Public companies will soon need to apply stricter standards and procedures to the selection of compensation committee members and compensation advisers, and will need to provide new proxy disclosures about potential conflicts of interest facing advisers.
The SEC recently released long-expected final rules that will require stock exchanges to change their corporate governance listing standards relating to compensation committees and compensation advisers. Like current stock exchange rules, the new standards will require that executive compensation decisions be made by independent directors, typically through an independent compensation committee. However, the exchanges will presumably set a higher bar in defining “independence” in the compensation committee context than the existing independence test for directors generally. The new SEC rules also address the compensation committee’s authority to engage independent advisers, mandate that compensation committees consider certain factors before engaging any outside advisers, including company counsel, and require disclosure relating to conflicts of interest of compensation consultants. The rules were first proposed in March 2011 in response to requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
Exchanges now have 90 days to propose listing standards that comply with the SEC rules. Their final listing standards must be in effect within one year. The final listing standards will contain procedures giving listed issuers an opportunity to cure any defects that could otherwise result in a delisting.
We do not believe that the new rules will have a significant effect on most listed companies, as the substance of the new rules is largely consistent with existing stock exchange requirements and general corporate governance practices. However, listed companies will want to keep an eye on the “independence” definitions promulgated by the exchanges. Most significantly, compensation committees will need to mind certain new procedural requirements in seeking advice from outside advisers, including company counsel, as well as proxy statement disclosure requirements relating to potential conflicts of interest with compensation consultants.
Compensation Committee Independence Standards
The exchanges will need to develop their own criteria for compensation committee independence. The only requirements of the SEC rule are that the exchanges “consider” relevant factors, including but not limited to (a) the source of a committee member’s compensation, including any advisory or consulting fees, and (b) whether a committee member is “affiliated” with the issuer, a subsidiary, or a subsidiary’s affiliates.
These standards echo the audit committee independence requirements that originated from the Sarbanes-Oxley Act of 2002, but with a very important difference. Sarbanes mandated that directors be excluded from audit committee service if they receive any outside compensation or are affiliated with the issuer (with a safe harbor for under 10% stockholders). Dodd-Frank merely requires that those factors be considered in setting the compensation committee standards. The stock exchanges may be reluctant to adopt a third variation on independence standards in addition to those already in effect for the majority of the board generally and for audit committee members. At the same time, however, it is difficult to argue that share ownership has the same sensitivity in the oversight of executive compensation as it may have with audit-related issues. Stock exchanges could determine to extend the audit committee test to compensation committees for simplicity. In theory they could even determine, after considering the required factors, that no additional independence requirements are needed beyond those that apply to the majority of the board. In promulgating the listing standards, however, the exchanges will need to demonstrate to the SEC that they appropriately considered the listed factors. A middle ground seems the most likely outcome, but it remains to be seen what course the exchanges will take.
Listed companies should stay tuned to see what standards their stock exchange adopts. We expect that most companies will already have a compensation committee whose members meet any new independence tests.
Retention of Advisers
Listed company compensation committees will also formally have the authority, as a matter of law, to retain or obtain the advice of independent compensation consultants, independent legal counsel and other advisers. This does not mean that a committee is required to hire its own consultants or counsel, that it may not seek the advice of management’s own consultants or the company’s inside or outside counsel, or, if it obtains advice from an independent consultant, that it must adopt the consultant’s recommendation. If it does retain a consultant or independent legal counsel, however, the committee will be directly responsible for the adviser’s appointment, compensation and oversight and the issuer must make appropriate funding available for its reasonable compensation.
Again, we do not believe that this requirement will be disruptive for most companies. NYSE issuers are required to have compensation committee charters that give sole authority to the committee to retain consultants, including the sole authority to retain them and to approve their fees. NASDAQ does not have a formal charter requirement, and the new listing requirements will not necessarily impose one. However, in our experience most NASDAQ-listed companies already have a charter that confers authority on the committee to retain independent advisers. Companies will, over the course of the next year, want to confirm that their compensation committee charters or other appropriate authorizing resolutions are consistent with the new requirements.
Compensation Consultant Independence
The compensation committee of a listed issuer must be authorized to hire its own consultants or legal advisers. However, it may only select an adviser after taking into consideration each of six enumerated factors, as well as any other factors that the stock exchanges may add. These factors relate to (1) other services that the adviser provides to the issuer; (2) the fees the adviser or the adviser’s employer receives from the issuer as a percentage of total revenue; (3) policies of the adviser or the adviser’s employer that are designed to prevent conflicts of interest; (4) any business or personal relationship between the adviser and a member of the compensation committee; (5) any business or personal relationship between the adviser and an executive officer of the issuer; and (6) any stock of the issuer owned by the adviser. The SEC emphasizes that neither Dodd-Frank nor its final rule requires a compensation adviser to be independent, only that the compensation committee consider the specified factors before choosing an adviser. After considering these factors, compensation committees may choose any adviser they like, including non-independent advisers. Committees who retain a compensation consultant with a “conflict of interest,” however, will have to make the new disclosures described below.
The requirement to consider these factors will not apply to consultation by the compensation committee with the issuer’s in-house legal counsel. It will, however, apply to consultation with any outside legal counsel or compensation consultants retained by management. When the standards become effective, a committee should consider periodically memorializing its determination on the independence (or otherwise) of those advisers with whom it regularly consults, as well as explicitly discussing these factors and independence issues generally with any newly engaged adviser.
Controlled companies, meaning those in which 50% of the voting power for election of directors is held by an individual, group or another company, are exempt from these standards. Smaller reporting companies, as defined in SEC rules, are also exempt. Limited partnerships, companies in bankruptcy proceedings and registered open-end management investment companies are exempt from the committee independence requirements, as are foreign private issuers that annually disclose the reasons why they do not have an independent compensation committee. The exchanges may, in drafting their listing standards, exempt other companies and may also exempt specified relationships from the independence tests.
Compensation Consultant Conflicts and Disclosure
The proxy disclosure rules already require issuers to describe any role of a compensation consultant in determining or recommending the amount or form of executive compensation. The identity of the consultant, the nature and scope of its assignment, whether the consultant was retained by the committee or someone else, and in some cases the fees paid must all be disclosed. Under the revised rule, if the work of any named compensation consultant has raised any conflict of interest, the nature of the conflict will also need to be disclosed, as well as how the conflict is being addressed. In determining whether there is a conflict of interest, the six independence factors enumerated above that the committee must consider in retaining the consultant should be considered.
This requirement applies to all companies subject to the proxy rules, including controlled companies, smaller reporting companies and non-listed issuers. Foreign private issuers will not have to provide this disclosure as they are exempt from the proxy rules.
Compensation Committee Not Necessarily Required
For simplicity, this client alert refers to the new requirements as applying to compensation committees, since the vast majority of companies listed on U.S. exchanges already have such committees. The SEC rules do not require that a listed company even have a compensation committee. The new listing standards will apply to any committee of the board that oversees executive compensation or, if there is no such committee, to the members of the board who oversee executive compensation matters on behalf of the board. In practice, this distinction is largely irrelevant. The New York Stock Exchange already requires its listed companies to have a compensation committee of independent directors. NASDAQ does not mandate that a listed issuer have a formal committee, but requires executive compensation to be determined or recommended by an independent committee, or by a majority of independent directors in a vote in which only independent members participate. NASDAQ Staff have publicly suggested that they may amend their rules to require a committee of at least two members, although these statements may have been made in anticipation of an SEC mandate that they do so.