Material Tax and Accounting Implications of the NEO Executive Compensation Program

Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”), generally disallows a tax deduction to public companies for certain compensation in excess of $1 million paid to the company’s Chief Executive Officer and the four other most highly compensated executive officers. Specified compensation, including qualified performance-based compensation, will not be subject to the deduction limit if certain requirements are met. Where possible, the Committee generally seeks to structure compensation amounts and plans that meet the requirements for deductibility under this provision. Specifically, the Committee has taken steps to qualify the stock option awards as performance-based compensation for this purpose. While the Committee believes it is important to consider Section 162(m), it also believes that stockholder interests are best served by not restricting the Committee’s discretion and

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flexibility in crafting the executive compensation program, even though such programs may result in non-deductible compensation expenses.

The Committee also considers the accounting implications to the Company of its executive compensation decisions, including, among other things, the financial statement impact of equity compensation awards as determined pursuant to Financial Accounting Standards Board Statement No. 123R, “Share Based Payment” (“SFAS 123R”).

Discussion and Analysis of our 2006 Compensation Program and Awards

This section describes and analyzes each of the elements of our compensation program for our NEOs, including why the Committee chooses to include these items in the compensation program, the details of the compensation amounts granted to NEOs in 2006 and the Committee’s rationale for awarding these compensation amounts.

Cash Compensation

Total cash compensation is delivered in the form of salary and annual cash incentive awards or bonuses under a performance-based Management Incentive Compensation Plan (the “MICP”) approved by the Committee at the beginning of each fiscal year. For 2006, base salaries constituted approximately 40% and approximately 50% to 60% of the total cash compensation of the CEO and other NEOs, respectively, with bonuses constituting the remaining portion of cash compensation. Salary is included in the Company’s NEO compensation package because the Committee believes it is both necessary and appropriate that some portion of the compensation be provided to NEOs in a form that is fixed and liquid. Performance-based bonuses under the MICP are included in the package because they permit the Committee to incentivize our NEOs, in any particular year, to pursue particular objectives that the Committee believes are consistent with the overall goals and strategic direction that the Board has set for our Company. The components comprising the cash portion of total compensation are described below.

Salary.    The Committee reviews and approves the salaries of the NEOs on an annual basis, as well as at the time of a promotion or other change in responsibilities. Increases in salary are based on an evaluation of an individual’s performance, contribution, and level of pay compared to the Peer Group. For the NEOs other than the CEO, our CEO makes recommendations to the Committee concerning adjustments to salary. In setting salaries, the Committee is generally mindful of its overall goal of keeping base salary compensation for its executive officers at the 50 th  percentile of base salary compensation paid by companies in the Peer Group. Because the Company is experiencing rapid growth and internal change, particular care is taken to ensure that expanded responsibilities are recognized in the calculation of base salary. Merit increases normally take effect January 1 of each year. As the value of the annual bonus is expressed as a multiple of base salary, a higher base salary will result in a higher bonus award, assuming the same level of achievement against goals.

For 2006, our CEO’s base salary was set at $1,129,000. Salaries for our other NEOs ranged from $405,600 to $525,000. The Committee believes that, overall, these base salaries are consistent with the 50 th  percentile of executive base salaries paid by our Peer Group companies for comparable positions.

Bonus Plan.    Our NEOs participate in a cash bonus plan, the MICP. This plan provides cash compensation to NEOs only if, and to the extent that, annual performance conditions set by the Committee are achieved. Whether, and to what extent, bonuses under the MICP are paid depends entirely on the extent to which the established corporate objectives contained within the MICP for that year are attained. The Committee believes that the achievement of these objectives ultimately will contribute to the long-term success of the Company.

