Final Rules on Compensation Committee Listing Standards

On June 20, 2012, the Securities and Exchange Commission (SEC) adopted Exchange Act Rule 10C-1 implementing listing standard requirements pursuant to Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) which, among other things, imposes new independence requirements for compensation committees of publicly traded companies. Rule 10C-1 directs U.S. stock exchanges (e.g., NYSE, NASDAQ, etc.) to prohibit the listing of any equity security of a company that does not comply with the new listing standards. On September 25, 2012, NYSE and NASDAQ proposed new listing standards pursuant to Rule 10C-1. Rule 10C-1 became effective on July 27, 2012. Each exchange must implement final rules that comply with the new listing standards approved by the SEC no later than June 27, 2013.

Listing Standards

The new listing standards apply to any committee of the board that performs functions typically performed by a compensation committee, including the oversight of executive compensation, whether or not such committee also performs other functions or is formally designated as a compensation committee. Rule 10C-1 also applies, with limited exceptions, to members of the board who oversee executive compensation in the absence of a board committee. Rule 10C-1 contains rules regarding committee independence and the use of compensation advisers as well as the independence of those advisers. Each is discussed in turn below.

Committee Independence Requirements

Section 952 of Dodd-Frank requires the SEC to direct the U.S. stock exchanges to adopt rules that prohibit the listing of companies that do not have an “independent” compensation committee.[1] Rule 10C-1 requires that each member of a company’s compensation committee be a member of the company’s board of directors and provides that the stock exchanges must take the following two factors into account when developing their own definitions of “independence:”

  • a director’s source of compensation, including any consulting, advisory or compensatory fee paid by the company; and
  • whether a director is affiliated with the company, a subsidiary of the company, or an affiliate of a subsidiary of the company.

Although the exchanges must consider affiliate relationships when establishing a definition of compensation committee independence applicable to compensation committee members, unlike the similar audit committee rules governing audit committee independence, Rule 10C-1 does not require the exchanges to prohibit any specific affiliate relationships based on significant stock ownership or any other relationship—nor does the rule separately define “affiliate” for compensation committee independence purposes. Rule 10C-1 is intentionally flexible, allowing the exchanges to craft their own definitions around the two considerations required by the rule.

The independence requirements of the new listing standards do not apply to controlled companies or smaller reporting companies (as defined in Exchange Act Rule 12b-2).[2] Rule 10C-1 also exempts limited partnerships, companies in bankruptcy proceedings, open-end management investment companies and foreign private companies that disclose in their annual reports the reasons why they do not have an independent compensation committee.

Compensation Adviser Requirements

Dodd-Frank requires that each compensation committee have the authority to retain or obtain advice from compensation consultants, legal counsel and other advisers, (collectively, but excluding in-house legal counsel, “Compensation Advisers”). Rule 10C-1 provides that compensation committees must take into account the following independence factors before selecting, or receiving advice from, Compensation Advisers:

  • whether the employer of the Compensation Adviser provides other services to the registrant;
  • the amount of fees received from the registrant by the employer firm of the Compensation Adviser as a percentage of such firm’s total revenue; the policies and procedures of the Compensation Adviser’s employer that are designed to prevent conflicts of interest;
  • any business or personal relationship of the Compensation Adviser with a member of the compensation committee;
  • whether the Compensation Adviser owns any stock of the registrant; and
  • any business or personal relationship between the executive officers of the registrant and the Compensation Adviser or the employer of the Compensation Adviser.

The compensation committee is required to be directly responsible for the appointment, compensation and oversight of Compensation Advisers. Additionally, each company must provide its compensation committee with appropriate funding for the payment of “reasonable compensation” to Compensation Advisers.

Although a compensation committee must consider Compensation Adviser independence, Rule 10C-1 clarifies that the rule does not require a compensation committee to follow the recommendations of Compensation Advisers the committee engages or otherwise impact the responsibility of a compensation committee to exercise its own independent judgment in the exercise of its duties.

Opportunity to Cure

The national securities exchanges must provide listed companies with a reasonable opportunity to cure any defects that would prohibit the listing of the company’s securities as a result of its failure to satisfy the listing standards described above. For example, if a member of the compensation committee ceases to be independent, the member may remain on 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 be no longer independent.

What to Do Now?

