Do You Really Need a Bank Holding Company?

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holding-company-2-23-18.pngThe boards of directors at three, multibillion-dollar, publicly traded banks recently chose to get rid of their holding companies. Bank of the Ozarks, BancorpSouth and Zions Bank, N.A. are now or soon will be stand-alone, publicly traded banks. For years, Republic Bank and Signature Bank have also operated as publicly traded banks without a holding company.

According to the public filings of Ozarks and BancorpSouth, the boards of those two organizations decided that having a holding company on top of their bank was way more trouble than it was worth in terms of dollars and time. The Zions board concluded that subject to regulatory approval, the bank would no longer be “systemically important” if it did not have a financial holding company structure. In the process, all three banks eliminated at least two regulators—the Federal Reserve, which oversees bank holding companies, and the Securities and Exchange Commission (SEC). None of the former holding companies were engaged in any significant nonbanking activities that couldn’t be conducted by the bank, either directly or through a subsidiary. For banks, the federal securities laws are administered by the bank’s primary federal banking regulator, rather than the SEC.

Life is a series of trade-offs, and none us can predict the future, but the increase in efficiencies for these organizations seems to have been worth giving up the flexibility afforded by operating in a bank holding company structure. For most banks that aren’t actively using their holding companies to engage in those non-bank activities that may only be performed under a holding company structure, the cost of eliminating the holding company is quickly recovered. If it turns out that eliminating the holding company was a bad idea, the Federal Reserve seems receptive to accepting and approving applications to form bank holding companies from many organizations, including those that had previously eliminated them.

Ozarks and BancorpSouth, like Signature and Republic before them, file their periodic reports under the Securities and Exchange Act of 1934 with the Federal Deposit Insurance Corp. Zions, which operates under a national charter, will make those filings with the Office of the Comptroller of the Currency. The shares of the banks are still listed on Nasdaq or the New York Stock Exchange.

Shareholders and analysts don’t seem to care that the banks’ filings are no longer available on EDGAR, an electronic filing system maintained by the SEC that investors can access. One can argue that bank holding companies that have over $1 billion in consolidated assets and thus are not eligible for the Fed’s Small One Bank Holding Company Policy Statement should consider whether their enterprise is getting its money’s worth from having a holding company—some are, and some aren’t. But remaining in a holding company structure simply because that is the way you’ve always done it is not sufficient analysis to withstand even polite questions from your shareholders.

The process of becoming a stand-alone bank is not intimidating for folks who know their way around the corporate and regulatory world in which banking organizations operate, but there are a number of important questions that bank boards need to consider, including: “Can we execute our business plan without a holding company?” Also, “Are the corporate laws applicable to banks chartered in our state as flexible as the laws applicable to our holding company?”

Three prominent banking organizations making a move like this in a six-month span might not signal a new trend, but it should cause directors at other banks to ask whether they really need a bank holding company.

Banking Blockchain: Making Virtual Currencies a Reality for Your Bank

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blockchain-10-17-17.pngBlockchain-based virtual currencies are gaining in popularity and evolving quickly. Blockchain currencies often are described as disruptive, but also have the potential to radically revolutionize the banking industry in a positive manner. The reality is that blockchain currencies may develop into a useful tool for banks. Their acceptance, however, is hindered by their own innovative nature as regulators attempt to keep pace with the technological developments. Potential blockchain currency users struggle to understand their utility. Despite these hurdles, many banks are embracing opportunities to further develop blockchain currencies to make them work for their customers.

What Are Virtual Currencies and Blockchain?
Virtual currencies, also referred to as “digital currencies,” are generally described as a digital, unregulated form of money accepted by a community of users. Currently, blockchain currencies are not centrally regulated in the United States. For example, the federal government’s Financial Crimes Enforcement Network (FinCEN) and the Securities and Exchange Commission view blockchain currencies as money, the Commodities Futures Trading Commission sees them as a commodity, and the Internal Revenue Service calls them property. The IRS has attempted to define virtual currency as:

a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value [and] does not have legal tender status in any jurisdiction.

