Driving Accountability in Incentive Compensation Governance

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compensation-7-17-19.pngI once flunked a math test because I didn’t show my work. Turns out, showing your work is important to both math teachers and bank regulators.

To drive accountability, it is important to document and “show your work” when it comes to governance of incentive compensation plans and processes. The largest banks, due to increased regulatory oversight, have made significant strides in complying with regulators’ guidance and creating robust accountability. Here are some resulting “better practices” that provide food for thought for banks of all sizes.

While the 2010 interagency guidance on sound incentive compensation policies is almost a decade old, it remains the foundation for regulatory oversight on the matter. The guidance outlined three lasting principles for the banking industry:

  • Provide employees incentives that appropriately balance risk and reward.
  • Create policies that are compatible with effective controls and risk management.
  • Support policies through strong corporate governance, including active and effective oversight by the organization’s board of directors.

Most organizations used the release of the 2010 guidance to take a fresh look at their incentive plans. It proposed a non-exhaustive list of risk-balancing methods, such as risk adjustment of awards and deferral of payment. Many banks changed their plan structures and provisions to increase sensitivity to, and better account for, risk. The changes made sense pragmatically but largely addressed only the first principle.

After the financial crisis, boards were expected to engage in the oversight and review of all incentive arrangements to ensure that they were not rewarding imprudent risk taking. However, most institutions quickly realized it was not practical for directors to be in the weeds of all their broad-based incentive plans and thus delegated that task to management.

Compensation committees outlined expectations for senior management regarding incentive plan creation, administration and monitoring in a formal document. Their expectations would include, for example, the process for reviewing incentive plan risk.

Comp, Risk Committees Cooperate
Banks also developed stronger communication or information sharing between the compensation and risk committees of the board. This was sometimes accomplished through cross-pollinating members between the committees or conducting joint meetings on the topic. It also became standard for the chief risk officer to participate in compensation committee meetings and present on incentive compensation risk, as well as the overall risk profile of the organization.

Incentive compensation review committees, made up of the most-senior control function heads such as the chief financial officer, chief human resource officer, general counsel and chief risk officer, are often delegated primary oversight responsibilities. To create accountability, this management committee operates under a formal charter, oversees the entire governance process, provides for credible challenges throughout and annually approves all non-executive plans. A summary of their activities and findings is presented to the compensation committee annually, at minimum.

Working groups representing various business lines and broad control functions support the management committee in actively monitoring incentive compensation plans. Every activity in the governance process—from plan creation or modification to risk reviews and back-testing—has a documented process map with roles and responsibilities.

These large bank practices might be overkill for smaller organizations. However, some level of documentation and process formalization is a healthy process for any size. My advice: Don’t get fixated on the red tape, as proper governance and controls can be scaled to the size and complexity of each individual bank.

Formalize the Process
The second and third principles of the 2010 guidance are aimed at driving greater accountability and efficient oversight, including enhanced information sharing. Formalizing the process simply helps to crystalize expectations for those involved and safeguards against the dodging of responsibilities.

Plus, regulators—just like that math teacher—want to see the work. It’s not enough to simply have the right answer. You must be able to document the process you went through to get there.

One Way to Compensate and Keep Your Bank’s Top Talent

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compensation-6-11-19.pngBank-owned life insurance (BOLI) continues to be an attractive investment alternative for banks, given the number of banks that hold policies and high retention rates across the industries. An increasing percentage of banks hold BOLI, many of them using the policies as an important part of their compensation and retention strategies for key personnel.

A significant industry trend driving interest in BOLI is their use by banks in compensation strategies to attract and retain the best talent. Bank management and boards of directors are reevaluating their existing compensation plans and strategically implementing new ones in order to retain key executives given increasing competition for scarce talent.

BOLI assets reached $171.16 billion at the end of 2018, growing 2 percent year-over-year, according to the Equias Alliance/Michael White Bank-Owned Life Insurance (BOLI) Holdings Report. Sixty-four percent of banks reported holding BOLI assets; about 71 percent of banks with more than $100 million in assets owned BOLI. Most BOLI purchased is by banks that hold existing policies; of those banks, more than half have purchased BOLI as an add-on for a current group of executives. In 2018, about 86 percent of new premiums were invested in general account products, compared to hybrid and separate account products, according to IBIS Associates.

Although the pace of BOLI purchases slowed last year compared to 2017, purchases exceeded $1.7 billion and were steady throughout 2018. The reasons for slower BOLI purchases were due to continued strong loan demand that reduced bank liquidity and the reduction in the tax-equivalent yield on BOLI following the federal corporate tax cut.

