By Cydney Posner
You may recall that, when the SEC adopted its final rules for listing standards for compensation committees and compensation advisors as required by Section 952 of Dodd-Frank (Section 10C of the Exchange Act), there really wasn't much direction provided, as they just essentially parroted what the statute said. (See my article from 6/20/12 and this CooleyAlert). As a result, it was left to the national securities exchanges to devise the real requirements. The exchanges were required to submit proposed new listing standards to the SEC by September 25. Not a minute too early, the NYSE has filed its proposal with the SEC. The new standards are expected to become operative on July 1, 2013, and listed companies would have until the earlier of their first annual meetings after January 15, 2014, or October 31, 2014, to comply with the new compensation committees independence standards.
SEC Rule 10C-1 directs the exchanges to adopt listing standards for public company boards of directors and compensation advisers that address the following:
- The independence of the members on a compensation committee;
- The committee's authority to retain compensation advisers;
- The committee's consideration of the independence of any compensation advisers; and
- The committee's responsibility for the appointment, compensation and oversight of the work of any compensation adviser.
Independence of Compensation Committee Members
Under the SEC rules, exchange listing standards must require that each member of a compensation committee be independent. The exchanges' definitions of independence must be developed after taking into account relevant factors, including, but not limited to, the following, which are similar to the special factors mandated for audit committee independence:
- The source of compensation of the director, including any consulting, advisory or other compensatory fee paid by the company to such director, and
- Whether the director is affiliated with the company, a subsidiary of the company or an affiliate of a subsidiary of the company.
Unlike the requirements for audit committee independence, the compensation committee rules adopted by the SEC did not mandate that failure to satisfy them would necessarily disqualify a member. As a result, one big looming question had been whether the exchanges would adopt any absolute prohibitions or numerical tests. The answer from the NYSE is "no."
You may recall that, in addition to several enumerated bright line tests, current Section 303A.02 of the NYSE Manual provides that no director qualifies as "independent" unless the board of directors makes an affirmative general determination that the director has no material relationship with the listed company (directly or indirectly as a partner, shareholder or officer of an organization that has a relationship with the company). This broad determination requires the board to consider all of the facts and circumstances, and commentary currently in the Manual highlights that "the concern is independence from management." The NYSE proposal builds on this subjective broad determination by requiring that, in determining independence for compensation committee purposes, the board also take the two special factors into consideration.
In the SEC's adopting release, the SEC suggested that the exchanges "might conclude" that the definition of independence should address business or personal relationships between a compensation committee member and executive officers of the listed company, although the SEC included no such mandate. The NYSE has taken the hint. Under the NYSE proposal, Section 303A.02(a) would be amended to add subsection (ii) to specify that, in affirmatively determining the independence of any director who will serve on the compensation committee, the board "must consider all factors specifically relevant to determining whether a director has a relationship to the listed company which 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 special factors identified above (emphasis added). In examining the director's sources of compensation, commentary to proposed Section 303A.02(a)(ii) requires the board to consider "whether the director receives compensation from any person or entity that would impair his ability to make independent judgments about the listed company's executive compensation." Similarly, with regard to affiliate relationships, the proposed commentary provides that the board should consider "whether the affiliate relationship places the director 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 ability to make independent judgments about the listed company's executive compensation." The proposing release emphasizes that, in contrast to the mandatory audit committee rules, the NYSE "does not intend to adopt an absolute prohibition on a board making an affirmative finding that a director is independent solely on the basis that the director or any of the director's affiliates are shareholders owning more than some specified percentage of the listed company." The NYSE echoes the commentary in the SEC release that share ownership may indeed align "the director's interests with those of unaffiliated shareholders, as their stock ownership gives them the same economic interest in ensuring that the listed company's executive compensation is not excessive." The NYSE also does not intend to modify any of the bright line tests for independence enumerated in Section 303A.02(b). The proposing release notes that "a single factor may be sufficiently material to render a director non-independent."
Compensation Committee Advisors
SEC Rule 10C-1 requires that the compensation committees of listed companies be:
- authorized, in their sole discretion, to retain or obtain the advice of compensation consultants, independent counsel and other advisers;
- directly responsible for the appointment, compensation and oversight of the work of compensation consultants and other advisers retained by the committee; and
- entitled to appropriate funding from the listed company to pay reasonable compensation to the committee's consultants, counsel and advisers.
Although this authority already is largely mandated under NYSE rules, the NYSE is proposing to make it more explicit in a proposed new subsection (c) of Section 303A.05.
