On September 25, the New York Stock Exchange and the NASDAQ Stock Market filed with the SEC proposed listing standards to implement recently adopted Rule 10C-1 under the Securities Exchange Act of 1934. As discussed in the SEC Update we issued on June 29, 2012, available here, Rule 10C-1 directs the national securities exchanges to establish listing standards concerning the independence of compensation committee members, the authority of compensation committees to engage advisers, and the independence factors compensation committees should consider in selecting their advisers.

The listing standards proposed by the NYSE and NASDAQ vary little from the specific requirements of Rule 10C-1. In one noteworthy action not required by Rule 10C-1, NASDAQ has proposed changing its standards to require listed companies to maintain a standing independent compensation committee rather than continuing to permit executive compensation decisions to be made by a majority of the board’s independent directors.

The SEC must approve listing standards implementing Rule 10C-1 for both exchanges by June 27, 2013. If approved as proposed, the NYSE standards relating to compensation committee responsibilities and funding and independence of compensation committee advisers would require compliance beginning on July 1, 2013. The NYSE’s compensation committee independence standards would require compliance by the earlier of the date of a listed company’s first annual meeting after January 15, 2014 or October 31, 2014. The proposed NASDAQ standards relating to compensation committee responsibilities and authority would be effective immediately upon SEC approval, while the remaining standards would require compliance by the earlier of the date of a listed company’s second annual meeting following SEC approval or December 31, 2014.

The NYSE’s proposed standards may be viewed here and NASDAQ’s proposed standards here.

NYSE proposed listing standards  

The NYSE’s proposed standards would amend Sections 303A.00, 303A.02(a) and 303A.05 of the NYSE Listed Company Manual.

Independence of compensation committee members. Under Rule 10C-1(b)(1), the national securities exchanges must adopt listing standards requiring each member of a listed company’s compensation committee to be “independent.” Rule 10C-1(b)(2) specifies two factors that listed company boards must take into account in assessing the independence of compensation committee members. The NYSE’s proposed standards relating to compensation committee independence incorporate the Rule’s requirements.

The NYSE proposes to amend Section 303A.05(a) of the Listed Company Manual to specify that, in addition to satisfying the current NYSE independence requirements for compensation committee service, committee members must satisfy the independence requirements of new Section 303A.02(a)(ii). Proposed Section 303A.02(a)(ii) would require a listed company’s board to make an affirmative determination of the independence of each director serving on the compensation committee. The board would have to consider all factors specifically relevant to determining whether the director has a relationship with the company that is material to the director’s ability to be independent from management in acting on executive compensation matters. Among such factors, the board would have to consider the two factors specified in Rule 10C-1:

  • The source of the director’s compensation, including any consulting, advisory or other compensatory fee paid by the listed company to the director; and
  • Whether the director is affiliated with the listed company or any of its subsidiaries or affiliates.

The NYSE proposes commentary clarifying that, when the board considers the two factors, it should assess whether the director receives compensation from the listed company, is under the control of the listed company or its management, or has a relationship with the listed company’s management that, in any of these cases, would impair the director’s ability to make independent judgments about the company’s executive compensation.

Compensation committee authority and funding. The NYSE proposes to add a new Section 303A.05(c) to the Listed Company Manual, which would list, verbatim, the specific compensation committee authority and funding powers set forth in Rules 10C-1(b)(2) and (3). Specifically, 303A.05(c)(i)-(iii) would provide that:

  • The compensation committee may, in its sole discretion, retain or obtain the advice of a compensation adviser (including legal counsel); 
  • The compensation committee will be directly responsible for the appointment, compensation and oversight of the work of any compensation adviser it retains; and
  • The listed company must provide for appropriate funding for compensation advisers retained by the compensation committee.

In the interests of clarity and emphasis, the NYSE chose to incorporate Rule 10C-1’s requirements into its listing standards, even though the commentary to existing Section 303A.05(b) provides for essentially the same committee authority and funding power. Accordingly, upon approval of the revised listing standard, the NYSE will eliminate the duplicative commentary from Section 303A.05(b).

Independence of compensation committee advisers. Rule 10C-1 directs the national securities exchanges to require compensation committees to consider the independence of their advisers as part of the adviser selection process. The NYSE’s proposed committee adviser independence standards duplicate the independence factors set forth in Rule 10C-1(b)(4). Thus, new Section 303A.05(c) of the Listed Company Manual would require the compensation committee to consider the following six independence factors before selecting a compensation consultant, external legal counsel or other adviser:

  1. The provision of other services to the listed company by the adviser’s employer;
  2. The amount of fees received from the listed company by the adviser’s employer, as a percentage of the employer’s total revenue;
  3. The policies and procedures of the adviser’s employer that are designed to prevent conflicts of interest;
  4. Any business or personal relationship of the adviser with a member of the listed company’s compensation committee;
  5. The adviser’s ownership of any stock of the listed company; and
  6. Any business or personal relationship of the adviser or the adviser’s employer with an executive officer of the listed company.

