's internal control over financial reporting was effective as of December 31, 2006. The independent registered public accounting firm Ernst & Young LLP has issued an audit report on management's assessment of the effectiveness of the Company's internal control over financial reporting as of December 31, 2006. This report is included herein. Alexander M. Cutler Richard H. Fearon Billie K. Rawot - ------------------- ------------------ --------------- Chairman and Chief Executive Vice President - Vice President and Executive Officer; Chief Financial and Planning Controller President Officer February 23, 2007 Page 21 EATON CORPORATION STATEMENTS OF CONSOLIDATED INCOME
Year ended December 31 -------------------------- (Millions except for per share data) 2006 2005 2004 ------- ------- ------ NET SALES $12,370 $11,019 $9,712 Cost of products sold 9,050 7,936 7,002 Selling & administrative expense 1,946 1,753 1,583 Research & development expense 321 285 259 Interest expense-net 104 90 79 Other (income) expense-net (40) (33) 21 ------- ------- ------ INCOME FROM CONTINUING OPERATIONS BEFORE INCOME TAXES 989 988 768 Income taxes 77 189 128 ------- ------- ------ INCOME FROM CONTINUING OPERATIONS 912 799 640 Income from discontinued operations, net of income taxes 38 6 8 ------- ------- ------ NET INCOME $ 950 $ 805 $ 648 ======= ======= ====== NET INCOME PER COMMON SHARE ASSUMING DILUTION Continuing operations $ 5.97 $ 5.19 $ 4.07 Discontinued operations .25 .04 .06 ------- ------- ------ $ 6.22 $ 5.23 $ 4.13 ======= ======= ====== Average number of Common Shares outstanding assuming dilution 152.9 154.0 157.1 NET INCOME PER COMMON SHARE BASIC Continuing operations $ 6.07 $ 5.32 $ 4.18 Discontinued operations .25 .04 .06 ------- ------- ------ $ 6.32 $ 5.36 $ 4.24 ======= ======= ====== Average number of Common Shares outstanding basic 150.2 150.2 153.1 CASH DIVIDENDS PAID PER COMMON SHARE $ 1.48 $ 1.24 $ 1.08
The notes on pages 27 to 51 are an integral part of the consolidated financial statements. Page 22 EATON CORPORATION CONSOLIDATED BALANCE SHEETS
December 31 ----------------- (Millions of dollars) 2006 2005 ------- ------- ASSETS Current assets Cash $ 114 $ 110 Short-term investments 671 226 Accounts receivable 1,928 1,785 Inventories 1,293 1,099 Deferred income taxes 267 243 Other current assets 135 115 ------- ------- 4,408 3,578 ------- ------- Property, plant & equipment Land & buildings 1,083 1,003 Machinery & equipment 3,863 3,652 ------- ------- 4,946 4,655 Accumulated depreciation (2,675) (2,480) ------- ------- 2,271 2,175 Goodwill 3,034 3,139 Other intangible assets 969 626 Deferred income taxes & other assets 735 700 ------- ------- $11,417 $10,218 ======= ======= LIABILITIES & SHAREHOLDERS' EQUITY Current liabilities Short-term debt $ 490 $ 394 Current portion of long-term debt 322 240 Accounts payable 1,050 810 Accrued compensation 305 277 Accrued income & other taxes 149 305 Other current liabilities 1,091 942 ------- ------- 3,407 2,968 ------- ------- Long-term debt 1,774 1,830 Pension liabilities 942 632 Other postretirement liabilities 766 537 Other long-term liabilities 422 473 Shareholders' equity Common Shares (146.3 million outstanding in 2006 and 148.5 million in 2005) 73 74 Capital in excess of par value 2,114 2,013 Retained earnings 2,796 2,376 Accumulated other comprehensive loss (849) (649) Deferred compensation plans (28) (36) ------- ------- 4,106 3,778 ------- ------- $11,417 $10,218 ======= =======
The notes on pages 27 to 51 are an integral part of the consolidated financial statements. Page 23 EATON CORPORATION STATEMENTS OF CONSOLIDATED CASH FLOWS
Year ended December 31 ------------------------- (Millions) 2006 2005 2004 ------- ------- ----- NET CASH PROVIDED BY OPERATING ACTIVITIES Net income $ 950 $ 805 $ 648 Adjustments to reconcile to net cash provided by operating activities Depreciation & amortization 434 409 400 Deferred income taxes 37 (20) (133) Pension liabilities 198 145 86 Gain on sales of businesses (56) Other long-term liabilities (45) 4 55 Other non-cash items in income 33 (1) (1) Changes in working capital, excluding acquisitions & sales of businesses Accounts receivable (40) (104) (218) Inventories (129) (28) (102) Accounts payable 185 25 143 Accrued income & other taxes (149) 27 46 Other current liabilities 72 (29) (122) Other working capital accounts 77 (37) 76 Voluntary contributions to United States & United Kingdom qualified pension plans (119) (64) (93) Other-net (17) 3 53 ------- ------- ----- 1,431 1,135 838 ------- ------- ----- NET CASH (USED IN) INVESTING ACTIVITIES Expenditures for property, plant & equipment (360) (363) (330) Cash paid for acquisitions of businesses (256) (911) (627) Proceeds from sales of businesses 65 (Purchases) sales of short-term investments-net (418) (4) 606 Other-net (42) 10 18 ------- ------- ----- (1,011) (1,268) (333) ------- ------- ----- NET CASH (USED IN) PROVIDED BY FINANCING ACTIVITIES Borrowings with original maturities of more than three months Proceeds 706 393 75 Payments (617) (63) (248) Borrowings with original maturities of less than three months-net, primarily commercial paper (35) 392 (33) Cash dividends paid (220) (184) (163) Proceeds from exercise of employee stock options 108 68 138 Income tax benefit from exercise of employee stock options 28 Purchase of Common Shares (386) (450) (250) Other 2 ------- ------- ----- (416) 158 (481) ------- ------- ----- Total increase in cash 4 25 24 Cash at beginning of year 110 85 61 ------- ------- ----- Cash at end of year $ 114 $ 110 $ 85 ======= ======= =====
The notes on pages 27 to 51 are an integral part of the consolidated financial statements. Page 24 EATON CORPORATION STATEMENTS OF CONSOLIDATED SHAREHOLDERS' EQUITY
Accumu- Total Common Shares Capital in lated other Deferred Share- ---------------- excess of Retained comprehen- compensa- holders' (Millions) Shares Dollars par value earnings sive loss tion plans equity ------ ------- ---------- -------- ----------- ---------- -------- BALANCE AT JANUARY 1, 2004 153.0 $76 $1,856 $1,816 $(585) $(46) $3,117 Net income 648 648 Foreign currency translation and related hedging instruments (including income tax benefits of $5) 99 99 Unrealized loss on available for sale investments (net of income tax benefits of $1) (2) (2) Deferred loss on cash flow hedges (net of income tax benefits of $1) (2) (2) Minimum pension liability (net of income tax benefits of $25) (48) (48) ------ Other comprehensive income 47 ------ Total comprehensive income 695 Cash dividends paid (163) (163) Issuance of shares under employee benefit plans, including tax benefit 4.5 3 188 (2) 10 199 Issuance of shares to trust 2 (2) Purchase of shares (4.2) (2) (53) (195) (250) Other-net 8 8 ----- --- ------ ------ ----- ---- ------ BALANCE AT DECEMBER 31, 2004 153.3 77 1,993 2,112 (538) (38) 3,606 Net income 805 805 Foreign currency translation and related hedging instruments (including income taxes of $33) (53) (53) Deferred gain on cash flow hedges (net of income taxes of $2) 6 6 Minimum pension liability (net of income tax benefits of $36) (64) (64) ------ Other comprehensive loss (111) ------ Total comprehensive income 694 Cash dividends paid (184) (184) Issuance of shares under employee benefit plans, including tax benefit 2.1 1 104 (2) 10 113 Issuance of shares to trust .1 8 (8) Purchase of shares (7.0) (4) (92) (354) (450) Other-net (1) (1) ----- --- ------ ------ ----- ---- ------
Page 25 BALANCE AT DECEMBER 31, 2005 148.5 74 2,013 2,376 (649) (36) 3,778 Net income 950 950 Foreign currency translation and related hedging instruments (including income tax benefits of $16) 95 95 Deferred gain on cash flow hedges (net of income tax benefits of $3) (5) (5) Minimum pension liability (net of income tax benefits of $1) (8) (8) ------ Other comprehensive income 82 ------ Total comprehensive income 1,032 Adjustment to initially apply SFAS No. 158 Pensions (net of income tax benefits of $85) (163) (163) Other postretirement benefits (net of income tax benefits of $119) (119) (119) Cash dividends paid (220) (220) Issuance of shares under employee benefit plans, including tax benefit 3.1 2 176 (2) 13 189 Purchase of shares by trust (5) (5) Purchase of shares (5.3) (3) (75) (308) (386) ----- --- ------ ------ ----- ---- ------ BALANCE AT DECEMBER 31, 2006 146.3 $73 $2,114 $2,796 $(849) $(28) $4,106 ===== === ====== ====== ===== ==== ======
The notes on pages 27 to 51 are an integral part of the consolidated financial statements. Page 26 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Dollars in millions, except per share data (per share data assume dilution) ACCOUNTING POLICIES CONSOLIDATION & BASIS OF PRESENTATION The consolidated financial statements include accounts of Eaton and all subsidiaries and other controlled entities. The equity method of accounting is used for investments in associate companies where the Company has a 20% to 50% ownership interest. These associate companies are not material either individually, or in the aggregate, to Eaton's financial position, results of operations or cash flows. Eaton does not have off-balance sheet arrangements or financings with unconsolidated entities or other persons. In the ordinary course of business, the Company leases certain real properties and equipment, as described in "Lease Commitments" in the Notes below. Transactions with related parties are in the ordinary course of business, are conducted on an arm's-length basis, and are not material to Eaton's financial position, results of operations or cash flows. FOREIGN CURRENCY TRANSLATION The functional currency for substantially all subsidiaries outside the United States is the local currency. Financial statements for these subsidiaries are translated into United States dollars at year-end exchange rates as to assets and liabilities and weighted-average exchange rates as to revenues and expenses. The resulting translation adjustments are recorded in Accumulated other comprehensive income (loss) in Shareholders' equity. INVENTORIES Inventories are carried at lower of cost or market. Inventories in the United States are generally accounted for using the last-in, first-out (LIFO) method. Remaining United States and all other inventories are accounted for using the first-in, first-out (FIFO) method. Cost components include raw materials, purchased components, direct labor, indirect labor, utilities, depreciation, inbound freight charges, purchasing and receiving costs, inspection costs, warehousing costs, internal transfer costs, and costs of the distribution network. In first quarter 2006, Eaton adopted Statement of Financial Accounting Standards (SFAS) No. 151, "Inventory Costs". SFAS No. 151 amends the guidance in Accounting Research Bulletin No. 43, Chapter 4, "Inventory Pricing", to clarify the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage). The effect of the adoption of SFAS No. 151 was not material to the Company's financial position, results of operations, or cash flows. DEPRECIATION & AMORTIZATION Depreciation and amortization are computed by the straight-line method for financial statement purposes. Cost of buildings is depreciated over 40 years and machinery and equipment over principally 3 to 10 years. At December 31, 2006, the weighted-average amortization periods for intangible assets subject to amortization were 14 years for patents, 18 years for tradenames, 28 years for distributor channels and 18 years for manufacturing technology and customer relationships. Software is amortized over a range of 3 to 5 years. Long-lived assets, except goodwill and indefinite life intangible assets as described in the Notes below, are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount may not be recoverable. Events or circumstances that would result in an impairment review primarily include operations reporting losses, a significant change in the use of an asset, or the planned disposal or sale of the asset. The asset would be considered impaired when the future net undiscounted cash flows generated by the asset are less than its carrying value. An impairment loss would be recognized based on the amount by which the carrying value of the asset exceeds its fair value. GOODWILL & INDEFINITE LIFE INTANGIBLE ASSETS In accordance with SFAS No. 142, "Goodwill and Other Intangible Assets", Eaton does not amortize goodwill and indefinite life intangible assets recorded in connection with business acquisitions. Indefinite life intangible assets primarily consist of trademarks. The Company completed the annual impairment tests for goodwill and indefinite life intangible assets required by SFAS No. 142. These tests confirmed that the fair value of the Company's reporting units and indefinite life intangible assets exceed their respective carrying values and that no impairment loss was required to be recognized. Page 27 FINANCIAL INSTRUMENTS In the normal course of business, Eaton is exposed to fluctuations in interest rates, foreign currency exchange rates, and commodity prices. The Company uses various financial instruments, primarily foreign currency forward exchange contracts, foreign currency swaps, interest rate swaps and, to a minor extent, commodity futures contracts, to manage exposure to price fluctuations. Financial instruments used by Eaton are straightforward, non-leveraged instruments for which quoted market prices are readily available from a number of independent sources. The risk of credit loss is deemed to be remote, because the counterparties to these instruments are major international financial institutions with strong credit ratings and because of the Company's control over the size of positions entered into with any one counterparty. Such financial instruments are not bought and sold solely for trading purposes, except for nominal amounts authorized under limited, controlled circumstances. No such financial instruments were purchased or sold for trading purposes in 2006, 2005 and 2004. All derivative financial instruments are recognized as either assets or liabilities on the balance sheet and are measured at fair value. Accounting for the gain or loss resulting from the change in the financial instrument's fair value depends on whether it has been designated, and is effective, as a hedge and, if so, on the nature of the hedging activity. Financial instruments can be designated as hedges of changes in the fair value of a recognized fixed-rate asset or liability, or the firm commitment to acquire such an asset or liability; as hedges of variable cash flows of a recognized variable-rate asset or liability, or the forecasted acquisition of such an asset or liability; or as hedges of foreign currency exposure from a net investment in one of the Company's foreign operations. Gains and losses related to a hedge are either recognized in income immediately to offset the gain or loss on the hedged item or are deferred and reported as a component of Accumulated other comprehensive income (loss) in Shareholders' equity and subsequently recognized in net income when the hedged item affects net income. The ineffective portion of the change in fair value of a financial instrument is recognized in income immediately. The gain or loss related to financial instruments that are not designated as hedges are recognized immediately in net income. WARRANTY EXPENSES Estimated product warranty expenses are accrued in Cost of products sold at the time the related sale is recognized. Estimates of warranty expenses are based primarily on historical warranty claim experience and specific customer contracts. Warranty expenses include accruals for basic warranties for products sold, as well as accruals for product recalls and other related events when they are known and estimable. ASSET RETIREMENT OBLIGATIONS In 2005, the FASB issued Interpretation No. 47, "Accounting for Conditional Asset Retirement Obligations" (FIN 47), to clarify the term "conditional asset retirement" as used in SFAS No. 143, "Accounting for Asset Retirement Obligations". FIN 47 requires that a liability be recognized for the fair value of a conditional asset retirement obligation when incurred, if the fair value of the liability can be reasonably estimated. Uncertainty about the timing or method of settlement of a conditional asset retirement obligation would be factored into the measurement of the liability when sufficient information exists. Eaton believes that for substantially all of its asset retirement obligations, there is an indeterminate settlement date because the range of time over which the Company may settle the obligation is unknown or cannot be estimated. A liability for these obligations will be recorded in the period when sufficient information regarding timing and method of settlement becomes available to make a reasonable estimate of the liability's fair value. STOCK OPTIONS GRANTED TO EMPLOYEES & DIRECTORS As described in "Stock Options" in the Notes below, effective January 1, 2006, in accordance with SFAS No. 123(R), "Share-Based Payment", Eaton has recorded compensation expense under the "fair-value-based" method of accounting for stock options granted to employees and directors. The Company adopted SFAS No. 123(R) using the "modified prospective application" method and, consequently, financial results for periods prior to 2006 were not restated for this accounting change. Under the modified prospective method, compensation expense for stock options includes expense for all options granted prior to, but not yet vested as of the end of 2005, and expense for options granted beginning in 2006, based on the grant date fair value of the options. Expense is recognized on a straight-line basis over the period the employee or director is required to provide service in exchange for the award. Prior to 2006, as allowed by SFAS No. 123, "Accounting for Stock-Based Compensation", stock options were accounted for using the intrinsic-value-based method in Accounting Principles Board (APB) Opinion No. Page 28 25. Under that method, no compensation expense was recognized on the grant date, since on that date the option exercise price equaled the market price of the underlying Common Shares. REVENUE RECOGNITION Sales are recognized when products are shipped to unaffiliated customers, all significant risks of ownership have been transferred to the customer, title has transferred in accordance with shipping terms (FOB shipping point or FOB destination), the selling price is fixed and determinable, all significant related acts of performance have been completed, and no other significant uncertainties exist. Shipping and handling costs billed to customers are included in Net sales and the related costs in Cost of products sold. Other revenues for service contracts are recognized as the services are provided. ESTIMATES Preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions in certain circumstances that affect amounts reported in the accompanying consolidated financial statements and notes. Actual results could differ from these estimates. FINANCIAL PRESENTATION CHANGES Certain amounts for prior years have been reclassified to conform to the current year presentation. ACQUISITIONS OF BUSINESSES In 2006, 2005, and 2004, Eaton acquired certain businesses and formed joint ventures in separate transactions for a combined net cash purchase price of $256 in 2006, $911 in 2005 and $627 in 2004. The Statements of Consolidated Income include the results of these businesses from the effective dates of acquisition or formation. A summary of these transactions for 2006 and 2005, and larger transactions in 2004, follows:
Business Annual Acquired business Date of acquisition segment sales - ------------------ ------------------- ----------- ----------- Schreder-Hazemeyer December 1, 2006 Electrical $9 for 2006 Eaton acquired the remaining 50% ownership of the Belgium manufacturer of low and medium voltage electrical distribution switchgear Diesel fuel processing technology & associated assets of October 26, 2006 Truck NM Catalytica Energy Systems Inc. A U.S. developer of emission control solutions for Trucks Senyuan International Holdings Limited September 14, 2006 Electrical $47 for A China-based manufacturer of vacuum circuit breakers and 2005 other electrical switchgear components Ronningen-Petter business unit of Dover Resources, Inc. September 5, 2006 Fluid Power $30 for A U.S.-based manufacturer of industrial fine filters and 2005 components Synflex business unit of Saint-Gobain Performance Plastics Corp. March 31, 2006 Fluid Power $121 for A U.S.-based manufacturer of thermoplastic hose and tubing 2005 Marina Power & Lighting March 24, 2006 Electrical $11 for A U.S. manufacturer of marine duty electrical distribution 2005 products Aerospace division of PerkinElmer, Inc. December 6, 2005 Fluid Power $150 for A U.S.-based provider of sealing and pneumatic systems for the year large commercial aircraft and regional jets ended June 30, 2005
Page 29 Aerospace fluid and air division of Cobham plc November 1, 2005 Fluid Power $210 for A U.K.-based company that provides low-pressure airframe 2004 fuel systems, electro-mechanical actuation, air ducting, hydraulic and power generation, and fluid distribution systems for fuel, hydraulics and air Assets of Pringle Electrical Manufacturing Company October 11, 2005 Electrical $6 for A U.S. manufacturer of bolted contact switches and other 2004, specialty switches one-third of which were to Eaton Industrial filtration business of Hayward Industries, Inc. September 6, 2005 Fluid Power $100 for A U.S.-based producer of filtration systems for industrial the year and commercial customers ended June 30, 2005 Tractech Holdings, Inc. August 17, 2005 Automotive $43 for A U.S.-based manufacturer of specialized differentials and 2004 clutch components for the commercial and specialty vehicle markets Morestana S.A. de C.V. June 30, 2005 Automotive $13 for A Mexican producer of hydraulic lifters for automotive engine 2004 manufacturers and the automotive aftermarket Eaton Electrical (Zhongshan) Co., Ltd. (a 51%-owned joint June 17, 2005 Electrical NM venture) A China-based manufacturer of medium-voltage switchgear components, including circuit breakers, meters and relays Winner Group Holdings Ltd. March 31, 2005 Fluid Power $26 for A China-based producer of hydraulic hose fittings and 2004 adapters Pigozzi S.A. Engrenagens e Transmissoes March 1, 2005 Truck $42 for A Brazilian agricultural powertrain business that produces 2004 transmissions, rotors and other drivetrain components Walterscheid Rohrverbindungstechnik GmbH September 1, 2004 Fluid Power $52 for A German manufacturer of hydraulic tube connectors and 2003 fittings primarily for the European market Powerware Corporation June 9, 2004 Electrical $775 for A U.S.-based supplier of Uninterruptible Power Systems (UPS), the year DC Power products and power quality services for computer ended manufacturers, industrial companies, governments, March 31, telecommunications firms, medical institutions, data centers 2004 and other businesses FAW Eaton Transmission Co., Ltd. (a 50%-owned joint venture) March 31, 2004 Truck NM Manufacturer of medium-duty transmissions for the China market
The allocations of the purchase prices for acquisitions in 2006 are preliminary and will be finalized in 2007. Page 30 On December 28, 2006, Eaton announced it had reached an agreement to purchase AT Holdings Corporation, the parent of Argo-Tech Corporation, for $695. This transaction is expected to close in the first quarter of 2007. Argo-Tech's U.S.-based aerospace business, which had sales for the fiscal year ended October 28, 2006 of $206, is a leader in high performance aerospace engine fuel pumps and systems, airframe fuel pumps and systems, and ground fueling systems for commercial and military aerospace markets. This business will be integrated into the Fluid Power segment. On January 5, 2007, the Company announced it had reached an agreement to purchase the Power Protection Business of Power Products Ltd., a Czech distributor and service provider of Powerware and other uninterruptible power systems, for $2. The transaction closed in February 2007. This business, which had 2006 sales of $3, will be integrated into the Electrical segment. As described above, on June 9, 2004, Eaton acquired Powerware Corporation, the electrical power systems business of Invensys plc, for a final cash purchase price of $573, less cash acquired of $27. Powerware's assets and liabilities were recorded at estimated fair values as determined by Eaton's management. The allocation of the purchase price for this acquisition is summarized below: Current assets $302 Property, plant & equipment 35 Goodwill 397 Other intangible assets 96 Other assets 53 ---- Total assets acquired 883 Total liabilities assumed 337 ---- Net assets acquired $546 ====
Other intangible assets of $96 included $24 related to trademarks that are not subject to amortization. The remaining $72 was assigned to patents and other intangible assets that have a weighted-average useful life of 8 years. Goodwill of $397 relates to the Electrical segment, substantially all of which is non-deductible for income tax purposes. Eaton has undertaken restructuring activities at acquired businesses, including workforce reductions, plant consolidations and facility closures. In accordance with EITF Issue No. 95-3, "Recognition of Liabilities in Connection with a Purchase Business Combination," liabilities for these restructuring activities were recorded in the allocation of the purchase price related to the acquired business. A summary of these liabilities, and utilization of the various components, follows:
Workforce Reductions Plant -------------------- closing Employees Dollars & other Total --------- -------- ------- ----- Balance at January 1, 2004 763 $ 22 $ 63 $ 85 Liabilities recorded in 2004 175 9 35 44 Utilized in 2004 (555) (18) (48) (66) ----- ---- ---- ---- Balance at December 31, 2004 383 13 50 63 Liabilities recorded in 2005 789 25 27 52 Utilized in 2005 (228) (14) (40) (54) ----- ---- ---- ---- Balance at December 31, 2005 944 24 37 61 Liabilities recorded in 2006 417 17 28 45 Utilized in 2006 (285) (8) (43) (51) ----- ---- ---- ---- Balance at December 31, 2006 1,076 $ 33 $ 22 $ 55 ===== ==== ==== ====
In accordance with EITF Issue No. 95-3, the Company finalizes its restructuring plans no later than one year from the date of the acquisition. Page 31 ACQUISITION INTEGRATION & EXCEL 07 PLANT CLOSING CHARGES ACQUISITION INTEGRATION CHARGES In 2006, 2005 and 2004, Eaton incurred charges related to the integration of acquired businesses. These charges were recorded as expense as incurred. A summary of these charges follows:
2006 2005 2004 ---- ---- ---- Electrical $ 7 $ 21 $ 33 Fluid Power 23 7 8 Truck 5 4 Automotive 5 4 ---- ---- ---- Pretax charges $ 40 $ 36 $ 41 ==== ==== ==== After-tax charges $ 27 $ 24 $ 27 Per Common Share $.17 $.15 $.17
2006 CHARGES Charges in 2006 related to the integration of primarily the following acquisitions: Powerware, the electrical power systems business acquired in 2004 and the Pringle electrical switch business; several acquisitions in Fluid Power including the acquired operations of Synflex, PerkinElmer, Cobham, Hayward, Winner, and Walterscheid; and the Pigozzi, Tractech, and Morestana businesses. Charges in the Electrical segment consisted of $7 for plant consolidations, integration and other expenses. Charges in the Fluid Power segment consisted of $20 for plant consolidations, integration and other expenses, and $3 for workforce reductions. Charges in the Truck segment consisted of $5 for plant consolidations, integration and other expenses. Charges in the Automotive segment consisted of $5 for plant consolidations, integration and other expenses. 2005 CHARGES Charges in 2005 related to the integration of primarily the following acquisitions: Powerware and the electrical division of Delta plc; several acquisitions in Fluid Power, including Winner, Walterscheid and Boston Weatherhead; and the Pigozzi and Morestana businesses. Charges in the Electrical segment consisted of $20 for plant consolidations, integration and other expenses, and $1 for workforce reductions. Charges in the Fluid Power segment consisted of $7 for plant consolidations, integration and other expenses. 2004 CHARGES Charges in 2004 related to the integration of primarily the following acquisitions: Powerware; the electrical division of Delta plc; and Boston Weatherhead. Charges in the Electrical segment consisted of $32 for plant consolidations, integration and other expenses, and $1 of workforce reductions. Charges in the Fluid Power segment consisted of $8 for plant consolidations, integration and other expenses. EXCEL 07 PLANT CLOSING CHARGES In first quarter 2006, Eaton announced, and began to implement, its Excel 07 program. This program was a series of actions concluded in 2006 intended to address resource levels and operating performance in businesses that underperformed in 2005, and businesses that were expected to weaken during second half 2006 and in 2007. As part of the Excel 07 program, charges were incurred related to plant closings in all four business segments, including three significant plant closings announced in third quarter 2006 for the heavy-duty truck transmission manufacturing plant in Manchester, United Kingdom; the engine valve actuation manufacturing plant in Saginaw, Michigan; and the engine valve manufacturing plant in Montornes del Valles, Spain. A summary of charges incurred by each segment in Page 32 2006 related to Excel 07 plant closings, including workforce reductions, plant integration and other charges follow: Electrical $ 12 Fluid Power 15 Truck 29 Automotive 50 ---- Pretax charges $106 ====
SUMMARY OF ACQUISITION INTEGRATION AND EXCEL 07 PLANT CLOSING CHARGES A summary of acquisition integration and Excel 07 plant closing charges, and utilization of the various components follows:
Workforce reductions Plant -------------------- closing Employees Dollars & other Total --------- ------- ----------- ----- Balance at January 1, 2004 21 $ 2 $ 8 $ 10 Charges in 2004 10 1 40 41 Utilized in 2004 (31) (3) (45) (48) ----- ---- ---- ---- Balance at December 31, 2004 0 0 3 3 Charges in 2005 173 4 32 36 Utilized in 2005 (7) (1) (34) (35) ----- ---- ---- ---- Balance at December 31, 2005 166 3 1 4 Charges in 2006 2,339 85 61 146 Utilized in 2006 (902) (39) (56) (95) ----- ---- ---- ---- Balance at December 31, 2006 1,603 $ 49 $ 6 $ 55 ===== ==== ==== ====
The acquisition integration and Excel 07 plant closing charges were included in the Statements of Consolidated Income in Cost of products sold or Selling & administrative expense, as appropriate. In Business Segment Information, the charges reduced Operating profit of the related business segment. DISCONTINUED OPERATIONS As part of the Excel 07 program, in third quarter 2006, certain businesses of the Automotive segment were sold, resulting in a $35 after-tax gain, or $.23 per Common Share. The gain on sale of these businesses, and other operating results of these businesses, were reported as Discontinued operations in the Statement of Consolidated Income. SHORT-TERM INVESTMENTS Eaton invests excess cash generated from operations in short-term marketable investments and classifies these investments as "available-for-sale" under Statement of Financial Accounting Standards (SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity Securities". In accordance with SFAS No. 115, available-for-sale investments are recorded at fair market prices, with the unrealized gain or loss recorded in Accumulated other comprehensive income (loss) in Shareholders' equity. A summary of the carrying value of short-term investments at December 31, 2006 follows: Time deposits & certificate of deposits with banks $323 Bonds issued by foreign governments 149 Money market investments 138 Corporate & agency bonds 60 Other 1 ---- $671 ====
The fair market value of short-term investments approximates the cost of these investments. Page 33 GOODWILL & OTHER INTANGIBLE ASSETS A summary of goodwill follows:
2006 2005 ------ ------ Electrical $1,039 $1,016 Fluid Power 1,689 1,811 Truck 144 145 Automotive 162 167 ------ ------ $3,034 $3,139 ====== ======
The net decrease in goodwill in 2006 was due to the final allocation of purchase price to acquisitions of businesses completed prior to 2006, partially offset by increases in goodwill for businesses acquired during 2006. These transactions are described in the "Acquisitions of Businesses" Note above. A summary of other intangible assets follows:
2006 2005 ------------------------- ------------------------- Historical Accumulated Historical Accumulated cost amortization cost amortization ---------- ------------ ---------- ------------ Intangible assets not subject to amortization (primarily trademarks) $430 $381 ==== ==== Intangible assets subject to amortization Patents $208 $107 $191 $ 90 Technology and customer relationships 337 57 101 26 Other 204 46 108 39 ---- ---- ---- ---- $749 $210 $400 $155 ==== ==== ==== ====
Expense related to intangible assets subject to amortization for 2006 was $51. Estimated annual pretax expense for intangible assets subject to amortization for each of the next five years is $50 in 2007, $49 in 2008, $47 in 2009, $44 in 2010 and $40 in 2011. DEBT & OTHER FINANCIAL INSTRUMENTS Short-term debt of $490 at December 31, 2006 included $472 of short-term commercial paper for operations in the United States and $18 for operations outside the United States. Borrowings for operations in the United States included 200 million of Euro denominated commercial paper. The foreign exchange translation gain or loss related to the Euro denominated commercial paper is recorded in Accumulated other comprehensive income (loss) in Shareholders' equity since these borrowings serve as a hedge of the Company's net assets of operations in Europe. Borrowings for operations outside the United States were largely denominated in local currencies. The weighted-average interest rate on the $472 of short-term commercial paper was 4.4% at December 31, 2006. The weighted-average interest rate on short-term debt for operations outside the United States was 2.7% at December 31, 2006. Operations outside the United States have available short-term lines of credit aggregating $399 from various banks worldwide. A summary of long-term debt, including the current portion, follows: Page 34
2006 2005 ------ ------ 1.62% Yen notes due 2006 $ 43 8% debentures due 2006 86 8.90% debentures due 2006 100 6% Euro 200 million notes due 2007 (100 million converted to floating rate by interest rate swap) $ 263 236 7.37% notes due 2007 (converted to floating rate by interest rate swap) 20 20 7.14% notes due 2007 3 3 6.75% notes due 2007 (converted to floating rate by interest rate swap) 25 25 Euro 100 million floating rate notes due 2008 (3.991% at December 31, 2006 - EURIBOR+.375%) 132 118 7.40% notes due 2009 (converted to floating rate by interest rate swap) 15 15 Floating rate senior notes due 2009 (5.53% at December 31, 2006 - LIBOR +.08%) 250 5.75% notes due 2012 ($225 converted to floating rate by interest rate swap) 300 300 7.58% notes due 2012 (converted to floating rate by interest rate swap) 12 12 5.80% notes due 2013 7 7 12.5% British Pound debentures due 2014 11 10 4.65% notes due 2015 (converted to floating rate by interest rate swap) 100 100 7.09% notes due 2018 (converted to floating rate by interest rate swap) 25 25 6.89% notes due 2018 6 6 7.07% notes due 2018 2 2 6.875% notes due 2018 3 3 8-7/8% debentures due 2019 ($25 converted to floating rate by interest rate swap) 38 38 8.10% debentures due 2022 100 100 7.625% debentures due 2024 ($25 converted to floating rate by interest rate swap) 66 66 6-1/2% debentures due 2025 145 145 7.875% debentures due 2026 72 72 7.65% debentures due 2029 ($75 converted to floating rate by interest rate swap) 200 200 5.45% debentures due 2034 ($100 converted to floating rate by interest rate swap) 150 150 5.25% notes due 2035 ($50 converted to floating rate by interest rate swap) 90 100 Other 61 88 ------ ------ Total long-term debt 2,096 2,070 Less current portion of long-term debt (322) (240) ------ ------ Long-term debt less current portion $1,774 $1,830 ====== ======
Eaton's United States operations have long-term revolving credit facilities of $1.5 billion, of which $300 will expire in May 2008, $700 in March 2010 and the remaining $500 in August 2011. One of the Company's international subsidiaries has a long-term line of credit of Euro 100 million. The Euro 100 million floating rate notes due 2008, which have a U.S. dollar equivalent of $132 at December 31, 2006, were borrowed under this line of credit. Aggregate mandatory annual maturities of long-term debt for each of the next five years are $322 in 2007, $133 in 2008, $268 in 2009, $1 in 2010 and $6 in 2011. Interest paid was $151 in 2006, $113 in 2005 and $96 in 2004. Eaton has entered into fixed-to-floating interest rate swaps to manage interest rate risk. These interest rate swaps are accounted for as fair value hedges of certain of the Company's long-term debt. The Page 35 maturity of the swap corresponds with the maturity of the debt instrument as noted in the table of long-term debt above. A summary of interest rate swaps outstanding at December 31, 2006, follows (currency in millions):
Interest rates at December 31, 2006 -------------------------------------------- Fixed interest Floating Basis for contracted Notional rate interest floating interest amount received rate paid rate paid - -------- -------- --------- --------------------- E 100 6.00% 4.10% 6 month EURIBOR+0.54% $ 20 7.37% 9.85% 6 month LIBOR+4.47% $ 25 6.75% 6.89% 6 month LIBOR+1.50% $ 15 7.40% 7.34% 6 month LIBOR+1.95% $225 5.75% 6.39% 6 month LIBOR+0.78% $ 12 7.58% 7.15% 6 month LIBOR+1.76% $100 4.65% 5.47% 6 month LIBOR+0.12% $ 25 7.09% 7.79% 6 month LIBOR+2.40% $ 25 8.88% 9.20% 6 month LIBOR+3.84% $ 25 7.63% 7.85% 6 month LIBOR+2.48% $ 75 7.65% 7.98% 6 month LIBOR+2.58% $100 5.45% 5.83% 6 month LIBOR+0.43% $ 50 5.25% 5.52% 6 month LIBOR+0.17%
The carrying values of cash, short-term investments and short-term debt in the balance sheet approximate their estimated fair values. The estimated fair values of other financial instruments outstanding follow:
2006 2005 ----------------------------- ----------------------------- Notional Carrying Fair Notional Carrying Fair amount value value amount value value -------- -------- ------- -------- -------- ------- Long-term debt & current portion of long-term debt (a) $(2,096) $(2,213) $(2,070) $(2,221) Foreign currency principal swaps $192 (5) (5) $ 83 (2) (2) Foreign currency forward exchange contracts (23) (6) (7) 12 5 5 Fixed to floating interest rate swaps 829 (15) (14) 1,080 12 12
(a) Includes foreign currency denominated debt. The estimated fair values of financial instruments were principally based on quoted market prices where such prices were available and, where unavailable, fair values were estimated based on comparable contracts, utilizing information obtained from established, independent providers. The fair value of foreign currency principal swaps, which related to the Euro and Pound Sterling, and foreign currency forward exchange contracts, which primarily related to the Euro, Pound Sterling, Japanese Yen and U.S. Dollar, were estimated based on quoted market prices of comparable contracts, adjusted through interpolation where necessary for maturity differences. These contracts mature during 2007 through 2009. RETIREMENT BENEFIT PLANS ADOPTION OF STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 158 On December 31, 2006, Eaton adopted Statement of Financial Accounting Standards (SFAS) No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)". SFAS No. 158 requires employers to recognize on their balance sheets the net amount by which pension and other postretirement benefit plan liabilities are overfunded or underfunded. SFAS No. 158 replaces SFAS No. 87's requirement to report at least a minimum pension liability measured as the excess of the accumulated benefit obligations over the fair value of plan assets. Under SFAS No. 158, all actuarial gains and losses and prior service costs are Page 36 recognized, with an offsetting increase in accumulated other comprehensive loss in shareholders' equity, net of income tax benefits. SFAS No. 158 does not change the amounts recognized in the income statement as net periodic benefit cost. The incremental effect on Eaton of applying SFAS No. 158 on individual line items in the Consolidated Balance Sheet at December 31, 2006 follows:
Effect of adopting SFAS No. 158 ------------------------- Before Other adoption postretire- After of SFAS Pension ment adoption of No. 158 liabilities liabilities SFAS No. 158 -------- ----------- ----------- ------------ Non-current deferred income tax assets $ 303 $ 85 $ 119 $ 507 Other assets 182 (26) 156 ----- ----- Total assets 11,239 $ 59 $ 119 11,417 ===== ===== Other current liabilities $(1,089) $ (10) $ 8 $(1,091) Non-current liabilities Pensions (730) (212) (942) Other postretirement benefits (520) (246) (766) ----- ----- Total liabilities (6,851) $(222) $(238) (7,311) ===== ===== Accumulated other comprehensive loss in Shareholders' equity $ 567 $ 163 $ 119 $ 849 ----- ----- Total Shareholders' equity (4,388) $ 163 $ 119 (4,106) ===== =====
RETIREMENT BENEFIT PLAN LIABILITIES AND ASSETS Eaton has defined benefit pension plans and other postretirement benefit plans. Components of plan obligations and assets, and recorded liabilities and assets follow:
Other postretirement Pension liabilities liabilities ------------------- -------------------- 2006 2005 2006 2005 ------- ------- ----- ----- Changes in benefit obligation Benefit obligation at beginning of year $(2,782) $(2,601) $(873) $(896) Service cost (144) (119) (17) (16) Interest cost (147) (141) (45) (48) Actuarial (loss) gain (165) (190) (9) 3 Benefits paid 224 206 97 97 Prescription drug subsidy received (5) Foreign currency translation (97) 83 Business acquisitions (4) (13) (2) Other (10) (7) (2) (11) ------- ------- ----- ----- Benefit obligation at end of year (3,125) (2,782) (854) (873) ------- ------- ----- ----- Change in plan assets Fair value of plan assets at beginning of year 1,916 1,852 Actual return on plan assets 246 204 Employer contributions 161 97 97 97 Benefits paid (224) (206) (97) (97) Foreign currency translation 66 (50) Business acquisitions 13 Other 8 6 ------- ------- ----- ----- Fair value of plan assets at end of year 2,173 1,916 0 0 ------- ------- ----- ----- Funded status (952) (866) (854) (873) Contributions after measurement date 3 2 7 8 Unrecognized net actuarial loss 1,053 246 Unrecognized prior service cost 23 (7) ------- ------- ----- ----- Amount recognized in Consolidated Balance Sheet $ (949) $ 212 $(847) $(626) ======= ======= ===== =====
Page 37 Amounts recognized in the Consolidated Balance Sheet, which reflect the adoption of SFAS No. 158 at December 31, 2006, follow:
Other postretirement Pension liabilities liabilities ------------------- -------------------- 2006 2005 2006 2005 ----- ----- ----- ----- Non-current assets $ 3 $ 27 Current liabilities (10) $ (81) $ (89) Non-current liabilities (942) (632) (766) (537) Accumulated other comprehensive loss 817 ----- ----- ----- ----- Amount recognized in Consolidated Balance Sheet $(949) $ 212 $(847) $(626) ===== ===== ===== =====
Amounts recognized in Accumulated other comprehensive loss at December 31, 2006, before income tax benefits, follow:
Other Pension postretirement liabilities liabilities ----------- -------------- Net actuarial loss $1,051 $245 Prior service cost 23 (7) ------ ---- Total before income tax benefits $1,074 $238 ====== ====
Prior to December 31, 2006, SFAS No. 87 required recognition of a minimum liability for those pension plans with accumulated benefit obligations in excess of the fair values of plan assets at the end of the year. Accordingly, in 2006, 2005 and 2004, Eaton recorded non-cash charges in Accumulated other comprehensive loss of $9, $100 and $73, respectively, ($8, $64 and $48 after income tax benefits, respectively) related to the additional minimum liability for certain underfunded pension plans. As a result of the adoption of SFAS No. 158, at December 31, 2006, Eaton recorded non-cash charges in Accumulated other comprehensive loss in Shareholders' equity of $248 ($163 after-tax) for pension benefits and $238 ($119 after-tax) for other postretirement benefits as a one-time adjustment to initially apply the new Standard. Pension funding requirements are not affected by the recording of these charges. PENSION PLANS The measurement date for all pension obligations is November 30. Effective for fiscal years ending after December 15, 2008, SFAS No. 158 will require year end measurements of plan assets and benefit obligations, eliminating the use of earlier measurement dates currently permissible. Assumptions used to determine pension benefit obligations and costs follow:
United States & non-United States United plans (weighted- States plans average) ------------------ ------------------ 2006 2005 2004 2006 2005 2004 ---- ---- ---- ---- ---- ---- Assumptions used to determine benefit obligation at year-end Discount rate 5.60% 5.75% 6.00% 5.39% 5.51% 5.81% Rate of compensation increase 3.50% 3.50% 3.50% 3.67% 3.67% 3.60% Assumptions used to determine cost Discount rate 5.75% 6.00% 6.25% 5.51% 5.81% 6.11% Expected long-term return on plan assets 8.75% 8.75% 8.75% 8.35% 8.41% 8.50% Rate of compensation increase 3.50% 3.50% 3.50% 3.67% 3.60% 3.60%
Page 38 The expected long-term rate of return on pension assets was determined separately for each country and reflects long-term historical data, with greater weight given to recent years, and takes into account each plan's target asset allocation. The components of pension benefit cost recorded in Statements of Consolidated Income follow:
2006 2005 2004 ----- ----- ----- Service cost $(144) $(119) $(103) Interest cost (147) (141) (134) Expected return on plan assets 166 166 179 Amortization (67) (49) (26) ----- ----- ----- (192) (143) (84) Curtailment loss (10) (1) (2) Settlement loss (41) (34) (31) ----- ----- ----- Costs recorded in Statements of Consolidated Income $(243) $(178) $(117) ===== ===== =====
Other changes in plan assets and benefit liabilities recognized in Accumulated other comprehensive loss, before income tax benefits, follow:
2006 2005 2004 ------ ---- ---- Accumulated other comprehensive loss at beginning of year $ 817 $717 $644 Change prior to adoption of SFAS No. 158 9 100 73 Change due to adoption of SFAS No. 158 248 ------ ---- ---- Accumulated other comprehensive loss at end of year $1,074 $817 $717 ====== ==== ====
The estimated net loss and prior service cost for the defined pension plans that will be recognized from Accumulated other comprehensive loss into net periodic benefit cost in 2007 are $106 and $3, respectively. The total accumulated benefit obligation for all pension plans at December 31, 2006 was $2,899 and at year-end 2005 was $2,544. The components of pension plans with an accumulated benefit obligation in excess of plan assets at December 31 follow:
2006 2005 ------ ------ Projected benefit obligation $3,101 $2,771 Accumulated benefit obligation 2,876 2,533 Fair value of plan assets 2,150 1,902
United States pension plans represent 67% and 70% of benefit obligations in 2006 and 2005, respectively. The weighted-average pension plan asset allocations by asset category at December 31, 2006 and 2005 are as follows:
2006 2005 ---- ---- Equity securities 80% 79% Debt securities 17% 18% Other 3% 3% --- --- 100% 100% === ===
Investment policies and strategies are developed on a country specific basis. The United States plan represents 68% of worldwide pension assets and its target allocation is 85% diversified equity, 12% United States Treasury Inflation-Protected Securities, and 3% cash equivalents. The United Kingdom plan represents 25% of worldwide pension assets and its target allocation is 70% diversified equity securities and 30% United Kingdom Government Bonds. Page 39 Contributions to pension plans that Eaton expects to make in 2007, and made in 2006, 2005 and 2004, follow:
2007 2006 2005 2004 ---- ---- ---- ---- Voluntary United States $150 $100 $50 $75 United Kingdom 27 19 14 18 Other 37 43 33 41 ---- ---- --- ---- $214 $162 $97 $134 ==== ==== === ====
At December 31, 2006, expected pension benefit payments for each of the next five years and the five years thereafter in the aggregate are, $190 in 2007, $198 in 2008, $207 in 2009, $217 in 2010, $230 in 2011 and $1,351 in 2012-2016. The Company also has various defined-contribution benefit plans, primarily consisting of the Eaton Savings Plan in the United States. Total contributions related to these plans charged to expense were $55 in 2006, $48 in 2005, and $44 in 2004. OTHER POSTRETIREMENT BENEFIT PLANS The measurement date for all other postretirement benefit plan obligations is November 30. Effective for fiscal years ending after December 15, 2008, SFAS No. 158 will require year-end measurements of plan assets and benefit obligations, eliminating the use of earlier measurement dates currently permissible. Assumptions used to determine other postretirement benefit obligations and cost follow:
2006 2005 2004 ---- ----- ----- Assumptions used to determine benefit obligation at year-end Discount rate 5.60% 5.75% 6.00% Health care cost trend rate assumed for next year 8.80% 9.60% 10.00% Ultimate health care cost trend rate 4.75% 4.75% 4.75% Year ultimate health care cost trend rate is achieved 2014 2014 2014 Assumptions used to determine cost Discount rate 5.75% 6.00% 6.25% Initial health care cost trend rate 9.60% 10.00% 9.00% Ultimate health care cost trend rate 4.75% 4.75% 5.00% Year ultimate health care cost trend rate is achieved 2014 2014 2007
The components of other postretirement benefits cost recorded in Statements of Consolidated Income follow:
2006 2005 2004 ---- ---- ---- Service cost $(17) $(16) $(17) Interest cost (45) (48) (53) Amortization (11) (10) (9) ---- ---- ---- (73) (74) (79) Curtailment loss (2) (1) ---- ---- ---- Costs recorded in Statements of Consolidated Income $(75) $(74) $(80) ==== ==== ====
Other changes in other postretirement benefit liabilities recognized in Accumulated other comprehensive loss at December 31, 2006 were $238, before income tax benefits. Estimated net loss and prior service cost for other postretirement benefit plans that will be recognized from Accumulated other comprehensive loss into net periodic benefit cost in 2007 are $12 and $(1), respectively. Assumed health care cost trend rates may have a significant effect on the amounts reported for the health care plans. A 1-percentage point change in the assumed health care cost trend rates would have the following effects: Page 40
1% Increase 1% Decrease ----------- ----------- Effect on total of service and interest cost $ 1 $ (1) Effect on other postretirement liabilities 22 (20)
At December 31, 2006, expected other postretirement benefit payments for each of the next five years and the five years thereafter in the aggregate are $92 in 2007 and 2008, $91 in 2009, $89 in 2010, $93 in 2011 and $419 in 2012-2016. The expected subsidy receipts related to the Medicare Prescription Drug, Improvement, and Moderation Act of 2003 that are included in the other postretirement benefit payments listed above for each of the next five years and the five years thereafter in the aggregate are, $8 in 2007, $9 in 2008, 2009 and 2010, $10 in 2011 and $49 in 2012-2016. PROTECTION OF THE ENVIRONMENT Eaton has established policies to ensure that its operations are conducted in keeping with good corporate citizenship and with a positive commitment to the protection of the natural and workplace environments. For example, each manufacturing facility has a person responsible for environmental, health and safety (EHS) matters. All of the Company's manufacturing facilities are required to be certified to ISO 14001, an international standard for environmental management systems. The Company routinely reviews EHS performance at each of its facilities and continuously strives to improve pollution prevention at its facilities. As a result of past operations, Eaton is involved in remedial response and voluntary environmental remediation at a number of sites, including certain of its currently-owned or formerly-owned plants. The Company has also been named a potentially responsible party (PRP) under the Federal Superfund law at a number of waste disposal sites. A number of factors affect the cost of environmental remediation, including the number of parties involved at a particular site, the determination of the extent of contamination, the length of time the remediation may require, the complexity of environmental regulations, and the continuing advancement of remediation technology. Taking these factors into account, Eaton has estimated (without discounting) the costs of remediation, which will be incurred over a period of several years. The Company accrues an amount consistent with the estimates of these costs when it is probable that a liability has been incurred. At December 31, 2006 and 2005, the balance sheet included a liability for these costs of $64 and $75, respectively. Based upon Eaton's analysis and subject to the difficulty in estimating these future costs, the Company expects that any sum it may be required to pay in connection with environmental matters is not reasonably likely to exceed the liability by an amount that would have a material adverse effect on its financial position, results of operations or cash flows. All of these estimates are forward-looking statements and, given the inherent uncertainties in evaluating environmental exposures, actual results can differ from these estimates. CONTINGENCIES Eaton is subject to a broad range of claims, administrative proceedings, and legal proceedings, such as lawsuits that relate to contractual allegations, patent infringement, personal injuries (including asbes- tos claims) and employment-related matters. Although it is not pos- sible to predict with certainty the outcome or cost of these matters, the Company believes that these matters will not have a material ad- verse effect on its financial position, results of operations or cash flows. SHAREHOLDERS' EQUITY There are 300 million Common Shares authorized ($.50 par value per share), 146.3 million of which were issued and outstanding at year-end 2006. At December 31, 2006, there were 8,868 holders of record of Common Shares. Additionally, 20,356 current and former employees were shareholders through participation in the Eaton Savings Plan (ESP) and Eaton Personal Investment Plan (EPIP). On January 22, 2007, Eaton announced that it had authorized a new 10 million Common Share repurchase program, replacing the 1.3 million shares remaining from the 10 million share repurchase authorization approved in April 2005. The shares are expected to be repurchased over time, depending Page 41 on market conditions, share price, capital levels and other considerations. During 2006, Eaton repurchased 5.286 million shares in the open market at a total cost of $386. During 2005, Eaton repurchased 7.015 million shares in the open market at a total cost of $450. During 2004, 4.249 million Common Shares were repurchased in the open market at a total cost of $250. Eaton has plans that permit certain employees and directors to defer a portion of their compensation. The Company has deposited $31 of Common Shares and marketable securities into a trust at December 31, 2006 to fund a portion of these liabilities. The marketable securities were included in Other assets and the Common Shares were included in Shareholders' equity at historical cost. STOCK OPTIONS Under various plans, stock options have been granted to certain employees and directors to purchase Common Shares at prices equal to fair market value on the date of grant. Substantially all of these options vest ratably during the three-year period following the date of grant and expire 10 years from the date of grant. During 1997 and 1998, stock options were granted that have a provision for accelerated vesting if the Company achieves certain earnings per Common Share targets or certain Common Share market price targets. One-half of these options vest based on the achievement of earnings per share targets and the other half vest based on the achievement of Common Share market price targets. If the targets are not achieved, these options vest 10 days before the expiration of their 10-year term. Subsequent to the issuance of these options, the Common Share price targets were achieved and the related options vested. As of December 31, 2006, 1.8 million stock options with earnings per share targets were outstanding that have not vested, because the earnings per share targets have not been achieved. Of these options, 1.4 million became exercisable, and were exercised during the second and third weeks of January 2007. Effective January 1, 2006, in accordance with SFAS No. 123(R), "Share-Based Payment", Eaton began to record compensation expense under the "fair-value-based" method of accounting for stock options granted to employees and directors. Expense for stock options in 2006 was $27 pretax ($20 after-tax, or $.13 per Common Share both assuming dilution and basic). Additionally, the adoption of SFAS No. 123(R) reduced cash provided by operating activities by $28 in 2006 and increased cash provided by financing activities by $28, because the new Statement requires, for the first time, certain income tax benefits resulting from exercises of stock options to be included in cash provided by financing activities. The Company adopted SFAS No. 123(R) using the "modified prospective application" method and, consequently, financial results for periods prior to 2006 were not restated for this accounting change. Under the modified prospective method, compensation expense for stock options includes expense for all options granted prior to but not yet vested as of the end of 2005, and expense for options granted beginning in 2006, based on the grant date fair value of the options. Expense is recognized on a straight-line basis over the period the employee or director is required to provide service in exchange for the award. Prior to 2006, as allowed by SFAS No. 123, "Accounting for Stock-Based Compensation", stock options were accounted for using the intrinsic-value-based method in Accounting Principles Board (APB) Opinion No. 25. Under that method, no compensation expense was recognized on the grant date, since on that date the option exercise price equaled the market price of the underlying Common Shares. The fair value of stock options granted was estimated using the Black-Scholes option pricing model. A summary of the assumptions used in determining the fair value of options follows:
2006 2005 2004 ----------- ----------- ----------- Expected volatility 25% 27% 28% Expected option life in years 5 5 5 Expected dividend yield 2.0% 2.0% 2.5% Risk-free interest rate 4.3% to 5.0% 3.7% to 4.4% 3.1% to 3.8%
Application of the Black-Scholes option pricing model involves assumptions that are judgmental and affect compensation expense. Historical information was the primary basis for the selection of expected volatility, expected option life, and expected dividend yield. Expected volatility was based on the most recent historical period equal to the expected life of the option. The risk-free interest rate was based on yields of U.S. Treasury zero-coupon issues with a term equal to the expected life of the option, on the date the stock options were granted. Page 42 The weighted-average fair value of stock options granted per option was $16.80 in 2006, $16.73 in 2005, and $13.29 in 2004. The total fair value of stock options vesting was $29 in 2006, $24 in 2005 and $21 in 2004. As of December 31, 2006, the total compensation expense not yet recognized related to nonvested stock options was $38, and the weighted-average period in which the expense is expected to be recognized is 1.5 years. A summary of stock option activity for 2006 follows (shares in millions):
Weighted- average Weighted- remaining Aggregate average price contractual intrinsic per option Options life in years value ------------- ------- ------------- --------- Outstanding January 1 $42.95 14.4 Granted 68.67 1.9 Exercised 35.82 (3.1) Canceled 62.73 (.2) ---- Outstanding December 31 $48.01 13.0 5.3 $352 ==== Exercisable December 31 $42.25 7.3 4.9 $239 Reserved for future grants December 31 5.2
The aggregate intrinsic value in the table above represents the total pretax difference between the $75.14 closing price of Eaton Common Shares on the last trading day of 2006 over the exercise price of the stock option, multiplied by the number of options outstanding and exercisable. Under SFAS No. 123(R), the aggregate intrinsic value is not recorded for financial accounting purposes and the value changes based on the daily changes in the fair market value of the Company's Common Shares. Information related to stock options exercised follows:
2006 2005 2004 ---- ---- ---- Proceeds from stock options exercised $108 $68 $138 Income tax benefits related to stock options exercised Reported in operating activities in statement of cash flows 8 21 44 Reported in financing activities in statement of cash flows 28 Intrinsic value of stock options exercised 102 74 142
Prior to 2006, Eaton applied the disclosure-only provisions of SFAS No. 123, "Accounting for Stock-Based Compensation". If the Company accounted for its stock options under the fair-value-based method of SFAS No. 123, net income and net income per Common Share would have been as follows:
2005 2004 ----- ----- Net income As reported $ 805 $ 648 Stock-based compensation expense, net of income taxes (18) (13) ----- ----- Assuming fair-value-based method $ 787 $ 635 ===== ===== Net income per Common Share assuming dilution As reported $5.23 $4.13 Stock-based compensation expense, net of income taxes (.12) (.08) ----- ----- Assuming fair-value-based method $5.11 $4.05 ===== ===== Net income per Common Share basic As reported $5.36 $4.24 Stock-based compensation expense, net of income taxes (.12) (.09) ----- ----- Assuming fair-value-based method $5.24 $4.15 ===== =====
Page 43 ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS) The components of Accumulated other comprehensive income (loss) as reported in the Statement of Consolidated Shareholders' Equity follow:
2006 2005 ----- ----- Foreign currency translation and related hedging instruments (net of income tax benefits of $22 in 2006 and $6 in 2005) $ (22) $(117) Deferred (loss) gain on cash flow hedges (net of income tax benefits of $1 in 2006 and income taxes of $2 in 2005) (1) 4 Pension liabilities (net of income tax benefits of $367 in 2006 and $281 in 2005) (707) (536) Other postretirement liabilities (net of income tax benefits of $119) (119) ----- ----- $(849) $(649) ===== =====
A discussion of the adjustments related to pension and other postretirement benefit liabilities is included in the "Retirement Benefit Plans" Note above. INCOME TAXES For financial statement reporting purposes, income from continuing operations before income taxes is summarized below based on the geographic location of the operation to which such earnings are attributable. Certain foreign operations are branches of Eaton and are, therefore, subject to United States as well as foreign income tax regulations. As a result, pretax income by location and the components of income tax expense by taxing jurisdiction are not directly related. For purposes of this note to the consolidated financial statements, non-United States operations include Puerto Rico.