FinCEN, the agency with the most developed guidance regarding virtual currency, regards it in a more practical fashion as a medium of exchange that operates like a currency in some environments, but does not have all the attributes of real currency. Whatever the regulatory definition, virtual currencies need more certainty in form and function before their use becomes commonplace.

Blockchain technology brings benefits to payment systems and other transactions that are quite revolutionary. Blockchain technology is essentially a decentralized virtual ledger (aka, distributed ledger), utilizing a comprehensive set of algorithms that records virtual currencies chronologically and publicly.

Some examples of blockchain currencies currently in use are Bitcoin, Dash, Ether, Litecoin and Ripple. These currencies are constantly evolving and are being developed by individuals, technology-based peer groups or financial institutions. In August 2016, a consortium of banks, led by UBS, Deutsche Bank, Santander and BNY Mellon, announced the development of the “utility settlement coin” or USC. The USC is meant to allow banks to transact payments in real time without the use of an intermediary. It is expected to go live in 2018.

Blockchain Currency Opportunities for Banks
Despite their reputation for being tools of illicit trade, blockchain currencies may be useful to banks in a variety of ways and can achieve certain benefits. Blockchain currencies could:

  • actually reduce fraud, including hacking or theft attempts, because the technology makes every step of the blockchain transparent.
  • reduce costs and risks associated with know-your-customer (KYC) programs because blockchain has the ability to store KYC information.
  • allow a financial institution to establish a new trading platform for exchange that eliminates intermediaries.
  • potentially could transform the payments industry. An obvious example is the USC, which permits payments to be made in real time, without the use of intermediaries; and strengthens the confidence in the authenticity of the transaction. Banks that are either able to establish a blockchain currency or adapt a proven technology for their operations will generate operational efficiencies and obtain a significant competitive advantage.

What Are the Regulatory Challenges?
Blockchain currencies currently are not centrally regulated in the United States. As discussed above, the lack of a uniform definition is a fundamental issue. FinCEN has classified any person or entity involved in the transfer of blockchain currencies as a money transmitter under money services business regulations.

As blockchain currencies continue to evolve, however, additional federal laws and regulations must be drafted to address the most substantial areas of risk. Some states are weighing in on the topic as well. For example, the Illinois Department of Financial and Professional Regulation recently issued guidance on the use of virtual currency in which the Department views virtual currency through the lens of the Illinois’ Transmitters of Money Act.

Additionally, the Uniform Law Commission is developing regulations that would, among other things, create a statutory structure (for each state that adopts it) to regulate the use of virtual currency in consumer and business transactions. Regardless whether the federal government or the states enact legislation affecting blockchain currencies, a more uniform regulatory approach would greatly aid their development and utility.

Conclusion
Blockchain currencies, and the laws and regulations governing them, are in a promising state of development. As new technologies emerge and existing technologies continue to evolve, banks are presented with real opportunities for innovation by successfully adapting blockchain for use by their customers. Those that figure it out are poised for real success.

The Board’s Role in the Transition to CECL

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CECL-9-30-16.pngThis summer, the Financial Accounting Standards Board (FASB) completed its project on credit losses with the issuance of a new standard that brings one of the most significant changes to financial reporting that financial institutions have seen in decades: The incurred loss model for estimating credit losses will be replaced with a new model, the current expected credit loss (CECL) model. In many cases, the new credit loss calculations are expected to result in an increase in the allowance, and, thus, might have a significant impact on capital requirements. Banks will need sufficient time to prepare and adjust capital planning and capital management strategies.

Banks are educating themselves on the changes, and boards of directors should be aware of the challenges faced by the banks they oversee.

As with any major initiative, a successful transition to the new standard will require the active involvement of the audit committee, the board of directors, and senior management. Given the audit committee’s responsibility for overseeing financial reporting, it has a critical role to play in overseeing implementation.

