UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

SCHEDULE 14A

Proxy Statement Pursuant to Section 14(a) of the Securities
Exchange Act of 1934 (Amendment No.  )

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Southwest Airlines Co.

(Name of Registrant as Specified In Its Charter)

 

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

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SOUTHWEST AIRLINES CO.

 

NOTICE OF ANNUAL MEETING OF SHAREHOLDERS

Wednesday, May 16, 2007

 

To the Shareholders:

 

The Annual Meeting of the Shareholders of Southwest Airlines Co. (the “Company” or “Southwest”) will be held at its corporate headquarters, 2702 Love Field Drive, Dallas, Texas on Wednesday, May 16, 2007, at 10:00 a.m., local time, for the following purposes:

 

(1) to elect ten Directors;

 

(2) to approve an amendment to the Company’s Articles of Incorporation to eliminate supermajority voting requirements;

 

(3) to approve the Company’s 2007 Equity Incentive Plan;

 

(4) to ratify the selection of Ernst & Young LLP as the Company’s independent auditors for the fiscal year ending December 31, 2007;

 

(5) to consider and vote on a Shareholder proposal to adopt a simple majority vote with respect to certain matters, if the proposal is presented at the meeting; and

 

(6) to transact such other business as may properly come before such meeting.

 

March 21, 2007 is the date of record for determining Shareholders entitled to receive notice of and to vote at the Annual Meeting.

 

Our Annual Meeting will be broadcast live on the Internet. To listen to the broadcast, log on to www.southwest.com at 10:00 a.m., CDT, on May 16, 2007.

 

We have made our 2006 Annual Report to Shareholders available to you on the Internet at www.southwest.com (click on “About SWA,” “Investor Relations,” “Annual Reports”).

 

If you do not have Internet access and you would like a copy of our 2006 Annual Report to Shareholders, you may request one from Investor Relations, Southwest Airlines Co., P.O. Box 36611, Dallas, Texas 75235. Additionally, the Company’s Annual Report on Form 10-K as filed with the Securities and Exchange Commission, but excluding exhibits, is attached to this Proxy Statement as Appendix D.

 

By Order of the Board of Directors,

 

Colleen C. Barrett
President and Secretary

 

April   , 2007

 

 

 

Southwest Airlines Co.
P.O. Box 36611
Dallas, Texas 75235-1611
(214) 792-4000

 

PROXY STATEMENT

 

SOLICITATION AND REVOCABILITY OF PROXIES; VOTING

 

The enclosed proxy is solicited by and on behalf of the Board of Directors of the Company for use at the Annual Meeting of Shareholders to be held on May 16, 2007, at 10:00 a.m., local time, at the Company’s corporate headquarters, 2702 Love Field Drive, Dallas, Texas, or any adjournment thereof. The Company will pay the cost of solicitation. In addition to solicitation by mail, solicitation of proxies may be made personally or by telephone by the Company’s regular Employees, and arrangements will be made with brokerage houses or other custodian’s nominees and fiduciaries to send proxies and proxy material to their principals. In addition, the Company has hired Georgeson Inc. to distribute and solicit proxies for a fee of $15,000 plus reasonable expenses. The proxy statement and form of proxy were first mailed to Shareholders of the Company on or about April   , 2007.

 

The enclosed proxy, even though executed and returned, may be revoked at any time prior to the voting of the proxy by the subsequent execution and submission of a revised proxy, by written notice to the Secretary of the Company, or by voting in person at the meeting. All Shareholders of record can vote by completing and returning the enclosed proxy card. All Shareholders of record can also vote by touch-tone telephone from the United States, using the toll-free number on the proxy card, or by the Internet, using the instructions on the proxy card. If you have shares held by a broker, bank, or other nominee as a custodian, you are a “street name holder.” In such case, you may instruct your nominee to vote your shares by following instructions that the nominee provides for you. You may also vote by telephone or the Internet if your nominee makes these methods available, in which case the nominee will enclose the instructions with the proxy statement. Shares represented by proxy will be voted at the meeting.

 

An automated system administered by the Company’s transfer agent will tabulate the votes. If your shares are held in street name, your nominee will ask for instructions on how you want your shares to be voted. If you provide instructions, your shares will be voted as you direct. If you do not provide instructions, your nominee will vote your shares only with respect to proposals as to which it has discretion to vote. For all other proposals, the broker cannot vote your shares at all, which is referred to as a “broker non-vote.” Abstentions and broker non-votes are each included in the determination of the number of shares present and voting for purposes of determining the presence or absence of a quorum for the transaction of business. Neither abstentions nor broker non-votes are counted as voted either for or against a proposal. Except as otherwise stated herein, provided a quorum is present, the affirmative vote of the holders of a majority of the shares entitled to vote on, and voted for or against, a matter is required to approve the matter.

 

In some cases, only one proxy statement is being delivered to multiple Shareholders sharing an address unless the Company has received contrary instructions from one or more of the Shareholders. Upon written or oral request, the Company will deliver a separate copy of the proxy statement to a Shareholder at a shared address to which a single copy of the proxy statement was delivered. A Shareholder can notify the Company at the above address that it wishes to receive a separate copy of the proxy statement in the future, or, alternatively, that it wishes to receive a single copy of the materials instead of multiple copies.

 

PROPOSAL 1
ELECTION OF DIRECTORS

 

At the Annual Meeting of Shareholders, ten Directors are to be elected for one-year terms expiring in 2008. Provided a quorum is present at the Annual Meeting, a plurality of the votes cast in person or by proxy by the holders of shares entitled to vote is required to elect Directors.

 

The persons named in the enclosed proxy have been selected as a proxy committee by the Directors of the Company, and it is the intention of the proxy committee that, unless otherwise directed therein, proxies will be voted for the election of the nominees listed below. Although the Directors of the Company do not contemplate that any of the nominees will be unable to serve, if such a situation arises prior to the meeting, the proxy committee will act in accordance with its best judgment.

 

The following sets forth certain information for each nominee for Director of the Company, as of January 1, 2007. Governor William P. Hobby, a director since 1990, will retire at the Annual Meeting. There are no family relationships between any of the Directors or between any of the Directors and executive officers of the Company.

 

 

Colleen C. Barrett has been President of the Company since June 19, 2001, at which time she was also named to the Board of Directors. Prior to that time, Ms. Barrett was Executive Vice President — Customers from 1990 to 2001 and Vice President — Administration from 1986 to 1990. Ms. Barrett has been Secretary of the Company since March 1978. Ms. Barrett is a Director of J.C. Penney Company, Inc.

 

David W. Biegler has been Chairman of Estrella Energy L.P., a company engaged in natural gas transportation and processing, since September 2003. He retired as Vice Chairman of TXU Corporation at the end of 2001, having served TXU Corporation as President and Chief Operating Officer from 1997 until 2001. He previously served as Chairman, President, and CEO of ENSERCH Corporation from 1993 to 1997. Mr. Biegler is also a director of Dynegy Inc., a company engaged in power generation, Trinity Industries, Inc., a diversified industrial company providing products and services for the transportation, industrial, and construction sectors, and Austin Industries, a company engaged in construction.

 

Louis E. Caldera has served as a Professor of Law at The University of New Mexico since August 2003. He served as President of the University of New Mexico from August 2003 through February 2006. He was the Vice Chancellor for University Advancement and President, CSU Foundation, at The California State University from June 2001 until June 2003. He was the Secretary of the Army in the Clinton Administration from July 1998 until January 2001. Mr. Caldera previously served as the Managing Director and Chief Operating Officer for the Corporation for National and Community Service, a federal grant-making agency, from September 1997 to June 1998. He served as a member of the California State Legislature from 1992 to 1997, representing the 46th Assembly District (Los Angeles). Mr. Caldera is a Director of Belo Corp. and IndyMac Bancorp, Inc.

 

C. Webb Crockett has been an attorney in the Phoenix, Arizona law firm of Fennemore Craig for more than the past five years and is a non-equity director in such firm. Fennemore Craig performed services for the Company in 2006 and will do so in 2007.

 

William H. Cunningham, Ph.D., holds the James L. Bayless Chair for Free Enterprise at the University of Texas at Austin Red McCombs School of Business. Dr. Cunningham was the Chancellor of the University of Texas System from 1992 to June 2000. He is a Director of the following publicly traded companies: Lincoln National Corporation, Introgen Therapeutics, Inc., LIN TV Corp., and Hayes Lemmerz International, Inc. He is a disinterested Director of John Hancock Mutual Funds and John Hancock Funds II and III.

 

Travis C. Johnson was a partner in the law firm of Johnson & Bowen for more than five years prior to 2001. Since January 2001, Mr. Johnson has practiced law as Travis Johnson, Attorney at Law. Mr. Johnson served as a Director of J.P. Morgan Chase Bank — El Paso from 1984 until 2005 and was Founder and Chairman of the Board, Texas Commerce Bank — Border City from 1971 until 1987. He is a former County Judge and served as a member of the University of Houston Board of Regents for 12 years. Mr. Johnson currently serves as Vice Chairman of the Board of Directors of the El Paso Museum of Art Foundation.

 

Herbert D. Kelleher has been Chairman of the Board of the Company since March 29, 1978. Mr. Kelleher became interim President and Chief Executive Officer of the Company in September 1981, and assumed those offices on a permanent basis in February 1982, relinquishing those titles on June 19, 2001. In January 2007, Mr. Kelleher was named to the board of the Federal Reserve Bank of Dallas for a one-year term.

 

Gary C. Kelly has been Vice Chairman of the Board of Directors and Chief Executive Officer of the Company since July 15, 2004. Prior to that time, Mr. Kelly was Executive Vice President — Chief Financial Officer from 2001 to 2004, and Vice President — Finance and Chief Financial Officer from 1989 to 2001. Mr. Kelly joined the Company in 1986 as its Controller.

 

Nancy B. Loeffler, a long-time advocate of volunteerism, currently serves as Vice-Chairman of the University of Texas M.D. Anderson Cancer Center Board of Visitors and on the Board of Regents at St. Mary’s University, The South Texas Community Foundation, the National Cowgirl Museum and Hall of Fame, the Vice President’s Residence Foundation in Washington, D.C., and the Capitol Advisory Committee for Texas Lutheran University. She also serves as co-chairman of the Blanton Museum of Art located on the University of Texas campus. The Loeffler Group LLP and the law firm of Loeffler Tuggey Pauerstein Rosenthal LLP have performed services for the Company in the past and will do so in 2007. Nancy Loeffler’s husband is a member of the law firm of Loeffler Tuggey Pauerstein Rosenthal LLP and The Loeffler Group LLP.

 

John T. Montford has been Senior Vice President — Western Region Legislative and Regulatory Affairs for AT&T Services, Inc., a global provider of telecommunications products and services, since November 2005. Between September 2001 and October 2005, Mr. Montford served as Senior Vice President of Governmental and External Affairs for SBC Communications, Inc. Prior to September 2001, Mr. Montford served as Chancellor of the Texas Tech University System from 1996 to 2001. Mr. Montford served in the Texas Senate from 1983 to 1996. He served as both Chairman of the Senate Finance Committee and Chairman of the Senate State Affairs Committee. He is a Director of Fleetwood Enterprises, Inc. In 2002, he was named Chancellor Emeritus of the Texas Tech University System. He is a former elected District Attorney.

 

Corporate Governance

 

General

 

The Board of Directors has adopted Corporate Governance Guidelines to set forth its policies concerning overall governance practices. The Corporate Governance Guidelines require that a majority of the members of the Company’s Board of Directors satisfy the independence requirements set forth in the rules of the New York Stock Exchange. The Company’s Board has determined that each of its current Directors, other than Messrs. Kelleher and Kelly and Ms. Barrett and Ms. Loeffler, meets these independence requirements. In addition, the Board determined that the two members of the Board who retired in May 2006, Rollin W. King and June M. Morris, met these independence requirements.

 

The Board of Directors held six meetings during 2006, and otherwise acted by unanimous consent. Each Director attended at least 75 percent of the total of the Board and Committee meetings that he or she was obligated to attend. Additionally, it is the Board’s policy that every Director and nominee for Director should make every

effort to attend the Company’s annual meeting of Shareholders. All but one of the Company’s Directors attended the 2006 annual meeting.

 

The Corporate Governance Guidelines also require the Board’s non-management Directors to meet at regularly scheduled executive sessions without management Directors. During 2006, they had five such meetings. Currently, Dr. Cunningham, Chairman of the Audit Committee, serves as the presiding Director for executive sessions of non-management Directors. Shareholders of the Company may contact the Board of Directors by mail addressed as follows: Board of Directors, c/o Southwest Airlines Co., Attn. William H. Cunningham, P. O. Box 36611, Dallas, Texas 75235.

 

The Board of Directors has appointed Audit, Compensation, Executive, and Nominating and Corporate Governance Committees and has adopted charters for the Audit, Compensation, and Nominating and Corporate Governance Committees. Copies of the Corporate Governance Guidelines and each of these committee charters, as well as the Company’s Code of Ethics, are available on the Company’s website, www.southwest.com.  Shareholders can obtain copies of these documents upon written request to Investor Relations, P.O. Box 36611, Dallas, Texas 75235.

 

Committees of the Board

 

Audit Committee.  The Audit Committee consists of Messrs. Cunningham (Chairman), Biegler, Caldera, Hobby (retiring), Johnson, and Montford. The Board of Directors of the Company has determined that all of the members of the Audit Committee are “independent,” as that term is used under applicable rules of the New York Stock Exchange. The Board has also determined that at least one of the members of the Audit Committee, Dr. Cunningham, satisfies the criteria adopted by the Securities and Exchange Commission to serve as the “audit committee financial expert” on the Committee. The Audit Committee held five meetings during 2006. Pursuant to the Audit Committee Charter, the Audit Committee is responsible for the appointment, compensation, retention, and oversight of the work of Southwest’s independent auditors. Its principal functions are to give additional assurance that financial information is accurate and timely and that it includes all appropriate disclosures; to ascertain the existence of an effective accounting and internal control system; to pre-approve all services provided by the independent auditors; to review and discuss related party transactions with management and the independent auditors; and to oversee the entire audit function, both independent and internal.

 

Compensation Committee.  The Compensation Committee consists of Messrs. Hobby (Chairman, retiring), Biegler, and Crockett. The Board of Directors of the Company has determined that all of the members of the Compensation Committee are “independent,” as that term is used under applicable rules of the New York Stock Exchange. The Compensation Committee held three meetings during 2006, and otherwise acted by unanimous consent.

 

Pursuant to the Compensation Committee Charter, the Compensation Committee (i) reviews and approves corporate goals and objectives relevant to the compensation of the Chief Executive Officer, (ii) evaluates the Chief Executive Officer’s performance in light of those goals and objectives, and (iii) determines and approves the Chief Executive Officer’s compensation level based on this evaluation. With the advice of the Chairman of the Board and the Chief Executive Officer, the Compensation Committee also conducts an annual review of the compensation of other senior executives and makes recommendations to the Board with respect to non-CEO compensation and incentive compensation plans that are subject to Board approval. The Compensation Committee also reviews and approves all stock-based compensation arrangements for Employees of the Company (including executive officers) and makes recommendations to the Board with respect to equity-based plans that are subject to Board approval. The Company’s processes and procedures for the consideration and determination of executive officer compensation (as well as the Chief Executive Officer’s role in such determinations) are discussed further below under “Compensation Discussion and Analysis.” To the extent permitted by applicable law and regulations, the Compensation Committee has the power to delegate its authority and duties to subcommittees or individual members of the Committee, as it deems appropriate.

 

With the approval of the Chairman of the Compensation Committee, the Company retained Longnecker and Associates in 2004 to provide guidance to the Compensation Committee in connection with the Company’s employment contracts with the Chief Executive Officer, Chairman of the Board, and President of the Company.

Longnecker and Associates was retained due to its longstanding history with the Company and its resulting understanding of the Company’s compensation practices and philosophies, in particular with respect to the Company’s employment contracts. From time to time, the Company, through its human resources department, also retains other consultants in connection with the design of compensation plans and programs that may impact executive officer compensation. As part of the review of the Company’s compensation practices discussed below under “Compensation Discussion and Analysis,” the Company requested input from Mercer Human Resource Consulting, ISS Corporate Services, Inc., and Georgeson Inc.

 

As discussed further below, the Nominating and Corporate Governance Committee is responsible for reviewing the compensation and benefits for non-Employee Directors.

 

Executive Committee.  The Executive Committee consists of Messrs. Kelleher (Chairman), Cunningham, and Johnson, and was appointed to assist the Board in carrying out its duties. The Executive Committee has authority to act for the Board on most matters during the intervals between Board meetings. The Executive Committee held one meeting during 2006.

