On March 30, 2011, the Securities and Exchange Commission (the “Commission”) proposed rules to implement requirements under new Section 10C of the Securities and Exchange Act of 1934 (the “Exchange Act”), which was established by Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).

The proposed rules would (1) require the national securities exchanges to adopt listing standards regarding the composition and independence of listed issuers’ compensation committees, as well as the appointment, independence, compensation and oversight of listed issuers’ compensation advisers, and (2) require all issuers subject to the Commission’s proxy rules to disclose such issuers’ use of compensation consultants, as well as conflicts of interest relating to their use of such compensation consultants.

Once final rules are adopted by the Commission and standards and requirements are implemented by the Commission and the exchanges, issuers will have to comply with such standards and requirements in order for their shares to continue trading on applicable exchanges. Issuers would be provided with a reasonable opportunity to cure any compliance defects prior to being delisted by an applicable exchange.

Compensation Committee Independence Requirements

The proposed rules would require each of the members of the compensation committee (or another committee charged with the oversight of executive compensation) of an issuer listed on a national securities exchange to be a member of the listed issuer’s board of directors and to be “independent.” Under the proposed rules, the exchanges would be required to develop definitions of “independence” after taking into consideration relevant factors including, without limitation:

  • The sources of compensation of a director of a listed issuer, including any consulting, advisory or other compensatory fee paid by the listed issuer to such director; and
  • Whether the director is affiliated with the listed issuer or a subsidiary or affiliate of the listed issuer.

Under the proposed rules, the exchanges would have broad discretion in establishing independence standards and definitions.1 The exchanges would need only to consider the foregoing factors and any other relevant factors they deem appropriate in establishing such standards and definitions, and they would have discretion to permit certain categories of persons to serve on compensation committees (e.g., directors affiliated with significant shareholders such as private equity funds and venture capital firms).

In addition, under the proposed rules, the exchanges’ rules could provide that if a compensation committee member ceases to be independent for reasons outside of such member’s reasonable control, such member, with notice by the listed issuer to the applicable exchange, may remain a member of the listed issuer’s compensation committee until the earlier to occur of the listed issuer’s next annual meeting and one year from the occurrence of the event that caused such member to no longer be independent.

Compensation Consultants and Advisers

Retention of Compensation Advisers; Independence Considerations

Under the proposed rules, listed issuers’ compensation committees would be permitted, in their sole discretion, to retain or obtain the advice of compensation advisers, including compensation consultants, independent legal counsel and/or other advisers (“Compensation Advisers”). Compensation committees would be directly responsible for appointing, supervising, compensating and overseeing the work of any such Compensation Advisers (though they would not be required to follow such advisers’ recommendations). Listed issuers would be required to provide appropriate funding to cover the payment of reasonable compensation to such Compensation Advisers.

The proposed rules would not require listed issuers’ compensation committees to engage Compensation Advisers, nor would they require that any Compensation Advisers engaged by the compensation committees be independent. However, prior to engaging any Compensation Advisers, listed issuers’ compensation committees would be required to consider several factors that may affect the independence of such Compensation Advisers, including, without limitation:

  • The provision of other services to the listed issuer by the employer of the Compensation Adviser;
  • The amount of fees received from the listed issuer by the employer of the Compensation Adviser, as a percentage of such employer’s total revenue;
  • The policies and procedures of the employer of 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; and
  • Any stock of the applicable listed issuer owned by the Compensation Adviser.

The proposed rules do not propose any materiality or numerical thresholds regarding the foregoing factors or any other factors which may be added by the Commission or the exchanges. The exchanges would have discretion to exempt certain categories of listed issuers from the foregoing requirement.

Disclosure Matters Relating to Compensation Consultants

Under the proposed rules, all issuers subject to the Commission’s proxy rules would be required to disclose the following information, pursuant to a revised Item 407(e) of Regulation S-K, in any proxy or information statement relating to an annual meeting of shareholders at which directors are to be elected (or a special meeting in lieu thereof):

  • Whether the issuer’s compensation committee retained or obtained the advice of a compensation consultant (including a compensation consultant who advises such issuer only regarding broad-based plans or who provides non-customized advice and/or benchmark data to the issuer); and
  • Whether the work of the compensation consultant has raised any conflict of interest, and if so, the nature of the conflict and how it is being addressed.

Under the proposed rules, revised Item 407(e) of Regulation S-K would contain instructions (1) indicating that the determination of whether the compensation committee has retained or obtained the advice of a compensation consultant relates to the issuer’s request for or receipt of such advice, regardless of any formal engagement or relationship with, or fee paid to, such consultant, and (2) identifying the five factors listed above under the caption “Retention of Compensation Advisers; Independence Considerations” as factors that issuers should consider in determining whether a conflict of interest exists.

Exemptions

The proposed rules relating to compensation committee independence and the retention and independence of compensation advisers would generally apply to all listed issuers, except as follows:

  • The following five categories of issuers would not be subject to the compensation committee independence requirements described above: (1) controlled companies2; (2) limited partnerships; (3) companies in bankruptcy proceedings; (4) open-end management investment companies under Section 5(a)(1) of the Investment Company Act of 1940; and (5) foreign private issuers that disclose in their respective annual reports the reasons that they do not have an independent compensation committee.
  • The following categories of issuers would be exempt from all of the proposed rules relating to compensation committee independence and the retention and independence of compensation advisers: (1) clearing agency issuers of security futures products and standardized options, and (2) controlled companies.

The exchanges would be permitted to exempt other relationships from the compensation committee independence requirements after considering issuer size and other relevant factors, and to exempt other categories of issuers from the requirements of Section 10C of the Exchange Act after taking into account the potential impact of such requirements on smaller reporting companies.

In addition, as noted above, the new compensation consultant and conflict of interest disclosures which would be required under the proposed amendments to Item 407(e) of Regulation S-K would apply to all issuers that are subject to the Commission’s proxy rules.

Timing

The Dodd-Frank Act requires the Commission to issue final rules regarding the foregoing matters by July 16, 2011. Under the proposed rules, the exchanges would have to:

  • Submit proposed rules and listing standards to the Commission for approval within 90 days of the publication of the Commission’s final rules in the Federal Register; and
  • Adopt final, Commission-approved rules within one year of the publication of the Commission’s final rules in the Federal Register.

The new compensation consultant and conflict of interest disclosures which would be required under the proposed amendments to Item 407(e) of Regulation S-K would not be required for proxy or information statements filed in definitive form before the effective date of the Commission’s final rules regarding such disclosures.

Comments to the Commission’s proposing release are due by April 29, 2011. The proposing release is available here.