The exchanges’ proposed transition periods will provide companies with time to comply with the new independence requirements and, if necessary, restructure their board committees. Most of the provisions of NASDAQ’s proposed rules would not, with one exception discussed below, require compliance until the earlier of (i) the registrant’s first annual meeting after January 14, 2014, or (ii) October 31, 2014. The NYSE’s proposed rules would not become operative until July 1, 2013 and set the same compliance deadlines as NASDAQ’s proposed rules. Although listed companies cannot be certain as to the final content of the exchanges’ proposed rules, we anticipate that the final rules will be substantially similar to the proposed rules, and, accordingly, companies may want to take steps now to prepare.

Review the Proposed Rules of NYSE, NASDAQ, etc.

The following chart sets forth the proposed compensation committee member and advisers’ independence standards and considerations for NASDAQ and NYSE.

Click here to view tables.  

Provide Authority Regarding Compensation Advisors (NASDAQ Companies Only)

NASDAQ proposed Rule 5605(d)(3) would, upon approval by the SEC, become effective on July 1, 2013. The proposed rule would require listed companies to grant compensation committees specific responsibilities and authority necessary to comply with sections of Rule 10C-1 relating to (i) the authority to retain Compensation Advisers, (ii) the authority to find such advisers, and (iii) the responsibility to consider certain independence factors before selecting such advisers. Where a company does not yet have a compensation committee, this rule would apply to the independent directors who either determine or make recommendations to the board regarding the compensation of the CEO and all other executive officers of the company. This proposed rule does not require that the company immediately adopt a compensation committee charter granting such responsibility and authority by July 1, 2013, rather companies may implement a charter according to the transition schedule. The proposed requirements of such a charter are discussed below. Reviewing applicable state law to determine the best method for granting such responsibility and authority may also be appropriate.

Review Director Independence Questionnaires

Both the NYSE- and NASDAQ-proposed rules relating to compensation committees incorporate the independence standards of their existing rules, but add language specific to compensation committee members per Rule 10C-1 to consider (i) sources of the director’s compensation and (ii) existing affiliations with the company. Companies may want to review, and revise if necessary, their director independence questionnaire to include questions broadly soliciting information regarding any relationship between the director or a family member and the company or its directors or executive officers, or its affiliates or their directors or executive officers, including any commercial, industrial, banking, consulting, legal, accounting, charitable, family or passive investments. Similarly, companies may want to review and revise their existing questionnaire to solicit information regarding the sources of director or family member compensation. In many cases, a company’s director independence questionnaire may already cover most of the relevant questions for compensation committee independence that are already covered by the traditional audit committee independence questions, although subtle differences may exist and may want to be considered.

Review Compensation Committee Composition

Companies may want to begin to review their current compensation committee composition and evaluate whether the composition of those committees may want to be adjusted. NASDAQ companies that do not yet have compensation committees may want to consider whether to implement one in conjunction with the proposed rule requiring companies to provide compensation committees with the necessary authority and responsibilities to act and the option of doing so through early adoption of a compensation committee charter.

Draft/Revise Compensation Committee Charter

Under the proposed rules, both NYSE and NASDAQ companies would need to provide for the proposed authority and responsibilities set forth in the table above. NYSE companies are already required to have charters in place. Under the proposed rules, however, NASDAQ would be required to certify to the adoption of a formal written charter and that the charter will be reassessed each year. Although NYSE companies have, and a number NASDAQ companies may already have, charters in place, all listed companies may want to carefully review the new charter requirements relating to the authority and responsibilities of the compensation committee as they prepare to draft new charters or to revise their existing charters. As discussed, companies will be able to implement the charter requirements according to the transition schedule. However, NASDAQ companies may consider drafting and adopting a charter much sooner as a means of providing the compensation committee with the authority and responsibilities companies would be required to provide by July 1, 2013, subject to approval of the proposed rules by the SEC.

Prepare Compensation Adviser Independence Questionnaire

Under the proposed SEC rules, including the conflicts-of-interest disclosure rules discussed below, and the corresponding rules proposed by the exchanges, companies may want to consider preparing a Compensation Adviser questionnaire soliciting the information required to consider the six factors set forth in Rule 10C-1, as well as any other factors that an NYSE-listed company may consider relevant to the Compensation Adviser’s independence from the management of the company.

Review Disclosure of Compensation Adviser Conflicts of Interest

Listed companies are already required to disclose in their proxy statements whether its compensation committee retained or obtained the advice of a Compensation Adviser and whether the work of the compensation adviser raised a conflict of interest. If a Compensation Adviser’s work raised a conflict of interest, the company must disclose the nature of the conflict and how the conflict is being addressed. However, in conjunction with Rule 10C-1, the SEC amended Item 407 of Regulation S-K to clarify this disclosure requirement applies when a Compensation Adviser plays “any role in determining or recommending the form or amount of executive and director compensation.” The “any role” disclosure trigger is intentionally broader than the “obtained or retained the advice” trigger included in Section 10C.[3] Thus, the amendment will apply to any compensation consultation whose work must be disclosed under Item 407(e)(3)(iii), regardless of whether the Compensation Adviser was retained by management or the compensation committee or any other board committee.