 

Nominating and Corporate Governance Committee.  The Nominating and Corporate Governance Committee consists of Messrs. Montford (Chairman), Caldera, Crockett, Hobby (retiring), and Johnson. The Board of Directors of the Company has determined that all of the members of the Nominating and Corporate Governance Committee are “independent,” as that term is used under applicable rules of the New York Stock Exchange. The Nominating and Corporate Governance Committee held two meetings during 2006. Pursuant to its charter, the Nominating and Corporate Governance Committee reviews possible candidates for Board membership and recommends a slate of nominees, and develops and recommends to the Board corporate governance principles applicable to the Company. In addition, pursuant to its charter, as well as the Corporate Governance Guidelines, the Nominating and Corporate Governance Committee, with the advice of the Chairman of the Board and the Chief Executive Officer, is required to conduct an annual review of compensation for the non-management members of the Board and for recommending to the Board any appropriate changes thereto. The compensation should be an appropriate mix of cash and Company equity-related compensation considering the Company’s unique culture. The Committee will consider nominees submitted by Shareholders, provided nominations are submitted in accordance with the Company’s Bylaws. Director nominations are discussed further below under “Other Matters — Notice Requirements.”

 

Board Qualifications

 

The qualifications to be considered by the Nominating and Corporate Governance Committee in nominating Board members are set forth in the Corporate Governance Guidelines. Members of the Board of Directors of Southwest Airlines Co. should possess the highest personal and professional ethics, integrity, and values. They must possess practical wisdom, mature judgment, and be committed to the best longterm interests of the Company’s Employees, Customers, and Shareholders. Directors must be willing to devote sufficient time to fulfill their responsibilities and be willing to serve on the Board for an extended period of time. While there is no specific limitation on service on other Boards, the Committee will take into consideration the nature and time involved in a Director’s service on other boards in evaluating the suitability of that Director. In addition, the Board will consider a number of factors in the nomination or appointment of new Board members, including finance, marketing, government, education, and other professional experience or knowledge relevant to the success of the Company in today’s business environment. The Board will also take into consideration factors such as diversity and independence (for non-management Directors) in the appointment of future Board members. The Board evaluates each Director in the context of the Board as a whole, with the objective of recommending a group that can best serve the longterm interests of the Company’s Employees, Customers, and Shareholders. In the case of current Directors being considered for renomination, the Board considers the Director’s past attendance at Board and Committee meetings and participation in and contributions to such meetings and Board activities. The Company’s Bylaws provide for a mandatory retirement age of 75 for members of the Board of Directors. The Chairman of the Board is exempted from the mandatory retirement provisions of the Bylaws.

 

Certain Relationships and Related Transactions, and Director Independence

 

Pursuant to its charter, the Audit Committee of the Board is required to review and discuss related person transactions with management and the independent auditors. In addition, the Company distributes Director and Officer Questionnaires at least annually, pursuant to which all Directors and executive officers of the Company are requested to disclose any direct or indirect interest that they may have in transactions with the Company. The Questionnaire further requires that these responses be updated to the extent circumstances change. The Board has taken these responses into account in making its independence determinations. In particular, in 2007, the Board evaluated the following relationships: (i) Mr. Crockett’s status as an attorney and non-equity director in a law firm that performs services for the Company and (ii) Mr. Montford’s status as an officer of AT&T Services, Inc., which does business with the Company. The Board determined that neither of such indirect relationships was material either to the Company or to the executive officer.

 

VOTING SECURITIES AND PRINCIPAL SHAREHOLDERS

 

At the close of business on March 21, 2007, the record date of those entitled to notice of and to vote at the meeting, there were outstanding           shares of Common Stock, $1.00 par value, each share of which is entitled to one vote.

 

Certain Beneficial Owners

 

The following table sets forth information with respect to persons who, to the Company’s knowledge, beneficially own more than 5 percent of the Common Stock of the Company.

 

 

 

 

Management

 

The following table sets forth as of December 31, 2006, certain information regarding the beneficial ownership of Common Stock by the Directors, each of the executive officers of the Company named in the Summary Compensation Table, and by all executive officers and Directors, as a group.

 

 

 

 

(footnotes continue on next page)

 

COMPENSATION OF EXECUTIVE OFFICERS

 

The following table discloses compensation earned for services performed by the Company’s Chief Executive Officer and Chief Financial Officer and the three remaining most highly paid executive officers during the year ended December 31, 2006. These executives will be referred to as the “named executive officers.”

 

Summary Compensation Table

 

 

 

 

 

Mr. Kelleher, Ms. Barrett, and Mr. Kelly receive their compensation in large part pursuant to the terms of their employment contracts, which are discussed in detail below under “Employment and Other Contracts; Potential Payments Upon Termination or Change-in-Control.” In addition, the amount of executive salary and bonus in proportion to total compensation is discussed in detail below under “Compensation Discussion and Analysis.”

 

Amounts included in “All Other Compensation” for the individuals named above in respect of the Company’s profit sharing plan and Southwest Airlines Co. 401(k) Plan are determined on the same basis as the calculation used for all Southwest Airlines Co. Employees.

Grants of Plan-Based Awards in Last Fiscal Year

 

The following table provides information on grants of plan-based awards in 2006 to the named individuals.

 

 

 

 

The factors supporting the Compensation Committee’s determinations with respect to the plan-based awards are discussed below under “Compensation Discussion and Analysis.”

Outstanding Equity Awards at Fiscal Year-end

 

The following table provides information regarding stock options held by the named executive officers as of December 31, 2006. Stock options are the only type of equity award that has been granted to the named executive officers.

 

 

 

 

In an effort to bridge the perceived gap between the lower level of cash compensation for Company officers as compared to their peers and to provide a longterm incentive for future performance that aligns officers’ interests with Shareholders in general, the Company has historically relied on stock options. Typically, officers (and other Southwest leaders) receive large grants upon appointment to office and annual merit grants. Many of these grants had a 10 year term and vested over the life of the options. In addition, officers (and other Southwest leaders) received an annual grant equal to 5% of the number of shares held by the Employee at December 31 of the given year, to the extent such shares were obtained as the result of option exercises.

 

Option Exercises in Last Fiscal Year

 

The following table provides information regarding stock options exercised, and the value realized upon exercise, by the named executive officers during 2006.

 

 

 

 

Nonqualified Deferred Compensation in Last Fiscal Year

 

The Company maintains a profit sharing plan pursuant to which the Company annually contributes a percentage of its profits to the accounts of eligible Employees. The profit sharing plan is a qualified deferred compensation plan. In conjunction with the profit sharing plan, the Company maintains an excess benefit plan, which is a nonqualified deferred compensation plan and which is available to all Employees. At the Employee’s election, the Company makes contributions to the accounts of participants in the excess plan to the extent such amounts cannot be contributed to the profit sharing plan due to contribution limits established by the Internal Revenue Code. The Company has also established nonqualified deferred compensation arrangements with Mr. Kelleher, Ms. Barrett, and Mr. Kelly as part of their employment contracts. Pursuant to these arrangements, the Company makes contributions to their accounts to the extent such amounts cannot be contributed to the profit sharing plan due to contribution limits and compensation limits established by the Internal Revenue Code.

 

The profit sharing plan allows plan participants to invest all or a portion of their accounts in investment funds selected by the plan administrator, including the Company’s Common Stock. The excess benefit plan provides that plan participants may elect to have their accounts credited with earnings determined by reference to the earnings of investment options selected by the plan administrator, but not Company stock. Participants in the profit sharing and excess benefit plans are generally entitled to a distribution of their accounts upon separation from service with the Company.

 

The deferred compensation arrangements with Mr. Kelleher, Ms. Barrett, and Mr. Kelly provide that amounts credited to their accounts will accrue simple interest at a rate of 10 percent annually, compounded annually on the accrued and unpaid balance of the deferred compensation credited to their accounts as of the preceding December 31. Deferred compensation is payable at the rate of $100,000 per calendar year, commencing with the calendar year following the year in which (i) the executive attains a specified age (76, in the case of Mr. Kelleher, and 65, in the case of Ms. Barrett and Mr. Kelly) or (ii) the executive’s employment terminates, whichever occurs later.

 

The following table provides information regarding nonqualified deferred compensation for the named executive officers for 2006:

 

 

 

 

Employment and Other Contracts; Potential Payments Upon Termination or Change-in-Control

 

Employment Contracts with Mr. Kelleher, Mr. Kelly, and Ms. Barrett.  The Company entered into a three-year employment contract with Herbert D. Kelleher, effective as of July 15, 2004. Mr. Kelleher’s contract provides for an annual base salary of $450,000 for the year ending July 14, 2007, and discretionary performance bonuses to be paid in cash at the times and in the amounts determined by the Board. Pursuant to his contract, Mr. Kelleher is also entitled to reimbursement for medical and dental expenses incurred by him and by his spouse and family and deferred compensation in an amount equal to any Company contributions that would otherwise have been made on behalf of Mr. Kelleher to the Company’s profit sharing plan, but that exceed the limits established by the Internal Revenue Code for qualified plans. Such deferred compensation bears interest at 10 percent. Mr. Kelleher has the right to terminate his employment contract within 60 days after the occurrence of a Change of Control of the Company, as defined below. In the event Mr. Kelleher so terminates his employment, his employment contract provides for a lump sum severance payment equal to his unpaid base salary for the remaining term of the contract plus $750,000. Had such an event occurred as of December 31, 2006, Mr. Kelleher would have been entitled to a lump sum payment of $993,750.

 

The Company entered into a three-year employment contract with Gary C. Kelly, effective as of July 15, 2004. Mr. Kelly’s contract provides for an annual base salary of $424,065 for the year ending July 15, 2007, and discretionary performance bonuses to be paid in cash at the times and in the amounts determined by the Board. Pursuant to his contract, Mr. Kelly is also entitled to reimbursement for medical and dental expenses incurred by him, his spouse, and his children and deferred compensation in an amount equal to any Company contributions that

would otherwise have been made on behalf of Mr. Kelly to the Company’s profit sharing plan, but that exceed the limits established by the Internal Revenue Code for qualified plans. Such deferred compensation bears interest at 10 percent. Mr. Kelly has the right to terminate his employment contract within 60 days after the occurrence of a Change of Control of the Company, as defined below. In the event Mr. Kelly so terminates his employment, the employment contract provides for a lump sum severance payment equal to Mr. Kelly’s unpaid base salary for the remaining term of his employment contract plus $750,000. Had such an event occurred as of December 31, 2006, Mr. Kelly would have been entitled to a lump sum payment of $979,702.

 

The Company entered into a three-year employment contract with Colleen C. Barrett, effective as of July 15, 2004. Ms. Barrett’s contract provides for an annual base salary of $368,752 for the year ending July 15, 2007, and discretionary performance bonuses paid in cash at the times and in the amounts determined by the Board. Pursuant to her contract, Ms. Barrett is also entitled to reimbursement for her medical and dental expenses and deferred compensation in an amount equal to any Company contributions that would otherwise have been made on behalf of Ms. Barrett to the Company’s profit sharing plan, but that exceed the limits established by the Internal Revenue Code for qualified plans. Such deferred compensation bears interest at 10 percent. Ms. Barrett has the right to terminate her employment contract within 60 days after the occurrence of a Change of Control of the Company, as defined below. In the event Ms. Barrett so terminates her employment, the employment contract provides for a lump sum severance payment equal to Ms. Barrett’s unpaid base salary for the remaining term of her employment contract plus $750,000. Had such an event occurred as of December 31, 2006, Ms. Barrett would have been entitled to a lump sum payment of $949,741.

 

Mr. Kelleher, Mr. Kelly, and Ms. Barrett would not be entitled to any special compensation or benefits in the event of termination of employment for any reason other than a Change of Control, with the exception of termination due to disability resulting from a job-related cause. In such event, pursuant to their employment contracts, they would be entitled to receive regular installments of their base salary in effect at the time of termination of employment for the remainder of the term of their agreements. Had such an event occurred as of December 31, 2006, Mr. Kelleher, Mr. Kelly, and Ms. Barrett would have been entitled to $243,750, $229,702, and $199,741, respectively.

 

For purposes of the foregoing agreements, as well as the Executive Service Recognition Plan discussed below, a Change of Control is generally deemed to occur in the event that a third party acquires 20 percent or more of the Company’s voting securities or a majority of the Directors of the Company are replaced as a result of a tender offer or merger, sale of assets or contested election.

 

Executive Service Recognition Plan.  In 1987, The Board of Directors of the Company established an Executive Service Recognition Plan to permit the Company to continue to attract and retain well-qualified executive personnel and to assure both the Company of continuity of management and its executives of continued employment in the event of any actual or threatened change of control of the Company. As contemplated by the Executive Service Recognition Plan, the Company has entered into employment agreements with Ms. Wright and Mr. Ricks. The terms of these employment agreements would be invoked only in the event of a Change of Control, and these executives would not be entitled to any special compensation or benefits in the event of termination of employment for any reason other than a Change of Control. Under the terms of these agreements, the executives must remain in the employment of the Company for one year after a Change of Control has occurred (the “Employment Year”). While employed pursuant to these agreements, the executives would be entitled to a base salary in an amount at least equal to the highest salary received by the executives during the preceding 12-month period. In addition, the executives would be entitled to an annual bonus in an amount at least equal to the highest bonus (the “Change of Control Bonus Amount”) paid or payable to the executive in respect of either of the two fiscal years immediately prior to the fiscal year in which the Change of Control occurs. If, during the Employment Year, the executive’s employment were to be terminated other than for cause or the executive were to resign for good reason (each as defined in the agreement), then the executive would be entitled a lump sum payment equal to:

 

(a) a pro rated bonus, which would be based on the annual bonus paid to the executive for the last full fiscal year of the Company prior to the fiscal year in which the date of termination occurs;

 

(b) the executive’s annual base salary in effect at the time of notice of termination;

 

(c) the Change of Control Bonus Amount paid to the executive for the last full fiscal year of the Company (being the year in which the Change of Control has occurred, but not the date of termination of employment), or, if no such bonus shall have been paid, the Change of Control Amount that would have been payable to the executive for the then current fiscal year (being the year in which the date of termination of employment occurs).

 

Had such an event occurred as of December 31, 2006, Mr. Ricks and Ms. Wright would have been entitled to $886,400 and $630,000, respectively.

 

In addition to the amounts discussed above, in the event of termination of their employment for any reason other than cause, each of the named executive officers would be eligible to participate in any non-contract retiree medical benefit plan or program that the Company may then make available to its retirees generally on the same terms as other retirees. In addition, the executives would be entitled to the amounts credited to their accounts pursuant to the Company’s qualified 401(k) and profit sharing plans, as well as nonqualified deferred compensation amounts credited to their accounts pursuant to the Company’s excess benefit plan and/or their employment agreements (as applicable), each as disclosed in more detail above under the heading “Nonqualified Deferred Compensation in Last Fiscal Year.”

 

Change of Control Severance Pay Plan.  The Board of Directors established in 1988 a Change of Control Severance Pay Plan (the “Severance Pay Plan”) to provide for severance payments to qualified Employees whose employment with the Company terminates due to certain conditions created by a change in control of the Company (as defined in the Severance Pay Plan). All Employees of the Company are participants in the Severance Pay Plan except any officer participating in the Executive Service Recognition Plan and all other Employees who are beneficiaries of an enforceable contract with the Company providing for severance payments in the event of a reduction in force or furlough (collective bargaining agreements). Generally, the Severance Pay Plan provides for severance payments, based upon the Employee’s salary and years of service with the Company, in the event the Employee is terminated, other than for cause (as defined in the Severance Pay Plan), death, voluntary retirement or total and permanent disability, within one year of a “change in control.” The Employee would also remain eligible for a 12-month extension of coverage under each “welfare benefit” plan of the Company, including medical, dental, etc., as in effect immediately prior to any change in control. For purposes of the Severance Pay Plan, a “change in control” is deemed to have occurred if 20 percent or more of the combined voting power of the Company’s outstanding voting securities ordinarily having the right to vote for Directors shall have been acquired by a third person or a change in the makeup of the Board of Directors shall have occurred under certain circumstances described in the Severance Pay Plan.

Directors’ Compensation

 

The following table provides information regarding compensation earned by the Directors during the year ended December 31, 2006:

 

 

 

Directors’ fees are paid on an annual basis in May of each year. Each Director of the Company who is not an Employee of the Company was paid $13,125 for his or her services as a Director during the 12-month period ending May 2006. These fees were increased to $13,780 for services during the 12-month period ending May 2007 and will be increased to $14,260 for services during the 12-month period ending May 2008. During 2006, the Board of Directors held six meetings and otherwise acted by unanimous consent. In addition, these Directors received $3,360 for attendance at each meeting of the Board of Directors during the 12-month period ending May 2006. These fees were increased to $3,525 for meetings during the 12-month period ending May 2007 and will be increased to $3,650 for meetings during the 12-month period ending May 2008. Committee members received $1,750 for attendance at each Committee meeting during the 12-month period ending May 2006. This fee was increased to $1,835 for

meetings during the 12-month period ending May 2007 and will be increased to $1,900 for meetings during the 12-month period ending May 2008. Members of the Executive Committee, other than Mr. Kelleher, received an additional $6,400 for their services on such Committee during the 12-month period ended May 2006. This fee was increased to $6,720 for services during the 12-month period ended May 2007 and will be increased to $6,955 for the 12-month period ending May 2008. The Chairmen of the Audit, Compensation, and Nominating and Corporate Governance Committees received annual fees of $7,100, $3,675, and $3,675 respectively, for their service as Chairs of such Committees during the 12-month period ended May 2006. These fees were increased to $9,000, $3,860, and $3,860, respectively, for the 12-month period ending May 2007 and will be increased to $9,320, $4,000, and $4,000, respectively, for the 12-month period ending May 2008. Officers of the Company receive no additional remuneration for serving as Directors or on Committees of the Board.

