With the 2015 proxy season largely over, now is the time for compensation committees and their advisors to take stock of developments that will likely impact the agendas of compensation committees and their efforts in the year ahead. Key areas of focus for compensation committees as they prepare for the 2016 proxy season include:

It is fairly typical for the compensation committee (or the governance committee) to determine or make recommendations to the board regarding director compensation. Director compensation has been under increased scrutiny over the past several years, particularly since the 2012 Delaware Court of Chancery’s decision in Seinfeld v. Slager ( (Del. Ch. June 29, 2012)). A recent case from the Delaware Court of Chancery serves as a reminder that, by their nature, director compensation decisions involve a matter in which the directors are interested, and therefore business judgment rule protection does not apply (Calma v. Templeton, No. 9579-CB (Del. Ch. Apr. 30, 2015)).

Calma v. Templeton involved a shareholder challenge to awards of restricted stock units (RSUs) to eight outside directors of Citrix Systems, Inc. under an equity incentive plan that had been approved by shareholders. The plan imposed no limits on grants to non-employee directors other than a limit of one million shares or RSUs per plan participant per calendar year. Based on the company’s stock price when the action was filed, a grant of one million shares would have had a value of over $55 million.

From 2011 to 2013, the compensation committee awarded each non-employee director 4,000 RSUs plus cash compensation each year, for an aggregate value of over $1 million for the three-year period. None of the awards were approved by shareholders. The plaintiff contended that the board breached its fiduciary duties and wasted corporate assets because the grants of RSU awards were “excessive” in comparison to the compensation received by directors at certain of Citrix’s peer companies.

The court dismissed the waste claim, finding that the allegations failed “to support an inference that Citrix’s non-employee director compensation was so one-sided that no reasonable business person could conclude that the Company received adequate consideration.” However, the court denied the defendants’ motion to dismiss the claim that the directors had breached their duties in awarding compensation to non-employee directors under Citrix’s equity incentive plan.

The court applied the entire fairness standard of review because the directors making the compensation decisions were not disinterested, as they would receive the awards. The court declined to find that shareholders ratified the awards at issue because the plan did not specify the amount or form of compensation to be issued to Citrix’s non-employee directors.

Under the entire fairness standard, a defendant must establish that the transaction was a product of fair dealing and fair price. The factual basis of this standard makes it very difficult to meet on a motion to dismiss. The issue in this case revolved around whether Citrix’s non-employee director compensation practices were in line with those of its peer group. The court found that the plaintiff had raised valid questions, which could not be answered at this procedural stage, as to whether companies with considerably higher market capitalizations, revenue and net income should be included in the peer group used to determine the fair value of compensation for Citrix’s non-employee directors.

This case emphasizes that any shareholder-approved equity plan should impose reasonable limits on the maximum size of director awards. It also highlights that benchmarking data for director compensation must be carefully considered and will not provide a clear defense in early stages of litigation involving a similar claim. Companies should take care to ensure that compensation committee minutes reflect the rationale for director compensation awards, especially regarding any significant one-time awards.

For more information on this decision, see Legal Update, Delaware Court of Chancery Applies Entire Fairness to Breach Claim Relating to Non-employee Director Equity Awards.

Compensation committees and their advisors should anticipate final rules from the SEC on long-awaited Dodd-Frank Act disclosure mandates concerning:

While it is uncertain when final rules will be adopted, it is fairly likely that there will be SEC activity on these matters within the next several months.

Section 954 of the Dodd-Frank Act requires the SEC and stock exchanges to adopt rules requiring listed companies to implement and disclose clawback policies. These are policies requiring the recovery of compensation paid to executive officers during the three-year period prior to an accounting restatement that is based on material noncompliance with financial reporting requirements.

While the Sarbanes-Oxley Act provides for the SEC to seek the return of compensation from the CEO and CFO, the Dodd-Frank Act provision is broader. For example:

On July 1, 2015, the SEC issued proposed rules that would direct the national stock exchanges to establish listing standards regarding clawback policies in accordance with the Dodd-Frank Act (Sidley Austin LLP, SEC Proposes Compensation Clawback Rules). A number of companies have already adopted clawback policies and provide disclosure on these policies in the annual meeting proxy statement.

For more information on the SEC's proposed rules, see Legal Update, SEC Proposes Rules Requiring Companies to Adopt Executive Compensation Clawback Policies.

Ever greater reliance on performance-based compensation is adding complexity to the work of the compensation committee. Creating a pay for performance program that works as intended is difficult. Efforts to improve on compensation programs have led to more structure and increasingly complicated program design features, and less compensation committee discretion. This in turn makes disclosure and the explanation of how program design choices relate to award values more challenging.

According to ISS, performance-based pay now accounts for over half of total CEO compensation, and is continuing to grow in proportion to other pay elements. The shift from stock options and stock appreciation rights to awards based on achieving specific performance goals requires compensation committees to identify:

Changes in performance metrics from year to year are common, occurring at more than half of companies. This adds to the complexity of long-term awards that span multiple years. In addition, the number of metrics that compensation programs rely on is growing, and companies are increasing their use of combined metrics (for example, by using one metric to modify, reduce or amplify an award that is based on other metrics). Companies are also increasing their use of relative metrics that benchmark company performance against a peer group. Additional complexity is provided through different payout structures, such as variations in payout levels that go beyond the standard threshold, target and maximum.

Compensation committees need to understand the elements of compensation and apply their compensation philosophy to ensure those elements accomplish the intended goal. Determining the appropriate metrics for performance is a key issue for compensation committee discussion.

Companies are under significant pressure to focus on TSR due to ISS’s policies and the shareholder view that TSR aligns the interests of shareholders and executives (and now the SEC’s proposed use of TSR as a measure of performance for purposes of pay for performance disclosure). However, there is growing recognition that relative TSR may be flawed as an incentive measure given that it is subject to temporary stock price swings and manipulation through repurchases. Additionally, it does not provide any incentive for the behaviors that drive performance, such as growing profits, innovating, expanding markets, cutting costs and executing operationally.

Other metrics that companies may also rely on are earnings per share and return on invested capital, in addition to profitability, revenue, cash flow and growth metrics. Key metrics should relate to measures that are within management’s control. Compensation committees should consider the value of simplicity and year-over-year consistency, as well as the balance of short-term and long-term metrics.

While compensation decisions have become far more complicated, compensation committee responsibilities have not changed. The focus of compensation committees continues to be:

Each individual compensation committee member owes the duties of care, loyalty and good faith and should fully understand:

Periodically, the compensation committee should step back and assess how well compensation decisions have supported the compensation philosophy and intended goals.

Given the increase in complexity in the work of the compensation committee, and the additional time that is required to fulfill those responsibilities, it is imperative that the compensation committee be comprised of the right members and is performing effectively. Compensation committee composition and performance should therefore be a key focus of the board’s and committee’s annual self-evaluation process.

According to a recent National Association of Corporate Directors (NACD) survey, nearly a quarter of public company directors are “not satisfied” with their company’s CEO succession plan (2014-2015 NACD Public Company Governance Survey). The compensation committee (or governance committee) is typically responsible for reviewing CEO succession and working with the board in evaluating potential successors to executive officer positions.

The compensation committee should ensure that it allocates appropriate time in its agenda each year to developing and refining a CEO succession plan to take effect in the event of an emergency or planned transition, and getting to know potential internal candidates (for example, through presentations at board meetings).