Navigating Compensation Risk

It’s been a rough couple of years for Cascade Financial Corp. in Everett, Washington. In the second quarter of 2007, the $1.6 billion banking company earned $4 million, or 32 cents per share, and nonperformers made up just 0.07% of assets. In the same quarter this year, Cascade lost $21.9 million, or $2.25 per share, while nonperformers-most of them related to a stumbling real estate market-ballooned to 7.1% of its assets.

Cascade’s share price has plunged 90% over that time, to less than $2, and the company has banked $39 million in government capital from the Troubled Asset Relief Program’s Capital Purchase Program. While CEO Carol Nelson is confident that Cascade can rebound, she concedes it’s still “too early to predict that the market has bottomed out.”

For 10-year board member Janice Halladay and her colleagues on Cascade’s compensation committee, this all poses a conundrum. The board doesn’t blame management for the present state of affairs. In fact, directors are confident Nelson and her team are handling a difficult economic situation well, and want to reward and retain them. The question is, how?

In the past, the committee has gone heavy on incentives, reckoning that aligning pay with performance was good for everyone. About half of Nelson’s total take has typically come from incentives tied to such metrics as return on equity and per-share earnings growth.

Paying for performance is pretty much unworkable in today’s environment. Not only is there no performance to reward, government rules prohibit TARP banks from paying incentives, aside from restricted stock equal to one-half of base salary. “The line on our committee this year has been, ‘The system worked until it didn’t work,’” says Halladay, 65, a former bank executive herself and the committee’s chairman. “It’s not working now.”

In fact, many observers would say the system worked just fine in Cascade’s case: profits are down and so is executive pay. Nelson’s total compensation in 2008 dropped from $650,000 to $337,000, thanks to a nearly $320,000 drop in bonus payments.

From the board’s perspective, however, it feels like something’s got to give, and the options are limited. Bumping up base salaries is one alternative. “The problem with that is, how do you reduce it later?” Halladay says. Cascade’s share price has dropped so far that the board doesn’t have enough restricted shares available to make much of a dent, and it would need investor authorization for more-a tough sell, to be sure.

In the end, the board might just ask executives to suck it up without much of an adjustment, and hope they stick around for a rebound. “It’s all very, very confusing,” Halladay confides.

Similar stories are being told in bank boardrooms across the country. The financial crisis has not only hit bank income statements hard, it has turned the world of executive compensation on its ear.

The whole notion of paying for performance looks, to many, like a ruse. Incentive payments, and the way they were structured, are considered by many to be a key culprit in the collapse, encouraging executives to juice performance numbers by taking unreasonable risks while having little regard for the long-term consequences.

As Judith Samuelson, executive director of the Aspen Institute’s Business and Society Program, wrote in a recent op-ed piece, “The economy did not get into a mess because people were paid too much. It got into a mess because they were paid to do the wrong things.” The root problem was “business leaders taking on excessive risk in the quest to increase next quarter’s profits.”

The anger over compensation’s perceived role in the crisis-and big bonus payments at a handful of institutions in the middle of the chaos-is palpable. A June Gallup poll found that 59% of Americans supported government-imposed limits on executive pay. Washington, under the gun for the bailout, is on the warpath.

And just as they were in the wake of the Enron and WorldCom scandals, boards are in the crosshairs. The differences this time are that banks are at the center of the storm, and it’s comp committee members, not their audit brethren, who are feeling most of the heat.

In short, this is probably the worst time in history to be sitting on a bank comp committee. Confusion reigns supreme and workloads are up substantially. Many boards are scrambling to strike a balance between what they think is right and what is possible, all while trying to stay abreast of an endless stream of rule changes and pronouncements coming out of Washington. Consultants and other outside experts have seen business boom.

Fears of compensation-related director liability and reputational damage are on the rise. Ron Glancz, chairman of the financial services group at Venable LLC, a Washington, D.C. law firm, tells of one bank client whose cease-and-desist order from regulators requires that the board overhaul its compensation plan. “If it’s violated, the bank and its directors could be subject to civil money penalties or worse,” he says.

South Financial Group in Greenville, South Carolina, made headlines when former CEO Mack Whittle resigned just before the company received TARP money, thus allowing him to collect $18 million in retirement funds-a payout that wouldn’t have been permitted once South Financial took the government’s capital. The state’s governor charged that taxpayers were being “gamed” by the move, the Federal Reserve investigated, and the company was forced to fork over $500,000 to settle a couple of shareholder lawsuits.

