Most banks face challenges to find, incentivize and retain their best employees in an increasing competitive market for talent. Often, smaller banks and banks structured as Subchapter S corporations have the added challenge of providing liquidity for their shareholders and founders. An employee stock ownership plan can be an excellent tool for addressing those issues.
An ESOP creates a buyer for the bank’s stock, generating liquidity for shareholders of private or thinly traded banks and providing market support for publicly traded ones. An ESOP’s buying activity can reduce shares outstanding and increase a bank’s earnings per share. It can also increase employee benefits and gives them a sense of ownership that can improve recruitment, retention and performance.
ESOPs are tax-qualified defined contribution retirement plans for employees that primarily invest in employer securities. ESOPs offer accounts to employees, similar to 401(k) retirement plans. But unlike a 401(k), employees do not contribute anything to the plan; instead, the bank makes the contribution on their behalf.
ESOPs are an excellent employee benefit and a recruitment, retention and performance tool. ESOPs do not pay taxes on an annual basis, so taxes are deferred while the stock remains in a plan. When the employee retires or takes a distribution from the plan, the value of the distribution is taxed as ordinary income. Employees also have the ability to roll over the distribution to an individual retirement account.
Employees at companies that offer an ESOP have, on average, 2.6 times more in retirement assets than employees working at companies that do not have an ESOP, according to the National Center for Employee Ownership. Additionally, companies with broad-based stock option plans experienced an increase in productivity of 20 percent to 33 percent above comparable firms after plans were implemented. Medium-sized companies saw gains at the higher end of the scale. Employee ownership is also associated with higher rates of employee retention. According to a survey by the Rutgers University’s NJ/NY Center for Employee Ownership, workers at employee-owned companies are less likely to look for other jobs and more likely to take action when co-workers are not working well.
There are a couple of different ways that banks can establish ESOPs. The simplest and most efficient is called a non-leveraged ESOP, where the bank or holding company makes a tax-deductible cash contribution. The contribution can be in stock or cash and is recorded as compensation expense. If the bank contributes cash, those funds can be used to purchase stock directly from shareholders and create liquidity and demand in the stock. However, it can take years for a non-leveraged ESOP to accumulate a significant enough position to make a meaningful difference to a bank.
The other method, called a leveraged ESOP, uses a bank’s holding company to lend money directly to the ownership plan. The holding company is required because banks are not permitted to lend directly to the ESOP or guarantee a loan made to the ESOP. The holding company can use cash on its balance sheet, borrow it from a third-party lender or guarantee a third-party loan made directly to the ESOP. The ESOP uses the funds to purchase a large block of non-issued shares from the holding company or directly from shareholders. Although leveraged ESOPs have higher costs and complexity, they can make an immediate, meaningful difference in liquidity and employee benefits. This approach also has the benefit of increasing earnings per share upfront, since the shares underlying the ESOP loan to make the purchase are not considered outstanding. However, the repurchased shares negatively impact tangible common equity and tangible book value.
An ESOP can help the right bank accomplish many of its goals and objectives. Banks should carefully review their goals and objectives with qualified professionals that know and understand both the ESOP and commercial bank industries.
The decision to take your bank public will set the course of your company for years to come. There are several critical steps to prepare your compensation program before the IPO and before your bank is a public company.
Steps to prepare for the IPO
1. Assemble Your Compensation Team Determine the team focused on compensation matters. If you have employees with IPO experience and compensation plans, they could be a key asset. Similarly, if you have employees without IPO experience but have public company experience, they could be a key team member as well.
2. Create Your IPO-Related Task List Your bank may have implemented many compensation and governance related items already, but they should be reviewed for their appropriateness for a public company.
Key tasks required prior to the IPO will vary, however, here is a list of compensation tasks on every pre-IPO list.
Develop an executive compensation philosophy and key objectives – What is your bank’s strategy? Where do you target compensation? Is your pay aligned with performance? What are the objectives of your compensation program? What message do you want to send to shareholders? Craft overarching guidelines to support the process going forward.
Evaluate and establish appropriate executive and director compensation levels – Prior to the IPO, your company will have to disclose its executive and director compensation. You want to be sure your compensation programs are reasonable, competitive, and based on peer group data. Establishing a suitable peer group and incorporating the data into your process is key.
