NYSE And NASDAQ Issue Proposed Listing Rule Changes For Compensation Committees And Compensation Advisers

INTRODUCTION

On September 25, 2012, the New York Stock Exchange ("NYSE") and The NASDAQ Stock Market LLC ("NASDAQ") proposed rule changes¹ addressing the independence of compensation committees and their advisers. These proposals were necessary to comply with the SEC's adoption of Rule 10C-1 under the Exchange Act of 1934, and represent another step toward implementation of Section 952 of the Dodd-Frank Wall Street Reform and Accountability Act of 2010 ("Dodd-Frank") and its directive that the exchanges adopt listing standards that, among other things, require compensation committees to: (i) be comprised solely of independent directors; (ii) have the authority to retain compensation advisers; and (iii) consider six independence factors in selecting not only compensation consultants but also any other advisers, including outside legal counsel.² The effective date provisions for the proposed rules establish 2013 as a key year for bringing compensation committees into compliance with the final independence requirements (see our table on page 6 for details).

Next Steps

Although the proposed NASDAQ and NYSE listing standards will not be fully effective before 2014, it makes sense to start assessing their impact now. Specifically, here are steps to consider taking at the next Compensation Committee meeting:

• Brief the board and committee about the upcoming independence rule changes, as well as say-on-pay and other corporate governance matters.
• Evaluate the independence of the members of the compensation committee, considering any fees other than directors' fees that are paid to such members and whether any member is an affiliate of the company or its subsidiaries. Also, consider any personal or business relationships between members of the committee and the company's executive officers, as the exchanges may conclude that such relationships should be addressed in the definition of independence.
• Review the compensation committee's charter and consider whether revisions may be required in light of listing standards regarding the committee's authority to retain compensation advisers, responsibility for the appointment, compensation and oversight of the work of any compensation adviser and funding for compensation of such advisers.
• Consider the advisability of adopting or revising written guidelines with respect to the hiring and retention of compensation consultants, independent legal counsel or other advisers (with one item for consideration being whether to require an annual assessment of the independence of compensation consultants and advisers).
• Evaluate any current compensation advisers or compensation advisers being considered for retention in light of the six factors outlined below under the heading "NYSE Proposed Listing Rule Changes Relating to Compensation Committees—Compensation Advisers" (which are applicable to both NYSE and NASDAQ listed companies). Again, consider the advisability of incorporating the six factors into any written guidelines for the hiring and retention of compensation consultants, independent legal counsel or other advisers.

• Determine whether the company currently makes, or will be required to make, disclosure of the role of any compensation adviser in determining or recommending the amount or form of executive or director compensation in its annual meeting proxy pursuant to Item 407(e)(3)(iii) of Regulation S-K and if so, have the compensation committee consider and apply the six independence factors outlined below to determine if there is a conflict of interest that may need to be disclosed with respect to such compensation consultants and how any conflict should be addressed.
• Update D&O Questionnaires to include questions relevant to making independence assessments relating to the new listing standards and the conflict of interest disclosure required by Item 407 of Regulation S-K. This will assist in demonstrating due diligence.

Background

Prior to the enactment of Dodd Frank, the SEC already required companies to comprehensively disclose all material features of executive compensation under Item 402 of Regulation S-K, including disclosure of the interaction of executives and the board with respect to determining executive compensation, the use of benchmarking practices, peer groups, and compensation consultants. With the passage of Dodd-Frank, Congress mandated, among other things, that companies hold non-binding shareholder votes to approve executive compensation and golden parachute payments⁴ and disclose the role and potential conflicts of compensation consultants.⁵ The rule changes being proposed by the NYSE and NASDAQ reflect the latest development in an on-going campaign from all sides – Congress, the SEC, listing agencies, proxy advisors, and shareholders – to hold corporate boards more accountable for their compensation-related procedures and decisions.

NYSE PROPOSED LISTING RULE CHANGES RELATING TO COMPENSATION COMMITTEES

The following is a general summary of the proposed changes to NYSE listing rules related to compensation committees.

Independence Standards

The proposed rule changes would be set forth under Section 3.03A.02(a) of the NYSE Listed Company Manual, and would require that boards of directors affirmatively assess the independence of compensation committee members. This would involve applying the five "bright line" tests currently set forth in Section 303A.02(b) of the NYSE Listed Company Manual that each independent director must satisfy, and considering "all factors specifically relevant to determining whether the director has a relationship to the listed company which is material to his or her ability to be independent from management," including:

• the source of the director's compensation, including whether any of it derives from a source that would impair the director's ability to make independent judgments regarding executive compensation; and
• any affiliate relationships between the director and the company or any of its subsidiaries, including whether the relationship places the director under the direct or indirect control of the listed company or its senior management.

