On June 20, 2012 the US Securities and Exchange Commission released a final rule (the "SEC's new rule"), under Section 10C of the Securities Exchange Act of 1934 (Section 10C") which was added by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank Act"). It was published in the Federal Register on June 27, 2012. The SEC's new rule requires national securities exchanges to adopt listing standards that mandate that compensation committees of public companies:

  • Be composed solely of independent board members.
  • Have authority to hire and pay compensation advisers, including consultants and legal counsel (and to be provided funds to do so).
  • Consider six enumerated independence factors before selecting a compensation adviser. This independence assessment is also required with respect to any adviser that provides advice to the committee (other than in-house counsel, as discussed below).

In addition, the SEC's new rule requires proxy statement disclosure with respect to a compensation consultant (for whom proxy statement disclosure is already required) as to whether the consultant's work has raised any conflict of interest and, if so, the nature of the conflict and how it is being addressed.

Discussion

Compensation committee member independence requirement. Most exchanges already require members of the company's compensation committee to be independent, using bright line standards that vary from exchange to exchange depending on the types of issuers typically listed on that exchange. See, for example, NYSE Listed Company Manual Section 303A.02(b); Nasdaq Rule 5605(a)(2). The existing listing standards preclude a director from being independent if he or she was recently employed by the company or if the a member of the director's immediate family is or was recently an executive officer of the company or received compensation in excess of specified limits.

In addition, both the NYSE and Nasdaq already provide that a director may be disqualified from being independent if the director has a material business relationship with the company, a family affiliations with the company's auditor or a family member employed by a business on whose compensation committee any of the executive officers of the listed company sit.

Further, Rule 16b-3 (exemption from short swing profit liability for certain equity transactions) Internal Revenue Code Section 162(m) (limitation on deduction for executive compensation) also require independence of the members of the committee approving the affected compensation (Rule 16b-3 uses the term "non-employee director").

Section 10C and the SEC's new rule do not define "independent." The statutory provision merely directs the SEC to require the exchanges to develop a definition of after taking into account the two relevant factors listed in Section 10C: a director's source of compensation from the company and whether the director is otherwise affiliated with the company or an affiliate of the company.

Unlike with audit committees (an audit committee member may not accept a fee from the company other than as a director), sources of compensation and affiliations need only be "considered" with respect to compensation committee members. Notably, the exchanges are not required (and indeed the Preamble to the SEC's new rule suggested it might not be appropriate to require) a limitation on stock ownership in order for a member of the compensation committee to be independent: "In establishing their independence requirements, the exchanges may determine that, even though affiliated directors are not allowed to serve on audit committees, such a blanket prohibition would be inappropriate for compensation committees, and certain affiliates, such as representatives of significant shareholders, should be permitted to serve." [Preamble at page 24.] However, the exchanges are encouraged to consider what other ties to the company a director may have, in addition to share ownership, that might impair the director's judgment as a member of the compensation committee.

The exchanges have flexibility in adopting the definitions, and may require consideration of other factors in addition to the two enumerated ones.

Authority to retain and compensate compensation advisers. Section 10C(d)(1) of the Exchange Act requires the compensation committee to be directly responsible, in its sole discretion, for the appointment, compensation and oversight of the work of compensation advisers (both consultants and counsel). Section 10C also requires companies to provide "appropriate funding" for "reasonable compensation" to compensation advisers.

Most compensation committee charters already grant authority to the committee to retain, oversee, and compensate compensation advisers, including both compensation consultants and legal advisers.

The SEC's new rule makes it clear that any oversight requirement with respect to compensation consultants and legal advisers will be limited to those who are specifically and separately retained by the committee. Also, any rules adopted by the exchanges are not to be construed to require the compensation committee to implement or act consistently with the advice of its compensation advisers. In this respect, the SEC's new rule is the same as proposed.

Compensation adviser independence factors. The SEC's new rule requires exchanges to adopt listing standards that require the compensation committee of a listed company to select a compensation adviser only after taking into consideration six specified independence factors. "Compensation advisers" include both consultants and legal advisers. Five of these factors are listed in the Dodd Frank Act itself. Any new factors added by the SEC are required to be "competitively neutral" to the advisers. The five statutory factors are

  • the provision of other services to the company by the adviser's firm or employer;
  • the amount of fees received from the company by the adviser's firm or employer, as a percentage of the total revenue of adviser's firm or employer;
  • the adviser's policies and procedures designed to prevent conflicts of interest;
  • any business or personal relationship of the adviser with a member of the compensation committee; and
  • any stock of the company owned by the adviser or the adviser's immediate family members.