Income from continuing operations before income taxes ------------------------------ 2006 2005 2004 ---- ---- ---- United States $152 $201 $115 Non-United States 837 787 653 ---- ---- ---- $989 $988 $768 ==== ==== ====
Income tax expense for continuing operations ---------------------- 2006 2005 2004 ---- ---- ----- Current United States Federal $14 $ 69 $ 129 State & local (9) 3 5 Non-United States 14 140 126 --- ---- ----- 19 212 260 --- ---- ----- Deferred United States Federal 25 (9) (132) State & local 24 Non-United States 9 (14) --- ---- ----- 58 (23) (132) --- ---- ----- $77 $189 $ 128 === ==== =====
Reconciliations of income taxes from the United States Federal statutory rate to the effective income tax rate for continuing operations follow:
2006 2005 2004 ----- ----- ----- Income taxes at the United States statutory rate 35.0% 35.0% 35.0% United States state & local income taxes 1.5% 0.5% 0.7% Other United States-net (0.9%) (3.7%) (0.9%) Non-United States operations (earnings taxed at other than United States tax rate) (18.6%) (12.7%) (14.2%) Adjustment of worldwide tax liabilities (9.2%) (3.9%) ----- ----- ----- 7.8% 19.1% 16.7% ===== ===== =====
Page 44 In 2006 and 2004, Eaton recorded income tax benefits of $90 and $30, respectively, resulting from the favorable resolution of multiple income tax items. The income tax benefit in 2006 reduced the effective income tax rate for full year 2006 from 17.0% to 7.8%. The income tax benefit in 2004 reduced the effective income tax rate for full year 2004 from 20.6% to 16.7%. Eaton has manufacturing operations in Puerto Rico that operate under certain United States tax law incentives related to the repatriation of earnings that expired at the end of 2005. Income tax credits claimed under these incentives were $33 in each of 2005 and 2004. The elimination of these repatriation laws did not have an adverse impact on the Company's effective income tax rate. Significant components of current and long-term deferred income taxes follow:
2006 2005 ------------------- ------------------- Current Long-term Current Long-term assets assets assets assets ------- --------- ------- --------- Accruals & other adjustments Employee benefits $ 74 $ 725 $ 85 $ 470 Depreciation & amortization (329) (288) Other accruals & adjustments 213 55 147 52 Other items 1 14 12 United States Federal income tax credit carryforwards 51 110 United States state & local tax loss carryforwards and tax credit carryforwards 92 91 Non-United States tax loss carryforwards 96 92 Valuation allowance (20) (201) (3) (187) ---- ----- ---- ----- $267 $ 490 $243 $ 352 ==== ===== ==== =====
At the end of 2006, United States Federal income tax credit carryforwards of $51 were available to reduce future Federal income tax liabilities. These credits include $5 that expire in 2025 through 2026, and $46 of which are not subject to expiration. United States state and local tax loss carryforwards with a future tax benefit of $63 are also available at the end of 2006. Their expiration dates are $9 in 2007 through 2011, $7 in 2012 through 2016, $25 in 2017 through 2021, and $22 in 2022 through 2026. A full valuation allowance has been recorded for these state and local tax loss carryforwards. There are also United States state and local tax credit carryforwards with a future tax benefit of $29 available at the end of 2006. Their expiration dates are $8 in 2007 through 2011, $11 in 2012 through 2016, $6 in 2017 through 2021, and $4 in 2022 through 2026. A valuation allowance of $26 has been recorded for the state and local tax credit carryforwards. A valuation allowance of $37 has also been recorded for certain other state and local deferred income tax assets. At December 31, 2006, certain non-United States subsidiaries had tax loss carryforwards aggregating $331 that are available to offset future taxable income. Carryforwards of $146 expire at various dates from 2007 through 2021 and the balance has no expiration date. A deferred tax asset of $96 has been recorded for these tax loss carryforwards and a valuation allowance of $90 has also been recorded for these tax loss carryforwards. No provision has been made for income taxes on undistributed earnings of consolidated non-United States subsidiaries of $2,530 at December 31, 2006, since it is the Company's intention to indefinitely reinvest undistributed earnings of its foreign subsidiaries. It is not practicable to estimate the additional income taxes and applicable foreign withholding taxes that would be payable on the remittance of such undistributed earnings. On October 22, 2004, the American Jobs Creation Act of 2004 (the Act) was signed into law. The Act provided for a special one-time tax deduction of 85% of certain foreign earnings that are repatriated (as defined in the Act) in 2005. In fourth quarter 2005, Eaton recorded income tax expense of $3 for the repatriation of $66 of foreign earnings under the Act. Worldwide income tax payments were $129 in 2006, $171 in 2005 and $161 in 2004. Page 45 In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation (FIN) No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109", which Eaton will adopt in first quarter 2007. FIN No. 48 clarifies the accounting for uncertainty in income taxes by establishing minimum standards for the recognition and measurement of income tax positions taken, or expected to be taken, in an income tax return. FIN No. 48 also changes the disclosure standards for income taxes. Eaton's historical policy has consistently been to enter into tax planning strategies only if it is more likely than not that the benefit would be sustained upon audit. For example, the Company does not enter into any of the Internal Revenue Service (IRS) Listed Transactions as set forth in Treasury Regulation 1.6011-4. Consequently, the Company does not expect the adoption of FIN No. 48 to result in the recording of a material cumulative effect of a change in the accounting principle in 2007. OTHER INFORMATION ACCOUNTS RECEIVABLE Accounts receivable were net of an allowance for doubtful accounts of $23 and $21 at December 31, 2006 and 2005, respectively. INVENTORIES The components of inventories follow:
2006 2005 ------ ------ Raw materials $ 570 $ 469 Work-in-process 321 265 Finished goods 504 442 ------ ------ Inventories at FIFO 1,395 1,176 Excess of FIFO over LIFO cost (102) (77) ------ ------ $1,293 $1,099 ====== ======
Inventories at FIFO accounted for using the LIFO method were 52% and 51% at the end of 2006 and 2005, respectively. WARRANTY LIABILITIES A summary of the current and long-term liabilities for warranties follows:
2006 2005 2004 ---- ---- ---- Balance at the beginning of the year $157 $152 $125 Current year provision 91 93 108 Business acquisitions 1 3 12 Claims paid/satisfied (83) (87) (94) Other 10 (4) 1 ---- ---- ---- Balance at the end of the year $176 $157 $152 ==== ==== ====
LEASE COMMITMENTS Eaton leases certain real properties and equipment. Minimum rental commitments under noncancelable operating leases, which expire at various dates and in most cases contain renewal options, for each of the next five years and thereafter in the aggregate were, $87 in 2007, $70 in 2008, $50 in 2009, $39 in 2010, $28 in 2011 and $49 thereafter. Rental expense was $124 in 2006, $115 in 2005, and $112 in 2004. Page 46 NET INCOME PER COMMON SHARE A summary of the calculation of net income per Common Share assuming dilution and basic follows (shares in millions):
2006 2005 2004 ------ ------ ------ Income from continuing operations $ 912 $ 799 $ 640 Income from discontinued operations 38 6 8 ------ ------ ------ Net income $ 950 $ 805 $ 648 ====== ====== ====== Average number of Common Shares outstanding assuming dilution 152.9 154.0 157.1 Less dilutive effect of stock options 2.7 3.8 4.0 ------ ------ ------ Average number of Common Shares outstanding basic 150.2 150.2 153.1 ====== ====== ====== Net income per Common Share assuming dilution Continuing operations $ 5.97 $ 5.19 $ 4.07 Discontinued operations .25 .04 .06 ------ ------ ------ $ 6.22 $ 5.23 $ 4.13 ====== ====== ====== Net income per Common Share basic Continuing operations $ 6.07 $ 5.32 $ 4.18 Discontinued operations .25 .04 .06 ------ ------ ------ $ 6.32 $ 5.36 $ 4.24 ====== ====== ======
BUSINESS SEGMENT & GEOGRAPHIC REGION INFORMATION Eaton is a diversified industrial manufacturer with 2006 sales of $12.4 billion. The Company is a global leader in the design, manufacture, marketing and servicing of electrical systems and components for power quality, distribution and control; fluid power systems and services for industrial, mobile and aircraft equipment; intelligent truck drivetrain systems for safety and fuel economy; and automotive engine air management systems, powertrain solutions and specialty controls for performance, fuel economy and safety. The Company had 60,000 employees at the end of 2006 and had sales to customers in more than 125 countries. Major products included in each business segment and other information follows. ELECTRICAL Low and medium voltage power distribution and control products that meet ANSI/NEMA and IEC standards; a wide range of circuit breakers, and a variety of assemblies and components used in managing distribution of electricity to industrial, utility, light commercial, residential and OEM markets; drives, contactors, starters, power factor and harmonic correction; a wide range of sensors used for position sensing; a full range of operator interface hardware and software for interfacing with machines, and other motor control products used in the control and protection of electrical power distribution systems; a full range of AC and DC Uninterruptible Power Systems (UPS); power management software, remote monitoring, turnkey integration services and site support engineering services for electrical power and control systems FLUID POWER All pressure ranges of hose, fittings, adapters, couplings and other fluid power connectors; hydraulic pumps, motors, valves, cylinders, power steering units, tube connectors, fittings, transaxles and transmissions; electronic and hydraulic controls; electric motors and drives; filtration products and fluid-evaluation products and services; aerospace products and systems -- hydraulic and electrohydraulic pumps, and integrated system packages, hydraulic and electromechanical actuators, flap and slat systems, nose wheel steering systems, cockpit controls, power and load management systems, sensors, fluid debris monitoring products, illuminated displays, integrated displays and panels, relays, valves, sealing and pneumatic systems for large commercial aircraft and regional jets, products for aircraft engines, fuel systems, cabin air and de-icing systems, hydraulic systems, low-pressure airframe fuel systems, electromechanical actuation, air ducting, hydraulic and power generation, and fluid distribution systems for fuel, hydraulics and air; products for industrial equipment; clutches and brakes for industrial machines; golf grips and precision molded and extruded plastic products Page 47 TRUCK Heavy-, medium-, and light-duty and agricultural mechanical transmissions; heavy- and medium-duty automated transmissions; heavy- and medium-duty clutches; and a variety of other products including gears and shafts, transfer boxes, gearshift mechanisms, rotors, electronic diagnostic equipment for commercial vehicles, and collision warning systems AUTOMOTIVE Engine valves, valve actuation components, engine displacement control components; advanced valvetrain and fuel management systems to enhance fuel economy and emissions; cylinder heads, superchargers, superturbo compounding; advanced air and hydrogen management devices for fuel cells; limited slip and locking differentials; electronically controlled traction modification devices; off road performance and racing differentials; precision gear forgings; compressor control clutches for mobile refrigeration; mirror actuators and powerfolding actuators; transmission controls; on-board vapor recovery systems; fuel level senders; exhaust gas recirculation valves for heavy-duty engines; turbocharger waste gate controls; and intake manifold control valves OTHER INFORMATION The principal markets for the Electrical segment are industrial, non-residential and residential construction, commercial, government, institutional, and telecommunications customers. These customers are generally concentrated in North America, Europe and Asia/Pacific; however, sales are made globally. Sales are made directly by Eaton and indirectly through distributors and manufacturers representatives to such customers. The principal markets for the Fluid Power segment are original equipment manufacturers and after-market customers of off-highway agricultural vehicles, construction vehicles, aircraft, and industrial and stationary equipment. These manufacturers are located globally and most sales of these products are made directly to such manufacturers. The principal markets for the Truck and Automotive segments are original equipment manufacturers and after-market customers of heavy-, medium-, and light-duty trucks and passenger cars. These manufacturers are located globally and most sales of these products are made directly to such manufacturers. No single customer represented more than 10% of net sales in 2006, 2005 or 2004. Sales from United States and Canadian operations to customers in foreign countries were $709 in 2006, $568 in 2005 and $504 in 2004 (6% of sales in 2006, and 5% of sales in 2005 and 2004). The accounting policies of the business segments are generally the same as the policies described under "Accounting Policies" above, except that inventories and related cost of products sold of the segments are accounted for using the FIFO method and operating profit only reflects the service cost component related to pensions and other postretirement benefits. Intersegment sales and transfers are accounted for at the same prices as if the sales and transfers were made to third parties. In accordance with SFAS No. 131, for purposes of business segment performance measurement, the Company does not allocate to the business segments items that are of a non-operating nature or corporate organizational and functional expenses of a governance nature. Corporate expenses consist of corporate office expenses including compensation, benefits, occupancy, depreciation, and other administrative costs. Identifiable assets of the business segments exclude goodwill, other intangible assets, and general corporate assets, which principally consist of cash, short-term investments, deferred income taxes, certain accounts receivable, certain property, plant and equipment, and certain other assets. Page 48 GEOGRAPHIC REGION INFORMATION
Segment operating Long-lived Net sales profit assets --------- --------- ---------- 2006 United States $ 8,556 $1,145 $ 1,188 Canada 337 44 16 Europe 2,423 80 579 Latin America 1,090 120 318 Asia/Pacific 898 92 170 Eliminations (934) ------- ------- $12,370 $ 2,271 ======= ======= 2005 United States $ 7,666 $1,018 $ 1,191 Canada 315 48 16 Europe 2,084 110 533 Latin America 1,036 136 298 Asia/Pacific 797 80 137 Eliminations (879) ------- ------- $11,019 $ 2,175 ======= ======= 2004 United States $ 6,806 $ 778 $ 1,215 Canada 261 37 16 Europe 1,922 138 547 Latin America 774 107 244 Asia/Pacific 679 79 125 Eliminations (730) ------- ------- $ 9,712 $ 2,147 ======= =======
Net sales and segment operating profit are attributed to geographical regions based upon the location of the selling unit. Long-lived assets consist of property, plant and equipment-net. Business segment operating profit was reduced by acquisition integration charges, as follows:
2006 2005 2004 ---- ---- ---- United States $23 $17 $22 Europe 7 7 18 Latin America 6 4 Asia/Pacific 4 8 1 --- --- --- $40 $36 $41 === === ===
Page 49 BUSINESS SEGMENT INFORMATION
2006 2005 2004 ------- ------- ------ Net sales Electrical $ 4,184 $ 3,758 $3,072 Fluid Power 3,983 3,240 3,098 Truck 2,520 2,288 1,800 Automotive 1,683 1,733 1,742 ------- ------- ------ $12,370 $11,019 $9,712 ======= ======= ====== Operating profit Electrical $ 474 $ 375 $ 243 Fluid Power 422 339 338 Truck 448 453 329 Automotive 137 225 229 Corporate Amortization of intangible assets (51) (30) (25) Interest expense-net (104) (90) (79) Minority interest (10) (5) (6) Pension & other postretirement benefit expense (152) (120) (75) Stock option expense (27) Other corporate expense-net (148) (159) (186) ------- ------- ------ Income from continuing operations before income taxes 989 988 768 Income taxes 77 189 128 ------- ------- ------ Income from continuing operations 912 799 640 Income from discontinued operations, net of income taxes 38 6 8 ------- ------- ------ Net income $ 950 $ 805 $ 648 ======= ======= ======
Business segment operating profit was reduced by acquisition integration charges, as follows:
2006 2005 2004 ---- ---- ---- Electrical $ 7 $21 $33 Fluid Power 23 7 8 Truck 5 4 Automotive 5 4 --- --- --- $40 $36 $41 === === ===
Page 50 BUSINESS SEGMENT INFORMATION continued
2006 2005 2004 ------- ------- ------ Identifiable assets Electrical $ 1,669 $ 1,454 $1,469 Fluid Power 2,007 1,787 1,527 Truck 1,015 1,064 940 Automotive 890 960 974 ------- ------- ------ 5,581 5,265 4,910 Goodwill 3,034 3,139 2,433 Other intangible assets 969 626 644 Corporate 1,833 1,188 1,088 ------- ------- ------ Total assets $11,417 $10,218 $9,075 ======= ======= ====== Expenditures for property, plant & equipment Electrical $ 74 $ 59 $ 55 Fluid Power 121 76 83 Truck 66 99 90 Automotive 79 108 91 ------- ------- ------ 340 342 319 Corporate 20 21 11 ------- ------- ------ $ 360 $ 363 $ 330 ======= ======= ====== Depreciation of property, plant & equipment Electrical $ 79 $ 84 $ 83 Fluid Power 105 94 91 Truck 77 70 61 Automotive 77 84 79 ------- ------- ------ 338 332 314 Corporate 22 19 23 ------- ------- ------ $ 360 $ 351 $ 337 ======= ======= ======
Page 51 MANAGEMENT'S DISCUSSION & ANALYSIS OF FINANCIAL CONDITION & RESULTS OF OPERATIONS Dollars in millions, except for per share data (per share data assume dilution) OVERVIEW OF THE COMPANY Eaton is a diversified industrial manufacturer with 2006 sales of $12.4 billion. The Company is a global leader in the design, manufacture, marketing and servicing of electrical systems and components for power quality, distribution and control; fluid power systems and services for industrial, mobile and aircraft equipment; intelligent truck drivetrain systems for safety and fuel economy; and automotive engine air management systems, powertrain solutions and specialty controls for performance, fuel economy and safety. The principal markets for the Electrical segment are industrial, non-residential and residential construction, commercial, government, institutional, and telecommunications customers. These customers are generally concentrated in North America, Europe and Asia/Pacific; however, sales are made globally. Sales are made directly by Eaton and indirectly through distributors and manufacturers representatives to such customers. The principal markets for the Fluid Power segment are original equipment manufacturers and after-market customers of off-highway agricultural vehicles, construction vehicles, aircraft, and industrial and stationary equipment. These manufacturers are located globally and most sales of these products are made directly to such manufacturers. The principal markets for the Truck and Automotive segments are original equipment manufacturers and after-market customers of heavy-, medium-, and light-duty trucks and passenger cars. These manufacturers are located globally and most sales of these products are made directly to such manufacturers. The Company had 60,000 employees at the end of 2006 and had sales to customers in more than 125 countries. HIGHLIGHTS OF RESULTS FOR 2006 Eaton experienced continuing strong economic conditions in 2006 in most of its end markets and posted record financial results. Sales of the Electrical, Fluid Power and Truck business segments improved in 2006 compared to 2005, setting new records. Sales of the Automotive segment were lower than 2005 due to declines in the North American and European automotive markets. Operating profit for the Electrical and Fluid Power segments were also new records in 2006. During 2006, Eaton continued to make progress towards key corporate goals of 1) accelerating organic growth by outgrowing end markets, 2) acquiring and integrating new businesses and 3) proactively managing its capital. In first quarter 2006, Eaton announced, and began to implement, its Excel 07 program. This program was a series of actions undertaken in 2006 intended to address resource levels and operating performance in businesses that underperformed in 2005 and businesses in which markets were expected to weaken during the second half of 2006 and 2007. This program included plant closings, as well as costs of relocating product lines and other employee reductions. The Excel 07 program, which also included savings generated from the actions noted above, gains from sales of non-strategic product lines, and other corporate actions, including the favorable resolution of multiple income tax items, had a net positive impact on net income for 2006, as described below. The following are highlights of 2006:
2006 2005 Increase ------- ------- -------- Continuing operations Net sales $12,370 $11,019 12% Gross profit 3,320 3,083 8% Percent of net sales 26.8% 28.0% Income before income taxes 989 988 -- Income after income taxes $ 912 $ 799 14% Income from discontinued operations, net of income taxes 38 6 ------- ------- Net income $ 950 $ 805 18% ======= ======= Net income per Common Share assuming dilution Continuing operations $ 5.97 $ 5.19 15% Discontinued operations .25 .04 ------- ------- $ 6.22 $ 5.23 19% ======= ======= Return on Shareholders' equity 23.0% 22.2%
Net sales in 2006 were a new record for Eaton, surpassing the previous record set in 2005. Sales growth of 12% in 2006 consisted of 6% from organic growth, 5% from acquisitions of businesses, and Page 52 1% from foreign exchange rates. Organic growth included 5% from end-market growth and 1% from outgrowing end markets. Gross profit increased 8% in 2006 primarily due to sales growth, the benefits of integrating acquired businesses and continued productivity improvements driven by the Eaton Business System (EBS). These improvements in gross profit were partially offset by costs of plant closings and other expenses associated with the Company's Excel 07 program, higher acquisition integration charges, increased pension expense, and higher prices paid for raw materials, supplies and basic metals. Net income and net income per Common Share assuming dilution for 2006 were new records for Eaton, increasing 18% and 19%, respectively, over 2005. These improvements were primarily due to sales growth; the benefits of integrating acquired businesses; continued productivity improvements driven by EBS; and a lower effective income tax rate. These factors leading to the increase in net income were partially offset by increased pension expense; higher prices paid for raw materials, supplies and basic metals; and expense for stock options recorded for the first time in 2006. Earnings per share also benefited from lower average shares outstanding in 2006 compared to 2005, due to the repurchase of 5.286 million shares in 2006, at a total cost of $386. The positive net impact on net income and net income per share of the Excel 07 program in 2006, as described above, was after-tax income of $8, or $.05 per Common Share. Pretax costs of this program for plant closings, relocating product lines and other employee reductions, offset by savings generated from these actions, were $154. These costs were offset by gains on the sale of businesses that totaled $35 after-tax, which were reported in the Statement of Consolidated Income as Discontinued operations, and by $90 of income tax benefits resulting from the favorable resolution of multiple income tax items during the year. In 2006, Eaton acquired various businesses in separate transactions. The Statements of Consolidated Income include the results of these businesses from the effective dates of acquisition. These acquisitions are summarized below: - - On December 1, 2006, Eaton acquired the remaining 50% ownership in Schreder-Hazemeyer, a Belgium manufacturer of low and medium voltage electrical distribution switchgear. This business had 2006 sales of $9 and is included in the Electrical segment. - - On October 26, 2006, Eaton acquired diesel fuel processing technology and associated assets of Catalytica Energy Systems Inc., a developer of emission control solutions for Trucks. This business, which has no sales, is included in the Truck segment. - - On September 14, 2006, the Company acquired Senyuan International Holdings Limited, a China-based manufacturer of vacuum circuit breakers and other electrical switchgear components. This business had 2005 sales of $47 and is included in the Electrical segment. - - On September 5, 2006, the Company acquired the Ronningen-Petter business unit of Dover Resources, Inc., a producer of industrial fine filters and components. This business had 2005 sales of $30 and is included in the Fluid Power segment. - - On March 31, 2006, the Company acquired the Synflex business unit of Saint-Gobain Performance Plastics Corporation, a manufacturer of thermoplastic hose and tubing. This business had 2005 sales of $121 and is included in the Fluid Power segment. - - On March 24, 2006, Eaton acquired Marina Power Lighting, a manufacturer of marine duty electrical distribution products. This business had 2005 sales of $11 and is included in the Electrical segment. In addition to the business acquisitions described above, on December 28, 2006, Eaton announced it had reached an agreement to purchase AT Holdings Corporation, the parent of Argo-Tech Corporation, for $695. This transaction is expected to close in the first quarter of 2007. Argo-Tech's U.S.-based aerospace business, which had sales for the fiscal year ended October 28, 2006 of $206, is a leader in high performance aerospace engine fuel pumps and systems, airframe fuel pumps and systems, and ground fueling systems for commercial and military aerospace markets. This business will be integrated into the Fluid Power segment. Cash generated from operating activities of $1,431 in 2006 was a new record for Eaton, increasing by $296, or 26%, over cash generated from operating activities of $1,135 in 2005. The increase was primarily due to higher net income in 2006, which rose $145 in 2006 over 2005 and a net reduction of Page 53 $162 in working capital funding due to changes in accounts receivable, accounts payable and in several other working capital accounts in 2006. Cash and short-term investments totaled $785 at the end of 2006, up $449 from $336 at year-end 2005. Total debt of $2,586 at the end of 2006 increased $122 from $2,464 at year-end 2005. Changes in debt included the issuance in August 2006 of $250 of floating notes due 2009, the repayment of $244 of notes and debentures in 2006 and a $96 increase in short-term debt. The net-debt-to-capital ratio was 30.5% at the end of 2006 compared to 36.0% at year-end 2005. The improvement in this ratio was primarily due to the increase of $328 in Shareholders' equity and the $327 decrease in net debt (total debt less cash and short-term investments) largely due to the $449 increase in cash and short-term investments. The increase in Shareholders' equity was due to net income in 2006 of $950. This increase was partially offset by the repurchase of 5.286 million Common Shares in 2006 at a total cost of $386; the recognition at year-end 2006 of $282 of after-tax adjustments for pensions and other post-retirement benefits due to the adoption of Statement of Financial Accounting Standards No. 158; and cash dividends of $220 paid during 2006. Net working capital of $1,001 at the end of 2006, increased by $391 from $610 at year-end 2005. The increase was primarily due to the $449 increase in cash and short-term investments, which largely resulted from strong cash flow from operations of $1,431; the $143 increase in accounts receivable resulting from increased sales; and the $194 increase in inventories to support higher levels of sales. These increases in working capital were partially offset by a net increase of $178 in short-term debt and current portion of long-term debt, and a net increase of $217 in accounts payable and several other working capital accounts to support higher levels of operations. The increase in current portion of long-term debt was primarily due to the reclassification to current liabilities of the 6% Euro 200 million Notes that will mature in March 2007 (U.S. dollar equivalent of $263 at December 31, 2006) and $48 of other long-term debt that will mature in 2007, partially offset by the repayment of $244 of notes and debentures in 2006. The current ratio was 1.3 at the end of 2006 and 1.2 at year-end 2005. In light of its strong results and future prospects, on January 22, 2007 Eaton announced that it was taking the following actions: - - Increasing the quarterly dividend on its Common Shares by 10%, from $.39 per share to $.43 per share, effective for the February 2007 dividend. - - Making a voluntary contribution of $150 to its qualified pension plan in the United States. - - Authorizing a new 10 million Common Share repurchase program, replacing the 1.3 million shares remaining from the 10 million share repurchase authorization approved in April of 2005. RESULTS OF OPERATIONS - 2006 COMPARED TO 2005
2006 2005 Increase ------- ------- -------- Continuing operations Net sales $12,370 $11,019 12% Gross profit 3,320 3,083 8% Percent of net sales 26.8% 28.0% Income before income taxes 989 988 -- Income after income taxes $ 912 $ 799 14% Income from discontinued operations, net of income taxes 38 6 ------- ------- Net income $ 950 $ 805 18% ======= ======= Net income per Common Share assuming dilution Continuing operations $ 5.97 $ 5.19 15% Discontinued operations .25 .04 ------- ------- $ 6.22 $ 5.23 19% ======= ======= Return on Shareholders' equity 23.0% 22.2%
Net sales in 2006 were a new record for Eaton, surpassing the previous record set in 2005. Sales growth of 12% in 2006 consisted of 6% from organic growth, 5% from acquisitions of businesses, and Page 54 1% from foreign exchange rates. Organic growth included 5% from end-market growth and 1% from outgrowing end markets. In first quarter 2006, Eaton announced, and began to implement, its Excel 07 program. This program was a series of actions in 2006 intended to address resource levels and operating performance in businesses that underperformed in 2005 and businesses in which markets were expected to weaken during the second half of 2006 and 2007. This program included plant closings, as well as costs of relocating product lines and other employee reductions. The net impact of this program also includes savings generated from the actions noted above, gains from sales of non-strategic product lines, and other corporate actions, including the favorable resolution of multiple income tax items. The total net positive impact of the Excel 07 program in 2006 was after-tax income of $8, or $.05 per Common Share. Pretax costs of this program for plant closings, relocating product lines and other employee reductions, offset by savings generated from these actions, were $154. These costs were offset by gains on the sale of businesses that totaled $35 after-tax, which were reported in the Statement of Consolidated Income as Discontinued operations, and by $90 of income tax benefits resulting from the favorable resolution of multiple income tax items during the year. Net pretax costs of plant closings and other actions associated with the Excel 07 program were included in the Statements of Consolidated Income primarily in Cost of products sold, with additional amounts in Selling & administrative expense or Other (income) expense-net, as appropriate. In Business Segment Information, the net pretax impact of the Excel 07 program was included in Operating profit of the related business segment, as separately discussed in the results of each business segment below. Gross profit increased 8% in 2006 primarily due to sales growth, the benefits of integrating acquired businesses and continued productivity improvements driven by the Eaton Business System (EBS). These improvements in gross profit were partially offset by costs of plant closings and other expenses associated with the Company's Excel 07 program, higher acquisition integration charges, increased pension expense, and higher prices paid for raw materials, supplies and basic metals. RESULTS BY GEOGRAPHIC REGION
Segment operating profit Operating Net sales ---------------------------- margin ---------------------------- Increase ----------- 2006 2005 Increase 2006 2005 (Decrease) 2006 2005 ------- ------- -------- ------ ------ ---------- ---- ---- United States $ 8,556 $ 7,666 12% $1,145 $1,018 12% 13.4% 13.3% Canada 337 315 7% 44 48 (8%) 13.1% 15.2% Europe 2,423 2,084 16% 80 110 (27%) 3.3% 5.3% Latin America 1,090 1,036 5% 120 136 (12%) 11.0% 13.1% Asia/Pacific 898 797 13% 92 80 15% 10.2% 10.0% Eliminations (934) (879) ------- ------- $12,370 $11,019 12% ======= =======
Growth in sales in the United States of 12% was primarily due to higher sales in Fluid Power, which resulted from growth in end markets; sales from businesses acquired in 2006, including the thermoplastic hose and tubing business of Synflex and the industrial filtration business of Ronningen-Petter; and the full year effect on sales of businesses acquired in 2005, including the aerospace division of PerkinElmer Inc., the aerospace fluid and air division of Cobham plc, and the industrial filtration business of Hayward Industries, Inc. Higher sales in the United States in 2006 were also due to increased sales in Electrical, largely resulting from growth in end markets, and higher sales in Truck, as a result of strong end market demand for heavy-duty trucks. These increases in sales were partially offset by a sales reduction in Automotive, primarily resulting from the decline in the North American (NAFTA) automotive market. The 12% increase in operating profit in the United States was mainly due to strong operating profit of Truck; higher operating profit of Fluid Power, which included profit from businesses acquired in 2006 and the full year effect of businesses acquired in 2005; increased operating profit of Electrical; and the benefits of integrating acquired businesses. These increases in operating profit were partially offset by costs of plant closings and other expenses associated with the Excel 07 program, as described above, and reduced operating profit of the Automotive segment. In Canada, sales growth of 7% in sales was primarily due to improved results in the Electrical businesses. The 8% reduction in operating profit was mainly due to the costs of relocation of certain businesses in the Electrical segment. Page 55 Sales growth in Europe of 16% was primarily due to higher sales in Fluid Power, which reflected growth in end markets and the full year effect on sales of the businesses acquired in 2005, including the aerospace fluid and air division of Cobham plc, the aerospace division of PerkinElmer Inc., and the industrial filtration business of Hayward Industries, Inc. Higher sales in Europe in 2006 also reflected increased sales in Electrical, largely due to growth in end markets. The 27% decrease in operating profit in Europe reflected reduced operating profit of Automotive and Truck, which primarily resulted from plant closings associated with the Excel 07 program, partially offset by improved results of Electrical and Fluid Power, due, in part, to the full-year effect of the Fluid Power acquisitions completed in 2005, and the benefits of integrating acquired businesses. In Latin America, growth of 5% in sales was largely due to higher sales in Truck, Automotive and Fluid Power. The 12% reduction in operating profit in Latin America was attributable to Excel 07 program expenses and an adjustment to Brazilian inventories in the Truck business, partially offset by improved results of Electrical, which included a gain on the sale of the Brazilian battery business. Growth in Asia/Pacific of 13% in sales and 15% in operating profit was primarily due to higher sales in Fluid Power and Electrical, which were the result of growth in end markets and sales from businesses acquired in 2006 and 2005. Acquisitions of businesses included the Senyuan China-based medium-voltage electrical business acquired in September 2006 and the Winner hydraulics business acquired in 2005. OTHER RESULTS OF OPERATIONS In 2006 and 2005, Eaton incurred charges related to the integration of acquired businesses. Charges in 2006 related to primarily the following acquisitions: Powerware, the electrical power systems business acquired in 2004, and the Pringle electrical switch business; several acquisitions in Fluid Power including the acquired operations of Synflex, PerkinElmer, Cobham, Hayward, Winner, and Walterscheid; and the Pigozzi, Tractech, and Morestana Truck and Automotive businesses. Charges in 2005 related to primarily the following acquisitions: Powerware and the electrical division of Delta plc; several acquisitions in Fluid Power, including Winner, Walterscheid, and Boston Weatherhead; and the Pigozzi and Morestana businesses. A summary of these charges follows:
2006 2005 ---- ---- Electrical $ 7 $ 21 Fluid Power 23 7 Truck 5 4 Automotive 5 4 ---- ---- Pretax charges $ 40 $ 36 ==== ==== After-tax charges $ 27 $ 24 Per Common Share $.17 $.15
Acquisition integration charges in 2006 included $23 for the United States, $7 for Europe, $6 for Latin America and $4 for Asia/Pacific. Charges in 2005 included $17 for the United States, $7 for Europe, $4 for Latin America and $8 for Asia/Pacific. These charges were included in the Statements of Consolidated Income in Cost of products sold or Selling & administrative expense, as appropriate. In Business Segment Information, the charges reduced Operating profit of the related business segment. In first quarter 2006, Eaton announced, and began to implement, its Excel 07 program. This program was a series of actions in 2006 intended to address resource levels and operating performance in businesses that underperformed in 2005 and businesses that were expected to weaken during second half 2006 and 2007. This program included plant closings, as well as costs of relocating product lines and other employee reductions. The program also included savings generated from these actions. The net costs incurred by each segment in 2006 related to the Excel 07 actions follows: Electrical $ 17 Fluid Power 23 Truck 60 Automotive 52 Corporate 2 ---- Pretax charges $154 ====
Page 56 Excel 07 net costs incurred in 2006 included $69 for the United States, $77 for Europe, $5 for Latin America, $2 for Asia/Pacific, and $1 for Canada. The net costs associated with the Excel 07 program were included in the Statements of Consolidated Income primarily in Cost of products sold. In Business Segment Information, the charges reduced Operating profit of the related business segment. Pretax income for 2006 was reduced by $65 ($42 after-tax, or $.28 per Common Share) compared to 2005 due to increased pension expense in 2006. This reduction primarily resulted from the lowering of discount rates associated with pension liabilities at year-end 2005 and the effect of increased settlement costs in 2006. Effective January 1, 2006, in accordance with Statement of Financial Accounting Standards (SFAS) No. 123(R), "Share-Based Payment", Eaton began to record compensation expense under the "fair-value-based" method of accounting for stock options granted to employees and directors. Expense for stock options in 2006 was $27 ($20 after-tax, or $.13 per share both assuming dilution and basic). The Company adopted SFAS No. 123(R) using the "modified prospective application" method and, as a result, financial results for periods prior to 2006 were not restated for this accounting change. This change in accounting is further explained in "Stock Options" in the Notes to the Consolidated Financial Statements. The effective income tax rates for continuing operations for 2006 was 7.8% compared to 19.1% for 2005. The lower rate in 2006 was primarily due to income tax benefits of $90 resulting from the favorable resolution of multiple income tax items. Excluding the income tax benefits resulting from the favorable resolution of income tax items, the effective income tax rate for continuing operations for 2006 was 17.0%. The change in the effective income tax rate in 2006 compared to 2005 is further explained in "Income Taxes" in the Notes to the Consolidated Financial Statements. As part of the Excel 07 program, in third quarter 2006, certain businesses of the Automotive segment were sold, resulting in a $35 after-tax gain, or $.23 per Common Share. The gain on sale of these businesses, and other operating results of these businesses, were reported as Discontinued operations in the Statement of Consolidated Income. Net income and net income per Common Share assuming dilution for 2006 were new records for Eaton, increasing 18% and 19%, respectively, over 2005. These improvements were primarily due to sales growth; the benefits of integrating acquired businesses; continued productivity improvements driven by EBS; and a lower effective income tax rate. These factors leading to the increase in net income were partially offset by increased pension expense; higher prices paid for raw materials, supplies and basic metals; and expense for stock options recorded for the first time in 2006. Earnings per share also benefited from lower average shares outstanding in 2006 compared to 2005, due to the repurchase of 5.286 million shares in 2006, at a total cost of $386. The total net positive impact on net income and net income per share of the Excel 07 program in 2006 was $8 and $.05 per Common Share, respectively, as described above. RESULTS BY BUSINESS SEGMENT ELECTRICAL
2006 2005 Increase ------ ------ -------- Net sales $4,184 $3,758 11% Operating profit 474 375 26% Operating margin 11.3% 10.0%
Sales of the Electrical segment reached record levels in 2006. Of the 11% sales increase, 9% was due to organic growth, 1% was from acquisitions of businesses, and 1% from foreign exchange rates. End markets for the Electrical segment grew approximately 5% in 2006 with strong growth in non-residential construction markets offsetting weakness in the residential market. Operating profit rose 26% in 2006, and was also a new record for this segment. The increase was largely due to growth in sales, the benefits of integrating acquired businesses, continued productivity improvements, a gain on the sale of the Brazilian battery business, and lower acquisition integration charges. These improvements in operating profit were partially offset by net costs of the Excel 07 program, and higher prices paid for raw materials, supplies and basic metals. Operating profit in 2006 was reduced by net costs of $17 related to the Excel 07 program, which reduced the operating margin Page 57 by 0.4%. Operating profit was also reduced by acquisition integration charges of $7 in 2006 compared to $21 in 2005, which reduced the operating margin by 0.2% in 2006 and by 0.6% in 2005. Acquisition integration charges in 2006 primarily related to the integration of Powerware acquired in June 2004 and the Pringle electrical switch business acquired in 2005. Acquisition integration charges in 2005 largely related to the integration of Powerware and the electrical division of Delta plc acquired in 2003. The incremental operating margin on overall sales growth in 2006 was 23%. Net costs of the Excel 07 program and acquisition integration charges lowered the incremental operating margin (increase in operating profit for the year compared to increase in sales for the year) by 1 percentage point. On January 5, 2007, the Company announced it had reached an agreement to purchase the Power Protection Business of Power Products Ltd., a Czech distributor and service provider of Powerware and other uninterruptible power systems, for $2. The transaction closed in February 2007. This business had sales of $3 in 2006. On December 1, 2006, Eaton acquired the remaining 50% ownership in Schreder-Hazemeyer, a Belgium manufacturer of low and medium voltage electrical distribution switchgear. This business had sales of $9 in 2006. On September 14, 2006, the Company acquired Senyuan International Holdings Limited, a China-based manufacturer of vacuum circuit breakers and other electrical switchgear components. This business had sales of $47 in 2005. On March 24, 2006, Eaton acquired Marina Power Lighting, a U.S. manufacturer of marine duty electrical distribution products. This business had sales of $11 in 2005. FLUID POWER
2006 2005 Increase ------ ------ -------- Net sales $3,983 $3,240 23% Operating profit 422 339 24% Operating margin 10.6% 10.5%
Sales of the Fluid Power segment were at record levels in 2006. The 23% increase in sales in 2006 over 2005 consisted of 16% from acquisitions of businesses, 6% from organic growth and 1% from foreign exchange rates. Acquisitions of businesses in 2006 included the Ronningen-Petter filtration business acquired in September and the Synflex thermoplastic hose and tubing business acquired in March, as described below. Acquisitions of businesses in 2005 included the aerospace operations of PerkinElmer, Inc., the aerospace fluid and air division of Cobham plc, the Hayward industrial filtration business, and the Winner hydraulic hose fittings and adapters business. Growth in the global hydraulics markets in 2006 was driven by continued investment in industrial and construction equipment worldwide. Fluid Power markets grew 6% compared to the same period in 2005, with global hydraulics shipments up 8%, commercial aerospace markets up 14%, defense aerospace markets down 1%, and European automotive production down 1%. Operating profit rose 24% in 2006, and was also a new record for this segment. The increase in operating profit was due to growth in sales, continued productivity improvements, implemented price increases, the benefits of integrating acquired businesses, and favorable business mix. These improvements in operating profit were partially offset by net costs of the Excel 07 program, higher acquisition integration charges, and higher prices paid for raw materials, supplies and basic metals. Operating profit in 2006 was reduced by net costs of $23 related to the Excel 07 program, which reduced the operating margin by 0.6%. Operating profit in 2006 was also reduced by acquisition charges of $23 compared to charges of $7 in 2005, reducing operating margin by 0.6% in 2006 and 0.2% in 2005. The 2006 charges primarily related to the acquired operations of Synflex, PerkinElmer, Cobham, Hayward, Winner, and Walterscheid. Acquisition integration charges in 2005 largely related to the Boston Weatherhead fluid power business. The incremental operating margin on overall sales growth in 2006 was 11%. Net costs of the Excel 07 program and acquisition integration charges lowered the incremental operating margin on overall sales growth by 5 percentage points. The incremental operating margin for acquired businesses was 14%. On December 28, 2006, Eaton announced it had reached an agreement to purchase AT Holdings Corporation, the parent of Argo-Tech Corporation, for $695. This transaction is expected to close in the first quarter of 2007. Argo-Tech's U.S.-based aerospace business, which had sales for the fiscal year Page 58 ended October 28, 2006 of $206, is a leader in high performance aerospace engine fuel pumps and systems, airframe fuel pumps and systems, and ground fueling systems for commercial and military aerospace markets. On September 5, 2006, the Company acquired the Ronningen-Petter business unit of Dover Resources, Inc., a producer of industrial fine filtration systems. This business had sales of $30 in 2005. On March 31, 2006, Eaton acquired the Synflex business unit of Saint-Gobain Performance Plastics Corporation. This business manufactures thermoplastic hose and tubing. This business had sales of $121 in 2005. TRUCK
Increase 2006 2005 (Decrease) ------ ------ ---------- Net sales $2,520 $2,288 10% Operating profit 448 453 (1%) Operating margin 17.8% 19.8%
The Truck segment posted record sales in 2006, growing 10% compared to 2005. Of the sales increase in 2006, 8% was due to organic growth and 2% from foreign exchange rates. Organic growth was attributable to strong end-market demand, primarily in NAFTA heavy-duty truck production, which rose 11% in 2006 to 378,000 units. NAFTA medium-duty production was up 9% compared to 2005, European truck production was up 5%, and Brazilian vehicle production was up 2%. Operating profit decreased 1% in 2006 primarily due to net costs of the Excel 07 program, partially offset by operating profit generated by growth in sales. Operating profit in 2006 was reduced by net costs of $60 related to the Excel 07 program, which reduced the operating margin by 2.4%. The Excel 07 costs included costs related to the closing of the heavy-duty truck transmission plant in Manchester, United Kingdom. Operating profit in 2006 and 2005 was also reduced by acquisition integration charges of $5 and $4, respectively, related to the Pigozzi agricultural powertrain business, which reduced the operating margin by 0.2% in 2006 and 2005. Net costs of the Excel 07 program and acquisition integration charges lowered the incremental operating margin on overall sales growth by 26 percentage points. On October 26, 2006, the Company announced the acquisition of the diesel fuel processing technology, research and development facility and associated business assets of Catalytica Energy Systems Inc. for $2. Catalytica, which has no sales, is engaged in the design and development of emission control solutions for Trucks. On September 29, 2006, Eaton announced the closure of its heavy-duty truck transmission manufacturing plant in Manchester, United Kingdom, by the end of 2006. Aggregate estimated pretax charges associated with this closure were $25. Total costs consist of cash charges of $16 for severance costs, charges of $3 related to pension costs, and $6 for other costs. This facility had 299 employees. AUTOMOTIVE
2006 2005 (Decrease) ------ ------ ---------- Net sales $1,683 $1,733 (3)% Operating profit 137 225 (39)% Operating margin 8.1% 13.0%
