Why Purchase Accounting Matters So Much During a Bank Deal

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accounting-12-24-18.pngBank management must understand how purchase accounting works, how it can impact a transaction, and being involved can ensure all assumptions are complete and accurate. Here’s a specific look at interest rate mark and Core Deposit Intangible (“CDI”) purchase accounting analyses.

These analyses establish fair value of balance sheet assets and liabilities through a series of mark-to-market valuations. In addition to cost savings and transaction expenses, purchase accounting is one of the transaction adjustments that can have the largest impact on the metrics of a deal. Purchase accounting, however, is often seen as less straight-forward than other transaction adjustment components.

Overview of Mark-to-Market Impact of Assets and Liabilities
To evaluate and engage in discussions with a financial advisor, management must first understand the mechanics of interest rate mark adjustments. A premium on an asset marked-to-market will increase the value of the asset and in capital on day 1, which is then amortized through interest income over the remaining life of the asset. Conversely, a discount on an asset marked-to market will decrease the value of the asset and in capital on day 1, which is then accreted into interest income over the life of the asset. 

As an offsetting entry in purchase price allocation, the higher fair value of an asset the lower the amount of goodwill created. A premium on an asset will increase tangible book value per share (TBVS) but decrease forward earnings as the mark is amortized, while a discount on an asset will decrease TBVS on day 1 but increase forward earnings as the mark is accreted. Liabilities are intuitively the opposite of assets, with a premium resulting in a negative hit to capital on day 1, but lower forward interest expense over the life of the products. A discount will bolster capital on day 1 but will increase forward interest expense over time.

One item of note in the mark-to-market of loans is exit pricing. To represent additional risk assumed with a loan acquisition, an exit premium should be applied to each loan type and should capture a liquidity discount as well as an underwriting discount. Exit prices should vary by loan type. The liquidity and underwriting risk on a 1-4 family residential loan is very different than a speculative construction loan, and the different characteristics should be captured in market values and exit prices.

Publicly reporting institutions now have to to begin reporting the fair value of its loan portfolio under the “exit” price application, which illustrates the importance and proliferation of exit price methodology across the industry, not just in M&A transactions.

Land and buildings are assessed by comparing the net book value (with accumulated depreciation) against a third-party valuation. The mark on buildings will be accreted/amortized over the remaining life of the property.

The CDI takes into account the qualitative value of deposit relationships. There are multiple variables that can impact a CDI but the following provides an overview of major components: weighted average life of a product, cost of core deposit related activities, fee income on core deposits and alternative cost of funding and discount rates. The higher the values for any of these components, the higher the CDI. These variables may be offset by noninterest expense associated with core deposit related activities and the discount rate, for which higher values will reduce the CDI.

Management Involvement
Given the intricacies with mark-to-market purchase accounting, it is clear management should engage a financial advisor to explain the assumptions driving each adjustment and the impact. 

Mark-to-market purchase accounting is not something that should be approached only as a requirement of closing. The financial advisor in a transaction should also be conducting purchase accounting as part of due diligence.

If detailed purchase accounting is not occurring, there could be material marks not accounted for that can drastically affect the metrics of a transaction. Your financial advisors should on a regular basis explain the fair value assessment process and the methodologies.

Key Takeaways
Transaction adjustments are rarely detailed in pro forma analytics, which limits management’s ability to engage in meaningful conversation with its financial advisor. The best financial advisors provide a detailed breakout of all transaction adjustments to provide management with as much knowledge as possible. Without that, it is impossible for management to have the understanding required to ask important questions and actively participate in review of assumptions.

Always request full detail on all adjustments and to have management walked through each adjustment, along with the assumptions and methodologies used. Have calls throughout the process, and remember that fair value analyses are not reserved for closing. This should start early in due diligence. Interest rate marks and CDI can have a meaningful effect on the metrics of a transaction and, if not modeled properly, can create a misleading picture. It is crucial to first verify that the firm has the capacity to model with management and have a meaningful dialogue on critical assumptions.

