Five Key Steps to Integration Success


When it comes to the completion of a merger or acquisition, whether you view the glass as half full or half empty will likely depend on your planned approach to integration. After all, there’s no shortage of statistics on the failure rate of mergers and acquisitions due to post-deal integration issues. And it’s easy to see why. The challenge of integrating the people, processes and technology of two organizations into one is a daunting exercise whose success depends on a variety of factors, many of which can be subtle, yet complex.

Still, such challenges are not deterring bankers from the pursuit. Through November of 2015, there were 306 M&A banking deals. With the December numbers not yet available, we would expect the total for 2015 to be about the same as the total for 2014. And, according to recent KPMG community banking survey, nearly two-thirds of the 100 bank executives surveyed anticipate being involved in a merger or acquisition as either buyer or seller during the next year. Moreover, one out of three of those community bank executives foresee integrating information technology systems as the most difficult integration challenge, followed closely by talent management.

While such challenges are undeniable, directors must play a key role in helping management achieve positive results. These five key steps can help directors guide management in driving a successful integration.

Step 1: Set the Tone at the Top
Prior to signing the deal, establish a set of goals that cascade a vision of the deal into high-level, practical operating objectives for the combined organization. Directors should review and provide input in these operating objectives to ensure they align with the bank’s overall strategy, risk appetite and the strategic rationale for the deal. With a strong set of operating objectives in place, executives can develop guiding principles which clearly define the key fundamentals that stakeholders should follow as they begin the planning phase of the integration.

Step 2: Assess the Integration Plan and Roadmap
An integration plan and roadmap needs to be established early in the deal lifecycle. Anchor the plan with a well-understood methodology and a clear, high-level and continuously monitored timeline that identifies key activities and milestones throughout the course of the integration. Develop an integration playbook that details the governance structure, scope of the work streams and activities in addition to well defined roles and responsibilities. Directors must fully understand the integration plan so they can provide valuable feedback, effectively challenge timelines, and have the requisite knowledge to determine if there is a prudent methodology for each phase of the integration. Key disclosures about the transaction should be reviewed to ensure communications to regulators and shareholders set realistic expectations for closing the deal, converting customers, and capturing synergies.

Step 3: Effectively Challenge and Monitor Synergy Targets
Operating cost and revenue efficiencies are identified as part of the deal model, factored into the valuation, and play a critical role in determining the potential success of a merger. Executive management should establish synergy targets at the line-of-business level to promote accountability. Directors should foster effective challenge of expected synergies and provide oversight of the process for establishing the baseline and tracking performance against targets over the course of the integration.

Step 4: Promote Senior Leadership Involvement and Strong Governance Oversight
The program structure and governance oversight is established during the initial planning phase to control the integration program and drive effective decision making. Executive management should identify an “integration leadership team’’ with sufficient decision-making authority and a combination of merger and operating experience to effectively identify risks, resolve issues and integrate the business. Directors should examine the team’s experience, track progress against goals, and closely monitor key risks to assess management’s ability to execute the integration activities.

Step 5: Evaluate Customer and Employee Impacts and Communication Plans
The objective of customer and employee experience programs is to take a proactive approach to help ensure that significant impacts are identified, analyzed and managed with the goal of minimizing attrition. Integrated and effective communication plans are established to address concerns of customer and employee groups to reduce uncertainty, rumors and resistance to change. Directors should scrutinize customer and employee impacts in an attempt to ensure management has an effective mitigation plan for negative impacts through communication, training and target operating model design. Planning for employee retention should include the identification of critical talent to mitigate risks to the integration while ensuring business continuity.

By taking these five steps, directors can provide management with the guidance and support needed for a successful integration.

Policing Your S Corporation Status: Six Simple Steps


s-corporation-12-30-15.pngS corporations have an obligation to police their shareholder base to see that all shareholders remain eligible. A common problem S corporations face is making sure that after the subchapter S election is made, it stays effective. When a bank is gearing up to make its S election, attorneys and accountants are typically reviewing shareholder documentation to confirm eligibility. But, after the S election is effective, most banks do not regularly review their shareholders’ list to confirm eligibility. Actions beyond the bankers’ control, such as the death or divorce of a shareholder, can result in an inadvertent termination of the S election. The tax consequences for the company and its shareholders can be disastrous.

