The Well Written Compensation Philosophy

12-2-13-Blanchard.pngTaking tests would certainly be easier if you had the answers beforehand. What if you also had the ability to determine those answers? Well, that is exactly what compensation committees and bank executives should be thinking when they develop a written compensation philosophy. Put in the effort up front, so when the tough decisions have to be made, you already have the answer key developed. A well thought out and well documented compensation philosophy makes life easier. So where do you start?

Strategic Discussions

If you don’t have a written compensation philosophy, I suggest you start discussions with the compensation committee and the CEO (add other key executives if appropriate) to get the ball rolling. Talk about the organization’s beliefs surrounding compensation and how you want to strategically position your compensation programs to help achieve your goals. And remember, there is no right or wrong compensation philosophy. You get to decide your unique answer.

Focus on Total Compensation

The philosophy should focus on the total compensation package. That means base salaries, incentives (cash and equity if available), benefits and perquisites. It should cover what programs you have, who qualifies for those programs, and where you want to be positioned compared to market. Ask yourself some critical questions, such as:

  1. What are we trying to accomplish with our compensation programs?
  2. Do we believe in pay for performance?
  3. Should certain employee levels qualify for certain compensation programs?
  4. Where do we want to be positioned compared to market?
  5. What can we afford? (Don’t forget this one.)

These questions will help get you started down the road that is right for you.

Put it on Paper

Once you have determined the answers to some key questions you can start to draft a philosophy statement. Be sure you cover all compensation components from a high level and discuss how they fit into the complete picture. For example, if you start with base salaries and think they should be positioned at market competitive levels for fully functioning employees, then you need to take the next step and determine your market and your job expectations. Often, specific percentile positions (i.e. 50th percentile) will be mentioned in philosophies and other times ranges may be utilized. Be as specific as possible (at least internally). Some organizations will choose to lead or lag the market for specific purposes. As an example, a very performance-driven company may choose to slightly lag the market on salary, but provide high incentive opportunities based on performance that would allow the employees to potentially earn a total compensation package that is above market. This will likely attract a certain type of employee and should be communicated at the time of recruitment.

Test Your Philosophy vs. Current Reality

Once you have drafted your philosophy, you should test your goals against reality. Start by asking yourself: Are we currently practicing what we just wrote down? Or will this require a cultural shift? Some organizations incorporate a reality philosophy and an aspiring philosophy. For example, maybe you want to target salaries between the 50th and 60th percentiles of the market, but you realize you are currently paying closer to the 40th. You can’t afford to make huge adjustments all at once, so you develop a plan to get there during a period of time. This has been very common in recent years where performance challenges in the banking industry created the need for a re-set button for a lot of compensation philosophies.

Communicate Your Philosophy

Once you feel you have developed a philosophy that works for your organization, you need to communicate this philosophy. Your human resources department and managers will be critical in helping with this phase. Every employee should understand your compensation philosophy and where their specific position fits. For example, if you have determined that certain levels of employees (i.e. senior vice presidents and above) qualify for participation in a long-term incentive plan, then use this as a motivator and performance driver for those employees at the vice president level or below to aspire to that level and be rewarded for that achievement.

Put it Into Practice, Revisit and Revise

Once the philosophy is developed, written, tested and communicated, you need to keep it current and use it to make life easier. Those making decisions around hiring, annual salary increases, incentive program payouts and executive benefits should annually go back to the compensation philosophy and be sure their decisions are consistent with the stated philosophy. Each year, the compensation committee, CEO, and human resources department should review the philosophy and determine if externally or internally things have changed significantly enough to require a strategic change. It is OK to revise the philosophy for strategic purposes from time to time, but it should generally be looked at as a document of guiding principles that provides more answers than questions.

Best Practices for Your Compensation Committee

11-13-13-Meridian.pngCompensation committees today face increased responsibilities, time commitments and risks. The Dodd Frank- Act, the Securities and Exchange Commission (SEC) and the stock exchanges are mandating new governance standards and disclosure rules. Bank regulators, shareholders and their advisory firms (e.g. Institutional Shareholder Services, Glass Lewis) create pressures to conform to their requirements, which often conflict. As external pressures continue to evolve, compensation committees need to address more complex issues and change their practices to ensure proper oversight.

Committee Governance

Establishing appropriate governance structures is critical to enabling compensation committees to make effective decisions in this complex environment. The SEC recently approved new independence requirements for compensation committees listed on NASDAQ and NYSE. In consideration of these requirements and other trends, below is a list of some best practices related to compensation committee governance. A compensation committee should have:

  • Composition comprised solely of independent board members, willing to encourage discussion, debate and challenge the status quo.
  • A charter that provides clear definition of authority and meets new SEC requirements.
  • Clear definition of its authority to manage compensation risk.
  • An annual calendar defining activities/actions to be taken throughout the year.
  • Oversight that includes CEO and top executives.
  • Agendas and meeting materials sent well in advance of meeting with clearly define topics for review, discussion and approval.
  • A two-review process for major decisions (e.g. one meeting to review materials and discuss; second meeting to approve).
  • Executive sessions without management at every meeting.
  • Annual self-assessments of the committee’s performance.
  • Annual assessments of independent advisors.
  • Ongoing director/committee education (through advisors, conferences).

