Compensation Issues That Can Determine the Success of Your Acquisition


compensation-9-6-17.pngMergers and acquisitions continue to be an important business strategy for many community and regional banks. The compensation areas that receive the most attention are change-in-control (CIC) related severance payments and the equity holdings that typically increase in value upon the change. The CIC severance payments that are covered under employment and severance agreements are often estimated and are frequently a part of the conversation prior to the actual CIC. Equity and deferred compensation programs that have accelerated vesting upon a CIC are also generally reviewed ahead of time. The executive groups that have these compensation programs get plenty of attention from the key parties involved in a transaction. However, there are also many non-executive related compensation issues that can have a big impact on the ultimate success of a merger or acquisition.

Once the transaction is complete and the executive related compensation payouts have been settled, there is a combined organization that needs to operate successfully. It is possible that the two organizations had significantly different compensation philosophies in place and one of the key first steps is to clearly identify and communicate the compensation philosophy of the merged bank going forward. For example, if one organization believes in leading the market and the other likes to “lag” the market on pay, you’ll need to determine the future direction. A strong compensation philosophy that guides the compensation decisions and clearly communicates the preferences of the organization will help accelerate the pace of the transition.

Additionally, the combined organization will need to determine the appropriate market benchmarking data to utilize. The bank is now larger following the the transaction and this creates a situation where new peers may be appropriate and new benchmarking surveys or data cuts may be necessary. The bank may have expanded into new states and/or regional markets, which impacts the external market benchmarking process. It is critical to identify the appropriate market data to use for external benchmarking and market competitiveness.

Another potential challenge after an acquisition is the possible need to combine and/or introduce formal salary grade structures. If both organizations had a salary structure system in place there will need to be a determination on whether adjustments need to be made to the future structure. If one organization did not have any salary grades in place, then they will likely need to be introduced to the concept. It can take some time to educate managers and employees as to how these salary systems work. The bank should have a non-discriminatory, market competitive, easily manageable and communicated salary structure to use.

Another common challenge is the realization that the actual pay ranges for certain positions within the combined organization are significantly different. This could be attributed to the differing compensation philosophies of the organizations, differing market locations and competitiveness, or simply differing pay practices that have developed over time. The first step to resolving these potential issues is to review the various positions and identify the significant pay differentials that exist. After identification, the challenge is to assess why the differences have occurred and if there isn’t a clear reason—for example, a geographical differential like a rural versus urban location–then the tough part becomes what to do about these internal pay differences. For example, should the pay grade be changed and/or different levels created for a job title?

Possibly the most significant challenge after a transaction is the combination and/or introduction of incentive-based pay methodologies. Most likely there are some differences in place between the two organizations. One may have a completely discretionary system and the other a true performance-based system. These differences often lead to cultural challenges, because formal systems generally emphasize the importance of pay for performance more heavily than discretionary systems. If both banks have formal performance-based incentives in place, then the challenge will be combining the plans and identifying the key differences that need to be resolved. Examples of differences would be the award opportunity levels, participants included in the various tiers and plans, types of goals used, documentation of the plans, and the award tracking systems in place. Someone will need to review the various incentive plans and determine how to best mesh the current practices for the future.

There are a number of compensation related challenges that can impact a successful merger. The challenges spread beyond the executive related severance payments, and continue well after the change-in-control event occurs. Careful consideration and planning should be used to harmonize differing compensation philosophies and practices through the compensation landscape of the combined entities. Compensation philosophies need to be reviewed, salary structures and market benchmark methodologies may need adjustment, and incentive plans will need to be combined or revamped. Finally, a timeline and communication strategy will need to be developed to ensure a successful compensation environment going forward.

A Cautionary Tale for Compensation Committee Members


committee-8-25-17.pngThe Office of the Comptroller of the Currency (OCC) recently took an enforcement action in the form of a consent order against a bank director that serves as a cautionary tale for the banking industry. The consent order, agreed to by and between the OCC and a director and former senior vice president of a small national bank in Wisconsin, reminds bank boards of directors of their fiduciary duties with respect to executive compensation and the consequences of breaching those duties. In particular, this action puts board compensation committee members on notice that they may be found liable for unsafe or unsound executive compensation practices that occur on their watch.

Enforcement Action Details
The consent order described that the director had a longstanding affiliation with the bank, serving in multiple operational positions throughout her tenure, culminating in her election to the bank’s board of directors in 2005. Despite these 32 years of service, the OCC’s findings in the consent order focused on the director’s relatively short period of service on the board’s executive compensation committee, where she served from 2010 to 2013.