 

In 2001, the Board adopted the Southwest Airlines Co. Outside Director Incentive Plan. The purpose of the plan is to align more closely the interests of the non-Employee Directors with those of the Company’s Shareholders and to provide the non-Employee Directors with retirement income. To accomplish this purpose, the plan compensates each non-Employee Director based on the performance of the Company’s Common Stock and defers the receipt of such compensation until after the non-Employee Director ceases to be a Director of the Company. Pursuant to the plan, on the date of the 2002 Annual Meeting of Shareholders, the Company granted 750 non-transferable Performance Shares to each non-Employee Director who had served as a Director since at least May 2001. Thereafter, on the date of each Annual Meeting of Shareholders, the Company granted 750 Performance Shares to each non-Employee Director who served since the previous Annual Meeting. Beginning with the May 2007 Annual Meeting of Shareholders, this will be increased to 1,000 Performance Shares. A Performance Share is a unit of value equal to the Fair Market Value of a share of Southwest Common Stock, based on the average closing sale price of the Common Stock as reported on the New York Stock Exchange. On the 30th calendar day following the date on which a non-Employee Director ceases to serve as a Director of the Company for any reason, Southwest will pay to such non-Employee Director an amount equal to the Fair Market Value of the Common Stock during the 30 days preceding such last date of service multiplied by the number of Performance Shares then held by such Director. The plan contains provisions contemplating adjustments on changes in capitalization of the Company.

 

Upon retirement from the Board of Directors, a Director who has served at least five years as of the date of retirement will receive $35,000 and a Director who has served at least ten years will receive $75,000.

 

COMPENSATION DISCUSSION AND ANALYSIS

 

The Salary Administration Program for Southwest’s non-contract people will be administered in a manner that promotes the attainment by Southwest of reasonable profits on a consistent basis in order to preserve job protection and security for such non-contract people; that promotes and rewards productivity and dedication to the success of Southwest as the collective embodiment of all of its people; that accomplishes internal equity among its people; and that responds pragmatically to the actual influence of external market forces.

 

Southwest Airlines Co.

Salary Administration Manual

 

The above principles are applied to all Southwest Employees who are not subject to collective bargaining agreements (non-contract Employees), including executive officers. The Compensation Committee of the Board of Directors reviews the compensation of Southwest’s executive officers on an annual basis. The Committee considers the total compensation (both salary and incentives), as well as the recommendation of the Company’s Chief Executive Officer, in establishing each element of compensation. Mr. Kelleher, Mr. Kelly, and Ms. Barrett have employment contracts with the Company, which are discussed in detail above under “Employment and Other Contracts; Potential Payments Upon Termination or Change-in-Control.”

 

At current cash compensation levels, the Committee does not expect Internal Revenue Service regulations regarding maximum deductibility of executive compensation to have any application to the Company.

 

The Company’s 1996 Incentive Stock Option Plan and 1996 Non-Qualified Stock Option Plan have both expired. In light of the unavailability of shares for future option grants to management under these plans, as well as the change in accounting for equity grants to Employees, the Company has recently undertaken a review of its compensation practices for management. The Compensation Committee of the Board of Directors has participated in this review, taking into consideration the Company’s operating results, compensation practices of comparable businesses, labor relations, and the Company’s egalitarian culture. Approximately 82% of the Company’s Employees are subject to collective bargaining agreements, and the relationship between executive pay and pay rates for contract Employees is an important consideration for the Committee. As a result of this review, the Compensation Committee, working together with the Company’s Chief Executive Officer, has continued the philosophy indicated above, implemented in the manner described below.

 

The principal elements of compensation for Southwest’s executive officers are the following:

 

Base Salary.  As a general rule, base salary for the executive officers of Southwest falls below the salaries for comparable positions in comparably sized companies and other airlines. The Committee bases this determination on comparative compensation studies for similarly situated businesses; its impression of the prevailing business climate; and the advice of the Company’s Chief Executive Officer. This approach is used to mitigate the myriad of risks inherent in the airline business, culminating in earnings volatility.

 

Annual salary increases, if any, for executive officers as a group are not more, on a percentage basis, than those received by other non-contract Employees.

 

Annual Incentive Bonus.  Officers of the Company are eligible for annual incentive bonuses. For the 2006 bonus, paid in January 2007, the Committee first considered the Company’s profitability in 2006, which increased 38% (economic), then the performance of each individual, his or her level of responsibility within the Company, the longevity in office of each officer, and each officer’s performance as a team member. No mathematical weighing formulae were applied with respect to any factors. In evaluating an individual’s performance, the Committee relied on the recommendation of the Chief Executive Officer, whose recommendation is based on his own perception of such officer’s performance. For 2006 compensation, the Company did not utilize defined performance targets in establishing compensation, nor did it employ minimum, targeted, or maximum amounts of bonuses or total compensation levels for the individual executive officers, and the final determination of compensation was subjective. Variable cash bonuses are used to help make up the difference between officers’ salaries and the market for their services, consistent with the Company’s earnings results.

 

For 2007, it is intended that salary plus bonus for each officer will provide total cash compensation for the Company’s top performers approximating median (average) market rates for similar positions, based on

information provided to the Committee by outside consultants or the Company’s own human resource professionals. It is also intended that the annual bonus program will continue to provide an opportunity for part of total compensation to fluctuate based on individual performance and Company profitability.

 

Longterm Incentives.  In an effort to bridge the perceived gap between the lower levels of cash compensation for Company officers as compared to their peers and to provide a longterm incentive for future performance that aligns officers’ interests with Shareholders in general, the Company adopted its 1996 Incentive Stock Option Plan and 1996 Non-Qualified Stock Option Plan (the “1996 Plans”). The number of options initially granted to an officer, as compared to other Southwest Employees, was dependent on the length of service with the Company and individual levels of performance and responsibility. Subsequent grants have been based on levels of individual performance. With respect to all options granted, the precise number of shares was determined on a subjective basis. All grants under the 1996 Plans were at current market value, vesting over a number of years, dependent on continued employment. Each grant was made based upon the individual’s compensation package for that year, without reference to previous grants.

 

Each of the 1996 Plans expired prior to April 2006. With this in mind, the Committee authorized the issuance of options to officers in March 2006, with vesting dates that were comparable to those that would have been in effect had the options been granted in December 2006 in accordance with past practice.

 

Subject to Shareholder approval at the 2007 Annual Meeting, and based on the Committee’s recommendation, the Board has adopted the Company’s 2007 Equity Incentive Plan (the “2007 Plan”). As discussed further under “Proposal 3 — Approval of the Company’s 2007 Equity Incentive Plan,” the 2007 Plan gives the Committee flexibility to grant stock options, restricted stock, or restricted stock units. The objectives of the 2007 Plan are to provide a vehicle to encourage retention of our best Leaders, to pay our Leaders competitively, near the middle of the market for total compensation in cases of outstanding Company and individual performance, and to provide a tool to attract future Employees in a tight labor market. If the 2007 Plan is not approved by Shareholders, it is the Committee’s intention to recommend the adoption of a longterm incentive plan for management that mirrors the characteristics of an equity plan, but that does not require Shareholder approval, such as a phantom stock plan.

 

CEO Employment Contract.  Effective as of July 15, 2004, Southwest entered into a three-year employment contract with Mr. Kelly pursuant to which Mr. Kelly serves as Chief Executive Officer of the Company, and, so long as he is on the Board of Directors, Vice Chairman of the Board. Mr. Kelly’s employment contract is discussed in more detail above under the heading “Employment and Other Contracts; Potential Payments Upon Termination or Change-in-Control.” Pursuant to his employment contract, Mr. Kelly’s annual base salary for the year ending July 15, 2006 was $411,714 and for the year ending July 15, 2007 is $424,065. In addition, in July 2004, Mr. Kelly was granted fair market value options to purchase 180,000 shares of Southwest Common Stock with one-third vested immediately and the balance vesting in increments of one-third on each of July 15, 2005 and July 15, 2006. Mr. Kelly received no stock option grants in 2006.

 

The Committee relied on information supplied by an independent consultant in determining that Mr. Kelly’s cash compensation for the three-year period covered by his employment contract was significantly below the market midpoint for comparable positions at the time in question. The options granted to Mr. Kelly, in accordance with Company practice, were designed to make up at least a portion of the difference between his cash compensation and that received by others in comparable positions, dependent on successful performance by the Company as reflected in the price of its stock.

 

The number of options granted to Mr. Kelly was based on the Committee’s review of compensation for similarly situated individuals in the transportation industry and the Committee’s perception of his expected future contributions to Southwest’s performance over the three-year term of his contract. The Committee did not consider the amount and value of other options granted to Mr. Kelly in the past, as those options were granted in connection with earlier compensation packages. The Company has no target ownership levels for Company equity holdings by executives.

 

Pursuant to his employment contract, Mr. Kelly is entitled to a performance bonus at the discretion of the Board of Directors. The bonus paid to Mr. Kelly in January 2007 in respect of his performance in 2006 was $462,000, an increase of 20% over the previous year’s amount of $385,000 (as compared to Company profitability,

which increased 38% (economic)). In fixing Mr. Kelly’s bonus, the Committee considered the factors indicated above for bonuses for all Officers of Southwest Airlines.

 

Executive officers participate in the Company’s profit sharing plan, excess benefit plan, and 401(k) plan, which are available to all Southwest Employees on the same basis. Officers of the Company, and their spouses, are eligible for unlimited, positive space travel on Southwest. Beyond such travel benefits, Southwest makes little use of perquisites for executive officers.

 

COMPENSATION COMMITTEE

 

William P. Hobby, Chair
C. Webb Crockett
David Biegler

 

AUDIT COMMITTEE REPORT

 

The Audit Committee has reviewed and discussed the audited financial statements of the Company for the year ended December 31, 2006 (the “Audited Financial Statements”) with management. In addition, we have discussed with Ernst & Young LLP, the independent auditing firm for the Company, the matters required by Codification of Statements on Auditing Standards No. 61, as amended by Statement on Auditing Standards No. 90, Audit Committee Communications.

 

The Committee also has received the written disclosures and the letter from Ernst & Young required by Independence Standards Board Standard No. 1, and we have discussed with that firm its independence from the Company and the compatibility of its provision of services other than auditing services with such independence. We also have discussed with management of the Company and the auditing firm such other matters and received such assurances from them, as we deemed appropriate.

 

Based on the foregoing review and discussions and relying thereon, we have recommended to the Company’s Board of Directors the inclusion of the Audited Financial Statements in the Company’s Annual Report for the year ended December 31, 2006 and in the Company’s Annual Report on Form 10-K.

 

AUDIT COMMITTEE

 

William H. Cunningham, Chair
David Biegler
Louis Caldera
William P. Hobby
Travis Johnson
John T. Montford

 

COMPENSATION COMMITTEE REPORT

 

The Compensation Committee has reviewed and discussed the Compensation Discussion and Analysis contained in this Proxy Statement with Southwest management. Based on such review and discussions and relying thereon, we have recommended to the Company’s Board of Directors that the Compensation Discussion and Analysis contained in this Proxy Statement be included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 and in this Proxy Statement.

 

COMPENSATION COMMITTEE

 

William P. Hobby, Chair
David Biegler
C. Webb Crockett

 

PROPOSAL 2
APPROVAL OF THE AMENDMENT TO THE COMPANY’S ARTICLES OF INCORPORATION TO
ELIMINATE SUPERMAJORITY VOTING REQUIREMENTS

 

The Board of Directors recommends that the Company’s Restated Articles of Incorporation, as amended (the “Articles”), be amended to remove the supermajority voting requirements found in the Articles. Article Nine of the Articles currently requires, subject to certain exceptions, a supermajority vote for the following actions:

 

 

At the 2006 Annual Meeting of Shareholders, the Shareholders approved, by a substantial margin, a Shareholder proposal requesting that simple majority voting be required on all matters for which Shareholders vote. The stated purpose of the proposal was to eliminate all supermajority voting requirements from the Company’s Articles of Incorporation and Bylaws. The Board of Directors continues to believe, as it has stated in prior years in response to similar proposals, that these supermajority voting requirements provide some protection against self-interested actions by one or a few holders of a large number of shares of Common Stock, and encourage persons making unsolicited bids for Southwest Airlines to negotiate with the Board. Although the proposal made at the 2006 Annual Meeting was not binding, given the size of the vote in support of the proposal, the Board of Directors and its Nominating and Corporate Governance Committee have reexamined the arguments for and against supermajority voting provisions and concluded that it is in the best interests of the Company’s Shareholders to allow the Shareholders the opportunity to vote on an amendment to the Articles to remove all supermajority voting requirements from the Articles. The Board has also recently amended the Company’s Bylaws to remove the supermajority provisions found in the Bylaws.

 

Accordingly, the Board has approved and submits to the Shareholders for their approval an amendment to the Articles to remove Article Nine of the Articles, a copy of which is attached to this Proxy Statement as Appendix A.

 

Vote Required for Approval

 

Article Nine of the Articles currently requires the affirmative vote of 80% of all classes of stock of the Company entitled to vote thereon to amend, alter, change or repeal any of the provisions of Article Nine.

 

If the amendment to the Articles is approved, articles of amendment to the Company’s Articles deleting Article Nine will be executed and filed in accordance with Texas law.

 

The Board recommends a vote FOR the approval of the Amendment to the Company’s Articles of Incorporation to Eliminate Supermajority Voting Requirements

 

PROPOSAL 3
APPROVAL OF THE COMPANY’S 2007 EQUITY INCENTIVE PLAN

 

The Board of Directors adopted the 2007 Equity Incentive Plan (the “Plan”) on March 15, 2007, subject to approval by the Company’s Shareholders. If approved by the Shareholders of the Company at the meeting, the Plan will become effective immediately. No awards will be granted under the Plan unless and until Shareholder approval is received.

 

As discussed in more detail above under “Compensation Discussion and Analysis,” the objectives of the Plan are to provide a vehicle to encourage retention of the Company’s best Leaders, to pay its Leaders competitively, near the middle of the market for total compensation in cases of outstanding Company and individual performance, and

to provide a tool to attract future Employees in a tight labor market. The Company has historically granted stock options to maintain adequate compensation for members of Company management as compared to their peers. While the Company believes that stock options have been an effective retention vehicle historically, in light of recent changes in accounting for equity grants to Employees, the Company deems it advisable to provide for increased flexibility in its equity grant practices going forward. Therefore, in addition to stock options, the Plan provides for grants of restricted shares of Common Stock and restricted stock units. In addition, the Plan has been designed to allow (to the extent deemed necessary and advisable) each of these types of awards to satisfy the performance-based compensation exception to the $1 million limitation on the Company’s deduction with respect to compensation of certain executives, as specified by Section 162(m) of the Internal Revenue Code.

 

Summary of the Plan

 

The following is a brief summary of the Plan and should be read in conjunction with, and is qualified in its entirety by reference to, the complete text of the Plan, which is attached to this Proxy Statement as Appendix B.

 

  Administration

 

The Plan must be administered by the Board or by a committee appointed by the Board consisting of at least two members of the Board. The Board or committee, as applicable, will be referred to as the “committee.” With respect to any award that is intended to satisfy the requirements of Rule 16b-3 under the Securities Exchange Act of 1934, as amended, the committee must consist of at least such number of Directors as is required from time to time by such rule, and each committee member must satisfy the qualification requirements of such rule. With respect to any award that is intended to satisfy the performance-based compensation exception provided for under Section 162(m) of the Internal Revenue Code, the committee must consist of at least such number of Directors as is required from time to time to satisfy such exception, and each committee member must satisfy the qualification requirements of the exception. To the extent required under the rules of the stock exchange or automated quotation system on which the Company’s Common Stock is listed for trading or is quoted, each member of the committee must satisfy any “independence” requirements of such exchange or quotation system. Subject to certain limitations, the committee may delegate some or all of its authority under the Plan to one or more members of the committee or to one or more officers of the Company.

 

The committee will have the power to interpret the Plan, to establish rules and regulations relating to the Plan, and to make all other determinations necessary or advisable for administering the Plan. The Plan does not permit the repricing of options or the granting of discounted awards, and no awards may be granted under the Plan after ten years from the date of the Plan’s adoption by the Shareholders.

 

  Eligibility and Plan Benefits

 

Any Employee of the Company or its affiliates and any Director who is not an Employee (a “non-Employee Director”) is eligible to participate in the Plan; however, only Employees of the Company or its subsidiaries are eligible to receive incentive stock options. Other than with respect to automatic formula grants to non-Employee Directors (which are discussed below), the selection of participants in the Plan and the number and type of awards to be granted to any individual is within the discretion of the committee.

