On March 30, 2011, the U.S. Securities and Exchange Commission
(the "Commission") issued proposed rules to implement the
provisions of Section 952 of the Dodd-Frank Wall Street Reform and
Consumer Protection Act of 2010 (the "Dodd-Frank Act").
The Dodd-Frank Act amended the Securities Exchange Act of 1934 (the
"Exchange Act") to add new Section 10C to the Exchange
Act dealing with compensation committees. Under the Dodd-Frank Act,
the Commission must, by rule, direct national securities exchanges
(such as the NYSE and NASDAQ Stock Market) to adopt certain listing
standards addressing the independence of the members of
compensation committees and their selection of advisors. The
proposed rules also revise applicable disclosure requirements
relating primarily to the use of compensation consultants and with
respect to conflicts of interest. The proposed rules can be found
here.
The proposed rules largely mirror the provisions of Section 952 of
the Dodd-Frank Act and leave it up to the exchanges to add more
specific or additional listing requirements as they deem
appropriate, although the Commission reserves the final word since
it must ultimately approve the listing standards promulgated by the
exchanges. The Dodd-Frank Act requires that the new rules be issued
by no later than July 16, 2011 and for the exchanges to have final
rules issued by no later than 90 days after publication of the
Commission's final rules. Public comment on the
Commission's proposed rules is required by April 29,
2011.
Compensation Committee Independence
Under proposed Rule 10C-1, each exchange will be required to
adopt rules prohibiting the listing of an issuer whose compensation
committee was not made up entirely of members of its board of
directors who are "independent." The definition of
"independent" is left up to the particular exchanges to
define, provided that they must take into account the following
"relevant factors" that are enumerated in the Dodd-Frank
Act:
- the source of compensation for a director, including any consulting, advisory, or compensatory fees paid by such issuer to the director; and
- whether such director is affiliated with the issuer, a subsidiary of the issuer, or is an affiliate of a subsidiary of the issuer.
Unlike the rules regarding which directors may serve on audit
committees under Section 10A(m) of the Exchange Act, listing
exchanges will have some discretion in establishing minimum
independence criteria for members of compensation committees. For
example, the exchanges might determine that directors who are
affiliates of major stockholders may meet the independence
standards for compensation committees even if they do not meet the
standards for serving on an audit committee. Further, the proposed
rules will only apply to listing standards for companies whose
equity securities are listed on an exchange.
The proposed rules do not require listed companies, if not already
required by an exchange to establish a compensation committee, to
do so. For example, the NYSE currently requires listed issuers to
have compensation committees composed solely of independent
directors and to assign executive compensation-related tasks to
such committee. Conversely, the NASDAQ Stock Market does not
mandate compensation committees, but requires that executive
compensation to be determined or recommended to the board of
directors for determination by either a compensation committee
comprised solely of independent directors or by a majority of the
independent members of the board of director. Under the proposed
rules, the new independence standards as to the make-up of the
compensation committees would apply to any committee of directors
charged with making decisions about executive compensation,
regardless of whether such committee is called a "compensation
committee." For example, the proposed rules would apply to the
nominating and corporate governance committee of a company where
that committee has been assigned compensation-related tasks.
The proposed rules request comment as to whether the final rules
should require other "independence" factors to be
considered such as business or personal relationships between a
director and an executive officer, board interlocks and employment
of a director at a peer-group company.
In conformity with Section 952 of the Dodd-Frank Act, the proposed
rules include several categories of companies that are expressly
exempt from the application of the independence standards of the
proposed rules. They are: (i) controlled companies, (ii) limited
partnerships, (iii) companies in bankruptcy proceedings, (iv)
open-end management investment companies registered under the
Investment Company Act of 1940, and (v) any foreign private issuer
that discloses in its annual report the reasons that the foreign
private issuer does not have an independent compensation committee.
Controlled companies are defined as listed companies as to which
more than 50 percent of the voting power with respect to an
election for the board of directors is held by an individual, a
group, or another issuer.