These assumptions will make or break a deal and will continue drive the resultant entity’s accounting long after the transaction closes.

Talent Strategy: Fueling the Future

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A tight labor market could be big risk if your bank lacks the talent to fuel its future. How can bank boards and management teams manage this risk? In this video, Julia Johnson of Wipfli shares why your bank should conduct a human resources review and provides tips to help banks tackle the talent challenge.

  • Four HR Areas Bank Leaders Should Be Watching
  • How Boards Can Better Understand HR Portfolio Risk
  • The Impact of Today’s Economic Environment

Three Essential Ingredients of a Successful Integration

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integration-8-16-17.pngA successful merger or acquisition involves more than just finding the right match and negotiating a good deal. As essential as those steps are, effectively integrating the two organizations is equally important—and equally challenging.

When participants in Bank Director’s 2017 Bank M&A Survey were asked to name the greatest challenge a board faces when considering a potential acquisition or merger, 26 percent cited achieving a cultural fit between the two organizations as their top concern. Other integration-related issues, such as aligning corporate objectives and integrating technology systems, were also cited by many survey respondents.

Altogether, nearly half (46 percent) of the survey respondents cited integration issues as their leading concern—even more than those who cited negotiating the right price (38 percent).

Banks’ Special Change Management Challenges
As employees adapt to new situations, they must work through a series of well-recognized stages in response to change—from initial uncertainty and concern to eventual understanding, acceptance and support for new approaches. One objective of change management is to help accelerate employees’ progress through these phases.

In the case of bank mergers, however, there is a complicating factor—the required regulatory approval. Once a proposed merger or acquisition is announced, both banks must wait for some time—typically a period of five to nine months—before decisions can be announced and the transition can begin. These delays extend the period of doubt and uncertainty for employees, customers and other stakeholders, and can significantly impede employees’ progress through the normal change management stages.

Three Critical Components
Successful post-merger integration involves hundreds of individual management steps and processes, and the board of directors must oversee the effectiveness of the effort. Directors can implement a few measures to help make the process a smooth one without micromanaging each step. At the highest level, directors should verify that management has established an environment in which success is more likely. Three organizational attributes merit particular attention:

1. Clear, continual communication. Management must develop a detailed communication plan to make sure merger-related stakeholder messaging is timely and consistent. It should provide employees, customers, the community and other stakeholders the information they need to adjust positively to the merger. This plan should spell out key messages by audience, provide a calendar of events, and use multiple communication tools for each of the stakeholder groups. One tool that has proven useful for customers is a dedicated toll-free phone number, staffed by employees specifically trained to answer customer questions. For employees, bi-weekly email messages that describe the integration process and answer questions have proven very useful.

2. Sound, timely decision-making. Basic decisions about how the organization will be structured, who is on the executive team, and how the post-merger bank is going to operate need to be made as quickly as feasible—but without rushing. Striking the right balance can be difficult. Decisions about key operational issues, such as which technology platforms will be used and how business and operational functions will be consolidated, also must be made promptly—subject to the regulatory constraints mentioned earlier.

3. Effective, comprehensive planning. Based on the key decisions regarding the future organization, management should develop detailed plans for the integration. It is tempting to shortcut the planning process and just “get on with it”—especially in organizations that have gone through a merger before. But overconfidence can lead to complacency and missteps. Successful integrations often involve more than 20 individual project teams. Take the time to make sure each team is capable and prepared, has clear timelines and areas of responsibility and understands its interdependency with other teams.

Finally, board members and executives alike should make it a point to see that there is adequate and active contingency planning. When unexpected challenges or conversion mistakes arise—as they always do—the bank must be ready to move quickly and effectively to address the issues.

When It Comes to Core Conversions, Look Before You Leap

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core-conversion-7-13-17.pngChanging your bank’s core technology provider is one of the most important decisions that a bank board and management team can make, and even when things go smoothly it can be the source of great disruption. The undertaking can be particularly challenging for small banks that are already resource constrained since the conversion requires that all of the bank’s data be transferred from one vendor’s system to another’s, and even for a small institution that can add up to a lot of bits and bytes. Also, changing to another vendor’s core technology platform typically means adopting several of its ancillary products like branch teller and online and mobile banking systems, which further complicates the conversion process.

