On Board With Shareholders

A bank director, in his few hours a month at the bank, has a veritable smorgasbord of issues to consider: capital management, mergers, technology investments, regulatory issues, and how well the CEO with whom he’s had lunch every month for two years is doing his job. He carefully considers the information provided to him, casts his votes according to wisdom and experience, collects his $500 or $1,000, and goes home. End of story.

But how different this scenario appears if this same director’s pay depends upon the performance of the bank’s stock price, say, or its return on equity. This is not to say that directors don’t already use their best judgment when they sit around the boardroom table. But the new theory is that only directors who themselves have something to gain or lose can make decisions that are in the best interests of shareholders.

For years, Wayne Turner, CEO of People’s State Bank of Groveland, Florida, had been trying to get his directors to think like shareholders.

“I was pushing them to quit focusing on return on assets,” he says. “I can do better on ROA and still not do a good job for the stockholders. I’m not here to impress my peers. I want to impress the stockholders with our performance.”

Then in January this year, the $92 million bank changed its directors’ compensation package. Now directors may elect to deposit a percentage of their pay into a deferred payment plan, with the bank matching the sum. The whole amount grows at the same rate as the bank’s return on equity.

“The board became very focused on ROE,” Turner says, noting that People’s State’s ROE grew more in the first quarter of 1999 than it had in all of 1998.

Which is why in recent years, as shareholder value has become the crusade of bankers, more are including stock, stock options, and phantom stock in their directors’ compensation packages. Many of the nation’s largest financial institutions have more than doubled the amount of stock and options in their compensation packages for outside directors in the last three years. And community banks are beginning to make options a standard feature. With banks churning out profits like never before, linking directors pay to bank performance seems an ideal arrangement. A pay package that rises with the bank’s stock offers multiple benefits: kindling the boards’ interest in performance and shareholder value; quieting the roar of stockholders opposed to so-called cushy retirement packages; and stirring little anxiety among regulators.

Despite this transformation, there are nonbelievers: those who worry that the directors’ focus on stock price may steer the board away from judicious long-term planning for the sake of short-term gains. Some directors themselves would rather receive their compensation in the form of deferred retirement benefits rather than receive current income at a high tax bracket. Other board members believe there are simply too many outside forces that affect bank performance to make incentive pay an equitable arrangement. Even so, those arguments have done little to stem the tide that is bringing equity-based directors pay to many banks.

Discovering shareholder value

According to Rich Chapman, president of Minneapolis-based Bank Compensation Strategies, which designs compensation packages for community banks, 80% to 90% of community banks with assets above $500 million offer stock options.

“The smaller banks are trending toward what the bigger banks are offering,” Chapman says.

Michael Ward, CEO of Charter Pacific Bank of Agoura Hills, California, says: “In this market, virtually everyone you talk to is using some form of equity incentive.” A $97 million institution, Charter was listed as the nation’s second-most profitable bank as of December 1998 according to SNL Securities. Charter has a return on equity of 25.89% and a return on assets of 2.52%.

“Stock options are very important to retaining solid board membership and attracting quality board members,” Ward says.

In addition, Charter pays directors $1,000 for meetings and $200 for committee meetings.

Michael Garelik, principal with consulting firm William M. Mercer in its Philadelphia office and a leader of its financial institutions practice, says the trend of using stock for a large portion of pay is relatively new. “Since consolidation, there are fewer inefficient banks; banks earn much more respectable returns on capital.”

In the 1980s, Garelik recalls, a bank would have been happy with 12% to 13% ROE. Now many are earning 17% to 19%.

Twenty years ago in banking, profits were limited, stocks had little value, and directors were often elder statesmen who, in effect, were rubber stamps for the wishes of the CEO. But with deregulation, technology, and mergers and acquisitions, by the 1990s, the seat of prestige was a hot seat. To keep directors from taking collective flight, banks began to sweeten the incentive package. Knowing that most of their directors were already affluent, banks began offering pension plans, health benefits, life insurance plans. Quickly, though, shareholders raised a cry against the new plans, saying they encouraged directors to get comfortable, rather than aggressive.

