On March 30, 2011, the SEC proposed rules1 regarding three subjects:
- National securities exchanges, including the NASDAQ Stock Market and the New York Stock Exchange, would have to adopt listing standards regarding the independence of compensation committee members
- Companies would be required to make additional disclosure in proxy statements regarding whether a compensation consultant has been retained, the terms of the engagement, and conflicts of interest related to compensation consultants
- National securities exchanges would be required to adopt listing standards regarding compensation committee authority to engage compensation consultants, independent legal counsel and other advisers, and funding for and independence of such advisers
The SEC proposed the rules to implement the provisions of Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The public comment period for the proposed rules expires April 29, 2011. The national securities exchanges must submit their rules to the SEC no later than 90 days after publication of the final SEC rules in the Federal Register, which is expected to occur between April and July 2011, according to the SEC Web site.
Independence of Compensation Committee Members
The proposed rules would direct national securities exchanges to adopt listing standards that require each member of a listed company's compensation committee to be “independent.” The proposed rules would not define the term “independent.” Rather, the term is to be defined by each of the national securities exchanges in rules that it adopts after considering the following factors:
- The source of compensation of a member of the board of directors of a listed company, including any consulting, advisory, or other compensatory fee paid by the company to such member of the board of directors
- Whether a member of the board of directors of a listed company is affiliated with the company, a subsidiary of the company, or an affiliate of a subsidiary of the company
The requirement to consider whether a member of the compensation committee is an affiliate of the listed company may be problematic for some companies, as large shareholders and their representatives may be deemed affiliates by virtue of their large shareholdings. Rule 10A-3 of the Securities Exchange Act of 1934, Listing Standards Relating to Audit Committees, prohibits any person who is an affiliated person of the company or any of its subsidiaries from serving on the audit committee. It is possible that the national securities exchanges will promulgate listing standards relating to compensation committee that are similar to Rule 10A-3, which would result in “affiliates” and others being deemed to be not independent and, therefore, ineligible to serve on the compensation committee.
The requirement to consider compensation of a compensation committee member may not have a significant effect on listed companies due to the requirement that currently exists for “outside directors” to approve certain compensation awards to executive officers to preserve tax deductions under Section 162(m) of the Internal Revenue Code. A director is an outside director under Section 162(m) if, among other requirements, the director does not receive “remuneration” from the listed company, directly or indirectly, in any capacity other than certain de minimis remuneration. However, for companies that utilize a subcommittee of the compensation committee to satisfy the requirements of Section 162(m) or are not concerned with the Section 162(m) limitation on tax deductions, new limitations on compensation of compensation committee members may be problematic. For example, it is possible that the rules will preclude a compensation committee member from continuing to serve on the committee if he or she would not satisfy the more stringent independence rules that now apply to audit committee members under Rule 10A-3. This would prohibit a director from serving on the compensation committee if the director's employer provides professional services to the company due to the prohibition in Rule 10A-3 on audit committee members receiving any consulting, advisory, or other compensatory fee.
Compensation Consultant Conflicts of Interest Disclosure
The proposed rules would expand Item 407(e) of Regulation S-K to require additional disclosure in proxy statements for the election of directors regarding compensation consultants. As amended, a company would be required to disclose whether the compensation committee directly engaged a compensation consultant, and if so, the company must describe the nature and scope of the consultant's assignment and the material elements of the instructions or directions given to the consultant with respect to the performance of the consultant's duties under the engagement. If the compensation committee retained or obtained the advice of a compensation consultant during the prior fiscal year, then the company would need to disclose whether the work raised any conflict of interest. If a conflict of interest exists, the company would need to disclose the nature of the conflict and how the conflict is being addressed.
