On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act, which amended certain provisions of the Internal Revenue Code of 1986. Bank boards and management teams should take time to familiarize themselves with these changes, as several amendments to the Code relate to the payment of executive compensation.
For corporate executives and compensation committees, the change to the Code that has garnered the most attention concerns an amendment to Code Section 162(m). Prior to the Act, Section 162(m) imposed a $1 million cap per executive on the tax deduction a public company could take on compensation paid to its chief executive officer and three other highest paid executive officers, excepting the chief financial officer—generally, the “named executive officers” included in the company’s annual proxy. Historically, most companies relied on an exemption for performance-based compensation to avoid this limit, which was fully deductible even if it exceeded $1 million. The new tax law has eliminated the performance-based compensation exemption.
In addition, the tax law has expanded coverage of Section 162(m) to apply to all Securities and Exchange Commission (SEC) reporting companies (i.e., companies required to file reports under Section 15(d) of the Securities and Exchange Act of 1934, which includes many companies required to file due to public debt), rather than solely those whose common stock is registered with the SEC. It also expanded the group of executives subject to the deduction limit to include not only the named executive officers during the current taxable year—now including the CFO as a “named executive”—but also any person who was a covered executive for any prior taxable year beginning after December 31, 2016. Companies subject to Section 162(m) should review their incentive plan documents, incentive award agreements, severance agreements and employment agreements in light of the removal of the exemption for qualified performance-based compensation because these documents may have been drafted to account for the Section 162(m) performance-based compensation exemption that no longer applies.
In addition, the Act amended Code Section 83 by adding a new subsection (i) regarding deferred taxation of equity compensation. Section 83 generally governs the amount and timing of income inclusion for property, including employer stock, transferred to an employee in connection with the performance of services. Under Code Section 83(a), most individuals must recognize income for the tax year in which the employee’s right to the stock is transferable or no longer subject to a substantial risk of forfeiture. This changes for some employees with the new Section 83(i), which allows non-executive and non-highly compensated employees of privately-held corporations to elect up to a five-year deferral in the taxation of illiquid shares issued to them upon the exercise of nonqualified options or the settlement of restricted stock units (RSUs), if certain conditions are satisfied. The options or RSUs must be granted under an equity compensation plan in which at least 80 percent of a company’s full-time U.S. employees are granted awards with the same rights and privileges. The amounts of the awards may vary by employee as long as each employee receives more than a “de minimis” grant—i.e., all participating employees must be eligible to receive a legitimate economic benefit. This deferred tax election is not available to the CEO or the CFO—or to certain persons related to them—or to any person who within the past 10 years was one of the four highest paid officers of the corporation or an employee that holds 1 percent of the company’s stock. Under this new regime, eligible employees of private companies receiving stock through equity compensation arrangements may consider making an election under Section 83(i) to defer taxation on such compensation.
The IRS is expected to issue guidance on these changes, particularly the amendments to Section 162(m). Stay tuned.
The tax law signed by the president on December 22, 2017, makes a significant change to the ability of public companies to deduct compensation paid to top executives.
Section 162(m) of the Internal Revenue Code limits a public company’s ability to deduct compensation of “covered employees” in excess of $1 million each year, but the old tax law provided a broad exception for certain types of performance-based compensation. A “covered employee” had been defined as any employee who, as of the last day of the taxable year, was the chief executive officer (or individual acting in that capacity) or an employee whose compensation is required to be reported to shareholders in the proxy statement because he or she is one of the four highest compensated officers, other than the CEO. As board members and compensation committee members of public companies are aware, the nuances and exceptions to section 162(m) limits were an important consideration in setting annual and long-term compensation for executives.
Below, we briefly explain the new limitations on the deductibility of executive compensation under Section 162(m), and offer some next steps for boards and compensation committees to consider in the first quarter of 2018. Public boards and compensation committees will need to take action on this before proxy season.
Performance-Based Compensation Exception Repealed Historically, performance-based compensation, such as stock-option income and compensation paid only on the attainment of performance goals, was excepted from the $1 million deduction limitation. The new law repeals this exception, and may change the approach of compensation committees regarding the mix of salary, bonus, performance awards and equity grants in compensation. Also, some plans that required shareholder approval due to the performance-based compensation exception will no longer require shareholder approval for deductibility.
