On September 25, 2012, the New York Stock Exchange (NYSE) and the NASDAQ Stock Market (Nasdaq) each proposed amendments to their respective listing rules in order to comply with the requirements of Securities Exchange Act Rule 10C-1. Rule 10C-1 was adopted to implement the provisions of Section 10C of the Exchange Act (added pursuant to Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010), which required the Securities and Exchange Commission (SEC) to adopt rules directing the national securities exchanges and national securities associations to prohibit the listing of any equity security of an issuer that is not in compliance with Section 10C’s requirements.
Exchange Act Rule 10C-1 directs national securities exchanges and associations to adopt listing rules pertaining to: (i) the independence of compensation committee members; (ii) the ability of a compensation committee to obtain the advice of consultants, independent legal counsel and other advisers (Advisers); (iii) the requirement for a listed issuer to provide appropriate funding for Advisers; and (iv) specified independence factors required to be considered by a compensation committee prior to selecting an Adviser. Rule 10C-1 is discussed in more detail in our client alert issued June 25, 2012 (June Alert).1
In addition to implementing Rule 10C-1, Nasdaq’s proposal would require listed companies to have a standing compensation committee consisting of at least two directors, all of whom must be independent, with a formal written charter.2 The NYSE already requires listed companies to have a standing compensation committee, all of whose members are independent, with a formal written charter.
Once adopted (after a comment period and final SEC approval), the rule changes effected by the NYSE proposal will become operative on July 1, 2013, provided that NYSE-listed companies must comply with the heightened independence requirements for compensation committee members by the earlier of their first annual meeting after January 15, 2014 and October 31, 20143; Nasdaq-listed companies must comply with its new requirements by the earlier of their second annual meeting held after approval of the rules and December 31, 2014 (except with respect to the new requirements described under “Compensation Committee Advisers” below, which will be effective for Nasdaq-listed companies immediately after adoption).4
Compensation Committee Independence Requirements
As stated in the June Alert, in crafting independence requirements for compensation committee members, Rule 10C-1 requires that exchanges consider relevant factors, including, but not limited to: (A) the source of the director’s compensation, including any consulting, advisory or other compensatory fee paid by the issuer to such director; and (B) whether such director is affiliated with the issuer, or a subsidiary or affiliate of a subsidiary of the issuer (Member Factors).
NYSE: In addition to the NYSE’s existing standards applicable to determining director independence generally, the NYSE proposal requires that, in making compensation committee member independence determinations, the board must consider all factors specifically relevant to determining whether a director has a relationship to the listed company which is material to that director’s ability to be independent from management in connection with the duties of a compensation committee member, including, but not limited to, the Member Factors. When considering the sources of a director’s compensation, the board should consider whether the director receives compensation from any person or entity that would impair his ability to make independent judgments about the listed company’s executive compensation, and when considering affiliate relationships, the board should consider whether the affiliate relationship places the director under the direct or indirect control of the listed company or its senior management, or creates a direct relationship between the director and members of senior management, in each case of a nature that would impair his ability to make independent judgments about the listed company’s executive compensation.
Notably, the NYSE did not propose any specific numerical tests or a requirement that a director who owns (or whose affiliates own) more than some specified percentage of the listed company not be considered independent. The NYSE noted that share ownership in the listed company aligns the director’s interests with those of unaffiliated shareholders, as their stock ownership gives them the same economic interest in ensuring that the listed company’s executive compensation is not excessive.
Nasdaq: In addition to Nasdaq’s existing standards applicable to determining director independence generally, Nasdaq’s proposal adopts the same standard for compensation committee members that applies to audit committee members under Rule 10A-3 under the Exchange Act with respect to compensatory fees. Specifically, Nasdaq’s proposal prohibits a finding of independence for a compensation committee member who accepts directly or indirectly any consulting, advisory or other compensatory fee from an issuer or any subsidiary, with no look-back period.5 Unlike the NYSE proposal, these requirements would be mandatory, and not subject to Board discretion.
With respect to affiliate relationships, boards are to consider whether the director is affiliated with the company, a subsidiary or an affiliate of a subsidiary to determine whether such affiliation would impair the director’s judgment as a member of the compensation committee, but with no bright-line rules and no required “look-back” period. For reasons similar to those articulated in the NYSE proposal, the Nasdaq proposal notes that a board may conclude that it is appropriate for a director who is an affiliate to serve on a compensation committee.
