How to Improve Compensation Committee Effectiveness

Finding the time and resources for board and committee development is an ongoing challenge.  But enhancing the effectiveness of your Compensation Committee can be done with a few key actions.  This blog and ones that follow will address:

  • Setting a workable Committee calendarCompensation Committee Calendar
  • Selecting membership
  • Continuing education on executive compensation

The beginning of the year is a great time to update or set up a calendar for your Compensation Committee.  Committee responsibilities and activities need to be spelled out in advance and scheduled throughout the year to:

  • Balance the Committee’s workload
  • Allow sufficient time for review before decisions are required
  • Ensure that decisions are well-timed for effectiveness as well as meeting any regulatory requirements

The first step in building the calendar is listing and grouping activities.  You may be surprised at how many issues need to be addressed when you write them all down.  Our basic categorized list includes:

  • Compensation Philosophy Statement
    • This roadmap for guiding Committee decisions should be reviewed at least annually.
    • If you don’t have one, you would be surprised how helpful having written principles can be.
    • Market and Peer Group Review
      • Update the peer group for relevancy.
      • Gather compensation data from surveys and proxies.
      • Monitor performance versus peers.
      • Performance and Salary Review
        • Board/Committee review of CEO performance; and CEO review and report on other senior officers.
        • Committee review of CEO salary and adjust based on market/peer pay levels and executive job performance.
        • Committee review of CEO recommendations for other senior officers.
        • Annual Incentive Plan
          • Update plan in terms of participation, payout ranges, objectives, weights, and performance ranges.
          • Review performance and potential payout levels at mid-year.
          • Complete end-of-year review and approve payouts.
          • Long Term Incentive Plan (if you use stock)
            • Review existing grants and remaining share reserve.
            • Determine any need for updating plan and/or share reserve.
            • Determine new grant (type of grant, total shares, terms, CEO allocation).
            • Review and approve CEO recommendation for grants to other officers.
  • Compensation Risk Assessment
    • Conduct at least annually – ideally just after the end of the year so the Committee can look back at the prior year and plan for the year just beginning.
    • Director Compensation
      • Determine frequency of review (we recommend an annual review; but at least every third year as a minimum).
      • Conduct review and recommend changes to Board.

Of course, companies participating in government programs like TARP or those who are required to report to the SEC have a number of other requirements and activities that we won’t try to cover here.  Suffice it to say that these requirements are a significant expansion of the previous list.

Filling out the calendar is best done using a grid with the major categories of work down the left side of the calendar, and the months across the top.  This approach allows you to schedule the items in each category in logical order as well as look at the volume of Committee work in each month.

Finally, this is a task best completed by the Committee Chair, CEO, and outside compensation consultant if you have one.  You may also want your CFO and Chief Human Resources Officer involved if they interact directly with the Committee.

Please add comments below, and if you want to know more about how we can help, call me at 919-644-6962 or ask us to contact you at http://matthewsyoung.com/contact.htm.

How to Improve Executive Compensation Committee Effectiveness – Membership Selection and Committee Structure

In a previous blog entry, I talked about improving Executive Compensation Committee Effectiveness by setting up an annual Committee calendar to balance workload, set priorities, and ensure timely and effective decisions.

This follow-on blog highlights four important elements for effectiveness from the standpoint of Committee membership, structure, and decision-making authority:

  • Characteristics of effective committee members
  • Appropriate committee size and turnover
  • Balancing other committee assignments
  • Assigning sufficient authority

 

Characteristics of Effective Committee Members

Some Director backgrounds are more appropriate than others for the Compensation Committee.  Candidates with formal corporate management experience or service as professional directors tend to have a better perspective for dealing with complex compensation issues.  Directors with entrepreneurial or smaller company experience may not have faced these kinds of issues before.

 

Appropriate Committee Size and Turnover

Our experience shows that the Compensation Committee needs at least three independent members but typically not more than five.  Decision-making is streamlined with a smaller committee; but don’t get so small that you limit important interaction and having a range of perspectives that ultimately builds strong consensus.  Also, you should change no more than one-third of the committee’s members in a year.  Otherwise, you lose “institutional memory” and valuable experience and expertise that takes a while to develop.

 

Balancing Other Committee Assignments

Because of the importance placed on the governance of executive compensation, membership on the Compensation Committee should be a director’s primary committee assignment.  If at all possible, don’t place directors on both the Compensation and Audit Committees.  While you want your best directors on your most critical committees, you don’t want to stretch them too thin.

 

Assigning Sufficient Authority

And finally, all Boards of Directors should take the time to determine what level of authority the Compensation Committee will hold.  We believe that Compensation Committees are most effective when the Board assigns them specific decision-making authority.   Where full Board voting is desired or required, the Committee should always bring a specific recommendation that the Committee has developed and fully supports.

If you would like a sample Compensation Committee Membership Profile, we would be happy to send you one.  Complete the following request form:

 

Performance-Based Long Term Incentives – Not Just a Best Practice

Executive compensation and performance-based pay continue to be a hot topics in board rooms and in the press. Corporate directors should be wary of compensation plans that can distort the pay for performance equation. Two pending SEC rule changes may impact how public companies implement executive compensation in the future: the Pay for Performance disclosure, and the CEO pay ratio. Where CEO pay and company performance are misaligned, proxy reporting will raise a red flag for shareholders and investor groups. Large pay packages that result in problematic CEO pay ratios (the ratio of CEO pay to employee median pay) have been key topics in the press as companies anticipate the implementation of the SEC’s new pay ratios rules.

Strategic PlanningAs the deadline nears for implementing these new pay disclosure rules, public boards and executives should focus on the effectiveness of all elements of executive pay. Since a large part of CEO compensation is long-term incentives, typically stock-based or plan-based compensation, these plans should be closely evaluated. While public companies will be concerned with the new pay rules, private companies will also be interested since pay for performance is a best practice. Consequently, long-term incentive pay will be a focus in the near term.

Historically, long-term incentives were granted to retain executive talent; executive retention is greatly enhanced when adding a vesting feature and a forfeiture clause for executives who leaves before vesting. Retention in the form of long-term incentives generally were implemented using stock grants, primarily in the form of restricted stock and RSUs with vesting after three or five year’s continuous service. Stock options could also be used to help with retention; however they often lose their effectiveness when the stock price drops and options fall underwater. While these types of grants are effective retention tools, they lack the focus that is generated with performance-based incentives.