The SEC's new rule adds a sixth factor the exchanges must require compensation committees to take into account, and that is

  • any business or personal relationship of the adviser or his or her firm or employer with executive officers of the company.

Note that this sixth factor, which requires consideration, not only of the individual adviser's relationship with the executive officers but also the relationship of the adviser's firm or employer, is broader than the statutory factor which requires consideration of the relationship of the adviser and a member of the compensation committee. The statutory factor does not mention relationships between the adviser's firm or employer and a member of the compensation committee, but it may be that committees will wish to take that into account as well.

The exchanges have the ability to add additional factors to be considered when they adopt their listing standards. Those additional factors may include materiality thresholds or bright line standards. However, the SEC is requiring that the listing standards not include any "materiality" or bright line thresholds or cut-offs for the six independence factors listed above. According to the SEC's preamble to the rule, the six factors should be considered in their totality and no one factor should be viewed as determinative.

The six independence factors need not be considered before the compensation committee obtains advice from in-house legal counsel, as it is generally understood that in-house counsel is not independent, and is not held out to be independent. However, the compensation committee will be required to consider the independence of outside legal counsel and compensation consultants or other advisers retained by management if the counsel or consultants provide advice to the compensation committee. Whether this requirement will lead to more compensation committees hiring their own compensation consultants or their own counsel remains to be seen.

Comment: It is not always clear when regular outside counsel to the company is providing advice to the compensation committee. Legal advice to management is often filtered through management's (or in-house counsel's) presentations and their advice to the compensation committee, and not directly presented to the compensation committee as the outside counsel's or compensation consultant's advice. Is the adviser (outside counsel or a compensation consultant) providing advice to the compensation committee if the advisor neither appears in person at a committee meeting nor prepares materials with the understanding the committee will use the materials as a basis for decision? Perhaps the listing standards, when issued, will provide guidance on this question.

Out of concern for the growing length of proxy disclosure statements, the company will not be required to describe in its annual proxy the compensation committee's process for selecting advisers under the new listing standards.

Enhanced proxy disclosure. Under current proxy disclosure rules (Item 407(d)(iii)), companies are required to:

  • Identify consultants.
  • State whether the compensation committee engaged them directly.
  • Describe the nature and scope of the consultants' assignment and the material elements of any instruction given to the consultant.
  • Disclose the aggregate fees paid to a consultant (not a legal adviser) for both executive (and director) compensation advice and other advice, if the adviser provides both and if the advice for other services (other than executive(and director) compensation) is over $120,000 during the fiscal year.

The SEC's new rule confirms that advice on a broad-based nondiscriminatory plan available to all salaried employees is excluded from the disclosure requirement, as is the provision of non-customized information. Also, the SEC's new rule does not require disclosure of fees paid to a consultant engaged by management if the committee also retained an independent consultant. The SEC's new rule adds an additional proxy disclosure requirement. In addition to the above disclosures, the company will be required to disclose with regard to any compensation consultant (not legal advisers) whose role is required to be identified under the previous standards, and whose work has raised any conflict of interest, the nature of the conflict and how the conflict is being addressed.

Impact

The SEC's new rule finalizes the position taken in the proposed rule, that the Dodd-Frank Act does not require the hiring of compensation advisers or legal counsel by the compensation committee and moreover does not require that any compensation advisers be independent. Thus it is clear that the compensation committee may receive advice from non-independent counsel and consultants, such as those engaged by management, as long as their independence is considered in advance.

In order to make the enhanced proxy disclosures, we expect many compensation committees will want to implement a process to document formal consideration of the 6 conflicts issues (and any additional issues that may be required by the exchanges) and to address how any identified conflicts are being addressed.