Sales of the Automotive segment decreased 3% in 2006. The reduction in sales reflected a 6% drop in sales volume, offset by a 2% increase from acquisitions of businesses and a 1% increase due to foreign exchange rates. The decline in sales was primarily due to automotive production for NAFTA declining by 3% in 2006 compared to 2005, while European production was down 1%. Sales were also affected by the continued loss in market share of domestic automobile manufacturers. The increase in sales reflected the full year effect of acquisitions of businesses in 2005, which included the Tractech traction control business and the Morestana engine lifters business. The 39% decrease in operating profit in 2006 was largely due to net costs of $52 related to the Excel 07 program, which reduced the operating margin by 3.1%. The decline in operating profit also Page 59 reflected lower automotive production volumes in North America and Europe. Operating profit in 2006 was also affected by acquisition integration charges of $5 compared to charges of $4 in 2005, which reduced the operating margin by 0.3% in 2006 and 0.2% in 2005. These charges related to the acquired operations of Tractech and Morestana. On September 29, 2006, Eaton announced its engine valve actuation manufacturing plant in Saginaw, Michigan, would close by second half 2008. Aggregate estimated pretax charges associated with this closure are expected to be approximately $21. Total costs consist of cash charges of $3 for severance costs, charges of $4 related to pension costs, $4 for the write-down of fixed capital, and $10 for other costs. This facility has 277 employees. On September 25, 2006, the Company announced the closure of its engine valve manufacturing plant in Montornes del Valles, Spain, by the end of 2006. Aggregate pretax charges associated with this closure were $21. Total costs consist of cash charges of $15 for severance costs, $2 for the write-down of fixed capital, and $4 for other costs. This facility had 154 employees. As part of the Excel 07 program, in third quarter 2006, certain businesses of the Automotive segment were sold, resulting in a $35 after-tax gain. The gain on sale of these businesses, and other operating results of these businesses, were reported as Discontinued operations in the Statement of Consolidated Income. CORPORATE Amortization of intangible assets of $51 in 2006 increased from $30 in 2005 due to amortization of intangible assets associated with recently acquired businesses. Pension and other postretirement benefit expense included in Corporate increased to $152 in 2006 from $120 in 2005. This increase primarily resulted from the lowering of the discount rate associated with pension and other postretirement benefit liabilities at year-end 2005, and the impact of increased settlement costs in 2006. Effective January 1, 2006, in accordance with Statement of Financial Accounting Standards (SFAS) No. 123(R), "Share-Based Payment", Eaton began to record compensation expense under the "fair-value-based" method of accounting for stock options granted to employees and directors. Pretax expense for stock options was $27 in 2006. This change in accounting is further explained in "Stock Options" in the Notes to the Consolidated Financial Statements. CHANGES IN FINANCIAL CONDITION DURING 2006 Throughout 2006, Eaton maintained a focus on management of its capital. Net working capital of $1,001 at the end of 2006 increased by $391 from $610 at year-end 2005. The increase was primarily due to the $449 increase in cash and short-term investments, which largely resulted from strong cash flow from operations of $1,431; the $143 increase in accounts receivable resulting from increased sales; and the $194 increase in inventories to support higher levels of sales. These increases in working capital were partially offset by a net increase of $178 in short-term debt and current portion of long-term debt, and a net increase of $217 in accounts payable and several other working capital accounts to support higher levels of operations. The increase in current portion of long-term debt was largely due to the reclassification to current liabilities of the 6% Euro 200 million Notes that will mature in March 2007 (U.S. dollar equivalent of $263 at December 31, 2006) and $48 of other long-term debt that will mature in 2007, partially offset by the repayment of $244 of notes and debentures in 2006. Cash and short-term investments totaled $785 at year-end 2006, up $449 from $336 at year-end 2005. Accounts receivable days outstanding were 56 days at the end of 2006 and 2005. Inventory days on hand at the end of 2006 were 51 days, up from 47 days at year-end 2005. The current ratio was 1.3 at the end of 2006 and 1.2 at year-end 2005. Cash generated from operating activities of $1,431 in 2006 was a new record for Eaton, increasing by $296, or 26%, over cash generated from operating activities of $1,135 in 2005. The increase was primarily due to higher net income in 2006, which rose $145 in 2006 over 2005 and a net reduction of $162 in working capital funding due to changes in accounts receivable, accounts payable and in several other working capital accounts in 2006. Total debt of $2,586 at the end of 2006 increased $122 from $2,464 at year-end 2005. Changes in debt included the issuance in August 2006 of $250 of floating notes due 2009, the repayment of $244 of Page 60 notes and debentures in 2006, and a $96 increase in short-term debt. The net-debt-to-capital ratio was 30.5% at the end of 2006 compared to 36.0% at year-end 2005. The improvement in this ratio was primarily due to the increase in Shareholders' equity of $328 and the $327 decrease in net debt (total debt less cash and short-term investments) largely due to the increase in cash and short-term investments of $449. The increase in Shareholders' equity was due to net income in 2006 of $950. This increase was partially offset by the repurchase of 5.286 million Common Shares in 2006 at a total cost of $386; the recognition at year-end 2006 of $282 of after-tax adjustments for pensions and other post-retirement benefits due to the adoption of Statement of Financial Accounting Standards No. 158; and cash dividends of $220 paid during 2006. In September 2006, Eaton entered into a new $500 long-term revolving credit facility, which will expire in August 2011. Eaton has long-term revolving credit facilities of $1.5 billion, of which $300 will expire in May 2008, $700 in March 2010 and the remaining $500 in August 2011, as described above. On July 19, 2006 Moody's Investors Service changed its outlook on Eaton to stable from negative. Moody's awarded Eaton a long-term rating of "A2". In June 2005, Standard & Poor's raised the Company's corporate credit rating to "A" from "A-minus" and its commercial paper rating to "A-1" from "A-2". On January 22, 2007, Eaton announced that it was increasing the quarterly dividend on its Common Shares by 10%, from $.39 per share to $.43 per share, effective for the February 2007 dividend. This increase is in addition to the increase announced in July 2006, when the Company raised the quarterly dividend on its Common Shares by 11%, from $.35 per share to $.39 per share, effective with the August 2006 dividend, and the 13% increase in the dividend, from $.31 per share to $.35 per share, which was announced in January 2006. On January 22, 2007, Eaton announced that it was authorizing a new 10 million Common Share repurchase program, replacing the 1.3 million shares remaining from the 10 million share repurchase authorization approved in April 2005. The shares are expected to be repurchased over time, depending on market conditions, share price, capital levels and other considerations. Under the April 2005 authorization, 5.286 million shares were repurchased in the open market in 2006 at a total cost of $386. As of December 31, 2006, Eaton adopted Statement of Financial Accounting Standards (SFAS) No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)". SFAS No. 158 requires employers to recognize on their balance sheets the net amount by which pension and other postretirement benefit plan obligations are overfunded or underfunded. This new requirement replaces SFAS No. 87's requirement to report a minimum pension liability measured as the excess of the accumulated benefit obligations over the fair value of plan assets. Under SFAS No. 158, employers are required to recognize all actuarial gains and losses, prior service costs, and any remaining transition amounts from the initial application of SFAS Nos. 87 and 106 when recognizing the plans' funded status, with an increase in accumulated other comprehensive loss in shareholders' equity. The effect on Eaton of applying SFAS No. 158 on the consolidated balance sheet at December 31, 2006 was an increase in the liability for pensions of $248 ($163 after-tax) and an increase in the liability for postretirement benefits other than pensions of $238 ($119 after-tax). These adjustments increased Accumulated other comprehensive loss in Shareholders' equity by a combined amount of $282, reducing total Shareholders' equity by a like amount. This change in accounting is further explained in "Retirement Benefit Plans" in the Notes to the Consolidated Financial Statements. The Pension Protection Act of 2006 (the Act) was signed on August 17, 2006. The Act establishes new minimum funding standards that become effective in 2008. Under the new law, a plan's funding shortfall (the amount the funding target exceeds the actuarial value of assets) will be amortized over seven years, and the minimum required contribution will be the sum of the target normal cost and the amortization charge. Eaton cannot reasonably estimate the funding status in future periods as it is dependent on the interest rates used to determine the funding target and the future return on assets. Eaton has made voluntary contributions to its United States pension plan of $50, $100, and $150 in 2005, 2006, and 2007 respectively. Future minimum required contributions are expected to be within a similar range. OUTLOOK FOR 2007 As Eaton surveyed its end markets for its business segments in mid-January 2007, it expected an overall decline of approximately 3.5% for full year 2007, primarily as a result of the expected dramatic decrease in the NAFTA heavy-duty Page 61 truck market. This is roughly 1.5% lower growth in end markets than had been expected one year ago, as the Company now sees the slowdown in the overall manufacturing sector experienced in the second half of 2006 extending into the early portion of 2007. Eaton expects to outgrow end markets in 2007 by approximately $200, and to record approximately $300 of additional sales in 2007 from the full-year impact of the six acquisitions completed in 2006, and the two acquisitions announced in December 2006 and January 2007, but not yet completed. As a result of the expected decline in end markets in 2007 being offset by additional sales in 2007 from out-growing end markets and from acquisitions of businesses, the Company anticipates sales in 2007 will be flat compared to 2006. For 2007, in the Electrical segment, Eaton expects markets to grow 4%, with growth in the nonresidential markets offsetting a decline in the residential market. Operating margins are expected to improve as a result of the additional volume, a reduced impact from commodity costs, and the benefits from the Excel 07 actions taken in 2006. For Fluid Power, the Company expects growth in the construction equipment markets to be lower than in 2006, while agricultural equipment markets are expected to grow for the first time in three years. Industrial markets are likely to post lower growth than in 2006. Growth in the commercial aerospace market is expected to be solid, while defense aerospace markets are expected to post modest growth. In total, the Company believes the Fluid Power markets will grow 4% in 2007. Fluid Power operating margins are expected to improve in 2007 as a result of the additional volume and the benefits from the Excel 07 actions taken in 2006. In the Truck segment, Eaton expects that production of NAFTA heavy-duty trucks in 2007 will be between 205,000 and 210,000 units, down approximately 44% from 2006. Truck operating margins will be lower due to the expected reduction in the end market for heavy-duty trucks in NAFTA, but the benefits from the Excel 07 actions taken in 2006 will help to cushion the overall sales reduction. For the Automotive segment, NAFTA automotive production is expected to weaken, and production in Europe is expected to be flat. Margins for the Automotive segment are expected to improve as a result of the substantial benefits from the Excel 07 actions taken in 2006. The significant restructuring of operations in 2006 resulting from the Excel 07 program is expected to offset much of the effect on net income in 2007 from the expected overall decline in end markets. Eaton believes the benefit to net income in 2007 now expected from the Excel 07 program will be $.60 per Common Share, double the target announced when the program was started in January 2006. With the Excel 07 program completed at the end of 2006, the Company believes its operations are well positioned for the balance of the decade. Eaton's guidance for net income per Common Share for full year 2007 is $6.05 to $6.25, after charges to integrate recent acquisitions and joint ventures of $.25 per share. For the first quarter of 2007, the Company anticipates net income per Common Share of $1.30 to $1.40, after acquisition integration charges of $.05 per share. FORWARD-LOOKING STATEMENTS This Annual Report to Shareholders contains forward-looking statements concerning Eaton's first quarter 2007 and full year 2007 net income per Common Share, worldwide markets, growth in relation to end markets, growth from acquisitions and joint ventures, and the benefits from Excel 07. These statements should be used with caution and are subject to various risks and uncertainties, many of which are outside the Company's control. The following factors could cause actual results to differ materially from those in the forward-looking statements: unanticipated changes in the markets for the Company's business segments; unanticipated downturns in business relationships with customers or their purchases from the Company; competitive pressures on sales and pricing; increases in the cost of material and other production costs, or unexpected costs that cannot be recouped in product pricing; the introduction of competing technologies; unexpected technical or marketing difficulties; unexpected claims, charges, litigation or dispute resolutions; acquisitions and divestitures; unanticipated difficulties integrating acquisitions; new laws and governmental regulations; interest rate changes; stock market fluctuations; and unanticipated deterioration of economic and financial conditions in the United States and around the world. Eaton does not assume any obligation to update these forward-looking statements. CRITICAL ACCOUNTING POLICIES The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires Eaton's management to make estimates and use assumptions in certain circumstances that affect amounts reported in the accompanying consolidated financial statements. In preparing these financial statements, management has made their best estimates and judgments of certain amounts included in the financial statements, giving due consideration to materiality. For any Page 62 estimate or assumption there may be other reasonable estimates or assumptions that could have been used. However, the Company believes that given the current facts and circumstances, it is unlikely that applying such other estimates and assumptions would have caused materially different amounts to have been reported. Application of these accounting policies involves the exercise of judgment and use of assumptions as to future uncertainties and, as a result, actual results could differ from estimates used. REVENUE RECOGNITION Sales are recognized when products are shipped to unaffiliated customers, all significant risks of ownership have been transferred to the customer, title has transferred in accordance with shipping terms (FOB shipping point or FOB destination), the selling price is fixed and determinable, all significant related acts of performance have been completed, and no other significant uncertainties exist. Shipping and handling costs billed to customers are included in Net sales and the related costs in Cost of products sold. Other revenues for service contracts are recognized as the services are provided. IMPAIRMENT OF GOODWILL & OTHER LONG-LIVED ASSETS Statement of Financial Accounting Standards (SFAS) No. 142 "Goodwill and Other Intangible Assets" provides that goodwill and indefinite life intangible assets must be reviewed for impairment, in accordance with the specified methodology. Further, goodwill and intangible assets are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount may not be recoverable. During 2006, Eaton completed the annual impairment tests for goodwill and indefinite life intangible assets as required by SFAS No. 142. These tests confirmed that the fair value of the Company's reporting units and indefinite life intangible assets exceed their respective carrying values and that no impairment loss was required to be recognized. Goodwill and other intangible assets totaled $4.0 billion at the end of 2006 and represented 35% of total assets. These assets resulted primarily from the $1.6 billion acquisition of Aeroquip-Vickers, Inc., a mobile and industrial hydraulics business, in 1999; the $1.1 billion acquisition of the electrical distribution and controls business unit of Westinghouse in 1994; and the $573 acquisition of Powerware Corporation, the electrical uninterruptable power systems business, in 2004. These businesses, as well as many of the Company's other recent business acquisitions, have a long history of operating success and profitability and hold significant market positions in the majority of their product lines. Their products are not subject to rapid technological or functional obsolescence. These factors, coupled with continuous strong product demand, support the recorded values of the goodwill and intangible assets related to acquired businesses. Long-lived assets, other than goodwill and indefinite life intangible assets, are reviewed for impairment whenever events or changes in circumstances indicate the carrying amount may not be recoverable. Events or circumstances that would result in an impairment review primarily include operations reporting losses, a significant change in the use of an asset, or the planned disposal or sale of the asset. The asset would be considered impaired when the future net undiscounted cash flows generated by the asset are less than its carrying value. An impairment loss would be recognized based on the amount by which the carrying value of the asset exceeds its fair value. INCOME TAX ASSETS & LIABILITIES Deferred income tax assets and liabilities have been recorded for the differences between the financial accounting and income tax basis of assets and liabilities, and for certain United States income tax credit carryforwards. Recorded deferred income tax assets and liabilities are described in detail in "Income Taxes" in the Notes to the Consolidated Financial Statements. Significant factors considered by management in the determination of the probability of the realization of deferred tax assets include historical operating results, expectations of future earnings and taxable income, and the extended period of time over which certain temporary differences will reverse. A valuation allowance of $221 has been recognized for deferred tax assets, because management believes there is a low probability of the realization of deferred tax assets related to certain United States Federal income tax credit carryforwards, most United States state and local income tax loss carryforwards and tax credit carryforwards, and tax loss carryforwards at certain international operations. In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation (FIN) No. 48, "Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109", which Eaton will adopt in first quarter 2007. FIN No. 48 clarifies the accounting for uncertainty in income taxes by establishing minimum standards for the recognition and measurement of income tax positions taken, or expected to be taken, in an income tax return. FIN No. 48 also changes the disclosure standards for income taxes. Eaton's historical policy has consistently been to enter into tax planning strategies only if it is more likely than not that the benefit would be sustained upon audit. For example, the Company Page 63 does not enter into any of the Internal Revenue Service (IRS) Listed Transactions as set forth in Treasury Regulation 1.6011-4. Consequently, the Company does not expect the adoption of FIN No. 48 to result in the recording of a material cumulative effect of a change in the accounting principle. PENSION & OTHER POSTRETIREMENT BENEFIT PLANS The measurement of liabilities related to pension plans and other postretirement benefit plans is based on management's assumptions related to future events including interest rates, return on pension plan assets, rate of compensation increases, and health care cost trend rates. Actual pension plan asset performance will either reduce or increase pension losses included in accumulated other comprehensive loss, which ultimately affects net income. The discount rate for United States plans was determined by constructing a zero-coupon spot yield curve derived from a universe of high-quality bonds as of the measurement date, which was designed to match the discounted expected benefit payments. The bond data (rated Aa or better by Moody's Investor Services) was obtained from Bloomberg. Callable bonds with explicit call schedules were excluded and bonds with "make-whole" call provisions were included. In addition, a portion of the bonds were deemed outliers and excluded from consideration. The discount rates for non-United States plans are appropriate for each region and are based on high quality long-term corporate and government bonds. Consideration has been given to the duration of the liabilities in each plan for selecting the bonds to be used in determining the discount rate. At the end of 2006, certain key assumptions used to calculate pension and other postretirement benefit expense were adjusted, including the lowering of the assumed return on pension plan assets from 8.35% to 8.31% and the discount rate from 5.51% to 5.39%. At the end of 2005, the assumed return on pension plan assets was lowered from 8.41% to 8.35%, and the discount rate from 5.81% to 5.51%. At the end of 2004, the assumed return on pension plan assets was lowered from 8.50% to 8.41% and the discount rate from 6.11% to 5.81%. The changes in these assumptions in 2005 and 2004 resulted in increased pretax pension and postretirement benefit expense of $66 in 2006 compared to 2005. These changes increased pretax pension and other postretirement benefit expense $55 in 2005 compared to 2004. Pretax pension and other postretirement benefit expense are expected to be flat in 2007 compared to 2006. A 1-percentage point change in the assumed rate of return on pension plan assets is estimated to have approximately a $24 effect on pension expense. Likewise, a 1-percentage point change in the discount rate is estimated to have approximately a $44 effect on pension expense. A 1-percentage point change in the discount rate is estimated to have approximately a $1 effect on expense for other postretirement benefit plans. Additional information related to changes in key assumptions used to recognize expense for other postretirement benefit plans is found in "Retirement Benefit Plans" in the Notes to the Consolidated Financial Statements. As of December 31, 2006, Eaton adopted Statement of Financial Accounting Standards (SFAS) No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R)". SFAS No. 158 requires employers to recognize on their balance sheets the net amount by which pension and other postretirement benefit plan obligations are overfunded or underfunded. This change in accounting is further explained in "Retirement Benefit Plans" in the Notes to the Consolidated Financial Statements. PROTECTION OF THE ENVIRONMENT As a result of past operations, Eaton is involved in remedial response and voluntary environmental remediation at a number of sites, including certain of its currently-owned or formerly-owned plants. The Company has also been named a potentially responsible party (PRP) under the Federal Superfund law at a number of waste disposal sites. A number of factors affect the cost of environmental remediation, including the number of parties involved at a particular site, the determination of the extent of contamination, the length of time the remediation may require, the complexity of environmental regulations, and the continuing advancement of remediation technology. Taking these factors into account, Eaton has estimated (without discounting) the costs of remediation, which will be incurred over a period of several years. The Company accrues an amount consistent with the estimates of these costs when it is probable that a liability has been incurred. At December 31, 2006, the balance sheet included a liability for these costs of $64. All of Page 64 these estimates are forward-looking statements and, given the inherent uncertainties in evaluating environmental exposures, actual results can differ from these estimates. CONTINGENCIES Eaton is subject to a broad range of claims, administrative proceedings, and legal proceedings, such as lawsuits that relate to contractual allegations, patent infringement, personal injuries (including asbes- tos claims) and employment-related matters. Although it is not pos- sible to predict with certainty the outcome or cost of these matters, the Company believes that these matters will not have a material ad- verse effect on its financial position, results of operations or cash flows. STOCK OPTIONS GRANTED TO EMPLOYEES & DIRECTORS Effective January 1, 2006, in accordance with SFAS No. 123(R), "Share-Based Payment", Eaton began to record compensation expense under the "fair-value-based" method of accounting for stock options granted to employees and directors. The Company adopted SFAS No. 123(R) using the "modified prospective application" method and, consequently, financial results for periods prior to 2006 were not restated for this accounting change. This change in accounting is further explained in "Stock Options" in the Notes to the Consolidated Financial Statements. OFF-BALANCE SHEET ARRANGEMENTS Eaton does not have off-balance sheet arrangements or financings with unconsolidated entities or other persons. In the ordinary course of business, the Company leases certain real properties and equipment, as described in "Lease Commitments" in the Notes to the Consolidated Financial Statements. Transactions with related parties are in the ordinary course of business, are conducted on an arm's-length basis, and are not material to Eaton's financial position, results of operations or cash flows. MARKET RISK DISCLOSURE & CONTRACTUAL OBLIGATIONS To manage exposure to fluctuations in foreign currencies, interest rates and commodity prices, Eaton uses straightforward, non-leveraged, financial instruments for which quoted market prices are readily available from a number of independent services. The Company is exposed to various changes in financial market conditions, including fluctuations in interest rates, foreign currency exchange rates, and commodity prices. Eaton manages exposure to such risks through normal operating and financing activities. Interest rate risk can be measured by calculating the near-term earnings impact that would result from adverse changes in interest rates. This exposure results from short-term debt, which includes commercial paper at a floating interest rate, long-term debt that has been swapped to floating rates, and money market investments that have not been swapped to fixed rates. A 100 basis point increase in short-term interest rates would increase the Company's net, pretax interest expense by approximately $15. Eaton also measures interest rate risk by estimating the net amount by which the fair value of the Company's financial liabilities would change as a result of movements in interest rates. Based on a hypothetical, immediate 100 basis point decrease in interest rates at December 31, 2006, the market value of the Company's debt and interest rate swap portfolio, in aggregate, would increase by $137. Foreign currency risk is the risk that Eaton will incur economic losses due to adverse changes in foreign currency exchange rates. The Company mitigates foreign currency risk by funding some investments in foreign markets through local currency financings. Such non-U.S. Dollar debt was $701 at December 31, 2006. To augment Eaton's non-U.S. Dollar debt portfolio, the Company also enters into forward foreign exchange contracts and foreign currency swaps from time to time to mitigate the risk of economic loss in its foreign investments due to adverse changes in exchange rates. At December 31, 2006, the aggregate balance of such contracts was $169. Eaton also monitors exposure to transactions denominated in currencies other than the functional currency of each country in which the Company operates, and periodically enters into forward contracts to mitigate that exposure. In the aggregate, Eaton's portfolio of forward contracts related to such transactions was not material to its financial position, results of operations or cash flows during 2006. Other than the above noted debt and financial derivative arrangements, there were no material derivative instrument transactions in place or undertaken during 2006. A summary of contractual obligations as of December 31, 2006 follows: Page 65
Payments due by period --------------------------------------- 2008 2010 to to After 2007 2009 2011 2011 Total ------ ----- ---- ------ ------ Long-term debt $ 322 $401 $ 7 $1,366 $2,096 Interest expense related to long-term debt 106 196 174 968 1,444 Reduction of interest expense from interest rate swap agreements related to long-term debt (3) (3) (5) (57) (68) Operating leases 87 120 67 49 323 Purchase obligations 412 171 43 20 646 Other long-term liabilities 225 26 25 34 310 ------ ---- ---- ------ ------ $1,149 $911 $311 $2,380 $4,751 ====== ==== ==== ====== ======
Long-term debt includes obligations under capital leases, which are not material. Interest expense related to long-term debt is based on the fixed interest rate, or other applicable interest rate related to the debt instrument, at December 31, 2006. The reduction of interest expense due to interest rate swap agreements related to long-term debt is based on the difference in the fixed interest rate the Company receives from the swap, compared to the floating interest rate the Company pays on the swap, at December 31, 2006. Purchase obligations are entered into with various vendors in the normal course of business. These amounts include commitments for purchases of raw materials, outstanding non-cancelable purchase orders, releases under blanket purchase orders and commitments under ongoing service arrangements. Other long-term liabilities include $214 of contributions to pension plans in 2007 and $96 of deferred compensation earned under various plans for which the participants have elected to receive disbursement at a later date. The table above does not include future expected pension benefit payments or expected other postretirement benefit payments for each of the next five years and the five years thereafter. Information related to the amounts of these future payments is described in "Retirement Benefit Plans" in the Notes to the Consolidated Financial Statements. RESULTS OF OPERATIONS - 2005 COMPARED TO 2004
2005 2004 Increase ------- ------ -------- Continuing operations Net sales $11,019 $9,712 13% Gross profit 3,083 2,710 14% Percent of net sales 28.0% 27.9% Income before income taxes 988 768 29% Income after income taxes $ 799 $ 640 25% Income from discontinued operations, net of income taxes 6 8 ------- ------ Net income $ 805 $ 648 24% ======= ====== Net income per Common Share assuming dilution Continuing operations $ 5.19 $ 4.07 28% Discontinued operations .04 .06 ------- ------ $ 5.23 $ 4.13 27% ======= ======
Sales for 2005 grew 13% compared to 2004 and were a record for Eaton. Sales growth in 2005 consisted of 7% from organic growth, 5% from acquisitions of businesses (primarily the full-year effect of the Powerware electrical power systems business acquired on June 9, 2004), and 1% from foreign exchange rates. Organic growth of 7% was comprised of 5% growth in Eaton's end markets and 2% from outgrowing end markets. Gross profit increased 14% in 2005, primarily due to sales growth, the benefits of integrating acquired businesses, continued productivity improvements driven by the Eaton Business System (EBS), and the full-year effect of the acquisition of Powerware. Improved gross profit in 2005 was also partially due to reduced acquisition integration charges in 2005, which were $36 compared to $41 in 2004. These increases in gross profit were partially offset by higher pension costs and higher prices paid, primarily for basic metals, in 2005. Page 66 RESULTS BY GEOGRAPHIC REGION
Segment operating profit Operating Net sales -------------------------- margin --------------------------- Increase ----------- 2005 2004 Increase 2005 2004 (Decrease) 2005 2004 ------- ------ -------- ------ ---- ---------- ---- ---- United States $ 7,666 $6,806 13% $1,018 $778 31% 13.3% 11.4% Canada 315 261 21% 48 37 30% 15.2% 14.2% Europe 2,084 1,922 8% 110 138 (20%) 5.3% 7.2% Latin America 1,036 774 34% 136 107 27% 13.1% 13.8% Asia/Pacific 797 679 17% 80 79 1% 10.0% 11.6% Eliminations (879) (730) ------- ------ $11,019 $9,712 13% ======= ======
Growth in sales in the United States of 13% was due to higher sales in Electrical, which included the full-year effect of the acquisition of Powerware; sharply higher sales in Truck due to strong end market demand; and, to a lesser extent, increased sales in Fluid Power from acquisitions completed in second half of 2005, including the aerospace division of PerkinElmer, Inc., the aerospace fluid and air division of Cobham plc, and the industrial filtration business of Hayward Industries, Inc. These increases in sales were partially offset by a sales reduction in Automotive. The 31% increase in operating profit in the United States was primarily the result of strong sales in Truck; higher profit of Electrical, including the full-year effect of the acquisition of Powerware; the benefits of integrating acquired businesses; and, to a lesser extent, increased profit of Fluid Power and Automotive. In Canada, growth of 21% in sales and 30% in operating profit were due to the full-year effect of the acquisition of Powerware and improved results in other Electrical businesses. Sales growth in Europe of 8% was due to higher sales in Electrical, largely the result of the full-year effect of the acquisition of Powerware; to a lesser extent, growth in Fluid Power, which included sales of the aerospace fluid and air division of Cobham plc; and growth in Automotive and Truck. Lower operating profit of 20% in Europe was primarily the result of a significant reduction in revenues in Fluid Power's automotive fluid connectors business, and reduced profit of Automotive, which included costs incurred in the fourth quarter to start-up new facilities in Eastern Europe. In Latin America, growth of 34% in sales and 27% in operating profit were largely due to significantly higher sales in Truck, which included the Pigozzi agricultural powertrain business acquired in March 2005; to a lesser extent, higher sales in Electrical, including the full-year effect of the acquisition of Powerware; and sales growth in Automotive, which included the Morestana hydraulic lifters business acquired in June 2005. Growth of 17% in sales of Asia/Pacific was due to the full-year effect of the acquisition of Powerware and higher sales of Fluid Power, which included the Winner hydraulics business acquired in March 2005. The 1% increase in operating profit primarily related to the full-year effect of the acquisition of Powerware and improved results of Fluid Power, partially offset by lower profit in Automotive and by start-up losses related to new operations of Truck. OTHER RESULTS OF OPERATIONS In 2005 and 2004, Eaton incurred acquisition integration charges related to the integration of primarily the following acquisitions: Powerware, the electrical power systems business acquired in June 2004; the electrical division of Delta plc; several acquisitions in Fluid Power, including Winner, Walterscheid, and Boston Weatherhead; the Pigozzi agricultural powertrain business; and the Morestana automotive lifter business. A summary of these charges follows:
2005 2004 ---- ---- Electrical $ 21 $ 33 Fluid Power 7 8 Truck 4 Automotive 4 ---- ---- Pretax charges $ 36 $ 41 ==== ==== After-tax charges $ 24 $ 27 Per Common Share $.15 $.17
Page 67 Acquisition integration charges in 2005 included $17 for the United States, $7 for Europe, $4 for Latin America and $8 for Asia/Pacific. Charges in 2004 included $22 for the United States, $18 for Europe and $1 for Asia/Pacific. These charges were included in the Statements of Consolidated Income in Cost of products sold or Selling & administrative expense, as appropriate. In Business Segment Information, the charges reduced Operating profit of the related business segment or were included in Other corporate expense-net, as appropriate. Pretax income for 2005 was reduced by $55 ($35 after-tax, or $.23 per Common Share) compared to 2004 due to increased pension and other postretirement benefit expense in 2005. This primarily resulted from the effect of the lower discount rates used in determining pension and other postretirement benefit liabilities at year-end 2004, coupled with the impact of declines during 2000 through 2002 in the market related value of equity investments held by Eaton's pension plans. The effective income tax rate for 2005 was 19.1% compared to 16.7% for 2004. The lower rate in 2004 was primarily due to an income tax benefit of $30 resulting from the favorable resolution in the fourth quarter of 2004 of multiple international and U.S. income tax issues. In fourth quarter 2005, Eaton recorded income tax expense of $3 for the repatriation of $66 of foreign earnings under the American Jobs Creation Act of 2004. This distribution did not change the Company's intention to indefinitely reinvest undistributed earnings of its foreign subsidiaries and, therefore, no U.S. income tax provision has been recorded on the remaining amount of unremitted earnings. The change in the effective income tax rate in 2005 compared to 2004 is further explained in "Income Taxes" in the Notes to the Consolidated Financial Statements. Net income and net income per Common Share assuming dilution for 2005 were new records for Eaton, increasing 24% and 27%, respectively, over 2004. These improvements were primarily due to sales growth and other factors described above. These improvements leading to the increase in net income were partially offset by higher interest expense and a higher effective income tax rate in 2005. The increase in earnings per share also reflected lower average shares outstanding for periods in 2005 compared to 2004, due to the repurchase of 7.015 million shares in 2005, at a total cost of $450. RESULTS BY BUSINESS SEGMENT ELECTRICAL
2005 2004 Increase ------ ------ -------- Net sales $3,758 $3,072 22% Operating profit 375 243 54% Operating margin 10.0% 7.9%
Sales of the Electrical segment grew 22% in 2005. Of the 22% sales increase, 11% was from acquisitions, 10% was due to volume growth, and 1% from foreign exchange rates. Acquisitions included the Powerware electrical power systems business acquired on June 9, 2004. Operating results for 2005 and 2004 include the results of Powerware from the date of acquisition. Volume growth of 10% in 2005 was driven by growth in end markets of approximately 6% and sales above end-market growth of an additional 4%. Operating profit rose 54% in 2005. The increase was largely due to growth in sales, continued productivity improvements, the full-year effect of the acquisition of Powerware, benefits of integrating Powerware, and favorable product mix. These improvements in operating profit were partially offset by higher prices paid, primarily for basic metals. The operating margin on overall sales growth was 19%. Increased sales from acquisitions generated a 6% operating margin. Increased sales from organic growth generated a 29% operating margin. The improved operating margin in 2005 also reflected reduced acquisition integration charges in 2005. Acquisition integration charges in 2005 were $21 compared to $33 in 2004, reducing operating margins by 0.6% in 2005 and 1.1% in 2004, and reducing the incremental profit margin by 1.7%. Acquisition integration charges in 2005 and 2004 related primarily to the integration of Powerware as well as the electrical division of Delta plc acquired in January 2003. On October 11, 2005, Eaton acquired the assets of one of its suppliers, Pringle Electrical Manufacturing Company. This business manufactures bolted contact switches and other specialty switches and had sales of $6 in 2004, with one-third of these sales to Eaton. Page 68 On June 17, 2005, Eaton signed an agreement to form a joint venture with Zhongshan Ming Yang Electrical Appliances Co., Ltd. to manufacture and market switchgear components in southern China. Eaton has 51% ownership of the joint venture, which is called Eaton Electrical (Zhongshan) Co., Ltd. The joint venture began operations in third quarter 2005. On June 9, 2004, Eaton acquired Powerware Corporation, the power systems business of Invensys plc, for a final cash purchase price of $573, less cash acquired of $27. Powerware, based in Raleigh, North Carolina, is a supplier of Uninterruptible Power Systems (UPS), DC Power products and power quality services that had sales of $775 for the year ended March 31, 2004. Powerware has operations in the United States, Canada, Europe, South America and Asia/Pacific that provide products and services utilized by computer manufacturers, industrial companies, governments, telecommunications firms, medical institutions, data centers and other businesses. FLUID POWER
2005 2004 Increase ------ ------ -------- Net sales $3,240 $3,098 5% Operating profit 339 338 -- Operating margin 10.5% 10.9%
Sales of the Fluid Power segment grew 5% in 2005. The increase in sales in 2005 over 2004 was due to acquisitions of businesses in 2005 and 2004 contributing 5%, with growth in end markets contributing another 3%, driven by strength in end markets for hydraulics and commercial aerospace, partially offset by weakness in end markets for defense aerospace and automotive fluid connectors. Sales in 2005 also reflected a significant sales decrease in the automotive fluid connector business reflecting the impact of expiring programs. Acquisitions in 2005 included the following businesses, which are described below: the aerospace operations of PerkinElmer, Inc. and the aerospace fluid and air division of Cobham plc; the industrial filtration business of Hayward Industries, Inc.; and the hydraulic hose fittings and adapters business in China of Winner Group Holdings Ltd. The sales increase also reflected the full-year effect of the acquisition of Walterscheid, a German manufacturer of hydraulic tube connectors and fittings, in September 2004. Growth in Fluid Power markets during 2005 was mixed, with global hydraulics shipments up 8%, commercial aerospace markets up 10%, defense aerospace markets down 7%, and European automotive production down 2%. Growth in the mobile and industrial hydraulics markets in 2005 slowed from 2004. In particular, agricultural equipment sales were sluggish due to a combination of drought conditions and reductions in farm income in several markets around the world. Operating margins were helped by the operating profit of acquired businesses, which generated incremental profit of 13% on the sales contributed, benefits of restructuring actions to integrate acquired businesses, and continued productivity improvements. Operating profit and margins were also affected by the significant reduction in revenues in the automotive fluid connectors business, which had a 26% reduction in operating profit on the lost volume. Additional program costs within the aerospace business, sluggish demand in the agricultural equipment sector, and higher prices paid, primarily for basic metals, also contributed to the lower operating margin. Acquisition integration charges in 2005 related to acquired businesses were $7 compared to $8 in 2004, reducing operating margins by 0.2% in 2005 and 0.3% in 2004. These acquisition integration charges related to the integration of recent acquisitions including Winner, Walterscheid acquired in September 2004, and Boston Weatherhead acquired in November 2002. On December 6, 2005, Eaton acquired the aerospace division of PerkinElmer, Inc., which is a provider of sealing and pneumatic systems for large commercial aircraft and regional jets. This business had sales of $150 for the 12 months ended June 30, 2005. On November 1, 2005, the Company acquired the aerospace fluid and air division of Cobham plc. This business provides low-pressure airframe fuel systems, electro-mechanical actuation, air ducting, hydraulic and power generation, and fluid distribution systems for fuel, hydraulics and air. This business had sales of $210 in 2004. On September 6, 2005, the industrial filtration business of Hayward Industries, Inc. was acquired. Hayward produces filtration systems for industrial and commercial customers. This business had sales of $100 for the 12 months ended June 30, 2005. Page 69 On March 31, 2005, Eaton acquired Winner Group Holdings Ltd., a producer of hydraulic hose fittings and adapters for the Chinese market. This business had sales of $26 in 2004. TRUCK
2005 2004 Increase ------ ------ -------- Net sales $2,288 $1,800 27% Operating profit 453 329 38% Operating margin 19.8% 18.3%
Sales of the Truck segment grew 27% in 2005. Of the 27% sales increase in 2005, 21% was due to organic growth, 5% from foreign exchange rates, and 1% from the acquisition of Pigozzi, as described below. Organic growth was attributable to strong end-market demand, primarily in NAFTA heavy-duty truck production, which rose 27% in 2005 to 341,000 units. Other markets also grew in 2005, with NAFTA medium-duty truck production increasing 16% in 2005 compared to 2004, European truck production increasing 7%, and Brazilian vehicle production increasing 10%. Operating profit grew 38% in 2005. The incremental profit margin on the increased sales volume was 25%, partly reflecting the benefits of productivity improvements. These improvements in operating margin were offset by higher prices paid, primarily for basic metals. Operating profit in 2005 was also reduced by 0.2% due to acquisition integration charges of $4 related to the integration of Pigozzi. On March 1, 2005, Pigozzi S.A. Engrenagens e Transmissoes, a Brazilian agricultural powertrain business that produces transmissions, rotors and other drivetrain components, was acquired. This business had sales of $42 in 2004. AUTOMOTIVE
2005 2004 (Decrease) ------ ------ ---------- Net sales $1,733 $1,742 (1)% Operating profit 225 229 (2)% Operating margin 13.0% 13.1%
Sales of the Automotive segment decreased 1% in 2005. The reduction in sales reflected sales volume that was lower by 2% in 2005, offset by a 1% increase due to foreign exchange rates. Automotive production in 2005 for NAFTA was flat compared to 2004, and in Europe decreased 2% from 2004. The change in sales also reflected additional sales volume from the acquisitions in 2005 of Tractech Holdings, Inc. and Morestana S.A. de C.V, as described below. The 2% decrease in operating profit in 2005 resulted from the reduction in sales in 2005, costs incurred to start-up new facilities in Eastern Europe and to exit a product line, and $4 of acquisition integration charges related to the acquisition of Morestana described below. Operating profit in 2005 was helped by continued productivity improvements, but was also hurt by higher prices paid, primarily for basic metals. Acquisition integration charges related to the integration of Morestana reduced operating margin by 0.2% in 2005. On August 17, 2005, Tractech Holdings, Inc., a manufacturer of specialized differentials and clutch components for the commercial and specialty vehicle markets, was acquired. This business had sales of $43 in 2004. On June 30, 2005, Morestana S.A. de C.V., a Mexican producer of hydraulic lifters for automotive engine manufacturers and the automotive aftermarket, was acquired. This business had sales of $13 in 2004. CORPORATE Pension and other postretirement benefit expense included in corporate increased to $120 in 2005 from $75 in 2004. The increase primarily resulted from the effect of the lower discount rates used in determining pension and other postretirement benefit liabilities at year-end 2004, coupled with the impact of declines during 2000 through 2002 in the market related value of equity investments held by Eaton's pension plans. Page 70 Other corporate expense-net in 2005 was $159 compared to $186 for 2004. The reduction was largely attributable to a charge of $13 for contributions to the Eaton Charitable Fund that was recorded in 2004, with no similar expense in 2005. Page 71 TEN-YEAR CONSOLIDATED FINANCIAL SUMMARY
(Millions except for per share data) 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 ------- ------- ------ ------ ------ ------ ------ ------ ------ ------ Continuing operations Net sales $12,370 $11,019 $9,712 $7,966 $7,123 $7,207 $8,219 $7,915 $6,276 $7,019 Income before income taxes 989 988 768 492 384 262 537 929 602 713 Income after income taxes $ 912 $ 799 $ 640 $ 375 $ 271 $ 158 $ 353 $ 593 $ 421 $ 515 Percent of net sales 7.4% 7.3% 6.6% 4.7% 3.8% 2.2% 4.3% 7.5% 6.7% 7.3% Extraordinary item - redemption of debentures (54) Income (loss) from discontinued operations, net of income taxes 38 6 8 11 10 11 100 24 (72) (51) ------- ------- ------ ------ ------ ------ ------ ------ ------ ------ Net income $ 950 $ 805 $ 648 $ 386 $ 281 $ 169 $ 453 $ 617 $ 349 $ 410 ======= ======= ====== ====== ====== ====== ====== ====== ====== ====== Net income per Common Share assuming dilution Continuing operations $ 5.97 $ 5.19 $ 4.07 $ 2.49 $ 1.89 $ 1.12 $ 2.43 $ 4.02 $ 2.90 $ 3.29 Extraordinary item (.35) Discontinued operations .25 .04 .06 .07 .07 .08 .69 .16 (.50) (.32) ------- ------- ------ ------ ------ ------ ------ ------ ------ ------ $ 6.22 $ 5.23 $ 4.13 $ 2.56 $ 1.96 $ 1.20 $ 3.12 $ 4.18 $ 2.40 $ 2.62 ======= ======= ====== ====== ====== ====== ====== ====== ====== ====== Average number of Common Shares outstanding assuming dilution 152.9 154.0 157.1 150.5 143.4 141.0 145.2 147.4 145.4 156.4 Net income per Common Share basic Continuing operations $ 6.07 $ 5.32 $ 4.18 $ 2.54 $ 1.92 $ 1.14 $ 2.46 $ 4.09 $ 2.95 $ 3.35 Extraordinary item (.35) Discontinued operations .25 .04 .06 .07 .07 .08 .70 .17 (.50) (.33) ------- ------- ------ ------ ------ ------ ------ ------ ------ ------ $ 6.32 $ 5.36 $ 4.24 $ 2.61 $ 1.99 $ 1.22 $ 3.16 $ 4.26 $ 2.45 $ 2.67 ======= ======= ====== ====== ====== ====== ====== ====== ====== ====== Average number of Common Shares outstanding basic 150.2 150.2 153.1 147.9 141.2 138.8 143.6 145.0 142.8 153.6 Cash dividends paid per Common Share $ 1.48 $ 1.24 $ 1.08 $ .92 $ .88 $ .88 $ .88 $ .88 $ .88 $ .86 ------- ------- ------ ------ ------ ------ ------ ------ ------ ------ Total assets $11,417 $10,218 $9,075 $8,223 $7,138 $7,646 $8,180 $8,342 $5,570 $5,497 Long-term debt 1,774 1,830 1,734 1,651 1,887 2,252 2,447 1,915 1,191 1,272 Total debt 2,586 2,464 1,773 1,953 2,088 2,440 3,004 2,885 1,524 1,376 Shareholders' equity 4,106 3,778 3,606 3,117 2,302 2,475 2,410 2,624 2,057 2,071 Shareholders' equity per Common Share $ 28.07 $ 25.44 $23.52 $20.37 $16.30 $17.80 $17.64 $17.72 $14.34 $13.86 Common Shares outstanding 146.3 148.5 153.3 153.0 141.2 139.0 136.6 148.0 143.4 149.4
Page 72 QUARTERLY DATA
Quarter ended in 2006 Quarter ended in 2005 --------------------------------------- --------------------------------------- (Millions except for per share data) Dec. 31 Sept. 30 June 30 March 31 Dec. 31 Sept. 30 June 30 March 31 ------- -------- ------- -------- ------- -------- ------- -------- Continuing operations Net sales $3,102 $3,115 $3,162 $2,991 $2,817 $2,767 $2,808 $2,627 Gross profit 802 802 874 842 775 784 788 736 Percent of net sales 25.9% 25.8% 27.6% 28.2% 27.5% 28.3% 28.1% 28.0% Income before income taxes 239 225 274 251 246 247 262 233 Income after income taxes $ 241 $ 213 $ 252 $ 206 $ 211 $ 197 $ 207 $ 184 Income (loss) from discontinued operations, net of income taxes 35 1 2 (1) 2 2 3 ------ ------ ------ ------ ------ ------ ------ ------ Net income $ 241 $ 248 $ 253 $ 208 $ 210 $ 199 $ 209 $ 187 ====== ====== ====== ====== ====== ====== ====== ====== Net income per Common Share assuming dilution Continuing operations $ 1.59 $ 1.39 $ 1.63 $ 1.35 $ 1.39 $ 1.29 $ 1.35 $ 1.17 Discontinued operations .23 .01 .01 (.01) .01 .02 .02 ------ ------ ------ ------ ------ ------ ------ ------ $ 1.59 $ 1.62 $ 1.64 $ 1.36 $ 1.38 $ 1.30 $ 1.37 $ 1.19 ====== ====== ====== ====== ====== ====== ====== ====== Net income per Common Share basic Continuing operations $ 1.62 $ 1.42 $ 1.66 $ 1.37 $ 1.42 $ 1.32 $ 1.38 $ 1.20 Discontinued operations .23 .01 .01 (.01) .01 .02 .02 ------ ------ ------ ------ ------ ------ ------ ------ $ 1.62 $ 1.65 $ 1.67 $ 1.38 $ 1.41 $ 1.33 $ 1.40 $ 1.22 ====== ====== ====== ====== ====== ====== ====== ====== Cash dividends paid per Common Share $ .39 $ .39 $ .35 $ .35 $ .31 $ .31 $ .31 $ .31 Market price per Common Share High $78.38 $74.86 $78.89 $73.29 $67.82 $67.55 $65.04 $71.13 Low 69.53 63.00 69.80 64.48 56.68 60.13 57.55 64.17
Earnings per Common Share for the four quarters in a year may not equal full-year earnings per share. Page 73 Eaton Corporation 2006 Annual Report on Form 10-K Exhibit Index Exhibits 3(i) Amended Articles of Incorporation (amended and restated April 27, 1994) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 3(ii) Amended Regulations (amended and restated April 26, 2000) - Incorporated by reference to the Form 10-Q Report for the six months ended June 30, 2000 4(a) Instruments defining rights of security holders, including indentures (Pursuant to Regulation S-K Item 601(b)(4), the Company agrees to furnish to the Commission, upon request, a copy of the instruments defining the rights of holders of long-term debt) 10 Material contracts (a) Master Purchase and Sale Agreement by and between PerkinElmer, Inc. and Eaton Corporation dated October 6, 2005 - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2005 (b) Purchase Agreement between V.G.A.T. Investors, LLC and Eaton Corporation dated as of December 24, 2006 - Filed in conjunction with this Form 10-K Report (c) Executive Incentive Compensation Plan (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2005 (d) 2005 Non-Employee Director Fee Deferral Plan (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2004 (e) Deferred Incentive Compensation Plan II (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2004 (f) Excess Benefits Plan II (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2004 (g) Incentive Compensation Deferral Plan II (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2004 (h) Limited Eaton Service Supplemental Retirement Income Plan II (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2004 (i) Supplemental Benefits Plan II (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2004 (j) Form of Restricted Share Award Agreement - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2004 (k) Form of Stock Option Agreement for Executives - Filed in conjunction with this Form 10-K Report (l) Form of Stock Option Agreement for Non-Employee Directors - Incorporated by reference to the Form 8-K Report filed January 26, 2007 Page 74 (m) 2004 Stock Plan - Incorporated by reference to the definitive Proxy Statement dated March 19, 2004 (n) Amendment to the Plan (originally adopted in 1985) for the Deferred Payment of Directors' Fees (effective January 1, 2005) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2004 (o) Plan for the Deferred Payment of Directors' Fees (originally adopted in 1985 and amended effective September 24, 1996, January 28, 1998, January 23, 2002, and February 24, 2004) - Incorporated by reference to the Form 10-Q Report for the three months ended March 31, 2004 (p) Limited Eaton Service Supplemental Retirement Income Plan (amended and restated January 1, 2003) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (q) Vehicle Allowance Program (effective January 1, 2003) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2003 (r) 2002 Stock Plan - Incorporated by reference to the definitive Proxy Statement dated March 15, 2002 (s) 1996 Non-Employee Director Fee Deferral Plan (amended and restated effective January 1, 2005) - Filed in conjunction with this Form 10-K Report (t) Form of Change of Control Agreement entered into with officers of Eaton Corporation - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (u) Form of Indemnification Agreement entered into with officers of Eaton Corporation - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (v) Form of Indemnification Agreement entered into with directors of Eaton Corporation - Incorporated by reference to the Form 8-K Report filed January 26, 2007 (w) Executive Strategic Incentive Plan I (amended and restated January 1, 2007) - Filed in conjunction with this Form 10-K Report (x) Executive Strategic Incentive Plan II (effective January 1, 2001) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (y) Deferred Incentive Compensation Plan (amended and restated March 31, 2000) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2000 (z) 1998 Stock Plan - Incorporated by reference to the definitive Proxy Statement dated March 13, 1998 (aa) Incentive Compensation Deferral Plan (amended and restated October 1, 1997) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2000 (bb) Trust Agreement - Officers and Employees (dated December 6, 1996) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (cc) Trust Agreement - Outside Directors (dated December 6, 1996) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 Page 75 (dd) 1995 Stock Plan - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (ee) Group Replacement Insurance Plan (GRIP) (effective June 1, 1992) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 1992 (ff) 1991 Stock Option Plan - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (gg) Excess Benefits Plan (amended and restated effective January 1, 1989) (with respect to Section 415 limitations of the Internal Revenue Code) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 (hh) Supplemental Benefits Plan (amended and restated January 1, 1989) (which provides supplemental retirement benefits) - Incorporated by reference to the Form 10-K Report for the year ended December 31, 2002 12 Ratio of Earnings to Fixed Charges - Filed in conjunction with this Form 10-K Report 14 Code of Ethics - Incorporated by reference to the definitive Proxy Statement to be filed on or about March 16, 2007 21 Subsidiaries of Eaton Corporation - Filed in conjunction with this Form 10-K Report 23 Consent of Independent Registered Public Accounting Firm - Filed in conjunction with this Form 10-K Report 24 Power of Attorney - Filed in conjunction with this Form 10-K Report 31.1 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of 2002, Section 302) - Filed in conjunction with this Form 10-K Report 31.2 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of 2002, Section 302) - Filed in conjunction with this Form 10-K Report 32.1 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of 2002, Section 906) - Filed in conjunction with this Form 10-K Report 32.2 Certification of Form 10-K (Pursuant to the Sarbanes-Oxley Act of 2002, Section 906) - Filed in conjunction with this Form 10-K Report Page 76 EX-10.B 2 l24244aexv10wb.txt EX-10(B) Exhibit 10 (b) EXECUTION COPY Eaton Corporation 2006 Annual Report on Form 10-K Item 15 (b) ================================================================================ PURCHASE AGREEMENT Between V.G.A.T. INVESTORS, LLC and EATON CORPORATION Dated as of December 24, 2006 ================================================================================ TABLE OF CONTENTS
Page Article I. DEFINITIONS........................................................................................... 1 Section 1.1. Certain Definitions................................................................... 1 Section 1.2. Terms Generally....................................................................... 12 Article II. PURCHASE AND SALE OF THE SHARES...................................................................... 12 Section 2.1. Purchase and Sale of the Shares....................................................... 12 Section 2.2. Purchase Price........................................................................ 12 Section 2.3. Estimated Purchase Price Adjustment................................................... 12 Section 2.4. Post-Closing Purchase Price Adjustment................................................ 13 Section 2.5. Closing............................................................................... 15 Section 2.6. Closing Deliveries.................................................................... 15 Section 2.7. Satisfaction of Conditions............................................................ 16 Section 2.8. Transfer Taxes........................................................................ 16 Section 2.9. Reorganization Taxes.................................................................. 16 Article III. REPRESENTATIONS AND WARRANTIES REGARDING THE COMPANY GROUP.......................................... 18 Section 3.1. Organization of the Company and the Company Group..................................... 18 Section 3.2. Noncontravention...................................................................... 18 Section 3.3. Title to Shares....................................................................... 19 Section 3.4. Subsidiaries of the Company; Capitalization........................................... 19 Section 3.5. Government Authorizations............................................................. 20 Section 3.6. Financial Statements; Securities Filings.............................................. 20 Section 3.7. Absence of Certain Changes............................................................ 21 Section 3.8. Tax Matters........................................................................... 21 Section 3.9. Real Property......................................................................... 23 Section 3.10. Intellectual Property................................................................. 23 Section 3.11. Environmental Matters................................................................. 24 Section 3.12. Contracts............................................................................. 25 Section 3.13. Insurance............................................................................. 27 Section 3.14. Litigation............................................................................ 28 Section 3.15. Employee Matters...................................................................... 28 Section 3.16. Legal Compliance...................................................................... 31 Section 3.17. Licenses and Permits.................................................................. 31 Section 3.18. Brokers' Fees......................................................................... 31 Section 3.19. No Undisclosed Liabilities............................................................ 32 Section 3.20. Internal Controls and Procedures...................................................... 32 Section 3.21. Transactions with Affiliates.......................................................... 32 Section 3.22. Customers and Suppliers............................................................... 33 Section 3.23. Warranties............................................................................ 33 Section 3.24. List of Government Contracts, Subcontracts and Bids................................... 33
Section 3.25. Compliance, Performance, Termination and Breach of Government Contracts............... 34 Section 3.26. Internal Controls, Audits and Investigations.......................................... 35 Section 3.27. Debarment, Suspension and Exclusion................................................... 35 Section 3.28. Absence of Unlawful Payments.......................................................... 35 Section 3.29. No Undisclosed Liabilities of Carter Ground Fueling, Ltd.............................. 35 Section 3.30. NO ADDITIONAL REPRESENTATIONS......................................................... 36 Article IV. REPRESENTATIONS AND WARRANTIES REGARDING SELLER...................................................... 36 Section 4.1. Organization.......................................................................... 36 Section 4.2. Authorization......................................................................... 36 Section 4.3. Noncontravention...................................................................... 37 Section 4.4. Brokers' Fees......................................................................... 37 Article V. REPRESENTATIONS AND WARRANTIES REGARDING BUYER........................................................ 37 Section 5.1. Organization.......................................................................... 37 Section 5.2. Authorization......................................................................... 37 Section 5.3. Financial Capacity.................................................................... 38 Section 5.4. Noncontravention...................................................................... 38 Section 5.5. Government Authorizations............................................................. 38 Section 5.6. Litigation............................................................................ 38 Section 5.7. Brokers' Fees......................................................................... 38 Section 5.8. Investment............................................................................ 39 Section 5.9. Information........................................................................... 39 Article VI. COVENANTS............................................................................................ 39 Section 6.1. Conduct of the Company................................................................ 39 Section 6.2. Access to Information................................................................. 42 Section 6.3. Commercially Reasonable Efforts....................................................... 43 Section 6.4. HSR Act Compliance; Government Approvals.............................................. 43 Section 6.5. Public Announcements.................................................................. 44 Section 6.6. Notification of Certain Matters....................................................... 45 Section 6.7. Post-Closing Access; Preservation of Records.......................................... 45 Section 6.8. Further Assurances.................................................................... 46 Section 6.9. Director and Officer Indemnification.................................................. 46 Section 6.10. Exclusivity........................................................................... 46 Section 6.11. Reorganization........................................................................ 47 Section 6.12. Severance and Transaction Bonus Payments.............................................. 48 Section 6.13. Split-Dollar Life Insurance Policy.................................................... 48 Section 6.14. Pre Closing Financials................................................................ 48 Section 6.15. Cooperation with Davis Litigation and LETS Dispute.................................... 48 Section 6.16. Support for Indemnification Obligations............................................... 49 Section 6.17. 280G Compliance....................................................................... 49 Section 6.18. Insurance Policies.................................................................... 50
