The SEC has approved new  rules required by the Dodd-Frank Act that:

  • direct national securities exchanges to adopt listing standards for public company boards of directors and compensation advisers
  • require disclosure of conflicts of interest by compensation consultants.

The first part of the new rules requires exchange listing standards to address:

  • The independence of the members on a compensation committee
  • The committee’s authority to retain compensation advisers
  • The committee’s consideration of the independence of any compensation advisers and
  • The committee’s responsibility for the appointment, compensation, and oversight of the work of any compensation adviser.

This part of new rules and rule amendments will take effect 30 days after publication in the Federal Register. No later than 90 days after effectiveness, each exchange that lists equity securities must propose listing standards that comply with the new rule. The new listing standards must be approved by the SEC within one year of the new rule becoming effective.

The second prong of the new rules provide that if any compensation consultant that has played a role in determining or recommending the amount or form of executive and director compensation, and the consultant’s work has raised any conflict of interest, then disclosure of the nature of the conflict and how the conflict is being addressed is required.  This rule is effective for any proxy or information statement for an annual meeting of shareholders at which directors will be elected occurring after January 1, 2013.

Independence Requirements

Under the final rule, the exchanges are directed to establish listing standards requiring each member of a listed issuer’s compensation committee to be a member of the board of directors and to be independent. The final rule does not require that exchanges establish a uniform definition of independence.

In developing their own definitions of independence applicable to compensation committee members, the exchanges are required to consider relevant factors, including, but not limited to:

  • 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.

The final rule does not specify any additional factors that the exchanges must consider in determining independence requirements for compensation committee members, nor does the final rule prescribe any standards or relationships that will automatically preclude a finding of independence. Because the rule’s relevant factors cover the same matters as the prohibitions in Exchange Act Section 10A(m)’s definition of audit committee independence, the SEC expects the exchanges to consider whether those prohibitions should also apply to compensation committee members. However, consistent with Exchange Act Section 10C, the exchanges are not required to adopt those prohibitions in their requirements and will have flexibility to consider other factors in developing their requirements.

As noted in the proposing release, Section 10C of the Exchange Act does not require that the exchanges prohibit all affiliates from serving on a compensation committee. In establishing their independence requirements, the exchanges may determine that, even though affiliated directors are not allowed to serve on audit committees, such a blanket prohibition would be inappropriate for compensation committees, and certain affiliates, such as representatives of significant shareholders, should be permitted to serve.

In addition, the final rule does not impose any required look-back periods that must be incorporated in exchange listing standards relating to the independence of compensation committee members. The SEC agreed with commentators that the determination of whether to impose a look-back period in evaluating compensation committee member independence should be left to the exchanges and noted that the exchanges already incorporate various look-back periods in their general criteria for director independence. In this respect, the final rule is similar to Exchange Act Rule 10A-3, which did not impose a mandatory look-back period for evaluating audit committee member independence in light of look-back periods already required by the exchanges for evaluating director independence generally.

Authority to Retain Compensation Advisers

The final rule does not require compensation committees to retain or obtain advice only from independent advisers.  A listed issuer’s compensation committee may receive advice from non-independent counsel, such as in-house counsel or outside counsel retained by management, or from a non-independent compensation consultant or other adviser, including those engaged by management.  The final rule does not require a compensation committee to be directly responsible for the appointment, compensation or oversight of compensation advisers that are not retained by the compensation committee, such as compensation consultants or legal counsel retained by management. Rather, the direct responsibility to oversee compensation advisers applies only to those advisers retained by a compensation committee, and the obligation of the issuer to provide for appropriate funding applies only to those advisers so retained.

Compensation Adviser Independence Factors

The SEC noted that the Dodd-Frank Act does not require a compensation adviser to be independent, only that the compensation committee of a listed issuer consider enumerated independence factors before selecting a compensation adviser. The final rules provide the compensation committee of a listed issuer may select a compensation consultant, legal counsel or other adviser to the compensation committee only after taking into consideration the following factors, as well as any other factors identified by the relevant national securities exchange or national securities association in its listing standards:

  • The provision of other services to the issuer by the person that employs the compensation consultant, legal counsel or other adviser;
  • The amount of fees received from the issuer by the person that employs the compensation consultant, legal counsel or other adviser, as a percentage of the total revenue of the person that employs the compensation consultant, legal counsel or other adviser;
  • The policies and procedures of the person that employs the compensation consultant, legal counsel or other adviser that are designed to prevent conflicts of interest;
  • Any business or personal relationship of the compensation consultant, legal counsel or other adviser with a member of the compensation committee;
  • Any stock of the issuer owned by the compensation consultant, legal counsel or other adviser; and
  • Any business or personal relationship of the compensation consultant, legal counsel, other adviser or the person employing the adviser with an executive officer of the issuer.

The final rule includes an instruction that a compensation committee need not consider the six independence factors before consulting with or obtaining advice from in-house counsel. Commentators noted that it is routine for in-house counsel to consult with, and provide advice to, the compensation committee on a variety of issues, such as, for example, the terms of an existing benefit plan or how a proposed employment contract would interrelate with other company agreements.

This instruction will not affect the obligation of a compensation committee to consider the independence of outside legal counsel or compensation consultants or other advisers retained by management or by the issuer. The SEC believes that information gathered from an independence assessment of these categories of advisers will be useful to the compensation committee as it considers any advice that may be provided by these advisers.

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