Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act) directs the national securities exchanges to adopt new listing standards applicable to compensation committees and compensation advisers. The Securities and Exchange Commission (SEC) implemented Section 952 of the Dodd-Frank Act by adopting Rule 10C-1 under the Securities Exchange Act of 1934, as amended, on June 20, 2012. Rule 10C-1 sets forth certain requirements regarding, in part, compensation committee independence, compensation committee authority to retain and be directly responsible for the consultants and advisers it retains, compensation committee analysis of the independence of compensation consultants and advisers, and disclosure of any conflicts of interests concerning compensation consultants. Rule 10C-1 directs the SEC to require the national securities exchanges and associations to adopt listing rules that implement the requirements of Rule 10C-1. On September 25, 2012, each of NYSE and Nasdaq filed proposed listing rules with the SEC (collectively referred to throughout this commentary as the Proposed Standards) to implement the requirements of Rule 10C-1. In general, the Proposed Standards closely track Section 952 and do not contain major changes or heightened requirements to the SEC’s Rule 10C-1.
Overview of Recommended Next Steps
With the release of the SEC’s final rules and the exchanges’ Proposed Standards, we recommend that companies:
- Begin preparing immediately for the compensation consultant conflict of interest and independence assessment and required proxy disclosure of any potential conflict of interest that will be in effect for 2013 proxy statements by collecting and confirming the information necessary to assess whether “conflicts of interests” exist and independence based on the six factors set forth in Item 407 of Regulation S-K and other factors deemed relevant by the company.
- Work with their other compensation advisers to determine whether any independence assessment will be required. The independence and conflict of interest assessments are new and impose additional burdens on companies and their compensation committees. Unfortunately, these requirements are far from clear as to their operation.
- Analyze the composition of their compensation committees, review sources of compensation paid to compensation committee members and any relationships such members have with the listed company, and confirm that all members will meet the new independence requirements. Ultimately, we expect many boards will conclude that existing compensation committee members meet the independence requirements set forth in the Proposed Standards as the compensatory arrangements and affiliate relationships required to be taken into account under the Proposed Standards were likely considered by boards in making their independence determinations under existing rules. Boards will continue to retain significant flexibility in making independence determinations related to compensation committee membership under the Proposed Standards.
- Review their compensation committee charters and consider changes that will be necessary to comply with the new requirements
The SEC’s rules regarding disclosure of the nature of any compensation consultant conflict of interest, found at Reg. S-K Item 407(e)(3)(iv), are effective for proxy statements (or information statements) for meetings at which directors are to be elected and occurring on or after January 1, 2013. As a result, it is advisable for companies to start the information gathering process promptly.
If approved by the SEC, NYSE’s Proposed Standards will become operative on July 1, 2013, but NYSE listed companies will have until the earlier of October 31, 2014 or their first annual meeting after January 15, 2014 to comply with the new listing rules with respect to compensation committee independence. Importantly, the independence assessment of compensation advisers and compensation committee charter requirements will be effective as of July 1, 2013.
If approved by the SEC, Nasdaq’s Proposed Standards require listed companies to comply immediately (upon approval by the SEC) with certain new rules regarding the responsibility and authority of the compensation committee, and the independence analysis of compensation advisers. Compliance with the remaining provisions of Nasdaq’s Proposed Standards is required by the earlier of December 31, 2014 or their second annual meeting held after the date of approval of the Proposed Standards (expected to be the annual meeting of stockholders held in 2014) . Given the anticipated approval of Nasdaq’s Proposed Standards in 2012, companies may need to take steps this year to ensure compliance with the Proposed Standards that become effective upon SEC approval.
