The SEC recently proposed rules implementing certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The period for public comment on these proposed rules ends on April 29, 2011. The Dodd-Frank Act amended the Securities Exchange Act of 1934 by adding Section 10C, which requires the SEC to direct the national securities exchanges and associations to establish listing standards requiring (i) listed issuers of equity securities to comprise their compensation committees solely of independent directors, (ii) that such compensation committees be empowered to retain and engage consultants, independent legal counsel or other advisers and (iii) that such compensation committees consider certain independence factors when engaging compensation advisers. Once the SEC adopts final rules, the exchanges will need to formulate new or modified listing standards and seek SEC approval of such standards.

Independence of Compensation Committee Members

The proposed rules direct the national securities exchanges and associations to establish listing standards that require each member of a listed issuer’s compensation committee to be a member of the board of directors and to be “independent.” The term “independent” is neither defined in the Dodd-Frank Act nor in the proposed rules. Rather, the exchanges are to consider relevant factors, including the source of compensation for the prospective committee member and whether such member is affiliated with the issuer or its subsidiaries or affiliates.

The NYSE and NASDAQ currently have listing standards requiring a majority of independent directors and setting forth their respective independence standards. The proposed rules do not necessarily require that NYSE and NASDAQ adopt different independence standards for compensation committees. However, the exchanges must review and discuss whether such existing standards satisfy the requirements of the proposed rules in light of the relevant factors that were considered by them.

Rule 16b-3 under the Securities Exchange Act of 1934 and Section 162(m) under the Internal Revenue Code also contain exemptions which entail requirements for compensation committee members, and to the extent they want to rely upon these exemptions, issuers will need to be mindful of such requirements when considering any new or modified listing standards. More specifically, in order for compensatory awards to directors and officers to be exempt from short-swing liability, the awards can be approved by a full board or a committee consisting solely of “non-employee directors.” In order to preserve the deductibility of performance-based awards paid to executive officers, the performance goals must be determined by a compensation committee consisting of “outside directors.” The definition of “non-employee director” and “outside director” are different and may also differ from any independence standards adopted by the exchanges.

Further, as “compensation committee” is also not defined under the Dodd-Frank Act, the proposed rules would direct that the independence standards be applicable to any committee overseeing executive compensation regardless of its formal name. However, neither the Dodd-Frank Act nor the proposed rules require that issuers have a compensation committee or that these new standards apply to independent directors who oversee executive compensation outside of a board committee structure. For example, current NASDAQ listing standards only require that executive compensation be determined or recommended to the board either by a separate compensation committee or by a majority of the board’s independent directors. Accordingly, the proposed rules do not necessarily require the exchanges to apply any new independence standards in the latter case.

Controlled companies, limited partnerships, foreign private issuers (subject to explanatory disclosure) and certain other issuers are not required to comply with these independence requirements. The exchanges may also exempt a category of issuers from these requirements, as each exchange determines is appropriate.

Authority to Engage Compensation Advisers

The proposed rules would also direct the exchanges to establish listing standards that would empower the compensation committee to retain or obtain the advice of a compensation consultant, independent legal counsel or other “compensation advisers.” Compensation committees would be required to be directly responsible for the appointment, payment and oversight of such advisers and the issuer would be required to appropriately fund any such engagement. With respect to engaging legal counsel, the Dodd-Frank Act contemplates that compensation committees will have express authority to engage independent legal counsel, but do not preclude a committee from retaining non-independent legal counsel, including in-house counsel.

Rules 10A-3(b)(4) and (5) expressly confer upon audit committees the authority to engage and compensate advisers, and as a best practice, many issuers already confer similar authority to their compensation committees. Accordingly, this provision may have little, if any, impact on how compensation committees operate.

Independence of Compensation Advisers

Pursuant to the Dodd-Frank Act and the proposed rules, listing standards to be adopted by the exchanges must require compensation committees to consider the following enumerated independence factors:

  • whether the person that employs the committee’s compensation adviser provides other services to the issuer (i.e., apart from the committee);
  • the amount of fees received by the person that employs the compensation adviser from the issuer, as a percentage of the total revenue of that person;
  • the policies and procedures of the person that employs the compensation adviser (including conflicts of interest policies);
  • any business or personal relationship which the compensation adviser has with a member of the compensation committee; and
  • any stock of the issuer owned by the compensation adviser.

These independence factors are not required to be satisfied for each selected compensation adviser, but are required to be considered by the compensation committee before selecting the compensation adviser. Under the proposed rules, the exchanges also may add other independence factors to be considered.  

Compensation Consultant Disclosure

The proposed rules also expand the proxy statement disclosure requirements for annual meetings at which directors are to be elected regarding the use and role of compensation consultants to include the additional disclosure requirements set forth in the Dodd-Frank Act. Generally, the current scope of disclosure would be broadened to require (a) details regarding the consultant’s engagement without regard to the existing exceptions for disclosure, such as the exception for consultants only advising on broad-based plans, and (b) a description of the nature of “any conflict of interest” raised by the consultant’s engagement and how the conflict was addressed. The proposed rules would apply these disclosure requirements specifically to compensation consultants and not other advisers, such as independent legal counsel.