Executive Compensation: Understanding the Tax Law’s Full Impact


compensation-3-12-18.pngOn December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act, which amended certain provisions of the Internal Revenue Code of 1986. Bank boards and management teams should take time to familiarize themselves with these changes, as several amendments to the Code relate to the payment of executive compensation.

For corporate executives and compensation committees, the change to the Code that has garnered the most attention concerns an amendment to Code Section 162(m). Prior to the Act, Section 162(m) imposed a $1 million cap per executive on the tax deduction a public company could take on compensation paid to its chief executive officer and three other highest paid executive officers, excepting the chief financial officer—generally, the “named executive officers” included in the company’s annual proxy. Historically, most companies relied on an exemption for performance-based compensation to avoid this limit, which was fully deductible even if it exceeded $1 million. The new tax law has eliminated the performance-based compensation exemption.

In addition, the tax law has expanded coverage of Section 162(m) to apply to all Securities and Exchange Commission (SEC) reporting companies (i.e., companies required to file reports under Section 15(d) of the Securities and Exchange Act of 1934, which includes many companies required to file due to public debt), rather than solely those whose common stock is registered with the SEC. It also expanded the group of executives subject to the deduction limit to include not only the named executive officers during the current taxable year—now including the CFO as a “named executive”—but also any person who was a covered executive for any prior taxable year beginning after December 31, 2016. Companies subject to Section 162(m) should review their incentive plan documents, incentive award agreements, severance agreements and employment agreements in light of the removal of the exemption for qualified performance-based compensation because these documents may have been drafted to account for the Section 162(m) performance-based compensation exemption that no longer applies.

In addition, the Act amended Code Section 83 by adding a new subsection (i) regarding deferred taxation of equity compensation. Section 83 generally governs the amount and timing of income inclusion for property, including employer stock, transferred to an employee in connection with the performance of services. Under Code Section 83(a), most individuals must recognize income for the tax year in which the employee’s right to the stock is transferable or no longer subject to a substantial risk of forfeiture. This changes for some employees with the new Section 83(i), which allows non-executive and non-highly compensated employees of privately-held corporations to elect up to a five-year deferral in the taxation of illiquid shares issued to them upon the exercise of nonqualified options or the settlement of restricted stock units (RSUs), if certain conditions are satisfied. The options or RSUs must be granted under an equity compensation plan in which at least 80 percent of a company’s full-time U.S. employees are granted awards with the same rights and privileges. The amounts of the awards may vary by employee as long as each employee receives more than a “de minimis” grant—i.e., all participating employees must be eligible to receive a legitimate economic benefit. This deferred tax election is not available to the CEO or the CFO—or to certain persons related to them—or to any person who within the past 10 years was one of the four highest paid officers of the corporation or an employee that holds 1 percent of the company’s stock. Under this new regime, eligible employees of private companies receiving stock through equity compensation arrangements may consider making an election under Section 83(i) to defer taxation on such compensation.

The IRS is expected to issue guidance on these changes, particularly the amendments to Section 162(m). Stay tuned.

Considering a Sale of the Bank? Don’t Forget the Board’s Due Diligence


due-diligence-5-16-16.pngIn today’s competitive environment, some bank directors may view an acquisition offer from another financial institution as a relief. With directors facing questions of how to gain scale in the face of heightened regulatory scrutiny, increased investor expectations, and general concerns about the future prospects of community banks, a bona fide offer to purchase the bank can change even the most entrenched positions around the board table.

So, how should directors evaluate an offer to sell the bank? A good starting place is to consider the institution’s strategic plan to identify the most meaningful aspects of the offer to the bank’s shareholders. The board can also use the strategic plan to provide a baseline for the institution’s future prospects on an independent basis. With the help of a financial advisor, the board can evaluate the institution’s projected performance should it remain independent and determine what premium to shareholders the purchase offer presents. Not all offers present either the premium or liquidity sought by shareholders, and the board may conclude that continued independent operation will present better opportunities to shareholders.

Once the board has a framework for evaluating the offer, it should consider the financial aspects of the offer. The form of the merger consideration—be it all stock, all cash, or a mix of stock and cash—can dictate the level of due diligence into the business of the buyer that should be conducted by the selling institution.

If the proposed offer consists of primarily cash consideration, the selling institution’s board should focus on the buyer’s ability to fund the transaction at closing. Review of the buyer’s liquidity and capital levels can signal whether regulators may require the buyer to raise additional capital to complete the transaction. Sellers bear considerable risk once a merger agreement is signed and the proposed transaction becomes public. The seller’s customers often think of the announcement as a done deal and the merger also naturally shifts the seller’s attention to integration rather than its business plan, which can benefit the combined company, but affect the seller’s independent results. It is difficult for the seller to mitigate these risks in negotiations, so factoring them into the board’s valuation of a sale offer is the best approach.