During this period, it appears, based on a notice of charges issued in 2016 and a $1.6 million civil money penalty issued in 2017—both against the bank’s former chief executive officer (who also held the titles of president and chairman of the board)—that this individual abused his power and used it to reap excessive compensation from the bank. In particular, the notice of charges cited a report finding that the former CEO “was a dominant influence in all aspects of bank operations,” which ultimately led to insider abuse with respect to compensation and breaches of his fiduciary duties.

Based on such abuse and the resulting action against the former CEO, the OCC apparently then turned its attention to the director. Indeed, the consent order identified the director’s conduct during the period of 2012 to 2013 as the relevant period leading to the issuance or the consent order. During this time, the OCC said that the director failed to do the following:

  • Oversee or control the use of bank funds by its former CEO for his personal expenses despite knowing that he had previously used bank funds for personal expenses.
  • Ensure that disinterested and independent directors determined and approved the compensation of the bank’s former CEO, thereby allowing him to receive excessive compensation.
  • Recuse herself from voting on the bank’s former CEO compensation even though she had a conflict of interest because he was personally indebted to the director and her husband in an amount exceeding $2 million.

Based on these failures as a member of the board’s executive compensation committee, the OCC concluded that the director engaged in conduct satisfying 12 U.S.C. 1818(i) and ordered her to pay a civil money penalty in the amount of $5,000.

Takeaways for Bank Directors
As banks continue to report an uptick in regulatory inquiries and examination findings focusing on executive and incentive compensation, agency enforcement actions relating to compensation issues may become more common in the coming years. This is a trend that is developing even in the face of recent reports that some of the federal banking agencies are likely to postpone consideration of currently proposed regulations regarding incentive compensation required under the Dodd-Frank Act.

Boards should utilize this trend and the lessons learned from the consent order as a reminder to periodically review compensation arrangements and compensation standards at their bank to ensure they are adequately fulfilling their fiduciary duties. Such reviews should critically analyze executive and incentive compensation arrangements and seek to ensure that bank and board policies governing such arrangements meet regulatory expectations. In addition, boards should periodically inquire about and analyze any relationships board compensation committee members may have with senior management to be able to confirm the independence of the committee members.

Compensation Planning In Today’s Talent Market



How do banks attract young employees and retain key executives? David Fritz Jr. and Patrick Marget of Executive Benefits Network explain that bank compensation plans should appeal to multiple generations and outline how Bank-Owned Life Insurance (BOLI) can offset compensation costs.

  • Challenges in Attracting & Retaining Employees
  • Focusing on Long-Term Incentives
  • BOLI’s Role in Compensation Planning

Reward Key Officers with a 401(k) Look-Alike Plan


compensation-6-15-17.pngCompensation is one of the most effective tools in motivating executives to higher levels of performance. However, in today’s market, the compensation committee and the board have a variety of alternative compensation approaches to select from to most effectively attract, motivate and retain executive talent. Banks are seeking maximum performance from executives while executives are seeking income and, especially, retirement security.

Although most banks do a fully satisfactory job retaining solid performers by paying competitive salaries and bonuses, they are uncertain what to do when it comes to providing something truly special for their top executives while, at the same time, prudently managing expenses to protect the interests of shareholders.

Saving for Retirement
According to the trade association the Insured Retirement Institute, baby boomers are turning age 65 at a pace of roughly 10,000 per day, and if you’re a baby boomer who is fast approaching retirement, you might be wondering if you’re on target with your retirement savings goals.

Compounding the problem are IRS rules requiring no discrimination in favor of higher paid employees. Amounts that can be contributed to qualified retirement plans, such as 401(k) plans, are subject to statutory limits. The 2017 maximum pre-tax contribution is $18,000, with a catch-up contribution limit for employees aged 50 or older of an additional at $6,000. Therefore, qualified benefit plans do not fully meet the financial needs of executives because of their low limit on annual deferrals.

Today, financial planners, advisors, and consultants all seem to agree that retirees should plan for replacing 60 percent to 80 percent of preretirement income during the retirement period. While the right income-replacement ratio is highly dependent on a number of factors, most bank executives will not reach this level without help from nonqualified benefit plans.

401(k) Look-Alike Plan
One way banks can address these limitations is by offering a 401(k) look-alike plan. This nonqualified deferred compensation plan allows a select group of executives to make voluntary deferrals on a pre-tax basis with a matching contribution from the bank. Interest may also be credited to the executives account. Executives defer paying income taxes on money contributed now until retirement, a time when they may be in a lower tax bracket.

