NYSE and NASDAQ Submit Proposed Listing Standards on Compensation Committee Independence and Compensation Adviser Engagement/Independence

On September 25, 2012, the New York Stock Exchange (“NYSE”) and the NASDAQ Stock Market (“Nasdaq”) submitted proposed listing standards to the U.S. Securities and Exchange Commission (the “SEC”) concerning the independence of compensation committees and the engagement and independence of compensation advisers, as required by the SEC’s final rules adopted on June 20, 2012 (the “SEC Rules”). Goodwin Procter’s Alert on the SEC Rules can be found here.

The proposed rules of the NYSE (the “NYSE Proposed Rules”) and Nasdaq (the “Nasdaq Proposed Rules”) generally mirror the requirements set forth in the SEC Rules, with two exceptions that would affect Nasdaq-listed companies. First, the Nasdaq Proposed Rules generally would prohibit a listed company’s compensation committee members from accepting, directly or indirectly, any consulting, advisory or other compensatory fee from the company, subject to limited exceptions. Second, the Nasdaq Proposed Rules would require listed companies to have (i) a formal compensation committee of at least two independent members and (ii) a written compensation committee charter.

Effective Date

The NYSE Proposed Rules and Nasdaq Proposed Rules are subject to public comment and to SEC review and approval.

If adopted as currently proposed, the NYSE Proposed Rules will be effective on July 1, 2013, with companies listed on the NYSE required to comply with the compensation committee independence standards on the earlier of (i) the first annual meeting held after January 15, 2014 or (ii) October 31, 2014.

The Nasdaq Proposed Rules with respect to the compensation committee’s responsibilities and authority with respect to compensation adviser engagement, funding and independence (see “Compensation Adviser Engagement – Nasdaq Proposed Rules” below), if adopted as currently proposed, would be effective immediately upon the effectiveness of the final rules. Compliance with the remaining provisions of the Nasdaq Proposed Rules, including among others the requirement to have a formal compensation committee and a written compensation committee charter, would be required on the earlier of (i) the second annual meeting held after the date of approval of the Nasdaq Proposed Rules or (ii) December 31, 2014.

New Nasdaq Compensation Committee and Compensation Committee Charter Requirements

As noted above, in a notable change from current Nasdaq rules, the Nasdaq Proposed Rules would require most domestic listed companies to have a formal compensation committee consisting of at least two independent directors. The Nasdaq Proposed Rules would also require most domestic listed companies to have a written compensation committee charter that complies with the requirements of the Nasdaq Proposed Rules, and would require listed companies to certify within 30 days after the relevant compliance date that they have adopted a formal written compensation committee charter that complies with Nasdaq rules. Current Nasdaq rules require independent director oversight of executive officer compensation, but do not require listed companies to establish a formal compensation committee or to have a written compensation committee charter. Although this technical change is not expected to impact the vast majority of the companies listed on Nasdaq, it is nevertheless important for all Nasdaq-listed companies to be aware of the fact that, under the Nasdaq Proposed Rules, they would have less flexibility regarding independent director oversight of executive officer compensation than they do under current Nasdaq listing standards.^[1]

There is no change in comparable NYSE requirements because NYSE listing standards currently require most domestic listed companies to have a formal compensation committee and written compensation committee charter.

Compensation Committee Independence

The SEC Rules required the exchanges to adopt listing standards requiring each member of a compensation committee of a listed company to be an independent member of the board of directors. The SEC Rules required 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.

NYSE Proposed Rules

The NYSE listing standards currently require all compensation committee members to be independent directors. The NYSE Proposed Rules would not make any changes in the objective independence requirements for compensation committee members, but for affirmative independence determinations of directors who will serve on the compensation committee the NYSE Proposed Rules would add a new requirement that the board of directors consider all factors specifically relevant to determining whether a director has a relationship to the listed company that is material to that director’s ability to be independent from management in connection with the duties of a compensation committee member, including but not limited to the two specific factors set forth in the SEC Rules.

Unlike the Nasdaq Proposed Rules, which are discussed below, the NYSE Proposed Rules do not establish a bright-line prohibition against the receipt of compensatory fees by compensation committee members. Rather, the commentary to the NYSE Proposed Rules states that the board should consider whether the director receives compensation from any person or entity that would impair his or her ability to make independent judgments about the listed company’s executive compensation.

The commentary to the NYSE Proposed Rules also states that the board should consider whether an affiliate relationship places a compensation committee member under the direct or indirect control of the listed company or its senior management, or creates a direct relationship between the director and members of senior management, in each case of a nature that would impair his or her ability to make independent judgments about the listed company’s executive compensation.