In the last few years, bankers regained their footing. Profits from new products are rolling in. Stock prices are up. And with the picture looking rosier than it had in years, bank managements have seen an opportunity to lure new directors and retain others through equity incentive plans.

The best-laid plans

In some ways designing the options for a compensation plan seems nearly limitless. Planners can take into consideration the needs of the existing board or put more emphasis on an ideal board the bank hopes to build. Some banks offer stocks or options as part of a basic compensation plan, with options being far more common than stock. Others offer them as bonuses. Some use phantom stock, which appreciates in value just like a share of real stock and pays dividends like a real stock but confers no ownership to its holder. Some defer pay to life insurance policies or retirement plans and assign “growth” to those deferred funds that mirrors stock. Plans can be either qualified or nonqualified. The nonqualified plans generally permit directors to put much more money away but that money is taxed when it appreciates, even if the director has not cashed in on it. Qualified plans permit directors less savings, but the appreciation is not taxed until the director actually receives the capital gain.

It used to be, Garelik says, that big banks used stock and small banks used options or deferred payment plans tied to stock prices. Now, he says, the size of the bank no longer dictates the form the compensation will take.

When The Banc Corp. of Birmingham, Alabama, opened its doors less than two years ago, CEO Jimmy Taylor wanted to offer the bank’s directors something unique. It created a compensation plan that included stock options and a payment-deferral retirement plan that invests the deferred fees into a life insurance policy. Directors can access their money at any time, the bank is enjoying an after-tax advantage of $1,500 a month and, Taylor says, the money they put into the account earns the bank more than federal funds.

“If you get retirement plans for key people, you keep them loyal to you,” Taylor says. The program helps recruit directors because fewer than a dozen Alabama banks are offering such a benefit, he explains. “It’s unique for us to do this, as new as we are.”

The bank now is the seventh largest in Alabama with more than $700 million in assets.

At $375 million Franklin Financial Corp. in Franklin, Tennessee, a company principle is “share the wealth.” Number four on SNL’s list of most-profitable banks, and located in one of the nation’s wealthiest counties, Franklin’s ROE was listed at 24.70% and its ROA at 1.59% as of December 1998. Richard Herrington, Franklin founder and president of the 10-year-old institution, credits the employee stock ownership plan for its success. Most of the senior executives, he says, are paid under market rates on their salaries, but the real value of their compensation plan is in their stocks and options. Since the company’s founding, the stock price has risen from 31 cents a share to $5 a share.

As for the board, the founding members, who spent countless hours in the bank in the early days, received options because of their extraordinary time investment. Newer members, whose commitment to the bank falls more along conventional lines, are not. But every Christmas, somewhere between 4,000 and 5,000 shares of stock are divvied up between the 13 directors. And all the directors, Herrington notes, are large acquirers of the bank’s stock. Franklin’s directors also receive a $6,000 annual retainer, but no meeting or committee fees.

The directors of Citizens Business Bank in Ontario, California, are also large stock acquirers. But then, they have no choice. One of the requirements of board membership is agreeing to purchase at least $100,000 worth of company stock within the first three years. Linn Wiley, president and CEO of the holding company, CVB Financial, says the company felt that policy was the only way to keep the board balanced. Five of the seven directors of the $1.5 billion institution were founders, have been with the bank since 1974, and hold easily that much stock. But though CVB does not issue stock as payment, it does include options in its compensation package and pays directors an annual retainer of about $37,000, which is an above-market rate for that size bank. (See story on page 28 for average compensation rates by asset size.) The company also has health insurance for directors.

Citizens does not pay meeting or committee fees but, Wiley says, directors are expected to attend regularly scheduled meetings and any special meetings that are called.