By tying the matching contributions to performance benchmarks, such as department and individual criteria, the executive is motivated to achieve higher results. When such plans are properly designed, if the shareholders do well, so will the executives. Note: As with any incentive-based compensation, matching contributions to the 401(k) look-alike plan should not provide executives with incentives to take imprudent risks that are not consistent with the long-term health of the bank.

Deferring income into nonqualified plans does have its disadvantages. For the bank, nonqualified plans—unlike their qualified counterparts—are not favored by a current tax deduction. The tax deduction is delayed until the officer receives the benefit.

There is also risk because nonqualified plans need to remain unfunded to achieve the desired tax deferral. A nonqualified plan must remain just a promise to pay a retirement benefit. It is a liability on the bank’s books and nothing more. In the event of bankruptcy or company takeover, executives in the plan stand to lose some or all of the money in the nonqualified plan.

Summary
Knowing that retirement security is a primary concern of your executives, it may be time for your bank to rethink its approach to executive compensation. By adding a 401(k) look-alike plan, the ability to attract and retain talented executives will be greatly enhanced.

Why You Still Can’t Ignore Succession Planning


succession-6-13-17.pngIn the evaluations that Bank Director conducts on behalf of bank boards, it’s common for directors to voice their dissatisfaction and uncertainty regarding succession planning, particularly for the chief executive. So I wasn’t too surprised to find in Bank Director’s 2017 Compensation Survey that almost half of the responding directors and senior executives of U.S. banks report that their bank hasn’t identified a successor or potential successors to replace the CEO.

The trials and tribulations of developing a successor is a problem faced by banks of all sizes: JPMorgan Chase & Co. announced on June 8, 2017, that its chief operating officer, Matt Zames, decided to leave the bank after 13 years. Zames was viewed as a potential successor to CEO Jamie Dimon.

Fifty-three percent of survey respondents say they don’t have a successor identified because the current CEO doesn’t plan to retire soon. One-quarter say they have a young CEO. Other than not knowing who’s going to captain the ship when the top executive gets run over by the proverbial bus, the latter could be in for shock if their young CEO leaves their bank for greener pastures at a larger institution.

The end result could be messy for unprepared institutions, no matter the age of the CEO. “A bank that needs a successor is willing to do whatever it takes to get one,” says Flynt Gallagher, president of Compensation Advisors, a member of Meyer-Chatfield Group. And that could include stealing yours.

Compensation Advisors sponsored the 2017 Compensation Survey.

Money, of course, goes a long way in ensuring the CEO stays on board. Ninety-one percent of respondents believe that their bank’s compensation package is competitive enough to retain the current CEO, or attract a new one. But for CEOs responding to that question, that approval drops to 78 percent—indicating a slight but visible disconnect between CEOs and boards.

How does your CEO salary compare?

  Median CEO salary, by bank size
  All banks >$5B $1B-$5B $500M-$1B <$500M
All regions $366,250 $826,731 $442,500 $320,202 $212,000
Southeast $310,000 $848,240 $481,750 $319,185 $190,000
MidAtlantic/Northeast $475,392 $735,000 $475,783 $360,000 $298,000
Midwest $300,000 $960,305 $371,502 $280,000 $208,000
West $436,000 $770,804 $438,500 $300,000 $213,000

Source: 2017 Compensation Survey
Regional definitions:
Southeast: Alabama, Arkansas, Florida, Georgia, Louisiana, Mississippi, North Carolina, South Carolina, Tennessee, Virginia, West Virginia
MidAtlantic/Northeast: Connecticut, Delaware, District of Columbia, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island, Vermont
Midwest: Illinois, Indiana, Iowa, Kansas, Kentucky, Michigan, Minnesota, Missouri, Nebraska, North Dakota, Ohio, Wisconsin, South Dakota
West: Alaska, Arizona, California, Colorado, Hawaii, Idaho, Montana, Nevada, New Mexico, Oklahoma, Oregon, Texas, Utah, Washington, Wyoming

The median salary reported for all CEOs was $366,250 for the fiscal year 2016, a 6 percent increase over the median salary reported for FY 2015. The salary median ranges from $212,000 for banks below $250 million in assets to $826,731 for banks above $5 billion.