Compensation Program Design

Compensation program designs and practices are changing as a result of the increased influence of bank regulators, shareholders and advisory firms such as ISS and Glass Lewis. Best practice compensation programs should:

  • Align and drive the bank’s strategic goals and business plans.
  • Reflect the bank’s unique compensation philosophy and guiding principles.
  • Provide a balance of or between:
    • Performance measures (e.g. return, operational, shareholder).
    • Fixed and variable/performance based programs.
    • Short and long-term performance.
    • Cash and equity-based compensation.
    • Bank, division and individual performance.
    • Formula versus discretion.
    • Absolute and relative performance.
  • Include a mechanism for risk-adjusted compensation. (Approaches vary but might reflect inclusion of risk metrics in the incentive plan, such as risk-adjusted returns, or deferral of incentive pay.)
  • Embrace meaningful stock ownership for executives and board members through ownership guidelines, holding requirements, payment in stock and outside purchases.
  • Include a clawback policy (which may need to be revised as rules are finalized implementing the Dodd Frank Act).

Compensation committees today need to conduct more rigorous analyses and testing to ensure total compensation programs are effectively meeting objectives and complying with today’s requirements and best practices. Some examples of good analyses include:

  • Compensation history and tally sheet of executives’ total compensation.
  • Pro forma illustration of the range of potential total compensation resulting from a variety of performance results.
  • Realizable pay analysis (total compensation likely to be paid based on performance).
  • Updates on progress toward annual and long-term performance goals.
  • CEO and executive performance and pay relative to peer group.
  • Current stock ownership and progress toward ownership guidelines.
  • Value of retention tools (e.g. stock awards, Supplemental Executive Retirement Plans).
  • Annual review of compensation risk assessment.
  • The ratio of CEO pay to median employee pay (this is required by the Dodd-Frank Act with an estimated implementation in the year 2015).

All of these analyses can provide helpful perspective for committees when designing programs and making pay decisions.

Communication and Disclosure

Communication with shareholders and regulators is more critical than ever, as both groups are seeking to determine if compensation programs align with their expectations. Best practices include the following:

  • Enhance your compensation disclosure and analysis on your proxy statement with an executive summary to tell your story and communicate to shareholders the objectives of your pay program and the resulting pay-performance relationship.
  • Understand the influence and perspectives of shareholder advisory groups (e.g. ISS, Glass Lewis) but don’t try to emulate them. Their policies evolve and their analysis is a one-size-fits-all approach.
  • Provide clear documentation of your incentive plans and be prepared for the formal documentation that will result as required by Section 956 of the Dodd Frank Act.
  • Engage in ongoing communication with shareholders; not just during annual say-on-pay voting.

These checklists provide a starting point for assessing the effectiveness of governance practices and could help a compensation committee review their own practices and see what they would like to change.

Changing the Way We Pay

Rewarding performance without increasing risk or running into problems with regulators or shareholder advisory groups has been a tough job for bank boards in recent years. Many have made changes to their long-term and short-term incentive plans and metrics. Bank Director asked some board member and management speakers at its upcoming Bank Executive and Board Compensation Conference in Chicago Nov. 4-5 to address what changes they have made recently.

Has your bank implemented any changes to compensation or to the compensation committee during the last year that you would view as an improvement? If so, please describe.

Samuels-Ron.pngAvenue Bank introduced a long-term incentive plan in 2012 for executives, key officers and directors. This is a performance-based plan. Based on achievement of annual goals, equity awards in the form of restricted stock will be granted at threshold, target or maximum and vested evenly over a four-year period. Objectives included the ability to attract and retain key employees in a highly competitive talent market; encourage ownership; provide a portion of total compensation in deferred compensation; minimize accounting expense and provide the most efficient long-term incentive vehicle.

— Ron Samuels, chairman & CEO, Avenue Bank, Nashville, Tennessee

Stephens-Barbara.pngFirst Business Financial Services, Inc., has undertaken two major projects over the past year to align compensation and performance.  CEO performance is now evaluated using a robust process, which incorporates both business results and excellence in leadership.  In addition, we have developed a new peer group that best reflects our business model, size and markets.  This peer group will be used in evaluating both our performance and our compensation.  When combining these tools with engaged directors, we believe we provide a solid foundation for both the art and the science of compensation.

