The Securities and Exchange Commission (“SEC”) adopted final rules relating to the Listing Standards for Compensation Committees on June 20, 2012 (See SEC Release 33-9330). The final rules implement Section 10C to the Securities Exchange Act of 1934 (the “Exchange Act”), which was adopted in response to Section 952 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

Section 10C requires the SEC to adopt rules directing the national exchanges and associations to establish listing standards that require each member of a listed issuer’s compensation committee to be “independent” (with appropriate exemptions) and directing the exchanges to establish listing standards that provide for the following requirements relating to compensation committees and compensation consultants:

  • Each compensation committee must have the authority, in its sole discretion, to retain or obtain the advice of compensation advisers;
  • Before selecting any compensation adviser, the compensation committee must take into consideration specific factors identified by the SEC that affect the independence of compensation advisers;
  • The compensation committee must be directly responsible for the appointment, compensation and oversight of the work of compensation advisers; and
  • Each listed issuer must provide appropriate funding for the payment of reasonable compensation, as determined by the compensation committee, to compensation advisers.
Section 10C also requires the SEC to adopt rules to require an issuer to disclose in any proxy material for an annual meeting of shareholders, whether the issuer’s compensation committee retained or obtained the advice of a compensation consultant; whether the work of the compensation consultant has raised any conflict of interest; and, if so, the nature of the conflict and how the conflict is being addressed.

The new rules will be effective 30 days after publication in the Federal Register – likely in July. Each national securities exchange must provide the SEC with proposed listing standards (or amendments to current listing standards) that comply with the new rules within 90 days of publication, and the SEC is required to approve the final listing rules or amendments that comply with the new rules within one year of publication. The changes to Regulation SK Item 407 will be in place for the 2013 proxy season. The timing of the application of the new listing requirements will depend on how quickly each exchange and the SEC act to finalize those rules.

Listing Standards Must Require Each Listed Issuer to Have an Independent Compensation Committee
Rule 10C-1(b)(1) directs the exchanges to adopt listing standards that require each member of the compensation committee of a listed issuer be a member of the board and be “independent.” The rule states that in determining the independence requirements, the exchanges must consider “relevant factors” including but not limited to (i) 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 (ii) 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.

Rule 10C-1(b)(1) exempts certain types of issuers from these listing requirements, including limited partnerships, companies in bankruptcy proceedings, registered open-end management investment companies and foreign private issuers. The new rules provide that the listing standards adopted by each exchange will apply not only to formally designated compensation committees, but to any committee of the company’s board that performs functions typically performed by a compensation committee, including, but not limited to, oversight of executive compensation.

Compensation Committee Authority to Retain Compensation Advisers
Rule 10C-1(b)(2) requires the exchanges to adopt rules that permit (but do not require) a compensation committee, in its sole discretion, to retain or obtain the advice of a “compensation consultant,” and “independent legal counsel and other advisers” (collectively, “compensation advisers”). Further, a compensation committee shall be directly responsible for the appointment, compensation and oversight of the work of such compensation advisers, but will not be responsible for the oversight of any compensation adviser not appointed by the committee (for example, a consultant or legal counsel retained by company management).

The authority of the compensation committee to retain, and the responsibility for overseeing the work of, compensation advisers may not be construed to require the compensation committee to implement or act consistently with the advice or recommendations of a compensation adviser, or affect the ability or obligation of the compensation committee to exercise its own judgment in fulfillment of its duties. Rule 10C(b)(3) requires the exchanges to propose listing rules that require the issuer to provide “appropriate funding,” as determined by the compensation committee, for the payment of reasonable compensation to compensation advisers.

