The Securities and Exchange Commission has approved changes to the rules of the NYSE MKT regarding compensation committees for listed companies. The revised rules implement Rule 10C-1 which was adopted last June pursuant to the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Rule 10C-1 required the exchanges to adopt new standards for independent compensation committees and mandated that compensation committees be given new authority and responsibility for the engagement of compensation advisers.

Independent Compensation Committees

Rule 10C-1 requires that listed companies’ compensation committees must be comprised solely of independent directors. Under Rule 10C-1, each member of the compensation committee of a listed company must be determined by the board of directors to be “independent” based on consideration of (a) the source of compensation to a director, including “any consulting, advisory or other compensatory fee paid by the issuer” to the director (the “Fee Factor”); and (b) whether the director is “affiliated with the issuer, a subsidiary of the issuer or an affiliate of a subsidiary of the issuer” (the “Affiliate Factor”).

The NYSE MKT rules directly incorporated both the Fee Factor and the Affiliate Factor from Rule 10C-1 into their new requirements for independent compensation committees without revision or addition of any bright-line tests or other specific factors. The new rules treat the Affiliate Factor as a determination of whether an affiliation would impair a director’s ability to make independent judgments about the company’s executive compensation. The NYSE MKT rejected a bright-line cap on share ownership by a member of the compensation committee or the member’s affiliates.

Currently, issuers on the NYSE MKT are permitted to set executive compensation by either a separate vote of the board’s independent directors or by a compensation committee composed of independent directors. The new rules retain this option. Current standards for director independence continue to apply to all independent directors with new additional independence criteria that apply only to members of the compensation committee. However, if an issuer does not have a compensation committee, the new independence criteria apply to all independent members of the board.

Consistent with prior NYSE MKT rules, compensation committees are not required to have a written charter, however, the rules set forth the responsibilities of the committee, which are discussed below. Where an issuer does not have a compensation committee, the responsibilities apply to the independent members of the board as a group.

Authority of Committees to Engage Compensation Advisers

Rule 10C-1 contains several requirements which the new NYSE MKT rules effectively adopt without modification. Rule 10C-1 mandates that the compensation committees of listed companies must have the authority to hire compensation consultants, independent legal counsel and other compensation advisers (collectively, “compensation advisers”) and exercise the sole responsibility to oversee the work of any compensation advisers retained to advise the committee. Listed companies must provide adequate funding to pay reasonable compensation to compensation advisers retained by a compensation committee. In addition, before engaging a compensation adviser, a compensation committee must consider at least six factors that could potentially impact the independence of the compensation adviser.

The six independence factors are:

  • The provision of other services to the listed company by the person that employs the compensation consultant, legal counsel or other adviser; 
  • The amount of fees received from the listed company by the person that employs the compensation consultant, legal counsel or other adviser, as a percentage of the total revenue of the person that employs the compensation consultant, legal counsel or other adviser; 
  • The policies and procedures of the person that employs the compensation consultant, legal counsel or other adviser that are designed to prevent conflicts of interest; 
  • Any business or personal relationship of the compensation consultant, legal counsel or other adviser with a member of the compensation committee; 
  • Any stock of the listed company owned by the compensation consultant, legal counsel or other adviser; and
  • Any business or personal relationship of the compensation consultant, legal counsel, other adviser or the person employing the adviser with an executive officer of the listed company.

Consistent with Rule 10C-1, the new NYSE MKT rules provide that the compensation committee is not required to follow the advice or recommendations of any compensation advisers and that the committee may exercise its own judgment “in fulfillment” of its duties. The new rules are also clear that a compensation committee may receive advice from an adviser that is not independent as long as the committee considers the six independence factors prior to engaging the adviser. No independence assessment under the six factors is required for in-house legal counsel or an adviser whose role is not required to be disclosed in the proxy statement because such adviser is consulting only on broad-based plans or providing information that is not customized for the listed company.

Exemptions and Transition Rules

The new NYSE MKT listing standards will not apply to (a) limited partnerships, (b) companies in bankruptcy proceedings, (c) open-end and closed-end funds registered under the Investment Company Act of 1940, (d) asset-backed issuers and other passive business organizations (such as royalty trusts), (e) certain derivatives and special purpose securities, (f) foreign private issuers that disclose that they do not have an independent compensation committee, or (g) controlled companies.

Foreign-based issuers frequently rely on an exemption from many of the NYSE MKT’s requirements due to the fact that the non-complying practice is not prohibited by home country law. Foreign-based issuers are not required to be foreign private issuers, as defined in Exchange Act Rule 3b-4(c), in order to rely on this exemption for many NYSE MKT requirements. However, only foreign-based issuers that are also foreign private issuers are eligible for an exemption from the new requirements.

The new NYSE MKT listing standards provide a cure period if a company fails to comply with the compensation committee composition requirements because a member of the committee ceases to be independent for reasons outside the member’s reasonable control and if a majority of the members of the compensation committee remain independent. The cure period ends at the earlier of the next annual shareholders' meeting of the listed company or one year from the occurrence of the event that caused the member to be no longer independent.

Compensation committees of smaller reporting companies have an exemption from the additional independence tests. These committees may have one director who does not meet the independence test so long as the committee has at least three members, the non-independent director is not an executive officer, employee or family member of an executive officer or employee and the board determines, under exceptional and limited circumstances, that the director’s membership on the committee is required by the best interests of the company and its shareholders. The issuer must disclose its reliance on this exemption, the nature of the relationship and the reasons for that determination in its next proxy statement, or if the issuer does not file an annual proxy statement with the SEC, in its annual report. The issuer may use this exemption for no more than two years.

The new standards also provide transition rules for companies that cease to qualify as smaller reporting companies and for IPO companies.

Effective Dates

The new NYSE MKT rules for compensation committee authority, funding and consideration of compensation adviser independence will be effective for listed companies on July 1, 2013. Listed companies must comply with the new standards for compensation committee director independence upon the earlier of their first annual meeting after January 15, 2014, or October 31, 2014.

Next Steps

NYSE MKT listed companies should develop a plan to:

  • Educate their boards and compensation committees on the new exchange rules; 
  • If the issuer does not have a compensation committee, consider whether it should create one; 
  • If the issuer’s compensation committee has a charter, revise the compensation committee charter for the new exchange rules; 
  • Update policies and procedures for engaging compensation advisers in line with the six independence factors; 
  • Engage compensation advisers in a discussion of the six independence factors and plan for an evaluation of any compensation advisers under the six independence factors by the compensation committee; 
  • Examine and revise timelines and responsibility charts with respect to the compensation process in light of the new rules; 
  • Evaluate the membership of the compensation committee (or if no compensation committee exists, the independent board members) under the new independence standards and plan for any adjustments to the committee or board memberships that may be required to comply with the new rules; and 
  • In the case of foreign-based issuers, determine whether the compensation committee will comply with the new requirements or whether the issuer will make public disclosure that the issuer does not have an independent compensation committee within the meaning of the NYSE MKT rules.