As discussed above, the new rule, as well as the corresponding rules proposed by the exchanges, applies to an issuer’s compensation committee with respect to any compensation consultant, legal counsel or other adviser that provides advice to the compensation committee. The rule does not apply to in-house counsel, who, as employees, are not considered independent. Importantly, the rule does not prohibit the compensation committee from receiving advice from Compensation Advisers who are not independent.

Listing companies must comply with these new disclosure rules for any proxy or information statement for an annual meeting of shareholders at which directors will be elected occurring on or after January 1, 2013. Although not required by the new rule’s broader disclosure trigger, at least one company has provided a “negative disclosure” in response to the new rule.

Conflict Minerals – You Need to Prepare Now

In August 2012, the SEC adopted its final rules for implementing the “conflict minerals” disclosure requirements enacted under Dodd-Frank. Affected companies will be required to file the new Form SD by May 31, 2014. While this implementation date may seem a long way off, the first covered calendar year under the new regulatory and reporting regime is 2013, which is now upon us. Despite this fact, a recent survey by the indicated that 85 percent of respondents were either “in denial” or had only begun to analyze their products, but had not yet begun implementing compliance systems.[4] Other commentators have sounded an alarm that echoes these results conveying the message that companies are benchmarking their progress against the public company universe that is, as a whole, behind in the implementation process. Thus, being “at or near the median” in the implementation process may not be much of an accomplishment.

Under the new rules, which apply to all public companies, if conflict minerals are necessary to the functionality of a product manufactured, or contracted to be manufactured, by your company, your company will be required to file a report on new Form SD disclosing whether such conflict minerals originated in a “conflict country,” based on a “reasonable country of origin” inquiry.

If a company meets the first criterion (i.e., if conflict minerals are necessary to the functionality of a product manufactured or contracted to be manufactured by the company), it is required to disclose that determination and the reasonable country of origin inquiry conducted in reaching the determination of whether or not the conflict minerals originated in a conflict country. If the conflict minerals did not originate in a conflict country (or originated from scrap/recycled sources), the disclosures on Form SD will be relatively short. But, if the conclusion is either that the conflict minerals originated in a conflict country or, during the first two years of the rules, the origin is “undeterminable,” the company will need to conduct due diligence on the source and chain of custody of its conflict minerals supply chain and file a more detailed Conflict Minerals Report on Form SD.

Following is a summary of key aspects of the new conflict minerals rules.