Here is a common scenario.  A bank has a shareholder who passes away. The executor, who is much more concerned with administering the estate than protecting the bank’s S election, either transfers the bank shares to an ineligible shareholder, such as a corporation, or does nothing and leaves the shares in the estate. While an estate is an eligible shareholder, an estate does terminate for tax purposes at some point, so as a general rule, shares cannot be held in an estate indefinitely. The executor fails to notify the bank that the shareholder has passed away for several years. Dividend checks continue to be cashed in the name of the deceased shareholder. All the while, the bank is not aware of what has happened

Then, sometimes years later, something raises the issue. For example, the executor may finally contact the bank to effect the transfer of the shares, or a new review of the bank’s shareholder list may raise questions about why an estate is still a shareholder. Only then does the bank realize that the shareholder’s will transferred the shares to a corporation or that the shares have been sitting in the estate for many years. As a result, the S election has been compromised.

The good news is that the IRS has a program in place for S corporations to request relief for inadvertent terminations. However, consent of 100 percent of the S corporation shareholders is required, along with a filing to the IRS and a substantial filing fee.

It can be time consuming to obtain the requested relief from the IRS, but going through the process is essential if there has been an inadvertent termination. However, through the suggestions below, bankers may be able to avoid the inadvertent termination in the first place, which is obviously preferable:

  1. Review shareholders’ list: The bank should conduct a detailed review of the list of shareholders at least annually to confirm all shareholders are eligible. In addition, every two years, the bank’s accountants or attorneys should conduct a detailed review of the list.
  2. Review the shareholders’ agreement: Most S corporations have a shareholders’ agreement in place to protect the S election. If the shareholders’ agreement was drafted several years ago, an attorney should review it to confirm that the agreement is up to date with current law. In addition, the agreement should contain protections in the event the S election is inadvertently terminated, such as shareholder indemnification of the expenses incurred in connection with obtaining relief for the inadvertent termination and a covenant by the shareholders to take all steps necessary to remedy the inadvertent termination. There are other provisions that are useful as well.
  3. Shareholder communication: On an annual basis, banks should send a certification to each shareholder to confirm the shareholder still qualifies as an eligible shareholder. This annual certification requirement can be built into the shareholders’ agreement or something that the bank just sends out on its own each year.
  4. Remind shareholders of estate planning issues: Either in conjunction with the annual certification or separately, remind shareholders about the consequences upon the shareholder’s death. For example, a shareholder should talk with the attorney who drafted his or her will to confirm that the shares pass to an eligible shareholder.
  5. Train the bank’s corporate secretary: The corporate secretary should be mindful of S corporation qualifications and eligibility issues as well as common issues that could impact the S election. The corporate secretary can possibly help avoid an inadvertent termination by being proactive and asking the right questions.
  6. Road map memos: Banks should consider requiring shareholders, for example, as part of the shareholders’ agreement, to have their estate planning attorneys provide the bankers with a letter or memorandum detailing what happens to the shares upon the death of a shareholder, especially if the shares are already held in a trust.

By taking the steps above, a potential inadvertent termination of a bank’s subchapter S election can be avoided. An ounce of prevention is worth a pound of cure.

A New Delaware M&A Case Is a Warning to Investment Bankers: Take Care That You Don’t Mislead the Board


investment-bankers-12-21-15.pngMerger and acquisition activity appears to be accelerating among community banks large and small. Despite the nearly ubiquitous shareholder lawsuit that follows a merger announcement from a publicly traded target company, the corporate law relating to the obligations of a board of directors in a merger transaction is well developed and favorable. There is a high bar for board culpability in an M&A transaction, and an even higher bar for board liability. However, recent Delaware court cases have highlighted potential liability for investment bankers that is not shared by directors. This is quite an alarming development, which is of obvious concern to investment bankers, but also should impact boards of directors as they consider deals.

Under Delaware law, which is followed by most states, the primary obligations of the board in a merger transaction relate to good faith, a component of the duty of loyalty, and making an informed decision, duty of care. Fortunately, most companies have a charter provision eliminating director personal liability for monetary damages for breaches of the duty of care, which is not allowed for breaches of the duty of loyalty. And, according to the Delaware Supreme Court in the Lyondell case, director personal liability for “bad faith” requires a knowing violation of fiduciary duties. For example, in a sale transaction, shareholders aren’t supposed to act on a goal other than maximizing value, or in a non-sale merger, act for reasons unrelated to the best interests of the stockholders generally.

