Compensation: Dividing the Wealth

Bankers get perks like company cars and theater tickets, not billions of shares of stock,” says Paul Dorf, a managing director at New Jersey-based Compensation Resources, Inc. “We’ve all heard the Enron and WorldCom stories that the media love to harp on, but we haven’t seen those types of compensation excesses within the banking industry.”

Bank compensation practices are, nevertheless, increasingly subject to media and regulator scrutiny, so directors need to be aware of best practices. For example, compensation and accounting professionals unanimously agree that expensing stock options will become mandatory soon, so companies that have not already examined their option programs need to do so. Accordingly, directors need to put some thought into designing executive pay packages that include an appropriate mix of short- and long-term incentives. Finally, director responsibilities have been increased, courtesy of the Sarbanes-Oxley Act of 2002 and new stock exchange requirements, so board fees are on the rise.

Executive compensation: changing the mix

Expensing options “puts options, to some degree, on a level playing field with many other forms of compensation,” notes Donald P. Delves, president of Chicago-based compensation consulting firm The Delves Group and author of the forthcoming Stock Options and the New Rules of Corporate Accountability. “Right now, the stock market is doing so poorly that it takes the gild off the lily of stock options.”

Banks never relied as heavily on options as did companies in other industries, in part because bank stocks do not normally experience significant appreciation outside of acquisitions. There is also a growing consensus that options are an inappropriate incentive for bank executives, because they reward exclusively short-term results and thus encourage risk taking. Experts, therefore, predict that banks will be early adopters of option expensing.

“Bank directors need to make sure the performance they’re seeking from the executives is what they’re rewarding,” says Diane Posnak, a managing director at Pearl Meyer & Partners, a New York-based unit of Clark Consulting (formerly Clark/Bardes Consulting) that deals mainly with Fortune 500 clients. “That depends not only on how much they’re being paid, but on how they’re being paid. That’s the toughest job a director has.”

With a decrease in emphasis on options, compensation committees should closely examine the mix of cash, full-value stock, and deferred incentives their executives are getting. Experts recommend some combination of cash and cash bonuses with restricted stock grants whose vesting schedule is not fixed, but based on performance goals. This system has several benefits: It rewards performance rather than tenure; the goals can be tailored to the institution’s size and complexity; and vesting can be partial instead of all-or-nothing.

“The program should be designed to reward current performance with awards that vest in the future based on continued good performance,” says J. Mark Poerio, an executive compensation attorney with Washington, D.C.-based Paul, Hastings, Janofsky & Walker, who also runs a website devoted to executive pay issues at www.xpay.net.

“If you replace options with restricted stock that vests on time, you’ve replaced a gamble with a gift,” says Delves. “A truly performance-based, long-term incentive is a better way to do it. These programs can be easily structured in such a way that they pay for themselves.”

The performance goals that determine the vesting schedule can be financial, based on comparison to peer companies, or clearly defined nonfinancial strategic benchmarks such as market share or new product rollouts. The goals should be disclosed, to some degree, to shareholders and certainly overseen by the board. Another limitation that can be placed on executive stock grants is in the form of a share retention requirement, which specifies a length of time that the shares must be held.

Directors should also make sure that a well-intentioned desire to pay their executives competitively does not give in to what Delves calls “the tyranny of the median.” He notes, “In the last 10 years, corporations have been very enamored with the idea of competitive pay. It’s an impossible situation, like Garrison Keillor’s Lake Wobegon, where all the children are above average. If there is pressure to pay CEOs at the median or better, you’ve got a self-perpetuating machine that keeps ratcheting up pay every year.”

Board compensation: on the rise

Board compensation, on the other hand, is due for a reality check in the opposite direction. “Bank boards in general tend to be almost mundane in their compensation, compared to corporate America,” says Robert E. Miller, president of the Compensation Consulting Group within the banking practice at Clark Consulting. “I’m still not convinced that boards are being adequately compensated yet, particularly at community banks.”

“Retaining and attracting good directors is getting harder and harder with all the liability that’s out there, especially in public companies,” notes Poerio. Other industry watchers predict a growing imbalance between director supply and demand, due in part to stock exchange requirements that audit and compensation committees contain independent directors, along with a strengthened definition of exactly what constitutes “director independence.”

Similar to the situation with executive pay, another trend is for boards to reject of stock options as inappropriately rewarding short-term risk taking. “The last people we want taking short-term risks are directors,” notes Delves. Both the shift away from options-based compensation and directors’ heightened responsibilities, are combining to produce strong growth in per-meeting fees, committee meeting fees, and, in some cases, annual retainers.

Director compensation has not historically undergone steady annual increases in the manner of executive compensation. Instead, the growth is in more of a stepped pattern, with boards seeing 20% to 30% increases every few years, with flat growth in between. This year, increases of 30% to 50% are not unusual.

“Committee compensation will go up faster than board compensation. The trend we’re seeing is differentiation among committees,” reports Wendy Hilburn, a principal at Frederic W. Cook & Co., a New York compensation consulting firm that serves money-center banks and other large clients nationwide. “Some companies that had moved away from meeting fees in favor of a larger retainer are reversing themselves, because having committee meeting fees is a way to equalize for the greater number of meetings required of the audit and compensation committees.”

Certain nonfinancial perks should also be included under the rubric of board compensation. Among these are director liability insurance and indemnification agreements giving directors contractual protection in the event of a merger. Says Poerio, “These represent significant protection that is often underappreciated, but make no mistake, they are a form of compensation.”

Another nonfinancial perk that has the added benefit of helping directors improve their ability to do their jobs is continuing education. “One thing that we hear consistently, more now than ever, is the desire by board members for more education,” says Clark Consulting’s Miller. “Smaller community banks can’t afford to send board members across the country to a seminar, so they want new ways to get it.”

Recommendations for the compensation committee

What should compensation committee members be asking as they address the complex topics of compensation for executives and for directors themselves? Compensation consultants advise taking a page from the accounting playbook. Says Miller, “The message we’ve been delivering is that banks have not been abusive, so compensation committees shouldn’t overreact, but at the same time, they should use good corporate governance practices and be proactive rather than waiting for regulators to do something similar to Sarbanes-Oxley.”

Just as Sarbanes-Oxley put the spotlight on audit committees, directors should examine the compensation committee’s charter and practices and amply document the reasons for every decision. Also, following the requirement for the audit committee, rather than management, to engage external auditors, the compensation committee should actively seek out an external opinion on compensation matters instead of accepting the word of a firm hired by management.

“There’s going to be more challenging of management and more ownership of the process of hiring independent consultants by the board, and the compensation committee in particular,” says Compensation Resource’s Dorf. “After all, the consultants are the ones that are going to insulate them from the potential liability of doing something without unbiased advice.”

But there are important differences between accounting and compensation. Accounting is about looking into the past, while compensation should ideally be about looking into the future and ensuring consistency with the present. “The compensation committee is the engine of change in the organization,” says Posnak of Pearl Meyer & Partners. “While the audit committee is making sure everything is sound, the compensation committee has the opportunity to be leaders.”

Banks occupy a position of trust in corporate America, and their history of fiduciary responsibility should serve them well in an era of public suspicion of corporate shenanigans. The highly qualified directors who serve banks and their shareholders deserve their fair share of the credit. “I’ve never felt more impressed by the competency of boards and the attentiveness they’re giving their responsibilities,” says Miller. “I’ve never seen a better group of board members than I see now.”

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