The Securities and Exchange Commission (the “SEC”) has issued a new proposed Rule 10C-1 and proposed amendments to Item 407(e) of Regulation S-K (“Reg S-K”) (collectively, the “Proposed Rules”) implementing Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which added a new Section 10C of the Securities Exchange Act of 1934 (the “Exchange Act”). Section 10C of the Exchange Act generally deals with the independence of compensation committee members and with compensation committee advisers.

Proposed Rule 10C-1 tracks Section 10C by requiring national securities exchanges to prohibit, with certain exceptions1 , the continued listing of equity securities of an issuer that is not in compliance with the required standards of Rule 10C-1. These required standards are:

  1. that each member of the compensation committee (or other committee performing oversight of executive compensation) be a member of the listed company’s board;
  2. that each member otherwise be independent;
  3. that the compensation committee have, in its sole discretion, the authority to retain or obtain the advice of a compensation consultant, independent legal counsel or other adviser, be directly responsible for the appointment, compensation and oversight of the work of any such person and be provided appropriate funding to pay the reasonable compensation of such an adviser; andthat the compensation committee select an adviser only after taking into consideration specified independence factors identified in the rule, as well as any others the exchanges might identify.2

Proposed Rule 10C-1 does not require a compensation committee to act consistently with the advice of the adviser, nor does it affect the ability or obligation of the committee to exercise its own judgment. Further, the Proposed Rule does not require a committee to hire its own counsel, although the committee must be free to do so. In its release relating to the Proposed Rules, the SEC stated (in the text around Note 54) that

“(w)e note that while the statute provides that compensation committees of listed issuers shall have the express authority to hire “independent legal counsel,” the statute does not require that they do so. Similar to our interpretation of Section 10A(m) of the Exchange Act, which gave the audit committee authority to engage “independent legal counsel,” we do not construe the requirements related to independent legal counsel and other advisers as set forth in Section 10C(d)(1) of the Exchange 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 inhouse counsel or outside counsel retained by the issuer or management.”

Curiously, the proposing release only refers to Section 10C(d)(1), which deals with counsel and other advisers, and is silent about Section 10C(c)(1), which deals with compensation consultants. This silence and the SEC’s interpretation of the term “obtained the advice” in the proposed amendments to Item 407(e) of Reg S-K, discussed below, may lead to confusion over the ability of a compensation committee to receive advice from a compensation consultant retained by management.

Each exchange is required to submit to the SEC within 90 days following adoption of final rule 10C-1 proposed listing rules complying with the provisions of Rule 10C-1. These must include the definition of independence which the exchange proposes to adopt, following a review of its existing listing standards. In determining how to define independence, the exchanges are directed to consider relevant factors, including the source of compensation of directors, including any consulting, advisory or other compensatory fee paid by the issuer, and whether they are affiliated with the issuer or an affiliate of the issuer. The SEC noted that the NYSE and NASDAQ already require that directors meet objective criteria of independence and that boards make affirmative determinations relating to independence. It also noted the similarity between the requirements for audit committees contained in the Sarbanes-Oxley Act and those that the exchanges might consider under the Proposed Rules, but said that unlike Sarbanes-Oxley, which prescribes minimum standards for audit committees, Proposed Rule 10C-1 gives the exchanges discretion to set their own minimum independence criteria for compensation committees. However, even if an exchange finds that its existing requirements are sufficient, it must submit its proposal to the SEC for its approval. Issuers must therefore wait for further action from the exchanges and the SEC before knowing whether there will be new independence requirements for their compensation committee members.

The Proposed Rules also would amend the corporate governance provisions of Item 407(e) of Reg S-K to address the requirement in Section 10C-2(c)(2) of the Exchange Act that an issuer disclose in its proxy statement whether the compensation committee has retained or obtained the advice of a compensation consultant during the prior fiscal year and, if so, the nature of the assignment, the material elements of the instructions given to the consultant, and whether such consultant was directly retained by the committee. Disclosure would also be required if the work of the consultant raises any conflicts of interest and, if so, the nature of any such conflict and how it was addressed. These provisions only apply to compensation consultants, and not counsel or other advisers.3 These provisions would modify an existing requirement that a company describe the role that a compensation consultant played in determining executive compensation and would apply to all companies subject to the SEC’s proxy rules, including controlled companies. Other provisions of Item 407(e) requiring disclosure of fees paid compensation consultants for non-compensation services in excess of $120,000 are generally retained.

The Proposed Rules do not define “conflict of interest,” but propose adding an instruction to the amended Item 407(e) directing issuers to consider the factors described in footnote 2 above in determining whether a conflict of interest exists. Another proposed instruction to Item 407(e) says that a compensation committee has “obtained the advice” of a compensation consultant if it has requested or received the advice, whether or not there is formal engagement or client relationship and whether or not any fees have been paid to the consultant for advice. Hopefully, the final rules will address the interplay between use of the term “obtain the advice” in the proposed amendment to Item 407(e), its use in Proposed Rule 10C-1(b)(2) dealing with listing standards, and the requirement that compensation committees be directly responsible for the appointment, compensation and oversight of its advisers. As noted above, the Proposed Rule amending Item 407(e) requires disclosure of whether a consultant from whom the committee obtained advice was directly retained by the committee, whether the work of the consultant raised any conflict, and if so, how the conflict was resolved. This suggests that receiving advice from a management-engaged consultant is permissible as long as the compensation committee considers independence factors and appropriate disclosure is made. In contrast, Proposed Rule 10C-1(b)(2) requires that the compensation committee be directly responsible for the appointment of any adviser to it. This provision follows the statement that a compensation committee may retain or obtain the advice of a compensation consultant, suggesting by proximity that “obtaining advice” from a management-engaged compensation consultant might violate the Proposed Rule.