The Securities and Exchange Commission (SEC) recently approved changes to the rules of the NASDAQ Stock Exchange (NASDAQ) regarding its independence requirements for members of listed companies’ compensation committees and their advisers. These rules were adopted under the Dodd-Frank Act.

Specifically, these rule changes require the following:

Use of Compensation Committee

Each listed company must have a compensation committee made up of two or more members who are independent directors under NASDAQ’s rules, as discussed further below. The changes eliminate the alternative that had allowed independent directors to make executive compensation decisions without forming a committee.

Charter Modifications

The compensation committee must have a formal, written charter, and certify to NASDAQ that it has adopted a charter and will review and reassess its adequacy on an annual basis. The charter must specify:

  • the scope of the committee’s responsibilities and how it carries out those responsibilities, including structure, process and membership requirements;
  • the committee’s responsibility for determining (or recommending to the board for determination) the compensation of the CEO and all other executive officers, and provide that the CEO may not be present during voting or deliberations on his or her compensation; and
  • the committee's responsibilities and authority with respect to retaining advisers, as discussed below.

Use of Advisers and Assessment of Their Independence

The compensation committee may, in its sole discretion, retain or obtain the advice of a compensation consultant, legal counsel or other adviser (hereafter, “adviser”); the committee is directly responsible for the appointment, compensation, and oversight of such adviser; and the listed company must provide for appropriate funding to pay reasonable compensation to such adviser.

The committee may select, or receive advice from, an adviser only after taking into consideration the following six factors regarding the independence of such adviser:

  • the provision of other services to the issuer by the entity that employs the adviser;
  • the amount of fees received from the issuer by the entity that employs the adviser, as a percentage of the recipient’s total revenue;
  • the policies and procedures of the entity that employs the adviser that are designed to prevent conflicts of interest;
  • any business or personal relationship of the adviser with a member of the compensation committee;
  • any stock of the company owned by the adviser; and
  • any business or personal relationship of the adviser or the entity employing the adviser with an executive officer of the company.

Notwithstanding its determination following the review of these six factors, the compensation committee may choose any adviser it prefers. 

Enhanced Independence for Compensation Committee Members

Beyond NASDAQ’s basic tests for director independence, two additional tests must be used to establish the independence of compensation committee members. These are:

  • The Fees Factor Each member of a compensation committee of a listed company must not accept directly or indirectly any consulting, advisory or other compensatory fee from the listed company or any of its subsidiaries. Like the analogous rule for audit committee members, directors may continue to receive fees for membership on the board or its committees, or fixed amounts of compensation under a retirement plan for prior service with the company.
  • The Affiliation Factor In determining a director’s eligibility to serve on the compensation committee, the board also must consider whether the director is affiliated with the company, a subsidiary of the company, or an affiliate of a subsidiary of the company to determine whether such affiliation would impair the director’s judgment as a member of the compensation committee. Unlike the analogous audit committee rule, there is no blanket prohibition; indeed, NASDAQ believes that “it may be appropriate for certain affiliates, such as representatives of significant stockholders, to serve on compensation committees since their interests are likely aligned with those of other stockholders in seeking an appropriate executive compensation program.”

Smaller Reporting Companies

NASDAQ specifically exempted smaller reporting companies (as defined in Rule 12b-2) from most of these rule changes. Smaller reporting companies must have a compensation committee made up of two or more members who are independent directors, and this committee must have a formal, written charter and certify to NASDAQ that it has adopted a charter. However, they do not need to comply with the additional compensation committee member independence requirements, adopt the charter changes, use the adviser independence factors set forth above, nor review their charters annually. Certain other issuers, such as controlled companies, are also exempt or partially exempt from the new rules.

That said, it is good practice for smaller reporting companies to be aware of these requirements and consider adopting them on a voluntary basis. Most smaller reporting companies have already established a compensation committee composed solely of independent directors, and should consider applying the additional independence requirements and adviser rules, as well.

Compliance Notes and Timing

NASDAQ-listed issuers may want to consider working with their corporate counsel to review and revise their compensation committee charters and review the independence of the individuals serving on their compensation committees and such committees’ advisers in light of these new rules. Companies must comply with these new rules starting July 1, 2013. Technically, issuers have a longer period to adopt the charter amendments (the earlier of the issuer’s first annual meeting after January 15, 2014 or October 31, 2014), but must act by board resolution or otherwise to give the committee the specified authority by July 1, 2013. If feasible, taking up the compensation committee charter now is a more straightforward approach. The many companies with spring or summer annual meetings, therefore, should finalize and obtain board approval of revised compensation committee charters, as well as make any needed changes to the composition of their compensation committees, within the next few months.

NASDAQ also requires issuers to certify their compliance with these requirements no later than 30 days after the applicable deadline.

The SEC has also approved similar changes to the rules of the New York Stock Exchange LLC (NYSE) which apply to NYSE-listed companies.