On June 20, 2012, the Securities and Exchange Commission adopted a final rule, pursuant to Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, requiring national securities exchanges to establish listing standards for the independence of compensation committees and compensation advisers. The Dodd-Frank Act amended the Securities Exchange Act of 1934 to add Section 10C to the Exchange Act which requires the SEC to adopt rules directing the national securities exchanges to prohibit the listing of any equity security of an issuer that is not in compliance with Section 10C's compensation committee and compensation adviser requirements.
New Rule 10C-1 of the Exchange Act requires national securities exchanges to establish listing standards with the following requirements:
- Each member of a listed issuer's compensation committee must be a member of the issuer's board of directors and "independent" as defined by the listing standards of the national securities exchange.
- A compensation committee that retains or obtains the advice of compensation advisers is directly responsible for the appointment, compensation, and oversight of that adviser.
- A compensation committee may select a compensation adviser only after considering six independence factors.
Smaller reporting companies and controlled companies are exempt from all of the requirements of the new listing standards. Certain categories of issuers are exempt from the compensation committee independence requirements.
The final rule also amends Item 407 of Regulation S-K requiring any public company subject to the proxy rules (whether listed or not listed) to disclose in its proxy statement any conflicts of interest that arise in connection with the work by a compensation consultant and how such conflict is being addressed.
Rule 10C-1 is effective on July 27, 2012. Each national securities exchange must provide the SEC with proposed listing rules that comply with the new rules by September 25, 2012. Each national securities exchange must have final listing rules approved by the SEC by June 27, 2013. Issuers must comply with the disclosure changes in Item 407 of Regulation S-K in any proxy or information statement for an annual meeting of shareholders (or a special meeting in lieu of an annual meeting) at which directors will be elected occurring on or after January 1, 2013.
The final SEC rule can be found here.
Compensation Committee Independence
The new rule directs each national securities exchange to establish listing standards that require each member of a listed issuer's compensation committee to be a member of the issuer's board of directors and "independent" as defined by the listing standards of the exchange. The new rule requires each national securities exchange to define "independence" with respect to a compensation committee member after considering several 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 an issuer.
The SEC does not define "affiliate" for purposes of Rule 10C-1. Although each exchange must consider affiliate relationships and sources of compensation in establishing a definition of independence for compensation committee members, there is no requirement to adopt listing standards precluding compensation committee membership based on the two factors listed above or any specific relationship.
The new rule also applies to those members of a listed issuer's board of directors or a committee of the board that oversees executive compensation matters on behalf of the board of directors in the absence of a compensation committee.
Section 10C of the Exchange Act provides that the compensation committee of a listed issuer may, in its sole discretion, retain or obtain the advice of a compensation consultant, independent legal counsel or other advisers (collectively, "compensation advisers"). A compensation committee that retains or obtains the advice of a compensation adviser is directly responsible for the appointment, compensation, and oversight of that adviser. A listed issuer must provide appropriate funding as determined by the compensation committee to ensure the compensation committee has the necessary funds to pay reasonable compensation to compensation advisers.
The new rule further provides that exchanges must establish listing standards that require a compensation committee to select a compensation adviser only after considering the following six independence factors:
- The provision of other services to the issuer by the person that employs the compensation adviser;
- The amount of fees received from the issuer by the person 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 person 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 relationship of the compensation adviser or the person employing the adviser with an executive officer of the issuer.
The new rules do not require that a compensation adviser be independent. Rather, a compensation committee must consider the six independence factors prior to selecting a compensation adviser. In addition, a national securities exchange may add other independence factors that a compensation committee must consider. A compensation committee is not required to consider these factors when it consults with or obtains advice from in-house counsel.
Opportunity to Cure Defects and Exemptions
The rule requires exchanges to provide appropriate procedures for listed issuers (if existing procedures are not adequate) to have a reasonable opportunity to cure any noncompliance with the new listing requirements based on the new rules before they are delisted.
The new rule exempts smaller reporting companies and controlled companies from all of the requirements of the new listing standards. Additionally, an issuer in the following categories cannot be prohibited from listing on an exchange for noncompliance with the compensation committee independence standards:
- Limited partnerships;
- Companies in bankruptcy proceedings;
- Open-end management investment companies registered under the Investment Company Act of 1940; and
- Foreign private issuers that disclose in their annual reports the reasons why they do not have an independent compensation committee.
The rule also authorizes exchanges to exempt a particular relationship from the compensation committee independence requirements as each exchange determines is appropriate, taking into consideration the size of the issuer and other relevant factors.
Compensation Consultant Disclosure and Conflicts of Interest
Existing Item 407(e) of Regulation S-K currently requires Exchange Act registrants that are subject to the proxy rules to disclose any role of compensation consultants in determining or recommending the amount or form of executive and director compensation. The amendment to Item 407(e) of Regulation S-K provided in the new rules requires disclosure of any conflicts of interest that arise in connection with the work by a compensation consultant and how the conflict is being addressed. The six independence factors used to determine the independence of a compensation consultant discussed above should be used to determine whether a conflict of interest exists. The new disclosure requirement applies only to compensation consultants (not all "compensation advisers") and to issuers subject to the proxy rules (whether listed or not listed).
What Companies Should Do Now
New exchange listing standards will likely be effective for the 2013 proxy season. Companies listed on national securities exchanges should reevaluate the independence of their compensation committee members and compensation advisers in light of the new rules. Companies should consider whether changes to the composition of their compensation committee may be necessary once the final exchange listing standards are adopted and become effective. Companies will also need to develop or modify procedures to determine relationships between issuers and compensation committee members and compensation advisers, including modifications to director and officer questionnaires. Companies should also develop procedures to identify conflicts of interest between issuers and compensation advisers, including with the use of a questionnaire that includes the six independence factors mentioned above. Companies should also review their existing compensation committee charter to determine if modifications may be required to the charter.