We believe that a meaningful way to measure the effectiveness of long-term incentive compensation is to evaluate whether the incentives reward senior executives for meeting and sustaining the strategic goals of the company. While service vested stock grants have an element of performance, too often vesting of large stock grants occur during a time when the company’s performance is declining. This misalignment of pay and performance can send a bad message to shareholders and regulators. A better message to send occurs when a large block of stock vests when the company achieves a key success or during a period of excellent performance. For this reason, we believe that long-term incentive pay should be primarily tied to company performance that is linked to long-term, sustained improvement in shareholder value.

Naturally, these incentives should be linked to the executive team’s success against the main goals outlined in the company’s strategic plan. This can be a complicated task. Executive teams are leery of setting performance expectations too far into the future due to the uncertainty of the business environment. The need to set goals that are measurable and meaningful is a significant factor in a plan’s success. A few key goals can be far more meaningful than a long list of performance objectives that may be difficult to track and fraught with confusion about final outcomes. Ultimately long-term incentive plans should (1) be simple enough to communicate to multiple constituencies, (2) reflect the expectations of the board over a long time period and (3) align with sustained and improved total shareholder value.

However, long-term incentives tied to key performance objectives often compete against the desire to meet annual incentive plan goals. Focus on short-term earnings performance and near-term outcomes to satisfy investor groups can be a detriment to achieving a long-term strategy. For public companies, too much emphasis is placed on quarterly results at the expense of meeting longer term objectives. Private companies have less pressure, but the tension between short-term performance and longer term strategic objectives still exists. Successfully implementing performance-based long term incentive plans is one way to counter the pressure of shorter term thinking.

For example, most financial institutions are experiencing pressure to boost their earnings because of declining revenues due to low interest rates. Could this lead bank executives to seek higher interest rate loans with greater risks or higher market concentration in order to generate higher rates and more fees? Could this pressure to boost earnings cause executives to drift away from the long-term strategy of the bank? Of course it could; this is reasonable outcome when pressure on short-term earnings overshadows the long term strategy of a bank; this focus could be a problem for future success. Our suggestion to counter this short-term behavior is to establish long-term incentives linked to an emphasis on loan portfolios that are more consistent with the bank’s strategic direction.

So what are some of the key issues to address if you want to implement a performance-based long-term incentive plan? As a first step, do you have an up-to-date and effective strategic plan? If not, start here. Next, you need to decide whether stock or cash is the best way to provide executive incentives. Also, determining the best time frame for vesting is another important step. We think a minimum of three to five years makes sense. However, you may want to tie the vesting to a major business initiative or a future liquidity event; these events don’t always occur on a fixed schedule. Using multiple grants (annual or biennial) can add another favorable dimension to the plan design. Having rolling vesting dates can help sustain the plan’s long-term momentum. These plan design features and many other plan design decisions must be made when implementing a new plan or moving the emphasis away from service vesting toward performance vesting.

In summary, performance-based long-term incentive plans are a recognized best practice among industry experts and corporate governance groups like ISS and Glass Lewis. With the SEC implementing new rules that will spotlight pay for performance and CEO pay, this may be an excellent time to evaluate your current executive compensation plans to make sure that executive pay is closely aligned with company performance. Finally, directors and executives should examine both the annual bonus plan and the long-term incentive plan to validate that these plans are fulfilling the long-term strategic needs of the company.

Author J. Henry Oehmann can be reached at Henry.Oehmann@MatthewsYoung.com

The Seventh Day Brings No Rest (Part 2)

History of BankingThe pace of progress is quickening as we begin this, our second in the series of our history of banking as if it occurred in one week.  But, it isn’t until 7:26 on Wednesday morning that the story of American banking starts to unfold. The actual date is 1741 and the problem is tight British control over the number of coins entering the Colonies. Americans are tired of relying on crop notes and barter, and decide to start banks of their own. The predictable response is a legal roadblock. The British prohibit banking and the experience sours many American Colonists on financial institutions.

This Wednesday of our banking week closes with a very significant American event, the end of the Revolutionary War. It is 14 minutes after midnight on Thursday before Alexander Hamilton establishes a federally chartered Bank of the United States over Thomas Jefferson’s strong objections. Yet the charter of the bank runs just 20 years and by Thursday evening it is dead.

In fact, when the U.S. Government needs to borrow $11 million to buy Louisiana – in our time sequence this 1803 event takes place at 9:29 on Thursday morning – no U.S. bank has enough clout to finance the deal. Fortunately, a British institution steps up to the plate. For America, Thursday turns into a very long night filled with the nightmare of the Civil War.  Yet as Friday dawns, the United States enters a promising new day. The country is unified and state banks are flourishing. Though state banks in the South had weakened or disappeared, a rebirth has begun.

It is mid-day on Friday – 11:31 a.m. – when the National Bank Act of 1863 passes. The leaders on this Friday are men of integrity like Israel Lash, who launches the First National Bank of Salem (N.C.) to serve thrift-conscious Moravians, after it becomes clear that The Bank of Cape Fear’s Salem branch (Lash’s former employer) will not be part of the revival. Late this Friday morning, Alfred Austell founds one of the oldest banks in Georgia in his home. Though the Reconstruction Act absolved Austell from any obligation to redeem his former bank’s Confederate money, Austell depleted his personal fortune to exchange this money for gold, an act of faith his former customers clearly remember. As the National Bank Act strengthens federal control over banking and currency, Austell, Lash and fellow bankers are encouraged to make new beginnings.

Over the lunch hour that Friday, it appears American banking has finally gained a stability that has been very elusive during its first two days of life. At long last the nation has a uniform currency, gained primarily by taxing state-chartered bank’s notes, rendering them of insignificant value.

On Friday – the fifth day in our banking week – the nation is charged with great creative energy. Before Friday ends, Thomas Edison produces the first commercially viable electrical lamp and George Eastman markets his first box camera. Yet as Friday – and the first five days of modern banking history – draw to a close, surprisingly little has changed in the way banks operate. The Monday morning customers of Amsterdam Wisselbank would feel comfortable in the Friday evening banks of the United States.

