As reported in our recent advisory, SEC Adopts Final Rules Implementing Dodd-Frank Provisions on Independence of Compensation Committees and Their Advisers, on June 20, 2012, the Securities and Exchange Commission (SEC) issued final Rule 10C-1 under the Securities Exchange Act of 1934 (“Exchange Act”) implementing the provisions of Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”).1
Right on schedule, the New York Stock Exchange (NYSE) issued proposed rules to amend its Listed Company Manual to comply with the requirements of Exchange Act Rule 10C-1, and The NASDAQ Stock Market (Nasdaq) followed with proposed rules to amend its Listing Rules on September 26, 2012.
This advisory summarizes the proposed NYSE and Nasdaq rules related to compensation committees and their advisors. Both exchanges’ proposed listing standards are subject to public comment and SEC approval and could change before going into effect.
Compensation Committee Director Independence
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The proposed NYSE rules do not, as many had speculated, apply to compensation committee members the more rigid independence standards that apply to audit committee members under Exchange Act Rule 10A-3(b)(1) (which is the approach adopted by the proposed Nasdaq rules for compensation committee members). Instead, boards of NYSE-listed companies are permitted to make a more holistic assessment of the independence of compensation committees. To guide the board in making such assessment, the proposed NYSE rules contain the following commentary:
“It is not possible to anticipate, or explicitly to provide for, all circumstances that might signal potential conflicts of interest, or that might bear on the materiality of a director’s relationship to a listed company (references to “listed company” would include any parent or subsidiary in a consolidated group with the listed company). Accordingly, it is best that boards making “independence” determinations broadly consider all relevant facts and circumstances. In particular, when assessing the materiality of a director’s relationship with the listed company, the board should consider the issue not merely from the standpoint of the director, but also from that of persons or organizations with which the director has an affiliation. Material relationships can include commercial, industrial, banking, consulting, legal, accounting, charitable and familial relationships, among others. However, as the concern is independence from management, the Exchange does not view ownership of even a significant amount of stock, by itself, as a bar to an independence finding.”
By not imposing bright-line or numerical standards for assessing compensation committee independence, the NYSE decidedly is not concluding that sources and amounts of compensation received by committee members or other such affiliations are not important. To the contrary, the responsibility for identifying and assessing pertinent factors that could impair a director’s ability to make independent judgments about the issuer’s executive compensation has effectively been shifted to the board and its nominating committee. There are no “safety nets” for this purpose.
Moreover, there are still numerical standards embedded in the standards for “non-employee director” status for purposes of Section 16 of the Exchange Act and for “outside director” status under Section 162(m) of the Internal Revenue Code. One would presume that if a director failed to meet one or both of these tests (particularly on a recurring basis), that would be a factor in the board’s assessment of independence of a compensation committee member for NYSE purposes.
The independence of compensation committee members can be particularly significant in other contexts (i.e., beyond compliance with exchange listing standards and maximizing tax deductions under Code Section 162(m)). Since the advent of say-on-pay in the United States, we have seen a proliferation of shareholder derivative suits filed against individual directors (for breach of fiduciary duty in making compensation decisions), executive officers (for unjust enrichment) and compensation consultants (for aiding and abetting). So far, most of these derivative suits have been dismissed on procedural grounds (which depends on the directors being found to be disinterested and independent with respect to the compensation decisions under attack). The plaintiffs’ bar is tireless in trying to break past this procedural barrier and will be looking for ways to discredit claims of director independence. Accordingly, boards should be very mindful of anything (including the acceptance of consulting or advisory fees in any amount) that, when viewed in hindsight, could be interpreted as impairing a director’s ability to make independent judgments about the issuer’s executive compensation.
Compensation Committee Advisers
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Compensation Adviser Independence
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Neither the NYSE nor Nasdaq elaborated on the six independence factors listed in Exchange Act Rule 10C-1, effectively leaving the committees to construe and interpret these factors as best they can. The NYSE (but not Nasdaq) widened the field of inquiry by requiring the committee to consider “all factors” relevant to the adviser’s independence from management, without giving direction as to what those might be.
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. The factors should be considered in their totality and no one factor should be viewed as a determinative factor of independence.
While independence of compensation consultants has been a matter of focus for several years, the notion of “independent” legal counsel for the compensation committee is more recent. Notably, the SEC emphasized in the release adopting Rule 10C-1 that it does not construe the Dodd-Frank Act 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.
The adopting release and an instruction in Rule 10C-1 confirms that a compensation committee need not even consider the six independence factors before consulting with or obtaining advice from in-house counsel (but still must do so before obtaining advice from outside counsel, whether engaged by the compensation committee, management or the issuer).
The NYSE proposed rules on adviser independence (including the requirement to assess the independence of compensation consultants, legal counsel and other advisers) would go into effect on July 1, 2013. The corresponding proposed Nasdaq rules would go into effect immediately upon the SEC’s approval of those listing standards.
As a practical matter, the assessment of independence of compensation consultants (as opposed to other types of advisers) should be well underway now, given the requirement to disclose in the 2013 proxy statement 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. The term “conflict of interest” is not defined. However, the proxy rules identify the six adviser-independence factors from Rule 10C-1(b)(4) (discussed above) as among the factors that should be considered in determining whether a conflict of interest exists.
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Effective Date and Transition Periods
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What to Do Now?
- The first order of business is to lay the groundwork for the 2013 proxy statement disclosure as to whether the work of a compensation consultant identified under Item 407(e)(3)(iii) has raised any conflict of interest and, if so, the nature of the conflict and how it is being addressed.
- Now that the proposed exchange listing standards are out, it is time to vet your compensation committee members against the two “heightened independence” factors. These are similar to the audit committee independence standards for Nasdaq companies but allow a more holistic review by NYSE companies.
- Now is the time to prepare your compensation committee to evaluate its current advisers under the six adviser-independence factors enumerated in Rule 10C-1 (and any other relevant factors if you are a NYSE-listed company), bearing in mind that there is no requirement that the committee’s advisers actually be independent under such standards or otherwise.
- Review your compensation committee charter to be sure it covers the specific provisions required by the proposed rules.
- Finally, be sure to add to your compensation committee’s annual work plan the annual assessment of compensation consultant conflicts of interest and adviser independence.