In another step toward implementation of the Dodd-Frank provisions on corporate governance, NYSE and Nasdaq have issued proposed listing standards on compensation committee and compensation adviser independence requirements. The proposed rules do not significantly expand the minimum requirements in Section 10C of the Exchange Act and SEC Rule 10C-1. See our prior summary of Rule 10C-1 from July 2012. One of the biggest changes is that Nasdaq will now require most issuers to have a separate compensation committee. In addition, there will be different implementation requirements and schedules for NYSE and Nasdaq issuers.
The SEC has a 45-day review period for the proposed rules. It is expected that the rules will go into effect as proposed. For Nasdaq issuers, the standards requiring compensation committees to have the power to retain compensation consultants, legal counsel and other advisers (“compensation advisers”) and to oversee and direct their work and set their compensation, as well as the obligation of compensation committees to examine the independence of any compensation adviser they select, would have a particularly quick implementation schedule. Nasdaq issuers should be aware that, within as little as 45 days, their compensation committees may need to have procedures in place for examining the independence of compensation consultants and outside legal counsel before obtaining advice from such advisers.
Otherwise, both exchanges’ rules would generally take effect for annual meetings starting in 2014.
NYSE
The NYSE proposed rules closely follow the SEC minimum requirements in Rule 10C-1. There are some points to note in the proposed rules.
Committee Independence. For determinations of independence of compensation committee members, the same general approach would be applied as for independence of any board member. However, in considering all factors, the process would need to consider factors material to the director’s independence from management in connection with the duties of a compensation committee member. There are two factors specifically listed in Rule 10C-1(b)(ii) that would need to be considered:
- Whether the director receives compensation from any person or entity that would impair the director’s ability to make independent judgments on executive compensation.
- In considering an affiliate relationship, whether the relationship places the director under the direct or indirect control of the issuer or otherwise impairs the director’s judgment on compensation issues.
The proposed rule would specifically note that ownership of stock should not bar a finding of independence as to compensation matters; in fact, the standards suggest that ownership of even a substantial amount of stock of the issuer by a compensation committee member may be beneficial. This is in contrast to the independence requirements for audit committee members where material stock holdings of the issuer can bar a finding of independence.
Compensation Adviser Retention. The proposed NYSE rules would require that compensation committee charters include the exact requirements of Rule 10C-1(b)(2) and (3) as to the ability of a compensation committee to engage and be responsible for the oversight of compensation advisers and have funding for these advisers.
Compensation Adviser Independence. In Rule 10C-1, the SEC set out six required independence-related factors to be considered whenever a compensation committee selects a compensation adviser. The NYSE proposed rules would adopt those six factors verbatim, without any additional ones. Also, the proposed rules would contain the same provisions as in Rule 10C-1 that a compensation committee is not required to hire an adviser or follow the advice of any adviser it does hire. The committee also does not have to analyze independence when getting advice from in-house counsel to the issuer, consistent with the Rule 10C-1.
Notably, the NYSE proposed listing standards provide that the requirement to examine the independence of a compensation adviser arises whenever a compensation adviser provides advice to a compensation committee. The proposed standards do not specifically address what it means for a compensation adviser to “provide advice.” In interpreting the standards, companies will need to consider how broadly the concept of “providing advice” extends. For example, it seems clear that the standard would apply whenever a compensation consultant or legal counsel is present at a compensation committee meeting for the purpose of advising the committee. But what if a compensation consultant has supplied data or materials but is not present at the meeting? Or what if outside legal counsel has helped draft or review materials to be approved at a meeting? As discussed below, these issues may be particularly urgent for Nasdaq issuers to consider, as the implementation schedule for this standard for Nasdaq issuers may be relatively short.
Implementation. For the compensation committee independence standards, issuers would have until the earlier of the first annual meeting after Jan. 15, 2014, or Oct. 31, 2014, to comply. After initial compliance, the proposed rules would provide a cure period if a compensation committee member ceased to be independent, as long as a majority of the committee is independent. There would be exemptions for newly listed companies, smaller reporting companies and other issuers currently exempt from the NYSE existing compensation committee requirements.
Nasdaq
The proposed Nasdaq listing requirements contain more changes in comparison to the NYSE proposal.
Compensation Committee. A major change under the Nasdaq proposed rules would be that all covered issuers would now be required to have a compensation committee. The current alternative of having executive compensation determined by a majority of independent directors would be eliminated. The minimum size for the compensation committee would be two directors.
Independence. The compensation committee would have to be composed solely of independent directors. To determine independence, the Nasdaq listing standards would apply its current rules with two modifications.
First, the proposed rules would impose the same prohibition on compensation committee members receiving any compensation (other than director fees or deferred compensation payments from prior service at the issuer) from the issuer that currently apply to audit committee members. This is in contrast to the NYSE proposed listing standards, which require issuers to consider the compensation and sources of compensation of compensation committee members in assessing their independence, but do not impose a strict ban on the receipt of compensation of less than $120,000 from the issuer.