Credited interest rates and net yields, the crediting rate minus the cost of insurance charges, on new BOLI purchases are expected be similar to 2018 figures. The interest rates that carriers can obtain on investment-grade securities held for between five and 10 years has remained relatively flat, given the modest increases in this portion of the yield curve. Corporate bonds usually comprise the largest holding in the portfolio, but it can also include commercial mortgages and mortgage-backed securities, private placements, government and municipal bonds, a small percentage of non-investment grade bonds and other holdings.

BOLI plans fund many of the most common retention plans, which can include supplemental executive retirement plans, deferred compensation plans, split-dollar plans and survivor income plans. Additionally, some banks are using deferred compensation plans to create flexibility in designing plans to retain young “up and coming” officers. Unlike a supplemental executive plan, which provides a specific benefit at a specific date or age, a deferred compensation plan allows the bank to make contributions to the executive’s account using a fixed dollar amount, fixed percentage of salary or bonus or a variable amount based on performance. A deferred compensation plan also permits voluntary deferrals of compensation, which could be valuable to executives who would prefer to defer more compensation but are limited in the 401(k) plans.

BOLI financing helps offset and recover some or all of the expenses for the employer. For example, a bank provides an officer with supplemental retirement benefits of $50,000 per year for 15 years, for a total cost of $750,000. The bank could purchase a BOLI policy on the officer with a net death benefit of $1 million to $2 million that would allow it to recover the cost of the paid benefits, as well as a return on its premium.

We expect that community banks will continue to implement these types of nonqualified benefit plans in 2019, using BOLI to help attract and retain key personnel.

What’s Changed in Executive Compensation Since the Crisis

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compensation-3-4-19.pngA decade ago we were in the middle of an economic downturn and the world of executive compensation was under intense scrutiny.

One target for that scrutiny was executive benefits and perquisites. Things like excessive change-in-control payouts with “gross-ups” and perquisites like vehicle allowances and country club memberships were placed under the microscope.

Executive perquisite policies were put in place, and additional focus was placed on the SEC proxy statement disclosures of perquisites in the Summary Compensation Table when the aggregate amount exceeds $10,000.

To track the impact of these changes, Blanchard Consulting Group has conducted a benefits and perquisites survey three times over the last 10-year period. The most recent survey was completed in early 2019.

Here are three key areas:

Change-In-Control Agreements & Gross-Ups
The prevalence of CIC agreements has been consistently between 50 and 60 percent each time we have conducted our survey, so there has really been no change in the market surrounding who has these provisions in place. For additional reference, our public bank database indicates this segment is slightly above 80 percent prevalence for CIC agreements and this hasn’t changed much either in recent years.

What about severance multiples paid? Consistently, the most common response (around 35 percent) is the multiple for CEOs has been between 2 and 2.5 times salary or cash compensation.

So how about the “gross-up” clauses that added pay to the executive severance package if their payout was deemed excessive for Section 280G of the tax code? Our research only shows a slight decrease in the prevalence of these clauses. About 25 percent of the sample indicated they had them when we first conducted the survey and now we are just below 20 percent of the sample.

In summary, not much has changed surrounding CIC agreements and “gross-up” clauses.

Supplemental Retirement Plans
The existence of supplemental executive retirement plans (SERPs) or salary continuation agreements (SCPs) have declined from 53 percent in 2011 to 47 percent in 2018, which is not a lot of movement. Prevalence of these plans at public banks has hovered around 45 percent.

What about the benefit amounts being paid under these plans? Not much has changed here either. Around 70 percent of CEOs with defined benefit amounts are targeting something below 55 percent of final compensation, which is the same in 2018 versus 2011.

Supplemental retirement plans have not experienced much change in the banking market either.

Perquisites
Executive perquisites have not changed much surrounding car allowances or country club, hovering around 70 percent prevalence. This is very similar to the numbers back in 2011. In fact, the percentage of banks who do not offer any perquisites to their executives has only dropped a couple of percentage points, from 12 percent to 8 percent.

So once again, not much has really shifted or changed in the world of executive perquisites either.

Summary
So what should we make of the fact that there appears to be no significant adjustment, “scale-down,” or elimination of executive benefits and perquisites in the last 10 years? Did regional and community banks simply ignore the government-focused initiatives?

Some might say yes, but there’s another argument to be made.