Recently, speakers from the Securities and Exchange Commission’s (SEC’s) Office of the Chief Accountant have emphasized the role that audit committees should have in implementing new significant accounting standards. In his speeches at Baruch College and the AICPA Bank Conference, Wes Bricker, interim chief accountant, addressed CECL implementation. Likewise, the federal financial institution regulatory agencies have addressed the role of the board in implementing the new credit loss standard. The agencies issued a joint statement on June 17, and in March the Federal Reserve System (Fed) released an article, “New Rules on Accounting for Credit Losses Coming Soon.” The speeches, joint statement, and article highlight tasks that boards of directors and audit committees may consider during transition, including:

  • Evaluate management’s implementation plan, including the qualified resources allocated for execution.
  • Monitor the progress of the implementation plan, including any concerns raised by the auditors or management that might affect future financial reporting.
  • Understand the changes to the accounting policies that are required for implementation.
  • Understand management’s transition to any new information systems, modeling methodologies, or processes that might be necessary to capture the data to implement the standard.
  • Oversee any changes to internal control over financial reporting in transitioning to the new standard.
  • Review impact assessments of the new standards, including impact on financial statements; key performance metrics, including credit loss ratios, that might be disclosed to investors outside the financial statements; regulatory capital; and other aspects of the organization such as compensation arrangements and tax-planning strategies.
  • Understand management’s plan to communicate the impact of the new standard on key stakeholders, including the new disclosures required by the standards and disclosures made leading up to the adoption date. Those who file with the SEC will need to disclose information about standards effective in future periods, including the expected impact when adopted.

In evaluating management’s implementation plan, it is important to develop an understanding of management’s timeline for implementing the new standards and to be aware of the effective date. Recognizing that the definition of a public business entity (PBE) under FASB includes many financial service entities, the FASB split the definition to provide additional time for PBEs that are not SEC filers.

  • For PBEs that are SEC filers, the standard is effective in fiscal years beginning after Dec. 15, 2019, and interim periods in those fiscal years. For calendar year-end SEC filers, it first applies to the March 31, 2020, interim financial statements.
  • For PBEs that are not SEC filers, the standard is effective in fiscal years beginning after Dec. 15, 2020.
  • For all other entities, the effective date includes fiscal years beginning after Dec. 15, 2020, and interim periods in fiscal years beginning after Dec. 15, 2021.
  • Early adoption is permitted for all entities in fiscal years beginning after Dec. 15, 2018, and interim periods in those fiscal years. That means, any calendar year-end entity may adopt as early as the March 31, 2019, interim financial statements.

While those dates might seem somewhat distant, there really is no time to lose in preparing for the transition.

Clawbacks Are Coming. Are You Ready?

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

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

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

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

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

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

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

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

Preparing for the New Reality of Bank Activism

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activism-4-8-16.pngFrom 2000 to 2014, activist hedge fund assets under management are reported to have swelled from less than $5 billion to nearly $140 billion. This sharp rise in assets under management is reflected in a 57 percent increase in activist campaign activity over the last five years. And while performance can vary greatly by fund, reports are that activist hedge funds have generally outperformed other alternative investment strategies in recent years. The upshot for the banking industry is clear: as more activist investors with more dry powder are looking for investment opportunities, activists have moved beyond the “low-hanging fruit” into regulated industries, including financial services, which had previously been considered too complex.

Banks historically were viewed as unlikely targets for activist investors. The burdens are significant on an investor deemed to “control” the bank (from a bank regulatory perspective). The investor must be concerned with an intrusive Change in Bank Control Act filing and fundamental changes may be mandated by the Bank Holding Company Act if the investor’s voting, director and activist activities result in it crossing often less than well-defined “control” thresholds. However, today’s activists have learned that even small holdings of a bank’s stock—for example less than 5 percent of voting stock—often suffice to generate the desired change and provide the desired return. Many activists thus have successfully achieved their objectives without triggering bank regulatory consequences.

As activist investors sharpen their focus on the banking sector, their criteria for which entities to target remain the same. Target companies generally share several key characteristics: underperforming (on a relative basis), broadly held ownership structures and/or easily exercisable shareholder rights. An underperforming business presents the potential for economic upside, while a dispersed ownership structure and easily exercisable shareholder rights provide access to the boardroom, or at least the ability to make demands. Activist stakes are often small as a percentage of overall capital and many activist campaigns rely on winning over institutional and other investors on measures to improve the performance of the business and, ultimately, the stock price. These measures can range from those intended to result in a sale of the bank, such as changing directors, to less disruptive, but nonetheless material changes, such as enhancing clawback features in executive compensation plans.