Equity plan considerations – Will a new equity plan be required, and when will you need shareholder approval? How will you determine the share pool so long-term incentive and equity grant needs can be met for three to five years? Have you evaluated the shareholder advisory firms’ current standards to receive favorable support? Avoid any pitfalls that would result in a “no” vote recommendation.
If the company is considering one-time IPO-related equity grants, evaluate these in light of market trends, shareholder expectations, retention concerns, financial impact to the company and dilution. Many institutions consider sizeable one-time grants a front-loaded award, and decide to wait before awarding additional equity. Such decisions are based on share pool impact, financial implications, and size of the one-time grants. Carefully determine the value of these awards to minimize risks of unfavorable optics and legal actions.
Design ongoing annual and long-term incentive plans – As a public company, it is important to have annual and long-term incentive plans that align pay and performance, are competitive, consistent with company objectives and provide an appropriate mix of pay. As new incentive plans are designed, know that plan details will be disclosed in future public filings. Private banks are accustomed to implementing plans that are regulatory compliant and competitive, but public disclosure has not been required.
Implement executive agreements – In many cases, new employment and change-in-control agreements are put in place, often the case even if similar agreements were in effect before the IPO. Several details, including the terms, are subject to public disclosure. Shareholder advisory firms take issue with certain terms and, and having them can automatically result in ‘no’ vote for Management Say on Pay and the re-election of the board’s compensation committee. It is critical to be aware of these pitfalls and avoid them whenever possible.
3. Determine appropriate technical and governance actions There are key technical and governance issues to evaluate. Some items are required while others are not. Many are considered best practices and important to achieving strong governance. Some of the key items in this category include:
Drafting of the SEC required filings including the CD&A (Compensation Discussion and Analysis), compensation tables and other requirements. Reporting errors and omissions can delay the IPO.
Determining company stock ownership guidelines – Many new public banks do not adopt stock ownership guidelines immediately, however, if one-time equity grants are awarded, adopting such guidelines immediately sets the parameters for holding these shares. Determine who will be covered by the guidelines (e.g., executives, Section 16 officers, non-employee directors), what the required holdings are, the timeframe permitted, and other terms.
Drafting the Compensation Committee Charter – A charter establishes the role and responsibilities of the committee, how it will interact with the board and management, and its ability to engage outside advisors. The charter is typically published on the company’s website.
4. Create a compensation committee calendar after the IPO Once the IPO is completed, it is important for the compensation committee to focus on its new role, responsibilities and annual tasks. Setting up a calendar of activities supports effective management and should include all areas of committee oversight.
Taking your bank public can be a very exciting endeavor. Do not underestimate the number of new issues management, the compensation committee and the board will have to become familiar with to complete a successful IPO and operate a public company. Being organized, having the right knowledge and support and a flexible timeline will be great tools to help your organization get through this process.
The evolution of pay and governance practices tends to be led by large companies—organizations that are under the watchful eyes of institutional shareholders, proxy advisors and the media. Smaller organizations have less visibility, fewer constituents, and can afford to take more time evaluating whether or not to adopt emerging pay practices, some of which may take years to be adopted or ultimately rejected due to unwarranted complexity, cost or irrelevance. But certain current pay and governance trends are worth considering right away, regardless of company size.
Pearl Meyer recently completed its annual Director Compensation Report analyzing director pay practices for 1,400 public companies. We have identified three practices that are nearly universal among the largest 200 companies in the S&P 500 (we’ll call them the Top 200) that we believe transcend company size and deserve consideration at banks, both large and small:
The shift toward retainer-based pay;
Delivery of over half of pay for board service in stock; and
The adoption of stock ownership guidelines.
Shift from Attendance-Based to Retainer-Based Pay The largest companies generally have the most complex compensation structures. But on rare occasions, they actually lead the way toward greater simplicity in pay practices. One example is the shift from a retainer plus meeting fees structure to a retainer-only approach. This simplification of director pay has been an increasing trend among large public companies for a decade. Today, fewer than one in five Top 200 companies now pay meeting fees for board service, while roughly 40 percent of companies with revenues of $50 to $500 million (so-called micro companies) continue this practice.