Many companies already have considered conflicts in engaging consultants, with the analysis focusing primarily on whether the consulting firm also performed other services for the company. In addition, consulting firms have already made substantial adjustments to their business structures and practices in light of the existing proxy disclosure requirements, including spinning off executive compensation consulting arms from the rest of the consulting firm. In the context of the required disclosure of the role of the compensation consultant, some companies have already included discussions of potential consultant conflicts of interest in their proxies. While some companies have specific policies setting bright line standards for independence, other companies merely require that the lead consultant engaged by the committee not do other work for the company. Examples of the disclosure of the potential conflicts and how they were resolved include ConAgra's 2010 proxy statement at page 22, Time Warner's 2009 proxy statement at pages 53-54, United Health's proxy statement at pages 22-23, and Textron Inc.'s 2009 proxy statement at page 17.

The SEC's new rule formally directs the exchanges to incorporate requirements that have been in the Exchange Act since 2009 as substantive listing standards. The SEC's new rule is not expected to have a seismic effect on the many public companies who already modified their policies and practices to the extent required, to comply with the law. However, other companies, who have waited for the final rule may continue to wait for the exchanges' listing requirements to be proposed. And companies who have adopted independence requirements may need to revise them once the listing standards are promulgated.

The full impact of the enhanced disclosure rule is not yet known. Some companies, in order to avoid a long discussion justifying their obtaining advice from advisers who have one or more of the conflict factors present, may simply require that compensation consultants and legal counsel who give advice to the compensation committee may not perform any other services to the company. It remains to be seen whether the burden of the disclosure requirement will result in compensation committees that currently rely on management-hired compensation consultants and counsel will begin to retain their own.

Effective Date

The requirement for the exchanges to adopt listing standards is generally in line with the rules as proposed in March 2011 to implement Section 10C of the Dodd Frank Act. The listing standards will take effect no later than one year and 90 days after June 27, 2012 (i.e., no later than approximately September 25, 2013). However, with quick action, the listing standards could be in effect for the 2013 proxy season.

The enhanced proxy disclosures on compensation consultant conflicts takes effect for proxies filed for annual meetings at which directors are to be elected occurring on or after January 1, 2013.

What if a member of the compensation committee ceases to be independent?

The listing standards to be adopted by the exchanges are required to include a reasonable opportunity to cure a defect than would be a basis for prohibiting listing. If a member of the compensation committee ceases to be independent for reasons outside the committee member's control, that person, with notice by the company to the applicable exchange, may remain on the committee until the earlier of the next annual shareholder meeting or one year from the event that causes the loss of independence.

Note that the opportunity to cure does NOT extend to situations where it is discovered that the committee member was never actually independent. It is limited to situations where there is a loss of independence by a previously independent committee member. Exchanges may adopt rules exempting or giving a transition period to comply with the independence requirement for categories of companies, such as companies that have just undergone an initial public offering.

Applicability and Exemptions

The SEC's new rule only applies to exchanges that list equity securities and to companies that list equity securities on those exchanges. Thus companies who, for example, only list public debt, are not affected. Similarly, companies whose securities are quoted in the OTC Bulletin Board (OTCBB) and the OTC Markets Group (formerly known as the Pink Sheets and the Pink OTC Markets) will not be affected unless they also have equity securities listed on a national exchange. The new SEC also rule exempts exchanges that list and trade only security futures products and standardized option products.

In addition, the following are exempt under the SEC rule:

  • Limited partnerships
  • Companies in bankruptcy proceedings
  • Open-ended management investment companies registered under the Investment Company Act
  • Foreign private issuers that disclose in their annual reports why they do not have an independent compensation committee.
  • Smaller reporting companies (as defined in 34 Ac Rule 12b-2).

Finally, controlled companies are generally exempt by statute, and the exchanges my propose their own exemptions.

In addition, under the SEC's new rule, public company compensation committees will be required

  • to consider at least 6 independence factors before selecting a compensation consultant, legal counsel or other adviser to the compensation committee other than in-house counsel (as proposed, the SEC rule listed 5 factors), and
  • to disclose in their annual proxies the nature of any compensation consultant (but not legal adviser) conflict of interest and how the conflict is being addressed.

The SEC's new rule directs each securities exchange to adopt its own listing standards requiring consideration of at least the 6 independence factors (discussed below) plus any additional factors deemed appropriate by the exchange that are "competitively neutral" for the consultants.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.