“Directors read about those things and they’re concerned” about liability, says Susie VanHuss, 69, chairman of the compensation committee at SCBT Financial Corp., the parent of $2.8 billion South Carolina Bank & Trust in nearby Columbia.

“Everyone on the committee feels like this is not the time we want to be making a mistake,” says VanHuss, a retired executive director of the University of South Carolina Foundations. Her committee is recording more details of its deliberations in the minutes than before. “We’ve got to be able to defend our decisions.”

David Lynn, co-chairman of the public companies practice at law firm Morrison & Foerster in Washington, says directors should be protected by the business judgment rule, provided they’re diligent and seek outside help when needed. “But we’re obviously in a different environment right now,” he adds. “No one can say for sure what will happen.”

This period of uneasiness and ultra-intense scrutiny will eventually pass, but probably not without some significant changes in how executives and other top earners are compensated.

“The underlying assumptions of executive compensation are being re-examined,” says George Paulin, CEO and head of the Los Angeles office of Frederic W. Cook & Co., a national compensation consulting firm. Paulin works with the boards of several large banks, including Wells Fargo & Co.

Paulin ticks off a list of questions he’s hearing from boards and outside constituents: “Is there too much upside leverage in these programs? Is there not enough penalty for underperformance? If you get a stock option grant, the share price goes down and you just get a lower priced one next year, is that right? If you don’t perform well, should you walk away with a $15 million severance?”

“There’s a huge effort under way now to rethink these things,” he adds. “A lot of questions are being asked. It’s a transitional process.”

Being in the bull’s-eye of reform is uncomfortable territory for most comp committees. Entering the 2010 proxy season, the Compensation Discussion & Analysis (CD&A) portion of proxies will prove especially important. “That narrative is your marketing plan,” Paulin explains. “That’s how you explain the business rationale to investors, and win their support.”

With so much of the comp committee’s thought process on display, boards are feeling pressure to get it right. “I always tell my committee, ‘Visualize the headline’ [that pay decisions will generate],” says Lori Aldrete, 62, chairman of the compensation committee at $715 million First Northern Community Bancorp in Dixon, California. “If you’re not comfortable with how it will look, then we’d better rethink it.”

To educate themselves, directors are meeting more, reading more, and talking more regularly with outside experts to understand the issues.

The SEC is now requiring boards to perform and make public “an analysis of the short-term risks and long-term value their compensation schemes promote,” explains Barbara Schlaff, a Baltimore-based Venable partner who specializes in executive compensation.

That has many comp committees adding financial expertise to their ranks. Others are inviting in the bank’s risk manager to help design metrics that reflect long-term risks imbedded in pay strategies and try to mute their effects.

Some boards are seeking more feedback from shareholders. At $1.8 billion Danvers Bancorp in Danvers, Massachusetts, directors use their big institutional investors as a “litmus test” for gauging shareholder reaction to pay plans. “They look at it and say what we’re doing is reasonable,” says comp committee chairman John Ferris, 52, president of Copley Capital LLC, a commercial real estate investment firm. “That’s reassuring.”

Only a few years ago, the comp committee was the clubbiest, lowest-pressure group on the board. Often comprised of the CEO’s golf buddies or directors that lacked expertise in areas such as audit, the group would sign off on ever-growing pay packages in relative anonymity. It’s not that they weren’t diligent. But some of the tools and practices employed by comp committees, if not flawed, were subject to abuse or failed to account directly for any sort of risk.

As pay for performance became the guiding mantra, and broader markets boomed, the numbers, in some cases, grew to be obscene. Most agreed that the metrics were overly simple-stock price appreciation or returns on equity, for instance-and complaints were registered. Even so, it was relatively easy to justify: The CEO would only get rich if shareholders did, no problem.

Now, bank boards-and everyone else-are seeing the flip side of that equation, and the numbers don’t match up. In 2008, taxpayers jumped in to provide capital for hundreds of banks, and shareholders took a beating. The Keefe, Bruyette & Woods Bank Index plummeted by 50%-by far its worst performance in history.

And executives? Not so much. A survey by Amalfi Consulting, a Bloomington, Minnesota bank compensation firm, found that median total CEO pay at 550 publicly traded banks where the CEO didn’t exit dropped just 1% in 2008 from the year before. Banks in the $5 billion to $15 billion range saw the biggest drop, at 10.3%, while CEO comp for those bigger than $15 billion fell 8.8%. The smallest institutions, those with under $500 million in assets, saw total pay jump 2.6%.