However, there are blips on the radar screen that predict a storm of activity. For example, when transatlantic cable is laid in the 1870s – 3:43 p.m. Friday in our time line – some bankers realize they can take advantage of small price differences in New York and London markets to profit on arbitrage. This begins a much more creative time and one that evidences strategic innovations that will ignite a tremendous leap forward in the pace of change, yet one that also will elevate that risks and develop new challenges for the industry.

We will discuss those changes over the next few weeks.

The Seventh Day Brings No Rest

ClockA few years ago, a well known and well respected bank CEO observed that in today’s world three years of change seem to be compacted into every six months of banking history.  I hardly ever disagreed with him, but in this case I believe that his compression idea is on target but a little too conservative.

After meditating on the observation, I thought it might be interesting to try to condense the history of modern banking into a single week—a mere seven days.  While daunting, I think it will depict just how much has happened in a relatively short span of time.  For the next few months, follow along with me as we review the 7 short days of the week and  the evolution and the rapidity of that change.  In this context, banking as we know it has developed within the last hour.  And, in the next few minutes, banking is almost certain to be changed beyond recognition by profound technological, economic, political and cultural changes buffeting our business.  Today, it is not change, but the pace of change that is unique and creates banking challenges of a new magnitude.  Creative strategy becomes a necessity, but difficult to tackle.

So, to depict how history’s pace has quickened, try to measure banking events in terms of one ordinary Monday-through-Sunday week.  The first day of this week – a Monday – marks the arrival of modern banking, while the latter part of Sunday represents 2009, the 400th anniversary of modern banking.  We will have just gone to bed when the first four years of the next century begins – and what a beginning!  For this exercise, the first minute of Monday – 12:01 a.m. – is the year 1609.  It is when the Amsterdam Wisselbank opens its doors – an excellent beginning for our modern era.

Of course, many aspects of banking predate 1609 and set the stage for our four century banking week.  But the banking week we have defined is more than adequate to demonstrate the accelerating pace of change.  On the Monday modern banking arrived, Shakespeare was busy writing sonnets, trade was flourishing and the merchant class was on the rise.  The Amsterdam Wisselbank opens with a broad charter – to accept deposits and bills of exchange, transfer payments among customer accounts, mint coins and lend money.  This institution thrives for 200 years – about 4 days in our compressed time capsule.

Throughout the wee hours of Monday morning, growing numbers of English goldsmiths who safeguard customer deposits discover that owners never demand more than a fraction of their reserves in payment.  So they gain more and more confidence about using promissory notes to lend on deposits.  These goldsmiths’ paper certificates serve as currency, increase the money in circulation and fuel economic expansion.  One might say that their strategic vision was to enable customers to build businesses through providing credit and thereby enhancing profitability.  It is now a short step to a bank check.  The first check is written at about 9:00 Monday night.  This 1659 check evolves from the practices of British institutions that specialize in mortgages and legal services.  Adding additional products and services has already begun.

By the end of the century –2:13 p.m. Tuesday, London has become a major financial center and the Bank of England has begun to serve as a role model for central banks.  Next time we will see what Tuesday evening and part of the rest of the week brings as the pace of progress is beginning to quicken.

How to Improve Compensation Committee Effectiveness

Finding the time and resources for board and committee development is an ongoing challenge.  But enhancing the effectiveness of your Compensation Committee can be done with a few key actions.  This blog and ones that follow will address:

  • Setting a workable Committee calendarCompensation Committee Calendar
  • Selecting membership
  • Continuing education on executive compensation

The beginning of the year is a great time to update or set up a calendar for your Compensation Committee.  Committee responsibilities and activities need to

be spelled out in advance and scheduled throughout the year to:

  • Balance the Committee’s workload
  • Allow sufficient time for review before decisions are required
  • Ensure that decisions are well-timed for effectiveness as well as meeting any regulatory requirements

The first step in building the calendar is listing and grouping activities.  You may be surprised at how many issues need to be addressed when you write them all down.  Our basic categorized list includes:

  • Compensation Philosophy Statement
    • This roadmap for guiding Committee decisions should be reviewed at least annually.
    • If you don’t have one, you would be surprised how helpful having written principles can be.
    • Market and Peer Group Review
      • Update the peer group for relevancy.
      • Gather compensation data from surveys and proxies.
      • Monitor performance versus peers.
      • Performance and Salary Review
        • Board/Committee review of CEO performance; and CEO review and report on other senior officers.
        • Committee review of CEO salary and adjust based on market/peer pay levels and executive job performance.
        • Committee review of CEO recommendations for other senior officers.
        • Annual Incentive Plan
          • Update plan in terms of participation, payout ranges, objectives, weights, and performance ranges.
          • Review performance and potential payout levels at mid-year.
          • Complete end-of-year review and approve payouts.
          • Long Term Incentive Plan (if you use stock)
            • Review existing grants and remaining share reserve.
            • Determine any need for updating plan and/or share reserve.
            • Determine new grant (type of grant, total shares, terms, CEO allocation).
            • Review and approve CEO recommendation for grants to other officers.
  • Compensation Risk Assessment
    • Conduct at least annually – ideally just after the end of the year so the Committee can look back at the prior year and plan for the year just beginning.
    • Director Compensation
      • Determine frequency of review (we recommend an annual review; but at least every third year as a minimum).
      • Conduct review and recommend changes to Board.

Of course, companies participating in government programs like TARP or those who are required to report to the SEC have a number of other requirements and activities that we won’t try to cover here.  Suffice it to say that these requirements are a significant expansion of the previous list.

Filling out the calendar is best done using a grid with the major categories of work down the left side of the calendar, and the months across the top.  This approach allows you to schedule the items in each category in logical order as well as look at the volume of Committee work in each month.

Finally, this is a task best completed by the Committee Chair, CEO, and outside compensation consultant if you have one.  You may also want your CFO and Chief Human Resources Officer involved if they interact directly with the Committee.

Please add comments below, and if you want to know more about how we can help, call me at 919-644-6962 or ask us to contact you at http://matthewsyoung.com/contact.htm.

Separate Roles in CEO Succession Process

Boards of Directors have a difficult, but critically important job to do with CEO succession planning.  If a Board selects the right person to succeed a departing CEO, shareholders, employees and regulators will be happy with the results.  On the other hand, a failure with CEO succession can bring about the failure of the enterprise.  If it is not THE most important thing a Board does, it is very close.