“It isn’t something to be taken lightly,” Quintin Sykes, a managing director at Scottsdale, Arizona-based consulting firm Cornerstone Advisors, says of the decision to switch core providers. “It is not something that should be driven by a single executive or the IT team or the operations team. Everybody has got to be on board as to why that change is occurring and what the benefits are…”

The Bank of Bennington, a $400 million asset mutual bank located in Bennington, Vermont, recently switched its core technology platform from Fiserv to Fidelity National Information Services, or FIS. President and Chief Executive Officer James Brown says that even successful conversions put an enormous strain on a bank’s staff.

“It’s not fun,” says Brown. “I have the advantage of having gone through two previous conversions in my career, one that was horrendous and one that was just horrible. [The core providers have] gotten better at it, but there’s no way to avoid the pain. There are going to be hiccups, things that no matter how you prepare are going to impact customers. There’s this turmoil, if you will, once you flip the switch, where everybody is trying to figure out how to do things and put out fires, but I will say [the conversation to FIS], in terms of how bad it could have been, was not bad at all.”

But even that conversion, while it went more smoothly than Brown’s previous experiences, put a lot of stress on the bank’s 60 employees. “There was a lot of overtime and a lot of management working different jobs to make sure our customers were taken care of,” he says.

Banks typically change their core providers for a couple of different reasons. If the bank has been executing an aggressive growth strategy, either organically or through an acquisition plan, it may simply have outgrown its current system. A lot of core providers can handle growth, particularly in the retail side of the bank, so that’s not usually the problem, Sykes says. Instead, the growth issue often comes down to the breadth of the bank’s product line and whether staying with its current core provider will allow it to expand its product set. When banks embark on a growth strategy, they don’t always consider whether their core data system can expand accordingly. “Usually they’re unable or just haven’t looked far enough ahead to realize they need it before they do,” Sykes explains. “The pain has set in by the time they reach a decision that they need to explore [switching to a new] core.”

Banks will also switch their core providers over price, especially of they have been with the same vendor through consecutive contracts and didn’t negotiate a lower price at renewal. “If any banker says price doesn’t have an impact on their decision, they’re not being honest,” says Stephen Heckard, a senior consultant at Louisville, Kentucky-based ProBank Austin.

Although the major core providers would no doubt argue differently, Heckard—who sold core systems for Fiserv for 12 years before becoming a consultant—says that each vendor has a platform that should meet any institution’s needs, and the deciding factor can be the difference in their respective cultures. And this speaks to a third common reason why banks will leave their core provider: unresolved service issues that leave the bank’s management team frustrated, angry and wanting to make a change.

“The smaller the bank, the more important the relationship is,” says Heckard. “When I talk about relationships, I’m also talking about emotions. They get played up in this. For a community bank of $500 million in assets, quite often if the vendor has stopped performing, there’s an emotional impact on the staff. And if the vendor is not servicing the customer’s needs in a holistic manner, and the relationship begins to degrade, then I do feel that eventually the technology that’s in place, while it may be solid, begins to break.”

Heckard says that core providers should understand their clients’ strategic objectives and business plans and be able to provide them with a roadmap on how their products and services can support their needs. “I don’t see that happening near enough,” he says. And if the service issues go unresolved long enough, the client may begin pulling back from the provider, almost like a disillusioned spouse in a failing marriage. “They may not be as actively attending user groups, national conferences and so forth,” Heckard says. “They don’t take advantage of all the training that’s available, so they become part of the problem too.”

