Considering All the Options

Directors and officers at Glacier Bancorp Inc. in Kalispell, Montana had always been confident that they were taking the right approach to employee compensation. But when Glacier’s 10-year compensation plan expired this past March, the bank’s management team and board of directors took a hard look at its pay practicesu00e2u20ac”thanks to several recent developments that have caught the attention of public companies everywhere.

One catalyst has been the recent series of high-profile accounting scandals that have rocked corporate America and has everyone from corporate directors down to the janitor riveted on governance issues. Another has been a new Financial Accounting Standards Board requirement known as Statement No. 123(R) which calls for public companies to begin recognizing and listing employee stock options as an expense on their income statements.

And now, many publicly owned U.S. banks are beginning a comprehensive overhaul of compensation programs designed to encourage and reward their employees’ loyalty and job performance. Mark Poerio, an executive compensation attorney with Washington, D.C.-based Paul, Hastings, Janofsky & Walker, who is advising Glacier on its new plan, says his firm’s clients are delving more into corporate governance issues than ever before and are spending significant time and money examining and developing compensation plans that are in line with federal regulatory standards.

“The new regulations are only part of the shift we’re seeing in the banking industry,” says Poerio. “Many banks are taking this opportunity to look at the criteria they use in setting up their compensation packages. What kind of pay is justifiable based on the performance of the executive? How do you reward someone beyond picking a number out of a hat when it comes to deciding on compensation?”

One very significant shift has been a change in the structure of incentive compensation plans. “I am seeing a move away from stock options and cash bonuses to restricted stock and deferred compensation,” Poerio says. Michael Blodnick, president and chief executive officer at $3.3 billion Glacier, agrees. “We have definitely seen a shift in our stock options and incentive plans,” he says. “In the past, there were not a lot of restrictions but there was not a lot of flexibility, either.”

Some financial institutions have already embraced the spirit of the new FASB requirement. Sovereign Bancorp in Philadelphia has been expensing stock options since January 2002. “We believe it’s the right thing to do on behalf of our shareholders,” says Cheryl Patnick, the bank’s director of human resources.

“Our stock incentive plan is broad-based, so it’s designed to reward all team members, not just executive management,” Patnick says. “Our philosophy is that we provide team members the opportunity to create wealth and share in the continued growth of Sovereign Bank.

“An ongoing challenge is mastering the design of our compensation program to effectively motivate all team members while, at the same time, meeting shareholder expectations and mastering the regulatory environment,” she continues. “All team members are eligible for long-term incentives. These rewards are first linked to company performance and then linked to individual team member performance. Our plan is specifically designed so that poor performers don’t get any rewards.”

At Glacier, Blodnick and the bank board are still formulating a new incentive plan, to be adopted in early 2006. Blodnick says the plan will look more closely at what types of incentives are offered and put special emphasis on offering a mix of cash, full-value stock and deferred incentives based on the level of responsibility.

Custom design

Many financial institutions like Glacier are doing away with the cookie-cutter approach to designing incentive plans. Compensation packages based on tailored performance goals, rather than those structured with a vesting schedule based on tenure, have several advantages, says Poerio, who also runs a website devoted to executive pay issues at www.xpay.net.

For instance, a performance-based package allows compensation committees and board members to tailor goals to fit a financial institution’s size and complexity. This is a win-win situation because execs have a clear idea of what has to be accomplished while shareholders look forward to the desired results. Vesting can also be partial instead of all-or-nothing, says Poerio.

Consultant Marc Baranski agrees, and adds: “We are also noticing an increase in performance conditions associated with the plans. Due to the old accounting regulations, performance conditions were considered bad from an accounting perspective.”

“Now that all plans need to be expensed, we are seeing most banks consider performance conditions on their option or restricted stock plans,” says Baranski, senior vice president and managing principal of the financial services practice at Sibson Consulting in Princeton, New Jersey. “The most typical measures are earnings per share, return on equity, and total return to shareholders.”