  • Conflict Countries. Defined as Democratic Republic Congo and the adjoining countries of Angola, Burundi, Central African Republic, the Republic of Congo, Rwanda, South Sudan, Tanzania, Uganda, and Zambia (collectively, DRC).
  • Conflict Minerals. Defined as coltan (ore from which tantalum is extracted), cassiterite (tin), wolframite (tungsten) and gold.
  • Meaning of Manufactured or Contracted for Manufacture. Unfortunately, the rules do not define these concepts. Generally, the determination of whether a product is manufactured or contracted for manufacture will turn on the degree of influence exercised by the company over the product. The SEC stated in its adopting release that the concept of “contracted for manufacture” is intended to capture companies that have some actual influence over the manufacturing of their products. For example, merely affixing a company’s brand, logo or label to a generic product manufactured by a third party should not be considered as “contracting for the manufacture” of that product.
  • Meaning of Necessary for the Functionality or Production of a Product. Here too, the rules do not define these concepts. The new rules apply where conflict minerals are necessary for the functionality or production of a product, even if very small amounts of the covered minerals are actually used (even trace amounts). The SEC’s adopting release suggests that companies may want to consider the following in making their determination: whether a conflict mineral is contained in, or intentionally added to, the product or production process vs. being a naturally-occurring by-product; whether a conflict mineral is necessary to the product’s generally expected function, use or purpose; and if the conflict material is added for purposes of ornamentation, decoration or embellishment, whether the primary purpose of the product is ornamentation or decoration (e.g., gold in a gold necklace).
  • Meaning of Product. Similar to above, the SEC’s adopting release does not provide a lot of guidance about the meaning of “product.” Depending on the size of a company and the industry in which it operates, it is easy to see a blurred line between what is product and what is service. For example, an airline flying an airplane containing conflict minerals is probably considered to be selling a service (air travel) vs. a product. But, the line is harder to determine for a cable TV company that sells cable TV converter boxes containing conflict minerals. Is the box a product, or is the company selling a “service” (cable TV)? Packaging of products also creates difficult questions. For example, chicken soup is a product, but what if that soup is sold in a can containing conflict minerals? Is the product soup, or soup in a can? Important Note: There is no de minimus exception to the rules. So, even if 99 percent of a company’s revenues are generated through the sale of services, if 1 percent of its revenues are generated through the sale of products, the new rules apply with respect to the products comprising that 1 percent.
  • Reasonable Country of Origin Inquiry. This inquiry is required whenever a public company determines that conflict minerals are necessary to the functionality or production of a product manufactured or contracted for manufacture by such company. The inquiry must be one that is reasonably designed to determine whether any of the conflict minerals originated in the DRC or are from recycled/scrap sources. The SEC’s adopting release provides guidance that a reasonable inquiry would be satisfied if a company obtains a reasonably reliable representation indicating the facility at which the conflict minerals were processed and demonstrating that those conflict minerals did not originate in the DRC. Important to this inquiry is that these representations may come directly from the facility or indirectly through the company’s immediate suppliers. Also important, the SEC makes clear that a company does not necessarily need to receive such representations from ALL of its suppliers. The SEC, however, did not set any bright-line standard of what an acceptable coverage level would be (although it is clear that a company cannot ignore warning signs or other circumstances indicating that non-responding suppliers may have used conflict minerals originating in the DRC).
  • Disclosure on Form SD Where Conflict Minerals Did NOT Originate in the DRC (or Are from Recycled/Scrap Sources). If a company determines with reasonable certainty, following a reasonable country of origin inquiry, that its conflict minerals did NOT originate in the DRC (or are from recycled/scrap sources), it must disclose its determination and provide a brief description of the country of origin inquiry it undertook and the results of that inquiry.
  • Supply Chain Due Diligence. Where a company concludes its products contain conflict minerals and those conflict minerals either (i) originated in the DRC or (ii) the company concludes it is “undeterminable” whether the conflict minerals originated in the DRC, it must undertake due diligence on the source and chain of custody of its conflict minerals supply chain. The due diligence undertaken must conform to a nationally or internationally recognized due diligence framework. Currently, the most cited accepted framework is the due diligence framework promulgated by the Organization for Economic Co-Operation and Development. There are four possible conclusions a company can reach as a result of its supply chain due diligence:

(1) DRC conflict free. Where the conflict minerals did not originate in the DRC or are from scrap/recycled sources.

(2) DRC conflict free. Where conflict minerals originated in the DRC, but did not finance or benefit armed groups.

(3) Not DRC conflict free. Where conflict minerals originated in the DRC but have not been determined to be DRC conflict free. Note: This is the default conclusion where a company CANNOT determine whether its conflict minerals originated in the DRC or are DRC conflict free.

(4) DRC conflict undeterminable. During a temporary two-year phase-in period (four years for smaller reporting companies), if a company is unable to determine whether its conflict minerals originated in the DRC (or are from scrap/recycled sources) or financed or benefited armed groups in those countries, it may conclude that its conflict minerals are “DRC conflict undeterminable.” Important point: DRC conflict undeterminable is only available during the two-year phase-in period. After that time, a finding of DRC conflict undeterminable would equate to a finding that the conflict minerals are NOT DRC conflict free. Our initial impression is that DRC conflict undeterminable will be a common conclusion for public companies during the temporary two-year phase-in period.

  • Conflict Minerals Report and Form SD. If a company concludes after conducting its due diligence that its conflict minerals are DRC conflict free because the conflict minerals did not originate in the DRC, or are from scrap/recycled sources (clause (1) above), the company is only required to file the Form SD (but not the Conflict Minerals Report); although it must briefly describe its due diligence and reasonable country of origin inquiry measures taken and the results of that inquiry.

If the company concludes after conducting its diligence that its conflict minerals are DRC conflict free (where conflict minerals originated in the DRC (but are not from scrap/recycled sources) (clause (2) above), the company must file the Form SD with the Conflict Minerals Report describing the measures the company has taken to exercise its due diligence.

If the company’s products have not been determined to be DRC conflict free (clause (3) above), the company must also disclose in its Conflict Minerals Report: a description of the products that are not DRC conflict free; the facilities used to process the conflict minerals in those products; the country of origin of the conflict minerals in those products; and the efforts to determine the mine or location of origin with the greatest possible specificity.

