Dangling the Carrot: How Banks Can Approach Incentive Compensation

May 24th, 2017

incentive-5-24-17.pngWith the dearth of talent at many community banks, particularly in the executive suite, it has become increasing important to make sure that key employees stay put and not pack their bags for the competitor down the street. It is one thing to tie up these executives with non-competition and non-solicitation restrictions, but finding that delicate balance between appropriately protecting the bank’s interests and over-reaching, thereby running the risk of unenforceability, can often be tricky. In addition, adopting a carefully drafted incentive compensation plan can have the benefit of not only improving executive loyalty, but also encouraging revenue-enhancing or other desirable behaviors.

Cash or Equity?
Each employee may be motivated by different things, so it is often difficult to gauge what will have the biggest impact from an incentive perspective. There a few things, however, that should be kept in mind in evaluating this decision:

  • Cash has the advantage of immediate gratification. Equity awards are often subject to vesting requirements and can be difficult to monetize due to the virtually non-existent markets for most community banks’ stock.
  • Because of the vesting requirement of equity, such awards have the advantage of providing a longer-term benefit to the bank, in that executives will be loath to leave while they hold unvested equity awards.
  • It can be difficult for both the bank and the executive to value equity awards, given the lack of an efficient market for the shares.
  • Any time stock is issued by a bank holding company, it must be issued pursuant to a registration statement with the Securities and Exchange Commission, or an appropriate exemption must be available. The most common exemption for equity incentive awards is Rule 701, which requires awards to be issued, among other things, pursuant to written compensatory plans.

Appropriate Triggers
There are endlessly creative ways that community banks and their compensation consultants use to determine incentive compensation awards. So much of this is driven by the types of behaviors that the bank desires to encourage. However, there are a few things to keep in mind as you decide how to design your particular plan:

  • Beware of the Wells Fargo effect. While it is not uncommon to tie awards to achieving certain revenue and sales metrics, it is important to have appropriate controls and/or claw back policies in place to recoup pay and discourage overly aggressive sales practices.
  • Avoid tying incentives to confidential supervisory information. Many banks want to tie incentive compensation to achieving certain examination findings or CAMELS ratings. However, regulators have consistently stated this is inappropriate on a number of levels, not the least of which is that they do not appreciate being one of the deciding factors in whether an executive gets a bonus or not.

Other Do’s and Don’ts

  • Revisit plans that have been in place for a while to ensure that they are Section 409A compliant. Section 409A of the Internal Revenue Code sets forth certain rules regarding the timing of deferrals and distributions with which non-qualified deferred compensation must comply. Non-compliance could have significant negative tax consequences on the employee and, potentially, the bank.
  • The worst time to adopt a new incentive compensation plan, particularly one that contains change-in-control provisions, is right before the board decides to put the bank up for sale. Doing so may be perceived by shareholders as a breach of the board’s fiduciary duties.
  • If any of the bank’s mortgage loan originators are included in the pool of executives entitled to participate in the executive compensation plan, additional attention will need to be given to ensure that any awards granted under the plan do not run afoul of the loan original compensation restrictions set forth in Regulation Z.

While it is certainly a good idea to make sure your most valuable assets—your executives—are protected, there are a lot of variables to consider in putting together incentive compensation plans, which should be carefully crafted to achieve the bank’s objectives while avoiding unintended consequences.

pmurphy

Patrick S. Murphy is a shareholder in the Banking & Financial Institutions and Securities Practice Groups in the firm's Milwaukee and Madison offices.