Another important hallmark of Delaware M&A case law is the extreme reluctance of judges to enjoin a stockholder vote on a merger transaction when there is no competing offer. And once a transaction closes, and the challenged target company directors were independent and disinterested, and did not act with the intent to violate their duties, judges typically dismiss the lawsuits against directors.

However, in a recent case, which involved the sale of a company called Rural/Metro Corporation, the Delaware Supreme Court ruled that third parties, such as investment bankers, can be liable for damages if their actions caused a board to breach its duty of care, even if directors are not liable for the breach. Moreover, simple negligence by the board, rather than gross negligence, can serve as the basis for third party liability.

In Rural/Metro, the investment bankers were found to have had numerous conflicts of interest, most of which were not discussed with the board. They sought to participate in the buyer’s financing of the acquisition and they sought to leverage their involvement with the seller, Rural/Metro, to obtain a financing role in another merger transaction. They were also found to have manipulated the fairness analysis to serve their conflicted interest in having a particular party win the bid for Rural/Metro. The court held the behavior of the investment bankers caused the board to be uninformed as to the value of the company and caused misleading disclosure. They were held liable to stockholders for $76 million in damages.

The Delaware Supreme Court stated that a board needs to be active and reasonably informed in its oversight of a sale process and must identify and respond to actual or potential conflicts of interest as to its advisers. Importantly, the Delaware Supreme Court rejected the lower court’s characterization of the role and obligations of an investment banker as a quasi fiduciary “gate keeper,” and stated that the obligations of an investment banker are primarily contractual in nature. It further held that liability of an investment banker will not be based on its failure to take steps to prevent a director breach but on its intentional actions causing a breach.

The case is a warning for both boards and investment bankers: Take care when there is a conflict of interest. Investment bankers should avoid conflicts where possible, disclose all conflicts to the board and the board and the investment bankers need to work diligently to address conflicts adequately. In order to do their job well, board members must make sure their advisors are telling them what they need to know.

Assessing Your Say-on-Pay Vote


As banks prepare for their annual shareholder meetings, most will have a say-on-pay vote where shareholders indicate whether they support the executive compensation program. This process has pressured companies to improve their compensation disclosures and clearly explain their pay practices and decisions. Today’s bank boards should engage with shareholders to understand their evolving perspectives on compensation and governance practices.

Meridian Compensation Partners’ Susan O’Donnell and Daniel Rodda discuss how to interpret your say-on-pay results and how to prepare for next year’s vote.

What do directors need to understand about the results of their 2015 say-on-pay vote?
Directors should know what percentage of their shareholders voted in favor of their executive compensation programs, and how that level of support compared to prior years. Receiving majority support isn’t enough. Over 70 percent of banks last proxy season received a favorable shareholder vote on their programs of 90 percent or more, so any result below that level suggests potential concerns. If your bank receives less than 70 percent support, shareholders and advisory firms such as Institutional Shareholder Services (ISS) will expect to hear specific details on how the company responded to feedback, and they will conduct a more rigorous assessment the following year. Strong shareholder support one year does not guarantee future success. We have seen the result change swiftly when not monitored.

How can directors understand what drove the results of their say-on-pay vote?
Directors should understand the makeup of their shareholder base, as there are differences in what drives the voting patterns of retail and institutional investors. Many institutional shareholders are influenced by ISS and another prominent shareholder advisory firm, Glass Lewis, so it is valuable to review their vote reports. Other institutional shareholders, like Blackrock and Vanguard, follow their own voting guidelines. While pay outcomes are more easily controlled, say-on-pay also reflects how shareholders view performance, primarily based on total shareholder return (both relative to peers and on an absolute basis). Directors need to take an objective look at how shareholders will view the relationship between executive pay and the bank’s performance.

How can banks improve the results of their say-on-pay vote?
Ensuring a significant portion of your total pay program is variable and that actual pay outcomes vary based on performance are the best ways to gain shareholder support. It is also important to maintain and disclose policies and practices that reinforce sound governance, such as stock ownership requirements, clawback policies, minimal perquisites and elimination of any tax gross-ups. The Compensation Discussion and Analysis (CD&A) section of your company’s annual proxy must effectively communicate the context and rationale for pay decisions, as well as how the programs ensure alignment between pay and performance. Investors want to understand the “how and why” of compensation decisions, including why performance measures were chosen, how pay decisions were made, and how the compensation program is aligned with shareholder value. If the say-on-pay vote receives less than 90 percent support, banks should consider reaching out to large shareholders to understand any concerns they may have. Additionally, banks that received negative recommendations from ISS and Glass Lewis should reach out to these advisory firms to discuss what led to their recommendation and what might address their concerns.