I am often asked whether a retiring CEO should be on the Search Committee.  There are times when the answer is an obvious “no.”  However, there are situations wherein the Board feels more comfortable with their role if they have a long-term, successful CEO heavily involved in the process.  My 35 years of participation in these processes has taught me that no two companies are exactly alike, so there is no right or wrong answer to the question.  To me the ideal is for both the CEO and the Board to have important, but different well-defined roles in the process.

The most productive role for a CEO in succession planning starts the day they become CEO.  From the beginning, a CEO should start preparing their potential internal successors by assessing strengths and weaknesses, getting them training, development and coaching as needed while exposing them to the Board.  The CEO should be sure the Board understands the efforts being made to develop successors internally and frequently share candid assessments with the Board.  If this work is done properly, the Board should have a good idea of their “bench strength” in case of an emergency and when it is time for the CEO to retire.

Roles Fork

CEO and Board work together until decision time

The role of the Board (usually with the help of a Search Committee) is to select the best candidate from inside or outside the company.  If the departing CEO has done his/her job, the internal candidates should be strong contenders, given their intimate knowledge of the company and its culture.  Nonetheless, today, most Boards feel like it is their fiduciary duty to look outside the company as well as inside.  So, most often the Board or Committee will have some good internal and external choices.  When it comes time to make a choice, a long-term, successful CEO should be available to the Board, but should take a passive role except in extenuating circumstances.

The departing CEO will justifiably favor the internal candidates, and any external candidates the CEO brought in early.  However, the departing CEO is most often not going to have to live with the consequences of the selection.  The CEO can still be on-call with the Board to answer technical questions about the job, but the sorting and grading of the candidates should not include the CEO unless there are strong reasons to include him or her.  Sometimes, the Board will choose a successor a year or two before the departing CEO steps down, in order to give the new CEO time to learn from the departing CEO.  In other situations, the departing CEO will be staying on in a Board role, which has its own issues that we will discuss in a future blog.

For now, suffice it to say that including a CEO in the final selection of their successor is fraught with issues and should be avoided unless there are compelling reasons to keep them involved to that extent.  If it would help your Board to have a full discussion about this issue, call me at 919-732-2716, or click here and give me your contact information.

The Daunting Challenges of the Future

At the end of last year we emphasized how strategic planning is critical for the survival of banks in the future, no matter how hazy the road to the future may be currently. Let’s drill down a little further.

Thinking strategically requires creative leadership—the ability to develop, sell and cultivate an idea from inception through implementation. Executives who want to lead their institutions as they build strategic plans must add varied skills to their management repertoire, especially skills as teachers and leaders.

Dynamic change is part of any good strategic plan

Strategic planning is a job that never ends. Because the environment and competition often prompt base assumptions to change, strategies need to be revisited at least every 12 to 18 months. Even if major tenets remain constant, strategic plans still should be reassessed periodically. Questions that bankers should ask themselves touch on internal attitudes as well as the outside world:man-with-questions-200x200

  • What have we done successfully?
  • How has the competition reacted?
  • What is different in our environment?
  • Should we continue on our current path or make changes?
  • Are any failures due to poor strategy or poor execution?

Obstacles to Success

The road from strategic planning to success may not be completely smooth. But, if executives are alert to common roadblocks, they can steer around them with as few serious detours as possible. For strategic planning to succeed, a CEO must view the process as an ongoing commitment and not an exercise to satisfy regulators. Strategic planning is a process, not a sheaf of paper.

Poor communication between an institution’s management and its board can present problems. If these two groups do not have a shared vision and are pulling in different directions, strategic planning has little chance of success. The secret is to engage both groups in the earliest planning sessions. Elitism also represents another common obstacle. In an elitist planning mode, a CEO and one or two top people may complete a strategic plan without involving any of the individuals who will actually execute it. This approach is fraught with peril. First, the planners fail to get input from people who often know far more than they do about operations, customer attitudes or competing products. Second, if middle-level managers do not play a role in developing strategy, they have little personal investment in its outcome.

A putting-out-the-fire management style can create other difficulties. In this case, the institution’s CEO and board may eagerly invest time in developing a strategy, but quickly lose interest when it comes to monitoring progress and overseeing implementation. As soon as the first crisis comes along, interest is diverted and planning is forgotten. A management team does not have to go through many planning-to-oblivion cycles before it loses complete faith in the process.

Strategic planning does not and cannot forecast the future. We have already acknowledged that while the road to the future is hazy, there is hope down the road. Planning cannot predict the exact time a quake might hit your institution, or the size and duration of the tremor. Accept the fact that you will make wrong decisions as well as right ones.

While strategic planning is not infallible, it will help you learn your institution’s strengths and weaknesses and how your resources can be marshaled to survive and thrive. Strategic planning strips change of its power to frighten and immobilize management. It offers executives the power and the skills to harness the energy of change as an engine of creativity.

Citigroup, Inc.’s New CEO Compensation Plan

Citi is finally getting CEO pay plans right! After losing their shareholder “say-on-pay” vote at the 2012 Annual Meeting of Shareholders, new Chairman Michael E. O’Neill, who just took over as Chairman last April, interviewed a large number of important shareholders. He was told that paying their CEO a $6 Million Incentive based on a two-year (2011 and 2012) cumulative pre-tax profit of $12 Billion, may sound like a good deal for the shareholders, but it was fraught with problems.

carrots

Incentive Pay Must Be Carefully Designed

To begin, the Company had 2010 pre-tax profit of approximately $12 Billion. So, the hurdle for earning the $6 Million was half of the actual earnings in 2010. Yes, the economy has made earnings difficult to produce, and yes, Citi is trying to overcome internal problems, but shareholders were unwilling to allow a hurdle rate that low. There were other problems with the design of the Plan.

Cumulative two-year pre-tax earnings ignores the fact that the bank could grow assets at a decreasing return on each dollar and meet the earnings hurdle while increasing their capital requirements significantly. Using volume of profit as a management performance measurement always has this inherent problem. In fact, increasing volume of profit can and often does result in lower returns on equity in banking. For that reason, shareholders can lose as management earns more, and a lose-win plan is never good.