— Barbara Stephens, compensation committee chairman, First Business Financial Services, Inc., Madison, Wisconsin

Holschbach-Leon.pngOur annual compensation review considers key factors such as: talent acquisition and retention needs, long term strategy of the bank, changes in competitive landscape, and the complexity of our growing company. In 2013, we continued the practice, established a few years ago, of shifting from options as our single, long-term incentive to a combination of options and restricted shares. Going deeper into our company with options has also allowed us to recognize the hard work and commitment of our management team as well as rewarding our promising young employees that have the potential to assume leadership roles in the future.

— Leon Holschbach, president and CEO, Midland States Bancorp, Effingham, Illinois

Sorrentino-Frank.pngAt ConnectOne Bank, we have recently focused on an alignment strategy for compensation. This was accomplished by creating both an annual cash incentive plan and a formal long-term incentive plan. The dynamic tension between these two different plans motivates and rewards short-term actions while making sure that those decisions also drive long-term value creation. For a high-growth, risk-compliant organization such as ours, retaining and rewarding our top talent has become a priority for our compensation committee. This balanced approach between short and long-term incentive aligns our employees’ goals with those of our shareholders, while also building leaders who reinforce our client-centric, sense of urgency culture. The result: good decision-making, added shareholder value and strategic focus.

— Frank Sorrentino III, chairman/CEO, ConnectOne Bank, Englewood Cliffs, New Jersey 

Hirata-Vernon.pngLast year, we changed one of the executive non-equity incentive plan performance measures from strategic/nonfinancial goals to a financial goal of measuring the holding company/bank’s nonperforming assets ratio against the company’s peer group. In discussions with some of our institutional investors and after reviewing some of our past proxies, we found that this previous goal was not easily explained and not clearly an objective performance measure.  As such, the old measurement might not clearly qualify for 162(m) treatment; which, if disqualified, would mean that part of the compensation awarded would not be tax-deductible by the company.

— Vernon Hirata, vice chairman, co-chief operating officer and general counsel, Territorial Bancorp Inc., Honolulu, Hawaii

Three Questions to Pull Back the Curtain on Discretionary Pay

3-19-13_Semler.pngJudgment by directors acting on shareholders’ behalf is a cornerstone of U.S. corporate governance. So why is it so controversial when CEO pay is based on judgment? 

This post focuses on a more structured approach to making and explaining discretionary pay decisions. It’s not a post about the say-on-pay shareholder advisory vote, which is now required for publicly traded firms, but we use it as an illustration because it has brought the issue to the fore in many boardrooms. A more transparent process, with clear expectations and discussions, can focus performance messages and de-mystify the pay decision for all employees in addition to informing shareholders publicly about CEO pay.  

Many of our financial services clients use discretionary approaches to deliver pay and performance messages. The virtue of this model is that it allows for a multi-faceted evaluation of corporate and individual performance. A strict formula does not necessarily create a holistic view of results delivered, no matter how complex or long-term the system.  

Say-on-pay has increased the external focus on understanding the relationship between senior executive (primarily CEO) pay and performance. The compensation discussion and analysis section of the proxy form is intended to provide shareholders with insight into the material elements of the pay decisions. Shareholders often rely on proxy advisors, whose recommendations can be highly critical when their simple analyses indicate a pay and performance “disconnect.” If the proxy does not provide enough insight, shareholders must come to their own conclusions about pay and performance.

A compensation committee may interpret this as a demand for a rigid formula by an outsider that “doesn’t get it.” Critiquing proxy advisors is a path well-worn. We’re taking a different tack, with greater potential benefit. Criticism of discretionary pay should prompt a committee to investigate the process and communications to ensure that shareholders and those getting paid have a clear understanding of performance and dollars earned.

Committees should start with three questions:

1. Do executives (and shareholders) know what results we value?
These vary. Financials and shareholder return over time are always important, but how results are achieved also must be reflected in the assessment. These can be environmental (e.g., good performance in a down cycle), or internally-focused (e.g., exceeding numbers in a business at the expense of companywide performance). These are often more nuanced and can be more critical to future success than just “making plan.” Of course, pay has to be affordable, but there’s value in investing in pay to encourage non-financial activity that creates future success. If you’re not clear about what results are important and how to achieve them, how can executives (shareholders) understand pay decisions?

2. Do executives (and shareholders) understand performance assessments?
This approach is formal, not formulaic, and has key questions of its own:

  • Are there individual performance discussions up front and throughout the year about key accountabilities? 
  • Does the compensation committee hear from the CEO and executives about results and individual performance? 
  • Are questions asked to fully understand successes and areas of development?
  • Are goals measurable and tied directly to financial, operational and strategic priorities?

There should be no pre-established weightings, allowing decisions to focus on what was really important, compensate executives accordingly and provide a clear rationale for pay decisions. If you aren’t talking about expectations and progress, how can you be clear about performance on the most important items?

