Uninteded Consequences of Executive Change in Control Provisions

You're a top performer at your bank and an executive from a competing bank wants you on their team. You recently got a new boss, and it isn't gelling. So the offer is timely.

You check out the competing bank. Do your due diligence. You respect their executives. Their numbers look good. Heck, you've lost a few deals to them. This bank deserves serious consideration for a job switch.

Hold on! You check their proxy statement. The CEO is 67. And he/she has a 2.99x change in control (CIC) contract. Nope. You're out. This bank's gonna sell so the CEO can pull the golden parachute rip chord. Why would they walk away with a gold watch when they can get paid for three years while sipping boat drinks in the Bahamas?

This hypothetical situation is an unintended consequence of executive CIC payments. The incentive gap between selling the bank and retiring while remaining independent is perceived as too big. 

Reasons for CIC Arrangements

There are legitimate reasons for change in control contracts. Meridian Compensation Partners, in their 2017 Study of Executive Change in Control Arrangements list the following reasons:

• Keep the Executive Neutral to Job Loss. The primary purpose for CIC arrangements is to keep senior executives focused on pursuing all corporate transaction opportunities that are in the best interest of shareholders, regardless of whether those transactions may result in their own job loss.

• Retain Key Talent. Corporate transaction activity may create uncertainty for critical executive talent. This uncertainty may create significant retention risk for a company. An executive with sufficient severance protection may be less likely to leave voluntarily to seek other employment in the face of transaction-related uncertainty.

• Maintain Competitive CIC Benefits. A majority of large public U.S. companies provide their senior executive officers with some level of CIC protection. Thus, companies provide CIC protection to attract and retain the top talent, especially in industry sectors undergoing substantial change or consolidation. 

Unintended Consequences

Aside from making it more difficult to get top performers to come to your bank when the CEO nears retirement, there are other unintended consequences. Other executives that may be retired in place (RIP) may hang on a little too long waiting for a buyer to come knocking and trigger their CIC payments. They are less likely to be making difficult decisions that will cause disruption yet might move your bank forward and position the bank for long-term success during this waiting period. 

Middle managers and high potential employees can read proxy statements too. Imagine the regional branch manager that wants to propose a change in hiring practices and development plans to turn branches into high performing sales and advisory centers. It will be difficult, but it is what customers are demanding. Should we do it? Nah, CEO is about to pull the chord. Multiply that perception several times over, and you have a bank that is losing pace with the market, making a sale a fait accompli. 

Shareholders celebrate the CEO's birthday too. I invest in bank stocks and have looked at a CEOs age on more than one occasion as a decision-point. This could artificially increase the valuation, making a sale more likely because the bank would have to earn its way into an inflated valuation. And shareholders may have bought in with the anticipation of a sale.

Development plans that help your high potential employees follow an executive track are shelved because of budget pressures. I am generally a cynic but most CEOs I know act in the very best interest of their bank. But what if, in the back of their mind where we rarely visit, they know that if they keep deferring the long and purposeful journey of developing multiple homegrown executives capable of becoming the next CEO, the board will opt to sell because there are little to no succession options. Under Jack Welsh, GE always had two or three people ready to go. Big company, I realize, but something to think about.

What To Do

What should you do about it? I asked a couple of executive recruiters and they didn't help me out. So I came up with one on my own. Unique, yes. A little out there, yes. Consistent with building a long and enduring business model, I believe yes.

Offer a Retirement Stock Plan (RSP) to ALL employees. Before you stop reading, let me describe it and run the numbers. One reason that institutional shareholders complain about CIC arrangements is because they put money in an executives pocket at the expense of shareholders. When a bank sells, the buyer assesses its value, then subtracts deal expenses. And a big deal expense is executive contracts.

But what if there was an incentive to stay and build the bank for the long-term, and retire? And instead of it only being available to executives, make it available to all employees that have been with you a minimum amount of years and retires.

This will put a premium on your talent management processes. Much like GE that shed 10% of its workforce each year using employee evaluations as the means to identify the 10%, a bank that implements an RSP must motivate high potential and otherwise good employees to stay, while having a process to improve or remove low performers so they don't hang on to get their RSP.

Math

It all comes down to a spreadsheet. Suppose Schmidlap National Bank, a $1.5 billion in asset bank, implements an RSP that pays 50% of a retiring employee's salary in Schmidlap stock if they retire after a certain age and have served between five and ten years at the bank. It would pay 100% of salary if they are there more than 10 years. Schmidlap can restrict the stock to protect against employees "retiring" and going to the competitor.

Here is what I think it would cost:

Many of the assumptions are aggressive, such as one executive retiring per year (at the average salary of all executives, including the CEO), and other employees retiring as a VP or AVP. If 5% of Schmidlap's 250 FTE employees retire annually, that's 13 per year at a $1.5 billion bank. That seems aggressive to me too. But I didn't want to undershoot the cost.

