Introduction

Amid the global focus on executive compensation, the independence of compensation committees has emerged in the United States as a cornerstone for assuring good corporate governance and accountability for the boards of directors of public companies. Accordingly, on June 20, 2012, the Securities and Exchange Commission (the "SEC") adopted Rule 10C-1 of the Securities Exchange Act of 1934 and amended Item 407(e) of Regulation S-K to implement the provisions of Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.¹ In the press release accompanying the final rule, SEC Chairman Mary Schapiro singled out the independence of compensation consultants and advisers as being a key consideration, stating "[t]his rule will help to enhance the board's decision-making process on executive compensation matters, particularly the selection, engagement and oversight of compensation advisers, and will provide more transparency with respect to conflicts of interest of consultants engaged by boards." ²

As discussed in more detail below, Rule 10C-1 applies to most public companies and requires the U.S. national securities exchanges to establish listing standards that, among other things:

• require each member of a company's compensation committee to be independent;
• provide that the compensation committee has the authority to retain compensation advisers and that such committee be directly responsible for the appointment, compensation, and oversight of the work of any compensation adviser; and
• require compensation committees to consider six independence factors in selecting not only compensation consultants but also any other advisers, including outside legal counsel.

The amendment to Item 407(e) of Regulation S-K requires disclosure regarding conflicts of interest associated with compensation consultants.

Compliance and Effective Dates

In order to implement Rule 10C-1, the exchanges must submit their proposed rule changes to the SEC not later than 90 days after its publication in the Federal Register, and must have their final rules or amendments approved by the SEC no later than one year after such publication in the Federal Register. Therefore, depending on how quickly the exchanges and the SEC move in proposing and approving the new listing standards, such listing standards could be in place for the 2013 proxy season. Any proxy or information statement for an annual meeting of shareholders (or a special meeting in lieu of an annual meeting) occurring on or after January 1, 2013, at which directors are to be elected, must comply with the new Item 407(e)(3)(iv).

Because the amendment to Item 407(e) will be, and the listing standards may be, applicable for the 2013 proxy season, we have suggested below certain action items listed companies should consider undertaking now to prepare them for compliance with the new listing standards and rule amendment.

Listing Standards Relating to Compensation Committees

The listing standards will be applicable to compensation committees, any committee of the board of directors that performs the functions of a compensation committee, and, subject to certain exceptions, will also be applicable to directors who oversee executive compensation matters on behalf of the board outside the formal structure of a board committee. Once the new listing standards are in effect, a listed company must meet such standards in order for its shares to remain listed on the applicable exchange.

Exemptions

Rule 10C-1 provides express exemptions for controlled companies and smaller reporting companies, as well as for limited partnerships, companies in bankruptcy proceedings, open-end management investment companies registered under the Investment Company Act of 1940, and any foreign private issuer that discloses in its annual report the reasons that the foreign private issuer does not have an independent compensation committee. Rule 10C-1 authorizes the exchanges to exempt other categories of issuers from these listing standards and to exempt a particular relationship from the independence requirements applicable to compensation committee members.

Independence of Compensation Committee Members

The listing standards will require that each member of the compensation committee be an independent member of the board of directors and although the exchanges will have flexibility in establishing their own minimum independence criteria, they must consider (i) a director's source of compensation, including consulting, advisory or compensatory fees paid by the company, and (ii) whether a director is affiliated with the company, any subsidiary of the company or any affiliate of such subsidiary.

Authority to Retain Compensation Advisers; Responsibility and Funding

The listing standards must provide that: (i) the compensation committee may, in its sole discretion, retain or obtain the advice of a compensation consultant, independent legal counsel or other adviser; (ii) the compensation committee, which includes those members of the board of directors overseeing executive compensation matters in the absence of a board committee, shall be directly responsible for the appointment, compensation and oversight of the work of any compensation consultant, independent legal counsel or other adviser retained by the compensation committee; and (iii) the listed company must provide for appropriate funding for payment of reasonable compensation, as determined by the compensation committee, to any compensation consultant, independent legal counsel or other adviser retained by the compensation committee.