If the company’s products have been determined to be DRC conflict undeterminable (clause (4) above), the company must disclose the following in its Conflict Minerals Report: a description of the products that are DRC conflict undeterminable; the facilities used to process the conflict minerals in those products (if known); the country of origin of the conflict minerals in those products; and the steps it has taken, or will take, to mitigate the risk that its necessary conflict minerals benefit armed groups, including any steps to improve due diligence.

A company required to file a Conflict Minerals Report must obtain an independent audit of its report, certify that it has obtained such an audit, include the audit report as part of its Conflict Minerals Report on Form SD and identify the auditor.

  • Content of Conflict Minerals Audit Report. The SEC has clarified that companies required to obtain an audit of their Conflict Minerals Report can engage an auditor using a “performance audit standard” (where a CPA is not required), or an “attestation engagement standard” (where a CPA is required). The audit objective is to express an opinion or conclusion as to whether the design of the company’s due diligence framework as described in its Conflict Minerals Report is in conformity with, in all material respects, the criteria set forth in the nationally or internationally recognized due diligence framework used by the company and whether the company’s description of its due diligence procedures in its Conflict Minerals Report is consistent with the due diligence procedures that the company undertook. The audit does NOT need to express an opinion on the company’s DRC conflict determination.

As indicated above, public companies need to prepare now because the first conflict minerals analysis, determinations and report will cover calendar year 2013, which is upon us. If you have not done so, you may want to consider:

  • Evaluate whether your company is subject to the rules (e.g., manufactures or contracts for the manufacture of a product; if so, are conflict minerals necessary for the functionality or production of the product(s)).
  • If your company is subject to the rules, it may want to form an implementation team (including representatives with legal, accounting, manufacturing, engineering and procurement expertise) and begin the country of origin inquiry sooner rather than later.
  • Companies may want to review their current risk factors to determine whether any enhanced disclosure is necessary in light of the new rules.

For your convenience, here is a link to the flowchart from the SEC’s adopting release that indicates which companies will need to file a Form SD and the contents of that filing.

Dodd-Frank Rulemaking Update

More than two years after Dodd-Frank was signed into law, federal regulatory agencies including the SEC, continue their efforts to implement the almost 400 separate regulations prescribed by the sweeping legislation. Although thousands of pages of new rules have been adopted, much of the work remains to be done; and as of November 2012, the agencies had yet to propose (much less adopt) approximately one-third of the rules mandated by Dodd-Frank. Many expect the coming year to be another eventful one in light of President Obama’s re-election, the adoption of the “Volcker Rule,” and other high-profile regulatory developments anticipated in 2013.

New SEC rules relating to compensation committee independence and conflict minerals are described elsewhere in this issue of the Corporate Communicator. The following is a brief summary of certain other final rules that were recently adopted, as well as the current status of additional rules prescribed by Dodd-Frank that have yet to be proposed or adopted.

  • Payment Disclosures by Resource Extraction Issuers. In August 2012, the SEC adopted rules requiring “resource extraction issuers” (i.e., public companies engaged in the commercial development of oil, natural gas or minerals) to disclose information about certain payments made to the U.S. government or any foreign government. Disclosure will be required with respect to tax, royalty, license, bonus, dividend and other payments that are “not de minimis” (i.e., single payments or related payments equaling or exceeding $100,000 during the fiscal year). The SEC is implementing a new form (Form SD, which will be subject to XBRL tagging) to facilitate the required disclosure, which will take effect for fiscal years ending after September 30, 2013. The report will be due no later than 150 days after the end of each fiscal year.

In October 2012, the American Petroleum Institute, Chamber of Commerce, Independent Petroleum Association of America and National Trade Counsel filed a petition for review in the U.S. Court of Appeals for the D.C. Circuit and requested that the SEC stay the final rules pending resolution of its complaint. The SEC denied that request in November 2012.

  • Corporate Governance and Executive Compensation Disclosures. In July 2012, the SEC further delayed rulemaking with respect to the following Dodd-Frank provisions:
    • Disclosure of pay-for-performance and pay disparity ratios
    • Disclosure of hedging of company stock by directors and employees
    • Recovery (“clawback”) of executive compensation

Previously, the SEC’s rulemaking calendar called for these rules to be proposed in December 2011 and adopted in the first half of 2012. In light of more urgent rulemaking priorities (including under the Jumpstart Our Business Startups (JOBS) Act), the issuance of proposed rules was postponed indefinitely and is now shown simply as “pending action” on the SEC’s website. It now appears that the rules will not take effect until the 2014 proxy season (at the earliest). As one commentator observed, “the SEC is conceding it has no idea when it will finish the rules.”[5]