On September 25, 2012, the NASDAQ Stock Market (Nasdaq) released a proposal (Proposal), subject to approval by the SEC, regarding independence requirements for compensation committees of Nasdaq-listed companies (Nasdaq Compensation Committees) based on the final rules that the SEC adopted June 20, 2012 (SEC Rules).1 The SEC Rules require Nasdaq, as well as other national securities exchanges, to adopt listing standards on three topics: (i) the independence of Compensation Committee members (Members); (ii) a Compensation Committee’s authority to retain its own compensation advisers; and (iii) consideration by a Compensation Committee of specified factors that could bear on the independence of compensation advisers.
Unlike the changes that the NYSE proposed,2 which largely follow the standards and requirements outlined in the SEC Rules, the changes that Nasdaq proposed go above and beyond the SEC Rules. Nasdaq’s proposed rules would, among other things: require Nasdaq-listed companies (Nasdaq Companies) to have compensation committees (as the NYSE listing standards already require); raise the independence standards for Members, in some cases applying the heightened independence standards established for audit committees; and require Nasdaq Compensation Committees to have charters establishing specified rules and standards (as the NYSE listing standards also already require). In contrast, with regard to standards for Nasdaq Compensation Committee advisers, Nasdaq proposes to adopt the standards set forth in the SEC Rules and does not propose to materially change or add to these standards.
Highlights of the Proposed Nasdaq Listing Standards
Compensation Committee Requirement
Although not required to do so under the SEC Rules, the Proposal would require Nasdaq Companies, including smaller reporting companies, to have a compensation committee consisting of at least two members of the Nasdaq Company’s board of directors (Board), each of whom must be an “Independent Director” as defined in the Nasdaq Listed Company Rules (Nasdaq Rules). The Proposal would effect this requirement by eliminating the ability of a Nasdaq Company to have Independent Directors vote to approve compensation as members of the Board rather than acting as a committee.
Independence of Nasdaq Compensation Committee Members SEC Rules.The SEC Rules direct national securities exchanges to adopt listing standards that require each Member to be “independent” and to define the term “independent” in its standards. The standards are required to be more stringent than the test that applies to directors generally (but do not need to be as stringent as the test that applies to audit committee members) and must take into account the following factors:
- The sources of compensation of Members, including any consulting, advisory, or other compensatory fee paid by the Company to any Member
- Whether a director is affiliated with the Company, a subsidiary of the Company, or an affiliate of a subsidiary of the Company
Nasdaq Proposed Standards. Under Nasdaq’s current listing standards, a Board is required to make an affirmative determination that an Independent Director does not have any relationship that, in the opinion of the Board, “would interfere with the exercise of independent judgment in carrying out the responsibilities of a director.” Presumably, for a director who will serve as a Member, the Board would need to take into account responsibilities in his or her role on the Nasdaq Compensation Committee. The Nasdaq Rules currently specify certain categories of directors that cannot qualify as Independent Directors, which categories would not change under the Proposal. Under the Proposal, however, Nasdaq will adopt additional independence standards applicable to Members based on the sources of compensation and affiliated-status factors that the SEC Rules enumerate.
With regard to sources of director compensation, Nasdaq proposes to apply to Members the same standard that currently applies to audit committee members under the SEC’s Rule 10A-3 (which rule is incorporated into Nasdaq Rule 5605(c)(2)(A)(ii)) and, thus, would prohibit Members from accepting, directly or indirectly, any consulting, advisory, or other compensatory fees (other than solely for Board service and certain retirement amounts) from the Nasdaq Company or any subsidiary of the Nasdaq Company. Also similar to the SEC’s Rule 10A-3, the prohibition on a Member’s receipt of fees would not include a “look-back” period; rather, the prohibition would apply as of the commencement of the Member’s service on the Nasdaq Compensation Committee. This prohibition is in contrast to the current Nasdaq Rules, which allow an Independent Director (including a director serving as a Member) to receive a limited amount of compensation from the Nasdaq Company and its subsidiaries.