New Proxy Disclosure of Compensation Consultant Conflicts of Interest
The SEC has adopted a new proxy disclosure requirement under Item 407(e)(3)(iv) of Regulation S-K regarding compensation consultant conflicts of interest that will automatically go into effect for the 2013 proxy season. As to any compensation consultant who has any role in determining or recommending the amount or form of executive or director compensation, companies will be required to assess whether their work raises any “conflicts of interest” and, if so, to disclose in their proxy statements information about the nature of any such conflicts of interest and how the conflict is being addressed.1 This requirement will only apply to those compensation consultants that are currently required to be identified in a company’s proxy statement under existing Item 407(e)(3)(iii) as having any role in determining or recommending the amount or form of executive or director compensation. In addition, it is clear that the conflicts of interest disclosure requirement applies to compensation consultants who advise on director compensation, not just executive compensation.
Item 407 does not define “conflicts of interest” but provides that at a minimum the following six factors, delineated by the SEC in Rule 10C-1 for the independence assessment of compensation advisers, should be considered in determining whether a conflict of interest exists:
- The provision of other services to the listed company by the firm employing the advisers
- The amount of fees received from the listed company by the firm that employs the adviser, as a percentage of the firm’s total revenues
- The policies or procedures of the firm employing 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 listed company owned by the adviser
- Any business or personal relationships between the executive officers of the listed company and the adviser or the firm employing the adviser
As these provisions of Item 407 are effective for the 2013 proxy season, companies should work with their compensation consultants to collect and confirm the information necessary to determine if the consultant’s work raises any “conflicts of interest” based on the six factors set forth above, as well as any other factors that the company may deem relevant. To this end, the steps a company could take include:
- Summarizing any services provided by the firm employing the advisers (the Consulting Firm), other than those services relating to determining or recommending the amount or form of executive or director compensation. There may be more than one Consulting Firm if the company uses a different firm to advise it regarding director compensation than the company uses for executive compensation, or if more than one firm advises regarding executive compensation due to foreign assignments, for example.
- Determining the total amount of fees paid by the company to the Consulting Firm as a percentage of revenue of the Consulting Firm. While there has not been any clarification in the rules regarding the time frame involved, the expected approach is that this would be determined on an annual basis, likely reviewing the percentage of revenue for the just completed fiscal year being reported in the proxy. In addition, determining the exact percentage should not be necessary, especially if the amount is less than a specified small percentage of revenues, such as less than 1 percent to 5 percent based on the facts and circumstances.
- Obtaining a copy or statement of, or having a conversation with the Consulting Firm regarding, the Consulting Firm’s policies and procedures designed to prevent conflicts of interest.
- Determining the proper individual advisers at the Consulting Firm that perform compensation consulting services for the company (each an Individual Consultant).
- Determining whether any business or personal relationships exists between any Individual Consultant, on the one hand, and any executive officer, any member of the compensation committee, or any member of any other board committee that determines director compensation, if applicable, of the company, on the other hand. No guidance has been provide by the SEC, the NYSE or Nasdaq as to the types of business or personal relationships that could implicate a conflict of interest, leaving that to the discretion of the company. Thus, in addition to reviewing direct relationships, the company should consider whether any indirect relationships, such as the employment of, or payment for services or goods from, an immediate family member or affiliate of an Individual Consultant could present any conflict of interest issues. In order to obtain timely and accurate information regarding any relationships of interest, companies should consider updating their director and officer questionnaires to ascertain the existence of any personal or business relationship, direct or indirect, with any Individual Consultant.
- Determining whether stock ownership of any Individual Consultant could implicate a conflict of interest, based on the ownership and control profile of the company, and the percentage of shares beneficially owned by the Individual Consultant. The SEC, NYSE and Nasdaq have acknowledged, however, that stock ownership often aligns the interests of the individual with the stockholders of the company and thus may not raise conflict or independence issues.
- Determining the appropriate process for ascertaining whether a conflict of interest exists. Given that these factors are the identical factors that are required to be considered by the Compensation Committee in determining the independence of its compensation consultants when selecting such consultants, it is anticipated that the compensation committee will be the body responsible for determining the existence of any conflicts of interest.
- To the extent any conflict is identified, steps should be taken to remove or mitigate the conflict and such steps will need to be disclosed in the proxy statement.
It is important to note that the SEC determined that given the additional burdens placed on companies from these expanded disclosure obligations, the rules do not require disclosure of potential conflicts of interest nor disclosure of the appearance of any conflict of interest.