3. Do executives (shareholders) get a clear explanation of the pay decision?  
A chief financial officer once told me that 90 percent of his time delivering pay decisions is spent with the lower performers, who tend to argue about their performance assessment and lobby for more money. A high-performing executive at the same bank told me, “Pay discussions last two minutes. They tell me my number and I say ‘thanks’.” This is a model working in reverse. The year-end discussion should be a proactive, rich overview of expectations, performance and next challenges. Arguably the most time should be spent with future leaders versus poor performers, and the conversation should be driven by the person delivering rather than receiving the message. If you don’t use the pay discussion wisely, how will your top performers be energized to continue to succeed? 

Fully discretionary pay is very powerful, but to quote from Uncle Ben in the Spider-Man comics, “with great power comes great responsibility.” Proxy advisor criticism in say-on-pay recommendations may seem like an obtrusion by uninformed third parties. We think there’s an alternative viewpoint. Before you dismiss or rail against your critics, ask three questions to ensure you’re getting everything you can from how you make and communicate pay decisions. 

Regulatory Fatigue Syndrome: Identifying the Symptoms and Treating the Patient

Rx.jpgDuring the annual Bank Director Bank Executive & Board Compensation conference that was held recently in Chicago, Illinois, peer exchange sessions revealed that board members and executives alike are struggling to keep pace with an industry that continues to change. 

In the directors’ peer exchange meetings, directors often said that trying to keep up with the changing regulatory environment is as distracting as it is fatiguing. 

This year’s conference seemed focused on the stabilizing market, and from a director’s standpoint, establishing best practices for approving, monitoring and maintaining appropriate compensation programs, rather than on technical updates as in years past. While all this can make you feel like you’re battling the flu—proper “diagnosis and treatment” can help directors through this malady.

Symptoms of Regulatory Fatigue Syndrome

1. Blurry vision from prolonged reading of legislation, proposed regulations, guidance and advisor mailings.

2. Frequent headaches from balancing the need to eliminate risk in compensation programs to appease regulators while at the same time trying to increase the connection between pay and performance to appease institutional investors—though in many respects they can be diametrically opposed.

3. Intermittent nausea from endless board meetings that move from one regulatory issue to the next with little time for the consideration of strategic business issues.

4. General fatigue from worrying about missing one or more of the many new regulations that may or may not yet be effective.


1. Focus on current rules. Be aware of and consider proposed rulemaking, but specifically address rules that are in effect or issues that are before you today.  For example, is the bank subject to TARP or its legacy constraints? Is the bank in troubled condition and subject to the compensation limitations of Rule 359? Has the bank taken steps to implement the principles of the Guidance on Sound Incentive Compensation? Has the bank reviewed its compensation programs for its mortgage lenders, or does the bank need to publicly address a “no” vote recommendation from Institutional Shareholder Services or a bad result on a say on pay vote?

2. Review your charter. Review your compensation committee charter to ensure that your charter addresses the duties that are required of your committee based on current law. Your charter should reflect the committee’s duty to assess risk in your compensation programs and should provide for authority and funding to hire independent advisors.  Consider a committee checklist that will track the duties outlined in the charter in order to help ensure that the committee addresses each of its tasks at some time during each year.

3. Rely on your advisors. Work with your advisors to understand what regulatory changes may be coming and rely on them to let you know when you need to focus on each of the new rules. For example, do you need to deal with claw-back policies, CEO pay vs. performance disclosure, the CEO pay ratio relative to employee median pay disclosure, the compensation committee member and advisor independence requirements, or mortgage lender pay practices? 

4. Understand that risk mitigation is scalable. When trying to decipher all of the possible plan changes that might help manage, mitigate or eliminate risks, you should be mindful that the actions you take can be relative to the size and complexity of your bank and its compensation plans.  The actions taken by a $50-billion bank with complex plans are not necessarily the same that will be taken by a $1-billion bank with less complex and understandable compensation programs.  Many good practices will trickle down from the more complex organizations, but the risks are different, so your actions should be different as well.

5. Focus on establishing good procedures. Make sure you have good internal controls in place with respect to your compensation plans and that your senior risk officer is involved in the plans’ development and management. Your compensation committee should understand how the plans work, what the associated risks may be, and if changes should be made. The committee does not need to manage the plans (unless they apply to proxy officers), but they need to understand and manage the risks presented.

Certainly, this is a tongue-in-cheek approach, but fundamentally the advice is sound. Though there are many moving parts with the regulation of bank compensation practices, they can be addressed and understood by taking them one step at a time.  The old adage that “inch by inch life’s a cinch, but yard by yard it’s very hard” holds very true in trying to digest the multitude of compensation governance influences and constraints.

Bank Directors Weigh In on Executive Pay at Chicago Conference

With the close of 2012 fast approaching, directors and compensation committees continue discussions on how to produce acceptable growth under the weight of banking reform legislation.  Understandably, banks are nervous. In the face of regulatory actions, weak performance, or cuts in compensation, valuable bank officers may opt to move elsewhere. 