Nasdaq Proposed Rules

The Nasdaq listing standards also currently require all compensation committee members (or directors exercising oversight of executive officer compensation, if the company does not currently have a formal compensation committee) to be independent directors. However, the Nasdaq Proposed Rules would impose an additional independence requirement for compensation committee members. The Nasdaq Proposed Rules would prohibit compensation committee members from accepting, directly or indirectly, any consulting, advisory or other compensatory fee from the company or any subsidiary, subject to limited exceptions for director and committee member fees and fixed compensation under a retirement plan (including deferred compensation) for prior service with the company (provided that such compensation is not contingent on continued service).

This prohibition is identical to current prohibitions relating to compensatory fees for audit committee members, and in the release relating to the Nasdaq Proposed Rules, Nasdaq stated that it had concluded that “there is no compelling justification to have different independence standards for audit and compensation committee members with respect to the acceptance of compensatory fees from a Company.” Nasdaq also indicated that, similar to the corresponding audit committee requirement, there is no “look back” period for the prohibition on receiving compensatory fees. As a result, compensatory fees received by a director prior to the time the director starts serving as a member of the compensation committee do not disqualify that director from serving as a member of the compensation committee.

Although the Nasdaq Proposed Rules do not specifically define what constitutes “indirect” acceptance of a compensatory fee, we expect that Nasdaq would interpret this phrase in the same manner as it does for audit committee members, which “includes acceptance of such a fee by a spouse, a minor child or stepchild or a child or stepchild sharing a home with the member or by an entity in which such member is a partner, member, an officer such as a managing director occupying a comparable position or executive officer, or occupies a similar position (except limited partners, non-managing members and those occupying similar positions who, in each case, have no active role in providing services to the entity) and which provides accounting, consulting, legal, investment banking or financial advisory services to the issuer or any subsidiary of the issuer.”

In addition to the prohibition on receiving compensatory fees, the Nasdaq Proposed Rules would also require the board to consider whether the director is affiliated with the listed company, a subsidiary of the listed company, or an affiliate of a subsidiary, and to determine whether any affiliation would impair the director’s judgment as a member of the compensation committee. While listed companies must consider such affiliations, Nasdaq made it clear that it did not believe that independent directors of a listed company that were affiliates could not serve on the compensation committee. In fact, in the release relating to the Nasdaq Proposed Rules, Nasdaq stated that “Nasdaq believes 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.”

Accordingly, while both the NYSE Proposed Rules and the Nasdaq Proposed Rules would require listed companies to consider additional information when making independence determinations for compensation committee members, only the Nasdaq Proposed Rules would impose a new objective independence requirement on compensation committee members.

Future Action

Although neither the NYSE Proposed Rules nor the Nasdaq Proposed Rules relating to the independence of compensation committee members would become effective until 2014 under the current proposals, listed companies may wish to begin reviewing the potential independence of current compensation committee members (or, in the case of Nasdaq listed companies that have not established a formal compensation committee, the directors who currently oversee executive compensation) in light of the proposed changes in independence requirements. Companies may also wish to consider how, and when, they will modify director eligibility and information gathering documents (such as director independence questionnaires) to reflect the NYSE and Nasdaq Proposed Rules.

Compensation Adviser Engagement and Independence

NYSE Proposed Rules and Nasdaq Proposed Rules

With respect to the retention of compensation consultants, legal counsel or other advisers (“compensation advisers”)^[2] by a compensation committee and the requirement that a compensation committee consider specific independence factors prior to selecting a compensation adviser, both the NYSE Proposed Rules and the Nasdaq Proposed Rules generally mirror the corresponding requirements of the SEC Rules in mandating the following:

• The compensation committee may, in its sole discretion, retain or obtain the advice of compensation advisers.
• The compensation committee shall be directly responsible for the appointment, compensation and oversight of the work of a compensation adviser retained by the compensation committee.
• The company must provide for appropriate funding, as determined by the compensation committee, for the payment of reasonable compensation to any compensation advisers retained by the compensation committee.
• Before selecting any compensation adviser, the compensation committee must take into consideration the following six independence criteria and, in the case of NYSE-listed companies, all other factors relevant to that person’s independence from management:

• The provision of other services to the company by the person (or firm) employing the compensation adviser. Neither of the proposed rules further define or provide 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. Neither of the proposed rules further define or give 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.

In considering the impact of these proposed new listing standards, there are three important practical considerations that listed companies should be aware of. First, as was made clear in the release adopting the SEC Rules, these rules do not prohibit a compensation committee from receiving advice from or otherwise utilizing a compensation adviser that is not specifically retained by the compensation committee (for example, a company’s regular outside counsel that is retained by management), nor do these rules require a compensation committee to be directly responsible for the appointment, compensation or oversight of compensation advisers that are not retained by the compensation committee. Second, the consideration of the independence criteria in the final bullet point above must be conducted with respect to any compensation adviser that provides advice to the compensation committee, whether or not retained by the compensation committee, other than in-house legal counsel. Third, in connection with the consideration of the independence criteria in the final bullet point above, the compensation committee is not required to make a formal determination regarding independence, and the compensation committee is not prohibited from selecting or otherwise obtaining advice from a compensation adviser that is not considered to be independent.

