Exchanges Propose Listing Standards for Compensation Committees as Required Under Dodd-Frank Act
Below is a detailed description of the NYSE and Nasdaq proposed changes to their respective public company listing standards with respect to the Compensation Committee and committee advisor independence requirements pursuant to Exchange Act Rule 10C-1 and Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “SEC Rules”).
Independence of Compensation Committee Members
SEC Rules. The SEC Rules require each Compensation Committee member to be a member of the Board of Directors and to satisfy independence standards, which must address:
- The source of compensation of the director, including any consulting, advisory or other compensatory fee paid by the listed company to such director; and
- Whether the director is affiliated with the listed company, a subsidiary of the listed company or an affiliate of a subsidiary of the listed company.
Cure Period. If a Compensation Committee member ceases to be independent for reasons outside the member’s reasonable control, such director may remain on the Compensation Committee until the earlier of the next annual meeting or one year from the occurrence of the event that causes the member to no longer be independent. Such event must be immediately disclosed to the applicable exchange.
NYSE Standards. While the NYSE already requires Compensation Committee members to be independent, the NYSE Standards incorporate the SEC Rules described above and provide guidance on how companies should go about considering a director’s independence for service on the Compensation Committee. In doing so, the board must consider “all factors specifically relevant to determining whether a director has a relationship to the listed company which is material to that director’s ability to be independent from management in connection with Compensation Committee duties.” NYSE does not define “all factors” and therefore boards may be left wondering what other factors must be considered to affirm the independence of a Compensation Committee member.
The NYSE comments that the Board should consider whether compensation received by the director or any affiliate relationships of the director would impair the director’s ability to make independent judgments about the listed company’s executive compensation. Notably, the NYSE explicitly comments that share ownership alone, no matter how significant the holdings, is not sufficient to preclude service on the Compensation Committee. Rather, the NYSE believes such ownership aligns the interests of these directors with those of other shareholders in ensuring that executive compensation is not excessive.
Cure Period. If a Compensation Committee member ceases to be independent for reasons outside the member’s reasonable control, such director may remain on the Compensation Committee until the earlier of the next annual meeting or one year from the occurrence of the event that causes the member to no longer be independent. Such event must be immediately disclosed to the applicable exchange. The NYSE Standards provide an additional restriction to the Cure Period under the SEC Rules. A member who ceases to be independent may only remain on the Compensation Committee if a majority of the Committee members are independent.
Nasdaq Standards. In addition to adopting the SEC Rules, the Nasdaq Standards impose an additional test in order for the Board to affirm the Compensation Committee member’s independence. Similar to requirements already in place for Audit Committee members, Compensation Committee members will be prohibited from receiving any consulting, advisory or other compensatory fee as of the date of the member’s term of service on the Committee. This test does not have a “look-back period”, and applies only to compensation received during the director’s service on the Compensation Committee. Like the NYSE Standards, Nasdaq explicitly comments that ownership of large equity stakes should not preclude individuals from serving on the Compensation Committee, and that in fact, such directors may be well suited to serve on the Compensation Committee.
The current Nasdaq listing standards allow a majority of the Board’s independent directors to review, recommend and approve compensation for the named executive officers. However, despite this leeway, it should be noted that the majority of Nasdaq listed companies have established a Compensation Committee to make these determinations. The Nasdaq Standards will now require that listed companies formally establish a standing Compensation Committee comprised of at least two independent directors. However, a non-independent director may serve as a member of the Compensation Committee under exceptional and limited circumstances. If the Compensation Committee consists of at least three members, one director who is not independent (and who is not an officer, employee or family member), may serve on the Compensation Committee for up to two years; provided that the Board determined that such individual’s membership on the Compensation Committee is required in the best interest of the company. A company must disclose (either on the company’s website or in the annual proxy) the nature of the non-independent relationship and the reasons for this determination by the company.
Cure Period. The Nasdaq Standards provide an additional restriction to the Cure Period under the SEC Rules, if the event causing the member to no longer be independent is within the 180 day period prior to the company’s annual meeting, then the company only has a 180 day cure period.
Authority and Funding of Compensation Committee
SEC Rules. The SEC Rules state that the Compensation Committee:
- May, in its sole discretion, retain or obtain the advice of a compensation advisor;
- Is directly responsible for the appointment, compensation and oversight of compensation advisors; and
- Must be appropriately funded by the listed company.
The SEC Rules explicitly state that no Compensation Committee is required to hire or to implement or act consistently with the advice or recommendations of a compensation advisor, and that nothing should limit the ability and obligation of the Compensation Committee to exercise its own judgment in fulfillment of the duties of its duties. Both the NYSE and Nasdaq Standards include commentary to this effect.
NYSE Standards. The NYSE already requires that the Compensation Committee have substantially the same authority and responsibilities, and the NYSE Standards adopt the SEC Rules above without modification or enhancement.
Nasdaq Standards. The Nasdaq Standards expressly require a listed company to amend their appropriate governance documents so as to ensure that the Compensation Committee have the specific responsibilities and authority required to comply with the SEC Rules.