When should banks begin preparing for the following year’s say-on-pay vote?
Directors should already be thinking ahead to next year’s vote. The board has likely already made pay decisions in 2015 that will be evaluated as part of the 2016 say-on-pay vote. Typically, salary increases and equity awards are made in the first quarter of the year, but shareholders will be evaluating those decisions through the lens of performance through the end of the year. This can at times lead to an unfortunate disconnect. As a result, it is never too early to consider decisions in light of shareholder perspectives and the potential impact on the say-on-pay vote. In addition, ongoing shareholder outreach is viewed positively by investors and can proactively surface potential issues while there is still time to make changes. Being proactive and considering pay in the broader context of bank performance and shareholder perspectives should be an ongoing process.

Don’t Sell the Bank


2-18-15-Al.pngI recently read a report from FIG Partners, an investment bank, that says “M&A pricing is actually much stronger than investors realize given the fact the capital levels are twice—or at least significantly higher—than the past cycle and now price-to-tangible book values are rising.” So if pricing is, in general, improving from a seller’s perspective, it is easy to see why a bank’s board of directors would consider putting the bank up for sale.

But my question is: Why sell now when better times might be ahead?

True, addressing this issue largely depends on how the institution is positioned, geographically, by product line and yes, asset size. Further, I realize a bird in hand is worth two in the bush, and this wait-and-see approach is one that a number of advisers warn boards from taking. However, while the pool of potential buyers is larger than previous years, I don’t see it as aggressive as some would lead you to think.

Still, figuring out when a bank should be a buyer—or a seller—has been on my mind since the Royal Bank of Canada announced a deal for “Hollywood’s bank,” City National Corp., for $5.4 billion. This is the most expensive large U.S. bank deal announced since the financial crisis, based on a price-to-tangible book value of 262 percent. Since that announcement, various media outlets have speculated that buyers will pay a premium for trophy properties like City National. Many anticipate banks that cater to the wealthy will be front and center. But I’m not so sure that institutions with a similar clientele, like San Francisco-based First Republic Bank, should sell, even if approached with a huge multiple.

If you’re not familiar with First Republic, I find the bank’s story fascinating. Jim Herbert founded the bank in 1985, sold it to Merrill in 2007 for 360 percent of book value, took it private through a management-led buyout in July 2010 after Merrill was acquired by Bank of America, then took it public again in December through an initial public offering. A few years ago I sat down with Jim in their New York City offices and came away impressed: not only is the bank solely focused on organic growth, it’s also focused solely on private banking.

So I wonder. Members of First Republic’s board have a fiduciary responsibility to shareholders; however, does a short-term premium trump sustained long-term potential?  For a bank that caters to the wealthy, business executives and owners, I’m sure the U.S. Department of Labor’s announcement that the U.S. economy created 257,000 jobs in January—making this the longest stretch of sustained monthly growth since the early 1990s—was well received. While the unemployment rate ticked back up to 5.7 percent, from 5.6 percent in December, The Wall Street Journal reports that the climb was likely because more Americans said they were looking for jobs, a sign of growing confidence.  As the tide begins to rise, why sell the proverbial boat?

Moreover, a recent report from Deloitte’s Center for Financial Services says that, “the encouraging M&A activity seen in 2014 is likely to continue through 2015, driven by a number of factors: stronger balance sheets, the pursuit of stable deposit franchises, improving loan origination, revenue growth challenges, and limits to cost efficiencies.” However, their 2015 Banking Outlook also acknowledged that “as banks move from a defensive to an offensive position to seek growth and scale, they should view M&A targets with a sharper focus on factors such as efficiencies, growth prospects, funding profile, technology, and compliance.”

So rather than consider an exit, isn’t now the time to double down on your growth efforts?

Performance-Driven Retirement Plans: Are They Right for Your Bank?