It’s possible that community and regional banks were simply never paying their executives inappropriately or excessively. The compensation designs in place at those institutions were market-based, competitive, and reasonable. During the downturn many executives experienced salary freezes and either zero or minimal cash bonuses as bank performance dropped.

This was appropriate under pay-for-performance incentive plan designs. Since that time, compensation has increased as bank performance has increased and not much has changed in the world of executive benefits and perquisites.

These benefits and perquisites were reasonable then and are still reasonable now in the eyes of the decision-makers at community and regional banks.

A Roadmap for Productive Board Discussions

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bank-board-10-11-18.pngYou can’t drive a car to a new destination without a roadmap, and a board can’t conduct a productive meeting—and ultimately, effectively oversee the organization—without a well-thought agenda that keeps meetings focused on discussing what’s important, and helping the board stay proactive on the potential opportunities and threats facing their bank. What’s placed on that agenda, and when it’s discussed, differs a bit from bank to bank. But there are several issues that should be on every agenda, and some that should be addressed regularly, albeit less frequently.

At every meeting
Bank board agendas don’t differ from a standard corporate agenda in many respects. There should be a call to order, review and approval of minutes from the previous meeting, and a review of reports.

For a bank, every meeting should include a review of financial reports, with the chief financial officer on hand to address questions and discuss items in detail. Directors will also want to review loan reports, at which point the board will typically hear from the senior loan officer. Reports from the committee chairs should also be heard at every board meeting.

New business will include updates on strategic initiatives, including milestones and progress. Actions taken by the bank to address regulatory concerns should also be addressed, though how frequently this item appears on the agenda will depend on how much hot water the bank is in with its examiners. Trends impacting the growth and financial performance of the bank should also be discussed.

Old business should also be addressed in the agenda, and it’s an area often overlooked by banks, according to Bob Brown, a managing director at Kaplan Partners and board member at $84 million asset County Savings Bank in Essington, Pennsylvania. He previously spent 40 years at PwC. If management was instructed to take a certain action, or the board decided it would circle back to an issue, those matters shouldn’t be dropped.

Regular items to address
Risk, cybersecurity and technology are top concerns for bank boards, but directors are split on how often these topics need to be discussed by the full board. Twenty-six percent of respondents to Bank Director’s 2018 Risk Survey said their board discusses cybersecurity at every meeting, compared to 37 percent who do so quarterly. Half of the respondents to the 2018 Technology Survey said their board discusses technology at every meeting, compared to 37 percent who cover the topic quarterly.

The board should discuss management and incentive compensation semiannually, advises Brown. And don’t forget the auditors: Internal auditors should address the board semiannually, and external auditors annually.

Board education should be woven into the agenda at least quarterly, and should cover a variety of topics relevant to directors’ level of expertise as well as any ongoing regulatory, economic or competitive concerns. Regularly bringing in outside experts can also stimulate productive dialogue among board members.

Every year, the board should review board and committee charters, as well as key policies and loan loss reserves. The makeup of the board should also be assessed annually, using a board matrix or evaluation, or both. A board matrix is a grid that lists all the directors on one axis, and the skill sets and attributes needed on the board on the other. This check-the-box-style exercise can be an easy way to identify gaps where additional expertise is needed.

Strategic planning should occur annually and will drive the agenda by setting the priorities that the board will want to follow up on throughout the year. “That then drives what senior management does,” says Jim McAlpin, a partner and leader of the financial services client service group at the law firm Bryan Cave Leighton Paisner. Does the bank need to renew its contract with its core vendor, or seek another solution? Does it make sense to build a new branch? These decisions should be fueled by the strategic plan. “It’s good to take stock, set direction and plan, and then over the course of the next year refer back to that plan and refer back to the priorities when engaging with the CEO,” he says.

McAlpin recommends that strategic planning take place off site if possible, with the board spending a half day or day talking about the bank’s strategic direction.

The board chairman—or the lead director, if the chairman is not independent—often develops the agenda, with input from the chief executive. Committee chairmen should also weigh in to ensure those areas are addressed. Individual directors should feel welcome to contribute to the agenda, and there should be room to speak up during meetings. “A good agenda should include a line item in which the chair asks if there are any additional matters the directors think should be addressed,” says McAlpin.

An annual discussion that sets the agenda for the year—tied to the strategic planning session—can help boards better drive what’s on the agenda, says Brown. The governance and nominating committee can then take that conversation and finetune the scope of the board’s agenda for the year, with input from the board before it’s finalized.