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The performance objectives contained within the MICP are developed with input from management, the Committee and the Board. Based on a review of internal forecasts, management, including the NEOs, develops preliminary recommendations for the Committee’s review. The Committee reviews management’s preliminary recommendations and establishes the final MICP goals and weighting, which are ratified by the full Board. In establishing final goals, the Committee strives to ensure that the incentives provided pursuant to the MICP are consistent with the strategic goals set by the Board for the Company, that the objectives set are sufficiently ambitious to provide a meaningful incentive and to ensure that bonus payments, assuming target levels of performance are attained, will be consistent with the overall philosophy of the executive compensation program established by the Committee. The Committee reserves the discretion to reduce or not pay bonuses under the MICP, even if the relevant performance targets are met. The Committee did not exercise this discretion in 2006.

The MICP for 2006 was approved by the Board at its January 2006 meeting. The MICP objectives for 2006 consisted of both financial and operational components, in varying percentages as detailed in the tables below. The Committee believes that the combination of the financial and operational performance objectives within the 2006 MICP created a significantly high hurdle for achievement by each NEO.

At the outset of each year, the Committee sets target bonuses under the MICP for each NEO. In determining the amount of target bonuses under the MICP, the Committee considers several factors, including:

·        the target bonuses set, and actual bonuses paid, in recent years;

·        the desire to ensure that a substantial portion of total compensation is performance-based;

·        the relative importance, in any given year, of the short-term performance objectives established pursuant to the MICP; and

·        the advice of Mercer as to compensation practices at other companies in the Peer Group.

The actual amount of an MICP award is determined based on each NEOs level of achievement against individual objectives. The MICP provides the NEOs with the opportunity to earn bonuses that exceed target levels for exceeding performance objectives and, conversely, penalizes the NEOs for missing their objectives. If a minimum MICP score is not achieved, a NEO will not be eligible to receive any award under the MICP. At the end of each fiscal year, the Committee is responsible for assessing the performance of each NEO against the MICP performance criteria and determining the level of awards, if any, under the MICP. The Committee presents its decisions to the independent members of the Board for ratification.

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The following two tables summarize the components of the 2006 MICP and the actual awards granted by the Committee for fiscal year 2006. The first table describes the MICP for the CEO; the second table describes the MICP for the other NEOs.

In 2006, the Company exceeded the total product sales target established in the MICP. Strong PROVIGIL® (modafinil) sales and slower than expected erosion of sales of ACTIQ® (oral transmucosal fentanyl citrate) more than offset the absence of revenue from SPARLON™ (modafinil), which had been targeted for approval and launch in 2006. The Company also significantly exceeded the pro forma net

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income targets in the MICP, due in part to the aggressive measures taken by management to reduce expenses during 2006 in the wake of the Company’s receipt from the U.S. Food and Drug Administration of a non-approval letter for SPARLON.

The Operational Goals included in the MICP were generally met or exceeded during 2006. In the area of clinical, while the Company failed to achieve its objective of achieving FDA approval of SPARLON in 2006, it did receive an approvable letter for NUVIGIL and also secured FDA approval of FENTORA® (fentanyl buccal tablet) earlier than expected. In addition, the Company made solid progress in advancing its ongoing clinical programs in the U.S. and Europe. Taken together, the Committee determined that the Company achieved approximately 50% of its clinical goal. For manufacturing, the Committee determined that the Company had met its established objectives for manufacturing new and existing products and providing manufacturing support for products in clinical development. For R&D, the Company met its established objective of advancing the Company’s research and development plan, which included supporting the filing of one investigational new drug application in 2006 and continuing pre-clinical development of specified oncology and neurology compounds.

Based on the above, the Committee calculated a MICP score for 2006 of 104, which yielded a MICP award percentage of 157% of base salary, or $1,772,500, for the CEO.

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The results of the Financial Goals for the other NEOs are described above. For each NEO, the Committee determined, based on input from the CEO, the MICP score for the individual performance component based on the level of achievement against the established individual performance goals. The range of MICP scores was 106 to 112, which yielded MICP bonuses in the range of 70% to 90% of base salary, depending on the NEO. The dollar amount of awards granted to the other NEOs for 2006 ranged from $325,500 to $404,300.

With respect to Section 162(m), payments under the Company’s MICP are generally subject to the Section 162(m) limits on deductibility and will not qualify as “performance-based compensation,” within the meaning of the applicable regulations as the MICP has not been approved by stockholders.