Finally, building on the last point, there is no clear link between shareholder returns and management pay in the Plan Citi was using. A common objective of executive compensation plans is to align the interests of management with those of the shareholders. The old Citigroup, Inc. Plan did the opposite to some degree. The Board of Citigroup consists of intelligent and successful people, but they got some bad advice along the way. After Chairman O’Neill spoke with shareholders, he tasked the Board’s Compensation Committee to redesign the CEO’s Compensation Plan to address the shareholders’ concerns. He was not about to get a negative “say-on-pay” vote after his first year as Chairman.

Now, in my many years of studying and designing executive compensation plans, I have yet to see the perfect plan. It just does not exist. Business is too complex to allow for such a thing, and the need to keep the plan as simple as possible is an important constraint.  Yet, the new Citigroup, Inc. Management Compensation Plan addresses shareholder concerns with an elegantly simple design.

Executives will be granted units worth a certain amount in three years if certain performance is achieved.  Citigroup stock must perform in the top three-quarters of a carefully selected peer group of stocks of similar companies, and Citigroup’s Return on Average Assets over the three years must beat a hurdle equal to the previous year’s actual or there will be no units rewarded.  Furthermore, if the Return on Average Assets over the three years is better than the previous year by a significant percentage, then a target number of additional units will be awarded.

This design is superior to the old design because it clearly:

  1. aligns management’s interests with those of the shareholders and
  2. it is tied to relative performance compared with peers as well as the Company’s strategic goals.

There are some potential draw backs to such a plan, but the new plan is so much better than the old plan, I will not spend words on the risks in this particular blog.  Perhaps in the future, we can look at some of the potential flaws.  In the meantime, I say congratulations to Mr. O’Neill.  I may go buy some Citigroup stock!

STRATEGIC PLANNING AND THE LONG JOURNEY AHEAD

Last month we discussed the alarmingly similar events and reactions that occurred in the periods of 1988-1992 and 2008-2012.  Yes, strategic planning is perhaps needed more today than at any time since the 1980’s; however, the challenges are daunting, and the road ahead has gotten hazier each day.

foggy road ahead

The road has gotten hazier

The good news is that for the banks and bankers who stick it out and survive over the next five years, the future does look bright because the very pressures bankers feel today will eventually and inevitably squeeze out lower performing banks enabling a return to rational pricing.   It is going to take some time for this to occur, but the path appears set.

A wise banker said recently, “there is a long way to go, and the journey has just begun.”  Well, just how long is that journey and just what is the future?  The regulators have given us a peak into their minds.  Here is some of their thinking:

  • The core deposit franchise will need to be nurtured and managed
  • An efficient, lean operation will be critical
  • Capital management will be essential
  • Sound strategies will be critical
  • Good financial skills and in-market knowledge will be required of Boards
  • Credit and Operational risks will be equally challenging

There are a litany of challenges and issues that will need attention for the future.  But, any way you slice it, making money in a prolonged low-interest rate environment, providing a decent return to your shareholders, dealing with over reactive regulations and returning to good old-fashioned fundamentals are the underpinnings of success in the future.

Strategic planning is not a panacea, but it is critical to survival.  As we stated before, good planning establishes objectives to achieve desired future results.  Though it cannot forecast the future, strategic planning does attempt to look at future possibilities so decision makers can rationally choose between courses of action that involve risk.  Strategic managers are proactive managers.  They tackle questions of structure and focus so they are prepared long before seismic activity is sensed.

Effective Strategic Planning in a Challenging Environment

Change?  No change is necessary.

That is what some bankers thought when their institutions began to suffer the first shocks of a quake that started rattling the financial industry in the mid-1980s.  These bankers figured that if they just hunkered down and minded their own business the tremors would subside.

Bank Strategic Planning

Bank Failures Since 1979, Source: SNL Financial and FDIC
Number of Failed Banks in 2012 is annualized based on 23 failures as of 5/1/12

Instead, many banks – and bankers – vanished.  From 1988 to 1992, the U.S. banking industry witnessed more bank failures than ever before, especially in any comparable five year period.

The reasons were complex.  Massive change hammered the industry.  New banking laws and regulations altered how financial institutions could do business and increased base-line costs.  For banks that were already on shaky financial footing, new capital requirements dictated cutbacks and/or injections of hard-to-find investment dollars.  The debut of interstate banking intensified price-cutting campaigns to win market share, and margins began to shrink.

Sound familiar?  It’s de ja vu all over again!  “Same events, different time.”  The earthquakes returned in 2008, and the financial world began to come undone once again.

For survivors of repeated quakes, reality has arrived.  If we hope to retain our jobs and help our institutions withstand external pressures, we had better prepare for life in an earthquake zone.  Strategic Planning is needed today more than any time since the 1980’s.  Through strategic efforts, banks can intelligently re-engineer their institutions to gain the resilience and strength needed to absorb shocks – and even expand – in our unstable economy.

Strategic Planning is extremely challenging in this environment, since it requires looking at the future and making assumptions.  Today, about the only given is that more massive change lies ahead.  Yet, an outline is emerging of the future that banks will face.  Over the next four or five months, we will comment on dealing with specific trends.

Five Requirements for Successful Strategic Planning

The plan is never finished.  Strategic Planning is a process that never ends.  Banks should revisit their strategies every 12 to 18 months.  Bankers should ask these questions to reassess internal attitudes and the outside world:

  • What have we done successfully?
  • How has the competition reacted?
  • What is different in our environment?
  • Should we continue on current path or make changes?
  • Are any failures due to poor strategies or poor execution?

For strategic planning to succeed, management and the Board must view the process as an ongoing commitment—not an exercise to satisfy regulators.

Management and Board must reach consensus.  Poor communication between a bank’s management and its board can present hurdles.  If these two groups do not have a shared vision, strategic planning has little chance to succeed.  Therefore, it is crucial to engage both groups in the planning sessions.

Many voices must speak.  A CEO and one or two people may complete a strategic plan without involving any of those who execute it.  The plan will be impractical, and managers will have no personal investment in its success.  Banks should search for ways to let employees share in the rewards and risks inherent in the development of strategic plans.  This may mean rewarding performance using bonuses or incentives, stock plans and other alternatives to pure salary.

