On June 20, 2012, the SEC adopted final rules (the “Final Rules”) under the Dodd-Frank Act, requiring the NYSE, NASDAQ and other national securities exchanges (the “Exchanges”) to implement new listing standards relating to listed company compensation committees.1 The Final Rules were promulgated pursuant to Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.2
The Final Rules include new independence standards for compensation committee members, new rules applicable to compensation advisers engaged by them, and new disclosure requirements covering advisor conflicts of interest. If the Exchanges and the SEC act promptly, the new listing standards may be in effect for the upcoming (2013) proxy season. Accordingly, listed companies may want to start considering, as next steps, the “Indicated Actions” set forth at the end of this memo.
Compensation Committee Independence
Under the Final Rules, each Exchange is required to establish listing standards requiring each member of a listed company’s compensation committee to be a member of the board of directors and to be “independent.”3 In developing their definition of “independence” for these purposes, each Exchange is required to consider relevant factors, including:
• a director’s source of compensation, including any consulting, advisory or compensatory fee paid by the issuer; and
• whether a director is affiliated with the issuer, a subsidiary of the issuer, or an affiliate of a subsidiary of the issuer.4
In formulating the definition of “independence” to be incorporated in their listing standards, it is expected that the Exchanges will also take into account (i) the various standards applicable to compensation committee members under existing tax and securities law rules, and (ii) the heightened independence standards already applicable to members of an issuer’s audit committee. The SEC notes, however, that certain aspects of the audit committee member independence rules5 —which sometimes operate to disqualify directors affiliated with large shareholders from audit committee service—would likely be inappropriate in the compensation committee context. 6 The Final Rules do not specify any additional factors that the Exchanges must consider in determining independence requirements for compensation committee members, nor are any standards or relationships enumerated which would automatically preclude a finding of independence.7
The Final Rules contain a cure provision, permitting compensation committee members who fall out of compliance with the independence standards for reasons outside their control, to continue to serve for a limited period.
Compensation Committee Advisers
Under the Final Rules, all Exchanges are obligated to adopt listing standards providing that:
- the compensation committee may, in its sole discretion, retain or obtain the advice of compensation consultants, independent legal counsel, or other compensation advisers;
- the compensation committee shall be directly responsible for the appointment, compensation and oversight of the work of any compensation adviser retained by the compensation committee; and
- each listed company must provide for appropriate funding for payment of reasonable compensation, as determined by the compensation committee, to any compensation adviser retained by the compensation committee.
These requirements are not controversial. They reflect current best practices and are likely already reflected in many listed company compensation committee charters.8
While compensation committees may continue to receive advice from in-house counsel, a listed company’s regular outside counsel retained by management, or other non-independent counsel, the new listing standards will require compensation committees to take into consideration the following six independence factors when selecting compensation consultants, legal counsel, or other compensation advisers:
- the provision of other services to the listed company by the entity that employs the compensation adviser;
- the amount of fees received from the listed company by the entity that employs the compensation adviser, as a percentage of the total revenue of the person that employs the compensation adviser;
- the policies and procedures of the entity that employs the compensation adviser that are designed to prevent conflicts of interest;
- any business or personal relationship of the compensation adviser with a member of the compensation committee;
- any stock of the issuer owned by the compensation adviser; and
- any business or personal relationships between the executive officers of the issuer and the compensation adviser or the entity employing the adviser.9
The Final Rules apply to all Exchanges that list equity securities, and provide that the new listing standards need apply only to issuers with listed equity securities.
Although listed companies are not required under SEC rules to form a compensation committee, the new listing standards will apply to any committee of an issuer’s board of directors, or to the members of the board of directors who oversee executive compensation matters on behalf of the board of directors -- whether or not such committee or members are formally designated as a compensation committee. Thus, issuers are not able to avoid the requirements of the Final Rules by simply eliminating their formal “Compensation Committee.”
As provided in the Dodd-Frank Act, the Final Rules exempt certain companies from the compensation committee independence requirements, including limited partnerships, companies in bankruptcy proceedings, controlled companies, smaller reporting companies, open-end management investment companies registered under the Investment Company Act of 1940, and certain foreign private issuers.