In spring of this year, Meyer-Chatfield Compensation Advisors and Bank Director conducted a comprehensive survey to understand industry viewpoints on executive and directors pay.  Download Full Report.  To further validate our findings, we identified six questions from the original spring survey, and re-surveyed the audience of bank directors and executives in attendance at the Bank Executive & Board Compensation conference in Chicago in November this year.  William MacDonald, advisory board member for Meyer-Chatfield Corp., the parent company of Meyer-Chatfield Compensation Advisors, talks about the survey results and trends in compensation, including the increasing use of stock in director compensation and the movement away from Supplemental Executive Retirement Plans (SERPs). 

1. How well do you believe your bank’s board is managing its executive and director compensation? 

Board members at the November conference felt they were doing a better job handling compensation than board members felt in the spring survey. In my opinion, the improvement in numbers is due to compensation committees and board members getting their arms around the changes, and developing a process to deal with the issues. 


Very Well 


Not Well At All 

Spring Survey 




November Survey 





2. What is your top compensation challenge for 2013? 

The top challenges in both the spring 2012 survey and November Chicago conference were “tying compensation to performance” and “retaining key people.” Historically, bank incentive plans have been tied to financial performance using matrixes such as return on assets and earnings per share. 

3. Do you have stock ownership guidelines for your directors? 

More than half (58 percent) of the Chicago survey group have directors’ guidelines in place, compared to 47 percent of the spring survey. Many banks use deferred compensation plans to offer restricted stock compensation for directors, and pay directors a larger portion of compensation in stock than they have historically.

4. If you have stock ownership guidelines for directors, what are the ownership requirements? 

In the annual spring study, most respondents who had stock ownership guidelines had guidelines requiring a minimum or fixed number of shares, while the Chicago group more often had a multiple of retainer or annual compensation.  I think a multiple is a better idea.  Not all directors are financially able to meet a fixed amount of shares. 

5. Who is primarily responsible for setting directors compensation levels at your bank? 

To follow high standards in corporate governance, a board should work with an outside consultant with access to meaningful data and best practices.  All parties need to weigh in on this subject; the chairman, full board, the compensation committee, as well as the bank CEO.

meyer-chart.pngSource: Bank Director and Meyer-Chatfield Compensation Advisors spring 2012 survey on director compensation.

6. Does your bank offer a nonqualified retirement benefit to your management team? 

Both survey groups weigh in at 60 percent roughly offering a nonqualified retirement benefit.  Nonqualified plans are effective tools for banks to attract, retain and reward key people. 

Many community banks structure supplemental executive retirement plans (SERPs) for senior management. SERPs became prevalent at community banks as a way to compete with major banks. Now, SERPs are on the chopping block. Institutional investors, shareholders and many boards are focused on inherent plan costs. Most SERPs are fixed defined benefits, and expensive from a profit and loss standpoint. During the conference and in a break-out session with Flynt Gallagher, president of Meyer-Chatfield Compensation Advisors, we discussed ways banks are maintaining these plans with much lower costs. In some cases, the bank can maintain the benefit at a 50 percent reduction in the expense that must be recorded for employee pensions (FAS 87). 

Going Forward

Compensation for executives and directors will remain a hot topic in 2013. Look for incentive compensation to gain momentum as banks align interests of executive teams with shareholders. What’s more, I envision the sprouting of new measurements to better balance shareholder and regulatory interests.  I would also watch for shareholders to require executive and director benefit plans do more heavy-lifting in the war for talent, because flexibility trumps tradition hands-down.

Old is New Again: Independence vs. Independent Judgment

thinking.jpgBankers are routinely inundated with “alerts” and “updates” from advisors setting forth current developments in the law as it applies to banks and their business.  As authors and recipients of such updates, we understand your pain, but also believe the information conveyed is critical to making informed decisions. However, every so often (now for instance), it’s important to reevaluate established practices and procedures to make sure we’re not forgetting something important.

As we approach year-end, it’s time to focus on compensation-related matters (yes, it’s that time of year already). In just a few weeks, many of us will be gathering in Chicago for Bank Director’s annual Bank Executive & Board Compensation Conference. No doubt, there will be much discussion surrounding the ever-increasing depth and breadth of laws, rules and regulations applicable to the banking industry generally and, in particular, compensation arrangements for directors and executives. But after a few years of focusing on the concept of risk, in all its glory, it’s likely there will be a fair amount of focus on independence this year. Over the summer, the Securities and Exchange Commission (SEC) announced its rules under the Dodd-Frank Act relating to compensation committee independence and, within the last few weeks, the New York Stock Exchange and NASDAQ OMX issued their own rules on independence as required by the SEC.