Long-term Incentive Compensation

The Committee believes that placing a heavy emphasis on equity compensation will better align the interests of NEOs with our stockholders.

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Types of Equity Awards.    Equity awards to our NEOs are made pursuant to our 2004 Equity Compensation Plan (the “2004 Plan”), which has been approved by Cephalon stockholders. Our officers and directors are not eligible to participate in the Company’s 2000 Equity Compensation Plan for Employees and Key Advisors. The 2004 Plan provides for awards in the form of incentive stock options and non-qualified stock options (collectively, “stock options”) and restricted stock units. The mix between these forms of awards changes somewhat from year to year. In 2006, the total value of equity awards granted to NEOs as calculated under SFAS 123R was split approximately equally between stock options and restricted stock units. In determining the mix of stock options to restricted stock, the Committee considers a number of factors, including: the performance and contribution of the NEOs; the total shares available in the equity pool and the most efficient use of the available shares; Peer Group comparisons; and, finally, retention of the NEOs.

Equity Compensation Awarded in 2006.    In 2006, the Committee approved, and the independent members of the Board ratified, equity awards to the NEOs that had a total value calculated under the Black-Scholes model equal to approximately four times cash compensation (including bonus opportunities, assuming performance at “target” levels) for Dr. Baldino and between 3 to 3.5 times cash compensation for the other NEOs.

On December 19, 2006, the Board ratified the Committee’s approval of a grant to our CEO of 160,000 stock options at an exercise price of $71.07, which was the closing price of our common stock on the date of grant, and 80,000 units of restricted stock. The stock options and RSUs awarded to the CEO in December 2006 represent the same number of shares granted in 2005.

For each of the other NEOs, the Board also ratified the Committee’s approval of a grant of 50,000 stock options at an exercise price of $71.07, which was the closing price of our common stock on the date of grant, and 15,000 units of restricted stock. The stock options and RSUs awarded to the other NEOs represent the same number of shares granted to each of the other NEOs in 2005.

The stock options and RSUs awarded during 2006 generally vest over a four-year period, with 25% becoming exercisable on each anniversary of the grant date. The stock options have a 10-year term.

The value of the equity compensation awards granted to the NEOs in 2006 is at approximately the 75 th  percentile of estimated equity values awarded to executives at the Peer Group companies. For the stock options, the estimated equity value was calculated based on the methodology defined in SFAS 123R; for RSUs, the estimated value was calculated based on the value of the underlying common stock on the date of grant. The Committee believed that the progress made in 2006 by the NEOs of furthering the Company’s long-term business plan supported equity awards above the 50 th  percentile target levels.

Additionally, on February 1, 2006, our CEO received a grant of 5,000 RSUs. The Committee determined that this special award was warranted in recognition for the lead role our CEO played in successfully resolving the four PROVIGIL patent litigation cases, the last of which settled on February 1, 2006, thereby securing the long-term future of the Company’s most important product. This grant vests over a four-year period, with 25% becoming exercisable on each anniversary of the respective grant date.

The Company’s equity compensation plans satisfy the requirements of Section 162(m) with respect to stock options, but not with respect to awards of RSUs. Accordingly, compensation recognized by the NEOs in connection with stock options is fully deductible, but compensation with respect to RSUs is subject to the $1,000,000 limit on deductibility.

Practices Regarding the Grant of Options

The Company generally has followed a practice of making all annual stock option grants to its executive officers on a single date each year. For at least the last 10 years, at its last regularly-scheduled meeting usually in early- to mid-December, the Board has ratified the annual option grants made by the

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Committee. The Committee approves these annual grants, subject to the ratification by the Board, at a meeting prior to the scheduled December Board meeting. Historically, the December Board meeting date has occurred approximately four to six weeks following the issuance of the press release reporting our third quarter financial results for the then-current fiscal year. The dates of the December Board and Committee meetings are determined at least a year in advance based on the Board members availability for an in-person meeting. The Committee believes that it is appropriate that annual awards be made at a time when material information regarding our performance for the current fiscal year has been disclosed. We do not otherwise have any program, plan or practice to time annual option grants to our executives in coordination with the release of material non-public information.