2 Article VII. CONDITIONS TO CLOSING............................................................................... 50 Section 7.1. Conditions Precedent to Obligations of Buyer and Seller............................... 50 Section 7.2. Conditions Precedent to Obligation of Seller.......................................... 50 Section 7.3. Conditions Precedent to Obligations of Buyer.......................................... 51 Article VIII. LIMITATIONS........................................................................................ 52 Section 8.1. Waiver of Damages..................................................................... 52 Section 8.2. Consequential Damages................................................................. 52 Article IX. INDEMNIFICATION...................................................................................... 53 Section 9.1. General Indemnification by Seller..................................................... 53 Section 9.2. General Indemnification by Buyer...................................................... 53 Section 9.3. Certain Limitations................................................................... 54 Section 9.4. Indemnification Procedures............................................................ 56 Section 9.5. Exclusive Remedy...................................................................... 58 Section 9.6. Mitigation............................................................................ 58 Article X. TERMINATION........................................................................................... 58 Section 10.1. Termination Events.................................................................... 58 Section 10.2. Effect of Termination................................................................. 58 Article XI. MISCELLANEOUS........................................................................................ 59 Section 11.1. Parties in Interest................................................................... 59 Section 11.2. Assignment............................................................................ 59 Section 11.3. Notices............................................................................... 59 Section 11.4. Amendments and Waivers................................................................ 61 Section 11.5. Exhibits and Disclosure Schedule...................................................... 61 Section 11.6. Headings.............................................................................. 61 Section 11.7. Construction.......................................................................... 61 Section 11.8. No Other Representations or Warranties................................................ 61 Section 11.9. Entire Agreement...................................................................... 62 Section 11.10. Severability.......................................................................... 62 Section 11.11. Expenses.............................................................................. 62 Section 11.12. Governing Law......................................................................... 63 Section 11.13. Consent to Jurisdiction; Waiver of Jury Trial......................................... 63 Section 11.14. Specific Performance.................................................................. 63 Section 11.15. Counterparts.......................................................................... 64
EXHIBITS Exhibit A - Form of Release Exhibit B - Form of Lease 3 DISCLOSURE SCHEDULES Schedule 2.3(a) Purchase Price Adjustment Schedule 3.1 Organization Schedule 3.2 Noncontravention Schedule 3.3 Title to Shares Schedule 3.4(a) Subsidiaries of the Company; Capitalization Schedule 3.4(b) Subsidiaries of the Company; Capitalization Schedule 3.4(c) Capital Stock Schedule 3.6 Financial Statements Schedule 3.7 Absence of Certain Changes Schedule 3.8 Past Tax Returns Schedule 3.8(k) Section 280G Matters Schedule 3.9(b) Leased Real Property Schedule 3.10(a) Intellectual Property Schedule 3.10(b) Intellectual Property Schedule 3.11 Environmental Matters Schedule 3.12(a)(i)-(xx) Material Contracts Schedule 3.13 Insurance Schedule 3.14 Litigation Schedule 3.15(a) Employee Benefit Plans Schedule 3.15(g) Defined Benefit Plans Schedule 3.15(i) Employee Welfare Benefit Plan Schedule 3.15(j) Foreign Plans Schedule 3.15(k) Labor Relations Schedule 3.15(l) Triggering Events Schedule 3.15(n) Employees Schedule 3.18 Brokers' Fees Schedule 3.19 No Undisclosed Liabilities Schedule 3.21 Transactions with Affiliates Schedule 3.22 Customers and Suppliers Schedule 3.23 Warranties Schedule 3.24 Government Contracts, Subcontracts and Bids Schedule 3.25 Compliance Regarding Government Contracts and Bids
4 Schedule 3.26 Internal Controls, Audits and Investigations Schedule 3.29 No Undisclosed Liabilities of Carter Ground Fueling, Ltd. Schedule 4.3 Noncontravention Schedule 4.4 Brokers' Fees Schedule 6.1 Conduct of the Company Schedule 6.11(a) Reorganization Schedule 6.12 Severance and Transaction Bonus Payments Schedule 6.13 Split-Dollar Insurance Policy Schedule 7.3(e) Consents and Approvals Schedule 7.3(f) Payoff Letters
5 PURCHASE AGREEMENT Purchase Agreement, dated as of December 24, 2006, by and between V.G.A.T. Investors, LLC, a limited liability company organized under the laws of Delaware ("Seller"), and Eaton Corporation, an Ohio corporation ("Buyer"). Seller and Buyer are referred to collectively herein as the "Parties." WITNESSETH WHEREAS, Seller owns all of the issued and outstanding shares of common stock (the "Shares") in AT Holdings Corporation, a Delaware corporation (the "Company"); WHEREAS, Seller and Buyer intend that Seller shall retain certain assets that are currently held by the Company or one of its Subsidiaries, as defined herein as the Excluded Assets; WHEREAS, Seller desires to sell to Buyer, and Buyer desires to purchase from Seller, all of the Shares, on the terms and subject to the conditions set forth in this Agreement; and NOW, THEREFORE, in consideration of the premises and the mutual covenants and promises herein made, and in consideration of the representations and warranties, herein contained, and for other good and valuable consideration the receipt and adequacy of which are hereby acknowledged, the Parties hereto, intending to become legally bound, hereby agree as follows: Article I. DEFINITIONS Section 1.1. Certain Definitions. As used in this Agreement, the following terms shall have the following meanings: "9.25% Notes" means the 9.25% notes issued under the Indenture, dated as of June 23, 2004, among Argo-Tech, the Subsidiary Guarantors (as defined therein) and BNY Midwest Trust Company, as Trustee. "11.75% Notes" means the 11.75% notes issued under and the Indenture, dated as of October 28, 2005, between the Company and the Bank of New York Trust Company, N.A., as Trustee. "ACS Spin-Off" means each of the creation of Aviation Component Solutions, Inc. ("ACSI"), the contribution of assets and Liabilities to ACSI and the distribution of the stock of ACSI to or from a member of the Company Group. "ACSI" has the meaning set forth in the definition of ACS Spin-Off. "Action" means any action, charge, complaint, material grievance, arbitration, investigation, suit, claim or other proceeding, at law or in equity, by or before any court or other Governmental Authority. "Affiliate" has the meaning set forth in Rule 12b-2 of the regulations promulgated under the Securities Exchange Act. "Agreement" means this Purchase Agreement, including all Exhibits and Schedules hereto (including the Disclosure Schedule), as the same may be amended, modified or supplemented from time to time in accordance with its terms. "Arbitrator" has the meaning set forth in Section 2.4(b). "Argo-Tech" means Argo-Tech Corporation, a Delaware corporation. "ATC Costa Mesa" has the meaning set forth in the definition of Excluded Assets. "ATC (HBP)" has the meaning set forth in the definition of Excluded Assets. "Audited Financial Statements" has the meaning set forth in Section 3.6(a). "Balance Sheet Date" means October 28, 2006. "Basket Damages" has the meaning set forth in Section 9.3(b). "Benchmark" has the meaning set forth in Section 2.3(b). "Bonus Payments" has the meaning set forth in Section 6.12. "Business Day" means any day other than Saturday, Sunday or any other day on which banking institutions in New York are not open for the transaction of normal banking business. "Buyer" has the meaning set forth in the preamble to this Agreement. "Buyer Group" has the meaning set forth in Section 9.1. "Buyer's Surviving Representations" has the meaning set forth in Section 9.2. "Capitalized Lease Obligations" means, with respect to any Person, for any applicable period, the obligations of such Person under a lease that are required to be classified and accounted for as capital lease obligations under GAAP, and the amount of such obligations at any date shall be the capitalized amount of such obligations at such date, determined in accordance with GAAP. "Cash" means at any particular time, all cash and cash equivalents of the Company Group, determined in accordance with GAAP, other than any cash and cash equivalents subject to any Lien or any limitation on repatriation to the United States or similar limitation. 2 "Closing" has the meaning set forth in Section 2.5. "Closing Adjustment Statement" has the meaning set forth in Section 2.4(a). "Closing Cash" has the meaning set forth in Section 2.4(a). "Closing Date" means the date the Closing occurs pursuant to Section 2.5. "Closing Debt" has the meaning set forth in Section 2.4(a). "Closing Working Capital" has the meaning set forth in Section 2.4(a). "COBRA" means Part 6 of Subtitle B of Title I of ERISA, section 4980B of the Code, and any similar state Law. "Code" means the United States Internal Revenue Code of 1986, as amended. "Commission" has the meaning set forth in Section 3.6(b). "Company" has the meaning set forth in the recitals to this Agreement. "Company Group" means the Company and the Company's Subsidiaries but excludes the entities and assets included in the Excluded Assets and the Excluded Liabilities. "Company Intellectual Property" has the meaning set forth in Section 3.10(b). "Company Plans" has the meaning set forth in Section 3.15(a). "Consents" means consents, approvals, exemptions, waivers, authorizations, filings, registrations and notifications. "Control" means, with respect to any Person, the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of such Person, whether through the ownership of voting securities or partnership interests, by contract or otherwise. "Costa Mesa Property" has the meaning set forth in the definition of Excluded Assets. "Credit Agreement" means the Fourth Amended and Restated Credit Agreement, dated as of September 13, 2005, between Argo-Tech, National City Bank, as Administrative Agent, and the other signatories thereto. "Cryogenics" has the meaning set forth in the definition of Excluded Assets. "Current Policy" has the meaning set forth in Section 6.18. "Damages" means all losses, claims, damages, payments, penalties, fines, interest, Taxes, Liabilities, costs and expenses (including costs and expenses of Actions, amounts paid in 3 connection with any assessments, judgments or settlements relating thereto, interest and penalties recovered by a third party with respect thereto and out-of pocket expenses and reasonable attorneys', experts', consultants' and other representatives' fees and expenses reasonably incurred in defending against any such Actions or in enforcing a Party's rights hereunder). "Davis Litigation" has the meaning set forth in the definition of Excluded Assets. "De Minimis Amount" has the meaning set forth in Section 9.3(b). "Disclosure Schedule" means the disclosure schedule delivered by Seller to Buyer on the date hereof. "Effective Time" has the meaning set forth in Section 2.5. "Environmental Laws" means any Law existing on the date hereof concerning (i) pollution or protection of the environment or (ii) exposure of persons to toxic or hazardous substances; provided, however, that the term "Environmental Law" shall not include any Law relating to worker safety matters to the extent not related to exposure to Hazardous Materials. "ERISA" means the Employee Retirement Income Security Act of 1974, as amended. "ERISA Affiliate" means any Person that at any relevant time is considered a single employer with the Company Group under section 414 of the Code. "Estimated Cash" has the meaning set forth in Section 2.3(a). "Estimated Debt" has the meaning set forth in Section 2.3(a). "Estimated Reorganization Taxes" means the amount of the Reorganization Taxes, as estimated in good faith by the Company's accountants, in consultation with Buyer's accountants, prior to the Closing. "Estimated Working Capital" has the meaning set forth in Section 2.3(a). "Excluded Assets" means: (i) the cryogenics division of Argo-Tech Corporation Costa Mesa, a California corporation wholly-owned by Argo-Tech ("ATC Costa Mesa", and the cryogenics division, "Cryogenics"), the assets and liabilities of which are identified on Section 6.11(i) of the Disclosure Schedule; (ii) the real property located at 671 West Seventeenth Street, Costa Mesa, California 92627 owned by ATC Costa Mesa (the "Costa Mesa Property"); (iii) Argo-Tech Corporation (HBP), a Delaware corporation wholly-owned by Argo-Tech ("ATC (HBP)"); (iv) Argo Tracker Corporation, a Delaware corporation wholly-owned by the Company; and (v) J.C. Carter Japan K.K., a Japanese limited liability company wholly-owned by ATC Costa Mesa ("JKK"). The Excluded Assets will also include all Intellectual Property that would otherwise constitute Company Intellectual Property but that primarily relates to, or is used in the business of or otherwise in connection with, any of the Excluded Assets identified in the prior sentence, subject to a worldwide, royalty-free, fully paid-up, non-exclusive right and license to Buyer and its Affiliates to use and sublicense such Intellectual Property in connection with the business of the Company Group and the business of Buyer and its Affiliates as of the 4 date hereof, including (A) a worldwide, royalty-free, fully paid-up, non-exclusive right and license to use and sublicense the "Carter" name and Mark and the "J.C. Carter" name and Mark in connection with the current businesses of Cryogenics and JKK and (B) a worldwide, royalty-free, fully paid-up, non-exclusive right and license to use the "Argo-Tech" name and Mark on existing inventory of stationary, signage and similar items, but only for a transitional period after the Closing Date. Notwithstanding the above, the term "Excluded Assets" shall not include the Company Plans (as defined in Section 3.15(a)) or any assets related thereto. "Excluded Assets Distribution" has the meaning set forth in Section 6.16(a). "Excluded Liabilities" means any and all Liabilities arising from or related to: (i) the ownership, use or operation of the assets or business constituting the Excluded Assets or of any entity the stock or other equity interests of which is included in the Excluded Assets; (ii) the Reorganization (including any Taxes arising out of or related thereto); (iii) the ACS Spin-Off and the ownership, use or operation of the assets or business of ACSI by any member of the Company Group; (iv) Brian Davis, et al. v. Argo-Tech Corporation, et al. (Cuyahoga County Court of Common Pleas, Case No. 05 CV 552002) (the "Davis Litigation") and (v) the contract dispute between Carter Ground Fueling, Ltd. and Leading Edge Technologies Services LLC, a Dubai based IT services company ("LETS Dispute"); provided that in no event will the Excluded Liabilities include any Liabilities for: (A) Taxes (except as expressly set forth in this Agreement); (B) any breach of Environmental Law or any permit or other authorization required by any Environmental Law; (C) any Action brought pursuant to any Environmental Law, any disposal or release of Hazardous Materials, or that otherwise relate to pollution or protection of the environment or the exposure of persons to toxic or hazardous substances; or (D) the Company Plans (as defined in Section 3.15(a)) or any Liabilities related thereto. "Expected Payment" has the meaning set forth in Section 3.8(k). "Expiration Date" has the meaning set forth in Section 10.1(b). "Expired Policy" has the meaning set forth in Section 6.18. "Final Closing Adjustment Statement" has the meaning set forth in Section 2.4(f). "Final Reorganization Taxes Statement" has the meaning set forth in Section 2.9(h). "Financial Statements" has the meaning set forth in Section 3.6(a). "Foreign Plans" has the meaning set forth in Section 3.15(j). "Fundamental Representations" has the meaning set forth in Section 9.1. "GAAP" means United States generally accepted accounting principles consistently applied. "Giveback Provision" has the meaning set forth in Section 6.16(a). 5 "Government Bid" means any bid, offer, proposal or response to solicitation that, if accepted or awarded, would result in the establishment of a Government Contract. "Government Contract" means any contract, agreement, subcontract, teaming agreement or arrangement, joint venture, basic ordering agreement, blanket purchase agreement, letter agreement, purchase order, delivery order, task order, grant, cooperative agreement, change order or other commitment or funding vehicle that exists between any member of the Company Group and (i) any Governmental Authority, (ii) any prime contractor to any Governmental Authority or (iii) any subcontractor with respect to any contract described in clause (i) or (ii). "Governmental Authority" means any US or foreign federal, state or local government, court of competent jurisdiction, administrative agency or commission or other governmental or regulatory authority or instrumentality. "Hazardous Materials" means (i) asbestos, polychlorinated biphenyls or petroleum, (ii) any substance that requires removal or remediation under any Environmental Law, or is defined, listed or identified as a "hazardous waste" or "hazardous substance" by any Environmental Law, or (iii) any substance, material or waste that is regulated by any Environmental Law because it is toxic, explosive, corrosive, flammable, infectious, radioactive, carcinogenic, mutagenic or otherwise hazardous. "HSR Act" means the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended. "Indebtedness" means, without duplication: (i) all indebtedness of the Company Group for borrowed money, whether current, short-term, or long-term, secured or unsecured (including all obligations for principal and accrued but unpaid interest, but excluding prepayment premiums, penalties, breakage costs and other similar obligations, and also excluding trade accounts payable); (ii) all indebtedness of the Company Group for the deferred purchase price for purchases of property outside the ordinary course of business that is not evidenced by trade accounts payables; (iii) any payment or obligations of the Company Group in respect of letters of credit (other than stand-by letters of credit in support of ordinary course trade payables); (iv) any Liability of the Company Group with respect to interest rate swaps, collars, caps and similar hedging obligations; (v) any Capitalized Lease Obligations of the Company Group; (vi) any indebtedness referred to in clauses (i) through (v) above that is directly or indirectly guaranteed by any member of the Company Group and (v) to the extent not paid at or prior to Closing, the Bonus Payments. "Indemnified Claim" has the meaning set forth in Section 9.4(f). "Indemnified Officers" has the meaning set forth in Section 6.9. "Indemnified Party" has the meaning set forth in Section 9.2. "Indemnifying Party" has the meaning set forth in Section 9.2. "Indemnity Reduction Amounts" has the meaning set forth in Section 9.3(c). 6 "Indentures" mean, collectively, the Indenture, dated as of June 23, 2004, among Argo-Tech, the Subsidiary Guarantors (as defined therein) and BNY Midwest Trust Company, as Trustee, and the Indenture, dated as of October 28, 2005, between the Company and the Bank of New York Trust Company, N.A., as Trustee. "Injunction" has the meaning set forth in Section 6.3. "Intellectual Property" means all: (a) patents and patent applications, together with reissues, continuations, continuations-in-part, revisions, divisionals, extensions and reexaminations thereof; (b) trademarks, service marks, trade dress, logos, trade names and Internet domain names, and applications, registrations, and renewals in connection therewith, and all goodwill associated therewith (collectively, "Marks"); (c) copyrights, whether registerered or unregistered and all other rights corresponding, registrations and applications thereof); (d) trade secrets, research records, processes, procedures, formulae, know-how, engineering process, records of invention, customer lists and related customer information, databases, confidential business information, copyrightable work, technology, blue prints, designs, plans, invention disclosures, inventions (whether or not patentable or reduced to practice), in each case to the extent protectable under applicable Law; and (e) computer software (including source code, data, databases and related documentation). "International Competition Laws" has the meaning set forth in Section 6.4(c). "Inventory" means inventory of raw materials, work in process, finished goods, packaging materials and supplies and related items, including all inventory (as defined in the Uniform Commercial Code in effect in the State of Ohio as of the date hereof), in each case whether on hand or in transit and including inventory on consignment to customers. "JKK" has the meaning set forth in the definition of Excluded Assets. "Knowledge" means: (i) with respect to Seller, the actual knowledge, or the knowledge one would be expected to have after reasonable inquiry and investigation with respect to matters within the scope of one's employment and/or assigned duties, of Michael Lipscomb, Paul R. Keen, Frank Dubey, Richard T. Walker, John S. Glover, Chris Michael and Catherine Kramer, and, solely with respect to Section 3.15 and the benefit related provisions of Section 3.8, Sharon Iafelice and Michelle McCormick; and (ii) with respect to Buyer, the actual knowledge, or the knowledge one would be expected to have after reasonable inquiry and investigation with respect to matters within the scope of one's employment and/or assigned duties, of David S. Barrie, Ken D. Semelsberger and Mary E. Huber. "Laws" means all applicable federal, state, local and foreign laws, statutes, constitutions, rules, regulations, ordinances and similar provisions having the force of law and all judgments, rulings, orders, decrees, injunctions, guidance and guidelines of Governmental Authorities. "Leased Real Property" has the meaning set forth in Section 3.9(b). 7 "Liability" means any liability (whether known or unknown, whether asserted or unasserted, whether absolute or contingent, whether accrued or unaccrued, whether liquidated or unliquidated, and whether due or to become due). "Licenses" means licenses, permits, consents, approvals, authorizations, registrations, qualifications and certifications of any governmental or administrative agency or authority (whether federal, state or local) and accrediting bodies. "Lien" means any mortgage, pledge, lien, encumbrance, restriction, option, charge, claim, easement, deed of trust, mortgage, conditional sales agreement, right of first refusal or other security interest or restriction on use, voting, transfer, receipt of income or exercise of any other attribute of ownership, voluntarily incurred or arising by operation of law. "LLC Agreement" has the meaning set forth in Section 6.16(a). "Marks" has the meaning set forth in the definition of Intellectual Property. "Material Adverse Effect" means: (a) with respect to the Company Group, an event, factor, circumstance, development, condition, change, effect, fact or occurrence having, individually or in the aggregate, a material adverse effect on: (A) the business, operations, assets, Liabilities or condition (financial or otherwise), or results of operations, of the Company Group, taken as a whole, excluding, in each case, any such event, factor or occurrence resulting from or arising out of or in connection with (i) general economic, industry or market events, occurrences, developments, circumstances or conditions, (ii) changes in applicable Laws, (iii) changes in accounting principles that are required to be made by the Company Group under GAAP, (iv) changes in political conditions (including acts of war, whether or not declared, armed hostilities or terrorism unless in any such case causing material damage to the facilities of the Company Group), (v) the public announcement of the transactions contemplated by this Agreement (other than the Reorganization), or (vi) any action permitted under this Agreement or taken with the consent of the Buyer, except in the case of each of clauses (i) and (ii), to the extent the Company Group is affected in a disproportionate manner as compared to other Persons engaged in the businesses in which the Company Group is engaged; or (B) the ability of Seller or the Company Group to perform its obligations under, or to consummate the transactions contemplated by, this Agreement; and (b) with respect to Buyer, a material adverse effect on the ability of Buyer to perform its obligations under, or to consummate the transaction contemplated by, this Agreement. "Material Contracts" has the meaning set forth in Section 3.12. "Merger" means the transactions consummated in connection with the Agreement and Plan of Merger, dated as of September 13, 2005, among the Company, Argo-Tech, Greatbanc Trust Company, as Trustee for the Argo-Tech Corporation Employee Stock Ownership Plan, Seller and Vaughn Merger Sub, Inc. "Nonassignable Policy" has the meaning set forth in Section 6.18. 8 "Non-Company Software" means any and all third party software, applications and modules, whether in source code or object code, licensed to, used by or held for use by any member of the Company Group. "Objection" has the meaning set forth in Section 2.4(b). "Open Source Software" means computer software or firmware that is distributed at no charge or under a compulsory license agreement (including but not limited to the GNU General Public License, GNU Lesser General Public License, Mozilla Public License, and Eclipse Public License) that requires the licensee to (i) include the source code of such software or firmware with any distribution of such software or firmware, (ii) distribute any modifications of such software or firmware under such license agreement, and/or (iii) permit the licensee's downstream licensees to modify such software or firmware. "Other Parties" has the meaning set forth in Section 3.12(b). "Owned Real Property" means all land, together with all buildings, structures, improvements and fixtures located thereon, and all easements and other rights and interests appurtenant thereto, owned by a member of the Company Group and used in the Company's business. "Parties" has the meaning set forth in the preamble to this Agreement. "Permitted Liens" means any: (a) mechanic's, materialmen's, laborer's, workmen's, repairmen's, carrier's and similar Liens, including all statutory Liens, arising or incurred in the ordinary course of business for amounts not delinquent; (b) Liens for Taxes, assessments and other governmental charges not yet due and payable as of the Closing Date or, if so due, (i) not delinquent or (ii) being contested in good faith through appropriate proceedings; (c) purchase money Liens and Liens securing rental payments under capital lease arrangements; (d) pledges or deposits under workers' compensation legislation, unemployment insurance Laws or similar Laws; (e) zoning, building codes and other land use Laws regulating the use or occupancy of real property or the activities conducted thereon which are imposed by any Governmental Authority having jurisdiction over such real property, which are not materially violated by the current use or occupancy of such real property or the operation of the Company Group thereon; (f) all exceptions, restrictions, easements, charges, rights-of-way and monetary and nonmonetary encumbrances which are set forth in any permits, licenses, governmental authorizations, registrations or approvals listed in the Disclosure Schedule; and (g) Liens that do not materially interfere with the use of any asset that is material to the business conducted by the Company Group. "Person" means an individual, partnership, limited liability partnership, corporation, limited liability company, association, joint stock company, trust, estate, joint venture, unincorporated organization, or governmental entity (or any department, agency, or political subdivision thereof). "Proposed Reorganization Taxes Statement" has the meaning set forth in Section 2.9(c). 9 "Public Reports" has the meaning set forth in Section 3.6(b). "Purchase Price" means $695,000,000, subject to adjustment as set forth in Article II. "Real Property Leases" has the meaning set forth in Section 3.9(b). "Remedies Exception" means (i) applicable bankruptcy, insolvency, reorganization, moratorium, and other Laws of general application, heretofore or hereafter enacted or in effect, affecting the rights and remedies of creditors generally, and (ii) the exercise of judicial or administrative discretion in accordance with general equitable principles, particularly as to the availability of the remedy of specific performance or other injunctive relief. "Reorganization" has the meaning set forth in Section 6.11(a). "Reorganization Taxes" means the net amount of Taxes payable by the Company or any of its Subsidiaries solely as a result of (i) the transactions constituting the Reorganization (as described in Section 6.11(a) of the Disclosure Schedule) and (ii) the ACS Spin-Off (for the avoidance of doubt, taking into account any item of loss or expense generated by any aspect of the Reorganization or the ACS Spin-Off). "Reorganization Taxes Indemnification Period" has the meaning set forth in Section 9.3(d). "Right" means any option, warrant, convertible or exchangeable security or other right, however denominated, to subscribe for, purchase or otherwise acquire any equity interest or other security of any class or any restricted stock or phantom equity, with or without payment of additional consideration in cash or property, either immediately or upon the occurrence of a specified date or a specified event or the satisfaction or happening of any other condition or contingency. "Securities Act" means the Securities Act of 1933, as amended. "Securities Exchange Act" means the Securities Exchange Act of 1934, as amended. "Seller" has the meaning set forth in the preamble to this Agreement. "Seller Group" has the meaning set forth in Section 9.2. "Seller's Surviving Representations" has the meaning set forth in Section 9.1. "Shares" has the meaning set forth in the recitals to this agreement. "Subsidiary," when used with respect to any Person, means any other Person of which (a) in the case of a corporation, at least (i) a majority of the equity or (ii) a majority of the voting interests are owned or Controlled, directly or indirectly, by such first Person, by any one or more of its Subsidiaries, or by such first Person and one or more of its Subsidiaries or (b) in the case of any Person other than a corporation, such first Person, one or more of its Subsidiaries, 10 or such first Person and one or more of its Subsidiaries (i) owns a majority of the equity interests thereof or (ii) has the power to elect or direct the election of a majority of the members of the governing body thereof. "Surviving Covenants" has the meaning set forth in Section 9.3(d). "Surviving Representations" has the meaning set forth in Section 9.2. "Tax" means any federal, state, local, or foreign tax, charge, duty, fee, levy or other assessment, in each case imposed by a Governmental Authority, including income, gross receipts, license, payroll, employment, excise, severance, stamp, occupation, premium, windfall profits, environmental (including taxes under Section 59A of the Code), customs duties, capital stock, franchise, profits, withholding, social security (or similar), unemployment, disability, real or personal property, sales, use, transfer, registration, value added, alternative or add-on minimum, estimated or other tax of any kind whatsoever, and including any interest, penalty, or addition thereto. "Tax Return" means any return, declaration, report, claim for refund, or information return or statement relating to Taxes, including any extension, schedule or attachment thereto, and including any amendment thereof, required to be filed with any taxing authority. "Third Party Claim" has the meaning set forth in Section 9.4(a). "Threshold Amount" has the meaning set forth in Section 9.3(b). "Transaction Documents" means this Agreement and all other documents delivered or required to be delivered by any Party pursuant to this Agreement. "Transfer Taxes" means all transfer or similar Taxes (excluding Taxes measured by net income), including sales, real property, use, excise, stock transfer, stamp, documentary, filing, recording, permit, license, authorization and similar Taxes, filing fees and similar charges. "Unaudited Financial Statements" has the meaning set forth in Section 3.6(a). "Unlawful Payment" has the meaning set forth in Section 3.28(a). "WARN Act" has the meaning set forth in Section 3.15(k). "Working Capital" means those categories of current assets and liabilities of the Company Group identified as being included in working capital as set forth in the "Working Capital" portion of Section 2.3(a) of the Disclosure Schedule; provided that for purposes of determining Estimated Working Capital in accordance with Section 2.3 and Closing Working Capital in accordance with Section 2.4, accrued but unpaid income Taxes which shall take into account any non-deductible payment under Section 280G of the Code and income Tax receivables, net of any applicable valuation allowance, shall be included in the calculation of "Working Capital" (for the avoidance of doubt, taking into account any deduction, expense or loss attributable to the payment of the Bonus Payments or the exercise or termination of all outstanding options to purchase Shares or any Expected Payments for any Tax period ending on 11 or prior to the Closing Date). Also for the avoidance of doubt, Working Capital shall exclude deferred Tax assets and Liabilities and the Excluded Assets and Excluded Liabilities and shall include accrued income Taxes of the Excluded Assets. Section 1.2. Terms Generally. The definitions in Section 1.1 shall apply equally to both the singular and plural forms of the terms defined. Whenever the context may require, any pronoun shall include the corresponding masculine, feminine and neuter forms. The words "include", "includes" and "including" shall be deemed to be followed by the phrase "without limitation." The words "herein", "hereof" and "hereunder" and words of similar import refer to this Agreement (including the Exhibits to this Agreement and the Disclosure Schedule) in its entirety and not to any part hereof unless the context shall otherwise require. All references herein to Articles, Sections, Exhibits and the Disclosure Schedule shall be deemed references to Articles and Sections of, and Exhibits and the Disclosure Schedule to, this Agreement unless the context shall otherwise require. Unless the context shall otherwise require, any references to any agreement or other instrument or statute or regulation are to it as amended and supplemented from time to time (and, in the case of a statute or regulation, to any successor provisions). Any reference to any federal, state, local, or foreign statute or Law shall be deemed also to refer to all rules and regulations promulgated thereunder, unless the context requires otherwise. Any reference in this Agreement to a "day" or a number of "days" (without explicit reference to "Business Days") shall be interpreted as a reference to a calendar day or number of calendar days. If any action is to be taken or given on or by a particular calendar day, and such calendar day is not a Business Day, then such action may be deferred until the next Business Day. Article II. PURCHASE AND SALE OF THE SHARES Section 2.1. Purchase and Sale of the Shares. Upon the terms and subject to the conditions of this Agreement, Buyer agrees to purchase from Seller, and Seller agrees to sell to Buyer, all of the Shares at the Closing, for the consideration specified in Section 2.2. Prior to the Closing Date, Buyer may, upon prior written notice to Seller, assign its right to purchase the Shares to one or more of its wholly owned Subsidiaries for the purpose of carrying out the transactions contemplated hereby; provided that no such assignment shall relieve Buyer of its obligations hereunder. Section 2.2. Purchase Price. At Closing, Buyer shall pay the Purchase Price in immediately available funds by wire transfer to an account or accounts that have been designated by Seller to Buyer at least five Business Days prior to the Closing. Section 2.3. Estimated Purchase Price Adjustment. (a) At least five Business Days prior to the Closing Date, Seller shall cause the Company to deliver to Buyer a statement, in substantially the form of Section 2.3(a) of the Disclosure Schedule (which sets forth a calculation of Cash, Indebtedness and Working Capital, determined as if the Closing had occurred on October 28, 2006), setting forth the Company's reasonable, good faith estimate of (i) the amount of Cash as of the Effective Time on the Closing Date (the "Estimated Cash"), (ii) the amount of Indebtedness as of the Effective Time on the Closing Date (the "Estimated Debt") and (iii) the amount of Working Capital as of the Effective 12 Time on the Closing Date (the "Estimated Working Capital") and, in each case, the basis for the calculation thereof. (b) The purchase price paid by the Buyer at Closing shall be increased by (i) the Estimated Cash, and (ii) if the Estimated Working Capital minus the Benchmark is positive, by the amount of such excess. The purchase price paid by the Buyer at Closing shall be decreased by (A) Estimated Debt, and (B) if the Benchmark minus the Estimated Working Capital is positive, by the amount of such excess. The "Benchmark" shall be $37,000,000. Section 2.4. Post-Closing Purchase Price Adjustment. (a) Within sixty days after the Closing Date, Buyer shall prepare and deliver to Seller a statement (the "Closing Adjustment Statement"), setting forth Buyer's calculation of (i) the amount of Cash as of the Effective Time on the Closing Date ("Closing Cash"), (ii) the amount of Indebtedness as of the Effective Time on the Closing Date ("Closing Debt") and (iii) the Working Capital as of the Effective Time on the Closing Date ("Closing Working Capital"). The (i) Closing Adjustment Statement shall be prepared in accordance with Section 2.3(a) of the Disclosure Schedule and otherwise in accordance with GAAP and (ii) the net book value of the Inventory shall be computed based upon the quantities of Inventory on hand as of the Closing Date as determined through a physical inventory conducted by Buyer within five days of such date. Seller or its representatives may observe such physical inventory. (b) If Seller reasonably disagrees with the calculation of Closing Cash, Closing Debt or Closing Working Capital set forth in the Closing Adjustment Statement (on the basis of mathematical errors, failure to adhere to the requirements of Section 2.3(a) of the Disclosure Schedule or failure to otherwise adhere to GAAP), Seller may deliver to Buyer a written notice of such objection no later than thirty days after the date on which Buyer delivered the Closing Adjustment Statement to Seller, which notice shall specify the nature of each dispute and the basis therefor (an "Objection"). Failure by Seller to deliver an Objection within such thirty-day period will be deemed to be Seller's acceptance of the Closing Adjustment Statement as the Final Closing Adjustment Statement. The Parties shall attempt in good faith to reach agreement resolving all disputes set forth in the Objection within thirty days after its delivery. If the Parties are unable to resolve any or all such disputes within such thirty-day period, the Parties shall, promptly after the expiration of such period, submit for resolution all unresolved disputes to the Cleveland, Ohio office of PricewaterhouseCoopers (or if the Cleveland, Ohio office of PricewaterhouseCoopers cannot or is unwilling to serve in such capacity, a nationally recognized, independent public accounting firm selected by mutual agreement of Seller and Buyer, or if they cannot agree, selected by mutual agreement of the independent public accounting firms regularly used by Seller and Buyer in the conduct of their respective businesses) (the "Arbitrator") as an arbiter for resolution. In selecting the Arbitrator in accordance with the preceding sentence for purposes of this Agreement, the Parties hereby waive any conflict or potential conflict arising from any services performed by such firm for the Company Group, Seller, Buyer or any of their respective Affiliates. (c) Promptly, but no later than thirty days after its acceptance of its appointment as Arbitrator, the Arbitrator shall determine, based solely on presentations by Buyer and Seller and not by independent review, those items in dispute on the Closing Adjustment Statement and 13 shall render a written report to Buyer and Seller as to the resolution of each dispute and the resulting calculation of Closing Cash, Closing Debt and/or Closing Working Capital, as applicable. In resolving any disputed item, the Arbitrator (i) shall not assign a value to such item greater than the greatest value for such item claimed by either Party or less than the smallest value for such item claimed by either Party; (ii) shall rule only on the objections raised by the Parties, accepting all other aspects of the Closing Adjustment Statement; and (iii) shall have no right, authority or discretion to employ any accounting standard or principles except for those provided for herein. The Arbitrator will have exclusive jurisdiction over, and resort to the Arbitrator as provided in this Section 2.4(c) will be the sole recourse and remedy of, the Parties against one another or any other Person with respect to any disputes arising out of or relating to Closing Cash, Closing Debt or Closing Working Capital. The Arbitrator's determination will be conclusive and binding on the Parties and will be enforceable in a court of competent jurisdiction. (d) Each Party shall cooperate with and make available to the other Party and its representatives all records, and shall permit access to its facilities and personnel, as reasonably required in connection with the preparation and analysis of the Closing Adjustment Statement and the resolution of any disputes with respect thereto. (e) The fees and expenses of the Arbitrator shall be borne by each Party in the proportion that the aggregate dollar amount of items submitted to the Arbitrator that are unsuccessfully disputed by such Party bears to the aggregate dollar amount of all items submitted to the Arbitrator. (f) As used herein, the term "Final Closing Adjustment Statement" means (i) the Closing Adjustment Statement if Seller does not deliver an Objection in accordance with Section 2.4(b); (ii) if Seller timely gives an Objection and all of the disputed items are resolved by agreement of the Parties, the Closing Adjustment Statement, as amended, if necessary, to reflect such resolution of all disputes; or (iii) if any disputed items are submitted to the Arbitrator for resolution, the Closing Adjustment Statement, as amended, if necessary, to reflect any resolution of any disputes by agreement of the Parties and the resolution of all other disputes by the Arbitrator. (g) If (i) Closing Working Capital plus Closing Cash is less than (ii) Estimated Working Capital plus Estimated Cash, Seller shall pay Buyer, as an adjustment to the Purchase Price, the amount of such deficit. If (A) Closing Working Capital plus Closing Cash is greater than (B) Estimated Working Capital plus Estimated Cash, Buyer shall pay Seller, as an adjustment to the Purchase Price, the amount of such excess. If (i) Closing Debt is greater than (ii) Estimated Debt, Seller shall pay Buyer, as an adjustment to the Purchase Price, the amount of such excess. If (A) Closing Debt is less than (B) Estimated Debt, Buyer shall pay Seller, as an adjustment to the Purchase Price, the amount of such deficit. (h) The net amount of any payment required to be made under this Section 2.4 shall (i) be made by wire transfer of immediately available funds no later than five Business Days after the date on which the Closing Adjustment Statement becomes the Final Closing Adjustment Statement as provided in this Section 2.4 and (ii) shall bear interest at a rate equal to 8% per annum from the Closing Date to the date of payment. 14 Section 2.5. Closing. Unless this Agreement shall have been terminated pursuant to Article X and subject to the satisfaction or, when permissible, waiver of the conditions set forth in Article VII, the closing of the transactions contemplated by this Agreement, other than the Reorganization, (the "Closing") shall take place (a) at the offices of Kirkland & Ellis LLP, 153 East 53rd Street, New York, New York 10022, as soon as possible but in no event later than the third Business Day after the date on which the last of the conditions set forth in Article VII (other than any such conditions which by their terms are not capable of being satisfied until the Closing Date) is satisfied or, when permissible, waived or (b) at such other time and/or place as the Parties may mutually agree in writing. The Closing shall be effective as of 12:01 a.m. on the Closing Date (the "Effective Time"). Section 2.6. Closing Deliveries. (a) At or prior to the Closing, Seller will deliver or cause to be delivered to Buyer the following: (i) stock powers endorsed in blank necessary to transfer the certificates representing the Shares to Buyer and originals of all certificated securities representing the equity interests in the Company; (ii) resignations or terminations of the executive officers, directors and managers of the Company Group from their status as executive officers, directors and managers effective as of the Closing (other than those Persons identified by Buyer prior to Closing with respect to whom such resignation or termination is not required); (iii) the certificates referred to in Sections 7.3(a) and 7.3(b); (iv) a non-foreign affidavit, dated as of the Closing Date, in form and substance required under the Treasury Regulations issued pursuant to Section 1445 of the Code, stating that Seller is not a "foreign person" as defined in Section 1445 of the Code; (v) a Seller Release, dated as of the Closing Date, in substantially the form attached hereto as Exhibit A, duly executed by Seller; (vi) a lease, between ATC (HBP) and Argo-Tech Corporation (OEM) in substantially the form attached hereto as Exhibit B, with such amendments as are in form and substance reasonably acceptable to Buyer, for the lease of space in Cleveland, Ohio, duly executed by the parties thereto; (vii) a lease, between ATC Costa Mesa and the owner of the Costa Mesa Property in substantially the form attached hereto as Exhibit B, with such amendments, including with respect to economic terms, as are in form and substance reasonably acceptable to Buyer, for the lease of space in Costa Mesa, California, duly executed by the parties thereto; and (viii) all other documents required to be delivered by Seller to Buyer at the Closing pursuant to this Agreement. 15 (b) At the Closing, Buyer will deliver or cause to be delivered to Seller the following: (i) the Purchase Price in immediately available funds to the account as provided in Section 2.2; (ii) the certificates referred to in Sections 7.2(a) and 7.2(b); and (iii) all other documents required to be delivered by Buyer to Seller at the Closing pursuant to this Agreement. Section 2.7. Satisfaction of Conditions. All conditions to the obligations of Seller and Buyer to proceed with the Closing under this Agreement will be deemed to have been fully and completely satisfied or waived for purposes of Article VII upon the Closing. Section 2.8. Transfer Taxes. All applicable Transfer Taxes (including any stock Transfer Taxes due as a result of the sale of the Shares and Transfer Taxes, if any, imposed upon the transfer of real and personal property) payable in connection with this Agreement, the transactions, other than the Reorganization, contemplated by this Agreement or the documents giving effect to such transactions will be paid by Buyer. Notwithstanding anything to the contrary herein, Seller shall be liable for all Transfer Taxes due or payable as a result of or in connection with the Reorganization. Section 2.9. Reorganization Taxes. (a) As soon as practicable after the date hereof, and in any event at least ten Business Days prior to the Closing Date, the Company shall deliver to Buyer and Seller a statement of the Estimated Reorganization Taxes. Buyer and Seller shall use their reasonable best efforts to agree on the amount of the Reorganization Taxes, or on as many elements thereof as are possible, prior to the Closing Date. Buyer, Seller and the Company shall cooperate, and shall cause their respective accountants to cooperate, in the determination of the Reorganization Taxes. If Buyer and Seller are not able to agree on the amount of the Reorganization Taxes, or on any element thereof, prior to Closing, then the amount of the Estimated Reorganization Taxes (or the element thereof) for purposes of Closing shall be the amount initially proposed by the Company. (b) At the Closing, the Purchase Price shall be increased or decreased, as applicable, by the amount of the Estimated Reorganization Taxes; (c) If Buyer and Seller have agreed on the amount of the Reorganization Taxes prior to Closing, then the agreed amount shall be the amount of Estimated Reorganization Taxes and also the amount of Reorganization Taxes. If there are unagreed items at Closing, then within 10 days after the Closing Date, Seller shall prepare and deliver to Buyer a statement (the "Proposed Reorganization Taxes Statement"), containing Seller's computation of the Reorganization Taxes. (d) If Buyer reasonably disagrees with the Proposed Reorganization Taxes Statement, then Buyer may deliver to Seller an Objection no later than thirty days after the date 16 on which Seller delivered the Proposed Reorganization Taxes Statement to Buyer; provided, however, that if Seller has not provided to Buyer prior to the Closing such appraisals and business valuations reasonably satisfactory to Buyer with respect to the value of any material Excluded Asset, then Buyer may deliver to Seller an Objection no later than ten days after Buyer has received, at Seller's cost, such appraisals and business valuations. Failure by Buyer to deliver an Objection within such thirty-day period will be deemed to be Buyer's acceptance of the Proposed Reorganization Taxes Statement as the Final Reorganization Taxes Statement. The Parties shall attempt in good faith to reach agreement resolving all disputes set forth in the Objection within thirty days after its delivery. If the Parties are unable to resolve any or all such disputes within such thirty-day period, then the Parties shall, promptly after the expiration of such period, submit all unresolved disputes to the Arbitrator as an arbiter for resolution. (e) Promptly, but no later than thirty days after its acceptance of its appointment as Arbitrator, the Arbitrator shall determine, based solely on presentations by Buyer and Seller and not by independent review, those items in dispute on the Proposed Reorganization Taxes Statement and shall render a written report to Buyer and Seller as to the resolution of each dispute and the resulting calculation of the Reorganization Taxes. In resolving any disputed item, the Arbitrator (i) shall not assign a value to such item greater than the greatest value for such item claimed by either Party or less than the smallest value for such item claimed by either Party; and (ii) shall rule only on the objections raised by the Parties, accepting all other aspects of the Proposed Reorganization Taxes Statement. The Arbitrator will have exclusive jurisdiction over, and resort to the Arbitrator as provided in this Section 2.9(e) will be the sole recourse and remedy of, the Parties against one another with respect to any disputes arising out of or relating to Reorganization Taxes (other than as provided in Section 9.1(iv)). In particular, Reorganization Taxes shall be excluded from the computation of Estimated Working Capital and Closing Working Capital pursuant to Sections 2.3 and 2.4. The Arbitrator's determination will be conclusive and binding on the Parties and will be enforceable in a court of competent jurisdiction. (f) Each Party shall cooperate with and make available to the other Party and its representatives all records, and shall permit access to its facilities and personnel, as reasonably required in connection with the preparation and analysis of the Proposed Reorganization Taxes Statement and the resolution of any disputes with respect thereto. (g) The fees and expenses of the Arbitrator shall be borne by each Party in the proportion that the aggregate dollar amount of items submitted to the Arbitrator that are unsuccessfully disputed by such Party bears to the aggregate dollar amount of all items submitted to the Arbitrator. (h) As used herein, the term "Final Reorganization Taxes Statement" means: (i) the Proposed Reorganization Taxes Statement, if Buyer does not deliver an Objection in accordance with Section 2.9(d); (ii) if Buyer timely gives an Objection and all of the disputed items are resolved by agreement of the Parties, the Proposed Reorganization Taxes Statement, as amended, if necessary, to reflect such resolution of all disputes; or (iii) if any disputed items are submitted to the Arbitrator for resolution, the Proposed Reorganization Taxes Statement, as amended, if necessary, to reflect any resolution of any disputes by agreement of the Parties and the resolution of all other disputes by the Arbitrator. 