Independence and Dodd-Frank

The concept of independence for compensation committees—which underlies Dodd-Frank Act §952—is not a new one. The specific Dodd-Frank Act rules might be new, and will require study and may result in changes to your existing practices and procedures, but the concept of independence is familiar and worth revisiting. The rules will require that compensation committee members be independent and have access to independent advisors. What is left unsaid is that the information garnered from those independent advisors should be the basis for—not the end of—independent thought by independent directors. Independent advisors are not a substitute for independent judgment.

Sarbanes-Oxley Act of 2002 (SOX)

This year marks the 10-year anniversary of the SOX. It was enacted in response to the corporate and accounting scandals that came to light around 2002 (Enron, Tyco and WorldCom, just to note a few).  SOX focused on corporate responsibility and oversight of the accounting industry. At its root, however, were a few familiar ideas, that a public company have an audit committee, all members should be independent, should have access to independent advisors (auditors should be independent) and should exercise independent judgment.

Global Financial Crisis of 2008 & Risk Assessment

Six years after SOX, the world experienced the global financial crisis. One of the congressional reactions to this crisis was the enactment of the Dodd-Frank Act. The Dodd-Frank Act put the focus squarely on risk assessment of compensation plans. Bank regulators and the SEC reminded us that risk assessment in connection with compensation plans was not a new concept. Banks (and other entities) were directed to mitigate unreasonable risk in compensation programs wherever it was found. There was a focus on risk itself, risk mitigation, risk policies, claw-back of incentive compensation (incentive compensation that may have led to excessive risk-taking) and so on.

Lack of independence on the compensation committee was rightly perceived as a potential risk. To mandate the mitigation of this risk, the Dodd-Frank Act directed the SEC to enact rules, through the exchanges, that would require public companies to ensure their compensation committees are independent with uninhibited access to independent advisors to assist them in the discharge of their duties. Again, the rules may be new, but they are focused on a familiar concept—independence.

This brings us back to the alerts, updates, conferences, seminars and the seemingly infinite sources of industry information. All of the information you obtain, regardless of the source, is of no use unless it’s put to work in an independent decision-making process. Advisors will help to educate you, but it’s up to your board members to exercise independent judgment.

Groping Toward Mortgage Compensation Rules

cutting-money.jpgRecently the Consumer Financial Protection Bureau (CFPB) issued a set of proposed rules on mortgage loan originations that include restrictions on compensation that will make it difficult for banks to structure bonus plans for their mortgage loan originators.

I wrote about this issue back in May, after the bureau had issued guidance stating that banks are permitted to make contributions to a mortgage loan originator’s 401(k) or some other type of qualified plan out of a profit pool derived from mortgage loan originations. However, the CFPB declined to indicate at the time whether banks could pay bonuses to originators based on the profitability of a pool of mortgage loans as part of a non-qualified incentive compensation plan. The distinction is important because in the case of a qualified plan like a 401(k) we’re talking about an individual’s future retirement income, while with a non-qualified bonus plan we’re talking about cash in their pocket today.

First a little bit of important background. Underlying this issue of mortgage originator bonuses is the focus of federal regulatory agencies—including the CFPB—on so-called compensation risk. During the subprime mortgage boom, originators often received extra compensation if they steered borrowers to higher cost loans, which often meant low-income borrowers paid more for their loans than they should have. The Federal Reserve Board proposed stricter rules on mortgage origination compensation in September 2010 under the Truth in Lending Act. Rulemaking authority for the Act was transferred to the bureau under the Dodd-Frank Act, and now the bureau is finishing what the Fed started.

Mortgage originators aren’t the only bankers impacted by all this attention on compensation risk. Banks are also being forced to change their incentive compensation practices for other kinds of lending activity, including commercial real estate and C&I lending. Generally speaking, the regulators don’t want lenders to be rewarded purely on volume; they want to see bonus payments spread out over a longer period of time than, say, just one quarter; and they want the size of the payout tied to the performance of the underlying loan portfolio over some reasonable period of time so lenders don’t get paid upfront for loans that later go bad. And in the case of mortgage originators, regulators don’t want them to be incentivized to screw their customers by pushing them unwittingly into high cost loans when they would qualify for a cheaper loan.

It was not clear last May whether the CFPB would allow banks to pay its mortgage originators any kind of bonus that wasn’t tied to a qualified plan. “Every bank is trying to do a better job of tying compensation to the profitability of the underlying business,” says Kristine Oliver, vice president at Pearl Meyer & Partners. But the bureau has now issued a proposed rule for non-qualified bonus plans that will make that goal much more difficult. Under the latest proposal, banks may pay employees a bonus derived from a pool of mortgage loans only if three conditions are met:

  • Compensation may not be based on the terms of the loans that were originated, so an employee can’t be rewarded for producing more of one kind of loan versus another.
  • The employee can’t have originated more than five mortgage transactions during the last 12 months.
  • However, if the individual’s transactions exceed five, the bonus pool can based on mortgage revenue limited to 25 or 50 percent of the overall revenue in the pool. The bureau has proposed two percentage cap alternatives, 25 percent and 50 percent.

