On June 20, 2012, the U.S. Securities and Exchange Commission (the “SEC”) adopted final rules (the “Final Rules”) to implement Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) concerning the independence of compensation committees, the engagement and independence of compensation advisers and new proxy statement disclosures regarding compensation consultants. With only a few exceptions noted below, the Final Rules do little more than mirror the requirements set forth in the Dodd-Frank Act, although they do establish a definitive timetable for implementation of those requirements.
Compensation Committee Independence and Compensation Adviser Engagement and Independence: Requirement for New Exchange Listing Standards
The Final Rules require the exchanges to submit proposed listing standards or amendments to existing listing standards that comply with the Final Rules to the SEC by September 25, 2012. The proposed listing standards or amendments will be subject to public comment and to SEC review and approval. Final listing standards or amendments must be approved by the SEC by June 27, 2013, but it is possible that they could become effective by late 2012 or early 2013 and could therefore apply to exchange-listed companies for the 2013 proxy/annual meeting season.
Compensation Committee Independence
Under the Final Rules, the exchanges must adopt listing standards that require each member of a compensation committee of a listed company to be an independent member of the board of directors. Neither the Dodd-Frank Act nor the Final Rules specifically define independence for this purpose. The Final Rules require the exchanges to consider relevant factors in determining the independence requirements, including the following:
- the source of compensation of the director, including any consulting, advisory or other compensatory fee paid by the company to the director; and
- whether the director is affiliated with the company or any of its subsidiaries or their affiliates.
Although the exchanges are required to consider the two factors above, they are not required to adopt them, and, moreover, they have the flexibility to consider other factors in developing the independence requirements to be included in the listing standards. As an example, the SEC stated in the adopting release that exchanges should consider, in their discretion, whether other ties between a company and a director that might impair the director’s judgment as a member of the compensation committee should be included in their listing standards.
For most purposes, the Final Rules define a “compensation committee” to mean (i) a committee of the board of directors that oversees executive compensation matters, whether or not formally designated as the compensation committee or (ii) the members of a company’s board of directors who oversee executive compensation on behalf of the board of directors. Under the Final Rule, the exchange listing standards need not require listed companies to have a formal compensation committee.
The independence requirements outlined above do not apply to limited partnerships, companies in bankruptcy proceedings, open-end management investment companies registered under the Investment Company Act of 1940, and foreign private issuers that disclose annually why they do not have an independent compensation committee.
Compensation Adviser Engagement
The Final Rules also require that the new exchange listing standards include the following requirements relating to the retention of compensation consultants, legal counsel or other advisers (“compensation advisers”) by the compensation committee:
- The compensation committee, in its sole discretion, must have authority to retain or obtain the advice of compensation advisers. Note that the Final Rules do not affect the obligation of the compensation committee to exercise its judgment in fulfilling its duties, nor do they create any obligation to implement or act consistently with the advice of any compensation adviser.
- The compensation committee must be directly responsible for the appointment, compensation and oversight of the work of any compensation advisers retained by the compensation committee.
- The company must provide appropriate funding, as determined by the compensation committee, for the payment of reasonable compensation to any compensation advisers retained by the compensation committee. This requirement applies regardless of whether the compensation adviser is independent.
- Before selecting any compensation adviser, the compensation committee must take into consideration the six independence criteria described below under “Compensation Adviser Independence,” as well as any additional factors specified in the final listing standards adopted by the exchanges.
The authority and funding provisions described above apply only to a formal board committee because the SEC believed that these requirements need not be applied where the board of directors was acting with respect to executive compensation matters.
The Final Rules, like the Dodd-Frank Act, do not mandate exchange listing standards that require a compensation committee to retain compensation advisers, or prohibit a compensation committee from receiving advice from compensation advisers that it did not retain (i.e., compensation advisers retained by management).
Compensation Adviser Independence
The Final Rules require the exchanges to adopt listing standards requiring that compensation committees consider specified independence factors, as well as any other relevant factors included by the exchange in their final listing standards, prior to selecting or obtaining advice from any compensation adviser, other than in-house legal counsel, whether or not engaged by the compensation committee. In this respect, the Final Rules expand upon the requirement of the Dodd-Frank Act, which had only required consideration of these factors prior to selecting a compensation adviser.
The specific independence factors that the exchange listing standards must require the compensation committee to consider are set forth below. The first five factors were required by the Dodd-Frank Act and the sixth factor was added by the SEC when it adopted the Final Rules based on comments received on the SEC’s original rulemaking proposal.
- The provision of other services to the company by the person (or firm) employing the compensation adviser. Note that the Final Rules do not further define, nor does the SEC give any guidance on how to interpret, the phrase “provision of other services.”
- The amount of fees received from the company by the person employing the compensation adviser, as a percentage of that person’s total revenue.