1-5-15-Equias.pngBank boards do not like to lose executive talent to competing banking organizations. Developing a compensation plan that is aligned with shareholder interests and retains key executives continues to be an important objective for compensation committees. Compensation committees need to evaluate a variety of compensation strategies to determine which will be the most effective at retaining and recruiting key high performing lenders and executives. While offering competitive salary and performance-based annual bonus amounts are a given, providing additional long-term incentives and/or retirement benefits can be the missing component. Equity plans provide an element of longer-term compensation, but are not available in many privately-held banks and, even where offered, can be complemented by other types of long-term incentive plans.

According to the American Bankers Association 2013 Compensation and Benefits Survey, 64 percent of respondents offered some kind of nonqualified deferred compensation plan for top management (CEO, C-level, executive vice president). (See our article, “Is Your Compensation Plan Generous Enough?”) Choosing the right retirement plan must incorporate the compensation committee’s overall compensation philosophy and bank objectives.

This article will focus on performance-driven retirement plans, a type of defined contribution nonqualified plan. Long-term incentive plans that are performance driven are generally well-received by shareholders. When such plans are properly designed, if the bank’s shareholders do well, so will the executives.

As an example, let’s assume the bank desires to implement a performance-driven retirement plan for a key lender who is 35 years old. Let’s also assume that if the lender meets both department and individual target goals along with the bank-wide net income goal, the lender will receive an annual grant of 10 percent of salary. The bank will cap the grant at 20 percent of salary if maximum performance goals are attained. For this individual, assume the annual contribution is based on a combination of loan growth, deposit growth and bank-wide net income. The goals and the weighting of each goal will vary by officer.

Assuming normal retirement age of 65, and 10 percent of salary contributions each year, the executive is projected to be credited with almost $400,000 in bank contributions. With interest added to the account, the retirement benefit is expected to be almost $80,000 per year for 15 years, a total benefit of $1.2 million. The payments are contingent on the executive not taking a job where he or she competes with the bank after retirement.

This type of arrangement is documented in a legal agreement between the bank and the executive. The agreement must comply with IRC Section 409A and should address various agreement terms and conditions including:

  • Early voluntary termination
  • Disability
  • Change in control
  • Pre-retirement death 
  • Death during payout
  • Non-compete and non-solicitation of customers and employees
  • Holdbacks
  • Qualifiers such as satisfactory performance evaluations and credit quality
  • Form (number of years) and timing (age or date) of benefit distributions

It is critical that bank-wide goals along with department and individual goals be linked to the bank’s budget and overall strategic plan. The goal setting process is typically the most challenging step in designing the plan. Some banks use moving averages (such as the bank’s three-year average net income) and other longer-term measures to determine executive performance and bank contributions.

Rewarding executives with a meaningful compensation package tied to long-term shareholder return is a balancing act. While there is not a one-size-fits-all approach for designing and implementing this type of plan, the facts and circumstances of each bank will dictate the best design after taking into account the bank’s culture and compensation philosophy.

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

Why Book Value Isn’t the Only Way to Measure a Bank


11-14-14-Al.jpgA few days ago, I woke up to the announcement that Winston-Salem, North Carolina-based BB&T Corp. has a deal in place to acquire Lititz, Pennsylvania-based Susquehanna Bancshares in a $2.5 billion deal. The purchase price is 70 percent stock and 30 percent cash and includes 0.253 BB&T shares and $4.05 in cash for each Susquehanna share. The implied price of $13.50 per share equates to 169 percent tangible book value, 16.3 times price as a multiple of last-twelve-months earnings per share and a 7.4 percent deposit premium.

While easy to see the deal as being strategically compelling from BB&T’s perspective (the deal makers expect to generate cost savings from the combined institution, targeting $160 million annually or 32 percent of Susquehanna’s non-interest expense), the announcement had me unexpectedly thinking about valuation issues and Warren Buffet.

Yes, Warren Buffet.

Let me explain the correlation between the two. A year ago, Buffet was on CNBC and took a question from a viewer about how he valued banks. In his words, “a bank that earns 1.3 percent or 1.4 percent on assets is going to end up selling above tangible book value. If it’s earning 0.6 percent or 0.5 percent on assets it’s not going to sell. Book value is not key to valuing banks. Earnings are key to valuing banks.