Brown says that when Bank of Bennington’s service contract was coming up on its expiration date, his management team started working with Heckard to evaluate possible alternatives. “We needed to implement some technology upgrades,” he says. “We felt we were behind the curve. Something as simple as mobile banking, we didn’t have yet.” The management team ultimately chose FIS, with Brown citing customer service and cybersecurity as principal factors in the decision. The decision was less clear cut when it came to the actual technology, since each of the systems under consideration had their strengths and weaknesses. “I’m sure [the vendors] wouldn’t like to hear this but in a lot of ways a core is a core,” Brown says.

Heckard, who managed the request for proposal (RFP) process for Bennington, says that bank management teams should ask themselves three questions when choosing a new core provider. “The first one would be, have you exhausted every opportunity to remain with the present vendor?” he says. As a general rule, Heckard always includes the incumbent provider in the RFP process, and sometimes having the contract put out to bid can help resolve long-standing customer service issues. The second question would be, why was the new vendor selected? And the third question would be, how will the conversion restrict our activities over the next 18 months? For example, if the bank is considering an acquisition, or is pursuing an organic growth strategy, to what extent will the conversion interfere with those initiatives?

Heckard also covers the conversion process in every RFP “so that by the time the bank’s selection committee reads that document they know what’s ahead of them, they know the training requirements…they understand the impact on the bank.”

And sometimes a bank will decide at the 11th hour that a core conversion would place too much stain on its staff, and it ends up staying with its incumbent provider. Heckard recalls one bank that he worked with recently decided at the last moment not to switch, even though another vendor had put a very attractive financial offer on the table. “The president of the holding company told me, ‘Steve, we can’t do it. It’s just too much of an impact on our bank. We’ve got a main office remodel going on,’ and he went through about four other items,” Heckard says. “I thought, all of these were present before you started this. But sometimes they don’t realize that until they get involved in the process and understand the impact on their staff.”

Should the Wells Fargo Board Resign?

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resign-5-5-17.pngWhat’s the minimum percentage of votes a director should get at the company’s annual shareholder meeting?

At San Francisco-based Wells Fargo & Co.’s recent shareholder meeting held April 25 in Ponte Vedra, Florida, nine of the 15 directors won re-election with less than 75 percent of the vote, even though there were no other candidates. Three of them plus the current chairman, Stephen Sanger, won with less than 60 percent of the vote, following last year’s revelation that thousands of employees had sold customers more than 2 million unauthorized accounts over several years to meet aggressive corporate sales goals. Then-CEO John Stumpf lost his job, and as did Carrie Tolstedt, the head of retail banking.

The question now is whether directors will lose their jobs as well. Sanger acknowledged that the vote last month wasn’t exactly a home run for the board.

“Wells Fargo stockholders today have sent the entire board a clear message of dissatisfaction,’’ he wrote in a statement. “Let me assure you that the board has heard the message, and we recognize there is still a great deal of work to do to rebuild the trust of stockholders, customers and employees.”

There was no word on whether Sanger intends to step down soon, but he did tell reporters after the meeting that he and five other directors would retire during the next four years when they reach the board’s mandatory retirement age of 72. Sanger turned 71 in March.

Directors on other bank boards have taken the hint when shareholder votes showed a loss of confidence. Following JPMorgan Chase & Co.’s London whale trading scandal, two directors stepped down in 2013.

Receiving less than 80 percent of the vote in a no-contest election is a pretty clear sign of discontent, says Charles Elson, a professor of finance at the University of Delaware and the director of the John L. Weinberg Center for Corporate Governance. (He also happens to be a Wells Fargo shareholder.) Most directors garner more than 90 percent of shareholder votes, he adds.

Some of Wells Fargo directors could barely get support from half the shareholders. “The vote is significant,’’ Elson says. “It’s probably time to refresh that board.”

The board’s own conduct may have raised further questions about whether members were fit to meet their responsibilities. A report compiled by Shearman & Sterling LLP, a law firm working for the board, said in April that the board wasn’t aware of how many employees had been fired for sales-related practices until 2016.

The Los Angeles Times first reported on the extent of the problem in 2013 in a series of investigative stories. In 2015, the city of Los Angeles filed a lawsuit against Wells Fargo related to the practices. [For more on how “Wells Fargo Bungled Its Cross-Sell Crisis,” see Bank Director’s first quarter magazine.]