New Listing Standards Regarding Authority and Responsibility of Compensation Committees, including Independence Assessment of Compensation Advisers
Consistent with the requirements of Rule 10C-1, the Proposed Standards require that the Compensation Committee have certain specified authorities and responsibilities, as follows:
- Compensation committees are to have the authority, in their sole discretion, to retain or obtain the advice of a compensation consultant, independent legal counsel or other adviser (collectively, compensation advisers).
- Compensation Committees are to be directly responsible for the appointment, compensation and oversight of compensation advisers retained by the compensation committees.
- Companies are to provide appropriate funding for the payment of reasonable compensation, as determined by a compensation committee, to its compensation advisers.
- Before selecting compensation advisers, compensation committees are to take into consideration six specified independence factors, as well as any additional factors specified by the exchanges. These six factors are identical to the six factors discussed above as required for the determination of whether a conflict of interest exists with a compensation consultant.
Nasdaq’s Proposed Standards provide that these authorities and responsibilities are to be effective immediately upon SEC approval of the Proposed Standards, while the NYSE gives companies until July 1, 2013 (the specified effective date of NYSE’s Proposed Standards) to comply. With the exception of the independence assessment specified in the fourth bullet above and discussed below, we expect that these requirements will not be problematic for most issuers, given the prevalence of provisions in existing compensation committee charters providing for this authority. Companies should review their compensation committee charters and authorizing resolutions to determine the extent to which these authorities and responsibilities have been previously delegated and whether under applicable state law any further action by the board or otherwise is required before the Proposed Standards are deemed effective. Apart from these requirements going effective when the Proposed Standards are deemed effective, NYSE requires that these responsibilities and authorities be delineated in the compensation committee charter by July 1, 2013, while Nasdaq gives its listed companies until 2014 to include these in the committee charter.
Independence Assessment. The independence assessment requirement is new and will impose additional burdens on compensation committees. Rule 10C-1 and the Proposed Standards generally provide that the compensation committee may select a compensation adviser only after taking into account the six factors discussed above when determining whether a conflict of interest exists. Neither the SEC’s rules nor the Proposed Standards provide for any materiality or quantitative thresholds with respect to any of these factors because the SEC intended for compensation committees to consider all relevant facts and circumstances, not just those meeting certain thresholds. The SEC’s adopting release clarifies that the independence factors should be considered in their totality and that no single factor should be determinative.
The immediate implementation of this requirement raises interesting interpretative questions and places pressure on compensation committees to determine how best to formalize its responsibilities in light of such uncertainties. Although we expected the exchanges to adopt definitions and workable rules with respect to important questions such as which advisers are subject to the independence assessment requirements, under what circumstances and when, the Proposed Standards have not provided any meaningful clarification.
As to the question of which advisers are subject to the committee’s independence assessment, Rule 10C-1 provides that “the compensation committee may select a compensation consultant, legal counsel or other adviser to the compensation committee” only after taking into consideration the six independence factors.2 The instruction to Rule 10C-1 clarifies that this assessment should occur for any compensation adviser “that provides advice to the compensation committee, other than in-house counsel.” The SEC in the adopting release discussed that it does not matter who retained the compensation adviser and that it could apply to outside legal counsel, compensation consultants or other advisers retained by management or the issuer. Thus, one cannot avoid an independence analysis by having management retain the compensation adviser if indeed, as stated in Rule 10C-1(4), the compensation adviser is “an adviser to the compensation committee.” Particularly as to potential compensation advisers who are not compensation consultants, it is not clear what it means to provide advice to the compensation committee or to be an adviser to the compensation committee. Factors that could be relevant include:
- Does the compensation committee oversee the work of the compensation adviser?
- Does the compensation committee determine the compensation of the compensation adviser?
- Did the compensation committee have input into which compensation adviser is hired?
- Does the compensation adviser provide advice as to the form and amount of compensation, and if it is to form, is the advice generally limited to clarifying or ensuring compliance with rules and regulations (such as section 409A, section 162(m), proxy disclosure obligations and the like)?