While the bulk of our stock option awards to NEOs have historically been made pursuant to our annual grant program, the Committee retains the discretion to make additional awards to NEOs at other times, in connection with the initial hiring of a new officer, for retention purposes or otherwise. The Committee has generally followed the practice of making such awards only during a time when our NEOs would be permitted, pursuant to our insider trading policy, to trade in our securities. Other than in this respect, we do not have any program, plan or practice to time equity awards in coordination with the release of material non-public information.

All stock option awards made to our NEOs are made pursuant to our 2004 Plan. As noted above, all options under the 2004 Plan (as well as awards to employees other than our officers under our 2000 Equity Compensation Plan) are granted with an exercise price that may not be less than the fair market value of our common stock on the date the grants are ratified by the Board. Fair market value is defined under the 2004 Plan to be the closing sale price of a share of our common stock on the date of grant as reported on the NASDAQ Stock Market. While the Charter of the Committee permits delegation of the Committee’s authority to grant options in certain circumstances, this delegated authority has never been exercised.

Other Benefits

Perquisites.    Our NEOs receive various perquisites provided by or paid for by the Company. These perquisites include automobile allowances, financial and estate planning services, supplemental long-term disability insurance, personal use of the corporate aircraft (subject to the execution of a Time Sharing Agreement as described below), executive health care benefits and gross-up payments equal to the taxes payable on certain perquisites.

We provide these perquisites because in many cases the perquisite makes our executives more efficient and effective and thereby is a benefit to the Company. Additionally, perquisites are provided by many companies in the Peer Group to their named executive officers and it is therefore necessary for retention and recruitment purposes that we do the same.

The Committee reviews the perquisites provided to its NEOs on a regular basis, in an attempt to ensure that they continue to be appropriate in light of the Committee’s overall goal of designing a compensation program for NEOs that maximizes the interests of our stockholders.

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The benefits are summarized as follows:

We also provide our executive officers with the option to utilize Cephalon’s corporate aircraft for personal use, subject to the execution of a Time Sharing Agreement with the Company. Under the Time Sharing Agreement and the Company’s internal policies, an executive must reimburse the Company for the personal use of the aircraft by the executive and the executive’s guests. It is our intent that, in all cases, the amount reimbursed by the executive for personal use is the greater of the incremental operating costs associated with the use of the aircraft and the amount of income that would be required to be imputed to the executive under Internal Revenue Service regulations, subject in each case to the maximum reimbursement amount permitted under Part 91 of the U.S. Federal Aviation Administration regulations.

Dr. Baldino has reimbursed the Company $63,157 for his personal use of the corporate aircraft during 2006. Because Dr. Baldino’s payment to the Company exceeded the value of his personal use as calculated in accordance with the standard industry fare level, or SIFL, rates set by the IRS, we did not impute any income to Dr. Baldino in 2006. Likewise, for SEC reporting purposes, we have determined that the amount reimbursed by Dr. Baldino to the Company exceeded the estimated incremental cost to the company of his personal use of the aircraft. For this reason, the Summary Compensation Table shown on page 25 does not include any compensation to Dr. Baldino related to this perquisite. None of the other NEOs used the corporate aircraft for personal use during 2006.

Deferred Compensation Plan.    Our Deferred Compensation Plan allows employees at the level of Vice President and above, including the NEOs, to defer receipt of all or a portion of bonus received under the MICP until either a date specified at election by the employee or retirement. Deferred amounts are credited with an annual fixed rate of return that is set each year by the Committee. The Committee determines the interest rate for the Deferred Compensation Plan based on the Prime Rate plus 1-3%. For 2006, the interest rate was 10%; for 2007, the interest rate is set at 9%. We do not “match” amounts that are deferred by employees pursuant to the Deferred Compensation Plan. Distributions from the plan are paid in a lump sum upon the six-month anniversary of the termination of the employee’s employment with the Company. Currently, only two NEOs participate in the Deferred Compensation Plan.