 

  Limits on Awards Under the Plan

 

The maximum number of shares of Common Stock that may be issued under the Plan with respect to all types of awards in the aggregate may not exceed 6,000,000; provided that no more than 2,400,000 of the 6,000,000 shares may be issued pursuant to restricted stock and restricted stock unit awards, collectively. For example, (i) if the Company were to issue 2,400,000 shares of Common Stock pursuant to restricted stock and/or restricted stock unit awards, 3,600,000 shares would remain available for issuance pursuant to stock options only; or (ii) if the Company were to issue 5,500,000 shares of Common Stock pursuant to stock options, 500,000 shares would remain available for restricted stock, restricted stock unit awards, and/or stock options. During the ten-year term of the Plan, the maximum number of shares of Common Stock with respect to which awards may be granted under the Plan to any participant will be 450,000. To the extent an award lapses or the rights of its holder terminate, any shares of

Common Stock subject to such award will again be available for grant under the Plan. Unless earlier terminated by action of the Board, the Plan will terminate on the date that is ten years from the date of its approval by Shareholders. Any outstanding awards at such time will nonetheless expire in accordance with their terms.

 

Stock Options

 

Stock options granted under the Plan may be either “incentive stock options,” within the meaning of Section 422 of the Internal Revenue Code, or non-qualified stock options, as determined by the committee. With the exception of automatic grants to non-Employee Directors (which are discussed below), the committee has the power to determine the exercise price, vesting schedule (including any performance measures, if applicable), and term of any stock option, as well as any other terms that are not inconsistent with the purposes and provisions of the Plan; provided that (i) no stock option may have a term of longer than ten years (five years in the case of an incentive stock option granted to a 10 percent Shareholder), and (ii) the per share exercise price of any stock option cannot be less than 100% of the fair market value of a share of Common Stock on the date of grant (110% of the fair market value in the case of an incentive stock option granted to a 10 percent Shareholder, as calculated pursuant to the rules of the Internal Revenue Code).

 

The Plan provides for automatic grants of stock options to new non-Employee Directors. Similar to the Company’s 1996 Non-Qualified Stock Option Plan, which expired in 2005, the proposed Plan’s formula provides that each individual who becomes a non-Employee Director after adoption of the Plan and who has not previously been granted stock options under any other plan of the Company will receive, on the date of his or her initial appointment or election to the Board, a non-qualified stock option to purchase 10,000 shares of Common Stock at a price equal to 100 percent of the fair market value of the Common Stock on such date. In addition, the proposed Plan provides that each individual who became a non-Employee Director prior to adoption of the Plan and who has not previously been granted stock options under any plan of the Company will, on the date of the 2007 Annual Meeting of Shareholders of the Company, be granted a stock option to purchase 8,000 shares of Common Stock at a price equal to 100 percent of the fair market value of the Common Stock on such date. (This provision is applicable to Mr. Biegler, who is the only current Director not to have received stock options, due to the expiration of the Company’s stock option plans prior to his election to the Board. In January 2007, Mr. Biegler also received a one-time grant of 2,000 shares of phantom stock in an effort to equalize his equity grants with those of other Directors who have received options to purchase 10,000 shares of Common Stock.) Formula grants under the Plan will have a ten-year term and will become exercisable with respect to one-third of the shares covered thereby annually, beginning on the first anniversary of the date of grant.

 

An option’s exercise price may be paid (i) in cash, (ii) in shares of Common Stock (in the discretion of the committee), (iii) through a cashless exercise, or (iv) in any other manner permitted by the committee. The closing price of a share of the Company’s Common Stock on March   , 2007, was $     .

 

In the event of the termination of a Plan participant’s service with the Company, any of the participant’s stock options that have not vested as of the date of termination will automatically become null and void on the date of termination. The vested portion of the participant’s outstanding stock options will become null and void on the date that is earliest to occur of the following (i) the date of the participant’s termination of service for cause; (ii) the expiration of two years following the date of termination of a participant’s employment if the participant is not also a Director; (iii) the expiration of five years following the date of termination of a Director’s service with the Board of Directors of the Company; (iv) the expiration of such period of time or the occurrence of such event as the committee in its discretion may provide in the participant’s stock option agreement; and (v) the expiration of ten years from the date of grant of the participant’s stock option.

 

Restricted Stock and Restricted Stock Units

 

Restricted stock is an award of Common Stock that is granted subject to restrictions that are established by the committee. A restricted stock unit is a right to receive a share of Common Stock in the future, subject to terms and conditions that are established by the committee. Restricted stock and restricted stock units granted under the Plan will be subject to a vesting schedule, which may include specified performance goals or other criteria that the committee determines must be satisfied in order to remove any restrictions with respect to such award; provided that

(i) in no event may restricted stock or restricted stock units with a vesting schedule based on the passing of time have (or be accelerated to have) a vesting schedule of less than three years from the date of grant; and (ii) in no event may restricted stock or restricted stock units with a vesting schedule based on the achievement of a performance measure vest (or be accelerated to vest) in under one year from the date of grant. In the event of the termination of a Plan participant’s service with the Company, any of the participant’s restricted stock or restricted stock units that have not vested as of the date of termination will be forfeited. Shares of restricted stock will be registered in the participant’s name or otherwise credited to the participant as of the date of grant, but will remain held by the Company for the account of the participant (and will not be transferable) until they have vested; however, a holder of restricted stock will have the right (to the extent applicable) to vote and to receive dividends or other distributions made or paid with respect to shares of Common Stock generally. A holder of restricted stock units will have not have these rights until the units have vested. Upon vesting, the participant will be entitled to receive one share of Common Stock for each restricted stock unit that has vested. If a participant’s service with the Company terminates for any reason, any of the participant’s unvested shares of restricted stock and unvested restricted stock units will be forfeited as of the date of such event.

 

Performance Goals

 

The committee may condition the grant, vesting, and/or exercisability of any award upon the attainment of one or more performance targets related to one or more performance measures over a performance period. Awards that are not intended to satisfy the performance-based compensation exception to the deduction limitation set forth in Section 162(m) of the Internal Revenue Code may be based on the achievement of such goals and be subject to such terms, conditions, and restrictions as the committee shall determine. Awards that are intended to satisfy the performance-based compensation exception based on the satisfaction of one or more performance measures must be conditioned on specified levels of one or more of the following: (1) the earnings or earnings per share of the Company or of any business unit of the Company designated by the committee; (2) the net operating margin of the Company or of any business unit of the Company designated by the committee; (3) the cash flow return on investment of the Company or any business unit of the Company designated by the committee; (4) the earnings before interest, taxes, depreciation, and/or amortization of the Company or any business unit of the Company designated by the committee; (5) the return on shareholders’ equity achieved by the Company; (6) the total shareholders’ return achieved by the Company; (7) any of the foregoing calculated on an “economic basis”; (8) the price of a share of Common Stock; (9) the Company’s market share; (10) the market share of a business unit of the Company designated by the committee; (11) the Company’s sales; (12) the sales of a business unit of the Company designated by the committee; (13) the economic value added; or (14) any combination of the foregoing. A measure that is calculated on an “economic basis” is a measure that is adjusted (to the extent consistent with Section 162(m) of the Code) to reflect the impact of special items, which are reflected from time to time in the Company’s published financials. Special items are material nonrecurring adjustments deemed appropriate to exclude by the committee and may include, without limitation, (a) unrealized gains or losses and other items that are recorded by the Company as a result of Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended; (b) impairment and other non-cash charges including the impact of changes in accounting principles or estimates or other unusual, infrequent non-cash items; and (c) other items not considered to be representative of the Company’s ongoing operations.

 

A performance period must be established within ninety days after the beginning of such period; provided that (i) the performance target is substantially uncertain at such time and (ii) no more than 25% of the overall performance period has elapsed. The committee may adjust performance measures for specified significant extraordinary items or events, to the extent consistent with Section 162(m) of the Internal Revenue Code.

 

Prior to the payment of any award that has been conditioned upon achievement of a performance goal that is intended to qualify for the performance-based compensation exception provided for under Section 162(m) of the Internal Revenue Code, the committee must certify whether the performance target(s) have been achieved. The committee will have the discretion to reduce any award.

 

Adjustments

 

In the event of a subdivision or consolidation of shares of the Company’s Common Stock or the payment of a stock dividend on the Common Stock without receipt of consideration by the Company, (i) the number of shares of Common Stock with respect to which an outstanding award may thereafter be exercised or satisfied, as applicable, will, in the event of an increase in the number of outstanding shares, be proportionately increased, and the exercise price per share (if applicable) will be proportionately reduced; and (ii) the number of shares of Common Stock with respect to which an outstanding award may thereafter be exercised or satisfied, as applicable, will, in the event of a reduction in the number of outstanding shares, be proportionately reduced, and the exercise price per share (if applicable) will be proportionately increased. In the event of any such change in the outstanding Common Stock, the aggregate number of shares available under the Plan may be appropriately adjusted by the committee.

 

In the event the Company recapitalizes or otherwise changes its capital structure, the number and class of shares of Common Stock covered by an outstanding award will be adjusted so that such award will thereafter cover the number and class of shares of stock and securities to which a participant would have been entitled pursuant to the terms of the recapitalization if, immediately prior to such recapitalization, the participant had been the holder of record of the number of shares of Common Stock then covered by such award. If the Company is not to be the surviving entity in any merger or consolidation (or survives only as a subsidiary of an entity other than a previously wholly-owned subsidiary of the Company), or if the Company is to be dissolved or liquidated, then, unless a surviving corporation assumes or substitutes new awards for awards then outstanding under the Plan, (i) all unvested options then outstanding will be accelerated and will become exercisable in full, and all restrictions and/or performance measures with respect to any award will be deemed to be satisfied, on or before a date fixed by the Company prior to the effective date of such merger or consolidation or such dissolution or liquidation, and (ii) upon such effective date, awards will expire.

 

Transfer Restrictions

 

The rights of a participant with respect to any award will not be transferable by the participant other than by will or the laws of descent or distribution.

 

Amendment and Termination

 

The Board in its discretion may amend or terminate the Plan at any time; provided that no change in the Plan may be made that would impair the rights of a participant with respect to an award theretofore granted without the consent of the Participant; and provided, further, that no amendment may be made without approval of the Shareholders of the Company if such approval is required under applicable law or by the requirements of any exchange or automated quotation system upon which the Common Stock is listed for trading or quoted.

 

Summary of Certain Federal Income Tax Consequences

 

The following discussion is intended as a general summary of the federal income tax consequences associated with the grant and exercise of stock options. This summary does not purport to be complete and does not address any applicable state or local tax law.

 

Non-Qualified Stock Options

 

In general, no taxable income is realized by a participant upon the grant of a non-qualified stock option, and no deduction is then available to the Company. Upon exercise of a non-qualified stock option, the excess of the fair market value of the shares on the date of exercise over the exercise price will be includable in the gross income of the participant as ordinary income. The amount includable in the gross income of the participant will also be deductible by the Company. The tax basis of the shares acquired by the participant will be equal to the exercise price plus the amount includable in the gross income of the participant as ordinary income. When a participant disposes of shares acquired upon exercise of a non-qualified stock option, any amount realized in excess of the tax basis of the shares generally will be treated as a capital gain; if the amount realized is less than such tax basis, the difference will be treated as a capital loss. Any capital gain or capital loss will be long-term or short-term, depending on whether the shares have been held for more than one year; the holding period commences upon exercise of the non-qualified

stock option. Certain additional rules may apply if the exercise price of a non-qualified stock option is paid in shares or other securities previously owned by the participant.

 

Incentive Stock Options

 

In general, no taxable income is realized by a participant and no deduction is available to the Company upon either the grant or exercise of an incentive stock option. If a participant holds the shares acquired upon the exercise of an incentive stock option for more than one year after the transfer of the shares upon exercise of the incentive stock option and at least two years from the date of the grant of the incentive stock option (the “ISO Holding Period”), the difference between the exercise price and the amount realized upon a subsequent sale of the shares will be treated as a long-term capital gain or loss and no deduction will be available to the Company. If the shares acquired upon exercise of an incentive stock option are disposed of before the expiration of the ISO Holding Period, the participant will realize ordinary income and the Company will be entitled to a deduction on the portion of the gain, if any, equal to the excess of the fair market value of the shares on the date of exercise over the incentive stock option exercise price (or, if less, the excess of the amount realized on the disposition over the tax basis of the shares); any further gain, or any loss, from such disposition will be taxable as a long-term or short-term capital gain or loss, depending upon whether the shares have been held for more than one year. Certain additional rules may apply if the exercise price of an incentive stock option is paid in shares or other securities previously owned by the participant.

 

The excess of the fair market value (at the time of exercise) of the shares acquired upon the exercise of an incentive stock option over the exercise price of such stock option may constitute an adjustment to taxable income for purposes of the alternative minimum tax. Special rules for computing alternative minimum taxable income also may apply in certain cases where there are subsequent sales of shares in disqualifying dispositions and to determine the basis of the shares for purposes of computing alternative minimum taxable income on a subsequent sale of the shares.

 

Vote Required for Approval

 

Provided a quorum is present at the Annual Meeting, approval of Proposal 3 requires the affirmative vote of a majority of the shares entitled to vote on, and voted for or against, the proposal.

 

The Board recommends a vote FOR the approval of the Company’s 2007 Equity Incentive Plan.

 

PROPOSAL 4
RATIFICATION OF SELECTION OF AUDITOR

 

Shareholder ratification of the selection of Ernst & Young LLP as the Company’s independent auditors is not required by our Bylaws or otherwise. However, the Board of Directors is submitting the selection of Ernst & Young to the Shareholders for ratification as a matter of good corporate practice. If the Shareholders fail to ratify the selection, the Audit Committee and Board of Directors will reconsider whether or not to retain Ernst & Young. Even if the selection is ratified, the Board of Directors, in its discretion, may direct the selection of a different independent accounting firm at any time during the year if the Board of Directors believes that this change would be in the best interests of the Company and its Shareholders.

 

The Board recommends a vote FOR the ratification of the selection of Ernst & Young LLP as the independent auditor of the Company.

 

RELATIONSHIP WITH INDEPENDENT AUDITORS

 

The firm of Ernst & Young LLP, independent auditors, has been selected by the Board of Directors to serve as the Company’s auditors for the fiscal year ending December 31, 2007. Ernst & Young LLP has served as the Company’s auditors since the inception of the Company. A representative of Ernst & Young LLP is expected to be present at the Annual Meeting in order to make a statement if he so desires and to respond to appropriate questions.

 

The following table sets forth the various fees for services provided to the Company by Ernst & Young in 2006 and 2005:

 

 

 

 

A copy of the Audit Committee’s Audit and Non-Audit Services Preapproval Policy is attached to this Proxy Statement as Appendix C. All of the services rendered by the independent auditor during 2006 were pre-approved by the Audit Committee, or by its Chairman pursuant to his delegated authority.

 

SHAREHOLDER PROPOSAL
ADOPT SIMPLE MAJORITY VOTE
(PROPOSAL 5)

 

RESOLVED:  Comprehensive Commitment to Adopt Simple Majority Vote. Shareholders recommend that our Board take each step necessary for adoption of a simple majority vote to apply to the greatest extent possible. This includes using all means in our Board’s power such as corresponding special company solicitations and one-on-one management contacts with major shareholders to obtain the majority vote required for formal adoption of this proposal topic.

 

This proposal is not intended to unnecessarily limit our Board’s judgment in crafting the requested change to the fullest extent feasible in accordance with applicable laws and existing governance documents.

 

This topic won our 77% yes-vote at our 2006 annual meeting. At least one proxy advisory service has recommend a no-vote for directors who do not adopt a shareholder proposal after it wins one majority vote. This topic also won a 66% yes-vote average at 20 major companies in 2006. The Council of Institutional Investors www.cii.org formally recommends adoption of this proposal topic.

 

Our current rule allows a small minority to frustrate the will of our shareholder majority. For example, in requiring an 80%-vote to make certain key governance changes, if our vote is an overwhelming 79%-yes and only 1%-no — only 1% could force their will on our 79%-majority.

 

It is important to take one step forward and support this proposal since our 2006 governance standards were not impeccable. For instance in 2006 it was reported (and certain concerns are noted):

 

 

Additionally:

 

 

The Corporate Library added: The mounting pressures of ever-increasing competition seem likely to take their toll on what little remains of the original Southwest vision. Failing a major overhaul, this is a board — and company — that appears now in serious decline, and we’ve downgraded our rating accordingly, from an overall B to an overall D.

 

The above status shows there is room for improvement and reinforces the reason to take one step forward now and vote yes for simple majority vote.

 

Adopt Simple Majority Vote

Yes on Proposal 5

 

BOARD OF DIRECTORS POSITION AGAINST THIS PROPOSAL

 

Your Directors recommend a vote AGAINST the adoption of this Shareholder Proposal for the following reasons:

 

We believe the Shareholder Proposal will be substantially implemented by our Company Proposal No. 2 contained in this Proxy Statement. By virtue of Company Proposal No. 2, we are proposing for Shareholder approval an amendment of our Restated Articles of Incorporation (the “Articles”) to delete the supermajority provisions currently found in the Articles. As discussed in Company Proposal No. 2, the Board of Directors earlier this year took the additional step of amending the Company’s Bylaws to remove the supermajority voting provisions previously existing in the Bylaws. Shareholder approval was not required for the amendment to the Bylaws.