- Does the compensation adviser directly communicate with the compensation committee and if so is it on a regular or limited basis (e.g., does the compensation adviser meet separately with the committee or attend any committee meetings and/or is the work product of the compensation adviser delivered to the committee)?
- As to whether any outside legal counsel qualifies as a compensation adviser, is there an in-house counsel or staff member who works with the outside counsel and who is primarily responsible for presenting materials and recommendations to the committee?
There are also many questions surrounding the timing requirements: How does the requirement that the independence assessment occur prior to “selection” of the compensation adviser apply to advisers who are already in place, or are these rules to be applied only to new engagements after the adoption of the rules? Are periodic reassessments required with respect to continuing advisers, and at what point would such a re-assessment be triggered? What if a listed company’s compensation committee has already engaged its compensation adviser(s) for 2013? Does it need to retroactively perform the independence assessment?
Hopefully, these ambiguities will be addressed in the final Proposed Standards, or over time through interpretations and best practices.3 In any event, companies should work with each of its potential compensation advisers to determine the extent to which these rules apply to that engagement.
It is important to remember that neither the SEC’s rules nor the Proposed Standards require compensation committees to obtain advice only from compensation consultants or other advisers who are independent. Furthermore, the new rules do not require disclosure in the proxy statement or otherwise of the results of the independence assessments. While the same six factors are reviewed to determine independence and to determine whether a conflict of interest exists, it does not follow that a finding of a lack of independence necessarily results in a finding of a conflict of interest. If it did, then there would be no need to distinguish the two and to require disclosure only in the event of a conflict of interest.
New Nasdaq Requirement to Have a Compensation Committee
Nasdaq currently requires executive compensation decisions to be determined either by (i) a compensation committee comprised of independent directors or (ii) independent directors constituting a majority of the board’ s independent directors. Nasdaq’s Proposed Standards provide that listed companies be required to have a compensation committee comprised of two or more independent directors. This change is expected to impact a small number of listed companies, as the vast majority of Nasdaq companies already have compensation committees. For those Nasdaq listed companies that do not currently have a compensation committee, a qualifying committee must be in place by the earlier of December 31, 2014, or their second annual meeting held after the date of approval of the Proposed Standards (expected to be the annual meeting of stockholders held in 2014).
No change is proposed under NYSE listing standards, which already require a listed company to have a compensation committee, with limited exceptions.
New Listing Standards Requiring Compensation Committee Member Independence
The SEC’s final rules directed the exchanges to establish listing standards that would require each member of a listed company’s compensation committee to be “independent.”4 As required by Rule 10C-1, the Proposed Standards require boards to take into consideration the following when assessing the independence of compensation committee members:
- The source of compensation of the director, including any consulting, advisory or other compensatory fee paid by the issuer to the director.
- Whether the director is affiliated with the issuer, or its subsidiaries or their affiliates.
Rule 10C-1 permits the exchanges to consider other factors in evaluating independence, but neither exchange proposed additional independence criteria beyond those discussed above. These two factors are specific to the compensation committee members and are in addition to the “bright-line” independence tests currently required by the respective exchanges in determining whether a director is independent and thus eligible to serve on the compensation committee (and other standing committees).
NYSE’s Proposed Standards require that the two above factors be “considered” with all other relevant factors in 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.” The focus is on whether the compensation (from any source) or affiliation would “impair his ability to make independent judgments about the listed company’s executive compensation.”
Nasdaq’s Proposed Standards took a more restrictive approach, outright prohibiting a compensation committee member from accepting directly or indirectly any consulting, advising or compensatory fee from the issuer (subject to certain limited exemptions). This is similar to the SEC’s requirement for audit committee member independence, and contains the same exceptions relating to fees received as a member of the committee or board or fixed amounts of compensation under a retirement plan for prior service. Nasdaq’s Proposed Standards further provide that the board must also consider whether the director is affiliated with the company and “whether such affiliation would impair the director’s judgment as a member of the compensation committee.”