The NYSE also proposes commentary to Section 303A.05(c) to confirm, consistent with Rule 10C-1(b)(2)(iii), that the company should not interpret the new listing standard to require the compensation committee to implement or act in accordance with the adviser’s advice or recommendations or to affect the committee’s ability to exercise its own judgment in fulfilling its duties. The proposed commentary to Section 303A.05(c) also would make it clear that the new listing standard requires consideration of the independence factors for all advisers to the compensation committee, other than in-house legal counsel.

Cure for noncompliance. Consistent with Rule 10C-1(a)(3), the NYSE proposes to amend Section 303A.00 of the Listed Company Manual to provide that, if a compensation committee member ceases to comply with the new independence standards for reasons outside of the director’s control, the director nevertheless may continue to serve on the committee until the company’s next annual meeting of shareholders or, if earlier, one year after the date on which the director ceased to be independent. This exemption would be available only where the compensation committee remains composed of a majority of independent directors. This cure provision is similar to that contained in Exchange Act Rule 10A-3(a)(3), which provides for a similar opportunity to cure defects in the composition of a listed company’s audit committee.

Exemptions. Rule 10C-1(b)(5) exempts controlled companies and smaller reporting companies from all requirements of the Rule. Rule 10C-1(b)(1)(iii)(A) provides an exemption from the Rule’s compensation committee independence requirements for limited partnerships, companies in bankruptcy, open-end management investment companies registered under the Investment Company Act, and any foreign private issuer that discloses in its annual report filed with the SEC or on its website the reasons why the foreign private issuer does not have an independent compensation committee.

The NYSE proposes to expand the exemption mandated by Rule 10C-1 to exempt from all of the new listing standards controlled companies, limited partnerships, companies in bankruptcy, closed-end and open-end funds registered under the Investment Company Act, passive business organizations in the form of trusts (such as royalty trusts), derivatives, special purpose securities and issuers whose only listed equity security is a preferred stock.

Smaller reporting companies. Consistent with the general exemption in Rule 10C-1(b)(5), the NYSE proposes to revise Section 303A.00 of the Listed Company Manual to exempt smaller reporting companies from the proposed compensation committee independence and adviser independence requirements.

NASDAQ proposed listing standards

In addition to listing standards necessary to implement Rule 10C-1, NASDAQ has proposed several other changes to its compensation-related listing rules.

Compensation committee requirement. In a notable change to its current rules, NASDAQ proposes to amend Listing Rule 5605(d)(3) to require its listed companies to maintain a standing independent compensation committee dedicated to determining executive compensation or recommending executive compensation to the full board for determination. Under NASDAQ’s current rules, a listed company may elect to forgo establishment of a compensation committee and instead make executive compensation decisions through action by a majority of the board’s independent directors.

A compensation committee operating under the amended listing rules would have to:

  • Consist of at least two directors who meet NASDAQ’s general standards for director independence and the special independence requirements implemented by NASDAQ under Rule 10C-1;
  • Adopt a written charter containing provisions relating to the committee’s structure, processes and membership requirements (which NASDAQ has copied from its listing rule relating to audit committee charters), as well as provisions addressing the responsibilities and authority set forth in the listing rules implementing Rule 10C-1; and
  • Certify to NASDAQ that it has adopted such a charter and will review and reassess the charter’s adequacy on an annual basis.

The modified listing rules would allow a transition period for a listed company operating without a compensation committee to establish its committee, and for a company operating with a single-member compensation committee to expand the committee’s membership to include at least two eligible directors.

Compensation committee authority and funding. As part of NASDAQ’s proposal to require an independent compensation committee with a written charter, proposed Listing Rule 5605(d)(3) would incorporate the compensation committee authority and funding entitlement required by Rules 10C-1(b)(2) and (3).

Independence of compensation committee members. NASDAQ, like the NYSE, proposes to require that compensation committee members meet the exchange’s general standards for director independence. Unlike the NYSE, however, NASDAQ proposes to prohibit compensation committee service by any director who accepts any consulting, advisory or other compensatory fee from the listed company or any subsidiary (with specified exceptions). The proposal thus extends to compensation committee members of NASDAQ-listed companies the per se disqualification applied to audit committee members under Exchange Act Rule 10A-3(b)(1). As discussed above, under Rule 10C-1 and the NYSE’s proposal, payment of such a fee would not constitute a bar to compensation committee service, but rather would be a factor considered by the board as part of its independence determination. NASDAQ’s proposal thus goes further than the requirements of Rule 10C-1 and the proposed NYSE standard. Consistent with Rule 10A-3, NASDAQ’s proposed requirement would not incorporate a “look-back” period. Instead, the prohibition on receipt of fees would apply prospectively from the time the director begins service on the compensation committee.