CFOs Again Subject to Section 162(m) The new law amends Section 162(m) to specifically include a publicly-held corporation’s principal financial officer as a “covered employee” that is subject to Section 162(m). This corrects an unintended gap that had left CFOs excluded from Section 162(m), due to changes in 2007 to the Securities and Exchange Commission’s executive compensation disclosure rules. For companies that had already included their CFO as a “covered employee,” this will not result in a change. However, for companies which had not included the CFO as a “covered employee,” this change limits the deduction for that executive.
Once Covered, Always Covered If an executive is a “covered employee” subject to Section 162(m) in 2017 or any later year, the new law provides that he or she remains a “covered employee” for all future periods, including after termination of employment for any reason, including death. This eliminates the ability to deduct, for example, severance payments made after termination of an executive’s employment, to the extent that the severance results in compensation in excess of the limit.
Expansion of Covered Companies Previously, Section 162(m) applied to a company issuing any class of common equity securities required to be registered under the Securities Exchange Act of 1934. The definition of a publicly held corporation subject to Section 162(m) is expanded by the new law to include any corporation “that is required to file reports under Section 15(d) of [the Securities Exchange Act of 1934]”. This change would subject private corporations with public debt that triggers Section 15(d) reporting to the $1 million deduction limitation.
Limited Grandfathering Rule The new law grandfathers in compensation provided pursuant to a written binding contract in effect on November 2, 2017, so long as it was not modified in any material respect on or after November 2, 2017.
Next Steps These rules are complicated and, with the grandfather rules, will require close attention by companies in advance of preparing their 2018 proxy statement. We recommend that boards and, as appropriate, compensation committees, do the following.
Educate the compensation committee on changes to the tax code.
Review all employment agreements, change in control agreements, severance plans, equity plans and cash bonus plans to determine if they qualify for grandfathering.
Evaluate the impact on bonus payment decisions for 2017.
Evaluate the non-equity bonus plan design for 2018.
Begin to redraft the Compensation Discussion and Analysis (CD&A) and other relevant sections of the proxy statement.
Determine which plans will be subject to shareholder approval going forward.
In addition to the changes that will need to be made to proxy statements to reflect the updates to Section 162(m), the SEC’s pay ratio disclosure requirements were not modified by the new tax legislation and are in effect for the upcoming proxy season as well.
Distinguishing between retirement plans for a bank’s older executives and other key high performers and shorter-term incentives for its younger millennials, who are the bank leaders of the future, continues to be an important strategy for boards of directors. Compensation committees are willing to provide some type of mid-term incentive plan as a retention strategy focused on their younger workers. Boards also want to have both short- and long-term, performance-driven plans in place that are aligned with shareholder interests and retaining their key officers.
As with most employees, effective compensation plans and performance management programs can help attract, retain and motivate millennials. Providing a competitive base salary may not be at the top of their priority list, but certainly being rewarded for performance is important.
The next generation of leaders have been impacted by the recession, both from watching their relatives endure job loss and financial stress and from experiencing the post-recession economy directly. They are also the largest group carrying student loan debt. As a result, money is very important to them and while they may not be worrying about retirement, they are focusing on shorter term financial needs.
While millennials have essentially the same financial needs as the generations preceding them, their time horizon to retirement can be 30-plus years or more, which is too far into the future for them to focus on when faced with immediate financial planning decisions, like retiring student debt, purchasing a home and providing for their children’s education.
Nonqualified benefit plans including deferred compensation plans can be an effective tool for attracting and retaining most key bank performers—both those focused on retirement as well as more interim financial needs—because of their design flexibility. According to the American Bankers Association (ABA) 2016 Compensation and Benefits Survey, 64.5 percent of respondents offered some type of nonqualified deferred compensation plan for top management (chief executive officer, C-Level, executive vice president).
For this next generation of leaders, boards should consider a type of plan that allows for in-service distributions timed to coincide with events such as a child entering college. Plan payments made to the participant while still employed can be made at some future point such as three, five or 10 years.
These plans could be used in lieu of stock plans with a similar time duration and are important to younger leaders looking to shorter, more mid-term financial needs in a long-term incentive plan. Plans with provisions linking plan benefits to the long-term success of the bank can help increase bank performance and shareholder value as well as to reward key employees for longer-term performance. Defined as either a specific dollar amount or percentage of salary, bank contributions are discretionary or dependent on meeting budget or other performance goals. Interest can be credited to the account balance with a rate tied to either an external index or an internal index such as bank return on equity.
The plan can also include a provision that the account balance, or a portion thereof, is forfeited if the key employee goes to a competitor. In addition, it is typical to see events such as a change in control or disability accelerate vesting to 100 percent.