Getting the right input
It’s important to hear from other members of the management team and ask questions directly of the heads of the respective areas of the organization, rather than relying on one source—the CEO—for that information. Ideally, the board should hear from the CFO at every board meeting to address financial matters. The heads of legal, compliance, human resources and information technology should also be available to address their areas of expertise, when needed. McAlpin recommends asking open-ended questions to gain their perspectives and address any of the board’s concerns. “If I were a board member, I’d rather [their answers] be unfiltered,” rather than through the CEO, he says.

Brown also recommends that the board hear from business line leaders at least annually, to better understand these important areas of the business.

Aside from better understanding the bank, it’s important for the board to understand the depth of the management team. “Perhaps the most important role a board has is selecting and evaluating the CEO,” says Brown. “Succession planning is a key responsibility, and understanding the management team’s depth, strengths and weaknesses of management team members, and having the chance to see them in action … is really important.”

Independent directors should also make time to discuss issues without management present, in an executive session, advises Brown.

Facilitating effective discussions
The board agenda will structure the discussion, but it’s on the board to ensure those discussions are fruitful. First and foremost, materials should be provided in advance, so directors have time to prepare.

Remote participation has become more common as technological solutions like web conferencing make this option easier and can be a good way to attract younger candidates with diverse backgrounds, who may still be building their careers, to the board, says Dottie Schindlinger, vice president at Diligent. But make sure discussions are secure. Don’t reuse the same conference call number and passcode every time—this can easily be accessed by a disgruntled ex-employee, for example, who then gains access to sensitive conversations. And directors shouldn’t use their personal emails to discuss board matters. Web portals, such as that offered by Diligent, can help boards store and access information, and communicate safely.

Remote attendance can have its disadvantages, and there are always directors who tend to dominate a discussion. An effective facilitator—usually the chairman or lead director—will overcome these hurdles and ensure everyone’s voice is heard. Pointed, open-ended questions can help engage introverted board members. Making sure one director speaks at a time cuts out crosstalk and helps remote directors understand what’s discussed.

McAlpin emphasizes that it’s important to have an actual discussion—not just directors passively listening to what the CEO has to say, or other members of management, or the committee chairs. And this underscores the need to assemble a strong board. “Some of the most effective CEOs, I’ve found, are those who purposefully build a strong board—a board consisting of board members with a range of strong experience, good insight and a willingness to share feedback and make suggestions,” he says.

A Long-Term Care Plan Can Attract Top Talent

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retention-7-13-18.pngOne of the biggest threats to retirement assets is the out-of-pocket cost of long-term care (LTC). While 51 percent of people see LTC as a financial concern and 70 percent of Americans 65 or older will need LTC assistance at some point in their lives, only about 8 percent of people of buying age and income own LTC insurance (LTCI), according to recent surveys and government data. Why is there such a disconnect, what can employers do to help solve the problem, and how does LTCI provide one more way to attract and retain top talent?

LTC is a growing concern because of escalating costs and because people are living longer. As they age, people become more likely to need help with two or more of their routine daily activities, such as dressing, eating, bathing, walking, toileting or getting in and out of a chair or bed. The need is more likely to impact women than men due to their longer life spans. But it is important to note that LTC is not just for the elderly: 40 percent of those receiving LTC services are between the ages of 18 and 64, according to the Robert Wood Johnson Foundation.

Despite the need, most people do not purchase LTCI for a variety of reasons, including cost, belief they will not need LTC services, uncertainty about when to purchase a policy, and lack of complete information provided to them. People usually become more motivated to seek coverage after a family member needs a nursing home or other LTC assistance and they become aware of the high costs ( average of $91,000 in 2015, according to a 2017 study by Genworth). Or, employees become more motivated after they have a medical issue that creates a concern. However once a significant medical issue occurs, it may become more difficult or very expensive to obtain coverage. Employer-provided health and disability insurance policies do not cover LTC costs.

Employers can help significantly by doing some of the vetting of LTC carriers and products and making them available on a voluntary, employer-paid, or employer-subsidized basis. Studies by LIMRA, an industry research firm, show that 59 percent of employees prefer buying insurance at their workplace. An employer-sponsored program can be offered to all employees as well as their family members. Spousal and marital discounts may apply and the policies are generally 100 percent portable, meaning the employee can choose to take over premium payments and retain the LTCI upon separation from the employer.