While no two activist campaigns are alike, activist engagement generally begins with a private approach to the board of directors or management. If the activist does not succeed in private conversations, more public disclosure of the activist’s campaign can take the form of public letters to the board of directors or management, public letters to stockholders, white papers laying out the activist proposal, or filings with the Securities and Exchange Commission related to ownership of the target’s stock. Finally, and at greater cost to the activist and target alike, activists can commence a proxy contest or litigation.

So how is a bank to know whether an activist has taken a position in its stock? For smaller, privately held banks, it is more important than ever to maintain close oversight of investor rolls. Publicly traded banks need to monitor Schedule 13D and Form 13F filings. An investor that accumulates beneficial ownership of more than 5 percent of a voting class of a company’s equity securities must file a Schedule 13D within 10 days. In an activist campaign, however, 10 days can represent a very long time and an activist can build up meaningful economic exposure through derivatives without triggering a Schedule 13D filing obligation. 13F filings are made quarterly by institutional investment managers. On the antitrust front, and likely more relevant to midsize and larger banks, an investor that intends to accumulate more than $78.2 million of a company’s equity securities must generally make a Hart-Scott-Rodino (HSR) filing with the Federal Trade Commission and notify the issuer of the securities. As with Schedule 13D filings, an activist can use derivative investments to avoid triggering an HSR filing. Given the limits of these regulatory filings, many publicly traded companies turn to proxy solicitors and other advisors who offer additional data analytics services to track a company’s shareholder base.

Boards must proactively prepare for such events. Any activist response plan will address a handful of key issues, including an assessment of the bank’s vulnerabilities, an analysis of the bank’s shareholder rights profile, engagement with shareholders on strategic priorities generally, identification of the proper team to respond to an activist approach, and ongoing analysis and monitoring of the shareholder base. No plan will address all potential activist approaches, but the planning exercise alone, done well in advance without pressures of an activist campaign, can position a bank to minimize exposure to activist pressures and to respond quickly, proactively and effectively to activist approaches.

Could You Be a Target of Shareholder Activism?

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shareholder-activism-2-2-16.pngShareholder activism appears to be on the rise again, after subsiding somewhat during the financial crisis, and hedge funds are driving most of it, according to speakers Monday at Bank Director’s Acquire or Be Acquired Conference in Phoenix.

“They want to create public discussion and increase value through an increase in stock price or sale,’’ said Bill Hickey, co-head of investment banking for the investment bank Sandler O’Neill + Partners.

Activist hedge funds’ assets have risen 11-fold from 2003 to the third quarter of 2015, to $131 billion, according to Hedge Fund Research reports.  Banks are hardly immune. In fact, Sandler O’Neil analyzed acquisitions above $50 million in value for banks and thrifts traded on a major exchange since January 1, 2014, and found 61 percent of the sellers had activist shareholders involved. Recent targets have included New York-based Astoria Financial Corp., which announced a sale to New York Community Bancorp late last year shortly after Basswood Capital Management filed what’s known as a 13-D letter with the Securities and Exchange Commission, announcing the hedge fund had acquired a significant stake in the bank. Some activists have even ganged up on banks together, which was the case with Harrisburg, Pennsylvania-based Metro Bancorp; Cincinnati, Ohio-based Cheviot Financial Corp.; and Alliance Bancorp, Inc. of Pennsylvania, the speakers said.

Underperforming community banks are most likely the targets but bigger banks such as CIT and Bank of New York Mellon also have been subject to activist attacks. “In the last couple of weeks, we’ve heard more and more noise about the potential for larger organizations to be targets,’’ Hickey said. But really, almost any bank can qualify as a target. According to Hickey, traits that often attract activist investors include having a stock that trades at a discount to intrinsic value, having substantial cash or liquid assets, underperforming a peer group of banks, having inefficient operations, or even just having the potential to sell for a premium. Even private banks are subject to shareholder activism. Peter Weinstock, an attorney with Hunton & Williams LLP, said he has represented banks as small as $100 million in assets with proxy battles and family-owned banks whose shareholders do battle with the board.