Let’s look at two examples, one for a retirement-based plan and the other for an in-service distribution to help pay for college expenses.
Assume that the bank contributes 8 percent of a $125,000 salary for a 37-year-old employee each year until age 65. At age 65, the participant will have $1,370,000 in total benefits, assuming a crediting rate equal to the bank’s return on assets, with an annual payment of $130,000 per year for 15 years. This same participant could also have had part of the benefit paid for out via in-service distributions to accommodate college expenses for two children. Assume there are two children ages three and seven and a desire to have $25,000 per year distributed for four years, for each child. Thus, these annual $25,000 distributions would be paid out when the employee was between the ages of 49 and 56. The remaining portion available for retirement would be an annual benefit of $78,000 for 15 years beginning at age 65.
Regardless of the participant’s distribution timing goals, both types of defined contribution plans can be tied to performance goals. The bank contribution percentage to each participant’s account could be based on some defined performance goal. Again, the ABA’s 2016 Compensation and Benefits Survey results showed that bonus amounts were based on several factors including: 85.6 percent bank; 74.9 percent individual; and 26 percent department/group. Aligning the bank’s strategic plan goals with the participant’s incentive plan provides a better outcome for both shareholder and participant.
In addition, many banks have implemented defined benefit type supplemental retirement plans as a way to retain and reward key executives. These plans can also be structured as performance based plans.
Regardless of a participant’s time horizon, it is important to reward both your older and younger leaders with compensation that is meaningful to them and will help them accomplish their personal financial objectives, while balancing the long-term interests of shareholders.
The Office of the Comptroller of the Currency (OCC) recently took an enforcement action in the form of a consent order against a bank director that serves as a cautionary tale for the banking industry. The consent order, agreed to by and between the OCC and a director and former senior vice president of a small national bank in Wisconsin, reminds bank boards of directors of their fiduciary duties with respect to executive compensation and the consequences of breaching those duties. In particular, this action puts board compensation committee members on notice that they may be found liable for unsafe or unsound executive compensation practices that occur on their watch.
Enforcement Action Details The consent order described that the director had a longstanding affiliation with the bank, serving in multiple operational positions throughout her tenure, culminating in her election to the bank’s board of directors in 2005. Despite these 32 years of service, the OCC’s findings in the consent order focused on the director’s relatively short period of service on the board’s executive compensation committee, where she served from 2010 to 2013.
During this period, it appears, based on a notice of charges issued in 2016 and a $1.6 million civil money penalty issued in 2017—both against the bank’s former chief executive officer (who also held the titles of president and chairman of the board)—that this individual abused his power and used it to reap excessive compensation from the bank. In particular, the notice of charges cited a report finding that the former CEO “was a dominant influence in all aspects of bank operations,” which ultimately led to insider abuse with respect to compensation and breaches of his fiduciary duties.
Based on such abuse and the resulting action against the former CEO, the OCC apparently then turned its attention to the director. Indeed, the consent order identified the director’s conduct during the period of 2012 to 2013 as the relevant period leading to the issuance or the consent order. During this time, the OCC said that the director failed to do the following:
Oversee or control the use of bank funds by its former CEO for his personal expenses despite knowing that he had previously used bank funds for personal expenses.
Ensure that disinterested and independent directors determined and approved the compensation of the bank’s former CEO, thereby allowing him to receive excessive compensation.
Recuse herself from voting on the bank’s former CEO compensation even though she had a conflict of interest because he was personally indebted to the director and her husband in an amount exceeding $2 million.
Based on these failures as a member of the board’s executive compensation committee, the OCC concluded that the director engaged in conduct satisfying 12 U.S.C. 1818(i) and ordered her to pay a civil money penalty in the amount of $5,000.
Takeaways for Bank Directors As banks continue to report an uptick in regulatory inquiries and examination findings focusing on executive and incentive compensation, agency enforcement actions relating to compensation issues may become more common in the coming years. This is a trend that is developing even in the face of recent reports that some of the federal banking agencies are likely to postpone consideration of currently proposed regulations regarding incentive compensation required under the Dodd-Frank Act.
Boards should utilize this trend and the lessons learned from the consent order as a reminder to periodically review compensation arrangements and compensation standards at their bank to ensure they are adequately fulfilling their fiduciary duties. Such reviews should critically analyze executive and incentive compensation arrangements and seek to ensure that bank and board policies governing such arrangements meet regulatory expectations. In addition, boards should periodically inquire about and analyze any relationships board compensation committee members may have with senior management to be able to confirm the independence of the committee members.