A win-win plan

For many banks, equity incentive plans put the emphasis on making the bank the best it can be. Rather than paying meeting fees to induce directors to show up, they lean on the ties to bank profit. And for many bank executives who want to find a way to reward directors for business development efforts, it takes the place of bonuses and rewards that regulators frown upon. According to statistics from the American Association of Bank Directors, fewer than 10% of banks give incentives or rewards for business development efforts. Some banks believe it’s akin to giving a double reward for directors doing their job. Others refer to regulators’ concerns: By rewarding directors for bringing in business it may compromise safety and soundness by making the board more concerned about meeting development quotas and less concerned about the quality of loans.

Central Trust & Savings Banks of Genesoe, Illinois is in the process of establishing performance goals for all its management positions, after which it will do the same for directors, says Dean Decker, president of the $175 million institution.

“It’s no different from putting out goals for management,” Decker says. “As banks go into the future that will be a necessary part of bank programs.”

But in the meantime, Central Trust has set up a phantom stock program that allows directors to defer part of their pay according to the value of the bank’s stock. Issuing real stock or options wouldn’t work because, Decker says, the bank’s stock is closely held and some families have passed shares down from generation to generation since the bank’s first days in 1907.

Central Trust also pays its directors $700 a month and the nine directors share a bonus at the end of each year equal to 1.5% of the bank’s adjusted earnings.

Great Southern Bank of Springfield, Missouri is counting on the stock options it issued directors at the initial public offering 10 years ago to keep them active in business development, says vice chairman Don Gibson. The options were vested over five years. Also, each director of the $825 million institution earns $1,250 a month plus $200 a month for committee meetings. Great Southern was the 14th-most profitable bank at yearend, with a nearly 22% return on equity and 1.86% ROA.

The institution’s directors, Gibson says, are “really out there on the streets” drumming up business, and he credits their feeling of ownership of the institution for that enthusiasm.

What to watch out for

While most bankers and experts agree that equity is becoming a standard piece in director compensation packages, many aren’t sure whetheru00e2u20ac”in bottom-line termsu00e2u20ac”it makes that much difference. Or whether it might even create problems.

Indeed, among the most profitable banks, bank executives wonder if their boards, coming once or twice a month for meetings, have that much impact on the bank’s profitability. One considered aloud whether, after a couple of years, a director hadn’t exhausted his contacts and ability to bring in new business.

David Berry, director of research with Keefe, Bruyette & Woods, says, however, that institutional investors greatly prefer putting money into companies in which the directors also have a stake. And stock can be a good carrot to offer for a position that has far too many sticks. “But if a director’s stake becomes huge,” he acknowledges, “you have to start thinking about personal agendas. It has escaped no one’s attention that banks get bought out from time to time and, in that sense, the directors could be looking too fixedly after the shareholders rather than weighing all their other responsibilities.”

Michael Ward of Charter notes that if someone stays at a small bank for a long time, gathering stocks and stock options all along, that person might wind up with a little more voting power than the bank would like any one director to have.

“Even if they aren’t good board members,” he says, they can, in effect, “elect themselves.” To counter that, he says, make it clear that contracts with directors are not “evergreen” and offer only a small interest in the bank, initially.

Slicing the pie

For most banks, says Mercer’s Garelik, the amount of stock being given relative to the amount in the market is minute. The real question is what the bank hopes to accomplish and what the directors hope to gain from their contribution. “What you want to ask yourself is, how do you improve the effectiveness of the board? What’s the composition of the board? What should the composition of the board be like? Is there a better way to attract the kind of board members you want?”

Not every board member gets excited about stock. Dr. Russell Jost, a veteran director of the First National Bank of Waterloo, Waterloo, Illinois, says his bank recently offered a stock gift to an executive candidate to woo him to the bank. Jost himself thought that although the stock of the $155 million bank is doing well, he’d rather stick to fees.

Not so at People’s State. The directors “are very excited about the whole thing,” says Wayne Turner. “When you only give directors $300 or $400 a month, it doesn’t cut it when they see the stockholders making millions.”