17 (i) If the amount of the Reorganization Taxes, as reflected on the Final Reorganization Taxes Statement, exceeds the amount of the Estimated Reorganization Taxes, then the Purchase Price shall be decreased by the amount of such excess and Seller shall pay to Buyer an amount equal to such excess. If the amount of the Reorganization Taxes, as reflected on the Final Reorganization Taxes Statement, is less than the amount of the Estimated Reorganization Taxes, then the Purchase Price shall be increased by the amount of such shortfall and Buyer shall pay to Seller an amount equal to such shortfall. The amount of any payment required to be made under this Section 2.9(i) shall (i) be made by wire transfer of immediately available funds no later than five Business Days after the date on which the Reorganization Taxes are finally determined as provided in this Section 2.9 and (ii) shall bear interest at a rate equal to 8% per annum from the Closing Date to the date of payment. Article III. REPRESENTATIONS AND WARRANTIES REGARDING THE COMPANY GROUP Seller represents and warrants to Buyer as of the date hereof and as of the Closing Date, except as set forth in the Disclosure Schedule, as follows: Section 3.1. Organization of the Company and the Company Group. The Company is a corporation, validly existing and in good standing under the laws of Delaware, and the Company has all requisite corporate power and authority to carry on its business as it is currently conducted and to own, lease and operate its properties where such properties are now owned, leased or operated. Each other member of the Company Group (i) is duly organized, validly existing and in good standing under the laws of the jurisdiction of its organization and (ii) has all requisite organizational power and authority to carry on its respective business as it is currently conducted and to own, lease and operate its respective properties where such properties are now owned, leased or operated, except in all cases where any failures of the representations in this sentence to be true would not, individually or in the aggregate, have a material and adverse effect on the Company Group. Each member of the Company Group is duly qualified or licensed to do business and is in good standing in each jurisdiction in which the property owned, leased or operated by it or the nature of the business conducted by it makes such qualification or license necessary, except in such jurisdictions where the failure to be so duly qualified or licensed or in good standing would not have a Material Adverse Effect on the Company Group. Section 3.1 of the Disclosure Schedule lists the jurisdictions in which any member of the Company Group is qualified or licensed to do business as a foreign Person. Section 3.2. Noncontravention. Neither the execution and delivery of this Agreement by Seller, nor the consummation by the Company Group of the transactions contemplated hereby or the performance by the Company Group of the transactions contemplated hereby and by the Transaction Documents will (i) violate, conflict with or result in a breach or default under any provision of the certificate of incorporation or bylaws, or other organizational documents, of any member of the Company Group, (ii) except as set forth in Section 3.2 of the Disclosure Schedule, violate, conflict, result in a breach of or default under, give rise to any notification or Consent requirement or any right of termination, cancellation, payment or acceleration under or result in the creation of any Lien (other than Permitted Liens) upon any of the properties or assets of any member of the Company Group under any Material Contract, or (iii) subject to the Consents of Governmental Authorities described in Section 3.5, 18 violate any Law to which any member of the Company Group is subject, except, in the case of clauses (ii) and (iii), for such matters which would not have a Material Adverse Effect on the Company Group. Section 3.3. Title to Shares. As of the date hereof, Seller holds of record and owns beneficially the Shares set forth as owned by it in Section 3.3 of the Disclosure Schedule which Shares constitute (as of the date hereof) 100% of the issued and outstanding capital stock of the Company, free and clear of any and all Liens, except for any restrictions on sales of securities under applicable securities Laws. As of the Closing Date, Seller will hold of record and own beneficially all issued and outstanding Shares, which Shares will constitute 100% of the issued and outstanding capital stock of the Company, free and clear of any and all Liens, except for any restrictions on sales of securities under applicable securities Laws All of the Shares have been duly authorized and validly issued and are fully paid and nonassessable. Except as set forth in Section 3.3 of the Disclosure Schedule, neither Seller nor any member of the Company Group is a party to any convertible securities, calls, preemptive rights, options, warrants, purchase rights or other contracts, agreements or commitments (other than this Agreement) that would require Seller to sell, transfer or otherwise dispose of the Shares held by it. Except for this Agreement and as set forth in Section 3.3 of the Disclosure Schedule, Seller is not a party to any voting trust, proxy or other agreement or understanding with respect to the voting of the Shares held by it. Section 3.4. Subsidiaries of the Company; Capitalization (a) Section 3.4(a) of the Disclosure Schedule sets forth for each of the Company's Subsidiaries (i) its name and jurisdiction of organization, (ii) its form of organization and (iii) the percentage of capital stock, membership interests or units held by the Company, directly or indirectly, in such Subsidiary. The Company is the sole beneficial and record owner of the outstanding shares of capital stock or other interests in the Company's Subsidiaries, free and clear of all Liens, except for (i) any restrictions on sales of securities under applicable securities Laws or (ii) any Liens falling within clause (b) of the definition of Permitted Liens. All of the issued and outstanding shares of capital stock or other equity interests of the Company's Subsidiaries have been duly authorized, validly issued and are fully paid and nonassessable. There are no outstanding Rights, warrants, conversion rights or similar agreements, commitments or understandings for the purchase or acquisition from any of the Company's Subsidiaries of any shares of capital stock or other equity interests of such Subsidiary. Except as disclosed on Section 3.4(a) of the Disclosure Schedule, neither the Company nor any of its Subsidiaries owns or has any right to acquire, directly or indirectly, any outstanding capital stock of, or other equity interests in, any Person. (b) Except as disclosed on Section 3.4(b) of the Disclosure Schedule, (i) the Company Group has no Subsidiaries and does not, directly or indirectly, own any interest in any other Person, foreign or domestic (whether through acquisition of an equity interest or otherwise) in any other Person other than a member of the Company Group, (ii) there are no stockholder agreements, voting trusts, proxies or other agreements with respect to the purchase, sale or voting of the capital stock or stock rights of any member of the Company Group, and (iii) there is no existing Right or contract to which any member of the Company Group is a party requiring, and there are no Rights or convertible securities of a member of the Company Group outstanding which upon conversion or exchange would require, the issuance of any shares of capital stock or other equity interests in any member of the Company Group or other securities convertible into 19 shares of capital stock or other equity interests of the Company or any Subsidiary, and there are no outstanding or authorized equity appreciation, phantom unit, profit participation or similar rights of the Company or any Subsidiary in any member of the Company Group. Except as set forth on in Section 3.4(b) of the Disclosure Schedule, no outstanding securities of the Company other than shares of its common stock have any right to vote on matters as to which the shareholders of the Company have a right to vote. Except as disclosed on Section 3.4(b) of the Disclosure Schedule, there are no restrictions on the transfer of the Shares or any equity securities of any member of the Company Group other than those imposed by applicable state and federal securities Laws. Except as disclosed on Section 3.4(b) of the Disclosure Schedule, no holder of any security of any member of the Company Group is entitled to preemptive or similar statutory or contractual rights, either arising pursuant to any agreement or instrument to which such member of the Company Group is a party, or which are otherwise binding upon such member of the Company Group. (c) The equity capitalization of the Company, including (i) each class of capital stock, and (ii) the name of each holder and the number of shares held, is as set forth in Section 3.4(c) of the Disclosure Schedule. Section 3.5. Government Authorizations. Except for (i) required filings under the HSR Act, (ii) compliance with any applicable requirements of the Securities Act, (iii) compliance with any other applicable securities Laws and (iv) Consents not required to be made or given until after the Closing, no material Consent of, with or to any Governmental Authority is required to be obtained or made by Seller in connection with the execution, delivery and performance of this Agreement by Seller or the consummation of the transactions contemplated hereby, other than any such requirement that is applicable as a result of the specific legal or regulatory status of Buyer or as a result of any other facts that specifically relate to the business or activities in which Buyer is engaged. Section 3.6. Financial Statements; Securities Filings. (a) Set forth in Section 3.6(a) of the Disclosure Schedule are correct and complete copies of (i) the audited consolidated balance sheets of Argo-Tech and its Subsidiaries as of October 29, 2005 and October 30, 2004 and the related consolidated statements of operations and cash flows for the fiscal years then ended (the "Audited Financial Statements") and (ii) the unaudited consolidated balance sheets of (A) Argo-Tech and its Subsidiaries as of the Balance Sheet Date and (B) the Company Group as of the Balance Sheet Date and October 29, 2005, and the related consolidated statements of operations and cash flows for the fiscal years then ended (the "Unaudited Financial Statements" and, together with the Audited Financial Statements, the "Financial Statements"). Except as set forth therein, (x) the Financial Statements present fairly and accurately, in all material respects, respectively, the consolidated financial position, statements of operations and cash flows of Argo-Tech and its Subsidiaries and the Company Group, as the case may be, at the respective dates set forth therein and for the respective periods covered thereby, (y) were prepared in accordance with GAAP, and (z) are consistent with the books and records of Argo-Tech and its Subsidiaries and the Company Group, as the case may be, in all material respects (which books and records are correct and complete in all material respects). 20 (b) Except as disclosed on Section 3.6(b) of the Disclosure Schedule, since January 1, 2004, Argo-Tech has made all filings with the U.S. Securities and Exchange Commission (the "Commission") that it has been required to make under the Securities Act and the Securities Exchange Act and pursuant to the terms of the Indentures (such reports collectively, the "Public Reports"). Each of the Public Reports as of its date has complied with the Securities Act or the Securities Exchange Act, as applicable, and the rules promulgated thereunder or pursuant thereto in all material respects. None of the Public Reports, as of their respective dates, contained any untrue statement of a material fact or omitted to state a material fact necessary in order to make the statements made therein, in the light of the circumstances under which they were made, not misleading. Section 3.7. Absence of Certain Changes. Since the Balance Sheet Date, except as contemplated by or disclosed in or pursuant to this Agreement or as set forth in Section 3.7 of the Disclosure Schedule, each member of the Company Group has conducted its business only in the ordinary course, and has not been subject to any event or development that would, individually or in the aggregate, have a Material Adverse Effect. Without limiting the generality of the foregoing, since the Balance Sheet Date, no member of the Company Group has engaged in any practice, taken any action, omitted to take any action or entered into any transaction which, if the same had occurred between the date hereof and the Closing Date, would violate or breach Section 6.1(b). Section 3.8. Tax Matters. Except as set forth in Section 3.8 of the Disclosure Schedule, with respect to periods ending on or before the Closing Date: (a) Each member of the Company Group has duly and timely filed, or caused to be timely filed, with the appropriate Tax authorities all material Tax Returns that it was required to file, and paid or caused to be paid all material Taxes that it owed, whether or not shown to be due thereon. No member of the Company Group is currently a beneficiary of any extension of time under which to file any material Tax Returns. There are no Liens for Taxes on any of the assets of any member of the Company Group other than Permitted Liens. (b) No member of the Company Group has waived or requested a waiver of any statute of limitations in respect of material Taxes or agreed to or requested any extension of time with respect to a material Tax assessment or deficiency, which waiver or extension is still in effect. (c) No member of the Company Group is a party to any Tax allocation, Tax sharing or other similar agreement. (d) No member of the Company Group has any Liability for the Taxes of any Person, other than itself, under Section 1.1502-6 of the Treasury Regulations (or any similar provision of state, local or foreign law) as a transferee or successor, by contract or otherwise. (e) No member of the Company Group has distributed stock of another Person, or has had its stock distributed by another Person, in a transaction that was purported or intended to be governed in whole or in part by Code Section 355 or Code Section 361. 21 (f) Each member of the Company Group has withheld and paid all Taxes required to have been withheld and paid in connection with amounts paid or owing to any Person. (g) There is no material dispute or claim concerning any Tax Liability of any member of the Company Group claimed or raised by any taxing authority in writing or, to Seller's Knowledge, otherwise claimed or raised by any taxing authority. Section 3.8 of the Disclosure Schedule lists, as of September 13, 2005, all federal, state, local, and foreign income or corporation Tax Returns filed with respect to any member of the Company Group for taxable periods ended on or after January 1, 2001, indicates those Tax Returns that have been audited, and indicates those Tax Returns that currently are the subject of audit. Seller has made available to Buyer correct and complete copies of all such material federal income and corporation Tax Returns, examination reports, and statements of deficiencies assessed against or agreed to by any member of the Company Group filed or received since January 1, 2001. The Company Group has filed all federal, state, local, and foreign income or corporation Tax Returns required to be filed with respect to any member of the Company Group since September 13, 2005, or has timely made a request for extension of such filing. Seller shall cause the Company to deliver to Buyer a list of all such filings or requests for extension made since September 13, 2005, within ten Business Days of the date hereof. (h) No member of the Company Group will be required to include any material item of income in, or exclude any item of deduction from, taxable income for any taxable period (or portion thereof) ending after the Closing Date as a result of any (i) change in accounting method for a taxable period ending on or before the Closing Date; (ii) "closing agreement" as described in Code Section 7121 (or similar provision of state, local or foreign Tax law) executed on or before the Closing Date; or (iii) installment or open transaction disposition made on or before the Closing Date. (i) No member of the Company Group has filed a consent under former Code Section 341(f) concerning collapsible corporations. No member of the Company Group has participated in any "listed transaction" within the meaning of Treasury Regulations Section 1.6011-4. No claim has been made in writing by any taxing authority that any member of the Company Group is or may be subject to taxation by a jurisdiction in which it does not file income Tax Returns. (j) To Seller's Knowledge, no executive officer of the Company Group has directed any member of the Company Group to take any Prohibited Action with respect to the administration of any arrangement such executive officer knew to be subject to Section 409A of the Code. For this purpose, a "Prohibited Action" means an actual, affirmative action that the executive officer believed, at the time of such action, would cause the administration of the relevant deferred compensation arrangement to fail to be in good faith compliance with Section 409A of the Code and/or its related guidance. (k) Based solely on the arrangements and compensation levels in effect on the date hereof, and assuming that no employee of the Company Group is terminated in connection with the change of control that will occur upon consummation of the transactions contemplated by this Agreement, other than those persons who are listed on Section 3.8(k)(i) of the Disclosure Schedule and except as reflected on Section 3.8(k)(ii) of the Disclosure Schedule, no "Expected Payment" that any member of the Company Group would otherwise deduct for federal tax 22 purposes during a taxable period commencing after the Closing will be non-deductible to such member of the Company Group pursuant to Section 280G of the Code. For purposes hereof, "Expected Payment" means a payment to any director, officer, employee, or agent of any member of the Company Group that such member of the Company Group owes or is required to provide pursuant to an arrangement in effect on the date hereof. Except as reflected on Section 3.8(k)(ii) of the Disclosure Schedule, the Company is not party to any binding agreement in effect on the date hereof that will require the Company to "gross up" or otherwise reimburse any such Person for any excise Tax imposed pursuant to Section 4999 of the Code. Section 3.9. Real Property. (a) Other than Owned Real Property that is included in the Excluded Assets, no member of the Company Group holds any Owned Real Property. (b) Section 3.9(b) of the Disclosure Schedule sets forth (i) a true and complete list of all licenses, agreements and leases of real property under which any member of the Company Group is a lessee, lessor, sub-lessee or sub-lessor and all amendments, extensions, renewals, guarantees, and other agreements with respect thereto (the "Real Property Leases") and (ii) a true and complete list of the addresses of all real property leased by any member of the Company Group. The real property leasehold or subleasehold estates and other rights to use or occupy real property subject to the Real Property Leases is hereinafter referred to as the "Leased Real Property". There are no oral Real Property Leases. Except as set forth in Section 3.9(b) of the Disclosure Schedule, (A) to Seller's Knowledge, neither any member of the Company Group nor any other party to any Real Property Lease is in breach or default in any material respect under any Real Property Lease, (B) each Real Property Lease is legal, valid, binding, enforceable and in full force and effect, subject to proper authorization and execution of such Real Property Lease by the other party thereto and to the Remedies Exception, (C) to Seller's Knowledge, no event has occurred or circumstance exists which, with the delivery of notice, the passage of time or both, would constitute a material breach or default of any Real Property Lease; (D) no security deposit or portion thereof deposited with respect to any Real Property Lease has been applied in respect of a breach or default under such Real Property Lease that has not been redeposited in full; and (E) no member of the Company Group owes any brokerage commissions or finder's fees with respect to any Real Property Lease, and no member of the Company Group has collaterally assigned or granted any other security interest in any Real Property Lease or any interest therein Section 3.10. Intellectual Property. (a) Section 3.10(a) contains a complete and accurate list of (i) all of the following that are owned by any member of the Company Group: (A) issued patents and pending patent applications, (B) registrations and applications for registration of any Marks, and (C) registered copyrights, and (ii) Non-Company Software (other than off-the-shelf software with a total replacement cost and/or license fee of less than $250,000). (b) A member of the Company Group (i) owns all Intellectual Property set forth on Section 3.10(a)(i) of the Disclosure Schedule, and (ii) subject to clause (B) below, owns or has the right to use all Intellectual Property that is necessary for the operation of the business of any member of the Company Group as each is currently conducted, and all such Intellectual 23 Property is free and clear of all Liens (other than Permitted Liens) (collectively, the "Company Intellectual Property"). All issuance, renewal, maintenance and other fees and payments that are or have become due with respect to Company Intellectual Property set forth on Section 3.10(a) of the Disclosure Schedule on or before the Closing have been timely paid by or on behalf of the Company Group. To Seller's Knowledge, (i) all of the Company Intellectual Property is valid, subsisting and in full force and effect, and (ii) the conduct of the business of the Company Group is not currently operated in a manner that infringes or misappropriates any Intellectual Property rights of any third parties. Except as set forth on Section 3.10(b) of the Disclosure Schedule, (A) there are no proceedings, claims or actions against any member of the Company Group that are presently pending, and, to Seller's Knowledge, no claims or actions have been threatened since January 1, 2002 that contest the validity, use, ownership or enforceability of any Company Intellectual Property; and (B) to Seller's Knowledge, no third party is infringing or misappropriating any Company Intellectual Property, which, in the case of each of subsections (A) and (B), if adversely determined or if such action is not redressed, would have a Material Adverse Effect on the Company Group. (c) All licenses, assignments and other contracts relating to the use of all Non-Company Software and the Intellectual Property material to the operation of the business of any member of the Company Group, as each is currently conducted, that is owned by third parties, are valid and in full force and effect. No employee or consultant of any member of the Company Group holds any right, title or interest in or to any Company Intellectual Property that is material to the business of any member of the Company Group as currently conducted. Each member of the Company Group has taken all commercially reasonable precautions to protect the proprietary nature of each material item of Intellectual Property, and to maintain in confidence all trade secrets and confidential information of the business comprising a part thereof. No software or other technology incorporated into any product of the Company or any of its Subsidiaries (excluding any third party's product) distributed or otherwise sold by the Company or any of its Subsidiaries constitutes Open Source Software or a derivative work based on any Open Source Software. The term "off-the-shelf software" as used above in this Section 3.10 does not include Open Source Software. Section 3.11. Environmental Matters. This Section 3.11 shall constitute the sole representations of Seller with respect to environmental matters, including matters relating to Environmental Law or Hazardous Materials. (a) Except as set forth on Section 3.11 of the Disclosure Schedule: (i) within the past three (3) years, no member of the Company Group has violated in any material respect any applicable Environmental Law or any permit, license or other authorization applicable to the Company Group required under Environmental Law; (ii) within the past three (3) years, no member of the Company Group has received any written notice, complaint or claim that remains uncured, alleging that any member of the Company Group is in material violation of any Environmental Law or subject to any material Liability under any Environmental Law; 24 (iii) no member of the Company Group is subject to any outstanding consent decree, compliance order or administrative order from or settlement agreement with any Governmental Authority, in each case containing material obligations for a member of the Company Group pursuant to any Environmental Law; (iv) there are no material Actions pending or, to Seller's Knowledge, threatened before any Governmental Authority against any member of the Company Group; (v) (A) to Seller's Knowledge, no asbestos or asbestos-containing material is or has been present at the Leased Real Property, and no member of the Company Group currently produces or manufactures, or (B) has produced, manufactured or sold, any products or inventory that contain asbestos, in each case so as would reasonably be expected to result in material Liability under Environmental Law to any member of the Company Group; and (vi) to Seller's Knowledge, there has been no disposal or release of any Hazardous Material on any site or facility owned, operated or leased by any member of the Company Group that would reasonably be expected to result in material Liability under Environmental Law to any member of the Company Group. (b) There are no material environmental audits, assessments or investigation reports with respect to the Leased Real Property in the possession, custody or reasonable control of the Company Group that have not been made available to Buyer. Section 3.12. Contracts. (a) Except as contemplated by this Agreement or as set forth in Section 3.12 of the Disclosure Schedule, the Company Group is not a party to or otherwise bound or affected by any oral or written: (i) customer contracts involving payments in excess of $500,000 in the aggregate or otherwise entered into outside of the ordinary course of business; (ii) supplier contracts involving payments in excess of $500,000 in the aggregate or otherwise entered into outside of the ordinary course of business; (iii) contract for the employment of any officer, director, individual, employee, consultant or other Person on a full-time, part-time or consulting basis which (i) provides for total cash compensation (salary and bonus) in excess of $150,000 for any 12-month period, (ii) provides for the payment of cash or other compensation or benefits upon the consummation of the transactions contemplated hereby, or (iii) provides any severance benefits or making any severance arrangements; (iv) bonus, pension, profit-sharing, retirement, hospitalization, insurance, stock purchase, stock option or similar plan, contract or understanding pursuant to which benefits are provided to any employee of the Company Group (other than group insurance plans and expense reimbursements applicable to employees generally); 25 (v) collective bargaining or similar agreements; (vi) agreement or indenture relating to the borrowing of money or to the mortgaging or pledging of, or otherwise placing a Lien on, any material asset, or any guarantee therefor; (vii) contract, agreement, license, or release with respect to the use, license, transfer, or disposition of any material Intellectual Property outside of the ordinary course of business (other than licenses for mass-marketed computer software with a replacement cost and/or annual license fee of less than $100,000); (viii) stockholders agreement, registration rights agreement, voting agreement, voting trust agreement or similar agreements to which the Company Group is subject; (ix) agreement, or group of related agreements with the same party or any group of affiliated parties, under which the Company Group has advanced or agreed to advance money or has agreed to lease any personal property as lessor in each case, involving consideration in excess of $100,000 in any 12-month period; (x) Lease of personal property by the Company Group involving annual payments in excess of $100,000; (xi) agreement concerning a partnership or joint venture or minority equity investment, or relating to loans or advances to any Person, other than loans and advances to employees made in the ordinary course of business; (xii) instrument or agreement whereby the Company Group grants any other Person a power of attorney outside the ordinary course of business or indemnifies outside the ordinary course of business any other Person against loss or Liability; (xiii) instrument or agreement whereby any other Person indemnifies outside the ordinary course of business any member of the Company Group against loss or Liability; (xiv) agreement concerning confidentiality or non-competition other than confidentiality agreements entered into by Argo-Tech in a commercial context in the ordinary course of business; (xv) agreement with any officer, director or stockholder of any member of the Company Group; (xvi) other than this Agreement, agreement under which the Company Group would reasonably be expected to have Liabilities or obligations in the future relating to the acquisition or disposition of assets having a value in excess of $250,000 by way of merger, consolidation, purchase, sale or otherwise, or granting to any Person a right at such Person's option to purchase or acquire any material asset or property of the Company Group or any interest therein (not including dispositions of inventory in the ordinary course); 26 (xvii) agreement, contract or commitment for the construction or modification of any building, structure or other fixed asset, or for the incurrence of any other capital expenditure involving amounts in excess of $250,000; (xviii) to Seller's Knowledge, agreement or contract for which any member of the Company Group is reasonably likely under the contract terms and applicable Law to have Liability for consequential damages in excess of $15,000,000; (xix) customer or supplier contract involving payments in excess of $500,000 in the aggregate which provides for the payment of liquidated damages; or (xx) other contract or group of related contracts with the same party involving more than $500,000 and continuing over a period of more than six months from the date or dates thereof (including renewals or extensions optional with another party), which contract or group of contracts is not terminable by the Company Group without penalty upon notice of 30 days, or less (collectively, all agreements listed, or required to be listed on Section 3.12 of the Disclosure Schedule pursuant to (i) through (xvii) of this Section 3.12 are referred to as the "Material Contracts"). (b) Except as set forth in Section 3.12 of the Disclosure Schedule, (i) each Material Contract is in full force and effect and is the legal, valid and binding obligation of a member of the Company Group which is a party to such Material Contract, subject to the Remedies Exception and, to Seller's Knowledge, the other parties thereto (the "Other Parties"), and (ii) no member of the Company Group or, to the Seller's Knowledge, any of the Other Parties to any Material Contract is in breach, violation or default in any material respect and has received written notice of such breach, violation or default in any material respect, and, to Seller's Knowledge, no event has occurred which with notice or lapse of time or both would constitute a breach, violation or default in any material respect by a member of the Company Group or any Other Party, or permit termination, modification, or acceleration by the Other Parties, under such Material Contract, except that, in order to avoid a default, violation or breach in any material respect under any Material Contract, the Consent of the Other Parties set forth in Section 3.2 of the Disclosure Schedule may be required in connection with the transactions contemplated hereby. (c) All products sold pursuant to any OEM contracts in the engine division to which a member of the Company Group is party will result in book losses, which losses through the Balance Sheet Date with respect to firm orders are reflected in the Unaudited Financial Statements. These losses are recovered by the Company Group from aftermarket and overhaul sales of such products over time. Any firm contracts other than OEM contracts in the engine division that can be reasonably expected to result in book losses have been fully reserved for in the balance sheet accounts of the Company Group through the Balance Sheet Date reflected in the Unaudited Financial Statements. Section 3.13. Insurance. Section 3.13 of the Disclosure Schedule contains a correct and complete list and description (including the name of the insurer, name of the policyholder, amount and type of coverage) of all material policies or binders of insurance provided to any member of the Company Group. All such policies are in full force and effect, are current on premium payments and no written notice of cancellation, non-renewal, 27 termination, premium increase or change in coverage has been received with respect thereto, and to Seller's Knowledge, there is no existing default by any insured thereunder. Following the Closing, the Company Group will have the full benefit of all such policies, or comparable replacement policies. Section 3.13 of the Disclosure Schedule sets forth a list or description of each claim made under any such policy since January 1, 2004 involving or which would reasonably be expected to involve an amount in excess of $250,000. Section 3.14. Litigation. Except as set forth in Section 3.14 of the Disclosure Schedule, (i) there are, and since January 1, 2004 there have been, no asserted claims in writing or Actions pending or, to Seller's Knowledge, threatened in law or in equity or before any Governmental Authority against (A) any member of the Company Group which are reasonably likely to result in Liability for any member of the Company Group or call into question the validity of this Agreement or the transactions contemplated by this Agreement or (B) to the Seller's Knowledge, any director or officer or any member of the Company Group that would be reasonably likely to result in Liability of the Company Group exceeding $1,000,000 or call into question the validity of this Agreement or the transactions contemplated by this Agreement, and (ii) there are no outstanding material injunctions, judgments, orders, decrees, rulings, decisions or charges to which any member of the Company Group is a party or by which any member of the Company Group is bound by or with any Governmental Authority. Except as set forth in Section 3.14 of the Disclosure Schedule, since January 1, 2004, no member of the Company Group has entered into any settlement agreement with respect to any Action (or threatened Action) involving a payment or provision of other consideration in an amount or value in excess of $500,000 by such member of the Company Group, whether or not covered by insurance or otherwise subject to indemnification or that had consequences that were otherwise material to the Company Group. Section 3.15. Employee Matters. (a) Section 3.15(a) of the Disclosure Schedule sets forth a complete and correct list of each "employee benefit plan " (as such term is defined in Section 3(3) of ERISA), and each other benefit or compensation plan, program, agreement or arrangement (excluding salaries, wages and de minimis fringe benefit plans, programs or arrangements) that any member of the Company Group on the date hereof maintains, provides or sponsors, or to which any member of the Company Group contributes or has any obligation to contribute, or with respect to which any member of the Company Group has any Liability (collectively, the "Company Plans"). (b) Each Company Plan (and each related trust, insurance contract, or fund) has been maintained, funded, and administered in accordance with the terms of such Company Plan and the terms of any applicable collective bargaining agreement and is in material compliance in form and in operation with the applicable requirements of ERISA and the Code, and all other applicable Laws. (c) All required reports and descriptions (including annual reports on Form 5500), summary annual reports, and summary plan descriptions) have been timely filed and/or distributed in accordance with the applicable requirements of ERISA and the Code with respect to each Company Plan, and the Company Group and each ERISA Affiliate have materially complied and are in material compliance with the requirements of COBRA. 28 (d) All contributions (including all employer contributions and employee salary reduction contributions) and premium payments that are due have been made within the time periods prescribed by ERISA and the Code with respect to each Company Plan, and all material contributions and material premium payments for any period ending on or before the Closing Date that are not yet due have been made with respect to each Company Plan or properly accrued. (e) Each Company Plan that is intended to meet the requirements of a "qualified plan" under section 401(a) of the Code has received a favorable determination letter from the Internal Revenue Service, and, to the Seller's Knowledge, nothing has occurred that could adversely affect the qualified status of any such Company Plan so as to result in any material Liability to any member of the Company Group. Each such Company Plan has been timely amended to comply with the provisions of the legislation commonly referred to as "GUST" and "EGTRRA" and submitted to the Internal Revenue Service for a determination letter that takes the GUST amendments into account within the GUST remedial amendment period. (f) Seller has made available to Buyer correct and complete copies of the plan documents and summary plan descriptions, the most recent determination letter received from the Internal Revenue Service, the three most recent annual reports (IRS Form 5500, with all applicable attachments), the most recent actuarial valuation and all related trust agreements, insurance contracts, and other funding arrangements that implement each Company Plan. (g) Except as set forth on Section 3.15(g) of the Disclosure Schedule, no member of the Company Group or any ERISA Affiliate maintains, sponsors, contributes to, or has any Liability under (or with respect to) any "defined benefit plan" (as defined in section 3(35) of ERISA), or, within the past five (5) years, any "multiemployer plan" (as defined in section 3(37) of ERISA), or otherwise has any Liability under Title IV of ERISA. No asset of any member of the Company Group is subject to any Lien under ERISA or the Code. There has been no application for or waiver of the minimum funding standards imposed by section 302 of ERISA and section 412 of the Code with respect to any Company Plan; no Company Plan has an "accumulated funding deficiency" within the meaning of section 412 of the Code; and there has been no "reportable event" (within the meaning of section 4043 of ERISA) with respect to any Company Plan for the prior three years. (h) To Seller's Knowledge: (1) there have been no non-exempt, uncorrected prohibited transactions (as defined in section 406 of ERISA or section 4975 of the Code) with respect to any Company Plan; (2) no fiduciary (as defined in section 3(21) of ERISA) has any Liability for any breach of fiduciary duty or any other failure to act or comply in connection with the administration or investment of the assets of any Company Plan; and (3) no Action with respect any Company Plan (other than routine claims for benefits) is pending or threatened, and there is no basis for any such Action. (i) Except as set forth on Section 3.15(i) of the Disclosure Schedule, no member of the Company Group maintains, contributes to or has an obligation to contribute to, or any Liability with respect to, the provision of medical, health, or life insurance or other welfare type benefits for current or future retired or terminated directors, officers, employees or contractors of any member of the Company Group (or any spouse or other dependent thereof) other than in accordance with COBRA. 29 (j) Section 3.15(j) of the Disclosure Schedule contains a complete and correct list of each benefit or compensation plan, program, agreement or arrangement (excluding salaries, wages and de minimis fringe benefit plans, programs or arrangements) with respect to which any member of the Company Group has any Liability relating to the provision of benefits to any current or former employee, officer, director or contractor of the Company Group residing or working outside the United States (each, a "Foreign Plan"). Each Foreign Plan has been maintained, funded and administered in all material respects in accordance with its terms and the requirements of all applicable Laws, and no Foreign Plan has any unfunded or underfunded Liabilities. (k) There is no labor strike, material labor dispute, or concerted work stoppage pending or, to the Seller's Knowledge, threatened, and since January 1, 2001 no member of the Company Group has experienced any labor strike or material concerted labor dispute. Except as set forth in Section 3.15(k) of the Disclosure Schedule no Company Group member is party to or otherwise bound by any collective bargaining agreement or relationship with any labor organization. Except as set forth in Section 3.15(k) of the Disclosure Schedule, each member of the Company Group has complied in all material respects with all applicable labor and employment Laws in connection with the employment of its employees, including those Laws relating to wages and hours, collective bargaining, equal employment opportunity and affirmative action, layoffs, immigration, workplace safety and the collection and payment of all Taxes and other withholdings. Within the past three years, no Company Group member has implemented any plant closing or layoff of employees that could implicate (without regard to any actions that could be taken by the Company following the Closing) the Worker Adjustment and Retraining Notification Act of 1988, as amended, or any similar foreign, state or local Law, (collectively, the "WARN Act"). (l) Except as set forth in Section 3.15(l) of the Disclosure Schedule, neither the execution and performance of this Agreement, nor the consummation by the Parties of the transactions contemplated hereby, will constitute a triggering event under any Company Plan that will result in any payment, whether a severance payment or otherwise, becoming due from such Company Plan or from the Company to any present or former employee (or dependents of such person). (m) The Company is in all material respects in compliance with the Health Insurance Portability and Accountability Act of 1996 (ERISA Section 701 et seq) to the extent applicable. (n) Section 3.15(n) of the Disclosure Schedule sets forth a true and complete list of (i) all directors of any member of the Company Group, (ii) all officers (with office held) of any member of the Company Group, (iii) all consultants and contract employees (with total cash compensation (salary and bonus) in excess of $150,000 for any 12-month period) retained by any member of the Company Group currently, and (iv) all employees of any member of the Company Group, including each such employee's job title, remuneration and duration of employment period. No more than twenty of the individuals identified on Section 3.15(n) of the Disclosure Schedule are "leased employees" as that term is defined under Section 414(n) of the Code. Seller shall cause the Company to deliver to Buyer a list of such individuals who are "leased employees" within ten Business Days of the date hereof. 30 (o) The Argo-Tech Corporation Employee Stock Ownership Plan has been terminated lawfully by its sponsor and in compliance with relevant provisions of the Code and ERISA. The sponsor of this Plan has received a favorable determination letter from the Internal Revenue Service providing that the termination of this plan did not adversely affect its Tax-qualified status under the Code, a copy of which has been provided to Buyer. To Seller's Knowledge, there are no pending or threatened claims regarding the termination of this Plan or any transactions flowing from such termination, including Actions for breach of fiduciary duties. (p) No member of the Company Group has any further Liability to any employee, former employee, owner or former owner of any member of the Company Group or its predecessors which arose as a result of the Merger. Section 3.16. Legal Compliance. Except with respect to Tax matters (which are addressed exclusively in Section 3.8), environmental matters (which are addressed exclusively in Section 3.11) and employee matters (which are addressed exclusively in Section 3.15), no member of the Company Group is, or for the past three years has been, in material violation of any Law applicable to its assets, properties, business or operations, including the Arms Export Control Act and the International Traffic in Arms Regulations. No member of the Company Group has received a written notice at any time in the past three years alleging any material failure to comply with any Law, including the Arms Export Control Act and the International Traffic in Arms Regulations. Each member of the Company Group is in compliance with any privacy policies or related policies, programs or other notices adopted by such member of the Company Group for such member's use and collection of personal information, except to the extent the failure of any such compliance would not have a Material Adverse Effect on the Company Group. To the Seller's Knowledge, (i) there has not been any notice to, complaint against, or audit, proceeding or investigation conducted with respect to any member of the Company Group by any Person (including any Governmental Authority) regarding any material violation of Laws related to the collection, use or disclosure of personal information by any Person in connection with the operation of the business of any member of the Company Group, (ii) none is threatened or pending and (iii) there is no reasonable basis for the same. Section 3.17. Licenses and Permits. The Company Group currently has all material Licenses which are required for the operation of its respective businesses as presently conducted. To the Seller's Knowledge, all material Licenses that the Company Group currently has will be available for use by the Buyer and the Company Group immediately after the Closing Date. No member of the Company Group is in default (and, to the Seller's Knowledge, no event has occurred that, with the notice or lapse of time or both, would constitute a default) of any term, condition or provision of any material License to which it is a party that would have a Material Adverse Effect on the Company Group. To the Seller's Knowledge, no written notice has been received by any officer of any member of the Company Group at any time in the past three years alleging the failure to hold any material License. Section 3.18. Brokers' Fees. Except as set forth on Section 3.18 of the Disclosure Schedule, no member of the Company Group has entered into any contract or other arrangement or understanding (written or oral, express or implied) with any Person which may result in the obligation of the Company or Buyer or any of its Affiliates to pay any fees, commissions or other compensation to any broker or finder or person providing comparable or 31 similar services as a result of the execution and delivery of this Agreement or the consummation of the transactions contemplated by this Agreement. Section 3.19. No Undisclosed Liabilities. Except as disclosed in Section 3.19 of the Disclosure Schedule or as disclosed or reserved against on the Financial Statements, neither the Company nor any of its consolidated Subsidiaries has any Liabilities of any kind that would have been required by GAAP to be reflected on a consolidated balance sheet of the Company Group or in the notes thereto, other than (a) Liabilities incurred in the ordinary course of business after the Balance Sheet Date (none of which results from, arises out of, relates to, is in the nature of, or was caused by any material breach of contract, material breach of warranty, material tort, material infringement, or material violation of a Law), (b) Liabilities relating to the current or future performance, or arising in accordance with any terms, of any contract or agreement to which the Company or any Subsidiary is subject and which are either listed on Section 3.12 of the Disclosure Schedule or are not required to be so listed (none of which results from, arises out of, relates to, is in the nature of, or was caused by any material breach of any such contract or agreement) and (c) Liabilities incurred in connection with the transactions contemplated hereby (other than the Reorganization). Section 3.20. Internal Controls and Procedures. Argo-Tech has established and maintains disclosure controls and procedures and internal control over financial reporting (as such terms are defined in paragraphs (e) and (f), respectively, of Rule 15d-15 under the Securities Exchange Act) as required by Rule 15d-15 under the Securities Exchange Act. Argo-Tech has disclosed, based on its most recent evaluation prior to the date of this Agreement, to its auditors and the Company's auditors and to the board of directors of Argo-Tech and audit committee of the board of directors of the Company: (A) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect in any material respect Argo-Tech's ability to record, process, summarize and report financial information and (B) any fraud, whether or not material, that involves Argo-Tech's executive officers or other employees who have a significant role in Argo-Tech's internal control over financial reporting. As of the date of this Agreement, to Seller's Knowledge, Argo-Tech has not identified any material weaknesses in the design or operation of internal control over financial reporting. There are no outstanding loans made by Argo-Tech or any of its subsidiaries to any executive officer (as defined in Rule 3b-7 under the Securities Exchange Act) or member of the board of directors of the Company. Section 3.21. Transactions with Affiliates. Except as disclosed on Section 3.21 of the Disclosure Schedule, no officer, director or Affiliate of the Company Group or Seller or, to Seller's Knowledge, any Affiliate of any such individual or entity (excluding, for the avoidance of doubt, any portfolio company or other Persons in which an equity holder of Seller or any of their respective Affiliates otherwise has an investment) (i) is a consultant, creditor, debtor, customer, distributor, supplier or vendor of, or is a party to any material contract or agreement (other than any employment, management services, retention, severance, change of control, transaction bonus or similar compensation contract or agreement listed on Section 3.12 of the Disclosure Schedule or not required to be so listed) with, any member of the Company Group or (ii) owns any direct or indirect interest in any material asset used in connection with the business of the Company Group. 