Large financial institutions with the biggest troubles, including Citigroup and Bank of America, have been the most egregious offenders. When AIG paid out $165 million in bonuses earlier this year, it sparked outrage all around. The insurer lost $99 billion in 2008 and received $180 billion in government assistance.

“It’s clear that a lot of compensation committees fell asleep at the switch,” says Claibourne Smith, 70, acting president of Delaware State University and chairman of the comp committee at $3.4 billion WSFS Financial Corp. in Wilmington, Delaware. “They said they were paying for performance, but when the market went down and their companies performed poorly, the executives still got paid very well. It doesn’t smell right.”

Such sentiments have set the table for what’s become a global effort to make risk management a bigger part of the executive pay equation-especially for financial institutions. In the short-term, every board must come at the task based on its own performance, past compensation history, local competitive conditions, and other circumstances.

For boards of banks with TARP money, it’s a bit like living in purgatory with handcuffs on, and could take an entire book to fully document. The rules change regularly-a last-minute say-on-pay provision in the spring forced many companies to redraft proxies, for instance, and many executive bonus payments for 2008 were left hanging in limbo well into this year.

In total, more than 600 banks and thrifts have received TARP money, and thus their comp practices continue to get special scrutiny. The biggest of them, including Citi and Bank of America, have the government’s new pay czaru2013President Obama’s “Special Master for Compensation,” Kenneth Feinberg-vetting pay packages for the 100 highest-paid employees. Feinberg can’t rip up bonus contracts, but does have the ability to subtract amounts deemed too high from future pay.

Smaller institutions don’t get the czar treatment, but still have plenty with which to grapple. In June, the government issued 120 pages of regulations governing pay practices at TARP recipients. The new rules ban golden parachute payments for 10 executives-typically the top five executive officers and the next five highest-paid employees-and also prohibit tax gross-ups for the top five executives and the next 20 highest-paid employees.

Comp committees must be comprised of independent directors. They must adopt policies for excessive or luxury expenses, and fully disclose the details of all consulting relationships. They also must review pay plans at least twice a year-across the organization, down to front-line tellers-with special attention being paid to tamping down policies that might encourage employees to take risk, such as incentives for mortgage loan production that don’t also include credit-quality metrics.

TARP rules require clawbacks be written into executives’ contracts, to recover pay that’s later found to have come from taking too much risk. The rules also restrict bonus payments to top executives and earners on a tiered, sliding scale: For banks that got less than $25 million in government money, the limits apply to just the CEO. For those that took between $25 million and $250 million, it’s the five highest-paid employees. Banks that received $250 million to $500 million in TARP funds must get pay approval for the top five proxy officers and the next 10 highest-paid workers. And if your institution got more than $500 million, it’s the top five proxy officers, plus the next 20 on the pay scale.

With only salary and half that total in restricted stock at their disposal, many boards have been forced to rework contracts. Their options center mostly on whether-or how much-to boost base pay. “It’s a pretty subtle discussion. On one hand, it’s fixed pay, so there’s nothing to discuss,” says Todd Leone, Amalfi’s founder and president. “On the other, you really need to keep those executives, because if they leave, who are you going to replace them with?

“It’s very difficult to attract good executives into a troubled situation if you can’t pay them because of TARP restrictions,” he adds.

An equally thorny issue revolves around nonexecutive managers of producer groups-such as mortgage originations, insurance, or leasing-that have traditionally been paid for what their units produce. While the actual sales force is covered-commissions count as salary, not bonus-“variable compensation” for folks not on the front lines is verboten under TARP rules.

Boards caught in this bind can take their chances with a smaller base pay, waiting to get out of TARP, and hope the manager doesn’t jump ship. Or they can pay a big base salary, roughly a best guess of what the manager would make under an incentive-based system, and add one-half of that total in restricted shares.

“This is terribly frustrating and confusing for the bank boards. It feels like bastardization of what should be happening,” says Leone, who is helping two boards address such situations right now. “The board doesn’t like it, because you’re giving fixed compensation, and what happens if it’s a bad year? And the individuals don’t like it, because they’re driven by an eat-what-you-kill mindset.”