If the employer pays for the coverage for 10 or more qualifying employees (possibly as a perk for key employees), the program may qualify for certain additional advantages, including simplified underwriting, which typically results in 90 to 95 percent approval, a standard health class for all approved applicants, a unisex rate structure and reduced premiums. Furthermore, the bank has the option of purchasing bank-owned life insurance (BOLI) to offset and recover any expenses it incurs in providing LTC benefits.

Current tax rules encourage the purchase of LTCI, with the largest tax benefits afforded to employer-provided policies. Generally, employer-paid premiums are deductible to the employer while being excluded from the employee’s taxable income. In addition, the employee is not taxed on LTC benefits received, up to certain limits.

As co-author of this article and someone with two parents who needed nursing home care, I (David Shoemaker) can attest to the value of LTCI and am grateful my parents purchased it while they were young. LTCI allowed for better care for them and kept their retirement assets mostly intact.

By offering LTCI, the bank can fill a need in its benefits portfolio, making it easier to attract and retain top talent.

2018 Compensation Survey: Board Composition a Key Issue

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compensation-6-4-18.pngAn effective board starts with having the right members, making board composition a key issue for today’s banking industry. Forty-five percent of the directors and executives responding to Bank Director’s 2018 Compensation Survey, sponsored by Compensation Advisors, a member of Meyer-Chatfield Group, say that developing a board succession plan is a top challenge related to board composition, followed by the recruitment of tech-savvy directors, at 44 percent.

More than 200 chief executive officers, human resources officers, senior executives and board members participated in the survey, conducted in March and April 2018, which examines the talent challenges faced by the banking industry. The survey also includes data collected from proxy statements to reveal how—and how much—CEOs, directors and chairmen were compensated in fiscal year 2017.

Thirty-five percent of respondents cite the recruitment of female directors as a top board challenge, an area where the industry appears to have made some improvement. Seventy-seven percent of respondents indicate that their board has at least one female member, up from two-thirds last year. However, boards still have progress to make, with just 14 percent indicating that their board has three or more female members. And boards still struggle to represent diverse ethnic backgrounds—77 percent report that their board doesn’t have a single ethnically diverse director. They also need to gain more age-diverse views, with just 16 percent reporting they have a director who is aged 40 years old or younger.

Conducting an effective board evaluation—which rates the effectiveness of individual directors, as well as the board—is cited by 42 percent as a top governance challenge. Board evaluations are often touted as effective tools to fuel board diversity efforts, because they identify ineffective directors and help push them out of the boardroom, leaving empty seats to be filled with the skill sets, expertise and backgrounds needed by today’s board.

Other key findings:

  • Commercial lenders remain in high demand, cited by 68 percent of respondents as an area where they expect to actively recruit employees in 2018, followed by technology, at 38 percent.
  • Forty-seven percent indicate their bank has increased salaries over the past three years to attract younger talent. Twenty-seven percent offer more equity compensation or profit-sharing incentives.
  • Forty-four percent indicate their bank has dedicated more resources to train young employees. Overall, 80 percent offer external training as a benefit to employees, and 74 percent say their bank has an in-house training program.
  • The median age of a bank CEO is 58 years old. The median CEO salary in FY 2017 was $370,232, with total compensation at $621,000.
  • Paying board members appears to be a low-level concern: Just 14 percent indicate that offering a competitive director compensation package is a top challenge faced by the board.
  • Seventy percent of non-executive chairmen and outside directors receive a meeting fee, at a median of $1,000 per board meeting in FY 2017. More than three-quarters of non-executive chairmen, and 71 percent of outside directors, receive an annual retainer, at a median of $35,000 and $24,000, respectively.
  • Fifty-one percent most recently increased director compensation in 2017 or 2018, and one-quarter raised director pay in 2016.

To view the full results to the survey, click here.

Competition for Credit Analysts Creating New Challenge for Banks

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analyst-5-3-18.pngSuccessfully recruiting a qualified credit analyst is proving to be quite a challenge in today’s banking environment. There are a number of contributing factors, including compensation compared to other industries, the evaporation of commercial credit training, and a lack of college graduates in certain areas.

With this shortage, credit analysts are highly sought after, and analysts are demanding higher wages than what the banking industry is accustomed to paying.

In the past, it has been common practice for banks to outsource loan review, compliance testing, and internal audit functions — so why not the credit analyst role?

Thin talent pools flow two ways
Historically, banks have hired recent college graduates as credit analysts with the expectation of developing them into commercial lenders and potentially future management. In theory, this practice makes sense. But in today’s market, the success rate of banks converting a credit analyst into a long-term employee seems to be the exception rather than the norm, causing many banks to abandon their commercial training programs.