32 Section 3.22. Customers and Suppliers. (a) Section 3.22 of the Disclosure Schedule lists the ten largest customers (based on net revenue received by the Company Group) and the ten largest suppliers (based on payments made by the Company Group) of the Company Group (on a consolidated basis) for the most recently completed fiscal year. Opposite the name of each such customer is the approximate percentage of consolidated net sales attributable to such customer. Except as disclosed on Section 3.22 of the Disclosure Schedule, since December 31, 2005, (a) no customer listed in Section 3.22 of the Disclosure Schedule has indicated in writing its plans or intent to stop, or materially decrease the rate of, buying products and services from the Company Group and (b) no supplier listed in Section 3.22 of the Disclosure Schedule has indicated in writing its plans or intent to stop, or materially decrease the rate of, supplying materials, products or services to the Company Group. (b) Section 3.22 of the Disclosure Schedule lists all top-level products sold by any member of the Company Group pursuant to FAA Parts Manufacturing Authority. No member of the Company Group has received written notice that any qualifications or approvals for its products as established by its customers have been revoked or terminated and, to Seller's Knowledge, no such revocation or termination is threatened or contemplated. No member of the Company Group holds any security clearances from the Department of Defense. Section 3.23. Warranties. The accrual for warranty claims (a) set forth on the Financial Statements for the year ended October 28, 2006, and (b) as set forth on Argo-Tech's books and records as of the date hereof, adequately reflect an amount required for satisfaction of warranty related Liabilities due in respect of goods sold or services rendered by the Company Group prior to each such date, as applicable. No member of the Company Group has agreed to provide any express product or service warranties other than (i) standard warranties, the terms of which have been provided to Buyer and identified as the Company's warranties, (ii) warranties for parts, components and original equipment that expressly provide that cure is to be effected by repair or replacement of the defective or noncomplying products and (iii) other warranties that will not, if material claims are made thereunder, have a Material Adverse Effect on the Company Group. Except as disclosed on Section 3.23 of the Disclosure Schedule, there are no pending, and during the past three years there have been no, material warranty claims made by any third parties with respect to any product manufactured or sold by the Company Group. Section 3.24. List of Government Contracts, Subcontracts and Bids. Section 3.24 of the Disclosure Schedule sets forth a current, complete and accurate list of all Government Contracts involving payments in excess of $500,000 that are currently active in performance (or have been active in performance in the past but have not been closed after receiving final payment, or have been active in performance for the three years prior to the Closing Date) and to which any member of the Company Group is a party. This schedule accurately reports for each such Government Contract the contractor, the customer, the contract number, as well as the applicable member of the Company Group's best estimate of the total value of the Government Contract. Each Government Contract listed in the schedule is in full force and effect and is valid and enforceable against the applicable member(s) of the Company Group in accordance with its terms, subject to the Remedies Exception. Seller has made available to Buyer complete and correct copies of all such Government Contracts listed in such schedule. Except as disclosed on Section 3.24 of the Disclosure Schedule, no Government Contract listed in the schedule was 33 awarded on the basis of any qualification as a "small business concern," "small disadvantaged business," protege status or other preferential status (including disadvantaged-business, minority-owned business, women-owned business or other business status based on ownership or control, or participation in or qualification under other preferential status programs, such as the Historically Underutilized Business Zone program or participation under Section 8(a) of the Small Business Act or similar preferences). Section 3.24 of the Disclosure Schedule also sets forth a current, accurate and complete list of each of the unexpired Government Bids involving payments in excess of $500,000 that any member of the Company Group has submitted to a Governmental Authority. Section 3.25. Compliance, Performance, Termination and Breach of Government Contracts. With respect to any and all Government Contracts and Government Bids to which any member of the Company Group is or has been a party, except as set forth in Section 3.25 of the Disclosure Schedule, at all times during the three year period prior to the Closing Date: (a) each member of the Company Group is, and has been, in compliance with all material terms and conditions of each Government Contract (including all provisions and requirements incorporated expressly, by reference or by operation of applicable Laws); (b) each member of the Company Group is, and has been, in compliance in all material respects with all requirements of applicable Laws pertaining to each Government Contract and Government Bid and all requirements of Governmental Authorities regarding such applicable Laws with respect to each Government Contract and Government Bid; (c) no Government Contract has been the subject of a termination for default or for convenience, and no member of the Company Group has received any written demand for cure or show cause regarding performance of a Government Contract or any written (or, to Seller's Knowledge, oral) notice of or claim for or assertion of a condition of default, a breach of contract, a violation of any applicable Laws or a violation of a contract requirement (including all provisions and requirements incorporated expressly, by reference or by operation of Law therein) in connection with a Government Contract or Government Bid, whether from a Government Authority or from any prime contractor, subcontractor, vendor or other third party; (d) to Seller's Knowledge, no event has occurred which, with the passage of time or the giving of notice or both, would reasonably be expected to result in a condition of default or breach of contract or a material violation of any applicable Laws with respect to a Government Contract or Government Bid; and (e) no member of the Company Group has violated in any material respect any applicable Laws or administrative or contractual restriction concerning the employment of (or discussions concerning possible employment with) current or former officials or employees of a Governmental Authority (regardless of the branch of government), including the so-called "revolving door" restrictions set forth at 18 U.S.C. Section 207 or similar provisions under state or local laws. 34 Section 3.26. Internal Controls, Audits and Investigations. (a) No member of the Company Group is currently being or has in the past three years been audited by any Governmental Authority, except in the ordinary course of business or as is customary in the industry or as provided by applicable regulations, or, to Seller's Knowledge, is being investigated by any Government Authority, nor to Seller's Knowledge, has such audit or investigation been threatened. (b) Except as disclosed on Section 3.26(b) of the Disclosure Schedule, during the past three years no member of the Company Group has been under administrative, civil or criminal indictment or criminal information, or audit by a Governmental Authority with respect to any deficient performance, mischarging, misstatement or omission or other alleged irregularity, arising under or relating to any Government Contract or Government Bid. Section 3.27. Debarment, Suspension and Exclusion. (a) During the past three years, no member of the Company Group and no director or officer thereof has been the subject of a debarment, suspension or exclusion from participation in programs funded by any Governmental Authority or in the award of any Government Contract, nor, to Seller's Knowledge, have any of them been listed on any list of parties excluded from participation in government-funded programs nor, to Seller's Knowledge, has any such debarment, suspension or exclusion proceeding or proposed listing been initiated or threatened in the past three years. (b) No written notice has been received that any determination has been made by a Governmental Authority that any member of the Company Group is nonresponsible or ineligible for award of a government contract within the past three years, nor, to Seller's Knowledge, do any circumstances exist that would reasonably be expected to warrant the institution of debarment, suspension or exclusion proceedings or any finding of nonresponsibility or ineligibility with respect any member of the Company Group in the future. Section 3.28. Absence of Unlawful Payments. (a) No member of the Company Group has within the past three years, (i) used any funds of any member of the Company Group or any of their predecessors, partners, Affiliates, principals or officers, for unlawful contributions, payments, gifts or entertainment, or (ii) made any unlawful expenditures relating to political activity to government officials or others (any payment pursuant to (i) or (ii) hereinafter referred to as an "Unlawful Payment"), nor has any member of the Company Group received written notice of any Unlawful Payment. The Company Group has reasonably adequate financial controls to prevent such Unlawful Payments. (b) The Company Group is in compliance in all material respects and has, during all periods for which any applicable statute of limitations has not expired, complied with the applicable provisions of the U.S. Foreign Corrupt Practices Act, as amended, and other applicable foreign laws and regulations relating to corrupt practices and similar matters. Section 3.29. No Undisclosed Liabilities of Carter Ground Fueling, Ltd. Except as disclosed in Section 3.29 of the Disclosure Schedule or as disclosed or reserved against on the 35 Financial Statements, Carter Ground Fueling, Ltd. does not have any material Liabilities of any kind, other than: (a) Liabilities incurred in the ordinary course of business after the Balance Sheet Date (none of which results from, arises out of, relates to, is in the nature of, or was caused by any breach of contract, tort, infringement, or violation of a Law); (b) Liabilities relating to the current or future performance, or arising in accordance with any terms, of any contract or agreement to which Carter Ground Fueling is subject and which is listed on Section 3.29 of the Disclosure Schedule (none of which results from, arises out of, relates to, is in the nature of, or was caused by any breach of any such Material Contract); and (c) Liabilities incurred in connection with the transactions contemplated hereby (other than the Reorganization). Section 3.30. NO ADDITIONAL REPRESENTATIONS. EXCEPT AS OTHERWISE EXPRESSLY SET FORTH IN ARTICLE III OF THIS AGREEMENT, THE COMPANY EXPRESSLY DISCLAIMS ANY REPRESENTATIONS OR WARRANTIES OF ANY KIND OR NATURE, EXPRESS OR IMPLIED, AS TO THE CONDITION, VALUE OR QUALITY OF THE BUSINESS OR THE ASSETS OF THE BUSINESS, AND THE COMPANY SPECIFICALLY DISCLAIMS ANY REPRESENTATION OR WARRANTY OF MERCHANTABILITY, USAGE, SUITABILITY OR FITNESS FOR ANY PARTICULAR PURPOSE WITH RESPECT TO THE ASSETS OF THE BUSINESS, OR ANY PART THEREOF, OR AS TO THE WORKMANSHIP THEREOF, OR THE ABSENCE OF ANY DEFECTS THEREIN, WHETHER LATENT OR PATENT, IT BEING UNDERSTOOD THAT, EXCEPT AS OTHERWISE EXPRESSLY SET FORTH IN ARTICLE III OF THIS AGREEMENT, SUCH SUBJECT ASSETS ARE BEING ACQUIRED "AS IS, WHERE IS" ON THE CLOSING DATE, AND IN THEIR PRESENT CONDITION, AND THE PURCHASER SHALL RELY ON ITS OWN EXAMINATION AND INVESTIGATION THEREOF. Article IV. REPRESENTATIONS AND WARRANTIES REGARDING SELLER Seller represents and warrants to Buyer as of the date hereof and as of the Closing Date, except as set forth in the Disclosure Schedule, as follows: Section 4.1. Organization. Seller is a limited liability company validly organized, validly existing and in good standing under the laws of the State of Delaware, and Seller has all requisite limited liability company power and authority to carry on its business as it is currently conducted and to own, lease and operate its properties and assets where such properties and assets are now owned, leased or operated. Section 4.2. Authorization. Seller has all requisite power and authority to execute and deliver this Agreement and the other Transaction Documents to which it is party, to perform its obligations hereunder and thereunder and to consummate the transactions contemplated hereby and thereby. The execution, delivery and performance by Seller of this Agreement and the other Transaction Documents to which it is party and the consummation of the transactions contemplated hereby and thereby have been duly authorized by all necessary action on the part of Seller and Seller's members. This Agreement and the other Transaction Documents to which it is party have been, or will be, duly executed and delivered by Seller and, 36 assuming this Agreement constitutes a legal, valid and binding obligation of Buyer, constitutes a legal, valid and binding obligation of Seller, enforceable against Seller in accordance with its terms, subject to the Remedies Exception. Section 4.3. Noncontravention. Neither the execution and delivery of this Agreement by Seller, nor the consummation by Seller of the transactions contemplated hereby or the performance by Seller of its obligations hereunder and under the Transaction Documents will (i) violate, conflict with or result in a breach or default under any provision of the organizational documents of Seller, (ii) except as set forth in Section 4.3 of the Disclosure Schedule, violate, conflict, result in a breach of or default under, give rise to any notification or Consent requirement or any right of termination, cancellation, payment or acceleration under or result in the creation of any Lien (other than Permitted Liens) upon any of the Shares under any Material Contract, or (iii) subject to the Consents specified in Section 3.5 and compliance with the HSR Act, violate any Law to which Seller is subject, except, in the case of clauses (ii) and (iii), for such matters which would not, individually or in the aggregate, have a Material Adverse Effect on the Company Group. Section 4.4. Brokers' Fees. Except as set forth on Section 4.4 of the Disclosure Schedule, Seller has not entered into any contract or other arrangement or understanding (written or oral, express or implied) with any Person which may result in the obligation of any members of the Company Group or Buyer or any of its Affiliates to pay any fees, commissions or other compensation to any broker or finder or Person providing comparable or similar services as a result of the execution and delivery of this Agreement or the consummation of the transactions contemplated by this Agreement. Article V. REPRESENTATIONS AND WARRANTIES REGARDING BUYER Buyer represents and warrants to Seller as of the date hereof and as of the Closing Date as follows: Section 5.1. Organization. Buyer is a corporation duly organized, validly existing, and in good standing under the laws of Ohio and Buyer has all requisite corporate power and authority to carry on its business as it is currently conducted and to own, lease and operate its properties where such properties are now owned, leased or operated. Buyer is duly qualified or licensed to do business and is in good standing in each jurisdiction in which the property owned, leased or operated by it or the nature of the business conducted by it makes such qualification or license necessary, except in such jurisdictions where the failure to be so duly qualified or licensed or in good standing would not, individually or in the aggregate, have a Material Adverse Effect on Buyer. Section 5.2. Authorization. Buyer has all requisite power and authority to execute and deliver this Agreement and the other Transaction Documents to which it is party, to perform its obligations hereunder and thereunder and to consummate the transactions contemplated hereby and thereby. The execution, delivery and performance by Buyer of this Agreement and the other Transaction Documents to which it is party and the consummation of the transactions contemplated hereby and thereby have been duly authorized by all necessary 37 action on the part of Buyer. This Agreement and the other Transaction Documents to which it is party have been, or will be, duly executed and delivered by Buyer and, assuming this Agreement constitutes a legal, valid and binding obligation of Seller, constitutes a legal, valid and binding obligation of Buyer, enforceable against Buyer in accordance with its terms, subject to the Remedies Exception. Section 5.3. Financial Capacity. At or prior to the Closing, Buyer will have sufficient cash, available lines of credit or other sources of immediately available funds to pay in cash the Purchase Price for the Shares in accordance with the terms of Article II and any other amounts to be paid by it hereunder. Section 5.4. Noncontravention. Neither the execution and delivery of this Agreement by Buyer, nor the consummation by Buyer of the transactions contemplated hereby or the performance by Buyer of its obligations hereunder and under the Transaction Documents will (i) violate, conflict with or result in a breach or default under any provision of the organizational documents of Buyer, or (ii) violate, conflict, result in a breach of or default under, give rise to any notification or Consent requirement or any right of termination, cancellation, payment or acceleration under or result in the creation of any Lien (other than Permitted Liens) upon the properties or assets of Buyer under any material agreement, contract, lease, license, instrument or other arrangement to which Buyer or any of its Affiliates is a party or by which any of their respective properties are bound, or (iii) subject to compliance with the HSR Act, violate any Law to which Buyer or any of its Subsidiaries is subject, except, in the case of clauses (ii) and (iii), for such violations or breaches which would not, individually or in the aggregate, have a Material Adverse Effect on Buyer. Section 5.5. Government Authorizations. Except for required filings under the HSR Act, no Consent of, with or to any Governmental Authority is required to be obtained or made by or with respect to Buyer or any of its Subsidiaries or Affiliates in connection with the execution, delivery and performance of this Agreement and the other Transaction Documents to which it is party by Buyer or the consummation by Buyer of the transactions contemplated hereby and thereby. Section 5.6. Litigation. There are no Actions pending or, to Buyer's Knowledge, threatened in law or in equity or before any Governmental Authority against Buyer or any of its Affiliates which would have, individually or in the aggregate, a Material Adverse Effect on Buyer, and there are no outstanding injunctions, judgments, orders, decrees, rulings, or charges to which Buyer or any of its Affiliates is a party or by which it is bound by or with any Governmental Authority which would have, individually or in the aggregate, a Material Adverse Effect on Buyer. Section 5.7. Brokers' Fees. None of Buyer or any of its Affiliates has any contract or other arrangement or understanding (written or oral, express or implied) with any Person which may result in the obligation of Seller or any of its Affiliates (other than any obligations of the Company Group after the Closing Date), or prior to Closing the Company or any of its Affiliates, to pay any fees, commissions or other compensation to any broker or finder or Person providing comparable or similar services as a result of the execution and delivery of this Agreement or the consummation of the transactions contemplated by this Agreement. 38 Section 5.8. Investment. Buyer is aware that the Shares being acquired by Buyer pursuant to the transactions contemplated hereby have not been registered under the Securities Act or under any state securities Laws. Buyer qualified as an "accredited investor" as such terms is defined in Rule 501(a) promulgated under the Securities Act, and Buyer is purchasing the Shares solely for investment and not with a view toward, or for sale in connection with, any distribution thereof within the meaning of the Securities Act, nor with any present intention of distributing or selling any of the Shares. Buyer and its Subsidiaries and Affiliates will not sell or otherwise dispose of the Shares except in compliance with the registration requirements or exemption provisions under the Securities Act and the rules and regulations promulgated thereunder, or any other applicable securities Laws. Buyer has knowledge, experience and expertise in business and financial matters and has the capability of understanding and evaluating the risks and merits associated with transactions contemplated by this Agreement. Section 5.9. Information. Seller and the Company Group have provided Buyer with such access to the facilities, books, records and personnel of each member of the Company Group and Affiliates as Buyer has deemed necessary and appropriate in order for Buyer to investigate to its satisfaction the business and properties of each member of the Company Group and Affiliates sufficiently to make an informed investment decision to purchase the Shares and to enter into this Agreement. Buyer agrees to accept the Shares on the Closing Date based upon its own investigation, examination and determination with respect thereto as to all matters and without reliance upon any express or implied representations or warranties of any nature made by or on behalf of or imputed to Seller, except as expressly set forth in this Agreement. Article VI. COVENANTS Section 6.1. Conduct of the Company. (a) Seller covenants and agrees that, except (i) as otherwise expressly permitted or required by this Agreement (including as described in Section 6.1 of the Disclosure Schedule and the other matters expressly set forth in the other Schedules and Exhibits hereto) and the other Transaction Documents, (ii) required by any change in applicable Law, (iii) as necessary or desirable for Seller to effectuate the retention of the Excluded Assets (through reorganization, disposition or otherwise) or (iv) as otherwise approved in writing by Buyer, during the period commencing on the date hereof and ending on the Closing Date, Seller will cause the Company to use commercially reasonable efforts to conduct the business of the Company Group in the ordinary course, to keep available the services of the officers and key employees of the Company Group and to maintain and preserve intact the business, organizations and relationships with customers, suppliers and others having business relationships with the Company Group in all material respects in order to preserve for Buyer to and after the Closing Date the business of the Company Group (it being understood that such efforts will not include any requirement or obligation to pay any consideration not otherwise required to be paid by the terms of an existing agreement or offer or grant any financial accommodation or other benefit not otherwise required to be made by the terms of an existing agreement). 39 (b) Until the Closing, Seller covenants and agrees that except (i) as otherwise contemplated by this Agreement (including as described in Section 6.1 of the Disclosure Schedule and the other matters contemplated by the other Schedules and Exhibits hereto) and the other Transaction Documents, (ii) required by any change in applicable Law, (iii) as necessary or desirable for Seller to effectuate the retention of the Excluded Assets (through reorganization, disposition or otherwise) or (iv) otherwise approved in writing by Buyer (which approval shall not be unreasonably withheld or delayed), Seller will cause each member of the Company Group not to take any of the following actions: A. (1) amend its certificate of formation, limited liability company agreement, certificate of incorporation, bylaws, partnership agreement or operating agreement, as applicable; or (2) authorize for issuance, issue, grant, sell, deliver, dispose of, pledge or otherwise encumber any shares of its capital stock or issue any Rights to subscribe for or acquire any shares of its capital stock; B. declare, set aside, pay or make any dividend or other distribution with respect to its shares of capital stock or any other payment to Seller or any Affiliate of Seller; C. except as required by GAAP, change any accounting methods, principles or practices; D. sell, transfer, lease or otherwise dispose of or encumber any of the material tangible assets or material properties pertaining to the business of the Company Group with a value in excess of $1,000,000 in each case or having an aggregate value of $5,000,000, other than the sale of inventory in the ordinary course of business; E. settle or knowingly compromise any litigation (whether or not commenced prior to the date of this Agreement), other than settlements involving amounts payable by the Company and its Subsidiaries that are not in excess of $250,000 in the aggregate or settlements that require satisfaction of monitoring or reporting obligations to any Governmental Authority in the ordinary course of business; F. amend in any respect, or enter into any new, contract or agreement with any labor unions representing employees of the Company or any Subsidiary; G. other than in the ordinary course of business, enter into or materially amend, modify, renew or terminate any Material Contract (or an agreement that would constitute a Material Contract if in effect on the date hereof), including any transaction involving any merger, consolidation, joint venture, license agreement, partial or complete liquidation or dissolution, reorganization, recapitalization, restructuring, or a purchase, sale, lease or other acquisition or disposition of any assets or capital stock; H. permit any of the member(s) of the Company Group to (1) create, incur or assume any material indebtedness for borrowed money other than borrowings under the Company's existing revolving line of credit and the incurrence of trade payables, in each case, in the ordinary course of business, (2) voluntarily assume, guarantee, endorse or otherwise voluntarily become liable or responsible (whether directly, contingently or otherwise) for any material obligations of any Person other than another member of the Company Group, (3) make 40 any loans or advances of cash or cash equivalents to any Person, other than any member of the Company Group that is not a Person included in the Excluded Assets, other than in the ordinary course of business, or (4) make any capital contributions to or equity investments in any Person other than any member of the Company Group; I. cancel any material third party indebtedness owed to any member of the Company Group or in a manner that would give rise to any material Liability of any member of the Company Group; J. (1) grant of any bonus, deferred compensation, material severance, retention or termination pay with a value in excess of $250,000 in the aggregate (other than pursuant to policies or agreements of any member of the Company Group in effect on the date hereof which have been disclosed to Buyer in the schedules hereto which are made without violating Section 409A of the Code) except as otherwise required by Law; (2) make any material change in the key management structure of the Company Group, including the hiring of additional officers or the termination of existing officers; (3) grant any increase in the base compensation or bonus opportunity of any director, officer or employee other than normal increases in base compensation or bonus opportunity consistent with past practices for employees who are not officers or (4) adopt, enter into or amend (or promise to adopt, enter into or amend) any Company Plan other than as required by Law, pursuant to policies or agreements of any member of the Company Group in effect on the date hereof which have been disclosed to Buyer in the schedules hereto, as described in Section 6.11 hereof, as would not reasonably be expected to result in an increase in the amount of Liability under any Company Plan of more than $250,000 or as would make the representations and warranties made by Seller in Section 3.8(k) untrue; K. impose any Liens upon any asset, tangible or intangible other than Permitted Liens; L. cancel, knowingly compromise, waive or release any valid right or claim of a member of the Company Group involving more than $250,000; M. other than in the ordinary course of business, (1) amend, modify, extend, renew or terminate any Real Property Lease; or (2) enter into any new lease, sublease, license or other agreement for the use or occupancy of any real property, in either case, requiring rental and other payments in excess of $250,000 annually as averaged over the term thereof; N. other than in the ordinary course of business, (1) abandon, fail to maintain or use commercially reasonable efforts to protect and defend in a manner consistent with past practice any Company Intellectual Property, or (2) license, sublicense, assign, sell or otherwise transfer any Company Intellectual Property, that, in the case of each of subsections (1) and (2), is either individually or in the aggregate material to the business of the Company Group as currently conducted; O. enter into any contract or agreement that contains a material covenant not to compete or materially restricts its rights to freely engage in business applicable to a member of the Company Group or any Affiliate of a member of the Company Group by virtue of such affiliation; 41 P. agree with any third party, whether in writing or otherwise, to do any of the foregoing; or Q. make any new Tax election or change any Tax election, change any method of accounting or accounting period, settle any Tax claim or assessment relating to any member of the Company Group, enter into any closing agreement, surrender any right to claim for refund of Tax, Consent to any extension or waiver of the limitation period applicable to any Tax claim or assessment relating to any member of the Company Group, or any other similar action relating to the filing of any Tax Return or payment of any Tax, if such election, adoption, change, amendment, agreement, settlement, surrender, Consent or other action would reasonably be expected to have the effect of materially increasing the Tax Liability of a member of the Company Group for any period ending after the Closing Date or materially decreasing any Tax attribute of a member of the Company Group existing on the Closing Date; provided that nothing in this Section 6.1(b)Q shall prohibit anything contemplated by this Agreement, including, without limitation the Reorganization. Section 6.2. Access to Information. Prior to the Closing Date, or, if earlier, the date this Agreement is terminated pursuant to Section 10.1, Buyer may make or cause to be made such investigation of the Company Group and of its financial and legal condition as Buyer deems reasonably necessary or advisable. Seller shall, and shall cause the Company Group to, permit Buyer and its authorized agents or representatives, including its independent accountants, to have reasonable access to the properties, books and records of the Company Group during normal business hours to review information and documentation relative to the properties, books, contracts, commitments and other records of the Company Group; provided that such investigation shall only be upon reasonable notice and shall not unreasonably disrupt personnel and operations of the business of the Company Group and shall be at Buyer's sole cost and expense; provided, further, that (i) neither Buyer, nor any of its Affiliates or representatives, shall conduct any environmental site assessment, compliance evaluation or investigation with respect to any member of the Company Group without prior consultation with Seller and without ongoing consultation with Seller with respect to any such activity (it being understood and agreed that in no event shall any subsurface investigation or testing of any environmental media be conducted) and (ii) Seller shall, and shall cause the Company Group to, make available to Buyer all information and reports relating to any such activity conducted in connection with the Reorganization. All requests for access to the offices, properties, books and records of the Company Group shall be made to such representatives of Seller as Seller shall designate, who shall be solely responsible for coordinating all such requests and all access permitted hereunder. It is further agreed that neither Buyer nor its representatives shall contact any of the employees, customers, suppliers, parties that have business relationships with or are joint venture partners of any member of the Company Group or any of their respective Affiliates in connection with the transactions contemplated hereby, whether in person or by telephone, mail or other means of communication, without the specific prior authorization of such representatives of Seller, such authorizations not to be unreasonably withheld or delayed. Any access to the offices, properties, books and records of the Company Group shall be subject to the following additional limitations: (a) such access shall not violate any Law or agreement to which Seller or any member of the Company Group is a party or otherwise expose Seller or any member of the Company Group to a 42 material risk of Liability; (b) Buyer shall give Seller notice of at least two (2) Business Days before conducting any inspections or communicating with any third party relating to any property of the Company Group, and a representative of Seller shall have the right to be present when Buyer or its representatives conducts its or their investigations on such property; and (c) none of Buyer or its representatives shall damage the property of the Company Group or any portion thereof. Section 6.3. Commercially Reasonable Efforts. Subject to the terms and conditions of this Agreement and applicable Law, each of the Parties hereto shall use its commercially reasonable efforts to take, or cause to be taken, all actions, and to do, or cause to be done, all things reasonably necessary, proper or advisable under applicable Laws and regulations or otherwise to consummate and make effective the transactions contemplated by this Agreement as soon as practicable, including such actions or things as any other Party hereto may reasonably request in order to cause any of the conditions to such other Party's obligation to consummate such transactions specified in Article VII to be fully satisfied. Without limiting the generality of the foregoing, the Parties shall (and shall cause their respective directors, officers and Subsidiaries to, and use their commercially reasonable efforts to cause their respective Affiliates, employees, agents, attorneys, accountants and representatives to) consult and fully cooperate with and provide reasonable assistance to each other in (i) obtaining all necessary Consents or other permission or action by, and giving all necessary notices to and making all necessary filings, meetings or appearances with and applications and submissions to, any Governmental Authority or other Person, (ii) lifting any permanent or preliminary injunction or restraining order or other similar order issued or entered by any court or Governmental Authority (an "Injunction") of any type referred to in Section 7.1(a) and (iii) in general, consummating and making effective the transactions contemplated hereby. Buyer and its Affiliates shall not enter into or complete any transactions that could reasonably be expected to delay, hinder or prohibit the consummation of the transactions contemplated hereby, including causing the failure of the closing conditions set forth in Article VII to be satisfied. Notwithstanding the foregoing, each Party hereby agrees to use its commercially reasonable best efforts to obtain the consent of the holders of the 9.25% Notes for the consummation of and to otherwise cause the reorganization to occur as contemplated by Section 6.11. Section 6.4. HSR Act Compliance; Government Approvals. (a) Buyer and Seller shall timely and promptly cause to be made all filings which may be required for the satisfaction of the closing condition set forth in Section 7.1(b) by each of them and their respective Affiliates in connection with the consummation of the transactions contemplated hereby. In furtherance and not in limitation of the foregoing, each of the Parties agrees to use its commercially reasonable efforts to file, and to cause each of their Affiliates to file in conjunction with such party, Notification and Report Forms under the HSR Act and similar applications with any other applicable Governmental Authority whose Law requires notification in connection with the consummation of the purchase by Buyer of the Shares as promptly as practicable following the date of this Agreement. Seller and Buyer agree, and shall cause each of their respective Subsidiaries and Affiliates, to (i) request in their respective Notification and Report Forms under the HSR Act for early termination of the waiting period under the HSR Act and (ii) to cooperate and to use their respective commercially reasonable efforts to obtain any governmental Consent required for the Closing (including through 43 compliance with the HSR Act, to respond to any governmental requests for information, and to contest and resist any Action, including any legislative, administrative or judicial Action, and to have vacated, lifted, reversed or overturned any decree, judgment, Injunction or other order (whether temporary, preliminary or permanent) that restricts, prevents or prohibits the consummation of the transactions contemplated by this Agreement, including by vigorously pursuing all available avenues of administrative and judicial appeal and all available legislative action). Notwithstanding anything contained herein to the contrary, no Party or any of their respective Affiliates shall be required to divest any assets in connection with this Section 6.4 generating annual revenues in excess of $35,000,000 or to defend any Action that would require any such divestiture. Each Party shall furnish to the other Party such necessary information and assistance as such other Party may reasonably request in connection with the preparation of any necessary filings or submissions by it to any Governmental Authority referred to in Section 7.1(b). Without in any way limiting the foregoing, the Parties will consult and cooperate with one another, and consider in good faith the views of one another, in connection with any analyses, appearances, presentations, memoranda, briefs, arguments, opinions and proposals made or submitted by or on behalf of any Party in connection with proceedings under or relating to the HSR Act. (b) Each of the Parties shall notify and keep the other Party advised as to (i) any material communication from the Federal Trade Commission, the United States Department of Justice or any other Governmental Authority regarding any of the transactions contemplated hereby and (ii) any Action pending and known to such Party, or to its knowledge threatened, which challenges the transactions contemplated hereby. Subject to the provisions of Article X, Seller and Buyer shall not take any action inconsistent with their obligations under this Agreement or, without prejudice to Buyer's rights under this Agreement, which would materially hinder or delay the consummation of the transactions contemplated by this Agreement. (c) Buyer shall pay all of the filing fees associated with the HSR Act and any antitrust filings or notifications that may be required in jurisdictions outside of the United States ("International Competition Laws"). Subject to the proviso in Section 6.4(a), Buyer agrees to take any and all steps necessary to avoid or eliminate each and every impediment under the HSR Act or International Competition Laws to enable the transactions contemplated by this Agreement to be consummated as expeditiously as possible, and in no event later than the Expiration Date, including proposing, negotiating, committing to and effecting, by consent decree, hold separate order or otherwise, the sale, divestiture or disposition of such assets or businesses (or otherwise taking or committing to take any action that limits the freedom of action with respect to, or its ability to retain, any businesses, product lines, or assets) as may reasonably be required in order to obtain any merger clearance under the HSR Act or International Competition Laws or to avoid the entry of, or to effect the dissolution of, any injunction, temporary restraining order, or other order in any suit or proceeding by any Governmental Authority or other person, which would otherwise have the effect of preventing the consummation of the transactions contemplated by this Agreement on or before the Expiration Date. Section 6.5. Public Announcements. Except to the extent otherwise required by applicable Law or the listing standards of the New York Stock Exchange (and then only after consultation with Seller), at any time prior to the Closing none of the Parties will issue any press 44 release or make any other public announcements concerning the transactions contemplated hereby or the contents of this Agreement without the prior written consent of the other Party. Following the Closing, either party may issue such press releases and make such public announcements contemplated above without the consent of the other Party hereto, provided each Party will use reasonable efforts to provide the other Party the prior opportunity to review and comment upon such communication. Section 6.6. Notification of Certain Matters. Between the date hereof and the Closing Date, each Party will give prompt written or electronic notice to the other Party after it becomes aware of: (i) any information that indicates that any of the representations or warranties contained herein are not true and correct , (ii) the occurrence or non-occurrence of any event which will result, or has a reasonable prospect of resulting, in the failure of any condition, covenant or agreement contained in this Agreement to be complied with or satisfied, (iii) any failure of Seller or Buyer, as the case may be, to comply with or satisfy any condition, covenant or agreement to be complied with or satisfied by it hereunder, (iv) any notice or other communication from any third party alleging that the Consent of such third party is or may be required in connection with the transactions contemplated by this Agreement or that such transactions otherwise may violate the rights of or confer remedies upon such third party, or (v) any filing or threatened filing of litigation or other matter related to this Agreement in the transaction contemplated hereby. Section 6.7. Post-Closing Access; Preservation of Records. (a) From and after the Closing, Buyer will make or cause to be made available to Seller all books, records, Tax Returns and documents of the Company Group (and the assistance of employees responsible for such books, records and documents or whose participation that Seller determines is otherwise necessary or desirable in connection therewith) during regular business hours as may be reasonably necessary for (i) investigating, settling, preparing for the defense or prosecution of, defending or prosecuting any Action, (ii) preparing reports to stockholders and Government Authorities or (iii) such other purposes for which access to such documents is believed by Seller to be reasonably necessary, including preparing and delivering any accounting or other statement provided for under this Agreement or otherwise, preparing Tax Returns or responding to or disputing any Tax audit; provided, however, that access to such books, records, documents and employees will not interfere with the normal operations of the Company Group and the reasonable out-of-pocket expenses of the Company Group incurred in connection therewith will be paid by Seller. Buyer will cause the Company Group to maintain and preserve all such Tax Returns, books, records and other documents for the greater of (A) seven years after the Closing Date or (B) any applicable statutory or regulatory retention period, as the same may be extended and, in each case, shall offer to transfer such records to Seller at the end of any such period by providing Seller with not less than twenty (20) days written notice of Buyer's intention to destroy or dispose of such records with Seller to exercise its rights to obtain such records within such twenty (20) day period. (b) From and after the Closing, Seller will make or cause to be made available to Buyer all books, records and documents of Seller relating to the business (and the assistance of employees responsible for such books, records and documents) during regular business hours for the same purposes, to the extent applicable, as set forth in Section 6.7(a); provided, however, that access to such books, records, documents and employees will not interfere with the normal 45 operations of Seller and the reasonable out-of-pocket expenses of Seller incurred in connection therewith will be paid by Buyer. Section 6.8. Further Assurances. Seller and Buyer each agree that from time to time after the Closing Date, they will execute and deliver or cause their respective Affiliates (including, with respect to Buyer, the Company Group) to execute and deliver such further instruments, and take (or cause their respective Affiliates, including, with respect to Buyer, the Company Group, to take) such other action, as may be reasonably necessary to carry out the purposes and intents of this Agreement and the other Transaction Documents. Section 6.9. Director and Officer Indemnification. For six (6) years from and after the Closing Date, to the fullest extent permitted by applicable Law, Buyer shall cause the Company Group to, indemnify and hold harmless the officers and directors of any member of the Company Group who held any such position at any time on or prior to the Closing (collectively, "Indemnified Officers") in respect of acts or omission occurring prior to the Closing, and Buyer shall cause the applicable member of the Company Group to, maintain, for six (6) years from and after the Closing, indemnification provisions in its organizational documents that are no less favorable to the Indemnified Officers than those in effect with respect to such member of the Company Group immediately prior to the Closing. Without limiting the foregoing and in connection therewith, the applicable member of the Company Group shall, and Buyer shall cause such member of the Company Group to, periodically advance or reimburse each Indemnified Officer for all reasonable fees and expenses of counsel as such fees and expenses are incurred, subject to the terms of such indemnification provisions and applicable Laws. Buyer shall cause to be obtained and maintained in effect, for a period of six (6) years after the Closing, policies of directors' and officers' liability insurance protecting the Indemnified Officers with coverages and containing terms and conditions (including with respect to deductible, amount and payment of attorneys' fees) that are no less favorable than those in existing policies; provided that in no event shall the Company or any its Subsidiaries be required to pay annual premiums for any such director's and officer's liability policy in excess of 300% of the annual premium of such policy in effect as of the date hereof and if such premiums for comparable coverage would exceed such limit then the Company will obtain the maximum coverage available within such limit. Buyer may, but shall not be obliged to, acquire a six (6) year tail policy for the persons currently covered by the Company's directors' and officers' liability insurance policy that is consistent with the preceding sentence. If acquired, such policy shall be prepaid and non-cancelable. Notwithstanding any other provision of this Agreement to the contrary, each of the Parties agrees that from and after the Closing Date each Indemnified Officer shall be a third party beneficiary under this Agreement for purposes of enforcing this Section 6.9. Section 6.10. Exclusivity. Seller will not and will cause its Affiliates not to (i) solicit, initiate or encourage the submission of any proposal or offer from any person relating to the acquisition of any capital stock or other voting securities, or any portion of the assets (other than the Excluded Assets) of the Company or any Subsidiaries (including any acquisition structured as a merger, consolidation or share exchange), or (ii) participate in any discussions or negotiations regarding, furnish any information with respect to, assist or participate in, or facilitate in any other manner any effort or attempt by any person to do or seek any of the foregoing. Seller will notify Buyer promptly if any person makes any proposal, offer, inquiry or contact with respect to any of the foregoing. Seller and the Company Group shall immediately 46 cease and cause to be terminated any existing activities, discussions or negotiations by Seller, the Company Group or any officer, director or employee of or investment banker, attorney, accountant or other advisor or representative of Seller or the Company Group, with any Persons conducted heretofore with respect to any of the foregoing and, subject to the terms of any applicable confidentiality agreements between such Persons and Seller, the Company Group or their representatives, shall give notice to such Persons to return to the Company Group or destroy any confidential information previously provided to such Persons, and any such Persons shall be denied access to any electronic dataroom or similar access to confidential information relating to the Company Group. Notwithstanding anything to the contrary contained in this Agreement, the Company Group and their officers, directors, employees, investment bankers, attorneys, accountants or other advisors or representatives may solicit proposals, enter into agreements and take any other action necessary or desirable to enable the Company Group to dispose of their interests in each of the Excluded Assets. Section 6.11. Reorganization. (a) Seller and the Company Group shall use their respective commercially reasonable efforts to cause the transactions described in Section 6.11(a) of the Disclosure Schedule, pursuant to which the Excluded Assets will be sold to a third party or distributed to Seller and the Excluded Liabilities will be assumed by such third party or Seller, as the case may be (collectively, the "Reorganization"), to be completed contemporaneously with the Closing substantially in accordance with the terms described in Section 6.11(a) of the Disclosure Schedule and pursuant to documentation, including any required consents that is in form and substance reasonably acceptable to Buyer (such acceptance not to be unreasonably withheld, conditioned or delayed). In the event that the Reorganization cannot be completed as outlined in Section 6.11(a) of the Disclosure Schedule, the Parties shall negotiate in good faith and use their commercially reasonable efforts to agree on an alternative structure that gives effect to the economic intent of the Reorganization or to such other structure or arrangement as the Parties may agree that will result in the Reorganization being consummated and the condition set forth in Section 7.3(g) being satisfied; provided that any such restructuring of the Reorganization shall be, for the avoidance of doubt, subject to the prior written approval of Buyer. In connection with the Reorganization: (i) Seller, the Company and Argo-Tech shall use their respective commercially reasonable efforts to obtain the consent of the requisite percentage of the lenders under the Credit Agreement and the holders of the 9.25% Notes, in each case to the transactions contemplated by the Reorganization and (ii) Seller and the Company shall use their respective commercially reasonable efforts to repurchase on or prior to the Closing Date all of the 11.75% Notes; provided that the costs of any consent, premium, prepayment penalty, breakage cost or other similar costs associated with (i) and (ii) above are to be borne by Buyer and Seller as set forth in Section 11.11. (b) Buyer shall, and shall use commercially reasonable efforts to cause its Subsidiaries and its and their respective officers, employees and representatives to, reasonably assist Seller and the Company Group, when reasonably requested to do so by Seller, in connection with the consummation of the transactions contemplated by this Section 6.11(a)(i) and (ii) and Section 7.3(g); provided that (i) such assistance does not unreasonably interfere with the ongoing business of Buyer and its Subsidiaries and (ii) Seller reimburses the reasonable out of pocket costs incurred by Buyer and its Subsidiaries in connection with such assistance. 47 Section 6.12. Severance and Transaction Bonus Payments. Seller and the Company shall use their respective commercially reasonable efforts to pay, or cause to be paid, the bonuses or severance or other compensation payable to any employees or representatives of the Company Group listed on Section 6.12 of the Disclosure Schedule due and payable as a result of or in connection with the consummation of the transactions contemplated hereby and any termination of employment of such Persons (such payments, the "Bonus Payments"). Section 6.13. Split-Dollar Life Insurance Policy. Seller and the Company Group shall use their respective commercially reasonable efforts to get the employees of the Company Group listed on Section 6.13 of the Disclosure Schedule to agree to the cancellation of their split-dollar life insurance policy arrangements and the replacement thereof with other arrangements reasonably proposed by Buyer. Section 6.14. Pre Closing Financials. Seller shall, and shall cause the Company to, use commercially reasonable efforts to deliver to Buyer as soon as it is reasonably available, the audited consolidated balance sheet of Argo-Tech and its Subsidiaries as of the Balance Sheet Date and the related consolidated statements of operations and cash flows for the fiscal years then ended. When delivered, such financial statements will (x) present fairly and accurately, in all material respects, respectively, the consolidated financial position, statements of operations and cash flows of Argo-Tech and its Subsidiaries at the dates set forth therein and for the periods covered thereby, (y) be prepared in accordance with GAAP, and (z) be consistent with the books and records of Argo-Tech and its Subsidiaries in all material respects. Section 6.15. Cooperation with Davis Litigation and LETS Dispute. (a) With regard to any Action and settlements relating to, arising out of or in connection with the Davis Litigation or the LETS Dispute: (i) Buyer: (A) hereby acknowledges and agrees that Seller shall have exclusive conduct and control relating to the Davis Litigation and the LETS Dispute, including the right to negotiate, settle, compromise, discharge any Liability and make any offer of the foregoing, and Buyer and the Company Group or any of their successors and assigns shall not do any of the foregoing without the prior written consent of Seller or unless requested by Seller to do so; (B) shall promptly provide Seller with all notices, requests, inquiries, minutes of meetings, correspondence, documents, claims, court papers and any other material received which is relevant to the Davis Litigation or the LETS Dispute; and (C) shall not engage in any correspondence, meeting or any other communication with any Person relating to or in connection with the Davis Litigation or the LETS Dispute; and (ii) Buyer shall, and shall cause the Company Group (after completion of the Closing) and their successors and assigns to, at Seller's sole cost and expense, give Seller and its Affiliates all reasonable cooperation and assistance as Seller may request from time to time, including: (A) access to information and records to the extent relevant to the Davis Litigation and the LETS Dispute (in each case, including the right to take copies and, if required, originals and use any such material in any Action or settlement); (B) access to any relevant premises and any computer/information systems; and (C) access to current and (to the extent within their power) former employees of any member of the 48 Company Group; provided that Seller shall reimburse Buyer, the Company Group or their respective Affiliates for all expenses reasonably incurred in complying with this Section, such reimbursement to be on a cost only basis and subject to Buyer providing all necessary evidence and documentation supporting the costs incurred. (b) All information and matters relating to the Davis Litigation and the LETS Dispute, including the requests for cooperation and assistance and the actual cooperation and assistance provided, are strictly confidential. Buyer and each member of the Company Group shall not, and shall cause its respective officers, directors and representatives not to, disclose such confidential information to any third party without the prior written consent of Seller (unless such disclosure is required by applicable Law or legal process). Section 6.16. Support for Indemnification Obligations. (a) The Management Committee of Seller shall amend the Amended and Restated Limited Liability Company Agreement of Seller, dated as of October 28, 2005 (the "LLC Agreement"), to provide that during the Reorganization Taxes Indemnification Period, in the event (i) Seller has distributed to its members any of the Excluded Assets or any proceeds resulting from the sale thereof (an "Excluded Assets Distribution") and (ii) Seller is obligated to provide indemnification to any member of the Buyer Group for any claim for Damages under Article IX of this Agreement but does not have adequate funds to satisfy such obligation, then Seller shall have the right to require each of its members to make a capital contribution to Seller in an aggregate amount equal to the lesser of (A) the amount necessary to satisfy such indemnification obligation or (B) the portion of the value of such Excluded Assets Distribution that were distributed to such member (such provision of the LLC Agreement, the "Giveback Provision"). For the avoidance of doubt, (1) any member's obligation to make any contribution to Seller pursuant to the Giveback Provision will be completely satisfied if such member returns to Seller the Excluded Asset(s) or proceeds thereof distributed to it and (2) no member shall have any liability to Seller or any other Person under the Giveback Provision for any Excluded Assets or proceeds distributed to any other member. Seller hereby agrees that it shall not amend the Giveback Provision without the prior written consent of Buyer. (b) Seller agrees that it shall, until the expiration of the Reorganization Taxes Indemnification Period, either (i) retain the Excluded Assets or the proceeds thereof or (ii) exercise and use its commercially reasonable best efforts to enforce its rights under the Giveback Provision in the event that during such period it does not have sufficient assets to meet its obligation to indemnify any member of the Buyer Group in accordance with Article IX of this Agreement. Section 6.17. 280G Compliance. Prior to Closing, the Company shall use reasonable efforts to obtain the approval by shareholders (in the manner contemplated by Q&A 7 of Treas. Reg. Section 1.280G) of any payments or benefits required to be paid or provided by the Company or its Subsidiaries in connection with the transactions contemplated by this Agreement that the Company determines prior to Closing are "excess parachute payments" within the meaning of Section 280G of the Code, it being understood and agreed that the refusal of any recipient of any such "excess parachute payments" to waive his or her rights to such payment and/or the failure of the Company to sanction any such recipient for such refusal shall not be deemed to violate this Section 6.17. 