While bank CEOs and boards generally despise them, activist shareholders argue that the pressure they apply to boards and management teams can lead to an increase in shareholder value and propel sluggish management teams to make improvements. Share prices often increase substantially after an activist hedge fund gets involved. Most often, activist hedge funds are looking for a sale of the bank, and if no suitable buyers appear, they go away, Hickey said. Sandler and Covington identified the major activist shareholders targeting banks right now, and they include PL Capital, Stilwell Value, Basswood Capital Management, Veteri Place Corp., Jacobs Asset Management, Clover Partners and Ancora Advisors.

Defenses against shareholder activists include tracking the bank’s performance to peers, as well as the bank’s shareholder rights practices and compensation in relation to peers, because that’s what the activists do, said Rusty Conner, an attorney with Covington & Burling. Boards should also pay close attention to shareholder advisory firms’ recommendations, especially if the bank has a significant institutional shareholder ownership. Also, Conner said it pays to beef up your communication with shareholders, and make sure you have a media relations and investor relations team ready to spring into action if your bank is targeted.

In general, banks are bit tougher for activist investors to crack, as they are heavily regulated and even gaining two seats on the board may constitute taking a controlling interest in the bank’s board, said John Dugan, an attorney with Covington. Investors who take a controlling interest potentially become subject to regulation as a bank holding company. Also, regulators have to approve a bank’s capital plan, including the payment of dividends and share buybacks, so struggling banks often are restricted in what they can do for shareholders.

Still, it pays to get your bank ready if you might be vulnerable to an attack.

Compensation and Governance Committees: Sharing the Hot Seat in 2016

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hot-seat-11-19-15.pngThe compensation committee has been on the hot seat for several years. Outrage regarding executive pay and its perceived role in the financial crisis has put the spotlight on the board members who serve on this committee. Say-on-pay, the non-binding shareholder vote on executive compensation practices, was one of the first new Securities and Exchange Commission (SEC) requirements implemented as part of the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010. Since that time, public companies have responded to shareholder feedback and changed compensation programs and policies to garner support from shareholders and advisory firms such as Institutional Shareholder Services (ISS) and Glass Lewis & Co. In recent years, only 2 percent of public companies have “failed” their say-on-pay vote. The significant majority of public companies (approximately 75 percent of Russell 3000 companies) received shareholder support of 90 percent or greater during the 2015 proxy season. Today, companies with less than 90 percent should increase their shareholder outreach, as a dip below that level is often an indicator of emerging concerns.

Compensation committees can’t sit back and relax on these results. The SEC’s proposed rule for pay versus performance disclosure (published in April) and the final rule for the CEO pay ratio (published in August) will further intensify the focus on executive pay and require compensation committees to dedicate much more time and energy to evaluate and explain their pay decisions in light of these new disclosures. Fortunately, implementation of the CEO pay ratio is delayed until the 2018 proxy season while the SEC has not yet adopted final rules for the pay versus performance disclosure (as of September). It is hard to predict what influence these additional disclosures will have on shareholders’ say-on-pay votes. What is clear is that boards will need to monitor these and other pending Dodd-Frank Act rules (i.e. mandatory clawback, disclosure on hedging policies, incentive risk management) in the coming year.  

In the meantime, however, boards may face increased shareholder scrutiny in key governance areas.

Proxy access, the ability of significant shareholders to nominate board members on the company’s proxy ballot, achieved momentum in 2015 when New York City Comptroller Scott Singer submitted proxy access proposals at 75 public companies as part of his 2015 Boardroom Accountability Project. We expect proxy access proposals will remain a focus among activist shareholders during the 2016 proxy season. Dissatisfaction with executive compensation and board governance are often the reasons cited by shareholders seeking proxy access.