Keep in mind that for many smaller community banks, book value has been the primary determinant of value on a trading basis. As the lion’s share of mergers and acquisitions have involved small community banks over the past few years, talk of book value has been quite prevalent. So the BB&T deal, the second largest so far this year, got me thinking about valuation issues and if an increased focus on price to earnings might be a more appropriate way to value banks.

To get some perspective on this topic, I reached out to Dory Wiley, president and CEO of Commerce Street Holdings. He sees earnings as more important, but was quick to remind me that tangible book value does matter.

John Gorman, a partner in the Washington, D.C.-based law firm of Luse Gorman Pomerenk & Schick, P.C. provided additional context. “Having value driven by earnings is the goal for most publicly traded community banks, and that goal is bearing fruit, but in a discriminating fashion. The market is being selective in terms of which companies it is rewarding with earnings-based valuation on a trading basis. And that reward provides those select companies with a competitive advantage in terms of paying the higher price-to-earnings and price-to-book multiples in the M&A marketplace.”

Andy Gibbs of Mercer Capital opined “it is earnings, after all, that are the source of the capital needed to reinvest in the bank (and grow its value), to pay dividends to shareholders, or to repurchase shares. A well capitalized bank can do those things in the short-run, but without earnings to replenish and expand capital, it’s not sustainable.”

Clearly, a bank that generates greater returns to shareholders is more valuable; thus, the emphasis on earnings and returns rather than book value. To this end, Gorman says: “If a company is a strong earner, and is located in an attractive geographic market, it may be able to obtain a significant M&A premium and thereby realize an earnings-based valuation.”

So investors and buyers will always use book value as a way to measure the worth of banks. But as the market improves and more acquisitions are announced, expect to see more attention to earnings and price to earnings as a way to value banks.

Say-On-Pay Trends at Banks: Proxy Firms Increase “No” Recommendations


What should public bank boards know about proxy firm recommendations? McLagan evaluated Institutional Shareholder Services’ (ISS) recommendation patterns for management say-on-pay (MSOP) votes at bank shareholder meetings this year. ISS’ “no” vote recommendations were up from 2013 to 2014, summarized in the chart below:McLagan_linechart.png

Larger banks receive greater scrutiny from ISS and are more likely to get a negative recommendation. Banks with assets greater than $5 billion received “no” recommendations almost twice as frequently as banks below $5 billion.

Despite the increase in negative recommendations, overall shareholder approval remained high. Nearly 75 percent of banks received greater than 90 percent support for MSOP, and half were above 95 percent approval.

Caution! Receiving a negative recommendation can have a dramatic impact on the level of shareholder approval. McLagan performed an analysis of actual shareholder votes after ISS had made a recommendation on pay practices, either “for” or “against.” The table below shows a distribution of vote results.

MSOP Vote Results
Percentile ISS Recommendation
For Against
25th Percentile 92% 59% 
50th Percentile 96% 75%
75th Percentile 98% 85%

At the median, those banks receiving a “for” vote recommendation from ISS also received a 96 percent approval vote from shareholders. In contrast, a bank receiving a “no” vote recommendation only received a 75 percent approval vote—a drop of 21 percentage points at the median! The drop was even more significant at the 25th percentile, where a “no” vote recommendation resulted in an approval rating of only 59 percent, down 33 percentage points from banks that received a “for” vote recommendation.

Here are the landmines to watch out for that can trigger a “no” vote recommendation.

Top 3 Reasons for ISS “No” Recommendation
Pay for Performance Disconnect
Mega-grants of Equity (e.g. sign-on or retention bonus)
Problematic Pay Practices (e.g. excise tax gross up or re-pricing options)

An example of a pay for performance disconnect is when the CEO is paid above the 75th percentile of ISS’ comparative group, but the bank’s performance as measured by total shareholder return (TSR) is below the 50th percentile. Another example would be an increase in CEO compensation as TSR decreases.

Some banks escaped receiving a “no” recommendation in 2014 even though their pay practices would presumably have merited one. The reason? One example is TSR for a bank may have improved and been relatively strong compared to the comparative group; as a result, some pay practices might be given a pass. But, if TSR slips, these banks may well receive a different recommendation.

In summary, don’t take your MSOP vote results for granted. Be proactive in making appropriate adjustments to executive compensation and watch out for the top 3 reasons for “no” vote recommendations, especially if your bank’s TSR is decreasing. It’s much easier to fix the problems before receiving a failing MSOP vote result.