This year, the survey reports that 80 percent of CEOs received a cash incentive in FY 2016, compared to 64 percent in last year’s survey. The overall median cash incentive paid to CEOs in FY 2016 was $131,697, a 155 percent leap from the previous year. Bank performance has continued to improve for the industry, leading to a larger bonus for their top executives. In a quarter-to-quarter comparison of return on average equity for the last two quarters of 2015 versus the same time period in 2016, banks in general across asset categories saw a lift in return on average equity (ROAE), based on data from S&P Global Market Intelligence. Bank stocks were also rising in December 2016 due to the so-called “Trump Bump” and optimism about the president’s agenda which includes deregulation for the banking industry, a cut in the corporate tax rate and an infrastructure spending plan.

“Since incentive compensation is typically directly tied to bank performance, and the overall performance of banks continues to get better, I would conclude that is what drove the increase,” says JR Llewellyn, senior vice president at Compensation Advisors.

Fifty-two percent report the CEO received equity grants, at a median fair market value of $240,160, a five percent increase from last year’s survey. Seventy-five percent received other benefits and perks, and 62 percent received a retirement benefit and/or nonqualified deferred compensation, which allows executives to delay part of their pay to a later date. This also delays the tax burden for the executive.

Banks rely on peer studies to evaluate and set pay levels throughout the organization. Peer groups—banks of a similar size, in a similar region and even with a similar business model—can help further benchmark pay practices. Bank Director’s survey finds that 93 percent of participants are confident that their compensation plans are on par with other banks. Smaller organizations below $250 million in assets express less confidence, with 24 percent saying their compensation plans are not competitive with other banks.

And in a competitive environment for talent, banks may wind up paying more for key executive positions. “We want to have really good people work for us,” says Glenn Parry, the senior vice president and director of human resources at $1.2 billion asset First National Bank and Trust Co., a subsidiary of Centre 1 Bancorp in Beloit, Wisconsin. He says that to do this, the bank is willing to pay more than what the competition pays for talent and has higher compensation costs as a result. In the past year, Parry’s bank has replaced a chief financial officer and investment officer, both of whom retired. “We were very successful in getting really good talent into those roles, well in our ranges of what we were paying,” he says.

The 2017 Compensation Survey was conducted in March and April of 2017, and surveyed 286 independent directors and senior executives of U.S. banks. Compensation data was also collected from the proxy statements of 108 publicly traded banks. The survey provides detailed information on CEO and board compensation packages.

2017 Compensation Survey: Procrastination About CEO Succession


succession-6-5-17.pngForty-eight percent of bank directors and executives—including chief executives, human resources officers and chief financial officers—say their bank does not have a successor to replace the CEO when the top executive retires or leaves, according to Bank Director’s 2017 Compensation Survey, sponsored by Compensation Advisors, a member of Meyer-Chatfield Group. Yet, just 17 percent say that developing a CEO succession plan is a top compensation challenge.

Twenty-nine percent of respondents expect their bank’s CEO to retire within the next five years. The median age for bank CEOs is 57 years, with 58 percent between the ages of 50 and 61, 26 percent between 62 and 73 years old, and 2 percent aged 74 to 86 years. Thirty-eight percent of respondents whose CEO is aged 62 or older have not identified a successor.

The 2017 Compensation Survey was conducted in March and April of 2017, and surveyed 286 independent directors and senior executives of U.S. banks. Compensation data was also collected from the proxy statements of 108 publicly traded banks. The survey provides detailed information on CEO and board compensation packages.

Banks below $5 billion in assets are less likely to have designated a successor or identified potential successors. Eighteen percent of respondents whose banks haven’t identified a successor—all from institutions below $5 billion in assets—say they lack the internal talent to take the place of the CEO.

Just 12 percent are willing to consider a candidate from outside the banking industry to replace the CEO. Respondents from publicly traded banks above $5 billion in assets are more likely to consider this type of candidate.