When considering a transaction in which a significant portion of the merger consideration is the buyer’s stock, the board has additional diligence responsibilities. First, the board should consider whether the buyer’s stock is publicly traded on a significant exchange or lightly traded on a lesser exchange. As the liquidity of the buyer’s stock decreases, the burden on the seller to understand the buyer’s business and future plans increase, as its shareholders will be “investing” in the combined company, perhaps for a lengthy period of time. The board should also consider if and when there will be opportunities for future shareholder liquidity.

On the other hand, when the seller’s shareholders are receiving an easily-traded stock, both parties will have an interest in mitigating the effects of market fluctuations on the pricing of the transaction. In most cases, a pricing collar, fixing the minimum and maximum amounts of shares to be issued, can allocate market risk between the parties. Such a structure can ensure that a market fluctuation does not cause the seller to lose its premium on sale or make the transaction so costly that it could affect the prospects of the buyer.

In addition to the financial terms of the proposed transaction, the seller’s organizational documents may include language allowing the board to consider a broad range of non-financial matters as part of the evaluation of a proposal. Certain matters, particularly with respect to how the seller’s executives and employees are integrated into the resulting institution and how the buyer’s business plan fits into the seller’s market, can have a significant impact on the success of the transaction. Just as community banking is largely a relationship-based model, the most successful mergers are those that make not only economic sense, but also address the “human element” to maintain key employee and customer relationships. The board can add value by raising these issues with management as part of its discussion of the merger proposal and definitive agreement.

In evaluating an offer to sell, the board is responsible for determining whether the bank’s financial advisors and management have considered a range of relevant items in evaluating an offer, including the offer’s financial terms, execution risks associated with the buyer, and social issues relating to the integration of the transaction. Using the bank’s strategic plan to determine which issues require closer scrutiny can focus the board’s attention on truly meaningful issues that will provide additional value to the institution’s shareholders.

It’s a New Day in Executive Pay


12-3-14-Naomi.jpgEver since the financial crisis, bank boards have been operating under a tremendous amount of scrutiny, and that is leading to substantial changes in pay packages. Changes that at first only impacted the largest, global banks are cascading down to smaller community and regional banks.

People such as John Corbett, the CEO of the $3.9-billion CenterState Bank of Florida, headquartered in Davenport, Florida, say their banks are paying executives more of their total compensation in long-term equity. If the bank’s shareholders do well, so do the executives, so the thinking goes. Half of the stock is time vested, meaning it takes a few years before executives have access to it. The other half is tied to performance goals. Also, the bank’s annual bonus plan for top executives is a mix of cash and stock, and the bonuses are deferred for three years in case the credit quality of the bank’s loan portfolio deteriorates.

Corbett spoke at Bank Director’s Bank Executive and Board Compensation Conference last month in Chicago.

Kevin O’Connor, president and CEO of Bridge Bancorp, Inc. in Bridgehampton, New York, also spoke at the conference and said his more than $2-billion asset banking company has made substantial changes, adding long-term incentives in the form of equity, tying those to individual and corporate performance, and requiring vesting periods for the stock.

O’Connor said not all banks provide employees with as much transparency into exactly how the bonus plan works as Bridge Bancorp does now. But his bank’s plan has generated more discussion about how to reach corporate and individual goals, and he feels good about that result.

“[Employees] want to know what the corporate goals are,’’ O’Connor said. “They want to know how they can affect it. What I like is there is actually a dialogue now with the manager as to what they should be focused on.”

Other changes that are happening in bank pay plans include:

  • More publicly traded banks are using restricted stock. The stock typically vests over a three-to-five year period, to provide a retention tool, or vests based on achievement of specific performance measures. Common performance measures include the company’s shareholder return relative to a peer group, return on assets, or earnings per share. Goals for the highest executives tend to be focused on corporate performance, while lower level employees have more weight given to individual and department goals. Private companies can offer incentives in the form of “synthetic stock” or “phantom stock” that increases in value with the company’s value, and is ultimately paid in cash.
  • Long-term incentives are an increasingly important part of the average executive’s pay, but the percentage varies greatly by size of bank. For example, CEOs at banks above $1 billion in assets on average receive 26 percent of compensation in long-term incentives, typically stock, according to a review of about 150 publicly traded companies by Blanchard Consulting Group. For banks between $500 million and $1 billion in assets, the percentage of total compensation that is long-term is 12 percent.
  • Stock options are going away. Regulators have a “stated disdain” for stock options, according to compensation consultant Todd Leone of McLagan. “They have been slowly dying on the vine,’’ he said. Powerful shareholder advisory groups, such as Institutional Shareholder Services and Glass Lewis & Co., don’t consider stock options tied to performance.
  • Gone are the days of executives getting change-in-control payouts when a sale occurred even when they didn’t lose their jobs. The payouts also are smaller, in the range of two to three times base pay, rather than four or five times base pay as was common five or six years ago, said Barack Ferrazzano attorney Andy Strimaitis.