Both exchanges provide boards with flexibility in determining to what extent affiliates would be able to serve on compensation committees and note that significant share ownership (or affiliation with a significant shareholder) is not a bar to compensation committee service. In fact, both exchanges expressly note that share ownership aligns a director’s interest with the interests of other shareholders in seeking an appropriate executive compensation program. The Proposed Standards provide welcome guidance in clarifying what many practitioners have concluded in the past – that representatives or designees of significant shareholders (including of venture capital, private equity or hedge fund firms) may be considered independent and serve on compensation committees.
In practice, the independence assessment conducted by boards is not expected to change significantly as a result of these Proposed Standards, as most companies already have compensation committees that will fall within the Proposed Standards’ concept of independence in order to take advantage of certain federal securities law exemptions and tax deductions.5 That being said, Nasdaq companies may find that the prohibition on any consulting, advisory or compensatory fees may result in a required change in committee membership. The Proposed Standards regarding compensation committee independence are not applicable, however, until 2014.6 Companies should ensure that their nominating committees and boards have the necessary information and take the necessary steps to confirm the independence of their compensation committee members in accordance with the Proposed Standards. Nasdaq companies will be required to certify to that effect no later than 30 days after their applicable implementation date.
Both exchanges provide for a cure period if a listed company fails to comply with the compensation committee composition requirements. Under NYSE’s Proposed Standards, if a member of the compensation committee ceases to be independent for reasons outside of the member’s reasonable control, that person, with prompt notice to NYSE and only so long as a majority of the members of the compensation committee continue to be independent, may remain a member of the compensation committee until the earlier of the next annual shareholders’ meeting or one year from the occurrence of the event that caused the member to no longer be independent. Nasdaq’s Proposed Standards are substantially similar except the cure period also applies in the case of a failure to comply with committee composition requirements due to one vacancy, and if the next annual shareholder meeting occurs no later than 180 days after the event that caused the noncompliance, the company will have 180 days to regain compliance.
New Compensation Committee Charter Requirements
Nasdaq’s Proposed Standards require that a formal written compensation committee charter be adopted. Among other things, the compensation committee charter must:
- Set forth the committee’s responsibility for determining or recommending to the board for determination, the compensation of the chief executive officer and all other executive officers.
- Provide that the chief executive officer may not be present during voting or deliberations on his/her compensation.
- Set forth the specific responsibilities and authority described under “New Listing Standards Regarding Authority and Responsibility of Compensation Committees, Including Independence Assessment Of Compensation Advisers” above.
Nasdaq compensation committee charters must be adopted by the earlier of December 31, 2014, or the second annual meeting held after the date of approval of the Proposed Standard (expected to be the annual meeting of stockholders held in 2014). Nasdaq companies will need to certify they have adopted a formal written compensation committee charter and that the compensation committee will review and reassess the adequacy of the formal written charter on an annual basis.7
NYSE’s Proposed Standards require that the compensation committee charter must include the rights and responsibilities described under “New Listing Standards Regarding Authority of Compensation Committees including Independence Assessment of Compensation Advisers” above. NYSE compensation committee charters must be revised by July 1, 2013. The annual affirmation required to be submitted by NYSE companies includes a certification that the compensation committee and its charter satisfy NYSE listing standards.
The above timeframes give companies time to more thoroughly vet the charter requirements and tailor them to the company’s needs, as well as to see what other practices emerge as companies and investors react to the new rules.
Exemptions to the Proposed Standards
None of the new rules apply to issuers which only have debt securities listed on an exchange. Further, except for the disclosure requirement relating to compensation consultant conflicts under Item 407 of Regulation S-K, controlled companies and smaller reporting companies are generally exempt from the requirements of the Proposed Standards. Additionally, limited partnerships, companies in bankruptcy proceedings, registered open-end management investment companies, and foreign private issuers that disclose annually why they do not have independent compensation committees are exempt from the compensation committee independence requirements. Generally speaking, the existing phase-in periods applicable to compensation committee composition (e.g., for newly listed companies) remain unchanged under both exchanges’ proposed rules.