 

Although the Shareholder is aware of the actions taken by the Company to address the issues raised by the Shareholder Proposal, and although the Shareholder Proposal itself states that, “[t]his proposal is not intended to unnecessarily limit our Board’s judgment in crafting the requested change,” the Shareholder has not withdrawn his Shareholder Proposal. We oppose the Shareholder Proposal because we believe it will be substantially implemented by Company Proposal No. 2. Additionally, the Shareholder Proposal is so vague and confusing that its implementation by the Company could subject us to claims we had failed to give full effect to its intent. We therefore oppose the Shareholder Proposal for the following specific reasons:

 

 

Therefore, the Board of Directors recommends a vote AGAINST this Shareholder Proposal. Proxies solicited by the Board of Directors will be so voted unless Shareholders specify a different choice.

 

OTHER MATTERS

 

Notice Requirements

 

To permit the Company and its Shareholders to deal with Shareholder proposals in an informed and orderly manner, the Bylaws establish an advance notice procedure with regard to the nomination (other than by or at the direction of the Board of Directors) of candidates for election to the Board of Directors and with regard to certain matters to be brought before an Annual Meeting of Shareholders. In general, under the Bylaws written notice must be received by the Secretary of the Company not less than 60 days nor more than 90 days prior to the meeting and must contain certain specified information concerning the person to be nominated or the matters to be brought before the meeting as well as the Shareholder submitting the proposal. Pursuant to the Company’s Bylaws, a Shareholder may nominate a person or persons for election to the Board by providing written notice to the Secretary of the Company not less than 60 and not more than 90 days prior to the meeting. The notice must contain (i) as to each nominee, all information required to be disclosed in solicitations of proxies for election of Directors pursuant to Regulation 14A under the Securities Exchange Act of 1934, (ii) the name and address of the Shareholder giving the notice, and (iii) the number of shares of the Company beneficially owned by the Shareholder giving the notice. If we do not receive notice of your proposal before          , 2008, it will be considered “untimely” and we may properly use our discretionary authority to vote for or against the proposal. A copy of the applicable Bylaw provisions may be obtained, without charge, upon written request to the Secretary of the Company at the address set forth on page 1 of this Proxy Statement.

 

In addition, any Shareholder who wishes to submit a proposal for inclusion in the Company’s Proxy Statement and proxy relating to the 2008 Annual Meeting of Shareholders must forward such proposal to the Secretary of the Company, at the address indicated on page 1 of this Proxy Statement, so that the Secretary receives it no later than December   , 2007.

 

Section 16(a) Beneficial Ownership Reporting Compliance

 

Section 16(a) of the Securities and Exchange Act of 1934, as amended, requires the Company’s executive officers and Directors to file reports of ownership and changes in ownership of Company Common Stock with the Securities and Exchange Commission and the New York Stock Exchange. Due to the Company’s administrative error, one filing related to the automatic grant of Governor Hobby’s Performance Shares in 2006 was late.

 

Discretionary Authority

 

In the event a quorum is present at the meeting but sufficient votes to approve any of the items proposed by the Board of Directors have not been received, the persons named as proxies may propose one or more adjournments of the meeting to permit further solicitation of proxies. A Shareholder vote may be taken on one or more of the proposals in this Proxy Statement prior to such adjournment if sufficient proxies have been received and it is otherwise appropriate. Any adjournment will require the affirmative vote of the holders of a majority of those shares of Common Stock represented at the meeting in person or by proxy. If a quorum is present, the persons named as proxies will vote these proxies which they have been authorized to vote on any other business properly before the meeting in favor of such an adjournment.

 

The Board of Directors does not know of any other matters that are to be presented for action at the meeting. However, if other matters properly come before the meeting, it is intended that the enclosed proxy will be voted in accordance with the judgment of the persons voting the proxy.

 

By Order of the Board of Directors,

 

Herbert D. Kelleher
Chairman of the Board

April   , 2007

TO: Participants in the Southwest Airlines Co. ProfitSharing Plan (the “Plan”)

 

The accompanying Notice of Annual Meeting of Shareholders and Proxy Statement relate to shares of Common Stock of Southwest Airlines Co. held by the Trustee for your profit sharing account, as well as any shares you may own in your own name.

 

Under the Plan, each participant has the right to direct the voting of stock credited to his or her account. In addition, you and the other participants are entitled to direct the voting of stock credited to the accounts of participants who do not give voting instructions.

 

The Trustee is required to vote the shares held for your account in accordance with your instructions. If you wish to instruct the Trustee on the vote of shares held for your account, you should vote via telephone or the Internet, or complete and sign the form enclosed and return it in the addressed, postage-free envelope by May 14, 2007.

 

If you do not vote by May 14, 2007, the Plan provides that the Trustee will vote your shares in the same proportions as the shares for which the Trustee receives voting instructions from other participants.

 

APPENDIX A

 

Articles of Amendment to the Articles of Incorporation

of Southwest Airlines Co.

 

ARTICLE ONE

 

Southwest Airlines Co., a Texas corporation (the “Corporation”), pursuant to the provisions of the Texas Business Corporation Act, hereby adopts these Articles of Amendment to its Articles of Incorporation.

 

ARTICLE TWO

 

ARTICLE NINE is hereby deleted in its entirety and replaced with the following:

 

‘‘[Intentionally Omitted]”

 

ARTICLE THREE

 

The amendment made by these Articles of Amendment was duly adopted by the shareholders of the Corporation on May 16, 2007.

 

ARTICLE FOUR

 

The number of shares outstanding on the record date for such shareholders meeting was           and the number of shares entitled to vote on such amendment was          . A total of           shares were voted for the amendment and           shares were voted against the amendment. This Amendment has been approved in the manner required by the Texas Business Corporation Act and the constituent documents of the Corporation.

 

IN WITNESS THEREOF, the Corporation has caused these Articles of Amendment to be executed this           day of          , 2007.

 

SOUTHWEST AIRLINES CO.

 

Laura H. Wright, Senior Vice President-Finance

and Chief Financial Officer

 

Appendix B

 

SOUTHWEST AIRLINES CO.

2007 EQUITY INCENTIVE PLAN

 

I.  PURPOSE

 

The purpose of the SOUTHWEST AIRLINES CO. 2007 EQUITY INCENTIVE PLAN (the “Plan”) is to secure for the Company the benefits of the additional incentive inherent in the ownership of its Common Stock by Directors and selected key Employees of the Company and its Affiliates who are important to the success and the growth of the Company and its Affiliates, and to help the Company and its Affiliates secure and retain the services of such Directors and key Employees.

 

II.  DEFINITIONS

 

The following definitions shall be applicable throughout the Plan, unless specifically modified by any provision of the Plan:

 

(a) “Affiliate” means any corporation, partnership, limited liability company or partnership, association, trust, or other organization which, directly or indirectly, controls, is controlled by, or is under common control with, the Company. For purposes of the preceding sentence, “control” (including, with correlative meanings, the terms “controlled by” and “under common control with”), as used with respect to any entity or organization, shall mean the possession, directly or indirectly, of the power (i) to vote more than 50 percent of the securities having ordinary voting power for the election of directors of the controlled entity or organization; or (ii) to direct or cause the direction of the management and policies of the controlled entity or organization, whether through the ownership of voting securities or by contract or otherwise.

 

(b) “Agreement” means an agreement, certificate, or other documentation (in each case, whether in written, electronic, or other format) governing the grant of an Award under the Plan, which shall contain terms and conditions not inconsistent with the Plan and which shall incorporate the Plan by reference.

 

(c) “Award” means, individually or collectively, any Option, Restricted Stock Award, Restricted Stock Unit, or Performance Award.

 

(d) “Board” means the Board of Directors of the Company.

 

(e) “Code” means the Internal Revenue Code of 1986, as amended. Reference in the Plan to any section of the Code shall be deemed to include any amendments or successor provisions to such section and any regulations under such section.

 

(f) “Committee” means the committee(s) appointed by the Board to administer the Plan, in accordance with Section IV(a) of the Plan.

 

(g) “Common Stock” means the common stock, par value $1.00 per share, of the Company, or any security into which such common stock may be changed by reason of any transaction or event of the type described in Section XI of the Plan.

 

(h) “Company” means Southwest Airlines Co., a Texas corporation.

 

(i) “Director” means an individual who is a member of the Board.

 

(j) “Employee” means any person (including a Director) in an employment relationship with the Company or any Affiliate.

 

(k) “Exchange Act” means the Securities Exchange Act of 1934, as amended.

 

(l) “Fair Market Value” means, as of any specified date, unless otherwise determined by the Committee, the closing price of the Common Stock as reported by the primary national stock exchange on which such stock is listed. If no sale shall have been made on that day, or if the Common Stock is not listed on a national exchange at that time, fair market value will be determined by the Committee in such manner as it deems

appropriate including, without limitation, by reference to the last preceding date on which the price of the Common Stock is reported by a national stock exchange or, if the Common Stock is traded over the counter at the time a determination of its fair market value is required to be made hereunder, by reference to the average between the reported high and low or closing bid and asked prices of the Common Stock on the most recent date on which the Common Stock was publicly traded.

 

(m) “Incentive Stock Option” means an incentive stock option within the meaning of Section 422 of the Code.

 

(n) “Non-Employee Director” means a member of the Board who is not an Employee of the Company or any of its Affiliates.

 

(o) “Non-Qualified Stock Option” means any Option that does not qualify as an Incentive Stock Option.

 

(p) “Option” means a right granted to a Participant under Section VII of the Plan to purchase shares of Common Stock at such time and price, and subject to such other terms, conditions, and restrictions, as are set forth in the Plan and in the applicable Agreement. Options may be Incentive Stock Options or Non-Qualified Stock Options.

 

(q) “Participant” means an Employee or Director who has been granted an Award under the Plan.

 

(r) “Performance Award” means an Award that includes performance measures in accordance with Section X of the Plan.

 

(s) “Plan” means the Southwest Airlines Co. 2007 Equity Incentive Plan, as amended from time to time.

 

(t) “Restricted Stock Award” means an Award of Common Stock granted under Section VIII of the Plan that is subject to the restrictions set forth in such Section and to such other terms, conditions, and restrictions as are set forth in the Plan and in the applicable Agreement.

 

(u) “Restricted Stock Unit” means a right granted under Section IX of the Plan to receive a share of Common Stock in the future, subject to such terms, conditions, and restrictions as are set forth in the Plan and in the applicable Agreement.

 

(v) “Rule 16b-3” means Rule 16b-3 promulgated under the Exchange Act, as such may be amended from time to time, and any successor rule, regulation, or statute fulfilling the same or a similar function.

 

(w) “Section 162(m)” means Section 162(m) of the Code and the regulations promulgated thereunder from time to time.

 

(x) “Section 162(m) Exception” means the exception under Section 162(m) for “qualified performance-based compensation.”

 

III.  EFFECTIVE DATE AND DURATION OF THE PLAN

 

The Plan shall become effective upon the date of its approval by the Shareholders of the Company. No Awards may be granted under the Plan after ten years from the date the Plan is adopted by the Board. The Plan shall remain in effect until all Options granted under the Plan have been exercised or have expired, all Restricted Stock Awards and Restricted Stock Units granted under the Plan have vested or been forfeited, and all Performance Awards have been satisfied or have expired.

 

IV.  ADMINISTRATION

 

(a) Composition of Committee.  The Plan shall be administered by the Board or by a committee of, and appointed by, the Board that shall be comprised of at least two members of the Board; provided that, (i) with respect to any Award that is intended to satisfy the requirements of Rule 16b-3, such committee shall consist of at least such number of Directors as is required from time to time by Rule 16b-3, and each such committee member shall satisfy the qualification requirements of such rule; (ii) with respect to any Award that is intended to satisfy the requirements of the Section 162(m) Exception, such committee shall consist of at least such number of Directors as is required

from time to time to satisfy the Section 162(m) Exception, and each such committee member shall satisfy the qualification requirements of such exception; and (iii) to the extent required under the rules of any stock exchange or automated quotation system on which the Common Stock is listed for trading or quoted, each member of such committee shall satisfy any “independence” or other requirements of such exchange or quotation system; provided, however, that if any such committee member is found not to have met the qualification requirements set forth in clauses (i) and/or (ii) above, any actions taken or Awards granted by such committee shall not be invalidated by such failure to so qualify. Subject to (i) the limitations set forth in this Section IV and (ii) any limitations set forth in the Texas Business Corporation Act, as well as any other laws, rules, or regulations that may apply from time to time, the Committee shall have the authority to delegate some or all of its authority under the Plan to one or more members of the Committee or to one or more officers of the Company.

 

(b) Powers.  Subject to the express provisions of the Plan, the Committee shall have authority, in its discretion, to determine the individuals who will receive an Award, the time or times when such Award shall be made, the type of Award that shall be made, and the number of shares of Common Stock to be subject to each Award. In making its determinations, the Committee shall take into account the nature of the services rendered by the respective individuals, their present responsibility level, performance, and potential contribution to the Company’s success, any other Awards received by them, and such other factors as the Committee in its sole discretion shall deem relevant. Subject to the express provisions of the Plan, the Committee shall have the power to interpret the Plan and the respective Agreements hereunder, to establish rules and regulations relating to the Plan, and to make all other determinations necessary or advisable for administering the Plan. The Committee may correct any defect, supply any omission, or reconcile any inconsistency in the Plan or in any Agreement relating to an Award in the manner and to the extent it shall deem expedient to carry it into effect. The Committee shall have the authority to amend the terms of any outstanding Award or to waive any condition or restriction applicable to any Award in any manner that is not inconsistent with the terms of the Plan; provided, however, that no amendment may materially impair the rights of the holder thereof without the holder’s consent. The determinations of the Committee on the matters referred to in this Section IV shall be conclusive.

 

With respect to any restriction in the Plan, or to which any Award is subject, that is based on the requirements of Rule 16b-3, Section 422 of the Code, the Section 162(m) Exception, the rules of any exchange upon which the Company’s securities are listed or automated quotation system upon which the Company’s securities are quoted, or any other applicable law, rule, or restriction, to the extent that any such restriction is no longer required, the Committee shall have the sole discretion and authority to grant Awards that are not subject to such restriction and/or to waive any such restriction with respect to outstanding Awards.

 

V.  SHARES SUBJECT TO THE PLAN

 

Subject to adjustment in accordance with Section XI below, the maximum number of shares of Common Stock that may be issued under the Plan with respect to all types of Awards in the aggregate shall not exceed 6,000,000; provided that no more than 2,400,000 of the 6,000,000 shares shall be issued pursuant to Restricted Stock and Restricted Stock Unit Awards, collectively. (For example, (i) if the Company were to issue 2,400,000 shares of Common Stock pursuant to Restricted Stock and/or Restricted Stock Unit Awards, 3,600,000 shares would remain available for issuance pursuant to Option Awards only, and no shares would remain available for Restricted Stock or Restricted Stock Unit Awards; or (ii) if the Company were to issue 5,500,000 shares of Common Stock pursuant to Option Awards, 500,000 shares would remain available for Restricted Stock, Restricted Stock Unit and/or Option Awards.) To the extent that an Award lapses or the rights of its holder terminate, any shares of Common Stock subject to such Award shall again be available for the grant of an Award under the Plan. Notwithstanding any provision in the Plan to the contrary, subject to adjustment in accordance with Section XI below, the maximum number of shares of Common Stock with respect to which Awards may be granted in the aggregate to any Participant during the term of the Plan shall not exceed 450,000.

 

The stock to be offered pursuant to the grant of an Award may be authorized but unissued Common Stock, Common Stock previously issued and outstanding and reacquired by the Company, or both. Any of such shares that remain unissued and that are not subject to outstanding Awards at the termination of the Plan shall cease to be

subject to the Plan but, until termination of the Plan, the Company shall at all times make available a sufficient number of shares to meet the requirements of the Plan.

 

VI.  ELIGIBILITY

 

Awards may be granted only to persons who, at the time of grant, are Employees or Directors; provided that Awards of Incentive Stock Options may only be granted to Employees of the Company or any parent or subsidiary corporation in accordance with Section VII(e) below.

 

VII.  STOCK OPTIONS

 

(a) Grants of Stock Options Generally.  The Committee may from time to time grant Options on the terms and conditions set forth in the Plan and on such other terms and conditions as are not inconsistent with the purposes and provisions of the Plan as the Committee, in its discretion, may from time to time determine.

 

(b) Automatic Grants of Options to Non-Employee Directors.  Each individual who becomes a Non-Employee Director after adoption of this Plan and who has not previously been granted Options under this or any other plan of the Company shall, on the date of his or her initial appointment or election to the Board, be granted a Non-Qualified Stock Option to purchase 10,000 shares of Common Stock at a price equal to 100 percent of the Fair Market Value of the Common Stock on such date. Each individual who became a Non-Employee Director prior to adoption of this Plan and who has not previously been granted Options under any plan of the Company shall, on the date of the 2007 Annual Meeting of Shareholders of the Company, be granted an Option to purchase 8,000 shares of Common Stock at a price equal to 100 percent of the Fair Market Value of the Common Stock on such date. Subject to Section VII(g) below, Options granted to Non-Employee Directors pursuant to this Section VII(b) shall have a term of ten years and shall become exercisable with respect to one-third of the shares covered thereby annually, beginning on the first anniversary of the date of grant.

