SEC Proposes Rules Implementing Dodd-Frank Provisions on Independence of Compensation Committees and their Advisers

On March 30, 2011, the Securities and Exchange Commission (“Commission”) voted unanimously to propose rules under the Securities Exchange Act of 1934 (“Exchange Act”) to implement the provisions of Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). The proposed rules would:

  • direct the national securities exchanges to adopt certain listing standards related to the compensation committee of a company’s board of directors, as well as its compensation advisers, and
  • require new disclosures from companies concerning their use of compensation consultants and conflicts of interest.

Compensation Committee Independence and Selection and Use of Advisers

Overview

The Dodd-Frank Act amended the Exchange Act to include a new Section 10C entitled “Compensation Committees.” Under this new law, the Commission must, by rule, direct the national securities exchanges (such as NYSE and Nasdaq) to adopt certain listing standards to address the independence of the members on a compensation committee, the committee’s authority to retain compensation advisers, and the committee’s responsibility for the appointment, payment and work of any compensation adviser.

In essence, the Commission’s proposed rules do little more than repeat the statutory requirements of Section 10C, leaving it up to the exchanges to add more specific requirements as they deem appropriate. However, the Commission will still get the final word, as the exchanges would need to seek the approval of the Commission before any new listing standards could go into effect. Once an exchange’s new listing standards are in effect, a listed company must meet these standards in order for its shares to continue trading on that exchange.

Compensation Committee Independence

Specifically, under the Commission’s proposed Rule 10C-1, the exchanges would be required to adopt listing standards that require each member of a company’s compensation committee to be a member of the board of directors and to be “independent.” In developing a definition of independence, the exchanges would be required to consider such factors as:

  • the sources of compensation of a director, including any consulting, advisory or compensatory fee paid by the company to such member of the board of directors, and
  • whether a member of the board of directors of a company is affiliated with the company, a subsidiary of the company, or an affiliate of a subsidiary of the company.

Rather than establishing minimum independence standards that the exchanges must apply to compensation committee members, the Commission’s proposed rules would permit each exchange to establish its own independence criteria, provided it considers the above factors relating to affiliate relationships and sources of compensation.

In the proposal, the Commission seeks public comment on whether its final rules should require that other factors be considered in assessing the independence of compensation committee members, such as:

  • business or personal relationships between a director and an executive officer, 
  • board interlocks, and 
  • employment of a director at a peer-group company.

Comment is also solicited on whether directors affiliated with large shareholders should continue to be permitted to serve on compensation committees because their interests are aligned with other shareholders with respect to compensation matters.

Observations:

Sound familiar? That’s because the “independence factors” for compensation committee members in Section 10C cover the same matters as the prohibitions in Section 10A(m)’s definition of audit committee independence. However, the exchanges would not be required to adopt the same prohibitions for determining compensation committee independence and will have flexibility to consider other factors in developing their definitions. For example, the exchanges might find compelling the line of argument that directors affiliated with significant investors (such as private equity funds or venture capital firms) should be permitted to serve on compensation committees, given their natural motivation to rigorously oversee compensation from the shareholders’ point of view.

Note, too, that the proposed independence factors relate to current relationships between the company and the compensation committee member, which is consistent with the approach in Rule 10A-3 for audit committee members.

Compensation Committee Advisers

As required by Section 10C, the Commission’s proposed rules would direct the exchanges to adopt listing standards providing that the compensation committee of a company:

  • must have sole discretion to retain or obtain the advice of a compensation consultant, separate legal counsel and other advisers; 
  • must be directly responsible for the appointment, compensation and oversight of the work of the compensation consultant, legal counsel or advisers so engaged; and 
  • must be provided appropriate funding from the company for the payment of reasonable compensation to any such advisers to the committee.

Such listing standards would further need to provide that a compensation committee may select an adviser only after considering the following five independence factors:

  • whether the compensation consulting company employing the compensation adviser is providing any other services to the company; 
  • how much the compensation consulting company who employs the compensation adviser has received in fees from the company, as a percentage of that person’s total revenue; 
  • what policies and procedures have been adopted by the compensation consulting company employing the compensation adviser to prevent conflicts of interest;
  • whether the compensation adviser has any business or personal relationship with a member of the compensation committee; and
  • whether the compensation adviser owns any stock of the company.

Again, the Commission’s proposed rules would allow the exchanges themselves to impose additional considerations, subject to the Commission’s approval of the submitted listing standards.

Observations:

The Dodd-Frank Act does not require that a compensation adviser be independent, only that the compensation committee consider the enumerated independence factors before selecting a compensation adviser. Because of this, the Commission notes that the proposed rules do not contemplate that the listing standards would establish materiality or bright-line numerical thresholds with respect to any factor.

While independence of compensation consultants has been a matter of focus for several years, the notion of “independent” legal counsel for the compensation committee has been less compelling. Interestingly, the Commission notes in the proposing release that it does not construe Section 10C as requiring a compensation committee to retain independent legal counsel or as precluding a compensation committee from retaining non-independent legal counsel or obtaining advice from in-house counsel or outside counsel retained by the company or management.

While the Commission believes the factors set forth in Section 10C are generally comprehensive, it seeks comment as to whether there are any additional independence factors that should be taken into consideration by a listed company’s compensation committee when selecting a compensation adviser. The Commission is also soliciting comment as to whether the enumerated factors are competitively neutral, as required by the statute.

Ability to Cure Defects

Proposed Rule 10C-1 provides that the exchanges’ rules may provide that if a member of a compensation committee ceases to be independent for reasons outside the member’s reasonable control, that person, with notice to the exchange, may remain a compensation committee member until the earlier of the next annual meeting or one year after the disqualifying event.