Institutional shareholders and governance groups have also started to focus on board independence, tenure and diversity. Institutional investors such as Vanguard and State Street Global Advisors consider director tenure as part of their voting process and ISS includes director tenure as part of their governance review process. This could lead to a push for term and/or age limits for directors in the near future. While many companies use retirement age policies as a means to force board refreshment, it is unclear if that will be enough. Boards would be wise to start reviewing their board composition and succession processes in light of their specific business strategies but also in consideration of these emerging governance and shareholder perspectives.

The intense scrutiny by investors and proxy advisors of public companies’ compensation and governance practices shows no signs of abating. Bank boards will need to develop their philosophies, programs and policies with an acknowledgement of emerging regulations and perspectives. Board composition and processes such as member education, evaluation, nomination and independence will gain focus. Executive pay levels and performance alignment will continue to be scrutinized based on new disclosures mandated by Dodd-Frank. The spotlight on pay and governance is not winding down, but rather widening and both the compensation and governance committees will need to spend more time addressing these issues in the years to come.

Taking the Fear out of Phantom Stock

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The use of equity compensation has increased in the banking industry in recent years, coinciding with enhanced compensation guidelines from the Securities and Exchange Commission (SEC), bank regulators, and the Dodd-Frank Act. These parties recommend that some executive compensation be deferred and tied to long-term performance. Equity programs typically accomplish both of these goals. A recent study of 177 public banks from Blanchard Consulting Group’s internal database found that the use of equity grants as a percentage of total compensation increased two to three times from 2009 to 2013, depending on the asset size of the bank.

Asset Size 2009 Proportion of Equity to Total Compensation 2013 Proportion of Equity to Total Compensation
Over $1B 15% 26%
$500M to $1B 4% 12%
Under $500M 4% 7%

Most publicly traded banks will use compensation plans tied to the organization’s stock to distribute long-term incentives in the form of stock options or restricted stock. Some private or thinly traded banks will use these types of “real” stock programs; however, many of these banks have limited availability of actual stock. As an alternative, private banks may use synthetic equity, such as phantom stock or stock appreciation rights, which are settled in cash.

Phantom stock programs are modeled to look and feel like restricted stock, where the participant receives the full value of the share plus any appreciation over time. The value of phantom stock is typically linked to the company’s stock price or book value per share. In addition, dividends could be factored into the phantom stock value during the vesting period, typically 3-5 years. Ultimately, the phantom stock awards will be settled in cash.

Advantages to Synthetic Equity
Banks concerned with equity dilution often prefer phantom stock, which provides a value comparable to that of restricted stock, but does not result in actual equity dilution. The value of the phantom stock is paid out in cash upon vesting, so the officer still receives value commensurate with having a real share of stock. Because phantom stock is settled in cash, it does not receive equity-based accounting treatment (value fixed at grant date). Instead, the expense is adjusted over time to reflect changes in the bank’s stock price or book value. The advantage of using phantom stock is the absence of any share dilution.

Stock Appreciation Rights (SARs) are another form of synthetic equity that are settled in cash. Cash SARs work similarly to stock options, as SARs give the participant the right to any appreciation in stock price or book value between the grant date and settlement. The appreciation value is paid in cash and taxed as ordinary income. Similar to phantom stock, cash SARs do not receive equity-based accounting treatment. The SARs are re-valued periodically, and the expense is adjusted to reflect the changes in value throughout the vesting period. This could lead to expensive accruals if the underlying stock price increases dramatically. Similar to phantom stock, there is no share dilution.

Other Considerations
Before implementing any type of equity or long-term incentive plan, a bank should consider a number of factors, such as the following:

  1. Performance-based awards: In today’s environment, equity awards are typically based on the achievement of bank-wide, department and/or individual goals.
  2. Service vesting: We typically see three to five-year vesting schedules within the banking industry. The vesting schedule may vary by grant or employee based on the bank’s retention goals.
  3. Dividends: The board should determine when and if the plan participant will receive value for dividends. This provision can be customized by the bank for each eligible employee.
  4. Termination of employment: If a participant voluntarily terminates employment during the plan term, the employee typically forfeits any unvested awards.
  5. Death or disability: Most banks will accelerate vesting and allow the participant or beneficiary to exercise shares in the event of a disability or executive’s death. All early disbursements will need to comply with Internal Revenue Service (IRS) restrictions (section 409A).
  6. Change-in-control: Shares will typically vest immediately and be paid upon the acquisition or merger of the bank if an employee is terminated as a result, also known as a “double trigger”.
  7. Clawback provision: This allows the bank to recoup incentive compensation payments made to plan participants in error from any unvested phantom stock or SAR grant.