 

(c) Option Period.  Subject to Section VII(b) above (regarding automatic grants to Non-Employee Directors), the term of each Option shall be as specified by the Committee at the date of grant of such Option, but in no event shall an Option be exercisable after the expiration of ten years from the date of its grant.

 

(d) Exercisability of Options.  Subject to Section VII(b) above (regarding automatic grants to Non-Employee Directors), an Option shall be exercisable in whole or in such installments and at such times as are determined by the Committee.

 

(e) Special Limitations on Incentive Stock Options.  The maximum number of shares of Common Stock that may be issued under the Plan with respect to Incentive Stock Options shall be 6,000,000, subject to the following limitations. An Incentive Stock Option may be granted only to an individual who is employed by the Company or any parent or subsidiary corporation (as defined in Section 424 of the Code) at the time the Option is granted. To the extent that the aggregate Fair Market Value (determined at the time an Incentive Stock Option is granted) of the Common Stock with respect to which Incentive Stock Options are exercisable for the first time by an individual during any calendar year under all incentive stock option plans of the Company and its parent and subsidiary corporations exceeds $100,000, such Incentive Stock Options shall be treated as Non-Qualified Stock Options. No Incentive Stock Option shall be granted to an individual if, at the time the Option is granted, such individual owns stock possessing more than 10 percent of the total combined voting power of all classes of stock of the Company or of its parent or subsidiary corporations, within the meaning of Section 422(b)(6) of the Code, unless (i) at the time such Option is granted the option price is at least 110 percent of the Fair Market Value of the Common Stock subject to the Option and (ii) such Option by its terms is not exercisable after the expiration of five years from the date of grant.

 

(f) Option Exercise Price and Payment of Exercise Price.  The exercise price of an Option shall be determined by the Committee but, subject to adjustment as provided in Section XI, such exercise price shall not be less than the Fair Market Value of a share of Common Stock on the date such Option is granted. The exercise price may be paid as follows: (i) in cash; (ii) in the discretion of the Committee, in shares of Common Stock (provided that the Committee may require that such shares have been held by the Participant for a specified period

time); (iii) by delivery (including by fax or electronic means in accordance with the procedures determined by the Committee) to the Company or its designated agent of an irrevocable Option exercise notice together with irrevocable instructions from the Participant to a broker or dealer, reasonably acceptable to the Company, to sell certain shares of Common Stock purchased upon exercise of an Option or to pledge such shares as collateral for a loan and promptly deliver to the Company the amount of sale or loan proceeds necessary to pay the exercise price for the Option (provided that, with respect to such a cashless exercise, the Option shall be deemed exercised on the date of sale of the shares of Common Stock received upon exercise); and/or (iv) in any other form of valid consideration that is acceptable to the Committee in its sole discretion.

 

(g) Rights Upon Termination of Service.  Subject to Section VII(e) above (regarding Incentive Stock Options), in the event of the termination of a Participant’s service with the Company or any Affiliate, such Participant’s Options that have not vested as of the date of termination shall automatically and without notice terminate and become null and void at 4:00 p.m., Eastern Time, on the date of termination. The vested portion of the Participant’s outstanding Options shall thereafter automatically and without notice terminate and become null and void at 4:00 p.m., Eastern Time, on the date that is the earliest to occur of the following (the “Option Termination Date”):

 

(i) The date of the Participant’s termination of service with the Company or an Affiliate for cause, including breach by the Participant of an employment agreement with the Company or an Affiliate or the Participant’s commission of a felony or misdemeanor (whether or not prosecuted) against the Company or an Affiliate;

 

(ii) The expiration of two years following the date of termination of a Participant’s employment with the Company or an Affiliate if such Participant is not also a Director of the Company;

 

(iii) The expiration of five years following the date of termination of a Director’s service with the Board;

 

(iv) The expiration of such period of time or the occurrence of such event as the Committee in its discretion may provide in the Participant’s Option Agreement;

 

(v) The expiration of ten years from the date of grant of such Option.

 

Upon the occurrence of any event described in this Section VII(g), any Participant who desires to exercise an Option prior to the Option Termination Date shall be required to provide notice of exercise to the Company prior to the close of trading on the New York Stock Exchange on the Option Termination Date.

 

(h) Restrictions on Repricing of Options.  Subject to Section XI below, the Committee may not reprice Options for any reason.

 

(i) Shareholder Rights and Privileges.  A Participant shall have no right to receive dividends, vote, or otherwise exercise the privileges and rights of a Shareholder with respect to an unexercised Option. The Participant shall be entitled to all the privileges and rights of a Shareholder only with respect to such shares of Common Stock as have been purchased under the Option and for which shares of Common Stock have been registered in the Participant’s name or otherwise credited to the Participant.

 

(j) Option Agreements.  Options granted under the Plan shall be evidenced by an Option Agreement in such form and containing such provisions not inconsistent with the provisions of the Plan as the Committee from time to time shall approve, including, without limitation, (i) the number of Options granted; (ii) the date of grant; (iii) the option exercise price; (iv) whether such Options are Incentive Stock Options or Non-Qualified Stock Options; (v) the period during which such Options may be exercised and any vesting schedule applicable to such Options, including any applicable performance measures (as set forth in Section X); (vi) the effect of termination of employment or service on the exercisability of the Options; and (vii) any other terms that the Committee deems appropriate.

 

VIII.  RESTRICTED STOCK AWARDS

 

(a) Grants of Restricted Stock.  The Committee may from time to time grant shares of Restricted Stock on the terms and conditions set forth in the Plan and on such other terms and conditions as are not inconsistent with the purposes and provisions of the Plan as the Committee, in its discretion, may from time to time determine.

 

(b) Vesting of Restricted Stock.  Shares of Common Stock that are the subject of a Restricted Stock Award shall be subject to restrictions on disposition by the Participant and an obligation of the Participant to forfeit and surrender the shares to the Company under certain circumstances, as determined by the Committee. The Committee shall establish the vesting schedule applicable to each Restricted Stock Award, provided that (i) in no event shall any Restricted Stock Award that has a vesting schedule based on the passing of time have (or be accelerated such that it has) a vesting schedule of less than three years from the date of grant, and no more than 331/3 percent of any such Award shall vest on each anniversary of the date of grant; and (ii) in no event shall any Restricted Stock Award that is a Performance Award vest (or be accelerated such that it vests) in under one year from the date of grant. The Committee may provide that the shares will vest upon (i) the Participant’s continued employment with the Company for a specified period of time; (ii) the attainment of one or more performance measures established by the Committee, as set forth in Section X; (iii) the occurrence of any event or the satisfaction of any other condition specified by the Committee in its sole discretion; or (iv) a combination of any of the foregoing.

 

(c) Rights and Restrictions Governing Restricted Stock.  Common Stock awarded pursuant to a Restricted Stock Award shall be registered in the Participant’s name or otherwise credited to the Participant. Unless provided otherwise in a Restricted Stock Agreement, the Participant shall have the right to receive dividends or other distributions with respect to shares of Common Stock subject to a Restricted Stock Award, to vote Common Stock subject thereto, and to enjoy all other Shareholder rights, except that (i) the Participant shall not be entitled to delivery of unrestricted shares until all conditions to vesting have been satisfied; (ii) the Participant may not sell, transfer, pledge, assign, exchange, hypothecate, or otherwise encumber or dispose of the shares until all conditions to vesting have been satisfied; and (iii) a breach of the terms and conditions established by the Committee pursuant to the Restricted Stock Agreement shall cause a forfeiture of the Restricted Stock.

 

(d) Payment for Restricted Stock.  The Committee shall determine the amount and form of any payment for Common Stock received pursuant to a Restricted Stock Award, provided that, in the absence of such a determination, a Participant shall not be required to make any payment for Common Stock received pursuant to a Restricted Stock Award, except to the extent otherwise required by law.

 

(e) Rights Upon Termination of Service.  In the event of the termination of a Participant’s service with the Company or any Affiliate, any of such Participant’s shares of Restricted Stock that have not vested as of the date of termination shall automatically and without notice be forfeited at 4:00 p.m., Eastern Time, on the date of termination.

 

(f) Restricted Stock Agreements.  Each Restricted Stock Award shall be evidenced by a Restricted Stock Agreement in such form and containing such provisions not inconsistent with the provisions of the Plan as the Committee from time to time shall approve, including, without limitation, (i) the number of shares of Restricted Stock granted; (ii) the date of grant; (iii) the price, if any, to be paid by the Participant for such Restricted Stock; (iv) the vesting schedule applicable to such Restricted Stock, including any applicable performance measures (as set forth in Section X) or other restrictions; (v) the effect of termination of service on the vesting of the Restricted Stock; and (vi) any other terms that the Committee deems appropriate.

 

IX.  RESTRICTED STOCK UNITS

 

(a) Grants of Restricted Stock Units.  The Committee may from time to time grant Restricted Stock Units on the terms and conditions set forth in the Plan and on such other terms and conditions as are not inconsistent with the purposes and provisions of the Plan as the Committee, in its discretion, may from time to time determine.

 

(b) Vesting of Restricted Stock Units.  The Committee shall establish the vesting schedule applicable to each Restricted Stock Unit Award; provided that (i) in no event shall any Restricted Stock Unit Award that has a vesting schedule based on the passing of time have (or be accelerated such that is has) a vesting schedule of less than three

years from the date of grant, and no more than 331/3 percent of any such Award shall vest (or be accelerated such that it vests) on each anniversary of the date of grant; and (ii) in no event shall any Restricted Stock Award that is a Performance Award vest in under one year from the date of grant. The Committee may provide that the Restricted Stock Units will vest upon (i) the Participant’s continued employment with the Company for a specified period of time; (ii) the attainment of one or more performance measures established by the Committee, as set forth in Section X; (iii) the occurrence of any event or the satisfaction of any other condition specified by the Committee in its sole discretion; or (iv) a combination of any of the foregoing.

 

(c) Settlement of Restricted Stock Units.  On the date on which Restricted Stock Units vest (or at such other time or times as the Committee may provide), the holder of such Restricted Stock Units shall be entitled to receive one share of Common Stock for each Restricted Stock Unit that has vested. In such event, the applicable number of shares of Common Stock shall be registered in the Participant’s name or otherwise credited to the Participant.

 

(d) Shareholder Rights and Privileges.  A Participant shall have no right to receive dividends, vote, or otherwise exercise the privileges and rights of a Shareholder with respect to outstanding Restricted Stock Units granted pursuant to this Section. The Participant shall be entitled to all of the privileges and rights of a Shareholder only with respect to such shares of Common Stock as have been issued pursuant to a Restricted Stock Unit Award and that have been registered in the Participant’s name or otherwise credited to the Participant.

 

(e) Rights Upon Termination of Service.  In the event of the termination of a Participant’s service with the Company or any Affiliate, any of such Participant’s Restricted Stock Units that have not vested as of the date of termination shall automatically and without notice be forfeited at 4:00 p.m., Eastern Time, on the date of termination.

 

(f) Restricted Stock Unit Award Agreements.  Each Restricted Stock Unit granted pursuant to this Section IX shall be evidenced by an Agreement in such form and containing such provisions not inconsistent with the provisions of the Plan as the Committee from time to time shall approve, including, without limitation, (i) the number of Restricted Stock Units granted; (ii) the date of grant; (iii) the price, if any, to be paid by the Participant in connection with such Restricted Stock Units; (iv) the vesting schedule applicable to such Restricted Stock Units, including any applicable performance measures (as set forth in Section X) or other restrictions; (v) the effect of termination of service on the vesting of the Restricted Stock Units; and (vi) any other terms that the Committee deems appropriate.

 

X.  PERFORMANCE AWARDS

 

The grant, vesting, and/or exercisability of any Award may, in the Committee’s sole discretion, be conditioned, in whole or in part, on the attainment of performance targets related to one or more performance measures over a performance period, in which case, such Award shall constitute a Performance Award under the Plan.

 

(a) Performance Measures.  (i) Performance Awards that are not intended to qualify for the Section 162(m) Exception may be based on the achievement of such goals and be subject to such terms, conditions, and restrictions as the Committee shall determine.

 

(ii) Performance Awards that are intended to qualify for the Section 162(m) Exception based on the satisfaction of one or more performance measures shall be conditioned upon the achievement during a specified performance period of specified levels of one or more of the measures listed below. The Committee shall establish the performance measures applicable to such performance either (i) prior to the beginning of the performance period or (ii) within 90 days after the beginning of the performance period if the outcome of the performance targets is substantially uncertain at the time such targets are established, but not later than the date on which 25 percent of the performance period has elapsed; provided such measures may be made subject to adjustment for specified significant extraordinary items or events to the extent consistent with Section 162(m) of the Code. The performance measures established by the Committee may be based upon (1) the earnings or earnings per share of the Company or of any business unit of the Company designated by the Committee; (2) the net operating margin of the Company or of any business unit of the Company designated by the Committee; (3) the cash flow return on investment of the Company or any business unit of the Company designated by the Committee; (4) the earnings before interest, taxes, depreciation, and/or amortization of the Company or any business unit of the Company designated by the

Committee; (5) the return on shareholders’ equity achieved by the Company; (6) the total shareholders’ return achieved by the Company; (7) any of the foregoing calculated on an “economic basis”; (8) the price of a share of Common Stock; (9) the Company’s market share; (10) the market share of a business unit of the Company designated by the Committee; (11) the Company’s sales; (12) the sales of a business unit of the Company designated by the Committee; (13) the economic value added; or (14) any combination of the foregoing. A measure that is calculated on an “economic basis” is a measure that is adjusted (to the extent consistent with Section 162(m) of the Code) to reflect the impact of special items, which items are reflected from time to time in the Company’s published financials. Special items are material nonrecurring adjustments deemed appropriate to exclude by the Committee and may include, without limitation, (a) unrealized gains or losses and other items that are recorded by the Company as a result of Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities, as amended; (b) impairment and other non-cash charges including the impact of changes in accounting principles or estimates or other unusual, infrequent non-cash items; and (c) other items not considered to be representative of the Company’s ongoing operations.

 

(b) Determination of Awards.  To the extent the Committee intends for Awards to qualify for the Section 162(m) Exception, prior to the Participants’ receipt of shares of Common Stock pursuant to such Awards (or prior to receipt of the Awards themselves, if applicable), the Committee shall certify whether the performance targets and measure(s) related to such Awards have been achieved. The Committee, in its sole discretion, may provide for a reduction in a Participant’s Performance Award during the performance period.

 

XI.  RECAPITALIZATION OR REORGANIZATION

 

(a) No Effect on Right or Power.  The existence of the Plan and the Awards granted hereunder shall not affect in any way the right or power of the Board or the Shareholders of the Company to make or authorize (i) any adjustment, recapitalization, reorganization, or other change in the Company’s or any Affiliate’s capital structure or its business; (ii) any merger or consolidation of the Company or any Affiliate; (iii) any issue of debt or equity securities ahead of or affecting Common Stock or the rights thereof; (iv) the dissolution or liquidation of the Company or any Affiliate; (v) any sale, lease, exchange, or other disposition of all or any part of the Company’s or any Affiliate’s assets or business; or (vi) any other corporate act or proceeding.

 

(b) Subdivision or Consolidation of Shares; Stock Dividends.  The shares with respect to which Awards may be granted are shares of Common Stock as presently constituted, but if, and whenever, prior to the expiration of an Award theretofore granted, the Company shall effect a subdivision or consolidation of shares of Common Stock or the payment of a stock dividend on Common Stock without receipt of consideration by the Company, the number of shares of Common Stock with respect to which such Award may thereafter be exercised or satisfied, as applicable, (i) in the event of an increase in the number of outstanding shares, shall be proportionately increased, and the exercise price per share (if applicable) shall be proportionately reduced; and (ii) in the event of a reduction in the number of outstanding shares, shall be proportionately reduced, and the exercise price per share (if applicable) shall be proportionately increased. In the event of any such change in the outstanding Common Stock, the aggregate number of shares available under the Plan may be appropriately adjusted by the Committee, whose determination shall be conclusive.

 

(c) Recapitalizations and Corporate Changes.  If the Company recapitalizes or otherwise changes its capital structure (a “recapitalization”), the number and class of shares of Common Stock covered by an Award theretofore granted shall be adjusted so that such Award shall thereafter cover the number and class of shares of stock and securities to which the Participant would have been entitled pursuant to the terms of the recapitalization if, immediately prior to such recapitalization, the Participant had been the holder of record of the number of shares of Common Stock then covered by such Award. If the Company shall not be the surviving entity in any merger or consolidation (or survives only as a subsidiary of an entity other than a previously wholly-owned subsidiary of the Company), or if the Company is to be dissolved or liquidated, then, unless a surviving corporation assumes or substitutes new Awards for Awards then outstanding hereunder, (i) all unvested Options then outstanding shall be accelerated and shall become exercisable in full, and all restrictions and/or performance measures with respect to any Award shall be deemed to be satisfied, on or before a date fixed by the Company prior to the effective date of

such merger or consolidation or such dissolution or liquidation; and (ii) upon such effective date, Awards shall expire.