Additional Proxy Disclosure Requirements
Aside from the existing proxy disclosure requirements relating to an issuer’s use of compensation consultants, the Final Rules require listed companies to disclose, with respect to any compensation consultant whose work has raised a conflict of interest with the issuer, a description of the nature of the specific conflict and how the conflict is being addressed.10
The Exchanges must propose new listing standards that comply with the Final Rules to the SEC within 90 days after publication of the Final Rules in the Federal Register. Furthermore, the Exchanges are required to have final standards approved by the SEC no later than one year after publication of the Final Rules in the Federal Register. The new rules regarding Additional Proxy Disclosure Requirements apply to proxy statements covering any annual meeting occurring on or after January 1, 2013.
In light of the Final Rules, compensation committees of listed companies will want to be prepared, once the new listing standards are promulgated, to:
- review their members’ independence (i.e., their eligibility to continue to serve);
- examine their processes for selecting advisers, including compensation consultants and independent committee counsel;
- review and revise relevant governance documents and policies (e.g., compensation committee charter);
- review, revise or adopt other materials (e.g., D&O Questionnaires, policies, protocols) relative to the independence of, and engagement of, compensation advisers; and
- identify and consider any conflicts of interest their advisors may have in serving the committee.
1 The SEC’s Adopting Release can be found at: http://www.sec.gov/rules/final/2012/33-9330.pdf.
2 The statute is codified as Section 10C of the Securities Exchange Act of 1934. The Final Rules are codified as Rule 10C-1 under the Exchange Act.
3 Like the Dodd-Frank Act itself, the Final Rules do not prescribe the functions of the compensation committee of a listed company. Also, like the statute, the Final Rules do not affirmatively require that a listed company have a compensation committee (see below). These determinations are presumably left to the Exchanges. Under current Rule 3.03A.05 of the NYSE, the compensation committee, among other things, must determine and approve the compensation level of the CEO, and make recommendations to the board with respect to nonCEO executive officer compensation, and incentive-compensation and equity-based plans that are subject to board approval. Under current NASDAQ Rule 5605(d), the compensation of the CEO and all other executive officers must be determined, or recommended to the board for determination, by a majority of the independent directors or a compensation committee comprised solely of independent directors.
4 These standards appear almost verbatim in Section 952(a) of the Dodd-Frank-Act.
5 See Section 10A(m) of the Exchange Act; Exchange Act Rule 10A-3.
6 In its commentary to Rule 303A.02, the NYSE states, “[A]s the concern is independence from management, the Exchange does not view ownership of even a significant amount of stock, by itself, as a bar to an independence finding.” The commentary to NASDAQ Rule 5605(a)(2) is to the same effect.
7 NYSE Rule 303A.05 requires compensation committees to be comprised solely of independent directors. NYSE Rule 303A.02 directs listed companies to broadly consider all facts and circumstances when determining “independence.” The Rule lists a series of factors that preclude a finding of independence, including compensation in excess of $120,000 (other than as a director) and employment within the past three years with the listed company among the circumstances. NASDAQ Rule 5605(e) similarly requires compensation decisions to be made by a compensation committee or by independent directors. The independence disqualifying factors under NASDAQ Rule 5605(a)(2) are similar to those of the NYSE. Accordingly, while the Exchanges can be expected to adjust their rules on compensation committee independence in response to the Final Rules, the changes should not constitute a departure in substance from the current rules.
8 In its commentary to Rule 303A.05, the NYSE states, “[I]f a compensation consultant is to assist in the evaluation of director, CEO or executive officer compensation, the compensation committee charter should give that committee sole authority to retain and terminate the consulting firm, including sole authority to approve the firm's fees and other retention terms.” The NYSE also grants boards the right to delegate the responsibilities of the compensation committee to committees of their own denomination, provided that such committees are composed entirely of independent directors and have a committee charter.
9 With the exception of the final factor, these factors appear substantially verbatim in Section 952(b) of the Dodd-Frank Act.
10 Item 407(e) of Regulation S-K already requires certain disclosures concerning compensation advisors, including any role compensation advisers played in determining or recommending executive or director compensation, including the nature and scope of the assignment; and in cases where the compensation advisers provide additional services to the company in excess of $120,000 per year, the aggregate fees of the adviser for determining compensation and for such additional services (with certain additional disclosures being required in this case as well).