Over the past decade, many banks have begun hiring seasoned credit analysts who aren’t looking to move to a customer-facing role, making it more difficult to find affordable, permanent analysts.

In recent years, outsourced providers have started meeting the demand for credit analysts. With the increase in compensation for this role, outsourcing may now be the cost-effective option. This is especially true when you factor in the time and effort spent recruiting and training, while accounting for increased efficiency or production from an experienced analyst/outsourced provider.

Banks Still Have Underwriting Control
It is clear many bankers do not want an outside vendor impacting their underwriting decisions. Banks want to make loans to familiar borrowers, and they don’t want the potential for an overly critical or negative analysis from a third party to hinder their ability to do so.

It’s important to understand that your bank will always own and control the underwriting process. The primary focus for outsourced credit analyst services is to provide all the relevant credit information in a consistent format, which will allow the bank to make a well-informed decision. Outsourcing credit analysis should not impact the bank’s underwriting practices.

Banks take pride in their ability to provide quick responses to their borrowers. Outsourcing analyst work doesn’t mean longer turnaround times. If you are considering an outsourced solution, make sure that you establish clear deadlines with your vendor.

You could also consider segmenting the credit analyst work flow between new credit requests and ongoing portfolio monitoring. It may make sense for a bank to analyze new money requests in-house, and then to outsource the less time-sensitive renewal requests and annual reviews.

Training, Retaining Analysts Can Cost You
Even if you are successful in hiring a qualified analyst candidate, the time and resources needed to properly train a new hire with little or no previous credit experience can be quite extensive. Typically, when a bank is large enough to have a pool of credit analysts, there is usually a full-time employee who helps train and develop their skill set. But if you work at a smaller community bank, you might only have one or two analysts on staff.

It is common for a senior analyst, credit officer, or a manager from the credit administration area to oversee a new analyst. But these employees usually maintain a full workload in addition, which may result in inadequate training, or an overstressed manager.

The challenge doesn’t end once you hire and train a new credit analyst. One of the biggest challenges still remains — keeping the analyst in the role. Most banks are lucky if they can keep an analyst in the role for two or three years before the individual leaves for higher pay or a more satisfying analyst role somewhere else. And then it’s time to start the recruiting and training process all over again.

At the end of the day, banks want a viable option to end the what seems like a revolving door of credit analysts. By outsourcing this role, banks have new opportunities to provide cost savings and improve quality for their customers.

The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, investment, or tax advice or opinion provided by CliftonLarsonAllen LLP (CliftonLarsonAllen) to the reader. For more information, visit CLAconnect.com.

Team Lift-Outs: Compensation to Entice and Integrate Revenue Producers

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A “lift-out” is often used to describe the hiring of a group of individuals from the same company who have worked well with each other and can make an immediate and long-term contribution. A successful lift-out can create financial gain or provide competitive advantage such as replacing or crowding out a competitor. It can help expand the bank’s geographic markets or solidify its existing footprint.

Lift-outs, however, are not without risk. Management that becomes too enamored with a team can overlook essential steps required to determine whether it would be accretive. Inadequate due diligence or simply “paying up” on compensation without having a reasonable understanding of the expected results can cause a myriad of issues. In order to mitigate the risk, bankers should follow a standardized process, as outlined below:

Stages of a Successful Lift-Out

Initial Conversation Due Diligence Team Transfer Cultural Integration
Bank and team leader discuss potential market opportunities and competitive advantages. Team leader gauges interest of other members, develops market projections and business plan for the bank’s review. Both sides investigate reputation, culture, resources and viability of a union. Team joins bank and transfers client relationships in accordance with any contractual agreements. The bank plans for and announces the acquisition of the team internally and externally. The team, which is now on the bank’s operational platform, becomes fully integrated and establishes relationships with other groups within the bank.

The compensation structure for the lift-out team should also support the four stages:

During the Initial Conversation stage, discuss high-level compensation expectations. Often, these conversations provide insight into the team’s current compensation levels and programs. It can help the bank determine whether the team can easily fit into the current compensation structure or whether additional compensation is required to entice the team to come onboard. If additional compensation is required, it is important to determine (i) how much?, (ii) in what form?, (iii) for how long?, and (iv) whether it will create any internal equity or pay compression issues for existing talent.

During the Due Diligence stage, the bank must determine compensation levels that are commensurate with the economic value of the lift-out. Understanding the amount and the timing of each team member’s individual production is essential. It can also help the bank make the determination about which team members are essential and truly accretive. Determining the expected production streams can help determine who needs a compensation package outside of the current structure and who within the team could readily be integrated into the current structure.