Key findings:

  • The vast majority—91 percent—believe the bank’s CEO compensation package is competitive enough to attract future CEOs or retain the current CEO. The median CEO salary for fiscal year 2016 was $366,250, with a median cash incentive of $131,697.
  • Of those who see room for improvement in the CEO compensation package, 67 percent say the bank needs to offer equity, and 22 percent say the bank should offer equity at greater levels. Fifty-two percent of all respondents say their CEO was awarded equity grants in FY 2016, at a median of $240,160.
  • Sixty-four percent believe that their bank’s compensation plans are not competitive with technology companies, but 93 percent believe they’re on par with other banks, and 70 percent believe they are competitive with other companies outside the banking sector.
  • Fifty-two percent say the bank offers both an in-house training program and external training options to develop executive-level skills. Eleven percent offer neither option.
  • One-third of respondents report that their bank has no women serving on the board, and just 13 percent have three or more female directors. Fifty-one percent say that their board seeks to be more diverse over the next two years.
  • Seventy-three percent believe that the board’s compensation structure is attractive enough to bring in new directors. Non-executive chairmen received a median of $50,782 in total compensation paid in FY 2016, and independent directors were paid a total median of $38,610. Forty-six percent report that outside directors receive no additional benefits or perks.

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

Dangling the Carrot: How Banks Can Approach Incentive Compensation


incentive-5-24-17.pngWith the dearth of talent at many community banks, particularly in the executive suite, it has become increasing important to make sure that key employees stay put and not pack their bags for the competitor down the street. It is one thing to tie up these executives with non-competition and non-solicitation restrictions, but finding that delicate balance between appropriately protecting the bank’s interests and over-reaching, thereby running the risk of unenforceability, can often be tricky. In addition, adopting a carefully drafted incentive compensation plan can have the benefit of not only improving executive loyalty, but also encouraging revenue-enhancing or other desirable behaviors.

Cash or Equity?
Each employee may be motivated by different things, so it is often difficult to gauge what will have the biggest impact from an incentive perspective. There a few things, however, that should be kept in mind in evaluating this decision:

  • Cash has the advantage of immediate gratification. Equity awards are often subject to vesting requirements and can be difficult to monetize due to the virtually non-existent markets for most community banks’ stock.
  • Because of the vesting requirement of equity, such awards have the advantage of providing a longer-term benefit to the bank, in that executives will be loath to leave while they hold unvested equity awards.
  • It can be difficult for both the bank and the executive to value equity awards, given the lack of an efficient market for the shares.
  • Any time stock is issued by a bank holding company, it must be issued pursuant to a registration statement with the Securities and Exchange Commission, or an appropriate exemption must be available. The most common exemption for equity incentive awards is Rule 701, which requires awards to be issued, among other things, pursuant to written compensatory plans.

Appropriate Triggers
There are endlessly creative ways that community banks and their compensation consultants use to determine incentive compensation awards. So much of this is driven by the types of behaviors that the bank desires to encourage. However, there are a few things to keep in mind as you decide how to design your particular plan:

  • Beware of the Wells Fargo effect. While it is not uncommon to tie awards to achieving certain revenue and sales metrics, it is important to have appropriate controls and/or claw back policies in place to recoup pay and discourage overly aggressive sales practices.
  • Avoid tying incentives to confidential supervisory information. Many banks want to tie incentive compensation to achieving certain examination findings or CAMELS ratings. However, regulators have consistently stated this is inappropriate on a number of levels, not the least of which is that they do not appreciate being one of the deciding factors in whether an executive gets a bonus or not.

Other Do’s and Don’ts

  • Revisit plans that have been in place for a while to ensure that they are Section 409A compliant. Section 409A of the Internal Revenue Code sets forth certain rules regarding the timing of deferrals and distributions with which non-qualified deferred compensation must comply. Non-compliance could have significant negative tax consequences on the employee and, potentially, the bank.
  • The worst time to adopt a new incentive compensation plan, particularly one that contains change-in-control provisions, is right before the board decides to put the bank up for sale. Doing so may be perceived by shareholders as a breach of the board’s fiduciary duties.
  • If any of the bank’s mortgage loan originators are included in the pool of executives entitled to participate in the executive compensation plan, additional attention will need to be given to ensure that any awards granted under the plan do not run afoul of the loan original compensation restrictions set forth in Regulation Z.

While it is certainly a good idea to make sure your most valuable assets—your executives—are protected, there are a lot of variables to consider in putting together incentive compensation plans, which should be carefully crafted to achieve the bank’s objectives while avoiding unintended consequences.

The Resurging Interest in Bank Supplemental Executive Retirement Plans


SERP-4-6-17.pngThe roller coaster ride in banking over the last eight to 10 years took another unexpected turn in November with the election results. The financial sector gained new life, bank stocks soared and community banks began to see the prospect of regulatory relief becoming a reality. Interest in de novo banks has been picking up, and the likelihood of interest rate increases and decent loan demand appear to bode well for banks.