“Sales practices were not identified to the board as a noteworthy risk until 2014,’’ the board’s investigation found. “By early 2015, management reported that corrective action was working. Throughout 2015 and 2016, the board was regularly engaged on the issue; however, management reports did not accurately convey the scope of the problem. The board only learned that approximately 5,300 employees had been terminated for sales practices violations through the September 2016 settlements with the Los Angeles City Attorney, the [Office of the Comptroller of the Currency] and the [Consumer Financial Protection Bureau].”

The report blames senior management, such as former CEO John Stumpf, a decentralized organizational structure and a culture of deference to the business units for missed opportunities in handling the problems sooner.

But the report also notes that the board could have handled things differently, by centralizing the risk function sooner than it did, for example. A decentralized risk framework meant the company’s chief risk officer was reduced to cajoling the heads of the different business units for information, each of whom had their own chief risk officers reporting to them. Also, the board could have required more detail from management.

Wells Fargo has lost unquantifiable sums in reputational costs and damage to its brand. It has paid about $185 million in settlements with regulators and recently paid out $142 million in a class action settlement with customers. It still is grappling with the loss of new customer accounts.

At this point, a board refresh—starting with the directors who polled less than 60 percent of the shareholder vote—might be the right signal to send.

The Resurging Interest in Bank Supplemental Executive Retirement Plans

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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.

Regulators Focus on Sales Practices: Responding to Heightened Scrutiny

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Regulators-2-13-17.pngFederal and state regulatory enforcement actions and unprecedented fines for alleged fraud—fraud that apparently originated with sales incentive compensation plans—have left bank executive management teams and boards wondering if the same thing could be happening at their institutions. These concerns are shared by banking regulators, as evidenced by the flurry of activity, including testimonies, speeches and information requests, in the fourth quarter of 2016.

Given the huge media attention to one bank’s alleged misdeeds, bank executive management teams and boards are wondering if the same thing could be happening at their institutions.

Excessive risk-taking, without proper risk management and controls, often has been cited as one of the root causes of the recession that begin in late 2007. Progress certainly has been made since the financial crisis, particularly in fostering a healthy compliance culture, committing to effective risk management and governance, and improving how customers are treated. However, the issues associated with sales and incentive plans have thrust these concerns back into the open to be scrutinized by the public, policymakers, law enforcement and regulatory agencies.

The 2010 Guidance on Sound Incentive Compensation Policies
In June 2010, the Office of the Comptroller of the Currency (OCC), the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision published their final Guidance on Sound Incentive Compensation Policies in the Federal Register. The guidance applies to all banking organizations supervised by the OCC, the FDIC and the Federal Reserve, regardless of the size of banking organization.

The guidance is based upon three key principles about incentive compensation arrangements, namely that they should:

  1. Provide employees with incentives that appropriately balance risk and financial results in a manner that does not encourage employees to expose their organizations to imprudent risks.
  2. Be compatible with effective controls and risk management.
  3. Be supported by strong corporate governance, including active and effective oversight by the banking organization’s board of directors.

The guidance, as well as other similarly focused rulemaking activities, clearly indicates that incentive-based compensation arrangements now are under the microscope. Every bank should review its incentive-based compensation arrangements to make sure they are in compliance with the applicable regulations.

What’s My Exposure?
Bank executives and directors who are trying to determine their entity’s exposure related to sales incentive programs need their bank to undergo a risk assessment focused on common activities that are aligned to their bank’s sales incentive practices. If the assessment reveals problems with improper behavior, the bank then must determine its level of exposure.