It may be helpful to create a program where the additional pay phases out over a period of time or is only paid if the individual (or team) meets the production expectations agreed on at the time of the lift-out. For example:

  • Special equity awards could vest based on the achievement certain levels of production within a specified period of time or could cliff vest (e.g., after 3 years) providing time to assess talent prior to vesting
  • Special bonuses could be paid if certain levels of production are achieved.

During the Team Transfer stage, care should be taken to address any internal equity concerns and ensure that non-competition/non-solicitation commitments are upheld.

Possible rationales for accepting differing levels of compensation among like positions could include the limited nature or timing of the differences or the financial impact of the additional revenue stream.

Revenue producing roles are increasingly subject to non-competition and non-solicitation agreements. To avoid litigation, it is extremely important to ask lift out team members for any documents that involve their interaction with clients or the solicitation of former employees. The bank should review these and seek the advice of legal counsel.

During the Cultural Integration Stage, the Bank should assess whether pay differences should (a) remain given the structure and/or economics of the team or (b) be discontinued.

Maintaining pay differences makes sense if the team continues to outperform or if the group is highly-sought after by other institutions. However, if the results are commensurate with those in similar roles, it may become increasingly divisive to maintain special programs. Integration into the existing pay programs is a more natural choice.

In summary, team lift-outs provide a way for banks to accelerate growth by acquiring, rather than developing, proven revenue producers. Thoughtful management of compensation during the stages of a lift-out ensures that individuals are enticed to move and are motivated to produce for the bank.

Clawbacks Are Coming. Are You Ready?

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clawbacks-8-1-16.pngFive years after the passage of Section 954 of Dodd-Frank adding new provisions on clawbacks, we expect the Securities and Exchange Commission (SEC) to make some minor adjustments to its proposal and adopt a final rule before summer’s end.

The proposal, which would amend Section 10D of the Securities Exchange Act of 1934, shifts responsibility for recouping excess compensation from the SEC to the registrant, creates a non-fault standard as opposed to the Sarbanes-Oxley “misconduct” standard, extends the clawback period to three years and significantly expands the number of executives subject to its reach. Almost all issuers publicly registered with the SEC, including smaller reporting companies and current or former executive officers, are covered. Small and emerging companies, which previously were exempt under Reg SK from making detailed compensation disclosures, will shoulder a disproportionate burden.

Which Officers Are Subject to Section 10D Clawback?
Unlike Sarbanes-Oxley, which only applies to the CEO and CFO, the proposal uses the definition of executive officer from Rule 240.16a-1. It includes principal officers as well as any vice president in charge of a principal business unit, division or function and any other persons who perform similar policy-making functions for the registrant.

What Triggers a Clawback?
The law requires that the company recoup excess compensation received during the three-year period prior to the date the issuer is required to prepare an accounting restatement. Again, unlike Sarbanes-Oxley, no misconduct or error on the part of the executive need be shown. The accounting restatement is the triggering event.

What Type of Compensation Is Subject to the Rule?
The proposed rule applies to all “incentive-based compensation,” which is defined as any compensation that is granted earned or vested based wholly or in part upon the attainment of any “financial reporting measure.” A financial reporting measure is defined to mean any measure derived wholly or in part from financial information presented in the company’s financial statements, stock price or total shareholder return. This is an expansion of the language of Dodd-Frank which states that the law applies to incentive-based compensation that is based on financial information required to be reported under the securities laws. The proposed rule excludes by its terms salaries, discretionary bonus plans, time-based equity awards or other payments not based on financial reporting measures, including strategic or operational metrics.

What Is Excess Compensation?
Excess compensation is defined to be erroneously awarded compensation that the officer receives based on erroneous information in excess of what would have been received under the accounting restatement. Examples include unexercised options, exercised options with unsold underlying shares still held and exercised options with underlying shares already sold. Similarly, all excess stock appreciation rights and restricted stock units awarded must be forfeited and if already sold, any proceeds returned to the company. The clawback would also apply to bonus pools and retirement plans based on the attainment of financial metrics. What should be emphasized is the law and proposed rule leave almost no discretion to the company. Clawback is mandatory except in cases where the pursuit of recovery would be futile or counterproductive.