With that as a backdrop, the need to retain key members of a bank’s management team has re-emerged. Loan demand is good, profits are rising, optimism regarding regulatory relief is growing and the need to stabilize the management team of the bank is on the front burner as the talent grab has begun to heat up. Comprehensive compensation plans that serve to retain, reward and appropriately retire management teams are back in the spotlight.

During the financial crisis, many banks maintained salaries, as well as short and long-term incentive plans. Qualified benefit plans were continued, though often temporarily curtailed. But one key element of retention and reward, non-qualified plans, were either terminated, frozen or not introduced at all. Supplemental Executive Retirement Plans, or SERPs, are some of the most common non-qualified plans. Since the financial crisis, SERPs have lately seen a resurgence due to their multi-faceted benefit to both the bank and executive.

Objectives of a SERP

  1. Retirement: Since inception, SERPs were designed to allow the company to provide supplemental benefits to executives whose contributions to traditional qualified plans such as 401ks and profit sharing plans were limited by the Internal Revenue Service or ERISA (The Employment Retirement Income Security Act). For example, the general employee base may be able to retire with 75 to 80 percent of final salary based on income from Social Security and qualified plans while the executive team was retiring at 35 to 45 percent from the same sources. In essence, those executives were discriminated against due to the ERISA and IRS caps. SERPs bridged the gap and allowed for the bank to provide commensurate benefits to key executives.
  2. Retention: SERPs are non-qualified plans. They do not have the restrictions of qualified plans regarding vesting terms. As a result, the bank can structure the terms in the SERP however they desire from a vesting perspective. For example, assume an executive is to receive $60,000 per year for 15 years in a SERP. If in year five, the executive gets an offer from another bank, depending on the plan vesting, the executive may be walking away from all, or a large portion, of their SERP benefit. That’s $900,000 in post-retirement income at risk. This deterrent becomes a “golden handcuff.”
  3. Reward: Banks can use SERPs whose value are determined based on performance measures. There may be a return on equity or return on assets threshold needed to get a minimum percentage of final salary from the SERP. That percentage would grow based on performance measures established in the plan.
  4. Recruiting: SERPs provide the bank a plan that attracts talent. If the target executive is working at an institution that does not provide SERPs, the plan becomes an added attraction to joining your organization.

Other Items of Consideration

Unfunded, unsecured promise to pay: It is important to note that non-qualified plans such as SERPs are balance sheet obligations of the company and must be accrued for under generally accepted accounting principles (GAAP). The plan is an unfunded promise to pay by the bank. As a result, if the bank were to fail, the executive would lose his or her benefit. The SERP benefit is often matched up with bank-owned life insurance (BOLI) to provide income to offset the SERP accrual. This is not a formal funding of the plan, but a cost offset.

Top-hat guidelines: Executives participating in a non-qualified plan must qualify under top-hat guidelines as provided under the Department of Labor. These guidelines are murky, and consider position in the organization, compensation, negotiating ability (with the bank) and number of participants as a percentage of full-time equivalents. If there is any concern about who can participate, it is best to have legal counsel review prior to implementation.

In summary, SERPs are back in favor. The practical need for equitable retirement benefits, as well as the ability to retain, reward and recruit all have been catalysts in the resurgence of SERPs in the banking marketplace.

Equias Alliance offers securities through ProEquities, Inc. member FINRA & SIPC. Equias Alliance is independent of ProEquities, Inc.

Understanding Your Bank’s Change-in-Control Severance Liability


severance-3-14-17.pngChange-in-control agreements, which provide a severance benefit to the covered executive in the event of an acquisition, are a common issue that must be addressed with in an M&A transaction. But while many bank CEOs and some senior executives have them, it’s not uncommon for boards to lose sight of just how expensive—and potentially troublesome—they can be if the compensation committee hasn’t been paying attention to that individual’s total compensation and benefit package. Here to explain how those problems can arise during an M&A transaction—and how they can be avoided—is Gary R. Bronstein, a partner at the law firm Kilpatrick Townsend. The following interview has been edited for clarity and length.

BD: How common are change-in-control contracts and who typically gets covered by them?
Before we get to contracts, let me explain that some banks have severance plans that are adopted pre-merger and spell out what kind of severance will be paid to all employees in the event that they don’t survive the merger. The benefit of having a severance plan in place is that it takes that issue off the table in merger negotiations.

Change-in-control contracts would be for those executives who aren’t part of a severance plan, if there is one in place. It would be unusual for the CEO not to have one. We also see agreements for other executives, depending upon the size of the institution.