Regarding the affiliated-status factor, the Proposal basically mirrors the SEC Rule and requires a Board to consider a Member’s affiliations with the Nasdaq Company and its subsidiaries and other affiliates in making an independence determination regarding such Member, although Nasdaq does not propose to adopt any “bright-line” tests regarding this factor. In particular, a Board need not make an affirmative finding that a Member is not independent based solely on the fact that the Member (and/or the Member’s affiliates) holds in excess of a specific percentage of the Nasdaq Company’s outstanding shares. Nasdaq considered whether to apply the same standards to Members as it currently applies to audit committee members, which standards prohibit affiliates from being audit committee members and include as affiliates persons having beneficial ownership of more than 10 percent of any class of voting shares of the Nasdaq Company. Nasdaq re-affirmed its position that share ownership in a Nasdaq Company aligns the Member’s interests with those of the Nasdaq Company’s shareholders and, thus, that it may be appropriate for such persons to serve as Members. No look-back period would apply under the Proposal with regard to the affiliated-status factor; hence, a Board would only be required to consider a Member’s affiliations that exist at and after the start of his or her service as a Member.
Nasdaq deems these standards to be sufficient to ensure a Member’s independence and, therefore, does not propose to adopt any additional factors. The Proposal also provides that Nasdaq would maintain its existing exception allowing certain non-independent directors to serve on a Nasdaq Compensation Committee under exceptional and limited circumstances.3 Furthermore, if a Nasdaq Company were to fail to comply in certain circumstances with the proposed Compensation Committee requirements, it may rely on the existing cure-period provision in the Nasdaq Rules, which provision would remain unchanged and be applicable to the new Nasdaq Rules under the Proposal.4
Compensation Committee Charter and Authority to Retain Advisers SEC Rules. Under SEC Rules 10C-1(b)(2) and (3), listing standards must require that (i) a Compensation Committee has the authority to retain its own compensation advisers, (ii) the Compensation Committee is directly responsible for the appointment, compensation, and oversight of each adviser that it retains, and (iii) the Company provide appropriate funding to the Compensation Committee to allow the committee to pay reasonable compensation to its advisers. The listing standards need not require, however, a committee to retain its own advisers.
Nasdaq Proposed Standards. Although not required by the SEC Rules, the Proposal would require each Nasdaq Company to adopt a formal, written Compensation Committee charter (Charter). A Charter would be required to specify the following:
- The scope of the Nasdaq Compensation Committee’s responsibilities and how it carries out those responsibilities, including structure, processes, and membership requirements
- The Nasdaq Compensation Committee’s responsibility for determining, or recommending to the Board for determination, the compensation of the chief executive officer and all other executive officers of the Nasdaq Company
- That the chief executive officer of the Nasdaq Company may not be present during voting or deliberations by the Nasdaq Compensation Committee on his or her compensation
- That a Nasdaq Compensation Committee must have the specific Compensation Committee responsibilities and authority necessary to comply with SEC rules relating to: (i) the authority to retain compensation consultants, independent legal counsel, and other compensation advisers; (ii) the authority to fund such advisers; and (iii) the responsibility to consider certain independence factors before selecting such advisers, other than in-house legal counsel
The first three Charter requirements are based on current Nasdaq Rules applicable to Compensation Committees (or committees currently performing functions typically performed by Compensation Committees) and, therefore, should not require any new action on the part of a Nasdaq Company’s Board or Compensation Committee (unless, of course, the Compensation Committee is newly formed).5 The final Charter requirement is modeled after Nasdaq Rule 5605(c)(1)(D) related to audit committee charters and, thus, would introduce new authority requirements and responsibilities for Nasdaq Compensation Committees. Compliance with the final Charter requirement also would require action on the part of a Board to ensure that the Charter explicitly provides the Compensation Committee with such authority and responsibilities.
Compensation Committee Review of Factors Impacting Compensation Adviser Independence SEC Rules. SEC Rule 10C-1(b)(4) directs national securities exchanges to adopt listing standards that require a Compensation Committee to take into consideration specified factors that could bear on the independence of any compensation consultant, legal counsel, or other adviser (Compensation Advisers) to the Compensation Committee, including Compensation Advisers that the Committee retains or that management retains (but excluding in-house legal counsel).