The most compelling argument for retainer-based compensation is the investor expectation that a director’s full commitment to attend all meetings should be a given. A retainer structure emphasizes that directors are compensated for the skills and experience they bring to the position, an expectation just as relevant for small companies as the Top 200. A side benefit of this approach is its greater simplicity, something community banks may find attractive.
Increase in Equity Pay A long-promoted principle of the National Association of Corporate Directors (NACD) is to align director compensation with the interests of the shareholders they represent, in part by delivering at least half of director pay in the form of stock. Two-thirds of all companies studied, and nearly 90 percent of the Top 200 companies, comply with this guideline. Practices among banks in the study were similar to the general industry. The prevalence of companies meeting this threshold generally increases with the size of the organization.
With certain exceptions (mutual organizations, family-owned, closely-held, etc.), the rationale for paying at least half of director compensation in equity is no less compelling for community banks than for large corporations:
Directors at community banks are equally responsible for representing their shareholders;
The governance practice of aligning director pay with the long-term interests of shareholders is universal; and
Stock-based compensation is more capital-friendly than cash, which may add special appeal for banking organizations.
Community bank boards may include a diverse group of directors and demographics, and cash-focused director pay may at times be more appropriate. However, the benefits of a greater mix of equity-based compensation may be appropriate for your organization.
Director Stock Ownership and Retention Larger companies have almost universally adopted stock ownership guidelines requiring directors to accumulate or retain shares received over a defined period of time. The rationale is consistent with the purpose of stock-based pay—greater alignment with the long-term interests of shareholders. This is a reasonable objective for stock companies, regardless of industry or size.
While ownership requirements vary from company to company, they are typically attainable through retention of shares received under the compensation program. A common structure might require ownership equal to a multiple of the annual cash retainer (for example, three to five times the retainer), with retention of at least 50 percent of shares until an ownership level requirement is met. For community banks looking to score points within the governance community, adopting modest, achievable stock ownership guidelines can be a relatively easy win.
Community banks aren’t known to be early adopters of pay trends, and that’s a good thing much of the time. But the three director compensation trends discussed above have been tested and refined at large companies for many years and they have direct and immediate applications to smaller organizations. Consider exploring the merits of these big company director compensation practices for your bank in 2016.
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 Payouts 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 Stock 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 Awards 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.
Though the executives and directors from privately held institutions in Bank Director’s 2014 Compensation Survey say that they face the same challenges as the board members and senior executives of publicly traded banks, the data on compensation and benefits show they are paid less and receive fewer benefits.
Privately held banks tend to be smaller, and this also impacts how well these boards can compensate their CEO. Still, there are pay issues particular to private banks, including how to compensate executives without publicly traded stock, that private banks must address.
Private Banks Offer Equity, Too Naturally, public banks are more likely to offer equity grants. Not only is a public company’s stock more liquid, but the company tends to have more shares outstanding. Just 31 percent of respondents from private banks report that their executives receive annual equity grants. Of those, almost half use restricted stock, and 40 percent grant stock options.
Many smaller, private institutions that offer equity compensation emulate the practices of big public banks, but don’t consider that their shares are not as actively traded and difficult to convert the cash—negatively impacting executives and shareholders, says Gallagher. Just 11 percent use synthetic equity, but this type of long-term incentive can be a good alternative to traditional equity. Synthetic equity behaves much like a traditional stock incentive—as the value of the company rises, so does the reward to the executive—but the reward is all cash.
Synthetic equity does have its drawbacks. Compared to stock, the cost of which is fixed at its initial value when granted to the executive, the cost of synthetic equity to the bank appreciates along with its value. If an executive’s reward doubles, then the cost to the bank doubles right along with it. However, Gallagher says that the value to the executive outweighs its costs—and executives reveal a preference for cash incentives, according to the survey.
The percentage of private institutions that award annual equity grants has dropped by five percentage points in 2014 since last year, while the percentage of banks allocating synthetic equity remains the same.
Does the bank allocate any of the following to executives annually?
No matter what the board decides is best to offer the CEO and other executives as a long-term incentive, it’s vital to think through the exit plan for the executive. Gallagher shares a story that would chill many bank directors. A privately-held community bank allocated a large amount of stock over the course of several years as part of its CEO’s compensation package. Since the stock isn’t traded, once the CEO retired, he had to sell a significant stake in the company, triggering a sale. “The board knows the only course of action is to sell the bank. That’s not a good answer,” he says.