One of the most difficult fiduciary issues facing boards is director compensation, since it is essentially and unavoidably a self-dealing transaction. The trend in recent years has been to increase the amount and proportion of director compensation that is comprised of equity. However, director stock compensation has also developed as a new frontier in stockholder litigation, and in response to successful challenges from stockholders to equity pay that has been viewed as excessive, several companies have been forced to modify director pay practices, including Facebook.
When challenged, board decisions are usually entitled to the protection of the business judgment rule, and will be dismissed unless the stockholder challenger can produce evidence of director bad faith or gross negligence. However, because directors have an interest in their decision as to their own compensation, business judgment protection is unavailable, and the burden is placed on the board to demonstrate that the award of compensation was fair, which means that stockholder challenges will rarely be dismissed at the pleadings stage.
Recent Delaware court decisions have provided important guidance for companies in terms of structuring equity compensation programs for directors. Directors can avail themselves of the protection of the business judgment rule, and challenges to director equity compensation will be dismissed under Delaware law, if disinterested stockholders have approved the payment of equity compensation for directors based on a fully informed and uncoerced vote. If the business judgment rule applies, a board’s decision as to its own compensation will be upheld if it can be attributed to any rational business purpose. As these court decisions further explain, however, not all stockholder approval is of equal effect.
In the 2014 lawsuit Calma v. Templeton, the board of software company Citrix Systems had annually awarded directors individual equity compensation of $250,000 to $350,000, in addition to annual cash compensation, over a multi-year period in accordance with the terms of a stockholder-approved equity plan. The equity plan allowed directors to participate in a plan to distribute up to 16 million shares as options, restricted stock awards, or restricted stock units (RSUs), of which up to 11 million shares could be awarded as RSUs, and authorized the compensation committee at its discretion to make all determinations with respect to awards granted, including to directors. The only limitation contained in the plan as to individual awards related to IRC Section 162m, and provided that no individual could receive more than 1 million shares in any one calendar year. The limit had an aggregate value of $55 million at the time of the litigation. The plaintiff claimed that the stock compensation paid to the directors, when combined with the annual cash compensation, was excessive, in breach of the board’s fiduciary duties. The Delaware Chancery Court declined to apply the business judgment rule and dismiss the stockholder challenge based on stockholder approval of the plan because the plan did not include any meaningful limit “bearing specifically on the magnitude of compensation to be paid” to the non-employee directors. The generic individual limit was insufficient for this purpose. The company settled the case, imposed annual dollar limits on the value of equity that annually could be granted to directors, and agreed to pay up to $425,000 to plaintiff’s counsel.
In another case, the Delaware Chancery Court this year dismissed a challenge to equity awards made to directors at Short Hills, New Jersey-based Investors Bancorp, which the court acknowledged were “quite large,” but which were made in accordance with the terms of the stockholder approved plan that included director-specific limits. Following stockholder approval of a stock benefit plan, the board of directors of the $23 billion asset Investors Bancorp had granted stock options and restricted stock awards to directors having an aggregate grant date value of approximately $2 million, which vested predominantly over a five-year period. The court noted that the compensation committee followed a diligent process involving four meetings and included input from an independent compensation consultant. The plan allowed for up to 30 million shares to be granted to officers, employees and directors. Of these shares, up to 17 million could be granted as stock options, and up to 13 million shares could be granted as restricted stock awards and RSUs. Importantly, the plan stipulated that no more than 30 percent of the shares reserved for issuance as stock options or restricted stock awards could be granted to outside directors, all of which could be granted in any one year. The court noted that this limit was unlike the “generic” limit for all beneficiaries found in the Citrix case, and that the plan meaningfully informed stockholders of the magnitude of the stock compensation that could be granted to directors.
Compensation is one of the most effective tools in motivating executives to higher levels of performance. However, in today’s market, the compensation committee and the board have a variety of alternative compensation approaches to select from to most effectively attract, motivate and retain executive talent. Banks are seeking maximum performance from executives while executives are seeking income and, especially, retirement security.
Although most banks do a fully satisfactory job retaining solid performers by paying competitive salaries and bonuses, they are uncertain what to do when it comes to providing something truly special for their top executives while, at the same time, prudently managing expenses to protect the interests of shareholders.
Saving for Retirement According to the trade association the Insured Retirement Institute, baby boomers are turning age 65 at a pace of roughly 10,000 per day, and if you’re a baby boomer who is fast approaching retirement, you might be wondering if you’re on target with your retirement savings goals.