Prior to 123(R), FASB’s accounting rules for stock-based compensation differentiated between those subject to fixed and variable accounting. Fixed awards of stock options resulted in financial expense only with regard to their in-the-money value on the grant date. Statement No. 123(R)’s most dramatic change requires issuers attribute a value to thes awards and recognize that expense over the vesting period, says Poerio. Before the stock-options ruling, the information used to be included as a footnote in quarterly and annual filings with the Securities and Exchange Commission.

A full load for comp committees

Compensation consultants say the new rule has created confusion. And while many agree stock options are a form of compensation and should be reported as such, the question remains: How do you determine the value of the stock options since employees can often buy stock cheaper than it is trading on the market?

“In the old days, all roads led to stock options,” says Todd Leone, managing director of the compensation group for Clark Consulting’s banking practice. “There was no accounting expense and everyone used them, so there really wasn’t much of a decision. The only decision was how many to grant in a particular year. The best companies used some form of performance criteria in the granting or the vesting of the options.”

Now companies have to put time and effort into redesigning their equity plans, says Leone. Compensation committees are addressing what type of equity to use, determining the grant structure, and analyzing the economic value and the accounting value.

“This level of review and decision making is going on in a compensation committee room that is already numb from three years of significant changes in governance,” says Leone. “From Sarbanes-Oxley to stock exchange requirements to the American Jobs Creation Act, the committees have been hit with a lot. The change in stock-option accounting is forcing good discussions, and companies are making positive changes. It’s just that a lot of committees are a little tired these days.”

u00c2 At least banks have never relied as heavily on options as other industries haveu00e2u20ac”particularly compared to the high-tech industry, says Leone. And traditionally, bank stocks do not experience the significant increase in appreciation seen in high-tech and biotechnology firms. In those sectors stock options have become a powerful form of compensation that cost companies next to nothing since the takeoff of the Internet in the 1990s.

Adding to the overwhelming changes for the banking industry are the expanded SEC disclosure rules, says Poerio. The new Form 8-K requirements accelerate the due dates for required filings and significantly expand the items that trigger filings, including the entry into, modifications, or termination of a “material definitive agreement” with a financial institution’s executive officers or directors. This relates to executive and director compensation, employment agreements, and termination from service, says Poerio.

Don’t leave yourself exposed

Other changes affecting the executive compensation climate center on stricter accountability issues for shareholders. As a result of numerous lawsuits in which executive compensation abuses and excess payouts were the focus of allegations, directors who make executive compensation decisions today are closely watched and are encouraged to follow corporate governance and best practices intensely.

“This is not the time for a ‘business as usual’ response,” says Poerio. “Corporate boards of directors and compensation committees should instead respond with a simple precaution. They should measure their processes and actions against the brighter standards that emerged from 2003 and 2004 for determining proper governance and waste. “

“The point is, compensation committees need to understand all elements of compensation, [including] the total compensation and how it fits and supports the bank’s business strategy,” says Susan O’Donnell, managing director for Pearl Meyer & Partners, a Clark Consulting practice. “The concept of tally sheets, which add up all the elements of compensation that might be paid under different scenariosu00e2u20ac”termination, change in control, or retirementu00e2u20ac”are becoming popular because of this need for education, and to satisfy future disclosure requirements.”

Sibson Consulting’s Baranski says compensation committees favor the “Wall Street Journal test.” “Boards are always asking the question: How would this package, and its alignment to our performance, play out if it made the front page of the Wall Street Journal?” he says. “Much press has been written on the ‘pay for failure’ in the past years at some companies, in that large executive pay packages were awarded when the return to shareholders was low.”

Baranski is currently working with a compensation committeeu00e2u20ac”he would not identify the companyu00e2u20ac”that recently reviewed its change-in-control provisions.

“They had not looked at the provisions in a while and when they saw the calculations of their exposure at any transaction, they were amazed at the many millions that the provisions would pay out, even though they had approved the provisions.”

Indeed, not the sort of news any director would want to read over morning coffee. |BD|

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