While the proposed rules would not otherwise expand the disclosure already required of companies under Item 407(e), the proposed rules would eliminate the current disclosure exception applicable to compensation consultants that permits companies to not disclose the details regarding the work of a compensation consultant if the role of the compensation consultant is limited to consulting on broad-based plans that do not discriminate in favor of directors or executive officers and that are generally available to all salaried employees. As a result, the proposed rules would result in more companies having to disclose specific details regarding the engagement of a compensation consultant and conflicts of interests regarding such consultant. As amended, the Item 407(e) disclosure requirements would still not apply to a committee's legal counsel and advisers other than its compensation consultant.
Compensation Committee Authority and Compensation Adviser Independence Requirements
The proposed rules also would direct national securities exchanges to adopt listing standards that require the following:
- Each compensation committee must have the authority, in its sole discretion, to retain or obtain the advice of compensation consultants, independent legal counsel, and other advisers (collectively, “compensation advisers”)
- Before selecting any compensation adviser, the compensation committee must take into consideration specific factors that will appear in the new SEC rule that affect the independence of compensation advisers
- The compensation committee must be directly responsible for the appointment, compensation, and oversight of the work of any compensation adviser
- Each listed company must provide appropriate funding for the payment of reasonable compensation, as determined by the compensation committee, to compensation advisers
The compensation committee would be required to take into consideration the following factors to determine whether a conflict of interest exists before selecting a compensation adviser:
- The provision of other services to the company by the person who employs the compensation adviser
- The amount of fees received from the company by the person who employs the compensation adviser, as a percentage of the total revenue of the person who employs the compensation adviser
- The policies and procedures of the person who employs the compensation adviser that are designed to prevent conflicts of interest
- Any business or personal relationship of the compensation adviser with a member of the compensation committee
- Any stock of the company owned by the compensation adviser
Notably, these are only factors to be considered. The SEC has not proposed any bright-line test for determining whether a conflict of interest exists. Further, the SEC has not proposed a requirement, or expressed a preference, that a compensation committee retain its own special legal counsel separate from the regular counsel to the company or the board, and the proposed rules state that these independence considerations are not meant to preclude a compensation committee from retaining non-independent legal counsel or obtaining advice from in-house counsel or outside counsel retained by the issuer or management. Nonetheless, it is unclear as to how these new rules will apply to the committee's use in the normal course of business of the company's legal counsel, whether from in-house counsel or outside counsel. For example, the rules may apply to legal counsel only where the committee seeks advice from “independent legal counsel.” It should be noted that the proposed rules do not require disclosure of conflicts of interest with respect to legal counsel or other advisors.
Action Companies Should Take Now
While the rules are only proposed, it is very possible that final rules, including the listing standards by the national securities exchanges, will become effective in time for 2012 annual meetings. As a result, companies should review the current members of their compensation committees to determine if any member would not satisfy the more stringent independence rules that now apply to audit committee members under Rule 10A-3. While the rules adopted by the national securities exchanges may not be as stringent as those under Rule 10A-3, such a review would highlight potential issues now. The proposed rules would require the national securities exchanges to provide appropriate procedures for a company to have a reasonable opportunity to cure defects before they prohibit the listing of, or delist, a company not in compliance with the new rules, so a company will have time after the exchange rules are released to shuffle committee assignments or appoint a new independent director if necessary. Still, we do not suggest a complacent approach, and in some circumstances a listed company may want to start its process of curing identified issues prior to the release of the exchange rules.
Similarly, companies should review their arrangements with compensation consultants to determine whether any conflicts of interest exist that would require disclosure under the proposed rules and whether any changes should be made. If issues are apparent, a company and its compensation committee may decide that it is prudent to act now to address policies and procedures that could cause problems under the proposed rules, if adopted, or they may use this time to determine whether a conflict of interest can be remedied and consider potential replacement compensation consultants. Further, companies may desire to ensure that they are engaging their compensation consultant in a way that will enable them to respond appropriately to the additional disclosure requirements. Finally, we believe companies need not rush to act with respect to the compensation committee's legal counsel and other advisers (other than compensation consultants) until there is greater clarity regarding the implications for these advisers.