It is common to have more agreements at a $10 billion bank compared to a $500 million bank. Many times, chief financial officers are covered, the chief lending officer—people that are part of the executive management team have agreements. Terms vary between three years, which is usually the max in terms of the amount of the payout, to one year.

BD: What benefits do they typically provide?
If it’s a three-year payout for example, it would provide for three times the annual pay in cash. There’s what’s called the 280G limit, named for a section of the Internal Revenue Code that provides for significant tax penalties if the payout exceeds 2.99 times the average of the executives’ W-2 income for the prior five years. (If the payment amount exceeds the 280G limit, then most of the payout is not deductible by the buyer and the executive is subject to an excise tax.)

The other aspect to this is that most of these agreements have what’s called a double trigger. The first trigger is an actual change-in-control event. The second trigger is that the employee is either terminated or constructively discharged, which means that the employee’s job changes in a material way. If both triggers are met, the executive can receive the payout.

BD: What’s the attitude of acquirers toward change-in-control contracts? Do they dislike them, or do they just see them as a cost of business if you’re going to do an acquisition?
It’s the latter. Particularly with experienced buyers, they look for it. It’s something they evaluate during the due diligence process, to determine the total cost and whether there are any 280G problems. That’s something that all buyers look to avoid. There are ways to structure around it. If the benefits exceed the 280G limit, then the buyer tries to get an agreement with the executives to live within the limit, but add a consulting agreement or a non-compete agreement to make the difference. It’s not a question of whether buyers like the agreements or not, it’s a question of how do you deal with it.

BD: Can they materially increase the cost of an acquisition?
In my experience, and I’ve seen statistics from compensation consulting firms, it’s going to vary depending upon the size of the transaction. But total change-in-control severance payments generally range somewhere in the 5 percent range of the deal price. And if they’re excessive, it can cause the buyer to either walk away or offer a lower purchase price.

BD: Have you ever seen an acquirer walk away from a deal because of these?
I’ve seen situations where negotiations have broken down because they were unable to structure around a 280G problem. That’s not typical and it puts the seller in a difficult position, because what you have is a situation where an attractive price has been put on the table and the board would be allowing the benefits to be paid to the insiders to get in the way of what would otherwise be in the best interest of shareholders. So, it’s almost always worked out, because it’s just too difficult for the seller to walk away from a deal under those circumstances. Also, if the severance payments are excessive, it exposes the seller’s directors to legal liability because the insiders are being unjustly enriched at the expense of shareholders.

BD: Is it true that sellers in an M&A transaction are sometimes surprised by the size of the required payouts in their change-in-control contracts? It’s as if they lose track of them.
I’ve had that experience in a number of circumstances. I think more often than not, the boards are aware of what they have, but there are certainly plenty of circumstances where they don’t. And what invariably happens is, an employment contract or a change-in-control agreement is put in place, and then other benefits are added down the road without proper advice being provided about what the consequences are of adding additional levels of compensation.

For example, a common pitfall that I’ve seen is that boards are unaware that any benefits that accelerate solely as a consequence of a change-in-control event are parachute payments under 280G. So, if you have a three-year payout under a change-in-control contract, but also have other benefits that will accelerate in the event of a change-in-control event, you will exceed the 280G limit.

It’s very common and appropriate to have equity benefits that are subject to a vesting schedule. And it’s also very common that the vesting schedule will accelerate in the event of a change in control. So that if you’re granting a large amount of equity benefits with a five-year vesting schedule, and there’s a change in control early on in that vesting period, you should be expecting a very large excess payment under 280G.

Most change-in-control agreements have what’s called a 280G cutback so that the maximum that an executive can receive is the 280G limit. So using a simple example, let’s say your 280G limit is $1 million and the value of the accelerated equity benefit is $500,000. What that means is: If your severance was going to be $1 million, your employment contract payment gets reduced from $1 million to $500,000. So it can be pretty significant.

The other situation we’ve commonly seen is an acceleration of non-qualified retirement benefits in a change in control. If you have a non-qualified plan such as a Supplemental Executive Retirement Plan that provides for a benefit to vest at age 65, or age 62, and you have an acceleration of that benefit upon a change in control for a 50- or 55-year-old executive, the amount of the accelerated benefit can be quite significant and exceed the 280G limit by a large amount.