In addition to the SEC Rules, the Nasdaq Standards generally require a Compensation Committee to adopt a formal written charter, which must be reviewed and assessed on an annual basis. The charter must specify:
- The scope of the Compensation Committee’s responsibilities and how it carries out these 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 other executive officers;
- That the CEO may not be present during voting or deliberations by the Compensation Committee on his or her compensation; and
- The specific responsibilities and authority required to comply with the SEC Rules regarding the ability to select and fund independent advisors, as well as the responsibility to consider independence factors in the selection of such advisors (as described in greater detail immediately below).
If a listed company does not have a Compensation Committee at the time the Nasdaq Standards become effective, the independent directors of the Board will hold the responsibilities, duties and authorities required by these provisions.
Independence of Advisors to Compensation Committee
SEC Rules. The SEC Rules require that before selecting an advisor to the Compensation Committee, the Committee must consider all factors relevant to such advisor’s independence from management, including the following six independence factors when selecting a compensation advisor, legal counsel or other advisor:
- Other services the advisor’s firm provides to the company;
- Amount of fees the advisor’s firm receives from the company as a percentage of the firm’s total revenue;
- Policies and procedures adopted by the compensation advisor’s firm to prevent conflicts of interest;
- Any business or personal relationship with a member of the Compensation Committee;
- Whether the compensation advisor owns any stock of the company; and
- Any business or personal relationship with an executive officer of the issuer.
It should be noted that neither the SEC Rules nor the standards proposed by either exchange address whether the independence of a compensation advisor engaged by senior management must also be considered when the advisor works with management on issues that go before the Compensation Committee.
NYSE and Nasdaq Standards. Both exchanges adopted the SEC Rules. The SEC Rules will replace the current NYSE listing standards with respect to the selection of independent advisors. While Compensation Committees must consider the six independence factors when selecting advisors (other than in-house counsel), it is important to note that there is no requirement that the advisors ultimately selected by the Committee are actually independent and there is no corresponding disclosure required to address the factors considered by the Committee in this selection process.
The SEC Rules provide each exchange with the authority to propose additional exemptions to the SEC Rules.
The following categories of companies are generally exempted from the Compensation Committee member independence and Compensation Committee advisor requirements under both NYSE and Nasdaq Standards:
- Smaller reporting companies (defined generally as companies with a worldwide market value of less than $75 million as of the last business day of the most recently completed second fiscal quarter);
- Controlled companies (companies with one or more investors holding more than 50% of the voting power for the election of directors);
- Limited partnerships;
- Bankrupt companies;
- Close-end and open-end funds registered under the Investment Company Act of 1940;
- Passive business organizations (trusts, derivatives, special purpose securities);
- Companies with only listed equity of preferred stock; and
- Foreign private issuers.
SEC Approval. The Proposed Standards must be approved by the SEC before they take effect. The SEC has 45 days to review the standards proposed by the exchanges, which the SEC may extend to up to 90 days or to whatever later date the exchanges may consent to (currently no such consent has been granted), provided that by statute the rules are required to be finalized by no later than June 2013. Given the similarity between the SEC Rules and the proposed standards, we believe it is likely that the standards will be approved in the form submitted.
NYSE Standards. The proposed effective date for most requirements is July 1, 2013. However, a company will have until the earlier of their first annual meeting after January 15, 2014, or October 31, 2014, to comply with the new standards with respect to Compensation Committee independence factors.
Upon the effective date, publicly listed NYSE companies (unless exempt) will be required to immediately comply with the rules relating to the independence of an advisor to the Compensation Committee. Therefore, upon effectiveness and before seeking further advice of a compensation advisor, the Compensation Committee will need to conduct an assessment of any compensation advisor based upon the six independence factors (as described above). As a result, we strongly suggest that NYSE issuers begin to consider procedures for implementing this requirement.
Nasdaq Standards. The proposed effective date is the date the SEC approves these amendments. As of the effective date a Compensation Committee (or independent directors who determine or recommend the compensation of the CEO and the other Executive Officers) must have the specific responsibilities and authority necessary to comply with the rules relating to: (i) the authority to retain compensation advisors; (ii) authority to fund such advisors; and (iii) responsibility to consider certain independence factors before selecting such advisors (other than in-house counsel). Companies must consider whether such authority and responsibilities should be granted through a charter, resolution or other board action; Compensation Committee charters will not be required until the earlier of the company’s second annual meeting after the approval date of the Nasdaq Standards, or December 31, 2014.
As with NYSE Standards, upon the effective date, publicly listed Nasdaq companies (unless exempt) will be required to immediately comply with the rules relating to the independence of an advisor to the Compensation Committee. Therefore, upon effectiveness and before seeking further advice of a compensation advisor, the Compensation Committee will need to conduct an assessment of any compensation advisor based upon the six independence factors (as described above). As a result, we strongly suggest that Nasdaq issuers begin to consider procedures for implementing this requirement.
Disclosure Requirements under Exchange Act Rule 10C-1
The SEC Rules require that a company’s proxy statement disclose the nature of any conflict of interest that arose for any consultant in determining or recommending the amount or form of executive or Director compensation. This disclosure requirement will apply to proxy statements for annual meetings in 2013 and thereafter.