- The policies and procedures adopted by the person employing 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. Note that the Final Rules do not further define, nor does the SEC give any guidance on how to interpret, the phrase “business or personal relationship.”
- The compensation adviser’s ownership of the company’s stock.
- Any business or personal relationship between an executive officer of the company and the compensation adviser or person employing the adviser.
The SEC noted in the adopting release that these six factors should be considered in their totality, and that no single factor should be viewed as a determinative factor. In addition, the SEC noted that because the Final Rules do not require compensation advisers to be independent, the SEC did not establish any materiality, numerical or other thresholds. As a result, all facts and circumstances relevant to the six factors should be presented to the compensation committee for its consideration of the independence of a compensation adviser.
The Final Rules do not require the compensation committee to make formal independence determinations or retain or obtain advice only from advisers deemed independent or require companies to describe the compensation committee’s process for selecting compensation advisers. However, as described below, if the work of a compensation consultant that had any role in determining or recommending the amount or form of executive and director compensation, subject to certain limited exceptions, raised any conflict of interest, the company must disclose the nature of the conflict and how the conflict is being addressed.
As noted by the SEC in the adopting release, compliance with the final exchange listing standards will likely require compensation committees to create procedures for collecting and analyzing information about potential compensation advisers before they can receive advice from such advisers.
Opportunity to Cure Defects
The Final Rules require the exchanges to provide appropriate procedures for a listed company to have a reasonable opportunity to cure any noncompliance with the compensation committee independence requirements that could result in the delisting of the company’s securities. The Final Rules permit – but do not require – the new listing standards to provide that if a compensation committee member ceases to be independent for reasons outside the member’s reasonable control, that person, with notice by the company to the applicable exchange, may remain a compensation committee member of the listed company until the earlier of the next annual shareholders’ meeting of the listed company or one year from the occurrence of the event that caused the member to be no longer independent.
The Final Rules exempt from the new exchange listing standards (i) smaller reporting companies, as defined in current SEC rules, (ii) controlled companies, (iii) the listing of securities futures products cleared by a registered clearing agency or a clearing agency exempt from registration and (iv) the listing of standardized options by a registered clearing agency. In addition, the Final Rules permit the exchanges to exempt any category of issuers from the listing standards called for under the Final Rules, taking into consideration relevant factors, including the potential impact on smaller reporting issuers (as distinguished from smaller reporting companies, which the SEC exempted under the Final Rules).
The expanded disclosure required by Item 407 applies to any proxy statement or information statement for an annual meeting (or special meeting in lieu of an annual meeting) at which directors are elected, filed by all companies, including smaller reporting companies, controlled companies and non-listed companies.
New Proxy Statement Disclosures
The Final Rules expand current SEC disclosure requirements regarding compensation consultants in proxy and information statements for annual meetings (or special meetings held in lieu of an annual meeting) at which directors will be elected. Under Item 407 of Regulation S-K, as amended, if the work of a compensation consultant that had any role in determining or recommending the amount or form of executive and director compensation, subject to certain limited exceptions, has raised any conflict of interest, the company must disclose the nature of the conflict and how the conflict is being addressed. For purposes of this disclosure, the Final Rules provide that, in determining whether a conflict of interest exists, the six specific independence factors listed above under “Compensation Adviser Independence” are among the factors that should be considered. This disclosure is only required for compensation consultants, and not for legal counsel or other compensation advisers.
Item 407 of Regulation S-K otherwise remains unchanged, with companies required to disclose any role of compensation consultants in determining or recommending the amount or form of executive and director compensation, including:
- the identity of the compensation consultant;
- whether the consultant was engaged directly by the compensation committee;
- the nature and scope of the consultant’s assignment and the material elements of the instructions or directions given to the consultant with respect to the performance of the consultant’s duties under the engagement; and
- the aggregate 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 provided both and the fees for the additional services exceeded $120,000 for the fiscal year.
Effective DateCompanies must comply with the additional disclosure required under Item 407 of Regulation S-K in proxy and information statements for any annual meeting (or special meeting in lieu of an annual meeting) at which directors will be elected held on or after January 1, 2013. As a result, the disclosure will need to be included in proxy statements for calendar year-end public companies for the 2013 proxy/annual meeting season.
 Listing Standards for Compensation Committees, Release Nos. 33-9330 and 34-67220 (June 20, 2012).
Daniel P. AdamsPartner
Lisa R. HaddadPartnerCo-Chair, Public M&A / Corporate Governance
Samantha M. KirbyPartnerCo-Chair of Banking and Consumer Financial Services
John O. NewellCounsel
Ettore A. SantucciPartnerCo-Chair of Debt Capital Markets, Co-Chair of REITs and Real Estate M&A