In order to retain and attract talent, private banks need to ensure that they have the compensation tools available to compete with public banks that use real stock compensation. By using phantom stock or SARs settled in cash, private banks can help ensure that they are competitive with the market.

Trends Emerging in Compensation Policies for Bank Executives

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Governance policies related to executive compensation are on the rise as a result of increased influence of bank regulators, shareholders and the Securities and Exchange Commission (SEC). These policies are intended to reduce compensation-related risk, encourage a long-term perspective and align executives with shareholder interests.

Meridian’s 2015 proxy research of banks with $10 billion to $400 billion in assets illustrates the prevalence of “standard” and “emerging” practices. Standard practices tend to be common regardless of asset size. Emerging practices are more prevalent at larger banks, but are likely to cascade to community banks over time.

Policies on Risk Adjusting Payoutsrisk-adjustment.PNG
Standard: Clawback Policies
Clawback policies allow the recovery of incentive compensation that has already been paid or vested when there has been a financial restatement and/or significant misconduct. Most banks currently have clawback policies; however, these may need to be revisited once the SEC issues final clawback rules. While many existing policies allow compensation committee discretion to seek recovery, the proposed rules (July 2015) would require a mandatory clawback of “excess” incentive pay in the event of an accounting restatement.

Emerging: Forfeiture Provisions
While clawback policies seek to recover awards already paid, forfeiture provisions provide for the reduction of incentive payouts and/or unvested awards based on negative risk outcomes such as  a lack of compliance with risk policies. While these provisions are standard at large banks that have faced significant regulatory scrutiny, they are only beginning to be used at smaller banks.

Policies on Use of Company Stockcompany-stock.PNG
Standard: Anti-Hedging Policies
Anti-hedging policies prevent executives and directors from participating in transactions that protect against or offset any decrease in the market value of company stock. Such transactions could create misalignment between shareholders and executives since executives would not suffer the same losses as shareholders if the share price drops.

The SEC’s proposed rule (issued February 2015) requires companies to disclose the types of hedging transactions (if any) allowed and the types prohibited for both employees and directors. As seen in our study, most banks already disclose formal anti-hedging policies.

Emerging: Pledging Policies
Pledging policies prevent or limit executives’ and directors’ ability to pledge company shares as collateral for loans. Pledged company stock creates a risk that executives may be forced to sell shares at a depressed stock price in order to raise cash to cover the loan margin, which could further the decline in stock price.

However, some companies allow limited pledging with pre-approval. Pledging enables executives to monetize share holdings without selling company stock. Since 2006, public companies have been required to disclose the amount of company stock pledged by executives and directors. Proxy advisory firms and shareholders typically criticize only significant levels of pledging.

Policies on Retention of Stock AwardsStock-retention.PNG
Standard: Stock Ownership Guidelines
Over 80 percent of banks in our study have stock ownership guidelines that require executives to maintain a minimum level of ownership. Ownership guidelines are typically defined as a multiple of base salary. For CEOs, the most common ownership requirement is five times base salary, while other executives range between one times and three times base salary.

Emerging: Post-Vesting Stock Holding Requirements
Many investors and shareholder advisory firms have started pushing for additional stock holding requirements. Holding requirements restrict executives from selling stock earned from equity awards or option exercises for a period of time after vesting or exercise. Some holding requirements require executives to hold a percentage of shares until ownership guidelines are met. More rigorous policies require executives to hold a percentage of shares for a set period of time (e.g., one year after vesting) or until (or even after) retirement.

Banks have been ahead of many industries in adopting these governance practices as a result of the regulatory scrutiny on compensation programs, and we expect the emerging practices will continue to gain in prevalence across banks of all sizes.