Compensation Advisers

The proposed rule changes under Section 3.03A.05 of the NYSE Listed Company Manual would replace existing NYSE rules regarding compensation committee advisers with guidelines specifically tracking the requirements of Rule 10C-1, and provide that:

• the compensation committee may, in its sole discretion, retain or obtain advice of a compensation consultant, independent legal counsel or other adviser;
• the compensation committee will be directly responsible for the appointment, compensation and oversight of the work of any such adviser;
• the company must provide appropriate funding, as determined by the compensation committee, for payment of reasonable compensation to any such adviser; and
• in selecting any adviser, the compensation committee must take into consideration all factors relevant to that person's independence from management, including:

1. the provision of other services to the company;

2. the amount of fees received from the company by the person that employs the adviser, as a percentage of that person's total revenue;

3. the policies and procedures of the person employing the adviser that are designed to prevent conflicts of interest;

4. any business or personal relationship of the adviser with a compensation committee member;

5. any stock of the company owned by the adviser; and

6. any business or personal relationship of the adviser or the person employing the adviser with an executive officer of the company.

The proposed rules clarify that the compensation committee is not required to follow the advice of any such adviser. Additionally, the independence assessment would not be required for in-house counsel. Companies would be required to include these provisions regarding compensation committee advisers in their compensation committee charter.

NASDAQ PROPOSED LISTING RULE CHANGES RELATING TO COMPENSATION COMMITTEES

The following is a general summary of the proposed changes to NASDAQ listing rules related to compensation committees.

Requirement to have a Compensation Committee with a Minimum of 2 Directors

Proposed Rule 5605(d)(2)(A) would require companies to have, and to certify that they have and will continue to have, a standing compensation committee comprised of at least two members of the board of directors responsible for determining, or making a recommendation to the board of directors for determination, the compensation of the CEO and all other executive officers. This requirement modifies the current rule by imposing a minimum requirement as to the size of the committee and eliminating the provision permitting executive compensation to be determined by independent directors constituting a majority of the board's independent directors. In proposing these changes, NASDAQ indicated its belief that it is appropriate to have a standing committee and at least two directors making compensation decisions, in light of the importance of such decisions to a company's stockholders, and so that directors on a standing compensation committee may develop expertise in the company's executive compensation policies and programs.

Independence – Limitations on Compensatory Fees and Consideration of Affiliations

NASDAQ will continue to require that a compensation committee be comprised of "independent directors" as such term is currently defined in Rule 5602(a)(2), which sets forth certain relationships that will automatically preclude a finding of independence and requires that the board make an affirmative determination that the director does not have a relationship that (in the board's opinion) would interfere with the director's exercise of independent judgment in carrying out his or her responsibilities. Companies will continue to be permitted, under proposed Rule 5605(d)(2)(B), to appoint a non-independent director to serve on the compensation committee if the committee is comprised of at least three members and, the board, under exceptional and limited circumstances, determines that such individual's membership on the committee is required by the best interests of the company and its stockholders.

In addition to compliance with existing independence standards, proposed Rule 5605(d)(2) would provide that:

• members of the compensation committee must not accept, directly or indirectly, any consulting, advisory or other compensatory fee from the company or any of its subsidiaries (regardless of any thresholds otherwise set forth under Rule 5602(a)(2); provided, however, that committee members would be permitted to accept compensatory fees for board and board committee service and fixed amounts received as compensation under a retirement plan for prior service with the company); and
• the board, in determining eligibility to serve on the compensation committee, must consider whether the director has any affiliations with the company, any of its subsidiaries or any affiliate of the company's subsidiaries that would impair the director's judgment as a member of the committee.

NASDAQ is also proposing to amend IM-5605-6 (Independent Director Oversight of Executive Compensation) to clarify that affiliate evaluations may be based on particular facts and circumstances and that ownership of company stock or possession of a controlling interest through ownership of stock, in each case by itself, would not preclude a finding of independence. In fact, NASDAQ states that it "may be appropriate for certain affiliates, such as representatives of significant stockholders, to serve on compensation committees since their interests are likely aligned with those of other stockholders in seeking an appropriate executive compensation program."