Compounding the problem are IRS rules requiring no discrimination in favor of higher paid employees. Amounts that can be contributed to qualified retirement plans, such as 401(k) plans, are subject to statutory limits. The 2017 maximum pre-tax contribution is $18,000, with a catch-up contribution limit for employees aged 50 or older of an additional at $6,000. Therefore, qualified benefit plans do not fully meet the financial needs of executives because of their low limit on annual deferrals.
Today, financial planners, advisors, and consultants all seem to agree that retirees should plan for replacing 60 percent to 80 percent of preretirement income during the retirement period. While the right income-replacement ratio is highly dependent on a number of factors, most bank executives will not reach this level without help from nonqualified benefit plans.
401(k) Look-Alike Plan One way banks can address these limitations is by offering a 401(k) look-alike plan. This nonqualified deferred compensation plan allows a select group of executives to make voluntary deferrals on a pre-tax basis with a matching contribution from the bank. Interest may also be credited to the executives account. Executives defer paying income taxes on money contributed now until retirement, a time when they may be in a lower tax bracket.
By tying the matching contributions to performance benchmarks, such as department and individual criteria, the executive is motivated to achieve higher results. When such plans are properly designed, if the shareholders do well, so will the executives. Note: As with any incentive-based compensation, matching contributions to the 401(k) look-alike plan should not provide executives with incentives to take imprudent risks that are not consistent with the long-term health of the bank.
Deferring income into nonqualified plans does have its disadvantages. For the bank, nonqualified plans—unlike their qualified counterparts—are not favored by a current tax deduction. The tax deduction is delayed until the officer receives the benefit.
There is also risk because nonqualified plans need to remain unfunded to achieve the desired tax deferral. A nonqualified plan must remain just a promise to pay a retirement benefit. It is a liability on the bank’s books and nothing more. In the event of bankruptcy or company takeover, executives in the plan stand to lose some or all of the money in the nonqualified plan.
Summary Knowing that retirement security is a primary concern of your executives, it may be time for your bank to rethink its approach to executive compensation. By adding a 401(k) look-alike plan, the ability to attract and retain talented executives will be greatly enhanced.
Change-in-control agreements, which provide a severance benefit to the covered executive in the event of an acquisition, are a common issue that must be addressed with in an M&A transaction. But while many bank CEOs and some senior executives have them, it’s not uncommon for boards to lose sight of just how expensive—and potentially troublesome—they can be if the compensation committee hasn’t been paying attention to that individual’s total compensation and benefit package. Here to explain how those problems can arise during an M&A transaction—and how they can be avoided—is Gary R. Bronstein, a partner at the law firm Kilpatrick Townsend. The following interview has been edited for clarity and length.
BD: How common are change-in-control contracts and who typically gets covered by them? Before we get to contracts, let me explain that some banks have severance plans that are adopted pre-merger and spell out what kind of severance will be paid to all employees in the event that they don’t survive the merger. The benefit of having a severance plan in place is that it takes that issue off the table in merger negotiations.
Change-in-control contracts would be for those executives who aren’t part of a severance plan, if there is one in place. It would be unusual for the CEO not to have one. We also see agreements for other executives, depending upon the size of the institution.
It is common to have more agreements at a $10 billion bank compared to a $500 million bank. Many times, chief financial officers are covered, the chief lending officer—people that are part of the executive management team have agreements. Terms vary between three years, which is usually the max in terms of the amount of the payout, to one year.
BD: What benefits do they typically provide? If it’s a three-year payout for example, it would provide for three times the annual pay in cash. There’s what’s called the 280G limit, named for a section of the Internal Revenue Code that provides for significant tax penalties if the payout exceeds 2.99 times the average of the executives’ W-2 income for the prior five years. (If the payment amount exceeds the 280G limit, then most of the payout is not deductible by the buyer and the executive is subject to an excise tax.)
The other aspect to this is that most of these agreements have what’s called a double trigger. The first trigger is an actual change-in-control event. The second trigger is that the employee is either terminated or constructively discharged, which means that the employee’s job changes in a material way. If both triggers are met, the executive can receive the payout.
BD: What’s the attitude of acquirers toward change-in-control contracts? Do they dislike them, or do they just see them as a cost of business if you’re going to do an acquisition? It’s the latter. Particularly with experienced buyers, they look for it. It’s something they evaluate during the due diligence process, to determine the total cost and whether there are any 280G problems. That’s something that all buyers look to avoid. There are ways to structure around it. If the benefits exceed the 280G limit, then the buyer tries to get an agreement with the executives to live within the limit, but add a consulting agreement or a non-compete agreement to make the difference. It’s not a question of whether buyers like the agreements or not, it’s a question of how do you deal with it.