A comprehensive approach to assessing exposure should encompass the following high-level areas and analyze associated data at a level sufficient to identify whether improper behaviors are occurring:

  • Review accounts, products and services offered to consumers or small businesses through all channels (including branches, phone, internet and private banking).
  • Analyze incentive program payments by product or service provided.
  • Consider noncash incentive programs.
  • Ensure reports are issued by internal audit, front-line self-assessments or an external party that cover sales practices or account opening or closing procedures.
  • Establish policies, procedures and reports of concerns with sales practices or account opening or closing procedures resulting from employee terminations or exit interviews, whistleblower or ethics hotlines or consumer complaints.
  • Develop training program materials for employees who sell products and services.
  • Institute policies, procedures and detection controls specific to account opening and closing metrics.

It is important that assessment and data analysis activities include third-party risk management programs to identify and effectively manage risks related to third parties that are involved in opening and maintaining customer accounts.

In addition, banks should consider performing culture assessments to determine if there are conflicting elements or subcultures that are misaligned. Many banks change their cultures by sequentially aligning strategies, structures, processes, rewards and people practices.

Actionable Information
With assessment information in hand, executives and boards are better able to make informed decisions and take appropriate actions necessary to help protect the bank and its customers. Depending on the assessment results, the bank then might need to take the following steps to mitigate the risk:

  • Further investigate the areas for which the exposure assessment identifies improper behavior or potential fraud.
  • Test the design and operating effectiveness of existing controls to prevent and detect account origination, servicing and termination fraud as well as unfair, deceptive, or abusive acts and practices (UDAAP) within the sales process.
  • Develop and implement new controls within the sales, account origination, servicing and termination processes.
  • Review incentive compensation plans and their governance processes.
  • If necessary, reshape overall compensation plans to eliminate incentives that could lead to a higher likelihood of fraud and undue risk-taking.
  • Design and implement systems or functions to identify, measure, monitor and control risk-taking and standards of behavior.

Do Bank Management Teams Need to Change?

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technology-1-31-17.pngU.S. Bancorp’s retiring CEO Richard Davis said that just before walking on stage at Bank Director’s Acquire or Be Acquired Conference in Phoenix, Arizona, yesterday to give the keynote address, he had to check President Donald Trump’s twitter feed to make sure nothing had fundamentally changed about the banking landscape.

In a world when the president can change the rules of the game with a single tweet, sending a company’s stock price soaring or sinking in a single chirp, and where customer demands are changing in the face of game-changing technology, the management teams of the future may need to be nimbler than they might have imagined a decade ago.

Keeping up an environment like this is hard to do. But a growing recognition among many attending the conference was that banks were going to have to get more agile and accept changes to the way they do business.

Huntington Bancshares’ CEO Stephen Steinour said at the conference that he’s less worried about 10,000 fintech companies than by technology giants such as Apple and Google. “They have a capacity to invest at a level most of us in the industry can’t think about,’’ he said. “If we give up on payments, we have a huge challenge in the future.” Steinour said that online lenders have technology that banks can learn from. “Speed is important,’’ he said. “We are eminently capable of meeting those challenges and offering great customer service.”

Joshua Siegel, CEO of asset manager StoneCastle Partners, which invests in community banks, agreed that banks are probably more resilient than many people give them credit for. But he said that many banks have been slow to adopt technology and management teams are often a barrier to making changes.

U.S. Bancorp’s Davis said boards can have a role in this transition, by keeping up with changes in the industry and holding management accountable. Small banks have traditionally lagged big banks by a few years in terms of adopting technology, but in some cases this will no longer work, he said. “You can’t be OK with catching up two to three years later,’’ Davis said. “You can’t lag anymore.”

Some banks also are looking to hire workers who are comfortable with change, who are more comfortable with technology and could propel the bank forward. “We tell them the one constant here is change,’’ said David Becker, the president and CEO of the First Internet Bank of Indiana. “If you are uncomfortable with that, don’t waste your time or ours.”

But bank management teams might need to change how they operate, too. Younger generations are more racially and ethnically diverse, and they are more focused on having a career with a purpose, and more likely to leave when don’t feel their needs are met. Young people might be more receptive to banks as employers, despite the poor reputation banks received following the financial crisis, if they feel that banks are making a positive impact on their communities. Getting better at telling the story of how banks make a positive contribution to their economies is another way that bank management teams could influence the future of their institutions, Davis said.