What to Do When Caught Between Investors and Regulators


hands-tied.jpgIt’s tough to please both regulators and shareholders these days, especially when they want contradictory things. Take the case of executive compensation.

Shareholder groups have been pushing for a greater tie between performance and executive pay. One of the most powerful of these, Institutional Shareholder Services, screens executive pay packages to see how they stack up against peers relative to performance and how the change in CEO pay mirrors change in total shareholder value over five years. ISS recommendations to shareholders on such matters can strongly influence a company’s say-on-pay shareholder advisory vote. Umpqua Holdings Corp. and other banks found this out, as described in a recent story in Bank Director magazine.

But looking at the stock price and shareholder value is exactly what regulators don’t like.

Jim Nelson, a senior vice president of supervision and regulator for the Federal Reserve Bank of Chicago overseeing large banks and savings institutions, is concerned with the use of stock price or return on equity as a measure of performance in making pay determinations. Return on equity doesn’t factor in the risk that executives might be taking to achieve such returns, he said at Bank Director’s Bank Executive & Board Compensation conference recently in Chicago.  There are many factors that can influence the stock price which are outside the realm of management’s control, he said.

“We think most of the people in the firm don’t have a direct impact on the value of the stock price,’’ he said. “We’re looking for a measurement tied to something that that person does control.”

Regulators also explained how they feel about shareholders in their 2010 Guidance on Sound Incentive Compensation Policies, which applies to all banks and thrifts.

The joint regulatory guidance says “shareholders of a banking organization in some cases may be willing to tolerate a degree of risk that is inconsistent with the organization’s safety and soundness.”

So there’s the rub. Do you please shareholders or do you please regulators? But there are ways to combine the concerns of both.

“It’s not the amount [of bonus or incentive pay],’’ Nelson said. “What we’re looking at is the arrangements. You should reward individuals who are producing an attractive risk-adjusted return for you. If they are making more money with low risk, they should be paid more than someone who is making money with high risk. I think that is aligned with what shareholders want and the board wants. There is a lot more free enterprise in this approach than people think.”

He said some big banks are adjusting their profits based on risk metrics before handing out bonuses.

Meanwhile, big banks also are taking into account the needs of shareholders and the recommendations of shareholder advisory groups. Tying short and long-term bonuses, at least in part, to shareholder return is one way to do that.

For example, Buffalo, New York-based First Niagara Financial Corp., one of the nation’s 25 largest bank holding companies with $35 billion in assets, paid out long term incentives to top executives in three ways: stock options, time-vested restricted stock and performance-based restricted stock that vests in three years based on total shareholder return relative to the SNL Mid-Cap Bank Index.

Barbara Jeremiah, a First Niagara director who chairs it compensation committee, said when the bank ran into troubles trying to raise capital for its acquisition last May of HSBC branches in New York and had to cut its dividend in half, the board recognized the hit shareholders took and wasn’t locked into paying short-term bonuses based on earnings per share. The board had made sure it had some level of discretion in determining the bonus, she said.

The board adjusted incentive compensation for CEO John Koelmel to reflect the decline in stock price and reduction of the dividend. Jeremiah encouraged compensation committee members and human resources directors at the Bank Director conference to read and stay abreast of how others viewed executive pay, making note of an article by Gretchen Morgenson of The New York Times entitled  “C.E.O.’s and the Pay-‘Em-or-Lose-‘Em Myth.”

 “We need to keep that outside view,’’ Jeremiah said. “How do our customers and others view us?”

Will Citigroup Shareholders’ “No” Vote Change the Compensation Game?


monopoly.jpgIn its discussion of its pay package this year for Vikram Pandit, Citigroup’s chief executive officer, the company extolled the accomplishments of the man brought in to clean up the mess that was left in the midst of the financial crisis.

Citigroup has been profitable for eight consecutive quarters. It has repaid the government’s Troubled Asset Relief Program money. Pandit had gone two years without drawing a salary in the midst of the company’s trouble, and was rewarded in 2011 with a salary and a bonus. Plus, the company had taken steps to align its incentive pay with future performance: 60 percent of top executives’ bonuses will be deferred over a four-year period based on performance.