BD: Can they materially increase the cost of an acquisition? In my experience, and I’ve seen statistics from compensation consulting firms, it’s going to vary depending upon the size of the transaction. But total change-in-control severance payments generally range somewhere in the 5 percent range of the deal price. And if they’re excessive, it can cause the buyer to either walk away or offer a lower purchase price.
BD: Have you ever seen an acquirer walk away from a deal because of these? I’ve seen situations where negotiations have broken down because they were unable to structure around a 280G problem. That’s not typical and it puts the seller in a difficult position, because what you have is a situation where an attractive price has been put on the table and the board would be allowing the benefits to be paid to the insiders to get in the way of what would otherwise be in the best interest of shareholders. So, it’s almost always worked out, because it’s just too difficult for the seller to walk away from a deal under those circumstances. Also, if the severance payments are excessive, it exposes the seller’s directors to legal liability because the insiders are being unjustly enriched at the expense of shareholders.
BD: Is it true that sellers in an M&A transaction are sometimes surprised by the size of the required payouts in their change-in-control contracts? It’s as if they lose track of them. I’ve had that experience in a number of circumstances. I think more often than not, the boards are aware of what they have, but there are certainly plenty of circumstances where they don’t. And what invariably happens is, an employment contract or a change-in-control agreement is put in place, and then other benefits are added down the road without proper advice being provided about what the consequences are of adding additional levels of compensation.
For example, a common pitfall that I’ve seen is that boards are unaware that any benefits that accelerate solely as a consequence of a change-in-control event are parachute payments under 280G. So, if you have a three-year payout under a change-in-control contract, but also have other benefits that will accelerate in the event of a change-in-control event, you will exceed the 280G limit.
It’s very common and appropriate to have equity benefits that are subject to a vesting schedule. And it’s also very common that the vesting schedule will accelerate in the event of a change in control. So that if you’re granting a large amount of equity benefits with a five-year vesting schedule, and there’s a change in control early on in that vesting period, you should be expecting a very large excess payment under 280G.
Most change-in-control agreements have what’s called a 280G cutback so that the maximum that an executive can receive is the 280G limit. So using a simple example, let’s say your 280G limit is $1 million and the value of the accelerated equity benefit is $500,000. What that means is: If your severance was going to be $1 million, your employment contract payment gets reduced from $1 million to $500,000. So it can be pretty significant.
The other situation we’ve commonly seen is an acceleration of non-qualified retirement benefits in a change in control. If you have a non-qualified plan such as a Supplemental Executive Retirement Plan that provides for a benefit to vest at age 65, or age 62, and you have an acceleration of that benefit upon a change in control for a 50- or 55-year-old executive, the amount of the accelerated benefit can be quite significant and exceed the 280G limit by a large amount.
BD: What advice would you give to a board if their CEO doesn’t have a change-in-control agreement and is pushing for one? If it’s a CEO that you have a lot of confidence in and you expect to continue the partnership for the foreseeable future, it would be advisable to provide [for a change-in-control agreement]. Having said that, I think it would be important to evaluate what else the executive has in place. Because again, it is important to understand any potential 280G issues. So, if there are other accelerated benefits in the event of a change-in-control severance benefit, you’d want to make sure that both the compensation committee and the executive is fully apprised of what they have and what would happen in the event of a change in control.
The good news is that over time, the 280G issue generally gets better. As a vesting period on these various benefits mature, the change-in-control cutback reduces. But in the short-term, it can be very challenging. If you look at peer studies, you’re going to find that at least CEOs, but many times several other officers as well, have some type of change-in-control benefit in place. Therefore, if a compensation committee wants to offer competitive compensation, employment agreements are common.
Starting with the 2018 proxy statement (covering fiscal year 2017), most public companies will be required to start reporting their CEO pay ratio, that is, the ratio of the CEO’s pay to the median of all other employees’ pay. While it is questionable whether the CEO pay ratio disclosure will be a truly meaningful or useful figure to aid shareholders understanding of a company’s compensation practices, the new disclosure is likely to be a focus of both the media and shareholder activists. Directors and management should be aware of how their CEO pay ratio compares to peers and how it may change from year to year. The good news is that banks are expected to produce lower CEO pay ratios compared to companies in other industries. However, as with any new process, this will require time and planning.
Here are some questions to ask to see if your bank is ready.