The obligations under the Deferred Compensation Plan are not funded by the Company, and therefore participants have an unsecured contractual commitment from the Company to pay the amounts due under the Deferred Compensation Plan. Because the plan is unsecured, the Committee believes it is appropriate to provide an above-market interest rate to compensate for this risk. When payments are due under the Deferred Compensation Plan, the cash will be distributed from the Company’s general assets.

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We provide this benefit because the Committee wishes to permit certain of our employees to defer the obligation to pay taxes on bonuses that they are entitled to receive. The Deferred Compensation Plan permits them to do this, while also receiving interest on deferred amounts, as described above. We believe that provision of this benefit is important as a retention and recruitment tool as many of the companies with which we compete for executive talent provide a similar plan to their senior employees.

Executive Severance Agreements.    While the Company does not have employment agreements with the NEOs, we have entered into executive severance agreements with our executive officers, including the NEOs. These agreements provide for payments and other benefits if the officer’s employment is involuntarily terminated by the Company for any reason other than “Cause,” death or “Disability,” as these terms are defined in the severance agreements. These severance agreements also provide for payments and other benefits upon a qualifying event or circumstances after there has been a “Change in Control” (as defined in the agreements) of the Company. The Committee reviews and approves the terms of each executive severance agreement prior to execution and believes that the terms contained in these agreements are reasonable and customary for agreements of this type. Additional information regarding the executive severance agreements, including a definition of key terms and a quantification of benefits that would have been received by our NEOs had termination occurred on December 31, 2006, is found under the heading “2006 Potential Payments upon Termination or Change in Control” on pgs. 28 - 30 of this Proxy Statement.

The Committee believes that these severance arrangements are an important part of overall compensation for our NEOs. The Committee believes that these agreements will help to secure the continued employment and dedication of our NEOs, notwithstanding any concern that they might have at such time regarding their own continued employment, prior to or following a change in control. The Committee also believes that these agreements are important as a recruitment and retention device, as most of the companies with which we compete for executive talent have similar agreements in place for their executive officers.

In late August 2006, the Company and Dr. Paul Blake agreed to end Dr. Blake’s employment as the Company’s Executive Vice President, Worldwide Medical and Regulatory Operations effective as of August 31, 2006. In connection with this matter, the Company and Dr. Blake executed a Separation Agreement providing for compensation and benefits that would have been paid under his existing Severance Agreement with the Company including (i) a lump sum cash payment of $697,000, which was equal to one and a half times Dr. Blake’s then-current annual base salary (or 18 months thereof); (ii) dental and medical coverage continuation for Dr. Blake, his spouse and dependents until February 2008; and (iii) payment of up to $15,000 to cover the costs of outplacement assistance services. In consideration of such benefits, Dr. Blake released the Company from all claims, demands and causes of action related to his employment with the Company.

401(k) Profit Sharing Plan.    Under the Cephalon, Inc. 401(k) Profit Sharing Plan (the “401(k) Plan”), a tax-qualified retirement savings plan, all employees located in the United States, including our NEOs, may contribute up to 100 percent of regular earnings on a before-tax basis into their 401(k) Plan accounts, subject to the limits imposed by the IRS. In addition, under the 401(k) Plan, we may determine to make a matching contribution to a participating employees account. Historically, we have determined to match an amount equal to one dollar for each dollar contributed by participating employees on the first six percent of their regular earnings, subject to any limitations imposed by the IRS. Because we do not sponsor a defined benefit pension plan, the 401(k) Plan matching contribution allows Cephalon to remain competitive with other companies in its industry that provide retirement savings vehicles for their executives and employees. Cephalon employees are immediately and fully vested in all matching contributions made by the Company under the 401(k) Plan. As of December 31, 2006, approximately 90% of the Company’s U.S.-based employees were participants in the 401(k) Plan.

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