What Is the Tax Consequence of a Clawback?
What is particularly troublesome is the tax complications. The most common problem is likely to be that the employee will be taxed fully on the original income. When income is paid back in a different tax year, it will be treated most likely as a miscellaneous itemized deduction and its full deductibility will be subject to whether the taxpayer has sufficient deductions to equal or exceed the 2 percent threshold of adjusted gross income. A clawback could have the effect of penalizing the employee through no fault of his own beyond the amount received.

How Should a SEC Registered Bank Adjust Its Compensation Approach?
Banks which may qualify to deregister should consider it. For companies that desire to remain registered or who have no alternative, then executives should consider purchasing insurance products with their personal funds to hedge against an unexpected loss of income already earned and spent. The SEC rule does not permit the issuer to indemnify or purchase insurance for the executive to cover clawbacks. What is unfortunate is that onerous rules governing circumstances out of the control of most executives only makes performance-based incentive compensation less desirable.

The Elements of a Compensation Plan: What a Board Needs to Know

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5-25-15-BCC.pngReviewing compensation within an organization is an integral part of the board’s duties, but it can be challenging to get right. There are a number of reasons for this.

Philosophy
Compensation committees need to determine the bank’s philosophy regarding compensation. Will it be a zero-sum equation where paying more compensation creates fewer dollars for management and/or the shareholders, or an abundance mentality where paying for performance generates shareholder value? Having tension between the two is healthy for setting compensation practices correctly while maintaining balance.

Regulatory
One facet that overlays any compensation structure is regulatory constraints. Over the last decade, there have been three major regulatory pronouncements affecting how banks can structure compensation.

The first is the adoption of the Internal Revenue Code Section 409A, which prohibits the acceleration of payment of deferred compensation.

The second major regulation originates from the Dodd-Frank Act. Essentially, mortgage compensation incentives can only be paid based upon: (i) the dollar volume of the mortgage loans made; or, (ii) the transaction volume generated by the mortgage lender. However, the incentives can vary as to how much is paid to each lender on either method.

The third regulation adopted is the Interagency Guidance on Sound Incentive Compensation Policies effective June 25, 2010. In the guidance, policy steps are set forth that require incentive compensation to be structured to balance the risk to the institution of such incentives, and the guidance dictates that boards are responsible for reviewing this.

Delivery
In what form will your bank deliver compensation? The following are some major ways that banks pay their executives.

Non-statutory stock options
Non-statutory options (NSOs) can be granted to just about anyone. It is not unusual for a participant to fail to realize that not only must they have sufficient funds to purchase the stock, but that there will be ordinary taxation on the gain in stock value from the exercise price for the shares compared to the fair market value of the shares at exercise. In addition, the participant will also owe Social Security and Medicare taxes on the gain.

Incentive stock options
Incentive Stock Options (ISOs) have the benefit of being taxed as capital gains upon the sale of the purchased shares for the gain over the exercise price. However, there can be one surprise in the way of alternative minimum tax (AMT).

Restricted stock
Restricted stock has become more popular as a delivered component of compensation since restrictions come with the grant of the shares. Unlike options, which do not have restrictions once the options become exercisable, restricted shares often carry a restriction as to when they can be sold. This avoids the potential of a quick sale that can occur with options, leading to volatility in the stock price and negative news when investors and others learn of executive sales of stock.

Deferred compensation
Many banks will use nonqualified deferred compensation to recruit, reward and retain key executives in various formats because plan design can be very flexible, structured as defined contribution or defined benefit plans. With closely-held organizations, the shareholders are not subjected to dilution of ownership with deferred compensation as it is accrues through the financial statements. Also, unlike the equity components previously mentioned, shareholder approval is not required. Programs of deferred compensation require board approval. There are various types of deferred compensation programs including, but not limited to, Supplemental Executive Retirement Plans (SERPs), deferred incentives, deferred grants, phantom stock, stock appreciation rights and elective deferrals.

BOLI
While it might appear that deferred compensation is expensive because the entire value of any program generates expense to the bank, often bank-owned life insurance (BOLI) is utilized as an asset to offset or recover the cost incurred by the deferred compensation. This happens in two ways. First, the interest earned while the BOLI contracts are owned informally counterbalance the expense of a deferred compensation program. Second, if the participant meets an untimely death, the death benefit the bank receives in addition to the return on its investment is available to offset the additional expense to complete the accrual of the deferred compensation benefit, so that such benefit can be paid in full to the employee’s beneficiaries.

While the components of compensation are numerous, banks can use the various components for certain tiers of executives within the organization. Further, no single component discussed is superior to the other. Each has its advantages and disadvantages, and can be tailored to the bank’s needs.