Executive Compensation: 
The Problem of Two Masters

By Ted Knutson

When it comes to compensation, boards are faced with the problem of two masters: Institutional Shareholder Services and the bank regulators. “They don’t always agree. Bank regulators have their own guidelines. ISS has an entirely different set,” says Susan O’Donnell, a banking compensation and governance consultant with Meridian Compensation Partners.

O’Donnell, who has spoken at numerous ABA conferences, explained that bank regulators are focused on risk mitigation, so they believe pay incentives are bad since they feel incentive compensation is risky.

ISS, on the other hand, likes incentive pay because it believes the practice creates a win-win situation for banks and shareholders. “You can be a high incentive compensation payer and get good marks from ISS as long as you are a high performer,” says O’Donnell.

She called this tug-of-war between regulators and the leading shareholder advisory services one of bank directors’ biggest challenges.

According to O’Donnell, there are many cases where bank consultants tell ISS that banks have to follow regulations and ISS simply doesn’t care. The end result is that a lot of bank compensation programs have come to look alike, as boards have to find a happy medium.

Changing practices

O’Donnell says the biggest change in how ISS rates compensation practices lately has been in regard to equity plan proposals.

Until this year, ISS focused on the concept of shareholder value transfer (SVT), which is simply the value of equity given to directors and executives that dilutes the holdings of other shareholders.

Now, the advisory firm has come up with a score sheet of pluses and minuses where SVT is one factor of several. In the revised ranking system for stock and stock option grants to board members and executives, 45 percent of the weight goes to SVT, 20 percent to plan features and 35 percent to grant practices including clawbacks, vesting requirements and historical grants.

When the firm comes up with its final report card for a bank (inevitably more complicated every year with more boxes to check for those filling out the rating agency’s forms), ISS wants boards to devote themselves to what it calls the four pillars of good governance: board structure, compensation, shareholder rights and audit and risk oversight.

ISS has always been controversial. Since it doesn’t put its money whether its mouth is, the service does not risk the downside of losing money if its recommendations are approved only to lead to declining share prices, profits and potentially worse.

Likewise, since its advice is taken by many of the largest pension funds in the nation, ISS acts as a super institutional investor. This has some concerned that the company wields too much power over corporate America and the fate of the millions of retirees who are owed a fiduciary duty directly by the institutional investors who hire ISS.

While the shareholder advisory rating 
is important, O’Donnell says board 
members have to keep in mind a 
higher duty.

“You don’t have to do everything 
ISS says,” she says. “You have 
to do what is right for you.”

Ted Knutson is a financial services writer 
in Washington, D.C.