Under the proposed rules, the exchanges are permitted to exempt
particular relationships from the independence requirements, as
each exchange determines is appropriate, taking into consideration
the size of the issuer and any other relevant factors. For example,
an exchange might grant smaller reporting companies or newly public
companies an exemption or a deferral from the application of the
proposed rules (subject to the Commission's overriding power to
approve or disapprove the exchange's rules in that regard). One
issue that will likely be on the table during the comment period is
whether the Commission should consider creating a blanket exemption
from the rules for smaller reporting companies or a deferral from
the application of the rules for newly public companies. While the
Commission chose not to include such provisions in the proposed
rules, it is clear that one or more of the commissioners may push
for consideration of such a provision in the final rules.
Compensation Advisers
Under the Dodd-Frank Act, the compensation committee of a listed
issuer may, in its sole discretion, retain the advice of a
"compensation consultant." Further, the Dodd-Frank Act
requires that compensation committees also have the right to retain
independent legal counsel and other advisors. Additionally, the
Dodd-Frank Act provides that compensation committees must be
afforded the sole discretion to appoint, compensate and oversee the
work of compensation consultants, legal counsel and other advisors
("compensation advisors") and that issuers are obligated
to provide "appropriate funding," as determined by the
compensation committee, for the payment of "reasonable
compensation" to the compensation advisors. The proposed rules
implement these requirements.
The proposed rules, in conformity with the requirements of the
Dodd-Frank Act, require that exchange listing standards include
provisions that require the compensation committee to consider the
independence of the advisor before selecting the advisor. The
provisions of the Dodd-Frank Act specify that the independence
factors identified by the Commission to be considered by the
compensation committee before it retains a compensation advisor
must be "competitively neutral" and must include, at a
minimum, consideration of the following five independence
factors:
- whether the entity employing the compensation advisor provides other services to the issuer;
- the amount of fees received from the issuer by the entity employing the compensation advisor as a percentage of the total revenues of the entity that employs the compensation advisor;
- the policies and procedures of the entity employing the compensation advisor that are designed to prevent conflicts of interest;
- any business or personal relationships between the compensation advisor and a member of the compensation committee; and
- any stock of the issuer owned by the compensation advisor.
Consistent with the proposed rules on the independence of
compensation committee members, exchanges are free to select other
factors that compensation committees are required to consider when
determining independence of compensation advisors. In that regard,
the proposed rules seek comments on two related issues: (i) while
the Commission states its view that the factors described above are
generally comprehensive, it asks whether there are additional
independence factors that should be required to be taken into
consideration by a compensation committee when selecting a
compensation advisor, and (ii) it asks whether the five enumerated
factors are "competitively neutral."
The Dodd-Frank Act does not require that a compensation advisor be
independent, only that the compensation committee consider the
enumerated independence factors before selecting a particular
compensation advisor, and the
Commission expressly states in the proposing release that the
listing standards should not establish materiality or bright-line
numerical thresholds with respect to any factor. However, the
Commission seeks comment on the application of the proposed
independence factors in a number of enumerated circumstances.
With respect to the retention of independent legal counsel, the
Commission states in the proposing release that the statute does
not require that a listed company's compensation committee hire
independent legal counsel. The Commission also expressly states
that nothing in the Dodd-Frank Act or the proposed rules is
intended to preclude a compensation committee from retaining
non-independent legal counsel or obtaining advice from in-house
counsel or outside counsel retained by the issuer or
management.
Compensation Consultant Disclosure and Conflicts of
Interest
Section 10C of the Exchange Act, as enacted in the Dodd-Frank
Act, requires that in connection with an annual meeting at which
directors are to be elected, an issuer must disclose whether the
compensation committee has obtained the advice of a compensation
consultant, whether the work of that compensation consultant has
raised any conflicts of interest and if so the nature of the
conflict and how the conflict is being addressed.
Item 407(e)(3) of Regulation S-K currently requires an issuer to
disclose "any role of the compensation consultants in
determining or recommending the amount or form of executive and
director compensation," including identifying the consultant,
stating whether the consultant was engaged directly by the
compensation committee or any other person, describing the nature
and scope of the consultant's assignment, and the material
elements of any instructions given to the consultant under the
engagement, disclosing the fees paid to the consultant for advice
or recommendations on the amount or form of executive and director
compensation and the aggregate fees for additional services if the
consultant provide both and the fees for additional services
exceeded $120,000 during the fiscal year. Further, Item 407(e)(3)
currently excludes from the disclosure requirement any role of
compensation consultants that was limited to consulting on a
broad-based plan that does not discriminate in scope, terms or
operation in favor of executive officers or directors and is
available generally to all salaried employees or limited to
providing non-customized benchmark data.
