Whether your bank is public, private, or mutual, the recent decline in stock prices has thrust a sword in the hands of your compensation committee.
Those who wield it wisely will retain valued executives and attract new talent. Those who are clumsy or slow will bleed as their best executives get lured away. The stakes are indeed this great.
Few bank directors blame their executives for stock prices that have plummeted 30% or more in recent months. They recognize that the vagaries of the marketplace have first inflated and now deflated their share prices. Nevertheless, most are ill-disposed to even hear about yearend compensation adjustments.
Here are direct quotes from board meetings at banks across the country:
"Let them suffer with our stockholders."
"Their pay rode the market up. Now it's time to accept the downturn."
It is hard to argue with these directors, especially if their bank's executive pay levels kept pace with the 10% or more annual increases that matched escalating stock prices over the past seven years.
Nevertheless, their sense of righteousness may find them saying goodbye to valued executives. Why? Because other directors-the pirates-are sure to see opportunity in this depressed environment.
"It Is a Glorious Thing to Be a Pirate King"
OK, Gilbert and Sullivan didn't have banking in mind when they penned this line from "The Pirates of Penzance."
Imagine, though, your directors in pirate garb gathered around the board table. "Who would bring energy and new business to the bank?" they wonder.
Down the street, a talented community banker may be frustrated due to stock options that are now worth little, no prospect of a significant yearend bonus, and unhappy stockholders and directors.
Once you identify this banker, it's time to pirate. Your board can lure him or her with stock options at today's depressed value. You can substitute, or add, deferred compensation. For example, an offer of $200,000 that becomes vested over a multiyear period would get the attention of most community bankers.
And if you are true pirates, you will condition your generous offer not only on a noncompetition agreement, but also on forfeiture of stock options and deferred compensation if the executive leaves your bank for a competitor. This arrangement is commonly referred to as a "golden handcuff."
No bank should be vulnerable to pirates. Your executive compensation structures should preemptively use golden handcuffs to secure the loyalty of valued executives. If your board hasn't yet done this, yearend 1998 is prime time.
Why? Because the disaster in the stock market has skewed the compensation expectations of most executives. Most have low, if any, expectations. This should make them agreeable to board efforts to provide significant new incentives-even if they come with noncompetition provisions attached.
Once a board decides to protect against pirating competitors, execution of the strategy presents some interesting choices.
Repriced stock options. This offer would encourage executives whose existing stock options are under water (i.e. out of the money, because their exercise price is above current market value).
These types of grants have, however, been a lightning rod for stockholder criticism over the past few years. Many institutional investors will automatically vote against approval of any new plan that permits the granting of repriced options.
Nevertheless, this summer's economic downturn has led many companies to reprice stock options. They include Oracle, Apple Computer, and Cendant.
We are unaware of any banks that have followed suit, although the action could be justified as advancing corporate goals if the new stock options are coupled with a vesting requirement or noncompetitive agreement.
For example, vesting could be contingent on the executive's satisfaction of a stock ownership guideline, the bank's achievement of a performance goal, or appreciation in the bank's stock price to specified levels.
For any company inclined to reprice options, prompt action is advisable. The Financial Accounting Standards Board is working on an exposure draft that would disallow favored accounting for repriced options. Currently, appreciation on the underlying shares does not require recognition of expense on an issuer's income statement.
Though the FASB is not contemplating a change in this rule as it relates to routine stock option grants, the change is being contemplated for stock options that are either repriced or are canceled and replaced with new grants. However, any new rule is unlikely to apply to grants made before the exposure draft is released early next year.
Deferred shares and deferred compensation. Basically, a bank may define the circumstances under which an executive will receive shares or dollars at a later date (usually related to termination of employment). A performance-based formula may determine both annual grants and future vesting or forfeiture.
Unlike stock options, common stock and deferred compensations have value even if stock prices are flat or declining. This makes these awards more valuable than stock options as a golden handcuff.
There is a cost: Deferred compensation credits and future appreciation must be expensed as vesting occurs. Similarly, deferred shares must be expensed over any vesting period. These shares are better than deferred compensation, because future appreciation carries no corporate expense. Their expense is locked in, based on the market value of the share on the award date.
Tandem stock options. Directors, stockholders, and stock analysts tend to view stock options as a win-win form of pay, because they are the only form of compensation that carries no corporate expense, and they have no value unless the underlying stock appreciates.
They are even more desirable-and justifiable-from a corporate perspective when vesting conditions encourage future employment, loyalty, actual stock ownership, or exercise of existing stock options.
Many directors mistakenly presume that a new stock option plan requires shareholder approval. This is seldom the case for community banks, unless their common stock is listed on the NYSE, the American Exchange, or Nasdaq National or SmallCap Markets.
At yearend there will be no shortage of reasons for inaction on executive pay. Depressed stock prices and fear of stockholders will harden many directors. It will be easy for them to imagine being vilified for new awards. It will be just as easy to tell executives that market conditions make it impossible to justify incentive awards (even when otherwise merited).
"Wait until next year" will be the word from many boards. Few executives will have the nerve to mention-much less push-the matter of their own pay.
This path of least resistance carries a potentially huge risk for banks. They stand to lose their best executives to the so-called offer that can't be refused.
Boards should not be surprised to encounter aggressive employment tactics. Stiffening competition, narrowing margins, excess capital, and stockholder pressures will encourage other banks to pirate your best executives. That strategy is faster, cheaper, and more likely to succeed than branch expansion or new products.
Responsible directors will recognize that their most important function centers on retaining and attracting a management team that runs a safe, sound, and profitable bank. Those who now pick up the executive pay sword will be the survivors of tomorrow. Those who do not will rue the day they let talent escape.