Aside from being comfortable with a diverse workforce, Davis said he polled the executive team of the Minneapolis-based bank in terms of what they were looking for in future C-suite executives, and they came to the conclusion that a whole different set of qualities would be needed than what had been needed nine years ago. Back then, strategic thinking skills were a major requirement. Now, his bank also needs managers who are great communicators.

“If you can’t sell your story, nobody cares,’’ he said. His bank is looking for highly ethical people who are lifelong learners, and are curious. “Do you care? Do you look forward to making a difference? Or do you just accept things?’’ he asked. “Well in that case, go away, because the world is curious now.”

Severance Pay May Be Forbidden, Court Rules

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severance-pay-8-31-16.pngNo one wants to imagine bad times for the bank. But it makes sense to plan in advance, just in case. Your bank needs to motivate and keep the executive management team in place during difficult times, and one way to ensure this is to put in place a competitive compensation package when times are good.

A troubled bank can have significant restrictions imposed on its executive compensation programs. In particular, 12 C.F.R. Part 359 (Part 359) broadly prohibits the payment of, or entering into an agreement for the payment of, any golden parachute payment without prior regulatory approval. For an overview of Part 359, see our BankDirector.com article dated September 23, 2011.

A decision in July of 2016 from the U.S. Court of Appeals for the 8th Circuit once again confirms the view of the “impossibility” of severance pay under Part 359 and serves as a reminder that prior planning can help a bank to work within those rules.

Overview of Von Rohr
Jerry Von Rohr was a long-serving senior executive at Reliance Bank, serving lastly as chief executive officer before Reliance terminated his employment. At the time, the bank was subject to Part 359. Von Rohr claimed he was entitled to compensation for a year following the effective date of his termination. Because it was subject to Part 359, Reliance asked the Federal Deposit Insurance Corp. (FDIC) whether the claimed payment could be made to Von Rohr. The FDIC advised that the payment would be a “golden parachute payment” under Part 359, which Reliance could not make without prior FDIC approval. Reliance declined to make the requested payment. Von Rohr filed a lawsuit against Reliance and the FDIC. He alleged breach of contract and requested a declaration that federal law does not prohibit the payment. The trial court upheld the FDIC’s determination and granted summary judgment to Reliance on the breach of contract claim. The appeals court affirmed the trial court’s decision.

In granting summary judgment to Reliance, the court affirmed the trial court’s finding that the FDIC’s determination made Reliance’s performance under Von Rohr’s contract “impossible.”

In upholding the FDIC’s determination that any post-employment payment to Von Rohr under his employment agreement would be a golden parachute because it would be a payment “for services he did not render,” the appeals court made clear that whether or not something is called severance or a “golden parachute” is irrelevant to the analysis as to whether it is prohibited under Part 359. Von Rohr had argued that the payment he was due was simply his compensation for the remainder of the term of his contract, not a payment solely and specifically contemplating his termination. The court indicated that, if it accepted Von Rohr’s view, it would “create a giant loophole” in the prohibitions of Part 359. The intent of the regulatory scheme is to prevent troubled banks from draining their already low resources with payments to terminated executives who may have been responsible for the bank’s condition. It would not serve that intent to allow artful drafting to avoid it.

Von Rohr also claimed that the FDIC’s position is in conflict with its consistently held view that Part 359 does not preclude payment of damages for statutory claims (e.g., discrimination, whistleblower retaliation, etc.). The court dismissed this claim by acknowledging the FDIC’s view on statutory claims and noting that Von Rohr was raising a contractual claim, not a statutory claim.

Planning Opportunities
Significantly, exempt from the scope of the prohibition of Part 359 are payments under tax-qualified retirement plans, benefit plans, bona fide deferred compensation plans and nondiscriminatory severance plans, as well as those required by statute or payable following death or disability.

In particular, Part 359 exempts bona fide deferred compensations and nondiscriminatory severance plans only where such arrangements have been in place at least (and not modified to increase benefits within) one year prior to the troubled condition designation.

