SEC Votes to Propose New Rules Regarding Independence of Compensation Committee Members, Consultants and Advisors

By Cydney Posner

At an open meeting this morning, the SEC voted to propose a new rule and rule amendments to implement Section 952 of the Dodd-Frank Act, which attempts to tackle the issue of independence of compensation committee members, consultants and advisers. The vote was unanimous, largely because the proposal was mandated by the DFA and does not interpret it expansively. However, Commissioner Casey expressed her disapproval of the practice of imposing these types of requirements through the exchanges; her preference is for "private ordering." Chair Schapiro indicated that the SEC was guided by Congress' intent in the DFA, as well as in parallel provisions of SOX: the SEC construed comparable provisions in SOX and the DFA as reflecting similar Congressional intent and likewise viewed dissimilar provisions as reflecting a different intent. Based on the description at the meeting, the proposal tracks Section 952 almost down to the last comma.  The proposing release has now been posted: http://www.sec.gov/rules/proposed/2011/33-9199.pdf.  

Under the DFA, the new SEC rules are required to be effective by July 16, although no deadline is stated for action by the exchanges.

As required by Section 952 (reflected in new Section 10C of the Exchange Act), the SEC's proposal would direct the stock exchanges to prohibit the listing of any securities of a company that does not comply with its requirements for independent compensation committee members and with the rules relating to authorization, funding and selection of compensation committee consultants, legal counsel and advisers, described below.

Committee Members. Under the proposal, as required by Section 952, each member of a listed company's compensation committee must be an "independent" director. Although "independence" is not expressly defined, the proposal identifies the factors set forth in Section 952 as factors that the exchanges must take into account in arriving at a definition, including the following: 

•  the source of compensation of a member of the board of directors of an issuer, including any consulting, advisory, or other compensatory fee paid by the issuer to such member of the board of directors; and
• whether a member of the board of directors of an issuer is affiliated with the issuer, a subsidiary of the issuer or an affiliate of a subsidiary of the issuer.

If these factors sound vaguely familiar, that's because they are comparable to the Exchange Act's requirements for audit committee members, although not mandatory as currently required for audit committee members. The requirements would apply to any committee that oversees executive compensation even if not called a "compensation committee," but, interestingly, the requirement as proposed would apply only if there is a "committee" that oversees executive compensation. As Commissioner Aguilar pointed out, there is currently no requirement that Nasdaq-listed companies have a "compensation committee," and he viewed this aspect of the proposal as problematic because, in effect, it makes compliance with the provision voluntary.

Consultants and Advisers. Proposed new Rule 10C-1, like Section 952, specifies that exchange listing standards must require compensation committees of listed companies to be authorized to select a compensation consultant, legal counsel or other adviser to the compensation committee, but only after taking into account the following five factors, along with any others the exchanges identify:

• the provision of other services to the issuer by the person that employs the compensation consultant, legal counsel or other adviser; 
•  the amount of fees received from the issuer by the person that employs the compensation consultant, legal counsel or other adviser, as a percentage of the total revenue of the person that employs the compensation consultant, legal counsel or other adviser;
• the policies and procedures of the person that employs the compensation consultant, legal counsel or other adviser that are designed to prevent conflicts of interest;
• any business or personal relationship of the compensation consultant, legal counsel or other adviser with a member of the compensation committee; and 
•  any stock of the issuer owned by the compensation consultant, legal counsel or other adviser.

Section 952 requires that all of the factors be "competitively neutral" and preserve the ability of compensation committees to retain the services of consultants, legal counsel or other advisers. Compensation committees would be responsible for the appointment, compensation and oversight of these advisers, and the company would be required to fund reasonable compensation. This provision of Section 952 was particularly interesting because it imposed a kind of "soft mandate" regarding independence for advisers; instead of requiring that consultants satisfy specific independence tests, the DFA just identified factors to be taken into account in the selection process. The proposal does not go beyond the DFA in that regard. Note that Section 952 also emphasized that a compensation committee must exercise its own judgment in fulfilling its duties and is not required to implement or act consistently with the advice or recommendations of a compensation consultant, legal counsel or other adviser.

Section 952 expressly exempts, among others, controlled companies (>50% of voting power held by an individual, a group, or another issuer), companies in bankruptcy and foreign private issuers that disclose annually the reasons that they do not have independent compensation committees. The exchanges are also granted authority to exempt particular relationships and to adopt other exemptions as appropriate, such as for smaller reporting issuers. Commissioner Paredes suggested that, instead, the SEC should take the action to exempt smaller reporting companies or, at least, exempt them as a default position, allowing the exchanges to opt out of that position. He offered a similar suggestion for newly public companies. Under Section 952, the SEC rules must provide issuers with a reasonable opportunity to cure any defects that would be the basis for the listing prohibition (although this provision was not addressed at the meeting).

Section 952 also requires each listed issuer to disclose in its annual meeting proxy statements whether its compensation committee retained or obtained the advice of a compensation consultant, whether the work of the consultant raised any conflict of interest and, if so, the nature of the conflict and how the conflict is being addressed. In the only apparent deviation from Section 952, the proposal would apply these disclosure requirements to all Exchange Act companies, not just listed companies. The staff noted that Reg S-K Item 407(e)(3) already requires disclosure regarding fees paid to consultants. The proposal would harmonize the Section 952 requirements with those currently in Reg S-K. For example, the proposal would replace the "any role in determining compensation" disclosure trigger with the "retained or obtained the advice" disclosure trigger. To be consistent with Section 952, the proposal would also remove the exemption in the current rules for consulting regarding broad-based plans and non-customized survey data. An instruction would be added to Item 407(e)(3) advising companies to take into account the five factors identified above in considering whether a conflict of interest was created. (Commissioner Casey objected that this instruction implicitly extends the listed-company guidance to non-listed companies.)