Independence Factors to be Considered in Selection of Compensation Adviser
Rule 10C-1(b)(4) directs the exchanges to adopt listing standards that require the compensation committee of a listed issuer to take into account the following six factors before selecting a compensation consultant, legal counsel or other adviser:

  • The provision of other services to the issuer by the person that employs the adviser;
  • The amount of fees received from the issuer by the person that employs the adviser, as a percentage of the total revenue of the person that employs the adviser;
  • The policies and procedures of the person that employs the adviser that are designed to prevent conflicts of interest;
  • Any business or personal relationship of the adviser with a member of the compensation committee;
  • Any stock of the issuer owned by the adviser (i.e. the individual providing advice and his or her immediately family); and
  • Any business or personal relationships between the executive officers of the issuer and the adviser.
The SEC noted that the factors should be considered in their totality, with no one factor being viewed as determinative of independence. The SEC emphasized in the release that the rules will not require a compensation adviser to be independent, only that the compensation committee consider the independence factors before selecting a compensation adviser.

These provisions apply to the selection of any compensation adviser, which includes compensation consultants, outside legal counsel or any other advisers retained by the compensation committee. Notably, the new rules contain an instruction that the listed issuer’s in-house counsel need not be subject to this process. In addition, the SEC indicated that this process would only apply to advisers selected by the compensation committee and would not apply to any advisers selected by management. The SEC confirmed in its final release that issuers will not be required to describe the process used by the compensation committee in selecting advisers.

Opportunity to Cure and Exemptions
Rule 10C-1(a)(3) provides that the exchange listing standards must allow issuers a reasonable opportunity to cure violations of the compensation committee listing requirements, but does not set forth specific procedures. It does specify, however, that listing standards may 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 issuer to the applicable exchange may remain a compensation committee member until the earlier of the next annual shareholders’ meeting of the issuer or one year for the occurrence of the event that caused the member to no longer be independent.

The final rules provide that the exchange listing standards required by the new rule shall apply only to issuers with listed equity securities. The SEC provided exemptions to some or all of the requirements under Rule 10C-1 to limited partnerships, companies in bankruptcy proceedings, registered open-end management investment companies and foreign private issuers. Controlled companies and smaller reporting companies, as defined in Exchange Act Rule 12b-2, are exempted from the committee member independence listing standards. Furthermore, the exchanges will be permitted to exempt particular relationships and categories of issuers from committee member independence requirements where it is deemed appropriate based on the size of the issuer and other relevant factors.

New Conflicts of Interest Disclosures
Item 407(e) of Regulation S-K currently requires Exchange Act registrants that are subject to the proxy rules (other than registered investment companies) to provide certain disclosures concerning their compensation committees and use of compensation consultants. The SEC has added a new subparagraph (iv) to Item 407(e)(3) to require disclosure of any compensation consultant conflicts of interest.

Disclosure will be triggered with respect to any role played by a compensation consultant in determining or recommending the amount or form of executive and director compensation, which differs from the trigger originally proposed by the SEC, and will apply to any compensation consultant whose work must be disclosed pursuant to Item 407(e)(3)(iii), regardless of whether the compensation consultant was retained by management or the compensation committee or any other board committee. The new disclosure required by Item 407(e)(3)(iv) will apply to both director and executive officer compensation.

The new disclosure requirement relating to compensation consultant conflicts of interests will be required in a proxy or information statement for an annual meeting (or special meeting in lieu of an annual meeting) at which directors are to be elected, and will apply to all issuers subject to the proxy rules, including controlled companies, non-listed issuers and smaller reporting companies. Issuers subject to the proxy rules will be required to disclose, with respect to any compensation consultant that is identified pursuant to Item 407(e)(3)(iii) as having played a role in determining or recommending the amount or form of executive and director compensation, whether the work of the compensation consultant has raised any conflict of interest and, if so, the nature of the conflict and how the conflict is being addressed. The SEC has instructed that a company evaluating the existence of a conflict should at a minimum reference the six factors for establishing compensation adviser independence listed above.

The final rules do not require disclosure of potential conflicts of interest or the appearance of a conflict of interest. The rules also require disclosure with respect to compensation consultants only and not other categories of advisers. Disclosures regarding broad-based plans and providing non-customized benchmark data continue to be exempted from the compensation consultant disclosure requirements under Item 407(e)(3).