The proposed rules relating to compensatory fees and affiliations do not have a "look-back" period and will begin with the committee member's term of service. Additionally, such rules would not apply to smaller reporting companies.

Written Charter Setting Forth Responsibilities and Authority to Retain Advisers

Proposed Rule 5605(d)(1) would require each listed company to certify that it has adopted a formal written compensation committee charter and that the committee will, on an annual basis, review and reassess the adequacy of such charter.⁶

In addition, the proposed rules would require that a company's compensation committee charter (or board resolution, for smaller reporting companies) specify:

• the scope of the committee's responsibilities and how it carries out those responsibilities, including structure, processes and membership requirements;
• the committee's responsibility for determining, or recommending to the board for determination, the compensation of the CEO and all other executive officers of the company;
• that the CEO may not be present during voting or deliberations by the committee on his or her compensation; and
• the specific committee responsibilities and authority set forth in proposed Listing Rule 5605(d)(3), which implements certain requirements of Rule 10C-1 under the Exchange Act⁷ (as set forth above for the NYSE under "Compensation Committee Advisers") relating to the (i) authority to retain compensation consultants and advisers; (ii) authority to fund such advisers; and (iii) responsibility to consider certain independence factors before selecting such advisers, other than in-house legal counsel; provided, however, that the requirements of clauses (i), (ii) and (iii) of this paragraph will not apply to smaller reporting companies.

CURE PERIODS AND EXEMPTIONS

NYSE and NASDAQ listed companies will be permitted to cure compliance defects with respect to the compensation committee composition, subject to certain applicable exceptions and conditions, by the earlier of: (i) the next annual meeting of shareholders; or (ii) one year after the event that caused non-compliance.⁹

As permitted by Rule 10C-1, the NYSE and NASDAQ propose to continue their current exemptions for, among others as specified in the applicable exchange rules, limited partnerships, management investment companies registered under the Investment Company Act of 1940, controlled companies, certain passive issuers and foreign private issuers.

CONCLUSION

Attention to executive compensation and control of compensation-related activities only continue to grow in importance. Over the past few years, the risks of derivative litigation have escalated dramatically, especially when shareholders perceive poor practices, pay-for-performance disconnects, or favorable litigation outcomes (most recently involving challenges to director compensation). To ensure compliance and minimize the personal liability risks for directors, companies should keep themselves well aware of new developments, not to mention being compliant with regulation at all levels: Congressional action, SEC regulation, and, as seen here, amendments to the exchange listing standards.

Footnotes

1 The proposed NYSE rule changes are available at http://www.nyse.com/nysenotices/nyse/rule-filings/pdf?file_no=SR-NYSE-2012-49&seqnum=1. The proposed NASDAQ rule changes are available at: http://nasdaq.cchwallstreet.com/NASDAQ/pdf/nasdaq-filings/2012/SR-NASDAQ-2012-109.pdf.

2 See, Mark Poerio and Elizabeth A. Razzano, SEC Finalizes Rules for Compensation Committee Listing Standards and Compensation Consultant Conflicts, a Stay Current Client Alert from Paul Hastings, June 2012.

3 NASDAQ-listed companies may currently act through a majority of the Board's independent directors.

4 See, Stephen Harris and Mark Poerio, The SEC Issues Proposed Rules on Dodd-Frank's Executive Compensation Shareholder Approval Rules, a Stay Current Client Alert from Paul Hastings, October 2010.

5 See, footnote 1 above.

6 Note, concurrently with this proposed change NASDAQ is also proposing to change the corresponding audit committee requirement under Rule 5605(c) to provide that the audit committee "will review and reassess" the adequacy of its charter on an annual basis, instead of the currently retrospective requirement that the audit committee "has reviewed and reassessed" its charter on an annual basis.

7 See, Mark Poerio and Elizabeth A. Razzano, SEC Finalizes Rules for Compensation Committee Listing Standards and Compensation Consultant Conflicts, a Stay Current Client Alert from Paul Hastings, June 2012, for a discussion of the requirements of Rule 10-C-1(b)(2)–(4) under the Exchange Act, including the six independence factors set forth therein.

8 See Section 3.03A.00 of the NYSE Listed Company Manual and NASDAQ Listing Rule 5605(d)(6).

9 See proposed NYSE Section 3.03A.00 and NASDAQ Listing Rule 5605(d)(4).

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.