The Current Status of Dodd-Frank Act Compensation Rules

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dodd-frank-8-17-15.pngWe have waited for five years since the Dodd-Frank Act became law and we are now seeing consistent movement to finalize several compensation provisions of the law.  

Meetings started in October with President Barack Obama gathering the heads of U.S. financial regulators and urging them to finish the Dodd-Frank rules. To date, we have already adopted Securities and Exchange Commission (SEC) rules that include shareholder votes on executive compensation (Section 951 on say-on-pay and so-called golden parachutes), and on independence of compensation committees (Section 952). Remaining Dodd-Frank provisions, designed to regulate behavior encouraged by compensation structures, are Sections 953, 954, and 956. Already, many institutions have implemented more stringent variable pay plans since 2010, with more compensation tied to longer term performance. The current status of the rules is highlighted below.

Pay Versus Performance Disclosure, Section 953(a)
The proposal for section 953(a) is intended to provide compensation information to augment the say-on-pay vote for public companies. The proposal highlights a new form of realized pay versus reported pay as well as a comparison of the company and peer group total shareholder return (TSR) over several years. The proposed disclosure reflects the SEC’s attempt to help shareholders gain a better understanding of how executive pay compares to company performance by comparing named executive officers’ total compensation as described in the summary compensation table to what the SEC is now defining as compensation actually paid. As an example, the vested value of equity will be incorporated into the actually paid definition versus the value of equity at grant date. Also, the new rule uses total shareholder return (TSR) as the performance measure comparing performance to compensation “actually paid,” and using TSR of a company’s peer group to provide additional context for the company’s performance. In addition, companies will be required to provide a clear description of the relationship between the compensation actually paid and cumulative TSR for each of the last five completed fiscal years.

Current Status of Rulemaking: We expect either a final, or re-proposed rule, by fall, 2015.

Pay Ratio Disclosure, Section 953(b)
The SEC finalized this rule in August, 2015, with implementation deferred to fiscal years beginning on or after January 1, 2017. The rule requires that public companies disclose the ratio of the CEO’s total compensation to the total compensation of all other employees. For example, if the CEO’s compensation was 45 times the median of all other employees, it can be listed as a ratio (1 to 45) or as a narrative. Total compensation for all employees has to be calculated the same way the CEO’s is calculated for the proxy. All employees means all full-time, part-time, temporary and seasonal employees.

Current Status of Rulemaking: The SEC finalized the rule on August 5, 2015. The first disclosure is expected for 2017 fiscal year as shown in proxy statements filed in 2018.

Clawbacks, Section 954
Section 954 is often referred to as the “clawback” provision of Dodd-Frank and applies to all public companies. The proposal requires companies set policies to revoke incentive-based compensation from top executives with a restatement of earnings if the compensation was based on inaccurate financial statements. The company has to take back the amount of compensation above what the executive would have been paid based on the restated financial statements. This rule applies to public company Section 16 officers, generally any executive with policy making powers. Variable compensation that is based upon financial metrics as well as total shareholder return would need to be clawed back, and there is a three year look-back for current and former executives.

Current Status of Rulemaking: Expect final rules in fall, 2015; once final from SEC, stock exchanges will create the listing rule and an effective date (expected late 2016 or early 2017).

Enhanced Compensation Structure Reporting, Section 956
This rule was proposed in April, 2011—more than four years ago. This rule applies to financial institutions, specifically banks greater than $1 billion in assets. The rule is primarily a codification of the principles as found in joint regulatory Guidance on Sound Incentive Compensation Policies, which stated that compensation needs to be:

  • Balanced to both risk and reward over a long-term horizon
  • Compatible with effective controls and risk management, and
  • Supported by strong corporate governance.

In addition, there is an annual reporting requirement and for large banks (greater than $50 billion in assets), there is a mandatory deferral of incentive pay. Given that there have been four years since the original proposal, we are expecting a number of changes as the global regulatory structures have changed greatly since 2011.

Current Status of Rulemaking: Originally proposed in April 2011, changes are expected to be re-proposed in 2015.