Independence Factors for Selection of Compensation Advisers

Compensation committees will be required to consider, at a minimum, the following six factors before selecting a compensation adviser, including consultants, legal counsel or other advisers providing advice to the committee, other than in-house legal counsel:

• other services provided to the issuer by the person that employs the compensation adviser;
• the amount of fees received from the company by the person that employs the compensation adviser, as a percentage of the total revenue of the person that employs the compensation adviser;
• the policies and procedures of the person that employs the compensation adviser that are designed to prevent conflicts of interest;
• any business or personal relationship of the compensation adviser with a member of the compensation committee;
• any stock of the issuer owned by the compensation adviser; and
• any business or personal relationships between the executive officers of the company and the compensation adviser or the person employing the adviser.

It is important to note that the rules do not require the compensation adviser to be independent, but rather only require that the compensation committee consider the foregoing six factors when selecting an adviser. Interestingly, a new SEC instruction indicates that compensation committees need to make an independence assessment before consulting with or obtaining advice from any adviser other than in-house counsel. With this standard in mind, compensation committees should begin establishing procedures to assure regular independence assessments. See "Actions to Consider" below for further thoughts.

Proxy Disclosure – Compensation Consultants and Conflicts of Interest

The SEC has adopted a new disclosure requirement under Item 407(e)(3)(iv) of Regulation S-K requiring companies to disclose:

• any conflict of interest with respect to any compensation consultant identified in response to Item 407(e)(3)(iii) (which requires disclosure regarding "any role of compensation consultants in determining or recommending the amount or form of executive and director compensation");
• the nature of the conflict; and
• how the conflict is being addressed.

The new disclosure is required regardless of whether the compensation consultant is hired by management, the compensation committee or any other committee of the board. In determining whether a conflict exists, compensation committees are required to consider, at a minimum, the six independence factors set forth above with respect to the selection of compensation advisers.

Actions to Consider

Because the amendment to Item 407(e) will be, and the listing standards may be, applicable for the 2013 proxy season, we suggest that the compensation committees of U.S. listed companies take the following steps during the second half of 2012, in order to prepare for compliance with the new listing standards and rule amendment:

[ ] Brief the board of directors regarding the upcoming changes to listing standards and new disclosure requirements with respect to compensation consultants, 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 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. The board of directors and the compensation committee should 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 above under the heading "Independence Factors for Selection of Compensation Advisers." Again, consider the advisability of incorporating the six factors (and any others that the exchanges may add) into any written guidelines with respect to 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 in its annual meeting proxy pursuant to Item 407(e)(3)(iii) and if so, have the compensation committee consider and apply the six independence factors outlined above 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. This will assist in demonstrating due diligence, on an annual basis.

Conclusion

Executive compensation continues to foster shareholder discontent, with these recent headlines suggesting global reverberations mainly from say-on-pay voting during the first half of 2012:

• "When shareholders topple CEOs" (Reuters re UK);
• "CEO Pay Revolt Threatens Xstrada Merger" (BusinessDay re Australia); and
• "Occupy Boardroom: Shareholders Revolt" (CNNmoney re U.S.).

Furthermore, while board members are generally faring well when shareholder derivative litigation challenges their executive compensation decisions, this requires ongoing diligence both with respect to applicable governance requirements such as the new independence listing standards and with respect to emerging trends and litigation risks. ³

Footnotes

^{1 SEC Release 33-9330 at: http://www.sec.gov/rules/final/2012/33-9330.pdf}

^{2 http://www.sec.gov/news/press/2012/2012-115.htm}

^{3 See, "Staying in Front of Shareholder Litigation Challenges to Executive Compensation" (Poerio, Sullivan, and Reynolds, The Corporate Governance Advisor, June 14, 2012).}

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.

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