May 2023 / 5 Min Read

Relative Performance Awards: Improving Equity Agreements After Bank Failures

Firms with peer relative performance equity awards should consider the ramifications of recent bank failures when tracking and certifying in-flight awards.

Key Takeaways

A quarter percent of firms with relative performance equity are impacted by recent U.S. bank failures, including firms beyond the financial services sector.
Firms should seek compensation committee and external counsel advice since most award agreements do not contemplate situations such as bank failures.
Firms with relative awards should consider updating award agreements in future years to clarify situations in which they need to manage a bankruptcy or entry to receivership.

Recent Bank Failures Impact Performance Equity Beyond the Financial Services Sector

Approximately 65-70 percent of the S&P 500 use relative total shareholder return (TSR or Relative TSR) as a performance metric.¹ This is the most common long-term incentive metric within the S&P 500 although smaller public companies use it as well. Relative awards constitute a growing portion of performance equity awards, especially within financial services firms beyond TSR.

In its most simple form, a relative TSR award compares the TSR of an issuing firm to the TSR of a set of peer companies, an index or select group of competitors, over a specific performance period. In most cases, the peer group is considered locked on the date of grant. Removals will only happen under specific circumstances described in the award agreement, e.g., a merger or acquisition. Other relative programs using other metrics, such as relative return on common equity, follow similar designs and are more common in the financial services sector.

The final peer group is linked to the final performance equity payout. In the design phase, the peer group selection process is one of the most crucial steps in relative performance equity design. However, companies often overlook scenario planning that concerns how different situations, e.g., mergers, acquisitions, bankruptcy, et al., will impact the final peer group.

Approximately 89 percent of firms utilize a closed peer group, which means the peer group constituents are locked at either the start of the performance period or the grant date.² On the contrary, about eight percent of firms compete against an index whose constituents are determined at the end of the performance period. This is commonly referred to as having an open peer group. The impact of recent bank failures will impact closed peer groups; however, Aon does not believe that this is a reason for a firm to change to an open peer group, which introduces a separate set of issues, including survivorship bias.

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Authors

Dan Kapinos
Partner, Human Capital Solutions
dkapinos@aon.com

Stephen Popowski
Director, Human Capital Solutions
stephen.popowski@aon.com

Phillip Sanderell
Consultant, Human Capital Solutions
phillip.sanderell1@aon.com

Financial Industry Volatility Challenges Tracking and Final Certification of Performance Equity

Performance equity award agreements may contain general guidelines relating to peer attrition, but these award agreements often fail to provide clear instructions on how to address situations where a peer goes bankrupt or enters Federal Deposit Insurance Corporation (FDIC) receivership.

Bankruptcy

Bankruptcy or liquidation is a process that diminishes or wipes out a shareholder’s accumulated value.

Once a peer goes bankrupt, the most common practices to address this from an on-going tracking perspective are to either:

keep the bankrupt firm within the peer group by assigning it the bottom ranking (such as a -100 percent TSR value) and reflecting the return experienced by shareholders or
remove the bankrupt firm from the peer group since the bankrupt peer would not have the same measurement period as other comparator firms.

Aon observes that most award agreements do not distinguish between Chapter Seven or 11 bankruptcy and believes that the best market practice is to keep the bankrupt peer within the peer group at the bottom ranking for the remainder of the performance period. This is because the investors’ dollars would have produced a greater return if invested in any of the other comparator companies’ stock.

FDIC Receivership

In contrast with bankruptcy, large banks entering receivership by the FDIC have not been a common occurrence since the Great Recession. FDIC data indicates that the size (as measured by bank assets) of the most recent bank failures is unmatched since the Great Recession.

Performance equity award agreements are significantly less likely to contemplate FDIC receivership as compared to bankruptcy.

We expect that the most common practices to address FDIC receivership will be to either:

view this as otherwise equivalent to bankruptcy or liquidation (pointing to the poor outcome for equity holders) or
view this as an otherwise equivalent delisting event from an exchange even though there may be other interpretations considered based on the facts and circumstances of each situation.

Aon believes that entering FDIC receivership due to a bank’s failure most naturally aligns with a forced sale or liquidation and should be treated in performance equity plans similar to an otherwise equivalent bankruptcy. However, we recognize that this outcome may not always occur given how teams draft in-flight performance equity awards.

Next Steps

Aon observes that actions surrounding recent bank failures occurred quickly, and it is important that all relevant facts are available before a firm takes action around their performance equity award peer groups.

Once all relevant information is known, we advise that firms review the relevant language within their performance equity award agreements. When the award agreement is not clear regarding how a peer bankruptcy or peer removal should settle, a firm should look to relevant organizational stakeholders acting on behalf of the board of directors such as internal or external counsel to understand how we treat these recent bank failures.

Aon recommends that companies document decisions and make sure to update any on-going tracking mechanism in place for periodic reporting or final certification. Lastly, Aon recommends that firms consider updating the relevant language within future performance equity award agreements to make clearer how we treat bankruptcy or entry into FDIC receivership. Award agreements rarely cover all situations peer companies will face over time; however, contemplating how a firm may handle similar situations will make some of the unforeseen situations easier to address going forward.

¹ Data sourced from Aon’s CGPro proxy data tool.
² Data sourced from Aon’s 2022 Relative TSR survey

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The information contained herein and the statements expressed are of a general nature and are not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information and use sources we consider reliable, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

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