Taking the Fear out of Phantom Stock

The use of equity compensation has increased in the banking industry in recent years, coinciding with enhanced compensation guidelines from the Securities and Exchange Commission (SEC), bank regulators, and the Dodd-Frank Act. These parties recommend that some executive compensation be deferred and tied to long-term performance. Equity programs typically accomplish both of these goals. A recent study of 177 public banks from Blanchard Consulting Group’s internal database found that the use of equity grants as a percentage of total compensation increased two to three times from 2009 to 2013, depending on the asset size of the bank.

Most publicly traded banks will use compensation plans tied to the organization’s stock to distribute long-term incentives in the form of stock options or restricted stock. Some private or thinly traded banks will use these types of “real” stock programs; however, many of these banks have limited availability of actual stock. As an alternative, private banks may use synthetic equity, such as phantom stock or stock appreciation rights, which are settled in cash.

Phantom stock programs are modeled to look and feel like restricted stock, where the participant receives the full value of the share plus any appreciation over time. The value of phantom stock is typically linked to the company’s stock price or book value per share. In addition, dividends could be factored into the phantom stock value during the vesting period, typically 3-5 years. Ultimately, the phantom stock awards will be settled in cash.

Advantages to Synthetic Equity
Banks concerned with equity dilution often prefer phantom stock, which provides a value comparable to that of restricted stock, but does not result in actual equity dilution. The value of the phantom stock is paid out in cash upon vesting, so the officer still receives value commensurate with having a real share of stock. Because phantom stock is settled in cash, it does not receive equity-based accounting treatment (value fixed at grant date). Instead, the expense is adjusted over time to reflect changes in the bank’s stock price or book value. The advantage of using phantom stock is the absence of any share dilution.

Stock Appreciation Rights (SARs) are another form of synthetic equity that are settled in cash. Cash SARs work similarly to stock options, as SARs give the participant the right to any appreciation in stock price or book value between the grant date and settlement. The appreciation value is paid in cash and taxed as ordinary income. Similar to phantom stock, cash SARs do not receive equity-based accounting treatment. The SARs are re-valued periodically, and the expense is adjusted to reflect the changes in value throughout the vesting period. This could lead to expensive accruals if the underlying stock price increases dramatically. Similar to phantom stock, there is no share dilution.

Other Considerations
Before implementing any type of equity or long-term incentive plan, a bank should consider a number of factors, such as the following:

1. Performance-based awards: In today’s environment, equity awards are typically based on the achievement of bank-wide, department and/or individual goals.
2. Service vesting: We typically see three to five-year vesting schedules within the banking industry. The vesting schedule may vary by grant or employee based on the bank’s retention goals.
3. Dividends: The board should determine when and if the plan participant will receive value for dividends. This provision can be customized by the bank for each eligible employee.
4. Termination of employment: If a participant voluntarily terminates employment during the plan term, the employee typically forfeits any unvested awards.
5. Death or disability: Most banks will accelerate vesting and allow the participant or beneficiary to exercise shares in the event of a disability or executive’s death. All early disbursements will need to comply with Internal Revenue Service (IRS) restrictions (section 409A).
6. Change-in-control: Shares will typically vest immediately and be paid upon the acquisition or merger of the bank if an employee is terminated as a result, also known as a “double trigger”.
7. Clawback provision: This allows the bank to recoup incentive compensation payments made to plan participants in error from any unvested phantom stock or SAR grant.

In order to retain and attract talent, private banks need to ensure that they have the compensation tools available to compete with public banks that use real stock compensation. By using phantom stock or SARs settled in cash, private banks can help ensure that they are competitive with the market.