Figuring out how to pay top executives has always been a huge challenge for the board. You don’t want to lose top talent to competitors, but you also don’t want to give overly lavish pay packages, either. There is no one way to do this. There are plenty of ways to get your bank in trouble with regulators or ensure a negative say-on-pay vote at the annual shareholders’ meeting, but each board has to come to its own decision about what makes an optimal pay package.

Banks Increasingly Use Restricted Stock


11-10-14-Blanchard.jpgEquity compensation practices at community banks have shifted significantly during the past 10 years. This shift has focused primarily on the type of equity, the way in which equity is granted, and the prevalence of equity use for both executives and directors. While some of the changes have been triggered by regulatory bodies, I believe some of the changes have also been the result of common sense and experience.

Executive Equity Grant Trends
In the early 2000s, before the implementation of stock option accounting, stock options were the most prevalent form of equity compensation. But with the implementation of stock option accounting under FAS123R (now ASC 718), companies now had to recognize a stock option expense and there was the chance that the executive never recognized a reward if the stock price declined after grant. In the late 2000s, numerous stock options were “underwater,” or no longer accomplishing the goals of equity compensation for executives, including reward, retention and link to shareholders. As such, the last five years have seen a significant rise in grants of full-value shares (commonly, restricted stock units or RSUs). These full-value shares will:

  1. Always have value (so long as the underlying stock has value). They can’t go “underwater.”
  2. Create executive shareholders. They are stock grants and executives become shareholders upon vesting.
  3. Promote retention if vesting provisions are included, with vesting typically ranging from three to five years.

In a Blanchard Consulting Group study of approximately 200 publicly traded banks, 86 percent of those that granted equity to the top executive in 2013 used restricted stock, 39 percent used stock options, and 24 percent used a blend of both. Restricted stock has clearly become the preferred equity compensation vehicle.

Another trend with executive equity grants is the use of performance criteria in determining the amount and/or vesting of the equity grant. Historically, equity was often granted on a discretionary basis and not tied to any performance criteria. Today, I see banks using performance-based grants, where the bank determines specific levels of performance that will result in equity awards if achieved. After the performance cycle is complete, the resulting equity award is granted, typically with additional time vesting. Performance-based vesting is also being utilized in larger banks and Fortune 500 companies. Under this concept, a number of shares are granted, but shares will only vest if performance levels are achieved. I have not seen a high prevalence of performance-vesting in community banks (time-based vesting is more common), due to some complexities with the performance-vesting methodology and accounting. However, banks certainly tie equity grants more frequently to performance than they did in the past.

Director Equity Grant Trends
Ten years ago, the use of equity grants for directors was somewhat sporadic. I have seen this change significantly in recent years, as bank boards decide that director pay should be based on time spent, as well as value and expertise brought to the board. There also is an increased need to attract qualified directors with specific skill sets to help assess risk and handle increased regulatory scrutiny.

These changes to the typical community bank board have created a situation where banks are granting directors equity, commonly as restricted stock. Often, this stock is granted in the form of an annual retainer with either immediate or very short vesting periods, often just a year. Blanchard Consulting Group conducted a study of approximately 150 publicly traded banks and found the following:

  • 75 percent of the banks have an equity plan in place for directors
  • 49 percent of the banks granted equity to directors in 2013
  • 90 percent of those banks which granted equity to directors utilized restricted stock

The goal is to provide directors with a specific amount of remuneration for their annual service on the board, and restricted stock retainers with quick vesting are the best way to tie a specific dollar value to director service. It also makes new directors shareholders and further links them to the people they represent. Our study also found 38 percent to be the median value of equity as a percent of total director compensation.

Another area that is gaining traction in larger organizations and among shareholder advisory firms is executive and director equity ownership guidelines and holding requirements. I have yet to see these items reach a significant prevalence level in community banks, but I expect a gradual increase in upcoming years.

In summation, community bank equity practices have shifted. The shift has been to full-value equity vehicles and restricted stock has become the clear choice. We will see what the future holds.