Strategic Planning

Strategic Planning Cannot Predict the Future

Follow-through is essential.  A frenetic management style can create difficulties.  The CEO and board may eagerly develop a strategy, but lose interest when it comes to monitoring progress and overseeing implementation.  As soon as the first crisis comes along, they forget about the planning.

Power to harness change creatively.  Strategic planning cannot predict the future.  You cannot predict exactly when a quake might hit your institution—or its size and duration.  With strategic planning, you can make wrong decisions as well as right ones.  But strategic planning will help you learn your institution’s strengths and weaknesses and discover how your resources can be marshaled to help your bank survive and thrive.  Strategic planning strips change of its power to frighten and immobilize bankers.  It offers executives the power to harness change creatively.

The Risk of Becoming Risk Averse in a Post Financial Crisis World

Some Federal officials and others from sectors that are removed from day-to-day commerce want to blame risk takers, represented by Wall Street investment bankers, for high unemployment and frozen financial markets, and certainly risk exploded during the decade leading up to 2008.  While Wall Street firms need to bear their share of the responsibility for participating in risk-run-wild, there is plenty of blame to go around, including government policies before and since the liquidity and credit crisis hit in late 2008.

It is important now to fully diagnose the reasons for our recent economic woes and pass regulation that helps identify the size and nature of systemic risk in the future.  It needs to start with governmental policies, federal, state and local, that interfere with the normal market-driven risk and reward mechanisms that have controlled free enterprise from its inception.  Risk rating agencies need to be truly independent in the future.  Corporations must do a much better job of assessing the risks they create or support in the marketplace.  In addition, American consumers need to be better educated in economics and free enterprise so that they can detect risk in offers that are too good to be true.

FDR is often quoted as saying in his first inaugural address, “The only thing we have to fear is fear itself.”  We need to remind ourselves of this wisdom in these times of frozen job markets and banks.  One of the primary tenets of capitalism is “no risk, no return.”  Fear of risk has things frozen.  It is time to take measured risks again, not the senseless risks we saw in the mortgage funding government policies or mortgage-backed securities that could never have produced a lasting return, but reasonable risks that produce reasonable, long-term returns.

Sharp Edges

Misguided Warning

One of our greatest risks at this point in the history of our great nation and its great economy is, as FDR put it, the “nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.”  We risk becoming so risk averse that we will never move ahead.  Government needs to stop punishing and get out of the way of growth.  Banks need to make loans in support of reasonable new ventures.  The unemployable must learn new skills.  Corporations need to expand and hire people to grow their businesses.  The global market will make a comeback if we don’t let our fears of risk prevent it.

Executive Pay Equity

A recent headline from WorldatWork indicates the gap between CEO and CFO pay is growing farther apart.   The study conducted by BDO USA, LLP indicates that CFOs average 40% of CEO pay at 600 public companies included in the study.  One reason offered for the increased disparity is due to CEO pay being more commonly tied to the increase in the company’s equity, which for most public companies, increased substantially in 2010 and 2011.

While CEO’s have historically been paid at levels higher than the rest of the executive team, this recent trend of an increased gap could lead to problems.  Shareholders may assume that the change in the CEO – CFO pay comparison could be a reflection of how the Compensation Committee values the relative roles of risk-taker vs. risk-controller.   Let’s hope not.  That led to some serious problems in the past.  It is more likely that the bigger recent gap is due to the 2010 and 2011 run up in stock prices and the CEO’s larger percentage of compensation tied to stock price gains.  Should the mix be so different for the two positions?  A return to a more equitable internal pay structure will help avoid potential perceptions among shareholders that CFOs are not valued as much as they have been in the past.

With slowly improving economic indicators, organizations are reviewing current compensation practices.   In addition to the scrutiny on executive compensation as a Pay Equityresult of Dodd-Frank, this renewed focus on executive pay will require organizations to focus on their philosophy and implement equitable compensation plans.  Compensation Committees may want to look at how relative compensation has changed over time and consider ways of optimizing compensation mix to stabilize the fluctuation in the comparisons.

In our Firm’s work with client executive teams, we have historically measured the internal pay equity of senior executives measured as a percentage of the CEO’s pay.   We have significant, historically viable data showing the relative pay for all executives on the senior team as related to that of the CEO.   Two critically important objectives of any company’s compensation philosophy should be to target external competitiveness and be internally equitable.

If you would like a review of your company’s current compensation practices measured against market, industry and custom peer groups, please give us a call (919-644-6962) or visit us at http://matthewsyoung.com.

Ideal Community Bank CEO Candidate

Needle in a Haystack

The Community Bank CEO of the future may be hard to find

Today’s “American Banker” had an editorial called “Chief Factor in Small-Bank Survival? It’s the Chief.”  No question about it!  Leadership matters and while the banking industry has always been about people, the quality of the leadership has never been as critical.

The model for success in the future for community banks is changing radically.  Margins will be thinner on the traditional business of gathering funds and lending them out.  Costs for doing business are rising, if for no other reason than increasing regulation.  Customers are shifting banking habits requiring banks to invest more in technology-based solutions.  The challenges to success will be sizable.  So, what does the ideal candidate profile for the future community bank CEO look like?

I am sure we don’t yet have all of the answers to this major question, but many of the features can be seen in other industries that have gone through massive change.  Retail distribution went through similar change over a couple of decades leading to the development of big-box and chain retailers taking the place of the local hardware store and clothier.  Some leaders saw the change coming and innovated.  Some changed the channel of distribution.  Some narrowed the definition of their niche.  In every case, survival depended on strategic vision, detailed knowledge of their communities and customers and the leadership abilities to take their people through the wrenching change without destroying their loyalty.

The ideal community bank CEO of the future will need to have a wide array of skills and abilities.  They will need a mix of technical skills and interpersonal abilities that may be difficult to find.  Technical skills to recognize and analyze risk and understand the opportunities and the limitations of technology will be key.  In addition, the leadership traits of visionary strategists and change agents will be essential.  The CEO of the future will also need to be able to drive a sales culture and hold people accountable for results.  They will need to be a community leader and a master politician to help the local community understand why he or she demands performance and is willing to turn over staff members that may be their neighbors.