1. Do you know how your CEO pay ratio will compare to the market? To avoid surprises, know where your CEO pay ratio fits in with similar sized banks. McLagan’s research shows that the estimated CEO pay ratio ranges from 10 to 67, depending on asset size for banks under $30 billion in assets. Business focus also matters. Retail-focused banks tend to have a higher ratio as compared to non-retail focused banks as a result of lower median employee compensation (about 20 percent lower on average). Start planning your communications strategy to proactively consider employee concerns and press coverage. You’ll also need to evaluate the need for supplemental disclosure in the proxy statement if your CEO pay ratio is outside the norm.
Bank CEO Pay Ratio Information
2. Does the CEO pay ratio apply to my bank? If you are a smaller reporting or an emerging growth company, you do not need to report the CEO pay ratio. However, even if you are not required to disclose the ratio publicly, your board may want to know how your CEO compares to the market.
3. How do I determine who is included in my employee population? Employees are identified based upon any date within the last three months of the year. It must include all full-time, part-time, seasonal and temporary employees (including subsidiary employees and potentially, independent contractors). While the date flexibility is less of a benefit for banks, this may simplify the process for some companies, such as those in the retail industry who have significant seasonal employees.
4. Is there flexibility in the methodology used to calculate the median employee? Yes, W2 data, cash compensation, or some other consistently applied compensation measure can be used. In addition, the time period for measuring compensation does not have to include the date on which the employee population is determined. Keep in mind that decisions regarding specific methodologies may affect the resulting median and may require additional disclosure.
5. Can I use estimates? Yes, reasonable estimates and sampling can be used; however, the methodology and assumptions must be disclosed. Regardless of the method used, ensure that your process is reliable, repeatable and able to be explained in the proxy. This is not likely a benefit for wholly owned U.S.-based banks with centralized human resource information or payroll systems.
6. How often is the disclosure required? Annually; however, the median employee may be updated every three years, provided the employee population has not changed significantly. Banks on an acquisition path may need to update the median employee each year.
7. Can all my data providers supply the information I will need and on time? Do your due diligence now to determine your data requests from payroll vendors, stock reporting systems, benefits providers, actuaries for retirement plan accruals, etc. The time and resources to comply could be substantial and working through the various decisions and establishing a methodology ahead of time will make for a smoother process in 2018.
In summary, don’t assume your CEO pay ratio calculation will be quick and easy. Getting started now will allow time to provide education and manage expectations. Be proactive to ensure your methodology is well tested to be ready for implementation in your 2018 proxy statement.
New compensation and governance standards are impacting boards of directors in all industries, but even more so in banking, which has more regulatory requirements and is under greater scrutiny. The recent Wells Fargo & Co. $185 million settlement over alleged accounts opened without customer permission illustrates that even the most admired banks with seemingly solid risk management practices can succumb to these challenges. Scrutiny of board oversight, risk management processes and incentive plans will continue to increase.
Recently proposed Dodd-Frank Act incentive compensation rules seek to mandate specific incentive design features that regulators believe will mitigate risk taking. If finalized as proposed, incentive arrangements will require both financial and non-financial measures and be subject to increased controls, documentation, governance and oversight by boards of directors, most notably the compensation committee. Larger banks ($50 billion in assets or greater) will be required to defer compensation over multiple years and include forfeitures, risk adjustments and clawbacks for top executives and other employees defined as “significant risk takers.
Publicly traded banks face additional pressures and scrutiny from shareholders. Shareholder advisory votes on executive pay have influenced pay program designs and practices. Today, there is a greater focus on long-term compensation that aligns executives with shareholder interests. Pay and performance is more rigorously assessed and criticized. Proxy disclosure has shifted from basic compliance with Securities and Exchange (SEC) requirements to a “marketing-based approach” for companies to communicate the rationale and results of their pay programs. Engagement with shareholders also is increasing.
Below are some of the characteristics that will define the board’s role in this new era:
Reinforce Risk Culture: As highlighted by the Wells Fargo situation, everyone from the branch manager to the board of directors needs to embrace a culture of sound risk management practices. Boards need to help reinforce a culture of risk management, monitor compliance and ensure there are consequences for bad risk behavior at all levels of the organization. Whether it calls for termination of employee(s) or clawback/forfeiture of compensation, accountability should be meaningful. Significant compliance failures can put a spotlight on board oversight.