The other modification is the consideration of whether a proposed compensation committee member is affiliated with the company. The proposal would not prohibit stockholders or their representatives from service on the compensation committee (in fact, like the NYSE, the Nasdaq proposed listing standards suggest that this may be beneficial). Also, the affiliation analysis would be applied only for relationships during the period of service on the compensation committee (i.e., there is no lookback requirement). Nasdaq would allow a nonindependent director to serve on the compensation committee under exceptional and limited circumstances, similar to the exceptions for service on audit and nominations committees.
Compensation Committee Charter. Consistent with the requirement for a separate committee, the compensation committee would be required to adopt a written charter. The committee would have to review and assess the adequacy of the charter annually. The charter would have to include:
- The scope of the committee’s responsibilities and how it carries out those responsibilities.
- The committee’s responsibility for determining, or recommending to the board for determination, the compensation of the CEO and other executive officers.
- Prohibition on the CEO’s being present during deliberations on the CEO’s compensation.
- The committee’s powers and responsibilities under SEC Rule 10C-1 about retaining, overseeing, compensating and assessing the independence of compensation advisers.
Compensation Adviser Provisions. The Nasdaq proposed listing standards would require that all covered issuers comply with the following three requirements of Rule 10C-1 related to compensation advisers by incorporating the SEC rules:
- The compensation committee must have the power to retain or obtain advice from a compensation consultant, independent legal counsel or other adviser and to oversee their work. (Rule 10C-1(b)(2)).
- The issuer must provide appropriate funding for payment of reasonable compensation to the compensation advisers to the compensation committee. (Rule 10C-1(b)(3).
- The compensation committee may select a compensation adviser only after considering six factors related to independence of the adviser. (Rule 10C-1(b)(4).
By incorporating Rule 10C-1, the Nasdaq proposed listing standard implies that the requirement that a compensation committee must assess the independence of compensation advisers before the advisers “provide advice” to the compensation committee would apply to Nasdaq issuers as well. The potential urgency of this issue is heightened in the case of Nasdaq issuers due to the faster implementation schedule for this requirement, as discussed below.
Implementation. Unlike for the NYSE, there are two separate proposed effective dates for the Nasdaq proposed listing standards. The requirements that would allow a compensation committee (or the board acting in that capacity) to retain compensation advisers and that would require assessment of the advisers’ independence would apply immediately upon effectiveness of the standard. The remainder of the rules would require compliance by the earlier of the second annual meeting after adoption of the rules or Dec. 31, 2014.
The Nasdaq proposal would require smaller reporting companies to have compensation committees and compensation committee charters (or board resolutions containing the same elements as a charter), but would modify the requirements for these companies such as by not having to include in the charter the requirements relating to the retention of compensation advisers. The proposed rules also would apply cure periods, exemptions and phase-in schedules for issuers consistent with the current compensation-related listing rules of Nasdaq.
Next Steps
The SEC has 45 days to review the proposed rules, which the SEC may extend to up to 90 days or to whatever later date the exchanges may consent to, provided that by statute the rules are required to be finalized by no later than June 2013. It is likely that the proposed rules will be approved as submitted.
The most immediate concern to many Nasdaq issuers would be the provisions in the Nasdaq proposal relating to compensation advisers, which are scheduled to go into effect immediately upon SEC approval. Upon effectiveness, the compensation committee (or independent directors if there is no compensation committee) would have to conduct an independence assessment of any compensation adviser based on the six listed factors before the compensation adviser provides advice to the compensation committee. Compensation committees of Nasdaq issuers should begin now to consider procedures for implementing this requirement.
Otherwise, the current listing standards will continue to apply until the effective dates for the new standards. It is likely that issuers will want to do at least a dry run of applying the new standards for committee member independence to the current compensation committee members before their 2013 board elections, and should start to consider whether any amendments to their D&O questionnaires may be needed to capture these new requirements.
The standards for compensation adviser independence pose a different decision for NYSE issuers. It is likely that a compensation committee will want to acquire the necessary information from its current advisers and do an evaluation of the independence of the advisers under the new standards. In particular, pursuant to the SEC rules that came out in July 2012, issuers will be required to disclose any conflict of interest posed by a compensation consultant in its proxy for its annual meeting in 2013, based on the same six factors that apply to assessing the independence of compensation advisers. Committees will need to engage in that analysis well in advance of the 2013 meeting. If the analysis results in a determination that a compensation consultant’s work poses a conflict of interest under those six factors, the committee would probably want to start the process of changing consultants (or consider why retention of a conflicted consultant is nevertheless in the committee’s interest).
The new standards will also result in the creation or amendment of most compensation committee charters. In addition, compensation committees may want to consider adopting internal procedures to implement portions of the standards, such as determining when the committee would engage independent counsel.
For further information, please contact one of the authors or any other member of the McGuireWoods employee benefits or securities and corporate finance group