Between bona fide deferred compensation, nondiscriminatory severance and death or disability benefits, a bank should be able to build the basics of an attractive compensation package for a member of executive management. However, many banks put off current consideration of these types of arrangements for one reason or another. The Von Rohr case should serve as a reminder that Part 359 is inflexible. Therefore, banks should consider today whether to implement such arrangements.

Finally, should a bank find itself involved in litigation related to an executive’s termination, it should remember that Part 359 does not prohibit payment of damages for statutory claims.

Four Best Practices to Help Bank Boards Manage New Cybersecurity Guidance

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cybersecurity-6-6-16.pngUpdates to the FFIEC Management Booklet portion of the IT Examination Handbook in late 2015 have placed your board of directors under more pressure than ever to ensure the health and stability of your institution’s overall IT and cybersecurity environment.

While the board has always held ultimate responsibility for institutional governance, the revised handbook places extra demands on their level of knowledge and involvement, particularly in the areas of cybersecurity, examination procedures and IT management.

It’s perhaps the IT management portion and its two major changes that will prove most taxing to board members. First, the description of the IT management structure is more granular, with the addition of two new parties: executive management and a chief information security officer. Specifically, executive management is expected “to understand at a high level the IT risks faced by the institution and ensure those risks are included in the institution’s risk assessments. In the event that executive management is unable to implement an objective or agree on a course of action, executive management should escalate that matter to the board for more guidance.” The chief information security officer’s duties are spelled out in depth, and the guidance requires that person to report directly to the board, a committee of the board, or senior management—but not to someone in IT. The board is responsible for implementing this new governance structure.

Secondly—and of more concern—the updated guidance requires board members to provide “credible challenges” to bank management before approving IT or security decisions. This means they must maintain enough understanding of IT and cybersecurity matters to ascertain how these decisions might pose risks to the institution and whether they align with its overall strategy. And if they don’t understand something, they must be able to ask thoughtful, intelligent questions until they do.

Now, as most of us know, it isn’t uncommon for board members to “rubber stamp” IT management decisions, sending approvals through with a modest amount of consideration. So, given their accountability for understanding these matters before signing off on them, how can you help your board succeed?

It helps to view this challenge as a two-way street: the board provides oversight and governance, and the bank’s management and subject matter experts (SMEs) share their knowledge and information with board members to help them carry it out. There are four best practices to accomplish this task:

  1. Request that bank management, as well as the IT and security departments, begin passing relevant information to the board. Specifically, this includes monthly or quarterly summaries of incident reports that can apprise the board of any major incidents involving downtime, deployment of business continuity plans or anything else that could affect business decisions.
  2. Have your bank’s IT and security SMEs—or possibly an outside firm—provide the board with continuous updates on regulators’ expectations surrounding cyber risk management and oversight, as well as which high-level risks are circulating in the current environment. The experts also can consult with board members about why this knowledge is important, and how they can incorporate it into their strategic decisions.
  3. Encourage the board members to actively educate themselves by doing their own reading and research. To that end, ask one or two members to sit in on IT or security steering committees, then take the information they learn back to the rest of the board. This gives them access at the ground level.
  4. Invite the board to get involved with the Financial Services Information Sharing and Analysis Center (FS-ISAC), which shares the latest threat intelligence and attack methods, and encourages its financial industry members to do the same. If your institution has a membership—and it should—board members can access those resources and take part in the center’s bi-weekly conference calls.

Again, board members don’t have to become overnight SMEs. But they need to be involved, engaged and ready to ask some tough questions to ensure IT and security strategies are aligned with board expectations and the risk appetite they’ve set. If not, they shouldn’t be voting to approve IT plans.

After all, when it comes to IT, you can have all the best technology in the world, but if it’s unreliable or exposes your bank to too much risk, what good is it? It’s within the best interest of your institution and its board of directors to carefully apply the updated FFIEC guidance to all IT and security decisions.