Nasdaq Proposed Standards. Nasdaq proposes to adopt exclusively the list of six factors set forth in the SEC Rules and does not propose to add any specific additional factors. The Proposal does not, in fact, specify the six factors; rather, Nasdaq Rule 5605(d)(3), as proposed, would require a Nasdaq Company to give its Nasdaq Compensation Committee the responsibility to consider the factors enumerated in the SEC Rules before selecting Compensation Advisers. Those factors are as follows:
- The provision of other services to the Nasdaq Company by the employer of the Compensation Adviser (Advisory Employer)
- The amount of fees received from the Nasdaq Company by the Advisory Employer as a percentage of the total revenue of the Advisory Employer
- The Advisory Employer’s policies and procedures designed to prevent conflicts of interest
- Business or personal relationships of the Compensation Adviser with Members
- Business or personal relationships of the Advisory Employer or the Compensation Adviser with executive officers
- Any stock in the Nasdaq Company owned by the Compensation Adviser
The Proposal makes clear that, consistent with SEC Rule 10C-1(b)(2)(iii), Nasdaq Compensation Committees would not be required to implement or act consistently with the advice or recommendations of retained Compensation Advisers. Moreover, factors to be considered by the Nasdaq Compensation Committee would not affect the ability or obligation of the Nasdaq Compensation Committee to exercise its own judgment in the fulfillment of its duties. Further, the Proposal states, “Like the Commission, Nasdaq seeks to emphasize that a compensation committee is not required to retain an independent compensation adviser; rather, a compensation committee is required only to conduct the independence analysis described in Rule 10C-1 before selecting a compensation adviser.”
The Proposal does not specifically address many questions relating to the new requirement and the six factors, which include the following:
- How often must the Nasdaq Compensation Committee consider the factors as to any given Compensation Adviser?
- Where a Compensation Adviser works with others in an Advisory Employer, as to which employees of the Advisory Employer must the Nasdaq Compensation Committee consider the factors?
- As to what period must the Nasdaq Compensation Committee consider fees?
- What relationships are relevant? And how can an Advisory Employer have personal relationships with individuals?
- How should stock ownership be calculated for the final factor?
Nasdaq proposes that the new listing standards become effective upon SEC approval, but Nasdaq Companies would have until the earlier of (i) their second annual meeting of shareholders held after the date of SEC approval of the Proposal or (ii) December 31, 2014 to comply with all but one of the proposed new rules. Nasdaq Companies would be required to comply with proposed Nasdaq Rule 5605(d)(3) regarding a Nasdaq Compensation Committee’s authority to retain and fund Compensation Advisers, and its responsibility to consider the six factors enumerated in the SEC Rules before selecting a Compensation Adviser, immediately upon SEC approval of the new listing standards. For the relatively few Nasdaq Companies that do not currently have a formal Nasdaq Compensation Committee, the provisions of proposed Nasdaq Rule 5605(d)(3) would apply to the independent directors that perform the same functions pertaining to compensation until such time as a Compensation Committee is established. Nasdaq Companies will be required to certify to Nasdaq that they have complied with the new listing requirements regarding Compensation Committees (including those requirements under proposed Nasdaq Rule 5605(d)(3) that would become effective immediately upon approval by the SEC) within 30 days after the applicable compliance dates. Thus, a Nasdaq Company would have to act in advance of SEC approval of the Proposal (or very quickly thereafter) to be able to make a certification regarding compliance with Nasdaq Rule 5605(d)(3) on a timely basis.
Under the Proposal, Nasdaq’s existing phase-in schedules for compensation-related listing rules, applicable to Nasdaq Companies listing in connection with an initial public offering, Nasdaq Companies emerging from bankruptcy, and Nasdaq Companies ceasing to be controlled companies, would remain generally unchanged. The Proposal clarifies that such Nasdaq Companies could phase in compliance with the minimum Compensation Committee size requirement and additional Member eligibility requirements, as described above.
The Proposal provides an exemption for all categories of issuers that are currently exempt from Nasdaq’s existing Compensation Committee requirements, including asset-backed issuers and other passive issuers, cooperatives, limited partnerships, management investment companies, and controlled companies, as well as foreign private issuers that provide the disclosures already required in the Nasdaq Rules.
Smaller reporting companies, which are currently exempt under the SEC Rules, would not be required to adhere to the proposed higher independence standards for Members or to consider the six factors enumerated in the SEC Rules before selecting Compensation Advisers (although smaller reporting companies would be required to have Compensation Committees and Charters).