Challenge Status Quo: The recent focus on the age, tenure and diversity of board members reflects a perception of potential entrenchment among boards of directors. The real issue isn’t necessarily age or tenure but rather ensuring board members are willing to challenge the status quo, ask potentially unpopular questions and embrace different perspectives needed to ensure the bank continues to succeed in an increasingly competitive and complex environment. Incorporating this behavior in board evaluations can reinforce acceptance of diverse perspectives.
Proactively Recruit for Future Skills: As banks change their strategies on cyber risk, technology and product innovation, the composition of the board of directors must also evolve. The nominating committee should proactively define the future skills and experience needed on the board and strategically fill board positions (e.g. seek board candidates that meet multiple needs, such as someone with public company and technology expertise). In addition, ongoing board education should be formalized to ensure current members receive up-to-date information on industry trends and regulations.
Embrace Engagement: As their risk oversight role increases, board members can expect to have more discussions with regulators. Public company board members are also becoming more involved in shareholder engagement. For example, lead directors and/or compensation committee chairs are increasingly participating in discussions with shareholders. Boards should discuss the objectives, messages, roles and processes related to these discussions.
Drive Strategy Through Compensation: As banks continue to evolve their strategic plans to respond to the changing competitive landscape, it is equally as important to select incentive measures that reflect and support these goals. The compensation committee should ensure the portfolio of metrics used in the annual and long-term plans communicate to participants, regulators and shareholders how performance is measured and what will be rewarded. Without alignment between goals and strategic plan, the bank could be expending dollars inefficiently and potentially motivating the wrong behaviors.
These are just some of roles for the board in a post-financial crisis era. Use this list to start a dialogue on how your board’s composition, processes and oversight might need to change to adapt to the new environment.
Compensation committees are responsible for setting the foundation of a bank’s compensation program, subsequently impacting the bank’s underlying culture. The banking industry is more competitive than ever, so attracting and retaining top talent should be the number one priority. With a compensation committee that is educated on industry trends and modern-day compensation best practices, your bank will be on its way to developing programs that attract and retain top talent. Here are the top four best practices a bank’s compensation committee should consider.
1. Committee Members Should Take Steps to Stay Educated Your committee members are responsible for staying aware of compensation trends. They need to always be in-the-know of complications, IRS penalties, and other factors with unintended consequences or expenses that can impact both the bank and the executives. Committee members should regularly review market trends in executive compensation; staying aware of banking trends as well as trends in other industries will better position the bank for success in recruiting, rewarding, and retaining talent. Your board should also be educated by the committee regarding your compensation philosophy and how the committee functions.
A few areas the compensation committee has direction over include equity grants, incentive structure, benefits, qualified plans, board compensation and other aspects of compensation. The directors should have a full understanding of structuring compensation plans, and if not, the committee should consult an adviser.
2. Establish the Duties and Responsibilities of Each Committee Member In addition to staying educated, members of the compensation committee must have a framework for their efforts. This involves establishing the duties and responsibilities of each member, but before you begin, you’ll need to develop a compensation philosophy if you don’t already have one. Without an established compensation philosophy, your compensation committee will lack direction, clarity, and consistency regarding compensation practices. In addition to putting your philosophy in print, you should ensure that everyone on your committee understands it and is able to relay its message. The philosophy should be comprehensive as well as consistent with the culture of your bank, the interests of your shareholders and market trends.
3. Review the Committee’s Performance Quarterly Quarterly, you should hold a meeting to assess the success of your committee. Check on what’s working and what isn’t with regards to committee function, meeting processes and other aspects. It’s important to look at whether you’re hitting benchmarks—and whether you’re attracting and retaining the talent you need to hit those benchmarks. There’s always room for improvement, so discuss what the committee may need to change in order for your bank to be more successful with recruiting and retention.
4. Engage Expert Consultants When Necessary There’s a delicate balance that must be struck with compensation; it needs to be competitive enough to retain executives but as efficient as possible to drive shareholder value. With the increasing competition for talent and the rising costs of benefits like health care plans, many banks have been pre-funding benefits through plans such as bank-owned life insurance (BOLI). Choosing the best insurance carriers and structuring pre-funding plans is something that requires outside help from qualified consultants.
Professionals can help you determine competitive compensation packages and discern what investments will bring you the greatest return for the lowest risk.
If you don’t feel your compensation committee is hitting the mark, it’s time for something to change. Rewarding talent and funding those rewards is a complicated topic, so outside help from a compensation consultant who specializes in banking may be helpful to bring direction to your committee. If your committee follows these four best practices, you’ll be on a path to success applying your finest approach to compensation and benefits plans.