Cure Periods and Transition Periods
Both the NYSE proposal and the Nasdaq proposal contain limited cure periods if a member of the compensation committee ceases to be independent for reasons outside the member’s reasonable control (and with respect to Nasdaq, also in the event of one vacancy). The conditions required and periods within which a listed company must regain compliance are described in the respective proposals. In addition, the Nasdaq proposal retains its current two-year exception for compensation committees with at least three members, which permits one director who is not independent (but is not currently an executive officer or employee or a defined family member of an executive officer) to be appointed to the compensation committee if the board, under exceptional and limited circumstances, determines that such individual’s membership is required by the best interests of the company and its shareholders.
Each of the NYSE and Nasdaq proposals also include transition periods with respect to compensation committee member independence requirements (and with respect to Nasdaq, the minimum size requirement) for specified groups of issuers, including companies listing in connection with their initial public offerings; companies listing upon emergence from bankruptcy; and companies that cease to qualify as a controlled company, a smaller reporting company or a foreign private issuer. Nasdaq’s transition schedule does not apply to the requirement to adopt a formal written compensation committee charter with the prescribed content.
Compensation Committee Advisers
Rule 10C-1 specifies that a compensation committee may, in its sole discretion, retain or obtain the advice of an Adviser; that such committee shall be directly responsible for the appointment, compensation and oversight of the work of such Adviser; and that each listed issuer must provide for appropriate funding, as determined by the compensation committee, for payment of reasonable compensation to such Adviser (Authority Requirements). In addition, Rule 10C-1 specifies that a compensation committee may select an Adviser only after taking into consideration six specific factors pertaining to the independence of such Adviser (Independence Factors), described in detail in the June Alert, as well as any other factors identified by the relevant national securities exchange or national securities association in its listing standards.
NYSE: Although the Authority Requirements are in significant part already required by the NYSE as mandatory elements of a compensation committee’s charter, these requirements are proposed to be included verbatim in a separate new section. The new section also requires a compensation committee to consider the Independence Factors, as well as any other factors that would be relevant to the Adviser’s independence from management, before engaging such Adviser (other than in-house legal counsel). The proposal includes an explicit statement that compensation committees shall not be required to implement the advice of any retained Adviser.
Nasdaq: The proposed Nasdaq listing rule includes the Authority Requirements and specifies that a compensation committee must consider the Independence Factors before retaining an Adviser (not including in-house legal counsel). No further independence considerations are mandated. The Nasdaq proposal emphasizes that a compensation committee is not required to retain an independent compensation adviser.
NYSE: The NYSE proposal would exempt from all of the proposed requirements: limited partnerships; companies in bankruptcy; open-end management investment companies registered under the Investment Company Act of 1940; any foreign private issuer that discloses in its annual report filed with the SEC the reasons that the foreign private issuer does not have an independent compensation committee; and all other categories of issuers that are exempt from the NYSE’s existing compensation committee requirements, such as controlled companies and issuers whose only listed equity security is preferred stock. In addition, the NYSE proposal would extend to its new compensation committee standards its current exemption from existing compensation committee listing standards for foreign private issuers that follow home country practice (in which case the annual report disclosure described above will not be required). Consistent with Rule 10C-1, smaller reporting companies would be exempt from compliance with the heightened compensation committee independence requirements and the requirement to consider the Independence Factors (and other relevant factors) prior to the selection of an Adviser.6
Nasdaq: The Nasdaq proposal specifies that its existing exemptions from the compensation-related listing rules remain generally unchanged (exemptions for asset-backed issuers and other passive issuers, cooperatives, limited partnerships, management investment companies and controlled companies). In addition, Nasdaq’s proposal will allow a foreign private issuer to continue to follow its home country practice in lieu of Nasdaq’s compensation-related listing rules if the foreign private issuer makes certain specified disclosures, including the reasons why it does not have an independent compensation committee. Smaller reporting companies would not be required to adhere to the heightened independence requirements for compensation committee members, or to incorporate into their formal written compensation committee charter or board resolution (permitted for smaller reporting companies) the Authority Requirements or the requirement to consider the Independence Factors prior to the selection of an Adviser. However, smaller reporting companies would be required to have a compensation committee comprised of at least two independent directors as defined under Nasdaq’s existing listing rules (subject to the independence exception and cure period described above).