Rather than overlay the new requirements on the existing disclosure
rules, the proposed rules integrate the existing disclosure
requirements with the requirements of the Dodd-Frank Act to create
a new disclosure rule. These new modified disclosure requirements
will apply to all Exchange Act registrants, whether or not listed
on a national securities exchange and whether or not they are a
controlled company. With respect to the proposed disclosure
requirement:
- the trigger for disclosure has been expanded from the existing standard, which is whether the consultant played "any role" in determining or recommending the amount or form of executive and director compensation, to whether the committee or management, as the case may be, "retained or obtained the advice" of a compensation consultant (the instructions to the new disclosure requirement clarify that the term "obtained the advice" relates broadly to whether the compensation committee or management has requested or received advice from a compensation consultant, regardless of whether there is a formal engagement of the consultant, a client relationship or any payment of fees to the consultant for its advice);
- the disclosure as to whether the consultant's work raised
any conflict of interest (and if so, the
nature of the conflict and how it was addressed) will be required without regard to the existing exceptions to required disclosure; consistent with the existing disclosure rules, the new modified disclosure rules only require disclosure with respect to compensation consultants and not with respect to independent legal counsel or other advisors (although the Commission seeks comments as to whether this is appropriate); - the proposed rules do not define the term "conflict of interest." However, in light of the linkage between the requirement that compensation committees of listed issuers consider independence factors before retaining compensation advisors and the disclosure requirements regarding compensation consultant conflicts of interest, the instructions to the proposed disclosure rules identify the same independence factors described above as a non-exclusive list of factors to be considered in determining whether there is a conflict of interest requiring disclosure. Notwithstanding, the Commission in the proposing release expressly states: (i) that it has not concluded that the presence or absence of any of these individual factors indicates that a conflict of interest exists; and (ii) that the existence of fees that trigger disclosure necessarily means that a conflict of interest is present;
- if the compensation committee determines that there is a conflict of interest with the compensation consultant based on the relevant factors and circumstances, the registrant will be obligated to provide a clear, concise and understandable description of the specific conflict and how the company addressed it (general descriptions of the registrant's policies and procedures with respect to addressing conflicts of interest will not be enough); and
- the existing fee-disclosure requirements remain essentially the same, including the existing exception for services that are limited to consulting on broad-based plans and the provision of non-customized benchmark data.
The proposing release also seeks comments on a series of
questions regarding the proposed disclosure rules, including
whether smaller reporting companies should be exempted from these
disclosure requirements.
Opportunity to Cure Defects
The proposed rules require that exchanges establish definitive
procedures and compliance periods (if they do not already have such
procedures and compliance periods in place) to be followed prior to
delisting an issuer's securities for failure to comply with
these rules. Further, as required by the Dodd-Frank Act and similar
to the provisions that are in place for audit committee members
under applicable Commission rules, the proposed rules include a
safe harbor for any member of a compensation committee who ceases
to be independent for reason outside such member's reasonable
control and allow such member to remain on the compensation
committee until the earlier of the issuer's next annual meeting
or one year from the event that caused the member to no longer be
independent.
Next Steps
It is unclear at this point whether these rules will be in
effect for the 2012 proxy season. However, companies may wish to
consider taking steps at this time to prepare for the adoption of
these proposed rules, including reviewing compensation committee
composition in anticipation that these proposed changes will be
adopted and adopting advisor retention policies that will permit
the compensation committee to assess up front, before consultants
are retained, whether conflicts of interest may exist. Further,
once the SEC's rules are finalized and even before new listing
standards are adopted, companies will become obligated, in
connection with stockholder meetings at which directors will be
elected, to make the required disclosures as to the retention of
compensation consultants and conflicts of interest. Finally, once
revised listing standards are adopted, compensation committees will
need to review and amend their committee charters to reflect the
implementation of the new rules.
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.