None of this was enough to please investors and shareholder advisory groups such as Institutional Shareholder Services (ISS). Investors voted down this week the CEO’s pay by 55 percent in an advisory vote made possible by the Dodd-Frank Act.  ISS claimed Pandit’s compensation was misaligned with total shareholder returns (Citigroup’s stock price was down 23 percent during the past 52-week period and it was down 93 percent during the past five years.) Future bonuses would be “essentially discretionary” based on a variety of factors such as execution of long-term strategic goals and return on capital, according to ISS.

Basically, the pressure is on for Citigroup and other publicly traded companies to tie incentive pay to specific metrics that benefit shareholders, rather than more vague goals that give the board wide discretion.

It didn’t help matters that Citigroup was one of few big banks to fail the federal government’s stress tests this year, meaning it won’t be able to return capital to shareholders in the form of dividends or stock buybacks.

Plus, ISS determined that Pandit would be paid more than his peers at other big financial firms. Although Citigroup reported that his total compensation for fiscal year 2011 was $15 million, ISS determined that future awards could be worth as much as $34 million. A $10 million award is tied to the company earning pre-tax income for a two-year period of at least $12 billion, which “does not appear challenging given that the company’s income from operations exceeded $15 billion in each of the last two fiscal years.”

Citigroup may be scrambling to deal with the bad publicity now from the “no” vote on pay, even if technically, the advisory vote is non-binding. But will other banks scramble to make sure they don’t suffer the same fate?

Maybe not, says Peter Miterko, a managing director in New York City for Pearl Meyers & Partners, a compensation consulting firm.

“It may be a more subtle impact, rather than everyone saying ‘Let’s redo our pay packages,’’’ he says.

Most banks already have sent out their proxy statements for the year, making it hard to revamp any pay practices. But Miterko thinks the publicity will encourage companies to communicate better in the future with shareholders about why they pay what they do.

A typical problem in proxy statements is that it’s not clear to shareholders what performance metrics must be met for an executive to get incentive pay, he says.

“The positive development [with say-on-pay] is that shareholders tend to see a lot more clear connect with how they’re better off,’’ he says. “Shareholders want to know that executives are told in the beginning of the year, ‘This is what you have to do to get your bonus.’ They want to know the goals are stretch goals and the financial improvement will warrant the incentive payment.”

Don Norman, an attorney for Barack Ferrazzano Kirschbaum & Nagelberg LLP in Chicago, who handles compensation issues for community banks, says many banks have already made changes in order to defer a portion of incentive pay for executives and many have tied it to specific performance that benefits shareholders.

Much of that was set in motion following regulatory guidance on incentive pay in the aftermath of the financial crisis and the compensation rules for banks that received Troubled Asset Relief Program money.

But tying pay almost entirely to shareholder returns can place too much emphasis on short-term performance and thereby create undue risk, he says.

“The market doesn’t have a long-term focus,’’ he says. “It’s ‘what have you done for me lately?’”

Instead, he thinks it is not unreasonable for bank boards to maintain some level of discretionary decision-making over bonuses.   This is much easier in the private bank setting.

“If there’s no discretion, why do you need a compensation committee?” he says. “You have an intelligent and educated group of board members for a reason and there should be some level of deference to their judgment. There are management efforts that should be rewarded that are not always reflected in formulas.  Good or bad, this should be part of any pay assessment.”

Banks without a lot of institutional ownership will have less reason to worry about shareholder advisory groups such as ISS. Still, no one wants to find a majority of their shareholders voting down their pay packages.

Last year, 41 firms in the Russell 3000 (or less than 2 percent of the total index) reported that they failed to win majority approval from investors on pay, according to ISS. This year, 175 companies have had proxy votes and the average shareholder vote has been 90.4 percent in favor, ISS says.

So ending up as one of the firms with a no vote doesn’t look so good.

McLagan, another compensation consulting firm, offers some advice to avoid a “no” vote:

  • Analyze the shareholder base to determine the level of ISS or other advisory firm influence.
  • Monitor changes in each of your institutional investor’s proxy voting guidelines.
  • Audit your compensation and governance plans and programs for any potential exposure to guidelines of proxy advisor groups and institutional investors.
  • Track 1-year, 3-year, and 5-year total shareholder return relative to your ISS-established peer group.
  • Use the proxy compensation discussion section to clearly tell the “story” of executive pay and explain pay and governance decisions.
  • Be prepared to engage in meaningful dialog with shareholders.