 

(d) Awards and Rights in Substitution for Awards Granted by Other Employers.  Awards may be granted under the Plan from time to time in substitution for Awards held by individuals providing services to corporations or other entities who become Employees or Directors as a result of a merger or consolidation or other business transaction with the Company or any Affiliate.

 

(e) Shareholder Action.  Any adjustment provided for in the above Subsections shall be subject to any required Shareholder action.

 

(f) No Adjustments Unless Otherwise Provided.  Except as hereinbefore expressly provided, the issuance by the Company of shares of stock of any class or securities convertible into shares of stock of any class for property, labor, or services, upon direct sale, upon the exercise of rights or warrants to subscribe therefor, or upon conversion of shares or obligations of the Company convertible into such shares or other securities, and in any case whether or not for fair value, shall not affect, and no adjustment by reason thereof shall be made with respect to, the number of shares of Common Stock subject to Awards theretofore granted or the exercise price per share, if applicable.

 

XII.  AMENDMENT AND TERMINATION OF THE PLAN

 

The Board in its discretion may terminate the Plan at any time with respect to any shares of Common Stock for which Awards have not theretofore been granted. In addition, the Board shall have the right to alter or amend the Plan or any part thereof from time to time; provided that no change in the Plan may be made that would impair the rights of a Participant with respect to an Award theretofore granted without the consent of the Participant; and provided, further, that no amendment shall be made without approval of the Shareholders of the Company if such approval is required under applicable law or by the requirements of any exchange or automated quotation system upon which the Common Stock is listed for trading or quoted.

 

XIII.  MISCELLANEOUS

 

(a) No Right to An Award.  Neither the adoption of the Plan nor any action of the Board or of the Committee shall be deemed to give any individual any right to be granted an Award nor any other rights hereunder except as may be evidenced by an Award Agreement, and then only to the extent and on the terms and conditions expressly set forth therein. The Plan shall be unfunded. The Company shall not be required to establish any special or separate fund or to make any other segregation of funds or assets to assure the performance of its obligations with respect to any Award.

 

(b) No Employment/Board Membership Rights Conferred.  Nothing contained in the Plan shall (i) confer upon any Employee any right with respect to continuation of an employment relationship with the Company or any Affiliate or (ii) interfere in any way with the right of the Company or any Affiliate to terminate his or her employment relationship at any time. Nothing contained in the Plan shall confer upon any Director any right with respect to continuation of membership on the Board.

 

(c) Other Laws; Withholding.  By accepting any shares of Common Stock issued pursuant to an Award granted under the Plan, the Participant thereby represents and warrants to the Company that the purchase or receipt of such shares shall be for investment and not with a view to distribution; provided that such representation and warranty shall be inoperative if, in the opinion of counsel to the Company, a proposed sale or distribution of such shares is pursuant to an applicable effective registration statement under the Securities Act of 1933, as amended, or is, without such representation and warranty, exempt from registration under such Act. The Company shall not be obligated to issue any Common Stock pursuant to any Award granted under the Plan at any time when the requirements of any securities exchange upon which the Company’s securities shall then be listed have not been met or when the shares covered by such Award have not been registered under the Securities Act of 1933, as amended, and such other state and federal laws, rules, and regulations as the Company or the Committee deem applicable and, in the opinion of legal counsel for the Company, there is no exemption from the registration requirements of such laws, rules, and regulations available for the issuance and sale of such shares. The Company may (i) endorse an

appropriate legend referring to the foregoing restrictions upon the certificate or certificates representing any shares of Common Stock issued or transferred pursuant to any Award granted under this Plan; or (ii) otherwise note such restrictions with respect to Common Stock that is not certificated. No fractional shares of Common Stock shall be delivered, nor shall any cash in lieu of fractional shares be paid. The Company shall have the right to deduct in connection with all Awards any taxes required by law to be withheld and to require any payments required to enable it to satisfy its withholding obligations. This authority shall include the authority to withhold or receive Common Stock or other property and to make cash payments in respect thereof in satisfaction of a Participant’s tax obligations, either on a mandatory or elective basis in the discretion of the Committee. The Committee, in its sole discretion, may require, as a condition to the exercise of any Option or delivery of any shares of Common Stock, that an additional amount be paid in cash equal to the amount of any taxes owed as a result of such exercise or delivery.

 

(d) No Restriction on Corporate Action.  Nothing contained in the Plan shall be construed to prevent the Company or any Affiliate from taking any action that is deemed by the Company or such Affiliate to be appropriate or in its best interest, whether or not such action would have an adverse effect on the Plan or any Award made under the Plan. No Participant, beneficiary, or other person shall have any claim against the Company or any Affiliate as a result of any such action.

 

(e) Restrictions on Transfer.  No Award granted under this Plan or any right evidenced thereby shall be transferable by the Participant other than by will or the laws of descent and distribution, and any Options shall be exercisable during the Participant’s lifetime only by such Participant or the Participant’s guardian or legal representative.

 

(f) Governing Law.  The Plan shall be governed by, and construed in accordance with, the laws of the State of Texas, without regard to conflicts of laws principles thereof.

 

APPENDIX C

Southwest Airlines Co.
Audit and Non-Audit Services Preapproval Policy
Adopted March 20, 2003

 

I.  Purpose

 

Under the Sarbanes-Oxley Act of 2002 (the “Act”) and the rules of the Securities and Exchange Commission (the “SEC”), the Audit Committee of the Board of Directors is responsible for the appointment, compensation, and oversight of the work of the independent auditor. The Audit Committee is required to pre-approve the audit and non-audit services performed by the independent auditor in order to assure that they do not impair the auditor’s independence from the Company. Accordingly, the Audit Committee has adopted, and the Board of Directors of Southwest Airlines Co. (the “Company” or “Southwest”) has ratified, this Audit and Non-Audit Services Preapproval Policy (the “Policy”), which sets forth the procedures and the conditions pursuant to which services proposed to be performed by the independent auditor may be preapproved.

 

The SEC’s rules provide that proposed services may be preapproved without consideration of specific case-by-case services by the Audit Committee (“general preapproval”) or may require the specific preapproval of the Audit Committee (“specific preapproval”). The Audit Committee believes that the combination of these two approaches in this Policy will result in an effective and efficient procedure to pre-approve services performed by the independent auditor. Accordingly, unless a type of service has received general preapproval, it will require specific preapproval by the Audit Committee if it is to be provided by the independent auditor. Any proposed services exceeding preapproved cost levels or budgeted amounts will also require specific preapproval by the Audit Committee.

 

For each preapproval, the Audit Committee will consider whether the services are consistent with the SEC’s rules on auditor independence. The Audit Committee will also consider whether the independent auditor is best positioned to provide the most effective and efficient service, for reasons such as its familiarity with the Company’s business, people, culture, accounting systems, risk profile and other factors, and whether the service might enhance the Company’s ability to manage or control risk or improve audit quality. All such factors will be considered as a whole, and no one factor will necessarily be determinative.

 

The independent auditor has reviewed this Policy and believes that implementation of the policy will not adversely affect the auditor’s independence.

 

II.  Delegation

 

The Act and the SEC’s rules permit the Audit Committee to delegate preapproval authority to one or more of its members. The member to whom such authority is delegated must report, for informational purposes only, any preapproval decisions to the Audit Committee at its next scheduled meeting.

 

III.  Audit Services

 

The annual Audit services engagement terms and fees will be subject to the specific preapproval of the Audit Committee. The Audit Committee will monitor the Audit services engagement as necessary, but no less than on a quarterly basis, and will also approve, if necessary, any changes in terms, conditions and fees.

 

In addition to the annual Audit services engagement approved by the Audit Committee, the Audit Committee may grant preapproval to other Audit services, which are those services that only the independent auditor reasonably can provide. Other Audit services may include services associated with SEC registration statements or other documents issued in connection with securities offerings.

 

IV.  Audit-related Services

 

Audit-related services are assurance and related services that are reasonably related to the performance of the audit or review of the Company’s financial statements or that are traditionally performed by the independent auditor. Because the Audit Committee believes that the provision of Audit-related services does not impair the independence of the auditor and is consistent with the SEC’s rules on auditor independence, the Audit Committee may grant general preapproval to Audit-related services. Audit-related services include, among others, due diligence services pertaining to potential business acquisitions/dispositions; accounting consultations related to accounting, financial reporting or disclosure matters not classified as “Audit services”; assistance with understanding and implementing new accounting and financial reporting guidance from rulemaking authorities; financial audits of Employee benefit plans; agreed-upon or expanded audit procedures related to accounting and/or billing records required to respond to or comply with financial, accounting or regulatory reporting matters; and assistance with internal control reporting requirements.

 

V.  Tax Services

 

The Audit Committee believes that the independent auditor can provide Tax services to the Company such as tax compliance, tax planning and tax advice without impairing the auditor’s independence, and the SEC has stated that the independent auditor may provide such services. The Audit Committee believes it may grant general preapproval to those Tax services that have historically been provided by the auditor, that the Audit Committee has reviewed and believes would not impair the independence of the auditor, and that are consistent with the SEC’s rules on auditor independence. The Audit Committee will not permit the retention of the independent auditor in connection with a transaction initially recommended by the independent auditor, the sole business purpose of which may be tax avoidance and the tax treatment of which may not be supported in the Internal Revenue Code and related regulations. The Audit Committee will consult with the Chief Financial Officer or Vice President — Finance to determine that the tax planning and reporting positions are consistent with this policy.

 

The Audit Committee must preapprove tax services to be provided by the independent auditor to any Executive Officer or Director of the Company, in his or her individual capacity, where such services are paid for by the Company.

 

VI.  All Other Services

 

The Audit Committee believes, based on the SEC’s rules prohibiting the independent auditor from providing specific non-audit services, that other types of non-audit services are permitted. Accordingly, the Audit Committee believes it may grant general preapproval to those permissible non-audit services classified as All Other services that it believes are routine and recurring services, would not impair the independence of the auditor, and are consistent with the SEC’s rules on auditor independence.

 

A list of the SEC’s prohibited non-audit services is attached to this policy as Exhibit 1. The SEC’s rules and relevant guidance should be consulted to determine the precise definitions of these services and the applicability of exceptions to certain of the prohibitions.

 

VII.  Preapproval Fee Levels or Budgeted Amounts

 

Preapproval fee levels for all services to be provided by the independent auditor will be established by the Audit Committee. Any proposed services exceeding these levels or amounts will require specific preapproval by the Audit Committee. The Audit Committee is mindful of the overall relationship of fees for audit and non-audit services in determining whether to pre-approve any such services.

 

VIII.  Procedures

 

All requests or applications for services to be provided by the independent auditor that do not require specific approval by the Audit Committee will be submitted to the Chief Financial Officer or Vice President — Finance and

must include a detailed description of the services to be rendered. The Vice President — Finance will determine whether such services are included within the list of services that have received the general preapproval of the Audit Committee. The Audit Committee will be informed on a timely basis of any such services rendered by the independent auditor.

 

Requests or applications to provide services that require specific approval by the Audit Committee will be submitted to the Audit Committee by both the independent auditor and the Vice President — Finance and must include a joint statement as to whether, in their view, the request or application is consistent with the SEC’s rules on auditor independence.

Exhibit 1

 

Prohibited Non-Audit Services

 

APPENDIX D

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

 

Commission File No. 1-7259

Southwest Airlines Co.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code:

(214) 792-4000

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark whether the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes þ     No o

 

Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

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.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The aggregate market value of the Common Stock held by non-affiliates of the registrant was approximately $12,811,246,960, computed by reference to the closing sale price of the Common Stock on the New York Stock Exchange on June 30, 2006, the last trading day of the registrant’s most recently completed second fiscal quarter.

 

Number of shares of Common Stock outstanding as of the close of business on January 29, 2007: 788,431,522 shares

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Proxy Statement for our Annual Meeting of Shareholders to be held May 16, 2007 are incorporated into Part III of this Form 10-K.

 

TABLE OF CONTENTS

 

 

Overview

 

Southwest Airlines Co. is a major passenger airline that provides scheduled air transportation in the United States. Based on the most recent data available from the Department of Transportation, Southwest Airlines is the largest carrier in the United States, as measured by originating passengers boarded and scheduled domestic departures. Southwest was incorporated in Texas in 1967 and commenced Customer Service on June 18, 1971, with three Boeing 737 aircraft serving three Texas cities — Dallas, Houston, and San Antonio. At year-end 2006, Southwest operated 481 Boeing 737 aircraft and provided service to 63 cities in 32 states throughout the United States. During 2006, the Company began service to Denver, Colorado, and Washington Dulles International Airport. The terms “Southwest,” the “Company,” “we,” “us,” and similar terms refer to Southwest Airlines Co. and its subsidiaries.

 

Southwest focuses principally on point-to-point, rather than hub-and-spoke, service, providing its markets with frequent, conveniently timed flights and low fares. At December 31, 2006, Southwest served 397 nonstop city pairs. Historically, Southwest has served predominantly short-haul routes, with high frequencies. In recent years, the Company has complemented this service with more medium to long-haul routes, including transcontinental service.

 

One of Southwest’s primary competitive strengths is its low operating costs. Southwest has the lowest costs, adjusted for stage length, on a seat mile basis, of all the major airlines. Among the factors that contribute to its low cost structure are a single aircraft type, an efficient, high-utilization, point-to-point route structure, and hardworking, innovative, and highly productive Employees.

 

The business of the Company is somewhat seasonal. Quarterly operating income and, to a lesser extent, revenues tend to be lower in the first quarter (January 1 - March 31) and fourth quarter (October 1 - December 31) of most years.

 

Southwest’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports that are filed with or furnished to the SEC, are accessible free of charge at www.southwest.com as soon as reasonably practicable after they are electronically filed with, or furnished to, the SEC.

 

Fuel

 

The cost of fuel is an item that has significant impact on the Company’s results of operations. The Company’s average cost of jet fuel, net of hedging gains and excluding fuel taxes, over the past five years was as follows:

 

 

From October 1, 2006 through December 31, 2006, the average cost per gallon was $1.55. Fuel costs and Southwest’s fuel hedging activities are discussed in more detail below under “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Regulation

 

 

 

In the third quarter of 2006, Southwest entered into an agreement with the City of Dallas, the City of Fort Worth, American Airlines, Inc., and the DFW International Airport Board. Pursuant to this agreement, the five parties sought enactment of legislation to amend the Act. On October 13, 2006, Congress responded by passing the Wright Amendment Reform Act of 2006 (the “Reform Act”), which provides for, among other things, (1) substantial repeal of the Wright Amendment in 2014, (2) immediate repeal of through service and ticketing restrictions, so that Customers can purchase a single ticket between Dallas Love Field and any U.S. destination (while still requiring the Customer’s flight to make a stop in a Wright Amendment State), and (3) reduction of the maximum number of gates available for commercial air service at Dallas Love Field from 32 to 20. Southwest currently uses 14 gates at Dallas Love Field. Pursuant to the Reform Act and local agreements with the City of Dallas with respect to gates, Southwest can expand scheduled service from Dallas Love Field and intends to do so.

 

Safety and Health.  The Company and its third-party maintenance providers are subject to the jurisdiction of the Federal Aviation Administration (“FAA”) with respect to the Company’s aircraft maintenance and operations, including equipment, ground facilities, dispatch, communications, flight training personnel, and other matters affecting air safety. To ensure compliance with its regulations, the FAA requires airlines to obtain operating, airworthiness, and other certificates, which are subject to suspension or revocation for cause. The Company has obtained such certificates. In addition, pursuant to FAA regulations, the Company has established, and the FAA has approved, the Company’s operations specifications and a maintenance program for the Company’s aircraft, ranging from frequent routine inspections to major overhauls. The FAA, acting through its own powers or through the appropriate U.S. Attorney, also has the power to bring proceedings for the imposition and collection of fines for violation of the Federal Air Regulations.

 

The Company is subject to various other federal, state, and local laws and regulations relating to occupational safety and health, including Occupational Safety and Health Administration and Food and Drug Administration regulations.

 

Security.  Pursuant to the Aviation and Transportation Security Act (the “Aviation Security Act”), the Transportation Security Administration (“TSA”), a division of the Department of Homeland Security, is responsible for certain civil aviation security matters. The Aviation Security Act mandated, among other things, improved flight deck security, deployment of federal air marshals onboard flights, improved airport perimeter access security, airline crew security training, enhanced security screening of passengers, baggage, cargo, mail, employees, and vendors, enhanced training and qualifications of security screening personnel, additional provision of passenger data to U.S. Customs, and enhanced background checks. Under the Aviation Security Act, substantially all security screeners at airports are federal employees, and significant other elements of airline and airport security are overseen and performed by federal employees, including federal security managers, federal law enforcement officers, and federal air marshals. Under the Aviation Security Act, funding for passenger security is provided in part by a $2.50 per enplanement security fee, subject to a maximum of $5.00 per one-way trip. The Aviation Security Act also allows the TSA to assess an Aviation Security Infrastructure Fee on each airline up to the total amount spent by that airline on passenger and property screening in calendar year 2000. Southwest was assessed a fee, and recorded expense, totaling approximately $50 million in each of 2005 and 2006 (of which approximately $24 million in each year is being contested by Southwest). Like the FAA, the TSA may impose and collect fines for violations of its regulations.