The proposal does address the concern some people had that branch managers who originate an occasional mortgage might not be allowed to receive a bonus based on the profitability of their branches if the branch’s revenue included, say, points or mortgage origination fees. Now those individuals can receive a bonus even if the branch’s revenue includes some mortgage related revenue.

“The bureau has proposed a diminutive exemption,” says Richard Andreano, Jr., a partner in the Washington, D.C. office of Ballard Spahr LLP. “That would work for [occasional originators] but doesn’t work for someone who does more than five but still doesn’t do a whole lot of originations.” An example might be someone manages a mortgage production office and originates more than five loans a year, but is still a low volume producer compared to their rest of their team, so they don’t qualify for a bonus based on mortgage revenue.

More importantly, the proposed cap on the percentage of mortgage-derived revenue that can be included in a bonus or profit-sharing plan will make it impossible for banks to structure incentive compensation plans that will reward their originators solely on the profitability of their business. To get around the cap, banks will have to enlarge the categories of revenue that bonus payments are based on to include other kinds of loans in the mix. That would make it more of a company-wide incentive plan—especially if the cap is as low as 25 percent—which might be what the regulators prefer, but could be a less powerful incentive than a plan where mortgage originators were the only participants.

“That’s where the bureau wasn’t willing to go,” says Andreano.

Banks and other financial services companies that are impacted by the proposed rules have until Oct. 16 to submit their comments to the CFPB. Dodd-Frank requires the bureau to adopt final mortgage originator rules by Jan. 21, 2013, so banks should expect a final rule by then. Unfortunately, as Oliver points out, “People are starting to pull together their incentive plans for 2013,” so any assumptions they make now—like, for example, will the allowable cap be 25 percent or 50 percent—could be subject to change.

Overworked, Underpaid and Unappreciated

Bank directors face familiar compensation challenges this year, but frustration with the board’s ability to handle these challenges appears to be increasing. That is according to the results of Bank Director’s 2012 board compensation survey co-sponsored by Meyer-Chatfield Compensation Advisors, which included nearly 550 CEO and director responses.

This year, only 58 percent of respondents feel their board is managing executive compensation well or very well, compared to 63 percent last year and 74 percent in 2010. Similarly, only 53 percent feel director compensation is being managed well or very well, compared to 56 percent last year and 68 percent in 2010.   

Meyer-Chatfield Compensation Advisors President Flynt Gallagher says that some of this dissatisfaction is the result of increased scrutiny from shareholders, regulators and the market.

In some cases, this increased scrutiny may be translating to increasing workloads for directors. The median hours spent on the job for institutions of all asset sizes remained the same this year as last year at 15 per month, but there were large changes in the hours reported by banks in the highest and lowest asset categories. While directors from the largest banks reported working fewer hours this year, the opposite was true for their small counterparts. Directors at banks with under $100 million in assets report working 20 hours per month this year; that is 5 hours more than they reported working last year and double the year before.

Justin Heideman, a director at Town & Country Bank in Saint George, Utah, a de novo institution with less than $70 million in assets, says he has no doubt directors at these smaller institutions are putting in more hours. He says the main reason is compliance.  “We have the same requirements on the [information technology] side in terms of safeguards that a major bank has,” says Heideman.  “It’s nonsensical the amount of time that is required to make sure that compliance is appropriate and to make sure we do all of our training. We have to do pop quizzes like I was in second grade during board meetings to make sure our training is done and to prove we are being trained.  It’s ridiculous.”

On a positive note for directors, more respondents (32 percent) expect director compensation at their banks to increase in 2013 than in 2012 (28 percent). Only 1 percent of respondents expect a decrease in compensation in 2013, and 67 percent expect director pay to stay the same.

Gallagher says the financial performance of many banks is showing an improvement after struggling with asset quality issues, lower margins and lower profits in recent years. With this improvement some banks are feeling relief and even optimism. 

The median board meeting fee for outside directors stayed the same this year as last year at $600 per meeting, while the median meeting fee for a chairman rose slightly from $600 last year to $675 this year. 

And yet, even as compensation holds steady or even increases, benefits for directors continue to erode. The number of banks offering zero benefits to outside directors has significantly increased—46 percent this year compared to 39 percent last year and only 28 percent the year before. 

Making cuts to benefits while keeping compensation steady might make sense for many banks, as it seems to align with what directors find most important when considering a new board seat. When asked to rank the importance of types of benefits and compensation when considering a new board seat, 51 percent of directors assign little or no importance to retirement plans while only 27 percent find them important or very important. Similarly, 44 percent of directors assign little or no importance to insurance benefits, while 28 percent find them important or very important.