The CEOs of privately held banks with between $500 million and $5 billion in assets are earning less in salary and cash bonuses than their peers at public institutions of the same size. The median compensation in 2013 for the CEO of a private bank between $1 billion and $5 billion was $373,000 in salary and a $75,000 cash bonus, less than his public peer, who earned $409,004 in salary and $122,000. For banks between $500 million and $1 billion in assets, the private CEO earned a median $266,490 salary and $50,000 cash incentive, compared to the public CEO with a median $278,417 salary and $54,000 cash bonus. Private banks are also less likely to offer retirement and deferred compensation benefits.
Median compensation for CEOs Private ownership, by asset size
$1B – 5B
$500M – $1B
$250M – $500M
Equity Grants (fair market value)
Benefits & Perks
Private Banks Mix Up Metrics The use of performance indicators by private banks has grown over the past year, from 56 percent in 2013 to 71 percent in this year’s survey. But compared to publicly traded banks, which place a high priority on asset quality and return on equity (ROE), private institutions as a whole are less likely to rely on one metric. One-third of respondents from private banks say they link CEO pay to return on assets (ROA) or ROE. Half tie CEO compensation to corporate goals.
Improved performance and conditions for many smaller, private banks is impacting their boards’ approach to incentive compensation, including the increased use of performance indicators. “They’re profitable again [and] they can start considering performance-based compensation,” Gallagher says. “Smaller banks were too focused on sheer survival [following the economic downturn].” With more banks able to pay for performance, more are apt to use a metric that makes sense for the bank as a way to determine whether the CEO met the bank’s goals.
Compensation Committees Decide Pay Forty-two percent of executives and directors from private banks say that the compensation committee bears the responsibility of setting director compensation levels for their bank, compared to three-quarters of publicly traded institutions and 60 percent of respondents overall. Private banks are more likely to rely on the board, at 30 percent. Less than 20 percent of respondents from public banks place the responsibility for director pay on the full board.
Sixteen percent of private banks place this responsibility in the hands of the CEO, which Gallagher says can indicate a dangerous board dynamic. If the board disagrees with an executive decision, the CEO could retaliate by cutting board pay. Directors should never be beholden to the CEO. “Boards should set their own pay with no say from the CEO,” he says.
Overall, the survey shows a shift from board meeting fees to annual retainers. For smaller, private banks, board meeting fees remain steady, though the percentage of directors receiving an annual cash retainer has risen by 10 percentage points, to 39 percent—still significantly lower than public banks, where 69 percent receive an annual retainer. As directors spend more time outside the boardroom on banking matters, retainers may better reflect a board member’s contribution to the governance of the institution. The median board fee for a private bank was $650 per meeting, and the median annual retainer totaled $9,300, for the independent director of a privately held bank in fiscal year 2014.
Median compensation for independent directors Private ownership, by asset size
$1B – 5B
$500M – $1B
$250M – $500M
Fee per board meeting
Annual cash retainer
Stock Guidelines Recommended Stock ownership guidelines, which outline the expectations of the company regarding the level of stock ownership by members of the board, may not be top of mind for the boards of private banks. Half of private bank respondents indicate that the bank does not have stock ownership guidelines for the board, though this represents a decline of 10 percentage points from 2013. Stock ownership guidelines are a best practice for bank boards, as they further align the board’s interests with that of bank ownership.
A stock ownership policy can be easily set by the bank’s board, setting the number or value of shares that must be owned by a director within a set amount of time. For those at private banks that set stock ownership guidelines, the majority require a minimum or fixed number of shares. Gallagher says that this makes sense for private boards, due to the illiquid nature of the stock. The price isn’t firm, so bank boards focus more on the number of shares.
About the survey Bank Director’s 2014 Compensation Survey, sponsored by Meyer-Chatfield Compensation Advisors, surveyed online 322 independent directors and senior executives, including chief executive officers and human resources officers, at banks of all sizes across the United States to uncover trends in executive hires as well as director and executive pay. Director pay data was also collected from the proxy statements of 99 publicly traded institutions. Based on regional definitions from the U.S. Census Bureau, 35 percent of the data came from banks in the Midwest, one-third from banks in the South, 23 percent from banks in the Northeast and 9 percent from banks in the West.