These are just some of the issues that separate TARP banks from the rest of the industry. Small wonder many bank boards that took government capital less out of need than a sense of patriotism now regret their decisions. Smith says WSFS tried to get out, but its primary regulator, the Office of Thrift Supervision, wouldn’t let it.

Iberiabank Corp. in Lafayette, Louisiana made headlines last spring as the first bank to buy its way out of TARP. While several factors went into the board’s decision, fear of government-imposed limits on executive pay was the biggest concern. “We began to feel that having our hands tied behind our backs on compensation could lead to someone raiding our executive team,” says William Fenstermaker, 60, the $5.6 billion company’s nonexecutive chairman.

Like other non-TARP bank directors, Fenstermaker, CEO of energy consulting firm C.H. Fenstermaker and Associates, also sees an opportunity to use Iberiabank’s pay flexibility to cherry-pick top loan officers and other producers from struggling rivals.

The effect, however, may only be temporary. In the end, many expect that TARP will serve as a best-practices template for broader pay rules. The tone will be set in Washington, where Congress, banking regulators, the Securities and Exchange Commission, and the Obama administration all seem to want a say in how executives are paid.

In August, Federal Deposit Insurance Corp. Chairman Sheila Bair went on record saying that banking regulators must get more hands-on and set “principles-based … standards” for incentive pay. “I’m not sure I buy that all these eye-popping salaries are necessary to keep folks for competitive reasons,” she said in an interview.

That came on the heels of a 137-page proposed proxy-rule amendment published by the SEC. While the rules aren’t final yet, the agency aims to boost disclosure in such areas as director qualifications, the corporate leadership structure, and disclosing relationships with outside compensation consultants.

It also wants to require say-on-pay shareholder resolutions on compensation plans for all public companies. Such nonbinding votes have already been voluntarily adopted by some companies, and were part of this past spring’s requirements for TARP banks.

In theory, says Michael Melbinger, chairman of the executive compensation practice at law firm Winston & Strawn in Chicago, say on pay could foster meaningful dialogue with shareholders. “But you also could open the door to activist investors who aren’t really interested in compensation and simply want to use it as a lever to get other things they want.” Either way, it’s bound to ratchet up shareholder pressure on boards.

In Congress, Democratic Rep. Barney Frank of Massachusetts, head of the House Financial Services Committee, is leading the charge on a pay crackdown that mimics many of the SEC’s proposals. It also would require financial institutions specifically to disclose incentive comp arrangements in greater detail and enable banking regulators to “proscribe inappropriate or imprudently risky compensation practices” for banks.

Treasury Secretary Timothy Geithner, meanwhile, has issued a set of “principles” the administration would like to see governing pay practices. The broad list covers such things as better accounting for risk in compensation; tying pay more closely to long-term valuations; and reexamining golden parachutes, supplemental retirement plans, and other costly comp add-ons.

In short, there’s plenty of momentum for reform, and the industry’s lobby is weak. Directors of smaller banks that didn’t engage in risky lending practices are girding for the worst. “We weren’t part of the problem. But people are angry, and politicians react strongly to anger,” WSFS’s Smith says. “I expect we’ll see things happen in Washington that make life miserable for the boards that did things wrong-and those who did things right.”

Just how many of these proposals and principles get enacted is anyone’s guess. Top of the list is revamping how performance is paid for. No one is saying the concept is bad, but the overriding consensus is that it needs to be reworked-in how performance is defined, what is measured, how long it is measured, how it is paid, and more.

Bank boards likely will be expected to count risk management and other qualitative measures, as opposed to merely quantitative ones, as part of “performance.”

Many banks, for instance, rewarded mortgage loan volume, but didn’t factor the quality of those loans into pay equations. That will need to change.

“You’re going to need to ensure not only that the compensation program supports the strategy, but that if the strategy is high leverage/high risk, you are dampening it in the program to avoid behavior that has negative, unintended consequences,” Paulin predicts.

Leone says he’s already talking with clients about adding risk management metrics to pay formulas that previously centered solely on growth measures like ROE, ROA, EPS, or asset growth. “The objectives are being rethought completely. You’re going to see measures for things like capital levels and credit quality going into the formulas,” he says.

This might be as simple as maintaining the core of old plans, he says, but instituting a “gate that says none of the plan will pay out if credit quality is worse than [a predetermined level].”