We build “Ideal Candidate Profiles” for Boards who ask us to find executives, and while every organization has its unique needs, there are certain traits that are usually needed based on the executive position.  We are exploring the changes needed for the future and the community bank CEO profile is one that will change dramatically.  Click the button below and register for a free presentation to your Board about the CEO of the future, or call 919-644-6962 and ask for Tim.

Request your Free Board Presentation

Succession Planning Without Three Envelopes

According to a recent WorldatWork survey of large companies, over 30% have no succession plans in place and 50% of executives say they do not have a successor for their current role.  Why?  They cited a number of reasons:

  • Not enough opportunities for employees to learn beyond their own roles (39%)
  • Process isn’t formalized (38%)
  • Not enough investment in training and development (33%)
  • Not actively involving employees or seeking their input (31%)
  • It only focuses on top executives (29%).

A lack of succession planning can lead to a lack of strategic direction and weakened financial performance, but it is hard work and Boards tend to make it a task instead of a strategy.  We will be happy to share an outline of succession planning as a strategy.  Just go here and request it:  http://matthewsyoung.com/contact.htm

The three envelopes for succession planning

The three envelopes for succession planning

Or, you could use the three envelope approach.  I learned this approach from a fellow who had just been hired as the new CEO of a large, publicly held company.  The CEO who was stepping down met with him privately and  presented him with three numbered envelopes. “Open these if you run up  against a problem you don’t think you can solve,” he said.

Well, things went along pretty smoothly, but six months later, the net interest margin  took a downturn and he was really catching a lot of heat. About at his  wits’ end, he remembered the envelopes.  He went to his drawer and took  out the first envelope.  The message read, “Blame your predecessor.”  The new CEO called a press conference and tactfully laid the blame at  the feet of the previous CEO.  Satisfied with his comments, the press – and Wall Street – responded positively, the stock price began to pick up and the  problem was soon behind him.

About a year later, the company was again experiencing a slight dip in  margins, combined with serious balance sheet problems. Having learned from his  previous experience, the CEO quickly opened the second envelope.  The  message read, “Reorganize.”  This he did, and the stock price quickly rebounded.

After several consecutive profitable quarters, the company once again fell on difficult times.  The CEO went to his office, closed the door and opened the third envelope.  The message said, “Prepare three envelopes……….”

You don’t need three envelopes if you use succession planning as a strategy.  http://matthewsyoung.com/contact.htm

Strategic Planning for New Skill Sets at Community Banks

All of the prognosticators (including us…see The Future Community Bank Model – Greater Diversity of Revenues and Reduced Risk) are talking about the need for community banks to diversify their product mix, rely less on concentrations of commercial real estate loans and develop new fee-based services.  The problem is that the current staff of most community banks has a set of knowledge, skills and abilities that do not apply in this new world community banking environment.

Commercial and Industrial Lending (aka C&I Lending) is a very different process than Real Estate lending.  Will the banks retrain real estate lenders or recruit C&I lenders from other banks?  Where can they find trained lenders?  Large banks have relatively few credit trained C&I lenders because these banks shifted years ago to a “hunter/gatherer” strategy that deployed many relationship developers (hunters), with limited credit training, who would bring the loan request to a few credit underwriters who made the deal work for the bank.  When this shift occurred, the large banks no longer developed the trained staff that community bank recruiters needed.

Banking gurus are also pushing the point that fee-based businesses need to be developed in the community banks to offset some of the continuing pressure on traditional net interest margins upon which community banks have historically depended.  There has been much written about understanding your local communities’ needs and the share of wallet your bank is getting.  This is how you determine what additional services are needed in your communities.  All true, but where do you get the talent to develop and then manage these new businesses?  Banks have not traditionally had strong sales teams, so once the new businesses are developed, will banks be able to build the businesses.

It has been estimated that half or more of the staff currently in most community banks will need to be replaced with people with new knowledge, skills and abilities needed in the new model of community banking.  In some cases, the change needs to begin at the top of the organization.  We hear from capital market players that investors often want a new team to deploy the new capital.  CEOs would be well advised to aggressively rethink their strategies for their banks and include strategies for attracting and retaining the new talent that will be needed in the new world of community banking.

For an assessment of your community bank’s strategic plan, click here:

Request an Assessment of You Plan

SEC Rules on Executive Compensation, Committee Governance and Advisor Independence

The Dodd-Frank Act, signed into law in July 2010 by President Obama, shines a bright light on many issues related to Executive Compensation and Corporate Governance.  Specifically, one section (952) requires the SEC to adopt rules  regarding Compensation Committee members’ independence and suggests a specific list of factors to be identified that will govern the Committee’s advisors.  To quote chapter and verse, Section 952 – The Commission is directed to establish competitively neutral independence factors for all who are retained to advise compensation committees

First, a couple of definitions according to Webster’s dictionary:

Independentnot subject to control by others, not requiring or relying on something else, not looki ng to others for one’s opinions or fo r guidance in conduct

Neutral – having no personal preference, not supporting or favoring either side…

Personally, I don’t know how “independence” can be anything other than “neutral”…this seems a little redundant, but I digress.

The SEC is required to adopt the new rules by July of 2011 (within one year of the law being signed).   The rules will require that public companies disclose in their proxy when they hire an outside compensation consultant, whether potential conflicts of interest exist (in other words – if the consultant has a personal preference or is potentially subject to control by others) and what the Committee has done to address the potential conflict.  This will obviously influence Committee behavior in hiring such advisors by encouraging them to avoid any potential conflicts or breaches of neutrality and independence.    In only the most extreme cases, could a Committee justify hiring an advisor that violates the independence test without public scrutiny and shareholder unrest.

Much like Sarbanes-Oxley’s requirements of independence and neutrality with regard to Audit Committee advisors, these new rules on corporate governance seem to fall into the category of “doing the right thing”.  Some consulting activities that seem to contradict this characteristic would be selling products to companies whom you advise, simultaneously working for management on other projects without full disclosure and prior approval of the Committee or an engagement advising companies for fees where the consulting principals have a significant ownership position (i.e. shareholder).

At Matthews-Young, we have always subscribed to the higher ideal of “doing the right thing”.  We require that we be hired and report directly to the Compensation Committee when we are engaged for Executive Compensation work.  We have no sources of revenue other than being paid for our  time and knowledgeable, expert advice without “supporting or favoring either side”.