Compensation Adviser Independence Factors
SEC rules provide that compensation committees are not required to select consultants, counsel or other advisers that are "independent," but instead, in making their selections, compensation committees must take into account the following six factors, which bear upon independence:
- the provision of other services to the company by the employer of the compensation consultant, counsel or other adviser (referred to as the "advisory firm," as distinguished from the individual adviser);
- the amount of fees received from the company by the advisory firm, as a percentage of the advisory firm's total revenue;
- the advisory firm's policies and procedures that are designed to prevent conflicts of interest;
- any business or personal relationship of the compensation consultant, counsel or other adviser with a member of the compensation committee;
- any stock of the company owned by the compensation consultant, counsel or other adviser; and
- any business or personal relationship between an executive officer of the company and the compensation consultant, counsel, other adviser or the advisory firm.
The NYSE's proposed Section 303A.05(c) echoes these factors and does not include any specific additional factors for consideration. However, the proposed listing standard would also require the compensation committee to consider any other factors that would be relevant to the adviser's independence from management. The proposed section will also include an explicit statement, consistent with SEC rules, that "nothing in Section 303A.05(c) shall be construed: (A) to require the Compensation Committee to implement or act consistently with the advice or recommendations of the compensation consultant, independent legal counsel or other adviser to the compensation committee; or (B) to affect the ability or obligation of the Compensation Committee to exercise its own judgment in fulfillment of the duties of the Compensation Committee (or, if applicable, the independent directors). The compensation committee is required to conduct the independence assessment outlined in Section 303A.05(c)(iv) with respect to any compensation consultant, legal counsel or other adviser that provides advice to the compensation committee, other than in-house legal counsel.
SEC rules require the exchanges to establish procedures giving companies a reasonable opportunity to cure any defects that would be the basis for delisting for non-compliance with the new listing standards and allow the exchanges to provide that, if a member of a compensation committee 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 until the earlier of the next annual meeting or one year from the occurrence of the event that caused the member to no longer be independent. Under the proposal, Section 303A.00 would be amended to adopt this cure provision period for events that are outside of the director's reasonable control, but it would be modified to limit use of this provision to circumstances where the committee continues to have a majority of independent directors. The purpose of the proposed modification is to "ensure that the applicable committee could not take any action without the agreement of one or more independent directors. The Exchange believes that this requirement addresses any actual or apparent conflict of interest which may arise due to the continued service of a non-independent director on the compensation committee."
As noted above, listed companies would have until the earlier of their first annual meetings after January 15, 2014, or October 31, 2014, to comply with the new Section 303A.02(a)(ii) compensation committees independence standards. In addition, the existing transition periods available to newly listed companies under Section 303A.00 (generally, permitting a gradual step-by-step transition to a completely independent committee within one year of listing) would continue to be available for those companies with respect to the proposed new compensation committee requirements.
Smaller reporting companies would be exempt from compliance with the proposed new compensation committee independence requirements of Section 303A.02(a)(ii), but would need to comply with Section 303A.05(c), which relates to the authority of the committee to engage advisors, with the exception of proposed Section 303A.05(c)(iv), which relates to consideration of compensation consultants' independence from management. As a result, a new transition provision is proposed that would require companies that cease to be smaller reporting companies to have a committee composed entirely of members that meet the independence requirements of proposed Section 303A.02(a)(ii) within six months of the date they determine that they are no longer smaller reporting companies. Companies that cease to be smaller reporting companies would also need to comply with Section 303A.05(c)(iv) as of the determination date.
In addition to the exemption noted above for smaller reporting companies, SEC rules provide an exemption from the listing standard requirements for controlled companies (defined as companies in which more than 50% of voting power in the election of directors is held by an individual, a group or another company). In addition, SEC rules exempt from the compensation committee member independence listing standards limited partnerships, companies in bankruptcy, registered open-end management investment companies and foreign private issuers that disclose annually the reasons that they do not have independent compensation committees, and the NYSE is proposing to expand this exemption to cover all the proposed requirements for these categories of issuers. Under the proposal, the NYSE would also provide a general exemption from all of the requirements to all of the other categories of issuers that are currently exempt from the NYSE's existing compensation committee requirements. Currently, the NYSE permits foreign private issuers to follow home country practice in lieu of compliance with the NYSE's compensation committee listing standard, and the proposal would continue this approach by granting those companies a general exemption. The NYSE notes that foreign private issuers are generally required to disclose any significant differences from corporate governance practices under the domestic NYSE listing standards.