Small Banks Lead the Way in Executive Pay

Sometimes, shareholders can be as persuasive as bank examiners or Congress.

Four far-flung community banks — Umpqua (UMPQ), Lakeland Financial (LKFN), The First of Long Island (FLIC) and Chemical Financial (CHFC) — found that out the hard way last year. Citigroup (NYSE: C) found that out similarly a couple of weeks ago.

Unlike Citi, the four companies were (and still are) small enough to avoid pay rules implemented in the wake of the financial crisis and aimed at banks with at least $50 billion of assets. But when shareholders at all four companies let directors know last year that they didn't like executives' compensation, the banks responded by implementing pay policies that discouraged excessive risk-taking and incentivized long-term improvement in the company's stock price.

Look at those companies now. After getting egg on their faces at their 2011 annual meetings, the boards at these four companies secured shareholder approval of at least 93% in this year's meetings. Each experienced an upward swing of at least 16 percentage points. Umpqua's approval vote rose by a whopping 60.4 percentage points.

"These votes absolutely get the attention of management," said Ron Schneider, a senior vice president at New York-based Phoenix Advisory Partners, which Umpqua hired for advice on communicating with institutional investors that cast a "no" vote in 2011. "Companies know that ultimately they'll get their report card at the end of the annual meeting."

And as shareholders continue to flex their muscles this proxy season and reject banks' executive compensation plans, more bank directors and executives may decide they need to reassess their own institutions' pay policies, even if their asset level isn't high enough to require them to do so.

Of the four banks experiencing big swings, only Portland, Ore.-based Umpqua received an official rejection in the non-binding, advisory votes. Still, for Lakeland Financial, the First of Long Island and Chemical Financial, the results were nonetheless concerning. Proxy advisory firm Glass Lewis considers any shareholder vote with an approval rating of less than 75% to be a negative result. Both Lakeland Financial, of Warsaw, Ind., and the First of Long Island, of Glen Head, N.Y., received less than 75% approval. Midland, Mich.-based Chemical Financial's approval rating barely cut the muster at 77.3%.

In the wake of the financial crisis, Dodd-Frank was passed with one of its goals to reduce excessive pay at large banks, specifically banks that received a federal bailout. Many of the rules contemplated by Dodd-Frank don't apply (at least not yet) to smaller institutions. But some bankers have concluded it's a better idea to get started now adjusting pay practices, instead of waiting until it's required.

"They know these things are coming, and they're not just sitting back to see how long they can stick with the status quo," said Michael Melbinger, an employee-benefits attorney at Winston & Strawn who has advised the Financial Services Roundtable.

Umpqua, with $12 billion of assets, started plotting its response immediately in the wake of its "say on pay" rejection, said General Counsel Steven Philpott. The first step was figuring out what caused shareholders to give their thumbs-down, since "say on pay" votes are not cast in response to specific elements of compensation rules.

"The 'say on pay' vote is a way for big institutional investors to register any concerns that they might have," Philpott said. "To understand what the concerns are, there actually has to be a productive dialogue."

Hiring outside compensation-consulting firms has been a popular way to start the conversation with investors. Umpqua retained Phoenix Advisory Partners to solicit proxies for the 2012 annual meeting and to "advise on outreach to our institutional shareholders who voted against our say on pay resolution," according to Umpqua's proxy statement. Umpqua also hired Towers Watson to review its pay practices and suggest changes. Lakeland Financial hired compensation consulting firm Frederic W. Cook last year, and Chemical Financial hired Aon Hewitt.

Some of the changes at Umpqua follow the guidelines set out for megabanks, to mitigate risk and defer pay to incentivize a focus on long-term results, Melbinger said. Those include limiting the vesting of executives' equity grants, if Umpqua's stock price trails a regional bank index; and requiring named executive officers to hold positions in Umpqua stock ranging from 150% to 400% of their base salaries.

Using a regional bank stock index as a measuring stick is something many institutional investors have been calling for — tying compensation to a company's performance.

"The key perspective we always start with is a demonstrable link between pay and performance," said Glenn Booraem, controller at mutual fund giant Vanguard. "That's the crux of engagement for us."

Changing pay policies isn't as easy as hiring a proxy-services firm to give advice on how to talk to institutional shareholders, said Don Delves, a Chicago-based bank compensation consultant. For smaller banks, it's a tricky proposition to mitigate risk without putting the bank's growth prospects on deep-freeze mode. Forcing executives to defer pay could have unintended consequences.

"Time-based restricted stock is the lowest-risk form of pay," Delves said. "It can mean that it encourages people to take no risk, to not do anything except sit behind their desks and not do their jobs."

"A lot of community banks are struggling with how to not put too much pay at risk, but put enough pay at risk to motivate people," Delves said.

Even managers of banks owned by the customers themselves feel compelled to address pay practices. Mutual banks traditionally haven't even had employment contracts with top executives, said Wayne Cottle, president and chief executive of $223 million-asset Dean Co-operative Bank in Franklin, Mass.

"You were hired to do a job and as long as you did it responsibly, you kept your job," Cottle said. "But as regulators are putting more pressure on us, I think you'll start to see mutuals sign contracts with their executives."

Then there are the banks that went in the opposite direction from Umpqua, Lakeland, Long Island and Chemical. Citigroup, Bank of New York Mellon (BK) and Hancock (HBHC) each saw their shareholders give assenting "say on pay" votes in 2011, only to reverse sides and either vote "no" this year, or give much small approvals.

It's early in the 2012 proxy season, and the votes at Citi, Bank of New York and Hancock are likely signs of more to come, Schneider said. "Say on pay" votes were held for the first time in 2011, and many institutional investors may not have realized the power they held in that voting right, and in the interim months, dedicated the staff and resources to examining their holdings' compensation rules, he said.

"The 95% yes vote you got last year may not have been because they loved you, but it may have been because they didn't get around to you," Schneider said.