Once these proposed new listing standards have become effective, listed companies will need to have procedures in place to ensure that their compensation committees are taking the necessary steps to consider all factors relevant to the independence from management of any compensation adviser prior to the selection of such compensation adviser or the time at which such compensation advisor provides advice to the compensation committee. In addition, listed companies may need to revise their compensation committee charters to ensure that the rights and responsibilities described above are clearly set forth therein.

Future Action

Both the NYSE Proposed Rules and the Nasdaq Proposed Rules require compensation committee charters to include the specific rights and responsibilities described above. As a result, although no action is required at this time, listed companies may wish to begin consideration and review of potential amendments to their current compensation committee charters. Nasdaq-listed companies that currently have no written compensation committee charter may wish to begin considering the form of charter that they will adopt when the Nasdaq Proposed Rules become applicable.

In addition, companies may wish to review their use of compensation advisers that provide or may be expected to provide advice to the compensation committee, although as noted above there is no requirement that advisors be independent. With respect to compensation consultants, this review will need to occur in advance of companies’ 2013 annual meetings in order to address the new proxy statement disclosure requirements regarding compensation consultant conflicts of interest that were adopted at the same time as the SEC Rules and were previously described in Goodwin Procter’s Alert on the SEC Rules.

Opportunity to Cure Noncompliance

NYSE Proposed Rules

As permitted by the SEC Rules, the NYSE Proposed Rules 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 NYSE, 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, provided that a majority of the members of the compensation committee continue to be independent.

Nasdaq Proposed Rules

The Nasdaq Proposed Rules provide that if a company fails to comply with the compensation committee composition requirements due to one vacancy, or one compensation committee member ceases to be independent due to circumstances beyond the member’s reasonable control, the company will have until the earlier of the next annual shareholders’ meeting of the listed company or one year from the occurrence of the event to regain compliance, provided that if the annual shareholders’ meeting occurs not later than 180 days following the event that resulted in the failure, the company will have 180 days from the date of the event to cure noncompliance. A company relying on this cure period is required to provide notice to Nasdaq immediately upon learning of the event or circumstance that caused the noncompliance. This cure period is the same as the cure period provided by current Nasdaq listing standards with respect to the majority independent board requirement. The Nasdaq Proposed Rules also would continue to allow a listed company to have a non-independent director serve on the compensation committee under exceptional and limited circumstances.

General Exemptions; Transition Periods for Newly Listed Companies

Consistent with the SEC Rules, both the NYSE Proposed Rules and the Nasdaq Proposed Rules exempt (i) controlled companies, (ii) foreign private issuers (subject, in the case of the NYSE Proposed Rules, to certain additional disclosure requirements) and (iii) certain other listed companies from the new listing standards.

The NYSE Proposed Rules generally exempt smaller reporting companies, as defined in current SEC rules, from the requirements that boards consider the two additional independence requirements for compensation committee members and the requirement to consider independence factors in connection with the selection of compensation advisers.

The Nasdaq Proposed Rules also generally exempt smaller reporting companies from the new heightened independence requirements for compensation committee members, the requirements relating to the retention of compensation advisers by the compensation committee, the requirement to consider independence factors in connection with the selection of compensation advisers and the requirement to have a written charter. The Nasdaq Proposed Rules do require that smaller reporting companies have a formal compensation committee of at least two members who satisfy current Nasdaq director independence requirements and that the compensation committee have a written charter (or equivalent board resolution) providing for the required responsibilities and authority.

Both the NYSE and Nasdaq Proposed Rules would apply the same transition periods to newly listed companies with respect to the proposed compensation committee requirements: (i) at least one independent member on the compensation committee at the time of listing, (ii) at least a majority of independent members within 90 days of listing, and (iii) a fully independent compensation committee within one year of the listing date. The release relating to the Nasdaq Proposed Rules also made it clear that a newly listed company would have up to one year from the listing date to meet the requirement to have at least two compensation committee members.

Summary of Actions to Consider Now

Although the final listing standards to be adopted by the NYSE and Nasdaq are subject to change prior to their adoption and effectiveness next year – and no action is required until that time – listed companies may wish to begin preparing for the effectiveness of the final listing standards. This may include the following:

• Consider modifying the company’s director eligibility and information gathering documents (such as director independence questionnaires) to gather the information necessary to evaluate the company’s current compensation committee membership and structure in light of the current proposed rules;
• Review the company’s current compensation committee membership and structure in light of the current proposed rules;
• Review the company’s compensation committee charter for compliance with the current proposed rules, or begin consideration of a compensation committee charter for Nasdaq companies that do not currently have a written compensation committee charter; and
• Review the company’s current use of compensation advisers that provide or may be expected to provide advice to the compensation committee in light of the current proposed rules.

Each of these is also discussed above in the relevant section of this Alert.