49 Section 6.18. Insurance Policies. In the event that any insurance policy (i) as set forth in Section 3.13 of the Disclosure Schedule (a "Current Policy") or (ii) that is no longer in effect but under which any member of the Company Group may, notwithstanding the expiration of such policy, seek recovery or recourse from such insurer (an "Expired Policy") is in the name of Seller or any entity included in the Excluded Asset and cannot be assigned to a member of the Company Group, Seller and the Company shall (A) provide comparable replacement policies, providing substantially the same coverage upon substantially the same economic terms as set forth in any such Current Policy and (B) if necessary, (1) assign to the Buyer any rights of Seller to make claims on behalf of the Company Group under any Current Policy or Expired Policy that can not be assigned to a member of the Company Group (a "Nonassignable Policy") or (2) if such rights of Seller cannot be assigned, at the sole expense of Buyer or the Company Group, make such claims and/or take such other actions with respect to such Nonassignable Policies on behalf of the Company Group as the Buyer or Company Group may reasonably request. Article VII. CONDITIONS TO CLOSING Section 7.1. Conditions Precedent to Obligations of Buyer and Seller. The respective obligations of each Party to consummate the transactions contemplated by this Agreement are subject to the satisfaction (or, where legally permissible, waiver by such Party in writing) at or prior to the Closing Date of each of the following conditions: (a) No Adverse Order. There shall be no Injunction, restraining order or decree of any nature of any Governmental Authority of competent jurisdiction that is in effect that restrains in any material respect or prohibits the consummation of the transactions contemplated hereby. (b) Antitrust Authorizations. All applicable waiting periods (and any extensions thereof) under any Laws (including the HSR Act) shall have expired or been terminated. Section 7.2. Conditions Precedent to Obligation of Seller. The obligation of Seller to consummate the transactions contemplated by this Agreement is subject to the satisfaction (or waiver by Seller) at or prior to the Closing Date of each of the following additional conditions: (a) Accuracy of Buyer's Representations and Warranties. The representations and warranties of Buyer contained in this Agreement, disregarding all qualifications contained herein relating to materiality or Material Adverse Effect, shall be true and correct, in each case on and as of the date hereof and as of the Closing Date, except to the extent that the failure of such representations and warranties to be true and correct would not, individually or in the aggregate, constitute a Material Adverse Effect on Buyer; and Seller shall have received a certificate signed by a duly authorized officer of Buyer confirming the foregoing as of the Closing Date. (b) Covenants and Agreements of Buyer. Buyer shall have performed and complied with all of its covenants and agreements hereunder in all material respects 50 through the Closing; and Seller shall have received a certificate signed by a duly authorized officer of Buyer confirming the foregoing as of the Closing Date. (c) Closing Documents. On or prior to the Closing Date, Buyer shall have delivered the Purchase Price and all agreements, instruments and documents required to be delivered by Buyer under Section 2.6(b). Section 7.3. Conditions Precedent to Obligations of Buyer. The obligation of Buyer to consummate the transactions contemplated by this Agreement is subject to the satisfaction (or waiver by Buyer) at or prior to the Closing Date of each of the following additional conditions: (a) Accuracy of the Seller's Representations and Warranties. The representations and warranties of Seller contained in this Agreement, disregarding all qualifications contained herein relating to materiality or Material Adverse Effect, shall be true and correct, in each case on and as of the date hereof and as of the Closing Date, except to the extent that the failure of such representations and warranties to be true and correct would not, individually or in the aggregate constitute a Material Adverse Effect on the Company Group; and Buyer shall have received a certificate from Seller signed by a duly authorized officer of Seller and a duly authorized officer of the Company confirming the foregoing as of the Closing Date. (b) Covenants and Agreements of Seller. Seller shall have performed and complied with all of its covenants and agreements hereunder in all material respects through the Closing; and Buyer shall have received a certificate from Seller signed by a duly authorized officer of Seller confirming the foregoing as of the Closing Date. (c) Closing Documents. On or prior to the Closing Date, Seller shall have delivered all agreements, instruments and documents required to be delivered by Seller pursuant to Section 2.6(a). (d) Material Adverse Effect. There shall not have occurred since the date hereof any Material Adverse Effect on the Company Group or any change, event or effect that would have a Material Adverse Effect on the Company Group, in each case taking into account any adverse changes in the financial performance or results of the Company Group as reflected in the audited consolidated balance sheet of Argo-Tech and its Subsidiaries as of the Balance Sheet Date and the related consolidated statements of operations and cash flows for the fiscal year then ended when compared to the unaudited consolidated balance sheet of Argo-Tech and its Subsidiaries as of the Balance Sheet Date and the related consolidated statements of operations and cash flows for the fiscal year then ended included in the Unaudited Financial Statements. (e) Consents and Approvals. All Consents listed in Section 7.3(e) of the Disclosure Schedule shall have been received, in form and substance reasonably satisfactory to Buyer. (f) Payoff Letters. The Company shall have delivered to Buyer executed receipts, payoff letters or similar documents executed by the Company Group's lenders 51 under all agreements and arrangements evidencing the repayment of Indebtedness identified on Section 7.3(f) of the Disclosure Schedule and the release of all Liens against the Company Group's assets existing in respect thereof, each in form and substance reasonably satisfactory to Buyer. (g) Reorganization. The Reorganization shall have been consummated substantially in accordance with the terms described in Section 6.11(a) or on such other terms as the Parties may agree in accordance with the terms hereof. (h) Company Plan Transfer. Each Company Plan that is sponsored or maintained by an entity that is an Excluded Asset shall have been transferred to a member of the Company Group, such that, as of the Closing, eligible current and former employees of the Company Group (and their eligible beneficiaries) shall participate in employee benefit plans sponsored by a member of the Company Group. The Company Plans shall have been amended, as necessary, to effectuate such transfer. (i) Stock Options. Seller shall have caused the exercise of, or otherwise terminated, all outstanding options to purchase Shares. (j) LLC Agreement. The LLC Agreement shall have been amended, in form and substance reasonably satisfactory to Buyer, to implement the Giveback Provision. (k) Audited Argo-Tech Financials. Seller shall have delivered to Buyer, prior to the Closing but in any event at least 5 Business Days prior to the Closing Date, the audited consolidated balance sheet of Argo-Tech and its Subsidiaries as of the Balance Sheet Date and the related consolidated statements of operations and cash flows for the fiscal year then ended, together with the audit report of Deloitte and Touche thereon. Article VIII. LIMITATIONS Section 8.1. Waiver of Damages. Notwithstanding anything to the contrary contained in this Agreement, Seller and Buyer agree that (i) the recovery by any Party of any Damages suffered or incurred by such Party as a result of any breach by the other Party of any of its obligations under this Agreement shall be limited to the actual damages suffered or incurred by such Party as a result of the breach by the breaching Party of its obligations hereunder and (ii) in no event shall any Party have any Liability to any other Party except (A) if there is a Closing, as expressly provided in Article IX and (B) if there is no Closing, for Damages incurred or suffered by such Party for any breach by the other Party of an obligation or covenant or willful breach of a representation or warranty contained in this Agreement to the extent such breach resulted in the failure of the Closing to occur, subject to any other express limitations set forth in this Agreement. Section 8.2. Consequential Damages. Notwithstanding anything contained herein to the contrary and in furtherance of and without limiting the foregoing, but subject to Article X, no member of the Seller Group and no member of Buyer Group will be entitled, after the Closing, to any recovery under this Agreement for its own special, exemplary, punitive, 52 consequential, incidental or indirect damages or lost profits (including any Damages on account of lost opportunities); provided, however, that nothing herein shall prevent any member of the Seller Group or Buyer Group from being indemnified pursuant to Article IX for all components of awards against them in claims by third parties for which indemnification is provided pursuant to Article IX, including special, exemplary, punitive, consequential, incidental or indirect damages or lost profits components of such claims. Article IX. INDEMNIFICATION Section 9.1. General Indemnification by Seller. Following the Closing and subject to the terms and conditions of this Article IX, Seller will indemnify, defend and hold harmless the Buyer, its Affiliates and each of their respective employees, directors and officers (collectively, the "Buyer Group") from and against any and all Damages actually incurred by any member of Buyer Group based upon or arising out of: (i) any breach of any Surviving Covenant of Seller contained in this Agreement; (ii) any breach of any of Seller's representations and warranties contained in (A) Section 3.3 (Title to Shares), Section 3.4(b) (Subsidiaries of the Company; Capitalization) solely to the extent such representations and warranties relate to the capital stock and other equity interests of the members of the Company Group and Section 3.18 and Section 4.4 (Broker's Fees) (the "Fundamental Representations") or (B) Section 3.1 (Organization), Section 3.2 (Noncontravention), Section 3.4(a) and (c) (Subsidiaries of the Company; Capitalization), Section 3.5 (Governmental Authorizations), Section 3.6 (Financial Statements; Securities Filings), Section 3.7 (Absence of Certain Changes), Section 3.8 (Tax Matters), Section 3.10 (Intellectual Property), Section 3.11(a)(v)(B) (Environmental Matters), Section 3.12 (Contracts), Section 3.13 (Insurance), Section 3.14 (Litigation), Section 3.15 (Employee Matters), Section 3.16 (Legal Compliance), Section 3.17 (Licenses and Permits), Section 3.19 (No Undisclosed Liabilities), Section 3.20 (Internal Controls and Procedures), Section 3.21 (Transactions with Affiliates), Section 3.22 (Customers and Suppliers), Section 3.23 (Warranties), Section 3.24 (Government Contracts), Section 3.25 (Compliance, Performance, Termination and Breach of Government Contracts), Section 3.26 (Internal Controls, Audits and Investigations), Section 3.27 (Debarment, Suspension and Exclusion), and Section 3.28 (Absence of Unlawful Payments) and Section 3.29 (No Undisclosed Liabilities of Carter Ground Fueling, Ltd.) (such representations, together with the Fundamental Representations, the "Seller's Surviving Representations"); (iii) the Excluded Liabilities; and (iv) any Reorganization Taxes in excess of the amount shown on the Final Reorganization Taxes Statement. Section 9.2. General Indemnification by Buyer. Following the Closing and subject to the terms and conditions of this Article IX, Buyer will indemnify, defend and hold 53 harmless Seller, its Affiliates and each of their respective employees, directors and officers (collectively, the "Seller Group") from and against, any and all Damages actually incurred by any member of the Seller Group based upon or arising out of (i) any breach of any Surviving Covenant of Buyer contained in this Agreement or (ii) any breach of Buyer's representations and warranties contained in Article V (the "Buyer's Surviving Representations", and, together with the Seller's Surviving Representations, the "Surviving Representations"). Any party providing indemnification pursuant to this Article IX is referred to herein as an "Indemnifying Party", and any member of Buyer Group or Seller Group seeking indemnification pursuant to this Article IX is referred to herein as an "Indemnified Party". Section 9.3. Certain Limitations. (a) Notwithstanding anything contained herein to the contrary, the maximum aggregate Liability of Seller to all members of Buyer Group (i) for indemnification pursuant to Sections 9.1(i) and (ii), excluding claims based upon or arising out of a breach of the Fundamental Representations, taken together with any and all Damages under this Agreement, shall be limited to the amount equal to $22,500,000 and (ii) for indemnification pursuant to Section 9.1(iii), taken together with any and all Damages under this Agreement, shall be limited to the Purchase Price actually paid to Seller. (b) Notwithstanding anything contained in this Agreement to the contrary, no member of the Buyer Group shall be entitled to indemnification under this Agreement, and Seller shall not be liable, with respect to any of the Buyer Group's Damages in respect of Buyer's Indemnifiable Claims pursuant to Section 9.1(ii), excluding claims based upon or arising out of a breach of the Fundamental Representations, (collectively, "Basket Damages"), unless (i) in the case of any particular Indemnifiable Claim, the amount of the Buyer Group's Damages with respect to such Indemnifiable Claim exceeds $100,000 (the "De Minimis Amount") and (ii) the aggregate amount of all Basket Damages that exceed the De Minimis Amount exceeds $2,250,000 (the "Threshold Amount"), at which point the Seller shall be liable for the entire aggregate amount of Basket Damages after such thresholds have been reached; provided that, in the case of any Indemnifiable Claim relating to a breach of Section 3.29 the De Minimis Amount shall not apply and the Threshold shall be $100,000; provided further that in the case of any Indemnifiable Claim relating to a breach of Section 3.8(k) the De Minimis Amount and the Threshold shall not apply (provided that no member of the Buyer Group shall be entitled to indemnification relating to a breach of Section 3.8(k) to the extent that the non-deductibility of the payment under Section 280G of the Code that is the subject matter of the Indemnifiable Claim has been taken into account in the calculation of Working Capital). (c) The amount which an Indemnifying Party is or may be required to pay to an Indemnified Party in respect of Damages for which indemnification is provided under this Agreement will be reduced by any amounts actually received (including amounts received under insurance polices) by or on behalf of the Indemnified Party from third parties and any Tax benefit available to any such Indemnified Party or its Affiliates arising in connection with the accrual, incurrence or payment of any such Damages (such amounts and benefits are collectively referred to herein as "Indemnity Reduction Amounts"). For purposes of this Agreement, a Tax benefit shall be deemed to have been realized at the time any refund of Taxes is received or applied against other Taxes due, or at the time of filing of a Tax Return (including any relating to estimated Taxes) on which a loss, deduction or credit is applied in reduction of Taxes which 54 would otherwise be payable; provided, however, that where a party has other losses, deductions, credits or similar items available to it, deductions, credits or items for which the other party would be entitled to a payment under this Agreement shall be treated as the last items utilized to produce a Tax benefit. If any Indemnified Party receives any Indemnity Reduction Amounts in respect of an Indemnified Claim for which indemnification is provided under this Agreement after the full amount of such Indemnified Claim has been paid by an Indemnifying Party or after an Indemnifying Party has made a partial payment of such Indemnified Claim and such Indemnity Reduction Amounts exceed the remaining unpaid balance of such Indemnified Claim, then the Indemnified Party will promptly remit to the Indemnifying Party an amount equal to the excess (if any) of (i) the amount theretofore paid by the Indemnifying Party in respect of such Indemnified Claim, less (ii) the amount of the indemnity payment that would have been due if such Indemnity Reduction Amounts in respect thereof had been received before the indemnity payment was made. An insurer or other third party who would otherwise be obligated to pay any claim shall not be relieved of the responsibility with respect thereto or, solely by virtue of the indemnification provisions hereof, have any subrogation rights with respect thereto, it being expressly understood and agreed that no insurer or any other third party shall be entitled to any benefit they would not be entitled to receive in the absence of the indemnification provisions by virtue of the indemnification provisions hereof. Seller and Buyer, as appropriate, will, or will cause each Indemnified Party to, use its commercially reasonable efforts to pursue promptly any claims or rights it may have against all third parties which would reduce the amount of Damages for which indemnification is provided under this Agreement. (d) Each and every representation and warranty of Seller or Buyer contained in this Agreement other than the Surviving Representations shall expire with the consummation of the sale of the Shares and shall not survive the Closing; and none of Seller, any member of the Company Group or Buyer shall have any Liability whatsoever with respect to any such representations and warranties thereafter. The Fundamental Representations shall survive the Closing Date until the two year anniversary of the Closing Date; the Surviving Representations (other than the Fundamental Representations and the representations and warranties contained in Section 3.29) shall survive the Closing Date until the later of (i) the one year anniversary of the Closing Date and (ii) March 31, 2008; and representations and warranties contained in Section 3.29 shall survive the Closing Date until the 18 month anniversary of the Closing Date; and, in each case, none of Seller, any member of the Company Group or Buyer shall have any Liability whatsoever with respect thereto thereafter. Each and every covenant contained in this Agreement (other than the covenants which by their terms are to be performed by either of the Parties following Closing (collectively, the "Surviving Covenants")) shall expire with the consummation of the sale of the Shares and shall not survive the Closing; and none of the Seller, any member of the Company Group or Buyer shall have any Liability whatsoever with respect to any such covenant thereafter. The Surviving Covenants will survive the Closing Date until, and will expire when, in each case, the applicable statute of limitations has expired. The indemnification obligation set forth in Section 9.1(iv) shall survive until the 60th day following the expiration of the applicable statute of limitations (such period from the Closing Date, the "Reorganization Taxes Indemnification Period"). Unless this Agreement is terminated prior to Closing, this Section 9.3(d) will survive until the last of the Surviving Representations and Surviving Covenants will expire. 55 (e) The obligations of each Party to indemnify, defend and hold harmless the other Party and other Persons pursuant to this Article IX shall terminate with respect to Sections 9.1 and 9.2 upon the expiration of the applicable survival periods as set forth in Section 9.3(d). (f) Notwithstanding anything contained in this Agreement, any amounts payable pursuant to the indemnification obligations under Section 6.9 and Article IX shall be paid without duplication, and in no event shall any Party be indemnified under different provisions of this Agreement for the same Damages. (g) Seller shall not be entitled to claim that any Indemnification Claim by any member of the Buyer Group is or has been released, waived or otherwise barred, in whole or in part, by any waiver, release or indemnity granted by Seller or any of its Affiliates to Ernst & Young, Deloitte and Touche or any other professional advisor engaged by Seller or any of its Affiliates in connection with the transactions contemplated by this Agreement. Seller shall not pursue any claim against Ernst & Young, Deloitte and Touche or any other professional advisor engaged by Seller or any of its Affiliates in connection with the transactions contemplated by this Agreement in response to any Indemnified Claim made by any member of the Buyer Group. Section 9.4. Indemnification Procedures. (a) If any claim or demand is made against an Indemnified Party with respect to any matter, or any Indemnified Party shall otherwise learn of an assertion or of a potential claim, by any Person who is not a Party (or an Affiliate thereof) (a "Third Party Claim") which may give rise to a claim for indemnification against an Indemnifying Party under this Agreement, then the Indemnified Party shall notify the Indemnifying Party in writing and in reasonable detail of the Third Party Claim within five (5) business days (including the factual basis for the Third Party Claim, and, to the extent known, the amount of the Third Party Claim); provided, however, that no delay on the part of the Indemnified Party in notifying the Indemnifying Party will relieve the Indemnifying Party from any obligation hereunder unless (and then solely to the extent) the Indemnifying Party is actually prejudiced as a result thereof (except that the Indemnifying Party will not be liable for any expenses incurred during the period in which the Indemnified Party failed to give such notice); it being understood and agreed that the failure of the Indemnified Party to so notify the Indemnifying Party prior to settling a Third Party Claim (whether by paying a claim or executing a binding settlement agreement with respect thereto) or the entry of a judgment or issuance of an award with respect to a Third Party Claim shall constitute actual prejudice to the Indemnifying Party's ability to defend against such Third Party Claim. Thereafter, the Indemnified Party will deliver to the Indemnifying Party, promptly after the Indemnified Party's receipt thereof, copies of all notices and documents (including court papers) received or transmitted by the Indemnified Party relating to the Third Party Claim. (b) The Indemnifying Party will have the right to participate in or to assume the defense of the Third Party Claim (in either case at the expense of the Indemnifying Party) with counsel of its choice reasonably satisfactory to the Indemnified Party. The Indemnifying Party will be liable for the reasonable fees and expenses of counsel employed by the Indemnified Party for any period during which the Indemnifying Party has failed to assume the defense thereof (other than during any period in which the Indemnified Party shall have failed to give notice of the Third Party Claim as provided above following a reasonable period of time to 56 provide such notice). Should the Indemnifying Party so elect to assume the defense of a Third Party Claim, the Indemnifying Party will not be liable to the Indemnified Party for any legal or other expenses subsequently incurred by the Indemnified Party in connection with the defense thereof; provided, however, that if the Parties reasonably agree that a conflict of interest exists in respect of such claim, such Indemnified Party will have the right to employ separate counsel reasonably satisfactory to the Indemnifying Party to represent such Indemnified Party and in that event the reasonable fees and expenses of such separate counsel (but not more than one separate counsel for all Indemnified Parties) shall be paid by such Indemnifying Party. If the Indemnifying Party is conducting the defense of the Third Party Claim, the Indemnified Party, at its sole cost and expense, may retain separate counsel, and participate in the defense of the Third Party Claim, it being understood that the Indemnifying Party will control such defense subject to the limitations set out in this Section 9.4. (c) No Indemnifying Party will consent to any settlement, compromise or discharge (including the consent to entry of any judgment) of any Third Party Claim without the Indemnified Party's prior written consent (which consent will not be unreasonably withheld or delayed); provided, that if the Indemnifying Party assumes the defense of any Third Party Claim, the Indemnified Party will agree to any settlement, compromise or discharge of such Third Party Claim which the Indemnifying Party may recommend and which by its terms obligates the Indemnifying Party to pay the full amount of Damages in connection with such Third Party Claim and unconditionally releases the Indemnified Party completely from all Liability in connection with such Third Party Claim and provided that such settlement does not impose any material non-monetary restrictions or material obligations on the Indemnified Party. Whether or not the Indemnifying Party shall have assumed the defense of a Third Party Claim, the Indemnified Party will not admit any Liability, consent to the entry of any judgment or enter into any settlement or compromise with respect to the Third Party Claim without the prior written consent of the Indemnifying Party (which consent will not be unreasonably withheld or delayed). (d) If the Indemnifying Party assumes the defense of any Third Party Claim, the Indemnifying Party will keep the Indemnified Party informed of all material developments relating to or in connection with such Third Party Claim. If the Indemnifying Party chooses to defend a Third Party Claim, the Parties will cooperate in the defense thereof (with the Indemnifying Party being responsible for all reasonable out-of-pocket expenses of the Indemnified Party (other than for the fees and expenses of its counsel) in connection with such cooperation), which cooperation will include the provision to the Indemnifying Party of records and information which are reasonably relevant to such Third Party Claim, and making employees available on a mutually convenient basis to provide additional information and explanation of any material provided hereunder. (e) Any claim on account of Damages for which indemnification is provided under this Agreement which does not involve a Third Party Claim will be asserted by reasonably prompt written notice (but in any event within the relevant period specified in Section 9.3(d)) given by the Indemnified Party to the Indemnifying Party. (f) In the event of payment in full by an Indemnifying Party to any Indemnified Party in connection with any claim (an "Indemnified Claim"), such Indemnifying Party will be subrogated to and will stand in the place of such Indemnified Party as to any events or circumstances in respect of which such Indemnified Party may have any right or claim 57 relating to such Indemnified Claim against any claimant or plaintiff asserting such Indemnified Claim or against any other Person. Such Indemnified Party will cooperate with such Indemnifying Party in a reasonable manner, and at the cost and expense of such Indemnifying Party, in prosecuting any subrogated right or claim. Section 9.5. Exclusive Remedy. After the Closing, the remedies set forth in this Article IX shall be the sole and exclusive remedy with respect to any and all claims (other than to the extent any such claims are grounded in fraud) relating, directly or indirectly, to the subject matter of this Agreement; it being understood and agreed that any claims brought prior to the Closing (other than to the extent any such claims are grounded in fraud) shall be extinguished and released at Closing if such claims could not have been made immediately after the Closing pursuant hereto. Without limiting the generality of the foregoing and subject to Article IX and Section 11.14, Buyer and Seller hereby waive, to the fullest extent permitted under applicable Law, any and all rights, claims and causes of action it or any of their respective Subsidiaries or Affiliates may have against the other Party or any of its Subsidiaries and Affiliates with respect to the subject matter of this Agreement (other than to the extent any such claims are grounded in fraud), whether arising under or based upon any Federal, state, provincial, local or foreign statute, Law, Environmental Law, ordinance, rule, regulation or common law. Section 9.6. Mitigation. Buyer and Seller shall cooperate with each other with respect to resolving any claim or Liability with respect to which one Party is obligated to provide indemnification hereunder, including by making commercially reasonable efforts to mitigate or resolve any such claim or Liability. Article X. TERMINATION Section 10.1. Termination Events. Without prejudice to other remedies which may be available to the Parties by Law or this Agreement, this Agreement may be terminated and the transactions contemplated hereby may be abandoned at any time prior to the Closing: (a) by mutual written consent of Seller and Buyer; (b) by either Seller or Buyer by giving written notice to the other Party if the Closing shall not have occurred by March 31, 2007 (the "Expiration Date"); provided that the right to terminate this Agreement under this clause (b) shall not be available to any Party whose failure to fulfill any obligation under this Agreement has been the cause of, or resulted in, the failure of the Closing to occur on or before such date; or (c) by either Seller or Buyer by giving written notice to the other Party if any Governmental Authority shall have issued an order, decree or ruling or taken any other action permanently restraining, enjoining or otherwise prohibiting the consummation of any of the transactions contemplated by this Agreement, and such order, decree, ruling or other Action shall not be subject to appeal or shall have become final and unappealable. Section 10.2. Effect of Termination. In the event of any termination of this Agreement pursuant to Section 10.1, all rights and obligations of the Parties hereunder shall 58 terminate without any Liability on the part of either Party or its Subsidiaries and Affiliates in respect thereof, except that (a) the obligations of Buyer and Seller under Section 6.5 (Public Announcements) and Article XI of this Agreement shall remain in full force and effect and (b) such termination shall not relieve any Party of any Liability for damages incurred or suffered by the other Party for any breach of an obligation or covenant or willful breach of a representation or warranty contained in this Agreement prior to termination to the extent such breach resulted in the failure of the Closing to occur. For the avoidance of doubt, the Parties understand and agree that any termination of this Agreement shall be without prejudice to, and shall not effect, any and all rights to damages that any Party may have hereunder or otherwise under applicable law. Article XI. MISCELLANEOUS Section 11.1. Parties in Interest. Except as provided in Section 6.9 and in this Section 11.1, nothing in this Agreement, whether express or implied, shall be construed to give any Person, other than the Parties or their respective successors and permitted assigns, any legal or equitable right, remedy, claim or benefit under or in respect of this Agreement. Section 11.2. Assignment. This Agreement shall be binding upon and inure to the benefit of the Parties and their respective successors and permitted assigns. Except as permitted under Section 2.1, no Party may assign (by contract, stock sale, operation of Law or otherwise) either this Agreement or any of its rights, interests, or obligations hereunder without the express prior written consent of the other Party, and any attempted assignment, without such consent, shall be null and void. Section 11.3. Notices. All notices and other communications required or permitted to be given by any provision of this Agreement shall be in writing and mailed (certified or registered mail, postage prepaid, return receipt requested) or sent by hand or overnight courier, or by facsimile transmission (with acknowledgment received), charges prepaid and addressed to the intended recipient as follows, or to such other addresses or numbers as may be specified by a Party from time to time by like notice to the other Parties: 59 If to Seller: V.G.A.T. Investors, LLC c/o Vestar Capital Partners 245 Park Avenue New York, NY 10167 Attn.: Brian O'Connor and General Counsel Facsimile: (212) 808-4922 and c/o Greenbriar Equity Group LLC 555 Theodore Fremd Avenue Suite A-201 Rye, NY 10580 Attn: Reginald Jones and General Counsel Facsimile: (914) 925-9699 with copies to: Kirkland & Ellis LLP Citigroup Center 153 East 53rd Street New York, NY 10022 Attn.: Michael Movsovich and Jeffrey Symons Facsimile: (212) 446-6460 and AT Holdings Corporation 23555 Euclid Avenue Cleveland, OH 44117 Attn: Michael Lipsomb and Paul R. Keen Esq. Facsimile: (216) 579-0212 If to Buyer: Eaton Corporation 1111 Superior Avenue Cleveland, OH 44114 Attn.: Office of the Secretary Facsimile: (216) 479-7103 with a copy to: Baker & Hostetler LLP 3200 National City Center 1900 East Ninth Street Cleveland, OH 44114 Attn.: John M. Gherlein Esq. Facsimile: (216) 696-0740 60 All notices and other communications given in accordance with the provisions of this Agreement shall be deemed to have been given and received when delivered by hand or transmitted by facsimile (with acknowledgment received), three (3) Business Days after the same are sent by certified or registered mail, postage prepaid, return receipt requested or one (1) Business Day after the same are sent by a reliable overnight courier service, with acknowledgment of receipt. Section 11.4. Amendments and Waivers. This Agreement may not be amended, supplemented or otherwise modified except in a written instrument executed by each of the Parties. No waiver by any of the Parties of any default, misrepresentation, or breach of warranty or covenant hereunder, whether intentional or not, shall be deemed to extend to any prior or subsequent default, misrepresentation, or breach of warranty or covenant hereunder or affect in any way any rights arising by virtue of any prior or subsequent such occurrence. No waiver by any of the Parties of any of the provisions hereof shall be effective unless explicitly set forth in writing and executed by the Party sought to be charged with such waiver. Section 11.5. Exhibits and Disclosure Schedule. (a) All Exhibits, Schedules and the Disclosure Schedule attached hereto are hereby incorporated herein by reference and made a part hereof. Any matter disclosed pursuant to any Section of or Schedule or Exhibit to this Agreement or the Disclosure Schedule (or any section of any Schedule or Exhibit to this Agreement or the Disclosure Schedule) whose relevance or applicability to any representation made elsewhere in this Agreement or to the information called for by any other Section of or Schedule or Exhibit to this Agreement or the Disclosure Schedule (or any other section of any Schedule or Exhibit to this Agreement or the Disclosure Schedule) is reasonably apparent on its face shall be deemed to be an exception to such representations and to be disclosed with respect to all such other Sections of and Schedules and Exhibits to this Agreement and the Disclosure Schedule (and all sections of all Schedules and Exhibits to this Agreement and the Disclosure Schedule) where it is so apparent on its face, notwithstanding the omission of a reference or cross-reference thereto. (b) Neither the specification of any dollar amount in any representation nor the mere inclusion of any item in a Schedule or in the Disclosure Schedule as an exception to a representation or warranty shall be deemed an admission by a Party that such item represents an exception or material fact, event or circumstance or that such item is reasonably likely to result in a Material Adverse Effect on the Company Group or Buyer. Section 11.6. Headings. The table of contents and section headings contained in this Agreement are for reference purposes only and shall not be deemed a part of this Agreement or affect in any way the meaning or interpretation of this Agreement. Section 11.7. Construction. The Parties have participated jointly in the negotiation and drafting of this Agreement. In the event an ambiguity or question of intent or interpretation arises, this Agreement shall be construed as if drafted jointly by the Parties and no presumption or burden of proof shall arise favoring or disfavoring any Party by virtue of the authorship of any of the provisions of this Agreement. Section 11.8. No Other Representations or Warranties. Except for the representations and warranties expressly set forth in this Agreement, Buyer acknowledges that 61 none of Seller or any of its respective Subsidiaries and Affiliates or any other Person makes any representation or warranty, express or implied, at law or in equity, with respect to the Company Group and Affiliates, the Shares or any of the assets or Liabilities of the Company Group and its Affiliates, or with respect to any other information provided to Buyer, whether on behalf of Seller, the Company or such other Persons, including as to the probable success or profitability of the Company Group after the Closing. Neither Seller nor any other Person will have or be subject to any Liability or indemnification obligation to Buyer or any other Person resulting from the distribution to Buyer, or Buyer's use of, any such information, including any information, document or material made available to Buyer in certain "data rooms," management presentations or in any other form in expectation or contemplation of the transactions contemplated by this Agreement. Section 11.9. Entire Agreement. This Agreement (including the Disclosure Schedule and the Exhibits hereto), the Transaction Documents and the Confidentiality Agreement constitute the entire agreement among the Parties with respect to the subject matter hereof and thereof and supersede any prior understandings, negotiations, agreements, discussions or representations among the Parties of any nature, whether written or oral, to the extent they relate in any way to the subject matter hereof or thereof. Section 11.10. Severability. If any provision of this Agreement or the application of any such provision to any Person or circumstance shall be declared by any court of competent jurisdiction to be invalid, illegal, void or unenforceable in any respect, all other provisions of this Agreement, or the application of such provision to Persons or circumstances other than those as to which it has been held invalid, illegal, void or unenforceable, shall nevertheless remain in full force and effect and will in no way be affected, impaired or invalidated thereby. Upon such determination that any provision, or the application of any such provision, is invalid, illegal, void or unenforceable, the Parties shall negotiate in good faith to modify this Agreement so as to effect the original intent of the Parties as closely as possible to the fullest extent permitted by applicable Law in an acceptable manner to the end that the transactions contemplated hereby are fulfilled to the greatest extent possible. Section 11.11. Expenses. Unless otherwise provided herein, each of Buyer and Seller agrees to pay, without right of reimbursement from the other, all costs and expenses incurred by it incident to, without limitation, the process leading to the execution of this Agreement, the negotiations and preparations of this Agreement and the performance of its obligations hereunder, including the fees and disbursements of counsel, accountants, financial advisors, experts and consultants employed by the respective Parties in connection with the transactions contemplated hereby, whether or not the transactions contemplated by this Agreement are consummated. In furtherance of the foregoing, Seller acknowledges and agrees that, except as expressly otherwise set forth in this Agreement, Seller shall bear all costs and expenses of Seller and the Company Group referred to in the previous sentence, including costs and expenses in connection with the Reorganization (but not the costs of any consent, premium, prepayment penalty, breakage cost or other similar costs associated with (i) obtaining the consent of the holders of the 9.25% Notes to the Reorganization, which shall be shared equally by Buyer and Seller up to $1,000,000, with any amounts in excess of $1,000,000 being paid by Seller, and (ii) the repurchase of the 11.75% Notes(the principal amount and accrued interest of which shall be borne by the Buyer), the costs of which shall be shared equally be Buyer and Seller up to 62 $4,000,000, with any amounts in excess of $4,000,000 being paid by Seller), whether incurred by Seller or the Company Group, up to and including the Closing (including satisfying any such cost and expense that is billed to the Company Group after the Closing Date) in the event that the transactions contemplated by this Agreement are consummated; provided, however, that for the avoidance of doubt Seller shall not be obligated to pay any expenses of the Company Group that are reflected in the Closing Working Capital and any tax benefits arising from the payment of the amounts set forth in (i) and (ii) above shall be allocated pro rata based on the actual amounts paid by Buyer and Seller. Buyer shall be obligated to pay any and all costs of any audit of any member of the Company Group as may be required to enable Buyer to obtain any financing or complete and file any filing by Buyer or an Affiliate of Buyer with any Governmental Authority or otherwise. Notwithstanding anything to the contrary in this Agreement, the provisions and covenants of this Section 11.11 will survive the Closing and will remain in force indefinitely. Section 11.12. Governing Law. This Agreement and all claims arising out of or relating to this Agreement and the transactions contemplated hereby shall be governed by the Laws of the State of New York, without regard to the conflicts of law principles that would result in the application of any Law other than the Law of the State of New York. Section 11.13. Consent to Jurisdiction; Waiver of Jury Trial. (a) Each of the Parties irrevocably submits to the exclusive jurisdiction of (i) state courts of the State of Ohio and (ii) the United States District Court for the Northern District of Ohio for the purposes of any suit, Action or other proceeding arising out of or relating to this Agreement or any transaction contemplated hereby (and agrees not to commence any Action, suit or proceeding relating hereto except in such courts). Each of the Parties further agrees that service of any process, summons, notice or document hand delivered or sent by U.S. registered mail to such Party's respective address set forth in Section 11.3 will be effective service of process for any Action, suit or proceeding in Ohio with respect to any matters to which it has submitted to jurisdiction as set forth in the immediately preceding sentence. Each of the Parties irrevocably and unconditionally waives any objection to the laying of venue of any Action, suit or proceeding arising out of or relating to this Agreement or the transactions contemplated hereby in (i) state courts of the State of Ohio or (ii) the United States District Court for the Northern District of Ohio, and hereby further irrevocably and unconditionally waives and agrees not to plead or claim in any such court that any such Action, suit or proceeding brought in any such court has been brought in an inconvenient forum. Notwithstanding the foregoing, each Party agrees that a final judgment in any Action or proceeding so brought shall be conclusive and may be enforced by suit on the judgment in any jurisdiction or in any other manner provided in law or in equity. (b) EACH OF THE PARTIES IRREVOCABLY WAIVES ALL RIGHT TO TRIAL BY JURY IN ANY ACTION, PROCEEDING OR COUNTERCLAIM (WHETHER BASED ON CONTRACT, TORT OR OTHERWISE) ARISING OUT OF OR RELATING TO THIS AGREEMENT, THE TRANSACTIONS CONTEMPLATED BY THIS AGREEMENT OR THE ACTIONS OF THE PARTIES IN THE NEGOTIATION, ADMINISTRATION, PERFORMANCE OR ENFORCEMENT HEREOF. Section 11.14. Specific Performance. Notwithstanding anything to the contrary contained herein, the Parties agree that irreparable damage would occur in the event that any of 63 the provisions of this Agreement were not performed in accordance with their specific terms or were otherwise breached and it is accordingly agreed that the Parties shall be entitled to an injunction or injunctions to prevent breaches of this Agreement and to enforce specifically the terms and provisions of this Agreement, in addition to any other remedy to which they are entitled at law or in equity. Section 11.15. Counterparts. This Agreement may be executed in any number of counterparts, each of which shall be deemed an original but all of which together will constitute one and the same instrument. * * * * * 64 IN WITNESS WHEREOF, the Parties hereto have caused this Agreement to be executed as of the date first above written. V.G.A.T. Investors, llc By:_____________________________________ Name: Title: (Signature Page to Purchase Agreement) IN WITNESS WHEREOF, the Parties hereto have caused this Agreement to be executed as of the date first above written. EATON CORPORATION By: ___________________________________ Name: D.S. Barrie Title: Authorized Signatory By: ____________________________________ Name: M.E. Huber Title: Authorized Signatory (Signature Page to Purchase Agreement) EX-10.K 3 l24244aexv10wk.txt EX-10(K) Exhibit 10 (k) (EATON LOGO) Eaton Corporation 2006 Annual Report on Form 10-K Item 15 (b) 2007 STOCK OPTION GRANT STOCK OPTION AGREEMENT UNDER THE 2004 STOCK PLAN OPTIONHOLDER: DATE OF GRANT: February 27, 2007 DATE OF EXPIRATION: February 27, 2017 TOTAL NUMBER OF STOCK OPTIONS: OPTION PRICE: MARKET VALUE: INCENTIVE STOCK OPTION SHARES: NON-QUALIFIED STOCK OPTION SHARES: EATON CORPORATION, an Ohio corporation (the "Company"), hereby grants to the Optionholder, in consideration of service by him or her to the Company or a subsidiary of the Company, the option to purchase from the Company the number of common shares of the Company with a par value of fifty cents each (the "Common Shares") specified above from time to time during a period which shall end at the close of business on the tenth anniversary of the date of the granting of this option (such period being referred to as the "fixed term of the option"), unless sooner terminated as hereinafter provided. For purposes of the foregoing sentence, "close of business" shall mean 4:00 p.m. Eastern Time on the day of the tenth anniversary. However, if that day falls on a Saturday, Sunday or other day when the principal stock exchange for the Common Shares is closed for trading, "close of business" shall mean 4:00 p.m. Eastern Time on the nearest preceding day when that stock exchange is open for trading. This option is subject to, and is granted in accordance with, the 2004 Stock Plan (the "2004 Plan"), and upon the terms and conditions herein set forth. I. TERMS OF EXERCISE OF OPTION A. By the Optionholder While an Employee of the Company or a Subsidiary The Optionholder may exercise this option only after he or she remains in the continuous employment of the Company for a period of one year from the date of granting of this option and only as to the number of shares which become vested as set forth below. Employment by a subsidiary shall be counted as employment by the Company. Subject to Section I. B. hereof, after one year of such continuous employment following the date of grant of this option, the Optionholder, while still so employed, may exercise this option as follows: 1. At any time after one year of such continuous employment from the date of grant, as to 33% of the Common Shares subject to this option; 2. At any time after two years of such continuous employment from the date of grant, as to an additional 33% of the Common Shares subject to this option; and (EATON LOGO) 2007 STOCK OPTION GRANT I. TERMS OF EXERCISE OF OPTION (CONTINUED) A. By the Optionholder While an Employee of the Company or a Subsidiary (continued) 3. At any time after three years of such continuous employment from the date of grant, as to an additional 34% of the Common Shares subject to this option. The Compensation and Organization Committee of the Board of Directors of the Company (the "Committee") reserves the right to decide to what extent leaves of absence for government or military service, illness, temporary disability, or other reasons shall not be deemed to be an interruption of continuous employment. B. By the Optionholder When No Longer Employed by Either the Company or a Subsidiary 1. Retirement. If the Optionholder ceases to be an employee as a result of retirement on or after normal retirement age (age 65 for U.S. employees), or on or after age 50 and 10 years of service to the Company or a subsidiary (early retirement), he or she may exercise this option with respect to all Common Shares then subject to this option which are vested at the date of such retirement in accordance with the schedule set forth in Section I.A above, for a period not to exceed the shorter of the remaining term of this option or five years after the retirement date. 2. Divestiture of a Facility. If the Optionholder ceases to be an employee as a result of the divestiture of a facility where the Optionholder is employed, he or she may exercise this option with respect to all Common Shares then subject to this option, both vested and unvested, for a period not to exceed 90 days after the effective date of the divestiture. If the divestiture results in the retirement of the Optionholder (as described in Subsection B.1), then he or she may exercise this option with respect to all Common Shares then subject to this option (both vested and unvested) for a period not to exceed the shorter of the remaining term of the option or five years after the retirement date. 3. Other Terminations. If the Optionholder ceases to be an employee for any reason other than those described in Subsections B.1. or B.2., he or she may exercise this option only for the number of Common Shares which are vested at the time he or she ceased to be an employee, and he or she may exercise this option only for a period not to exceed 90 days following the termination of employment. 4. Company Discretion. In the case of a termination of an officer of the Company that is subject to Subsections B.1 or B.3, the officer may exercise this option for such number of Common Shares that is greater than the number provided by those Subsections as the Committee may authorize by acceleration of vesting or extension of the exercise period (but not beyond the ten year term of this option). In the case of the termination of employment of an employee who is not an officer of the Company that is subject to Subsections B.1 or B.2, the employee may exercise this option for such number of Common Shares greater than provided by those Subsections as the Management Compensation Committee ("Management Committee") may authorize by acceleration of vesting or extension of the exercise period (but not beyond the ten year term of this option). The Optionholder should have no expectation that the Committee or the Management Committee will take any discretionary action contemplated by this Subsection B.4. 2 (EATON LOGO) 2007 STOCK OPTION GRANT B. By the Optionholder When No Longer Employed by Either the Company or a Subsidiary (continued) 5. Incentive Stock Options To receive favorable tax treatment afforded Incentive Stock Options, the Incentive Stock Option Shares must be exercised within 90 days of retirement or other termination of employment or within one year of termination of employment due to permanent and total disability. Incentive Stock Option Shares that are not exercised within those periods will, for tax purposes, be treated the same as Non-Qualified Stock Options. C. By the Optionholder After Change in Position If the Optionholder should be assigned to any position with the Company or its subsidiaries which is, in the sole and absolute discretion of the Committee, of lesser responsibility than that which is held by the Optionholder upon the date hereof, thereafter the Optionholder may exercise this option (during the term of the option) only for the number of Common Shares for which the option was exercisable at the time of such assignment or such greater number of Common Shares as determined by the Committee in the exercise of its sole and absolute discretion. D. In Case of the Death of the Optionholder Upon the death of the Optionholder, this option shall be exercisable by the Optionholder's estate, or by a person who has acquired the right to exercise this option by bequest or inheritance, (i) during the period of 12 months after the date of death (but no later than the end of the fixed term of the option) for the number of Common Shares for which the option was exercisable upon the date of death, and (ii) during such period of time, if any (but ending no later than the end of the fixed term of the option), which the Committee may determine in its sole and absolute discretion, for the number of Common Shares for which the Optionholder could have exercised this option in accordance with its terms prior to the expiration of that period of time if the Optionholder had lived. E. Term The option shall in no event be exercisable after the expiration of 10 years from the date of the granting of the option, notwithstanding anything to the contrary in Sections I. A, B, C or D above. The option hereby granted shall be considered terminated and cancelled, in whole or in part, to the extent that it can no longer be exercised under the terms hereof or under the terms of the 2004 Plan, for the Common Shares originally subject to this option, or in the event the Optionholder shall fail, within 60 days after the granting of this option, to deliver to the Company an acceptance of such option executed by him or her. II. EXERCISING OPTION--RIGHTS AS A SHAREHOLDER A. Exercise and Payment This option may be exercised only at time when the principal exchange for the Common Shares is open for business. An exercise of this option will be effective when the person or estate entitled to exercise it shall indicate the decision to do so, as to all or any part of the Common Shares for which it may then be exercised, by any method of communication expressly authorized by the Company and at the same time tenders or makes available to the Company (by any method expressly authorized by the Company) payment in full the exercise price in cash or by delivery to the Company of Common Shares owned by the Optionholder, or by tender of a combination of cash and Common Shares. A partial exercise of this option shall not affect the right to exercise it from time to time thereafter as to the remaining Common Shares subject to the option. The Company shall notify the Optionholder of the expiration date of the fixed term of this option no less than 90 days, nor more than 180 days, in advance of such expiration date. 3 (EATON LOGO) 2007 STOCK OPTION GRANT II. EXERCISING OPTION--RIGHTS AS A SHAREHOLDER (CONTINUED) B. Shareholder Rights No holder of this option shall have any rights as a shareholder with respect to any Common Shares subject to the option unless and until he or she shall have received a certificate or certificates for such Common Shares. Subject to compliance with all the terms and conditions hereof and of the 2004 Plan, including all rules, regulations and determinations of the Committee, the Company shall, as promptly as possible after any exercise of this option, deliver a certificate or certificates for an appropriate number of Common Shares; provided, however, that no such certificate or certificates shall be so delivered unless and until adequate provision has, in the judgment of the Company, been made for any and all withholding taxes in respect of the exercise of the option. III. TRANSFER OF OPTION This option shall not be transferable otherwise than by will or the law of descent and distribution or to the extent permitted by rules or regulations under Section 16(b) under the Securities Exchange Act of 1934 (the "Exchange Act") and the Committee. IV. COMPLIANCE WITH LAWS, REGULATIONS AND RULES The Company will use its reasonable best efforts to comply with all federal and state laws and regulations and all rules for domestic stock exchanges on which its Common Shares may be listed, which apply to the issuance of the Common Shares subject to this option, and to obtain such consents and approvals to such issuance which it deems advisable from federal and state bodies having jurisdiction of such matters. However, anything herein to the contrary notwithstanding, this option shall not be exercisable, and the Company shall not be obligated to issue or deliver any certificate for shares subject to this option, in violation of any such laws, regulations or rules and unless and until such consents and approvals have been obtained. Any share certificate issued to evidence Common Shares as to which this option is exercised may bear such legends and statements as the Committee shall deem advisable to assure compliance with federal and state laws and regulations. If a person or an estate purporting to acquire the rights to exercise this option by bequest or inheritance shall attempt to exercise this option, the Company may require reasonable evidence as to the ownership of this option and may request such consents and releases of taxing authorities as it deems advisable. V. ADJUSTMENT UPON CHANGE OF SHARES In the event of a reorganization, merger, consolidation, reclassification, recapitalization, combination or exchange of shares, stock split, stock dividend, rights offering or other event affecting Common Shares, the number and class of Common Shares subject to this option, the price per share payable upon exercise of this option and the conditions on which this option shall become exercisable, shall be equitably adjusted by the Committee so as to reflect such change. No adjustment provided for in this Section V shall require the Company to sell or transfer a fractional share. VI. EFFECT ON EMPLOYMENT The granting of this option shall not give the Optionholder any right to be retained in the employ of the Company or any subsidiary, and shall not affect the right of the Company to terminate the employment of the Optionholder at any time with or without assigning a reason therefore to the same extent as the Company might have done if this option had not been granted. 