BD: What advice would you give to a board if their CEO doesn’t have a change-in-control agreement and is pushing for one?
If it’s a CEO that you have a lot of confidence in and you expect to continue the partnership for the foreseeable future, it would be advisable to provide [for a change-in-control agreement]. Having said that, I think it would be important to evaluate what else the executive has in place. Because again, it is important to understand any potential 280G issues. So, if there are other accelerated benefits in the event of a change-in-control severance benefit, you’d want to make sure that both the compensation committee and the executive is fully apprised of what they have and what would happen in the event of a change in control.

The good news is that over time, the 280G issue generally gets better. As a vesting period on these various benefits mature, the change-in-control cutback reduces. But in the short-term, it can be very challenging. If you look at peer studies, you’re going to find that at least CEOs, but many times several other officers as well, have some type of change-in-control benefit in place. Therefore, if a compensation committee wants to offer competitive compensation, employment agreements are common.

Rewarding Executives for Successful Bank M&A


compensation-1-29-17.pngMergers and acquisitions (M&A) can create significant value for shareholders. Accordingly, bank executives should be rewarded when completing and integrating successful transactions. However, in today’s environment of heightened executive pay scrutiny, some approaches to providing additional compensation for M&A can result in criticism from shareholders and advisory firms such as Institutional Shareholder Services and Glass Lewis & Co. Clearly documenting the rationale of rewards and how they align with value enhancement can increase the effectiveness and shareholder support for such compensation.

Evaluate the Context

Roles of involved employees: While M&A activity is an expected part of some executives’ responsibilities, others may be required to go beyond their day jobs as part of the due diligence or integration processes. The extent of work required outside an employee’s normal responsibilities and job expectations should impact discussions of additional compensation.

Activities versus results: Another consideration is whether compensation should result from the additional, typically shorter-term activity during the M&A process or the actual longer term results of the transaction. In some cases, additional pay for transaction activities will be important to retain key talent who have been asked to go beyond their normal responsibilities. Larger, more significant rewards should depend on whether the merger produces improved bank performance and value creation.

Timing of additional compensation: Compensation can reward M&A results at different points during the transaction process. While the closing of the deal may be viewed as a trigger point for additional pay, the integration process is critical to ensuring the deal reaches its expected potential. Shareholders will be most concerned with the financial results generated from the transaction, and may be more receptive to additional compensation tied to the long-term financial impact of the deal.

Current programs: The current compensation program may already provide the opportunity to reward M&A, lessening the need for additional one-time pay that can be scrutinized.

Evaluate Rewards
There are many ways to reward M&A activity and results. Where possible, it is preferable to reward executives through existing programs, although special awards may be appropriate in some cases. Creating flexibility within the total pay program in advance of any transactions can help increase the number of tools the bank has to recognize executives. All of the potential components should be considered together since recognition may result from more than one of the following components:

Base Salary Adjustments: M&A activity can result in executives taking on new responsibilities, and pay increases may be appropriate. Since salaries can drive the size of incentive awards, considering the potential target total compensation of the new role can help ensure the executive is rewarded over the short and long-term.

Annual Incentives: Annual incentive plans can recognize short-term contributions and efforts during transactions and through integration. Depending on the plan’s structure, recognition could be incorporated as a component in a goal-based plan (i.e. based on strategic or individual performance) or as a consideration in a discretionary plan. Significant special cash bonuses solely for merger completion are not favored by shareholders.

Long-term Incentives: These programs are designed to recognize the long-term performance and value creation resulting from a company’s business strategy. Prior awards such as stock options and restricted stock will recognize stock price appreciation and shareholder views of the acquisition. Performance shares also recognize the long term value from successful transactions. The structure of the grant process should be considered. Is there flexibility to recognize individual contributions during the M&A process, for example, through a grant of stock? If so, this can be an effective way to reward contributions immediately, with compensation tied to shareholder value creation.

Special Awards: In some situations, additional, one-time awards may be appropriate. The best practice is to provide recognition in the form of long-term equity, preferably with some performance criteria or hurdle. This can help address concerns of some shareholders and advisory firms that are critical of M&A bonuses or grants.

Other Considerations: In more significant M&A transactions, it is appropriate to review the compensation peer group and assess whether compensation opportunities should be adjusted to reflect the new organization’s size and complexity. It is also important to monitor the pay-performance alignment over subsequent years to ensure compensation is appropriately recognizing performance.

Conclusion
Successful M&A, over the longer term, should result in commensurate rewards for the executives that execute the transaction. The key is ensuring that current pay programs have the flexibility to provide such recognition and that the pay levels, over time, are aligned with the company’s performance and shareholder value creation.