Exemptions

As directed by Section 10C, the Commission’s proposed rules would require the exchanges to exempt the following five categories of companies from the compensation committee independence requirements:

  • controlled companies (companies of which more than 50 percent of the voting power for the election of directors is owned by an individual, a group or another company);
  • limited partnerships;
  • companies in bankruptcy proceedings;
  • open-end management investment companies registered under the Investment Company Act of 1940; and
  • any foreign private issuer that discloses in its annual report the reasons that the foreign private issuer does not have an independent compensation committee.

The exchanges would be permitted to exempt a particular relationship from the independence requirements applicable to compensation committee members.

The Commission’s proposed rules also would authorize the exchanges to exempt any category of company from all of the requirements of the new compensation committee listing standards. However, as required by the statute, the proposed rules would exempt controlled companies from all of the requirements of the new compensation committee listing standards.

As with all listing standards, the exchanges would need to seek the approval of the Commission before adopting any exemptions.

Disclosure of Use of Consultants and Conflicts of Interest

Section 10C requires that proxy materials for an annual meeting must disclose whether the compensation committee has retained or obtained the advice of a compensation consultant, whether the work of the compensation consultant has raised any conflict of interest and, if so, the nature of the conflict and how the conflict is being addressed.

In the proposing release, the Commission noted that Item 407(e)(3) of Regulation S-K already requires Exchange Act registrants subject to the federal proxy rules to disclose information about their use of compensation consultants, including specific information about fees paid to consultants if they exceed $120,000. The current item excludes from the disclosure requirement any role of compensation consultants limited to advice on broad-based plans or in which the consultant provides only non-customized benchmark data.

Given the similarities between the disclosures required by new Section 10C and existing Item 407(e)(3) of Regulation S-K, the Commission proposes to integrate the two disclosure requirements by modifying Item 407(e)(3), rather than simply “tacking on” the new requirements to the existing ones.

The modified Item 407(e)(3) would differ from the existing item in two principal respects:

  • First, the trigger for disclosure would change from whether the consultant played “any role” in determining or recommending the amount or form of executive and director compensation to whether the committee or management, as the case may be, “retained or obtained the advice” of the consultant. As noted by the Commission, this is a minor change that would have little practical effect, and was done merely to avoid the confusion of having separate triggers for different aspects of the disclosure.
  • Second, disclosure of whether the compensation committee retained or obtained the advice of a compensation consultant and whether the consultant’s work raised any conflict of interest (and, if so, the nature of the conflict and how it is being addressed) would be required without regard to the existing exceptions in Item 407(e). For example, disclosure about the compensation consultant would be required even if the consultant provides only advice on broad-based plans or provides only noncustomized benchmark data.

The existing fee-disclosure requirements of Item 407(e)(3) would remain essentially the same, including the existing exception for services that are limited to consulting on broad-based plans and the provision of noncustomized benchmark data.

A new instruction to modified Item 407(e)(3) would clarify that the phrase “obtained the advice” relates to whether a compensation committee or management has requested or received advice from a compensation consultant, regardless of whether there is a formal engagement of the consultant, a client relationship or any payment of fees to the consultant for its advice.

The proposed rules purposely do not define the term “conflict of interest.” However, a new instruction to modified Item 407(e)(3) would identify the five adviser independence factors from Rule 10C-1 (discussed above) as among the factors that should be considered in determining whether a conflict of interest exists. The Commission has not concluded that the presence or absence of any of these individual factors indicates that a conflict of interest exists or that other factors might not present such a conflict. Moreover, the Commission says in the proposing release that the existence of fees that trigger disclosure does not necessarily reflect a conclusion that a conflict of interest is present.

If a compensation committee determines that there is a conflict of interest with the compensation consultant based on the relevant facts and circumstances, the company would be required to provide a clear, concise and understandable description of the specific conflict and how the company has addressed it. A general description of a company’s policies and procedures to address conflicts of interest or the appearance of conflicts of interest would not suffice.

Observations:

  • The new modified disclosures would be required only in proxy materials for an annual meeting at which directors are to be elected, as opposed to all annual meetings. 
  • The new modified disclosures would be required for all Exchange Act registrants subject to the proxy disclosure rules, whether or not listed on a national securities exchange and whether or not they are controlled companies. The Commission proposes this expansion beyond what is required by the Dodd-Frank Act, due to the similar nature and apparent common purpose of the existing and new conflicts of interest disclosure requirements. 
  • Consistent with the existing requirements of Item 407(e)(3), the new modified disclosures would be required only with respect to compensation consultants and not independent legal counsel or other advisers. The Commission seeks comment as to whether this is appropriate.

Deadline for Public Comments

Public comments on the Commission’s proposed rules should be received on or before April 29, 2011.

Transition and Timing

The Commission has until July 16, 2011, to issue final rules under Section 10C. The exchanges would be instructed to submit their proposed listing standards no later than 90 days after publication of the Commission’s final rules in the Federal Register (which would be in October 2011, assuming the Commission adopts its final rules close to the statutory deadline). Following that, the exchanges would be required to have final listing standards approved by the Commission no later than one year after publication of the Commission’s final rules in the Federal Register (making the deadline for the exchanges likely sometime in July 2012). If this schedule is followed, the new disclosure rules about the use of compensation consultants and conflicts of interest would not be in effect for the 2012 proxy season for most companies. But stay tuned, as we all know by now that anything can happen.