NASDAQ proposes to specify in Listing Rule 5605(d)(2) that the board’s independence determination also must include consideration of whether the director is affiliated with the listed company, a subsidiary of the company or an affiliate of a subsidiary, and whether any such affiliation would impair the director’s judgment as a member of the compensation committee. In new commentary to Listing Rule 5605, NASDAQ would clarify that it does not believe that ownership of stock of the listed company itself would disqualify a director from compensation committee service. NASDAQ notes that it may be appropriate for certain affiliates, such as representatives of a significant shareholder, to serve on the compensation committee, since their interests in maintaining an appropriate executive compensation program likely will be aligned with the same interest of other shareholders.

Independence of compensation committee advisers. Like the NYSE, NASDAQ proposes to implement without change the requirement that compensation committees consider the six independence standards for committee advisers set forth in Rule 10C-1(b)(4) and described above. Under amendments to Listing Rules 5605(d)(1) and (d)(3), a listed company’s compensation committee charter would have to specify the committee’s responsibilities, including the requirement that the committee consider the six standards before selecting any adviser, other than in-house legal counsel.

Cure for noncompliance. Consistent with Rule 10C-1, NASDAQ proposes to afford a listed company an opportunity to cure defects in the composition of its compensation committee. Under the proposal, a listed company would have a specified period to cure noncompliance with the compensation committee independence requirement where a compensation committee member ceases to be independent due to circumstances outside of the member’s reasonable control, or where the compensation committee ceases to be composed of at least two independent directors because of a vacancy. The cure period would be the same period currently available to NASDAQ-listed companies to cure noncompliance with the requirement that they have a majority of independent directors. Under proposed Listing Rule 5605(d)(4), the company generally would have to cure either instance of noncompliance by the earlier of its next annual meeting of shareholders or one year from the date of noncompliance. If the annual meeting were to occur within 180 days after the date of noncompliance, the company would have 180 days to regain compliance.

Exemptions. NASDAQ proposes to exempt from all requirements of the new standards categories of listed companies currently exempt from NASDAQ’s compensation-related listing rules and companies exempt under provisions of Rule 10C-1 described above. Accordingly, asset-backed and other passive issuers, cooperatives, limited partnerships, management investment companies and controlled companies would be exempt from the revised listing rules. Foreign private issuers would not have to comply with the revised listing rules if they disclose in their annual reports or in their websites that they follow their home country practices relating to compensation committees and disclose the reasons why they do not have an independent compensation committee.

Smaller reporting companies. Although Rule 10C-1(b)(5) exempts smaller reporting companies from all of its requirements, NASDAQ’s current listing rules do not include any such exemption. Consistent with the exemption in Rule 10C-1, however, NASDAQ proposes in Listing Rule 5605(d)(5) to require smaller reporting companies to comply solely with the proposed requirement that listed companies maintain an independent compensation committee. Accordingly, smaller reporting companies listed with NASDAQ would be required to have an independent compensation committee consisting of at least two members and to certify to NASDAQ that the committee has adopted a charter.

Looking Ahead

The implementation of Rule 10C-1 by the NYSE and NASDAQ will require companies and their compensation committees to adopt procedures for discharging their obligations under the new listing standards, including evaluating directors under the new independence standards and amending existing committee charters.

Companies listed on the exchanges will need to put in place appropriate processes for soliciting information relevant to evaluation of compensation committee members under the new independence standards. One ready source of such information is the annual questionnaire distributed to directors in connection with preparations for the annual meeting of stockholders.

Although many compensation committees and compensation consultants already have in place policies and procedures for identifying and addressing any potential conflicts of interest on the part of consultants, companies can expand those processes to incorporate the factors under Rule 10C-1 adopted by the exchanges and to extend them to the selection of the committee’s other advisers. Pending effectiveness of the new standards, companies should consider the potential effects of the requirements on the functions of the compensation committee, the committee’s policies, and the manner in which the committee receives advice.

NASDAQ-listed companies operating without a compensation committee will have to plan for their transition to a committee-based process for determining executive compensation. In addition, NASDAQ’s proposed prohibition on compensation committee service by a director receiving consulting, advisory or other compensatory fees may require changes to the membership of committees constituted under the more flexible independence assessment process permitted under the current listing rules.