Actions Companies Should Take Now
Nasdaq Companies should begin taking steps now to ensure that they will be able to comply with the new listing standards promptly, assuming that they are approved by the SEC, including the following:
- Establish a Compensation Committee. If a Nasdaq Company does not already have a Compensation Committee, the Nasdaq Company should begin forming this committee. In light of the heightened Compensation Committee requirements, a Board will require sufficient time to establish a Compensation Committee that meets the existing and new standards, especially those regarding the independence of potential Members.
Review current Compensation Committee membership in light of the proposed membership standards. Nasdaq Companies should pay special attention to the proposed heightened standard prohibiting Members from receiving any consulting, advisory, or other compensatory fees (other than solely for Board service and certain retirement amounts) paid by the Nasdaq Company or any of its subsidiaries.
A Nasdaq Company also should focus on whether a director is affiliated with the Nasdaq Company, a subsidiary of the Nasdaq Company, or an affiliate of a subsidiary of the Nasdaq Company. A Board has broad discretion to determine how this factor may affect a director’s independence, but it should be able to show that this factor was carefully considered and justify why certain affiliations would not disqualify a Member from being independent.
Review current arrangements with Compensation Advisers for problematic facts. Nasdaq Companies should review arrangements with current Compensation Advisers and carefully consider each of the six factors cited in the SEC Rules and incorporated into the Proposal. Nasdaq Companies should keep in mind that this rule becomes effective immediately upon SEC approval and that the Nasdaq Company will need to certify as to compliance within 30 days thereafter.
A Nasdaq Company or its Nasdaq Compensation Committee should obtain from Compensation Advisers adequate information to enable the Nasdaq Company or Nasdaq Compensation Committee to consider the enumerated factors. The Nasdaq Company or Nasdaq Compensation Committee may then consider whether there is information as to any Compensation Adviser that the committee did not already know that is likely to trouble the Nasdaq Compensation Committee, keeping in mind that there is no requirement that a Nasdaq Compensation Committee only use Compensation Advisers that are in fact independent in the sense that they do not present questions under any of the factors. If the Nasdaq Company, rather than its Nasdaq Compensation Committee, is generally involved in this preliminary work, then the Nasdaq Company should nonetheless advise the Nasdaq Compensation Committee of the new rules and perhaps seek preliminary feedback. Of course, if the preliminary work raises valid concerns, then the Nasdaq Company and its Nasdaq Compensation Committee will need to consider what actions to take to address the situation.
Prepare or review the company’s Compensation Committee Charter. The Proposal expressly lays out the required elements of a Charter. If a Nasdaq Company does not currently have a Charter, or if the Charter does not include all of the Proposal’s requirements, the Nasdaq Company should prepare or amend its Charter accordingly, including formal adoption or amendment by the Board. Once the Charter is in effect, the Board should be able to show that it has complied with the terms of its Charter in connection with the evaluation and selection of each Member. A Nasdaq Company must review and reassess its Charter on an annual basis.
While a Nasdaq Company has until one of the two dates noted above under the caption “Timing” to adopt a Charter with the elements specified in the Proposal, a Nasdaq Company must comply with Nasdaq Rule 5605(d)(3) immediately upon approval of the Proposal by the SEC. The company will have 30 days thereafter, however, to certify as to such compliance, as described above. Thus, by the time of SEC approval of the Proposal (or, in any event, no later than 30 days thereafter, when the required certification is due), a Nasdaq Company must make sure that its Compensation Committee has, through effective Board action, the authority to retain and fund Compensation Advisers and the responsibility to consider the six factors discussed above as to Compensation Advisers. Under the Proposal, Nasdaq states, “Companies should consider under state corporate law whether to grant these specific responsibilities and authority through a charter, resolution or other board action; however, Nasdaq proposes to require only that compensation committees immediately have such responsibilities and authority.”
- Review engagement arrangements with Compensation Advisers that the Committee has retained. Given that a Nasdaq Company’s Compensation Committee is directly responsible for the appointment, compensation, and oversight of the work of any Compensation Advisers that the Nasdaq Compensation Committee retains, the Nasdaq Company should review the relevant relationships with any Compensation Advisers that the Nasdaq Compensation Committee retains to ensure the proper level of committee involvement.