It is important to note that many respondents report liability and potential growth of the institution are even more important factors when considering a board seat than the compensation or benefits package. Clyde White, chairman and CEO of Ouachita Independent Bank, a commercial bank in Monroe, Louisiana, with $570 million in assets, had this to say: “If I were considering joining a bank board, I would want to know what investment opportunity I would have and what the potential for growth is of that investment. I would also want to know what value I would be expected to bring to the table [i.e., business development activities, business acumen].”

The compensation survey was emailed throughout April and May to CEOs and directors at banks ranging in asset size from under $100 million to more than $5 billion. The response rate was 5.7 percent, with 549 responses. Of the banks represented, 9 percent have less than $100 million in assets, 25 percent are between $100 million and $250 million, 24 percent are between $251 million and $500 million, 17 percent are between $501 million and $1 billion, 18 percent are between $1.1 billion and $5 billion and 6 percent have more than $5 billion in assets. Of the respondents, 40 percent are publicly traded, 56 percent are private and 4 percent are mutual. Only 14 percent are de novo banks. 

For the survey report including committee fee pay breakdowns, click here.

The Movement to Redefine Compensation, Cost and Control in the Era of Consolidation

merger-chess.jpgMergers have become a big part of the banking landscape. The number of banks and savings institutions in the US dropped by 10 percent between 2004 and 2009, due to a record number of struggling banks either closing or merging with financially healthy ones. Increasing regulation could lead to more consolidation among community banks as well. The uptick in activity continued in to 2011 and is expected to increase throughout 2012.  

With this increase, bank directors, C-suite executives and others in the banking industry are challenged to better understand the compensation plans of all parties involved in a merger or acquisition. Interestingly, the March 2011 Harvard Business Review points out that 70 to 90 percent of mergers and acquisitions fail.  The primary reason for many of these failures stems from an inability to address personnel issues. 

Flynt Gallagher, president of Meyer-Chatfield Compensation Advisors, recently spoke at Bank Director’s Acquire or Be Acquired conference, where he provided insights into the trends impacting compensation in the banking industry. The primary trends include:

Shareholder Activism:  the need for shareholders to have a say on pay for executives, as well as to have better control on executive golden parachutes.

Sensitivity to Wealth Accumulation:  a new mentality on excessive annual bonuses and abusive stock options.

Compensation Arrangements under Scrutiny:  In today’s cost-cutting economy, compensation is viewed as costly to a corporation and its shareholders and a place where concessions can be made.

Understand Your Agreements

It’s important to fully understand the compensation plans for all of the parties involved in a merger or acquisition.  Without comprehending the terms of your compensation plans, you could find yourself in an ugly situation.  In one case, a bank was able to terminate an executive, but could not terminate his compensation.  The executive was paid for nearly 20 years after he was fired.  On the opposite end of the spectrum, an executive who could not quit or be terminated for any reason because he would have to pay his bank for one year of his salary.  Frustrations such as these showcase the need to review and understand the terms of all your compensation plans.

Use Non-Compete Agreements to Avoid Higher Tax Burden

To avoid issues, Gallagher recommends addressing employment agreements during compensation negotiations.  Limit the scope, revise or remove change-in-control provisions that expose the executive and the bank to IRC 280G, the tax on excessive golden parachute payments.  This results in a 20 percent excise tax to the executive, loss of income tax deduction to the bank, as well as the need to pay income taxes on the benefit payment.  Instead, Gallagher recommends using non-compete agreements that eliminate the bank’s exposure for IRC 280G and the excise tax.   This instantly provides shareholders with a value equal to the payment for service and allows the bank (and the executive) to retain a greater portion of the payment —unlike change-in-control agreements.

Use Performance-Adjusted Restricted Stock

Gallagher also recommends taking a closer look at using Performance-Adjusted Restricted Stock (PARS) to control the expenses on compensation.  This approach mitigates any shortfalls compared to other options in the marketplace. 

Consider Nonqualified Plans

More executives are realizing more of their benefits from nonqualified plans than ever before.  This approach is also viewed favorably by regulators, plus it reduces the bank’s obligations and establishes a fixed cost for a defined benefit.  It also maintains the current level of executive benefits without any additional cost to the bank.  Gallagher’s company, Meyer-Chatfield Compensation Advisors, also has a program called LINQS+ that reduces the expense associated with nonqualified deferred compensation plans such as supplemental executive retirement plans (SERP) or salary continuation plans without reducing retirement benefits due to executives.

Through the accounting methodology of LINQS+, traditional defined benefit SERP plans are extended from a 15 years into a lifetime benefit to the executive.  This reduces the expense to bank, saving them a significant amount of money without reducing the benefits paid to the executive.  

Improve your Chances for Success

In order to orchestrate a successful merger or acquisition, it’s crucial to develop a plan that enables you to review compensation plans, evaluate non-compete agreements and look for new ways to retain and motivate your key employees.  Put yourself in a better position and avoid costly mistakes by implementing programs based on these principles.