If we can assist you with improving your company’s governance and committee effectiveness please give us a call at 919-644-6962 or ask us to contact you at http://matthewsyoung.com/contact.htm.

Synopsis: SEC’s Final Rules for “Say-On-Pay” and “Golden Parachutes”

The SEC issued Final Rules regarding public company requirements to disclosure and ask shareholders for a non-binding vote on    executive compensation practices, known as “Say-On-Pay.”

News

  • The new rules specify that say-on-pay votes required under the Dodd-Frank Act must occur at least once every three years beginning with the first annual shareholders’ meeting taking place on or after Jan. 21, 2011.
  • Companies also are required to hold a “frequency” vote at least once every six years in order to allow shareholders to decide how often they would like to be presented with the say-on-pay vote. Following the frequency vote, a company must disclose on an SEC Form 8-K how often it will hold the say-on-pay vote.
  • Under the SEC’s new rules, companies also are required to provide additional disclosure regarding “golden parachute” compensation arrangements with certain executive officers in connection with merger transactions.
  • The Commission also adopted a temporary exemption for smaller reporting companies (public float of less than $75 million). These smaller companies are not required to conduct say-on-pay and frequency votes until annual meetings occurring on or after Jan. 21, 2013.  “Public Float” is typically defined as the portion of a company’s outstanding shares that is in the hands of public investors, as opposed to company officers, directors, or controlling-interest investors.

For further details see http://www.sec.gov/news/press/2011/2011-25.htm.

How to Do a Compensation Plan Risk Assessment

The SEC, US Treasury and jointly for banks the Federal Reserve, OCC and FDIC in a joint agency statement have made risks in compensation plans a high priority and point of emphasis.  Furthermore, SEC proxy disclosure requirements for 2010 require an explanation of the relation between compensation plans (primarily incentive compensation) and risks that may be more encouraged due to motivations caused by such compensation plans.  Specifically, these regulatory agencies want to identify and eliminate compensation plans that “create risks that are reasonably likely to have a material adverse effect on the company.”

Matthews, Young – Management Consulting has worked with several clients assisting them with the necessary process and review of Compensation Policy and Plans, including a number of community banks participating in the TARP program who must comply with similar regulatory requirements.  Randy McGraw, a Senior Consultant with our Firm, collaborated with me to layout the specifics of Compensation Plan Risk reviews.

Scope and Timing of our Review

Our assessment of compensation programs requires a review of all compensation plans and practices (with emphasis on incentive compensation) to ensure that they do not encourage participants:

  • To take unnecessary and excessive risks which threaten the value of the company.
  • To manipulate reported earnings to enhance compensation.
  • To focus attention exclusively on short-term results at the expense of longer term performance that adds value to the institution.
  • For organizations taking TARP funds from the Treasury, at least every six months, the Committee and Senior Risk Officer (SRO) review all employee compensation plans related to excessive risk, manipulation of earnings, and short-term over long-term results.  The Committee is required to limit and/or eliminate any plan features that encourage such behavior.
  • For TARP recipients, SEC reporting companies, and all financial institutions, at least once every fiscal year, the Committee and SRO, in addition to review, discuss results and prepare a narrative description of findings and actions taken on any adverse findings in review.
  • For TARP recipients, within the first 120 days of the end of the fiscal year, the Committee prepares a narrative report describing Committee meetings, discussions, and actions.  The report must be submitted to both U.S. Treasury and primary regulator  For SEC reporting companies, results of review are reported in the proxy statement.

Key Elements of our Analysis

We will look at an overview of total compensation to ensure that:

  • There is a balanced mix of pay elements (base salary, annual cash incentives, long-term equity award incentives)
  • Base salaries are sufficiently competitive to avoid undue emphasis on earning incentives in order to earn reasonable cash compensation.
  • Potential incentive levels achieved from short-term and long-term plans are balanced to ensure sufficient focus on long-term results.

For short term incentive compensation, our review will be focused to ensure:

  • Reasonable number of participants.
  • Maximum incentives are capped and potential incentives are reasonable.
  • Performance measures require a balance between earnings, return, revenue or asset growth, operating efficiency, and asset quality or other risks.
  • Performance measures support achievement of operating as well as strategic goals.
  • Performance measures strengthen teamwork as well as match a participant’s areas of accountability.
  • Incentives do not create a conflict of interest for officers with compliance and audit responsibility.
  • Whether plans contain a claw-back provision which has been communicated to participants.

For long term incentive compensation (as applicable), our review will be focused to ensure:

  • Reasonable number and category of participants.
  • Stock overhang and run rate are in line with prevailing market practice.
  • There is balance between appreciation-oriented (options) and full-value (restricted stock) grants; as well as balance in full-value grants between time-vested and performance-based grants.
  • Option grant exercise price is at or above fair market value; and re-pricing is prohibited.
  • Vesting and performance periods are sufficient to emphasize multi-year service and performance.

Review Methodology

Bank regulations require that the Compensation Committee meet with the Bank’s designated Senior Risk Officer (SRO) to discuss relevant issues; and suggest using an outside compensation advisor to facilitate the compensation review.  This approach is also recommended for other types of organizations.  Our recommended methodology is as follows:

  • Matthews, Young – Management Consulting will assess compensation plans and practices based on information provided by client.
  • Matthews, Young – Management Consulting will draft a letter that describes our review and findings along with any recommendations for change and provide this letter to the SRO.  With client’s input, we prepare a table summarizing key terms of all incentive compensation plans specifically Plan Name, Plan Purpose, Participant List, Administrative Responsibility, Performance Measures and Incentive Payout Potentials.
  • SRO reviews our letter; assesses the potential risk created by compensation in the following risk areas: Credit, Market, Liquidity, Operational, Legal, Compliance, and Reputation.
  • SRO then prepares their own letter to the Committee summarizing the review process and findings.
  • Compensation Committee meets with outside consultant and SRO, reviews both letter and reports, identifies any actions required to modify plans, and documents meeting activities.

We are currently offering a free telephone consultation to further discuss the regulatory requirements and risk review process.  Please contact us if you would like to discuss your compensation plans and an assessment of the risks they may pose to your company.  Call 919-644-6962 and ask for David Jones, Randy McGraw or Tim O’Rourke.  You can also complete the request form at http://matthewsyoung.com/risk_review_contact_landing.htm.

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