Based on my assumptions, this would cost Schmidlap $1.0 million per year and represent a 5% reduction in net income, and a 2.6% increase in operating expenses. I think banks can look hard within themselves to offset this cost with a mix of process improvements resulting in cost savings, and asset growth. My firm recently did a process review for a similar sized bank and made recommendations for $3 million in improvements, most of which were annual and recurring. We just taped a podcast with an emerging core processor that has 50% cost savings from your current core costs as a target. If half of the RSP was paid by growth, that would be $25 million in growth if it was added with a 2% incremental ROA.

I think the benefits would far exceed the costs. For one, it is a stock grant plan that adds to the bank's capital position to support growth. Second, it puts executives and employees on an even keel. It benefits both. Third, it reduces the incentive for the CEO and other executives to "pull the chord" and sell when they near retirement, which in turn helps the culture throughout the bank to manage it with an eye toward building a long-term future. It's a culture builder.

This doesn't mean the bank won't sell. If it hasn't earned its right to remain independent, that option remains on the table. And executives wouldn't be able to collect both a CIC and RSP at a sale event, in my opinion. Most states have laws that boards should consider all constituencies when making decisions: shareholders, customers, employees, and communities. An RSP would benefit all employees that gave a significant portion of their professional lives in service to the bank. 

What do you think? Any other ideas out there?

~ Jeff

In Banking, Soft Skills Remain Blah Blah Blah

Weakness: Middle Management. I hear this often. Why is it so common in community banks?

I have opinions. Peter Principle is alive and well in banking. We elevate superior performers in their functional position to leadership positions to which they are ill prepared. We promote them to the level of ineffectiveness.

But that doesn't mean that the experienced and high performing loan servicing person cannot become a great manager of Loan Servicing. It means that the skills to motivate those under you to perform at their peak are different than pushing yourself to perform at your peak. But it takes more than revising their business card and giving them an office to get from here to there. It takes organizational effort.

My local newspaper featured the director of training and development at a long-standing construction company. In the article, she spoke of emotional intelligence and body language. Not skills that were critical to maximizing the tickler feature of your Jack Henry core. 

The construction company had $414 million in revenue. Enough to have a high level person that is the Director of Learning and Development. So what does a $40 million in revenue community bank do?

Do I Think Leadership Is Important?

I searched this blog for what I have written on Leadership. Here is what I came up with:

Lead Like Lincoln. Identifying attributes that made arguably our greatest president so great.  

Do We Care About Leadership? Discussing the military's take on leadership development.

Leadership: In My Own Words. My uninhibited opinions on leadership in a changing industry. 

Do you think I believe this is an important discipline?

What To Do

Back to middle management being a weakness. When I hear this in strategic planning retreats I look in the face of bank executives and quote one of my Navy division officers: "Careful pointing your finger, because the other three are pointing at you." To translate Lt. Proper's quote, it means that if your middle managers are not strong, perhaps it's because of you.

Here is what I suggest that you do about it...

1. Develop. Always develop high potential employees for the next level. If the next level includes supervising others, then their development plans should include how best to do that given your bank's culture. There are scores of programs out there to develop people into being great leaders and managers. Choose a reputable one that fits your bank's philosophy on maximizing the abilities of those that report to you. It doesn't have to be within our industry. The Positive Coaching Alliance program that I took when learning how to be a girls lacrosse coach has made a significant impact on me, for example. It taught me how to "fill the emotional tank" of those that report to me. Most college business programs have leadership and management courses, but the noise of college might have diluted their impact. So why not have the employee do a white paper on leadership and management best practices for re-enforcement? Don't just assume they get it if they went to college. But your approach may be different.

2. Empower. This means that you allow mistakes. But in so doing, create an environment that learns from mistakes. Nothing is more deflating than something going wrong and all that the employee does is defend their actions. That means that you have created an environment where they think they are in trouble. Instead, create an environment that when things go wrong, we look at why. Was the data used to make the decision incomplete? Did we miss on the execution? Allow mistakes, and reflect on them to make us better the next go round. Don't create the environment where mistakes lead to a stern discussion. So many cumbersome bank processes where born from a 'no mistakes' culture. And it stifles a high potential employee's development and the continuous pursuit of doing things better. 

3. Cheer. The assistant manager of Loan Servicing is so good that you are afraid to lose her. So in that ops meeting the COO gives kudos to automating insurance tracking, and you nod. Your assistant manager came up with the concept and led the execution. But you know that Loan Admin is looking for a new leader, and you don't want to lose your superstar. You got nobody in the wings! And you really didn't follow "1" above because you couldn't afford to have your assistant manager away for a couple days anyway. When I was in the Navy, a part of leadership's evaluations was how well your subordinates promoted. This led to unintended consequences like inflated performance reviews, but the concept was correct, in my opinion. If you are a manager and leader, then you should be advocating for your high potential employees' upward mobility. 

Those are only three ideas for building a stream of potential future leaders. Building the capability of developing high potential employees into future leaders is the best way to preserve and advance your culture. Because if you are forced to always go outside of your bank to fill leadership positions you will dilute your culture and deflate your employees trying to reach the next level.

You can do this.

~ Jeff