At SCBT, VanHuss’s committee believes EPS increases remain important, “but right now, we don’t want too much growth with the kind of risk you’d have to take to get it,” she says. Asset growth, once a factor, has been removed-at least temporarily-from the executive pay formula, while tangible common equity levels and the bank’s CAMELS ratings and asset-quality measures have been added.

“Before, we assumed that we’d have good credit quality. Now we’re looking at setting some minimum targets,” VanHuss says. “We’d much rather prefer to be safe and sound and profitable, and then go from there.”

Winston & Strawn’s Melbinger says some of his comp committee clients are tiering their pay plans to make incentive payments less of an all-or-nothing proposition. He offers the example of a plan that pays $1 million for reaching a specific EPS goal, and nothing for falling just 5% short. “It creates too much incentive to reach for that number,” he explains.

Better to have some kind of “phase down,” such as paying 75% for coming close to the target. “Executives will do their best to hit the numbers you put out there, so remove some of the temptation,” Melbinger adds. “You don’t want to pay only for hitting grand slams. You want to pay for playing solid defense, too.”

Time horizons on incentive plans are up for reconsideration, as well. In his compensation principles, Geithner specifically highlighted the role of incentives that allowed bank executives “to earn immediate gains without their compensation reflecting the long-term risks they were taking.”

Clawback provisions likely will be required going forward and are one way of protecting shareholders’ interests, but prevention is better. Leone says he’s talking with several clients about measuring ROE or EPS growth over several years instead of just one. “If everything has been paid annually, based on annual measures, that’s going to change,” he explains. “You want to take away the incentive to chase short-term profits and reward long-term value creation.”

Peer group use is another area up for review. Halladay says Cascade’s comp committee spent one recent meeting “discussing whether peer group comparisons are valid or not.” The practice and how those surveys are typically used-targeting the CEO’s pay at, say, the 75th percentile of peers for good performance-has undeniably fueled the rise in compensation levels.

“It’s a systemic problem,” Paulin says. “You look at the data and say, ‘We’re low.’ So you increase what you’re [paying], that goes into the data, and the next guy sees it and wants to be above the middle. … It keeps climbing.”

The question is, what are the alternatives? Cascade has tried to do its own customized surveys, and has prodded consultants to come up with a better way. In the meantime, boards still need to “justify their decisions based on hard data,” Halladay says. “And the only hard data we have is peer group information.”

The way peer group information is compiled and used, however, can be tweaked. At SCBT, directors now incorporate seven criteria into their benchmarking: peers need to be roughly the same size and with a commercial loan portfolio of similar size. West Coast banks and those in big metro areas are out, and all banks on the list need to be at least somewhat profitable, with nonperformers of less than 3% of total assets.

Nearly half of SCBT’s peer group has changed as a result. “They didn’t meet our performance standards,” VanHuss explains. “We want to compare apples to apples.”

In the end, the composition of comp plans appears bound to change. Equity grants will continue to trend away from options, Paulin predicts, and salaries will likely make up more of the total pay package. There also could be a serious rethinking of some other questionable components of pay, including severance packages, SERPs, and perks. Aimed primarily at retention, critics argue that they don’t have any direct bearing on value creation, but can cost a lot.

Last year, SCBT’s comp committee reviewed what VanHuss calls a “fairly hefty” SERP package, and didn’t like what it saw. The company’s top three executives are all in their early 40s, giving them another 20 years or more to grow the plan. “It was a huge liability hanging out there,” she recalls.

In response, the committee and management renegotiated the plan, swapping the SERPs for equity with a vesting schedule that achieved the same retention goals. “We gave them a ton of vested stock-and because of where the market was, it was at a relatively low price,” VanHuss says. “We like it because it aligns their interests more with shareholders. What they basically said was, ‘If we can’t make the value of the bank grow, we don’t deserve anything.’ “

Having such an understanding is important. The combination of public outrage and new rules-along with heavy job losses in the industry-would seem to argue for executive pay decreases going forward.

Will that happen? Most consultants and comp committee members doubt it. While the bulk of layoffs have come in the lower ranks, “the stars can go anyplace,” Paulin says. “They’re more in demand than they were before. You’ve got to pay up to keep them.”

The best guess: Total comp drops a bit more in the short term, but look for increases down the road. Executives who have received equity grants while share prices are depressed will be in position to cash in big-time if and when market conditions return to “normal.”

It might be ironic, and people will be angry, but for executives who stick to their knitting, it could be viewed as just reward for their patience and diligence in a difficult environment.