4 (EATON LOGO) 2007 STOCK OPTION GRANT VII. COMPETITION BY OPTIONHOLDER In the event that the Optionholder voluntarily leaves employment of the Company or a subsidiary and within one (1) year after exercise of any portion of this option enters into an activity as employee, agent, officer, director, principal or proprietor which, in the sole judgment of the Committee, is in competition with the Company or a subsidiary, the amount by which the fair market value per share on the date of exercise of any such portion exceeds the option price per Common Share hereunder, multiplied by the number of Common Shares subject to such exercised portion, shall inure to the benefit of the Company and the Optionholder shall pay the same to the Company, unless the Committee in its sole discretion shall determine that such action by the Optionholder is not inimical to the best interest of the Company or its subsidiaries. VIII. CHANGE OF CONTROL A. Exercise of Option Notwithstanding anything in Section I.A to the contrary, effective upon a Change of Control of the Company (as defined below), this option shall become fully exercisable for 100% of the Common Shares subject to this option. B. Definition For the purpose of this Agreement, a "Change of Control" shall mean: 1. The acquisition by any individual, entity or group (within the meaning of Section 13(d)(3) or 14(d)(2) of the Exchange Act) (a "Person") of beneficial ownership (within the meaning of Rule 13d-3 promulgated under the Exchange Act) of 25% or more of either (i) the then outstanding common shares of the Company (the "Outstanding Common Shares") or (ii) the combined voting power of the then outstanding voting securities of the Company entitled to vote generally in the election of directors (the "Outstanding Company Voting Securities"); provided, however, that for purposes of this subsection 1, the following acquisitions shall not constitute a Change of Control: (i) any acquisition directly from the Company, (ii) any acquisition by the Company, or (iii) any acquisition by any employee benefit plan (or related trust) sponsored or maintained by the Company or any corporation controlled by the Company; or 2. Individuals who, as of the date hereof, constitute the Board (the "Incumbent Board") cease for any reason to constitute at least a majority of the Board; provided, however, that any individual becoming a director subsequent to the date hereof whose election, or nomination for election by the Company's shareholders, was approved by a vote of at least two-thirds of the directors then comprising the Incumbent Board shall be considered as though such individual were a member of the Incumbent Board, but excluding, for this purpose, any such individual whose initial assumption of office occurs as a result of an actual or threatened election contest with respect to the election or removal of directors or other actual or threatened solicitation of proxies or consents by or on behalf of a Person other than the Board; or 3. Consummation by the Company of a reorganization, merger or consolidation or sale or other disposition of all or substantially all of the assets of the Company or the acquisition of assets of another corporation (a "Business Combination"), in each case, unless, following such Business Combination, (i) all or substantially all of the individuals and entities who were the beneficial owners, respectively, of the Outstanding Common Shares and Outstanding Company Voting Securities immediately prior to such Business Combination beneficially own, directly or indirectly, more than 75% of, respectively, the then outstanding common shares and the combined voting power of the then outstanding voting securities entitled to vote generally in the election of directors, as the case may be, of the corporation resulting from such Business Combination (including, without limitation, 5 (EATON LOGO) 2007 STOCK OPTION GRANT VIII. CHANGE OF CONTROL (CONTINUED) B. Definition (continued) 3. a corporation which as a result of such transaction owns the Company or all or substantially all of the Company's assets either directly or through one or more subsidiaries) in substantially the same proportions as their ownership, immediately prior to such Business Combination of the Outstanding Common Shares and Outstanding Company Voting Securities, as the case may be, (ii) no Person (excluding any employee benefit plan (or related trust) of the Company or such corporation resulting from such Business Combination) beneficially owns, directly or indirectly, 25% or more of, respectively, the then outstanding common shares of the corporation resulting from such Business Combination or the combined voting power of the then outstanding voting securities of such corporation except to the extent that such ownership existed prior to the Business Combination and (iii) at least a majority of the members of the board of directors of the corporation resulting from such Business Combination were members of the Incumbent Board at the time of the execution of the initial agreement, or of the action of the Board, providing for such Business Combination; or 4. Approval by the shareholders of the Company of a complete liquidation or dissolution of the Company. Notwithstanding the foregoing, a "Change of Control" shall not be deemed to have occurred as a result of any transaction or series of transactions which the Optionholder, or any entity in which the Optionholder is a partner, officer or more than 50% owner initiates, if immediately following the transaction or series of transactions that would otherwise constitute a Change of Control, the Optionholder, either alone or together with other individuals who are executive officers of the Company immediately prior thereto, beneficially owns, directly or indirectly, more than 10% of the then outstanding common shares of the Company or the corporation resulting from the transaction or series of transactions, as applicable, or of the combined voting power of the then outstanding voting securities of the Company or such resulting corporation. IX. ENFORCEABILITY This Agreement shall be binding upon and inure to the benefit of the Company, and its successors and assigns, and upon the personal representatives, executors, administrators, legatees and distributees of the Optionholder. X. 2004 PLAN CONTROLS The terms and conditions of the 2004 Plan, as amended from time to time in accordance with the provisions of Section 12 thereof, shall control the terms and conditions of this option, and anything contained in this Agreement inconsistent with or in violation of the terms and conditions of the 2004 Plan shall be of no force or effect and shall not be binding upon the Company or the Optionholder. The 2004 Plan and this Agreement represent the entire agreement and understanding between the parties hereto with respect to the subject matter hereof and supersedes all prior agreements, representations and understandings, whether written or oral. 6 (EATON LOGO) 2007 STOCK OPTION GRANT XI. CONSTRUCTION It is intended that acquisition of this option by the Optionholder shall qualify for exemption from the provisions of Section 16(b) of the Exchange Act, and each and every provision of this Agreement shall be construed, interpreted and administered so that the grant of this option, whether made to an officer or director of the Company or to any other employee of the Company or a subsidiary, shall so qualify. Any provision of this Agreement that cannot be so construed, interpreted and administered shall be of no force or effect. XII. GOVERNING LAW This Agreement shall be construed in accordance with the laws of the State of Ohio, except as otherwise specifically provided herein. EATON CORPORATION By -s- S. J. Cook ------------------- And By -s- E. R. Franklin ------------------- ACCEPTANCE OF OPTION BY OPTIONHOLDER Accepted by_____________________________ Signature Date____________________________________ 7 EX-10.S 4 l24244aexv10ws.txt EX-10(S) Exhibit 10 (s) Eaton Corporation 2006 Annual Report on Form 10-K Item 15 (b) 1996 NON-EMPLOYEE DIRECTOR FEE DEFERRAL PLAN I. PURPOSE The 1996 Non-Employee Director Fee Deferral Plan (the "Plan") enables each Director of Eaton Corporation ("Eaton" or the "Company") who is not employed by the Company to defer receipt of fees that may be payable to him or her for future services as a member of the Board of Directors of the Company (the "Board") or as chairman or as a member of any committee of the Board. The purpose of the Plan is to help attract and retain highly qualified individuals to serve as members of the Company's Board of Directors and as members of committees thereof. II. ELIGIBILITY All members of the Board who are not employed by the Company are eligible to participate in the Plan with respect to amounts earned as fees for services as a member of the Board or as chairman or a member of any committee of the Board. III. DEFINITIONS The terms used herein shall have the following meanings: Account - A bookkeeping account established by Eaton for a Participant to which may be credited Deferred Fees and earnings or losses thereon. Agreement - A written agreement between Eaton and a Participant deferring the receipt of Fees and indicating the term of the deferral. Beneficiary - The person or entity designated in writing executed and delivered by the Participant to the Committee. If that person or entity is not living or in existence at the time any unpaid balance of Deferred Fees becomes due after the death of a Participant, the term "Beneficiary" shall mean the Participant's estate or legal representative or any person, trust or organization designated in such Participant's will. Board - The Board of Directors of Eaton Corporation. This document constitutes part of a prospectus covering securities that have been registered under the Securities Act of 1933. Change in Control of Eaton - Shall be deemed to occur if (i) a tender offer shall be consummated for 25% or more of the combined voting power of Eaton's then outstanding voting securities, (ii) Eaton shall be merged or consolidated with another corporation and as a result less than 75% of the outstanding voting securities of the resulting corporation shall be owned by the former shareholders of Eaton, other than affiliates (within the meaning of the Securities Exchange Act of 1934 (the "Exchange Act")) of any party to such merger or consolidation, as the same shall have existed immediately prior to such merger or consolidation, (iii) Eaton shall sell substantially all of its assets to another corporation that is not a wholly owned subsidiary of Eaton, (iv) any "person" (as such term is used in Sections 3(a)(9) and 13(d)(3) of the Exchange Act) is or becomes the beneficial owner, directly or indirectly, of 25% or more of the combined voting power of Eaton's then outstanding securities; or (v) during any period of two consecutive years, individuals who at the beginning of that period constitute the Board cease to constitute at least a majority thereof unless the election, or the nomination for election by Eaton's shareholders, of each new director was approved by a vote of at least two-thirds of the directors then still in office who were directors at the beginning of the period. For purposes of this Plan, ownership of voting securities shall take into account and include ownership as determined by applying the provisions of Rule 13d-3(d)(l)(i) of the Exchange Act (as then in effect). Committee - The Governance Committee of the Board or such other committee as the Board may from time to time designate for purposes of administration of the Plan. Common Share Retirement Deferred Fees - Retirement Deferred Fees that are converted into share units in accordance with Article VI. Deferral Plans - This Plan and any other prior plan sponsored by the Company pursuant to which Fees may be deferred. Deferred Fees - That portion of Fees deferred pursuant to the Plan. Eaton - Eaton Corporation, an Ohio corporation, and its subsidiaries and successors and assigns. Eaton Common Shares - The common shares of Eaton Corporation with a par value of $.50 each. Failure to Pay - The circumstances described in either (i) or (ii) have occurred:(i) Any Participant shall have notified the Company and the Trustee in writing that the Company shall have failed to pay to the Participant, when due, either directly or by direction to the trustee of any trust holding assets for the payment of benefits pursuant to the Plan, at least 75% of any and all amounts which the Participant was entitled to receive at any time in accordance with the terms of the Plan, and that such amounts remain unpaid. Such notice must set forth the amount, if any, which was paid to the Participant by the Company, and the amount which the Participant believes he or she was entitled to receive under the Plan. The failure to make such payment shall have continued for a period of 30 days after receipt of such notice by the Company, and during such 30-day period the Company shall have failed to prove, by - 2 - clear and convincing evidence as determined by the Trustee in its sole and absolute discretion, that such amount was in fact paid or was not due and payable; or (ii) More than two Participants shall have notified the Company and the Trustee in writing that they have not been paid when due, either directly or by direction to the Trustee, amounts to which they are entitled under the Plan and that such amounts remain unpaid. Each such notice must set forth the amount, if any, which was paid to the Participant, and the amount which the Participant believes he or she was entitled to receive under the Plan. Within 15 days after receipt of each such notice, the Trustee shall determine, on a preliminary basis, whether any failure to pay such Participants has resulted in a failure to pay when due, directly or by direction, at least 75% of the aggregate amount due to all Participants under all the Deferral Plans in any two-year period, and that such amounts remain unpaid. If the Trustee determines that such a failure has occurred, then it shall so notify the Company and the Participants in writing within the same 15 day period. Within a period of 20 days after receipt of such notice from the Trustee, the Company shall have failed to prove by clear and convincing evidence, in the sole and absolute discretion of the Trustee, that such amounts were paid or were not due and payable. Fees - Any amount payable to a Participant for services as a member of the Board or as chairman or a member of any committee of the Board. Funded Amount - With respect to the Account of any Participant, the value of any assets which have been placed in a grantor trust established by the Company to pay benefits with respect to that Account, as determined at the time initial payments are to be made pursuant to the selections made by the Participants in accordance with Section 10.03. Interest Rate Retirement Deferred Fees - Retirement Deferred Fees that are credited with Treasury Note Based Interest in accordance with Article VII. Participant - A member of the Board who is not an employee of Eaton and who elects to defer receipt of Fees. Periodic Installments - Monthly, quarterly, semiannual or annual payments, over a period not to exceed fifteen years, as determined by the Committee in its sole discretion, which are substantially equal in amount, or, in the case of Common Share Retirement Deferred Fees, substantially equal in the number of share units being valued and paid or the number of Eaton Common Shares being distributed, except that earnings attributable to periods following Retirement or Termination of Service as a Director shall be included with each payment. Plan - This 1996 Non-Employee Director Fee Deferral Plan pursuant to which Fees may be deferred for later payment. Retirement - The Termination of Service as a Director of a Participant who is age 55 or older and who has at least ten years of service as a member of the Board, who is age 68 or older, or who is approved by the Committee to qualify as a retirement. - 3 - Retirement Deferred Fees - That portion of Fees deferred for payment at Retirement, at one year following Retirement, at two years following Retirement or in Periodic Installments commencing after Retirement. Short-Term Deferred Fees - That portion of Fees deferred for payment as determined by the Committee in accordance with Article V. Termination and Change in Control - The Termination of Service as a Director of a Participant for any reason whatsoever prior to a Change in Control if there is a subsequent Change in Control or the Termination of Service as a Director of a Participant for any reason whatsoever during the three-year period immediately following a Change in Control. Termination of Service as a Director - The time when a Participant shall no longer be a member of the Board, whether by reason of retirement, death, voluntary resignation, divestiture, removal (with or without cause), or disability. Treasury Bill Interest Equivalent - A rate of interest equal to the quarterly average yield of 13-week U.S. Government Treasury Bills. Treasury Note Based Interest - A rate of interest equal to the average yield of 10-year U.S. Government Treasury Notes plus 300 basis points. Trustee - The trustee of any trust which holds assets for the payment of the benefits provided by the Plan. - 4 - IV. ELECTION TO DEFER Section 4.01 Deferral Options. For each calendar year commencing with 1997, a Participant may elect to defer the receipt of all or part of his or her Fees as Short-Term Deferred Fees or Retirement Deferred Fees. Once a Participant has made an effective election, he or she may not thereafter change that election or change any allocation between Short-Term Deferred Fees or Retirement Deferred Fees. Section 4.02 Amount Deferred. Not less than 10% of Fees payable for any calendar year may be deferred under the Plan. If a Participant elects to allocate a portion of Fees to both Short-Term Deferred Fees and Retirement Deferred Fees, the amount allocated to each shall be not less than 10% of the Fees payable for any calendar year. Section 4.03 Election Deadline. To be in effect, a Participant's election must be completed, signed and filed with the Committee on or before such date as is necessary to defer inclusion of the Fees in the Director's gross income for Federal income tax purposes. Section 4.04 Transfers. Notwithstanding anything herein to the contrary, a Participant may elect to have held and distributed in accordance with the terms and conditions of the Plan all or part of his or her compensation which was deferred under the 1980 Plan for Deferred Payment of Directors' Fees, and any such election with respect to amounts to be held and distributed as Retirement Deferred Fees for any Participant in payment status upon the effective date of such election may be held only as Interest Rate Deferred Fees if to do otherwise would be administratively impractical. V. SHORT-TERM DEFERRED FEES If elected by a Participant, payment of the amount of Fees allocated to Short-Term Deferred Fees will be deferred. Short-Term Deferred Fees shall be credited to the Participant on the date such amount would have been distributed to him or her if there had been no valid deferral election by establishing an Account in the Participant's name. Treasury Bill Interest Equivalents shall be credited quarterly to the Participant's Short-Term Deferred Fees Account until such compensation is paid to the Participant. Short-Term Deferred Fees, together with credited Treasury Bill Interest Equivalents, shall be paid to the Participant in a lump sum or in not more than five annual installments as determined by the Committee. VI. RETIREMENT DEFERRED FEES Section 6.01 Duration. If elected by a Participant, payment of the amount of Fees allocated to Retirement Deferred Fees will be deferred to Retirement or to one year after Retirement or to two years after Retirement, but subject to Committee discretion as to date of payment as provided herein. Retirement Deferred Fees shall be credited to the Participant on the date such amount would have been distributed to him or her if there had been no valid deferral election by establishing an Account in the Participant's name. - 5 - Section 6.02 Common Share Retirement Deferred Fees. Between 50% and 100%, as elected by the Participant, of the amount allocated to Retirement Deferred Fees shall be credited to Common Share Retirement Deferred Fees, and the balance shall be credited to Interest Rate Retirement Deferred Fees. Common Share Retirement Deferred Fees shall be converted into a number of share units based upon the average of the mean prices for Eaton Common Shares for the twenty trading days of the New York Stock Exchange during which Eaton Common Shares were traded immediately preceding the end of the calendar quarter in which the Fees to be deferred were earned. For purposes of the Plan, "mean price" shall be the mean of the highest and lowest selling prices for Eaton Common Shares quoted on the New York Stock Exchange List of Composite Transactions on the relevant trading day. On each Eaton Common Share dividend payment date, dividend equivalents equal to the actual Eaton Common Share dividends paid shall be credited to the share units in the Participant's Account, and shall in turn be converted into share units utilizing the mean price for Eaton Common Shares on the dividend payment date. Upon payment of Common Share Retirement Deferred Fees in Eaton Common Shares, the share units standing to the Participant's credit shall be converted to the same number of Eaton Common Shares for distribution to the Participant. Upon payment of Common Share Retirement Deferred Fees in cash, including any installment thereof in the case of Periodic Installments, the share units required to make the cash payment shall be converted to an amount equal to the greater of: (a) the product of the average of the mean prices for an Eaton Common Share for the last twenty trading days of the New York Stock Exchange during which Eaton Common Shares were traded in the month immediately preceding the month in which the date of payment occurs, multiplied by the number of share units then credited to the Participant's Account, or (b) if a Change in Control of Eaton shall have occurred at any time within thirty-six months immediately preceding the payment, the product of the number of share units credited to the Participant's Account at the time of payment multiplied by the highest of (i) the highest price paid for an Eaton Common Share in any tender offer in connection with the Change in Control of Eaton; (ii) the price received for an Eaton Common Share in any merger, consolidation or similar event in connection with the Change in Control of Eaton; or (iii) the highest price paid for an Eaton Common Share as reported in any Schedule 13D within the sixty-day period immediately preceding the Change in Control of Eaton. Section 6.03 Interest Rate Retirement Deferred Fees. Retirement Deferred Fees not credited to Common Share Retirement Deferred Fees shall be credited to Interest Rate Retirement Deferred Fees. Interest Rate Retirement Deferred Fees shall be credited to the Interest Rate Retirement Deferred Fees Account, which shall earn Treasury Note Based Interest, compounded quarterly, until paid. Section 6.04 Periodic Installments. Upon the death of a Participant who has commenced receiving Periodic Installments, the entire remaining amount of his or her Retirement Deferred Fees shall be distributed to the Participant's Beneficiary. Such distributions - 6 - may be made either in a lump sum or in installments in such amounts and over such periods, not exceeding the remaining number of annual installments from the date of death of the Participant, as the Committee may direct in its sole discretion. Section 6.05 Termination of Service as a Director. The Retirement Deferred Fees Account of a Participant whose Termination of Service as a Director occurs for reasons other than Retirement shall be distributed in a lump sum or in Periodic Installments, as the Committee may determine in its sole discretion. The lump sum payment shall be made, or the Periodic Installments shall commence, when the Committee may determine in its sole discretion, no later than February 1 of the calendar year immediately after the calendar year that includes the earliest of: (i) the Participant's death, (ii) the Participant's attainment of age 55 if he or she was credited with at least 10 years of service for Eaton (or an affiliate of Eaton), (iii) the Participant's attainment of age 68, or (iv) the fifth anniversary of the Participant's Termination of Service as a Director. Earnings shall be credited on undistributed Retirement Deferred Fees Accounts, and annual installment payments shall be adjusted to reflect such additional earnings, based on the remaining number of installment payments to be distributed and based on Treasury Note Based Interest, computed quarterly. VII. AMENDMENT AND TERMINATION Eaton fully expects to continue the Plan but it reserves the right, except as otherwise provided herein, at any time by action of the Committee, to modify, amend or terminate the Plan for any reason, including adverse changes in the federal tax laws. Notwithstanding the foregoing, upon the occurrence of a Change in Control of Eaton, no amendment, modification or termination of the Plan shall, without the consent of any particular Participant, alter or impair any rights or obligations under the Plan with respect to that Participant. VIII. ADMINISTRATION The Plan shall be administered by the Committee. The Committee shall interpret the provisions of the Plan where necessary and may adopt procedures for the administration of the Plan which are consistent with the provisions of the Plan and any rules adopted by the Committee. After Retirement or other Termination of Service as a Director, the Committee shall determine in its sole discretion (i) whether Retirement Deferred Fees shall be paid in a lump sum or in Periodic Installments, (ii) the date on which a lump sum payment will be made or Periodic Installments will commence, which in the case of Retirement shall be not later than one year following the date to which the deferral was made, and in the case of Termination of Service as a Director for reasons other than Retirement shall be in accordance with Section 6.05, (iii) whether to change the Periodic Installments or the number of years over which they are to be paid, and (iv) whether Common Share Retirement Deferred Fees will be paid in cash or in Eaton Common Shares. In making these determinations, the Committee may consider the wishes and needs of the Participant or his or her Beneficiary. - 7 - Each Participant or Beneficiary must claim any benefit to which such Beneficiary may be entitled under the Plan by a written notification to the Committee. If a claim is denied, it must be denied within a reasonable period of time in a written notice stating the specific reasons for the denial. The claimant may have a review of the denial by the Committee by filing a written notice with the Committee within sixty days after the notice of the denial of his or her claim. The written decision by the Committee with respect to the review must be given within 120 days after receipt of the written request. The determinations of the Committee shall be final and conclusive. IX. TERMINATION AND CHANGE IN CONTROL - FAILURE TO PAY Section 9.01 Termination and Change in Control. Notwithstanding anything herein to the contrary, upon the occurrence of a Termination and Change in Control, the Participants shall be entitled to receive from the Company the payments as provided in Section 9.03. Section 9.02 Failure to Pay. Notwithstanding anything herein to the contrary, upon the occurrence of a Failure to Pay, each Participant covered by the situation described in clause (i) of the definition of Failure to Pay, or each of the Participants in the event of a situation described in clause (ii) of that definition, as the case may be, shall be entitled to receive from the Company the payments as provided in Section 9.03. Section 9.03 Payment Requirement. No later than (i) the first to occur of six months following the date hereof, a Termination and Change in Control or a Failure to Pay for any person who is a Participant upon such event or (ii) the date upon which any person who is not subject to clause (i) becomes a Participant, each Participant shall select one of the payment alternatives set forth below with respect to that portion of the Participant's Account equal to the full amount of the Account minus the Funded Amount, and with respect to that portion of the Account equal to the Funded Amount. The payment alternatives selected with respect to the two portions of the Account need not be the same. The payment alternatives are as follows: (a) a Lump Sum Payment within 30 days following the Termination and Change in Control or Failure to Pay, as the case may be; (b) payment in monthly, quarterly, semiannual or annual payments, over a period not to exceed fifteen years, as selected by the Participant at the time provided in the first paragraph of this Section 9.03, commencing within 30 days following the Termination and Change in Control or Failure to Pay, as the case may be, which are substantially equal in amount or in the number of share units being valued and paid or in the number of Eaton Common Shares being distributed, except that earnings attributable to periods following Termination and Change in Control or Failure to Pay shall be included with each payment. Payment of such amounts shall be made to each such Participant in accordance with his or her selected alternative as provided in Section 9.01 and 9.02. - 8 - X. MISCELLANEOUS Section 10.01 Adjustments. In the event of a reorganization, merger, consolidation, reclassification, recapitalization, combination or exchange of shares, stock split, stock dividend, rights offering or similar event affecting shares of the Company, the Committee shall equitably adjust the number of share units previously allocated to the Accounts of Participants as Common Share Retirement Deferred Fees. Section 10.02 Designation of Beneficiaries. Each Participant shall have the right, by written instruction to the Committee, on a form supplied by the Committee, to designate one or more primary and contingent Beneficiaries (and the proportion to be paid to each, if more than one is designated) to receive his or her Account balance upon his or her death. Any such designation shall be revocable by the Participant. Section 10.03 Committee Actions. All actions of the Committee hereunder may be taken with or without a meeting, as permitted by law and by the Company's Amended Regulations. Section 10.04 Assignment. No benefit under the Plan shall be subject to anticipation, alienation, sale, transfer or encumbrance, and any attempt to do so shall be void. No benefit hereunder shall in any manner be liable for the debts, contracts, or liabilities of the person entitled to such benefits. If a Participant or Beneficiary shall become bankrupt, or attempt to anticipate, alienate, sell, transfer or encumber any benefit hereunder, then such benefit shall, in the discretion of the Committee, cease and terminate, and the Committee may hold or apply the same for the benefit of the Participant or his or her spouse, children, or other dependents, or any of them, in such manner and in such amounts and proportions as the Committee may deem proper. During a Participant's lifetime, rights hereunder are exercisable only by the Participant or the Participant's guardian or legal representative. Notwithstanding the foregoing, nothing in this Section shall prohibit the transfer of any benefit by will or by the laws of descent and distribution or (if permitted by applicable regulations under Section 16(b) of the Securities Exchange Act) pursuant to a qualified domestic relations order, as defined under the Internal Revenue Code and the Employee Retirement Income Security Act. Section 10.05 No Funding Required. The obligations of Eaton to make payments shall be a liability of Eaton to the Participant. Eaton shall not be required to maintain any separate fund or reserve, or purchase or acquire life insurance on a Participant's life, or otherwise segregate assets to assure that any particular asset of Eaton is available to make such payments by reason of Eaton's obligations hereunder. Nothing contained in the Plan shall be construed as creating a trust or other fiduciary relationship between Eaton and a Participant or any other person. Section 10.06 No Contract for Services. The Plan shall not be deemed to constitute a contract for services between Eaton and a Participant. Neither the execution of the Plan nor any action taken by Eaton or the Committee pursuant to the Plan shall confer on a Participant any legal right to be continued as a member of the Board or in any other capacity with Eaton whatsoever. - 9 - Section 10.07 Governing Law. The Plan shall be construed and governed in accordance with the law of the State of Ohio to the extent not covered by Federal law. - 10 - EX-10.W 5 l24244aexv10ww.txt EX-10(W) Exhibit 10 (w) Eaton Corporation 2006 Annual Report on Form 10-K Item 15 (b) EATON CORPORATION EXECUTIVE STRATEGIC INCENTIVE PLAN I (Originally Effective as of January 1, 1991 and Amended and Restated as of June 21, 1994, July 25, 1995, April 21, 1998, April 1, 1999, January 1, 2001 and January 23, 2007) EATON CORPORATION EXECUTIVE STRATEGIC INCENTIVE PLAN I 1. PURPOSE The purpose of the Executive Strategic Incentive Plan I (the "Plan") is to promote the growth and profitability of Eaton Corporation (the "Company") through the granting of incentives intended to motivate executives of the Company to achieve demanding long-term corporate objectives and to attract and retain executives of outstanding ability. 2. ADMINISTRATION Except as otherwise expressly provided herein, the Plan shall be administered by the Compensation and Organization Committee (the "Committee") of the Company's Board of Directors (the "Board") which shall consist of at least three directors of the Company selected by the Board. Except as otherwise expressly provided herein, the Committee shall have complete authority to: (i) interpret all provisions of the Plan consistent with law; (ii) designate the executives to participate under the Plan; (iii) determine the incentive targets and performance objectives applicable to participants; (iv) adopt, amend and rescind general and special rules and regulations for the Plan's administration; and (v) make all other determinations necessary or advisable for the administration of the Plan. 3. ELIGIBILITY Any executive of the Company designated by the Committee in its sole discretion shall be eligible to participate in the Plan. 4. INCENTIVE TARGETS (A) Establishment of Incentive Amounts and Conversion to Phantom Common Share Units Individual Incentive Amounts for each participant with respect to each Plan Award Period (as defined below) shall be determined by the Committee. With respect to Award Periods beginning on or after January 1, 1998, participant incentive targets will be expressed in the form of Phantom Common Share Units which will be determined by the Committee by: (a) first establishing 2 the Individual Incentive Amount in cash for each participant with respect to each Award Period and (b) then dividing such Individual Incentive Amount by the average of the mean prices for the Company's common shares for the first twenty(20) trading days of each Award Period. In all cases, the resulting Phantom Common Share Units shall be rounded up to the nearest 50 whole units. For purposes of the Plan, "mean price" shall be the mean of the highest and lowest selling prices for Company common shares quoted on the New York Stock Exchange List of Composite Transactions on the relevant trading day. Notwithstanding the foregoing provisions of this Section 4(A), the Committee may, in its sole discretion, use a different method for establishing incentive targets for participants under the Plan. (B) Award Periods Each Award Period shall be the four-calendar year period commencing as of the first day of the calendar year in which the performance objectives are established for the Award Period as described in Section 4(C). A new Award Period shall commence as of the first day of each calendar year, unless otherwise specified by the Committee. (C) Establishment of Company Performance Objectives As soon as practicable at the beginning of each Award Period, threshold, target, and maximum Company performance objectives for such Award Period shall be established by the Committee. For Award Periods commencing on or after January 1, 1998, unless otherwise determined by the Committee in its sole discretion, performance objectives will be established using a CFROGC/EPS Growth Performance Matrix which shall use the Company's average cash flow return on gross capital ("CFROGC") for such period along one axis and the Company's cumulative earnings per share ("EPS") for such period along the second axis. Within sixty (60) days after the performance objectives have been established by the Committee, each participant will be provided with written notice of his or her established objectives. In its sole discretion, the Committee may modify previously established performance objectives due to any change in conditions, the occurrence of any events or other factors which make such objectives unsuitable. Notwithstanding the foregoing, after a Change in Control (as hereinafter defined), neither the Committee nor the Board shall have the authority to modify performance objectives in any manner which could 3 prove detrimental to the interests of the Plan's participants. (D) Determination of Payments For each Award Period, payments ranging from 50% to 200% of the Phantom Common Share Units credited under Section 4(A) will be determined by the Committee for the attainment of performance objectives between either threshold and target or target and maximum. For Award Periods beginning on or after January 1, 1998, Final Individual Phantom Common Share Unit Awards shall be determined by the Committee as promptly as practicable after the completion of the Award Period: (a) determining the CFROGC/EPS Growth Matrix Performance Percentage applicable for the Award Period (equal to (i) 50% upon attainment of the threshold performance objective; (ii) 100% upon attainment of the target performance objective; and (iii) 200% upon attainment of the maximum performance; or the applicable percentage for performance between threshold and target or target and maximum); (b) multiplying such percentage by the number of Performance Share Units credited to the participant and (c) further multiplying the result by an Individual Performance Rating which will be a whole percentage between zero and 150% established by the Committee in its sole discretion after considering the recommendations of Company management. The Final Individual Phantom Common Share Unit Award shall be converted to cash at a market value of Company common shares as determined by the Committee based on the average of the mean prices for the Company's common shares for the final twenty (20) trading days of the Award Period), and distributed to the participate within ninety (90) days, unless the participant has made an irrevocable election to defer all or part of the amount of his or her award pursuant to any long term incentive compensation deferral plan adopted by the Committee or the Company. Notwithstanding any provision in this Section 4(D)to the contrary, the amount of the cash award with respect to the Chairman and Chief Executive Officer for the 2003-2006 Award Period Plan shall be limited to the amount of his award for the 2002-2005 Award Period. 5. PRORATA PAYMENTS 4 A participant must be employed by the Company or one of its subsidiaries at the end of an Award Period in order to be entitled to a payment in respect to such Award Period; provided, however, that a payment, prorated for the participant's length of service during the Award Period, may be authorized by the Committee, in its sole discretion, in the event the employment of a participant terminates before the end of an Award Period due to death, permanent disability, normal or early retirement, closure or divestiture of an Eaton facility or any other reason. Notwithstanding the foregoing, upon any termination of the Plan by the Committee during the term of any Award Period, payments to all participants will be made, prorated for each participant's length of service during the Award Period prior to the date of Plan termination. 6. OTHER PROVISIONS (A) Adjustments upon Certain Changes In the event of changes to the structure or corporate organization of the Company's businesses which affect the participants and/or the performance prospects of the Company, the Committee may make appropriate adjustments to individual participant Incentive Targets or to the established performance objectives for incomplete Award Periods. Adjustments under this Section 6 shall be made by the Committee, whose determination as to what adjustments shall be made, and the extent thereof, shall be final, binding and conclusive. Notwithstanding the foregoing, after a Change in Control, neither the Committee nor the Board shall have the authority to change established Performance Objectives in any manner which could prove detrimental to the interests of the participant. (B) Change in Control Defined For purposes of the Plan, a Change in Control shall be deemed to have occurred if: (i) a tender offer shall be made and consummated for the ownership of 25% or more of the outstanding voting securities of the Company, (ii) the Company shall be merged or consolidated with another corporation and as a result of such merger or consolidation less than 75% of the outstanding voting securities of the surviving or resulting corporation shall be owned in the aggregate by the former shareholders of the Company as the same 5 shall have existed immediately prior to such merger or consolidation, (iii) the Company shall sell substantially all of its assets to another corporation which is not a wholly-owned subsidiary of the Company, (iv) a "person" within the meaning of Section 3(a)(9) or of Section 13(d)(3) of the Securities Exchange Act of 1934 (as in effect on the effective date of the Plan) shall acquire 25% or more of the outstanding voting securities of the Company (whether directly, indirectly, beneficially or of record). For purposes of the Plan, ownership of voting securities shall take into account and shall include ownership as determined by applying the provisions of Rule 13d-3(d)(1)(I) under the Securities Exchange Act of 1934 (as in effect on the effective date of the Plan), or (v) during any period of two consecutive years, individuals who at the beginning of such period constitute the Board cease for any reason to constitute at least a majority thereof unless the election, or nomination for election by the Company's shareholders, of each new director was approved by a vote of at least two-thirds of the directors then still in office who were directors at the beginning of the period. (C) Non-Transferability No right to payment under the Plan shall be subject to debts, contract liabilities, engagements or torts of the participant, nor to transfer, anticipation, alienation, sale, assignment, pledge or encumbrance by the participant except by will or the law of descent and distribution or pursuant to a qualified domestic relations order. (D) Compliance with Law and Approval of Regulatory Bodies No payment shall be made under the Plan except in compliance with all applicable federal and state laws and regulations including, without limitation, compliance with tax requirements. (E) No Right to Employment Neither the adoption of the Plan nor its operation, nor any document describing or referring to the Plan, or any part thereof, shall confer upon any participant 6 under the Plan any right to continue in the employ of the Company or any subsidiary, or shall in any way affect the right and power of the Company or any subsidiary to terminate the employment of any participant under the Plan at any time with or without assigning a reason therefore, to the same extent as the Company might have done if the Plan had not been adopted. (F) Interpretation of the Plan Headings are given to the sections of the Plan solely as a convenience to facilitate reference; such headings, numbering and paragraphing shall not in any case be deemed in any way material or relevant to the construction of the Plan or any provisions thereof. The use of the masculine gender shall also include within its meaning the feminine. The use of the singular shall also include within its meaning the plural and vice versa. (G) Amendment and Termination The Committee may at any time suspend, amend or terminate the Plan. Notwithstanding the foregoing, upon the occurrence of a Change in Control, no amendment, suspension or termination of the Plan shall, without the consent of the participant, alter or impair any rights or obligations under the Plan with respect to such participant. (H) Effective Dates of the Plan The Plan was adopted by the Board on April 24, 1991 but the effective date of the Plan shall be January 1, 1991. The Plan was amended and restated as of June 21, 1994, July 25, 1995, April 21, 1998, April 1, 1999 and January 1, 2001 (which includes changes which affect Awards granted on or after January 1, 1998). 7 APPROVAL AND ADOPTION The Eaton Corporation EXECUTIVE STRATEGIC INCENTIVE PLAN I, in the form attached hereto, is hereby approved and adopted. ________________________________________ Name Date: _____________ ________________________________________ Title ________________________________________ Name ________________________________________ Title 8 EX-12 6 l24244aexv12.txt EX-12 EATON CORPORATION 2006 ANNUAL REPORT ON FORM 10-K ITEM 15(B) EXHIBIT 12 RATIO OF EARNINGS TO FIXED CHARGES
Year ended December 31 --------------------------------------- 2006 2005 2004 2003 2002 ------ ------ ---- ----- ------ (Millions of dollars) Income from continuing operations before income taxes $ 989 $ 988 $768 $ 492 $ 384 Adjustments - ----------- Minority interests in consolidated subsidiaries 10 5 7 12 14 Loss (income) from equity investees 1 1 (3) (1) Interest expensed 139 109 88 93 110 Amortization of debt issue costs 1 1 1 2 2 Estimated portion of rent expense representing interest 41 38 37 38 34 Amortization of capitalized interest 12 12 17 13 13 Distributed income of equity investees 1 4 3 ------ ------ ---- ----- ----- Adjusted income from continuing operations before income taxes $1,194 $1,158 $921 $ 647 $ 556 ====== ====== ==== ===== ===== Fixed charges Interest expensed $ 139 $ 109 $ 88 $ 93 $ 110 Interest capitalized 14 13 7 7 8 Amortization of debt issue costs 1 1 1 2 2 Estimated portion of rent expense representing interest 41 38 38 38 34 ------ ------ ---- ----- ----- Total fixed charges $ 195 $ 161 $134 $ 140 $ 154 ====== ====== ==== ===== ===== Ratio of earnings to fixed charges 6.12 7.19 6.87 4.62 3.61
EX-21 7 l24244aexv21.txt EX-21 EATON CORPORATION 2006 ANNUAL REPORT ON FORM 10-K ITEM 15(B) EXHIBIT 21 SUBSIDIARIES OF EATON CORPORATION Eaton is publicly held and has no parent corporation. Eaton's subsidiaries as of December 31, 2006 and the state or country in which each was organized are as follows:
Consolidated subsidiaries (A) Where Organized - ----------------------------- --------------- Eaton MDH Company Inc. California Eaton Aerospace HiTemp Inc. Colorado Aeroquip International Inc. Delaware Eaton Administration Corporation Delaware Eaton Aerospace LLC Delaware Eaton Asia Investments Corporation Delaware Eaton Aviation Corporation Delaware Eaton Aviation Products Corporation Delaware Eaton Electrical de Puerto Rico Inc. Delaware Eaton Electrical Inc. Delaware Eaton Filtration LLC Delaware Eaton Hydraulics Inc. Delaware Eaton International Corporation Delaware Eaton MDH Limited Partnership Delaware Eaton Nocadoli Holding LLC Delaware Eaton USEV Holding Company Delaware ERC Corporation Delaware Intelligent Switchgear Organization LLC Delaware Modern Molded Products, Inc. Delaware Tractech Holdings Inc. Delaware Tractech Inc. Delaware U.S. Engine Valve Delaware Vickers International Inc. Delaware Eaton Aeroquip Inc. Michigan Eaton Inoac Company Michigan Aeroquip-Vickers, Inc. Ohio Eaton Electrical IDT Inc. Ohio Eaton Leasing Corporation Ohio Eaton Power Quality S.A. Argentina Eaton Electric Systems Pty. Ltd. Australia Eaton Finance G.P. Australia Eaton Finance Pty. Ltd. Australia Eaton Industries Pty. Ltd. Australia Eaton Power Quality Pty. Ltd. Australia Eaton Pty. Ltd. Australia Vickers Systems Pty. Ltd. Australia Eaton Holding G.m.b.H. Austria Aeroquip Ltd. Barbados Aeroquip-Vickers Assurance Ltd. Barbados Eaton Holding Srl Barbados Eaton Filtration, BVBA Belgium Aeroquip-Vickers International Inc. Bermuda Eaton Services Limited Bermuda Saturn Insurance Company Ltd. Bermuda Aeroquip do Brasil, Ltda. Brazil Eaton Ltda. Brazil Eaton Power Solutions Ltda. Brazil Senyuan International Holdings Limited Cayman Islands Team Achieve Investments Limited British Virgin Islands Winner Hydraulics Ltd. British Virgin Islands Aeroquip-Vickers Canada, Inc. Canada Eaton ETN Offshore, Company Canada Eaton Power Quality, Company Canada Eaton Yale, Company. Canada Cutler-Hammer Company Cayman Islands Cutler-Hammer Electrical Company Cayman Islands Cutler-Hammer Industries Ltd. Cayman Islands
Eaton Holding III Limited Cayman Islands Georgetown Financial Services Ltd. Cayman Islands Senyuan International Holdings Limited Cayman Islands Changzhou Lanling Electrical Co., ltd. China Changzhou Senyuan Switch Co. Ltd. China Eaton (China) Investments Co., Ltd. China Eaton Electrical (Suzhou) Co., Ltd. China Eaton Fast Gear (Xi'an) Co., Ltd. China Eaton Filtration (Shanghai) Co. Ltd. China Eaton Fluid Power (Jining) Co., Ltd. China Eaton Fluid Power (Shanghai) Co., Ltd. China Eaton Hydraulics Systems (Jining) Co. Ltd. China Eaton Industries (Shanghai) Co. Ltd China Eaton Power Quality (Shanghai) Company Ltd. China Eaton Senstar Automotive Fluid Connectors (Shanghai) Co., Ltd. China Eaton Truck and Bus Components (Shanghai) Company, Ltd. China Hangzhou Eaton Power Quality Co., Ltd. China Nkt Electrical Components (Changzhou) Co., Ltd. China Shanghai Eaton Engine Components Company, Ltd. China Eaton Electrical S.A. Costa Rica Eaton Industries s.r.o. Czech Republic Eaton Electric ApS Denmark Eaton Holec, OY Finland Eaton Power Quality Oy Finland Eaton Aviation SAS France Eaton Power Quality S.A. France Eaton Power Solutions SAS France Eaton SAS France Eaton Technologies S.A. France Eaton Automotive G.m.b.H. Germany Eaton Filtration G.m.b.H. Germany Eaton Fluid Connectors G.m.b.H Germany Eaton Fluid Power G.m.b.H. Germany Eaton Holding G.m.b.H. Germany Eaton Holding Investments G.m.b.H & Co. KG Germany Eaton Power Quality G.m.b.H Germany Eaton Filtration Holdings G.m.b.H. Germany Eaton Filtration Limited Hong Kong Eaton Power Quality Limited Hong Kong Team Billion Investment Limited Hong Kong Vickers Systems Limited Hong Kong Eaton Industries Private Ltd. India Eaton Power Quality Private Limited India Vickers Systems International Ltd. India PT Fluid Sciences Batam Indonesia Eaton Automotive Ltd. Ireland Tractech (Ireland) Limited Ireland Eaton Fluid Power Srl Italy Eaton Srl Italy Eaton Filtration Ltd. Japan Eaton Fluid Power Limited Japan Eaton Japan Co., Ltd. Japan Eaton Holding S.a r.l. Luxembourg Eaton Holding II S.a.r.l. Luxembourg Eaton Holding III S.a.r.l. Luxembourg Eaton Electric Manufacturing Holdings Sdn. Bhd. Malaysia Eaton Electric Switchgear Sdn. Bhd. Malaysia Aeroquip de Mexico S. de R.L. de C.V. Mexico Eaton Controls, S. de R.L. de C.V. Mexico Eaton Electrical Mexicana S. de R.L. de C.V. Mexico Eaton Finance, S. de R.L. de C.V. Mexico Eaton Industries S. de R.L. de C.V. Mexico Eaton Molded Products S. de R.L. de C.V. Mexico Eaton Power Solutions, S. de R.L. de C.V. Mexico Eaton Truck Components, S. de R.L. de C.V. Mexico Eaton Automotive S. de R.L. de C.V. Mexico Operaciones de Maquila de Juarez S. de R.L. de C.V. Mexico Eaton Automotive B.V. Netherlands
Eaton B.V. Netherlands Eaton C.V. Netherlands Eaton Electric B.V. Netherlands Eaton Holding B.V. Netherlands Eaton Holding I B.V. Netherlands Eaton Holding II B.V. Netherlands Eaton Holding III B.V. Netherlands Eaton Holding IV B.V. Netherlands Eaton Holding International I B.V. Netherlands Eaton International B.V. Netherlands Hydrowa B.V. Netherlands Eaton Finance N.V. Netherlands Antilles Eaton Power Quality Company New Zealand Vickers Systems Limited New Zealand Eaton Automotive Components Spolka z o.o. Poland Eaton Automotive Spolka z o.o. Poland Eaton Automotive Systems Spolka z o.o. Poland Eaton Truck Components Spolka z o.o. Poland Eaton Madeira SGPS Ltd. Portugal Aeroquip Singapore Pte. Limited Singapore Eaton Filtration Pte. Ltd. Singapore Vickers Systems Asia Pacific Pte. Ltd. Singapore Aeroquip (South Africa) Pty. Ltd. South Africa Eaton Truck Components (Pty.) Limited South Africa Eaton Automotive Controls Limited South Korea Eaton Limited South Korea Aeroquip Iberica S.L. Spain Eaton S.L. Spain Productos Eaton Livia S.L. Spain Eaton Holec, AB Sweden Eaton Power Quality AB Sweden Eaton Industries Manufacturing G.m.b.H. Switzerland Modern Molded Products Limited Taiwan Rubberon Technology Corporation Limited Thailand Eaton Aerospace Limited United Kingdom Eaton Electric, Ltd United Kingdom Eaton Filtration Limited United Kingdom Eaton Holdings, Ltd United Kingdom Eaton Industries Limited United Kingdom Eaton, Ltd United Kingdom Eaton LP United Kingdom Eaton Power Quality Ltd. United Kingdom Eaton Power Solutions Ltd. United Kingdom Ultronics, Ltd. United Kingdom Eaton Electrical, S.A. Venezuela
(A) Other Eaton subsidiaries, many inactive, are not listed above. If considered in the aggregate, they would not be material. EX-23 8 l24244aexv23.txt EX-23 EATON CORPORATION 2006 ANNUAL REPORT ON FORM 10-K ITEM 15(B) EXHIBIT 23 CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM We consent to the incorporation by reference in the following Registration Statements and related Prospectuses of our reports dated February 23, 2007 with respect to the consolidated financial statements of Eaton Corporation, Eaton Corporation management's assessment of the effectiveness of internal control over financial reporting and the effectiveness of internal control over financial reporting of Eaton Corporation, included in this Annual Report (Form 10-K) for the year ended December 31, 2006.
Registration Number Description Filing Date - ------------ ----------- ----------- 333-136292 Eaton Corporation Incentive Compensation August 4, 2006 Deferral Plan - Form S-8 Registration Statement - 70,000 Shares 333-136291 Eaton Corporation - Shareholder Dividend August 4, 2006 Reinvestment and Direct Share Purchase Plan -1,000,000 Shares -Prospectus 333-130318 Eaton Corporation - Form S-3 Automatic Shelf December 14, 2005 Registration Statement 333-129602 Eaton Corporation Shareholder Dividend November 9, 2005 Reinvestment Plan - Form S-3 Registration Statement - 75,000 Shares 333-125836 Eaton Savings Plan - Form S-8 Registration June 15, 2005 Statement - 9,000,000 Shares 333-124129 Eaton Corporation Incentive Compensation April 18, 2005 Deferral Plan II - Form S-8 Registration Statement - 400,000 Shares 333-124128 Eaton Corporation Deferred Incentive April 18, 2005 Compensation Plan II - Form S-8 Registration Statement - 750,000 Shares 333-124127 2005 Non-Employee Director Fee Deferral Plan April 18, 2005 - Form S-8 Registration Statement - 30,000 Shares 333-116974 Eaton Corporation Deferred Incentive June 29, 2004 Compensation Plan - Form S-8 Registration Statement - 750,000 Shares 333-116970 Eaton Corporation 2004 Stock Plan - Form S-8 June 29, 2004 Registration Statement - 7,000,000 Shares 333-106764 Eaton Corporation - Form S-3 Registration July 2, 2003 Statement - $250,000,000 of Debt Securities, Debt Warrants, Preferred Shares and Common Shares 333-105786 Eaton Corporation - Form S-3 Registration June 3, 2003 Statement - $47,850,000 of Common Shares 333-104366 1996 Non-Employee Director Fee Deferral Plan April 8, 2003 - Form S-8 Registration Statement 333-104367 Eaton Savings Plan - Form S-8 Registration April 8, 2003 Statement - 5,000,000 Shares 333-97365 Eaton Corporation Incentive Compensation July 30, 2002 Deferral Plan - Form S-8 Registration Statement 333-97373 Cutler-Hammer de Puerto Rico Inc. Retirement July 30, 2002 Savings Plan - Form S-8 Registration Statement 333-97371 Eaton Corporation 2002 Stock Plan - Form S-8 July 30, 2002 Registration Statement 333-43876 Eaton Corporation 401(k) Savings Plan - Form August 16, 2000 S-8 Registration Statement - 500,000 Shares 333-35946 Deferred Incentive Compensation Plan - Form May 1, 2000 S-8 Registration Statement - 375,000 Shares 333-86389 Eaton Corporation Executive Strategic September 2, 1999 Incentive Plan - Form S-8 Registration Statement
333-77245 Eaton Corporation 401(k) Savings Plan - Form April 28, 1999 S-8 Registration Statement 333-77243 Eaton Corporation Share Purchase and April 28, 1999 Investment Plan - Form S-8 Registration Statement 333-74355 Eaton Corporation $1,400,000,000 of Debt March 12, 1999 Securities, Debt Warrants, Common Shares and Preferred Shares - Form S-3 Registration Statement (Including Post-Effective Amendment No. 1 filed on April 23, 1999 and Amendment No. 2 filed on May 11, 1999) 333-62375 Eaton Corporation 1998 Stock Plan - Form S-8 August 27, 1998 Registration Statement 333-62373 Eaton Holding Limited U.K. Savings - Related August 27, 1998 Share Option Scheme [1998] - Form S-8 Registration Statement 333-35697 Cutler-Hammer de Puerto Rico Company September 16, 1997 Retirement Savings Plan - Form S-8 Registration Statement 333-28869 Eaton 401(k) Savings Plan and Trust - Form June 10, 1997 S-8 Registration Statement 333-23539 Eaton Non-Employee Director Fee Deferral March 18, 1997 Plan - Form S-8 Registration Statement 333-22597 Eaton Incentive Compensation Deferral Plan - March 13, 1997 Form S-8 Registration Statement 333-03599 Eaton Corporation Share Purchase and May 13, 1996 Investment Plan - Form S-8 Registration Statement 333-01365 Eaton Corporation Incentive Compensation March 1, 1996 Deferral Plan - Form S-3 Registration Statement 33-64201 Eaton Corporation $120,837,500 of Debt November 14, 1995 Securities and Debt Warrants - Form S-3 Registration Statement 33-60907 Eaton 1995 Stock Plan - Form S-8 July 7, 1995 Registration Statement 33-52333 Eaton Corporation $600,000,000 of Debt February 18, 1994 Securities, Debt Warrants, Common Shares and Preferred Shares - Form S-3 Registration Statement 33-49393& Eaton Corporation Stock Option Plans - Form March 9, 1993 33-12842 S-8 Registration Statement
/s/ Ernst & Young LLP - ------------------------------------- Cleveland, Ohio February 23, 2007 EX-24 9 l24244aexv24.txt EX-24 EATON CORPORATION 2006 ANNUAL REPORT ON FORM 10-K ITEM 15(B) EXHIBIT 24 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS: That each person whose name is signed below has made, constituted and appointed, and by this instrument does make, constitute and appoint, Richard H. Fearon, Billie K. Rawot or William J. Nowak his or her true and lawful attorney, for him or her and in his or her name, place and stead to subscribe, as attorney-in-fact, his or her signature as Director or Officer or both, as the case may be, of Eaton Corporation, an Ohio corporation, to its Annual Report on Form 10-K for the year ended December 31, 2006 pursuant to the Securities Exchange Act of 1934, and to any and all amendments to that Annual Report, hereby giving and granting unto each such attorney-in-fact full power and authority to do and perform every act and thing whatsoever necessary to be done in the premises, as fully as he or she might or could do if personally present, hereby ratifying and confirming all that each such attorney-in-fact shall lawfully do or cause to be done by virtue hereof. This Power of Attorney shall not apply to any Annual Report on Form 10-K or amendment thereto filed after December 31, 2007. IN WITNESS WHEREOF, this Power of Attorney has been signed at Cleveland, Ohio this 24th day of January, 2007. /s/ Alexander M. Cutler /s/ Richard H. Fearon - ------------------------------------- ---------------------------------------- Alexander M. Cutler, Chairman Richard H. Fearon, and Chief Executive Officer; Executive Vice President--Chief President; Principal Executive Financial and Planning Officer; Officer; Director Principal Financial Officer /s/ Billie K. Rawot - ------------------------------------- Billie K. Rawot, Vice President and Controller; Principal Accounting Officer * * - ------------------------------------- ---------------------------------------- Christopher M. Connor Michael J. Critelli Director Director * * - ------------------------------------- ---------------------------------------- Charles E. Golden Ernie Green Director Director * * - ------------------------------------- ---------------------------------------- Ned C. Lautenbach Deborah L. McCoy Director Director * * - ------------------------------------- ---------------------------------------- John R. Miller Gregory R. Page Director Director * * - ------------------------------------- ---------------------------------------- Victor A. Pelson Gary L. Tooker Director Director EX-31.1 10 l24244aexv31w1.txt EX-31.1 EATON CORPORATION 2006 ANNUAL REPORT ON FORM 10-K ITEM 15(B) EXHIBIT 31.1 CERTIFICATION I, Alexander M. Cutler, certify that: 1. I have reviewed this annual report on Form 10-K of Eaton Corporation; 2. Based on my knowledge, this 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 report; 3. Based on my knowledge, the financial statements, and other financial information included in this 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 report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, 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 report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: February 28, 2007 /s/ Alexander M. Cutler ---------------------------------------- Alexander M. Cutler Chairman and Chief Executive Officer; President EX-31.2 11 l24244aexv31w2.txt EX-31.2 EATON CORPORATION 2006 ANNUAL REPORT ON FORM 10-K ITEM 15(B) EXHIBIT 31.2 CERTIFICATION I, Richard H. Fearon, certify that: 1. I have reviewed this annual report on Form 10-K of Eaton Corporation; 2. Based on my knowledge, this 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 report; 3. Based on my knowledge, the financial statements, and other financial information included in this 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 report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, 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 report is being prepared; b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles; c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: February 28, 2007 /s/ Richard H. Fearon ---------------------------------------- Richard H. Fearon Executive Vice President - Chief Financial and Planning Officer EX-32.1 12 l24244aexv32w1.txt EX-32.1 EATON CORPORATION 2006 ANNUAL REPORT ON FORM 10-K ITEM 15(B) EXHIBIT 32.1 CERTIFICATION This written statement is submitted in accordance with Section 906 of the Sarbanes-Oxley Act of 2002. It accompanies Eaton Corporation's Annual Report on Form 10-K for the year ended December 31, 2006 ("10-K Report"). I hereby certify that, based on my knowledge, the 10-K Report fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934 (15 U.S.C 78m), and information contained in the 10-K Report fairly presents, in all material respects, the financial condition and results of operations of Eaton Corporation and its consolidated subsidiaries. Date: February 28, 2007 /s/ Alexander M. Cutler ---------------------------------------- Alexander M. Cutler Chairman and Chief Executive Officer; President EX-32.2 13 l24244aexv32w2.txt EX-32.2 EATON CORPORATION 2006 ANNUAL REPORT ON FORM 10-K ITEM 15(B) EXHIBIT 32.2 CERTIFICATION This written statement is submitted in accordance with Section 906 of the Sarbanes-Oxley Act of 2002. It accompanies Eaton Corporation's Annual Report on Form 10-K for the year ended December 31, 2006 ("10-K Report"). I hereby certify that, based on my knowledge, the 10-K Report fully complies with the requirements of Section 13(a) of the Securities Exchange Act of 1934 (15 U.S.C 78m), and information contained in the 10-K Report fairly presents, in all material respects, the financial condition and results of operations of Eaton Corporation and its consolidated subsidiaries. Date: February 28, 2007 /s/ Richard H. Fearon ---------------------------------------- Richard H. Fearon Executive Vice President - Chief Financial and Planning Officer -----END PRIVACY-ENHANCED MESSAGE-----