 

Enhanced security measures have had, and will continue to have, a significant impact on the airport experience for passengers. While these security requirements have not impacted aircraft utilization, they have impacted our business. In particular, the third quarter of 2006 presented challenges to the airline industry due to new security measures mandated by the TSA, as a result

of a terrorist plot uncovered by authorities in London. The stringent new rules, mostly regarding the types of liquid items that can be carried onboard the aircraft, had a negative impact on air travel beginning in mid-August, especially on shorthaul routes and with business travelers. Although the TSA has relaxed some of the requirements for carryon luggage, the Company is not able to predict the ongoing impact, if any, that these security changes will have on passenger revenues, both in the shortterm and the longterm.

 

The Company has invested significantly in facilities, equipment, and technology to process Customers efficiently and restore the airport experience. The Company’s Automated Boarding Passes and E-Ticket Check-In self service kiosks, which the Company has implemented in all airports it serves, have reduced the number of lines in which a Customer must wait. The Company has also installed gate readers at all of its airports to improve the boarding reconciliation process and offers baggage checkin through E-Ticket Check-In kiosks at certain airport locations, as well as Internet checkin and transfer boarding passes at the time of checkin.

 

Environmental.  The Airport Noise and Capacity Act of 1990 gives airport operators the right, under certain circumstances, to implement local noise abatement programs, so long as they do not unreasonably interfere with interstate or foreign commerce or the national air transportation system. Some airports, including San Diego and Orange County, California have established airport restrictions to limit noise, including restrictions on aircraft types to be used, and limits on the number of hourly or daily operations or the time of such operations. In some instances, these restrictions have caused curtailments in service or increases in operating costs, and such restrictions could limit the ability of Southwest to expand its operations at the affected airports. Local authorities at other airports may consider adopting similar noise regulations, but such regulations are subject to the provisions of the Airport Noise and Capacity Act of 1990 and regulations promulgated thereunder.

 

Operations at John Wayne Airport, Orange County, California, are governed by the Airport’s Phase 2 Commercial Airline Access Plan and Regulation (the “Plan”). Pursuant to the Plan, each airline is allocated total annual seat capacity to be operated at the airport, subject to renewal/reallocation on an annual basis. Service at this airport may be adjusted annually to meet these requirements.

 

The Company is subject to various other federal, state, and local laws and regulations relating to the protection of the environment, including the discharge or disposal of materials such as chemicals, hazardous waste, and aircraft deicing fluid. Regulatory developments pertaining to such things as control of engine exhaust emissions from ground support equipment and prevention of leaks from underground aircraft fueling systems could increase operating costs in the airline industry. The Company does not believe, however, that such environmental regulatory developments will have a material impact on the Company’s capital expenditures or otherwise adversely affect its operations, operating costs, or competitive position. Additionally, in conjunction with airport authorities, other airlines, and state and local environmental regulatory agencies, the Company is undertaking voluntary investigation or remediation of soil or groundwater contamination at several airport sites. The Company does not believe that any environmental liability associated with such sites will have a material adverse effect on the Company’s operations, costs, or profitability.

 

Customer Service Commitment.  From time to time, the airline transportation industry has been faced with possible legislation dealing with certain Customer Service practices. As a compromise with Congress, the industry, working with the Air Transport Association, has responded by adopting and filing with the DOT written plans disclosing how it would commit to improving performance. Southwest Airlines’ Customer Service Commitment is a comprehensive plan which embodies the Mission Statement of Southwest Airlines: dedication to the highest quality of Customer Service delivered with a sense of warmth, friendliness, individual pride, and Company Spirit. The Customer Service Commitment can be reviewed by clicking on “About Southwest” at www.southwest.com. The DOT and Congress monitor the industry’s plans, and there can be no assurance that legislation or regulations will not be proposed in the future to regulate airline Customer Service practices.

 

Operations and Marketing

 

Operating Strategies.  Southwest focuses principally on point-to-point, rather than hub-and-spoke, service, providing its markets with frequent, conveniently timed flights and low fares. Southwest’s average aircraft trip stage length in 2006 was 622 miles with an average duration of approximately 1.7 hours, as compared to an average aircraft trip stage length of 607 miles and an average duration of approximately 1.7 hours in 2005. Examples of markets offering frequent daily flights are: Dallas to Houston Hobby, 30 weekday roundtrips; Phoenix to Las Vegas, 19 weekday roundtrips; and Los Angeles International to Oakland, 22 weekday

roundtrips. Southwest complements these high-frequency shorthaul routes with longhaul nonstop service between markets such as Baltimore and Los Angeles, Phoenix and Tampa Bay, Las Vegas and Orlando, and Houston and Oakland.

 

Most major U.S. airlines have adopted the “hub-and-spoke” system, which concentrates most of an airline’s operations at a limited number of hub cities and serves most other destinations in the system by providing one-stop or connecting service through the hub. Southwest focuses on nonstop, not connecting, traffic over its point-to-point route system. The point-to-point route system, as compared to hub-and-spoke, allows for more direct nonstop routings for our Customers and, therefore, minimizes connections, delays, and total trip time. As a result, approximately 79 percent of the Company’s Customers fly nonstop.

 

Southwest serves many conveniently located secondary or downtown airports such as Dallas Love Field, Houston Hobby, Chicago Midway, Baltimore-Washington International, Burbank, Manchester, Oakland, San Jose, Providence, Ft. Lauderdale/Hollywood, and Long Island Islip airports, which are typically less congested than other airlines’ hub airports. This operating strategy enables the Company to achieve high asset utilization because aircraft can be scheduled to minimize the amount of time they are at the gate (currently approximately 25 minutes). This in turn reduces the number of aircraft and gate facilities that would otherwise be required. The Company is also able to simplify scheduling, maintenance, flight operations, and training activities by operating only one aircraft type, the Boeing 737. All of these strategies enhance the Company’s ability to sustain high Employee productivity and reliable ontime performance.

 

Introduction of Codesharing.  In first quarter 2005, Southwest began its first codeshare arrangement, with ATA Airlines. Under its codeshare arrangement with ATA, Southwest may market and sell tickets for certain flights on ATA that are identified by Southwest’s designator code (for example, “WN Flight 123”). Conversely, ATA may market and sell tickets under its code designator (TZ) for certain flights on Southwest Airlines. Any flight bearing a Southwest code designator that is operated by ATA is disclosed in Southwest’s reservations systems and on the Customer’s flight itinerary, boarding pass, and ticket, if a paper ticket is issued. As a result of the ATA codeshare, Southwest’s Customers are able to purchase single ticket service on Southwest connecting to ATA’s service to Hawaii, New York’s LaGuardia Airport, and Washington Reagan National Airport. Also, members of Southwest’s and ATA’s respective frequent flier programs are able to earn and redeem awards in the other carrier’s program. Finally, beginning in 2006, Southwest began selling ATA-only service at www.southwest.com. Other than the ATA arrangement, Southwest does not interline or offer joint fares with other airlines, nor does Southwest have any marketing or commuter feeder relationships with other carriers.

 

Simplified Fare Structure.  Southwest employs a relatively simple fare structure, featuring low, unrestricted, unlimited, everyday coach fares, as well as even lower fares available on a restricted basis. As of November 1, 2006, the Company’s highest non-codeshare, oneway unrestricted walkup fare offered was $319 for any flight. Even lower walkup fares are available on Southwest’s short and medium haul flights.

 

Ticketless Travel.  Southwest was the first major airline to introduce a Ticketless travel option, eliminating the need to print and then process a paper ticket altogether, and the first to offer Ticketless travel through the Company’s home page on the Internet, at www.southwest.com. For the year ended December 31, 2006, more than 94 percent of Southwest’s Customers chose the Ticketless travel option and over 70 percent of Southwest’s passenger revenues came through its Internet site, which has become a vital part of the Company’s distribution strategy. The Company has not paid commissions to travel agents for sales since December 15, 2003.

 

Competition

 

The airline industry is highly competitive. We believe the principal competitive factors in the industry are:

 

 

We currently compete with other airlines on all of our routes, some of which airlines have larger fleets and some of which airlines may have wider name recognition in some markets. Certain major U.S. airlines have established marketing or codesharing alliances with each other, including Northwest Airlines/Continental Airlines/Delta Air Lines; American Airlines/Alaska

Airlines; and United Airlines/US Airways. These alliances are more extensive than ours and enable the carriers to expand their destinations and marketing opportunities. The Company is also subject to varying degrees of competition from surface transportation in its shorthaul markets, particularly the private automobile. In shorthaul air services that compete with surface transportation, price is a competitive factor, but frequency and convenience of scheduling, facilities, transportation safety and security procedures, and Customer Service are also of great importance to many passengers.

 

The competitive landscape for airlines has changed significantly over the last few years. Following the terrorist attacks on September 11, 2001, the airline industry, as a whole, incurred substantial losses through 2005. The war in Iraq and significant increases in the cost of fuel have exacerbated industry challenges. As a result, a number of carriers have sought relief from financial obligations in bankruptcy, including UAL Corporation, the parent of United Airlines; ATA Airlines; US Airways; Northwest Airlines Corporation, the parent of Northwest Airlines; and Delta Air Lines. UAL Corporation and ATA Airlines emerged from bankruptcy in 2006. US Airways’ emergence from bankruptcy in 2005 culminated in its merger with America West Airlines in September of that year. Northwest Airlines Corporation and Delta Air Lines remain under the protection of bankruptcy proceedings. Other, smaller carriers have ceased operations entirely. In addition, post-9/11, many carriers shrank capacity, grounded their most inefficient aircraft, cut back on unprofitable service, and furloughed employees. Reorganization in bankruptcy has allowed carriers to decrease operating costs through renegotiated labor, supply, and financing contracts. As a result of those events, as well as actions taken by some carriers outside of bankruptcy, differentials in cost structures between traditional hub-and-spoke carriers and low cost carriers have significantly diminished. Nevertheless, throughout this entire time period, Southwest has continued to maintain its cost advantage, improve Employee productivity, pursue steady, controlled growth, and provide outstanding Service to its Customers. The factors discussed above have, however, led to more intense competition in the airline industry generally. Some carriers reported profitable results in one or more quarters in 2006 for the first time since 9/11.

 

The re-emerging competitiveness of some of the larger carriers, such as United, US Airways, and American, has put pressure on smaller carriers such as AirTran Airways, JetBlue, and Frontier. AirTran Airways and JetBlue have announced scaled back growth plans, and many carriers have expressed interest in industry consolidation. For example, US Airways is pursuing a merger with Delta Air Lines, and AirTran Airways has recently announced an unsolicited offer for Midwest Airlines. The Company cannot predict the timing or extent of any such consolidation or its impact (either positive or negative) on the Company’s operations or results of operations.

 

Insurance

 

The Company carries insurance of types customary in the airline industry and at amounts deemed adequate to protect the Company and its property and to comply both with federal regulations and certain of the Company’s credit and lease agreements. The policies principally provide coverage for public and passenger liability, property damage, cargo and baggage liability, loss or damage to aircraft, engines, and spare parts, and workers’ compensation.

 

Following the terrorist attacks, commercial aviation insurers significantly increased the premiums and reduced the amount of war-risk coverage available to commercial carriers. The federal Homeland Security Act of 2002 requires the federal government to provide third party, passenger, and hull war-risk insurance coverage to commercial carriers through a period of time that has now been extended to August 31, 2007. The Company is unable to predict whether the government will extend this insurance coverage past August 31, 2007, whether alternative commercial insurance with comparable coverage will become available at reasonable premiums, and what impact this will have on the Company’s ongoing operations or future financial performance.

 

Frequent Flyer Awards

 

Southwest’s frequent flyer program, Rapid Rewards, is based on trips flown rather than mileage. Rapid Rewards Customers earn a credit for each one-way trip flown or two credits for each roundtrip flown. Rapid Rewards Customers can also receive credits by using the services of non-airline partners, which include car rental agencies, hotels, telecommunication companies, and credit card partners, including the Southwest Airlines Chase^® Visa card. Rapid Rewards offers two types of travel awards. The Rapid Rewards Award Ticket (“Award Ticket”) offers one free roundtrip award valid to any destination available on Southwest after the accumulation of 16 credits. The Rapid Rewards Companion Pass (“Companion Pass”) is granted for flying 50 roundtrips (or 100 one-way trips) on Southwest or earning 100 credits within a consecutive twelve-month period. The Companion Pass offers unlimited free roundtrip

travel to any destination available on Southwest for a designated companion of the qualifying Rapid Rewards member. For the designated companion to use this pass, the Rapid Rewards member must purchase a ticket or use an Award Ticket. Additionally, the Rapid Rewards member and designated companion must travel together on the same flight.

 

Award Tickets and Companion Passes are automatically generated when earned by the Customer rather than allowing the Customer to bank credits indefinitely. Award Tickets are valid for 12 months after issuance. Award Tickets issued before February 10, 2006 have no seat restrictions, but are subject to published “Black out” dates. Effective February 10, 2006, systemwide “Black out” dates for Award Tickets were eliminated, but Award Tickets are subject to seat restrictions. Companion travel has no seat restrictions or “Black out” dates.

 

The Company also sells credits to business partners including credit card companies, hotels, telecommunication companies, and car rental agencies. These credits may be redeemed for Award Tickets having the same program characteristics as those earned by flying. Southwest’s codeshare agreement with ATA Airlines offers Customers of each airline the opportunity to earn and redeem frequent flier award credits on the other.

 

Customers redeemed approximately 2.7 million, 2.6 million, and 2.5 million Award Tickets and flights on Companion Passes during 2006, 2005, and 2004, respectively. The amount of free travel award usage as a percentage of total Southwest revenue passengers carried was 6.4 percent in 2006, 6.6 percent in 2005, and 7.1 percent in 2004. The number of fully earned Award Tickets and partially earned awards outstanding at December 31, 2006 was approximately 10.1 million, of which approximately 81 percent were partially earned awards. The number of fully earned Award Tickets and partially earned awards outstanding at December 31, 2005 was approximately 6.8 million, of which approximately 78 percent were partially earned awards. However, due to the expected expiration of a portion of credits making up partial awards, not all of them will eventually turn into useable Award Tickets. Also, not all Award Tickets will be redeemed for future travel. Since the inception of Rapid Rewards in 1987, approximately 14 percent of all fully earned Award Tickets have expired without being used. The number of Companion Passes for Southwest outstanding at December 31, 2006 and 2005 was approximately 58,000 and 60,000, respectively. The Company currently estimates that an average of 3 to 4 trips will be redeemed per outstanding Companion Pass.

 

The Company accounts for its frequent flyer program obligations by recording a liability for the estimated incremental cost of flight awards the Company expects to be redeemed. The estimated incremental cost includes direct passenger costs such as fuel, food, and other operational costs, but does not include any contribution to overhead or profit. Revenue from the sale of credits to business partners and associated with future travel is deferred and recognized when the ultimate free travel award is flown or the credits expire unused. The liability for free travel awards earned but not used at December 31, 2006 and 2005 was not material.

 

Employees

 

At December 31, 2006, Southwest had 32,664 active Employees, consisting of 12,954 flight, 2,056 maintenance, 13,446 ground, Customer, and fleet service and 4,208 management, accounting, marketing, and clerical personnel.

Southwest has ten collective bargaining agreements, which agreements covered approximately 82 percent of Southwest’s Employees as of December 31, 2006. Our relations with labor unions are governed by the Railway Labor Act (the “RLA”), which establishes the right of airline employees to organize and bargain collectively. Under the RLA, a collective bargaining agreement between an airline and a labor union generally does not expire, but instead becomes amendable as of a stated date. If either party wants to modify the terms of such agreement, it must notify the other party in the manner required by the RLA and/or described in the agreement. After receipt of such notice, the parties must meet for direct negotiations, and, if no agreement is reached, either party may request the National Mediation Board (the “NMB”) to appoint a federal mediator. If no agreement is reached in mediation, the NMB may determine that an impasse exists and offer binding arbitration to the parties. If either party rejects binding arbitration, a 30-day “cooling off” period begins. At the end of this 30-day period, the parties may engage in “self-help,” unless a Presidential Emergency Board is established to investigate and report on the disputes. The appointment of a Presidential Emergency Board maintains the “status quo” for an additional 60 days. If the parties do not reach agreement during this period, the parties may then engage in “self-help.” “Self-help” includes, among other things, a strike by the union or the airline’s imposition of any or all of its proposed amendments and the hiring of new employees to replace any striking workers. The following table sets forth the Company’s Employee groups and collective bargaining status: