News + Events
SEC Issues Final Rules on Independence of Compensation Committees and Consultants
July 3, 2012
David M. Carter
David I. Meyers
John T. Bradley
Larry A. Cerutti
W. Brinkley Dickerson, Jr.
David W. Ghegan
Mark Windon Jones
Seth A. Winter
As required by Section 952 of the Dodd-Frank Act, on June 20, 2012, the Securities and Exchange Commission adopted final rules instructing national securities exchanges (e.g. NYSE and NASDAQ) to adopt listing standards relating to the independence and authority of compensation committees and the independence of compensation consultants and other advisers retained by a compensation committee. In addition, the SEC adopted final rules requiring additional proxy statement disclosure on compensation consultant conflicts of interest.
The final rules provide the exchanges substantial discretion in crafting their own listing standards, provided that the exchanges consider certain relevant factors specified in the Dodd-Frank Act and subject to final SEC review and approval.
While the impact on the composition of compensation committees is uncertain until the exchanges adopt new listing standards, we believe that most compensation committee members will continue to qualify as independent. In addition, although compensation committees must implement additional controls in order to meet the other requirements of the final rules, we believe that there will be minimal impact on the current operation of compensation committees or their retention of consultants and other advisers.
A copy of the final rules can be found here.
Timing of Implementation
The final rule requires the exchanges to propose the new listing standards no later than September 25, 2012, and for the SEC to approve final listing standards no later than June 27, 2013. While it is unclear whether the new listing standards will be in effect for the 2013 proxy season, we believe it is unlikely given the potential need to nominate new compensation committee members to comply with the final listing standards.
The additional compensation consultant conflicts of interest disclosure must be included in any proxy statement for an annual meeting of shareholders at which directors will be elected occurring on or after January 1, 2013.
Compensation Committee Independence Listing Standards. The final rules direct the exchanges to adopt new listing standards that require each member of a listed company’s compensation committee to be an “independent” member of the company’s board of directors. Each exchange may craft its own definition of “independence” for this purpose. In doing so, however, the final rules require that each exchange consider “relevant factors,” including, but not limited to:
- the source of any compensation paid to a director, including any consulting, advisory or compensatory fee paid by the issuer to the director; and whether a director is affiliated with the issuer, a subsidiary of the issuer or an affiliate of a subsidiary.
While the final rules do not prescribe any bright-line bars to independence or require a “look back” period, the exchanges could choose to include such provisions in the definition of independence.
Advisers to the Compensation Committee. The final rules require the exchanges to adopt listing standards that require a listed company to give its compensation committee sole discretion to retain or obtain the advice of a compensation consultant, independent legal counsel, or other advisers and to provide appropriate funding for the retention of such advisers. The final rules also require the exchanges to adopt listing standards that require a listed company’s compensation committee to be directly responsible for the appointment, compensation and oversight of any retained adviser (compensation consultant, legal counsel or other advisor) and to consider the following factors relating to independence prior to selecting an adviser:
- whether the adviser’s employer is providing any other services to the listed company;
- the amount adviser’s employer has received from the listed company in fees, as a percentage of the employer’s total revenue;
- the policies and procedures of the adviser’s employer that are designed to prevent conflicts of interest;
- whether the adviser has any business or personal relationship with a member of the compensation committee;
- whether the adviser owns any stock in the listed company;
- whether the advisor, or the adviser’s employer, has any business or personal relationship with an executive officer of the listed company; and
- any other factors identified in the listing standards of the relevant exchange.
Notably, the final rules do not require compensation consultants, legal counsel or other advisers to the compensation committee of a listed company to be independent. Rather, the final rules only require that the compensation committee consider factors that bear on independence in selecting its compensation consultants, legal counsel or other advisers. The final rules therefore make clear that the compensation committee is not required to obtain its own independent legal counsel and may receive advice from in-house or outside counsel to the listed company, but in the case of advice from outside counsel to the listed company, the compensation committee will now be required to conduct an assessment of factors that bear on the outside counsel’s independence.
Definition of “Compensation Committee.” For most purposes, the final rule defines “compensation committee” to mean (i) a board committee designated as the compensation committee, (ii) in the absence of a formal designation, a board committee that performs functions typically performed by a compensation committee, or, (iii) in the absence of any board committee, the members of the board of directors who oversee executive compensation matters on behalf of the board of directors. As a result, a listed company cannot avoid complying with the new independence standards merely by not involving a board committee in executive compensation matters.
Exemptions from the New Listing Standards. Issuers who do not have listed equity securities, smaller reporting companies and controlled companies and are completely exempted from the requirements of the new listing standards (but would remain subject to any existing listing standards regarding independence of compensation committee members). Limited partnerships, companies in bankruptcy proceedings, open-end management companies and foreign-private issuers that disclose in their annual report the reasons why they do not have an independent compensation committee are exempt from complying with the new independence requirements but are subject to the other new compensation committee listing rules. In addition, each exchange retains the authority to adopt additional exemptions for other categories of issuers or particular relationships between a compensation committee member and the issuer in the exchange’s discretion.
Proxy Disclosure of Compensation Consultants Conflicts of Interest. Currently, issuers subject to the federal proxy statement rules (which includes controlled companies and smaller reporting companies but excludes issuers who do not have listed equity securities) are required in Item 407(e)(3)(iii) of Regulation S-K to provide, subject to limited exceptions, certain disclosures with respect to their compensation committees and the use of compensation consultants. The final rules amend Item 407 to include a new subsection 407(e)(3)(iv) which requires companies to disclose, for any compensation consultants that advised on executive or director compensation and whose work raised any conflict of interest, the nature of such conflict of interest and how the conflict is being addressed. The final rules instruct companies to determine whether a conflict of interest exists based on the mandatory factors for evaluating the independence of compensation consultants, discussed above.
Practical Observations and Advice.
Practical effects of the independence standards remain unclear until the exchanges issue proposed rules. The SEC’s final rule gives the exchanges broad discretion in defining independence for purposes of compensation committee membership. Therefore, a listed company will not be able to meaningfully assess the composition of its compensation committee until the exchange on which it is listed issues proposed rules with specific information about the new listing standards.
Compliance burden to increase. Complying with the new listing standards and the additional conflicts of interest analysis and disclosure requirements will likely increase a listed company’s compliance burden. The degree of increase will be unknown until the exchanges begin issuing their proposed listing standards. When selecting compensation consultants, legal counsel and other advisers, compensation committees should memorialize their consideration of the factors that will be mandated for consideration by the new listing standards. If exchanges create independence standards for compensation committees that are significantly divergent from existing independence standards, managing board composition and committee membership will become more complex. Companies should review their compensation committee charter to ensure that it complies with the new rules and should update D&O questionnaires once the final independence standards are known.
Conflicts of Interest. Companies should consider adopting controls and procedures to analyze compensation consultant independence, including a consideration of the factors set forth above.
Consider obtaining representations from advisers. Compensation committees should consider obtaining from their compensation consultants, legal counsel and other advisers a questionnaire that responds to the independence factors set forth above.